Full text of Economic Perspectives (Federal Reserve Bank of Chicago) : May/June 1984, Volume VIII, Issue 3

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ECONOMIC

PERSPECTIVES




m m

IM S

Bank mergers today: New guidelines,
changing markets
The right rabbit: Which intermediate
target should the Fed pursue?

(

ECONOM IC PERSPECTIVES

>1

C o n te n ts
Bank m ergers today: New guidelines,
changing m arkets

lice president and
associate director o f research
Randall C. Merris, research economist
Edward G. Nash, editor
Harvey Rosenblum,

graphics
typesetting
editorial assistant

Roger Thryselius,
Nancy' Ahlstrom,
Gloria Hull,

Econom ic Perspectives is
published by the Research Department of
the Federal Reserve Bank of Chicago. The
views expressed are the authors’ and do
not necessarily reflect the views of the
management of the Federal Reserv e Bank
of Chicago or the Federal Reserve System.
Single-copy subscriptions are avail­
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Articles may be reprinted provided
source is credited and Public Information
Center is provided with a copy of the
published material.

____________________________ /

ISSN 0164-0682




Bank mergers are being treated gently
as the Justice Department responds
to rapid and revolutionary changes
in the banking industry

The right rabbit: W hich interm ediate
target should th e Fed pursue?

Out of a wealth of candidates, only a few
have the proper credentials as intermediate
targets in the conduct of monetary policy

3

*5

B an k m e rg e rs to d ay : N ew g u id e lin e s,
c h a n g in g m ark ets
Jo h n J . D i C lem en te a n d D ian a A lam prese F ortier
In June of 1982, the Department o fju stice (the
Department) issued the long-awaited merger
guidelines, replacing those issued in 1968. The
guidelines have as their principal objective the
reduction of uncertainty associated with the
enforcement of the antitrust laws. This reduc­
tion of uncertainty is expected to assist manag­
ers in their expansion strategies by increasing
their understanding of the principles and stan­
dards involved in the Department’s antitrust
analysis. By issuing guidelines, the Department
reveals to the business community the nature
and extent of its antitrust evaluation.
The reduction of uncertainty regarding the
Department’s antitrust analysis is important.
Uncertainty is not costless. The predictability of
competitive problems is critical in the identifica­
tion of likely merger or acquisition candidates.
Some merger proposals make economic or finan­
cial sense (i.e., are profitable) only if they are
handled in a facile manner. Some mergers may
not be worthwhile if substantial amounts of legal
costs are required to defend the merger before
federal agencies or in the courts.1
In addition to affecting the choice of merger
candidates, uncertainty revolving around the
antitrust standard may also affect the timing of
merger proposals. This is reflected in the prepa­
ration of documents (e.g., merger applications
and supporting docum ents) relating to the
proposal.
If antitrust problems are perceived to exist
by the merging parties because they are uncer­
tain of the existing antitrust standard, an undue
length of time may be spent in preparing an
John J. Di Clemente and Diana Alamprese Fortier are
regulatory economists at the Federal Reserve Bank of Chi­
cago. This article extends and revises their article, “Antitrust
and Banking—Written and Revealed Standards,” appearing
in
(Winter 1984) pp. 11-19-

Issues in Bank Regulation

'Paul M. Horvitz, “Alternative Avenues to Interstate
Banking,”
Federal Reserve Bank of Atlanta
(May 1983), p. 37.

Economic Review,

Federal Reserve Bank o f Chicago




extensive antitrust defense where none is re­
quired. On the other hand, the merging parties
may believe that their proposal has little chance
of encountering opposition on antitrust grounds
and, therefore, be totally unprepared when the
issue is raised. Again, it will take a lengthy period
of time to prepare a rebuttal to an antitrust
challenge.
Thus, the Department issued the merger
guidelines to reduce the uncertainty surround­
ing the applicable antitrust standard and, there­
by, reduce the costs associated with this uncer­
tainty in the process. Business management has
m ore productive pursuits than wondering
whether contemplated mergers will pass anti­
trust scrutiny. The Department has established
criteria to indicate which mergers are likely not
to be challenged and which mergers are likely to
be challenged from an antitrust perspective.
The D epartm ent o fju stice criteria
The 1982 guidelines assume a structural
approach toward antitrust policy. With regard to
horizontal mergers, that is, mergers involving
firms in the same relevant market, the guidelines
focus on market structure and the change in that
structure as a result of merger proposals should
such proposals be consummated.2 To imple­
ment this policy the Department used the
Herfindahl-Hirschman Index (H H I) as a sum­
mary measure of market structure.3*5The guide­
lines establish classes of mergers that are likely
to be challenged by the Department based on
the post-merger level of the HHI and the change

2The guidelines are also concerned with conglomerate
and vertical mergers. Interested readers should consult the
guidelines for the standards regarding these types of mergers.
5The HHI is simply the sum of the squares of market
shares of each of the firms in the relevant market. Thus, the

3

Table 1
Department of Ju stic e Merger Guides
Post-merger
market concentration

Department responses

Increase in HHI

Highly concentrated
(HHI
1800)

Less than 50 points
Greater than 100 points
Between 50 and 100 points

Unlikely to challenge
Likely to challenge
Possible challenge*

Moderately concentrated
(1000
HHI
1800)

Less than 100 points
Greater than 100 points

Unlikely to challenge
Possible challenge*

Unconcentrated
(HHI
1000)

Not relevant

Unlikely to challenge

‘ The Department evaluates a number of additional factors in determining whether to challenge a merger in this
range. Readers should consult the guidelines for an explanation of these factors.

in the HHI resulting from the merger.4 Table 1
indicates the critical levels of the post-merger
HHI and increases in the HHI and the likelihood
of a challenge by the Department.
With issuance of the 1982 guidelines, the
business community is acquainted with the
Department’s u ritten standards. However, the
question remains whether the Department ad­
heres to these standards in its analysis of actual
merger proposals. If it does not, business is again
confronted with uncertainty and its attendant
costs.
The following sections address the Depart­
ment’s analysis of bank merger proposals under
the 1982 guidelines. All of the Department’s
competitive factors reports, for the period June
1982 through Decem ber 1983 that concluded
that mergers would entail substantially adverse
competitive effects, have been tabulated. It is4*
HHI for a market having the structure indicated below is

2200 .

Firm
A
B
C
D
E

Share (% )
30
20
20
20
10

Share2
900
400
400
400
100

2200
100
The HHI ranges from near zero (unconcentrated mar­
kets) to 10,000 (monopoly markets).
4The increase in the HHI as a result of a merger is twice
the product of the market shares of the merging firms. Thus,
from the preceding footnote, if Firm D merges with Firm E,
the resulting increase in the HHI would equal 400 points ( 20
x 10 x 2 ) and the resulting post-merger HHI would equal
2600.

4




hoped that this tabulation will shed some light
on the concentration levels and market shares
the Department deems critical in assessing bank
merger proposals. With this in hand, it may be
easier to judge whether a bank merger proposal
is likely to run into the Department’s opposition.
Com petitive factors rep ort
Section 1 8 (c ) of the Federal Deposit Insur­
ance Act (FDIA) provides, in part, that:
In the interests of uniform standards, before
acting on any application for approval of a
merger transaction, the responsible [bank­
ing] agency . . . shall request reports on
the competitive factors involved from the
Attorney General and the other two bank­
ing agencies . . .

The reports submitted under section 18( c )
assess on ly the competitive factors of the merger
and do not evaluate managerial, financial, or
convenience and needs factors that are required
to be considered by the agency which will ulti­
mately act upon the merger application. Further­
more, the antitrust standard embodied in sec­
tion 18( c ) is virtually identical to that contained
in section 7 of the Clayton Act. That is, the
responsible agency may not approve any merger
“which would result in a monopoly . . . or whose
effect in any section of the country may be sub­
stantially to lessen com petition” unless the
agency finds that the anticompetitive effects are
“clearly outweighed” by convenience and needs
considerations. Thus, it has been held that an

Economic Perspectives

agency may not deny a bank merger or acquisi­
tion on competitive grounds under this standard
except where the anticompetitive effects rise to
a violation of the antitrust laws.5
The importance of predicting whether the
Department will issue a “substantially adverse”
competitive factors report is obvious. First, such
reports are carefully considered by the banking
agencies in their merger analysis. Any discrep­
ancy in conclusions between the Department
and the banking agency must be carefully recon­
ciled. While each banking agency makes an
independent analysis of the probable com peti­
tive effects of each merger under its jurisdiction,
the views of the Department are accorded con­
siderable weight, even if conclusions may differ.6
Second, and perhaps more important, the
Department may sue to enjoin the merger.
Hence, even if the merger passes muster under
the analysis of the banking agency responsible
for acting upon it, the Department may, nonethe­
less, seek to prevent the merger under the anti­
trust laws. Indeed, section 1 8 (c ) directs the
responsible banking agency to notify the Attor­
ney General of any approval of a merger transac­
tion and delays consummation of the transaction
for 30 days after approval to allow the Depart­
ment time to intercede.7
The first eig h teen m on th s o f en fo rcem en t
In the first 18 months of antitrust enforce­
ment under the 1982 guidelines, the Depart­
ment issued 11 “substantially adverse” competi­
tive factors reports involving mergers or acquisi­
tions of banking organizations under Section
1 8 (c ) of the FDLA.8 In each merger it was found
that the substantial increase in concentration in
an already (highly) concentrated market, and

5County National Bancorporation v. Board o f Gover­
nors o f the Federal Reserve System , 654 F.2d 1253 ( 8th Cir.
1981); Mercantile Texas Corporation v. Board o f Governors
o f the Federal Reserve System , 638 F.2d 1255 (5th Cir.
1981); and Washington Mutual Savings Bank v. FDIC 482
F.2d 459 (9th Cir. 1973).

6See, for example, St. Joseph Valley Bank, 68 Federal
Reserve Bulletin 673 (1 9 8 2 ).
7Shorter waiting periods are provided for mergers
requiring expeditious action.

Federal Reserve Batik o f Chicago




the decrease in the number of banking alterna­
tives in the relevant market would result in a
substantial lessening of competition in the rele­
vant geographic area.9
The relevant m arkets
In order to determine the lawfulness of any
proposed merger under the antitrust laws, the
appropriate question to be addressed is whether
the effect of the merger would be to substantially
lessen competition in any line of commerce in
any section of the country. This requires a
determination of the relevant geographic and
product markets prior to any structural analysis.
G eographic m arket
In determining the relevant geographic
market ( “section of the country” ) in the 11 sub­
ject mergers, the Department approximates that
area where the banks com pete and where cus­
tomers can practicably turn for alternative bank­
ing services.10
The Department considers several factors
in determining that area in which bank custom­
ers who are neither very large nor very small find
8A11 competitive factors reports issued by the Depart­
ment between June 14,1982 and December 31,1983 involv­
ing mergers or acquisitions between depository institutions
in which the competitive effects were deemed to be substan­
tially adverse were requested. Eighteen such reports were
received. Hereafter, for the purpose of simplicity, all subject
transactions will be referred to as mergers. For reasons of
consistency and uniformity, this article analyzes only the 11
mergers filed under the FDIA. Of the remaining seven
reports, four were issued to the Federal Home Loan Bank
Board, involving transactions between savings and loan asso­
ciations, and three were issued to the Board of Governors of
the Federal Reserve System, involving transactions under the
Bank Holding Company Act. An analysis of the thrift mergers
is available from the authors upon request.
9In only one merger was the market not classified as
highly concentrated subsequent to the proposed transaction
Since June of
1982 the Department has issued no substantially adverse
competitive factors reports involving market extension
mergers of depository institutions.

( Commercial National Bank o f Little Rock).

10 “ . . . the area of effective competition in the known
line of commerce must be chartered by careful selection of
the market area in which the seller operates, and to which
the purchaser can practicably turn for supplies, . . . ”
v.
374 U.S. 321, 359 (1 9 6 3 ).

Philadelphia National Bank

U.S.

5

it practical to do their banking business. Among
the factors the Department takes into account
are: (1 ) the d istan ce b etw een the m erg­
ing parties; ( 2 ) the distance and travel time to
the nearest banking alternative and ease of
transportation betw een banking alternatives;
( 3 ) worker commuting patterns; ( 4 ) shopping
patterns; ( 5 ) the location of employment, social,
and governmental centers; ( 6 ) the economic
base of the community (e.g., agricultural or
industrial); ( 7 ) advertising coverage by various
media (television, radio, print); and ( 8 ) the
locations of other major services (e.g., colleges,
hospitals, airports).
Product m arket
The Department has used two different
product markets in its bank merger antitrust
analysis: wholesale banking services and retail
banking services. By using the wholesale prod­
uct market, the Department adheres to the doc­
trine that commercial banking is a distinct line of
commerce identified as “the cluster of products
(various kinds of cred it) and services (such as
checking accounts and trust administration)
denoted by the term ‘commercial banking’.”11
Wholesale banking services are defined by the
Department as generally those services provided
to commercial customers, including demand
deposit accounts, time and savings accounts, and
commercial loans. This product market, in the
Department’s view, is composed of commercial
banks.
By also defining the relevant product market
as retail banking services, the Department has
taken into account the thrust of changes in the
financial services industry as a result of the De­
pository Institutions Deregulation and Monetary
Control Act of 1980 and the Garn-St Germain
Depository Institutions Act of 1982. In so doing,
the Department seems to be indicating that the
banking industry is at a stage where it may be
unrealistic to distinguish savings banks and sav­
ings and loan associations from commercial
11US. v. Philadelphia National Bank at 356; U.S. v. Phillipsburg National Bank 399 U.S. at 360 ( 1970); and U.S. v.
Connecticut National Bank 418 U.S. at 664 (1974 ).

6




banks for purposes of the antitrust laws.12Among
the retail banking services provided to individual
( noncom m ercial) customers, as defined by the
Department, are transaction accounts, time and
savings accounts, consumer loans, and residen­
tial mortgage loans. Both commercial banks and
thrifts (generally) are considered by the Depart­
ment as part of this product market.
C haracteristics o f th e m ergers
The salient characteristics of the 11 mer­
gers are presented in Table 2. Two mergers
were appraised by the Department using only
the product market of wholesale banking ser­
vices (N ev ad a B a n k & Trust Co. and C itizens
A m erican B an k, N A .). There were also two
mergers analyzed using only retail banking ser­
vices as the relevant product market (N a tio n a l
B a n k & Trust Co. o f N orw ich and The B an kin g
C en ter).Xi In the remaining seven mergers, the
Department’s structural analysis was premised
on the use of both relevant product markets—
wholesale banking services and retail banking
services.
Market co n cen tratio n
Whether using wholesale or retail banking
services as the relevant product market, in all but
one case the markets were highly concentrated
(HHI greater than 1 8 0 0 ) subsequent to con­
summation of the proposed transaction. With
respect to wholesale banking, the high, median,
and low post-HHI for the eight highly concen-

U.S.

Connecticut National Bank
Economic Perspectives

,2See
v.
at 665. For
information on these acts see:
, Fed­
eral Reserve Bank of Chicago ( September/October 1980)
and
, Federal Reserve Bank of Chicago
(March/April 1983).

Economic Perspectives

Nevada Bank & Trust Co.

,}In
the two subject banks
held 96.5 percent of the market deposits and two public
credit unions together held an insignificant 3-5 percent of
the market’s total deposits. In
it was concluded that the inclusion of thrift institutions
would have a negligible impact on market concentration.
dealt with the merger of two mutual
savings banks.
involved two banks located in markets where thrifts have
traditionally been considered to provide significant competi­
tion to commercial banks.

Citizens American Bank, N.A.

The Banking Center
National Bank & Trust Co. o f Norwich

Economic Perspectives

Table 2
Bank M e rg ers and th e 1 9 6 2 D ep artm e n t of Ju stice M e rg e r G uidelines

F ed eral R eserve B an k o f C hicago

M ergers
(D a te o f D e p a rtm e n t
o f J u s tic e R e p o r t )3*
First N a tional Bank o f
South C a rolina /Th e Bank
o f Lancaster a n d
Central C arolina Bank

A c q u ir in g o r g a n iz a t io n
D e p o s it s
ra n k
sh a re %
( $ m il.)* 5

N ational Bank and Trust
Company o f N o rw ic h /
N ational Bank o f O xfordd

F o u r - f ir m
c o n c e n tra tio n
Post
P re

1st

4023

6132

2109

100

100

2 5 .2

1st

1912

2333

421

N .A .

N .A .

15

4 .5

7 th

3262

3750

488

79 8

2nd

9

6 4 .8

1st

5216

9324

4108

100

267

1 4 .0

4 th

1335

1712

377

6 6 .0

9 .0

6 th

925

1171

246

4 .9

6 th

1525

1813

288

N .A .

8 .2

N .A .

242

5 4 .2

1st

4

3 1 .7

(c o m m o n ly o w n e d b a n k s )
(A u g . 2 5 . 1 9 8 2 )

H e r f in d a h l- H i r s c h m a n
In d e x
Post
C hange
P re

5 7 .2

1 8 .3

825

O r g a n iz a t io n t o b e a c q u ir e d
D e p o s it s
ra n k
sh a re %
( $ m il . )b
50

Type of
m a rk e t0

R u ral

A p p ro ved
(N o v . 1 5 , 1 9 8 2 )

84 3

R u ral

A p p ro ved
(A p r il 8 . 1 9 8 3 )

100

R u ral

P e n d in g
A p p ro ved
(M a y 2 7 , 1 9 8 3 )

(S e p t. 10, 1 9 8 2 )

Nevada Bank and Trust
Com pany/N evada N a tional
Bank ( b r a n c h ) e

Agency
d e c is io n
(D a te )

(N o v . 9 . 1 9 8 2 )

Com m ercial N a tional Bank
o f L ittle R ock/The First
N ational Bank in L ittle Rock

1 4 .0

2nd

1 0 .0

4 th

627

2 8 .7

1st

103

64

3 7 .8

1st

48

280

(D e c . 3 . 1 9 8 2 )

The Banking Center/The
W oodbury Savings Bankd

(D e c . 6 , 1 9 8 2 )

O ld N a tional Bank
o f M artin sburg/
Citizens N a tional Bank
o f M artinsburg

(D e c . 1 3 . 1 9 8 2 )

First N a tional Bank
o f M a yfie ld /
The Exchange Bank

27

(D e c . 1 6 . 1 9 8 2 )

Citizens Am erican Bank,
N .A ./S ta te Bank
o f Green Valleye

(J a n . 1 4 . 1 9 8 3 )

F irst S e cu rity Bank
o f Utah. N .A ./
Bank o f Iron C ounty

38
1 ,7 0 0

(M a r c h 9 . 1 9 8 3 )

Peoples Trust Bank/
Indiana Bank and Trust
Company

295

The Peoples N a tional Bank
Bank o f Central
Pennsylvania / Farmers
C om m unity Bank

110

(J u n e 3 0 . 1 9 8 3 )

(N o v . 1 8 . 1 9 8 3 )

3 2 .7

1st

2 2 .6

2nd

1 2 .2

4 th

1 5 .9

3 rd

21
20

4 0 .2

1st

3 3 .3

1st

1 7 .9

3 rd

1 4 .4

3 rd

2 3 .3

3 rd

16 2

4 th

22

341

52

7 4 .0

U rb a n

5 9 .0

U rb a n

6 7 .0

7 2 .0

U rb a n

A p p ro ved
(F e b . 2 8 . 1 9 8 3 )

R u ral

A p p lic a tio n
W it h d r a w n
(J a n . 2 4 , 1 9 8 3 )

R u ral

D e n ie d
(A p r il 2 0 , 1 9 8 3 )

D e n ie d
(M a r c h 2 . 1 9 8 3 )
D e n ie d
(J u n e 2 2 . 1 9 8 3 )

2 3 .5

2nd

2759

4536

1777

100

100

2 0 .4

2nd

2191

3525

1344

8 6 .6

9 7 .5

1 8 .3

3 rd

3384

4211

827

98 8

N .A .

9 .8

5 th

2083

2322

239

8 4 .0

9 3 .8

7 .3

6 th

1849

2082

233

7 7 .5

8 4 .8

R u ral
R u ral

1 7 .9

3 rd

2986

4429

1443

9 5 .1

100

14 8

3 rd

2237

3225

988

8 7 .5

9 2 .1

1 6 .2

4 th

2191

2769

578

89 5

9 7 .4

1 3 .1

4 th

1574

1951

377

7 2 .3

8 2 .7

1 1 .1

4 th

2139

2656

517

8 8 .0

9 1 .8

7 .7

5 th

1971

2219

248

8 4 .0

9 1 .7

U rb a n

D e n ie d
(A u g . 1 5 , 1 9 8 3 )

U rb a n

P e n d in g
(F e b 1 6 . 1 9 8 4 )

3 C a s e s a r e l i s t e d in c h r o n o l o g i c a l o r d e r b y d a t e o f c o m p e t i t i v e f a c t o r s r e p o r t . b D e p o s i t d a t a r e p r e s e n t t o t a l b a n k d e p o s i t s ( n o t m a r k e t d e p o s i t s ) a n d a r e in m il lio n s o f d o l l a r s .
c A m a r k e t is d e s i g n a t e d a s u r b a n i f it is in w h o l e o r in p a r t a n S M S A o r R M A ; o t h e r w i s e , t h e m a r k e t is d e s i g n a t e d a s r u r a l. d O n l y r e t a i l p r o d u c t m a r k e t w a s u s e d in c o m p e t i t i v e f a c t o r s
 r e p o r t . e O n l y w h o l e s a l e p r o d u c t m a r k e t w a s u s e d in c o m p e t i t i v e f a c t o r s r e p o r t . N . A . N o t a v a i l a b l e in c o m p e t i t i v e f a c t o r s r e p o r t .


trated markets were 9324, 4320, and 2082,
respectively. Using retail banking as the relevant
product market lowers these figures significant­
ly to high, median, and low post-HHI of 3750,
2328, and 1813, respectively. The only market
that was not highly concentrated had a post-HHI
of 1712 using wholesale banking services and
1171 using retail banking services as the relevant
product market.
While the basis of the structural analysis in
the guidelines is the post-HHI and the change in
the HHI, the four-firm concentration ratio was
discussed in each merger. Apparently, this ratio
still has some significance in the Department’s
antitrust appraisal. A look at market concentra­
tion using the concentration ratio provides a
rough comparison to the old ( 1 9 6 8 ) guidelines.
Of the eight wholesale markets classified as
highly concentrated under the 1982 guidelines,
all have a concentration ratio greater than 75
percent prior to the transaction, and hence
would be considered highly concentrated under
the 1968 guidelines. Similarly, of the eight highly
concentrated retail markets pursuant to the
1982 guidelines, all but two are also highly con­
centrated according to the 1968 guidelines
prior to the proposed transaction.
Relative size an d ch an g e in HHI
In all cases the increase in the HHI resulting
from the proposed merger significantly exceeds
the thresholds of challenge outlined in the
guidelines. The smallest increase in the HHI, 233
points, resulted from a merger between the third
largest and sixth largest banks in the market with
15.9 percent and 7.3 percent market shares,
respectively (C itizen s A m erican B an k, N A .).
The largest increase in the HHI, 4 1 0 8 points,
involved a merger betw een the top two banks in
the banking market, controlling 64.8 percent
and 3 1 7 percent of market deposits (N ev ad a
B a n k & Trust C o.). The smallest and largest
increases in the HHI for all markets (i.e., both
retail and wholesale markets) occurred in whole­
sale banking markets.
Focusing on retail product markets, the
smallest increase in the HHI is 2 3 9 points result­

8




ing from the combination of the fourth and fifth
largest banks in the market, holding 12.2 percent
and 9 8 percent of market deposits (F irst N a­
tio n a l B a n k o f M ay field ). Notice that this HHI
figure is not significantly different from that in
the wholesale markets. However, the largest
increase in the HHI for retail markets is 1344
points, which is significantly lower than that for
wholesale markets. The 1344 point increase in
the HHI involved the merger of the two largest
banking organizations in the relevant market,
controlling 32.7 percent and 20.4 percent of
total market deposits ( O ld N a tio n a l B a n k o f
M artin sbu rg).
As indicated, the large relative size of the
subject organizations contributed directly to the
prohibitively large increases in the HHI. In all but
two of the eight wholesale markets, one of the
merging parties is either the largest or second
largest organization in the market. And in the
two exceptions, the acquiring banks ranked
third largest in the relevant market. Similarly, for
the eight mergers using retail product markets,
five involved the largest organization in the
market.
Absolute size
Percentages aside, small absolute size seems
to provide no barrier to the issuance of a signifi­
cantly adverse competitive factors report by the
Department.14 Although three mergers involved
an acquiring organization that ranked among the
ten largest financial institutions in the state, the
remaining cases all involved organizations with
less than 35342 million in total market deposits.
Indeed, of these eight mergers, the median size
of the acquiring organization was $87 million in
total market deposits, whereas the median size
of the acquired firm was only $35 million in total
market deposits.

H“Mergers of directly competing small commercial
banks in small communities, no less than those of large banks
in large communities, are subject to scrutiny under these
standards. Indeed, competitive commercial banks play a par­
ticularly significant role in a small community unable to
support a large variety of alternative financial institutions.”
v.
at 356.

US. Phillipsburg National Bank

Economic Perspectives

Actual e n fo rcem en t
All eleven mergers significantly surpassed
the 1982 guidelines’ structural thresholds indi­
cating likelihood of a challenge by the Depart­
ment. Notwithstanding the violations of the
guidelines, only four mergers were denied by the
relevant bank regulatory authority. Two mergers
( O ld N a tio n a l B a n k o f M artin sbu rg a n d Ne­
v a d a B a n k & Trust C o.) were withdrawn.
Another merger remains pending before the
Comptroller ( The P eoples N ation al B a n k o f
C en tral P en n sy lv an ia ) .
O f the four mergers approved by the bank
regulatory agencies, the Department has filed
suit in only one ( N atio n a l B a n k & Trust Co. o f
N orw ich) . 15 In determining whether to litigate,
the Department reviews all its competitive fac­
tors reports in which the competitive effects
were considered to be substantially adverse.
Additional information pertinent for a more indepth antitrust analysis is sometimes requested.
Such information may be obtained from other
banking organizations and bank customers as
well as other sources.
Differing analyses
Each bank regulatory agency, in ruling upon
mergers between depository organizations, uses
the Department’s guidelines as an aid in its analy­
sis. Although each of the approved mergers vio­
lated the structural criteria of the 1982 guide­
lines, each banking agency also considered other
nonstructural factors that lessened the anticom­
petitive effects implied from a purely structural
analysis.
There are several differences between the
analysis used by the Department in issuing its
substantially adverse competitive factors reports
and that used by the relevant regulatory agency
in reaching its approval on the same merger. One
is the consideration of convenience and needs
factors, and the conclusion that such factors

"US. National Bank & Trust Co. o f Norwich

v.
No. 83
CIV 537 (N.D. N.Y., filed May 6 ,1 9 8 3 ). The Department has
filed a consent decree to end this suit. The decree calls for
the divestiture of two branch offices and an end to defen­
dant’s home office protection.

Federal Reserve Bank o f Chicago




outweigh the anticompetitive effects of the pro­
posed transaction (T h e B an kin g C en ter). An­
other difference was in a basic premise of the
analysis, the determination of the relevant geo­
graphic market ( F irst N a tio n a l B a n k o f South
C arolin a, N a tio n a l B a n k a n d Trust Co. o f N or­
w ich, and C om m ercial N ation al B an k o f L ittle
R o ck ) . ( For an elaboration on the basic premises
of the structural analyses, see the following sec­
tion. ) Approval also resulted from an analysis of
“nonstructural factors” of the merger, i.e., sec­
tions III(B ) & III(C ) of the guidelines. Among
such factors considered were ease of entry and
market characteristics (N a tio n a l B a n k & Trust
Co. o f N orw ich and The B an kin g C enter).
The Comptroller, unlike the Department,
also extended its analysis beyond mere market
shares (N a tio n a l B a n k & Trust Co. o f N orw ich
and C om m ercial N atio n a l B a n k o f L ittle R ock) .
As indicated in section 11(D) of the 1982 guide­
lines, a firm’s market share may overstate or
understate its true competitive influence.16
Continuing u n certainties
Evidence from the first year and one-half of
operation under the guidelines indicates that the
bank regulatory agencies and the Department
differ somewhat in their antitrust analyses. Also,
it is clear that the Department becomes con­
cerned with bank mergers only when the guide­
lines are significantly surpassed.
That the Department’s application of the
merger guidelines in the sphere of commercial
banking differs significantly from the thresholds
as stated in the guidelines should not be viewed
as an inconsistency. The reason for this is that the
guidelines a ssu m e that the major premises of the
structural analysis—the relevant markets—are
properly defined. In regard to commercial bank­
l6By using total organization deposits rather than market
deposits and market share, the Comptroller in this particular
instance
employs the theory that the competitive ability (market
power) of a firm within a relevant market should not be
measured only by its presence in the market but also should
include all or part of its services provided outside of the
market. On this point see, William Landes and Richard
Posner, “Market Power in Antitrust Cases” 94
937 at 963-67.

(National Bank & Trust Company o f Norwich)

Review

Harvard Law

9

ing, it is not at all clear as to what precisely are
the relevant product and geographic markets.
Thus, market shares calculated using wholesale
or retail banking as the product markets and
countywide approximations as the geographic
markets will not generally possess the signifi­
cance they might when markets are more accu­
rately defined. The ambiguities of market defini­
tion that rob market shares and concentration
measures of their ordinary significance are dis­
cussed below. It is important, therefore, to be
aware of the differences between the Depart­
ment’s written standards as expressed in the
guidelines and the revealed standards as ex ­
pressed in the competitive factors reports under
discussion. It is likely that these differences exist
because o f market definition problems. The
Department is well-advised to be more lenient in
seeking to apply the merger guidelines to com ­
mercial bank amalgamations.
Product m arket issues
A long line of court decisions regarding the
relevant product market in commercial bank
merger cases has held that commercial banks
compete only with other commercial banks. P hil­
a d elp h ia N atio n a l B a n k 17 represented the first
time the antitrust laws of the U.S. were applied to
commercial bank mergers by the Supreme Court.
The Court determined that commercial banks
were unique institutions that were more or less
insulated from the competition provided by
other financial services firms based on the
unique “cluster” of products and services offered
by commercial banks.
This rationale has been upheld by the
Supreme Court in later decisions, notably in Phillipsbu rg N ation al B a n k 18 and C on n ecticu t N a­
tio n a l B a n k .19 Lower courts also have generally
followed the lead of the Supreme Court in this
matter, as have the bank regulatory agencies.
And, to a great extent, the Department is bound
l7U.S. v.
(1963).
I8U.S. v.
(1970).
19U.S. v.
(1974).

10

Philadelphia National Bank

374 U.S. 321

Phillipsburg National Bank

399 U.S. 350

Connecticut National Bank

418 U.S. 656




by these prior decisions. Yet much has happened
in the years following the Supreme Court’s most
recent affirmation of its product market deter­
mination in 1974.
Market forces and legislative and regulatory
change have served to erode the commercial
banking cluster argument to such an extent that
it is now unreasonable to consider commer­
cial banking a distinct line of commerce. The
market forces that compelled legislative and
regulatory change are by now well known.
Foremost among these market pressures were
the high and volatile interest rates associated
with the latter 1970s that caused bank and thrift
deposit rate ceilings to bind and that subse­
quently resulted in severe bouts of disintermedi­
ation. During this period, new, unregulated insti­
tutions and instruments were developed; the
money market mutual fund is the most promi­
nent manifestation. Finally, technological ad­
vances in the processes of collecting, storing,
manipulating, and transmitting data have revolu­
tionized cash management and facilitated innova­
tions such as sweep accounts. The advances in
technology have made entry into banking (at
least in a d e fa c t o sense) easier, thereby reduc­
ing barriers to competition between depository
and nondepository financial institutions.
The market forces compelling these changes
have pressured legislators to liberalize restric­
tions on depository institutions, especially those
restrictions related to thrift institutions. The
Depository Institutions Deregulation and Mone­
tary Control Act of 1980 and the Garn-St Ger­
main Depository Institutions Act of 1982 have
far-reaching effects with respect to the com peti­
tiveness of thrifts vis-a-vis commercial banks.
The Monetary Control Act authorizes all
federally chartered savings and loan associations
to offer nonbusiness negotiable order of with­
drawal (N O W ) accounts; invest up to 20 per­
cent of assets in consumer loans, commercial
real estate loans, commercial paper, and corpo­
rate debt securities; issue credit cards and
extend credit in connection therewith; and
apply for trust and fiduciary powers under re­
strictions and protections similar to those appli­
cable to national banks. In addition to the
expanded powers granted savings and loan asso­

Economic Perspectives

ciations, federal mutual savings banks were
authorized to invest up to 5 percent of assets in
commercial loans and to accept demand depos­
its in connection with commercial, corporate,
and business loan relationships.
Through the Monetary Control Act, feder­
ally chartered thrifts were able to offer individu­
als the convenience of “one-stop shopping” and,
in effect, becom e their “department store of
finance.” Nevertheless, the Monetary Control
Act did little to aid thrifts in serving the business
customer. Without expanded powers to make
loans to commercial enterprises, thrifts were not
likely to be viewed as full competitors of com ­
mercial banks.
With Garn-St Germain, the resemblance of
federally chartered thrifts to commercial banks
becom es even greater. The ability of thrifts to
provide services to commercial enterprises was
enhanced in the interest of preserving the viabil­
ity of thrifts. The act increases the percentage of
assets that may be invested in commercial real
estate and consumer loans to 40 percent and 30
percent, respectively. In addition, thrifts are
permitted to invest up to 10 percent of capital
and surplus in state and local securities and
invest up to 10 percent of assets in personal
property (leasing). Most important, however, is
the authority granted thrifts to invest up to 10
percent of assets in secured or unsecured com ­
mercial loans ( “pure” commercial loans) and to
offer demand deposits to business customers
with whom the thrift has a business, corporate,
commercial, or agricultural loan relationship.
These expanded powers granted under Garn-St
Germain allow a federally chartered thrift to
invest up to 75 percent of its assets in com m er­
cial investments.
While commercial banks and thrifts may be
different entities with different missions, the dif­
ferences between them are not substantial in an
antitrust perspective. It is problematic whether
the new powers granted thrifts will be enough to
qualify them as being within the line of com ­
merce of bank mergers. In this vein, the Supreme
Court indicates that in delineating a line of
comm erce
its contours must, as nearly as possible, con­
form to competitive reality. Where the area

Federal Resente Bank o f Chicago




of effective competition cuts across indus­
try lines, so must the relevant line of
comm erce . . .20

Thus, in C o n tin en tal C an , the Court held
that because of the in terin d u stry competition
between glass and metal containers, it was
necessary to treat as a relevant product market
the combined glass and metal container indus­
tries, noting that for some end uses glass and
metal containers did not and could not compete.
Indeed, co m p lete in d u stry o v erla p n eed n ot b e
show n .
In reality, a federal thrift might closely
resemble a commercial bank, notwithstanding
the percentage of asset limitations on commer­
cial assets available for investment and the pro­
hibition on offering demand deposits to individ­
uals. Although technically more limited, the
powers granted thrifts under the Monetary Con­
trol Act and Garn-St Germain suggest that serious
consideration be given to including thrifts in the
line of com m erce.21
However, to limit the line of commerce in
bank mergers to thrifts and commercial banks
would be irrational. Competition must be rec­
ognized where, in fact, competition exists.22 The
Department has recognized the expanded pow­
ers of thrifts to some extent. This recognition is
manifested in its dichotomy of banking into
wholesale and retail banking in several of the
mergers herein reported. The presence of thrifts
alone would serve to erode the significance of
bank market shares and concentration measures.
Yet, the Department must also be cognizant of
the competition afforded commercial banks by
nondepository institutions. The presence of a
20U.S. v.
(1 9 6 4 ).

Continental Can Company 378 U.S. 441, 457

2'The Board of Governors has taken cognizance of the
expanded powers of thrift institutions:
. . . thrift institutions have becom e, or at least have the
potential to beco m e, m ajor com petitors o f com m ercial
banks not only in the provision o f consum er banking ser­
vices but also in th e provision o f com m ercial lending ser­
vices. These developm ents, coupled with the size and
market share held by thrift institutions in numerous
markets, persuaded the Board that in many cases the com ­
petition afforded by thrift institutions to com m ercial banks
may be substantial.
69
299 ( 1983).

First Tennessee National Corp.,
Federal Reserre Bulletin

2iBrown Shoe Company

v.

U.S.

370 U.S. 294, 326

( 1962).

11

substantial number of nondepository com peti­
tors in various submarkets, such as business
loans, consumer loans, and trust services that
comprise the “cluster” of commercial bank ser­
vices has been documented in a number of stud­
ies by the Federal Reserve Bank of Chicago.23 In
addition to these studies, a number of surveys
have revealed that businesses, particularly small
businesses, obtain financial services from a broad
spectrum of financial services providers aside
from commercial banks and thrifts.24
Moreover, although commercial bank chief
executive officers feel that other local or regional
banks provided the current source of their most
significant competition, a large percentage of
these executives mentioned thrifts (6 4 percent)
and brokerage and insurance firms (3 5 percent)
as providing significant competition.25 More
important perhaps is the impression held by the
bank executives that Sears, Merrill Lynch, Shearson/American Express, Prudential-Bache, and
E. F. Hutton will be their major competitors by
1990. The first three of these organizations are
presently viewed as strong competitors by the
bank executives (see Table 3 ).
Thus, even though the competition pro­
vided by thrifts and nondepository institutions is
difficult to quantify, it must neither be ignored
nor understated. Because of the difficulty of
coming to grips with nonbank competition, the
Department is justified in not relying solely on
the HHI thresholds contained in its guidelines in
assessing bank mergers. The apparent liberaliza-

Table 3
Strong competitor
Now
By 1990

Institution
Sears
Merrill Lynch
Shearson/American Express
Prudential-Bache
E. F. Hutton
Kroger
Aetna

83%
47%
38%
15%
12%
1%
—

86%
85%
70%
40%
25%
11%
9%

SOURCE: American Banker, March 15, 1984. Table reflects
the percentage of bank chief executive officers surveyed
responding to whether the listed institutions are regarded as
strong competitors to commercial banks.

tion of the guidelines in the case of bank mergers
is a reasonable position to take given the uncer­
tainties of product market definition.
G eographic m arket issues
Uncertainties in the definition of the rele­
vant product market engender uncertainties in
the definition of the relevant geographic market
in bank mergers. The delineation of the appro­
priate section of the country as an economically
viable and realistic geographic market is not
without theoretical and practical problems.
The m arket in th e o ry and p ractice

24For example, see P. Watro, “Financial Services and
Small Businesses”,
(January 11,
1982), Federal Reserve Bank of Cleveland and V. Andrews
and P. Eisemann, “Who Finances Small Business Circa
1980?”,
, The Interagency
Task Force on Small Business Finance (1 9 8 1 ).

Theoretically, a geographic market is that
area which encompasses those buyers and sellers
that exert and react to common demand and
supply forces that determine the price and qual­
ity (nonprice attributes) of a particular output.
Although there is agreement conceptually on
the definition of a market there is less agreement
in practice as to the proper delineation of a
geographic market. The lack of a single definitive
and pragmatic method of determining the appro­
priate geographic market is evident in the differ­
ing methodologies used by the courts and regu­
latory agencies.26

25
, March 15, 1984, p. 4. These are
excerpts from a national survey of bank chief executive
officers compiled by Egon Zehnder International, a man­
agement consulting firm. Chief executive officers of the
nation’s largest 2,000 banks were surveyed.

25Discussion of the relevant product and geographic
market is continued in Section IIA-IID of the Department’s
guidelines.

2,H. Rosenblum and D. Siegel, “Competition in Financial
Services: The Impact of Nonbank Entry”,
(May 1981); H. Rosenblum and C. Pavel, “Financial Services
in Transition: The Effects of Nonbank Competitors”,
(January 1984); and H. Rosenblum, D.
Siegel, and C. Pavel, “Banks and Nonbanks: A Run for the
Money”,
, Federal Reserve Bank of
Chicago (May/June 1983), pp. 3-12.

Memorandum 84-1
Economic Perspectives

Staff Study 83-1
Staff

Economic Commentary

Studies o f Small Business Finance

American Banker

12




Economic Perspectives

Having determined in prior Supreme Court
bank merger cases that the relevant product
market is commercial banking, the task remained
to define a relevant geographic market both con­
sistent with econom ic theory and the commer­
cial realities of the banking industry. This market
must encompass that area where the competi­
tive effects of the merger would be direct and
immediate given the location of the merging
banks and the practical alternatives available to
customers. In this case, practical alternatives are
considered other commercial banks.27
Recognizing that in the cluster of banking
services some services/products are more local
in nature than others, and that each customer’s
econom ic scale determines his range of practical
alternatives of bank services, the Court faced a
dilemma. It was concluded that the antitrust
standard for analysis should focus on the locallylimited customer, i.e., consumers and small
businesses. Thus, geographic markets were de­
termined to be the localized area encompassing
the parties to the merger.28
In applying this standard, the Department
and the bank regulatory agencies disagree on the
appropriate methodology to determine the geo­
graphic market.29 This is evident in agency
approvals of bank mergers where the Depart­
ment has issued substantially adverse com peti­
tive factors reports. This is not surprising con­
sidering that the practice of geographic market
definition is more of an art than a science and
includes a good deal of judgment. Even if one
a ssu m es the relevant product market to be
commercial banking, the determination of the
geographic area in bank mergers is subject to
dispute.
As market forces and regulatory and legisla­
tive change have affected the appropriate prod­
uct market relevant to bank mergers, so too have
they influenced relevant geographic markets. As

far back as 1965, the lower courts divided the
commercial banking business into two distinct
product submarkets, wholesale accounts and
retail accounts. Each was found to have a differ­
ent geographic market.50
Over the past decade, the U.S. has witnessed
a relaxation of legal barriers to entry in terms of
the liberalization of state branching laws and
holding company bank expansion both intra­
state and interstate. In addition, the Board of
Governors has significantly broadened the array
of bank-like services that bank holding compan­
ies may offer without geographical constraint.51
Moreover, unregulated financial services con­
cerns providing bank-like services are not bound
by the geographic constraints faced by banking
institutions.
Perhaps more important than the relaxation
of legal restraints on location are the develop­
ments in technology that serve to reduce trans­
actions costs, facilitating competition over wider
geographic areas. This can be observed in the
development and expansion of ATM networks,
videotex home banking services, and banking by
mail and telephone.
In light of the above, the once locallylimited banking customer is now confronted
with a broader range of financial services pro­
viders serving a broadened geographic area.
Inasmuch as these important developments are
extremely difficult to assess quantitatively, a
strick application of the Department’s guidelines
to commercial bank mergers is inappropriate.52
C onclusion
Based on this limited sample of mergers, it
appears that the Department becomes concerned

Manufacturers Hanoi>er Trust Co., 240 F. Supp.

v.
867 (S.D.N.Y. 1965).

27Philadelphia National Bank at 359; Phillipsburg Na­
tional Bank at 362 and Connecticut National Bank at 668.
28Philadelphia National Bank at 360-61 and Phillips­
burg National Bank at 363-64.

spectives,

29See Paul R. Watro, “Geographic Banking Markets,”
(September 12, 1983), Federal
Reserve Bank of Cleveland.

32This view is expressed in a forthcoming Federal
Reserve Board
by Jim Burke, “Antitrust Laws and
the Limits of Concentration in Local Banking Markets.”

Economic Commentary

Federal Reserve Bank o f Chicago




J1Sue F. Gregorash., “Seventh District: Leader or Fol­
lower in the Interstate Banking Movement?”
Federal Reserve Bank of Chicago (March/April
1984). Also see Federal Reserve System Regulation Y (12
CFR Part 225).

Economic Per­

Staff Study

13

and comments on those mergers which would
sig n ifican tly surpass the thresholds of the guide­
lines’ structural criteria. As we have discussed,
the Department is justified in not opting for a
strict application of the guidelines in bank
mergers because of the uncertainties associated
with the definition of the relevant markets. It
should be noted that in all its competitive factors
reports the Department notes that its analysis,
which is based solely on information in the sub­

14




ject merger application and other available facts,
“is not intended, and should not be relied upon,
as precedent or policy” of the Department’s
Antitrust Division. Notwithstanding this dis­
claimer, which, if taken seriously, would render
the reports essentially otiose, competitive fac­
tors reports do provide guidance to interested
parties, including the bank regulatory agencies,
concerning the application of the merger guide­
lines by the Department.

Economic Perspectives

T h e rig h t rab b it: W h ich in te rm e d ia te ta rg e t
sh o u ld th e F ed p u rsu e?
G illian G arcia
The importance of monetary policy to economic
well-being is widely acknowledged. Given the
recurring problems of recession and inflation
that have plagued the U.S. and the world econo­
mies for the past two decades, there is general
interest in attempts to improve the conduct of
monetary policy. During the 1970s and the early
1980s monetary policy has been conducted
using an intermediate targeting approach. This
paper discusses the relative merits and demerits
of the several alternative candidate intermediate
targets.
The Federal Reserve uses one or more
intermediate targets when it conducts monetary
policy because it believes that it operates more
effectively this way than if it directed its tools
immediately at its ultimate objectives. Under
intermediate-targeting, the Fed first sets goals
for the final economy in terms of the rate of
g r o w th o f final o u tp u t an d th e ra te o f in flation . It

then estimates the level or the growth rate for its
intermediate target or targets that are most con­
sistent with achieving these ultimate goals. Finally
it sets its policy instruments at levels commensu­
rate with hitting the intermediate target. That is,
policy is conducted according to the schema

Note the use of an indicator in the conduct of
monetary policy. This is some variable (n ot one
of the final objectives) which is influenced by
monetary policy and which gives early informaGillian G. Garcia is a senior economist at the Federal
Reserve Bank of Chicago. The author thanks Thomas A. Gittings, Anne Marie Gonczy, and Harvey Rosenblum for com­
ments on an earlier draft of this paper and Gus Backer for
competent research assistance.

Federal R esent Bank o f Chicago




tion on the likely outcomes for the final goals.
For example, data on retail sales (available more
quickly and more frequently than GNP figures)
provide one of many possible indicators.
R ecent e x p e rie n ce
In the years immediately before October
1979, the Fed used an interest rate as its main
intermediate target, but it was felt that this
procedure encouraged inflation. Consequently,
in O ctober 1979, the Fed increased its emphasis
on the M1 targets and switched to using nonborrowed reserves as the instrument to hit those
targets. However, even after the change, inflation
initially continued to be a severe problem; inter­
est rates rose to high levels and became more
volatile. The economy experienced two reces­
sions within a short period. Many observers
argued that the change in operating procedures
had exacerbated the economy’s ills and a lively
debate developed both within and outside the
Fed on the relative merits of various potential
intermediate targets.
During fall 1982, the Federal Reserve an­
nounced that it would pay less attention to
movements in M 1 in the near term. It pointed
out that the relationship between M l’s behavior
and the final economy was being obscured by
several developments in the financial markets. In
particular, the phaseout of All Savers Certificates
and introduction of the money market deposit
accounts (MMDAs) and Super NOW accounts
were expected to obscure M l’s underlying
movements. In the short run, the portfolio shifts
resulting from these developments would most
likely be effected via M l, the medium of ex ­
change. Consequently, observed changes in M1
growth might reflect merely a reshuffling of
funds between accounts with similar purposes,
but which happened to be in different money
classifications (M l, M2, e tc.), rather than a sig-

15

r

Glossary

O n in te rm e d ia te ta rg e tin g

Goals. The features of the economy which
the Fed wishes ultimately to influence, such as the
growth of real GNP, the inflation rate, or the
unemployment rate.
Indicators. Variables that are not final goals
but which provide advance information on the
economy’s likely performance in achieving its
goals.
Instruments. Variables which the Fed most
closely controls such as the federal funds rate, the
discount rate, the level of depository institution
reserves, and the reserve requirement ratios.
Intermediate targets. Variables between the
instruments and goals over which the Fed has some
leverage, such as a monetary aggregate, a credit
aggregate, an interest rate, or a money index.
Instruments
Reserve requirements. The amount of funds
(held either as vault cash or, directly or indirectly,
as deposits at Federal Reserve Banks) that deposi­
tory institutions must hold in support of their trans­
actions (and some other) accounts.
Federal funds rate. The interest rate at
which depository institutions trade reserves and
other immediately available funds overnight.
Discount rate. The rate the Federal Reserve
Banks charge depository institutions to borrow
reserves to meet any deficiencies.

K. Total domestic nonfinancial debt.

Monetary base. Currency in circulation and
depository institution reserves.
Divisia indices. Quantity index numbers
corresponding to M l, M2, M3, and L that weight
the components of each aggregate by their user (o r
opportunity) cost.
Debit-weighted index. A quantity index of
available media of exchange that are weighted to
reflect their respective turnover rates.
N om inal in terest ra te . The annual rate of
interest received on a given investment, particu­
larly risk-free Treasury bills.
Real rate of interest (before taxes). The
nominal annual rate received or expected over a
time interval, less the inflation rate experienced or
expected over the same interval. No allowance is
made for taxes.
Real after-tax rate of return. The real rate
adjusted for the taxes incurred by the particular
investor on the interest earned.

Technical terms
Velocity. The speed with which money (par­
ticularly M l) changes hands during any year—
calculated usually as the ratio of GNP to Ml.
Reserve multiplier. The relationship be­
tween the stock of depository institution reserves
and the quantity of money (usually M l).

Intermediate targets
Ml. Currency in circulation, demand depos­
its, other checkable deposits, and travelers checks.
M2. Ml plus overnight repurchase agree­
ments (R Ps) and overnight Eurodollars (issued to
U.S. residents by foreign branches of U.S. banks
worldwide), most money market mutual funds
(general purpose and broker-dealer), money
market deposit accounts, small time and savings
deposits.
M3. M2 plus term RPs and term Eurodollars,
institution-only money market mutual funds, large
time deposits.
L. M3 plus nonbank public holdings of U.S.
savings bonds, short-term Treasury securities, com ­
mercial paper, and bankers acceptances.

Repurchase agreement (RP). A bookkeep­
ing transaction that temporarily converts a (d e ­
mand ) deposit into a deposit backed, typically, by a
Treasury security. RPs allow an institution to
reduce the level of its required reserves and the
customer to earn (higher) interest rates on his
funds.
Turnover. The rate at which any aggregate
(o r its components) changes hands per year.
Debits. The volume of funds deducted from
the different kinds of bank account, i.e., a measure
of the work being performed by the account in
effecting transactions.

____________________ ‘__________________

16




Economic Perspectives

nificant shift in either monetary policy or the
public’s demand for transactions balances. This
possibility was regarded as even more likely
because velocity, the ratio of nominal GNP to
M1, was behaving more oddly than usual during
the 1981-1982 recession. Since the end of World
War II, the trend in velocity has been upwards. In
recessions this growth typically decelerates, but
in 1981 -82 velocity actually d eclin ed sharply, as
shown in Figure 1.

Figure 1

T h e v e lo c ity o f m o n e y d e c lin e d s h a rp ly in 1 9 8 1 -8 2
velo city

even no intermediate target at all—the public had
several opportunities to express its views. Two
surveys of professional opinion were conducted.
One surveyed academic economists and the
second reported the views of financial market
participants.
The results of these two surveys are reported
in Table 1. Academic economists surveyed by
the House Banking Committee in April 1983
showed a 2:1 preference for switching away
from a monetary aggregate to some other inter­
mediate target. Favored alternatives were, in
order of preference: a mix of economic indica­
tors, the monetary base, nominal GNP, and
interest rates. Financial market participants, sur­
veyed by Money Market Services Inc. in July
1983, favored retaining a monetary aggregate
target, particularly M l. Alternatives favored by
this group were, in order: nominal GNP, a credit
aggregate, a mix of indicators, and the monetary
base.

Table 1
Results from two surveys of public preference
regarding intermediate targeting

Target

Thus, in fall 1982, the question of what
alternative intermediate target to use became
more urgent. That an answer had to be found
was clear — for the Humphrey Hawkins Act
mandates that the Fed report its intentions for
money and credit growth to Congress semi­
annually. And, in fact, it does so each February
and July. Moreover, several bills had been intro­
duced into the Congress to direct the Federal
Reserve to adopt one of several alternative
targets.
Public o p in ion o n th e issue
While Congress and the Financial press
were debating the relative merits of the alterna­
tives—M l, M2, M3, L (th e Federal Reserve’s mea­
sure of liquid assets), a broad credit aggregate, a
real or a nominal interest rate, nominal GNP or

Federal Reserve Bank o f Chicago




Percentage of
academic
economists
who prefer'

Percentage of
financial
analysts
who prefer2

Monetary aggregate:
Ml
M 2 /M 3

30.8

56.6
(37.7)
(18.9)

Other:
Monetary base
Credit aggregate
Interest rate
Mix of indicators
International variables
Other
Nominal GNP
Reserves

62.6
(15.5)
(3.3)
(7.7)
(24.3)
(1.1)
(1.9)
(8.8)
(0.0)

39.5
(5.6)
(9.4)
(1.9)
(7.5)
(0.0)
(0.0)
(13.2)
(1.9)

2.2
(1.1)
(1.1)
4.4

3.7
(0.0)
(3.7)
0.0

Final goals directly
Real GNP
Inflation
Don't know/Unclear

100.0

98.8

'90 academic economists were surveyed.
253 financial economists were surveyed.
SOURCE: Academic economists were surveyed by Con­
gressman Fernand St Germain for the Domestic Monetary Policy
Subcommittee of the House Banking, Finance and Urban Affairs
Committee in April 1983. The bankers and dealers were surveyed
by Money Market Services Inc., in July 1983.

17

These surveys indicate a substantial diver­
gence of opinion. Three possible reasons come
to mind to account for this divergence. First,
there is a difference in the timing of the reports.
Academic economists were surveyed by letter by
Congressional chairman Fernand St Germain in
April 1983. Money Market Services surveyed
dealers and brokers by telephone three months
later. However, it seems unlikely that such a
small lapse in time could have been responsible
for such a large divergence of opinion.
Second, it is possible that different seg­
ments of the population hold different opinions.
It is often argued that those more concerned
about unemployment than about inflation prefer
nonmonetary indicators. Many academic econ­
omists fall into this category. Those who worry
about inflation more than unemployment, choose
a narrow money aggregate. Market participants,
concerned about the adverse effects of inflation
on the money and capital markets, may belong to
this group.
Third, and this is the position taken in this
paper, it may be that there are genuine uncer­
tainties about the relative merits and demerits of
the various alternatives. Therefore, these advan­
tages and disadvantages are explored further
here.

The pros and th e co n s
The intermediate target question is not
new, but the events described above prompted a
surge of research into the topic. This article
summarizes some of the recent research and
discusses the pros and cons of the several pro­
posed targets: the monetary base, M l, M2 and/or
M3, a credit aggregate, an interest rate (either
real or nominal), nominal GNP, or one of the
two new money index numbers.
Four criteria are used to evaluate the alter­
native targets. First, the chosen intermediate
target should be closely and causally related to
the final targets set for monetary policy. Second,
it should be an accurate leading indicator of
those final targets. Third, it should be closely and
reliably connected to the instruments over which
the central bank has direct control. Fourth, its

18




data should be available on an accurate and
timely basis.1
Ml
M l consists of currency in circulation,
demand deposits, other checkable deposits, and
travelers checks. That is, it measures transac­
tions balances.*2 Despite the Federal Reserve
Board’s expressed concern about M l’s useful­
ness in the recent environment, four strands of
current research support its continued use in
the long run. First, Batten and Stone (1 9 8 3 )
show that M1 continues to meet the first crite­
rion listed above. That is, it explains real GNP
and inflation well. The relatioship can be summa­
rized in a “St Louis equation” for the period
1960.II to 1982.IV. The St. Louis equation relates
the annualized quarterly growth rate of GNP (Y )
to the similar growth rates for M l and high
employment government expenditures (E ) for
the current and previous four quarters. That is,
4
Y

t =

a

+

2

i=0

.
nrij

4
M

t _j

.
+

2

ej

E

t _j +

u t

i=0

Batten and Stone show that, despite changes
in operating procedures, M1 continues to explain
GNP. It explains GNP before O ctober 1979,
when the Fed was using a nominal interest rate
as its intermediate target. It explains GNP when
the Fed was using M1 as its intermediate target
and it explains GNP during late 1982 when the
Fed changed its intermediate target emphasis
once again—this time to the broader aggregates,
M2 and M3. For example, Batten and Stone find
that Ml explains 31 percent of the quarter-toquarter variation in nominal GNP and over 80
percent o f the short-term variation in the infla­
tion rate. Moreover, despite an estimation bias
'The Federal Reserve, itself, has some ability to influence
the performance of any intermediate target when judged by
the third and fourth criteria. An important issue is whether
the Fed could, if it wished to, change its procedures to allow
it to directly control, via its instruments ( existing or new), an
important economic variable. An ancillary issue is whether it
could then arrange to have the necessary data available on an
accurate and timely basis.
2It does not, however, include money market mutual
funds or money market deposit accounts, which have limited
transactions features.

Economic Perspectives

against the monetarist model, it is found to be as
successful as are the well-known large econo­
m etric models in forecasting nominal and real
GNP and the inflation rate.
Second, research by Thomas Gittings (1 9 8 3 )
at this bank demonstrates the usefulness of M1 as
an intermediate target. Gittings has built a small
macro model in the St. Louis tradition, but with
the long-run neutrality of money assumption
formally imposed. The neutrality assumption
means that a change in the growth rate of money
or credit, when this is used as the intermediate
target, eventually causes an equal change in the
rate of inflation and does not have a permanent
effect on the level of real output. The model’s
specification contrasts with the St. Louis models,
which do not impose this assumption, and with
the several large macro models, which are so
constituted that neutrality is achieved only after
very long lags.3 The model works well until the
last quarter of 1982. At that time, many macro
models experienced difficulty—a difficulty re­
flecting the unusual behavior of velocity, which
will be discussed further below.
Gittings’ model can be used to ask which of
several money and credit aggregates best explains
GNP and inflation. The answer is M1. The supe­
riority of M1 over this period is demonstrated in
Figures 2-7.
The Gittings model of real GNP and infla­
tion was built on data that ended with 1976.
Consequently, four tests are available for judging
the performance of the three intermediate targets
examined in these charts (M l, M2, and the Fed­
eral Reserve’s credit aggregate, K). These are the
ability of each aggregate to track real GNP both
“in-sample” (through 1 9 7 6 ) and “out-of-sample”
(after 1 9 7 7 ) and to track inflation over both
intervals, as well.
M l, in sample, tracks the extent and the
timing of the upward and downward spurts in
both real GNP and inflation reasonably well.
While M2 and K track real GNP well, they do not
so accurately portray in-sample the inflation rate.
Out-of-sample, none of the three variables suc­
'Some economists feel that the lags observed in the large
macro models are artifically long because of econometric
estimation problems.

Federal Reserve Bank o f Chicago




cessfully tracked the range of post-1976 varia­
tion in real GNP or inflation. But then it is
(deliberately) asking a lot (m uch more than is
asked of the large commercial econometric
models) to forecast seven years out of sample. In
short, these simulations show that M1 predicts
real GNP and the inflation rate better than does
the monetary base or M2 and as well as any credit
aggregate. That is, M1 meets the first and second
criteria for an intermediate target better than do
most alternatives and at least as well as credit.
Third, research by William Barnett (1 9 8 2 )
and Paul Spindt ( 1 9 8 3 ) shows that Ml con­
tinues to explain the economy well in normal
times. However, in abnormal times, such as
1974-76 and 1982-83, the policymaker may find
supplementary information provided by one of
the two new monetary indices useful. These are
discussed further below.
Fourth, several economists have advocated
using a credit target as a supplement or replace­
ment for M l. In justifying this position, Benjamin
Friedman (1 9 8 2 ) has conducted a large number
of empirical tests on time series data. These tests,
together with those by Edward K. Offenbacher
and Richard D. Porter ( 1 9 8 3 ) at the Federal
Reserve Board, show that while some credit
measures perform as well as M l in explaining
econom ic events, none does better than Ml
alone.
No intermediate target is perfect; there are
three main disadvantages to using M1 in this way.
First, the continuing process of financial innova­
tio n -s u c h as the growing use of credit cards
and repurchase agreements, has served to in­
crease the (velocity) relationship between Ml
and GNP. Second, this regular upward trend was
sharply reversed ( see Figure 1) during the 19812 recession. The reasons for velocity’s decline
were not (and still are n ot) well understood.
Third, the gradual extension of reserve require­
ments to nonbank depository institutions and
the downward adjustment of requirements for
many banks has distorted the multiplier relation­
ship between reserves and M1. These problems,
particularly the first two, caused the Fed to deemphasize the use of M1 during Fall 1982. There­
after M2 and M3 were given greater attention
than before.

19

Figure 2

The M1 version of Gittings M odel predicts real
GNP reasonably well until 1 9 8 2 . . . .

Figure 3
. . . And does almost as well with the implicit
GIMP deflator (price index)

annual rates of change

Nevertheless, the four strands of research
support M l’s usefulness in explaining move­
ments in the economy. While it failed during the
last quarter of 1982, during the first half of 1983,
and also in 1974-76, Ml has otherwise been a
good predictor of the economy. M 1 also meets
the last two criteria for an intermediate target.
That is, it is closely related to the Fed’s instru­
ments such as the federal funds rate, and the
supply of nonborrowed reserves ( Bryant, 1983).
Further, the Fed has experience in its use and
this experience has provided detailed, accurate,
and timely data on the movements of M1 and its
components.4
The m o n etary base
The monetary base consists of currency in
circulation and depository institution reserves.
Such bank and thrift reserves are comprised of
currency on hand and deposits held at the Fed­
eral Reserve. Some economists are currently
advocating use of the monetary base as a surro­
gate for Ml in the present environment. Advo-*

*The Fed does acknowledge problems in obtaining
accurate seasonal adjustments for its M1 data. These prob­
lems hamper the use of daily and weekly, rather than longer
period data, and they make the “fine tuning” of monetary
policy more difficult. Consequently work is currently under­
way to improve the Fed’s seasonal adjustment procedures
(Pierce, Grupe, and Cleveland).

20




cates of the base argue that the Fed is better able
to control the base than M l, while the base
governs the growth of M 1 and should, therefore,
also be closely related to the final economy.
According to these economists, the base meets
criteria ( 3 ) and ( 1) above. There is, however,
debate on these issues.
For example, currency is supplied accord­
ing to the public’s needs, so that the Fed does not
control this component of the base. Further,
there is debate as to what extent the Fed con­
trolled the supply of reserves to depository insti­
tutions under a system of lagged reserve account­
ing, (LRA), which was in effect in the period
from September 1968 through January 1984.
Under lagged reserve accounting, depository
institutions held reserves in one week against
the deposits they had held two weeks earlier.
Then, if the institutions were to meet their legal
obligations, the Fed had to supply the necessary
quantity of reserves, which had already been
determined. Thus, while the Fed could control
the quantity of unborrowed reserves, it was
forced to supply any deficiency in the form of
borrowed reserves. In short, critics question
whether the Fed under LRA actually had any
better control over the base than it had over M1.
In February 1984, the Fed moved to a sys­
tem of almost contemporaneous reserve ac­
counting. It is too early to say what are the impli­
cations of this change for the choice of an
intermediate target. Students of reserve account­
ing predict some small improvement in mone­
tary control (Laurent 1984).

Economic Perspectives

Figure 4
In its M 2 version, the Gittings M odel does not
predict real GNP as well . . .
annual ra te s o f change

The question of control over the monetary
base has been tackled by Balbach ( 1 9 8 1 ), who
argues that while the Fed does not control all
items of its balance sheet at all times, it does have
sufficient control for enough of the time to
counteract any currency or reserve accretion
that exceeds the target. Moreover, base data are
accurate and are available on a very timely basis,
so they satisfy the fourth criterion.
Other critics have disputed whether the
relationship of the base to the level of GNP is
either stable or predictable—properties neces­
sary if the Fed is to be able to use the base to
adequately control the economy. This question
was answered earlier in the affirmative by Bal­
bach and also by Johannes and Rasche (1 9 8 2 ).
With both of these relationships taken care of,
the Fed should be able to use the base as its
intermediate target. However, Hafer and Hein
( 1 9 8 3 ) admit that the base has recently failed
the third criterion test. That is, the base multi­
plier, which measures the relationship between
the quantity of the monetary base and the stock
of money, becam e erratic in 1982. In fact, Hafer
and Hein argue that much of the well-known and
oft-criticized volatility in money growth during
1982 was attributable to shifts in the base multi­
plier and was not due to erratic base growth. In
such a case, the Fed would need to react quickly
and to anticipate accurately changes in the mul­
tiplier if it were to precisely control M1. Conse­
quently, economists who essentially want to
control the M 1 money supply, and who are will­
ing to do so by monitoring the monetary base

Federal Reserve Bank o f Chicago




Figure 5

. . . and does even worse with the price index
annual rates o f change

when they are prevented from using Ml itself,
would have had difficulty in successfully pursu­
ing this alternative during the last two years or
more.
M2 and M3
These are the two aggregates which the Fed
has said it is, at the time of writing, following
most closely, together with M l. M2 consists of
M1 plus money market deposit accounts, small
time and savings deposits, most money market
mutual funds (general purpose and brokerdealer), overnight repurchase agreements ( RPs),
and Eurodollars. M3 adds term RPs and Eurodol­
lar deposits, large CDs and other large time de­
posits, and the remaining money market mutual
funds (institution-only MMMFs).
The switch from M 1 to the broader aggre­
gates involved the least dramatic revision of
intermediate targeting procedures and so would
allow an easy return to M1 targeting. There are
some problems in adopting this approach how­
ever.
First, the introduction and rapid growth of
the MMDA during the first quarter of 1983 made
it difficult to interpret M2 movements.5 This
presented a practical problem for the Federal
Reserve in deciding upon the target range of
growth rates to set for the broader aggregates at
the beginning of 1983 and specifically what rates
■'The effect of the new accounts on the money aggre­
gates is discussed further in Garcia and McMahon (1984 ).

21

Figure 6

Figure 7

The K (debt) version of Gittings M o del predicts
real GNP b etter than the M 2 version, but not as
well as M1

K predictions of the implicit GNP deflator are
better than the M 2 predictions
annual rates of change

annual rates of change

to report to Congress in February 1983- During
this espisode, the problem was overcome by shift­
ing the period used for base comparison from
fourth quarter 1982 (th e calendar quarter typi­
cally used as a base for com parison) to the mid­
dle of the first quarter of 1 9 8 3 —after the major
part of the disruption had passed.
However, other problems are more difficult
to cope with. For example, M2 (and a fo r tio r i
M 3) is a conceptual mish-mash. Unlike M l,
which measures transactions balances, M2 has
no particular distinguishing features, such as
operationalizing the concepts of transaction bal­
ances (o r credit supply in the case of K). Conse­
quently, the transactions demand approach to
monetary theory and policy, which is applicable
to M l, does not relate readily to M2, M3, or L.
Some economists use an alternative theory, that
of portfolio balance, to rationalize the use of M2
as an intermediate target. In this case, M2 would
represent transactions balances plus their very
close substitutes. But the composition of M2,
which includes some illiquid, long-term time
deposits, and other shorter-term time deposits
which carry withdrawal penalties, call into ques­
tion M2’s ability to represent this concept.
Moreover, the increasing ability under dereg­
ulation to pay market interest rates on compo­
nents of M2 has confused the relationship of M2
to output, employment, and inflation. This prob­
lem is so serious that it is not even clear what is

22




the direction of the effect of an increase in inter­
est rates on the level of M2, which perversely
could rise. For example, this happened in the
case of money market mutual funds, a component
of M2. MMMFs rose sharply with market interest
rates during the late 1970s and early 1980s.
In this situation, reliance has to be placed
on empirical relationships—estimates of the
multiplier and of velocity—in setting policy. But
in times of change, past empirical relationships
may be unreliable. For example, empirical rela­
tionships are now being disrupted by the chang­
ing financial structure. Financial innovation and
financial deregulation have increased the per­
centage of M2 and, to a lesser extent, Ml com ­
ponents that pay market interest rates. Ten years
ago this percentage was very small. In December
1978 it was 6.3 percent. By December 1983 it
had risen to 63 percent.6
This makes an important difference to the
way M2 responds to policy stimuli. Ten years
ago if the Fed considered that the economy was
growing too rapidly, it would tighten policy.
When the Fed tightened (i.e., slowed down the
rate of growth of reserves), market interest rates
rose. Then, money’s opportunity cost rose be­
cause it did not earn interest. Consequently, its
growth decreased. When the money stock growth
decreased, the stimulus to the economy sub6Moreover, since the introduction of the money market
certificate in June 1978, most of the growth in the nontrans­
actions components of M2 has occurred among those com­
ponents that pay market-related rates. This fact serves to
strengthen the arguments made in the text.

Economic Perspectives

Table 2
Correlations between M2 and RGNP
growth rates

M2 Growth
Contemporary
Lagged one quarter
Lagged two quarters
Lagged three quarters
Lagged four quarters

1968.1 —
1978.2

1978.3—
1984.1

0.520
0.584
0.533
0.394
0.217

0.017
0.384
0.341
0.041
0.227

sided. By fall 1982 the scenario had changed. If
the Fed were to tighten, interest rates would
rise, money market mutual funds (a component
of M 2) and M2 itself might also rise, instead of
declining. Consequently, if the Fed were to
tighten some more, the growth of econom ic
activity would slow because of interest rate pres­
sures. However, M2 might continue to rise
because it contains components that pay market
interest rates, whose volume rises as rates rise.
This change has served to weaken the rela­
tionship between M2 and real GNP. In the
prederegulation era, real GNP (RGNP) rose
with (and also one or two quarters after) M2.
This association is demonstrated in Table 2.
However, since the second quarter of 1978, the
association has becom e weaker. The deteriora­
tion is also demonstrated in the table.
In fact, recently M2 has been behaving
countercyclical^ to the business cycle, instead
of procyclically. This change is demonstrated as
occuring during 1980 in Figure 8. Research by
Ross Starr ( 1 9 8 2 ) also makes this point well.
Such behavior makes M2 (o r M 3) a potentially
misleading intermediate target: it thus fails the
first two tests.7

theory of M2 demand. As M2 components have
increasingly come to pay market rates, the inter­
est sensitivity of M2 has declined. In a portfolio
demand model, money holders allocate their
wealth among alternative assets. Consequently
household net worth replaces GNP as the prin­
cipal explanatory argument of the M2 demand
function. This relationship can be used for policy
purposes, if a stable and predictable relationship
can be demonstrated between household net
worth and GNP. Simpson’s work provides evi­
dence that household net worth can be used as a
leading indicator of GNP.
Nevertheless, neither M2 nor M3 perform
well on the remaining two criteria. Under cur­
rent operating procedures, the Fed controls the
quantity of its chosen aggregate through the
supply of depository institution reserves. The
configuration of reserve requirements is impor­
tant here. Some components of M2 (and M3)
carry reserve requirements and some do not.
Consequently, any Fed attempt to limit the
growth of M2 or M3 aggregates can be thwarted
by portfolio shifts out of components that carry
reserves to those that do not. Control via a
reserve instrument, therefore, may be difficult.
Further, data on M2 and M3 are not so read­
ily available as those for M l. While Ml data are
available weekly, some M2 and M3 components
are available only monthly. In short, M2 and M3
are generally agreed to be impractical interme-

Figure 8

Q u arterly growth in real GNP and M 2
percent change

However, recent research by Thomas D.
Simpson at the Federal Reserve Board demon­
strates how M2’s changed relationship to the
business cycle can be utilized in policy setting.
This research is based on a portfolio allocation

7More work is needed to clarify this phenomenon. For
example, the question arises whether the same phenomenon
will carry over to M1 with the advent of Super NOW accounts
and the likely introduction of business transaction accounts
paying market rates.

Federal Reserve Bank o f Chicago




23

diate targets for sole use on a long term basis;
they do, however, provide valuable supplemen­
tary information.
Credit
During the past two years there have been
several recommendations that the Federal Re­
serve use a credit aggregate instead of, or in
addition to, a monetary target. Attention within
the Federal Reserve System was drawn to this
matter when Frank E. Morris ( 1 9 8 2 ), President
of the Federal Reserve Bank of Boston said, “I
have concluded, most reluctantly, that we can no
longer measure the money supply with any kind
of precision.” And, “the time has com e to design
a new control mechanism for monetary policy,
one which targets neither on interest rates nor
on the monetary aggregates.”
At the same time, several analysts advocated
using a debt or credit variable instead of a mone­
tary aggregate as the intermediate target. The
research work to support these claims derived
from two sources.
First, Modigliani and Papademos ( 1 9 8 0 )
showed how com m ercial bank credit could be
integrated into a traditional, pre-DIDMCA (D e­
pository Institutions Deregulation and Monetary
Control A ct) model of the monetary sector. The
research demonstrated that to operationalize a
bank-credit-alternative intermediate target, the
system of reserve requirements would need to
be redrawn to control credit rather than money.
This work provides the theoretical framework
for meeting criteria ( 1 ) and ( 3 ) above.
Changes in the technology of financial inter­
mediation and in the laws governing it, have
reduced the disparities between banks and thrifts.
Now both groups supply transactions balances.
In recognition of this fact, transactions account
balances provided by both industry groups are
included in M l. By analogous argument, the
supplies of credit issued by both groups must be
recognized as influencing the level and growth
of real GNP and the inflation rate. However, the
fundamental theoretical work has not (y et)
been extended to describing the transmission of
both bank and thrift credit to the final economy.
Such an extension is necessary if depository

24




institutions credit is to becom e the principal
intermediate target.
Second, empirical work by Benjamin Fried­
man, using vector autoregression techniques,
has demonstrated that a different credit variable
(total domestic nonfmancial credit) has been as
closely associated to GNP as M1. Moreover, it has
been more closely associated than other poten­
tial intermediate targets in the recent past.
Friedman argues [1982, pp. 4-5] that,
The evidence indicates that, in each of the
four criteria considered, total net credit is
just as suitable as any of the monetary
aggregates to serve as an intermediate
target for monetary policy in the United
States. As long as the Federal Reserve Sys­
tem continues to use an intermediate target
procedure, this evidence is consistent with
adopting a two-target framework based on
both money and credit, thereby drawing on
information from both sides of the public’s
balance sheet for the set of signals that gov­
ern the systematic response of monetary
policy to economic events.

This advocacy caught the attention of Con­
gress, particularly when the economy was endur­
ing the worst recession since the 1930s. Several
bills were introduced into Congress to compel
the Federal Reserve to adopt some alternative to
monetary targeting.
There are, however, several problems with
the credit alternative. On the one hand, the
absence of a currently relevant theoretical model
for either depository institution credit or for the
Fed’s debt variable, K, (and Friedman’s domestic
nonfmancial credit variable ) leaves the possibil­
ity that the observed empiricial relationships
might be accidental. This position is supported
by empirical research by Offenbacher and Porter
( 1 9 8 3 ) of the Federal Reserve Board staff. Their
research shows that the performance ranking of
the various intermediate targets as obtained by
Friedman is peculiar to the particular set of tests
he conducted. The same tests conducted in a
different order yield different results, ones more
favorable to M l.
It may also happen (particularly in the
absence of the necessary theoretical model) that
on accomplishing the revision of reserve require­

Economic Perspectives

ments needed to provide “credit control,” the
observed empirical relationships would change.
Credit could then even cease to be closely asso­
ciated with GNP.8 More likely is the case that the
observed size of the response would change, as
lenders sought ways to avoid the tax imposed by
reserve requirements. This would leave the Fed
in a quandary as to the level of stimulus necessary
to achieve any desired objective.
The absence of experience in operating in
this way naturally gives rise to caution. Caution is
especially appropriate where carefully construct­
ed and timely data are lacking. While the data
situation is improving, credit and debt data are
not available in such rich detail, or on such a
timely and accurate basis, as are those for M l.9
In terest rates
The large macro models of Keynesian de­
scent use interest rates as the transmitter of
monetary policy to the final econom ic goals. The
modus operandi of monetary policy during much
of the early and mid 1970s was also expressed in
terms of interest rates. That is, the theoretical
and empirical relationships necessary to meet
criteria ( 1 ) , ( 2 ) , and ( 3 ) have been met and
have been acted upon in the past. Moreover,
accurate data are available on a timely basis, so
that interest rates evidently present a viable
alternative target.
As the 1970s progressed, however, a fun­
damental problem was perceived in applying
these theoretical and empirical relationships.
The interest rate which the Fed influences most
directly—the federal funds rate—is a n o m in a l
interest rate, unadjusted for inflation, past, pres­
ent, or anticipated. But the rate which influences
spending plans and ultimately the production of
goods and services, is a r e a l rate ( or numerous
real rates). The problem in using a nominal
interest rate target is that the relationship be­
8Charles Goodhart ( 1984 ) of the Bank of England has
made this point so forcefully that it has become known as
“Goodhart’s law.”
9If the Federal Reserve decided to make credit its prin­
cipal intermediate target, it could require institutions to
provide the data it needed. However, this adjustment would
take time to be made satisfactorily.

Federal Reserve Bank o f Chicago




tween the nominal rate and the final goals can be
subject to great uncertainty. This occurs when
the policy maker is unable to distinguish between
the real and the inflationary components of the
nominal rate.
Conceptually, the real rate adjusts for infla­
tion ( and sometimes also for taxes), which over­
states the true return on investments. That is, the
real (before-tax) rate that will be earned on a
pending investment of say, one year’s maturity, is
the interest rate to be earned less the inflation
rate that will hold over the year.
A different question then arises as to wheth­
er the Fed can hit a real interest rate target.
Several practical problems exist, concerning the
translation from nominal to real rates and con­
versely. Should the Fed want to use a real rate as
its intermediate target (as proposed, for exam­
ple, in two 1982 Congressional bills), these dif­
ficulties must be resolved. Examples of the prac­
tical problems are given and pursued in research
by C. Cumming and C. Miners ( 1 9 8 2 ) of the
Federal Reserve Bank of New York. For example,
the authors ask whether in choosing, say, a nom­
inal rate, it should be one important to house­
holds in their spending/saving decisions, or to
businesses in making their capital investment
plans. Both rates are relevant to determining the
economy’s direction. But pairs o f interest rates
influencing these plans have not followed the
same path in the past and cannot be expected to
do so in the future. They can give conflicting
signals, therefore. The authors also ask whether
the targeted rate should be adjusted for taxes—
and if so, whose? In both cases, the authors argue
that a market rate available to households and
adjusted for their taxes, is relevant.
If a real rate is to be used, should it be ex
post or ex ante? That is, should it be the real rate
that held in the recent past, or the one antici­
pated for the near future? Economists respond
that the expected real rate is the variable rele­
vant to decision-making. But a proxy for expected
inflation may not be readily available. Instead,
therefore, past or present data are often used.
Moreover, the question then arises, which defla­
tor—there are several to choose from—should
be adopted? If ex ante, over what horizon should
the interest rate expectations be formed?

25

The authors debate these questions in their
paper, then they construct several after tax
and/or real rates, which implement the different
alternatives. The behavior of the several result­
ing measures clearly illustrates the difficulties
and potentially serious ambiguities that beset
interest-rate targeting. For example, the differ­
ent interest rate series have behaved differently
over times past. They yield different turning
points, have different growth rates, and have dif­
ferent cyclical patterns. As a result of their differ­
ent responses, the different series would give
rise to very different policy prescriptions with
regard to the policy necessary to achieve any
given Fed objective.
Public and Congressional pressure to re­
adopt nominal interest rate targeting or to
switch to real interest-rate targeting now appears
to be over. W hether this change should be
attributed to the practical problems illustrated
in the research or to the end of the recession is
debatable. Ironically, at the same time that Con­
gressional pressure has receded, many Fed
watchers claim that since fall 1982 the central
bank has once again, de facto, been targeting
interest rates ( specifically the federal funds rate )
rather than M2, M3, or M1. This interpretation is
denied by the Federal Reserve.10
Nominal GNP
Several eminent economists, Robert Gor­
don (1 9 8 3 ), Robert Hall ( 1 9 8 3 ), John Taylor
(1 9 8 4 ), James Tobin (1 9 8 0 ) , and Jam es Meade
(1 9 7 8 ) have recently spoken favorably of target­
ing nominal GNP. First, the argument needs to
be made that the growth of nominal GNP
(NGNP) should be considered a potential inter­
mediate target, rather than one of the Federal
10Govemor Henry C. Wallich ( 1984 ) explains how this
misperception can arise. The Federal Reserve states that it is
using the level of depository institution reserves as its princi­
pal instrument to influence the growth of the money aggre­
gates. To do so the system needs accurate projections of
reserve availability.
“In the absence of trustworthy projections, the funds
rate at times may be a more accurate indicator of reserve
availability than the ( Staffs) reserves projections. If the man­
ager decides to act on the signal from the funds rate in
assessing the volume of reserves needed, he may create the
appearance that he is working to influence the rate. . . ”
(Wallich 1984, p. 14).

26




Reserve’s ultimate goals. (However, as the dis­
cussion below reveals, NGNP would be an
intermediate target of a different color.) The
growth of nominal GNP (Y ) equals the growth
of real GNP (Q ) plus the inflation rate (P ).
Y= 6 + P
While both of the right hand variables are final
goals, one is a good and the other is a bad. Setting
targets for the growth of nominal GNP does not
directly imply a growth rate for either goal so
NGNP would be an intermediate target. How­
ever, proponents argue that NGNP targeting
would work to produce a favorable outcome in
the resulting division of NGNP growth between
inflation and growth in real output. This
argument—one about stabilizing the business
cycle—will be discussed further below.
Pros
Proponents argue that NGNP targeting
would improve the economy’s performance with
respect to the first criterion, the relationship
between the target and the goals. That is, target­
ing NGNP would tend to stabilize real GNP
when velocity goes off track (as it did seriously,
from 1981 to 1983). The reason is that in order
to keep NGNP (w hich is the product of the
money stock and velocity) growing at a fixed
rate, the money supply must be increased when
velocity declines or velocity growth slows. The
depressing effects of a decline in velocity, or the
inflationary effects of its rise, are thus countered.
Targeting NGNP, it is argued, would also
combat inflationary shocks. Because nominal
GNP is the product of real GNP and the price
level, an upward shock to the price level would
be countered by a decrease in output. The result­
ing excess capacity in the economy puts down­
ward pressure on the price level, which allows
real GNP to recover.
Similarly, an upward stimulus to output
growth arising from an improvement in produc­
tivity would produce a decrease in the inflation
rate where NGNP growth was being held
constant.
Thus, the important arguments in favor of
NGNP targeting concern its power to stabilize
the economy. However, a recent paper by Pro­

Economic Perspectives

fessor John Taylor (1 9 8 4 ) points out that the
answer is not so clearly in favor of NGNP target­
ing as the proponents claim. The issue is more
complex.
Cons
Professor Taylor argues that the stabiliza­
tion advantages of NGNP targeting are more
apparent than real. The arguments presented
above say only that the direction of the initial
response to new shocks to velocity or prices is
correct. Beyond the initial response, however,
Taylor argues that NGNP targeting leads to over­
shooting and the propagation of cycles.
With regard to the second criterion for an
intermediate target—that of being a leading
indicator—the principal argument in favor of Ml
as an intermediate target is that it leads GNP. If
this is so, to target on NGNP instead of M1 would
delay the policymaker’s response, a response
which is often already criticised for being too
slow.
This issue has been ignored in the recent
academic discussions. These discussions typi­
cally begin-, “if NGNP and Ml were contempo­
raneous then . .
But if Ml does indeed lead
NGNP, as is almost universally claimed, the issue
would be clear cut in favor of M1.
In response to this criticism, Robert Gor­
don ( 1 9 8 3 ) suggests that the Fed target fore­
casts of NGNP to reestablish the leading indica­
tor property of the intermediate target. But to
make this proposal more convincing Gordon
would need to show that an average of consen­
sus forecasts of GNP is a better indicator of GNP
than current M l. And this has not yet been
demonstrated.
With regard to the third criterion for eval­
uating an intermediate target, the verdict is not
favorable to NGNP. That is, the relationship of
the policy instruments (open market operations,
e tc .) to NGNP are not well understood. Chair­
man Volcker in his July 20, 1983 testimony to
Congress expressed this most forthrightly by
denying that the Fed can control NGNP. “The
Federal Reserve alone cannot achieve within
close limits a particular GNP objective—real or
nominal—it or anyone else would choose. The
fact of the matter is monetary policy is not the

Federal Reserve Bank o f Chicago




only force determining aggregate production
and incom e” (Volcker 1983, p. 14). Finally,
with respect to the fourth criterion, the NGNP
data are available only quarterly and after a delay.
In short, NGNP would n o t be a useful
intermediate target for fine-tuning monetary
policy on a weekly basis. Its forecasts do, how­
ever, have value as an indicator. When accurate,
they give advance notice of the likely successes
(o r failures) of a monetary policy that is formu­
lated in terms of one or more monetary targets.
Such an NGNP indicator would be particularly
useful in keeping policy on track. And, to some
extent, NGNP may already be used by some
FOMC members in this manner, for the Federal
Reserve Board staff regularly prepares forecasts
of GNP behavior for use by FOMC members. But
that is n o t using NGNP as a intermediate target,
in the usual sense of that term.
In d ex num bers
Some of the most interesting work on the
definition of money has been conducted at the
Federal Reserve Board by William Barnett,
Edward Offenbacher, and Paul Spindt (1 9 8 1 ).
For many years the definition of money was
straightforward: it consisted of currency in cir­
culation and demand deposits. Both were the
principal accepted means of payment. On a va­
riety of rationales, the public’s holdings of these
means of payment reflected its spending inten­
tions. Increases in the stock of money foretold
increased spending plans and conversely. But
more recently, financial innovations (spurred by
advances in communications technology, and
previously by incentives provided when high
market interest rates were confronted by regula­
tory restrictions on the payment of interest on
many depository institution accounts) have made
it increasingly difficult to distinguish transac­
tions from savings balances.
The growth of multi-purpose financial assets
made controversial the old all-or-nothing ap­
proach to defining money. Under the old ap­
proach, a decision had to be made at what level
of aggregation ( M1, M2, or some broader aggre­
gate) a financial instrument should enter the
money aggregate hierarchy. As an alternative, or

27

r
Indexing money
The Divisia Indices
Divisia Indices are quantity index numbers
that are measured relative to the money stock
available in some arbitrarily chosen base year
whose stock is set at TOO. Thus, they have no
physical dimension; that is, they are not expressed
as dollars. The research is this area has been done
principally by Barnett (1 9 8 2 ) , but also in co ­
operation with Offenbacher and Spindt ( 1 9 8 1 ) at
the Federal Reserve Board.
Divisia numbers are constructed to corre­
spond to the current aggregates, so there are Divisia
M1, M2, M3, and L. The Divisia numbers differ from
the traditional monetary aggregate numbers in that
the components are weighted. A distinguishing
feature of the weighting scheme used is a price,
called a “user cost” in the technical literature. The
user cost is measured by the spread between the
rate of return earned by the component (zero on
demand deposits and currency and during 1983
near 7% on Super NOW accounts) and that earned
on some benchmark financial asset. The bench­
mark asset is one supposed to serve only as a store
of value, and one which does not cater to money’s
other functions—as a medium of exchange, a unit
of account, or a standard of deferred payment.
The idea here is that people reveal the money­
ness of any asset by the amount of interest they are
willing to forego in payment for the monetary ser­
vices it provides. In practice then, demand deposits
get large weights in the index, because demand
deposits are many and they have a large interest
rate spread. On the other hand, money market
mutual funds’ weights are reduced because they
receive near benchmark interest rates and, there­
fore, have a low spread. The weight given to Super
NOWs is small for two reasons. First, there are few
Super NOWs relative to demand deposits. Second,
they have smaller interest rate spreads than demand
deposits.

The debit-weighted index numbers

(M

q

28

T u rn o v e r ra te s of s o m e M q c o m p o n e n ts
D ecem ber 1983
Data at annual rates
Demand Deposits
ATS - N O W Accounts
M M D Accounts

453.0
16.4
3.6

SOURCE: Board of Governors of the Federal
Reserve, Federal Reserve Bulletin, February 1984,
Table A14.

)

These quantity index numbers ignore the cur­
rent monetary aggregate definitions in an attempt
to construct a measure of money as a medium of




exchange. Any asset so usable is to be included in
the index, where it is given a weight which reflects
its turnover rate during the same time interval. The
intuition behind the weights used here is that peo­
ple reveal the “moneyness” of a third-party transfer­
able asset through its turnover rate.
A complex modern economy has several dif­
ferent transactions media (such as currency, de­
mand deposits, NOW and Super NOW accounts,
money market deposit accounts, and money market
mutual funds). These different transactions media
are weighted by their share in the total value of
debits (transactions) that is encompassed by the
aggregate. Consequently, the M q data constitute a
“debit-weighted” index. Thus, the different
weighting scheme makes this index different in
purpose and behavior from the Divisia numbers.
The total value of debits achieved by a com ­
ponent is equal to the number of its dollars avail­
able for use times their turnover rate. Here then,
the weight given to a component depends on both
its relative size and its turnover rate. Consequently,
demand deposits are again doubly important com ­
pared to Super NOW accounts, because not only
are demand deposits bigger in value but they also
turn over much more rapidly. Some relevant data in
turnover rates are given in the table.

The M q numbers are potentially useful when
M1 velocity (as recently) is changing in an unusual
way and when new financial assets are being intro­
duced into the financial system.

Economic Perspectives

supplement, an index number approach is now
being recommended. In it, money data would be
constituted by weighting financial asset compo­
nents according to their “money ness.” That sug­
gestion has now been twice implemented—in
the Divisia and debit-weighted quantity index
numbers.
With respect to the four criteria listed for an
intermediate target, Divisia aggregates, described
in the box, do not appear at present to be viable
alternatives or supplements to the regular money
stock data. The theory underlying the transmis­
sion mechanism is not readily available, new
techniques for Fed control would need to be put
into place, the data are not well developed, and
the empirical relationships of Divisia aggregates
to the final economy show similar problems to
those of the aggregates themselves. In short, Divi­
sia aggregates do not offer a practicable alterna­
tive intermediate target, at this time.
The more recent debt-weighted index num­
bers, M q , appear more promising, however.
These index numbers, the work of Paul Spindt
(1 9 8 3 ) , are also pure quantity index numbers
measured relative to some arbitrary base year.
They differ from the Divisia numbers in not
beginning from the existing M l, M2, M3, and L
definitions. Rather, as described in the box, they
seek to approximate the medium of exchange
function of money. That is, they weight the trans­
actions components of the monetary aggregates
by their usage rates, measured by the value of
debits accomplished.
Im plications o f

M

q

fo r policy

During the first half of 1983, data for Ml
levels and growth rates were substantially above
target, which suggested that monetary policy
should be tightened. The problem was less
serious for the broader aggregates, however; this
suggested that tightening might have been inap­
propriate. In this type of situation where regula­
tory innovations are causing portfolio shifts, the
debit-weighted index can be helpful. It makes
allowance for the fact that the turnover rates on
the new money market deposit and Super NOW
accounts are low. Consequently, a dollar housed
in a Super NOW may not carry the same implica­

Federal Reserve Bank o f Chicago




tions for consumer spending and GNP as would a
dollar of demand deposits. It also recognizes that
relocating savings from demand deposits to
market-rate-paying assets will ra ise the turnover
of remaining demand deposit funds.
The bottom line is that in the years 19731975 the debit-weighted index grew somewhat
faster than M l, reinforcing the belief that mone­
tary growth was very expansive at that time. On
the other hand, from 1979 through 1983, the
debit-weighted numbers have grown more slowly
than M 1, suggesting that money growth has been
less expansive than some people fear.
With regard to the four intermediate target
criteria, the debit-weighted index numbers prom­
ise to provide useful supplementary material.
(Spindt does not propose that M q be used as an
alternative target.) The debit-weighted numbers
meet the first two criteria well. Being derived
theoretically from the quantity equation that
relates the money stock to GNP, these index
numbers are closely related to GNP and (given
that GNP behavior tends to lag behind any mone­
tary stimulus or decline) they are good predic­
tors of future GNP behavior.111 With regard to the
third criterion, Fed policy procedures are not
currently designed to control such an index
number. Further, they are not likely to be rede­
signed to this end, because the numbers are
being recommended as indicators, not targets.
The main argument against their use lies in
data problems. Not all the necessary data are
currently available. For example, no data exist on
the turnover rate of currency. The scarcity of
information about currency use should be
remedied when the results of a survey of house­
hold usage of currency and transaction ac­
counts—a survey designed by the Federal Reserve
Board and executed by the Survey Research Cen­
ter in Michigan—become available. There remain,
however, problems in separating solely financial
transactions from those directly concerned with
the creation of GNP. Consequently, it appears

1'The quantity equation in its income version, defines
the nominal value of GNP—real GNP (Q ) times the price
level ( P )—to the stock of money ( M ) times the velocity of
circulations; this is
MV = PQ.

29

that these index numbers provide potentially
valuable supplementary information, but that
they need further development before they will
reach their full potential.
Conclusion
This article has discussed the pros and cons
of several currently favored intermediate targets.
The evidence presented suggests that no alterna­
tive improves on M 1 in meeting the four criteria,
although each of those suggested provides valu­
able supplementary information. While further

research on the subject is under way, the passing
o f two problem s—the disruptive effects of
financial innovations on the growth of Ml and
puzzling steepness of the 1982-83 fall in
velocity—suggests that the case for using Ml as
the preeminent intermediate target is strength­
ening. Even so, a reinstatement should not be
etched in stone. Interest rate deregulation is
now spreading to transactions deposits and the
implications for M1 are not yet well understood.
Consequently, any reemphasis on M l, may last
only until some better approach to policymaking
can be devised.

R eferences
Balbach, Anatol B., “How Controllable is Money
Growth?” Federal Reserve Bank of St. Louis,
Volume 63, No. 3, April 1981, pp. 3-12.

Review

Barnett, William A., “The Optimal Level of Monetary
Aggregation,”
Vol. 14, No. 4 Part 2, November 1982, pp.
687-710.

ing

Journal of Money, Credit and Bank­

_________________, Edward K. Offenbacher and Paul A.
Spindt, “New Concepts of Aggregated Money,”
36, May 1981, pp. 497-505.

Journal of Finance Vol

Batten, Dallas S. and Courtenay C. Stone, “Are Moneta­
rists an Endangered Species?” Federal Reserve
Bank of St. Louis,
Vol. 65, No. 5, May 1983,
pp. 5-16.

Review

Garcia, Gillian and Annie McMahon “Regulatory Inno­
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March/April 1984, pp. 12-23-

Economic Perspectives ,

Gittings, Thomas A., “Models of the Long-Run Neutral­
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internal memorandum 1983.

Monetary Theory and Practice:
The U.K. Experience, Macmillan, London 1984.

Goodhart, Charles,

Gordon, Robert J., “The Conduct of Domestic Mone­
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Working Paper No. 1221, October 1983-

Federal

Hafer, R. W. and Scott E. Hein, “The Wayward Money
Supply: A Post-Mortem of 1982,” Federal Reserve
Bank of St. Louis,
, Vol. 65, No. 3, March
1983, pp. 17-25.

Controlling Money: The Federal
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30




Johannes, James M. and Robert H. Rasche, “Can the
Reserves Approach to Monetary Control Really
Work?”
Vol. 13, August 1981, pp. 298-313-

Journal of Money, Credit and Banking,

Modigliani, Franco and Lucas D. Papademos, “The
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Economic Perspectives

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Spindt, Paul A., “Money is What Money Does: A
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Federal Reserve Bank o f Chicago




Starr, Ross, “Variation in The Maturity Composition of
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___________________, “Commentary',” in
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31

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