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The Midwest and the recession
Interest rate volatility in 1980
Economic events in 1980—
a chronology
1980 developments in rural credit
markets

The Midwest and the recession

3

For complicated and deep-seated
reasons, the Midwest has shouldered a
disproportionate share of the nation's
trouble during the recession.

Interest rate volatility in 1980

8

Interest rates in 1980 were more
variable not only in a cyclical sense,
but also in their weekly and daily
behavior.

CONTENTS

Economic events in 1980—a
chronology

12

1980 developments in rural credit
markets
18
Volatile interest rates and credit
demands strongly affected farm lend­
ing in 1980.
ECONOMIC PERSPECTIVES
January/February 1981, Volume V, Issue 1
Economic Perspectives is published bimonthly by the Research Department of the Federal
Reserve Bank of Chicago. The publication is edited by Harvey Rosenblum, Vice President. The
views expressed in Economic Perspectives are the authors’ and do not necessarily reflect the
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of charge. Please send requests for single- and multiple-copy subscriptions, back issues, and
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Controlled circulation postage
paid at Chicago, Illinois.




The Midwest and the recession
George W. Cloos
For almost two years the economy has
been stumbling on a rocky path marked by
soaring inflation, record-high interest rates,
and a constant specter of fuel shortages. Dur­
ing this period the Midwest, which includes
the Seventh Federal Reserve District, has
shouldered a disproportionate share of the
trouble. Primarily, this reflects reduced de­
mand for the products of some of the domi­
nant industries in this region—cars and trucks,
construction equipment, agricultural equip­
ment, recreational vehicles, and home ap­
pliances. Residential construction also has
been much more seriously depressed here
than nationally, partly because of slower
growth of population.
Some say that there has not been a reces­
sion anywhere except in the Midwest. This is
an exaggeration. The sharp drop in general
activity in the second quarter of 1980 was evi­
dent almost everywhere. Over the longer
period the chronic problems of the motor
industry have affected all regions to some
degree. Finally, the impact of reduced availa­
bility of mortgage credit has dampened home
building everywhere to some extent, even in
the booming California market.

restraint programs adopted by lenders fol­
lowed the evocation of the Credit Control
Act by the President and its implementation
by the Federal Reserve. With the economy on
an uneasy plateau, the effect of further abrupt
tightening of credit was immediate. New
orders were slashed in virtually all industries
as managers tried to reduce inventories. New
mortgage commitments dried up. In the sec­
ond quarter of 1980, real GNPdropped at a 10
percent annual rate. The Federal Reserve's
industrial production index dropped 8 per­
cent from March to July, and payroll employ­
ment declined by 1.3 million.
In the late spring of 1980, many profes­
sional forecasters thought that the decline in
activity would continue through 1980 and
perhaps into the new year. However, as credit
eased in the summer, most activities revived.
Real GNP rose slowly in the third quarter and
at an accelerated pace in the fourth quarter,
but failed to regain the first-quarter high.
From July to December industrial production

1980 reviewed

percent change

Since the spring of 1979, fears that the
nation would slide into a deep and extended
recession have been almost continuous. The
common measure of the performance of the
economy is the gross national product adjust­
ed for inflation (real GNP). Perhaps never
before has this measure performed as erratically.
Real GNP dipped at an annual rate of 2
percent in the second quarter of 1979, pri­
marily because of oil stringencies resulting
from the Iran shutoff. However, this decline
was more than offset by a rise in the third
quarter of that year, and modest gains con­
tinued into early 1980.
In March and April of 1980, severe credit

Federal Reserve Bank o f Chicago




1979

1980

3

rose7 percent,and payroll employment regain­
ed the March level, despite a lag in manufac­
turing employment.
For 1980 as a whole, real GNP just equaled
1979, after a 3 percent rise in 1979. In the last
recession real GNP had declined 1 percent in
two successive years, 1974 and 1975. Industrial
production declined 3.6 percent last year,
much less than the 9 percent drop in 1975.
Payroll employment averaged 800,000 higher
in 1980, compared with a 1.3 million decline
in 1975. Housing starts at 1.3 million were
down 36 percent from the recent cyclical high
of 1978. From 1972 to 1975 housing starts had
dropped by a half.
Inventories kept in line

Why did the economy right itself and
start growing again after the one-quarter
declines of 1979 and 1980? Historically, gen­
eral business declines usually gather momen­
tum and continue for two to four quarters.
Large gains in personal income helped by
government transfer payments, and rapid
growth in other budget outlays provide part
of the answer. Perhaps of greater importance
was the fact that no classic inventory cycle
developed. In each of the business recessions
since World War II, the shift from inventory
accumulation to liquidation played a major
role.
In 1979 and 1980 most business managers
had kept inventories lean. Lead times on new
orders remained short as "hand-to-mouth”
buying was the rule. With final demand main­
tained at high levels, decisions to reduce
stocks further were self-limiting, assuming
businesses wanted to maintain satisfied
customers.
In 1975 nonfarm inventories, adjusted for
inflation, declined by $8 billion after a rise of
$12 billion in 1974. The change from inven­
tory accumulation to liquidation between
these two years amounted to $20 billion and
exceeded the $14 billion decline in real GNP.
In contrast, inventories declined by less than
$1 billion in 1980, followinga rise of $8 billion
in 1979. The impact on total output was only
half as great as in 1975.

4




Business managers always try to keep
inventories as low as is consistent with maxim­
izing profits. Interest expense, along with
rent, taxes, and insurance, is one of the rea­
sons. In the 1950s and 1960s, when money
could be borrowed at about 6 percent, inter­
est cost was not a critical factor in inventory
management for most firms. Interest is tax
deductible, and the moderate inflation of
those years meant that interest cost might be
offset by appreciation in the value of the
inventory. In 1979 and 1980 the prime rate was
never under 11 percent and in some periods
in 1980 exceeded 20 percent, levels un­
dreamed of in earlier decades. Moreover,
floating rates on bank loans meant that rates
could be raised while items remained in
stock. Such interest costs made it imperative
to keep stocks at an irreducible minimum
even at the risk of losing sales. Firms with
surplus cash to invest also found it profitable
to hold down inventories to increase short­
term investments at high rates.
Another factor that kept inventories low
during the expansion of 1975-80 was a desire
not to repeat the experience of the last reces­
sion. In 1973-74 widespread shortages, ag­
gravated by price controls on materials and
components, caused many firms to lay in

Manufacturing output recovered
in late 1980
i n d e x 1967=100

1977

1978

1979

1980

E c o n o m ic P e r s p e c tiv e s

extra supplies for precautionary reasons. The
sharp drop in activity in the fourth quarter of
1974 led to widespread order cancellations
with resultant production cutbacks and ad­
verse effects on profits. No such rash of can­
cellations accompanied the short-lived reces­
sions of 1979 and 1980.
Various industries, including steel, nonferrous metals, paperboard, motor vehicles,
and household appliances, experienced one
or more inventory cycles of their own in 197980. Cutbacks in output were limited by the
need for distributors and retailers to restock
after moderate liquidations.
Customers slow payments

In 1980 complaints by businesses, large
and small, that collections on receivables had
slowed were probably more frequent than at
any time since the early 1930s. The Credit
Research Foundation reported that outstand­
ing receivables of manufacturers averaged 45
days' sales, and receivables of wholesalers
averaged 43 days, up from 41 and 38 days,
respectively, in 1977. Delinquencies and bad
debts also increased. A slowing in collections
tends to cumulate because payments often
are dependent upon timely collection of
receivables from others. In many cases pastdue receivables reflected serious financial
problems of companies whose very existence
was threatened. More frequently, however,
firms slowed payments wherever possible to
avoid increasing borrowings at high rates.
Other firms with large cash reserves held
back on payments in order to increase earn­
ings on short-term investments.
Some sellers of goods and services reacted
to the tendency for customers to stretch out
payments by refusing to ship, or render addi­
tional services, until payments were updated.
Some resorted to COD (cash on delivery)
shipments, requiring that truck drivers have
certified checks in hand before unloading
their vans. Credit investigations and criteria
became more exacting.
Restraints on trade credit, like hand-tomouth inventory buying, tend to hold down
general business activity. However, such re­

Federal Reserve Bank of Chicago




straint also reduces the likelihood of a classic
boom and bust resulting from unbridled
credit expansion.
Capital spending trimmed

In the years 1977-79, business capital
spending on new structures and equipment
rose at an average of 17 percent annually,
while nominal GNP rose at an average rate of
12 percent. In this period the ratio of capital
spending to GNP rose from 10.1 percent to a
record 11.6 percent. In 1980 GNP rose 9 per­
cent, while capital spending rose 5 percent.
High interest rates, along with greater
uncertainties regarding the future caused
some firms to cut back on planned capital
spending in 1980. This was true not only of
small firms lacking access to the capital mar­
kets, but also of some hard-pressed large
firms. Private rating agencies responded to
poor financial results by reducing credit rat­
ings, making it more difficult to sell debt on
acceptable terms. Most large companies with
adequate resources went ahead with expan­
sion plans already under way, but many post­
poned approvals of new projects.
Corporate bond issues in the first half of
1980 were half again as large as a year earlier,
but volume dropped in the second half as

Consumer price index has out- paced
the general price level
percent change

14

consum er prices

12

Gross National Product
(fixed w e ig h t p r ic e in d e x )

10

1971 72

73 74

75

76

77 78

79 '80

5

interest rates rose sharply. New high-grade
corporate bonds yielded about 9.5 percent in
most of 1979, high by past standards but man­
ageable. Last year the rate moved to the 13
percent range in the early spring, turned
down in the summer, and then set new highs
in the 14-15 percent range in December.
Many corporate treasurers refused to sell
bonds at these rates. A huge backlog of issues
was said to be building up to be offered if
rates dropped to 12 percent or less.
Nonresidential construction projects are
commonly financed with mortgages pur­
chased by insurance companies and other
institutions. Commitments are usually made
well in advance of actual construction. Thus,
construction activity can continue at a high
level for months after commitments have
been cut back. Such a cutback occurred in
the summer of 1980. Some insurance com­
panies, worried about withdrawals of funds
by policyholders, halted all commitments
despite yields of 15 percent or more available
on high-grade mortgages.
Much capital equipment is financed on
instalment loans similar to consumer credit.
Examples are construction equipment, agri­
cultural equipment, heavy trucks, and trail­
ers. The upsurge in interest rates in 1980
caused many dealers to reduce orders to
manufacturers because of floor planning
costs. Many buyers were deterred by heavy
monthly payments necessitated by rates in
the 18-20 percent range or failed to meet
stricter credit criteria.
Autos and trucks nosedive

Sales of domestic autos dropped to 6.6
million in 1980, 30 percent below 1978, the
best recent year and the lowest since 1961.
Sales of imports at 2.4 million set a new high,
but even the most popular imports were
meeting sales resistance late in the year.
Truck sales at 2.5 million, including a half mil­
lion small imports, were 40 percent below the
1978 level.
Sales of cars were at a respectable annual
rate of 11 million in the first quarter of 1980.
But tight money and the recession brought an

6




Interest rates soared to
record highs in 1980
percent

1978

1979

1980

‘ Effective com m itm ent rates, 80% conventional loans.

abrupt decline in the second quarter and only
an incomplete recovery in the second half.
Output of cars and trucks combined was
only 8 million in 1980, 38 percent below the
record 12.9 million total of 1978 and the low­
est level since 1961. Production of steel, nonferrous metals, rubber, and glass intended for
the auto industry declined even morethan 38
percent because of the smaller average size of
vehicles. In a related development, produc­
tion of recreational vehicles in 1980 was 76
percent below 1978.
Employment in the motor vehicle indus­
try dropped from over a million in early 1979
to 730,000 last May. Indefinite layoffs totaled
250,000 at one point last summer, and they
remained at over 180,000 late in the year.
Tight credit depressed sales of autos and
trucks in three ways. First, dealers' floor plan
rates rose to unheard of levels of 22 percent,
24 percent, and more, causing them to order
fewer vehicles and pushing many of them to
the wall. Second, higher rates on consumer
loans increased monthly payments for instal­
ment buyers. Third, lenders became more
selective in accepting risks, and some com­
pletely stopped making auto loans.

Econom ic Perspectives

The troubles of the motor industry can­
not be blamed entirely on tight money. Prices
of vehicles have risen very sharply because of
liberal labor contracts, higher materials prices,
and costs of complying with government
regulations. Meanwhile, the Japanese have
been offering cars and trucks that many
Americans have found to be more suitable
than domestic products. Finally, soaring gaso­
line prices have reduced driving and cars are
lasting longer.
Housing slumps

Last year construction was started on 1.3
million housing units nationally (860,000
homes and 450,000 apartments), down from
1.7 million in 1979 and 2 million in 1978. From
1978 to 1980 total starts dropped 34 percent,
homes by 40 percent, and apartments by 23
percent. The decline for apartments was soft­
ened by increased federal funds for subsid­
ized projects and by strong demand for con­
dominiums in some areas.
The Midwest was affected much more
than the nation by the housing slump. Data
compiled by Bell Federal Savings forthe Chi­
cago area show that permits for new housing
units totaled only 13,000 in 1980, down 74
percent from 50,000 in the best year, 1977,
with homes off 82 percent and apartments off
59 percent. Reports from other large Midwest
centers were almost as bad, and some smaller
communities reported no activity at all.
Part of the Chicago area’s problem is
outmigration. The central city had been los­
ing population in the 1950s and 1960s, but in
the 1970s the population of the whole metro­
politan area stabilized. Loss of population, in
part, reflects loss of jobs. Nevertheless, the
drop in housing construction would have
been much less severe if credit had remained
as available as before.
Conventional mortgage rates pierced the
10 percent level in 1978. Last spring, and again
late in 1980, rates were quoted in the 15 per­
cent to 17 percent range. FJowever, virtually
no loans were made at these high rates. Loans

Federal Reserve Bank o f Chicago




closed were largely based on commitments
made months earlier or represented "crea­
tive financing” balloon notes,short-term roll­
over mortgages, and other innovations. Ana­
lysts contend that a viable conventional mort­
gage market must await a drop in mortgage
rates to the 11-13 percent range.
As in the case of autos, home sales have
been depressed by rapidly rising prices. Since
1974 the median priceof homes has doubled,
reflecting rising costs of labor, materials, and
developed land. Higher prices combined with
higher interest rates priced many potential
buyers out of the market.
The financial picture in housing is com­
plicated by the fact that rising interest rates
have placed S&Ls, the principal mortgage
lenders, under growing financial pressures.
Many S&Ls have reported net outflows of sav­
ings as depositors have shifted to high-yielding
money market instruments. Attempts to coun­
ter this outflow by offering money market
certificates tied to six-month Treasury bill
rates have caused some major S&Ls to suffer
operating losses for the first time in their
history.
Hope for improvement

Early in 1981 the economy was showing
surprising strength. Employment rose again
in January, and some large retailers reported
a favorable level of sales. Motor vehicles and
housing remained seriously depressed, with
the Midwest still shouldering a dispropor­
tionate share of the burden.
Credit restraint and high interest rates
are intimately related to the rapid pace of
price inflation. Ready availability of credit
under standard contracts at affordable rates
provided the underpinnings for the great
expansion of the housing and motor vehicle
industries after World War II. If inflation can­
not be reduced well below the two-digit pace
and interest rate volatility cannot be reduced,
the whole structure of financing home and
vehicle purchases must be modified to pro­
tect both borrowers and lenders.

7

Interest rate volatility in 1980
Paul L. Kasriel
Interest rates displayed extreme volatility in
1980, reaching record highs in early spring,
then plummeting until midsummer, only to
rise above their previous peaks by late fall.
Interest rates were more variable notonly in a
cyclical sense, but also in their weekly and
daily behavior. It is unlikely that any single
factor was responsible for the volatile behav­
ior of interest rates in the past year, as rates
are subject to myriad influences. These include
changing inflationary expectations, exogen­
ous commodity-specific supply shocks, fiscal
and monetary policy actions, and national
and international political developments.
Although these or similar factors are
present to some degree every year, one of
them—monetary policy—underwent a pro­
found change just prior to 1980 that un­
doubtedly had important effects on rates dur­
ing the year. On October 6,1979, the Federal
Reserve announced a new operating proce­
dure that placed "greater emphasis in day-today operations on the supply of bank reserves
and less emphasis on confining short-term
fluctuations in the federal funds rate." As
later explained, the reason for the change in
operating procedure
was to underscore, in terms of public
perception and debate, the central im­
portance of maintaining control over
monetary growth and bank reserves to
deal with inflation, and to better disci­
pline . . . [Federal Reserve] internal policy­
making with respect to monetary and
credit growth, thus enhancing . . . [the
Federal Reserve's] ability to achieve . . .
[its] objectives.1
’ Paul A. Volcker, Chairm an, Board of Governors of
the Federal Reserve System, “ Supplem entary State­
ment— The New Operating Procedures,” before the
Subcommittee on Domestic Monetary Policy of the
Committee on Banking, Finance and Urban Affairs,
House of Representatives, November 19, 1980, p. 1;
processed.

8




This article examines some of the implications
of the new operating procedure with respect
to the variability of interest rates and dis­
cusses the economic costs of interest rate
variability.
Old vs. new operating procedures

From 1970 through October 6, 1979, the
Federal Open Market Committee (FOMC)
generally attempted to achieve its economic
goals by specifying a federal funds rate trad­
ing range for the period between FOMC
meetings (usually one month) thought con­
sistent with these goals.2 Although, as the
decade progressed, more and more attention
was focused on achieving specified growth
rates in a family of monetary aggregates as
intermediate targets of policy, the immediate
operating target remained the federal funds
rate. Each week within the intermeeting
period, a federal funds rate target was chosen
by a representative of the FOMC in consulta­
tion with staff members of the Board of Gov­
ernors and the Trading Desk of the Federal
Reserve Bank of New York (Desk).
Shifts in the demand for nonborrowed
reserves within the statement week would be
accommodated by the Desk in order to main­
tain the targeted federal funds rate. Similarly,
changes in nonborrowed reserves caused by
unexpected changes in so-called "market
factors," such as Federal Reserve float, tended
to be offset by Desk open market operations
if they caused the federal funds rate to
deviate from its targeted level. This federal
2For a discussion of pre-O ctober 6, 1979, Federal
Reserve monetary policy operating procedures, see
Peter Keir and Henry W allich, "The Role of Operating
Guides in U.S. Monetary Policy: A Historical Review,”
Federal Reserve Bulletin, vol. 65 (September 1979), pp.
679-691, and Raymond E. Lombra and Raymond G. Torto,
“ The Strategy of Monetary Policy,” Economic Review,
Federal Reserve Bank of Richmond (Septem ber/October 1975), pp. 3-14.

Econom ic Perspectives

funds rate targeting strategy was tantamount
to the provision of a perfectly elastic supply of
nonborrowed reserves at a given federal
funds rate until the afternoon of the last day
of the reserve settlement week.3
Each Friday morning the FOMC received
new projections of monetary growth rates
and could then choose a new weekly federal
funds rate target thought appropriate for
achieving its goals. Thus, under the old oper­
ating procedure in effect prior to October 6,
1979, daily variation in the federal funds rate
was minimal. But because it was largely the
direct result of a policy decision, weekly vari­
ation could have been about whatever the
FOMC desired.
Under the new operating procedure
adopted October 6, 1979, the FOMC con­
tinues to set intermediate-term (two- or
three-month) growth targets for the mone­
tary aggregates. Now, however, the specified
intermeeting federal funds rate trading range
is typically much wider than under the old
operating procedure.4 The Federal Reserve
Board staff determines an average level of
nonborrowed reserves over the intermeeting
period thought to be consistent with the
FOMC's desired growth in the monetary
aggregates. The Desk is then directed to
attempt to hit a weekly average level of non­
borrowed reserves with relatively little regard
for the level of the federal funds rate unless
the boundaries of the intermeeting trading
range are in danger of being violated. In con­
trast to the old operating procedure, the new
procedure does not accommodate shifts in
banks' demand for nonborrowed reserves
3After 1 P.M ., New York time, it becom es increas­
ingly impractical for the Desk to buy or sell U.S. govern­
ment securities for same-day delivery and, thus, to affect
reserves on that day. Since W ednesday is the last day of
the reserve settlement week for depository institutions
subject to reserve requirem ents, the supply of nonbor­
rowed reserves becom es, for all intents and purposes,
perfectly inelastic after 1 P.M. on W ednesdays, and the
federal funds rate rises or falls to clear the market.
4From O ctob er 1978 through September 1979, the
average specified intermeeting federal funds rate range
was 0.62 percentage points in contrast to 5.45 percentage
points from O ctob er 1979 through September 1980.

Federal Reserve Bank o f Chicago



within the reserve settlement week. Moreover,
because daily federal funds rate control has
been deemphasized, the Desk is less likely to
take immediate action to offset undesired
daily movements in nonborrowed reserves—
and, thus, in the federal funds rate—caused
by unexpected changes in reserve market
factors.
In light of the new projections of mone­
tary growth rates usually available on Friday
mornings, a decision is made as to how to
distribute nonborrowed reserves on a weekly
average basis over the remaining weeks of the
policy period so as to achieve the FOMC's
intermeeting average level objective. Occa­
sionally, it is decided to change the inter­
meeting average level objective.5 For a given
level of the Federal Reserve discount rate and
a given relationship between the level of bor­
rowing from the Fed and the nonpecuniary
costs associated with that borrowing, the fed­
eral funds rate will rise (fall) if the specified
level of nonborrowed reserves implies a higher
(lower) level of borrowed reserves.6 Under
the new operating procedure, weekly changes
in the federal funds rate tend to be more
automatic, whereas they were more discre­
tionary or policy-determined before. For ex­
ample, if the monetary aggregates were grow­
ing faster than the FOMC desired, then,
5For a discussion of the m echanics of the nonbor­
rowed reserves targeting procedure, see Steven H. Axilrod and David E. Lindsey, “ Federal Reserve System
Im plementation of M onetary Policy: Analytical Founda­
tions of the New A pproach” (paper presented at the
Denver meeting of the Am erican Econom ic Association,
Septem ber 6, 1980; processed); Board of Governors of
the Federal Reserve System, "Appendix B: Description of
the New Procedures for Controlling M oney” (appended
to “ M onetary Policy Report to Congress Pursuant to the
Full Employment and Balanced Growth Act of 1978,”
February 19, 1980; processed); Warren L. Coats, Jr.,
“ Recent Monetary Policy Strategies in the United States”
(unpublished paper, August 8, 1980; processed); and
“ M onetary Policy and O p en M arket Operations in
1979,” Quarterly Review, Federal Reserve Bank of New
York, vol. 5 (Summer 1980), pp. 60-62.
6Under lagged reserve accounting, depository insti­
tutions’ required reserves in the current reserve settle­
ment w eek depend on the level of their reservable liabili­
ties two weeks prior. Assuming a constant level of excess
reserves, the level of nonborrow ed reserves in the cur­
rent w eek defines the level of borrowed reserves.

9

presumably, required reserves would be
growing faster than targeted nonborrowed
reserves. As a result, borrowed reserves would
rise and so too would the federal funds rate.
Under the old operating procedure, the fed­
eral funds rate would rise only within the
range specified at the last FOMC meeting
unless the FOMC made a conscious decision
to let it rise further.
In sum, then, there is a strong presump­
tion that day-to-day variability in the federal
funds rate will be greater under the new
operating procedure than under the old one.
Week-to-week variability in the federal funds
rate might also be expected to be greater
under the new operating procedure because
the level of the federal funds rate, given the
level of the Federal Reserve discount rate,
depends critically on depository institutions’
“ reluctance” to borrow from the Fed, which
also may be variable.
With regard to longer-run cyclical
movements in the federal funds rate, it is not
clear why the two procedures should yield
markedly different outcomes. Under the old
procedure, the level of the federal funds rate
was a direct FOMC policy decision.7 Under
the new operating procedure, the level of the
federal funds rate is indirectly determined by
policy decisions, in that it depends on the
targeted path of nonborrowed reserves, the
level of the discount rate, and the nonpecuniary costs associated with borrowing from the
Fed.

day-to-day and week-to-week variability in
the year since October 6, 1979, compared
with the year before. As already discussed,
one of the reasons for this greater variability is
that under the new procedure, shifts in banks’
demand for nonborrowed reserves within
the reserve settlement week are not accom­
modated by Desk open market operations.
Moreover, it could be expected that these
intraweek demand shifts would be more vola­
tile in the post-October 6 period.
Under the old procedure when the fed­
eral funds rate was being targeted within nar­
row bands on a weekly basis, banks had little
incentive to increase or decrease their federal
funds purchases or sales in order to take
advantage of a higher or lower federal funds
rate on any particular day. If the federal funds
rate moved above (below) the perceived
upper (lower) limit of the FOMC's targeted
range, then bidding (offering) would subside
as market participants expected the federal
funds rate to fall (rise) either on its own
accord or as a result of Desk open market
operations.

Standard deviations of percentage changes
of selected interest rates
O ctober 1978O ctob er 1979

O ctob er 1979O ctob er 1980

(p e rcen t)

(p e rcen t)

3.672
2.061

8.118
3.154

1.425
0.731

2.612
1.353

0.630
0.319

1.580
0.845

0.398
0.201

1.357
0.647

Federal funds rate
Daily
W eekly averages*

Federal funds rate variability
Three-m onth Treasury

As the graph and table make clear, the
federal funds rate has indeed shown greater
7For discussions of why the federal funds rate was not
moved by greater amounts under the p re-O ctober 6
operating procedure, see John P. Judd and John L. Scadding, ‘‘Conducting Effective Monetary Policy: The Role
of Operating Instruments," Economic Review, Federal
Reserve Bank of San Francisco (Fall 1979), pp. 29-30;
Thomas A. Lawler, “ Fed May be Shifting to a True
Reserves-Targeting Policy," The Money Manager, De­
cember 8,1980, p p .8 ,11; Paul A. Volcker, op. cit., pp. 1-2,
5,6; and Henry C. W allich, M em ber, Board of Governors
of the Federal Reserve System, "Federal Reserve Policy
and the Econom ic O u tlo o k” (remarks to the Chesapeake
Chapter of Robert M orris Associates, Bethesda, M ary­
land, Decem ber 3, 1980, pp. 2,8; processed).

70




bill rate
Daily
W eekly averages**
Five-year constant maturity
Treasury security rate
Daily
W eekly averages**
20-year constant maturity
Treasury security rate
Daily
W eekly averages**

•Seven-day averages of daily effective rates for the week ending
W ednesday.
••Five-d ay averages of daily closing bid rates for the w eek ending
Friday.

Econom ic Perspectives

Daily percentage changes in selected interest rates
th r e e - m o n th T re a su ry b ill rate

fe d e ra l fu n d s rate

1978

1980

Since October 6, however, the weekly
federal funds rate trading range tolerated by
the FOMC has widened significantly. As a
result, depository institutions may enjoy large
gains or suffer large losses depending on the
accuracy of their intraweek federal funds rate
forecasts.8 If the federal funds rate starts to
rise, depository institutions no longer have
the assurance they once did that the rate will
fall later in the settlement week. Given greater
8Because of lagged reserve accounting, depository
institutions know, entering the reserve-settlement week,
the w eekly average level of reserves they must hold to
avoid a deficiency. Their decision is how to distribute
their reserve holdings within the week in order to meet
their known reserve requirements at minimum cost.

Federal Reserve Bank o f Chicago




1978

1979

uncertainty as to the level of the federal funds
rate later in the day or settlement week, bid­
ding may continue, forcing the rate even
higher. Conversely, a falling federal funds
rate might not result in the withdrawal of
offers to sell federal funds.
Even if there were no change in deposi­
tory institutions' intraweek demand for nonborrowed reserves under the new operating
procedure, greater day-to-day volatility in
the federal funds rate could be expected due
to changes in nonborrowed reserves result­
ing from movements in uncontrollable reserve
market factors that were unanticipated by the
Fed. Under the old procedure, the Desk had
good reason to believe that the demand for

77

Economic events in 1980—a
chronology
Jan 1 M in im u m w age rises fro m $2.90 to $3.10. (It goes to $3.35 on
Jan u ary 1 , 1981.)
Jan 1 Social S e c u rity w age base rises fro m $22,900 to $25,900. T ax rate
stays at 6.13 p e rc e n t. (O n Ja n u ary 1 ,1 9 8 1 , base rises to $29,700, and tax
rate to 6.65 p e rce n t.)

M ar 21 A d m in is tra tio n su sp e n d s "trig g e r p ric e m e c h a n is m ” in ­
ten d e d to cu rb steel im p o rts. (M e ch a n ism is reinstated O c to b e r 21.)
M ar 23 R o ck Island R ailro ad ceases o p e ratio n s.
M ar 24 B o n d -e q u iv a le n t yie ld on th re e -m o n th T reasu ry b ills ju m p s
sh arply to 17.5 p e rce n t.

*"

M ar 25 Large C h icag o S&L in cre ase s m ortgage rate to 17 p e rce n t.

^

M ar 27 Spot p ric e of s ilv e r d ro p s $5 to $10.80 p er o u n c e . (Peak of $50

Jan 1 R e g u lato ry a u th o ritie s rep lace fo u r-y e a r flo atin g rate C D
(established Ju ly 1 ,1 9 7 9 ) w ith 2’/2-year “ sm all save r” C D .

was reach e d in Jan u ary .)

Jan 1 T re a su ry D e p a rtm e n t starts issuing d o u b le -E bonds y ie ld in g 7
p erce n t o ve r 11 years.

c ia lly distressed farm ers is e xte n d e d and e xp an d e d .

Jan 4 Presiden t C a rte r d e n o u n c e s R u ssian in va sio n of A fg h an istan .
He em b arg oes sh ip m e nts of a g ricu ltu ral p ro d u cts to Russia.
Jan 23 State of U n io n m essage calls fo r d raft reg istratio n and 5 p e r­
ce n t boost in real d e fe n se sp e n d in g .
Jan 28 Saudi A rab ia raises its basic o il p ric e to $26.
Feb 1 Trad e ag re e m e n t b etw ee n the U .S . and th e Peoples R e p u b lic
of C h in a goes into e ffe ct.
Feb 6 IM F au ctio n s4 4 4 , OOOounces of gold at$712 p er o u n c e , up fro m
reco rd $563 on Jan u ary 2.
Feb 7 Fed eral R e se rve Board a n n o u n ce s n e w m o n etary aggregate
d e fin itio n s : M -1A is old M-1 but e xclu d e s d em an d d ep osits held by
fo reig n banks and in stitu tio n s. M -1B adds o th e r ch e c k a b le d ep o sits,
in clu d in g N O W and ATS acc o u n ts. M -2 adds savings and sm all tim e
acco u n ts at b an ks and th rifts, o v e rn ig h t RPs and E u ro d o lla rs, and
m o n ey m arket fu n d s. M -3 adds larg e C D s and o th e r RPs. L (for
“ liq u id ity ” ) adds savings b o n d s, sh o rt-te rm T re a s u rie s , o th e r E u ro ­
d o llars, co m m e rcial p ap e r, and b a n k e rs’ acce p tan ce s.
Feb 14 C h ic a g o fire m e n go on s trik e . (T h e y retu rn to w o rk M a rch 8.)

*.

M ar 29 F m H A ’s E co n o m ic E m e rg e n cy Loan Program to aid fin a n ­

M ar 31 D e p o sito ry In stitu tio n s D e re g u la tio n and M o n e ta ry C o n tro l
A ct (M o n e ta ry C o n tro l A c t) is a p p ro v e d . A m o n g its m any p ro v isio n s:
all d ep o sito ry in stitu tio n s, m e m b e r and n o n m e m b e r, w ill be phased^
in to th e sam e n e w rese rve re q u ire m e n ts o ve r a p erio d of ye a rs;
Fed e ra l R e se rve m e m b e r b an ks can no lo n g e r avoid rese rve r e q u ire ­
m ents by w ith d ra w in g fro m th e system ; all in stitu tio n s w ill h ave fu ll
access to the Fed eral R e se rv e ’s d isco u n t w in d o w and se rv ice s; Federal R e se rve w ill e stab lish a p ric in g s ch e d u le for its s e rv ice s ; alT
in stitu tio n s w ill be ab le to o ffe r N O W acco u n ts b eg in n in g Decem ber^
31, 1980; in tere st rate c e ilin g s on savings and tim e d ep osits w ill be
phased out in six ye a rs; th rift in stitu tio n s w ill have exp an d e d asset^
p o w e rs; state u su ry ce ilin g s fo r m ortgages and ce rtain o th e r loans are
o v e rrid d e n ; F D IC / F S L IC in su ra n c e lim its are boosted fro m $40,000 to
$

100 , 000 .

Apr 2 M ajo r bank boosts p rim e rate to 20 p e rce n t.

w

Apr 2 A ct im p o sin g " w in d fa ll p ro fits” (e xcise ) tax on d o m e stic cru d e
o il ou tp u t is a p p ro v ed . T ax is retro activ e to M arch 1.

-*•

Apr 7 U .S . b reaks d ip lo m atic relatio n s w ith Ira n , and cuts o ff all trade.^
Apr 16 M a jo r bank cu ts its p rim e rate fro m 20 to 19.75 p e rce n t.
Apr 17 Fed eral R e se rve Board e xte n d s seasonal b o rro w in g p riv ile g e -

Feb 15 Algeria boosts oil p rice $3.00 p er b arrel to $37.21.

to sm all n o n m e m b e r banks.

Feb 15 Fed eral R e se rve raises d isco u n t rate fro m 12 p erce n t to a

Apr 17 C h in a rep laces T aiw an as a m e m b e r of th e In te rn a tio n a l

record 13 p erce n t.

M o n e tary Fu nd .

Feb 18 In C an ad a T ru d e a u ’s Lib e rals d efeat Joe C la r k ’s C o n se rvativ e s

Apr 20 In te rn a tio n a l H arve ste r w o rk e rs en d longest U n ite d A u to ­

en din g n in e -m o n th g o ve rn m e n t.

m o b ile W o rk e rs strik e after 172 days.

Feb 19 Fed eral R e se rve a n n o u n ce s m o n ey and cre d it g ro w th targets
fo r1 9 8 0 : M-1 A , 3V2-6 p e rc e n t; M -1B,4-6V2 p e rc e n t; M -2 ,6 -9 p e rc e n t;
M -3,6Vi-9V2 p e rce n t; total bank c re d it, 6-9 p e rce n t.

Apr 21 D o w Jon es in d u strial averag e closes^at 759, low fo r th e year.

Feb 27 O n e -y e a r T reasu ry b ills sell at 15.3 p erce n t b o n d -e q u ivale n t
y ie ld , highest e ve r fo r any U .S . se cu rity .
Feb 28 N u clear R e g u lato ry C o m m issio n lifts m o rato riu m on new
n u cle ar plants im p osed after T h re e M ile Island a cc id e n t.
M ar 1 R e g u lato ry a u th o ritie s im p o se te m p o ra ry c e ilin g s on "sm a ll
sa ve r" C D s , 11% p erce n t fo r b an ks, 12 p erce n t fo r th rifts.
M ar 12 C h icag o b ank raises its m ortgage rate to 16.25 p e rce n t.
M ar 13 President C a rte r e n d o rse s 7.5-9.5 p e rce n t w age rise g u id e ­

(See Nov 20.)

„

*

Apr 25 P resid en t C a rte r a n n o u n ce s fa ilu re of a irb o rn e attem p t to
rescu e U .S . hostages held in Ira n .
A pr 28 S ecretary of State V an ce is su cce e d e d by Senator M u s k ie . K
M ay 4 U .S . stops g ran tin g visas to C u b a n refu g ees.
M ay 7 F ed eral R e se rve e lim in a te s 3 p e rce n t su rch arg e on fre q u e n t
b o rro w in g s by large b an ks.
May 14 Saudi A rab ia raises its basic o il p rice fro m $26 to $28.
M ay 17 U n e m p lo ym e n t co m p en satio n claim s reach a n e w h ig h .

-

lines fo r 1980, up fro m 7 p erce n t in 1979.
Mar 14 President C a rte r an n o u n ce s n e w an ti-in flatio n p ro g ram , and
activates C re d it C o n tro l Act of 1969.

M ay 18 N ational G u a rd m oves to co n tro l rio tin g in M iam i.

M ar 14 Fed eral R e se rve Board a n n o u n ce s 15 p erce n t "s p e c ia l d e ­
posit” on g ro w th of m o n ey m arke t fun d s and som e types of
co n su m e r c re d it, a vo lu n ta ry "S p e c ia l C re d it R e strain t Pro g ram ” to
restrict business c re d it, an in cre ase in m arg in al reserves on m anaged
liab ilities fro m 8 to 10 p e rc e n t, and a 3-po int “ s u rch a rg e ” on fre q u e n t

ness “ d ro p p e d lik e a ro c k ” in A p ril and M ay.

b o rro w in g s fro m Fed eral R e se rve by large b an ks. B an ks are urged to
lim it loan grow th to 6 to 9 p e rce n t.

72

M ay 18 M t. St. H e le n s eru p ts vio le n tly causing e xte n sive d am age.

May 30 A lu m in u m w o rk e rs w in 42 p erce n t boost o ve r th re e ye ars,
assum ing 11 p erce n t in flatio n rate.




*
May 22 N ational A sso ciation of Purchasing A gents su rve y sh ow s b u s i­

May 22 Fed eral R e se rve eases cre d it restraint p ro gram .
M ay 27 Lyle G ra m le y jo in s Fed eral R eserve B oard .

#

M ay 29 F ed eral R e se rve re d u ce s d isco u n t rate fro m 13 to 12 p e rc e n t.

Economic Perspectives

Jun 13 F ed e ra l R e se rv e re d u ce s d isco u n t rate fro m 12 to 11 p e rce n t.
Jun 13 M a n y b an ks re d u ce p rim e rate to 12 p erce n t.
Jun 24 C h ry s le r o b tain s $500 m illio n lo an after g ove rn m e n t board
ap p ro ves fed e ra l g u aran te e.
Jim 30 S yn fu el act cre ates S yn th e tic Fu el C o rp o ra tio n .

O ct 9 R e g u lato ry a u th o ritie s set 514 p e rce n t ce ilin g on N O W a c­
co u n ts, e ffe ctive D e ce m b e r 31.
O ct 14 Staggers R ail A ct p ro vid e s fo r grad ual d ere g u latio n .
O ct 14 La w re n ce K le in w in s N ob el p riz e in e co n o m ic s.

4un 30 Pu n ish in g heat w ave hits th e S o u th w est.

O ct 20 A g ric u ltu re D e p a rtm e n t an n o u n ce s that d ro u g h t cut m ajor
cro p s— p e a n u ts, 37 p e rc e n t; so yb e an s, 23 p e rc e n t; c o rn , 17 p erce n t.

Ju l1 C h e c k s to 35.2 m illio n Social S e cu rity re c ip ie n ts rise 14.3 p e r­
c e n t based on C o st o f Livin g A d ju stm e n t (C O L A ) fo rm u la.

O ct 22 A g ric u ltu re D e p artm e n t a n n o u n ce s fo u r-y ear ag reem ent
co m m ittin g C h in a to substantial p urch ase s of w h eat and co rn .

Jul 1 M o to r C a rrie r R e fo rm A ct p artially d ere g ulate s tru c kin g .

Nov 4 Spot o il p rice s on w o rld m ark e t in cre ase to $37-40 range, $6-9
o ve r o fficial p rice s.

Jul 1 D e p a rtm e n t o f La b o r rep o rts w h ite -c o lla r salaries rose 9.1 p e r­
cen t on averag e in 12 m o n th s e n d in g in M a rch .

Nov 4 Reagan w in s th e P re sid e n cy . G O P w in s co n tro l of th e Senate,

Jul 3 Fed e ra l R e se rve Board a n n o u n ce s co m p lete p haseout of cre d it
Restraint p ro g ram .

and m akes gains in the H o use.

Jul 3 Fed e ra l H o m e Lo an B an k B oard a u th o rize s S&Ls to issue cre d it
"Jards and o ffe r u n se c u re d loans.

Nov 9 M a jo r steel co m p an y reo p e n s strip m ill clo sed last M ay.

)J>.I7 In d e fin ite layoffs at Big Fo u r auto m akers hit a record 246,000.

Nov 10 In te rn a tio n a l T ra d e C o m m issio n tu rn s d o w n req u est by Ford
and U A W fo r quotas on im p orts of cars and light tru cks.

Jul 12 D e tro it city w o rk e rs settle 11-day strik e that had halted buses
»nd garbage p ick u p s on e ve of G O P co n v e n tio n .

Nov 13 First phase of re se rve re q u ire m e n t p ro visio n s of M o n e tary
C o n tro l Act b eco m es e ffe c tiv e .

Jul 15 S e cretary of La b o r M a rsh a ll bars F iresto n e fro m g o vern m en t
co n tracts b ecau se of jo b bias ch arg es.

Nov 13 C o p p e r p ro d u c e rs settle re c o rd 19-w eek strik e . Pact calls for
39 p erce n t boost o v e r th re e ye ars, assum ing 11 p erce n t C O L A .

Jul 16 R e p u b lica n s n o m in a te Reagan and B ush.

Nov 17 Fed eral R e se rve raises d isco u n t rate fro m 11 to 12 p erce n t,
w ith 2 p o in ts ad d ed fo r $500 m illio n in stitu tio n s that b o rro w

Jul 21 M a jo r b an k cu ts p rim e rate fro m 11.5 to 11 p e rce n t,
ftil 27 T h e Shah of Iran d ies in C a iro .

Nov 6 M a jo r banks raise p rim e rate fro m 14.5 to 15.5 p erce n t.

fre q u e n tly .

Jul 28 F ed eral R e se rve re d u ce s d isco u n t rate fro m 11 to 10 p erce n t.

Nov 20 G o v e rn o r T h o m p so n of Illin o is o rd e rs 60-day h irin g fre e ze .

Jul 28 C h ry s le r b eg ins assem b ly of n e w K -cars.

Nov 20 T h e D o w jo n e s in d e x clo ses at 1000, high fo r th e ye ar. (See
Apr 21.)

Tul 29 C h a irm a n V o lc k e r ’s le tte r to C o n g re ss states that m o n ey
g ro w th targets fo r 1981 are Vi p e rce n ta g e p oin ts u n d e r 1980 targets
Tor M -1 A , M -1 B , and M -2, b ut w arn s that p re cise n u m e rica l targets
m ay co n fu se rath e r th an cla rify .
Aug 11 A T & T th re e -y e a r la b o r co n tra c t gives 34.5 p erce n t pay boost
o ve r th re e ye ars, assu m in g 9.5 p erce n t rise in C P I.
Aug 13 D e m o crats re n o m in a te C a rte r and M o n d a le .

Aug 17 Polish fa cto ry w o rk e rs strik e d em an d in g pay h ik e , sh orter
w e e k , m o re fo o d , fre e sp e e ch , and fre e ch u rc h .
Aug 18 Ford b eg ins assem b ly of its n e w sm all “ E rik a ” cars.

Nov 24 N ew Y o rk le g islatu re e lim in a te s u su ry ce ilin g s on most loans.
Dec 5 Fed eral R e se rve raises d isco u n t rate to 13 p e rc e n t, equ aling
high of last sp rin g , and raises su rch arg e to 3 p erce n t.
Dec 10 A u to m akers e xte n d h o lid ay clo sings to cut in ve n to rie s.
D ec 10 M a jo r b an ks raise p rim e rate fro m 19 to 20 p erce n t.
D ec 15 B o n d -e q u iv a le n t yie ld on th re e -m o n th T reasu ry b ills hits
17.64 p e rce n t, passing 17.5 p erce n t high on M arch 2 4,1980.
D ec 15 Saudi A rab ia raises its basic o il p ric e fro m $30 to $32. M a x i­
m um O P E C p rice w ill be $41.

A u g 21 Im p ort d u ty on sm all tru c k s rises fro m 4 to 25 p erce n t.
Aug 22 M a jo r b an ks boost p rim e rate to 11.25 p e rce n t, first of a series
erf in creases.

D ec 16 C o u n c il on W ag e and P rice S tab ility d e c id e s not to issue new
p rice and w age stan d ard s, e ffe c tiv e ly e n d in g its ca re e r.

Aug 28 Fed e ral R e se rv e p u b lish e s p ro p o se d p ricin g sch e d u le and
p ricin g p rin c ip le s fo r its se rv ice s.

D ec 16 A m e ric a n M o to rs C o rp o ra tio n sto ck h o ld e rs vo te to allow

S ep 1 R e vise d R e g u la tio n A , as re q u ire d by M o n e ta ry C o n tro l A c t,
gives all d e p o sito ry in stitu tio n s access to th e d isco u n t w in d o w .

Dec 19 M ost m ajo r banks raise p rim e rate to reco rd 21.5 p erce n t.
Dec 21 Iran d em an d s $24 b illio n ransom to release hostages.

Sep 12 M ilita ry co u p seizes p o w e r in T u rk e y .

D ec 22 M a jo r banks re d u ce p rim e rate fro m 21 to 20.5 p erce n t.

Sep 17 Saudi A rab ia boosts its o il p ric e $2 to $30 per bbl.

D ec 22 Y ie ld s on T reasu ry b ills d ro p sh arp ly.

Sep 22 Ira n -lra q w a r b eg ins o v e r d isp u ted b o rd e r w ate rw ay.

D ec 23 Labor D e p artm e n t an n o u n ce s that N o vem b e r C o n su m er

S ep 26 F ed eral R e se rve raises d isco u n t rate fro m 10 to 11 p e rce n t.
M ajo r b an ks boost p rim e rate to 13 p e rce n t.

Price In d e x was 12.7 p erce n t ab o ve th e level of a year e a rlie r.

Sep 29 B o n d -e q u iv a le n t y ie ld on th re e -m o n th T reasu ry b ills ju m p s a
fu ll p oin t to 12 p e rce n t.

D ec 29 Libya raises its o il p rice fro m $37 to $41, O P E C m axim u m .

O ct 1 F ed eral e m p lo y e e s re c e iv e a 9.1 p e rce n t g en e ral pay b oost, in
ad d itio n to a n n u al step in cre ase s.

tion loans on all co rn in rese rve p ro g ram .

O ct 2 M a jo r b an k lead s boost in p rim e rate to 14 p erce n t.

Federal Reserve Bank of Chicago




R e nau lt to a cq u ire co n tro l.

Dec 26 R e taile rs rep o rt strong p re -C h rsitm as sales.

Dec 30 A g ric u ltu re D e p a rtm e n t calls C o m m o d ity C re d it C o rp o ra ­

D ec 31 M a jo r S&L says high in tere st rates have virtu a lly shut d ow n
C h ic a g o area resid e n tial real estate m arkets.

13

nonborrowed reserves on a day-to-day basis
within the settlement week was relatively sta­
ble. Consequently, a movement of the fed­
eral funds rate outside its targeted range was a
warning that the supply of nonborrowed
reserves might be something other than what
the Fed had forecast.9 The Desk often under­
took “ defensive” open market operations
based on the deviation of the actual level of
the federal funds rate from its expected level.
Since October 6, however, the daily federal
funds rate has provided the Desk with less
information about the actual level of nonbor­
rowed reserves because changes in the rate
may reflect not only changes in the supply of
nonborrowed reserves, but also shifts in the
demand for them.
Variability in longer-term rates

Although increased day-to-day volatility
in the federal funds rate was expected to
accompany the new operating procedure,
there was more uncertainty about the
response of longer-term rates to the increased
volatility of one-day rates. The relationship
between interest rates and the maturity of
securities is known as the term structure of
interest rates. Although there are variants on
the theme, most theories of the term struc­
ture posit that expectations about the future
level of short-term rates play a major role in
the determination of longer-term rates.1 *For
0
example, according to the pure expectations
theory, the current 90-day Treasury bill rate is
a geometric average of 90 expected future
one-day Treasury bill rates. The degree to
which greater variability in the federal funds
rate, a one-day rate, will lead to greater varia­
bility in longer-term rates depends on the
degree to which daily changes in the federal
9ln the pre-O ctober 6 period, the Fed also made
daily reserve projections and had some intuition as to the
rate level at which federal funds would trade, given
required reserves and the level of the discount rate.
10For a discussion of different theories of the term
structure of interest rates, see Burton G. M alkiel, The
Term Structure of Interest Rates (Princeton University
Press, 1966).

14




funds rate affect expectations of future daily
federal funds rates.
It has been argued that under the old
operating procedure, short-term movements
in the federal funds rate contained more
information about future movements in this
rate because the FOMC was targeting its level
within narrow bands. Thus, it was believed
that short-term movements in the federal
funds rate had significant effects on expecta­
tions and were quickly translated into
movements of longer-term rates. Because
short-term movements in the federal funds
rate under the new operating procedure con­
tain less information about policy intentions,
such movements are likely to have less of an
effect on expected future federal funds rates.
Thus, the response of longer-term rates to
short-term movements in the federal funds
rate might be diminished under the new
operating procedure.1
1
The first part of this argument may have
some empirical validity. That is, movements
in the federal funds rate since October 6,
1979, appear to have conveyed less informa­
tion about its future movements than before
in as much as the correlation coefficient
between daily percentage changes in the
federal funds rate on the current and preced­
ing day decreased from -0.51 in the year
preceding October 6,1979, to -0.34 in the year
after.1 Despite this, as shown in the graphs
2
and table, the variability of longer-term rates,
as represented by the three-month Treasury
bill rate and the five-year and 20-year con­
stant maturity Treasury securities rates, in­
creased in the year following October 1979,
compared with the year before. Moreover,
the correlation between daily percentage

’’See Judd and Scadding, op. cit., pp. 30-31; and
Raymond Lombra and Frederick Struble, “ Monetary
Aggregate Targets and the Volatility of Interest Rates: A
Taxonomic Discussion,” journal of Money, Credit, and
Banking, vol. 2 (August 1979), pp. 290-291.
^Correlations using w eekly average percentage
changes in the federal funds rate tell a different story. The
correlation coefficients between the current week and
the previous w eek for the year prior to and the year after
October 6,1979, were -0.11 and 0.21, respectively.

Econom ic Perspectives

changes in the federal funds rate and in the
three-month Treasury bill rate and the fiveyear and 20-year constant maturity Treasury
securities rates increased from 0.06,0.004, and
-0.04 to 0.13, 0.12, and 0.12, respectively,
between the two periods.
Increased correlation coefficients, how­
ever, do not necessarily mean that longerterm rates have become more sensitive to
daily movements in the federal funds rate
since the new operating procedure was
adopted. Given the enormous increase in the
variability of the federal funds rate under the
new procedure, even a diminished sensitivity
could be expected to produce greater varia­
tion in longer-term rates and to increase the
proportion of that variation which is explained
by variation in the federal funds rate; that is
precisely what a correlation coefficient
measures.1 *
3
A more meaningful measure of the sensi­
tivity would be the regression coefficients
calculated from regressions of daily percent­
age changes in longer-term rates on daily
percentage changes in the federal funds rate
before and after the adoption of the new
operating procedure. As seen in the table, the
regression coefficients (bi) have increased in
size and statistical significance in the year fol13To illustrate this point a little more clearly, suppose
that the relationship between some variable Y and some
explanatory variable X were as follows:
Y = a + bX + e
w here a and b are constants and e is a random distur­
bance term. So long as X and e are independent, the
greater the variability of X, the more variable Y will be
and the greater the proportion of the variability of Y that
will be attributable to variation in X. But if X is held
constant or nearly so (as was the case with the federal
funds rate from Thursday through Tuesday under the old
operating procedure) then (a + bX) will be a constant, and
movements in X will account for virtually none of the
total variation in Y— even though the basic relationship
between Y and X, as measured by coefficient b, is
unchanged. An alternative way of showing this is to look
at the formula for the correlation coefficient,

^

sv

w here r is the correlation coefficient, P is the estimate of
the coefficient b in the equation, Sx is the sample stand­
ard deviation of X, and Sy is the sample standard devia­
tion of Y. If Sx is very low (the variability of X is very low), r
will be small regardless of the size of 0 .

Federal Reserve Bank o f Chicago




Daily % A Interest Rate = bQ + b-] Dai ly % A Federal Funds Rate + e
O ctob er 1978O ctober 1979
Dependent Variable

O ctober 1979O ctober 1980

bi

b0

h

bp

0.1135
(1.25)

0.0254
(1.03)

0.0063
(0.04)

0.0409*
(2.01)

0.0602
(1.50)

0.0008
(0.07)

0.0502
(0.50)

0.0228**
(1.85)

0.0381
(1.50)

-0.0044
( -0.64)

0.0660
(0.77)

0 .02 02"
(1.91)

Three-m onth Treasury
bill rate

Five-year constant m aturity
Treasury security rate

20-year constant maturity
Treasury security rate

T-statistics in parentheses.
'Statistically significant at the 0.05 level.
"S ta tistic a lly significant at the 0.10 level.

lowing the adoption of the new operating
procedure compared with the year before.
Thus, contrary to expectations, the regression
coefficients confirm the result suggested by
the correlations—that longer-term rates have
become more sensitive to short-term move­
ments in the federal funds rate under the new
operating procedure.
Together with the marked increase in the
volatility of all maturities of interest rates
immediately after October 6, 1979, and its
continuation throughout 1980, these results
constitute suggestive but not conclusive evi­
dence that the new operating procedure has
been primarily responsible for the increased
variability in longer-term rates. As mentioned
at the outset, since the adoption of the new
operating procedure, the financial markets
have been subjected to a number of extraor­
dinary events including dangerous turmoil in
the Middle East, sharp increases in energy
prices, uncertainties with respect to the fed­
eral budget, the temporary imposition of
credit controls, and the bursting of specula­
tive bubbles in the commodity markets.
Moreover, given the relatively short period of
time that the new operating procedure has
been in effect, it is reasonable to assume that
market participants are still discovering its
nuances and may occasionally be misinterpretingthe meaningof short-run movements

75

in the federal funds rate. As they learn more
about the new procedure, some of the
increased volatility may disappear.
Economic costs of interest rate variability

Most investors are risk averters. That is,
the higher the risk associated with a particular
investment, the higher the expected return
must be to induce the investor to purchase
the investment. For example, consider two
investment alternatives. The first guarantees a
return of $100 at the end of some specified
time period. The second alternative offers
possible returns of $150 and $50, each with a
50 percent probability. The expected return
of the second investment is $100, the same as
the first.1 But because of the higher risk—
4
that is, variability or uncertainty of return—
associated with the second alternative, most
people would prefer the no-risk or certain
first investment choice. If the equally probable
outcomes of the second alternative were
raised to $200 and $100, so that the expected
return was $150, then some investors would
be induced to opt for it despite its higher
risk.1
5
Because the market price or capital value
of a fixed-income security varies inversely
with its market yield, interest rate variability is
an inherent risk of holding such a security.
Assuming that the demand for a given class of
fixed-income securities is dominated by riskaverse investors, an increase in the interest
rate variability of these securities would lead
investors to hold fewer securities at any given
level of expected return. In order to induce
investors to hold the same quantity as in the
period of lower rate variability, the expected

14Expected return is defined as the sum of the pro­
ducts of the probability of an investment outcom e o ccu r­
ring and the value of that outcom e. Thus, in the hypo­
thetical second alternative, the expected return is equal
to .5 x $50 plus .5 x $150 or $100.
15For a formal discussion of the effects of risk on asset
demands, see James Tobin, “ Liquidity Preference as
Behavior Towards Risk," Review of Economic Studies,
vol. 25 (February 1958), pp. 65-86.

76



return must rise to reflect the higher risk.1
6
Because of their highly leveraged po­
sitions—i.e., the relatively low ratio of their
capital to the value of their securities in­
ventory—government securities dealers are
particularly sensitive to interest rate variabil­
ity. An unexpected sharp rise in interest rates,
even of short duration, can have a profound
negative impact on dealer solvency. As a
result, an increase in interest rate volatility
may reduce dealers’ willingness to make
markets in government securities, resulting in
lower dealer inventories and a widening of
the spread between the prices at which deal­
ers stand ready to buy and sell securities (the
bid-ask spread).1 This hypothesized decline
7
in the ''efficiency” of the government securi­
ties market implies higher costs of marketing
government debt.
A comparison of dealer bid-ask spreads
on Treasury billsfor the years before and after
October 6, 1979, confirms that they have
widened. The average spread on the current
three-month Treasury bill has increased from
3.6 basis points to 6.2 basis points.1 Similar
8
16ln a world in which there is one riskless asset and
more than one risky asset and the variances of return on
all of the risky assets have increased, the expected returns
on all the risky assets need not increase unless all of them
are gross substitutes for each other. Assets are gross sub­
stitutes for each other if, in response to an increase
(decrease) in the price of one of them, the individual
demands for all other assets increase (decrease).
17For theoretical analysis and empirical evidence
concerning dealer behavior, see Louise Ahearn and Jan­
ice Peskin, “ Market Performance as Reflected in Aggreg­
ative Indicators,"yoint Treasury-Federal Reserve Study of
the Government Securities Market—Staff Studies, part 2,
pp. 93-153; M icha Astrachan, “ The Costs of Interest Rate
Variability,” Federal Reserve Bank of New York Research
Paper No. 7821, Decem ber 1977; and Burton Zw ick,
“ Interest Rate Variability, Governm ent Securities Deal­
ers, and Stability in the Financial M arkets,” Federal
Reserve Bank of New York Research Paper No. 7734,
September 1977.
1 The data used in these calculations were the first
8
available when-issued quotes (usually Tuesday) on the
most recently auctioned three-month Treasury bill. The
data source was the Federal Reserve Bank of New Yo rk’s
closing composite quotations of U.S. government securi­
ties. It should be noted that empirical studies indicate
that other factors, in addition to interest rate variability,
affect bid-ask spreads. Thus, it would be im prudent to
attribute the widening of bid-ask spreads in the postO ctob er 6, 1979, period solely to increased interest
rate volatility.

Econom ic Perspectives

results obtained for the current six-month
Treasury bill. However, an examination of
monthly data since October 6, 1979, fails to
reveal any decrease in dealer net positions in
U.S. government securities as a proportion of
all marketable U.S. government securities
held by the public. If anything, the data show
a slight increase in net deflated positions.
Increased uncertainty concerning future
interest rate levels resulting from the observed
increase in rate variability could also produce
wider dispersions of accepted bids in Treas­
ury securities auctions. In the weekly auctions
of six-month Treasury bills, the average per­
centage point spread between the highest
accepted bid (in terms of rates) and the lowest
increased from 0.045 in the year prior to
October 6,1979, to 0.125 in the year following
the adoption of the new operating proce­
dure. Insofar as this increased bidding disper­
sion reflects greater investor uncertainty, and
investors are risk averse, it might imply that
the Treasury paid higher interest rates than it
otherwise would have had to in order to
compensate investors for the higher perceived
risk.
Finally, the increased day-to-day vari­
ability of the federal funds rate imposes an
obvious cost on depository institutions sub­
ject to reserve requirements. Because of the
greater uncertainty about the rate level at
which federal funds will trade during the
week and the associated higher penalties for
“ poor” timing of federal funds transactions,
depository institutions could be expected to
devote more resources to forecasting daily
federal funds rate levels and/or end up hold­
ing higher levels of excess reserves.1 In either
9
19Average w eekly excess reserves increased from
0.486 percent of total reserves in the year prior to
O ctob er 6,1979, to 0.622 percent in the year after. This

Federal Reserve Bank o f Chicago




case, the depository institutions would attempt
to pass on their higher costs to their customers.
Summary

Since the Fed adopted its new operating
procedure on October 6,1979, the short-run
variability of interest rates has increased drama­
tically across the maturity spectrum. Although
greater variability of the federal funds rate
was expected as a direct implication of the
new operating procedure, arguments based
on the expectations theory of the term struc­
ture of interest rates suggested that the vari­
ability of longer-term rates might not increase
commensurately. However, the results re­
ported in this paper indicate that longer-term
rates have become both more variable and
more sensitive to movements in the federal
funds rate.
Regardless of its source, increased varia­
tion in interest rates implies a decreased
demand forfixed-incomesecuritiesasa result
of increased risk or uncertainty of return. The
general level of interest rates must rise in
order to induce investors to hold the quantity
of fixed-income securities outstanding. Thus,
increased interest rate variabililty implies
higher marketing costs of Treasury debt.
Most of the empirical evidence presented is
consistent with this hypothesis. Of course, in
assessing experience under the new operat­
ing procedure, these costs of increased inter­
est rate variability must be weighed against
any benefits of the new procedure in terms of
more stable growth of the monetary aggre­
gates and of nominal income.
increase marginally misses being statistically significant at
the 5 percent level for a single-tailed test.

17

1980 developments in rural
credit markets
Gary L. Benjamin
The volatility in interest rates and credit
demands in national markets last year was
more evident in rural areas than in past cycli­
cal swings of the economy. The increased
volatility in rural credit markets partially re­
flected bleak farm income prospects and
uncertainties about the intent and implica­
tions of the credit controls imposed in midMarch. But the increased reliance of agricul­
tural banks on interest-sensitive deposits was
probably the major factor contributing to the
greater volatility in rural credit markets.
The implications of this and other devel­
opments of last year are not yet fully comprehendable. But if there is a lesson in the devel­
opments of last year, it is probably that many
of the barriers that shielded rural credit
markets from cyclical swings in national finan­
cial markets in the past have been removed.
This lesson may be more evident as various
provisions of the Depository Institutions Dere­
gulation and Monetary Control Act, signed
on March 31, are implemented in the years
ahead.
Farm income in 1980

The 1980 performance of agricultural
lenders was greatly affected by the increased
volatility in credit markets. It would be an
oversimplification, however, to attribute their
performance solely to credit market condi­
tions. Developments in the real sector had a
significant impact.
Farm income prospects were very bleak
in the first half. Farm production expenses
registered one of the largest relative increases
in the past five decades in 1979 and further
large increases were in store for 1980. Record
crop production in 1979 portended large
increases in carryover stocks and lower grain
prices. Grain prices were also held in check
by an embargo that lowered grain sales to the
USSR from 25 million to 8 million metric tons

18




and halted virtually all other agricultural ship­
ments to the USSR. Livestock prices were
suppressed because per capita meat supplies
were at record levels following several years
of expansion in pork and poultry production.
The bleak first-half farm income prospects
contributed to a plummeting in capital expen­
ditures by farmers and a temporary decline of
unusual proportions in farmland values. Sur­
veys show that Seventh District farmland
values declined 4 percent in the first half of
1980. These developments dampened bor­
rowings by farmers, as did the record high
interest rates that emerged early last year.
Farm income prospects improved con­
siderably in the second half, but interest rates—
after declining inthesecond quarter—roseto
new highs again late in the year. The recovery
in farm income was largely captured by live­
stock producers and those crop farmers whose
production was least affected by the summer
drought and searing heat. The brighter in­
come prospects in the second half contrib­
uted to a strong rebound in farmland values,
but did little to boost capital expenditures by
farmers.
Commercial lending slowed

Institutions that lend to farmers are a
diverse lot with differing organizational struc­
tures, investment alternatives, funding arran­
gements, and management objectives. This
diversity accounts for considerable variation
among agricultural lenders in their ability to
weather periods of extreme volatility in credit
markets. Banks and life insurance companies
are most likely to curtail farm lending in the
face of credit market volatility because of
their many investment alternatives, internal
profit objectives, and limited access to fund­
ing. The performance of the cooperative farm
credit system (CFCS) is less susceptible. Be­
cause the CFCS consists of cooperatives, its

Econom ic Perspectives

profit objectives are subordinated to the
interests of borrowers. Investments by the
CFCS are largely limited to the making of
loans to farmers and their cooperatives. The
system’s access to national money markets
minimizes funding problems. Government
agencies—such asthe Farmers Home Admin­
istration, the Commodity Credit Corporation,
and the Small Business Administration—enjoy
even greater insulation from volatility in credit
markets. Funding of government agency loans
is provided directly or indirectly through the
U.S. Treasury. Because government agency
lending to farmers is mandated by the Con­
gress or the administration, decisions as to
when and how much to lend are dictated by
social objectives rather than profits.
The growth in farm debt held by all
reporting farm lenders slowed in 1980.1 Pre­
liminary estimates show farm debt held by
reporting institutional lenders rose only 11
percent last year, the smallest annual rise
since 1972. But the increase was dominated by
government agencies whose farm lending
provides various degrees of subsidization.
Farm debt held by commercial (private)
lenders—banks, life insurance companies,
and the CFCS—rose only 9 percent last year.
Except for the 1968-70 period—a time also
marked by tight credit markets—that was the
smallest annual rise in farm debt held by
commercial lenders since the early 1960s.
Moreover, farm debt held by commercial
lenders increased by a smaller percentage last
year than cash production expenses in the
farm sector.* This had occurred in only two
2
other years—1973 and 1979—since the 1940s.
Had it not been for huge increases in gov­
ernment agency lending to farmers, the
squeeze on farm financing resulting from the
R e p o rtin g institutional lendersaccountforabout78
percent of the outstanding farm debt. The remainder is
held by individuals and nonreporting institutions for
which rigorous “ benchm ark” data are far less readily
available.
2Despite inflation a cutback in capital purchases held
the 1980 rise in cash expenditures for the farm sector to
about 10 percent, below the increases of the previous
two years.

F e d e r a l R e s e r v e B a n k o f C h ic a g o




Last year’s slower rise in farm debt
was particularly evident at banks
and life insurance companies
percent change in farm loans outstanding
0
10
20
30
40
50
60

11980
banks

1979
1976-78 average

life insurance
companies
federal land
banks
production
credit
associations
Farmers Home
Administration
all reporting
farm lenders

volatility in credit markets would have been
far more severe the past two years.
Commercial banks. Of the major types of
commercial lenders, banks were affected the
most by the volatility in credit markets last
year. This was of particular significance be­
cause banks account for nearly half of the
institutionally held nonreal estate farm debt
and a fourth of all farm debt. The liquidity of
agricultural banks tightened substantially dur­
ing the latter half of the 1970s as loan growth
outstripped deposit growth. Loan/deposit
ratios at District agricultural banks peaked in
1979 at levels 10 percentage points higher
than in the mid-1970s. Moreover, the cost of
funds at agricultural banks escalated rapidly
as new types of interest-sensitive deposits
proved especially attractive to rural savers. By
the end of the first quarter of 1980, money
market certificates (MMCs) accounted for 22
percent of resources at District agricultural
banks, up from 12 percent six months earlier
and up from 6 percent a year earlier. Large
time deposits of $100,000 or more—which
are also interest-sensitive—accounted for an
additional 5 percent of agricultural bank
resources.

19

Banks’ share of all institutionally held
farm debt has declined since 1973
percent

1950

'55

'60
'65
'70
year ending Decem ber 31

'75

'80

The surge in growth of interest-sensitive
deposits largely reflected a restructuring of
existing deposits rather than new deposit
inflows. Savers converted balances from
checking accounts and time and passbook
savings accounts into the record-yielding
MMC accounts. But total deposit growth at
rural banks was abnormally sluggish through­
out much of 1979 and the first half of 1980,
further aggravating the liquidity positions of
rural banks.
The growth in interest-sensitive deposits
sharply escalated the cost of funds to rural
banks. Because of the higher cost and a rise in
the potential returns on alternative invest­
ments, rates on bank loans kept pace with the
sharp upturn in market rates of interest to a
much greater degree than in previous peri­
ods of tight credit.
Because of tight liquidity and high loan
rates at rural banks, there was widespread
concern about the availability of credit to
farmers. Some observers, linking the credit
availability and low farm income issues to­
gether, argued that the plight of farmers was
the worst since the Depression. To help ease
the situation, the Federal Reserve System in

20




mid-April temporarily streamlined the eligi­
bility requirements for the “ seasonal borrow­
ing” privilege, and—for the first time ex­
tended that privilege to nonmember banks.
Many banks were eligible and initial interest
in the program was very high. But only two
loans were actually made under the program
because agricultural banks found that the
volume of farm loans demanded was unex­
pectedly low as a consequence of high inter­
est rates and the pessimistic farm income
situation.
The effects of these factors on farm bor­
rowings at banks was evident throughout last
year. Preliminary estimates show outstanding
farm debt held by banks at the end of 1980
was only 1 percent higher than the year
before. That represented the smallest rise
since the mid-1950s and contrasted sharply
with the average annual rise of nearly 11 per­
cent the previous four years. It also marked
the seventh consecutive year that the relative
increase in farm debt held by banks has
lagged that for all reporting institutional farm
lenders. As a result, banks’ share of all institu­
tionally held farm debt has dropped from
43 percent to a post-World War II low of
30 percent.
The sluggishness that characterized farm
lending in 1980 was also evident in all other
credit extensions at rural banks. But while
total loan portfolios showed little or no growth
in 1980, deposit growth at agricultural banks
rebounded to an uncommonly high level in
the second half. The contrasting trends re­
sulted in a remarkable improvement in li­
quidity, particularly at rural banks in the Mid­
west. At agricultural banks in the Seventh
District, for example, loan/deposit ratios at
the end of 1980 averaged about .605, down
sharply from the peak of .676 the year before
and the lowest in nearly four years.
Life insurance companies. The 1980 per­
formance of life insurance companies—which
account for 20 percent of farm real estate
debt held by institutional lenders and 7 per­
cent of all farm debt—was also affected ad­
versely by the volatility in credit markets last
year. As in the case of banks, last year's

E c o n o m ic P e r s p e c tiv e s

retrenchment in farm lending by life insur­
ance companies was more pronounced than
in past cyclical swings of interest rates. The
retrenchment, which started in late 1979 and
lasted throughout 1980, was particularly evi­
dent in farm mortgage commitments and
acquisitions. New farm mortgage commit­
ments made by life insurance companies in
1980 were down about 55 percent from the
year before, while farm mortgage acquisi­
tions were down more than 40 percent. These
declines substantially exceeded the retrench­
ment undertaken by life insurance compan­
ies during the 1974-75 cyclical swings in finan­
cial markets. Because of last year's cutback,
farm mortgages held by life insurance com­
panies at the end of 1980 were only 5 percent
higher than the year before. This increase was
down sharply from the average annual in­
crease of 18 percent the three previous years
and was the smallest annual rise for life insur­
ance companies since 1972.
Last year's retrenchment in farm mort­
gage lending by life insurance companies
primarily reflected liquidity problems, although
borrowings were also suppressed by low farm
earnings and high mortgage rates. The liquid­
ity pressures arose from the strong policy loan
demands that life insurance companies were
facing. During the first half, gross policy loans
made by major life insurance companies
were 71 percent above the rapidly rising level
of the year before. Funding those loans proved
a substantial burden on life insurance com­
panies' cash flows.
The developments in credit markets last
year may have lasting implications for farm
mortgage lending by life insurance compan­
ies. Life insurance companies have long prided
themselves as the last "fixed-rate” commer­
cial farm mortgage lender. But fixed-rate
financial contracts of all types have been
called into question by the volatility in inter­
est rates over the past year or so. It now
appears that, just as in the case of residential
mortgage lending, renegotiable rate mort­
gages became widespread in farm mortgage
lending by life insurance companies in 1980.

Federal Reserve Bank o f Chicago




A return to fixed-rate lending is doubtful, at
least until interest rates are more stable.
The cooperative farm credit system

The volatility in financial markets last
year affected the performance of the CFCS far
less than that of other commercial lenders.
The CFCS is the leading farm lender, account­
ing for 42 percent of all institutionally held
farm debt and 32 percent of all farm debt. The
system is comprised of three borrower-owned
cooperatives that raise funds in national credit
markets through the sale of consolidated
debentures and lend those funds almost ex­
clusively to farmers and farm cooperatives.
Two parts of the system serve farmers direct­
ly. Production credit associations—working
through Federal Intermediate Credit Banks—
provide farmers with short- and intermediateterm loans. Federal Land Banks (FLBs) provide
mortgage financing to farmers.
The ability of the CFCS to weather volatil­
ity in financial markets better than other
com m ercial farm lenders reflects some
unique characteristics of the CFCS that affect
liquidity and borrower demand. Because of
the ability of the CFCS to raise funds in
national money markets through regularly
scheduled debenture sales, the system avoids
the liquidity problems that typically confront
banks and life insurance companies during
periods of tight credit markets. The funds cost
more, but liquidity is less of a constraint to the
CFCS than to private lenders.
Another characteristic that provides the
CFCS an advantage during periods of tight
credit is the system's practice of pricing loans
on the basis of its average cost of funds plus a
markup for administrative overhead. This fea­
ture, plus the basic cooperative business
structure of the CFCS and the restrictions lim­
iting its investments exclusively to loans to
member borrowers, provides the CFCS with
competitively low interest rates on loans dur­
ing periods of rising market rates of interest.
Loan pricing practices of banks and life insur­
ance companies, in contrast to the CFCS, tend
to be tied more to the marginal cost of

21

funds—the cost of funding a new loan—
and/or the opportunity rate of return—the
return that could be earned by investing the
funds in some asset other than a loan. When
market rates of interest are rising, the average
cost of funds approach to loan pricing results
in lower loan rates than the marginal cost or
the opportunity rate of return approach.
During most of 1980, CFCS loan rates
were substantially below rates quoted by
other commercial farm lenders, allowing the
CFCS to attract a disproportionately large
share of the farm sector's credit demands.
While the loan rate advantage typically shifts
to other lenders during periods of declining
interest rates, the lower rates offered by the
CFCS during 1979 and 1980 probably ac­
counted for much of its relatively strong
performance.
Production credit associations. Loans
made by production credit associations (PCAs)
were growing rapidly in 1979 and early 1980,
exceeding year-earlier levels by 25 percent.
But the year-to-year gains narrowed abruptly
in the spring and exceeded year-earlier levels
by only 5 percent in the second half. For the
year as a whole, the rise in outstanding nonreal estate farm debt held by PCAs was less

New lending by FLBs and PCAs
slowed in the second half of 1980
percent change from year earlier

22



than 9 percent, the smallest since 1972 and
well below the annual average of 15 percent
during the 1970s.
Federal Land Banks. Lending activity at
FLBs followed a pattern similar to that at
PCAs. However, the cutback came late in the
second quarter and—because new lending
represents a far smaller share of the loan port­
folio at FLBs than at PCAs—the dampening
effect of no growth in the second half had a
much less pronounced impact on outstand­
ings. For the year outstanding loans at FLBs
rose more than a fifth, substantially above the
average annual rise of 16 percent in the 1970s.
The CFCS for years has used variable-rate
lending practices exclusively. Ironically, in
1980 some FLBs modified the variable-rate
practice at the very time that other lenders
were beginning to realize that variable-rate
loans could protect earnings in periods of
rising interest rates. Fundingthesharply higher
new loan demands greatly escalated the aver­
age cost of funds at FLBs. At the same time,
however, their practice of pricing mortgages
on the average cost of funds basis held FLB
mortgage rates well below rates available
from other lenders, encouraging still higher
demand for new borrowing.
To ease the burden of the rising cost of
funds on existing variable-rate borrowers and
todiscourage inordinately high demands from
new borrowers, some FLBs in early 1980 tem­
porarily fixed rates on existing loans and
adopted fees on new loans. The loan fees
reached as high as 6 percent in the spring.
Combined with a basic billing rate of 101/2
percent and the normal stock purchase re­
quirements, the rise in fees increased borrow­
ing costs at FLBs to market levels and contrib­
uted to the flat performance in new FLB
lending during the second half.
Government lending strong

Government agencies that lend to farmers
filled some of the slack left by commercial
lenders in 1980. In April concerns over low
farm income and a perceived shortage of

Econom ic Perspectives

credit from commercial lenders prompted
the Congress to extend and expand the Eco­
nomic Emergency Loan Program of the Far­
mers Home Administration (FmHA). The orig­
inal terminating date for that program was
extended from May 1980 to September 1981
and authorized outstandings for the program
were expanded from $4 billion to $6 billion.
Later in the year, widespread drought losses
triggered a surge in applications for the
FmHA's Disaster Loan Program. Such loans
are available at interest rates as low as 5 per­
cent to farmers who suffer a production loss
of 20 percent or more due to a natural
disaster.
Overall, farm debt held by the FmHA
rose 26 percent last year. The increase, al­
though less than the year before, extended
the FmHA’s record of disproportionately rapid
growth since the mid-1970s. The FmHA now
accounts for 15 percent of all institutionally
held farm debt, up from 7 percent in the
mid-1970s. Together, all government farm
lending agencies—the FmHA, the SBA, and
the Commodity Credit Corporation (CCC)—
now account for 20 percent of all institutional­
ly held farm debt, up from 8 percent in the
mid-1970s and the highest proportion since
the late 1950s when huge surplus stocks of

Federal Reserve Bank o f Chicago




grain rendered the CCC a major holder of
farm debt.
The rapid rise in the share of farm debt
held by government agencies reflects genuine
congressional concerns about saving the socalled family farm, supporting beginning
farmers, and protecting farmers from abnor­
mal economic and natural disasters. Despite
these concerns, the greatly expanded market
share of government agencies has triggered a
growing debate over the agencies’ proper
role in farm lending. The debate is largely
focused on the FmHA and involves questions
of degree of subsidization, the impact of
FmHA lending on commercial lenders, misallocation of resources, and whether the FmHA
is serving borrowers that would otherwise be
adequately served, given the risk standards of
commercial lenders. The outcome of the
debate will be partially reflected in legislation
that will replace the expiring farm program
statutes in 1981. Whatever the outcome, those
desiring a responsive government agency
role in farm lending have received an addi­
tional bargaining point from the impact of
volatile credit markets on farmers. It is clear
that government agencies have mitigated
much of the impact of credit market volatility
on the farm sector.

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