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A BUSINESS AND FINANCIAL REVIEW BY THE FEDERAL RESERVE BANK OF CHICAGO

November/December 1978

EC O N O M IC




Capital spending—the sluggish boom
The new grain reserve programs
Some insights on member bank borrowing
Automatic transfers: Evolution of
the service and impact on money
Index for 1978

CONTENTS

Capital spending— the
sluggish boom

3

Business outlays on new capital
goods will probably exceed $220
billion in 1978.

The new grain reserve programs

November/December 1978, Volume II, Issue 6

ECONOM IC PERSPECTIVES
Single-copy subscriptions of Economic
Perspectives, a bimonthly review, are
available free of charge. Please send requests
for single- and multiple-copy subscriptions,
back issues, and address changes to Public
Information Center, Federal Reserve Bank of
Chicago, P. O. Box 834, Chicago, Illinois
60690, or telephone (312) 322-5112.

10

Under the Food and Agricultural
Act of 1977, the accumulation o f a
buffer stock of grain has been mandated.

Some insights on member
bank borrowing

16

Member bank borrowing at the
Federal Reserve banks is affected by a
number of elements.

Automatic transfers: Evolution
of the service and impact
on money

Articles may be reprinted provided
source is credited and Public Information
Center is provided with a copy of the
published material.

Commercial banks now offer
automatic transfers from consumer
savings to checking accounts.

Controlled circulation postage
paid at Chicago, Illinois.

Index for 1978

22




27

Capital spending— the sluggish boom
George W. C/oos
Business outlays on new capital goods—
structures and equipment—will probably ex­
ceed $220 billion in 1978. That will be about 16
percent more than the record high set last
year. Perhaps half the rise will represent price
inflation.
As a proportion of GNP, capital outlays
will increase to about 10.6 percent this year. In
a statistical record that begins in 1929, this
ratio has been surpassed only twice, in 1966
and 1974, and then only slightly. Equipment
order backlogs and the recent high volume of
nonresidential construction contracts suggest
the uptrend will continue into 1979.
Capital spending has been frequently
characterized as sluggish. This seems
paradoxical in view of the high current and
prospective levels of spending. The judgment
takes on more weight, however, when
relative rates of inflation and the growing
amount of capital spending going for non­
productive purposes that do not add capacity
or improve efficiency are taken into account.

Business capital spending approaches
record proportion of GNP
percent of GNP

Digitized forFederal Reserve Bank of Chicago
FRASER


These nonproductive capital outlays in­
clude spending to comply with government
regulations relating to environment, health
and safety, and other social objectives. They
also include energy-related spending to
develop increasingly scarce resources, to im­
prove fuel efficiency, and to convert
operations to coal and other fuels. They in­
clude substantial outlays on projects that have
been delayed or abandoned because of law­
suits, often costly in themselves, pressed by
both public bodies and private parties. In
some industries— motor vehicles, for
example—management contends that non­
productive outlays account for the bulk of
current and prospective capital spending
programs.
Capital spending data usually appear as
gross figures, rather than as net figures that
allow for erosion of the existing capital stock.
The same factors that force nonproductive
outlays have also stepped up obsolescence
and retirements of existing assets.
These nonproductive outlays cannot be
quantified with precision. It seems probable,
however, that current capital spending does
not fully offset the erosion of existing stock. If
so, net investment is actually negative. Aside
from adding to capacity, a high level of capital
spending is essential to the fight against infla­
tion. New and better capital goods provide
the surest means of increasing productivity
(output per worker hour) and holding down
costs of production. One thing is certain.
Capital spending will have to increase sub­
stantially relative toGNP if living standards are
to rise, or even be maintained.
Strength widespread

The Department of Commerce does not
publish an industry breakdown of the GNP
component “ nonresidential fixed invest-

3

Industry boosts capital spending
for third straight year
percent change
0

1

4

8

12

16

I------ 1------1------1------1------1------1------1
- - - - - -

manufacturing

public utilities

other

merit.” Such breakdowns are available,
however, in another less comprehensive
series, "Expenditures for New Plant and
Equipment,” based on quarterly surveys of
business plans.
LikeCommerce's nonresidential fixed in­
vestment, the data on plant and equipment
exclude expenditures overseas. They also ex­
clude outlays by agricultural and nonprofit
organizations, and any outlays that are written
off as they occur, as opposed to fixed assets
that are depreciated over time. Current write­
offs of spending on oil and gas exploration
and development, for example, are large.
Spending on plant and equipment
reported in this series is now expected to
reach $152.5 billion in 1978, up slightly from
estimates earlier this year. That will be 12.3
percent more than in 1977, when P&E outlays
increased 12.7 percent.
Almost all industries plan to increase
their capital spending this year, the notable
exception being ocean shipping lines. The
biggest outlays in 1978, as in most years, will
be made by electric utilities, which expect to
spend $24.5 billion on plant and equipment,
14 percent more than in 1977. The com­
munication industries, mostly telephone
companies, expect to increase their spending
15 percent.
4




Larger-than-average increases in
manufacturing are reported for the electrical
machinery, building material, food process­
ing, and textile industries. After reducing its
outlays in 1976 and 1977, the steel industry ex­
pects to increase its outlays this year, but only
2 percent. Transportation companies, hard
pressed to meet demands, plan large in­
creases in spending. Airlines, railroads, and
trucking companies are buying equipment at
such a rate that suppliers are operating at full
capacity with backlogs stretching months, in
some cases years, into the future.
Output of equipment and components is
especially important to the Seventh Federal
Reserve District states. With 15 percent of the
country's population, the five states of the
district—Illinois, Indiana, Iowa, Michigan,
and Wisconsin—produce almost a third of the
producer equipment. Demand this year has
been especially strong for equipment
produced in the district for construction,
earth-moving, transportation (heavy trucks,
trailers, freight cars, and locomotives),
agriculture, material handling, machine tools,
and electrical and mechanical controls.
Strength in orders for cutting-type
machine tools, also important in the district, is
particularly significant. These are the
machines that make machines. Through
September, new orders were running 52 per-

New orders for capital goods
have outpaced shipments
billion dollars

Economic Perspectives

cent higher than a year earlier. Shipments
were up 40 percent. The order backlog on
October 1, at $2.6 billion, was 55 percent
higher than a year before. Earlier this year,
orders for cutting-type machine tools were
dominated by the motor vehicle industry.
More recently, however, strength has been
widespread, covering most industries that
produce equipment and components for
both producers and consumers.
Equipment and structures

Equipment accounted for 66 percent of
business capital spending last year. The rest
went for structures. Early in the decade, the
ratio was 62:38. Twenty years ago, it was about
60:40.
Adjusted for inflation, the trend toward
equipment is even more pronounced. In con­
stant dollars (1972 prices equal to 100), the
ratio last year was 69:31. It was 61:39 in the ear­
ly seventies. Twenty years ago, it was 55:45.
Several factors are reflected in the grow­
ing emphasis on equipment over buildings.
One is that modernization projects are usual­
ly made up mostly of equipment. The same is
true for environmental projects. Construc­
tion outlays are usually aimed more at basic
expansion. But the sluggishness of spending
on new structures also reflects overbuilding
of office and retail facilities during the heyday
of the REITs in the late sixties and early
seventies.

Business equipment outlays
surge while structures lag
billions of 1972 dollars

Digitized forFederal Reserve Bank of Chicago
FRASER


Adjusted for inflation, outlays on equip­
ment declined 17 percent during the reces­
sion, dropping from a peak rate in the second
and third quarters of 1974 to the trough in the
fourth quarter of 1975. By the third quarter of
1978, they were up 28 percent from the trough
and 7 percent from the 1974 peak.
Outlays on structures peaked earlier in
the last cycle than spending on equipment.
From a high in the third quarter of 1973,
spending on structures (again adjusted for in­
flation) declined 21 percent to the 1975 low. It
rose slowly in 1976 and 1977, and at a faster
pace this year. In the third quarter, outlays for
business construction were running 23 per­
cent higher than at the trough of the reces­
sion. But they were still 3 percent less than at
the peak in 1973. The volume of construction
contracts suggests that the new highs in
business construction may be reached late
this year or early next year.
Equipment output soars

The index of industrial production
prepared by the Federal Reserve Board
provides a broad measure of output. Being in
physical terms, it does not have to be adjusted
for inflation. Component series of the index
are aggregated into market groupings, one of
which is business equipment. This category,
which accounts for 13 percent of all industrial
production, includes all types of producer
equipment used by farms, factories, offices,
construction, transportation, and utilities.
Unlike the Commerce series on outlays, the
business equipment index includes output
destined for export, an important segment of
the output of some types of equipment. Also
reflected in this series are changes in
manufacturers' inventories, both of goods in
process and finished products.
Equipment output was strong in 1974,
right up to the sharp downturn that began in
October. Even then, production of equip­
ment did not fall off as much as most
manufacturing. The index shows production
of business equipment at 147 (1967=100) in
September 1974, compared with an average
of 132 for all manufacturing. By March 1975,
5

Gain in equipment output has
left consumer goods far behind
FRB index, 1967=100

ponents, eliminating many of the earlier
bottlenecks and alleviating others. The
biggest constraint in recent months has been
supplies of large and special castings, a
development that reflects the closing of many
small foundries that did not meet pollution
standards.
Inflation and investment

output of business equipment had fallen 14
percent, but total manufacturing was down 17
percent. In most recessions, business equip­
ment output has declined more than other
manufacturing, often much more. Moreover,
instead of lagging the general upswing as had
been typical, business equipment output
began picking up again in 1975, almost simul­
taneously with other manufacturing.
Equipment manufacturing recovered
more slowly than total manufacturing in 1975
and 1976, but it has been rising faster for the
past two years. In September 1978, business
equipment output was 9.3 percent higher
than a year before. Total manufacturing was
up 6.6 percent. Output of business equip­
ment was 13.4 percent higher than at its 1974
peak. Manufacturing was 12.2 percent higher.
This is a striking performance. Until October
1974, equipment manufacturers were hard
pressed to meet demand.
The surge in equipment output since
1976 has attracted less attention than the
surge of 1973 and 1974. This may be because
most producers have been able to expand
output more in line with demand. In 1973and
1974, everything was in short supply.
Bottlenecks held up the production of com­
ponents, like engines, transmissions, and ax­
les. Since then, manufacturers have expanded
capacity to produce these types of com­

6




Business has been getting less for its
capital spending dollars. Changes in quality
always present a problem in comparing price
developments. This is particularly true of
producer equipment. Every new line of
producer equipment incorporates new and
often radically different features. To a lesser
extent, comparisons of construction costs also
present problems. Despite these limitations, it
seems clear that prices of plant and equip­
ment, as estimated by the Department of
Commerce, have been increasing faster than
the general price level.

Total
GNP

Business
fixed
investmentStructures

Equipment

(percent increase in average prices)
1957-72
1972-77

+54
+42

+41
+47

+55
+60

+33
+41

From 1957 to 1972, the general price level,
measured by the GNP deflator, rose faster
than the average prices of equipment and
structures. From 1972 through 1977, however,
prices of structures and equipment rose faster
than prices generally. Prices of structures and
equipment rose more during these last five
years than in the previous 15 years. Construc­
tion costs rose faster than equipment prices
throughout this 20-year period, the
difference reflecting not only the rapid rise in
costs of construction labor and materials but
also higher costs of complying with
regulations. Productivity performance in con­
struction has compared poorly with other
activities.
Prices of plant and equipment this year
will probably average about 7.5 percent
Economic Perspectives

higher than last year. Most analysts expect a
similar or larger increase next year. Such in­
creases would be about in line with increases
expected for prices in general.
Unfortunately, higher prices for labor
and materials are not the only factors causing
increases in the final cost of particular pro­
jects, which sometimes far exceed original
e s tim a te s a p p ro ve d by co rp o ra te
managements. Delays and modifications re­
quired by government decrees have fre­
quently been a major factor.
Regulatory compliance

Companies have spent over $38 billion
since 1972 on facilities to ''abate and control”
air, water, and solid waste pollution. This ac­
counts for over 5 percent of all their spending
on plant and equipment. Most of this spend­
ing has been to bring into compliance with
the Clean Air Act and the Water Pollution
Control Act. For some industries, such as
primary metals, paper, chemicals, petroleum
refining, and electric utilities, the proportion
of P&E spending for pollution has been much
higher, ranging up to 16 percent.
Although the proportion of spending on
plant and equipment for pollution control
continues to rise, the rate of rise has slowed.

Costs of new business structures
have soared
index 1972=100

Federal Reserve Bank of Chicago



Some industries, having come a long way
to w ard co m p lia n ce with regulatory
deadlines, have been able to reduce their
spending.
The total cost of pollution control
remains uncertain. Data on pollution expen­
ditures do not include outlays to redesign and
tool up for new products, especially vehicles,
that meet emission and fuel economy stan­
dards. Nor do they include the often substan­
tial costs of operating the equipment. And
finally, there is no accounting for facilities that
were closed because of the costs of meeting
standards. Compliance considerations may
be only one of several factors leading to
decisions to close older facilities.
New rules for abatement of pollution are
under study at state and federal levels. A con­
tinuing argument rages over the proposed in­
stallation of "scrubbers” at coal-fired elec­
tronic generating plants to reduce sulfur
dioxide emissions. Some experts contend that
scrubbers may cost billions and still not
operate effectively.
Large sums have been spent on comply­
ing with state and federal laws to protect
health and safety, control toxic substances,
reduce noise, protect endangered species,
and maintain or restore scenic areas. No data
on these costs are available.
Another unquantified cost has involved
postponements and cancellations of projects
as a result of litigation, public and private.
Some of the most spectacular examples relate
to nuclear power plants, pipelines, metal
processing plants, oil refineries, chemical
complexes, highways, airports, dams, and
harbor facilities. Local zoning authorities
often reject proposed projects, citing the
limitations of water, sewerage, and utility
facilities—or simply to slow growth in the
area.
Some executives say that regulations in
themselves are less of a problem than uncer­
tainties related to shifting policies and con­
flicts among regulatory bodies. If mandated
restrictions on new projects were clarified,
eased, or expedited, a heavy volume of post­
poned investments would doubtless be
activated.
7

There can be no question that many of
the restrictions on the operation and
development of facilities are long overdue.
But it should also be recognized that untold
billions—some suggest a round figure of a
trillion dollars—will be needed to achieve
announced goals for the next decade.
Energy needs

Fuel prices have increased two, three,
and four times in the past five or six years.
There are various reasons: the OPEC oil
cartel, the depletion of readily available
domestic oil and gas reserves, restrictions on
the use of high sulphur coal and oil, closings
of older underground coal mines, and op­
position to the development of new coal
mines, nuclear plants, and pipelines.
Costs of facilities to provide new sources
of energy have increased apace with the price
of fuel. Huge outlays have been made to bring
oil from the North Slope and from fields
offshore and to produce synthetic natural gas
(SNG). Large investments, still unproductive,
have been made to extract oil from shale and
gas from coal. Outlays on solar energy, fast
breeder reactors, and other unconventional
sources are still written off as research and
development.
Conservation of energy involves large ex­
penditures that would not have been under­
taken in the days of cheap fuel. Examples in­
clude additional insulation, redesign or re­
placement of equipment, and conversions
from oil or gas to coal—sometimes reversing
changes made only a few years ago. Airlines
have found that fuel costs alone can justify the
replacement of aircraft. The auto industry is in
the midst of a vast program to build cars and
trucks that use fuel more economically. Near­
ly all the capital outlays of the auto industry in
recent years can be traced to efforts to
decrease emissions and to improve fuel
economy.
As in the case of regulation, businessmen
complain of uncertainties in government
energy policy. New plants are usually design­
ed to use particular fuels, and related
decisions must be made early in the planning
8



process. Mandatory curtailment of supplies
may mean plant shutdowns or emergency
conversions, similar to those required during
the natural gas crisis in January 1977.
Capacity limitations

Government could induce business to
step up its capital spending to some extent by
increasing the investment tax credit, lowering
tax rates, or liberalizing depreciation
methods for income-tax purposes. The main
limitation, however, is not funding but
physical capacity. This reflects an inadequate
level of capital investment in the past de­
cade, especially in industries producing basic
materials.
Estimates of utilization rates of manufac­
turing capacity suggest a significant margin of
unused resources. Federal Reserve Board
data show manufacturing as a whole
operating at about 85 percent of capacity.
Operating rates for broad industry groups are
about the same.
The experience has been that an overall
operating rate of 88 percent is close to prac­
tical capacity. Overall rates of utilization,
however, are of little use in analyzing the
potentials of specific industries.
For several months, for example, there
has been a serious shortage of cement. Users
have been put on allocation. Prices have in­
creased sharply. Many projects are being
delayed by the shortage.
There are several reasons for the cement
shortage: the high rate of consumption,
strikes that slowed production, closings of ob­
solete plants, and transportation costs that
have kept cement from moving from areas of
excess supply to areas of scarcity.
Some equipment producing industries
are operating at maximum rates. Included are
industries producing heavy trucks, aircraft,
freight cars, and locomotives—all reflecting
the heavy use of existing transportation
equipment. If tranportation facilities are fully
utilized, a lid is placed on the whole
economy.
Other basic industries operating at prac­
tical capacity are those producing machine
Economic Perspectives

tools, construction equipment, gypsum
board, insulation, lum ber, petroleum
products, and some aluminum and steel
products. In addition to castings, cobalt and
molybdenum are in short supply. Both these
elements are needed in steel alloys used
mainly in capital equipment.
More oil products and steel could be im­
ported, but at the cost of additional deficits in
the balance of trade. At current levels of
economic activity, the country must import
over 40 percent of its oil and perhaps 10 per­
cent of its steel. At least half of various essen­
tial minerals are imported, and all of some.
Equipment industries are short of skilled
workers, especially in the metalworking
trades. Without adequate reserves of both
workers and experienced managers, in­
dustries cannot go into additional shifts. The
skilled worker shortage cannot be alleviated
rapidly because proper training of appren­
tices takes years.
No easy solutions

Although business capital spending has
increased rapidly in the past three years,
assurance of a comfortable and prosperous
future depends on substantial further growth
in these investments. Needed especially are
renovations and expansions in the basic in­
dustries: steel, aluminum, electric power,
minerals of all types, oil and gas, and coal.
Often new large-scale facilities take three,

Federal
 Reserve Bank of Chicago


four, or more years from conception to
com pletion— a span often lengthened
nowadays by regulatory processes.
A substantial part of capital spending
now is required to meet social rather than
economic objectives, to conserve energy, and
expand sources of fuel. For that reason, there
is little use comparing the current proportion
of capital spending to GNP with peak propor­
tions of the past. Even higher levels are
needed.
A M cG raw -H ill preliminary survey
released in November indicates capital
spending will increase 10 percent in 1979, but
only 2 percent in real terms. Realization of
even such an inadequate rise will probably
depend on a further expansion of the gen­
eral economy. Either a recession (predicted
by some analysts) or additional increases in
interest rates (associated with reduced
availability of credit) would cause spending
plans of some companies to be postponed or
scaled down. Fears that arbitrary wage and
price rules may be mandated by the govern­
ment also increase uncertainties and,
therefore, the risks of financial loss.
Investment activity is limited more in late
1978 by availability of men and materials than
by availability of funds. Partly reflected in
these limitations are the demands placed on
resources by consumers and governments.
Investment in plant and equipment requires
that current consumption be limited to
provide the means for increasing consump­
tion in the future.

9

The new grain reserve programs
Gary L. Benjamin
Large stocks of grain are nothing new in this
country. During the fifties, stocks grew to par­
ticularly burdensome levels as a result of
government programs that kept grain prices
above market clearing levels without facing
up to the controls needed to rein in the over­
production capacity of U.S. agriculture. These
policy shortcomings were corrected in the
sixties. Yet grain stocks were still considered
excessive in the early seventies.
Despite this backdrop, the concept of a
grain reserve evolved rapidly during the first
half of the seventies. As surpluses turned to
shortages, the value of a buffer stock of grain
attracted increasing attention in both inter­
national and domestic policy forums. From an
international perspective, the idea of a grain
reserve is still pretty much just a concept.
Most major nations have endorsed the idea
but they differ on the size, funding, and
management of an international reserve.
On the domestic side, the concept of a
grain reserve has been brought to fruition
with the rebuilding of stocks and the enact­
ment of the Food and Agricultural Act of 1977.
That act marked the first in the long history of
agricultural legislation to mandate the ac­
cumulation of a buffer stock of grain. It
authorized a domestic grain reserve that shifts
the emphasis from publicly held to privately
held stocks. The act also encourages the
formulation of an international Emergency
Wheat Reserve that could be fully operational
next year.

In the past, depending on the size of the
carryover and the mechanics of government
programs, the carryover was held entirely by
private interests, such as farmers, processors,
and manufacturers, or jointly with the
government. Theamount held by the govern­
ment usually represented the widely fluc­
tuating difference between total carryover
and the more constant level held by private
interests.
From 1950 to 1976, privately held
carryover stocks varied from 19 million to 55
million metric tons and averaged 35 million.1
This was a fairly narrow range compared with
government-held stocks, which fluctuated
from almost none to as much as 85 million
metric tons and averaged 32 million.
1A metric ton weighs 2,204.6 pounds and is roughly
equivalent to 36.7 bushels of wheat or 39.4 bushels of
corn.

The rebuilding in carryover grain
stocks reflects a shift from publicly
held to privately held stocks
million metric tons
140 '

120

B

-

100

Total carryover stocks
privately owned stocks
government-owned

-

80 -

stocks

1

60 -

Historical perspective

There is no exact definition of buffer
stocks. Many consider the term synonymous
with carryover stocks, meaning the grain on
hand at the end of a crop marketing year.
Others, however, view buffer stocks as that
part of the carryover which exceeds the
amount private interests willingly hold.
10




1951

’54

’57

’60
’63 ’66
'69
crop year ending**

’72

'75

’78

•N early 20 m illion m etric tons of the privately held stocks
w ere in the dom estic grain reserve program.
**Y ear-endingSeptem ber 30 for corn and sorghum ; M ay 31
for oats, barley, w heat, and rye, and July 31 for rice.

Economic Perspectives

Stocks owned by the government were
accumulated mostly through the Commodity
Credit Corporation loan program. For many
years, farmers have been able to place their
grain under loan with the CCC. This has been
one way for farmers to raise working capital
without selling crops in markets glutted just
after harvest.
The basic mechanics of CCC loan
programs are the same today as three decades
ago. A farmer that acquires a loan agrees to
store the grain, holding it off the market until
the loan is repaid or matures. The farmer can
fulfill the loan obligation two ways. He can
repay the loan plus interest anytime up to
maturity and keep unencumbered control of
the grain. O r, because there is no recourse to
the borrower, he can default at maturity,
keeping the proceeds of the loan and turning
the grain over to the CCC. The choice he
makes depends on the market price of grain
and the loan rate (the amount per bushel ex­
tended by the CCC). If prices go enough
above the loan rate to cover the interest,
charge, the farmer is inclined to sell the grain,
paying off the loan and pocketing the dif­
ference. If prices do not rise that much, the
tendency is to default, giving up control of the
grain.
Loan defaults led to a huge accumulation
of government stocks in the late fifties and
early sixties. The loan rate for wheat ranged
from $1.82 to $2.24 in the fifties. The range for
corn, with only minor exceptions, was $1.12 to
$1.62. Market prices nearly always averaged
less than the loan rates, resulting in predic­
table defaulting on CCC loans. This, coupled
with the absence of effective production con­
trols, led to a record 85 million metric tons in
government-owned grain stocks in 1961.
These policy shortcomings were cor­
rected during the first half of the sixties. Grain
production was pulled into better balance
with utilization through programs that re­
moved considerable acreage from produc­
tion. The loan rate for wheat was scaled down
to $1.25 a bushel by the mid-sixties, and the
rate for corn was lowered to $1.05. These rates
prevailed for nearly a decade.
These developments and an expansion in

Fe d e ra l R e se rv e Ba nk o f Chicago




exports of CCC stocks through the Food for
Peace Program had reduced government
stocks of grain to 44 million metric tons by
1965, down nearly a half from the 1961 peak.
Thereafter, government stocks stabilized at
around 16 million metric tons until shortages
emerged and prices skyrocketed in 1973.
Since CCC stocks could be sold in commercial
markets when prices exceeded the loan rate
by 15 percent, government stocks of grain
were virtually exhausted by 1974.
Alternatives for the future

The International Emergency Wheat
Reserve is the least developed of the two new
programs for accumulating a buffer stock of
grain. The Administration announced the
program under authorization of the 1977 act,
and nominal amounts of grain have been ac­
cumulated for the program. Clarification of
the size and the purpose of the international
reserve, nevertheless, still awaits Con­
gressional action. Since Congress spent con­
siderable time on this program during the
past session, final action is expected shortly
after Congress reconvenes in January.

Stocks in the International Emergency
Wheat Reserve will be owned by the govern­
ment. The stocks can be acquired either
through defaults on CCC loans or (more like­
ly) through direct purchases in commercial
markets. The Administration originally an­
nounced that the international reserve would
contain up to 6 million metric tons of wheat.
This was scaled down, however, to 3 million in
recent Congressional debate.
The International Emergency Wheat
Reserve is intended to provide a stockpile of
grains that can be used to meet the
government's international food and aid
commitments. A tentative accord in the
negotiations for an International Wheat
Agreement provides that member countries
will furnish 10 million metric tons of grain a
year for aid and humanitarian purposes. If the
agreement is eventually adopted, the inter­
national reserve will presumably provide a
backstop fortheU.S. part of the commitment.
The producer-held domestic grain

11

reserve program now serves as the major
vehicle for accumulating buffer stocks of
grain. It encompasses both a feed grain
reserve (corn, sorghum, oats, and barley) and
a wheat reserve. The Secretary of Agriculture
can decide when the program will be open
and which crops, by year of harvest, are eligi­
ble for entry. When open, the program is
available to grain producers complying with
the voluntary requirements (such as produc­
tion controls) that determine eligibility for all
farm program benefits.
The reserve operates as an extended CCC
loan program. While in the reserve, a farmer
keeps the proceeds of the original CCC loan
and, subject only to the reserve's tighter
marketing restrictions, ownership of the
grain. Participants agree to keep their crop off
the market for three years or until market
prices go above designated trigger levels.
Penalties discourage early withdrawals from
the program.
Several features of the domestic reserve
program encourage participation, provided
prices stay below the trigger levels. One is the
government payment to participants for stor­
ing grain. Current regulations call for an an­
nual "up front" storage payment of 25 cents a
bushel (19 cents for oats). This is roughly com­
parable to commercial storage rates. In addi­
tion, interest charges on theCCC loan are ter­
minated after the grain has been in the
reserve a year. Still another inducement for
participation is a companion program for
lending farmers enough to build or repair
facilities for storing two years' worth of grain
production. Because the loans are fully amor­
tized over eight years, reserve storage
payments are typically enough to meet the
annual payment on the storage facility loan.
Flows in and out of the domestic grain
reserve are determined by the relationship
between grain prices at the farm level and the
trigger prices. Prices lower than the trigger
encourage entry into the reserve because the
storage payment offsets the cost of holding
the grain while the farmer waits for a possible
price rise. Alternatively, grain flows out of the
reserve when market prices exceed the
trigger.
12




Trigger prices are implemented at two
tiers. The lower tier (called the release price)
is the price at which farmers can begin volun­
tarily repaying loans and leave the program
without penalty. The uppertier (known as the
call price) is the price at which farmers would
be required to repay their loans.
Activation of either trigger does not re­
quire a farmer to sell the grain. Oncethe loan
is repaid, whether payment is voluntary or
mandatory, the farmer is free to sell as he
pleases. Storage payments end, however,
when market prices go above the release
price for more than a month. If prices later fall
back below the release price, storage
payments are resumed for participants still in
the program.
Trigger prices are tied to the prevailing
loan support rates. Under current reg­
ulations, the release price of corn is set 25
percent higher than the loan rate, and the call
price is set 40 percent higher. For wheat, the
release price is 40 percent higher than the
loan rate and the call price is 75 percent
higher.
The size of the producer-held grain
reserve is left largely to the discretion of the
Secretary of Agriculture. The Food and
Agricultural Act of 1977 calls for a wheat
reserve of 8 million to 19 million metric tons
but puts no limit on the size of the feed grain
reserve. Initially, the secretary proposed a 9
million metric ton goal for the wheat reserve.
Later the goal was raised to 11 million tons.
The Administration goal for the feed grain
reserve is 17 million to 19 million metric tons.
By late November, 28 million metric tons
of grain had entered the reserve. The goal of
11 million metric tons for the wheat reserve
had been reached, and further expansion of
the reserve is not expected. The reserve is not
open for the 1978 wheat crop, and almost all
the 1977 wheat still under CCC loan has
already entered the reserve.
Although the feed grain reserve has
reached the minimal goal of 17 million metric
tons, there may be some additional enroll­
ment. The feed grain reserve was briefly
opened to direct entries of 1978 crop corn,
but that option was terminated on November

Ec o n o m ic Persp ectives

Enrollment in the wheat reserve
reached the Administration’s goal
in October . . .

. . . and the goal for the feed grain
reserve was achieved in November
million metric tons

1978

30. However, CCC loans on some 200 million
bushels of 1977 crop corn not yet in the
reserve will soon mature, forcing farmers to
repay, default, or extend the loans by enter­
ing the reserve. As a result, the feed grain
reserve could surpass the 19 million ton mark.
Fe d e ra l R e se rv e Ba nk o f Chicago




Implications

There are a number of likely effects of the
new reserve programs. For one, government
costs could be substantial. Under current
regulations, for instance, the Administration's
goal of a 28 million to 30 million metric ton
domestic reserve translates into an annual
government expenditure of roughly $275
million in storage payments alone. And based
on current loan rates, the waiver of interest
charges after the grain has been in the reserve
for a year would add another $150 million in
net annual government costs. Accumulating a
3 million metric ton international wheat
reserve, if approved by Congress, might re­
quire $300 million in government outlays, not
counting storage charges.
For another, the domestic reserve
program also encourages expansion of onfarm storage facilities, which most studies
show is less economical than commercial
storage. Although still sketchy, data clearly
show this and companion programs as having
their effects. In fiscal 1978, the Farm Storage
Facility Loan Program alone helped finance
over 750 million bushels in new on-farm
storage, equivalent to a third of all the storage
financed in the previous 28-year history of the
program.
The expansion in on-farm storage will
give farmers more flexibility in marketing
their crops and more control over market
prices. That was clear this fall, when increased
storage stiffened farmers' reluctance to sell
grain and contributed to unexpected strength
in prices during the harvest season.
The new reserve programs are designed
partly to constrain the volatility in grain
prices. The constraints are tied to loan rates
and trigger prices. When enough grain is
eligible for loan, the loan rate amounts to a
floor under grain prices. Likewise, buffer
stocks that are isolated from free market
supplies place a ceiling—at least tem­
porarily—on prices at the point where the
stock can re-enter the market.
If storage facilities are adequate and the
buffer stock is large enough to offset a short­
age in free market supplies, these constraints

13

will be effective in guarding against extreme
swings in grain prices. But compared with
former programs that accumulated large
government stocks, the new domestic reserve
program incorporates a wider margin
between the upper and lower price con­
straints. And within this wider margin, prices
are apt to be more volatile than under
previous programs.
In the past, the CCC could usually sell
grain when the market price rose above the
loan rate by 15 percent, plus carrying charges.
The margin was sometimes as narrow as 5 per­
cent. By contrast, the release prices of the new
domestic reserve program will widen the
margin to at least 25 percent for corn and 40
percent for wheat. The margins could go as
high as 40 percent for corn and 75 percent for
wheat if farmers did not leave the reserve un­
til they were forced out when call prices were
reached.
Prices are more volatile, within the con­
straints, simply because of the wider margins
in the new program. But other factors will also
contribute to price volatility. To the extent
that the expansion in on-farm storage gives
farmers more control over free market
supplies, prices are apt to fluctuate more to
accommodate a wider range of price objec­
tives. In addition, there is more uncertainty
under the new program, both as to whether
the domestic reserve will be open and to what
extent farmers will participate. And since
farmers will own the buffer stock, the
problem of concessional government sales
underminingcommercial foreign demand for
grain is not as likely to arise as under past
programs.
Concluding comments

Despite the shift in emphasis from
residually acquired government stocks to
government-encouraged private stocks, the
Secretary of Agriculture has considerable
flexibility in the management of the domestic
reserve. Maybe most important of all, he can
change the goal for the size of the reserve,
subject only to the statutory limits of 8 million
to 19 million metric tons placed on the wheat

14




reserve. Beyond this, he can change a number
of variables that encourage or discourage par­
ticipation in the reserve.
He can decide which crops, by year of
harvest, are eligible for the reserve, and he
can terminate eligibility at any time. He can
raise or lower storage payments and waive or
impose interest charges on loans covering
grain in the reserve. He can extend the time
the grain has to be held in the reserve up to
five years. He can change loan rates,
automatically setting new trigger prices, or he
can change the formula that ties trigger prices
to loan rates. In directly, the Secretary of
Agriculture can change the size of the reserve
through his choice of the variables associated
with basic farm programs, including the loan
rates, potential deficiency payment rates, and
acreage set-aside requirements.
These flexibilities are important for
several reasons. The overlapping variables
between the domestic reserve program and
the basic farm programs, for instance, could
make the two hard to manage. Meeting a par­
ticular reserve goal will require careful coor­
dination in implementing the farm programs.
Alternatively, changing the variables of the
farm programs to achieve a particular level of
production could effect the intended scope
and function of the reserve program.
The flexibilities are also important
because they are broad enough to accom­
modate widely differing views on the best size
for a grain reserve. It is conceivable, though
not likely, that the domestic reserve could
result in the accumulation of a buffer stock as
large as the stock the government held in the
early sixties. O r, the reserve could be squeez­
ed down to an almost inconsequential level.
The new grain reserve programs have
two main objectives. One is to constrain wide
swings in grain prices by absorbing market
supplies during times of surplus and sup­
plementing market supplies during times of
shortages. The other is to provide a buffer
stock that will ease the effects of grain short­
ages on domestic consumers and livestock
producers, foreign trading partners, and
recipients of foreign aid.
These objectives are broad, with no

Ec o n o m ic Persp ectives

gauge for measuring success or failure. There
is little doubt that the programs will con­
tribute to the achievement of these objec­
tives. Over the long run, however, the
programs will be judged by the relationship
between the size of the reserve, the stocks
that would have been held without formal
government programs, and the prevailing
production/utilization balance of grains, at
home and abroad.
Any judgment of success or failure at this
point would be premature. As already
pointed out, the size of the reserve can be in­
fluenced by political considerations. Even
greater uncertainties—such as weather,

governm ent p o licy, and technological
developments—will also bear on the future
balance between production of grains and
their utilization.
Nevertheless, if buffer stocks build up to
the size of those the government held in the
early sixties, the new programs could be as
costly and as hard to manage as the old ones.
Alternatively, current buffer stocks would be
virtually ineffective in offsetting chronic
production shortfalls of the magnitude
witnessed from 1972 to 1975. In the case of
either extreme, history might eventually
record that the new programs were only
cosmetic changes from the old programs.

New Film Available
A new film, “The Fed . . . O u r Central Bank,” has been produced in order to acquaint general
audiences with the purpose and functions of the Federal Reserve System. Banks, high schools, col leges, and
other interested groups can obtain the up-to-date 20-minute, 16 mm color film by contacting the Federal
Reserve Bank serving their area. The area served by the Federal Reserve Bank of Chicago is indicated by the
shaded area on the accompanying map.
G roups in Iowa and the Seventh District portions of Illinois, Indiana, or W isconsin should contact:
Public Information Center
Federal Reserve Bank of Chicago
230 South LaSalle Street
Chicago, Illinois 60604
(312) 322-5112

Seventh District states

Those in the lower peninsula of Michigan
should contact:
Public Information Department
Detroit Branch, Federal Reserve Bank
of Chicago
160 W est Fort Street
Detroit, M ichigan 48231
(312) 961-6880, ext. 427
These offices also w elcom e inquiries from
Seventh District residents as to other available
films and educational materials. Note that when
requesting film bookings, it is best to make reser­
vations at least two months ahead and to specify
alternate showing dates.

Fe d e ra l R e se rv e Ba nk o f Chicago




15

Some insights on member
bank borrowing
Elijah Brewer
The amount of member bank borrowings at
the Federal Reserve banks has averaged about
$1.2 billion for the past six months, ranging
between $500 million and $1.7 billion on a
weekly average basis. This compares with the
less than $100 million level that prevailed
between late 1975 and early 1977.
Because member bank borrowings are
usually higher in times of monetary restraint,
concern occasionally arises that the discount
window amounts to a leak in the Federal
Reserve's control over commercial bank
reserves and money.
This article focuses on the major ele­
ments affecting the volume of borrowings,
both over the interest rate cycle and in the
short run. It also explains why borrowing is
not a significant obstacle to the achievement
of policy goals.
Under current Federal Reserve pro­
cedures and regulations, three factors in­
fluence the volume of borrowings:
• The cost of borrowing from the Federal
Reserve (the discount rate) relative to the cost
of short-term funds from other sources.
• The volume of funds the Federal
Reserve makes available to the banking
system through open market operations
relative to the total amount of required
reserves.
• Federal Reserve administrative policy
regarding the extension of credit to member
banks.
Providing for bank reserves

The Federal Reserve System provides
aggregate reserves to the commercial bank­
ing system through both open market
76




operations and loans to individual member
banks.1 While the former are undertaken at
the initiative of the System, the latter are at the
initiative of the member banks.
There is an incentive for banks to borrow
when the discount rate is below the cost of
buying funds in the federal funds market—a
major avenue through which reserves
supplied by open market operations are dis­
tributed among banks.1 Although some
2
borrowing is clearly related to the size of this
rate incentive, the very process of policy im­
plementation under current regulations vir­
tually ensures that borrowing will increase
when the fed funds rate rises. This would be
true even if the discount rate were tied to the
fed funds rate so that a rate incentive could
not develop.
Because of the way the discount window
is administered, borrowed reserves are tem­
porary and self-constraining. Not only are
1
There are also other factors that cause changes in
the reserves of the banking system. The three principal
factors are (1) changes in Federal Reserve float; (2) flows
of currency between banks and the public; and (3)
changes in Treasury balances at Federal Reserve banks.
These outside factors, which often affect reserves by hun­
dreds of millions of dollars in a single day, are offset or
supplemented by open market operations in accordance
with overall reserve needs.
2
The interest rate on the bulk of m ember bank
borrowing is the base rate applicable to loans secured by
paper "eligible” for discount or purchase by the Reserve
banks under the provisions of the Federal Reserve Act.
This is generally referred to as the “ discount rate” even
though loans are not made on a discount basis. An ad­
ditional one-half of 1 percent is required on loans
secured by other collateral satisfactory to the lending
Reserve bank. Since 1974, a special discount rate has been
applied to member banks requiring exceptionally large
loans extended over a prolonged period of time. This rate
has typically been set at one to two percentage points
above the basic rate.

Ec o n o m ic Pe rsp e c tive s

they taken into account when the Desk (the
securities department at the Federal Reserve
Bank of New York) determines its operational
strategy in conducting open market
operations, but they reflect operational
problems.
Member bank reserve accounts at
Federal Reserve banks serve as working
balances through which many transactions,
such as check clearings, arechanneled. Banks
with a greater value of checks written on their
deposits than the value of checks deposited
with them pay the difference by drawing
down their reserve accounts.
Normal deposit flows between the
thousands of commercial banks in the United
States result in significant shifts in the distribu­
tion of deposits among banks. Banks hold
funds on deposit at Federal Reserve banks to
cover these day-to-day shifts.
In addition, banks are required to hold
on average for each weekly reporting period
(Thursday through Wednesday), a proportion

Member bank borrowings tend to vary
with the spread between the federal
funds rate and discount rate
basis points*

1977

1978

•O n e basis point is one-hundredth of one percent.
••W e ekly averages of daily effective federal funds rate.

Fe d e ra l R e se rv e Ba n k o f Chicago




of their deposits as reserves at the Federal
Reserve banks. Because the amount of
reserves required to be held in the current
week is based on deposits two weeks earlier
(lagged reserve requirements), every bank
knows at the beginning of a statement week
what its reserve balance will have to be on
average for that week. Also, the Federal
Reserve knows the aggregate of required
reserves that all member banks will have to
hold.
Reserve availability—controlling the
fed funds rate

In supplying reserves to the banking
system to influence bank deposits and credit,
the Federal Reserve pursues its monetary ob­
jectives through its influence on the price of
reserves in the market—the fed funds rate.
The policy decisions involve estimates of the
level of this key money market rate that would
be consistent with the rate of monetary ex­
pansion being sought. If deposits are growing
faster than the Federal Reserve wants them to,
the flow of reserves to the banking system is
slowed through open market operations. The
fed funds rate rises, discouraging banks from
expanding deposits and their holdings of
loans and investments.
Because of lagged reserve requirements,
however, constraints on total reserves are
limited in the short run. If the amount of
reserves supplied to the banking system falls
short of the amount needed, the banks in
deficit bid up the fed funds rate. As the rate
rises, some banks will respond to the rate
differential by borrowing atthediscount win­
dow. Regardless of the differential, however,
enough has to be borrowed to cover the
overall reserves shortage. If more reserves are
supplied through open market operations
than required, the fed funds rate falls relative
to the discount rate and both the need and
cost-savings incentive for banks to borrow are
reduced.
By supplying through open market
operations either more or less reserves than
required to meet reserve needs overall, the
monetary authorities can achieve the fed
17

funds rate they believe is consistent with the
rate of monetary expansion they seek.
Member bank borrowings serve as a residual
source of reserves that equates the supply of
reserves overall to the amount of required
reserves, which is fixed in advance.
Shortages of reserves created in the
process of pushing the fed funds rate up force
borrowings to rise as the funds rate rises. But
the tighter conditions—with respect to both
availability of reserves and their cost—also
discourage credit and money growth in the
weeks that follow.
Borrowing complements
open market operations

While the lagged reserves rule gives the
Desk advance knowledge of the average
amount of reserves that will have to be held
each week, there is less certainty about the
amount that will be supplied from outside
sources and, therefore, the volume of tran­
sactions needed to cover required reserves at
a particular level of monetary ease or
restraint.
Changes in purely technical factors,
moreover, can make the necessary offsets
hard to achieve. These operational difficulties
can happen because of shortages in collateral,
delivery problems, and constraints on interest
rates.
Movements in aggregate borrowing at
the discount window give clues to whether
non-borrowed reserves are sufficient,
deficient, or excessive during the reserve
settlement week. Member bank borrowings
reflect not only the response of monetary
authorities to the strength of credit demand
and monetary growth but also to imbalances
in the supply and demand for bank reserves
brought on by day-to-day operational
problems. These imbalances can result from
errors in projecting reserves and from tem­
porary inabilities to implement the actions
intended.
In conducting operations to implement
monetary policy, the Federal Reserve
attempts to offset potential disturbances to
the money market and changes in credit

18




availability caused by other factors that affect
bank reserves. These include changes in
Federal Reserve float, currency in the hands
of the public, and especially shifts of funds out
of private deposits into Treasury balances at
Federal Reserve banks.
Such changes are estimated in advance,
but the estimates are subject to error. The
most likely amount of member bank borrow­
ing is also estimated on the basis of recent ex­
perience and the spread between the fed
funds rate and the discount rate. Based on the
net effect of all these elements, projections
are made of the amount of reserves that will
be available during the period and the
probable need to add or drain reserves so that
the total supply equates to the total required,
allowing for some minimal amount of excess
reserves.
To the extent open market operations fail
to compensate for a net reserve drain from
other elements affecting reserves during the
settlement week, member banks in the
aggregate will have to borrow from Federal
Reserve banks to cover the reserve deficien­
cy. Such borrowing will be necessary by the
end of the settlement week, regardless of the
reason for the deficiency—whether it is an
unexpected increase in currency in the hands
of the public, a sharper decline in float than
had been expected, or a delay in the cashing
of Treasury checks.
The only question is who will do the
borrowing. As in a game of musical chairs, the
net deficiency nationwide will impact on
some individual bankers when the settlement
period ends.
The uncertainties banks face also affect
their borrowing. When normal deposit
patterns are expected to change or reserves
are expected to be less available, some banks
borrow in anticipation of the change in their
needs. A bank may borrow over a long holi­
day weekend, for example, to make sure
reserve needs are covered. The Federal
Reserve's discount facility, therefore, is an im­
portant mechanism for meeting the needs of
bank liquidity arising from uncertainties
about deposits. Such uncertainties are
naturally greater in periods of monetary

Ec o n o m ic Pe rsp e c tive s

restraint. To the extent that such borrowing
overcompensates for actual shortages in
availability, the Federal Reserve may have to
take offsetting open market action to absorb
reserves.
Even when the Desk's estimates of
reserve needs nationwide are reasonably ac­
curate, implementation of monetary policy is
not simple. The Federal Reserve controls the
supply of reserves over the long run mainly
through the outright purchase and sale of
government securities. An outright purchase
of securities permanently provides reserves.
A sale permanently reduces reserves. But the
Federal Reserve also has to provide or absorb
reserves for short periods, often just a day or
so within the reserve settlement week.
Repurchase agreement transactions (RPs)
with government securities dealers are par­
ticularly useful in providing reserves to offset
temporary reserve drains resulting from fac­
tors other than Desk operations. Matched
sale-purchase transactions in government
securities can be used to withdraw reserves
on a temporary basis.
RPs involve the purchase of government
securities by the Federal Reserve and com­
mitments on the part of dealers to repurchase
the securities at a specified date and price.
The Federal Reserve pays for the securities by
crediting the reserve accounts of the dealers’
clearing banks, which receive an equal in­
crease in customer deposits. Such transac­
tions are effectively short-term loans by the
Federal Reserve to the dealers, collateralized
by government securities.
Conversely, if the Federal Reserve is
withdrawing reserves from the banking
system, it enters into matched sale-purchase
agreements with securities dealers. These
contracts involve the sale of blocks of
securities to dealers for immediate delivery
with a simultaneous purchase for delivery at a
specified later date. The securities sold by the
Federal Reserve are paid for by debits to the
reserve balances of the dealers' banks, with
the result that bank reserves decline.
The ability to provide reserves through
open market operations depends, however,
on the ability of government securities

Fe d e ra l R e se rv e Ba nk o f Chicago




dealers to pledge collateral. Collateral is no
problem when reserves are being withdrawn.
But the success of the Federal Reserve in
negotiating enough repurchase agreements
to achieve reserve objectives depends on the
ability of securities dealers to draw collateral
from their customer networks.
When interest rates are rising, dealers
tend to keep their inventories low and
collateral isnotas readily available as when in­
terest rates are declining. This makes a large
open market operation difficult. At other
times, when dealers have substantial inven­
tories of government securities, it is fairly easy
to inject a large volume of reserves into the
banking system as needed to meet predeter­
mined reserve requirements.
In weeks when the Federal Reserve is not
successful in providing needed reserves
through open market operations, loans to
member banks rise. Such increases can be
quite sharp, but they are usually only tem­
porary. In the interim, of course, the fed funds
rate also tends to rise.
Constraints through
window administration

Borrowed reserves, even in times of tight
money, are only a small part of total bank
reserves. Federal Reserve policy regarding
loans to individual banks is an important con­
straint on expansion in borrowing. While this
policy is applied consistently, whether money
is tight or easy, its impact is felt mainly during
periods of restraint, when member banks
need to borrow.
If the discount window actually re­
presented an open line of credit to member
banks, the difference between the fed funds
rate and discount rate would be much more
important in determining the level of borrow­
ing. The privilege of borrowing, defined by
Federal Reserve Regulation A, is not freely
available to member banks on a continuing
basis.
Borrowing by member banks is intended
to cover unusual short-term needs. Ad­
ministration of the discount window imposes
an implicit cost in the form of surveillance of

19

Borrowed reserves account for a
small proportion of total reserves,
even in periods of monetary restraint
percent
7.0 r

average of monthly figures

6.0

-

includes seasonal borrowings since 1973

straining the growth in total borrowings.
An exception to the rule is the seasonal
borrowing privilege, created in 1973 through
revision of Regulation A. The authority for
Federal Reserve banks to accommodate small
banks in covering shortfalls in deposits
relative to loans was intended to assist banks,
especially those serving agricultural or resort
areas, to meet the credit needs of their com­
munities. While credit can be arranged for
several months under this program, the total
outstanding has usually been less than $200
million. The desk managing open market
operations knows the amount in advance.
Large banks dominate profile

1966 '67 '68

'69 '70

'71 '72

'73 '74

'75 '76

77

member banks that use the window for ex­
tended periods. Because borrowings today
tend to reduce the willingness of the Federal
Reserve to accommodate future borrowings,
banks tend to use the window sparingly,
reserving their access for times of urgent
need.
Banks borrow only to cover reserve
deficiencies during the reserve settlement
week. They do not borrow to obtain excess
reserves. As long as a bank's performance
shows its intentions to operate within the
limits of its own resources, it can usually
arrange for credit to meet its needs. A bank
can use the discount window, for example,
for temporary aid in working out portfolio ad­
justments to meet unexpectedly strong local
credit demands.
Continuous borrowing at the window is
considered inappropriate, for whatever pur­
pose. Continuous borrowing suggests the
bank is using Federal Reserve funds to supple­
ment its capital resources. It also indicates the
bank has basic difficulties with its reserve
position, which ought to be corrected
through portfolio adjustments. Federal
Reserve surveillance, including frequent con­
tact with borrowers, tends to discourage ex­
tended use of the discount window, con­

20




In periods of monetary ease, borrowing
tends to bounce along at very low levels. With
open market operations taking care of the
supply of reserves, member bank use of the
window results mainly from frictional
problems that distort the distribution of
reserves to small banks.
When the economy is sluggish, the
Federal Reserve, in freely accommodating a
fairly modest rate of growth in bank credit
and deposits, supplies reserves faster than
they are being absorbed by deposit growth.
These are conditions associated with a low fed
funds rate and a low volume of member bank
borrowing at the discount window.
The fed funds rate was consistently below
the discount rate in 1976 and early 1977 and,
although occasional bulges reflected
problems at the end of settlement weeks,
member bank borrowing was minimal. The
volume of borrowings began increasing sub­
stantially about mid-1977, however, as did the
volatility.
With credit demands accelerating and
deposits growing faster than desired under
monetary policy objectives, the Federal
Reserve ceased accommodating all the
associated reserve demands through open
market operations. Demand for reserves rose
faster than the supply, and money market in­
terest rates rose. The fed funds rate has been
persistently above the basic discount rate
since April 1977, although progressive in-

Ec o n o m ic Persp ectives

Peak demand for credit at the
discount window reflects residual
pressures on large banks
billion dollars
2.4 r

2.0

total member bank borrowings
[at Federal Reserve banks

1.6
1.2

.8
.4

0
Jul.

Sep. Nov.
1977

Jan.

Mar.

May
Jul.
1978

Sep.

•Banks with w e e kly average net dem and deposits
(gross dem and deposits m inus cash items in process of
collection and dem and balances due from dom estic
banks) greater than $400 m illion.

creases in the latter have kept the margin fair­
ly narrow.
In times of monetary restraint, member
banks of all sizes come to the discount win­
dow in increasing numbers and with in­
creasing frequency, especially when the dis­
count rate lags the rise in money market in­
terest rates. Even then, however, the number
of borrowers is a small proportion of member
banks. Less than 10 percent of member banks
borrowed at the window in any single week in
the second quarter of 1978, and probably no
more than 25 percent borrowed at any time
during that quarter.
Small banks step up their use of the dis­
count window as their deposit growth fails to
keep up with loan demands. This is because
many small banks do not have access to
money market sources of funds. Peak

Digitized forFe d e ra l R e se rv e Ba nk o f Chicago
FRASER


demands for Federal Reserve loans reflect the
convergence of residual pressures on the
large banks in major cities. There are com­
paratively few large banks and they do not
borrow as often as the small borrowers. When
they do borrow, however, a large amount of
credit often is involved. The sharp short-run
fluctuations in total member bank bor­
rowings reflect the intermittant borrowings of
large banks, some of which have required
reserves of more than a half billion dollars.
It is on these large banks that the net
pressures in the money market converge at
the end of the reserve settlement week when
there is a shortfall in the overall supply of
reserves below the required level. This is part­
ly because of the role these banks play in
accommodating the needs of smaller cor­
respondent banks.
Borrowing by large banks tends to be
concentrated on Wednesdays and they rarely
borrow for more than a day at a time. The
average daily volume of member bank
borrowing in 1977 was $454 million, while the
average for Wednesdays only was $737
million, including some Wednesdays at more
than $2 billion.
The sharp but irregular Wednesday
spurts in borrowings clearly reflect shortages
in the aggregate supply of reserves relative to
required reserve levels, whether the short­
ages were the result of policy moves or
operational problems.
The pattern of member bank borrowing
at Federal Reserve banks suggests strongly
that the large commercial banks come to the
window, not because of a rate differential, but
mainly because reserves are not available in
the money market. Any benefits they receive
from a favorable discount rate are largely
fortuitous.

21

Automatic transfers: Evolution of the
service and impact on money
Randall C. M err is
Commercial banks began offering automatic
transfers from consumer savings to checking
accounts November 1. With transfers made
automatically through prior arrangements
with their banks, consumers can keep more
of their bank balances in interest-bearing
savings accounts. Automatic transfers also are
intended to reduce the volume of checks
returned for insufficient funds—a costly in­
convenience for everybody concerned. They
are also expected to make it easier for con­
sumers to meet the minimum balance re­
quirements of their checking agreements.
The authorization extends only to con­
sumer accounts. Corporations, partnerships,
and other organizations, including units of
government, are excluded from use of the
service under plans approved last May by the
Federal Reserve and the Federal Deposit In­
surance Corporation. A majority of mutual
savings banks can also offer automatic
transfers.
Voluntary for both banksand consumers,
automatic transfers can be made only on
written authorization of the customer. The
authorization must be given when the
customer signs up for the transfer program.
Arrangements can be made for banks to
transfer funds automatically from interestbearing accounts at thrift institutions, such as
savings and loan associations. In that case, all
three parties, of course, have to agree to the
transfers in advance.
Although ordinarily waived, banks have
the right to require 30 days' notice for
withdrawals from savings accounts. Reg­
ulations governing automatic transfers re­
quire that banks prominently disclose the in­
formation that they reserve this right for
automatic transfer accounts, just like any
other savings plans.

22




Banks must also keep monthly records on
the dollar volumes of savings subject to
automatic transfer, the number and volume
of transfers, and any service charges or in­
terest forfeitures that result from transfers.
As with other innovations in banking, the
advent of automatic transfers has created un­
certainties, for both banks and the monetary
authorities, about the pricing and packaging
patterns that will emerge. There are also un­
certainties about the effects of this new ser­
vice on the money supply and the conduct of
monetary policy.
Impact on money

With consumers able to keep more of
their bank balances in savings accounts, there
will be a tendency for automatic transfers to
reduce the money supply, as conventionally
defined. The shift, therefore, has implications
for monetary policy.
The money supply, defined most com­
monly as currency plus demand deposits
held by the public, excludes savings deposits.
This definition, called M l, is one of the
measures of the money supply the Federal
Reserve uses in conducting monetary policy.
Money supply figures based on this definition
will reflect any reductions in consumer
checking balances resulting from the in­
troduction of the automatic transfer service.
And there will be no indication of the offset­
ting increase in savings deposits.
Although the Federal Reserve does not
control M1 directly or completely, it sets
target ranges for growth of M1. And efforts
are made to meet the M1 targets through
policy actions that directly affect the reserve
holdings of member banks and indirectly in­
fluencing all financial markets. To gauge the

Ec o n o m ic Pe rsp e c tive s

effectiveness of monetary policy, the Federal
Reserve monitors movements in M1 along
with other changes in economic data.
As automatic transfers allow consumers
to transact the same volume of business with
smaller balances in their checking accounts,
the income velocity of M1 can be expected to
rise. This velocity, called V1, isGNP divided by
M1. Because both GNP and M1 are expressed
in dollars, V1 is a pure number rather than a
dollar or percentage figure.
Although the income velocity of M1
tends to vary with economic conditions, rising
with expansions and falling with contractions,
the trend has been essentially upward since
the Second World War. Calculated from
seasonally adjusted data, V1 nearly tripled in
just over three decades, rising from 2.0 in
early 1947 to 5.9 in early 1978. Reflected in this
trend is better economizing on M1 holdings
as interest rates have risen and improvements
in the techniques of money management that
have opened up for both consumers and
businesses.
Automatic transfers are just another in a
series of innovations that, like bank credit
cards, have allowed consumers to make more
effective use of their money and, like savings
certificates, have provided attractive alter­
natives to holding money.
Consumers held almost $93 billion in de­
mand deposits lastJune.1Thatwasoverathird
of the demand deposits counted in M1. Itwas
over a fourth of the $352.8 billion seasonally
adjusted M1 total.
Consumer demand deposits at weekly
reporting banks—which include the large
banks that are most likely to introduce
automatic transfers—totaled almost $37
billion. These deposits accounted for close to
15 percent of the demand deposit component
of M l and about 10 percent of total M1.
If reductions in consumer demand
deposits even approach the amounts that
could eventually be shifted into savings ac­
counts, the increase in the income velocity of
M1 could be substantial. How much V I in­
1
The consum er deposit figures are estimates of gross
demand deposits. They are slightly larger than the ad­
justed demand deposits used in calculating M l.

Fe d e ra l R e se rv e Ba nk o f Chicago




creases, and how soon, depends on the
number of banks that introduced automatic
transfers and the success of the pricing and
promotion schemes they employ.
Pricing and packaging

Some of the most important features of
automatic transfer programs are still being
determined—the types of savings plans being
offered , transfer charges and account
maintenance fees, minimum balance re­
quirements, minimum transfer sizes, and the
provisioning of complementary and com­
peting bank services.
Savings plans. Most banks offering
automatic transfer programs are marketing
the new s e rv ic e through separate
savings/checking plans set up as automatic
transfer accounts. A few banks, however,
have linked automatic transfers to regular
checking and savings accounts, provided
customers want the service and are willing to
pay the fees and meet the minimum balance
requirements. This second strategy possibly
could lead to faster customer acceptance of
automatic transfers. If it becomes a popular
strategy, it could speed the shift in deposit
balances, tending to reduce M l.
The plans banks have announced show
they favor service charges and balance re­
quirements for pricing automatic transfers,
ratherthan interestforfeituresand reductions
in the interest rates paid on savings deposits
subject to automatic transfer.
Most banks offering automatic transfers
have announced they will pay the highest in­
terest rate legally allowed on bank savings—
currently 5 percent a year. As with other
savings accounts, however, banks have pick­
ed various means of compounding interest
(continuous compounding, daily interest,
and less frequent compounding) and various
rules for when deposited funds begin to earn
interest.
Minimum balance requirements. Banks
have announced various minimum balance
requirements, stating the requirements in
terms of checking balances and savings
balances, separate minimums for both types
23

of balances and minimums for the combined
totals of both. Banks that previously used
minimum checking balances as an implicit
charge for handling checks seem in some
cases to still be using this device, but com­
bined now with a minimum savings balance
that implicitly prices transfers.
Many banks are promoting zero-balance
checking, while relying on explicit transfer
charges, monthly maintenance fees, and
minimum savings balances for reimburse­
ment of their check-clearing and transfer
costs. Some banks, especially the large ones,
waive transfer fees and monthly charges when
the savings balances are large enough. Where
the exact amounts for cleared checks are
transferred—rather than minimum dollar
amounts—the zero-balance checking plans
are practically the same as the NOW accounts
available in New England (see box).
To the extent that minimum balances on
checking accounts are used to cover the costs
of automatic transfers, shifts from checking to
savings balances are apt to be mitigated and
the tendency to reduce M l eased. Larger
minimum balance requirements for savings
accounts subject to automatic transfers, on
the other hand, will tend to increase the shift
from demand deposits to savings balances,
reducing M l.
M inim um transfer amounts. Several
banks have set minimums for the amounts
that can be transferred. Most of these
minimums are in the $25 to $100 range. For
banks that want to develop broad markets for
their automatic transfer programs, minimum
amounts that can be transferred have to be
low enough for a moderate-wage earner to
deposit a weekly paycheck and make at least
one transfer before the next payday and still
not significantly lower the original savings
balance. The range of minimums from $25 to
$100 seems to suit this marketing purpose.
Because the minimum amount that can
be transferred determines the amount that is
apt to be put in a checking account at any one
time, balances in consumer demand accounts
can be expected to vary directly with
minimum transfer amounts. For that reason,
the prevalence of large-amount minimum

24




transfers would reduce the downward effect
of automatic transfers on M l.
Transfer
fees and m o n th ly
charges. Some banks are charging a fee for
every automatic transfer of funds. Others are
charging for every transfer over a certain
number allowed free every month. Most of
the charges that have been announced are
from 10 to 50 cents per transfer. I n a few cases,
transfers are priced at a dollar or more. A few
banks charge by the check, rather than the
transfer.
Many banks levy monthly charges for
maintaining accounts, either instead of pertransfer charges or in combination with them.
In some cases, both the monthly charge and
the transfer charge are waived if the savings
balance is high enough—usually $1000 to
$5000. Waiver of charges and the large
minimum balance requirements indicate the
banks are target marketing their transfer
plans to savers with big balances and low ac­
tivity in their accounts.
In terms of the price mechanism, month­
ly charges tend to reduce the number of con­
sumers enrolling in automatic transfer plans.
Per-transfer charges tend to reduce both the
number of enrollees in the plans and the ac­
tivity in their accounts. Either way, the higher
the charge, the less the downward influence
on demand deposits and, therefore, M1.
The per-transfer charges in many plans
are probably high enough to bring a signifi­
cant reduction in the activity in consumer
checking accounts. Checking accounts free
of service charges have led many consumers
away from economizing on their check
writing in the past decade. Transfer fees could
bring a slight reversal in this trend.
O t h e r bank se rv ice s. Autom atic
transfers do not provide one service already
offered under overdraft protection plans—
the provision of automatic loans. Because of
the credit these plans provide, some cus­
tomers will still want overdraft protection.
But, because of the comparatively high in­
terest charges for overdraft loans (18 percent
a year for credit card plans and often 15 to 18
percent for other plans) this service will pro­
vide only limited competition with automatic

Ec o n o m ic Pe rsp e c tive s

transfers. Because of the convenience, bank
customers will also still want preauthorized
payment of their bills. This service, however,
can be tied to automatic transfer plans.
The only banking service that will
probably be replaced at most banks offering
automatic transfers is telephone transfers
from savings to checking accounts.
Many banks are evidently using the in­
troduction of automatic transfers as a catalyst
to the revision of their schedules for the pric­
ing of other retail banking services. Several
banks have taken the occasion to announce
changes in their charges for regular checking
accounts and requirements for minimum
balances, as well as increases in charges for
checks returned due to insufficent funds.
Some banks are also taking a look at
preauthorized bill payment and telephone
transfer services for the first time, to be used
either in conjunction with automatic transfers
or as a substitute for them.

Impact on monetary policy

Considerations of pricing and packaging
create uncertainties about the extent of shifts
that can be expected from checking to savings
deposits. But while these uncertainties com­
plicate the use of M1 targets in the conduct of
monetary policy, two factors are working in
favor of the monetary authorities.
One is that the shift will not come all at
once. Automatic transfers are expected to
bring only a gradual downward shift in the de­
mand for M1 and, therefore, a fairly slow in­
crease in the income velocity of M1. Many
banks indicate they have no immediate plans
for introducing automatic transfers. Many
customers will not sign up at first. For many,
automatic transfers are simply priced out of
their reach for now. Also, some of the plans
that have been announced require that
customers still maintain some checking
balances.

Automatic transfers and NOW accounts compared
Automatic transfers from savings have been
compared—too closely in some cases—with
NOW accounts. NOW is an acronym for a
check-type draft called a negotiable order of
withdrawal. NOW accounts pay explicit interest
and offer their owners the privilege of writing
orders of withdrawal that, like checks, can be
made payable to third parties.
Savings banks in Massachusetts and New
Hampshire began offering NOW accounts in
1972. Under special authorization by Congress,
these accounts are available today at savings
banks, savings and loan associations, and com­
mercial banks throughout New England. And
despite approval of automatic transfers by the
Federal Reserve and the FDIC, congressional
authorization of NOW accounts has recently
been extended to federally chartered banks and
thrift institutions in New York State.
Although acceptance of NOW accounts
was slow at first, even by some banks and thrift
institutions, they have become widely used as a
form of savings and payments in all six New
England states. Over 70 percent of the com­
mercial banks in New England were offering
NOW accounts at the beginning of 1978.
Altogether, that was 682,855 accounts worth
$1.8 billion. They earned over $7.3 million in in­
terest in December 1977. An average of 13 NOW
drafts were written that month on each account.

Digitized forFe d e ra l R e se rv e Ba nk o f Chicago
FRASER


Automatic transfers from savings can be
viewed to some extent as a substitute for
authorization of NOW accounts nationwide—
an idea that was considered in 1976 and 1977.
The two, however, are very different, and com­
parisons between NOW accounts in New
England and automatic transfers should be
drawn with caution.
The experiment in New England, where
banks and thrift institutions offer NOW ac­
counts on the same terms, differs sharply from
the automatic transfer services that are becom­
ing available at many of the nation’s largest and
most innovative banks, without the direct par­
ticipation of savings and loan associations.
The experience in New England has been of
some help to banks in providing an initial guide
to pricing transfers and tailoring them to
customer needs. But NOW accounts are im­
perfect as a guide to longer-range planning for
automatic transfers, which will surely show their
own patterns of consumer demand, account
activity, and bank operating costs.
Experience with NOW accounts is apt to be
of little use either in predicting how long it will
take automatic transfers to become widely
accepted as a banking service or in estimating
initial and long-run deposit shifts from checking
to savings balances.

25

As automatic transfer services become
more widely available, the Federal Reserve
will have already been monitoring its use,
studying the effects on M l, and adjusting its
M1 targets as needed.
The other is that M l is not the only defini­
tion the Federal Reserve uses in making
monetary policy. A more broadly defined
monetary aggregate is M2, which includes the
currency and demand deposits in M1 plus
time and savings deposits at commercial
banks, excluding large negotiable CDs (those
of $100,000 or more). This measure is not
affected directly by shifts from consumer
checking accounts to savings accounts. It in­
cludes both.
Although dollar-for-dollar shifts from
checking to savings balances do not affect M2
directly, this measure is influenced indirectly
by the declines in the average reserves
member banks are required to hold against
their deposits. Reserve requirements for
banks belonging to the Federal Reserve
System are stated in terms of non-interestbearing reserves as a proportion of deposits of
a particular type.
Requirements for demand deposits vary
from 7 percent to 16.25 percent, graduated by
the deposit holdings of the banks. Re­
quirements for savings deposits are 3 percent,
regardless of the dollar holdings of a par­
ticular bank.
Shifts into savings deposits reduce the
average reserve requirement as a proportion
of total deposits. Without offsetting action by
the Federal Reserve, lowering the ratio of re­
quired reserves to deposits can lead to expan­
sion of bank credit, and consequently, M2.
The introduction of automatic transfers
is expected to take long enough that the
Federal Reserve will not need to engage in
sudden large-scale moves to absorb member
bank reserves. Reserves released through
growing acceptance of automatic transfers
can be neutralized by the Federal Reserve
through its day-to-day dealings in govern­
ment securities.
Through open-market operations, the
Fed can sell government securities, reducing

26



total reserves in the banking system. The
volume of safes arising from the introduction
of automatic transfers will probably be small,
comparable certainly to the operations used
in connection with earlier revisions in average
reserve requirements and occasionally to
offset Treasury financing activities.
A fall in average reserve requirements
resulting from automatic transfers will be
consistent with the secular decline in member
bank reserve requirements since the Second
World War. Having to hold reserves in the
form of non-interest-earning assets is a
burden on member banks that is not shared
by the many state-chartered banks that have
elected not to become members of the
Federal Reserve System.
With no change in the current structure
of reserve requirements, automatic transfers
will reduce the implied costs of membership
in the Federal Reserve through the reduction
in average reserve requirements.
By making bank savings accounts more
attractive, automatic transfers could bring
savings flows that amount to more than mere
shifts from checking balances. Not only will
bank savings accounts be made more attrac­
tive compared with other interest-earning
assets consumers may hold, but depositors
may in some instances need to switch funds
from other sources to meet the minimum
balance requirements of automatic transfer
plans. Unexpected changes in M2 arising
from these shifts are not apt to be large.
Introduction of automatic transfers may
also increase the general acceptance of M2 as
a definition of money. By making bank
savings deposits more readily available for
consumer purchases and payments, auto­
matic transfers can enhance inclusion of these
deposits in the money supply. From the stand­
point of policy, M2 will certainly be easier to
follow during the transition than M l.
Crucial to policy makers, of course, are
linkages between the money supply and
economic activity. As always, the Federal
Reserve will be watching both M1 andM2and
their relationships to movements in the real
economy.

Ec o n o m ic Pe rsp ectives

E C O N O M IC PERSPECTIVES
In d ex for 1978
Agriculture and farm finance
Agriculture in the seventies—
a decade of turbulence ......................................................
The new grain reserve programs .......................................

Issue

Pages

September/October
November/December

3-11
10-15

March/April
March/April
March/April
May/June
May/June

7-9
14-21
22-31
10-13
14-16

May/June

20-23

Banking, credit, and finance
Banking insights: Trends in capital
at district banks: 1965-76....................................................
Loan commitments and facility fees .................................
Bank failures ..............................................................................
Disintermediation again? ......................................................
Prime rate update ...................................................................
Convenience and needs:
a post-audit survey ...............................................................
New six-month money market certificates—
explanations and implications .........................................
Competitive equality and
Federal Reserve membership—
The Board of Governors' proposal .................................
Liquidity ratios weakened at
district banks in 1977 .............................................................
Multibank holding company
expansion in Michigan .........................................................
Some insights on member bank borrowing .................
Automatic transfers: Evolution of the service
and impact on money .........................................................

July/August

3-7

July/August

8-13

July/August

14-17

September/October
November/December

18-24
16-21

November/December

22-26

January/February

3-31

Economic conditions
Review and outlook: 1977-78 ..............................................
Business insights: Instalment credit—
benefits and burdens ...........................................................
Indexation and inflation........................................................
Capital spending—the sluggish boom ............................

March/April
May/June
November/December

3-6
3-9
3-9

Government finance
Federal grants-in-aid—solvency
for state and local governments.......................................

May/June

17-19

March/April
July/August

10-13
18-23

September/October

25-31

September/October

12-17

International finance
What is happening to the U.S. dollar? ............................
Canadian-U.S. auto pact—13 years after ........................
Edge Act and agreement corporations:
Mediums for international banking ..............................
Money and money supply
Effects of seasonal adjustment
on the money stock .............................................................

Federal Reserve Bank of Chicago



27