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FEDERAL RESERVE BANK OF NEW YORK

155

The Business Situation
The domestic economy posted a good gain in the sec­
ond quarter, and early indications of July developments
point to continued strength. The solid expansion in busi­
ness activity in the April-June period brought over-all
output to a seasonally adjusted annual rate of $658 bil­
lion, higher than had generally been expected. Notwith­
standing the fact that steel stocks probably will be run off
over the latter portion of the year, there are good indica­
tions that business activity will remain on an uptrend over
the balance of 1965. Businessmen’s spending plans, which
point to rising outlays for plant and equipment in the
months ahead, may become somewhat firmer against the
background of recently released highly buoyant secondquarter profits reports; Federal tax and expenditure pro­
grams should provide a more expansionary impact on
activity than was the case in the first half of the year; state
and local government expenditures should advance fur­
ther; and consumers appear to be in a mood to continue
spending their rising incomes. Thus, providing there is no
major steel strike, prospects seem good for realizing or
perhaps even exceeding somewhat the “standard” forecast,
made at the start of the year, of $660 billion for 1965 as
a whole.
It is, of course, much too early to draw any firm conclu­
sions about the prospects for still further advances during
the early months of 1966. To be sure, it is entirely possible
that the expected rundown of steel stocks may spill over
into the first part of 1966. Moreover, the recently enacted
increase in social security taxes will drain more from the
private economy’s income stream than will be restored
through the second round of excise tax cuts scheduled for
January 1. On the other hand, it is clear that the Adminis­
tration’s recent decisions with regard to Vietnam will re­
sult in additional Federal spending in the months ahead.
The potentialities of stimulus from other areas of demand
such as plant and equipment spending and residential con­
struction will, of course, become easier to assess as the




months unfold. It is reassuring that the Administration
has indicated its continued concern with developing feasible
fiscal policies that could be used to help sustain balanced
over-all economic expansion should the need arise. In this
connection, the Chairman of the President’s Council of
Economic Advisers recently stated that “we have the
means, and I believe the will, to adjust the budget if that
should be necessary, in a way which will contribute to the
steady and adequate expansion of private purchasing
power in the economy”. The widespread confidence that
much has been learned in recent years about the uses of
fiscal policy to encourage business expansion will itself
be a positive influence on business and consumer spending
decisions.
While the prospects for continued economic expansion
are bright, there remains the danger that such gains might
spark further upward pressure on prices. The wholesale
price index rose by 0.7 percentage point in June, the
largest monthly advance since January 1964, and at 102.8
per cent of the 1957-59 average, the index was at a new
high for the fourth consecutive month and 2.8 per cent
above June 1964. Most of the June advance was attribut­
able to higher prices for processed foods and meats,
although prices for industrial commodities continued on
their uptrend of the past several months, with price in­
creases for hides and textile products supplying much of the
pressure. The industrial component of the wholesale price
index apparently edged up again in July amid reports of
further price increases for hides. In the consumer sector,
prices rose by 0.5 percentage point, the largest month-tomonth advance in two years, and the index at 110.1 per
cent of the 1957-59 average was 1.9 per cent above the fig­
ure in the corresponding month a year earlier. The June
increase in the over-all level of consumer prices took place
despite lower prices for new automobiles and air condi­
tioners, on which excise taxes had been reduced retroactive
to May 15, and was due mainly to sharply higher food

156

MONTHLY REVIEW, AUGUST 1965

prices. The substantial June run-up in food prices ap­
parently reflected unfavorable weather conditions that are
also expected to contribute to additional food price rises in
July. This expected upward pressure, however, may be off­
set to a somewhat greater degree than was the case in June
by lower prices for a large number of items on which the
excise tax reduction did not take effect until June 22, after
the data for the June index had been collected.
PATTERNS OF DEMAND IN THE SECOND QUARTER

Gross national product (measured at a seasonally ad­
justed annual rate) rose by $9.2 billion in the second
quarter, according to preliminary estimates of the Com­
merce Department (see Chart I). The second quarter ad­
vance was, of course, markedly less than the unusually
strong rise of $14.2 billion in the previous quarter, and
would have been still less had there not been a sharp
turnaround in net exports, which had been depressed by

Chart I

RECENT CHANGES IN GROSS NATIONAL PRODUCT
AND ITS COMPONENTS
S e a s o n a l l y a d ju st e d a n n u a l ra t e s

I

i Q u a r t e r l y c h a n g e , fo u rth q u a rte r
' 1 9 6 4 to first q u a r t e r 1 9 6 5

Q u a r t e r ly c h a n g e , first q u a r t e r
to se c o n d q u a rte r 19 6 5

G R O S S N A T IO N A L PRODUCT

Inventory investment

Final expenditures

Consum er expenditures for
durable good s
C onsum er expenditures for
n o n d u ra b le go o d s
C onsum er expenditures for services

Residential construction

Business fixed investment

Federal G overnm ent purchases

State and local governm ent purchases

N et exports of goo d s and services
-4

-2

0

2

4

6

8

B illio n s o f d o lla r s
Source: United States Departm entof Commerce.




10

12

14

dock strikes in the January-March period. Even after al­
lowing for this development, however, the slowing in
business activity that did occur from the first to the second
quarter seems to be largely accounted for by the absence
of the special circumstances stimulating the steel and auto­
mobile industries that had served as a temporary boost
to over-all output in the opening months of the year.
The only two major GNP sectors that showed declines
in the second quarter were consumer purchases of durable
goods and business inventory investment. In the consumer
sector, the decline largely reflected the fact that automo­
bile sales returned to a more “normal” level in the second
quarter following the first-quarter surge. Consumer spend­
ing on nondurables and on services, in contrast, both rose
by more than the increases in the first quarter, indicating
that consumers continued to be in an over-all spending
mood. In July, unit sales of new automobiles chalked up
another strong performance, wThile the dollar volume of to­
tal retail sales apparently moved past the record set in May.
The decline in the rate of inventory investment during
the second quarter can be traced in good part to recent
fluctuations in the pace of steel stockpiling. With steel
users facing the possibility of a steel strike after April 30,
the rate of stockpiling was heavy in the fourth quarter of
last year and in the first quarter of this year. While steel
inventory building continued after the interim labor settle­
ment was reached in April, the pace was much less rapid.
That industries generally have continued to maintain close
over-all control on their inventory positions is suggested
by the further decline in inventory-sales ratios during the
second quarter.
Among other sources of demand, business spending for
plant and equipment moved up by $0.7 billion in the sec­
ond quarter, right in line with the gain called for by the
latest Commerce Department-Securities and Exchange
Commission survey. This rise in capital outlays, a good
part of which was apparently devoted to an expansion of
capacity, has been reflected in a further continuous rise in
industrial and commercial construction. Residential con­
struction outlays, which turned up in the first quarter fol­
lowing movements on the down side in the three previous
quarters, rose very slowly in the April-June period. Fore­
shadowing indicators of residential activity, however, con­
tinue to hold out the possibility of some further modest
strength in this sector. Thus, nonfarm housing starts were
up a bit in June, with the average for the second quarter
some 4 per cent higher than in the opening quarter of the
year (see Chart II).
In the government sector, outlays were up by $2.6 bil­
lion in the second quarter, with purchases at both the
Federal and the state and local levels showing appreciable

157

FEDERAL RESERVE BANK OF NEW YORK

gains. Even with the rise, however, Federal purchases were
still little changed from the level of a year earlier. In the
months ahead, however, Federal expenditures on goods
and services are scheduled to expand further, in part, owing
to stepped-up outlays for defense. The recently enacted
increase in social security benefits will add substantially
to Federal cash disbursements in the last half of this year
and thus add to private spending.
PRODUCTION, ORDERS, AND EMPLOYMENT

The Federal Reserve Board’s seasonally adjusted index
of industrial production rose in June for the eighth consecu­
tive month, advancing by 0.5 percentage point to 141.9 per
cent of the 1957-59 average (see Chart II). The June gain
for the most part reflected a considerable further expansion
in output of industrial materials, although production of con­
sumer goods and equipment also showed small advances.
The step-up in materials output, in turn, was apparently
largely attributable to further increases in seasonally ad­
justed steel production. Weekly data for July indicate that
automobile workers assembled new cars at a pace close to
the seasonally adjusted annual rate of 9.6 million units of
the month before, despite shutdowns at some plants for
model change-over toward the latter part of the month. Steel
ingot producers, on the other hand, increased their already
advanced rate of activity in an effort to work down their
order backlogs before a possible strike that could take place
on or after September 1.
New orders booked by manufacturers of durable goods
in June were essentially unchanged following a decline in
the month before. New bookings in the transportation
equipment producing industry fell off in June, largely be­
cause of a sharp cutback in the often erratic and volatile
flow of orders registered by producers of aircraft and
parts. Excluding the transportation equipment producing
industry, new orders for hard goods actually posted a mod­
est advance. At the same time, the backlog of unfilled
orders held by such producers moved up for the eighteenth
month in a row, and the ratio of unfilled orders to ship­
ments, at 2.8, was over 5 per cent above the figure in
the corresponding month a year ago.
The number of persons on nonfarm payrolls rose by




C h a rt II

RECENT BUSINESS INDICATORS
S e a s o n a lly ad ju ste d

M i l l io n s o f d w e l li n g u n its

M i ll io n s o f d w e l l i n g u n it s

1962

1963

1964

1965

S o u rc e s : B o a rd of G o v e rn o rs of the Fe d e ral Re se rve Sy ste m ; U nited States D e pa rtm ents
ofC o m m e rc e a n d L abor.

208,000 (seasonally adjusted) in June to 60.3 million, a
solid 2.2 million above the reading for the corresponding
month last year. Employment gains were widespread in
June, with a particularly large increase in the manufactur­
ing sector as producing and fabricating industries added
significantly to the number of workers on their payrolls
(see Chart II). In July, according to the household survey,
total employment expanded for the ninth month in a row,
and the gain was considerably greater than the concurrent
increase in the civilian labor force. As a result, the over­
all unemployment rate moved down 0.2 percentage point
to 4.5 per cent, the lowest reading since October 1957,
with all major worker groups sharing in the improvement.

158

MONTHLY REVIEW, AUGUST 1965

Recent Banking and Monetary Developments
Total bank credit advanced substantially in the second
quarter. To be sure, the rise was less rapid than in the un­
usually strong January-March period, primarily reflecting
some slowdown in the pace of over-all economic expansion
following the exceptional first quarter. Nonetheless, the
advance held above the average recorded earlier in the
current business upswing. Business loan demand remained
the dominant factor in the general strength of bank credit.
Despite scattered evidence of somewhat less liberal lending
conditions, funds extended to business borrowers rose dur­
ing the quarter at a rate more than half again as fast as in
1964. At the same time, commercial bank deposit liabilities,
created during the quarter as a counterpart to the over-all
credit extended by these banks, continued to grow more
rapidly than the nation’s output of goods and services. A
larger than average rise in the Treasury’s cash balance,
which closed the fiscal year ended June 30 at a record level,
contributed to this growth in total deposits. The public’s
holdings of deposits along with other liquid instruments,
however, also rose to new highs. As a result, for the quarter
as a whole, the ratio of total liquid assets held by the non­
bank public to gross national product moved up again,
virtually equaling the highest level of the past ten yeass.
COMMERCIAL BANK CREDIT AND LIQUIDITY

Total loans and investments at all commercial banks
increased at a 9.7 per cent seasonally adjusted annual rate
in the second quarter, following an exceptionally rapid 12.4
per cent rate of advance in the first quarter. Over the first
six months of the year as a whole, bank credit grew at an
annual rate of 11 per cent, compared with the generally
steady 8 per cent per annum rate of growth that had char­
acterized the preceding four years of general business ex­
pansion.
As has been generally true since mid-1963, the secondquarter advance in bank credit was accounted for almost
entirely by a further expansion of loans. Indeed, banks
again ran down their holdings of Government securities dur­
ing the quarter (see Chart I ) , but continued to acquire other




securities (primarily obligations of state and local govern­
ments) so that total investments were about unchanged.
Among the loan categories, gains were widespread.
Loans to commercial and industrial borrowers were
up sharply during the quarter, at an annual rate of
18 per cent at all commercial banks. While this was less
than the extraordinary 26 per cent annual rate of increase in
such loans in the first quarter, which stemmed in part from
enlarged foreign lending, it remained appreciably above

FEDERAL RESERVE BANK OF NEW YORK

the 12 per cent rise experienced during 1964. In part, this
strength in business loans probably reflects the need for
financing the further buildup in steel inventories that
occurred during the second quarter. Loan demand extended
far beyond steel-using industries, however, as businesses
generally sought funds to finance their expanding capital
investment projects. There was also heavy borrowing over
the June dividend and tax dates, a good part of which
apparently remained on bank ledgers for a longer period
after the mid-June period had passed than had been the
case in other recent years.
With bank asset growth continuing to take place mainly
in loan portfolios, loan-deposit ratios1 moved further up­
ward in the second quarter. At the end of June, the ratio
for all commercial banks as a group stood at 61 per cent
(see Chart II), the highest level since the end of World
War II. The willingness of bankers to channel a larger
proportion of their funds into loans appears to be related
to a number of factors. Portfolio management has become
more effective. In addition, the ability of banks to cover
their liquidity needs through purchase of Federal funds,
and sometimes through sale of negotiable certificates of
deposit, has probably made them willing to live with
higher loan-deposit ratios. These developments, together
with a rise in the proportion of deposits held in relatively
nonvolatile forms, such as savings accounts, would tend
to permit banks to operate with average loan-deposit ratios
that would have represented considerable stringency in
times past. Moreover, a long period of relatively stable
growth in economic and financial activity has also encour­
aged the acceptance of relatively high loan-deposit ratios.
Nevertheless, there appears to have been some concern
^developing on the part of bankers about declines in liquidity
positions, and there have been increasingly frequent re­
ports that some banks are introducing or enforcing more
selective lending policies in an attempt to prevent their
portfolios from becoming unbalanced. To the extent that
banks give closer attention to their loan-deposit ratios,
further increases in total bank credit may begin to be
split more evenly between loans and investments, rather
than consisting almost entirely of loans as has been the case
since mid-1963. If this were to happen, businesses and in­
dividuals could find it somewhat less easy to obtain accom­
modation in the months ahead than earlier in the current
business expansion.

159

C h o rt II

INDICATORS OF BANK LIQUIDITY
M i ll io n s o f d o lla r s

M i ll io n s o f d o l l a r s

1500

-

1500

1000

“

1000

500

500

1953

54

55

56

57

58

59

60

61

62

63

64

65

N ote: S h a d e d a re a s represent recession p e rio d s, a c c o rd in g to N a tion al Bureau
of Econom ic R e se a rc h c h ron ology .
*

Ratios com puted b y this B a n k (see fo otnote 1 in text).

Source: Boa rd of G o v e rn o rs of the Fe d e ral Reserve System.

DEPOSITS AND BANK RESERVES

With bank credit continuing to expand, total commer­
cial bank deposits and the private money supply also
moved up during the second quarter. During the first two
months of the year, time deposits were rising at an un­
usually rapid rate in the wake of the November rise in
maximum interest rates permissible under Regulation Q,
while the daily average money supply showed no net
growth. In the March-June period, however, the money
supply grew at a seasonally adjusted annual rate of 3.9
1 Loan-deposit ratio equals loans (adjusted), less loans to bro­
per
cent, only moderately below the 4.3 per cent expan­
kers and dealers, as a percentage o f total deposits (less cash items
in process of collection).
sion that had occurred in 1964. Over the same March-June




MONTHLY REVIEW, AUGUST 1965

160

period, time deposits grew at an 11.2 per cent annual rate,
moving back to a rate of expansion actually slightly below
the 12.8 per cent rise in 1964.
Private deposits probably would have grown more
rapidly during the first half of the year had it not been for
an abnormally large buildup in Treasury deposits. This
buildup reflected both lower Federal cash outlays and
larger tax receipts than had been foreseen at the begin­
ning of the year. Treasury deposits always show very wide
fluctuations over the year in response to differences in
timing of expenditures and tax receipts. Typically, Gov­
ernment deposit balances are low at the end of a calendar
year and then rise appreciably during the spring and early
summer to a peak around midyear. This year the size of
the upswing was much larger than in other recent years.
By the end of June, Treasury balances at commercial banks
had reached a postwar record of $11.9 billion, up $3.5
billion from the end of March and almost double the
balance at the end of 1964. Addition of this growth in
public deposits (after some estimate to allow for normal
seasonal movements) to the advance in private deposits
produces a series for total deposits that more adequately
reflects the large size of the recent expansion in bank credit.

Supporting the growth of deposits, bank reserves in­
creased further in the second quarter. The rise in member
bank nonborrowed reserves mainly reflected Federal Re­
serve net open market purchases of $1,509 million of Gov­
ernment securities over the three months from the beginning
of April to the end of June. These purchases more than
offset reserve drains stemming from movements of market
factors, primarily a $629 million decline in the gold stock
and a $872 million net increase in currency in circulation.
The rise in the average level of nonborrowed reserves
for the quarter as a whole was, however, not so great as the
buildup of reserves required to support deposit growth.
Member banks thus found it necessary to resort to the Fed­
eral Reserve “discount window” on a larger scale to meet
their reserve needs, with total borrowings averaging $501
million in the second quarter, compared with an average of
$373 million in the first quarter. With these increased bor­
rowings, the net borrowed reserve position of member banks
(borrowings less member bank excess reserves) rose to
an average of $157 million for the quarter as a whole.
This is the first calendar quarter since 1960 in which aver­
age borrowings of the banking system have exceeded aver­
age excess reserves (see Chart I I ) .

Monographs on Banking Structure and Bank Mergers
The Board of Governors of the Federal Reserve
System has announced the availability of two mono­
graphs in a series of studies on banking structure.
The first monograph, entitled Bank Mergers &
The Regulatory Agencies: Application of the Bank
Merger A ct of 1960, by George R. Hall and
Charles F. Phillips, Jr., presents an analysis of bank
merger decisions for the period May 13, 1960December 31, 1962. It compares the policies of the
three Federal banking agencies regarding bank merg­
ers and examines the similarities and differences be­
tween the standards applied in the Bank Merger Act
of 1960 and those applied under the Clayton Act.
The second monograph, entitled Banking Market
Structure & Performance in Metropolitan Areas: A
Statistical Study of Factors Affecting Rates on Bank




Loans, by Theodore G. Flechsig, presents the results
of a statistical analysis of the relationship between
various structural characteristics of commercial
banking markets in major metropolitan areas and
bank performance as measured by rates charged on
short-term business loans.
Requests for copies of the monographs should be
sent to the Division of Administrative Services,
Board of Governors of the Federal Reserve System,
Washington, D. C. 20551. Remittances should ac­
company orders and be made payable to the Board of
Governors of the Federal Reserve System. Price of
first monograph $1.00 each— 85 cents each when 10
or more copies are sent to the same address. Price of
second monograph 50 cents each — 40 cents each
when 10 or more copies are sent to the same address.

FEDERAL RESERVE BANK OF NEW YORK

161

The Money and Bond Markets in July
The money market was generally firm throughout July,
though the degree of firmness was somewhat greater
in the first half of the month than in the second. Federal
funds traded predominantly at 4Vs per cent, with small
amounts trading as high as 4Va per cent in the early part of
the period. At the same time, member bank borrowings
from the Reserve Banks ranged around $600 million. Later,
Federal funds traded as often at 4 per cent as at 4 Vs per
cent, and member bank borrowings receded. Treasury bill
rates rose until around midmonth, as the high cost of
financing inventories led to increased professional offerings
of bills. Thereafter, bill rates declined in response to
a good investment demand and an increased willingness
of dealers to hold inventories with the approach of the
Treasury’s August refinancing.
Prices of Treasury notes and bonds fluctuated in a nar­
row range during the month. Activity was light, and
the atmosphere was cautious. Investment interest was
dampened by a sizable flow of corporate offerings and by
the proximity of the Treasury’s refinancing of August maturies, announced after the close of business on Wednesday,
July 28.
In the corporate bond market, prices were initially firm
in the wake of the successful distribution of a very large
volume of new issues in June. Subsequently, the sizable
flow of new corporate bonds offered in July encountered
mixed receptions, and reoffering yields on issues marketed
late in the month were slightly above June levels. In the taxexempt market, demand picked up and dealers were able
to work down their inventories despite large offerings of
new issues.
THE MONEY MARKET AND BANK RESERVES

Nationwide net reserve availability and member bank
borrowings fluctuated somewhat more widely on a weekto-week basis during July than in other recent months,
but the over-all tone of the money market remained
generally firm. Federal funds traded mainly at 4Vs per
cent through the first half of the month, and on occasion
there was some trading at 4 V a per cent. During the second




half of the month, however, it was as common for Federal
funds to trade at 4 per cent or below as at 4 Vs per cent (see
left-hand panel of the chart on page 163). Rates quoted by
major New York City banks on new call loans to Govern­
ment securities dealers were predominantly in a 4% to 4 5/s
per cent range through the middle of July, while rates on
renewal call loans were quoted most frequently in the 4%
to 4Vi per cent range— in both cases about Vs of a per­
centage point higher than the range of such rates quoted
in other recent months. After midmonth, rates dropped
back to a predominant range of 4 V a to 4 V i per cent on new
loans and of 4 V a to 4 3/s per cent on renewals. Offering rates
for new time certificates of deposit issued by leading New
York City banks were essentially unchanged over the
month. On July 1, the major finance companies lowered
their offering rates of 30- to 89-day directly placed paper
by Vs of a percentage point to 4 Vs per cent. Their offering
rates on 90- to 270-day paper, however, were maintained at
4 V a per cent. Rates on bankers’ acceptances were reduced
by Vs of a percentage point late in the month, as dealer in­
ventories of acceptances dropped to relatively low levels.
The new rates on 90-day prime acceptances were set at
4 V a per cent bid-4 V6 per cent offered.
At the beginning of the month, banks in the central
money market were under substantial reserve pressure. In
part, this pressure reflected heavy demands for loans by
Government securities dealers whose inventories were
swollen by allotments of the June one-year bill as well as
by bills which had been pressed on the market by com­
mercial banks following the midyear bank statement date.
At the same time, banks sought to avoid accumulating
large reserve deficiencies over the long Independence Day
weekend. While Federal Reserve open market operations
offset the bulk of the reserve drain stemming from the
preholiday increase in currency in the hands of the non­
bank public, Federal funds were in particularly strong de­
mand at 4Vs per cent. A small amount, however, traded at
4 V a per cent. Member bank borrowings from the Reserve
Banks rose, but net reserve availability was changed little
from the preceding week.
Over the middle two statement weeks of the month, there

MONTHLY REVIEW, AUGUST 1965

162
Table I

CHANGES IN FACTORS TENDING TO INCREASE OR DECREASE
MEMBER BANK RESERVES, JULY 1965
In millions of dollars; (+ ) denotes increase,
(—) decrease in excess reserves
Daily averages—week ended
Factor

“ Market” factors

Member bank required reserves* .......
Operating transactions (subtotal) . ..
Federal Reserve float ......................
Treasury operations! ......................
Gold and foreign account ...............
Currency outside banks* ............... .
Other Federal Reserve
accounts (net)$ ................................

Net
changes

July
7

July
14

July

July
28

— 264
— 536
4- 40
4- 245
— 293
— 805

+ 244
— 76
+ 165
— 273
+ 16
+ 52

+ 108
+ 478
+ 323
— 62
— 33
+ 143

+ 196
— 266
— 532

21

+ 106

-f 277
+ 168

Total “market" factors ...............

+ 284
— 400
— 4

+
+

4
12

+

23

+

33

+ 59
— 5

+ 116

+ 228

—

86

— 298
— 382

+ 586

Direct Federal Reserve credit
transactions

Open market instruments
Outright holdings:
Government securities .................
Bankers' acceptances .................
Repurchase agreements:
Government securities ...............
Bankers' acceptances .................
Member bank borrowings .................
Other loans, discounts, and advances
Total

+ 310
+ 408
+
1
4- 96
—

+

45

—

2

+

38

2

- 485
-

Excess reserves* ..............................

2

+ 198

+ 103

+

54

-

—

1

+ §

...........................................

+ 84
— 13
— 7
— 14

12

- 195

+ 176

— 330

+ 128

— 13

22,103
21,578
525
620
— 95
21,483

21,665
21,470
195
425
— 230
21,240

21,597
21,274
323
479
— 156
21,118

21,884§
21,536§
348§
627§
— 179§
21,358§

at both 4 per cent and 334 per cent after the weekend.
Thus, even with the sharp drop in over-all net reserve
availability, member bank borrowings from the Reserve
Banks declined to $425 million.
The money market continued free of stress in the final
statement week of the month. The major New York City
banks developed a substantial reserve surplus, and there
was a good flow of Federal funds at both 4Vs per cent and
4 per cent. Member bank borrowings were also moderate at
$479 million.
Over the month as a whole, “market” factors absorbed
$116 million of reserves, while System open market opera­
tions provided $125 million. The weekly average of
System outright holdings of Government securities rose by
$59 million from the final statement week in June
through the last week in July, and average System hold­
ings of Government securities under repurchase agree­
ments increased by $84 million. Average net System
holdings of bankers’ acceptances, both outright and under
repurchase agreements declined by $18 million during
the month. From Wednesday, June 30, through Wednes-

Daily average level of member bank:

Total reserves, including vault cash*
Required reserves* ............................
Excess reserves* .................................
Borrowings .........................................
Free reserves* ....................................
Nonborrowed reserves* .......................

22,171
21,822
349
582
— 233
21,589

Table II
RESERVE POSITIONS OF MAJOR RESERVE CITY BANKS
JULY 1965
In millions of dollars

Note: Because of rounding, figures do not necessarily add to totals.
* These figures are estimated,
t Includes changes in Treasury currency and cash.

t

Includes assets denom inated in foreign currencies.

$ Average for four weeks ended July 28, 1965.

Daily averages—week ended
Factors affecting
basic reserve positions

July
7

July
14

July
21

July
28*

Average of
four weeks
ended
July 28*

Eight banks in New York City

was a marked divergence between statistical reserve avail­
ability and money market conditions. In the statement week
ended July 14, there was a sharp increase in nationwide
net reserve availability. “Country” banks, however, built
up their excess reserves to an unusual degree in the first
week of their new statement period, reducing the supply
of Federal funds to the market. Consequently, the money
market was quite firm, and member bank borrowings
from the Reserve Banks rose to $620 million for the
week. In contrast, the money market was distinctly less
taut in the statement week ended July 21, even though net
borrowed reserves rose to $230 million. Country banks—
now in the second week of their settlement period—
worked down their excess reserves to $142 million from
$482 million in the previous week. At the same time there
was an improvement in the basic reserve positions of the
money center banks, and Federal funds traded in volume




23
6
15
Reserve excess or deficiency(—) t .......
181
Less borrowings from Reserve Banks..
172
43
Less net interbank Federal funds
481
338
244
purchases or sales(—) .........................
930
922
866
Gross purchases ...............................
592
441
622
Gross sales ........................................
Equals net basic reserve surplus
or deficit (—) ......................................... - 4 9 7 - 6 4 8 —272
Net loans to Government
929
654
696
securities dealers ...................................

13
7

14
101

-4 2 9
660
1,089

159
845
686

435

-2 4 6

479

690

18
15
Reserve excess or deficiency (—) t .......
13 3
Less borrowings from Reserve Banks....
118
157
119
177
Less net interbank Federal funds
512
670
756
581
purchases or sales(—) .........................
1,293 1,227 1,324 1,240
Gross purchases ..............................
556
568
658
781
Gross sales .........................................
Equals net basic reserve surplus
or deficit(—) ........................................ - 6 1 1 - 812 -8 6 2 -7 6 1
Net loans to Government
304
285
402
426
securities dealers ..................................

11
143

Thirty-eight banks outside New York City

630
1,271
641
-7 6 2
354

Note: Because of rounding, figures do not necessarily add to totals.
* Estimated reserve figures have not been adjusted for so-called “as of” debits
and credits. These items are taken into account in final data,
t Reserves held after all adjustments applicable to the reporting period less
required reserves and carry-over reserve deficiencies.

163

FEDERAL RESERVE BANK OF NEW YORK

SELECTED INTEREST RATES*
M a y - J u ly 1965
P e rce n t

P e rce n t

M ay

Ju n e

J u ly

M ay

Ju n e

J u ly

Note: D a ta a re sh o w n for b u s in e ss d a y so n ly .

from und e rw ritin g sy n d ic a te reoffering y ie ld o f a g iv e n issu e to m a rk e t y ie ld o f the sa m e issue

* M O N E Y M A R K E T RA T ES Q U O T E D : D a ily ra n g e of rates p o ste d b y m ajor N e w Y o rk C ity b a n k s o n new

im m ediately after it h a s b e e n re le a se d from sy n d ica te restrictions); d a ily a v e r a g e s o f y ie ld s of

call lo a n s (in F e d e ra l f u n d i) se cu re d b y U nited State s G o v e rn m e n t se curities (a p oin t in d ica te s the

long-term G o v e rn m e n t securjtigs (b o n d s d u e o r c a lla b le in ten ye a rs o r more) a n d o f G ov e rn m e n t

a b s e n c e of a n y rang e ); offe rin g rates for directly p la c e d f i a n c e c o m p a n y p_aeer; the effective

s e c y 't ig s d u e in three tp five y e a rs, c om puted on the b a s is o f c lo sin g bid p ric e s;T h u rsd a y

rate on F e d e r a lf u n d s (the rate m ost re p re se n ta tive o f the tra n sa ctio n s executed); c lo sin g b id rate s

a v e r a g e s o f y ie ld s of tw enty se a s o n e d tw enty -y e a r ta x -e x e m p t b o n d s (c arrying M o o d v ’s

(quoted in terms of rate of discount) o n new est o u tsta n d in g t h re e -a n d six-m onth T re a su ry bills.

ra t in g s of A a a , A a , A , a n d Baa).

B O N D M A R K E T YIE LD S Q U O T E D : Y ie ld s o f new A a a - a n d A a -ra te d p u b lic u tility b o n d s a re plotted
a ro u n d a line sh o w in g d a ily a v e ra g e y ie ld s of se a so n e d A a a -ra t e d c o rp o ra te b o n d s (arrow s point

day, July 28, System holdings of Government securities
maturing in less than one year rose by $131 million, while
holdings of issues maturing in more than one year remained
unchanged.
THE GOVERNMENT SECURITIES MARKET

An atmosphere of caution prevailed in the market for
Treasury bills during the first half of July. The taut money
market conditions and associated high costs of inventory
financing at the beginning of the period led to an expan­
sion in professional offerings early in the month. The re­
sulting upward movement in bill rates (see left-hand panel
of the chart) was accelerated by sizable bill sales on the part
of commercial banks following the June 30 statement




So u rce s: Fede ral Reserve B a n k o f N e w Y o rk, B o a rd o f G o v e rn o rs of the Fed e ral R eserve System ,
M o o d y 's Investors Service, a n d The W e e k ly B o n d B u ye r.

date. Investment demand began to improve at the higher
rate levels around midmonth, however, and as professional
selling tapered off, a better atmosphere developed. At the
same time, the more comfortable money market conditions
after midmonth made it less expensive for dealers to finance
their positions. In this environment, Treasury bill rates
again moved lower— spurred in part by professional ex­
pectations that the Treasury’s August financing would be
likely to generate additional demand.
At the last regular weekly auction of the month, held
on July 26, average issuing rates were 3.803 per cent for
the new three-month issue and 3.873 per cent for the new
six-month bills, about 2 and 5 basis points higher than the
average issuing rates at the last weekly auction in June.
The $1 billion of new one-year bills sold in the July 27

MONTHLY REVIEW, AUGUST 1965

164

auction at an average issuing rate of 3.875 per cent, com­
pared with 3.807 per cent for a comparable issue sold on
June 24. A more hesitant tone developed in the wake of the
July auction and persisted through the end of the month, as
reinvestment demand from the refunding proved disap­
pointing. The newest outstanding three- and six-month
bills were bid at rates of 3.81 per cent and 3.89 per cent, re­
spectively, at the close of the month.
In the market for Treasury notes and bonds, the down­
ward drift in prices that had begun toward the end of June
continued in early July as investor activity remained light.
(The right-hand panel of the chart shows the rise in bond
yields that accompanied this decline in prices.) A tem­
porary firming in market tone appeared at the end of the
first week, partly in response to press discussion regarding
the tenability of the current interest rate levels and the im­
proved atmosphere in the corporate bond market. Activity
once again subsided, however, and buyers became more
price conscious. A contributing factor to the renewed
caution was the high volume of new corporate issues being
marketed combined with the relatively wide rate differential
between Government and corporate bonds. As the
month progressed, market activity was further restrained
by reports of a deterioration in the Vietnamese situation
and by the approach of the Treasury’s August refinancing.
Discussion of the possibility that an intermediate issue
might be offered led to declines, during July, of generally
%2 to %2 in prices of issues maturing in two to five years.
Prices of most longer issues also closed lower over the
month.
After the close of business on Wednesday, July 28, the
Treasury announced that holders of $7.3 billion of 3% per
cent notes maturing on August 13— about $3.2 billion of
which was publicly held— would have the opportunity to
exchange their holdings for either new 4 per cent 18-month
notes or reopened 4 per cent 3 Vi -year bonds. The new 4 per
cent notes, which will mature on February 15, 1967, were
offered at 99.85 to yield about 4.10 per cent. The reopened
4 per cent bonds of February 15, 1969 were offered at
99.45 to yield about 4.17 per cent. Subscription books were
open from August 2 through August 4, with payments for
and delivery of the securities scheduled for August 13.
While the terms of the financing were considered attractive,
the trading activity that developed was only moderate, and
prices tended to ease further after their initial adjustment to
the refunding terms.
OTHER SECURITIES MARKETS

Attention in the markets for both corporate and taxexempt securities in July was dominated by the substantial




volume of new issues that were offered during the month.
Activity in both markets was light at the beginning of the
month as investors awaited the terms of the new issues, the
major portion of which was scheduled to be offered later in
the month. In the corporate market, a better tone emerged
at the beginning of the month as the market assessed the
successful sale of the preceding month’s heavy volume of
offerings. Subsequently, investors became selective, resist­
ing efforts of underwriters to price new issues aggressively.
This investor resistance restrained underwriter bidding and
led to slightly higher yields on offerings late in the month.
A $150 million negotiated offering of the Baa-rated deben­
tures of a leading merchandising chain was quickly sold
out at a reoffering yield of 4.90 per cent in late July.
In the tax-exempt market, an element of caution pre­
vailed early in the period, reflecting the slow sales of older
issues and still sizable dealer inventories. Around mid­
month, however, the demand for new offerings and for un­
sold balances of old offerings picked up substantially as
commercial banks began to show renewed interest in taxexempt securities. Later, investor interest became more
selective, but dealers were able to hold down their inven­
tories, despite the substantial supply of new issues coming
into the market. Over the month as a whole, the average
yield on Moody’s seasoned Aaa-rated corporate bonds rose
by 1 basis point to 4.48 per cent. During the same period,
the average yield on The Weekly Bond Buyer's series for
twenty seasoned tax-exempt issues (carrying ratings rang­
ing from Aaa to Baa) declined by 5 basis points to 3.25 per
cent. (These yield series are shown in the right-hand panel
of the chart.)
The volume of new corporate bonds publicly floated in
July amounted to an estimated $535 million, compared
with $720 million in June 1965 and $230 million in July
1964. The largest publicly offered new corporate bond
issue of the month consisted of the offering— mentioned
above— by a leading merchandising chain of $150 million
of 4% per cent sinking fund debentures nonrefundable for
five years and maturing in 1990. New tax-exempt flotations
totaled about $980 million, as against $885 million in June
1965 and $835 million in July 1964. The Blue List of taxexempt securities advertised for sale closed the month at
$756 million, compared with $834 million at the end of
June. The largest new tax-exempt bond flotation during the
month was a $175 million municipal Baa-rated offering. It
consisted of $111 million of general purpose bonds re­
offered to yield from 2.80 per cent in 1967 to 3.565 per cent
in 1995 which were quickly sold, and $64 million of bonds
maturing in 1966-70. The latter were awarded at a net in­
terest cost of 3.499 per cent, but reoffering was delayed
pending settlement of a legal question.

FEDERAL RESERVE BANK OF NEW YORK

165

Interregional Interest Rate Differentials
By R ic h a r d G. D a v is

The various regions of the United States in many im­
portant respects form a single, well-nigh perfectly unified
capital market. In this “national” market, transactions in
comparable securities take place on identical terms at
different points of the compass, and borrowers located in
different areas, but otherwise identical as to creditworthi­
ness, are accommodated on an equal basis. Obviously, a
national market exists for securities of the Federal Gov­
ernment and its agencies as well as for such private
money market instruments as Federal funds, bankers’ ac­
ceptances, prime commercial paper, and negotiable cer­
tificates of deposit. By and large, the securities of state
and municipal governments and of the larger and better
known corporations also can be regarded as trading in a
national market. For these widely accepted securities, the
going rate of interest on a given issue (or on comparable
issues) is the same in California as in New York, while
the price received for a new issue does not depend upon
the borrower’s location or state of incorporation— except
to the extent that these are directly associated with risk
or tax factors. For securities trading in the national mar­
ket, interregional interest rate differentials, when they
exist at all, tend to be very quickly eliminated as buyers
seek the lowest available price while sellers seek the
highest.
For some important types of debt instruments, in con­
trast, there are persistent regional differences in going
interest rates. In magnitude, to be sure, these differentials
are considerably smaller than the interest rate differentials
which can arise between the capital markets of different
nations. Moreover, the scattered evidence available sug­

* Senior Economist and Economist, Research Department.




and

L o is B a n k s *

gests that these interregional differentials are considerably
smaller today than they were in the late nineteenth and
early twentieth centuries. Nevertheless, by the standards
of the modern capital market, where differences of a few
cents per thousand dollars can be of consequence, these
interregional rate differentials seem by no means negligible.
The persistence of regional interest rate differentials
over very long periods and the tendency for particular
regions to show persistently higher or lower than average
rates for a variety of different instruments strongly suggest
that differences in regional interest rates stem at least in
part from underlying differences in the balances between re­
gional supplies and demands for capital. Interregional rate
differentials would be expected to set in motion flows of
funds from regions of relative capital abundance to re­
gions of relative capital scarcity, and there is ample
evidence that such flows are in fact important. Neverthe­
less, for a variety of reasons— some legal, some institu­
tional, and some related to investor attitudes toward the
risks of investing in geographically remote areas— inter­
regional flows of capital have not been large enough to
offset completely the differences in intraregional balances
of supply and demand for capital.
This article examines the characteristics of inter­
regional rate differentials in the United States and seeks
to explain why these differentials do persist. The sig­
nificance of the findings for the efficiency of interregional
capital allocation is also briefly assessed.
CHARACTERISTICS OF INTERREGIONAL
RATE DIFFERENTIALS

The available statistical evidence on the existence and
extent of interregional interest rate differentials is con­
fined to a few series on savings deposit and savings share

166

MONTHLY REVIEW, AUGUST 1965

rates, mortgage rates, and rates on bank loans to business.
Interregional rate differentials may well exist in other
markets, however, such as the market for consumer
credit. Indeed, if the rate differentials for which data are
available do stem basically from differences in regional
supply-demand balances, then it would not be surprising
to find regional rate differentials in other markets as well.
Nevertheless, the “hard” evidence on regional rate dif­
ferentials is pretty well limited to the markets discussed
in this article.
Interregional interest rate differentials in six different
series are plotted in Chart I for the 1949-64 period. Note
that the chart shows maximum regional differentials, that
is, for a given instrument the difference between the highest
regional interest rate prevailing at a given time and the
lowest regional rate prevailing at that time. The geographic
identities of the highest and lowest rate regions are not
necessarily the same from one period to the next. Never­

Chart

I

M A X IM U M INTEREST RATE DIFFERENTIALS BETWEEN REGIONS
OF THE UNITED STATES

P ercentage point

1949

theless, as discussed below, there has in fact been a tend­
ency for highest and lowest average rates to be located
rather consistently in particular parts of the country.
The top panel of Chart I records interregional differ­
entials in average rates paid on commercial bank time
and savings deposits and in average rates paid on savings
and loan shares. The middle panel shows differentials in
average rates paid on conventional mortgages for single­
family homes and differentials in the yield equivalents of
prices paid in the so-called “secondary market” for mort­
gages on one- to four-family dwellings insured by the Fed­
eral Housing Administration (F H A ). Finally, the bottom
panel shows regional differentials for average rates
charged by commercial banks on short-term loans to busi­
ness for loans within the $1,000 to $10,000 size-class, the
smallest sized class for which data are available, and dif­
ferentials for the largest sized class, loans of $200,000
and over. The ranges of the differentials plotted in the

1950

1951

1952

1953

1954

1955

1956

1957

1958

1959

1960

1961

P e r c e n t a g e p o in t

1962

1963

N o te : The s h a d e d b a n d s covering month's in 1 9 4 9 , 1 9 5 3 -5 4 ,1 9 5 7 -5 8 , a n d 1960-61 re p re se n t r e c e ss io n p e r io d s ,a c c o r d in g to N a tio n a l B u re a u of E c o n o m ic R e s e a rc h c h ro n o lo g y .
S o u r c e : B a s e d u p o n statistics from Fed e ral H om e L o a n B a n k B o a r d ; F e d e ra l D e p o s it In su ra n c e C o rp o ra tio n ; F e d e ra l H o u sin g A d m in istra tio n ; B o a rd of G o v e r n o r s of the
Fe d e ral R e serve Sy stem . F or a d e s c r ip t io n o f the d ata, see footnote 1 in text.




1964

167

FEDERAL RESERVE BANK OF NEW YORK

chart are given in the following table.1
As Chart I and the table indicate, the interest rate differ­
entials in all these series show a good deal of variation
over time, but as a group do not exhibit any consistent re­
sponse to the business cycle. There is no evidence of a trend
toward a narrowing of the differentials during the postwar
period, although some scattered data for much earlier
periods give the distinct impression that interregional rate
differentials were once a great deal larger than they have
been in the more recent past. For example, Census data in­
dicate that maximum interregional mortgage rate differ­
entials were as high as 3.80 percentage points in 1890,
more than four times the largest differential seen in recent
years, and that they showed a progressive, long-term tend­
ency to narrow as the decades passed.2 Similarly, some data
for average rates charged by banks in large cities on various
types of short-term business loans indicate that differences
between the highest and lowest rate regions averaged nearly
1 percentage point during the early and mid-1920’s.3
Comparable differentials averaged only about half as large
in the 1950’s and 1960’s. In view of the vast improvements
in transportation and communication, the greater uniform­
ity of economic structure, and the development of financial
intermediaries, including such governmental agencies as the
Federal National Mortgage Association (FN M A ), it is
hardly surprising that interregional rate differentials should
have narrowed over the decades. The facilities for trans-

1 Th& regional breakdowns for all series other than the bank
loan series correspond to the FH A regions: Northeast (which in­
cludes New York State), Middle Atlantic, Southeast, Southwest,
West, and North Central. (In 1964, the FHA combined the North­
east and Middle Atlantic regions.) The bank loan data are derived
from the Federal Reserve Board’s Quarterly Interest Rate Survey.
New York City, shown separately in the Board’s published data,
has been included in the data for other “Northern and Eastern”
cities. Commercial bank time deposit interest rates were obtained
by dividing total interest paid on time and savings deposits by
average levels of these deposits. The necessary state data were ob­
tained from the Annual Report, 1949-63, of the Federal Deposit
Insurance Corporation. A similar procedure was used to compute
regional rates on savings and loan shares, with the data coming
from the Combined Financial Statements, 1948-63, of the Federal
Home Loan Bank Board. Data on conventional and FHA-insured
mortgages are released by the FHA. The conventional series covers
new and existing homes combined prior to May 1960. Data since
then represent the quantitatively more important existing home
category. The FHA-insured mortgage data represent conversion of
price data into yield equivalents by assuming a 25-year maturity
and a 12-year prepayment period. Data for 1956 and later years
are in fact solely for mortgages with 25-year maturities.
2 See Leo Grebler, David Blank, and Louis Winnick, Capital
Formation in Residential Real Estate (New York: National Bu­
reau of Economic Research, 1956), p. 229.
3 See Winfield Riefler, M oney Rates and M oney M arkets in the
United States (N ew York: Harper, 1930), pp. 101-103.




RANGES OF INTERREGIONAL
DIFFERENTIALS FOR VARIOUS INTEREST RATE SERIES
1949-1964
Differential
Series

Smallest

Largest

In percentage points
Commercial bank time and savings deposits* ...................

.16

.88

Savings and loan shares* ......................................................

.38

.91

Conventional mortgages! ....................................................

.20

.85

Federal Housing Administration—insured mortgages.....

.02

.43

$1,000 to $10,000 ................................................................

.02

.45

$10,000 to $100,000 ............................................................

.01

.39

$100,000 to $200,000 ..........................................................

.04

.39

$200,000 and over ..............................................................

.16

.55

Bank short-term business loans by size of loan:

Note: Ranges, for the years covered, are taken from data showing difference be­
tween highest and lowest rate region at any given point of time.
* Data through 1963 only,
t Data cover 1954-64.

ferring capital from surplus to deficit regions have vastly
improved, and the risks of lending to geographically remote
areas have been greatly reduced. What is somewhat surpris­
ing at first sight is that, despite these changes, significant
differentials between regions still exist.
g e o g r a p h i c c h a r a c t e r is t i c s . Interregional interest rate
differences show a marked degree of geographical stability.
By and large, the “Northeast” tends to be a low interest rate
region while the “West” tends to be a high rate region— a
pattern which has always existed. It is somewhat more dif­
ficult to generalize about the relative positions of the
other regions, and it is true, of course, that the definition
of a region is bound to be somewhat arbitrary. With one
exception noted below, the “Northeast”, as used in the
available data, includes the six New England states and
New York, while the “West” includes the Rocky Moun­
tain states, the three Pacific Coast states, plus Alaska and
Hawaii. Obviously there is no clear-cut basis for including
some of these states or excluding others, and changes in the
precise geographical content of the regional averages would
result in some differences in the rate differentials observed.
Moreover, the very concept of a regional average conceals
the sharp differences in rates that may exist within a region,
particularly between urban and rural areas. Indeed, these
differences may be larger than the average rate differences
between the broad regions themselves.
In Chart II, interest rate levels have been plotted for
the Northeast, the West, and for the nation as a whole in

MONTHLY REVIEW, AUGUST 1965

168

Chart

II

INTEREST RATES IN SELECTED REGIONS
OF THE UNITED STATES
Per cent

Per cent

^ !n 1 96 4 N o r th e a st inclu d e s M id d le A tla n tic z on e .
S o urce s: B a s e d u p o n statistics from F e d e ra l H o m e L o a n B a n k B o a r d ; F e d e ra l H o u s in g A d m in istra tio n ; B o a rd o f G o v e rn o rs of the F ede ral R e se rve Sy ste m .
For a d e s c r ip t io n of the d ata, see footnote 1 in text.

various series. As can be seen, rates paid by savings and
loan associations have been substantially lower in the
Northeast than in the West for every year plotted. A
fairly similar pattern has existed for West-Northeast dif­
ferentials in average rates paid on time and savings deposits
at commercial banks (not shown on the chart). These
latter differentials have narrowed at times, however, when
general pressures on interest rates have pushed a sub­
stantial proportion of banks up against geographically
uniform Federal rate ceilings.
Differentials on mortgage rates also display a con­
sistent geographic pattern. As Chart II shows, average
rates on conventional mortgages have been significantly
higher in the West than in the Northeast in every year
plotted. Rates on FHA-insured mortgages (not plotted)
have also been persistently higher in the West, though
the differentials have been generally smaller. In the data




cited earlier for the more distant past, Western mortgage
rates were also invariably higher than rates charged in
the East.
Unfortunately the data do not permit comparison of
business loan rates in the FHA “Western” and “North­
eastern” regions since only an even broader geographical
breakdown— “Northern and Eastern” versus “Southern
and Western”— is available. Differentials in business loan
rates between these latter regions have been relatively
small and, as Chart II shows, there have been periods
when the differences have melted away altogether. Never­
theless, when measurable differences have existed— which
has been most of the time— rates have almost invariably
been higher in the “Southern and Western” region. This
is true not only for the $10,000 to $100,000 loan class
plotted in the chart, but also for the smaller and larger
classes not plotted. Moreover, it is virtually certain that,

FEDERAL RESERVE BANK OF NEW YORK

if a further regional disaggregation were made in the
bank loan data, so that separate data on Western cities
(exclusive of the South) and on Northeastern cities were
available for each loan size-class, larger and even more
consistent interregional differentials would be visible. In­
deed, data representing these additional geographical break­
downs for average rates charged on loans in all size-classes
do support this conclusion. Again the data for the more
distant past cited earlier confirm a pattern of relatively
high Western rates on bank loans.
a d e q u a c y o f t h e d a t a . The persistence
of inter­
regional differences in the interest rate data for a variety
of series and the stability of the regional pattern of these
differences over time leave little doubt that the apparent
regional differences in capital market conditions are in fact
a reflection of real differences in regional economic charac­
teristics. Nevertheless, it should be noted that the data on
interregional rate differentials are less than ideal. One limi­
tation of the bank loan data, for example, is that they do not
take explicit account of whatever regional differences may
exist in the average characteristics of borrowers or in the
average nonrate characteristics of loans. To the extent that
such differences exist, regional interest rate data would re­
flect them and therefore might not be indicative of true re­
gional differences in rates charged on loans of comparable
risk. There seems to be good reason to believe, however,
that stratification of the data by size of loan greatly reduces
the risks of major distortions due to any regional dif­
ferences in borrower characteristics. The available evi­
dence suggests that the average size of a group of loans
is highly correlated with such borrower characteristics as
the proportion of corporate to noncorporate borrowers
and the average asset size of borrowers.4 The size of bor­
rowers, in turn, is likely to be associated with average
credit standing and access to alternative sources of credit.
Hence, loans that are homogeneous as to size may tend
to be roughly homogeneous with respect to average bor­
rower characteristics, so that data from different regions
for loans in a given size-class probably tend to be roughly
comparable.
It is still possible, however, that regional differences
with respect to industrial composition of borrowers, aver­
age compensating balance deposits, or other nonrate
features of lending might tend to make Eastern (or West­
ern) borrowers in each loan size-class more desirable at a

169

given interest rate than Western (or Eastern) borrowers,
thus tending to distort the meaning of average rate dif­
ferentials. It is conceivable, for example, that interest
rate data for New York City may be biased downward
somewhat by a relatively heavy concentration of indus­
tries that typically obtain lower than average rates for any
given loan size. Moreover, average New York City inter­
est rates in the largest loan size-class ($200,000 and over)
may be pushed down by a particularly heavy concentra­
tion of borrowing at the “prime rate” by the very largest
firms. Even if New York City is removed from the data,
however, the general tendency for Southern and Western
rates to exceed rates in the Northern and Eastern region
remains.
With regard to mortgage rates, data on nonrate con­
tract terms raise the possibility that for conventional
mortgages at least, the nominal interest rate differential
between the East and West may overstate to some degree
the true differential on mortgages with similar nonrate
characteristics. Rates on conventional mortgages for new
homes in Boston and Philadelphia, for example, currently
average around 5.30 per cent, compared with an average
of around 5.95 per cent for the Los Angeles-Long Beach
and San Francisco-Oakland areas. On the other hand, the
average term to maturity of the Western mortgages is
around 28.5 years, compared with a shorter average of
about 23.5 years for the two Eastern cities. Moreover,
the ratio of the amount of the loan to the price of the
property for the West Coast cities is about 77 per cent, as
against a loan-price ratio averaging only about 69 per
cent in the two East Coast cities. Whatever their cause,
these easier nonrate terms on the West Coast represent
a partial offset to the higher average interest rates
charged.5 It seems very doubtful, however, that the offset is
complete in view of the size of the interest rate differ­
entials, the fact that substantial rate differentials also exist
in FHA-insured mortgages of comparable terms,6 and in

5 Relatively restrictive legal maximum term to maturity in some
Eastern states may be a factor, and legal restrictions may also play
a role in the apparently lower average loan-value ratio in some
Eastern states. It might also be noted that there may be some non­
rate considerations that have the effect of understating the size of
the true East-West differentials for mortgages of seemingly com­
parable features. Thus, for example, the average age of existing
houses is almost certainly lower on the West Coast, which would
tend to push average rates for mortgages on existing homes down
relative to areas where the average age of the housing stock is
older.

6 To ensure maximum uniformity, data on FHA-insured mort­
4 Mona Dingle, “Interest Rates on Business Loans”, Business gages (from which the regional differentials are computed) for
Loans of American Commercial Banks (ed. B. H. Beckhart, New
1956 and later are based on new homes with 10 per cent down­
York: Ronald Press, 1959), pp. 336-43.
payments and 25-year maturities.




MONTHLY REVIEW, AUGUST 1965

170

view of the persistent ability of the Western mortgage
market to attract Eastern funds.
RATE DIFFERENTIALS AND INTERREGIONAL
CAPITAL FLOWS

The problem of interregional (and international) in­
terest rate differentials is intimately bound up with the
problem of interregional (or international) capital flows.
Regions may differ with respect to the balance between
local supplies and local demands for funds. In the ab­
sence of interregional capital flows, these differences
would tend to result in higher interest rates in areas of
relative capital scarcity. Suppose, however, that capital
moves freely across regional lines with borrowers seeking
to borrow at the cheapest rates regardless of the geo­
graphical location of the lender and with lenders lending
at the highest available rates regardless of the location of
the borrowers. Flows of funds should take place from
surplus to deficit regions, with claims against the borrow­
ing region rising accordingly. Indeed, the rate of these
interregional flows should be just sufficient to eliminate
any differences in regional interest rates. Any lesser rate
of flow (or no flow at all), leaving rates in the deficit
region high relative to the surplus region, would provide
the incentive for an acceleration in the rate of lending
across regional lines. On the other hand, a rate of inter­
regional capital flows in excess of the rate necessary to
eliminate regional rate differentials would be similarly
self-correcting.
A zero interest rate differential, it should be noted,
would be perfectly compatible with the flow of some part
of the new savings of the surplus region into the deficit re­
gion. In a dynamic world, new savings are constantly being
generated, as are new investment demands, and in the geo­
graphically unified market assumed, savers would not re­
quire any special incentive to lend to borrowers in remote
areas. Indeed the lack of a need for such a special incentive
is the distinguishing feature of a “geographically perfect”
capital market. Yet, if a rate differential does open up, a
special incentive for funds to flow to the deficit area does
exist and such flows should therefore accelerate until the
differential is eliminated.
In a modern economy, of course, funds are not gen­
erally lent directly by individual savers to the ultimate
borrowers but, instead, pass through financial inter­
mediaries such as banks, savings and loan associations,
insurance companies, and the like. Under these condi­
tions, capital flows between surplus and deficit regions
can take two forms. Savers in capital surplus regions can
lend their savings to financial intermediaries in the deficit




regions attracted by relatively high rates paid for savings
in those regions. At the same time, intermediaries in the
capital surplus regions can be induced to extend credit to
the ultimate borrowers in the deficit regions by the rela­
tively high interest rates these borrowers are willing to pay.
Up to a point, these general features of the inter­
regional capital market mechanism are reasonably well
exemplified by the behavior of the United States market.
It is not at all difficult, for example, to think of reasons
why the West Coast should be a region of relative capital
shortage, or the Northeast a region of relative capital
abundance. The West is a rapidly growing, comparatively
“new” region with higher demands for new capital than
the settled, more slowly expanding Northeast. From 1950
to 1960, the population of states here defined as the
“West” expanded by fully 39 per cent, compared with
an increase of 19 per cent for the nation as a whole. In
the capital-surplus Northeast, population rose by only 13
per cent over this period. Similarly, housing units grew
by 43 per cent in the West and by only 23 per cent in
the Northeast.
Given the rapid advance experienced by the West, a
persistent strain on the local supply of savings has existed,
leading to upward pressures on local interest rates. Further­
more, the upward pressure on rates has attracted outside
capital— capital which has, in turn, moderated the upward
pressure on local rates and at the same time has provided
the needed funds for a continuation of the rapid rate of
growth. Finally, outside capital has been attracted from
areas such as the Northeast, which has high per capita
wealth and the capacity to generate heavy flows of savings
but which also has a relatively lower demand for new
capital.
e a s t -w e s t f l o w s o f f u n d s . While there are no com­
plete data on flows of funds between states and regions,
the data that are available point to the conclusion that
funds have, in fact, tended to flow into California from
the East and other parts of the country— at least in some
of the markets where interregional interest rate differen­
tials exist. Thus, savers in other parts of the country have
evidently been induced to transfer funds to financial inter­
mediaries located in California. One study suggests that
some 15 per cent of savings and loan shares outstanding at
California savings and loan associations in 1960 were held
by out-of-state sources.7

7 Leo Grebler, “California’s Dependence on Capital Imports for
Mortgage Investment”, California Management R eview (Spring
1963), p. 48.

FEDERAL RESERVE BANK OF NEW YORK

At the same time, a substantial portion of California
mortgage debt appears to be held by out-of-state lenders.
Thus the study just cited indicates that some 7 per cent
of California mortgages were held by mutual savings
banks.8 These institutions, which do not exist at all in
California, are located mainly in New England and the
Middle Atlantic states. In addition, a substantial propor­
tion of California mortgages in 1960 appears to have
been held by national lenders such as life insurance com­
panies, while FNMA has also been a significant net sup­
plier of funds from the rest of the country to the
California mortgage market.
There is additional evidence that local or regional capi­
tal shortages are associated with generally higher local
interest rates and with capital inflows. Thus there appears
to be a positive statistical association between one mea­
sure of the importance of past capital inflows, the propor­
tion of mortgage debt in a large metropolitan area held
by lenders located outside the area, and average mort­
gage rates on residential properties located within the
area.9 There also appears to be a significant (though
weaker) tendency for rates on short-term bank loans to
business in the $1,000 to $10,000 and in the $10,000 to
$100,000 size-classes to be higher, on average, the larger
the portion of residential mortgage money supplied out­
side the metropolitan area. This finding lends some sup­
port to the view that the relationship between local capital
shortages and interest rates reflects a general shortage not
confined to the mortgage market alone.
In summary, the available evidence is consistent with
the presumption that areas of capital shortage tend to be
associated with higher interest rates and that these rates
attract funds from other regions, both indirectly through
flows of outside savings to local intermediaries and
directly through lending by outside intermediaries to
local borrowers. There is no reason to doubt, moreover,
that these interregional flows have tended to narrow inter­
regional rate differentials greatly, compared with what
they would otherwise have been. Thus, the only element
in the situation that remains to be explained is the fact that
interregional differentials, though reduced, still do exist.
There are, however, a number of interferences to inter­
regional capital flows that prevent these flows from being
large enough to wipe out remaining rate differentials com­
pletely.

171

IMPEDIMENTS TO THE INTERREGIONAL
FLOW OF FUNDS
t h e m o r t g a g e m a r k e t . The mortgage market is the most
important single sector of the capital market and is a ma­
jor channel for interregional movements of funds. Never­
theless, impediments to the free flow of funds in the
mortgage market are numerous and complex, reflecting the
complexity of the market itself. Mortgages, whether con­
ventional or Federally insured, may be “originated” by com­
mercial and savings banks, savings and loan associations,
mortgage companies, and insurance companies as well as by
others. In some cases the originator of the loan expects to
sell the mortgage to an ultimate investor and may obtain a
commitment by such an investor to purchase the mortgage
even before its origination. Mortgages originated by
mortgage companies, for example, are intended mainly
for resale. In addition, commercial banks often originate
mortgages for resale, as do other financial institutions
though less frequently. The bulk of trading in the so-called
secondary market consists of sales between originators and
ultimate investors rather than of sales of seasoned mort­
gages from one long-term holder to another.10 Inter­
regional lending in the mortgage market generally takes
the form of a purchase by an outside financial institu­
tion of a mortgage originated by a local lender in expec­
tation of later resale. In such cases the local originator
will frequently continue to service the mortgage during
its life for a fee. In some cases, however, the outside
financial institution will maintain regional offices that
originate and service mortgages.
Why does the existing interregional mortgage market
fail to generate a flow of funds from surplus to deficit
areas large enough to eliminate the existing regional rate
differentials? A “perfect” interregional market in mort­
gage funds capable of eliminating rate differentials on
mortgages of similar quality would require (1 ) that all
lenders be permitted to allocate their funds geographically
solely according to their best business judgment, (2 ) that
the tangible and intangible costs of making mortgages of
given quality be the same for out-of-state as for local
properties, and (3 ) that lenders be completely indifferent
between local and out-of-state mortgages equal in quality
and yielding an equal net return. None of these three
conditions is met in the American market.
First, as a result of a complex web of customs and of

8 Grebler, op. c i t p. 48.
9 Theodore Flechsig, “The Effect of Concentration on Bank
Loan Rates”, Journal of Finance (May 1965), pp. 301-302.




10 See Saul Klaman, The Postwar Residential Mortgage Market
(Princeton, 1961), pp. 195-213.

172

MONTHLY REVIEW, AUGUST 1965

state and Federal laws and regulations, only life insurance
companies among the main institutional lending groups
in the mortgage market have had, as a group, substantial
freedom to allocate their conventional mortgage lending
among regions on the basis of business judgment alone.
Regulations and custom have greatly restricted nonlocal
lending by savings and loan associations— though in re­
cent years there has been a moderate amount of such
lending, mainly through purchases of “participations” in
loans originated by out-of-state associations. A number
of states forbid nationwide lending in the conventional
mortgage market by mutual savings banks and these in­
stitutions have had only a very limited impact on inter­
regional flows of funds in the conventional market.11
Similarly, commercial bank participation in the nation­
wide market has been restricted by law and, more impor­
tantly, by custom, particularly with regard to conventional
mortgage lending.
Second, the tangible and intangible costs associated
with the making of both conventional and Federally un­
derwritten nonlocal mortgages appear to be higher than
those associated with local mortgages. Thus, the servicing
costs of out-of-state mortgages may be higher than for
local mortgages. Moreover, there are legal uncertainties
associated with out-of-state lending relating to state-bystate differences in the rights and obligations of creditor
and debtor, the liability of the out-of-state lender to state
and local taxes, and the rights of the out-of-state lender in
local courts.12 Coping with these problems may involve
additional legal costs and may add a psychological barrier
to out-of-state lending. Lenders will be willing to under­
take these additional costs and worries only if rates on
out-of-state mortgages are somewhat higher than rates
obtainable on local mortgages.
Third, lenders may hold back in their purchases of
mortgages from high interest rate regions even if no legal
barriers exist and even if the yield on out-of-state mort­
gages is more than sufficient to compensate for any spe­
cial costs of out-of-state lending. Some thrift institutions,
for example, may feel an obligation to meet all demands
for credit by qualified local borrowers even when more
profitable out-of-state investments exist. Furthermore,

11 For a discussion of out-of-state lending in the conventional
market by mutual savings banks, see John Krout, “How to Operate
Nationwide Conventional Loan Programs”, Savings Bank Journal
(April 1965), pp. 40-42; see also George Hanc, “Report on Outof-State Lending”, ibid., pp. 42-45.
12 J. J. Redfield, “Problems Facing Savings Banks in Out-ofState Mortgage Purchases”, Mortgage Banker, January 1956.




geographical diversification of mortgage portfolios is one
way of hedging against risk, and this consideration may
mean that out-of-state lending is not always directed at
regions with the highest prevailing rates. In summary,
while interregional mortgage lending represents profitable
business for lenders and does take place on a fairly large
scale, it is, for various reasons, unlikely to result by itself
in the complete elimination of interregional rate differ­
entials.
It should perhaps also be noted that differences in legal
maximum interest rates permitted under the laws of the
various states do not appear to have been a significant
factor in accounting for differences in average mortgage
rates between areas such as the West and the Northeast.
In the case of the data on FHA-insured mortgages, which
represent the yield equivalents of the prices paid by one
lender to another for mortgages purchased in the sec­
ondary market, these legal maxima are not a relevant con­
sideration. For the conventional mortgage data, which do
reflect the terms made with the borrower, differences in
legal maxima could be a factor in determining average
regional rates. It is doubtful, however, that any substan­
tial part of the Northeast-West differential has in fact
been due to differences in legal maximum rates among
the states of these regions. First, legal maxima are not
uniformly higher in the states of the West than in the
states of the Northeast. Second, the average rate on con­
ventional mortgages in the Northeast has always been be­
low the lowest legal maximum of 6 per cent applying in
some Northeastern states, and over a large part of the
postwar period the average rate was much lower than 6
per cent. Of course, it is likely that there have been some
mortgages drawn up at 6 per cent that would, in the
absence of a ceiling, have been contracted at a higher
rate. Instances of this sort would tend to depress average
New York State rates, for example, where the maximum
is 6 per cent, relative to average rates in a state such as
California where the legal maximum rate is higher. Yet
the question still arises as to why a lender would be will­
ing to make such a deal rather than use the funds to
purchase a California mortgage of at least comparable
quality at a higher rate. The answer must lie in one or
more of the impediments to interregional lending already
mentioned.
IMPEDIMENTS TO INTERREGIONAL BANK LENDING TO BUSI­

Barriers to interregional bank lending and the result­
ing persistence of interregional rate differentials are bound
up with the need for a reasonably close bank-customer re­
lationship. The credit standing and reputation of the smallor medium-sized business will usually be unknown outside
NESS.

FEDERAL RESERVE BANK OF NEW YORK

its own locale, and in the great majority of cases, such
firms will simply not have the option of borrowing from
banks in remote areas. In addition, the rate charged to a
given business borrower by a bank, and even the willing­
ness of a bank to lend at all, is frequently related to the
volume of deposits the potential borrower maintains with
the bank. Naturally a small- or medium-sized business
would normally tend to keep its working balances at banks
located in the area where most of its business is actually
transacted. This factor further limits the ability of such
firms to borrow from nonlocal banks at competitive rates
and thereby reduces their opportunity to escape whatever
borrowing conditions the local balance of supply and de­
mand for funds may impose.
Of course the larger and better known a firm is, the
more likely it is to have the option of borrowing from
banks in different areas. Indeed for the very largest firms,
nationwide borrowing from a large number of banks is
common. As might be expected, interregional interest
rate differentials generally do not exist for these largest
borrowers who are able to borrow in a truly national
market at the so-called prime rate, a rate that has gen­
erally tended to be uniform throughout the country.13

173

highest available savings and loan dividends. Yet it is un­
doubtedly still true that the greater convenience of having
an account with local associations and the greater sense of
security that many savers feel in keeping their funds near
at hand are important factors in restricting movements
in response to geographic rate differentials. Perhaps the
classic explanation once offered by David Ricardo for
the persistence of international interest rate differentials
also has some relevance to interregional differentials. He
noted that “the fancied or real insecurity of capital, when
not under the immediate control of its owner . . . [will]
induce most men of property to be satisfied with a low
rate of profits in their own country, rather than seek a
more advantageous employment for their wealth in for­
eign nations”.14
THE EFFICIENCY OF INTERREGIONAL
CAPITAL ALLOCATION

The existence of differences in regional interest rates
may seem to raise questions about the efficiency of the
United States market in allocating capital geographically.
To be sure, this problem— if it is a problem— would have
to be regarded as of relatively minor importance: the
differentials that do exist are limited in size. Moreover,
IMPEDIMENTS TO INTERREGIONAL SAVINGS FLOWS. D e s p i t e
the expanded use of such techniques as banking by mail aided by a myriad of factors as diverse as national rating
and advertising, the flow of savings from surplus regions services for new bond issues and the facilities for a national
to financial intermediaries in deficit regions remains in­ market in Federal funds, the bulk of capital market trans­
sufficient to eliminate either the savings rate differentials actions takes place virtually without regard to geo­
themselves or, indirectly, lender-rate differentials such as graphical considerations. Nevertheless, where regional dif­
exist in the mortgage and bank loan markets. Commercial ferences in rates exist, there may appear to be some
bank demand deposits, of course, carry no monetary in­ presumption that a type of regional “misallocation” of
terest rate at all so that there can be no rate incentive to capital also exists. Thus, to the extent that relatively high
transfer funds. Commercial bank savings depositors are financial interest rates in a given region are mirrored by
presumably motivated at least as much by convenience fac­ a relatively high social productivity of real capital at the
tors as by interest rate considerations, and hence regional margin in that region, transfers of capital into the region
differences in deposit rates probably have little or no power from other parts of the country might mean a gain in real
to induce interregional flows of funds. Holders of savings productivity for the country as a whole. In theory, only
and loan shares may be assumed to be more rate conscious when interest rates are uniform throughout the country
as a class, and there are no legal or significant cost factors is capital allocated in such a way that all opportunities for
that would inhibit this class of savers in seeking out the socially useful redistributions among regions have been
exhausted. Only at this point can the regional allocation
of capital be said to meet the minimal requirements of
efficiency.
13 As would be expected, the largest loan size-class in the avail­
There is a difficulty with this argument, however. It
able statistics ($200,000 and over) contains a far larger proportion
ignores
the fact that, in significant part, the interest rate
of lending at the prime rate than any of the other loan sizeclasses. It is therefore somewhat surprising at first sight that the
data show regional differentials for this group of loans to be typi­
cally somewhat larger than for the smaller loans. This is most
likely due to an uneven geographical distribution of these prime
rate borrowers, however. There is a tendency for prime rate loans
to be relatively more important in the East, and particularly in
New York City, than in the West and South.




14 Principles of Political Economy and Taxation (G. Bell and
Sons: London 1922), p. 117.

174

MONTHLY REVIEW, AUGUST 1965

differentials that do exist between regions reflect some
real costs, tangible or intangible, of transferring capital
across regional lines. The existence of such costs was
noted in the interregional mortgage market. In connec­
tion with bank lending to small- and medium-sized busi­
ness, moreover, the absence of interregional lending can
be interpreted as indicating in part that the costs of evaluat­
ing potential nonlocal borrowers are prohibitive or, al­
ternatively, that the rate premiums required to offset the
risks involved are prohibitive. In the savings deposit mar­
ket, the reluctance of many savers to deposit their funds




with geographically remote institutions may or may not
seem well-founded, but such attitudes can no more be
dismissed from the economic calculus than other kinds of
consumer preferences.
The influence of these economically real, though some­
times intangible, costs of transporting capital can be
likened to the role of transportation costs in producing
geographical differentials in the prices of goods. As long
as such costs exist, the absence of geographical uniformity
in prices or in interest rates need not indicate geographical
misallocation of goods or capital.