The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
MONTHLY REVIEW, AUGUST 1972 186 Th e Business Situation The economy continues to exhibit an impressive and broadly based expansion. Real gross national product (GNP) rose at a vigorous 8.9 percent seasonally adjusted annual rate in the second quarter, as almost all major components contributed to the advance. Moreover, this gain followed sizable upward revised increases in real GNP in the two preceding quarters. Industrial production posted only a moderate increase in June, but over the first half of the year output rose at a rapid 8.5 percent annual rate. Both civilian employment and labor force changed little in July, on a seasonally adjusted basis. Consequently, the unemployment rate remained at 5.5 percent for the sec ond consecutive month, down markedly from its average level of 5.9 percent that had prevailed since late 1970. Recent data on wages and prices show some definitely encouraging developments. The pace of wage increases has slowed somewhat, and unit labor costs declined in the sec ond quarter for the first time in over six years. The im plicit GNP price deflator—the most comprehensive available measure of price behavior—rose at a relatively modest 2.1 percent annual rate in the second quarter, but shifts in the composition of output caused some under statement of actual inflation. The rise in consumer prices has been appreciably slower in the last four months. On the other hand, throughout the period since the end of the price freeze last November the wholesale price index has continued to rise rapidly. GROSS N ATIO N AL PRODUCT AND R ELA TE D D EVELO PM EN TS According to preliminary estimates by the Department of Commerce, the market value of the nation’s output of goods and services rose by $29.9 billion during the second quarter to a seasonally adjusted annual rate of $1,139 billion. Measured in current dollars, the increase was a bit smaller than the advance in the first quarter. However, only about one fifth of the most recent gain was accounted for by price increases, whereas in the first quarter price rises constituted almost half of the expansion in nominal GNP. Hence, the growth in real GNP— that is, GNP adjusted for price changes— accelerated sharply in the April-June period to a seasonally adjusted annual rate of 8.9 percent, the largest quarterly percentage increase in real GNP since the fourth quarter of 1965. Along with the preliminary data for the second quarter, the Department of Commerce released its annual revisions of the GNP data going back through 1969. Estimates of real GNP were revised upward significantly for the final quarter of 1971 and the first quarter of this year. Over these two quarters combined, real GNP growth is now estimated to have averaged 6.6 percent per annum, nearly 1 percentage point more than was previously reported. These latest figures bring the increase in real GNP over the four quar ters ended in the second quarter of 1972 to a healthy 6.1 percent, significantly above the gain for any comparable period in the past six years (see Chart I). Inventory investment as well as final spending appar ently rose substantially in the second quarter. Tentative and incomplete data indicate that the annual rate of inventory accumulation in the GNP accounts accelerated to $4.3 billion in the April-June period as compared with only $0.4 billion in the preceding quarter. Thus, after a prolonged period of sluggishness, inventory spending provided a $3.9 billion stimulus to the overall advance of GNP (see Chart II). Prospects appear to be good for further gains in inventory investment in the months ahead in line with increases in sales. Business inventory-sales ratios, particularly in the manufacturing and retail sectors, remain at relatively low levels. Moreover, the latest survey conducted by the Department of Commerce found that manufacturers expect to add substantially to their inven tories in the third quarter. The second-quarter rise in current-dollar final expendi tures— i.e., GNP net of inventory accumulation— amounted to $26.1 billion, down from $32.2 billion in the first quarter. In real terms, however, final spending rose at a rapid 7.2 percent annual rate, a shade higher than the growth over the January-March period. Among the components of final expenditures, consumer spending FEDERAL RESERVE BANK OF NEW YORK and business fixed investment were particularly strong, while residential construction rose modestly. Net exports of goods and services was the only major component which failed to contribute to the overall expansion of GNP, as the gap between imports and exports of goods and services widened slightly to an annual rate of $4.9 billion. Personal consumption expenditures rose by $16.4 billion over the April-June period to a seasonally adjusted annual rate of $712.5 billion. Outlays for nondurable goods and services posted relatively strong gains, while the increase in spending for durables moderated somewhat from the pace of the previous quarter. The large secondquarter rise in overall consumer spending as recorded in the GNP accounts had been presaged by developments in retail sales during the quarter. Such sales were particularly strong in May, but according to preliminary June data— which could be revised substantially— retail sales declined by $500 million in that month after increasing by an average of $400 million per month over the January-May period. Automotive sales as well as sales of other durables and nondurables were all down substantially in June. 187 However, retail sales may have been held back significantly in that month by the effects of flooding in the northeastern part of the country. In any event, recent surveys of con sumer attitudes indicate that the consumer remains in a relatively strong buying mood. In addition, the recently enacted social security measures which provide a 20 per cent general benefit increase with payments beginning in October should provide a boost in consumer spending in the fourth quarter. The severe flooding in the East seems also to have had a significant effect on personal income in the final month of the quarter. After registering sizable gains in April and May, personal income was essentially flat in June when sharp declines in proprietors’ income and rental income offset the rise in wage and salary disbursements. Over the quarter as a whole, personal income rose by $15.5 billion, a considerably smaller increase than the $25.5 billion advance of the first quarter. It should be noted, though, that the first-quarter rise was boosted by several non recurring special factors. Disposable after-tax income grew by $12.4 billion over the April-June period, about the 188 MONTHLY REVIEW, AUGUST 1972 Chart II RECENT CHANGES IN GROSS NATIONAL PRODUCT AND ITS COMPONENTS Seasonally adjusted Change from fourth quarter 1971 ^^^HChange from first quarter to first quarter 1972 to second quarter 1972 GROSS NATIONAL PRODUCT Inventory investment Final expenditures Consumer expenditures for d urab le goods Consumer expenditures for nondurable goods Consumer expenditures for services Residential construction Business fixed investment Federal Government purchases State and local government purchases Net exports of goods and services i -5 0 5 10 15 20 B illions of dollars 25 30 35 Source: United States Department of Commerce. same gain that was posted in the preceding quarter. At the same time, the ratio of personal savings to disposable income declined for the fourth consecutive quarter to 6.6 percent. The latest reading for the savings rate is the lowest since the fourth quarter of 1969 and is only slightly above its average for the entire post-Korean war period. While the overwithholding of personal income taxes has probably artificially depressed the savings rate in the last two quar ters, it appears that even allowing for this effect there has still been a significant decline. For example, it is estimated that overwithholding increased Federal tax payments by approximately $8 billion at an annual rate in each of these two quarters. Even if all of this overwithholding were fully intentional, the implied value of the true savings rate in the April-June period would still be about 1 percentage point below the record 8.6 percent posted in the second quarter of 1971. Business fixed investment grew by $4 billion in the second quarter, with the gain concentrated almost exclu sively in producers’ durable equipment. This increase, coupled with the extraordinary $6.3 billion rise in capital expenditures during the January-March period, brought the growth in the first half of this year to an annual rate of 19.6 percent. Moreover, recent data suggest continued strength in spending for new capital equipment in the months ahead, as new orders for nondefense capital goods rose sizably in both April and May and edged up further in June. In light of this evidence, it appears quite possible that the rise in plant and equipment expenditures for 1972 as a whole will surpass the 10.3 percent increase that was expected in the May survey of spending plans conducted by the Department of Commerce and may be closer to the 14 percent gain indicated in the McGraw-Hill spring survey. By comparison, plant and equipment expenditures rose by a small 1.9 percent in 1971. Spending on residential construction increased by $0.8 billion over the April-June period. This was the smallest quarterly gain in almost two years, suggesting that the housing boom may be peaking out— albeit at a very high level. Housing starts in the second quarter averaged 2.2 million units at an annual rate, down from the unprece dented 2.5 million unit pace set in the January-March period. In addition, the second-quarter level of building permits was slightly below its average of the previous three-month period. Government purchases of goods and services contributed $5.2 billion to the second-quarter GNP advance. Federal expenditures rose by $2.5 billion, about half the increase of the January-March period which was swollen by civilian and military pay raises. The bulk of the rise in Federal expenditures in the second quarter reflected an increase in defense spending. This increase brought Federal spend ing for defense to an annual rate of $78.6 billion, the highest level in more than two years. At the state and local levels, spending rose by $2.7 billion in the April-June period, down $0.8 billion from the increase of the previ ous quarter. PRICES, WAGES, PR O D U CTIVITY, AND E M P LO Y M E N T With the exception of movements in the wholesale price index, recent price data confirm a definite easing of infla tionary pressures. The slow advance of the consumer price index in the last four months is especially encouraging. Taking a somewhat longer perspective, June marked the first time since 1967 that the year-to-year change in this index was less than 3 percent. Moreover, the GNP de 189 FEDERAL RESERVE BANK OF NEW YORK flator posted a relatively modest increase in the second quarter, although shifts in the composition of output caused some understatement of actual inflation. According to preliminary estimates, the implicit GNP price deflator rose at a 2.1 percent seasonally adjusted annual rate in the second quarter, down sharply from the 5.1 percent rate of the January-March period. This com parison overstates the deceleration in the underlying pace of inflation since the first-quarter deflator was given a temporary boost by the post-freeze clustering of price in creases and the Federal pay raises. Beyond this, the slow down partly reflected shifts in the composition of output in the second quarter toward goods— such as producers’ durable equipment—whose prices have risen less rapidly relative to the prices of others since the base year for the index. These shifts had a depressing effect on the deflator in the April-June period because this index is a weighted average of component price indexes, with the weights de termined by the composition of output in each quarter. Thus, the chain price index, a measure of prices which is not affected by changes in the composition of output be tween adjacent quarters, rose at a 3.2 percent annual rate in the second quarter, down from the 3.9 percent average gain posted over the preceding four quarters. Recent movements in the consumer price index are encouraging. In June, consumer prices rose by only 0.7 percent on a seasonally adjusted annual basis. This small increase followed a 4 percent rise in May but very modest advances in the two preceding months. During the MarchJune period as a whole, increases in the consumer price index had averaged less than 1.8 percent per annum, the slowest advance in this index for any four-month period— including the months covered by the price freeze—in al most seven years. Overall, in Phase Two thus far, con sumer prices have risen at an annual rate of 3.1 percent, down 0.7 percentage point from the pace of the first eight months of 1971 and substantially below the increases reg istered in each of the preceding three years when con sumer prices rose annually between 4.7 percent and 6.1 percent. To some extent, this comparison may understate the recent deceleration in the advance of consumer prices, since increases that might otherwise have occurred during the price freeze tended to be bunched in the immediate post-freeze period. Thus, when the price-freeze and Phase Two periods are combined the slowdown is even more ap parent (see Chart III). The small June increase in the consumer price index resulted from virtually no change in prices of nonfood commodities as a whole, coupled with a 3.7 percent an nual rise (not seasonally adjusted) in prices of services and a 2 percent gain in food prices. In the nonfood com modity group, the prices of some individual products— such as homes and used cars— moved up appreciably, but these increases were balanced by declines in the prices of apparel, gasoline, liquor, and fuel oil and coal. Within the service sector, mortgage interest rates moved up for the first time since October of last year and doctors’ fees rose at a 6 percent annual rate. Not surprisingly, given recent movements in food prices at the wholesale level, retail prices of meats and poultry climbed sharply in June, and vegetable and fresh fruit prices also rose. In the light of the steep advance of wholesale food prices in July, the rise in consumer food prices seems likely to accelerate in coming months. At the wholesale level, prices rose in July at a sea sonally adjusted annual rate of 8.6 percent, the sharpest gain since August of last year. This huge July bulge mainly reflected a large increase in prices of farm products and processed foods and feeds which surged ahead at over a 24 percent annual rate. Livestock prices, particularly for hogs, and prices of fresh fruits, eggs, and poultry posted steep increases. At the same time, however, the rise in industrial commodity prices moderated to an annual rate of 2.8 percent. July was the first month this year in which industrial commodity prices rose by less than 4 percent. While the rapid advance of such prices during the first few months of the year was expected in view of the post-freeze cluster Chart III RECENT CHANGES IN CONSUMER PRICES Annual rates Percent Percent 10 8 0 ; Dec 1969-Dec 1970 [ .t 'j Dec 1970-Aug 1971 Aug 1971-Jun 1972 Note: Data are seasonally adjusted with the exception of services. Source: United States Department of Labor, Bureau of Labor Statistics. 190 MONTHLY REVIEW, AUGUST 1972 ing of price increases, the sharp increase of 4.5 percent posted in the second quarter remains somewhat disturbing despite the more moderate July increase. Overall, in Phase Two thus far, industrial commodity prices have climbed at an annual rate of 4.1 percent, down 0.6 percentage point from the rise in the first eight months of 1971 but 0.6 percentage point above the average gain registered in the 1968-70 period. The pace of wage increases has slowed somewhat in recent months. Compensation per hour of work in the private economy rose at a 5.6 percent seasonally ad justed annual rate in the April-June period, down from an average increase of 6.5 percent over the previous four quarters. Average hourly earnings— one of the monthly sources for the series on compensation per hour of work— rose very rapidly in April, posted very small increases in both May and June, and then rose moderately in July. Moreover, the latest Bureau of Labor Statistics survey reveals some moderation in the rate of increase in wages and benefits under major collective bargaining settle ments. For example, in the manufacturing sector the mean life-of-contract wage and benefit gain for settlements, covering 5,000 or more workers, negotiated from January through June was 6 percent in contrast to 7.7 percent in 1971. The slowdown was even more pronounced in the construction sector, where the increase in the average life-of-contract settlements for wage and fringe benefits was 7.6 percent in the first half of 1972, down sharply from last year’s 12.1 percent gain. It should be noted, however, that this survey covers contracts involving only 616,000 workers for all industries and excludes wage settlements, involving 750,000 workers, which had not been acted upon by either the Pay Board or the Con struction Industry Stabilization Committee. In addition, 1972 is a relatively light collective-bargaining year and a much heavier load of settlements is expected to be nego tiated in 1973. Thus, the extent to which this recent slow down in the pace of wage increases under collective bar gaining agreements proves to be of a permanent rather than temporary nature depends in part on future decisions of the Pay Board and perhaps more fundamentally on whether price inflation is brought under control. The growth of productivity, as measured by the index of output per hour of work in the private nonfarm econ omy, accelerated to a 4.8 percent seasonally adjusted an nual rate in the second quarter. Including the farm sector, where productivity changes tend to be quite volatile on a quarterly basis, output per hour of work climbed at a 6.3 percent annual rate. This gain coming on the heels of the sizable advance in output per hour of work over the pre vious nine-month period brought growth in the second quarter from four quarters earlier to a rapid 4.4 percent, about 1.2 percentage points above its long-run trend. As a consequence of the substantial increase in productivity coupled with the moderation in compensation per hour of work, unit labor costs declined slightly in the second quar ter for the first time in over six years. In contrast, unit labor costs climbed at an average annual rate of 6 percent over the 1968-70 period and rose by 2.2 percent in 1971. According to the monthly survey of households, both civilian employment and the labor force were virtually unchanged in July, after adjustments for seasonal varia tions. As a consequence, the unemployment rate remained unchanged from June’s level of 5.5 percent. Prior to these two months, the rate of unemployment had hovered near 5.9 percent since late 1970. Notably, the jobless rate for men twenty-five years of age and older declined in July by 0.3 percentage point to 3.0 percent, its lowest level in nearly two years. Jobless rates for teen-agers and men and women between twenty and twenty-four years of age rose during the month after posting declines in June. Following several months of sizable gains earlier in the year, the most recent survey of establishments indicates that non farm payroll employment was essentially flat for the sec ond consecutive month. In July, employment in the construction and manufacturing industries was particularly weak. It should be noted, however, that the decline in construction employment in this month partly reflected an increase in strike activity. Also, according to the Bureau of Labor Statistics, employment in both construction and manufacturing seems to have been held back by the effects of tropical storm Agnes. FEDERAL RESERVE BANK OF NEW YORK 191 Financial Developments in the Second Quarter During the second quarter of 1972, the narrow money supply (MO grew at a seasonally adjusted annual rate of 5.3 percent, 4 percentage points below its rate of advance in the first three months of the year. At the same time, the broad money supply (M2) and the volume of reserves available to support private nonbank deposits (RPD) expanded at far slower rates than had been witnessed in the January-March interval. However, aggressive bank marketing of large negotiable certificates of deposit (CDs) allowed the more comprehensive mea sure of member bank liabilities— the adjusted bank credit proxy— to expand at virtually the same rate as in the first quarter. On the asset side of the commercial banking system’s balance sheet, bank credit growth slowed over the quarter, although the extent of the slowing may have been exaggerated by the manner in which bank credit is measured. Despite the slowdown in the expansion of the monetary and reserve aggregates, upward movements in interest rates were quite moderate. To be sure, those money market yields most closely tied to the availability of funds to the banking system— the Federal funds rate, the rate on large negotiable CDs, and the prime loan rate— ad vanced somewhat over the interval. However, Treasury bill rates were virtually stable, as were commercial paper rates following an initial upward surge in this latter rate in April. At the longer end of the maturity spectrum as well, there was only a slight upward drift in yields, reflecting in part the easing of the demand for funds by the Federal Government and private corporations. The healthy tone of the capital markets manifested by these interest rate developments was further reflected in the performance of the nonbank depository institutions as suppliers of funds to the residential mortgage market. The inflow of deposits to these institutions continued strong, though the rate of growth decelerated substantially from that witnessed in the first quarter. However, the data avail able through May suggest that despite the slowdown of deposit growth the combined rate of acquisition of mortgages by these institutions accelerated. M O NETAR Y AGGREGATES Following its rapid first-quarter growth at a rate of 9.3 percent, Mx— defined as currency outside banks plus private demand deposits— expanded at a more moderate rate of 5.3 percent in the second quarter (see Chart I). As a result, the growth rate of Mx for the entire six-month period ended June 1972 was 7.4 percent. Moreover, from November 1970—which the National Bureau of Economic Research has tentatively dated as the trough of the cur rent business cycle— through June of this year, Mx grew at a seasonally adjusted annual rate of 6.8 percent, a rate only slightly above that regarded by many as commen surate with the goal of viable economic recovery. The decline in Mx growth over the quarter was accompanied by reductions in the rate of advance of RPD and M2— which adds to Mx commercial bank savings accounts and time deposits except negotiable CDs in denominations of $100,000 or more. In the April-June interval, the seasonally adjusted annual rate of growth of RPD slowed to 7.4 percent, compared with 11 percent in the first three months of the year. Growth of M2 took place at a rate of 8.6 percent through the April-June pe riod, in contrast to its first-quarter rate of 13.3 percent. This decline in M2 growth was attributable not only to the slowing of Mx expansion, but also to a marked decline in the rate of advance of consumer-type savings deposits from 17.1 percent in the first quarter of the year to 11.8 percent in the second. As a result, the growth rate of M2 over the six months ended June 1972 was 11.1 percent, the same as its rate of growth over all of 1971. Despite this deceleration in the growth of private deposits, a broader measure of liabilities of banks that are members of the Federal Reserve System— the adjusted bank credit proxy—increased at a rate of 11.1 percent in the second quarter, a rate of growth only 0.2 percentage point below that realized in the first quarter. To a large extent the continued strength of the bank credit proxy in contrast to the slowdown in the growth of the deposit aggregates reflected the ability of commercial banks to 192 MONTHLY REVIEW, AUGUST 1972 Chart I CHANGES IN THE RESERVE AND M ONETARY AGG REG ATES Seasonally adjusted annual rates rate during both of the first two quarters of 1972, bank earning assets— measured as loans and investments adjusted for loan sales to affiliates— displayed a marked slowing in their rate of growth during the second quarter of the year. After having expanded at an annual rate of 15.1 percent over the January-March period, bank credit increased at a rate of 7.3 percent during the second quar ter of 1972 (see Chart II). The slowing in bank credit growth resulted in part from a lower rate of purchase of securities, both United States Government and others. It also reflected a June decline in business loans, which had grown rapidly over the first two months of the second quarter. In contrast, the growth of real estate and con sumer loans accelerated in the second quarter from their already rapid growth in the first three months of the year. To some extent, the disparate growth patterns of bank credit and the proxy during the second quarter reflect the ADJUSTED BANK CREDIT PROXY 1971 1972 RPD - Total member bank reserves less those required to support United States Government and interbank deposits. Ml = Currency plus adjusted demand deposits held by the public. M2 = Ml plus commercial bank savings and time deposits held by the public, less negotiable certificates of deposit issued in denominations of $100,000 or more. Chart II CHANGES IN BANK CREDIT AND ITS COMPONENTS Seasonally adjusted annual rates TOTAL BANK CREDIT* Adjusted bank credit proxy = Total member bank deposits subject to reserve requirements plus nondeposit sources of funds, such as Euro-dollar borrowings and the proceeds of commercial paper issued by bank holding companies or other affiliates. Source: Board of Governors of the Federal Reserve System. TOTAL L O A N S * attract funds through the use of large-denomination CDs. Over the quarter, the rate on three-month CDs in the secondary market rose from 4.28 percent at the beginning of the quarter to 4.67 percent by its end. The volume of CDs outstanding expanded over the quarter by $3.7 billion seasonally adjusted, an annual rate of increase of 44 percent. At the outset of the period, this CD growth was accompanied by large increases in the level of Treasury deposits in Tax and Loan Accounts. However, the accounts were drawn down sharply in June and showed a small net decline over the quarter. 4 \\ BANK C R ED IT, IN TE R E S T R A TES , AND T H E BOND M AR K ET * Adjusted for loans sold to affiliates. Although the sources of bank funds, as indicated by the adjusted bank credit proxy, grew at virtually the same Source: Board of Governors of the Federal Reserve System . FEDERAL RESERVE BANK OF NEW YORK different methods used in calculating these aggregates. To place this matter in proper perspective, it should be re called that the bank credit proxy as well as the other monetary aggregates, when calculated monthly or weekly, are obtained on a daily average basis. In contrast, sea sonally adjusted bank credit is reported monthly at its level on the last Wednesday of the month. Judging from the data available on a nonseasonally adjusted basis for weekly reporting banks, it appears that bank credit dropped temporarily in the last statement week in June, a week in which bank credit had been rising seasonally in recent years. There was moderate upward pressure on short-term interest rates during the second quarter (see Chart III). For example, the average effective rate on Federal funds rose from 3.83 percent in March to 4.46 percent in June. CD rates also rose over the quarter. As the cost of funds to banks drifted upward, the prime business loan rate at most major commercial banks was raised from 4% percent at the end of March to 5V4 percent by the end of June. 193 Chart IV LONG-TERM INTEREST RATES Percent Percent Note: The Aa-rated utility yields are taken from Salomon Brothers indexes of yields on newly issued Aa-rated utilities with deferred call. Beginning and end of month quotes have been averaged to form monthly yields. Yields on three- to five-year Government securities are monthly averages of daily figures. Yields on twentyyear municipal bonds are monthly averages of Thursday figures. Sources: Salomon Brothers, Board of Governors of the Federal Reserve System, and The Bond Buyer. Chart III SHORT-TERM INTEREST RATES Percent 9 Note: Yields on three-month Treasury bills and four- to six-month commercial paper are monthly averages of daily figures. The prime rate is the interest rate posted by major commercial banks on short-term loans to their most creditworthy business borrowers. Source: Board of Governors of the Federal Reserve System. Treasury bills were firmer than the rest of the market, with rates on three-month bills rising only about 20 basis points over the quarter. Yields on intermediate- and long-term securities were for the most part little changed during the second quarter, with modest increases outnumbering slight declines. Inter est rates etched an irregular pattern over the quarter, generally rising through most of April, declining in late April and through May, and then rising again in June (see Chart IV ). One particularly interesting development during the quarter was the strengthening of the intermedi ate sector of the market for United States Government coupon obligations. Although yields in this sector had declined in general concert with the downward movement of interest rates following President Nixon’s announcement of the new economic program, the decline in rates on three- to five-year Governments ended earlier than those on instruments in other sectors of the market, as inves tors became concerned about the financing implications of the prospective Federal deficit for the fiscal year 1973. Consequently, the first-quarter average yield on three- to 194 MONTHLY REVIEW, AUGUST 1972 five-year Government securities was higher than it had been in the first quarter of last year at the same time that most other securities were yielding less than they had dur ing the same period last year. With the announcement of the Treasury’s May refunding plans on April 26, which disclosed that a portion of the maturing securities would be redeemed, market expectations for this sector of the market brightened considerably and yields dropped sharply throughout May. Although rates backed up slightly in June, the average yield on three- to five-year Governments over the entire quarter was below that witnessed in the second quarter of last year. The relative stability of intermediate- and long-term interest rates during the second quarter reflected in part the absence of heavy demands for funds in the capital markets. The United States Government repaid a net of $6 billion of debt, in contrast to the $1.6 billion raised during the second quarter of 1971. The Federal budgetary deficit for the fiscal year that ended June 30, 1972 was $23 billion—large historically but far below the $38.8 bil lion projected in the Budget document submitted by the Administration last January. Outlays were $5 billion be low the January estimates, while receipts exceeded the esti mates by $10.8 billion. The larger than expected tax rev enues reflected not only overwithholding of individual income taxes but also the impressive strength of the recov ery in economic activity during the fiscal year. In addition, the Treasury obtained during the second quarter $2.5 billion through the sale of special nonmarketable securities to foreign central banks which had acquired dollars in foreign exchange markets in an effort to prevent the ex change rates of their currencies against the dollar from exceeding the limits specified in the Smithsonian Agreement of December 18, 1971. The corporate bond market was bolstered by a rela tively light calendar of securities offerings. In part, this reflected the buildup of corporate liquidity that was accomplished through the record volume of bond offerings during 1970 and 1971 and the recent increases in cash flow as a result of increasing profits and accelerated depreciation allowances. Consequently, nonfinancial cor porations floated only $10 billion of securities in the corporate bond market in the first six months of 1972, after having raised $15 billion through bond flotations over a comparable period last year. At the same time, state and local governments raised $12 billion in the bond market during the first half of this year. While it was almost equal to the record $12.5 billion in funds dur ing the first half of 1971, a larger part of this year’s gross proceeds have gone toward retirement of outstanding debt. T H R IF T IN S TITU TIO N S The slowdown in the growth of small-denomination time deposits at commercial banks was paralleled at thrift institutions. Savings and loan association shares grew at an annual rate of 16 percent during the April-June inter val, compared with the near-record rate of growth of sav ings and loan association capital of 23Vi percent in the first quarter, while mutual savings bank deposit growth decelerated from its 14Vi percent rate in the first quarter to 11 percent during the second (see Chart V ) . As a result of the total buildup of savings and loan association capital during the previous five quarters, however, the growth of mortgage holdings by savings and loan associations ac celerated to a rate of 18 percent, compared with a growth rate of 15 percent in the first quarter of the year. At mutual savings banks, data available through May suggest Chart V THRIFT INSTITUTION DEPOSIT FLOWS AND HOME M O RTG AG E LENDING Seasonally adjusted annual rates Percent Percent Note: Mutual savings bank mortgage statistics for the second quarter of 1972 are based on April and May data. Sources: Federal Home Loan Bank Board and National Association of Mutual Savings Banks. FEDERAL RESERVE BANK OF NEW YORK that the growth of mutual savings bank mortgage holdings accelerated to an 8 percent annual rate in the second quarter, after having been IV 2 percent in the first quarter. With this continued strong participation of thrift institu tions in the mortgage market, yields on new home conventional mortgages averaged 7.53 percent, 11 basis points below their average in the first quarter. The deceleration of thrift institution deposit growth in the second quarter of this year notwithstanding, the over all performance of these deposits over the eighteen-month interval ended June 1972 was unusually strong. Over that 195 period of a year and a half, savings and loan association capital grew at a seasonally adjusted annual rate of 21 percent, while mutual savings bank deposits increased at a rate of 14 percent. To be sure, much of this growth occurred in a period when the ratio of personal savings to disposable income was unusually high and when rates on competing market instruments were relatively low. How ever, it was also attributable to the aggressiveness with which thrift institutions have been offering higher yield ing certificate-type accounts as a means of attracting de posit liabilities. Th e Money and Bond Markets in July Interest rates generally drifted slightly lower in July. At the beginning of the month, it had been widely expected that the upward trend exhibited in June would continue. However, increases in interest rates during the month were generally small and were later reversed. In conse quence, most interest rates closed a bit lower on balance. Late in July, rates were influenced by anticipations concerning the Treasury’s refunding announcement. More uncertainty than usual preceded the announcement. On the one hand, the Treasury continues to enjoy an unusually comfortable cash position. On the other hand, the Trea sury’s longer run cash needs are believed to be quite large in view of the sizable Federal budgetary deficit expected in fiscal 1973. The Treasury announced the terms of a massive refinancing operation after the close of business July 26. Along with the $2.3 billion of publicly held notes and bonds maturing August 15, an additional $17.4 billion of coupon issues maturing at later dates this year and at selected dates in 1974 and 1975 was eligible for the refunding. One of the Treasury’s goals is to lengthen the maturity structure of the debt. The average maturity of marketable Federal debt outstanding had fallen from five years four months in 1965 to less than three years three months by mid-1972. The shortening of the debt occurred partly because the AVa percent interest rate ceiling on Treasury bonds had prevented the issue of new bonds from 1965 until the 1971 suspension of this ceiling, which permitted the Treasury to issue up to $10 billion of bonds at rates in excess of AVx percent. The new offering did not include a short-term note but instead consisted of 3 Vi-year and 7-year notes and 12-year bonds. The offering was enthusiastically received, and an impressive $8.7 bil lion of new securities was subscribed. Because of the Treasury’s currently strong cash position, no companion issue was offered for cash. In part, the strong cash position reflects the recent sale of special nonmarketable issues to foreign official institutions. About $3.1 billion of special certificates of indebted ness was issued in July to absorb the large volume of dollars purchased by foreign central banks. This operation was one of the repercussions that followed the British decision in late June to allow the pound to float. Other governments quickly reaffirmed their determination to maintain the exchange rate structure established in the Smithsonian Agreement, but even so widespread specula tion developed in favor of several continental European currencies. With exchange rates driven hard against their 196 MONTHLY REVIEW, AUGUST 1972 upper limits against the dollar, the foreign central banks were required to absorb large quantities of dollars, with which they in turn purchased both marketable and nonmarketable United States Treasury securities. On July 19, the Federal Reserve initiated a new line of operations by of fering German marks in the New York exchange market. Federal Reserve Board Chairman Arthur Burns explained that the United States authorities “are now moving to play our part to restore order in foreign exchange markets and to do our part in upholding the Smithsonian Agreement”. The Chairman said that such operations would continue on whatever scale and whenever transactions were deemed desirable, and he disclosed that the suspension on use of the Federal Reserve swap lines that went into effect last August 15 had been lifted. During the remainder of July, the exchange markets were quieter and dollar rates improved. BANK RESERVES AND T H E MONEY M AR KET Short-term interest rates generally declined slightly over the month of July. There were a number of minor upward movements early in the month, which were reversed as the month progressed. For example, rates on 90- to 119-day dealer-placed commercial paper increased Vs percentage point in the first week of July but fell back Vs point in the third week to 4% percent (see Chart I). Rates on most other maturities of commercial paper were also lowered Vs to V4 percentage point during July. Secondary SELECTED INTEREST RATES M ay-July 1972 Percent M ONEY MARKET RATES BON D MARKET YIELDS Percent Note: Data are shown for business days only. MONEY MARKET RATES QUOTED: Bid rates for three-month Euro-dollars in London; offering rates (quoted in terms of rate of discount) on 90- to 119-day prime commercial paper quoted by three of the four dealers that report their rates, or the midpoint of the range quoted if no consensus is available; the effective rate on Federal funds tthe rate most representative of the transactions executed); closing bid rates (quoted in terms of rate of discount) on newest outstanding three-month Treasury bills. BOND MARKET YIELDS QUOTED: Yields on new Aa-rated public utility bonds (arrows point from underwriting syndicate reoffering yield on a given issue to market yield on the same issue immediately after it has been released from syndicate restrictions); daily averages of yields on seasoned Aaa-rated corporate bonds,- daily averages of yields on long-term Government securities (bonds due or callable in ten years or more) and on Government securities due in three to five years, computed on the basis of closing bid prices; Thursday averages of yields on twenty seasoned twenty-yea/ tax -exempt bonds (carrying Moody's ratings of Aaa, Aa, A, and Baa). Sources: Federal Reserve Bank of New York, Board of Governors of the Federal Reserve System, Moody's Investors Service, and The Bond Buyer. 197 FEDERAL RESERVE BANK OF NEW YORK In millions of dollars; (+) denotes increase (—) decrease in excess reserves Changes in daily averages— week ended Net changes Factors July July 12 July 19 July 26 + 291 + 336 + 714 — 640 — 28 + 164 + — 439 — 230 + 76 — 358 — 312 4+ — — — + 192 199 215 143 72 633 — 2 5 “ Market” factors Member bank required reserves .................. Operating transactions (subtotal) ................ — Federal Reserve float ................................... — Treasury operations* ..................................... + Gold and foreign account .......................... _ Currency outside banks ............................... — Other Federal Reserve liab ilities and capital ....................................................... — 638 176 444 998 98 66 23 OO T able I F A C T O R S T E N D I N G TO IN C R E A S E O R D E C R E A S E M E M B E R B A N K R E S E R V E S , J U L Y 1972 — + 4+ — — 795 331 219 691 117 476 + 16 194 + 134 + market rates on large negotiable certificates of deposit (CDs) climbed about 20 basis points at the start of July but were reduced later in the month by as much as 30 basis points. Rates on bankers’ acceptances were reduced by Vs percentage point late in July. Euro-dollar rates continued to be sensitive to uncertainties in the foreign exchange markets. The three-month Euro-dollar rate generally advanced through July 18. After that, some de gree of calm was restored to the exchange markets partly in response to Federal Reserve sales of German marks. Euro-dollar rates subsequently declined and ended the month at 5¥s percent, 3/s percentage point above the opening rate. A few large banks raised their prime com mercial loan rate to 5V2 percent in response to previous increases in market rates. Most banks did not feel, however, that loan demand was sufficiently strong to justify such an increase, and therefore they retained a 5Va percent prime rate. Effective July 31, in response to a drop in commercial paper rates, two major banks with floating prime rates reduced their prime rate from 5V2 percent to 5% percent. The average effective rate on Federal funds in July was 4.55 percent, 9 basis points above the June level. For the statement week ended July 5, excess and borrowed reserves increased sharply (see Table I). However, in each succeeding week, excess and borrowed reserve levels were both reduced. Since excess reserves fell more rapidly, free reserves declined, becoming negative after the first state ment week. The growth in reserves available to support private nonbank deposits (RPD) accelerated in July to an esti mated 9 Vi percent seasonally adjusted annual rate. By excluding reserves backing Treasury and net interbank deposits, which are not included in the money supply, the RPD series is more closely related to the money supply than is the total reserves series. According to preliminary data for the period through July 26, the growth of the narrowly defined money supply (M O — adjusted demand deposits plus currency outside banks— also accelerated in July, to an estimated 15 percent seasonally adjusted annual rate from its more restrained 5.3 percent pace in the second quarter. The acceleration took place during the first two weeks of July after which the money supply fell back slightly. As was indicated by Federal Reserve Board Chairman Burns in testimony before the Joint Economic Committee of the United States Congress, the System is still “in a favorable position to continue pursuing a path of moderate monetary growth”. Despite the bulge in July, longer term growth rates, generally considered to be more meaningful in evaluating the impact of money supply behavior, show somewhat 814 + 627 — 668 + 391 — 464 + 827 — 698 -j- 612 — 505 + 236 -h 4- 804 2 21 — 732 — 2 — 11 + 300 _ 1 — — 72 — 3 — 7 4 - 400 — 4 — 39 40 4 6 183 8 + 33 + 6 + 247 4- 45 — 329 — 58 — 36 — 4 — — Total “ market” f a c t o r s ................................. - Direct Federal Reserve credit transactions Open market operations (subtotal) ........... Outright holdings: Treasury securities ........................................ Bankers’ acceptances ................................... Federal agency obligations ........................ Repurchase agreements: Treasury securities ........................................ Bankers’ acceptances ................................... Federal agency obligations ...................... Member bank borrowings ............................... Other Federal Reserve assetsf ...................... Total __ -h — + + + .................................................................... + 1 ,0 1 8 Excess reserves ............................................................ + 204 9 11 1 51 + 21 — 51 4 - 54 41 + 42 4 - 154 — 732 4- 614 — 468 4 - 432 — 105 — — 77 — 32 + 8 — 85 + 54 + — Monthly averages Daily average levels Member bank: Total reserves, including vault ca sh ............. Required reserves .............................................. Excess reserves ................................................... Free, or net borrowed ( — ), reserves........... Non borrowed reserves ........................................ Net carry-over, excess or deficit ( — ) § . . . . 33,143 32,815 328 312 16 32,831 98 32,747 32,524 223 227 — 4 32,520 209 33,333 33,164 169 175 — 6 33,158 182 33,064 32,972 92 171 — 79 32,893 133 33,072$ 32,869$ 203t 221$ — 18* 32,851$ 156$ N ote: Because of rounding, figures do not necessarily add to totals. *Includes changes in Treasury currency and cash, fln clu d es assets denom inated in foreign currencies. lAverage for four weeks ended July 26. §Not reflected in data above. more moderate rates of advance. Over the three months through July, M! increased at an annual rate of about 8 percent (see Chart II). In the past year, Ma grew by about 5V2 percent. 198 MONTHLY REVIEW, AUGUST 1972 The broad money supply (M 2) — defined as M t plus time deposits other than large CDs— accelerated slightly in July to a 12 percent annual rate of growth from a IOV2 percent rate in June. The acceleration in this aggre gate resulted entirely from the speedup in M l Time deposits other than large CDs advanced more slowly than they had in June. The adjusted bank credit proxy, consisting of member bank deposits subject to reserve requirements and certain nondeposit liabilities, advanced at an estimated 13 percent seasonally adjusted annual pace in July, quite close to the rate of growth of M2. Treasury deposits and net interbank deposits at member banks, both of which are included in the proxy but not in the money supply, rose only slightly in July. However, large CDs, the other major element of the proxy excluded from the money supply, increased at a significantly faster pace than did other types Chart II CHANGES IN MONETARY AND CREDIT AGGREGATES Seasonally adjusted annual rates Percent Percent Ml >— ^ ^ 4 \ / From l!2 months ear Her 1 ~ / \ / i r From 3 months earlier 1 _1_L J 1_ _1 . 1 1 1 1 1 1 1 1 1 1 1 i i 1 i i 1 i i 1 I ; 1 M2 From 12 months earlier / / From 3 months earlier \ V — \ / — 1 1 1 1 1 1 I 1 1 1 I 1 I 1 1 i I ADJUSTED BANK!CREDIT PROXY ss,. From 3 months earlier / 1 .1 From l2 months earlier I 1 1 I 1970 -JLJ..1. I JL..J 1971 1 1 1 1 J_ . 1 I 1.1 1,1... 1972 Note: Data for July 1972 are preliminary estimates. Ml = Currency plus adjusted demand deposits held by the public. M2 = Ml plus commercial bank savings and time deposits held by the public, less negotiable certificates of deposit issued in denominations of $100,000 or more. Adjusted bank credit proxy = Total member bank deposits subject to reserve requirements plus nondeposit sources of funds, such as Euro-dollar borrowings and the proceeds of commercial paper issued by bank holding companies or other affiliates. Sources: Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York. of deposits so that, on balance, proxy growth paralleled that of the monetary aggregates. TH E GOVERNM ENT SECURITIES M AR KET The market for United States Government securities was subject to conflicting sets of influences in July. Vari ous news items indicating that the economy was experi encing a vigorous expansion, along with the concern about the impact of the large Federal budget deficit on the size of future Treasury financing needs, worked toward push ing up interest rates on Government securities. However, continuing turmoil in the foreign exchange markets tended to depress yields, particularly in the shorter maturities, as foreign central banks purchased Government securities with the dollars they acquired in support operations. Add ing to the downward pressure in rates was the rather thin floating supply of securities, especially in certain inter mediate maturity ranges. The Treasury had actually retired debt on balance in the second quarter and raised only a modest amount in July through weekly additions of $200 million to the maturing bills beginning July 13. On July 26, the Treasury announced a major refunding operation. In the refunding, holders of the remaining five issues of notes and bonds maturing in 1972— on August 15, September 15, November 15, and December 15—were offered 5% percent 3Vi-year notes priced to yield 5.96 percent, 6 V4 percent 7-year notes priced at par, and 6 3/s percent 12-year bonds priced to yield 6.45 percent. In ad dition, the holders of notes and bonds due in November 1974 and February 1975 were given the opportunity to exchange those securities for either the 7-year notes or the 12-year bonds. The bonds were also offered for cash to individuals in amounts not to exceed $10,000. Preliminary results of the refunding indicate that it was highly successful. Of the $2.3 billion of publicly held securities maturing August 15, $1.67 billion was ex changed for an attrition rate of 27.6 percent, somewhat lower than usually expected in refunding operations con taining no new short-term issue. In addition, $3.3 billion of the $6.2 billion maturing between September and De cember 1972 and $3.1 billion of the securities due to ma ture in 1974 and 1975 were exchanged. The holders of issues maturing in 1972 purchased primarily the 3Vi-year notes, but the longer term issues sold well because of orders from holders of the 1974 and 1975 securities. Pre liminary figures show subscriptions for $3.9 billion of the new 3Vi-year notes, $3 billion of the 7-year notes, and $1.1 billion of the 12-year bonds, including $22 million sold to individuals for cash. Treasury bill rates were particularly sensitive to the 199 FEDERAL RESERVE BANK OF NEW YORK foreign situation. With large dollar-support operations undertaken by foreign central banks, prices tended to be bid up in the bill market in anticipation of probable for eign official demand for bills. Although there was some upward pressure on bill prices from official foreign sources, it was smaller than it might have been because much of the foreign demand was channeled into special nonmarketable Treasury certificates of indebtedness. Over the month, the Treasury issued about $3.1 billion of special certifi cates to foreigners while marketable United States Govern ment securities held by the Federal Reserve in custody for foreign official accounts increased by $670 million. Against this background, three-month Treasury bill rates declined by about 15 basis points through July 19. During this period, several other short-term rates increased. Then, as speculative pressures eased in the foreign ex change markets, bill rates began to edge upward again. In the final days of the month, bill rates fell once more as the absence of a short-term issue in the refunding pointed to limited supply conditions. On balance, secondary market rates ended the month about 3 to 40 basis points below their opening levels. The weekly auction of three- and six-month Treasury bills that would normally have been held in the first week of July was pushed forward to June 30, since July 3 was a holiday for many. At that auction, interest rates had moved up somewhat—by 12 basis points on the threemonth bills. Beginning with the first auction actually held in July, bill rates began to slide. At that auction, on July 10, three-month rates declined 4 basis points to an average 4.102 percent (see Table II). In the intervening week, purchases by foreigners were heavy and, at the auction held on July 17, three-month Treasury bill rates fell a further 15 basis points to an average of 3.948 percent. Bill rates climbed 10 basis points in the auction held on July 24 after foreign exchange jitters began to ease. In light of this turnaround, the monthly auction of nine- and twelve-month Treasury bills, held on July 25, exhibited mixed results. Yields on the nine-month bills averaged 2 basis points less than those on equivalent bills offered in June. On the other hand, the yield on the one-year bill climbed 6 basis points to 4.918 percent, the highest rate posted since last September. In the final auction of threeand six-month bills, held July 31, yields dropped substan tially— to 3.794 percent on the three-month bills— in response to previous declines in secondary market rates. Yields on intermediate-term Treasury issues declined early in July, but later these yields moved back up so that they were little changed over the month as a whole. Long term Government bond yields edged lower through most of the month. Treasury bond issues have benefited in the T able II A V E R A G E IS S U I N G R A T E S * A T R E G U L A R T R E A S U R Y B IL L A U C T IO N S In percent Weekly auction dates— July 1972 Maturities July 31 July 10 July 17 July 24 4 .102 3.948 4.047 3.794 4.605 4.455 4.585 4 .2 9 8 Monthly auction dates— May-July 1972 May 23 June 23 July 25 4.367 4.754 4.731 4 .465 4.854 4.918 * Interest rates on bills are Quoted in terms of a 360-flay year, with the discounts from par as the return on the face amount of the bills payable at m aturity. Bond yield equivalents, related to the amount actually invested, would be slightly higher. last few months from the low level of new financing. Yields have remained significantly below the highest levels for the year established in April. On April 13, the average yield on Treasury bonds maturing in more than ten years reached 5.79 percent. By the end of July, however, the average yield had fallen to 5.52 percent, the lowest level of the year. OTHER SECUR ITIES M ARKETS Corporate bond prices stabilized early in July, braking at least temporarily the decline of the previous month. Dur ing the remainder of July, the market was jostled by al ternately favorable and unfavorable news, but it still man aged to absorb an expanded volume of issues with little difficulty. A particularly light calendar during the holidayshortened Fourth of July week contributed to the early stabilizing of rates. In the succeeding two weeks, how ever, the volume of new corporate bonds placed on sale mushroomed to about $1.7 billion. On July 11, a utility issue rated Aa sold well at a yield of 7.60 percent, the same yield as another Aa bond which had been poorly received in late June. The next day, a much larger Aarated utility bond was offered to yield 7.50 percent. A surge of activity late in the day led to heavy sales. On the following day, however, a relatively small utility issue rated Aa by one rating service and A by another met with a poor reception despite its 7.55 percent yield. 200 MONTHLY REVIEW, AUGUST 1972 In the week beginning July 17, market sentiment vac illated. Observers were generally glum at the beginning of the week, as several older issues were released from syndicate price restrictions on Monday and quickly climbed as much as 10 basis points in the secondary mar ket. The next day the market regained some stability when a heavy demand greeted a finance company bond and two new industrial issues. But the succeeding day, optimism was dissipated as a two-part $250 million Aaa-rated offer ing by a Bell Telephone subsidiary met with a disappoint ing reception in spite of a 7.45 percent yield on the 38-year debenture, the same rate that was offered on a similar Bell System obligation in June which had sold well. This bond was released from syndicate price restrictions on the fol lowing Tuesday, and the yield quickly climbed 4 basis points in the secondary market. In the final July week, the volume of corporate financing slackened. In that week, two utility issues rated Aa and priced to yield 7.55 percent and 7.52 percent, respectively, attracted only lukewarm interest initially but sold well on Friday following the announcement of prime rate reduc tions by two banks. Prices on most tax-exempt securities were relatively stable over the month of July. The Bond Buyer index of twenty municipal bond yields remained unchanged at 5.43 percent for three weeks through July 6. During the next two weeks the index fluctuated slightly, then declined at the end of the month to 5.35 percent. The volume of taxexempt securities was light in the first and third weeks, but heavy in the second and fourth weeks. Dealers were able to reduce their inventories somewhat, with the Blue List of dealers’ advertised inventories declining by $80 mil lion to $674 million during the month. New York City offered $267.2 million of securities on July 12. These bonds, rated Baa-1, were priced to yield from 4.25 per cent in 1974 to 6.80 percent in 2013. By comparison, a similar New York City offering in April was priced to yield 6.90 percent on the longest maturity. Most of the new is sue was reported sold the first day. Other tax-exempt se curities marketed the same week did not fare quite so well, but in the maturity ranges considered to be generously priced the securities stimulated substantial interest. The final week’s sizable volume of offerings met with generally favorable receptions despite instances of aggressive pricing. KEY TO T H E GOLD V A U LT Key to the Gold Vault, a new, sixteen-page pam phlet, unlocks some of the mysteries of gold, exposes some of its often glamorous past, and reveals the work-a-day operations of the New York Fed’s gold vault— the depository for the world’s largest gold treasure. Key to the Gold Vault is available without charge from the Public Information Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, N.Y. 10045. FEDERAL RESERVE BANK OF NEW YORK 201 Reform of Reserve Requirements By G e o r g e G a r vy Economic Adviser, Federal Reserve Bank of New York The Board of Governors has concluded that the ORIGINS prospect of eliminating a considerable amount of float as a result of extending same-day payment of collection Formalization of the traditional cash reserves of com items offers an opportunity for making simultaneously the mercial banks into a set of legally required reserve ratios first significant change in the structure of reserve require was an American invention. Not until the Great Depres ments since the creation of the Federal Reserve System.1 sion of the 1930’s did reserve requirements begin to be The purpose of this article is to place these changes in re widely used abroad as a policy instrument. Legal reserve serve requirements in perspective by reviewing, first, the requirements became part of much of the banking legisla shortcomings of the system of reserve requirements which tion that was enacted or modified in foreign countries dur the new changes in Regulation D are designed to remedy ing World War II and the early postwar years. Some of the and, then, past efforts directed at improvements. leading countries, such as the United Kingdom and France, Banks must hold a certain amount of cash as a matter introduced reserve requirements only a few years ago. So of sound banking practice to meet possible deposit losses. far, the Bank of England continues to rely on voluntary In addition, most countries, including the United States, compliance with ratios set by it. In several other countries have legal provisions stipulating a minimum amount of of Western Europe, central banks have obtained powers to reserves that must be held in prescribed form. These “legal impose reserve requirements but have made use of them reserves” provide a fulcrum against which Federal Re only intermittently or not at all. In Germany, however, serve System control over reserve availability becomes reserve requirements have become a main tool of monetary effective in influencing bank credit and the monetary ag control. The present structure of member bank reserve require gregates. Achieving the objectives of monetary policy de pends primarily on the System’s ability to control the ments based on a geographical classification of banks was availability of member bank reserves, rather than on a inherited from the National Banking Act which specified particular average level of prescribed reserve ratios. reserve ratios, in increasing amounts, for three classes of The average (weighted) reserve ratio for demand and banks: country, reserve city, and central reserve city time deposits sets an upper limit on the deposit multiplier. banks. Prior to the enactment of the Federal Reserve Act, However, attempts to define an optimal average reserve a specified portion of reserves could be held on deposit ratio, or even to agree on criteria for determining it, have with banks in designated cities. Indeed, the rationale for not been successful. Required reserves can perform their higher reserve requirements in reserve and central reserve fulcrum function even when set at a relatively low level. cities was undermined by the provision in the Federal Re Arguments have been put forward in academic literature serve Act which required that reserves be deposited (after in favor of large as well as small deposit multipliers. a transition period) with the Federal Reserve and not with other banks. The system of reserve requirements embodied in the Federal Reserve Act linked reserve requirements to assumed liquidity needs. The liquidity function of reserves, in turn, was related to location, because of the presumed 1 A summary of the amendments to Regulations D and J greater exposure of banks in cities which served as clearing appeared in this Review (July 1972), page 154. 202 MONTHLY REVIEW, AUGUST 1972 centers to sudden and/or sizable deposit withdrawals.2 For all banks in cities designated as reserve cities the Act imposed requirements that were higher than those for country banks, and still higher ones for those in the central reserve cities.3 After the transfer in 1917 of re serves of member banks to the Federal Reserve Banks, the three-tier structure of ratios was justified on different grounds, such as the smaller velocity or volatility of de mand deposits at country banks. While the geographic principle had become outmoded a long time ago, the existing system became more and more anachronistic with the succeeding changes in banking practices and advances in transportation and communica tions that have taken place over the years.4 It failed to ac cord equal treatment to banks that were similar in most significant aspects of their activities but different in terms of location, or to provide differential treatment reflecting a bank’s place in the banking system as it affects the con duct of monetary policy. As a result, banks with virtually identical net demand deposits and similar business have been often subject to different reserve ratios. Specifically, a number of large banks participating in the money mar ket and/or having extensive foreign operations through branches or affiliated Edge Act corporations have con tinued to be classified as country banks because of their location. PAST CHANGES While no comprehensive reform has been undertaken since the passage of the original Federal Reserve Act, 2 On the history of minimum reserve requirements, see Phillip Cagan, “The First Fifty Years of the National Banking System— An Historical Appraisal” in Banking and Monetary Studies, Deane Carson, ed. (Homewood, Illinois: 1963), notably the Figure 2 showing required, excess, and total reserve ratios of national banks, 1865-1913. Reserve requirements stipulated in some state banking laws antedated those of the National Banking Act. 3 The Federal Reserve Act originally designated three central reserve cities: New York, Chicago, and St. Louis. In 1922 St. Louis was reclassified as a reserve city. 4 Irving M. Auerbach pointed out in “Reserve Requirements of Commercial Banks”, this Review (July 1948), reprinted in an updated and expanded version in this Bank’s publication Bank Reserves (1953), that a proposal to base reserve requirements on the class of deposits was advanced even before the Federal Reserve Act was enacted. For a review of the earlier history of reserve requirements, in addition to Auerbach’s article, see “The History of Reserve Requirements for Banks in the United States”, Federal Reserve Bulletin (November 1938), pages 953-72. See also “Member Bank Reserve Requirements— Heritage from His tory,” Business Conditions (Federal Reserve Bank of Chicago, June 1972. there have been several changes in the definitions of de mand deposits subject to reserves as well as assets qualify ing as reserves, in reserve accounting, and in the struc ture of reserve requirements. The following may be con sidered the most significant: (1) In 1935, reserve requirements were made variable within specified ranges by giving the Board of Governors the authority to increase the reserve ratios up to double the ratios then in force. (2) The next important change was in 1959, when the Board of Governors was given broad dis cretionary powers to reclassify individual banks in reserve cities as country banks, thus exempting these banks from the higher reserve ratios attached to the reserve city bank status; previously, only banks in “outlying areas” could be so reclassified. This change recognized the fact that banks located in a reserve (or central reserve) city could differ greatly in significant features, and these differences were not necessarily systematically related either to a bank’s size or its location within a city. (3) Banks were permitted to count a portion of their vault cash as a reserve asset in 1959; all vault cash was permitted to be counted in 1962. (4) The central reserve city classification was abolished in 1962, thereby reducing the reserve requirements to which twenty-two large banks in New York City and Chicago were subject at that time. (5) The principle of graduation was introduced in 1966, by establishing a higher reserve ratio for time deposits other than savings deposits of over $5 million at any bank. In 1968, it was expanded by raising requirements for net demand deposits above $5 million, for country as well as reserve city banks. (6) Lagged reserve accounting was introduced in 1968. Since then, reserve requirements against de mand and time deposits in any statement week have been based on average deposit liabilities two weeks earlier. (7) Reserve requirements on borrowings from foreign branches (or foreign banks) were introduced in 1969, in the form of marginal requirements on amounts above an exempt base figure. Reserve re quirements on commercial paper issued by bank affil iates, another nondeposit source of funds, became effective in 1970. FEDERAL RESERVE BANK OF NEW YORK The introduction in 1935 of variable reserve require ments was widely hailed as a significant innovation in techniques of monetary control; subsequently they were adopted by many other countries. The actual use of reserve requirements has varied with monetary conditions and with the prevailing views within the System but, on the whole, changes have been quite infrequent. Some of the most notable episodes include the sharp (and contro versial) increase in requirements in 1936-37 to mop up excess liquidity, the successive reductions in 1942 at central reserve city banks from maximum levels to facilitate bank absorption of war loans, the modest increases in 1951 to cushion the initial impact of the Korean war on bank credit,5 followed by gradual reduc tions from 1953 to 1966 to meet a widespread criticism that requirements were at excessively high levels. The very modest increases in 1968 and 1969 were related to over heated conditions in the economy, though no similar in creases had been made when the economy approached cyclical peaks in the previous fifteen years. Yet, for both classes of member banks, reserve ratios for demand de posits at the beginning of 1972 were not far from the late-1930’s levels, a period when bank reserves were considerably enlarged by gold inflows. In the ten years (1949-58) following the immediate postwar adjustment period, the lowering of reserve ratios supported most of the deposit growth at member banks, but in the following years the further growth of deposits was supported mostly through open market operations. The possibility of reducing reliance on open market operations by making frequent changes of small percentage amounts in reserve requirements has been explored, but no experimentation along these lines has been undertaken as open market operations have provided an effective tool for implementing policy objectives. Indeed, monetary policy was revived in the early fifties under conditions which offered a unique opportunity to control reserves through open market operations. The public debt was large and widely distributed and was comprised largely of mar ketable securities with a wide range of maturities. Thus, in recent years, there has been a clear tendency to use the reserve tool sparingly. To be sure, reductions in requirements were usually timed so as to be coordinated 203 with other moves to ease credit conditions and/or to meet seasonal demands. On several occasions the possibility of changing reserve requirements was considered, but no action was taken. On the whole, the System seemed to agree with Allan Sproul who, when president of the Fed eral Reserve Bank of New York, remarked that reserve requirements were a “blunt instrument”. When reserve ratios were changed, in most instances cushioning open market operations were undertaken. The respective advantages of the two means of supply ing and absorbing reserves have been the subject of study and discussion within the System and also of lively debate in academic journals.6 There was less interest among aca demic economists in devising a better system of reserve requirements.7 REFORM PROPOSALS Over the years the Board of Governors and several committees of the Conference of Federal Reserve Bank Presidents and of the System’s research function have con sidered and tested numerous ways of placing member bank reserve requirements on a more logical footing and of making them more flexible on either an automatic or a discretionary basis. Numerous attempts were made to de velop an alternative system which, even though not ideal or even wholly logical, would constitute a sufficiently de sirable improvement (without posing significant adminis trative problems) to warrant a request for appropriate Congressional legislation. Because of uniformity of reserve requirements on time deposits for all classes of banks and because ratios have consistently been considerably lower than those on de mand deposits (which resulted in about 80 percent of aggregate reserve assets being held against demand deposits), the System’s efforts to find an alternative sys tem have been focused on demand deposits alone. While 6 See, for instance, J. Ascheim, “Open-Market Operations versus Reserve Requirement Variations”, Economic Journal, (December 1959); C. A. Thanos, “Open-Market Operations and the Portfolio Policies of the Commercial Banks”, ibid. (September 1961); H. N. Goldstein, “The Relative Security Market Impact of Open-Market Sales and ‘Equivalent’ Reserve-Requirement Increases”, ibid. (Sep tember 1962); John H. Kareken, “On the Relative Merits of Reserve-Ratio Changes and Open-Market Operations”, Journal of Finance (March 1961). 5 The Board of Governors also exercised its power, granted for a limited period by the Anti-Inflation Act of 1948, to raise 7 See, however, Frank E. Norton and Neil Jacoby, Bank D e reserve requirements above the statutory limit. It did not make posits and Legal Reserve Requirements, UCLA (Los Angeles, full use of these powers, which lapsed less than a year after they 1959) and Neil Jacoby, “The Structure and Use of Variable Bank were enacted. Reserve Requirements”, in Banking and Monetary Studies. 204 MONTHLY REVIEW, AUGUST 1972 the need for legal reserve requirements on time deposits was occasionally questioned both within and outside the System, the various schemes considered focused on demand deposits. Studies of alternative structures of reserve requirements were, of course, limited by the prac tical considerations of public acceptance and the problems of transition. It was clear that any alternative system should permit effective control of bank deposit expansion. Further more, it was recognized that, in order to facilitate transi tion, a new plan should result in aggregate reserve liabili ties not much different from those held at the time by all member banks combined. Various sets of ratios were suggested and tested with this constraint in mind. The history of endeavors to achieve a more equitable and more defensible system of reserve requirements and to reassess its role in relation to other instruments of monetary control is a good example of the difficulty of finding practical solutions to complex problems, of achiev ing a sufficiently broad agreement within the System when the problem at hand has considerably different regional aspects, and of the interplay between academic discussion and internal System efforts. Proposals for a more rational system of reserve ratios proceeded along two lines. Earlier efforts had concentrated on finding a substitute for the reserve city bank classifica tion by relating reserve requirements either to the rate of activity (turnover velocity) of deposits or to the relative importance of interbank deposits at a given bank. Differ ent reserve ratios on various classes of deposits were proposed primarily on the presumption that different rates of use of such deposits reflected significant differences in the function of each class of deposits in our monetary system. Higher reserve requirements on interbank de posits were proposed not so much on the basis of a theory which justified them, but rather as a means of abandon ing the outmoded geographic classification without chang ing considerably the existing pattern of reserve liabilities among individual banks and without lowering or raising the aggregate volume of reserves by a significant amount. Later endeavors concentrated on devising a system of graduated reserve requirements that would apply to all banks irrespective of location. Attempts to devise a more rational system for distribut ing the burden of member bank reserve requirements go back at least to 1931, when an elaborate study (by a Fed eral Reserve System committee chaired by W. Riefler) resulted in a published report which served as the basis for recommendations to the Congress, on which, however, no action was taken. Since that time, the issue has come to life intermittently. The Board of Governors discussed many, but endorsed none, of the various proposals de veloped over the years by its own staff, by various System committees, or outside the System. When, after World War II, the banking situation reemerged little changed and with the war-generated liquid ity replacing the prewar influx of reserves from abroad, consideration of the problem of reserve structure was placed on the agenda again. In 1948 the Board presented to the Joint Economic Committee, without endorsement, a version of the “uniform reserve plan” .8 This plan, de veloped by Karl Bopp, then director of research of the Federal Reserve Bank of Philadelphia, would have sup planted the geographic classification, in that different ratios would apply to interbank and to other demand de posits. Under this plan, reserve requirements for demand deposits could ultimately have been made completely uniform merely by lowering the initially higher ratio on interbank deposits. A closely related plan would have related reserve re quirements directly to deposit velocity. It is likely that the System did not formally endorse the velocity version of the uniform reserve plan because no workable solution could be foand to deal with the special situation of “stock yard banks”, which, although few in number, had some importance and an association to defend their interests. These banks, servicing primarily accounts maintained by sellers and buyers at major cattle markets, held an excep tionally high amount of interbank deposits in relation to demand deposits (up to 50 percent), and their deposits had an exceedingly high velocity. There were other small groups of banks which had similar characteristics, such as banks in tobacco-auction centers. More importantly, the association of velocity with certain relevant characteristics, such as bank location, type of business, or structure of deposit liabilities, was too erratic and too complex (some of these characteristics being interrelated) to permit gen eralizations that could be used as a basis for an alternative system of reserve requirements. There were, furthermore, considerable doubts with regard to the theoretical under pinnings of the proposal. Interest in a reform of reserve requirements was revived in the early fifties as a result of continuing post-World War II inflationary pressures, which were reinforced by the outbreak of the Korean war. Also, System officials recognized that over the longer run the System would have to provide support for continuous deposit growth either through an ever-growing scale of open market operations 8 See Credit Policies, Joint Economic Committee, 79th Congress, Second Session (1948). FEDERAL RESERVE BANK OF NEW YORK 205 or, in part at least, by lowering average reserve require (even though a partially offsetting increase in reserve re ments. quirements for country banks was made at the time), and A variant of the velocity proposal was recommended establishing a lower reserve ratio on the first $5 million of for consideration by the “Douglas Subcommittee” in demand (and also for “other time” ) deposits— all con 1950,9 and was again discussed in 1952 in System replies tributed to improving the structure of reserve require to a questionnaire and in oral testimony in connection with ments. Liberal use of the discretionary authority to de the “Patman Subcommittee” inquiry.10 A committee of classify reserve city banks (as well as mergers) resulted System economists studied the problem again in 1953-54 in a reduction of this group to only 179 by the time the but, after producing numerous analyses and conducting new Regulation D was promulgated. While the Board had discussions which revealed considerable differences of the power to designate new reserve cities (as well as to views on several important issues, failed to agree on recom terminate such designation), no such actions were taken mendations. Two proposals, which, in fact, represented after December 1965. Some quite large banks have re variants of the velocity plan, were circulated within the mained in the country bank category, including, for in stance in this District, several banks in Albany, the state System in the following years. In 1957, a committee of Federal Reserve Bank officers capital, and in Newark, New Jersey. On the other hand, studied a report by an American Bankers Association three large and rapidly expanding suburban country banks, committee which recommended moving toward a single by acquiring New York City banks through merger, reserve ratio on all demand deposits. It rejected the velocity became subject to reserve city requirements. Interest in a reform of reserve requirements acquired approach and differential ratios for interbank deposits. While endorsing a uniform reserve plan as the ultimate new urgency in recent years as withdrawals from member goal, it recommended that further studies be made to de ship became widespread in some Federal Reserve Dis termine the range within which the Board should have tricts. The System, of course, always has been aware of the effect of reserve requirements on profits and on member the power to vary reserve ratios. Subsequently, discussions within the System centered ship. Requirements imposed by state authorities are typi on a system of graduated reserve requirements put forward cally lower than those in force for member banks, and can in April 1963 by the President’s Committee on Financial be satisfied in a less onerous manner. In particular, inter Institutions (known as the Heller Committee) but, even bank deposits held for business purposes can usually be though a good deal of testing with a variety of sets of counted among eligible reserve assets. In some states, a ratios and size brackets was undertaken, no urgency was proportion of reserves can be held in specified (usually felt to find an immediate solution to the problem of re United States Treasury) securities. In the recent past, some states have taken various steps to liberalize further serve structure. Every plan considered in the past would have resulted the reserve requirements for nonmember banks. in increasing total reserve liabilities for some significant group of banks; it was obvious that only a general lowering T H E NEW SYSTEM of average reserve ratios could avoid it. The change which is to take effect for the reserve period Nearly all proposals considered in the past required changes in the Federal Reserve Act. For a variety of rea September 21 to September 27 is thus the result of a sons, the System has been reluctant to recommend for forty-year search to find a workable solution for a situa mally new legislation to reform reserve requirements, tion which, in fact, antedated the creation of the Federal or else concluded that chances for passage were too Reserve System. By redefining reserve city banks on the slim to try. In the meantime, liberal interpretation of basis of net deposit size, it abolishes the geographic prin the authority to reclassify banks in reserve cities as coun ciple through administrative action within the framework try banks, permitting use of vault cash as a reserve asset of existing legislation. The uniform treatment of all member banks, irrespec tive of location, will be achieved under the revised Regula tion D by applying a uniform set of graduated reserve ratios to all member banks and by defining reserve cities 9 M onetary, Credit and Fiscal Policies, Joint Economic Com other than those with Federal Reserve offices as a func mittee, 81st Congress, Second Session (1950). tion of the net demand deposit size of the largest mem 10 Monetary Policy and the Management of the Public Debt, ber bank located in a given city. Every city with a bank Joint Economic Committee, 82nd Congress, Second Session having net demand deposits of over $400 million will (1952). 206 MONTHLY REVIEW, AUGUST 1972 automatically become a reserve city. However, country bank status will be granted to all banks located in such a city having net demand deposits of $400 million or less. A number of centers (none in this District) will lose the reserve city designation because even their largest banks will be reclassified as country banks, and a few centers (probably Albany in this District) will become reserve cities. With the passage of time, more banks now in the country bank category will reach the demand deposit size that will shift them automatically into the reserve city bank category. In fact, however, the reserve city-country bank distinction will lose much of its meaning. A borderline bank would be considered a reserve city bank only for the reserve periods when its demand deposits subject to re serves exceed $400 million. The provisions in the Federal Reserve Act relating to these two classifications will merely continue to set an upper and lower limit for graduated reserve ratios that can be imposed within the range stipu lated in the Federal Reserve Act as amended in 1935. The revised Regulation D establishes five net demand deposit-size brackets, with reserve ratios ranging from 8 to H V 2 percent and which apply cumulatively. More than 4,200 member banks will henceforth be subject to the firstand second-bracket ratios only, which will reduce signifi cantly reserve liabilities for each of them. The lowest reserve ratio (8 percent) applies to the first $2 million of net demand deposits, instead of the 12V^ percent ratio now in force for country banks. For the fol lowing tranche, between $2 million and $10 million, the reserve ratio is 10 percent, still substantially below the average ratios formerly in force for this deposit size (12V^ percent applying to deposits of $5 million and under, and 13 percent for amounts exceeding $5 million). A bank with net demand deposits of $10 million will be subject to an average reserve ratio of only 9.6 percent, and the ratio is smaller for banks below this size. Given the average rela tionship between net demand deposits, time deposits, cash items in process of collection, and capital funds, a bank with $10 million in net demand deposits would typically have a balance sheet of about $25 million. The reserve ratio for net demand deposits in excess of $10 million, but less than $100 million, will be 12 per cent. A reserve ratio of 13 percent (formerly applicable to net demand deposits in excess of $5 million at country banks) will apply to deposits in excess of $100 million and up to $400 million (with a \6Vi percent ratio applicable in the transitional week on deposits at existing reserve city banks which now are subject to a 11V2 percent reserve requirement). Institutions formerly classified as country banks with net demand deposits of $400 million or less benefit from the new system to the extent that the first $100 million of such deposits are now subject to an average ratio of 11.76 percent instead of 12.98 percent, as formerly. This reduc tion is quite significant for banks with net demand deposits in excess of $10 million, but for a country bank with de posits at the upper limit the reduction of reserve liabilities (by $1,215,000) is fairly small, only about two cents for each dollar of reserves now required. The reduction under the new regulation is also signifi cant for the fewer than sixty institutions which will continue to be classified as reserve city banks, even though their net demand deposits in excess of $400 million will continue to be subject to a HV 2 percent reserve ratio— the same ratio as now applicable to net demand deposits at such banks in excess of $5 million. Banks in this category are benefiting from a reduction in their reserve liabilities against the first $400 million; the reduction amounts to $19,215,000 for each bank, irrespective of size. Again, the relative value of this reduction for members continuing in the reserve city bank classification is the greatest (about 27 percent of the liabilities prior to the revision) at the lower limit of the bracket, that is, for banks with total assets of about $1 billion, but diminishes rapidly for the giant money market banks. The only institutions that are experiencing an increase in their reserve liabilities are four or five banks being shifted from the country to the reserve city bank classification. It is estimated that the revised Regulation D will reduce reserve requirements by about $3.4 billion, or approxi mately $1.4 billion more than the estimated loss resulting from the change in Regulation J. The prospective shrinkage of float as a result of same-day payment occasioned by the revision of Regulation J which will also become effective September 21 is expected to reduce member bank reserves by approximately $2 billion on average. There is no sure way of knowing to what extent the reduced reserve liability will offset, or more than offset, the loss of Federal Reserve float (and thus of reserves) experienced by each given member bank, although the various Federal Reserve Banks have endeavored to obtain as complete an analysis of their situation as possible from the individual member banks. Some banks may reap a con siderable advantage from changes in Regulation D, while losing little from the change in Regulation J; but the oppo site case is likely to occur quite frequently. Also, the re duction of reserve liabilities will become effective on a single date, while additional losses of float may result from a number of changes in the collection mechanism beyond the establishment of additional county or regional clearing arrangements, not all of which are directly related to the current change in Regulation J. Even the effects of changes FEDERAL RESERVE BANK OF NEW YORK resulting from the revision of Regulation J may take some time to work themselves out. The new version of Regulation D removes, in effect, the anachronistic basis for the structure of reserve require ments, but the much-delayed reform is becoming effective at a time when the banking system is undergoing what might well be the most profound changes in its history. Indeed, the most conspicuous developments— liabilities management and formation of multibank holding com panies— are only two of a wide range of changes that are profoundly affecting the environment in which banks operate. The relationship of deposits to other categories of short-term assets and liabilities and of commercial banks to other categories of financial institutions are also undergoing important changes, as are banking prac tices and policies. The geographic area of operations open to individual banks is widening in many states, and the diversification of services which individual banks or holding companies are able or willing to offer is growing. On the other hand, a variety of influences, including the generally less onerous burden of reserve requirements in almost all states, has resulted in a decline in membership and a result ing shrinkage of the percentage of total demand deposits held by member banks. Clearly, revisions in Regulations D and J, taken to gether, represent a significant change in operating condi tions for member banks. It remains to be seen what their effect will be on the collection mechanism and on banking structure. For instance, the graduated structure of reserve requirements might favor the holding company route over mergers as a means of banking growth. The new Regulation D leaves room for subsequent moves toward more complete uniformity in reserve ratios. Under existing legislation a single ratio could be set within the range of 10 and 14 percent. The desirability of making identical reserve requirements applicable to all commercial banks, irrespective of membership,11 continues to be debated. A good case can be made for extending reserve requirements to all short-term liabilities at all depository institutions or at least at all commercial banks —particularly if some of the developments that are taking place or are being widely discussed further blur the distinc tion of demand accounts of commercial banks from other short-term liabilities, or reduce considerably the unique role of banks in the payments mechanism.12 Questions also have been raised as to whether, by substituting (with proper adjustment in reserve ratios) gross for net demand deposits as the basis for assessing bank liabilities, addi tional simplification and uniformity could be achieved. 11 The Board o f Governors of the Federal Reserve System has requested legislation along these lines in several of its Annual Reports since 1964. 12 The President’s Commission on Financial Structure and Regulation has recommended in its Report of December 22, 1971 that membership in the Federal Reserve System be made manda tory not only for all state-chartered commercial banks but also for all savings and loan associations and mutual savings banks that offer third-party payment services (with identical reserve ratios becoming applicable after a transitional period). Subscriptions to the m o n t h l y r e v i e w are available to the public without charge. Additional copies of recent issues may be obtained from the Public Information Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, N.Y. 10045. Persons in foreign countries may request that copies of the m o n t h l y r e v i e w be sent to them by “air mail-other articles”. The postage charge amounts to approximately half the price of regular air mail and is payable in advance. Requests for this service and inquiries about rates should be directed to the Public Information Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, N.Y. 10045. 207
@FedFRASER