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federal
Reserve Bankof
NeHlbiic
Quarterly Review
Autum n 1985 Volum e 10 No. 3
1
P ublic and P rivate Debt
A c c u m u la tio n : A P erspective
6
Federal Tax R eform and the R egional
C h a ra c te r of the M u n icip a l Bond M arket
16
R ecent In s ta b ility in M 1 ’s V elocity
23
The S trong D o lla r and U.S. Inflation
30
Federal D e p o sit In surance and D eposits
at Foreign B ranches of U.S. Banks
39
A R M s: T h e ir F inancing Rate and
Im pact on H ousing
50
Treasury and Federal R eserve
F oreign E xchange O p e ra tio n s
The Quarterly Review is published by
the Research and Statistics Function
of the Federal Reserve Bank of New
York. Remarks of E. GERALD
CORRIGAN, President of the Bank,
on a perspective of public and
private debt accumulation begin on
page 1. Among the members of the
staff who contributed to this issue
are ALLEN J. PROCTOR and JULIE
N. RAPPAPORT (on federal tax
reform and the regional character of
the municipal bond market, page 6);
LAWRENCE J. RADECKI and JOHN
WENNINGER (on recent instability in
M1’s velocity, page 16); CHARLES
PIGOTT and VINCENT REINHART
(on the strong dollar and U.S.
inflation, page 23); CHRISTINE M.
CUMMING (on federal deposit
insurance and deposits at foreign
branches of U.S. banks, page 30);
and CARL J. PALASH and ROBERT
B. STODDARD (on the financing rate
and impact on housing of ARMs,
page 39).
A semiannual report on Treasury and
Federal Reserve foreign exchange
operations for the period February
through July 1985 starts on page 50.
Public and Private Debt
Accumulation: A Perspective
I welcome this opportunity to address the American
Bankers Association annual gathering of Chief Financial
Officers. In reflecting on possible topics for my remarks,
it struck me that this was a good opportunity to raise
some questions about an all too well-known four-letter
word. That word is “debt”. Specifically, I want to review
with you the facts as they pertain to the disturbing rate
at which the U.S. economy is accumulating debt; to cite
some of the factors which may lie behind the rapid
growth in debt; and to make a few suggestions as to
ways in which the growth in debt can be— perhaps I
should say must be— moderated over time.
In each of the past several years total debt in the
economy has risen markedly faster than GNP...
Over the 1981*85 period, the ratio of debt to GNP
will have risen by about 20 basis points to over
1.60—a very large change in a ratio of this nature.
By way of a general background, until recently, the
growth in total debt in the economy tended to track
closely the growth in nominal GNP. To be sure, there
were some departures from this pattern for cyclical and
other reasons, but the long run parity between the
growth in debt and the growth in GNP was strikingly
similar. But, beginning in the 1981-82 time frame
Remarks of E. Gerald Corrigan, President, Federal Reserve Bank of
New York, before the American Bankers Association Chief Financial
Officers’ Forum on Wednesday, September 18, 1985.
something seems to have happened to that relationship.
In each of the past several years debt has risen mark
edly faster than GNP. In fact, using 1981 as a base, the
cumulative gap between the growth in debt and the
growth in GNP is fifteen percentage points. Stated
somewhat differently, over the 1981-85 period, the ratio
of debt to GNP will have risen by about 20 basis
points to over 1.60— a very large change in a ratio
of this nature. A straight extrapolation of this recent
trend over the next decade would suggest that by
1995 we would have about $2.25 in debt for every
dollar of GNP.
In a proximate sense, it is widely recognized that the
major factor contributing to the rise in total debt in
recent years has been the string of massive Federal
budget deficits which have been chalked up in the
decade of the 80s. While that is certainly true, the rate
at which debt is being accumulated in the private sector
is also cause for concern. Let me cite a few statistics
that seem particularly telling.
In the Federal sector, commentary about $200 billion
deficits is now so commonplace that we may tend to
lose sight of the financial implications of those mega
deficits. For example:
• This year, interest costs of servicing the burgeoning
Federal debt will total about $130 billion. That will
be roughly equal to total personal income tax col
lections from every taxpayer west of the Mississippi
River. At the same time, more than $20 billion of
those interest payments will go to foreign holders
FRBNY Quarterly Review/Autumn 1985
1
of Treasury securities. This, in effect, implies that
a very sizable percentage of the proceeds of sales
of new Treasury securities to foreigners are being
used to pay interest to existing foreign holders of
Treasury debt.
only 20 to 30 percent of net private savings flows
despite the fact that in the cases of West Germany
and the United Kingdom, the cyclical component of
their deficits was larger than for the United States.
If the current efforts at reducing Federal budget
deficits are not successful, then even under fairly
optimistic economic conditions, the annual cost of
servicing the Federal debt by 1990 will be in the
neighborhood of $210 billion...For every five
dollars collected from the individual income tax,
two dollars will go toward paying Federal net
interest liabilities.
The growth in Federal debt lies at the root of another
dramatic development regarding the United States, and that,
of course, is the sudden and sizable shift in the position of
the United States from a net creditor to the rest of the world
to a net debtor. The immediate cause of this development
is, of course, the unprecedented current account deficits we
are running, but as this audience would recognize, the
underlying causes for those current account deficits are
importantly related to the budget deficit via the interest rate,
exchange rate nexus. Here too, orders of magnitude are so
large that they can lose meaning, but the following provides
some perspective:
• Looking out over the next few years, if the current
efforts at reducing Federal budget deficits are not
successful, then even under fairly optimistic eco
nomic conditions, the annual cost of servicing the
Federal debt by 1990 will be in the neighborhood
of $210 billion. That will mean that for every five
dollars collected from the individual income tax, two
dollars will go toward paying Federal net interest
liabilities. Moreover, even if near-term deficits were
reduced to levels consistent with the targets spec
ified in the recent Budget Resolution, annual net
interest payments by the Federal Government would
still grow to $180 billion five years from now.
• Federal debt relative to GNP, which had been on a
pronounced downward trend over most of the post
war period, is now rising very rapidly. Indeed, for
1985, Federal debt will amount to almost 40 percent
of GNP—a rise .of more than twelve percentage
points since 1981.
• At this juncture, and short of worldwide economic
conditions that would be most distasteful, it is dif
ficult to foresee circumstances in which the foreign
debt of the United States would not approach $500
billion by the end of the decade. Indeed, some
would suggest that we would have to be quite lucky
if that figure were not larger than $500 billion. In
considering the possible implications of external
debt of this size, there is at least a question as to
whether foreigners will be eager to continue to
accumulate dollar denominated assets of the
amounts suggested at current, much less lower,
rates of interest.
For the private sector as a whole, the ratio of
debt to GNP is at an unprecedented level and is
still rising.
Short of worldwide economic conditions that
would be most distasteful, it is difficult to foresee
circumstances in which the foreign debt of the
United States would not approach $500 billion by
the end of the decade.
• Servicing $500 billion in external debt at roughly
current interest rates could produce a $35 to $45
billion gap between our trade and current account
deficits and would imply that even approaching
current account balance will require not just a bal
ancing of our trade account but moving the trade
account into a sizable surplus position.
• An even more alarming picture arises when we look
at the deficit relative to our domestic savings flows.
In 1984, for example, the deficit consumed twothirds of our net private domestic savings. While
international comparisons are flawed, it is never
theless noteworthy that in Japan, West Germany,
and the United Kingdom, budget deficits consumed
• The “Catch-22” of this situation, however, is that
so long as our budget deficits are so large and our
domestic savings so meager, we are vitally
dependent on those same foreign savings flows
which finance the current account deficit to finance
our domestic activities including the budget deficit.
At present, foreign savings flows are augmenting
our net private domestic savings by a factor of
2
FRBNY Quarterly Review/Autumn 1985
more than one-third and are directly or indirectly
financing half or more of the budget deficit.
In summary, looking at the rate at which we are
building debt in the Federal sector and looking at the
closely related issue of the rate at which the United
States is accumulating external debt, it is difficult to
escape the conclusion that we are approaching or in
uncharted waters. But, even that’s only part of the story
since it does not take account of developments
regarding debt accumulation in the private sector.
Abstracting from internally generated equity, the
1984-85 period will, if current trends continue, see
the net retirement of $150 billion of equity in the
nonfinancial corporate sector—an amount which
in nominal dollars exceeds the net issuance of
equity by nonfinancial business over at least the
entire post-Korean War period.
To some extent, private sector debt accumulation has
been overshadowed by events in the public sector. And,
to some extent they have been muted by what, in my
judgment, may be a false sense of security growing out
of some statistics which, for example, suggest that
consumer liquidity is relatively high and rising or that
certain debt ratios for nonfinancial business have
stopped rising, or are falling slightly. Takir\g those and
other statistical indicators at face value, one could,
perhaps, conclude that outside of the Federal Govern
ment, all is reasonably well. Perhaps that is so, but I
would suggest that a closer look at trends in the private
sector may not justify that complacency.
existing levels of debt in a less favorable economic
and interest rate environment could prove very dif
ficult. This is especially true since generalized
financial indexation has shifted a sizable fraction of
overall interest rate risk from the financial sector to
the nonfinancial and household sectors.
• Taking account of where we are in the business
cycle, some measures of credit quality problems are
disquietingly high. This is especially true, for
example, for delinquency rates on home mortgages,
and of the overall level of nonperforming loans in
the banking system.
• The recent growth in debt has been associated with
a very rapid retirement of equity which, in turn, is
importantly—but not exclusively— related to lever
aged buyouts and the threats of hostile takeovers.
For example, abstracting from internally generated
equity, the 1984-85 period will, if current trends con
tinue, see the net retirement of $150 billion of equity in
the nonfinancial corporate sector—an amount which in
nominal dollars exceeds the net issuance of equity by
nonfinancial business over at least the entire postKorean War period.
Given all that has happened regarding patterns of
debt accumulation in recent years, it is not easy to
capture the underlying reasons for these developments
in a few paragraphs. In the case of the Federal sector,
I believe that most would now agree that the problem
is primarily one of a political nature. Thus, rather than
rehashing the familiar elements of that situation, allow
me to focus my commentary on the major factors which
seem to lie behind developments in the private sector.
I say that for several reasons including the following:
• For the private sector as a whole, the ratio of debt
to GNP is at an unprecedented level and is still
rising. To be sure, the increase is not as pro
nounced as for the Federal Government, but there
is at least a question as to whether it is reasonable
to assume there is that much more good quality
debt relative to GNP today than there was a
decade or two ago.
• The recent spurt in private sector debt accumulation
has, to a large extent, occurred on the upside of
the business cycle and the downside of the nominal
interest rate cycle and despite what are generally
seen as relatively high real interest rates. Since it
does not seem at all prudent to assume that the
business cycle is a thing of the past, servicing even
It would appear that at least some borrowers and
their lenders are still assuming—consciously or
subconsciously—that inflation will bail them out.
To the extent that is true, it strikes me as a very
bad bet.
To some extent, recent developments regarding pri
vate debt accumulation reflect longer-term trends.
Among the longer-term factors, demographics are such
that we now have a relatively heavy clustering of the
population in age groups that are more prone to borrow.
Similarly, a case can be made that a host of techno
logical, institutional, and innovational factors ranging
from credit cards to junk bonds are working in the
direction of enhancing the accessibility to credit. So too,
FRBNY Quarterly Review/Autumn 1985
3
a case can be made that the worldwide integration of
money and capital markets broadens financing options
and alternatives for many corporations at any given level
of interest rates. These and other factors may be
playing a role in the burgeoning rate of debt accumu
lation but they don’t seem capable of fully explaining
why the experience of the recent few years looks so
different than earlier periods. At the margin at least, it
would seem that still other factors must be at work. Let
me suggest two or three factors that may help to further
explain recent behavior.
• It would appear that at least some borrowers and
their lenders are still assuming—consciously or
subconsciously—that inflation will bail them out. To
the extent that is true, it strikes me as a very bad
bet. For one thing, it makes an assumption about
monetary policy that, from my perspective, is simply
wrong. However, it’s a bad bet in a more funda
mental way because renewed inflation would inev
itably bring more instability, not less. Indeed, I don’t
think it unreasonable to assume that even a sniff
of a new outburst of inflation would produce a
financial market response in interest rates that
could be quite harmful to those with high debt
service burdens.
Reducing the budget deficit is central not only to
establishing a better balance in the utilization of
our domestic saving, but it is the only vehicle
through which we can achieve an orderly
reduction of our dependency on foreign savings
while still leaving enough room to finance the
domestic investment ultimately needed for
economic growth.
• It is possible that very intense competitive forces
in the banking and financial sector are such that the
pricing of loans and other debt obligations does not
fully take account of differences in credit risk,
thereby diminishing the rationing effects of the
pricing mechanism for debt.
• Financial innovation may be aiding and abetting the
debt accumulation process in part by transferring
the incidence of credit and interest rate risk in ways
that may give rise to the illusion that such risks
have been reduced or eliminated.
• Innovational forces have also given rise to certain
highly sophisticated financing techniques which are
designed to take maximum advantage of certain
4
FRBNY Quarterly Review/Autumn 1985
features of the tax code—a tax code which has
strong incentives for debt accumulation in the first
instance. Highly leveraged buyouts are the obvious
example, but sophisticated tax shelter devices—
which by definition spur debt creation—are now
readily available even to individual investors with
relatively modest income levels. A casual reading
of the book Funny Money which deals with the
Penn Square debacle provides a number of
amusing but tragic insights into how easily even
sophisticated investors can get duped by sure fire
"deals” of this nature.
We must continue to resist the temptation that the
solution to our debt accumulation problem lies
with accepting a little more inflation.
What’s interesting about those episodes in Funny
Money is that they may be symptomatic of a cultural
revolution about debt. Homeowners no longer burn the
mortgage when it’s paid; they quickly get another, and
preferably one which, in effect, requires no payment of
principal; commercial real estate developers shun even
minimal equity investments in new projects; corporate
takeover specialists finance their activity by leveraging
to the hilt; and in each of these cases somewhere there
seems to be a financial institution that will eagerly
oblige.
In short, the factors that lie behind the rapid growth
in debt in the U.S. economy represent a complex
interaction of political, economic, technological, market,
and attitudinal considerations that will not easily be
reversed. Yet, common sense tells us that a continuation
of recent trends is not sustainable over the long haul.
Looked at in that light, the crucial question, of course,
is how can we best go about the process of slowing the
rate of debt accumulation in a way that maximizes the
prospects for more balanced non-inflationary economic
growth in the period ahead. From my perspective, the
answer to that question lies in several closely related
areas of public policy and private initiative, as follows:
• First, and perhaps most essentially, we simply must
do more to reduce the budget deficit in a timely and
credible manner. The recently enacted budget res
olution—if adhered to— is a positive step and pro
vides a margin of breathing room in the near term.
But, more needs to be done in a context in which
the next steps may be even more difficult to
achieve. Reducing the budget deficit is central not
only to establishing a better balance in the utili
zation of our domestic saving, but it is the only
vehicle through which we can achieve an orderly
reduction of our dependency on foreign savings
while still leaving enough room to finance the
domestic investment ultimately needed for economic
growth. And, only with that need for foreign savings
reduced can we bring about the orderly adjustment
in our external deficits that is also so essential.
• Second, we should continue to explore ways in
which tax policy can be tilted in the direction of
greater incentives for savings and equity invest
ment. Indeed, the current tax codes—with acrossthe-board deductibility of interest and the de facto
double taxation of profits—create powerful motives
for debt accumulation by households and busi
nesses alike. To the extent that situation can be
altered somewhat in the direction of greater incen
tives to save and to finance through equity, we will
be that much better off. Indeed to the extent we
can achieve that tilt in a context in which the deficit
is also coming down in a decisive way, our pros
pects for sustained growth will have been enhanced
appreciably.
Despite enormous competitive pressure that works
in the opposite direction, managers and directors
of individual financial institutions will have to
more fully recognize that more conservative
lending and funding policies are ultimately in their
individual and collective interests.
• Third, we must continue to resist the temptation that
the solution to our debt accumulation problem lies
with accepting a little more inflation. Indeed, and as
I noted earlier, more inflation can only bring more
instability and greater problems down the road.
• Fourth, we must seek out ways to adapt the bank
supervisory process to the realities of contemporary
banking markets—markets in which many of the
traditional sources of restraint have been eliminated
by a combination of deregulation and technologicallydriven innovation. This effort must entail a general
strengthening of the bank supervisory process but
also the active exploration of approaches that can
move in the direction of encouraging financial
institutions to take on more liquid and less risky
assets. The latter is one of the reasons why I am
strongly attracted to the concept of seeking to take
account of risk characteristics in the development
and administration of capital adequacy standards
for banking institutions.
• Fifth, turning to the private sector, we must see a
greater renewal of the precepts of prudence and
discipline in the management of banking and
financial institutions. Even now there is some evi
dence to suggest that renewal is beginning to take
hold as illustrated, for example, in the number of
institutions that are maintaining capital positions
well in excess of regulatory minimums. Yet, short
term preoccupation with growth and quarterly
earnings performance still seems unbalanced and
misplaced. More generally, and despite enormous
competitive pressure that works in the opposite
direction, managers and directors of individual
financial institutions will have to more fully recog
nize that more conservative lending and funding
policies are ultimately in their individual and col
lective interests.
In conclusion, the debt accumulation problem is a
matter of concern. Some elements of it will be selfcorrecting but others will need an assist from public
policy and from private initiatives. Those initiatives
constitute something of an insurance policy—and a
relatively inexpensive one at that—which can signifi
cantly raise the probabilities that we can sustain an
economic and financial environment conducive to growth
without inflation.
FRBNY Quarterly Review/Autumn 1985
5
Federal Tax Reform and
the Regional Character of the
Municipal Bond Market
Of the various tax proposals that could affect the
municipal bond market, reduction of marginal tax rates
and repeal of state income tax deductibility require
special attention. Analysts are aware that repeal of state
income tax deductibility would increase the out-ofpocket, effective level of state taxation. They also know
that lower federal marginal tax rates would reduce the
value of federal tax exemption of municipal bonds.
That analysis is incomplete, however, because of two
important characteristics of the municipal bond market.
First, most states impose taxes on the income their
residents earn from bonds issued out-of-state. Any
increase in effective state income taxes would raise the
value of in-state bonds to investors and equivalently
penalize borrowers who need funds from out-of-state.
Second, because the majority of municipal bonds are
bought by local investors, the effects of reducing the
value of a bond’s federal tax exemption depend on how
many investors are affected in each state.
Current federal tax law fosters some uniformity in the
municipal bond market by limiting the variations across
states due to these two market characteristics.
Repealing deductibility and establishing fewer brackets
at lower marginal rates would remove these limits. They
would raise interest costs for borrowers in some states
and lower costs for those in other states. Though these
are only two of many reform proposals that affect the
The authors would like to thank Daniel Chall for his derivations of
state tax formulas.
6
FRBNY Quarterly Review/Autumn 1985
municipal bond market, they are interesting because
each state is affected differently.1
In attempting to identify how widely the effects of
reform may vary across states, this analysis begins by
describing how state tax laws contribute to the regional
character of the bond market. The second section
describes the role of demand for bonds by state resi
dents relative to in-state borrowing needs. State tax
laws and populations in each tax bracket are then
analyzed to contrast the effects of current federal law
with those of the most recent Administration proposals.
The findings suggest that these proposals may have
effects on the cost of borrowing that vary widely from
one state to another.
’ Some other proposals may affect the bond market to a larger
degree, but their effects should be roughly similar across all states.
They would raise or lower interest rates about the same for one
state as for another. But the overall combined effect of the other
proposals is uncertain. Viewed in isolation, some may create upward
pressures on yields across states while others may create downward
pressures. For example, the proposed elimination of federal tax
exemption on many types of revenue bonds may reduce supply and
lower yields. At the same time, a reduced number of alternative tax
shelters may increase the value of tax-exempt bonds, raise demand,
and lower yields. However, eliminating special treatment of
commercial bank investment in tax-exempt bonds is likely to move
many banks out of the market, lower demand, and raise rates over
time. On balance, it is difficult to know whether yields will rise or fall
as a result. For detailed analysis of the influence of federal tax law
on commercial bank investment in municipal bonds, see Allen J.
Proctor and Kathleene K. Donahoo, “Commercial Bank Investment in
Municipal Securities”, this Q uarterly R eview (Winter 1983-84). For
approximations of possible effects on the average national level of
interest rates, see Andrew Silver, "Three Aspects of the
Administration’s Tax Proposal: Tax-Exempt Rates”, this Q uarterly
R eview (Summer 1985).
State tax laws and the favored treatment of
in-state bonds
The municipal bond market has a regional orientation
for most borrowers. In general, local investors buy the
bonds local borrowers issue and local market conditions
determine their borrowing costs.2
There is also a more familiar national market, con
sisting of a relatively small number of nationally rec
ognized borrowers who regularly issue large volumes of
bonds. Investors throughout the country buy and sell
their bonds, and national market conditions determine
their borrowing costs.
One factor shared by municipal bonds in both markets
is exemption from federal income taxes. Because no
bond income needs to be set aside to pay federal taxes,
investors are willing to accept lower yields than they
would on investments subject to federal tax. The ratio
of tax-exempt to taxable yields is often used to identify
the federal tax bracket of the marginal investor in the
national market.
Outside the national market, state taxation of munic
ipal bonds becomes an important reason for the cost of
borrowing to vary from one state to another. Puerto
Rican municipal bonds are not taxable in any state, but
38 states presently impose some form of tax on other
municipal bonds. Of the remaining 12, seven have no
tax on any form of income and five impose no taxes on
municipal bond income (Table 1).
Thirty-five of the states that tax municipal bond
income use their tax laws to create special preferences
for in-state borrowers. In-state bonds are tax-exempt
while out-of-state bonds are not. For example, an
investor who lives in a state with tax preferences earns
$900 in annual aftertax income from a $10,000 in-state
bond paying a 9 percent yield. If the state income tax
is 5 percent, an equivalent out-of-state bond would
provide only $855 of income after $45 in state taxes
was paid. To return the same aftertax income as the in
state bond, the outside borrower must offer a resident
investor a before-tax yield of 9.47 percent.3 This pref
erence creates an incentive for borrowers to sell their
bonds in th e ir home states. The preference also
encourages residents to switch from out-of-state bonds
to in-state bonds of equivalent value.
The primary reason for creating tax barriers against
outside borrowers is to improve the balance of supply
2For a discussion of the regional and national segments of the
municipal bond market, see Robert Lamb and Stephen P. Rappaport,
Municipal Bonds: The Comprehensive Review of Tax-Exempt
Securities and Public Finance (1980), pages 27-50.
’ Local income taxes are not considered in this study. These taxes will
enlarge the basis point disadvantage placed on out-of-state bonds.
Factors other than yield will also affect an investor’s decision to buy
out-of-state bonds: diversification, familiarity with the borrower, credit
risk, etc.
and demand between resident borrowers and investors.
By making out-of-state entry into their markets more
expensive, states hope to increase the demand for in
state bonds among resident investors. If demand for
municipals by residents is large enough to meet bor
rowing needs, then in-state borrowers may be able to
sell their bonds exclusively to residents and achieve the
maximum reduction of borrowing costs that the tax
barriers permit. If demand by resident investors remains
too small to absorb the supply of in-state bonds, despite
the state’s encouragement of in-state investment, bor
rowers will need to attract investors from outside the
state.
A municipal borrower who goes out of state to find
enough funds, however, must compete in other bor
rowers’ home markets and overcome whatever tax
Table 1
Effective State Income Taxes
on Municipal Bonds
No
state
tax*
Type of
security
Out-of-state
municipal ..
In-state
municipal ..
Number
of states ...
All
municipals
exem ptf
No tax
preference
for in-state
bonds
No
municipals
exempt^
Tax
preference
for in-state
bonds
Only in-state
municipals
exempt§
—
—
S (1 - F)
S (1 -F )
—
—
S (1 —F)
—
7
5
3
35
Key:
F= Federal marginal income tax rate.
S= State marginal income tax rate.
— = No income tax.
The exact tax preference for in-state bonds depends on state
tax rules (Appendix 1) and is generally equal to the state tax
rate reduced by the federal deduction of state taxes.
’ Alaska, Florida, Nevada, So. Dakota, Texas, Washington, and
Wyoming.
flndiana, Nebraska, New Mexico, Utah, and Vermont.
^Illinois, Iowa, and Wisconsin. Iowa exempts only Iowa State
Board of Regents bonds and Wisconsin exempts only
Housing Authority bonds.
§Alabama, Arizona, Arkansas, California, Colorado,
Connecticut, Delaware, Georgia, Hawaii, Idaho, Kansas,
Kentucky, Louisiana, Maine, Maryland, Massachusetts,
Michigan, Minnesota, Mississippi, Missouri, Montana, New
Hampshire, New Jersey, New York, No. Carolina, No. Dakota,
Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, So.
Carolina, Tennessee, Virginia, and West Virginia. Colorado,
Kansas, Ohio, and Oklahoma tax some types of in-state
bonds.
Source: Hueglin and Ward, op. cit.
FRBNY Quarterly Review/Autumn 1985
7
barriers may be imposed. The borrower needs an
underwriter who has a broad and strong broker network
that can convince individual investors to buy unfamiliar,
out-of-state bonds. The bonds must also offer a taxable
yield that provides at least the same aftertax return the
investor can earn from untaxed in-state bonds.
For the 15 states without tax preferences, the
advantage of borrowing from resident investors and the
importance of resident demand and supply is less clear
(Table 1). Resident investors in these “free access”
states receive the same tax treatment on in-state and
out-of-state bonds. Outside borrowers, therefore, face
no barriers to seeking resident investors, and in-state
borrowers must always compete against borrowers from
the other 14 free-access states. This generally will raise
the in-state cost of borrowing. Moreover, changes in
resident demand for in-state bonds may not be sym
metrical when there are nationwide changes in demand
for municipal bonds. Out-of-state borrowers have access
to resident investors to try to shift part of any increase
in demand away from in-state borrowers. At the same
time, they may shift any reduction of demand onto in
state borrowers by intensified bidding for resident
investors.
Current effectiveness of tax preferences
Even though use of tax preferences is widespread, their
current importance depends on the size of the tax bar
riers and the need for borrowers to cross the barriers.
Federal tax law plays an important role in each.
Federal deductibility of state income taxes lowers in
state bond demand by reducing the out-of-pocket cost
of state taxes. This reduction occurs because each
dollar of state income tax is partially offset by a reduc
tion of federal taxes for taxpayers who deduct state
income taxes. Instead of a combined federal (F) and
state (S) tax rate of F + S, taxpayers face a rate of
F - FS + S, where FS represents the federal tax
reduction from deduction of state taxes. The effective
out-of-pocket cost of state taxes is S - FS, which is
restated as S(1 - F ) in Table 1.
For example, an investor in the 25 percent federal tax
bracket, who faces a 5 percent state tax on a $10,000
out-of-state bond yielding 9 percent, can use deduct
ibility to reduce his federal taxes by one-fourth of his
$45 state tax bill. Thus, he pays a $33.75 state tax on
the income from his out-of-state bond.
Deductibility increasingly blunts the effectiveness of
tax barriers as the federal tax bracket increases. At the
top federal bracket of 50 percent, for example, state
taxes are reduced by half. If the resident investor with
the $10,000 bond and $45 state tax bill were in this
bracket, his effective state tax would be only $22.50.
This federal offset also limits the yield an out-of-state
8
FRBNY Quarterly Review/Autumn 1985
borrower would have to offer a resident to equal the
aftertax return of a comparable in-state bond. In the
example above, the out-of-state borrower would have to
pay a top-bracket investor 9.23 percent to equal the
aftertax return on a 9 percent in-state bond. However,
this increase of 23 basis points is lower than the 47
basis points the outside borrower would have to pay
without federal deductibility.
Estimates of the size of tax preferences in each state
show that current law with federal deductibility results
in relatively modest barriers to outside borrowers.4 Using
comprehensive measures of effective state tax rates,
Steven Hueglin and Karyn Ward calculate the aftertax
return of equivalent bonds in each of the states with tax
preferences. In about one-third of the states, the aftertax
return of an equivalent outside bond is less than 30
basis points below an in-state bond. In all but five
states, state taxation lowers the return on out-of-state
bonds by less than 50 basis points. The states with
larger barriers to outside borrowers are Delaware (61),
Minnesota (89), Montana (52), New York (63), and West
Virginia (71).s
Whether borrowers need to cross these tax barriers
depends on the demand for their bonds in their home
states. Each state’s tax schedule and specific tax rules
provide a unique schedule of effective tax rates by
income bracket. Based on these tables and the actual
interest rates on municipal, Treasury, and corporate
bonds, it is possible to specify those investors who
would prefer in-state municipal bonds to all other bonds.
This pool of potential investors can be characterized as
all taxpayers above a certain income tax bracket, which
varies by state.
In California in 1984, for example, in-state municipal
bonds provided the highest average aftertax returns for
residents with taxable incomes above $24,600. Based
on the tax formulas in Appendix 1, the average Treasury
bond yielding 12.46 percent and the average medium
grade corporate bond yielding 14.14 percent gave a
California investor in that tax bracket aftertax returns of
9.35 percent and 10.07 percent, respectively. By com
parison, the average California bond in 1984 yielded
10.11 percent. At higher tax brackets, the superiority of
in-state municipals would widen. At lower tax brackets,
Presum ably all municipal bond investors lower their effective tax
rates through deductibility. Seventy percent of all married taxpayers
filing joint returns with taxable incomes over $30,000 deduct state
and local income taxes. This income level coincides closely with the
minimum taxable income for resident investors in most states.
*Steven Hueglin and Karyn Ward, G u id e to S ta te a n d L o c a l Taxation
o f M u n ic ip a l B onds (1981). Their calculations are based on a 9
percent coupon bond selling at par using approximations of the
formulas presented in Appendix 1. They also include personal
property taxes for states that have such taxes. Since they performed
their calculations, Connecticut has introduced taxation on out-ofstate bonds.
corporate bonds would have a higher aftertax yield than
both California municipals and Treasury bonds.
In other states with different tax schedules, rules, and
average yields, the aftertax return on in-state bonds
becomes superior at different income levels. These
brackets are presented in Table 2 (column 1) based on
1984 tax laws and interest rates. In Alabama, for
example, the average in-state yield becomes superior
to other yields above the $35,200 income bracket.
The need for borrowers to go outside the state to find
sufficient investors can be approximated by the ratio of
total municipal borrowing in the state and the number
of potential resident investors.6 A high dollar value per
investor suggests a high probability that borrowers in
that state often cross state lines and possibly encounter
tax barriers. This may occur because the state has few
high-income residents to demand the bonds or because
its borrowing needs create a relatively large supply of
bonds. Conversely, a low value suggests that a state is
able to function as a self-sufficient market in which all
supply is taken up by resident demand. This may occur
because demand is high owing to a large high-income
population or because supply is low owing to relatively
limited borrowing needs.
The estimates of bonds issued per potential resident
investor range from a high of $60,700 in Wyoming to a
low of $2,800 in Ohio and Indiana (Table 2, column 3).
There is no particular level of per capita borrowing at
which a state becomes self-sufficient. However, results
from a study by Kidwell, Koch, and Stock suggest that
at this time the majority of states are self-sufficient.7 The
•The number of investors is approximated by the number of federal
tax returns above the minimum taxable income level for each state.
For this article, the alternative investments available to an investor
are limited to U.S. Treasury bonds and corporate bonds. For other
types of investments it is assumed that other factors, such as capital
gains taxes or depreciation rules, are more important in calculating
return than are income taxes, which are the focus of this article. See
Appendix 1 for a discussion of how aftertax returns are calculated
for each type of bond. An alternative measure of the ability to sell
exclusively to residents is the ratio of dollars issued to the
aggregate income of potential resident investors. Use of this
measure does not alter the results appreciably.
7David Kidwell, Timothy Koch, and Duane Stock, "The Impact of
State Income Taxes on Municipal Borrowing Costs", N a tio n a l Tax
Jo u rn a l 37 (Decem ber 1984) pages 551-562. Their study examines
yields on general obligation bonds of less than $5 million which
were bid competitively in 1980. The study finds that tax preferences
on average are successful in reducing the cost of borrowing for in
state borrowers relative to outside borrowers. Significantly, however,
the average reduction is a fraction of the value of the tax
preferences. This partial effect may occur if the marginal investors
for some of the bonds are not state residents and therefore do not
benefit from tax preferences. In that sense, these results confirm
that, while some municipal bonds are sold in-state (where tax
preferences lo w er the cost of borrowing), a significant proportion of
municipal bonds are sold out-of-state, where tax preferences raise
the cost of borrowing.
estimates in Table 2, then, are one way to sort out
which states lower their costs through tax preferences
by being self-sufficient and which see their costs raised
because they must cross other states’ tax barriers.
About 30 of the 35 states with tax preferences may
have enough resident investors to be self-sufficient for
in-state borrowing needs if around $10,000 of borrowing
per investor were the cutoff point. These^ may be the
states, then, that are able to lower their borrowing costs
by imposing taxes on out-of-state bonds.
On the other hand, Michigan, New Jersey, North
Carolina, and North Dakota may not benefit from their
taxation of out-of-state bonds. Borrowers in these four
states issue much more than $10,000 per resident
investor. They are more likely, therefore, to require
additional investors from outside the state.
Most of the 15 states which do not protect their in
state borrowers have low borrowing needs relative to
their investor pool. Their borrowers are probably able
to avoid the increased costs of crossing the tax barriers
of other states.
In sum, under present law, demand and supply con
ditions in most states do not indicate that a great deal
of interstate borrowing is occurring in the municipal bond
market. Local borrowing from local investors appears
sufficient to satisfy financing needs in most states. For
the relatively few borrowers who may depend on outof-state sales, the effective state taxes they may
encounter seem to be relatively modest.
Tax reform and its effect on interstate competition
for investors
Federal tax reform has important effects on interstate
differences in the municipal bond market. Resident
demand for in-state bonds is sensitive to any change
in federal tax rates, and the size of tax preferences is
sensitive to any change in federal deductibility of state
income taxes. Most proposals for federal tax reform will
change at least one of these provisions. The remainder
of this article uses the President’s Tax Proposals to the
Congress for Fairness, Growth, and Simplicity (Treasury
II) to illustrate what the effects of these two provisions
would be on regional municipal bond markets and why
the effects would vary widely across states.
Increased need to borrow out-of-state
The federal tax reform proposal is structured so that
tax rate cuts are not the same for every state pool
of potential resident investors. Treasury II proposes
marginal tax rates of 15 percent for incomes to
$29,000, 25 percent for incomes to $70,000, and 35
percent for incomes over $70,000. In states like
Colorado, present marginal investors in the resident
pool have taxable incomes under $30,000. For them,
FRBNY Quarterly Review/Autumn 1985
9
the marginal tax rate will remain unchanged at 25
percent. In other states like Alabama, the marginal
investor at current interest rates has taxable income
of $35,200. The proposal reduces that investor’s tax
rate from the current level of 33 percent to 25 per
cent. And in states like New Jersey where the tax
able income of the marginal investor is $45,800, the
marginal tax rate declines from 38 to 25 percent.
These lower tax rates will reduce the appeal of
municipal bonds relative to taxable bonds. Many of
today’s marginal investors will drop out of the market,
causing demand for in-state bonds to decline and the
minimum income level of the rem aining potential
investors to be higher. Estimates of these new income
levels are presented in Table 2 (column 2) for current
rates of interest.
For most states, the return on in-state municipal
bonds will no longer appeal to residents earning less
than $70,000. The current before-tax yield spread
between in-state municipals and taxable bonds is too
wide for most residents in the proposed middle tax
bracket. In only nine states (Arkansas, California, Col
orado, Delaware, Hawaii, Idaho, Maryland, Montana,
and Oregon) do state and federal taxes on Treasury and
corporate bonds combine to make current in-state
municipal yields attractive to the middle-bracket investor
earning between $29,000 and $70,000.
Estimates of the percentage of current potential
investors who will continue to demand in-state munic
ipals are presented in Table 2 (column 5). The nine
states where m iddle-bracket investors are likely to
remain in the market at current yields should face only
Table 2
State Characteristics of the Regional Municipal Bond Market
State
A la b a m a .................................... .............
Alaska ........................................ .............
Arizona ...................................... ............
Arkansas ................................... .............
California ................................... .............
Colorado ................................... ............
Connecticut .............................. .............
Delaware ................................... .............
Florida ........................................ .............
G e o rg ia ...................................... ............
Hawaii ........................................ .............
Idaho ......................................... .............
Illin o is ......................................... ............
Indiana ...................................... ............
Io w a............................................ ............
Kansas ...................................... .............
Kentucky ................................... .............
Louisiana ................................... ............
Maine ......................................... .............
Maryland ................................... .............
Massachusetts ......................... ............
Michigan ................................... ............
Minnesota ................................. ............
Mississippi ................................ .............
Missouri .................................... .............
Montana .................................... .............
Nebraska ................................... .............
Nevada ...................................... .............
New Hampshire ........................ .............
New Jersey .............................. ............
New Mexico .............................. ............
New York ................................... ............
No. C a rolin a .............................. ............
No. Dakota ................................ .............
O h io ............................................
10
Minimum tax bracket
of resident investors*
In dollars
1984 law
Proposed law
(D
(2)
35,200
29,900
29,900
29,900
24,600
24,600
50,000
24,600
32,500
29,900
24,600
29,900
45,800
35,200
45,800
35,200
35,200
29,900
35,200
29,900
35,200
45,800
35,200
29,900
29,900
24,600
29,900
35,200
35,200
45,800
35,200
29,900
45,800
35,200
35,200
FRBNY Quarterly Review/Autumn 1985
70,000
70,000
70,000
29,000
29,000
29,000
70,000
29,000
70,000
70,000
29,000
29,000
70,000
70,000
70,0001
70,000
70,000
70,000
70,000
29,000
70,000
70,000
70,000
70,000
70,000
29,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
Dollar borrowing per
potential resident investor^
In thousands of dollars
1984 law
Proposed law
(3)
(4)
8.7
24.8
8.1
3.3
7.0
8.7
11.0
7.8
11.1
9.5
6.1
3.9
15.8
2.8
19.2
7.0
8.8
8.4
4.2
3.7
4.6
13.7
7.5
5.8
5.3
10.5
5.3
7.1
3.2
18.4
8.9
5.3
21.7
16.9
2.8
79.1
116.4
66.9
3.3
7.0
8.7
18.4
7.8
70.2
77.7
6.1
3.9
27.2
28.4
33.51
53.3
78.7
61.1
39.8
3.7
33.5
24.4
63.8
49.3
44.3
10.5
44.6
52.2
27.7
32.1
73.7
34.2
37.1
136.1
25.6
Retention of potential
resident investors
under proposed law}
In percent
(5)
11.0
21.3
12.1
§
§
§
59.6
§
15.8
12.2
§
§
58.2
9.9
57.11
13.1
11.2
13.7
10.6
§
13.8
56.0
11.8
11.7
11.9
§
11.8
13.6
11.5
57.2
12.0
15.6
58.5
12.4
11.1
a small change in demand. All other states may face a
significant loss of investors.8
The effect of these changes on the cost of bor
rowing in each state depends on how much demand
falls short of local borrowing needs. Table 2 (column
4) presents estimates of the amount of borrowing per
investor if 1984 borrowing needs continue. Virtually
all the 41 states losing middle-bracket investors will
have per capita borrowing levels that exceed current
levels.
New York provides an illustration of the consequences
of losing a large number of investors in the critical
•The current spread between municipals and taxable bonds is larger
at short maturities than at longer-term maturities. The loss of in-state
demand will be largest at the maturities with the largest spreads
along the future yield curve.
$29,000 to $70,000 range. New York borrowers currently
issue about $5,000 in bonds per potential resident
investor annually. This is low, but m iddle-bracket
investors represent all but 15 percent of the investor
pool. This is the very group that is likely to drop out of
the market at current yields. If New York borrowers were
to lose middle-bracket investors, their sales to resident
investors would need to average $34,000 per potential
investor. At present, only two states issue such a large
amount of debt per capita.
The reduced pool of investors may not absorb so
much debt at current yields. Evidence cited earlier
suggests that the states with per capita borrowing above
$10,000 may currently rely on out-of-state investors for
at least part of their borrowing needs. Short of reducing
their future bond issuance substantially, borrowers in the
Table 2
State Characteristics of the Regional Municipal Bond Market, continued
State
Oklahoma ............................ .................
Oregon ................................. .................
Pennsylvania ......................... .................
Rhode Island ........................ .................
So. Carolina ............................................
So. Dakota ............................ .................
Tennessee ...............................................
Texas...................................... .................
U ta h ..........................................................
Vermont.................................. .................
Virginia .................................. .................
W ashington............................ .................
W. Virginia ...............................................
Wisconsin ...............................................
Wyoming ............................... .................
Minimum tax bracket
of resident investors*
In dollars
1984 law
Proposed law
(1)
(2)
35,200
29,900
35,200
35,200
35,200
35,200
35,200
35,200
35,200
45,800
35,200
29,900
35,200
35,200
45,800
70,000
29,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
70,000
Dollar borrowing per
potential resident investorf
In thousands of dollars
1984 law
Proposed law
(3)
(4)
5.6
4.7
5.3
11.2
10.1
11.5
5.5
8.3
21.2
30.6
4.1
3.5
4.4
3.6
60.7
Retention of potential
resident investors
under proposed lawt
In percent
38.5
4.7
45.5
95.7
94.5
115.8
46.7
53.2
215.0
55.0
28.4
28.3
46.0
36.3
104.4
(5)
14.4
§
11.6
11.7
10.7
9.9
11.8
15.6
9.9
55.6
14.3
12.3
9.7
10.0
58.1
*The minimum taxable income in 1984 at which the Public Securities Association estimates of the average net interest cost on in-state
municipal bonds exceeds both the aftertax return on ten- and 20-year Treasury bonds (whose 1984 yields averaged 12.46 percent) and
the aftertax return on Baa corporate bonds (whose 1984 yields averaged 14.14 percent). See Appendix 1 for the formulas used to
calculate combined federal and state income taxes. State and federal tax schedules are available from the authors on request. Use of
narrower yield spreads in the calculations would result in lower minimum income levels Calculations under the proposed law take into
account both revised income tax brackets and repeal of federal deductibility, except for Iowa (see footnote below).
fFor states with minimum taxable income levels up to $35,200 the number of potential investors is approximated by the number of federal
returns with adjusted gross income (AGI) above $30,000. For states with minimum taxable income levels of $45,800 or $50,000 the proxy
is the number of returns with AGI above $50,000. For a taxable income level of $70,000, the number of returns with AGI over $70,000 is
computed as all returns above $100,000 AGI and one half the returns between $50,000 and $100,000 AGI. These estimates assume that
1984 levels of borrowing continue. Some other tax proposals may reduce future borrowing from current levels.
tThe estimated number of potential resident investors under the proposed law as a percentage of current potential resident investors.
§Virtually all potential resident investors will be retained.
I lf deductibility is repealed, the spreads used in the calculations are too large for in-state municipals to be attractive to residents at any
income level. Therefore, the effect of repeal of deductibility is not reflected here.
Sources: Public Securities Association; Hueglin and Ward, op. c i t Internal Revenue Service, Statistics of Income; Advisory Commission
on Intergovernmental Relations; and Federal Reserve Bank of New York staff estimates.
FRBNY Quarterly Review/Autumn 1985
11
majority of states, therefore, would have two options.9
• They could increase yields by enough to induce the
remaining resident investors to increase their
holdings of in-state bonds.
• They could sell their bonds out-of-state and pay
premium yields to overcome the tax barriers other
states may impose.
Table 3 (column 1) presents estimates for selected
states of the increased yields necessary to replace the
lost investors. For states losing investors, the estimated
increases range from 4 to almost 60 basis points. For
example, for New York borrowers to sell all their bonds
to the remaining resident investors, they would need to
increase the average yield by an estimated 46 basis
points over the 1984 average interest cost of 9.04 per
cent reported by the Public Securities Association. In
dollar terms, this increased yield would raise the debt
service on a $10 million, 20-year bond issue by
$920,000 over the life of the issue.
An important reason some states may need larger
increases in yields than others is the difference in the
share of resident demand for in-state bonds which
middle-bracket residents now represent. Appendix 2
presents a method for estimating these shares.
In states with the largest estimated cost increases,
middle-bracket residents currently represent a dispro
portionately large share of demand compared with tppbracket residents. To replace middle-bracket demand,
the remaining top-bracket investors must be induced by
large increases in yields to raise the share of their
income being invested in local bonds.
By contrast, states in which top-bracket residents
already account for most resident demand would
have an easier time replacing their middle-bracket
resident investor pool. For example, even though
middle-bracket residents comprise about 90 percent
of Utah’s pool of potential resident investors, they
have only an estimated 73 percent of the income of
the pool. Utah may have to give only a 4-basis-point
increase in yields to convince its top-bracket resi
dents to invest enough additional income in local bonds.
As an alternative, borrowers may try to attract outof-state investors. In outside markets they will have
to compete with more borrowers, some of whom are
facing the same problem. In addition, they may need
to attract investors from states that tax the income
on out-of-state bonds. Repeal of federal deducti
bility of state income taxes will have important
•A reduction of borrowing may occur in some states as a result of
proposed restrictions on certain types of municipal bonds. Data are
not available to permit estimation of possible reductions by state.
12
FRBNY Quarterly Review/Autumn 1985
effects on their cost of going out-of-state.
Increased barriers against out-of-state borrowing
Repeal of federal deductibility of state income taxes
would remove the moderating role of federal tax law
on state tax preferences. Effective state taxes on
out-of-state bonds would rise, placing outside bor
rowers at a much greater yield disadvantage than
they currently face relative to in-state borrowers.
Estimates of the increased size of these preferences
are shown in Table 3 (column 2) for selected states.
Since states differ in their tax rates and rules, repeal
of federal deductibility would have different effects
across states on the value of tax preferences.
For example, for a New York resident, repeal of
deductibility would reduce the aftertax return of an outof-state municipal bond by 35 basis points.10 An outside
borrower would have to increase the before-tax yield it
pays by at least that much before it could compete with
comparable New York borrowers for New York investors.
This increase comes in addition to the 63-basis-point
disadvantage out-of-state borrowers currently face in
attracting New York residents.11
Some in-state borrowers in the 35 states with tax
preferences may benefit from the increased barriers
against outside borrowers. The increased value of state
tax exemption may allow some in-state borrowers to
reduce the yields they offer to residents. Residents who
now hold out-of-state bonds may also replace some of
them with in-state bonds and soften the effect of the
loss of middle-bracket investors.
Combined effects of federal changes
The majority of municipal bonds are already sold on a
regional basis in the United States. Revision of federal
tax rates and repeal of deductibility would reinforce and
possibly strengthen this local orientation of municipal
financing. Repeal of deductibility would increase the
incentive for borrowers to rely exclusively on resident
demand for their bonds. At the same time, the possible
loss of middle-bracket demand because of reduced
federal tax rates would create a need for more intensive
regional marketing of bonds in order to ensure enough
resident investors for current borrowing needs.
Self-sufficiency in financing local borrowing with
local investment, however, will be far easier for some
states than for others. The combined effects of fed
eral tax reduction and repeal of deductibility divide
the states into three classes according to the
10New York City residents will be affected to a greater extent because
they also pay local income taxes on out-of-state bonds.
"Hueglin and Ward, op.cit.
Table 3
Possible Effects of Personal Income Tax
Reform on In-State Borrowing Costs
In basis points
State
Increased tax
Increased cost of
barriers against
in-state borrowing* Qut-of-state borrowerst
Alabama ................
Arkansas ..............
California ..............
Delaware ..............
Florida ...................
Hawaii ...................
Indiana .................
Kentucky ..............
Maryland ..............
New York ..............
O h io ........................
Oregon .................
Texas......................
U ta h ........................
Wisconsin .............
14
0
0
0
17
0
59
19
0
46
54
0
25
4
39
15
19
13
19
0
21
0
18
20
35
17
27
0
0
0$
‘ The increase in in-state borrowing costs necessary to
maintain current resident demand if federal tax rates become
15 percent for incomes to $29,000, 25 percent for incomes to
$70,000, and 35 percent for incomes over $70,000.
fThe decrease in a resident investor’s aftertax return on an
out-of-state bond relative to an equivalent in-state bond if
federal deductibility of state income taxes is repealed.
}:The repeal of federal deductibility will reduce the resident
investor’s aftertax return on both in-state and out-of-state
bonds by about 30 basis points. Because this state taxes
both in-state and out-of-state municipal bonds, however, the
repeal of deductibility will not affect the spread between the
two types of bonds for a resident investor, A similar effect will
occur in Iowa and Illinois.
Source: Federal Reserve Bank of New York staff estimates.
probable future cost of financing public projects:
• states which are most likely to face increased
borrowing costs because of a large decline in
middle-bracket demand and an absence of tax
barriers to discourage residents from financing outof-state projects;
• states that are most likely to become more auton
omous with reduced borrowing costs because of a
continued large potential resident investor pool and
increased tax barriers to discourage out-of-state
investment; and
• states that may become more autonomous but with
varying changes in borrowing costs because a
reduced resident investor pool will face increased
barriers to investing out-of-state.
The 15 states without tax preferences will be the
markets of choice for borrowers from out-of-state who
need to replace their lost middle-bracket investors. The
increased number of borrowers competing for a reduced
investor pool may create substantial pressures on bor
rowers to raise yields.
For example, Texas borrowers may need to increase
yields by an estimated 25 basis points in order to induce
top-bracket resident investors to replace the demand of
middle-bracket residents. If more out-of-state borrowers
also try to attract investors in this state, the larger
supply may force yields even higher for in-state bor
rowers. This effect could be limited if tax preferences
were introduced.12
By contrast, nine states would encounter no loss of
resident demand and their protection from outside
competition would increase. For example, Oregon bor
rowers would increase their yield advantage over out
side competition by an estimated 27 basis points while
their borrowing needs would remain at the low level of
$4,700 per resident investor. One consequence is that
they might be able to reduce the yields they offer
residents.
Twenty-six states may encounter the third class of
effects: reform would increase the benefits of financial
self-sufficiency at the same time that it would erode their
ability to be self-sufficient. New York best represents this
conflicting situation. In-state borrowers would be pro
tected from outside competition for funds by one of the
largest increases in tax preferences for in-state resident
investment. At the same time, the predominance of
middle-bracket residents in the New York investor pool
would cause one of the largest decreases in resident
demand. If the latter effect is larger, as estimated in
Table 3, enhanced tax barriers would be of little benefit,
and local borrowers might need to go out-of-state. They
would have to find new markets, introduce unfamiliar
New York local bonds to new investors, and possibly
pay high enough yields to offset out-of-state taxation.
A final issue in evaluating federal tax reduction and
repeal of deductibility is the effect of increased reliance
on regional municipal bond markets. Under current law,
states with large borrowing needs but relatively small
high-iqcome populations can seek investors in other
states usually at little additional cost. These tax pro-
12The benefits of introducing tax preferences would be especially
large in Wisconsin, Iowa, and Illinois which may lose resident
demand as a result of each federal tax proposal. These states
currently have no tax preferences because in-state bonds are taxed
at the same rate as out-of-state bonds. Uniquely for them, repeal of
deductibility would reduce resident aftertax returns on in-state
bonds—by as much as 30 basis points in Wisconsin. Exemption of
in-state bonds would prevent this effect and limit the problem to the
replacement of middle-bracket demand.
FRBNY Quarterly Review/Autumn 1985
13
posals would encourage states to tax out-of-state
investment and to solve their financing needs more
completely in local markets. Because of the variety of
state tax laws and the diverse abilities of states to be
financially self-sufficient, however, not all regional mar
kets would fare equally well.
Allen J. Proctor and Julie N. Rappaport
Appendix 1: State Tax Formulas
This appendix presents the formulas used to calculate
effective state and federal income tax rates on municipal,
corporate, and Treasury bonds. These formulas are
applied to taxable bond yields to determine the minimum
income tax bracket for potential resident investors in
each state (Table 2). They are also used to calculate the
effect of repeal of deductibility on aftertax returns of outof-state municipal bonds (Table 3, column 2). Tax rates
on fixed income securities for states can be divided into
six groups on the basis of their deductibility formulas.
The formulas use the following symbols:
F = Federal marginal income tax rate
S = State marginal income tax rate
d = Deductibility of state and local income tax
from the federal tax base:
d = 1 under 1984 tax law
d = 0 under proposed federal tax law
C = Effective combined federal and state income
tax rate on corporate bonds
T = E ffective com bined income tax rate on
Treasury bonds
M = Effective combined income tax rate on outof-state municipal bonds
Under current law, taxpayers who itemize on their
federal returns may deduct their state and local income
tax from their federal taxable income, for states that
impose a state tax. In those states that do not, only the
federal tax rate, F, applies to both Treasury and corporate
bonds, and the effective tax rate on all municipal bonds
is zero. These states are Alaska, Florida, Nevada, South
Dakota, Texas, Washington, and Wyoming.
For many states, deduction of state and local income
tax from federal taxable income reduces the effective
state tax rate. These are their formulas:
C = F + [S(1 —dF)]
T = F
M = S(1 - dF)
These tax formulas apply to Arkansas, California, Con
necticut, Delaware, Georgia, Idaho, Illinois, Indiana,
Maine, Maryland, Massachusetts, Michigan, Mississippi,
New Hampshire, New Jersey, New Mexico, New York,
North Carolina, Ohio, Oregon, Pennsylvania, South
14
FRBNY Quarterly Review/Autumn 1985
Carolina, Tennessee, Virginia, West Virginia, and Wis
consin. For Illinois and Wisconsin, the formula is the
same for out-of-state municipals and in-state municipals.
Some states seek to lessen the tax burden further by
also allowing the deduction of federal income taxes from
state taxable income. For Alabama, Arizona, Iowa,
Kentucky, Louisiana, Montana, and Oklahoma these tax
formulas apply:
C = F + [[(1 —dF)(S - FS)]/(1 -d F S )]
T = F - [[(1 -dF)(FS)]/(1 -d F S )]
M = [S(1 -dF )]/(1 - dFS)
For Iowa the formula for out-of-state municipals also
applies to in-state municipals.
In other states, however, the additional tax savings
from state deductibility of federal taxes are reduced
because all state and local income taxes that were
subtracted from the federal tax base must be added back
into the state tax base. As a consequence, Colorado,
Kansas, Minnesota, Missouri, North Dakota, and Utah
use these formulas:
C = F + [[(1 - d F )( S - F S )]/(1 - d F S -d S )]
T = F - [[(1 -dF)(FS)]/(1 -d F S - d S ) ]
M = [S(1 ~dF)]/(1 - d F S -d S )
In some states, income tax is calculated as a per
centage of federal income tax. For Nebraska, Rhode
Island, and Vermont, one formula applies to both cor
porate and Treasury bonds:
C = T = [F(1 + S)]/(1 +dFS)
Tax treatment of municipal bonds differs among the
three. Since Rhode Island exempts only in-state munic
ipals from income tax, it has a separate tax formula for
out-of-state municipals:
M = [FS(1 - dF)]/(1 +dFS)
On the other hand, Nebraska and Vermont exempt all
municipal bonds, so that the effective combined tax rate
on these securities is zero.
Finally, in Hawaii, state income tax is deductible from
the state income tax base as well as from the federal
tax base. As a result, Hawaii has unique tax formulas:
C = F - [[dFS/(1 + S)] + [S /(1+S )]]
T = F
M « [S/(1 +S)] - [dFS/(1 +S))
Appendix 2: Estimating Resident Demand
This appendix summarizes the methodology for esti
mating the demand fo r in -sta te bonds by resident
investors. It also explains the calculation of the interest
rate effects presented in Table 3 (column 1). In order to
estimate the aggregate demand of potential investors in
a given state two problems must be overcome. First,
data on aggregate state income by bracket are provided
for adjusted gross income (AGI). In contrast, taxable
income is the basis for determining the minimum income
of a potential investor. Consequently, the minimum tax
able income levels in Table 2 must be converted to AGI.
The initial AGI estimate is based on the ratio of AGI
and ta xa b le incom e fo r each state and the ratio
nationally for each AGI bracket. This estimate is further
adjusted by the average amount of state and local
income tax deducted by the average taxpayer at that
level of AGI.
The second problem occurs in estimating the aggre
gate AGI of residents above this minimum level. Internal
Revenue Service (IRS) data on state aggregate AGI by
income level use bracket ranges that are larger than the
range of most of the income levels examined in this
study. As a result, interpolating aggregate income within
the published income brackets requires estimating an
income distribution function for each state using the
following procedure.
Based on IRS data on the number of returns and the
value of income in each AGI bracket, we plotted two
cumulative logarithmic distribution functions for each
state: the cum ulative percentage of returns by AGI
bracket and a Lorenz curve of cumulative percentage
AGI and cumulative percentage returns. We located the
estimated minimum AGI levels along each distribution
function with a cubic spline function and then converted
the results into the total state AGI above each minimum
AGI level.
The aggregate AGI of resident investors above the
minimum taxable income level is approximated under
1984 law and the proposed law. The change in aggre
gate income due to the proposals is adjusted for the
assumption that 70 percent of the residents deducted
state income tax from federal taxable income and that
they invested an average of one percent of their gross
income in municipal bonds each year. This income
reduction is divided by bond issuance in each state to
approximate the percent change in demand for in-state
bonds. Using an interest elasticity of 1.27, the percent
change in net interest cost is calculated. The value in
basis points is based on the 1984 average net interest
cost for each state estimated by the Public Securities
Association. The elasticity estimate is taken from Patric
Hendershott and Timothy Koch, “An Empirical Analysis
of the Market for Tax-exempt Securities”, Monograph
Series in Finance and Economics, New York University,
Monograph 1977-4. For a discussion of using cubic
spline interpolations of income distributions, see Christine
Cumming and Roger Kubarych, "The Economic Effects
of the Tax Deductibility of Interest”, Nominal and Real
Interest Rates: Determinants and Influences, Bank for
International Settlements (1985).
FRBNY Quarterly Review/Autumn 1985
15
Recent Instability in M1’s
Velocity
The behavior of M1’s velocity during the 1980s has
been remarkably different from the 1970s. After
increasing about 3.5 percent per year during the 1970s,
M1’s velocity has shown virtually no growth during the
1980s (chart). And its volatility has increased remark
ably. Velocity growth in the 1980s (measured from the
fourth quarter of one year to the fourth quarter of the
next) has already ranged from - 5 .6 percent to +5.3
percent. Over the entire decade of the 1970s, the range
was from -0 .1 percent to + 6.0 percent.1 Since the
predictability of M1’s velocity is a key element in
implementing a monetary targeting strategy, such dra
matic changes in the behavior of velocity raise questions
about what the underlying causes might be.2
This article explores some of the reasons for the
changed behavior of M1’s velocity. The introduction of
NOW accounts nationwide in 1981 is one factor. Another
is the sharp decline in interest rates that has accom
panied the reduction of inflation. In addition, swings in
inventories and the deteriorating trade balance appear
to be important. While the unusual behavior of velocity
can be traced to several factors, these factors them
selves, however, are not very predictable. Hence,
movements in velocity measured in terms of GNP will
probably continue to be difficult to anticipate.
The first section of this article presents a brief review
of recent movements in money, income, interest rates, and
velocity. The second section analyzes the recent behavior
of velocity using a conventional money demand equation.
The final section presents an alternative analysis using
the money-income reduced form equation.3
Review of recent velocity movements
The declines in M1’s velocity in three of the last four
years are certainly related to movements in interest
rates (Table 1, column 3).4 In each year that velocity
declined the Federal funds rate fell, with the largest
decline in velocity occurring in the year with the largest
percentage drop in the funds rate (1982-11 to 1983-11,
shown in Table 1, columns 2 and 3). In contrast, over
the period from 1983-11 to 1984-11 the funds rate rose
and velocity increased as well. Clearly, fluctuations in
interest rates explain a large part of the movements in
velocity. These movements reflect the public’s changing
demand for money as the level of interest rates and the
opportunity cost of holding M1 balances change.
However, too much weight might be assigned to
changes in interest rates if GNP is not a good proxy for
’ Velocity is the ratio of GNP to M1. The behavior of velocity during
the 1960s was quite similar to the 1970s. It grew about 3 percent
per year, and stayed in a range of - 0 . 2 to 5.9 percent.
Econom ists tend to look at the relationship between money and GNP,
i.e ., velocity, from two different perspectives, the demand for money
and the reduced form equation. In the demand for money, the
public’s holdings of M1 balances are related to current and lagged
values of interest rates and GNP The interest rate variable measures
the cost of holding funds in M1 as opposed to investing them, while
GNP measures the need for money for transactions purposes. In the
reduced form equation, the growth of M1 is viewed as the primary
determinant of aggregate demand. Hence, the growth of nominal
GNP is related to current and lagged values of M1. Both of these
approaches are useful in analyzing unusual movements in velocity.
*For more background on the 1982-83 decline in velocity, see
“Monetary Targeting and Velocity”, Conference Proceedings, Federal
Reserve Bank of San Francisco (Decem ber 1983).
4The one-year periods run from the second quarter of one year to the
second quarter of the next so that the first half of 1985 could be
included.
16
FRBNY Quarterly Review/Autumn 1985
the volume of transactions that is important for money
demand. That is, in each of the three periods when
velocity declined during the 1980s, GNP growth slowed
because of a decumulation in inventories or a reduction
of net exports or both. These two components of GNP
may not generate demand for money to nearly the same
extent as the other components of GNP. Hence GNP
growth during the periods when velocity declined could
have been understating the increase in the quantity of
transactions balances demanded.
Velocity should measure the number of times per year
a dollar of M1 is used for transactions purposes. GNP,
however, is a measure of total production which can
differ from total transactions for many reasons. For
example, if consumers increase their transactions bal
ances to purchase more goods, but firms choose to
liquidate inventories rather than increase production,
GNP is unchanged w hile M1 grows, and velocity
declines. Likewise, if consumers increase their money
balances to purchase more goods, but buy imports
made attractive by a strong dollar, the money supply
increases while GNP is constant, and velocity declines.
Also, U.S. exports may affect the demand for money
balances in foreign countries more than in the United
States. Very little demand for M1 may be generated
domestically by exports if inter-business transactions at
the various stages of the production process result in
relatively small balances in the checking accounts of
business firms, compared with the balances consumers
would keep to purchase the final product. Hence, if U.S.
exports decline because of weak foreign demand, GNP
falls while M1 demand remains relatively unaffected, and
velocity weakens. In general, it might be better to look
at gross domestic final demand (GNP less inventory
investment and net exports) when assessing the trans
actions demand for M1.5
Inventories and net exports appear related to the
recent declines in velocity measured in terms of GNP
(Table 1, column 7). Over the past year, for example,
gross domestic final demand has been running about
two percentage points above GNP, and in the first half
of 1985 when the decline in velocity was particularly
sharp, the divergence was 3.2 percentage points. In the
two earlier periods when velocity was declining, GNP
growth was also weaker than gross domestic final
5As long as the em p irica l analysis is done in a long-run context, the
distinction b e tw ee n G N P and gross dom estic final d e m a n d w ould
not be all that im portant. T heir long-run a v e ra g e growth rates have
been about the sam e. H ow ever, during the 1980s net exports and
inventories h ave had m uch larg er effects than in the past and,
therefore, the distinction b etw een G N P and gross dom estic final
dem a n d has b e c o m e m ore im portant for understanding the dem a n d
for M 1. For exa m p le , the m ean absolute d iffe re n c e b etw een the
growth rates of G N P and gross dom estic final dem and has been 2.7
p e rce n ta g e points in the 1 980s c o m p a re d with 2.1 p e rce n ta g e
points in the 1970s and 1.8 p e rc e n ta g e points in the 1960s.
demand. Since the transactions demand for M1 was
stronger than GNP, velocity growth (measured in terms
of GNP) appeared unusually weak. If no allowance was
made for the effects of inventories and net exports, then
too much weight might be given to interest rates in
explaining movements in velocity.
Changes in net exports and inventories have also
been an important source of quarter-to-quarter volatility
in velocity. Table 2 presents the ten largest deviations
in M1’s velocity (measured in terms of GNP) from its
trend growth rate over the past ten years in descending
order. The third column shows the reduction of the
deviations when velocity is computed with net exports
and inventories excluded from GNP. In every case, the
deviation of velocity from trend becomes smaller, with
an average reduction of four percentage points.
M1 Velocity
P e rc e n t
2 0 x \\
v Growth
,^
5
-1 0
G N P /M 1
7 .5 sx\s
Levels
.^
70
S h a d e d a re a s re p re s e n t p e rio d s of re c e s s io n , as
d e fin e d by th e N a tio n a l B ureau of E c o n o m ic R e s e a rc h .
S o u rc e s : U .S. D e p a rtm e n t of C o m m e rc e and B o a rd of
G o v e rn o rs of th e F e d e ra l R e s e rv e S ys te m .
FRBNY Quarterly Review/Autumn 1985
17
Analysis using a demand for money equation
An econometric model of the demand for M1 can also
illustrate the effects of inventories and net exports. In
the conventional transactions approach, real GNP and
short-term nominal interest rates, currently and in past
quarters, determine the volume of real M1 balances.6 In
this article, the difference between real GNP and real
gross domestic final demand (that is, the impact of net
exports and inventories on GNP growth) is an additional
explanatory variable used to capture the effect noted in
the previous section.
A few calculations will show the contribution of this
variable in the money demand equation. Ignoring time
lags and the impact of the interest rate variable, assume
an income elasticity of 0.5. That would yield a relation
ship: m = 0.5y, where m is the growth rate of real M1
and y is real GNP’s growth rate. If GNP increases 10
percent, real M1 increases 5 percent. Including the dif•ln the past, the most conventional specification related the log level
of real M1 balances to the log levels of a short-term interest rate,
real GNP, and lagged real M1 balances. For example, see Stephen
M. Goldfeld, "The Demand for Money Revisited” , Brookings Papers
on Economic Activity III (1973), pages 577-638, and "The Case of
the Missing Money” , Brookings Papers on Economic Activity III
(1976), pages 683-739. More recent research, however, suggests
changes in logs, rather than log levels, would be a better way to
specify the equation. See, for further detail, James S. Fackler and W.
Douglas McMillin, “ Specification and Stability of the Goldfeld Money
Demand Function” , Journal of Macroeconomics (Fall 1983), pages
437-459. In such equations, the coefficient on lagged money
balances is quite small, suggesting that the lag from income and
interest rates to money demand is short. To avoid constraining both
GNP and the interest rate to the same implicit lag structure by using
a lagged dependent variable, in this article the current and lagged
values were incorporated directly in the regression. It appears to be
an important distinction to make because the interest rate is
insignificant in the current quarter, but significant lagged one
quarter. GNP, on the other hand, is significant in the current quarter,
but insignificant lagged one quarter.
ference between real income and gross domestic final
demand (yf) would result in the following equation,
assuming the elasticities of y and yf are both 0.5:
m = 0.5y - 0.5 (y - y f)
In this case, a 10 percent increase in GNP due to a 10
percent increase in gross domestic final demand causes
m to increase 5 percent as in the previous example.
However, if yf increases 10 percent but y does not
increase because inventories are run down, m will still
increase 5 percent. In other words, the transactions
demand for m will increase when the volume of trans
actions increases, even if GNP (the level of gross
domestic production) does not increase because of
inventory rundowns or increased imports.
The empirical results show that inventory investment
and net exports are statistically important in a money
demand equation (Table 3). The estimated coefficient for
this variable is highly significant (at the 98.6 to 99.9
percent levels) in the three sample periods, thus
improving the explanatory power of the equation about
20 percent. Moreover, the coefficient on the current
quarter’s GNP becomes more significant with the addi
tion of this variable.
To show the importance of this additional variable for
tracking the growth of M1 during the past few years, the
regression equation was simulated after estimating the
coefficients with and without the additional variable
(Table 4). The simulation results are reported using
coefficient estimates obtained from the 1971-80 and
1975-84 sample periods. The earlier sample period
allows for an 18 quarter simulation period beyond the
last year used for estimation. Alternatively, the 1975-84
sample period includes several quarters important for
obtaining good coefficient estimates. Movements in M1,
GNP, interest rates, inventories, and net exports were
Table 1
Recent Velocity Movements
In percent
Change
in the level
of Federal
funds rate
(1)
Percentage
change
in the level
of Federal
funds rate
(2)
Velocity
growth
(3)
1984-11 to 1985-11 ..
- 2 .6
-2 5
-1 .4
+ 7.3
1983-11 to 1984-11 ..
+ 1.8
+ 20
+ 3.7
+ 7.5
Time period
18
M1
growth
(4)
Gross domestic
final demand
growth
(6)
Difference
(7) = ( 6 ) - (5 )
+ 5.8
+ 7.6
+ 1.8
+ 11.6
+ 10.9
- 0 .7
Nominal
GNP growth
(5)
1982-11 to 1983-11 ...
- 5 .7
-3 9
- 4 .6
+ 11.9
+ 6.7
+ 8.4
+ 1.7
1981-11 to 1982-11
- 3 .3
-1 8
- 0 .2
+ 5.1
+ 4.9
+ 5.7
+ 0.8
FRBNY Quarterly Review/Autumn 1985
quite sharp in the 1980s. Moreover, financial innovation
and deregulation have affected the demand for M1 since
the mid-1970s, suggesting that earlier data might bias
coefficient estimates.
In the 1971-80 sample period, including the difference
between GNP and gross domestic final demand in the
equation causes the average absolute forecast error of
the one-quarter growth rate of M1 to fall 1.4 percentage
points, or almost one-third. This, of course, still leaves
an average quarterly miss of three percentage points.
In the second sample period, ending the estimation
period in 1984 leaves only two quarters to test the
model’s ability to track actual money growth beyond the
estimation period.
However, these two quarters are of particular interest
because of the extremely sharp decline in velocity.
Therefore, the objective of this exercise is to see
whether an equation estimated through the early 1980s,
when v e lo c ity grow th slow ed and its v a ria b ility
increased, could track this most recent acceleration in
M1 growth. The equation predicts 9 percent growth for
the first half of 1985, while the actual growth is 10.4
percent. This relatively accurate forecast results from
the larger estimated interest rate elasticity (in absolute
value) in the later time period that occurs when earlier
Table 2
Ten Largest Deviations in Velocity
(Quarterly growth rates, from 1975 to 1985)
In p e rc e n ta g e points at annual rates
D ate
Deviation In velocity growth
from 1975 to 1985 average
U sing G N P
U sing
less inventories
GNP
and net exports
D iffe re n c e in
absolute value
1981-1 ......
16.0
8.3
7.7
1982-IV ...
—13.7
- 8 .6
5.1
1982-1 ......
-1 0 .8
-6 .1
4.7
2.9
1978-11 ....
10.3
7.4
1980-111 ...
- 8 .3
- 6 .5
1.8
1985-11 ....
- 7 .6
- 3 .6
4.0
1981-111 ...
7.5
4.7
2.8
1985-1 ......
- 7 .0
- 5 .8
1.2
1975-111 ...
6.8
3.1
3.7
1984-1
5.8
0.8
5.0
M ean
absolute
av e ra g e
9.4
5.5
3.9
data are excluded and from the additional variable to
control for the effects of inventories and net exports.7
Analysis using a reduced form equation
Another way to analyze velocity movements is by using
a reduced form equation relating the current quarter’s
GNP growth rate to current and past M1 growth.8 In this
section, the analysis with the reduced form equation
shows that much of the apparent instability in velocity,
particularly in 1982 and 1985, stems from inventories
and net exports as well as from the introduction of
nationwide NOW accounts in 1981.
The reduced form equation says that GNP growth
equals average velocity growth plus a weighted average
of M1 growth in the current and four past periods. In
other words, recent M1 growth is the primary determi
nant of current nominal aggregate demand. The basic
form of this equation is shown as equation 1 in the right
side of Table 5. To further refine this relationship, an
article in an earlier Quarterly Review showed that M1
growth coming from other checkable deposits (OCD)
tends to have only a little more than half of the impact
on GNP that M1 growth coming from currency and
demand deposits (MA) has.9 This result appears in
equation 2. The third equation in Table 5 is the same
as the second equation except that gross domestic final
demand (YF) replaces GNP (Y) as the dependent
variable.
In the context of the reduced form equation, the logic
for subtracting inventories and net exports from GNP is
different from that for money demand. In this case,
stronger M1 growth creates greater demand for goods
and services, but if imports or inventories satisfy some
of that demand, GNP growth does not pick up as much
7O ther analysts have noted that the interest elasticity in the
conventional m oney d e m a n d equation in creases in a bsolute value
when the sam ple period exc lu d e s earlie r d a ta . In part, this could be
due to the nationw ide introduction of N O W a c counts in 19 8 1. N O W
accounts e arn e xplicit interest and consum ers with N O W accounts
could be m ore sensitive to c h a n g e s in m arket rates than those with
dem and deposits. M oreover, with the introduction of m oney m arket
funds and M M DAs, it has b e c o m e e a s ie r for consum ers to shift their
liquid assets into and out of M1 w hen m arket rates c h a n g e . For
more detail, see H ow ard Roth, “ Effects of Financial D e re g u la tio n on
M onetary Policy", Economic Review, Federal R es erv e Bank of K ansas
C ity (M arch 1985); and M .A . Akhtar, “ Financial Innovations and Their
Im plications for M onetary Policy: An International P erspective", Bank
for International Settlem ents, Economic Papers No. 9 (D e c e m b e r
1983).
•O ve r the years, m any objections have been raised to the red u c ed
form app ro a c h . In particular, M 1, like GNP, is an end o g e n o u s
v ariable and the correlation o b s e rve d in the red u c ed form equation
results from both v a ria b le s respo nding in a system atic w ay to other
factors in the econom y. Even if M1 is not exogenously d e te rm in e d ,
however, this relationship can be useful if M1 respo nds sooner to
these other factors and hence is a good lead in g in d icato r of GNP.
For m ore detail, see John W enninger, “The M 1 -G N P R elationship:
A C om ponent A pproach", this Quarterly Review (A utum n 19 8 4).
•W enninger, op. cit.
FRBNY Quarterly Review/Autumn 1985
19
Table 3
Estimation Results for the Demand for Money
Sample period
Dependent
variable
Coefficient estimates
Summary statistics
Constant
r
r( —1)
y
y( - 1 )
N E+II
P
R2
SE
1960-84 ................
m
-0.0 0 1 3
(10 )
0.0065
(1.1)
-0 .0 3 9
(6.3)
0.32
(4.1)
0.094
(1.2)
*
0.28
0.41
0.0070
1960-84 ................
m
-0.0024
(1.9)
0.0063
(1.1)
-0.031
(5.3)
0.49
(5.8)
. 0.036
(0.5)
—0.49
(4.1)
0.29
0.48
0.0065
1971-80 ................
m
-0.0 0 4 3
(2.7)
0.014
(16)
-0 .0 2 7
(3-2)
0.48
(4.3)
-0 .0 1 3
(0.1)
*
0.10
0.51
0.0070
1971-80 ................
m
-0.0 0 5 6
(3.8)
0.011
(13)
-0.021
(2.6)
0.63
(5.3)
-0 .0 0 9
(0.1)
-0 .5 5
(2.5)
0.06
0.58
0.0065
1975-84 ................
m
-0.0001
(0.0)
0.0055
(0.5)
-0.061
(5.8)
0.24
(1.8)
0.095
(0.7)
*
0.32
0.50
0.0081
1975-84 ................
m
-0.0014
(06)
0.0038
(0.4)
-0 .0 4 5
(4.7)
0.46
(3.6)
-0 .0 0 5
(0.0)
-0 .6 9
(3.9)
0.38
0.61
0.0069
Definition of variables:
m = Ain (M1/GNP deflator), r = Ain (3-month Treasury bill rate), y = Ain (real GNP).
NE + II = A(ln [real GNP] - In [gross domestic final sales/GNP deflator]).
'Not included.
Table 4
Simulation Results for the Demand for Money
In percent at annual rates
Predicted M1 growth using
equation estimated 1971-80
Actual
M1 growth
Without net exports
plus inventory
investment
With net exports
plus inventory
investment
Without net exports
plus inventory
investment
With net exports
plus inventory
investment
1981-1.........................................
1981-11 ........................................
1981-111 ......................................
1981 -IV ......................................
3.3
8.8
3.1
5.1
6.6
- 2 .2
14.0
- 3 .8
5.1
- 0 .2
12.3
- 2 .4
0.7
5.5
12.4
- 0 .2
- 0 .2
6.1
11.5
0.6
1982-1 .........................................
1982-11 ........................................
1982-111 ......................................
1982-IV ......................................
8.9
2.9
5.9
16.3
6.9
7.3
0.6
10.2
7.8
4.9
4.0
10.4
8.1
2.3
3.5
12.9
9.7
0.3
6.9
12.6
1983-1 .........................................
1983-11 ........................................
1983-111 ......................................
1983-IV ......................................
11.3
12.2
10.2
6.3
19.0
9.7
11.5
9.9
13.9
13.5
10.6
10.1
16.1
6.0
12.4
9.6
10.1
11.3
10.7
10.2
1984-1 .........................................
1984-11 ........................................
1984-111 ......................................
1984-IV ......................................
6.2
6.5
4.5
3.2
10.1
3.1
4.2
3.6
8.0
7.2
2.2
3.6
10.4
3.0
4.9
3.3
7.7
8.1
2.6
3.7
1985-1 .........................................
1985-11 ........................................
10.6
10.2
6.7
7.7
6.3
9.8
10.5
5.7
9.0
9.1
4.5
3.1
3.0
2.3
Date
Average absolute e rr o r ...........
20
Predicted M1 growth using
equation estimated 1975-84
FRBNY Quarterly Review/Autumn 1985
average absolute error (lower half of Table 5). The
average absolute error declines from 5.3 to 4.4 per
centage points when OCD and MA are allowed to have
different-sized impacts, and declines further to 2.7
percent when gross domestic final demand is used as
the dependent variable. The reduction of the error for
the period as a whole is found in mostly 1981, 1982,
and the first half of 1985.
The questions remain whether GNP growth in indi
vidual quarters has been particularly difficult for these
equations to track and whether the distinction between
GNP and gross domestic final demand would have
made any difference in those quarters.10 Table 6 shows
as would be expected. Slow GNP growth relative to M1
growth reduces velocity from what it would have been
if domestic production had risen. Likewise, the demand
for exports can weaken significantly for reasons unre
lated to M1 growth; for example, sluggish growth in the
economies of our trading partners. Reduced demand for
exp orts w eakens GNP but leaves M1 grow th
unchanged, causing velocity growth to slow.
The left side of Table 5 shows the simulation errors
from each of these three equations. Average errors
appear in the upper half of the table and average
absolute errors in the lower half. The average error (a
measure of bias) for the entire period falls from - 2 .8
percentage points to -1 .1 percentage points when OCD
and MA are allowed to have different impacts on GNP
growth. It declines further, to just - 0 .4 percentage
point, when YF replaces Y as the dependent variable.
The reduction of the average error for the entire period
stems mostly from better performance in 1982 and in
the first half of 1985.
Another striking improvement is the decline in the
10One way of exploring this question is to include a zero-one dummy
variable for each quarter since 1979. Those dummy variables that
are statistically significant—the estimated coefficient before the
dummy variable is significantly different from zero using a t-test—
occur in quarters where the equation had significant forecast errors
For more on this approach, see R.W. Hafer, “ Monetary Stabilization
Policy: Evidence from Money Demand Forecasts” , Federal Reserve
Bank of St. Louis Review (May 1985).
Table 5
Reduced Form Results
In percentage points at annual rates
In-sample
average errors
Y on M
(1)
1980 ............................
-0 .1
Y on
MA, OCD
(2)
YF on
MA, OCD
0.0
0.1
1981 ............................
1.5
4.1
2.7
1982 ............................
- 7 .6
- 4 .2
- 1 .8
1983 ............................
- 3 .6
- 1 .9
-3 .4
1984 ............................
0.6
2.0
1.6
1985 (first half) .........
- 6 .3
- 5 .8
- 2 .6
1980-85 ........................
- 2 .8
-1 .1
-0 .4
(1) Y = 3.4 + 0.97M
(6.2)
0.23
(2) Y = 2.9 + 1.17MA + 0.65 OCD
(6.7)
(3.4)
0.27
(3) YF = 3.4 + 1 08MA + 0.660CD
(7.1)
(3.9)
0.30
Sample periods: 1949-11 to 1985-11
Y = quarterly growth rate of GNP.
In-sample average
absolute errors
1980 ............................
2.4
2.5
2.7
1981 ............................
6.8
6.2
3.3
1982 ............................
7.6
4.2
1.8
1983 ............................
3.6
2.6
3.5
1984 ............................
2.3
2.9
2.1
1985 (first half)
6.3
5.8
2.6
1980-85 ........................
5.3
4.4
2.7
_
R2
Equations
M = quarterly growth rate of M1.
OCD = quarterly M1 growth due to the other checkable
deposit components of M1.
MA = quarterly M1 growth due to M1 less OCD.
YF = quarterly growth rate of GNP less inventories and
net exports.
The equations are estimated with polynominal distributed
lags covering the current quarter and four lags.
FRBNY Quarterly Review/Autumn 1985
21
Conclusions
While it is not possible to account precisely for every
quarterly movement in velocity, several factors have
played important roles in recent years. From the point
of view of money demand, these factors include the
declines in interest rates, an increased responsiveness
in the public’s demand for M1 when interest rates
change, and the consideration that GNP is not a good
proxy for the total volume of transactions when net
exports or inventories are strongly affecting its growth
rate. From the perspective of the reduced form equation,
the errors in predicting GNP with M1 are lowered when
M1 growth is split into its interest bearing and non
interest bearing components, and when the distinction be
tween GNP and gross domestic final demand is made.
However, it is very difficult to predict swings in
inventories, net exports, interest rates, and the split in
M1 growth among its components. Moreover, there has
not been enough experience with M1 in this more de
regulated environment to estimate very precisely the
interest elasticity of the demand for M1. Hence, even
though some of the reasons for the instability of velocity
in the 1980s (measured in terms of GNP) can be iden
tified ex post, velocity is not likely to be more predict
able as a result.
the results by year for GNP and gross domestic final
demand.11
In terms of GNP, four quarters out of 22 in the sim
ulation period show statistically significant errors ranging
from 10.7 to 13.5 percentage points: 1981-1, 1982-1,
1982-IV, and 1985-11. In all four cases, however, the
errors become smaller (roughly half as large) in absolute
value and turn statistically insignificant when gross
domestic demand rather than GNP is used as the
dependent variable. But the error in the first quarter of
1983 becomes larger in absolute value and turns sig
nificant when gross domestic final demand is used. In
that quarter, when net exports and inventories were
adding five percentage points to GNP growth, its growth
was still considerably weaker than would have been
expected from the very rapid pace of M1 growth. Hence,
it appears that some “ outliers” will still occur from time
to time, even though the distinction between gross
domestic final demand and GNP can reduce many of
the large errors in the reduced form equation.
11The distinction between OCD and MA could not be made in this
exercise. Nationwide NOWs were introduced in 1981. With a dummy
variable for each quarter in the post-1979 period, it is not possible
for the regression to assign separate weights to OCD and MA.
Table 6
Significant Errors in Reduced Form Equations
In p e rc e n ta g e points at annual rates
Q uarter
1 980
1982
1981
Y
YF
Y
YF
Y
YF
Y
.......................
1.8
(0 .4 )
1.0
(0 .2 )
10.7
(2 .3 )*
3.1
(0 .7 )
-1 1 .8
(2 5 )*
- 5 .9
(1 .4 )
— 9.4
(1 .9 )
II ...............................
-1 .3
(0 .2 )
-5 .0
(1 .1 )
-6 .1
(1 .3 )
-4 .5
(1 .1 )
-3 .8
(0 .8 )
-5 9
(1 .4 )
Ill ...............................
-3 .8
(0 .8 )
-0 .5
(0 .1 )
5 .3
(1 .1 )
2 .0
(0 .5 )
-6 .8
(1 .5 )
I V ...............................
-1 .0
(0 .2 )
1.0
(1 .2 )
-5 .7
(1 2 )
-4 .1
(1 0 )
A v erag e error ...
A v erag e
a bsolute error .. .
-1 .1
-0 .9
1.1
2 .0
1.9
7.0
I
1984
1983
YF
198 5
Y
YF
Y
YF
-1 2 .5
(2 .9 )*
4 .6
(1 0 )
-0 .9
(0 .2 )
-6 .5
(1 .4 )
-4 .4
(1 .0 )
-6 .0
(1 .2 )
-4 .7
(1 1 )
0 .7
(0 .1 )
4.2
(1 .0 )
-1 0 .0
(2 .1 )*
-4 .3
(1 .0 )
-2 .2
(0 .5 )
-5 .9
(1 .2 )
-6 .3
(1 5 )
-3 .2
(0 .6 )
-2 .3
(0 .5 )
-1 3 .5
(2 8 )*
-5 .9
(1 -3 )
-1 .3
(0 .3 )
-2 .3
(0 .5 )
-0 .2
(0 .0 )
-0 .6
(0 .1 )
-0 .9
-9 .0
-5 .0
-5 .7
-6 .5
0 .5
0.1
-8 .3
-4 .3
3.4
9.0
5.0
5.7
6.5
2 .2
2 .0
8 .3
4 .3
Equations:
Y = 2 .9 + 1 .1 9 M + dum m y v a ria b le for e ach p o s t-1 9 7 9 quarter.
(6 .7 )
YF = 3 .2 + 1 .1 2 M + dum m y v a ria b le for e ach p o s t-1 9 7 9 quarter.
(6 7)
'S ig n ific a n t at 9 5 p e rce n t level, see notes in Table 5 for exp lan atio n of variables.
Lawrence J. Radecki and John Wenninger
22
FRBNY Quarterly Review/Autumn 1985
The Strong Dollar and U.S
Inflation
U.S. inflation has changed remarkably little during the
present recovery. Consumer prices rose at a 3.8 percent
annual rate during the first half of 1985, barely different
from the 3.7 percent increase posted for the first year
of expansion.
The steadiness of the inflation rate over the past two
and one-half years is somewhat surprising in view of
several factors that might have reduced it further. Oil
and several other key commodity prices have fallen
sharply since 1982 (Table 1), while significant slack
remains in labor markets, as indicated by an unem
ployment rate still above (according to most analysts)
the “full-employment” level. In addition, the dollar has
appreciated nearly 17 percent (trade-weighted average
basis) over the same period (Chart 1). In the past, these
conditions have often been associated with falling
inflation—so why not during this recovery?
This article focuses on the dollar’s impact on U.S.
inflation over the last several years. The dollar’s rise
since 1982 has not led to the fall in aggregate import
prices that past experience would have suggested,
perhaps helping to explain why inflation has not mod
erated further. Much of the surprising relative strength
of import prices can be attributed to the sharp recovery
in domestic real growth, which led to increases in import
demand that substantially offset the downward pressure
on import prices from the dollar appreciation. This
experience suggests that the dollar depreciation since
February may not add much if at all to domestic inflation
unless domestic demand picks up markedly from the
sluggish pace of the first half of 1985.
Experience
The recent pattern of a strong dollar with virtually
unchanged domestic inflation differs considerably from
1980 to 1982, when the dollar rose by 20 percent while
the inflation rate fell nearly eight percentage points. It
differs as well from the late 1970s experience of dollar
depreciation accompanied by rising inflation. Of course,
other factors, notably substantial differences in gov
ernment policies, were primarily responsible for this
contrast. Still, the impression persists that inflation has
not responded to the dollar as much in the last two
years as it did in the past.
Statistical estimates of the response of domestic
prices to changes in the dollar, most derived from data
drawn largely from the 1970s, reinforce this impression.
Though estimates vary substantially, depending on the
model and period of estimation (appendix), the con
sensus is that a 10 percent rise in the dollar’s value will
reduce the Consumer Price Index (CPI) inflation rate by
about 0.6 percent in each of the following two years.
On this basis, the dollar’s appreciation since the last
cyclical trough should have reduced the CPI by nearly
1.5 percent below the level it would otherwise have
reached. But such a dampening effect on inflation from
the rising dollar is not obvious from the actual data.1
This raises a natural question prompted by the sub
stantial fall in the dollar since last February: will U.S.
inflation remain unaffected, or will it rise as the expe
rience prior to 1982 might suggest?
Import prices
That the relation between exchange rate movements
and inflation seems to vary is not surprising since the
two are linked through several channels.2 Changes in
’This is not to say that inflation did not fall through 1984. Rather, the
extent of that decline, 0.4 percentage point, was slight relative to
the movements in factors generally thought to influence inflation.
2By “linkage" we mean an association between the two endogenous
variables (exchange rates and prices), not a statement about causation.
FRBNY Quarterly Review/Autumn 1985
23
Chart 1
Inflation and the Value of the Dollar
Percent
Index 1980=100
Year-over-year annual rate.
^Trade-w eighted average of dollar's value vis a vis
12 industrial countries’ currencies; weights are
bilateral shares of U.S. trade.
Chart 2
Price and Dollar Cost of Imports
U.S. dollar index, 1980=100
110---------------------------------------------------------------------------------------------------------------
Non-oil im port p r ic e *
the dollar directly affect import prices, which are com
ponents of the CPI and other dom estic price level
measures. Dollar appreciation, for example, reduces the
cost expressed in dollars of foreign produced goods,
allowing import prices to fall without any reduction of
foreign exporters’ profit margins. However, the extent to
which this cost-reduction is “ passed-through” to import
prices may change with economic circumstances. Fur
thermore, the response of inflation to the dollar will also
depend on how domestic product prices and wages are
affected by import price changes, on the response of
government policies, and possibly on other factors as
well. Thus there are several potential explanations for
the apparent change in the relation between the dollar
and-U.S. inflation in recent years.
Nonetheless, the following data suggest that a shift
in the pass-through of dollar cost changes to import
prices may be a significant part of the explanation. The
trade-weighted value of the dollar increased by nearly
17 percent from the first quarter of 1983 through the
second quarter of 1985, while foreign export costs (as
measured by local currency export prices) rose by an
average of 8 percent. Taken together, these suggest that
the cost expressed in dollars (“ dollar cost” ) of goods
exported to the United States has declined by over 7
percent since the first quarter of 1983.3 Since aggregate
non-petroleum import prices have risen by nearly 0.4
percent over the same period, there effectively has been
no pass-through of this change in dollar cost to the
average price paid for imports in the United States.
(Pass-through, as defined here, is the ratio of the actual
change in import price to the change in dollar import cost
over a given period). In effect, foreign exporters’ profit
margins have widened significantly with dollar apprecia
tion. Note, however, that while nominal import prices have
remained nearly flat, they have fallen substantially relative
to prices of domestically produced goods.4
3The dollar cost of im ports refers to their foreign p roduction cost (in
local c urrency) c o nverted to dollars at p revailing e x c h a n g e rates.
Thus, for exam p le, a 10 p e rce n t rise in the dollar w ould, all other
factors u n c hanged, lower the dollar cost of U .S . im ports by the
sam e am ount. U sing a g g re g a te foreign export price indexes to
m easure the local c u rren cy production cost c le arly is only
a p proxim ate (in part b e c a u s e the com position of a g g re g a te foreign
exports m ay differ from that of their exports to the U n ited S tates).
H ow ever som e a lte rn ative m easures (e .g ., foreign w h o les a le p rices)
lead to very sim ilar conclusions.
*N o n -o il im port unit value index.
+ Measured as the average of foreign e xp o rt p rice
indexes of 12 countries converted to dollars; weights
are bilateral shares of U.S. trade.
Sources: International Monetary Fund, International
Financial S ta tistics, various years and U.S. Department
of Commerce.
24
FRBNY Quarterly Review/Autumn 1985
4lm port prices have d e c lin e d nearly 9 p e rce n t relative to the CPI
since the first quarter of 1 9 8 3, so that do llar a p p re c ia tio n has had a
s ignificant im pact on the "re a l" price {i.e., relative to pric es of
dom estic substitutes) and volum es of im ports. Furtherm ore, the
virtually zero pass-through (as d e fin e d h e re) d o es not m ean that
im port prices necessarily w ould h ave rem ain e d u n c h a n g e d had the
dollar not a p p re c ia te d . In d e e d , the arg um ents later in the text and
in the box suggest that im port pric es w ould h ave risen significantly
further had the dollar s tayed at its first q u a rte r 1 9 8 3 level.
The pass-through over the current recovery has been
substantially lower than that seen in 1981-82, and
strikingly lower than during the late 1970s (Table 2 and
Chart 2). Indeed, the pass-through was more than
complete over 1977-78, when the dollar was depre
ciating and U.S. inflation was rising, while it was about
one-quarter over 1981-82, when inflation was declining.
Underlying the apparently low pass-through of the
dollar appreciation to aggregate import prices is a fairly
wide divergence among major product components
(Table 3). The average price of imported automobiles
(including parts) has increased nearly 10 percent since
the cyclical trough, and over 30 percent since the end
of 1980. Prices of imported capital goods have also
risen over the recovery while imported consumer goods’
prices have fallen only slightly. The price of industrial
supplies (and of agricultural imports since 1980) has,
by contrast, fallen considerably more. This divergence
also differs from the 1977-78 period, when, except for
autos, the increase in prices was significantly more
uniform among categories.
The rise in auto prices after 1980 might be considered
a special factor that has distorted the measured pass
through. This is because imports from Japan (which
account for the bulk of total imports of finished autos)
until recently were lim ited by an effective quota.
Because of this quota, the dollar’s rise is unlikely to
have affected auto import prices significantly over this
period. The price of imports excluding autos and parts
has fallen by nearly 2.5 percent during the recovery, and
by nearly 9 percent since the end of 1980, but the
implied pass-through is still well below that for 1977-78.
Possible explanation
The apparently low pass-through of the dollar’s appre
ciation to import prices might seem to reflect “ monop
olistic” or other noncompetitive practices. However,
there is an alternative explanation that seems reason
ably consistent with the actual record and is compatible
with competitive behavior by exporting and importing
firm s.5 This is based on changing relations among
inflation, growth, and exchange rates since the 1970s,
which have altered movements of import costs relative
to the domestic demand for imports.
The dollar’s depreciation over 1977-78 was substan
tially offset by differential U.S.-foreign inflation. Con
sequently, the dollar cost of imports from abroad, U.S.
import prices, and the prices of domestically-produced
goods all rose togethe r and by roughly the same
amount. By contrast, the dollar’s rise since 1980 has
*This explanation is not meant to exclude the possibility of
oligopolistic or monopolistic practices, at least in some industries.
Furthermore, it does generally presume that U.S. import demand is
a significant share of the world total.
Table 1
Consumer Prices and the Exchange Rate
Percent change
End of period
level:
Unemployment
rate
(4)
Period
United
States
CPI
(1)
1985-11/1984-11 .
1983-IV/1982-IV
1982-IV/1981 -IV
1981-IV/1980-IV
1980-IV/1979-IV
.. 3.7
.. 3.3
.. 4.5
.. 9.6
.. 12.5
9.5
0.8
11.1
9.4
- 0 .7
- 1 .9
-1 3 .7
- 5 .0
8.6
43.2
7.3
8.5
10.6
8.2
7.4
1985-11/1983-I .. .. 9.3
1982-IV/1980-IV .. 14.4
1978-IV/1976-IV .. 16.2
16.5
21.5
- 9 .9
-1 3 .4
3.2
9.8
7.3
10.6
5.9
Dollar
Index
exchange
of oil
rate* prices
(2)
(3)
’ Trade-weighted average value of the dollar vis-d-vis
currencies of 12 foreign industrial countries.
Table 2
Import Prices and the Exchange Rate
Percent change
Foreign
Dollar
export exchange
cost*
rate
(2)
(1)
Period
1985-11/1983-I
1982-IV/1980-IV .
1978-IV/1976-IV
8.0
9.8
7.9
16.5
21.5
- 9 .9
Dollar
import
co stf
(3)
- 7 .3
- 9 .6
19.8
Import
price
(4)
0.4
- 2 .3
23.8
•Foreign export cost is measured as a trade-weighted average
of export prices (in local currency) of 12 foreign industrial
countries.
fChange in foreign export cost.expressed in dollars
(approximately equal to column 1 minus column 2).
Table 3
Components of Import Price Change
Category
Percent change unit value over:
1985-11/
1982-IV/
1978-1V/
1983-1
1980-IV
1976-IV
Total non-oil ..............................
Autos .........................................
Capita! .......................................
Consumer .................................
Industrial supplies ...................
Food, feeds, and beverages
0.4
9.7
7.3
- 3 .3
- 8 .2
- 0 .3
- 2 .3
17.5
- 6 .9
3.2
- 7 .6
-1 3 .6
23.8
34.7
22.8
19.8
16.0
16.7
Import price excluding autos..
- 2 .4
- 5 .3
21.2
FRBNY Quarterly Review/Autumn 1985
25
greatly exceeded U.S. relative to foreign inflation.6 Thus
the dollar cost of imports has fallen during the 1980s
while domestic U.S. prices have continued to rise,
although more slowly than before. In short, cost pres
sures reinforced domestic demand pressures to push
im port prices up during the late 1970s, but more
recently these forces have tended to offset one another.
®This amounts to saying that the dollar’s real value— its nominal value
adjusted for U.S.-foreign inflation—has risen sharply since 1980,
whereas it changed considerably less over 1977-78.
Supply and Demand Explanation
The argument can be put in the familiar supply and
demand framework. The supply of imports typically
increases with the ratio of the domestic selling price to
the dollar cost of their production. This is represented
by the upward-sloped supply schedule in Chart 3. Import
supply also increases with foreign export capacity (which
shifts the supply curve). Import demand declines as the
domestic import price rises relative to the prices of
d o m estically produced products, as shown by the
downward-sloped schedule in Chart 3, and increases
with domestic real income.
An exchange rate depreciation amounts to a reduction
of supply—an upward shift in the supply schedule. With
no change in demand, the extent of pass-through
depends on the relative slopes of import supply and
demand, and will generally be incomplete. The pass
through will be greater the more elastic is supply and
inelastic is demand, and will be complete only if supply
is perfectly elastic or demand inelastic. (More generally,
the pass-through from an exchange rate change, given
no change in domestic or foreign prices and incomes,
is equal to the ratio of the supply price elasticity to the
sum of the supply and demand price elasticities.)
However, when exchange rate depreciation is accom
panied by domestic price and income increases, the
demand schedule also shifts up (Chart 4). In this case,
domestic demand increases reinforce the impact of dollar
depreciation in raising the dollar cost of imports (the shift
in supply), leading to a higher pass-through than when
supply alone is shifting. The observed response of
imports to the depreciation will thus be greater the more
demand increases. Indeed, if domestic prices increase
(relative to abroad) by the same proportionate amount
as the exchange rate depreciates, the observed pass
through will be complete, regardless of the elasticities
of import supply and demand (unless real growth rates
diverge considerably). This is essentially the environment
that prevailed over 1977-78, during which the pass
through of the dollar’s decline appeared virtually com
plete in nearly all major import categories.
26
FRBNY Quarterly Review/Autumn 1985
This can be seen in terms of the specific contributions
of changes in import costs and import demand to import
prices. To a foreign supplier sending goods into the U.S.
market, a dollar depreciation amounts effectively to a
proportionate increase in the dollar cost of delivering a
given amount. But the extent to which this increase in
cost is passed-through to the actual dollar import price
also depends on what is happening to import demand.
If demand is not growing, the foreign supplier can fully
pass-through the increased cost to the price only by
selling less than before. For this reason, the price is apt
to rise somewhat less than the cost, that is, the pass
through will be less than complete, and exporters’ profit
margins probably will fall. However, the pass-through is
apt to be greater if demand is increasing, either because
prices of dom estically produced goods are rising,
making imports more attractive, or because domestic
real income is growing. More generally, this implies that
the apparent impact of exchange rate changes on
domestic import prices is likely to be significantly greater
when cost and demand pressures are reinforcing one
another than when they are not (box).
In the general inflationary environment of 1977-78, the
increasing dollar cost of im ports associated with
exchange depreciation was accompanied by increasing
domestic prices and real income and hence increasing
demand for imports. The apparent pass-through would
be expected to be relatively high under these circum
stances. This is because the effect of rising domestic
prices and income on domestic demand for imports
reinforced the exchange rate depreciation in pushing up
import prices. Furthermore, with costs and demand
pressures moving so closely together, it is not surprising
that the pass-through was virtually complete— and in all
major categories.
Since 1980, however, the dollar’s appreciation has led
to a fairly steady decline in import dollar costs. A sig
nificant portion of this cost decrease continued to be
passed-through to prices over 1981-82, in large part
because domestic demand growth also slowed mark
edly.7 Subsequently, however, aggregate demand has
grown fairly rapidly on average, so that the falling dollar
cost of imports has been partially offset by the upward
pressures on import demand from rising domestic prices
and strong real income growth. This may largely explain
why the pass-through of exchange rate changes to
import prices now appears to be much lower than before
(as well as why exporters’ profit margins have widened).
And with import prices varying with exchange rates less
7Pass-through averaged 25 percent over 1980-IV to 1982-IV although
there was considerable variation within the interval. Despite the
dollar’s appreciation, substantial pass-through would be expected
during this period given that weakening domestic activity probably
exerted little, if any, offsetting pressure on import prices.
than before, the seeming failure of inflation to respond
to recent dollar appreciation is more understandable.
The same patterns emerge in the data for major
product categories. Investment and, to a lesser extent,
consumer spending have been unusually strong (on
average) over the current recovery, suggesting that the
domestic demand influence on the prices of these
products has been expanding relatively rapidly. These
factors may help explain why the dollar’s appreciation
seems to have had especially little impact on prices of
imported capital and consumer goods.8
Chart 3
Determination of Import Price Under
Depreciation
Price
Chart 4
Depreciation Accompanied by Domestic
Price Inflation
Price
(PM)
Import
supply
( d e p re c ia tio n )
Import
dem and
(dom estic
inflation)
If the dollar falls
If the changing import pass-through over the past ten
years is due to shifting import cost and domestic
demand influences, then it could be m isleading to
extrapolate mechanically from recent behavior to assess
the implications of future dollar movements. Suppose,
for example, that the dollar were to fall substantially
from its present level over the coming year. What would
be the likely impact on inflation of this reversal?
The pass-through observed during the last two and
one-half years might suggest no significant change in
either import prices or domestic consumer prices.
However, this overlooks a fundamental change in import
cost relative to demand movements that could occur
with a dollar decline. A substantial dollar depreciation
would raise the dollar cost of imports considerably,
reversing the pattern of the last two and one-half years.
The response of import prices again will largely depend
on the course of domestic demand.
If strong U.S. growth were to resume, the cost and
demand influences would reinforce one another, leading
to a higher pass-through than has been observed over
the last several years. Indeed, prior experience suggests
that the pass-through to import prices could be as high
as 50 to 70 percent. This means that exporters’ profit
margins would absorb one-third to one-half of a sub
stantial dollar depreciation, or perhaps even more given
that these margins are now relatively high, with the
remainder passed on to higher import prices. On the
other hand, if the economy were to expand sluggishly,
the demand pressures on import prices would be much
less, even absent. In that case, shrinking profit margins
probably would largely offset a dollar decline, leaving
little if any impact on import prices.
8As explained in the box, the pass-through would be expected to be
lower the more elastic is demand. Previous studies suggest that
demand for imported capital and consumer goods is more price
elastic than that for materials and agricultural imports, which also
helps explain the contrast.
Quantity
Charles Pigott and Vincent Reinhart
FRBNY Quarterly Review/Autumn 1985
27
Some Recent Evidence on the Dollar/Price Link
This appendix surveys the recent literature on the impact
of dollar depreciation on domestic inflation. These results
are summarized in the table.
Two main strategies have emerged in the work on the
inflation consequences of exchange rate changes. In the
first, a “ small-model" approach, an import price variable
is included among the explanatory variables in a
standard inflation-determination equation. This is the
approach taken in the small models summarized in the
first portion of the table. To estimate the impact of
exchange rates on domestic prices, we must first gauge
th e ir im pact on im port prices. In what follow s we
assumed that 60 percent of a change in the exchange
rate is passed-through to import prices.*
The second approach to judging the impact of the
dollar appreciation is to consider the predictions gen
erated by large scale macroeconometric models where
the linkages between exchange rates and dom estic
prices are made explicit in a number of equations. Such
structural models often report the impact on both con
sumer prices and the GNP deflator, and typically it is the
former that increases more. This is because imports
directly enter the CPI but enter the deflator only indirectly
(through the prices of domestically produced goods).
*To replicate Gordon’s results his basic intlation determination
equation was re-estimated. The coefficient estimates
obtained, which are close to those Gordon reports, are used
for the simulation results reported in the table.
The Impact on Domestic Inflation of a 10 Percent Dollar Depreciation in One Quarter
Measured as percentage points added to average yearly rates
Study
Price index
First
year
Second
year
Remarks
Small model
results
Dornbusch-Krugman (1976) ......
Consumer prices
0.8
0.5
• Import prices are included in a standard inflation
determination equation.
• Elasticity of CPI inflation with respect to import price
inflation is 0.14 in the short run, 0.42 in the long run.
•Estimates use annual data from 1957 to 1973.
•We assumed a pass-through of 0.6.
Kwack (1977) ................................
Consumer prices
1.5
0.3
*The model specifies the price linkages for 12 coun
tries, determining consumer, import, and export prices.
•Estimates from 1957 to 1973 use annual data.
•A 1 percent change in the exchange rate causes a
more-than-complete pass-through of 1.23.
•We simulated the U.S. sector in isolation.
Spitaller (1978) ............................
Consumer prices
0.5
0.5
•Estimates are derived from CPI inflation equation
using money growth, industrial production relative to
trend, and import price inflation.
• Elasticity of CPI inflation with respect to import price
inflation is 0.04 in the short run and 0.27 in the long
run.
•Estimates from 1958 to 1976 use four-quarter rates of
change.
•We appended a pass-through equation.
Fixed weight
GNP deflator
1.1
0.8
*The model estim ates an in fla tio n d e te rm in a tio n
equation using la g g e d in fla tio n , exch a ng e rate
changes, the unemployment rate, and dummy vari
ables.
• Gordon does not report enough coefficients to simu
late the model so we re-estimated over the quarterly
data from 1975 to 1984.
Gordon (1982 and 1983)
FRBNY Quarterly Review/Autumn 1985
Some Recent Evidence on the Dollar/Price Link, continued
The Impact on Domestic Inflation of a 10 Percent Dollar Depreciation in One Quarter
Measured as percentage points added to average yearly rates
Study
Price index
First
year
Second
year
Remarks
Large model
results
Federal Reserve
Board of Governors’
Multi-Country Model
Consumer prices
IMF's Multilateral Exchange
Rate Model ....................................
Consumer prices
Low feedback ...........................
High feedback ...........................
OECD interlink
Federal Reserve Board of
Governors’ FMP Model ....
Data Resources
0.5
0.5
1.4
4.4
(total impact)
• The model links domestic macro models for the United
States, Germany, Japan, the United Kingdom, and the
rest of the world.
•The equations, with a few exceptions, were estimated
over the quarterly observations available from 1961 to
1975.
•This is a mathematical simulation model with a com
plete microeconomic specification in which a priori
judgment is used in the choice of parameters.
»The MERM estimates the medium term (two to three
years) effects of exchange rate changes.
•The low feedback case assumes that a 1 percent
increase in the CPI raises wages by 0.5 percent.
•The high feedback case assumes that a 1 percent
increase in the CPI raises wages by 0.85 percent.
Domestic
demand deflator
1.0
0.4
• The model groups together m edium -sized macro
models (about 150 equations each) for 23 countries.
• Some of the coefficients are estimated with the rest
assigned according to the judgment of the modelers.
Consumer prices
GNP deflator
0.8
0.5
0.5
0.3
• This is a quarterly model with approxim ately 500
equations.
• There is a complete modeling of capital flows, with
exchange rates endogenous to the system.
Consumer prices
GNP deflator
0.4
0.1
0.3
0.4
"This is a quarterly model with approximately 1200
equations.
• The exchange rate is determined endogenously.
FRBNY Quarterly Review/Autumn 1985
29
Federal Deposit Insurance and
Deposits at Foreign Branches of
U.S. Banks
Should the Federal Deposit Insurance Corporation
(FDIC) charge insurance premiums on deposits in for
eign branches and International Banking Facilities (IBFs)
of U.S. banks? Such a proposal has appeared as one
of many possible changes to the Federal deposit
insurance system, but the issue has received relatively
little attention.1
This article airs the issues involved in an extension
of the FDIC premium to foreign branches without taking
a position on the question. Levying premiums on these
deposits would alter the distribution of premium charges
significantly. But as this study shows, how equitable the
proposed redistribution would be depends on how one
views key characteristics of FDIC insurance coverage.
Further, the change could have important repercussions
for the competitive structure of banking inside and out
side the United States.
The nature of the proposal
Several proposals have been made to include deposits
at foreign branches of U.S. banks in the base used to
compute FDIC insurance premiums. These proposals
The author would like to thank Edward Frydl, Sherrill Shaffer, Robert
McCauley, and Melissa Berman for their comments, and David Bush
for his assistance.
1R eco m m en d atio n s for C h a n g e in the F e d e ra l D e p o s it In su ran ce
System , Working Group of the Cabinet Council on Economic Affairs
(January 1985), and D e p o s it In s u ra n c e in a C hanging Environm ent,
Federal Deposit Insurance Corporation (April 15, 1983).
30
FRBNY Quarterly Review/Autumn 1985
would not, however, extend FDIC insurance coverage to
foreign branch deposits. For this article, foreign branch
deposits are defined to be both the deposits of foreign
and U.S. residents booked at U.S. banks’ offices located
overseas and foreigners’ deposits in IBFs and Edge
Acts located in the United States. Deposits by foreigners
in domestic offices of U.S. banks are already covered
under the FDIC insurance system.
This article considers a general version of the pro
posals. Banks would pay a gross premium rate of onetwelfth of 1 percent on deposits at their foreign
branches, the same rate as on deposits at their
domestic offices, but would receive no FDIC insurance
coverage on these deposits.2
Proponents of imposing FDIC premiums on foreign
branch deposits identify two major benefits from the
proposed change: a fairer division of the FDIC premium
burden and an improved competitive position for small
banks relative to large ones. This article will analyze the
proposal only in light of these two goals. Equity and
competitiveness are desirable characteristics of an
effective deposit insurance system, but not its overriding
goals. The primary purpose of deposit insurance is to
provide a safety net for depositors in the event of a
bank failure and thereby to protect the integrity of the
2Banks pay the gross premium rate on their deposits, but the FDIC
has always rebated a portion of it at the end of the fiscal year. The
gross premium rate less the portion rebated is the net, or effective,
premium.
banking system. Equity and competitiveness are also
not the only goals that have been put forward in the
broader discussion of deposit insurance reform.
The two goals represent separate issues, which can
and should be analyzed separately, as they are in this
article. Analysis may suggest accepting one goal but not
the other. Considering the goals separately is mean
ingful because a deposit insurance scheme can be
designed to accomplish both goals, or one goal without
the other.3
The first goal, a fairer division of the premium
burden, is a matter of equity. The relevant issue is the
relationship between the burden borne by an individual
bank and the benefits accruing to the bank and its
depositors.4
The second aim, improved competitive position for
small banks, focuses on the marginal cost of deposit
insurance, the premium rate on those liabilities that
banks use to adjust their funding on a short-run basis.
Here the analysis concentrates on the limited issue of
whether large banks face such significantly lower mar
ginal deposit insurance costs under the present premium
arrangements that they have a competitive advantage
over smaller banks in pricing loans.
This is not the only bank competitiveness issue raised
by deposit insurance. Another, perhaps more important
issue relates to depositor perceptions of how deposit
insurance coverage applies in practice. Small bank
representatives generally maintain that they are at a
competitive funding disadvantage because the public
views insurance of large bank deposits as more exten
sive. The cost consequences of perceptions of deposit
insurance coverage are different from the cost conse
quences of the deposit base for insurance premiums
and are not examined here.
A fairer distribution of premiums
The first goal of the proposed extension of the premium
base is to produce a fairer distribution of the premium
burden. And the proposal does substantially redistribute
the burden toward large banks. But the proposal’s equity
*For example, it could be achieved through a combination of lump
sum and marginal insurance premiums.
4This article focuses on one aspect of the fairness of the distribution
of premium charges— the relationship of the premium base to
insured deposits. There are other aspects of fairness that the
proposal does not address and which therefore are not discussed
here. Among them is the extent to which differing riskiness of
individual banks should be incorporated into the premium structure.
A second issue is the extent to which deposit insurance is equally
valued by the depositors at small and large banks. Depositors can
evaluate the creditworthiness of large depository institutions better
than smaller ones because more financial analysis and credit
evaluation is available for large banks. For small banks, deposit
insurance can substitute for this kind of information.
depends on how one views the insurance coverage—
this is a matter open to considerable debate. Differing
views involve distinctions on two crucial issues: how
extensively uninsured deposits are covered and how
banks of different types are treated in the event of a
failure.
The distinction concerning coverage can be described
in terms of limited de jure versus more comprehensive
de facto insurance coverage. De jure insurance cov
erage may be used to denote the insurance explicitly
provided by law, which is limited to $100,000 for each
depositor.5 De facto insurance coverage, in this dis
cussion, refers to the protection uninsured depositors
perceive they have, since they may actually suffer no
losses when the FDIC merges or sells, rather than liq
uidates, troubled institutions. The need to economize
and conserve FDIC resources requires minimizing the
cost of handling troubled institutions. In the vast majority
of cases this has resulted in purchase and assumption
arrangements that have maintained the value of all
deposits. Even in circumstances where a merger or sale
of assets cannot be arranged, other considerations,
such as fears of systemic risk and the desire to avoid inter
ruptions in depositor service may lead the FDIC to provide
more than the legally required deposit protection.
A second distinction involves perceptions of how the
FDIC treats banks of different types, particularly in the
event of a failure. If all banks receive the same treat
ment, the system may be termed unified. But if banks
fall into two groups according to their size, for example,
with uninsured liabilities treated differently if they fail,
the system should be described as two-tiered or dual.
To highlight the role of these distinctions in evaluating
the proposal’s equity, this article examines two very
stylized versions of the deposit insurance system. Actual
FDIC practice lies somewhere between them. It is
important to remember that far more often than not, the
practice here and abroad is to merge or sell failing
institutions rather than to liquidate them. Thus, unin
sured depositors have generally not suffered losses in
bank failures. Moreover, the decision to merge or to
liquidate is made on a case-by-case basis according to
the specific circumstances of the troubled bank, and not
just on the basis of a bank’s size, as these highly styl
ized versions of coverage might suggest. Therefore,
some uncertainty about the extent of de facto coverage
exists for all banks, regardless of their size. The caseby-case approach means that depositors probably would
technically, coverage is limited to the first $100,000, aggregated
over all accounts for each right and capacity of the depositor. This
means that an individual can set up separate rights and capacities
through joint accounts or trusteeships in addition to his or her
individual right and capacity. For corporations, the ability to establish
additional rights and capacities through joint tenancy is a matter of
controversy.
FRBNY Quarterly Review/Autumn 1985
31
not perceive the level of de facto coverage based solely
on the observed frequency of mergers or sales in
resolving bank failures.
The two very stylized views of the insurance system
which emerge from these distinctions are:
• Deposit insurance coverage as a unified system.
Depositors at all banks receive the same de jure
protection of insured deposits and no coverage of
uninsured liabilities. A variant of this first view
perceives a unified system in which as a general
practice uninsured depositors at all banks, regard
less of size, receive the same de facto coverage
of legally uninsured liabilities.
• FDIC insurance coverage as a dual system. Legally
uninsured as well as insured liabilities are de factocovered at larger banks, but as a general practice
only insured deposits are protected at smaller
institutions. Since the dividing line between large
banks and small banks is unclear, large depositors
have an incentive to evaluate carefully the credit
worthiness of banks holding their deposits.
As the next sections explain, each of these stylized
views of FDIC coverage leads to a different assessment
of the proposed extension of the FDIC premium base.
Under the unified system view, the proposal appears to
increase inequity when coverage is only de jure, but as
the extent of de facto coverage increases, this effect
diminishes. Under the dual system view, the effect of
the proposal would be ambiguous.
Discrepancy between cost and benefit
under the current premium system
FDIC insurance protects the first $100,000 of each
domestic deposit account at premium-paying banks. In
return, banks pay a uniform premium rate of one-twelfth
of 1 percent on all domestic deposits, including that
portion of deposits over the $ 1 0 0 , 0 0 0 ceiling and thus
not covered by FDIC insurance.
The FDIC describes this as a “ flat-rate” system,
because banks pay the same premium on all domestic
deposits. But “ flat rate” may be a misnomer since it
suggests that banks pay a uniform price for insurance
coverage. In fact, they do not. Based on the cost per
dollar of domestic deposits, a bank that relies heavily
on large (over $100,000) Certificates of Deposit (CDs)
for its funding will pay more for its de jure coverage
than a bank with mostly retail deposits under $ 1 0 0 , 0 0 0
each. If the deposit insurance system is viewed as
unified and de jure, treating all banks equally and
insuring each depositor only up to $ 1 0 0 ,0 0 0 , then the
average large bank may subsidize the average small
32
FRBNY Quarterly Review/Autumn 1985
Table 1
Share of Large Deposits at Insured Banks
By size of bank, as of June 30, 1984
FDIC-insured banks
with assets of:
Number of
banks
Uninsured
domestic
deposit
liabilities*
Deposits at
foreign
branches
0 to $300 million ............
$300 million to $1 billion .
$1 billion to $5 billion
$5 billion to $10 billion ...
Over $10 billion ..............
13,670
453
201
34
23
10.7
19.8
27.7
28.9
22.6
0.1
0.4
7.0
14.1
48.3
All FDIC-insured banks ..
14,381
20.1
18.4
'Calculated as total deposits over $100,000 (large deposits) less
$100,000 times the number of large deposits.
Source: Call Reports (June 1984).
bank (assuming that all banks are equally risky),
because proportionally more uninsured liabilities are
held at large banks (Table 1 ) . 6 Subsidization may also
occur among banks of similar size, since the reliance
on uninsured d e p o sits am ong banks v a rie s . For
example, some small banks have substantial uninsured
deposit liabilities.
What if the system is viewed as unified but offering
partial de facto coverage for legally uninsured liabilities?
According to the FDIC , 7 uninsured depositors assume
that they have at least partial de facto deposit protection
because the FDIC tends to arrange the merger or pur
chase of a troubled or closed bank, rather than its (liquidation. If so, then charging insurance premiums on the
legally uninsured portion of deposits can be appropriate,
but the premium rate should reflect the extent of de
facto coverage, generally less than for fully insured
deposits. Under the current premium arrangements, if
there is the same partial de facto coverage for all
banks, the extent of subsidization of some banks by
others becom es unclear. Banks w ith s u b s ta n tia l
domestic and few foreign uninsured liabilities still pay
more for their coverage than banks with mostly insured
deposits, since the premiums do not reflect the different
levels of coverage of insured and uninsured deposits,
but the disparities are smaller than those under a unified
•June 1984 rather than March 1985 data are used because data on
insured and uninsured liabilities are collected only once a year on
the Call Reports. Uninsured liabilities are measured as the excess of
each deposit over $100,000, a somewhat inaccurate measure (see
footnote 5 for further reference).
7Deposit Insurance, op. cit.
system with de jure coverage only. The situation is less
clear for banks with substantial foreign as well as
domestic uninsured liabilities. The premiums on the
domestic uninsured liabilities may be high relative to the
partial coverage they receive, but banks pay no pre
miums on the foreign branch liabilities. Thus, whether
these banks pay too much or too little for their coverage
depends on the level of de facto coverage and the
distribution of deposits between foreign and domestic
uninsured liabilities.
Adopting the dual system view alters the evaluation
dramatically. Some observers have suggested that de
facto insurance coverage of uninsured deposits at large
banks, but only large banks, is widely perceived to be
100 percent. The view is an extreme characterization,
but for some it seems to be reinforced by the manner
in which the problems of Continental Illinois were han
dled last year.8
Perception is inherently hard to ascertain, however.
Reasoning very generally that the disruption and drain
on the FDIC’s resources in the event of a large bank
failure could be too great, depositors may assume that
the FDIC would never liquidate in such a case, but
would arrange for a purchase or merger into another
institution. Large depositors would generally suffer no
losses in such a merger.9 Under this view, large
depositors in large banks may appear to face less risk
than large depositors in small and medium-sized banks.
But experience shows that at the first sign of trouble,
large depositors may quickly shift deposits to another
institution. Such behavior is potentially inconsistent with
a perception of full de facto coverage.
Under the dual system view, the largest banks pay too
little for their insurance, because they do not pay pre
miums on their foreign branch deposits which are cov
ered de facto. Meanwhile, smaller banks with substantial
uninsured domestic deposits pay too much. How equi
table the system is to small banks with mostly insured
deposits under such a system is unclear; their premiums
per dollar of insured deposits could be higher or lower
depending on the distribution of uninsured deposits in
the dual system’s two tiers. Of course, this analysis
ignores any differences in risk among different classes
of banks.10
■The sharp rise in rates paid on Continental Illinois’ and other banks’
CDs during the late spring and early summer of 1984, however,
indicates that this perception was not universally held.
•A recent proposal by the FDIC to introduce a modified payout (only
partial reimbursement) to uninsured creditors could affect these
perceptions.
,0But note that the risk-related premium system advocated by the
FDIC and the Treasury studies already cited would not correct the
discrepancy between the premium base and the amount of
coverage.
In summary, then, if one analyzes the current premium
arrangements according to the stylized unified system
view with de jure coverage of legally uninsured liabili
ties, banks with sizable uninsured domestic liabilities
appear to pay more for their insurance coverage than
banks with mostly insured liabilities, assuming they are
of equal risk. If all banks have some de facto coverage,
banks with uninsured domestic liabilities and no foreign
liabilities still appear to pay more for their insurance
coverage. Banks with substantial foreign liabilities,
however, may pay more or less relative to other banks
depending on the extent of the de facto coverage and
the distribution between uninsured domestic and foreign
deposits. If one accepts the stylized dual system view,
small and medium-sized banks with substantial domestic
uninsured deposits appear to pay more for their cov
erage than large banks.11
Redistribution of premiums under the proposal
The proposed extension of the premium base would
redistribute premiums substantially (Table 2). Based on
March 31, 1985 Call Reports data for 14,379 FDICinsured banks, the major burden of expanding the pre
mium base would fall on the 24 banks with assets of
$10 billion or more; their combined increase in pre
miums would amount to $239 million per year. Another
137 banks with assets between $1 billion and $10 billion
would pay $35 million in additional premiums. Among
smaller banks, 53 have foreign branch deposits and
these banks together would pay $1 million more. The
result would be a rise of $276 million in total FDIC
premiums, an increase of 21 percent.
The proposal as a repricing of FDIC insurance
Bringing the deposits of foreign branches into the FDIC
premium base can be viewed as a way to reprice the
insurance. Comparing the proportion of selected large
liabilities before and after foreign branch deposits are
included shows how the repricing would work (Table 3).
Under the current premium arrangements, the largest
banks pay relatively more for their de jure insurance
coverage. The de jure protection declines as the share
of uninsured domestic deposit liabilities increases—and
that share is much higher for large banks than for small
banks (Table 3, column 1). Adding the foreign deposits
to both the uninsured liabilities and the base produces an
even steeper rise in the share. Now, the share rises from
11There are more sophisticated ways to measure the degree of
subsidization, including incorporating a measure of the institution’s
riskiness. See, for example, Alan J. Marcus and Israel Shaked, “The
Valuation of FDIC Deposit Insurance Using Option-Pricing Estimates",
J ournal o f M oney, C redit, a n d B anking, Volume 16, No. 4, Part 1
(November 1984), pages 446-460. But as the sophistication of the
methodology grows, the possible objections multiply and uncertainty
about the validity of the result increases.
FRBNY Quarterly Review/Autumn 1985
33
11 percent for the smallest banks to 44 percent for the
largest. Under the proposed arrangements, it would range
from 11 percent all the way up to 71 percent.
It is not just large banks that currently face this kind
of gap between the premium base and insured deposits.
At 300 banks, the share of uninsured domestic deposit
liabilities in all domestic deposits exceeds 40 percent,
the average share of these accounts at large banks. Of
the 300 banks, more than half have assets of less than
$300 million, about 1 percent of all banks in that size
class.
Under a unified deposit insurance system with the
same partial de facto coverage of uninsured liabilities
for all banks, to include foreign branch deposits would
still leave a gap between the deposit base and insur
ance coverage. The size of the disparity would depend
on how much partial coverage uninsured liabilities
received; it would only disappear when de facto insur
ance coverage reached 100 percent. All told, under the
stylized unified system view, the proposal would make
banks with large deposits pay more for their coverage
relative to smaller banks than they do now.
However, if one sees the insurance system as dual,
the repricing creates different effects. The size of foreign
Table 2
FDIC Premiums Under the Proposed Extension of the Premium Base
Computed as of March 31, 1985
Millions of dollars
Group of banks
All insured banks
Banks with assets
Banks with assets
Banks with assets
............................................
of less than $1 billion........
of $1 billion to $10 billion ..
of $10 billion or m ore ........
Number
in group
Number with
foreign
deposits
Domestic
deposits
Foreign
deposits*
Current
premiumf
Proposed
premium}
14,379
14,106
249
24
214
53
137
24
1,605,560
789,898
490,838
324,824
330,702
1,422
42,044
287,237
1,338.0
658.2
409.0
270.7
1,613.6
659.4
444.1
510.1
Difference
275.6
1.2
35.1
239.4
"Deposits at foreign branches, Edge Acts, and International Banking Facilities.
fOne-twelfth of 1 percent of domestic deposits.
^One-twelfth of 1 percent of total deposits.
Source: Call Reports (March 1985).
Table 3
Proportion of Selected Large Deposits in the Premium Base
As of June 30, 1984
Using domestic deposits as the
__________________________ premium base
(1)
FDIC insured banks
with assets of:
Number of banks
Uninsured domestic
deposit liabilities*
(2)
Foreign branch
deposits
Using all deposits
as the premium base
(3)
Uninsured domestic
deposit liabilities plus
foreign branch
deposits
0 to $300 million ..........................................................
$300 million to $1 billion .............................................
$1 billion to $5 billion ..................................................
$5 billion to $10 billio n ................................................
Over $10 b illion...........................................................
13,670
453
201
34
23
10.7
19.9
29.8
33.7
43.7
0.1
0.4
7.6
16.3
93.5
10.8
20.2
34.7
43.0
70.9
All FDIC insured b a n k s f.............................................
14,381
24.6
22.5
38.5
’ Calculated as all deposits over $100,000 (large deposits) less $100,000 times the number of large deposits.
fSince the large banks dominate the average, especially after the inclusion of foreign deposits, a comparison of the large bank proportion to the average
is not very meaningful.
Source: Call Reports (June 1984).
34
FRBNY Quarterly Review/Autumn 1985
deposits relative to the base provides an indicator of the
amount of excess de facto coverage large banks now
receive. The foreign branch deposits of banks with
assets over $1 billion are substantial, relative to the
present premium base, and jump sharply with bank size
(Table 3, column 2); for the top 23 banks, foreign branch
deposits nearly equal all domestic deposits. Under the
dual system view, these very large banks would wind
up paying less for their actual coverage than smaller
banks because the FDIC to some extent protects foreign
branch deposits of large banks.12
Including foreign branch deposits redistributes, but
does not eliminate, the discrepancy between the base
on which premiums are charged and the deposits cov
ered by insurance, under the dual system view. The
revised premium base narrows the gap for any banks
viewed as being in the first tier which has some de
facto coverage, eliminating it only if the de facto cov
erage is 100 percent. But for banks considered to be
in the second tier, adding foreign branch deposits has
the same effect as the unified system view implies: it
creates a sharp rise in large banks’ share of uninsured
liabilities in their premium base. For the 34 banks with
assets between $5 billion and $10 billion, the share
increases from 34 percent to 43 percent, while for the
23 largest banks, it jumps from 44 percent to 71 per
cent. Among banks with assets under $1 billion, foreign
branch deposits are so small that including them makes
little difference.
To sum up, the proposed extension of the premium
base cannot produce an unambiguously fairer distri
bution of the FDIC premium burden, no matter which of
the two views of the deposit insurance system one
accepts. These stylized views should help to highlight
how differentiation in the treatment of banks and in the
extent of de facto coverage influence the fairness of the
proposed redistribution. Under the unified system view,
the proposal only exacerbates the disparity between the
premiums paid and the deposits insured, unless de
facto coverage is thought to be total. Even under the
dual system view, the change does not fully align pre
miums with the perceived differences in coverage
between the dual system’s two tiers of banks because
the first tier (with de facto insurance) is not distin
guished from the group of banks with large uninsured
and foreign branch deposits. The proposed redistribution
will not be fair to some members of the latter group. An
arrangement that imposes premiums by deposit type,
rather than bank type, charges some banks for coverage
they will not get under the dual system view. Indeed, a
full evaluation of the equity of the proposal under the
12Some of these uninsured deposits are liabilities to other U.S. banks,
as they are in the domestic market.
dual system view would require an explicit definition of
the first and the second tiers. The inherently arbitrary
nature of such a distinction underscores the extreme
character of the dual system view.
Improving the competitiveness of small banks
The second goal of a proposed extension of the FDIC
premium base is to improve the competitive position of
small domestic banks relative to large ones. To
accomplish this, the proposal tries to equalize the
marginal cost of deposit insurance across all deposit
types for all U.S. banks.13
The change would tend to raise the marginal cost of
funding for large banks relative to small ones. Applying
an FDIC premium to deposits at foreign branches would
equalize the marginal insurance cost (but not neces
sarily the total marginal cost) on international and
domestic deposits. Funding costs for U.S. banks in the
international markets would increase, because the highly
competitive nature of those markets would prevent U.S.
banks from passing on much of the increased cost to
their deposit customers. If the new relative funding costs
then get incorporated into loan pricing, the cost of loans
at large banks with access to the Euromarket would rise
relative to that of small banks with a purely domestic
base. The change would in theory tend to shift market
share of total loans and deposits held by U.S. banks
toward small banks and away from large banks.
The size of the impact would depend on how much
small funding cost differences determine market struc
ture in the banking industry. Research on this question
suggests that other factors—such as regulation, econ
omies of scale in providing certain services, and
advantages gained by specializing in particular ser
vices—play an important role in the structure of com
petition between large and small banks.14 This literature
emphasizes that local banking markets are small; as a
consequence, regulatory control of entry and branching
is very important. Further, cost savings may arise from
the joint production of several banking services. By
contrast, the funding cost advantage of access to the
Euromarkets has received little or no weight. Therefore,
13Differences in marginal insurance premiums are only a part of the
difference in marginal funding costs across banks, so the proposal
would not equalize marginal funding costs for all banks.
14See, for example, George J. Benston, Gerald A. Hanweck, and
David B. Humphrey, “Scale Economies in Banking: A Restructuring
and Reassessment”, Jo u rn a l of M oney, C re d it, a n d B anking, Volume
14, No. 4, Part 1 (November 1982), pages 435-456; Thomas Gilligan,
Michael Smirlock, and William Marshall, “Scale and Scope
Economies in the Multi-Product Banking Firm”, J o u rn a l o f M o n e ta ry
Econom ics, Volume 13, No. 3 (May 1984), pages 393-405; and
Sherill Shaffer, "Competition, Economies of Scale, and Diversity of
Firm Sizes”, A p p lie d E conom ics, forthcoming. A number of studies
are summarized in R. Alton Gilbert, “Bank Market Structure and
Competition”, Jo u rn a l o f M oney, C redit, a n d B anking, Volume 14,
No. 4, Part 2 (November 1984), pages 617-645.
FRBNY Quarterly Review/Autumn 1985
35
small changes in relative funding costs alone are
unlikely to have any great effect. Altogether, the degree
of competition among banks of similar size is quite
possibly greater than that among banks of different size.
Some observers have argued that perceived differ
ences in bank safety are a major factor affecting com
petition. Since the proposal does not include formal
extension of FDIC coverage to deposits at foreign
branches of U.S. banks, implementing it should not alter
these perceptions.
However, the analysis of the impact of FDIC premiums
on market terms and market shares would be different
if foreigners and U.S. residents viewed deposits in for
eign branches of U.S. banks as effectively having more
insurance protection than before, notwithstanding the
lack of formal (de jure) coverage. Such reassurance
could be quite valuable. The normal tiering in the
Euromarket suggests that safety may be worth more
than 8 basis points, the increase in cost from imposing
FDIC premiums on foreign branch deposits.
Extending FDIC insurance premiums to foreign
deposits of U.S. banks may not give such a clear signal
to market participants, however. Extending the base
appears consistent with the dual insurance system view
by implying that some de facto coverage for large
deposits at international banks already exists. But
important features of that system remain unspecified,
particularly the boundary between banks with some
protection of uninsured liabilities and those without it.
Foreign branch depositors would be left uncertain about
just how much of their deposits would be covered in a
bank failure—as is now the case.
U.S. competitiveness in domestic markets and abroad
The proposed change in premium structure could alter
the competitive structure of banking in the United States
and abroad. To begin with, applying an FDIC premium
to foreign branch deposits would raise the cost of
external funds. Under the assumption that the FDIC
would rebate nothing from the gross premium, the
effective rate of premium would be one-twelfth of 1
percent or 8.3 basis points.15 For banks subject to the
3 percent reserve requirement on Eurocurrency liabili
ties, the effective cost of external funds would rise 8.6
basis points.16 These are small changes compared with
the daily volatility of Eurodollar rates, for example, which
15The FDIC rebate has declined in recent years; it rebated only 13.5
percent of the premium to the banks in 1983 compared with as
much as 60 percent earlier.
'•For banks subject to reserve requirements on Eurocurrency liabilities,
the effective cost of external funds is:
iE$ + FDIC
iE$ + .083
1
- RRe$ ~ 1 - .03
where iE$ is the relevant Eurodeposit offer rate (e .g ., three months),
36
FRBNY Quarterly Review/Autumn 1985
in 1984 averaged 140 basis points when measured by
the standard deviation. However, these small changes
are large relative to current Euromarket margins. Fur
ther, the change would create a permanently higher
average cost of external funds and their effects would
tend to persist.
Higher external funding costs could place modest
upward pressure on domestic funding costs and lending
rates. Applying an FDIC premium to foreign branch
deposits would reduce the competitiveness of U.S.
banks with foreign deposits relative to non-U.S. banks
operating in the Euromarkets. The increased cost of
external funds, relative to domestic funds, would lead
large banks to adjust their marginal funding from foreign
to domestic markets, especially since they might not be
able to shrink assets rapidly enough in response to
declines in liabilities.
Impact on the market shares of U.S. banks
at home and abroad
How much market shares in the Eurocurrency and
domestic lending markets change would depend on how
market terms responded to a shift in U.S. bank funding
costs. While the cost differences would be small, they
would be large relative to current Euromarket margins,
and since the volumes are large, the size of the impact
cannot be determined precisely. However, since the
Eurocurrency market is highly competitive, flows might
well be significantly redirected.
In the domestic market, higher marginal funding costs
could lead large banks to price loans higher, at least on
the parts of their loan portfolio with thin profit margins.
On loans with higher profit margins, the banks might
instead absorb all the funding cost increase. Smaller
domestically-funded banks, with lower marginal funding
costs, could build up profits or quote slightly lower loan
costs. That would push market share toward small
banks.
In the Euromarkets where profit margins are already
thin, more expensive funds would probably impel U.S.
banks to quote less favorable terms. Since U.S. banks
form a large segment of the market, foreign banks
would find themselves attracting depositors and bor
rowers in the Euromarkets away from U.S. banks, thus
increasing their market share.
Of course, foreign banks would only be willing to
expand their Eurocurrency balance sheets at current
interest rates if they faced no legal or internal balance
sheet constraints.17 In the short run, such constraints
Footnote 16, co n tin u ed
FDIC is the premium rate, and RREt is the reserve requirement on
Eurocurrency deposits.
17Another possibility is that foreign banks not now active in the
Euromarket would enter. This seems less likely now than it would (p .3 8 )
How Interest Elasticity Affects Deposit Losses
rates at non-U.S. Euromarket banks fall, their decline
would blunt the impact of the FDIC premium.
Only at fairly high elasticities would the deposit losses
and FDIC revenue reductions become substantial. The
deposit losses range from one-tenth of 1 percent if rates
were high and the elasticity low, to about 17 percent at
an interest rate of 5 percent and an elasticity of ten. The
maximum loss of revenue to the FDIC on the table is
$46 million, still less than one-third of the amount
rebated for 1983. Larger declines are possible if the
interest elasticity of foreign branch deposits is higher.f
The relatively small share of branch deposits in total
deposits limits the maximum possible revenue loss
through this channel to about 17 percent of revenues,
the share of foreign deposits in total deposits.
Assuming no FDIC rebate, not just the foreign but the
domestic deposit base could also erode. FDIC revenue
shortfalls would eventually require higher FDIC pre
miums, which would lower domestic deposit rates in the
United States. The interest sensitivity of domestic
deposits in aggregate is likely to be less than that of
foreign deposits, since domestic deposits include small
transactions accounts and time deposits with low interest
elasticity along with highly interest-sensitive ones. But
since the base of domestic deposits is much larger, even
modest declines in deposit rates following an FDIC pre
mium increase could produce very substantial revenue
losses.
The extent of deposit losses under the proposed exten
sion of the premium base would depend on the interest
elasticity of deposits and the level of interest rates.
Estimating these losses requires knowledge of depositor
interest sensitivity, and the overall level of interest rates.
The elasticities are difficult to measure, since the small
differences in rates to which banks and depositors
respond are not observable without continuous data
collection on interest rates over the day. One can only
infer that the elasticity is quite high.
Sample computations provide some idea of the mag
nitude of deposit losses and revenue shortfalls under
different assumed depositor interest elasticities and
levels of interest rates in the Euromarket (table). Interest
elasticities can range from zero (interest insensitivity) to
infinity.* The elasticities here reflect a range of low to
high, but it is quite likely that foreign branch deposits are
even more interest-sensitive than implied by the interest
elasticity of ten. The range of the interest rate is rep
resentative of Eurodollar rates over the last ten years.
The computations here assume that imposing an FDIC
premium on deposits at foreign branches of U.S. banks
would have no effect on U.S. domestic rates or on
deposit rates at non-U.S. Euromarket banks. If deposit
*The interest elasticity gives the percentage decline (increase)
in deposits for a 1 percent decline (increase) in interest
rates. Interest sensitivity increases as the elasticity rises in
value. As it approaches infinity, small changes induce
depositors to withdraw all their deposits and invest them in
an alternative instrument.
fThe revenue losses will increase proportionally with the
elasticity (e.g., an elasticity of 20 will produce double the
revenue decline of an elasticity of ten).
FDIC Revenue Reductions Under Alternative Interest Rate and Interest Elasticity Assum ptions
In millions of dollars
Assumed
interestelasticity
Domestic
deposits
Foreign
deposits
Premiums under
proposed
premium
base extension
Reduction of
premium from
base case
*
1,605,560
330,702
1613.6
*
Interest rates of 5 percent ................ ............
0.2
1.0
10.0
1,605,560
1,605,560
1,605,560
329,600
325,190
275,585
1612.7
1609.0
1567.7
-0 .9
-4 .6
-45 .9
Interest rates of 10 p ercent.............. ............
0.2
1.0
10.0
1,605,560
1,605,560
1,605,560
330,151
327,946
303,144
1613.1
1611.3
1590.6
-0 .5
-2 .3
-2 3 .0
Interest rates of 15 p ercent.............. ............
0.2
1.0
10.0
1,605,560
1,605,560
1,605,560
330,335
328,865
312,330
1613.3
1612.1
1598.3
-0 .3
-1 .5
-15.3
Current (March 1985).......................
'Not applicable.
FRBNY Quarterly Review/Autumn 1985
could leave foreign banks little choice but to adjust to
some of the impact of higher U.S. bank funding costs
in larger spreads and higher profit margins. But even
tually, accumulated capital from those higher profits
would ease the balance sheet constraint and allow for
eign banks to pursue a larger market share. Similarly,
foreign banks would only expand their balance sheets
at current rates if the marginal costs of loan production
do not rise too sharply. Credit evaluation and loan
servicing costs may be higher for loans to new bor
rowers than for their normal loan portfolio. This would
lead foreign banks to compensate by increasing their
spreads charged over LIBOR, possibly eliminating their
competitive advantage. But experience and economies
of scale may allow spreads to narrow in the longer run.
In summary, the extent to which U.S. banks would
lose market share and bid-offer spreads would widen
depends mainly on two things: the willingness of foreign
banks to increase their Eurocurrency balance sheets,
and the interest sensitivity of depositors, borrowers, and
lenders. Euromarket participants could, of course, shift
their activities to other markets as well as to other
agents in the Euromarket. In general, the more willing
foreign banks are to increase balance sheets and the
more sensitive market participants are to interest rates,
the greater U.S. losses in market share would be and
the smaller changes would be from current market
terms. These effects would be mitigated if depositors
perceived greater coverage for their funds in foreign
branches or reinforced if depositors became more
uncertain of the extent of coverage.
Consequences of a falling U.S. market share
Any reduction of the U.S. banks’ share of the domestic
or Eurodeposit market would tend to shrink the deposit
base on which premiums would be charged, assuming
no growth in deposits. The magnitude of the decline is
difficult to judge, but the possibility that it could be siz
able cannot be ignored.18 Moreover, the deposit
Footnote 17, c o n tin u ed
have been in the 1970s, when participation in the Euromarket was
increasing rapidly.
’•The decline in the deposit base does not necessarily have to reflect
a shrinking U.S. share of world bank liabilities. Financial innovation,
in the form of new non-deposit liabilities, could follow a rise in
insurance premiums on Eurodeposits. The proposed premium could
also further encourage the growth of off-balance sheet transactions
by banks.
shrinkage does not imply that the FDIC would imme
diately need less funds. In the long run the FDIC’s
exposure should decline along with the deposit base
(assuming the deposit base does not fund riskier
assets). In the short run, however, its exposure reflects
past experience.
Thus, the financing cushion the proposed change
would provide to the FDIC may be smaller than
expected. With a substantial erosion of the deposit
base, revenues from the foreign branch deposits might
not be as high as projected (box). Currently, the FDIC
rebates the excess premium paid, and this allows some
margin for the inevitable error in gauging its needs and
revenues. That margin has been disappearing, though,
and the rebate has shrunk.
Conclusion
Extending the premium base for FDIC insurance to
deposits at the foreign branches of U.S. banks would
raise FDIC revenues by 21 percent and substantially
redistribute deposit premiums from small and medium
sized banks to large ones. Whether this redistribution
is appropriate depends largely on how one views the
extent of de facto coverage and the unity of treatment
of banks of differing characteristics, including size. At
one extreme, if one accepts the dual insurance system
view that large banks regularly receive more de facto
insurance protection than small banks, then large banks
would in fact be paying more for the effectively higher
coverage they receive. At another extreme, if one views
the system as unified, the proposal would raise the
insurance cost per dollar of insured deposits to all banks
with deposits at foreign branches. This is true whether
all banks tend to receive the same partial de facto
coverage of uninsured deposits or none at all. But the
proposed change would not eliminate the discrepancy
between the premium base and the amount of insurance
coverage for all groups of banks, under either stylized
view of the system. For many medium-sized and fairly
large banks with foreign deposits, the proposal may
widen the gap substantially.
The competitive implications of the proposal also raise
questions. Equalizing the marginal insurance cost of
funds between the Euromarkets and the domestic
money markets for U.S. banks would necessarily raise
the funding costs of U.S. banks relative to those of other
banks in the Euromarkets.
Christine M. Cumming
38
FRBNY Quarterly Review/Autumn 1985
ARMs: Their Financing Rate and
Impact on Housing
When widespread use of adjustable rate mortgages
(ARMs) was permitted in April 1981, some analysts
expected housing demand to become stronger and less
sensitive to interest rate fluctuations as prospective
homebuyers turned to this new way of financing homes.
Because housing is one of the most interest-sensitive
sectors of the economy, this effect could influence the
dynamics of the business cycle and the countercyclical
effectiveness of monetary policy. Recent evidence
suggests, however, that ARMs have not had a large
impact on housing demand. This seems paradoxical
because ARMs have captured a large share of new
mortgages, particularly between mid-1983 and mid-1984.
We offer a twofold explanation for this paradox. First,
we show that ARMs have in effect generally not been
priced much lower than fixed-rate mortgages (FRMs).
Second, we examine some characteristics of ARMs that
may explain their popularity over FRMs as a mode of
finance, even though these features have not signifi
cantly increased the incentives to purchase a home.
Econometric evidence on housing demand
In several recent studies, analysts have found that
adding variables representing ARMs contributes little, if
any, tracking power to traditionally specified models of
housing demand.1 For example, the equation specified
The authors would like to thank the following individuals for their
comments and suggestions: M. A. Akhtar and A. Steven Englander
(Federal Reserve Bank of New York); James L. Freund and John L.
Goodman (Board of Governors of the Federal Reserve System);
Michael J. Lea (Federal Home Loan Mortgage Corporation); and
Randall J. Pozdena (Federal Reserve Bank of San Francisco).
'S ee Howard Esaki and Judy Wachtenheim, "Explaining the Recent
Level of Single-Family Housing Starts”, this Q uarterly R ev ie w (Winter
by Esaki and Wachtenheim, which has no ARMs vari
able, has a post-sample (1982-1 to 1984-IV) mean
absolute error of 77,000 units, about 8 percent of single
family housing starts (Table 1). And it shows no con
sistent tendency to underpredict, a tendency that would
indicate a failure to capture the positive influence of
ARMs in the housing market; instead the equation
mostly overpredicts. The tracking performances of the
Esaki/Wachtenheim and other recent models suggest
that at most ARMs have had a minor impact on housing
demand.
The econometric approach, however, may be of lim
ited value for analyzing the impact of this financial
innovation since there is not a long series of consistent
data on ARMs. Thus, we obtain independent confir
mation of these analysts’ results by evaluating the long
term expected financing rate of a mortgage, i.e., the
average rate an owner expects to pay over the period
of home ownership. If the long-term financing rate
of ARMs has been significantly below the FRM rate,
then housing demand should have been boosted
substantially.
The financing rate of mortgages
The financing cost underlying the demand for housing
is the interest an individual expects to pay over the
Footnote 1, con tin u ed
1984-85), pages 31-38; James L. Freund, "A Small Econometric
Model for Predicting Residential Construction Activity: Some
Preliminary Results", Board of Governors of the Federal Reserve
System, paper presented at the 1984 meeting of the American Real
Estate and Urban Economics Association; and Michael J. Stutzer
and William Roberds, “Adjustable Rate Mortgages: Increasing
Efficiency More Than Housing Activity", Federal Reserve Bank of
Minneapolis Q uarterly R eview (Summer 1985), pages 10-20.
FRBNY Quarterly Review/Autumn 1985
39
period of ow nership. In the case of an FRM, the
expected cost, excluding the initial points that exist also
for ARMs, never exceeds the amount determined by the
contract rate and may be lower if market rates fall
enough to make refinancing advantageous. With an
ARM, the expected cost is contingent upon future short
term rates. Thus, the first-period rate discount of an
ARM is only one element of the total financing cost, and
has to be considered along with the likely course of
future rates and the expected holding period in judging
the costs of an ARM.
Nonetheless, some analysts believe that this relatively
low first period rate of ARMs boosts housing demand,
regardless of the expected course of interest rates, by
permitting more people to qualify for a mortgage. Many
more individuals will meet a stipulated maximum limit
on the share of income earmarked for mortgage pay
ments if the first-year ARM rate instead of the FRM rate
is used to calculate the carrying costs for a prospective
borrower . 2 From the lenders’ perspective, relaxing
screening procedures may have been one way to
encourage a faster reshuffling of their portfolios from
FRMs to ARMs; the lower interest rate risk of ARMs to
lenders may more than compensate for the higher credit
risk. Moreover, some market observers say that lenders
may have eased qualification criteria in the belief that
the default risk is carried by mortgage insurers and
repurchasers. Some of these insurers and repurchasers,
however, have recently responded by encouraging or
requiring lenders to tighten their qualification criteria for
ARMs.3 Independently, borrowers may be “ self-policing”
by avoiding a commitment that might have a high risk
of default .4 On balance, the extent of the effects of the
ARM qualification criteria on housing demand are not
clear.
The low initial ARM rate also might raise housing
demand through its effect on the pattern of mortgage
payments over time. When the market yield curve is
upward sloping, the early years’ payments with an ARM
2See John L. Goodman, Jr., "Adjustable Rate Home Mortgages and
the Demand for Mortgage Credit", Board of Governors of the Federal
Reserve System, presented at the 1984 meeting of the American
Real Estate and Urban Economics Association. He shows that the
use of a 10 percent first-year ARM rate allows 38 percent of
households to qualify for a mortgage, while a 13.5 percent FRM rate
allows only 25 percent to qualify. Both are representative rates for
the period July 1983-May 1984. Esaki and Wachtenheim, op. cit.,
though, do not find that a variable representing such an ARMrelated reduction of mortgage carrying costs helps their econometric
model predict single-family housing starts.
3See Dennis Jacobe, "Mortgage Insurers Mix ARMs and GPMs to
Justify Rates", Savings Institutions (October 1984), pages 41-45.
4See John L. Goodman, Jr., op. cit., for evidence supporting this
view.
40
FRBNY Quarterly Review/Autumn 1985
Table 1
Tracking Performance of the
Esaki/Wachtenheim Econometric Model of
Housing Demand*
Predicted less actual; thousands of units at an annual rate
Post-sample prediction errors
1982-1 .........................................
1982-11 .......................................
1982-111 ......................................
1982-IV
40
122
59
4
1983-1.
1983-11
1983-111
1983-IV
60
143
140
12
1984-........................................... 1
1984-11 .......................................
1984-111
1984-IV
-9 2
94
105
57
Positive errors indicate overprediction, i.e., predicted level
exceeds actual level.
‘ Howard Esaki and Judy A. Wachtenheim, op. cit. The
equation tracks single-family housing starts. The sample
period is 1959-IV—1981 -tV, and the mean absolute error of the
sample period is 55.
are less than with an FRM, but payments are likely to
be higher in later years. Similar to the advantages of
graduated payment mortgages, this tim ing of ARM
payments might be desired by some people because
they feel that their incomes are also likely to rise in the
future. In this case, the carrying burden of a mortgage
may be more uniform over time instead of being heavier
initially as it is with an FRM. It is not clear, though,
whether this feature of ARMs, by itself, would signifi
cantly boost housing demand. Esaki/Wachtenheim, for
instance, do not find that variables representing the
different payment streams of ARMs and FRMs, e.g., the
spread between the FRM and initial ARM rates, help
their equation track housing in recent years. Moreover,
basing a purchase decision solely on this consideration
would be risky given the uncertainty of future ARM
rates.
In any case, the long-term expected financing rate of
ARMs is likely to be a key element in a home purchase
decision. However, individuals’ expectations of future
rates—the main component of this expected financing
rate—are not observable. And there is no consensus on
how these expectations are formed. Some analysts
believe that people base their expectations on the most
recent movements of rates. Others believe that individ
uals tend to accept the expectations built into the
market yield curve, i.e., the relationship between long-
and short-term rates.5 For example, when long-term
rates exceed short-term rates, people generally expect
that short-term rates will increase but on average will
be equal to the current long-term rate. This second
viewpoint may well describe a prospective homebuyer.
Because a house represents a large share of a typical
homeowner’s total assets, the consequences of basing
a purchase decision on wrong expectations can be quite
costly. To reduce this risk, people probably are most
comfortable relying on market expectations in making
the decision. Our analysis of the long-term financing rate
of ARMs, thus, is based on the assumption that the
market yield curve essentially represents the average
of expected future interest rates held by prospective
homebuyers.
Whether most borrowers view the long-term financing
rate of ARMs as being higher or lower than the FRM
rate, therefore, depends on how lenders price ARMs
and FRMs relative to the market yield curve. The rel
ative pricing of these mortgages, in turn, depends on
the net balance, from the lenders’ perspective, of the
risks and other characteristics of each type of mortgage.
Specifically, ARMs are more attractive than FRMs to
lenders because they eliminate or reduce risks related
to balance sheet considerations—i.e., the possibility of
lower income when the return from mortgage-type
assets does not rise as quickly as the cost of funds to
a lender— and mortgage prepayment. On the other
hand, increased credit risk, a less developed secondary
ARM market, and interest rate caps may push up the
relative cost of ARMs.
One important factor that would cause lenders to
lower the financing rate of ARMs is the shift of interest
rate risk to the borrower. If the expected financing rate
of an ARM, however, is below that of an FRM only
because of this shift, then ARMs would not boost
housing demand: the risk of greater-than-expected
increases in rates still would have to be compensated
for by the return from home ownership. Indeed, given
the size of investment a home purchase represents, as
well as the substantial costs and discomfort of having
to default if rates climb much higher than expected,
individuals might require a relatively large cut in the
ARM rate to compensate them for assuming the interest
rate risk. In other words, a significant increase in
•For an analysis of “term structure" theory, see Franco Modigliani
and Robert J. Shiller, "Inflation, Rational Expectations, and the Term
Structure of Interest Rates", E co nom ica (February 1973), pages
12-43. Recent tests indicate some slight variation in the behavior of
interest rates from that implied by term structure theory. However,
this variation might be explained in terms of a variable risk premium
in long-term rates, which would not be inconsistent with our
approach to analyzing ARMs. See Robert J. Shiller, John Y.
Campbell, and Kermit L. Schoenholtz, "Forward Rates and Future
Policy: Interpreting the Term Structure of Interest Rates", B rookings
Papers on E co nom ic A ctivity I (1983), pages 173-223.
housing demand might result only if lenders price ARMs
much below FRMs.
On the basis of the analysis which follows, however,
we conclude that, at least since the start of 1984, the
net effect of the various factors that distinguish an ARM
from an FRM has been small. That is, the long-term
expected financing rate of an ARM for most people has
been about the same as an FRM. To arrive at this result,
we first look at the various factors underlying ARM pricing.
Balance sheet considerations of lenders
By reducing the interest rate exposure of an entire asset
portfolio, ARMs may significantly improve the viability of
thrift institutions since for tax purposes they are required
to hold a large portion of their assets as mortgages.*
When financial deregulation, particularly the phasing out
of Regulation Q, allowed rates on deposits to vary with
market conditions, the large concentration of FRMs in
these institutions’ assets made them vulnerable to
substantial income losses when interest rates rose.7
ARMs permitted a better match between their return on
assets and their cost of funds. This may be an addi
tional gain beyond the reduction of interest rate risk
inherent in each mortgage, and thus may persuade
these lenders to price ARMs attractively.
Lenders that are not required to hold mortgages in
their portfolios, e.g., commercial banks, credit unions,
and insurance companies, presumably were less
affected by the introduction of ARMs. If in response to
financial deregulation these institutions chose to hold
fewer fixed-rate instruments, they had a broader choice
of variable-rate assets, e.g., commercial loans, from
which to select. The major impact of ARMs on these
lenders may have been to maintain their presence in the
mortgage market, thus helping to prevent mortgage
rates from rising relative to other interest rates. It is not
surprising, then, that thrift institutions have been the
most active lenders of ARMs. In 1984, for instance,
ARMs accounted for about two-thirds of the mortgages
originated by thrifts, but less than 40 percent of those
issued by commercial banks.8
•See Robert Van Order, “A Simple Model of Variable-Rate Mortgages",
H ousing F in an ce R ev ie w (July 1982), pages 299-311.
Because of the large losses sustained by many thrift institutions in
recent years, some have enough loss carryover that they do not pay
any taxes. As a result, these institutions do not feel compelled to
hold the required portion of their portfolios as mortgages.
Nevertheless, according to Flow of Funds data, mortgages (including
ARMs) and U.S. government agency issues (mostly mortgage pass
through securities) constituted substantially more than half of thrift
institutions' assets during 1984.
7Some thrift institutions have addressed this interest rate risk by
hedging in futures markets and engaging in interest rate “swaps".
These activities, though, have not been widespread.
•See Federal Home Loan Bank Board, N ew s (February 4, 1985).
FRBNY Quarterly Review/Autumn 1985
41
Prepayment risk
Lenders also may price ARMs more favorably than
FRMs because of the reduced risk of borrowers pre
paying before maturity. Since individuals are often per
mitted to prepay a mortgage at face value without
penalty, the expected return from an FRM is uncertain
even though its rate is fixed. The FRM rate, therefore,
may embody a charge to cover this uncertainty.9 In
contrast, ARMs are less likely to be prepaid when
market interest rates fall since their rates, assuming
there are no binding caps, would decline as well.
Moreover, even if an ARM is prepaid, its rate would
likely be the same as that on the newly issued ARM that
replaces it. Thus, ARM rates are likely to contain no
prepayment premium, or at most one that is not as large
as that embodied in the FRM rate.
Credit risk
Other factors, however, may reduce the attractiveness
of ARMs to lenders. Both ARMs and FRMs are vulner
able to the typical factors behind borrower default, e.g.,
cuts in income and net worth, but ARMs are also sub
ject to rising interest rates, which may raise the prob
ability of default. The prospect of higher interest rates
in the future does not necessarily mean that defaults on
ARMs will increase, particularly if the rise in rates is a
result of higher inflation. In this case, most household
incomes should expand as well, permitting borrowers to
handle the larger carrying costs of ARMs. Indeed, to the
extent that lenders use some measure of the long-term
expected financing rate of ARMs (which embodies
expectations of future rates) to screen borrowers, the
default risk may be kept down. Relatively tough quali
fication criteria and rate caps also may help reduce this
risk. Nevertheless, future interest rates might rise sub
stantially more than was expected when the loan was
originated and result in an increase in defaults, partic
ularly if the increase in rates is not matched by com
parable income gains.
So far, defaults on ARMs do not appear to be a major
problem. Since January 1985, when separate data on
ARMs were first reported, the ARM delinquency rate has
been below that of FRMs, possibly because interest
rates were falling.10 Nonetheless, ARMs may not always
•The risk of prepayment is an important consideration in the pricing
of a mortgage. See Henry J. Cassidy, "Selection of an Index for
Variable Rate Mortgages", J o u rn a l o f R etail B anking (Winter 1982),
pages 27-36; Alden L. Toevs and Jeffrey H. Wernick, "Hedging
Interest Rate Risk Inclusive of Prepayment and Credit Risks”,
Id e n tific a tio n a n d C ontrol o f Risk in the Thrift Industry, Federal Home
Loan Bank of San Francisco, Proceedings of the Ninth Annual
Conference (Decem ber 1983), pages 97-122.
’"Delinquency rate data were obtained from the U.S. League of
Savings Institutions. These data, however, may be biased against
42
FRBNY Quarterly Review/Autumn 1985
have the better record, particularly if interest rates climb
steeply. For example, the default rate for ARMs could
jump sharply if their rate rises faster than individuals’
incomes, particularly among borrowers with relatively
little accumulated equity in their homes.11 Thus, the
credit riskiness of ARMs may represent a potential
problem.
Mortgage liquidity
Another factor that could impinge on the advantages of
ARMs to lenders is the absence of a large secondary
market for these mortgages. As a result, ARMs are
much less liquid than FRMs, for which a well-developed
secondary market exists. According to market
observers, the growth of a secondary market has been
slow because ARMs lack uniformity and because
investors are concerned that ARMs may carry more
credit risk than FRMs.
Caps on ARM rates
Unlike the other characteristics of ARMs that affect
either borrowers or lenders, caps on the periodic change
and life-of-loan level of ARM rates affect both borrowers
and lenders. For instance, while these caps may prevent
the return on ARMs from keeping pace with a lender’s
cost of funds, they also reduce the interest rate risk
for a borrower. Consequently, even if caps increase
ARM rates, borrowers may be willing to pay for these
safeguards.
The value of caps depends on the course of future
interest rates. Thus, an ex ante valuation should be
based on the yield curve. When the yield curve is steep,
indicating that interest rates are likely to rise sharply in
the future, caps should be worth more to a borrower.
In addition, caps would be more valuable to the extent
that they prevent an initial ARM rate reduced by a firstperiod discount from climbing to the fully indexed level
after the first period.12 At the other extreme, when the
yield curve is downward-sloping, a cap on the periodic
change in an ARM rate may have negative value to
borrowers if it prevents an ARM rate from falling as
much as market interest rates.
In principle, borrowers and lenders can value caps
Footnote 10, co n tin u ed
FRMs because no adjustment is made for the length of time
mortgages are in existence. Since the FRMs in this sample were
outstanding for more years than ARMs, they, according to market
observers, are more prone to default.
11See Peggy J. Crawford and Charles P. Harper, "The Effect of the
AML Index on the Borrower", H ousing Fin a n c e R ev ie w (October
1983), pages 309-320. See also Robert M. Buckley and Kevin E.
Villani, “Problems with the Adjustable Rate Mortgage Regulations”,
H ousing F inance R ev ie w (July 1983), pages 183-190.
12The initial period pricing of an ARM is the sum of three parts. The
first element is an index rate, e .g ., the one-year Treasury (p . 4 4 )
Valuation of Caps
To estimate the value of caps, we analyze how ARMs
would have behaved with and without caps if they had
been available through the 1970s. By determining, ex post,
how the financing costs would have differed with varying
discounts and caps, we hope to capture the current ex
ante expectations for these ARM modifications.
Two horizons for expected home ownership are con
sidered: three and eight years. The eight-year horizon
represents the average duration of a mortgage,* while
the three-year horizon is applicable to about one-quarter
of homebuyers, those who expect to resell quickly, f In
each case, the fully-indexed ARM rate was assumed to
equal 2.8 percentage points above the one-year Treasury
rate and to adjust every twelfth month. The use of a
’ Frederick E. Balderston, op. cit.
fJohn L. Goodman, Jr., op. cit.
constant markup and the one-year Treasury rate as a
representative index are consistent with recent surveys.*
Simulations of hypothetical ARMs, with and without caps,
were run starting in 1970 for each month for which there
was data, i.e., ending in 1977 with the eight-year horizon
and in 1982 with the three-year.
From the simulation results we can find the discounted
present values of caps in each month.§ First, we cal
culate the present value of the mortgage payments,
|The first survey was taken in November 1984; see The
Primary Mortgage Market, Federal Home Loan Mortgage
Corporation (January 1985). The later survey, taken in
February 1985, is unpublished.
§Our technique is similar to one developed independently by
Patrick H. Henderschott and James 0. Shilling, Valuing ARM
Rate Caps: Implications of 1970-84 Interest Rate Behavior,
unpublished paper, Ohio State University.
Effective Values of Caps
In percentage points
A: 8-Year Horizon
Effective value of:
Yield curve slope
First-period discount
Lifetime cap: 5%
Annual cap: 2%
Both caps
Low ....................
<0.5
0.0
1.0
2.0
3.0
0.00
0.01
0.06
0.17
-0 .0 2
0.04
0.11
0.19
0.00
0.06
0.16
0.30
Middle ................
0.5-1.5
0.0
1.0
2.0
3.0
0.13
0.24
0.39
0.61
0.20
0.26
0.34
0.44
0.29
0.41
0.59
0.88
H ig h ....................
>1.5
0.0
1.0
20
3.0
0.68
0.93
1.24
1.59
0.43
0.49
0.64
0.89
0.73
1.04
1.36
1.78
Yield curve slope
First-period discount
Lifetime cap: 5%
Annual cap: 2%
Both caps
Low ....................
<0.5
0.0
1.0
2.0
3.0
-0 .0 4
0.00
0.01
0.02
-0 .2 2
-0 .1 3
-0 .0 5
0.02
-0 .2 2
-0 .1 3
-0 .0 5
0.02
Middle ................
0.5-1.5
0.0
1.0
2.0
3.0
0.00
0.01
0.02
0.06
0.00
0.04
0.12
0.27
0.00
0.04
0.12
0.27
H ig h ....................
>1.5
0.0
1.0
2.0
3.0
0.06
0.12
0.21
0.35
0.27
0.42
0.61
0.81
0.27
0.42
0.61
0.81
Group*
B: 3-Year Horizon
Effective value of:
Group*
‘ Each group consists of one-third of the simulation results, ranked by the magnitude of the value of both caps.
FRBNY Quarterly Review/Autumn 1985
along the lines of option pricing models, which assign
probabilities to possible future interest rate paths and
then average them.13 Rather than using this approach,
we estimate the value of caps by calculating the extent
to which they would have held down the interest costs
of ARMs if they had been issued since 1970 (box).
To represent the holding period of a mortgage, we use
two horizons: eight and three years. The eight-year
horizon approximates the average holding period of all
mortgages, and as such is representative of the holding
period for borrowers in the aggregate.14 We assume that
most ARMs have an annual cap of two percentage
points and a lifetime cap of five percentage points.
These caps are among the most popular of the recFootnote 12, continued
rate. The second element is a constant markup. The sum of these
two is called the fully-indexed rate. The third element is the firstperiod discount, which reduces the fully-indexed rate for the first
period of the mortgage only. The fully-indexed ARM rate less the
first-period discount is called the initial rate.
In the second period, the uncapped ARM rate has only two parts.
It is the sum of the index rate as of the beginning of the period and
the same markup as in the first period.
13See Randall J. Pozdena and Ben Iben, “ Pricing Mortgages: An
Options Approach’1, Federal Reserve Bank of San Francisco
Economic Review (Spring 1984), pages 39-55.
14See Frederick E. Balderston, Thrifts in Crisis (1985).
ommended configurations proposed by the Federal
National Mortgage Association.
According to our calculations, the value of these caps
for an eight-year horizon varied between zero and 1.8
percentage points, depending in part on the size of the
first-period discount. For example, an ARM issued in
1970 without a discount would not have been affected
at all by the presence of our caps. Thus, their value at
that time was zero. In contrast, the rate on an ARM
issued after 1971 would have been constrained not only
by the annual caps but also by the lifetime cap. In these
cases, the worth of the caps moved toward the high end
of the range.
As we expected, caps would have been less valuable
to people with short horizons, e.g., three years, than to
those with long horizons. The three-year and eight-year
values differ mostly because lifetime caps were never
binding over the first three years of an ARM during the
1970s. In general, our calculations indicate that bor
rowers with short horizons face little likelihood that
lifetime caps will ever come into play. To be sure, these
individuals would value first-period discounts more
highly than people with longer horizons since they
amortize the discounts over fewer years. Nevertheless,
we find that the combined value of caps and discount
usually favors borrowers with longer horizons.
Valuation of Caps, continued
including prepayment of the principal, over the mortgage
horizon assuming no caps; we call this the base present
value. Second, we recalculate the present value
imposing, individually and combined, caps of two per
centage points each year and of five percentage points
over the life of the mortgage. The differences between
these values and the base present value measure the
present values of the cost saving resulting from the
respective caps. Expressing each difference as a percent
of the face value of the loan converts the saving into the
equivalent of closing points. Then calculating how much
these points change the effective yield provides a
measure of the effective value of the cap.
For a borrower to accept an uncapped ARM instead
of a capped ARM, its markup (over the base rate) would
have to be lower by this effective value. (Equivalently,
a larger first-period discount could be offered.) Since, in
our simulations, the cap was tied to the initial rate rather
than the fully-indexed rate, the value of a cap increases
sharply as the discount increases.
Since caps only have value when they lower the
interest rate on the mortgage, their value depends on the
course of future interest rates. Thus, an ex ante val
44
FRBNY Quarterly Review/Autumn 1985
uation is based on the steepness of the yield curve.
When the yield curve rises sharply, reflecting a market
expectation of high future interest rates, caps will be
worth more. On the other hand, when the yield curve is
downward-sloping, caps may turn into “floors” for bor
rowers and could have a negative value.
To capture the effect of the market yield curve, we
divide the months of the simulations into three equal
groups, ranked by value of the caps. (This ranking is
similar to one based on the steepness of the yield curve
at the time a hypothetical ARM was issued.) Then we
average the values in each group. For each group we
show, in the tables, for different first-period discounts,
the effective value of the caps, singly and in combina
tion. In examining the recent ex ante valuation, we use
the relative steepness of the yield curve to select an
appropriate value from the tables. For example, when the
difference between the ten-year and one-year Treasury
rates exceeds 1.5 percentage points, we use the average
of the highest third as the value of the cap or caps. The
average of the lowest third applies to yield curve differences
of less than one-half percentage point. In cases near a
boundary, we chose an average value of the two groups.
Using our estimates of the value of caps, we next
determine the extent to which the long-term expected
ARM financing rate has been below the FRM rate.
Financing rate: ARMs versus FRMs
We evaluate the financing rates by comparing the initial
period pricing of an ARM and the FRM rate with the
corresponding points on the yield curve in the market
for Treasury securities. Since the Treasury yield curve
embodies only expectations of future rates and an
interest rate risk premium in longer-term rates, sub
tracting it from the yield curve implicit in the mortgage
market shows the impact of the other factors that dis
tinguish ARMs from FRMs . 15 Consider, for example, an
15Shiller, Campbell, and Shoenholtz, op. cit., show that long-term
Treasury rates can be expressed as the sum of an interest rate risk
premium and an arithmetic average of weighted expected future
ARM without a discount or caps whose first-period rate
is three percentage points above the one-year Treasury
rate. If the FRM rate were only, say, two percentage
points above a long-term Treasury rate, then the net
effect of the distinguishing factors would make the long
term expected financing rate of an FRM lower than that
of an ARM by one percentage point (Chart 1) . 16
Footnote 15, continued
short-term rates, where the weights sum to one. Expected rates
receive less weight the further they are in the future.
16More precisely, in this case all expected ARM rates in the future are
also three percentage points above expected future one-year
Treasury rates, since the markup is constant. Thus, the expected
long-term ARM rate exceeds the expected average one-year
Treasury rate by three percentage points. This difference can be
compared with the spread between the FRM and longer-term
Treasury rate, in which the expected future short-term rates and
interest rate risk premium are netted out. What is left over are the (p.46)
Table 2
Value of Discounts and Caps in 1984 and 1985
In percentage points
Eight-year horizon
Size of
discount*
Quarter
Yield
cu rve t
__________ Three-year horizon
Effective value Effective value
of discount}:
of caps}
Effective value Effective value
of discount}:
of ca p st
1984-1 .................................... .............2.0
1984-11 ................................................2.9
1984-111
.............2.5
1984-IV
.............1.4
1.8
1.7
1.1
1.7
0.4
0.6
0.5
0.3
1.4
1.6
0.9
0.9
0.8
1.2
1.0
0.6
0.6
0.7
0.3
0.4
1985-1..
1985-11
2.2
2.3
0.3
0.2
1.2
0.9
0.6
0.4
0.5
0.3
.............1.4
............ .............0.9
’ Discount is estimated as the excess of the sum of the one-year Treasury rate and 2.8 percentage points over the initial rate, as reported
by the FHLMC.
fDifference between the rates on ten-year Treasury notes and one-year Treasury bills.
}:The effective values of the discount and caps are the consequential reductions of the effective yield of a mortgage over the stated
horizon.
Estimated by the authors using data from the Federal Home Loan Mortgage Corporation and the Federal Reserve Bulletin.
Table 3
Evaluation of the Financing Rate of ARMs in 1984 and 1985
In percentage points
______________________________ Eight-year horizon
Quarter
\
Adjusted ARM rate
less one-year
Treasury rate’
FRM rate
less ten-year
Treasury rate
Difference
Three-year horizon
Adjusted ARM rate
FRM rate
less one-year less three-year
Treasury rate*
Treasury rate
Difference
1984-1 ..............................
1984-11 ............................
1984-111
1984-IV
1.0
0.6
1.4
1.6
1.4
0.9
1.6
1.9
- 0 .4
- 0 .3
- 0 .2
- 0 .3
1.4
0.9
1.5
1.8
2.1
1.4
1.8
2.5
- 0 .7
- 0.5
- 0 .3
- 0 .7
1985-1..
1985-11
1.3
.1.7
1.5
1.9
- 0 .2
- 0 .2
1.7
2.1
2.4
3.0
- 0 .7
- 0 .9
’ Calculated as the constant ARM markup of 2.8 percentage points less the sum of the effective values of caps and discounts, shown in
Table-2.
FRBNY Quarterly Review/Autumn 1985
45
Evaluating the expected long-term ARM financing rate
involves several steps. To take account of caps and the
first-period discount, we add the present value of each
to the face value of a mortgage and calculate the
reduction of the effective yield over the holding period.
We call this reduction the “ effective value” of the caps
and first-period discount. By subtracting this effective
value from the fully-indexed ARM rate in the first period,
the net result, the “ adjusted” ARM rate, can be com
pared with the one-year Treasury rate as previously
discussed.
We apply this approach beginning in 1984, which is
the first year for which rates on a fairly homogeneous
sample of ARMs are available. These data, compiled by
the Federal Home Loan Mortgage Corporation (FHLMC),
show the initial ARM rate. The difference between this
rate and the one-year Treasury rate equals the markup
less the first-period discount. To disentangle the firstperiod discount, we rely on two FHLMC surveys, taken
at different times, indicating that the markup over the
one-year Treasury rate for a typical ARM has been
constant at 2.8 percentage points.17 On the basis of
these survey results, we assume that all the variation
in the initial ARM/one-year Treasury spread represents
changes in the first-period discount. Since January 1984
this discount has varied between 0.9 and 2.9 percentage
points, which, for an eight-year horizon, translates into
a range of effective values between 0.2 and 0.6 per
centage point (Table 2).
Effective values of caps depend on the expectations
of and the risks associated with future rates— both of
which are embodied in the yield curve—and the dis
count. Thus, we apply our estimated values to 1984
according to the slope of the yield curve and the size
of the discount in each month, as described in the box.
Caps were worth the most for ARMs issued in 1984-11
and the least in the second half of 1984 and 1985-11.
Using the Treasury yield curve and our estimated
values of the discount and caps, we now determine how
attractive ARM pricing has been for the average holding
period. For each quarter since the beginning of 1984 we
calculate the adjusted ARM rate, as described above,
and subtract from it the one-year Treasury rate. We then
compare this difference with the spread between the
FRM rate and ten-year Treasury rate.18 Table 3 shows
that the two spreads were similar in every quarter,
implying that the long-term expected financing rates of
ARMs and FRMs were about the same. In other words,
to the extent that individuals had the same expectations
as the market, the average of expected ARM rates over
the length of home ownership was close to the FRM
rate. This has been the case when FRM rates were low,
as in early 1984 and 1985, as well as when they were
temporarily high, as in mid-1984.
Even if ARMs do not appear to have been priced
much below FRMs for the typical individual, ARMs might
be favored by people with short horizons, e.g., an
expected length of home ownership of three years, to
avoid paying a long-term rate on a short-term loan.
To evaluate the expected financing rate of an ARM for
these borrowers, we compare the spread between the
adjusted ARM rate and the one-year Treasury rate with
the spread between the FRM rate and the three-year
Treasury rate. In this comparison, the adjusted ARM/
one-year Treasury difference has varied between 0.3
percentage point and 0.9 percentage point less than the
FRM/three-year Treasury rate difference since January
1984. While the differences may have been large
enough to significantly affect these individuals’ demand
18The ten-year Treasury rate most closely matches the average holding
period of a mortgage. Because the yield curve in the past several
years has been essentially flat past a maturity of seven years,
choosing other long-term rates does not significantly alter our
results.
C h a rt 1
ARM P ricing and the Treasury Market
Yield Curve: An illu s tra tio n *
P e rc e n t
15
14
13
12
11
Footnote 16, continued
effects of the distinguishing characteristics of FRMs from ARMs. The
long-term expected financing rate of an FRM would differ from that
of an ARM by these effects as well as the interest rate risk premium.
17The first survey was taken in November 1984; see Federal Home
Loan Mortgage Corporation, The Primary Mortgage Market (January
1985). The later survey, taken in February 1985, is unpublished. The
one-year Treasury rate has gained in popularity as the index rate for
ARMs over cost-of-fund indexes and by 1984 was used by about 90
percent of lenders surveyed.
46
FRBNY Quarterly Review/Autumn 1985
A < B-*-ARM is fa vorably priced.
10
A>B-*-ARM is not favorably priced.
10
15
20
Years to maturity
* C onstru cte d by the authors.
25
30
Table 4
Spread Between the FRM and Ten-year
Treasury Rates
In percentage points
1970-78 average .....................................................................
1979
1980
1981
1982
1983
1984
1.3
1.8
2.3
2.7
3.1
2.1
1.4
Federal Home Loan Mortgage Corporation and Board of
Governors of the Federal Reserve System.
for housing, this group includes somewhat less than a
quarter of all homebuyers at a given time . 19 Thus, any
resulting boost to aggregate housing demand is likely
to have been relatively small.
In sum, our estimates indicate that ARMs have gen
erally not been priced significantly below FRMs. Inas
much as our c a lc u la tio n s are based on several
approximations, however, the precise estimates should
not be taken literally. Nevertheless, the pricing of an
ARM most likely has to be substantially more favorable
than an FRM to persuade someone to purchase a house
on the basis of the more risky financing rate. In this
light, our results suggest that even if some of our
approximations are not entirely correct, the alternatives
are unlikely to be so different as to change the basic
conclusion: ARMs do not seem to have been priced
attractively enough to raise housing demand in the
aggregate by a large amount.
ARMs and the FRM rate
ARMs may have still provided an indirect boost to
housing by putting downward pressure on the FRM rate.
Two arguments have been advanced along this line.
First, to the extent that the FRM rate in the past con
tained a premium to cover the risk associated with the
im balanced portfolios of th rifts, the ARM-induced
reduction of this risk might cut the premium . 20 Second,
with ARMs having captured a growing share of new
mortgages, the supply of FRMs in the secondary mort
gage market may not have kept up with demand,
especially after demand was bolstered by the devel
opment of collateralized mortgage obligations in 1984.21
’•John L. Goodman, op. cit.
“ Robert Van Order, op. cit.
21See Joseph Hu and Judy Hustick, "Major Developments in Housing
and Mortgage Finance", Bond Market Research, Salomon Brothers
Inc. (January 1985).
As a result, the price of FRMs may have been bid up,
which reduced the FRM rate.
Unfortunately, experience with ARMs has been too
brief to distinguish their effect on the FRM rate from
other influences. In fact, the FRM rate fell relative to
other long-term rates over the past two years (Table 4).
However, in 1982 the spread between them had wid
ened to an unprecedented extent, most likely reflecting
to some degree a jump in the FRM’s prepayment risk
premium that ocurred when interest rates climbed to
exceptionally high levels. The FRM rate subsequently
declined relative to other rates at least in part because
this risk premium fell along with the overall level of
rates.
The share of ARMs in newly issued mortgages
Even though our calculations point to little impact of
ARMs on housing demand, small differences in the
perceived financing costs of ARMs and FRMs could still
have a large effect on how people choose to finance a
home. Because these two types of mortgages are so
closely substitutable, the differences may greatly influ
ence the choice between an ARM or an FRM once an
individual has decided to purchase a home. Although it
is very difficult to know at this point all the determinants
of the share of ARMs in new mortgages, we investigate
in this section two systematic factors that might tilt the
financing choice: the distribution of risks surrounding the
market’s expectations of future rates and the pattern of
mortgage payments over time.
In deciding whether to finance a home purchase with
an ARM or an FRM, individuals presumably consider the
risks surrounding market expectations of future rates.
When interest rates look as if they will be rising, i.e.,
the yield curve slopes upward sufficiently, FRMs may
be viewed as a better hedge than ARMs. Conversely,
when rates look as if they will be falling, i.e., the yield
curve is downward sloping, ARMs might be considered
a good risk. From this perspective, then, the slope of
the yield curve may indicate the predominant financing
choice.
Another factor that may influence the mode of home
finance is the pattern of mortgage payments over time.
One way to represent the different payment patterns of
ARMs and FRMs is to use the difference between the
FRM and the first-period ARM rates. The larger this
spread, the lower the near-term payments of ARMs
relative to those of FRMs and, thus, the more attractive
ARMs may appear.
Experience to date seems to support the roles played
by these two factors. Since mid-1981 there have been
two periods in which the share of ARMs in new mort
gages has risen sharply—the first half of 1982 and the
second half of 1983 through the first half of 1984
FRBNY Quarterly Review/Autumn 1985
47
Chart 2
Share of ARMs in Mortgages Closed
Shading shows periods of increasing ARM popularity
Percent
The predicted values are from the estimated equation:
( t-statistics are shown in parentheses )
YTt = -2.333 + 1.130 IN ITG A P t - 0.366 SLOPEt-2 + 0.142 RFRMt-1
(-1.78) (8.17)
(-3.40)
(1.68)
Sample period:
January 1982 - July 1985
R2 = 0.65
D-W = 0.822
YT
= loge(JARM) - loge(1-JARM)
JARM
= Share of ARMs in new single-family home mortgages
closed
INITG A P = Interest rate on FRMs less the initial interest rate on
ARMs
SLOPE
= Yield on 20-year Treasury bills less the yield on
one-year Treasury bills (constant maturity)
RFRM
= Interest rate on FRMs for new single-family homes
The transformation of the predicted values of YT into the share is given by:
A
^
JARMt = (1+eYTt)-i
The dependent variable is so transformed to restrict its range to the interval
[0.1].
Sources: Federal Home Loan Bank Board and Board
of G o v e rn o rs of the Federal Reserve System .
48
FRBNY Quarterly Review/Autumn 1985
(Chart 2). During the first episode, the share peaked
at 46 percent, and during the second period it reached
68 percent. Outside of these episodes—from the end
of 1982 to the summer of 1983, and in late 1984 and
early 1985—ARMs lost some of their popularity.
In the first episode, the prim ary reason fo r the
increased use of ARMs may have been related to the
risks surrounding the yield curve. Over the first year or
so since widespread use of ARMs was permitted in April
1981, the yield curve was downward sloping or fairly flat
(Chart 3). People may have taken advantage of ARMs
in the belief that the potential for future declines in
interest rates made this form of financing a good risk.
In contrast, the timing of ARM payments was probably
not important since the initial ARM rate was not much
different from the FRM rate during this period.
The second surge in ARM popularity that began in the
fall of 1983 may have been related to a widening spread
between the FRM and initial ARM rates. In the spring
of that year, first-period discounts became widely
available and were more and more prevalent through
the first half of 1984. These heavily advertised discounts
may have reinforced people’s perceptions of the dif
ferent payment streams associated with ARMs and
FRMs. The yield curve was fairly steep during this
period and, thus, was unlikely to be behind the growing
share of ARMs in newly issued mortgages. However, the
yield curve flattened substantially in the summer of last
year and may have helped extend the popularity of
ARMs through most of the remainder of 1984, despite
a narrowing in the FRM/ARM spread.
Finally, in almost all the periods when most people
turned to FRM financing, neither the yield curve nor the
FRM/ARM spread would have encouraged the wide
spread use of ARMs; the yield curve was steep and the
FRM/ARM rate difference small. Individuals with short
horizons, however, would have chosen ARMs on the
basis of the steep yield curve.
Since the beginning of 1985, though, the FRM/ARM
spread has begun to widen at the same time that the
yield curve has remained very steep. So far, the share
of ARMs has stayed around 50 percent, well below its
previous peak. One factor that may be bolstering FRMs
is that since the end of 1984 their rates have been close
to their lowest level of this expansion. The long-term
financing rate of a mortgage, thus, is perceived to be
about as low as can be expected, thereby encouraging
borrowers to lock in the FRM long-term financing
rate.22
For confirmation that these systematic factors play a
role in determining the mode of mortgage, we estimated
“ S ee Freddie Mac Fleports, Federal H om e Loan M o rtg a g e C orporation
(M ay 19 8 5), for a sim ilar analysis.
Chart 3
Slope of the Treasury Market Yield Curve
and Spread Between the FRM and
Initial ARM Rates
Shading shows periods of increasing ARM popularity
Percent
*D iffe re n c e between ten-year and one-year
T reasury rates.
Sources: Federal Home Loan Bank Board and
Board of G overnors of the Federal Reserve System.
several simple equations relating the share of ARMs to
the yield curve, the FRM/ARM spread, and the level of
the FRM rate. In the best of these equations, the
explanatory variables, for the most part, were statisti
cally significant and explained much of the variation in
the share of ARMs (Chart 2).
Conclusion
Our analysis suggests that ARMs have not had a major
effect on the demand for housing. We have shown that
for most people the pricing of ARMs has been such that
their expected* long-term financing rate may not have
differed much from the FRM rate, assuming individuals
have the same expectations of future rates as the
market. For people who hold mortgages only a short
time, the effects could be important, but this group tends
to be less than one-quarter of all homebuyers at a given
time. Nonetheless, small differences between ARMs and
FRMs may have produced large swings in the mode of
home finance, once the decision to purchase a house
was made. We believe that this dual approach goes a
long way in resolving the apparent paradox of the recent
econometric findings that indicate little impact of ARMs
on housing and the observed popularity of ARMs.
Our results, to be sure, are based on short and limited
experience with ARMs. The economy has not yet gone
through a period of sharply rising interest rates while ARMs
were widely available and familiar to most people. The
impact of ARMs on housing demand might then be more
pronounced than under recent financial market conditions.
Judging from recent experience, however, our analysis
also implies that ARMs have not significantly influenced
the dynamics of the business cycle by altering the
interest responsiveness of housing demand. Of course,
ARMs may have other effects on the business cycle by
making spendable income after mortgage payments, and
thus consumption, more sensitive to interest rate
changes. Nevertheless, since the long-term expected
financing rate of ARMs seems to move broadly in line
with the FRM rate, the aggregate demand for housing
should continue to respond to interest rate movements
as it has in the past.
Carl J. Palash and Robert B. Stoddard
FRBNY Quarterly Review/Autumn 1985
49
February-July 1985 Semiannual Report
(This report was released to the Congress
and to the press on September 6, 1985)
Treasury and federal Reserve
Foreign Exchange Operations
During the period under review many observers of the
foreign exchange markets were uncertain about the
sustainability of the global economic expansion, now
into its third year. The vigorous upswing in the United
States had faltered in the third quarter of 1984, and
market participants were anxious for evidence whether
domestic demand would remain strong enough to sup
port renewed increases in production and employment
in 1985. Doubts developed about other countries’ ability
to continue to expand should U.S. growth remain sub
dued, since exports to the United States had been the
major source of stimulus abroad.
Meanwhile, inflation had decelerated in almost all of
the industrial countries, but the scope for making further
progress in the fight against inflation was seen as more
limited at this stage of the business cycle. At the same
time, market attention was focused on concerns about
the imbalances in the structure of the current recovery—
imbalances reflected in a large U.S. fiscal deficit,
unprecedented disparities in the current account posi
tions of the largest industrialized countries, interest rates
at levels that appeared high relative to current inflation
rates, and persistent unemployment problems abroad.
With the major money and capital markets of the
world increasingly integrated through progressive lib
eralization of exchange controls and other regulations,
A report by Sam Y. Cross, Executive Vice President, Federal Reserve
Bank of New York and Manager of the Foreign Operations of the
System Open Market Account. Officers of the Foreign Exchange
Function, together with Richard F Alford, Elizabeth A. Goldstein,
Thaddeus D. Russell, and Elisabeth S. Klebanoff contributed to its
preparation.
50
FRBNY Quarterly Review/Autumn 1985
shifts in sentiment about these uncertainties were
associated with sizable movements in dollar rates.
During the six months February through July, the dollar
briefly continued its four and one-half year climb,
advancing strongly to hit record levels in the floating
rate period. Thereafter it depreciated, at times quickly,
to close the period much lower.
The dollar’s continued rise: February to early-March
The dollar was buoyed early in the period by an
improving outlook for the U.S. economy and the impli
cations for U.S. monetary policy. Data being published
at the time pointed to a significant rebound in the fourth
quarter that had been unanticipated just months before,
and economic forecasters were beginning to present
reassuring projections of moderate growth for 1985. An
accelerating expansion of monetary aggregates was
seen as limiting the scope for any further easing of U.S.
monetary policy and might even suggest some tight
ening. As a result, there was a perception in the market
that the decline in U.S. interest rates, which had brought
short-term deposit rates down more than three per
centage points in about six months and was marked by
two half percentage point cuts in Federal Reserve dis
count rates, was not likely to continue. As this shift in
expectations occurred, market rates for long-term as
well as short-term instruments backed up somewhat
during February and into early March.
The economic outlook abroad was more guarded. The
performance of many of the European economies had
not been sufficient to dispel concerns about their longerterm growth potential. Industrial production statistics for
the first quarter, while hard to interpret because of
temporary disruptions associated either with labor dis
putes or an unusually severe winter, pointed to declines
in output in many large countries. Also, business opin
ions and press commentary appeared to reflect a lack
Chart 1
The Dollar against Selected
Foreign Currencies
Percent
J A
S O N
1984
D
J
F
M
A
M J
J
1985
Percentage change of weekly average bid rates for dollars
from the average rate for the week of July 2-6, 1984. Figures
calculated from New York noon quotations.
of confidence in most countries that domestic demand
could revive sufficiently to ensure a continued expansion
should U.S. growth be subdued. Fiscal policies abroad
were regarded as being almost universally restrictive,
as the authorities sought further progress in achieving
their medium-term goal of reducing fiscal deficits as a
proportion of national income. Monetary policies were
also generally restrained.
Thus, few market observers thought that foreign
central banks would welcome pressures emanating from
either a renewed firming of interest rates in the United
States or a continuing decline in their currencies to
tighten monetary policy any more. Yet the impact on
domestic prices of the progressive decline in these
countries’ currencies against the dollar was showing
through, at least in Germany where import prices were
rising more quickly. Market participants therefore
became wary of the possibility that the authorities there,
as well as in other countries, might use intervention in
an effort to stop the currency depreciations.
The full range of these international issues had
already been discussed at a G-5 meeting late in Jan
uary. Moreover, the May 1983 Williamsburg agreement
to undertake coordinated intervention as necessary was
reaffirmed at that meeting and visible foreign exchange
market operations had subsequently been undertaken
by the authorities of several countries. Market partici-
Chart 3
Real GNP and Real Domestic Demand Growth
Chart 2
U.S. Interest Rates
Percent
13---------------------------------------
6l l
J
I I I I I I I I I I 1 _ L ,1 11 1 I I I 1 I I 1 I 1
F
M
A
M
J
J
1985
In 1984
Percent
9 ---------
Source: O rganization for Economic C ooperation and
Developm ent, 1984.
FRBNY Quarterly Review/Autumn 1985
51
pants perceived the central banks to be more willing to
intervene than before. But they were uncertain about the
circumstances in which the central banks would judge
intervention to be appropriate.
At the same time dealers remained impressed by the
strength of demand for dollars in the exchange market.
Enthusiasm spread about the degree of interest coming
from abroad in the Treasury’s February refunding oper
ations. Commercial entities were frequently seen as
buyers of dollars, presumably to hedge future commit
ments in light of the improving outlook for the dollar. As
sentiment toward the dollar became increasingly bullish,
the dollar rose through levels at which, in earlier
months, some central banks had intervened and pre
viously provided resistance. The dollar’s rise then gained
momentum, markets became one-sided, and dollar rates
moved quickly to successive highs against several
European currencies. By February 26, the dollar had
risen nearly 10 percent against major European cur
rencies while rising 3 percent against the Japanese yen.
At this point the dollar was at its highest level of the
six-month period under review, trading around DM3.48
and $1.03 against the German mark and British pound,
respectively.
On three occasions during the first three weeks of
February, the U.S. authorities intervened, selling a total
of $242.6 million against marks, $48.8 million against
yen, and $16.4 million against sterling to counter dis
orderly market conditions in operations coordinated with
foreign central banks. Between February 27 and March
1, the U.S. authorities sold another $257.4 million
against marks in the New York market in a concerted
intervention. These operations brought the total of U.S
intervention sales of dollars, between the January 21
G-5 meeting and March 1 , to $659 million.
As for the central banks of most other G-10 countries,
they intervened much more heavily between February
27 and March 1 than before, selling dollars, buying
German marks and other currencies, or doing both. For
all G-10 countries as a group, the total of dollars sold
during the five weeks between January 21 and March 1
was about $10 billion. This series of operations con
stituted one of the biggest dollar interventions during the
floating rate period. The sales of dollars by G-10
countries other than the United States was large enough
to cause a sizable drop in their official foreign currency
reserves.
The decline: mid>March to end-July
Even after the large interventions of late-February to
early-March, the dollar traded close to its late February
highs for about two weeks. But the intervention had
resulted in an accum ulation of dollar-denom inated
assets in private hands. Talk had begun to spread ear-
52
FRBNY Quarterly Review/Autumn 1985
Table 1
Federal Reserve
Reciprocal Currency Arrangements
In millions of dollars
Institution
Amount of facility
July 31, 1985
Austrian National Bank ................................
National Bank of Belgium ...........................
Bank of Canada ...........................................
National Bank of Denmark .........................
Bank of England ...........................................
Bank of France ............................................
German Federal B a n k .................................
Bank of Italy .................................................
Bank of Japan ..............................................
Bank of Mexico ............................................
Netherlands Bank ........................................
Bank of Norway ............................................
Bank of Sweden ...........................................
Swiss National Bank ...................................
Bank for International Settlements:
Swiss francs-dollars.................................
Other authorized European
currency-dollars.....................................
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
Total.................................................................
30,100
600
1,250
her that portfolio managers were gearing up to provide
more currency diversification to customers’ portfolios,
taking advantage of assets that appeared undervalued
at current exchange rates and capitalizing on the pos
sibility of future currency appreciation. Then, around
mid-March, a more pessimistic reassessment of the
outlook for the U.S. economy and a shift of view about
interest rates began to weigh on the currency.
By mid-March, a variety of statistics were indicating
that economic activity in the United States was pro
ceeding only at a relatively slow pace. W hile final
demand remained buoyant, the demand for labor and
growth of production in the manufacturing sector were
much weaker than had been assumed in most forecasts
earlier in the year. Market participants came to realize
the extent that demand was being diverted away from
U.S.-produced goods, thereby jeopardizing the sus
tainability of economic expansion here.
At the same time, signs of strain in U.S. financial
markets became more prominent, raising the risk that
financial as well as economic dislocations would inten
sify. The failure of three secondary government secu
rities dealers, though constituting a very small part of
the market, imposed losses for a number of customers,
including several local governments and thrift institu
tions. The repercussions of these incidents revealed
weaknesses in private deposit insurance systems and
led to large deposit outflows from state-insured thrifts,
particularly in Ohio, before the governor of that state
temporarily closed the affected institutions. Pictures
displayed prom inently by the media of queues of
depositors unable to withdraw their funds heightened
concern about the authorities’ ability to deal adequately
with problem situations. Since difficulties had already
been identified in energy, real estate, and agricultural
portfolios, this weakness was perceived as having
potentially far-reaching implications.
Against this background, market participants adjusted
their assessments of the outlook for U.S. monetary
policy and interest rates. Dealers were sensitive to the
implications of the imbalances in the economy for the
industrial sector and the prospects for sustained growth.
Money as measured by M1, though remaining well
above target, was growing somewhat more slowly on a
month-to-month basis. Inflation rates were still low, a
renewed weakness in oil prices helped keep inflationary
expectations at bay, and signs of Congressional action
to reduce the fiscal deficit lent some relief to the bond
market.
Thus, most observers came to expect the Federal
Reserve to give priority to supporting the economy and
providing assistance to the domestic financial system.
Market interest rates of all maturities started to decline
in a trend that was to last about three months, while
expectations developed that the Federal Reserve would
announce a series of cuts in its discount rates. By midJune short-term interest rates had fallen two percentage
points or more, with the Federal Reserve lowering its
official rates just once— by half of a percentage point,
effective May 20. Long-term rates also declined, but
more slowly. As a result of these declines, most U.S.
interest rates were below levels prevailing at the depth
of the 1982 recession.
As these developments began to unfold, the dollar fell
substantially in the exchange markets. Many market
participants were concerned for a time about the mag
nitude of any drop in the dollar, if foreign investors tried
to liquidate dollar assets accumulated during previous
years. Indeed investors acted to protect the value of
their portfolios, mostly by selling dollars in the forward
market but also by shifting into assets denominated in
other currencies. Commercial customers postponed
dollar purchases in the expectation of being able to buy
later at more attractive rates. Bank dealers and spec
ulators on organized exchanges also sought to sell the
dollar and to establish short positions. Under these
circumstances the dollar moved lower. As it fell through
levels at w hich re sista n ce had p re v io u s ly been
expected, the pace of the decline quickened. From its
peak in late-February to the middle of April, the dollar
dropped 20 percent against sterling, 15 percent against
the continental currencies, as well as 6 V2 and 4 percent
against the Japanese yen and C anadian dollar,
respectively.
Late in April, however, the dollar firmed and then
traded relatively steadily through the end of June.
Market participants perceived that foreign investors had
not liquidated their dollar holdings in large scale so that
fears of an early and precipitous fall in the dollar faded.
Instead, inflows of new funds were continuing, especially
from Japan at the beginning of that country’s new fiscal
year in April, as well as from countries suffering from
serious inflation problems. Also, persistent strains in the
U.S. financial sector were being well contained. Interest
yields on dollar investments were still relatively attrac
tive. The scope for hedging the currency risk should the
dollar decline had been dem onstrated. And profits
realized from earlier hedging operations increased the
overall rate of return on dollar portfolios sufficiently to
protect against even significant future declines in the
dollar. In effect, the dollar retained its stature as the
principal medium for investment.
Meanwhile, the currencies that traditionally benefit
from a shift of investor preference out of dollars, the
German mark and Japanese yen, had appreciated rel
FRBNY Quarterly Review/Autumn 1985
53
atively modestly as the dollar had declined. The U.S.
economy had still outperformed those of most other
industrialized countries and talk continued of a renewed
acceleration of U.S. growth in the second half of 1985.
The only currency to challenge the dollar as an invest
ment alternative was pound sterling. With the outlook
for economic growth in the United Kingdom brighter than
for most other countries and interest rate levels there
comparatively high, sterling-denominated assets pro
vided an attractive outlet for investors reluctant to
accept declines in yields elsewhere. Thus by the end
of June, the dollar was trading above its mid-April lows
against all currencies except sterling.
Many market observers had supposed that the
authorities abroad would have taken advantage of the
decline in U.S interest rates that occurred during the
spring to ease their own monetary policies. But in
Germany and Japan the authorities appeared reluctant
to cut short-term interest rates until they were more
confident about the exchange market situation. In the
other countries, the authorities were cautious about
letting interest rates at home get too far out of line
with those of their closest trading partners. To varying
degrees, foreign central banks instead took advantage
of the decline in the dollar to rebuild their foreign
currency reserves. The authorities in several countries
acquired sizable amounts of both dollars and German
marks, currencies that could be used in future inter
vention operations to support their own currencies. By
the end of June the G-10 countries as a group had
largely recovered the reserves lost in the early months
of the year.
In July the dollar resumed its decline. During the
spring, the gap had continued between strong growth
of U.S. dom estic demand and weak expansion of
domestic production. As a result, the regular flow of
economic statistics had presented conflicting signals. By
early July, however, it again became clear that U.S.
economic activity had not increased as much as most
observers had expected. An acceleration of real GNP
growth in the second quarter was more moderate than
anticipated, and anecdotal information for July sug
gested that the third quarter was getting off to no better
a start. The mounting U.S. trade and current account
deficits were increasingly perceived by market partici
pants as a drag on the domestic economy. Noting an
increase in protectionist pressures, they considered the
possibility that the Administration might welcome a fur
ther decline in the dollar to help restore external bal
ance. At the same time, disappointment developed over
the prospects for meaningful reduction of the fiscal
deficit, as efforts in the Congress to adopt a compro
mise budget resolution appeared to falter.
During the month, interest rate developments tended
to move in the dollar’s favor. In the United States,
interest rates started to firm. Market participants here
came to expect the Federal Reserve would not be more
accommodative until it could assess more fully the
implications of the drop in interest rates that had already
occurred and of a renewed acceleration in M1 growth.
In Europe, interest rates began to ease more rapidly.
The central bank in Germany began to provide liquidity
at progressively lower interest rates and, at least for a
time, central banks in other continental countries moved
in a similar direction. Thus, interest differentials actually
moved in favor of the dollar during the month.
Nonetheless, sentiment toward the dollar had become
cautious. Market professionals had already begun to set
up positions in anticipation that the dollar might resume
its decline. Thus, when others came into the market to
sell, dollar rates moved down through the end of the
month, dropping well below the lows of mid-April. Ster
ling continued to lead the rise in foreign currencies
against the dollar. After mid-July, however, when a
Table 2
Drawings and Repayments by the Argentine Central Bank Under Special Swap Arrangements
with the U.S. Treasury
In millions of dollars; drawings ( + ) or repayments ( - )
Drawings on the
United States Treasury
$500 million ..............................................
$150 million ..............................................
Data are on a value-date basis.
’ Not applicable.
54
FRBNY Quarterly Review/Autumn 1985
Outstanding
September 31, 1984
1984-IV
1985-1
1985-11
Outstanding
July 31, 1985
*
+ 500
-2 3 0
-2 7 0
-0-
-0-
+ 75
+ 68
+ 143
realignment within the European Monetary System
(EMS) drew attention to the mark’s potential for reval
uation in that arrangement, the German currency also
began to strengthen more rapidly than before. During
the entire February-July period under review, the dollar
had fallen on balance 20 percent against sterling to
$1.4135, 12 percent against the mark to DM2.7850 and
by approximately similar magnitudes relative to most
other continental currencies, and by 8 percent against
the Japanese yen to ¥236.
Meanwhile, during late June and July, progress was
being made in some of the largest Latin American
countries to deal with the serious imbalances in their
economies. In Argentina, the government came to an
agreement with the International Monetary Fund (IMF)
on a stabilization program that entailed currency and
wage/price reform designed to brake the country’s rap
idly accelerating inflation. Upon completion of an
agreement by the IMF to provide a standby, the U.S.
Treasury and 11 other monetary authorities acted to
facilitate the provision of a $483 million bridge financing
facility for Argentina, of which the U.S. portion was $150
million. Argentina made two drawings of roughly equal
size on this facility, on June 19 and on June 24, for a
total of $460 million. The Treasury’s portion of these
drawings was $143 million. Argentina is scheduled to
repay the drawings in two installments after the period.
In Mexico, the government tightened fiscal policy, lib
eralized trade policy, and made major changes in the
structure of its exchange market. These actions were
undertaken in order to align Mexico’s cost and price
structure more closely with world markets and aid in
bringing inflation down to targeted levels.
In the period February through July, the Federal
Reserve and the Exchange Stabilization Fund (ESF)
realized no profits or losses from exchange transactions.
As of July 31, cumulative bookkeeping or valuation
losses on outstanding foreign currency balances were
$871 million for the Federal Reserve and $578 million
for the Treasury’s Exchange Stabilization Fund. These
valuation losses represent the decrease in the dollar
value of outstanding currency assets valued at end-ofperiod exchange rates, compared with the rates pre
vailing at the time the foreign currencies were acquired.
The Federal Reserve and the ESF invest foreign
currency balances acquired in the market as a result of
their foreign operations in a variety of instruments that
yield market-related rates of return and that have a high
degree of quality and liquidity. Under the authority pro
vided by the Monetary Control Act of 1980, the Federal
Reserve had invested $1,009.2 million equivalent of its
foreign currency holdings in securities issued by foreign
governments as of July 31. In addition, the Treasury
held the equivalent of $1,756.0 million in such securities
as of the end of July.
Chart 5
Changes in Currency Reserves of
G-10 Countries
Excluding United States
Billions of U.S. dollars equivalent
mam
Table 3
Net Profits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Current Foreign Exchange Operations
In millions of dollars
Period
February 1 - July 31 ..
Valuation profits and
losses on outstanding
assets and liabilities
as of July 31, 1985
Federal
Reserve
United States Treasury
Exchange Stabilization
Fund
-0-
-0-
i—
Jan
i
Feb
i
Mar
i
Apr
1985
i
i
May
i
Jun
J
Jul
Foreign currency reserves shown in this and the following
charts are drawn from IMF data published in International
Financial Statistics.
-871.1
Data are on a value-date basis.
-5 7 8 .3
Adjustm ents fo r gold and fo re ig n exchange swaps
against European cu rre n cy units done with the
European M onetary Fund are incorporated.
FRBNY Quarterly Review/Autumn 1985
55
European currencies
Coming into the six-month period, progress appeared to
stall in resolving the economic problems facing Euro
pean countries. During the months of severe winter
weather, growth in several countries slowed, unem
ployment in some continued to drift upward, and a
deceleration in inflation petered out. At the same time
the trend toward greater convergence of economic
performances started to dissipate, notwithstanding the
fact that governments in almost all of these countries
continued to be committed to common goals for eco
nomic policy: reducing government deficits and con
taining inflation. Under these circumstances, there were
some adjustments among the relationships of all Euro
pean currencies as they declined and then rose against
the dollar.
Early in the period, with the dollar strengthening
across the board, the continental currencies as a group
fell about 10 percent. The Swiss franc dropped to
SF2.9405, the lowest level in more than 10 years, and
the German mark posted a low for the floating-rate
period at DM3.4780. The Dutch guilder, the French and
Belgian francs, and the Italian lira dropped to record
lows of NG3.9430, FF10.6300, BF69.90, and LIT2167,
respectively. Sterling, which had been the target of
especially heavy selling pressure just before the period,
declined somewhat more slowly against the dollar during
February. Nevertheless, by February 26 it had declined
nearly 9 percent and also recorded a record low of
$1.0370.
Meanwhile, authorities in Germany and the United
Kingdom were concerned that inflation was picking up
as a result, at least in part, of the impact on import
prices of the continuing strength of the dollar. In the
United Kingdom, inflationary expectations were also
stimulated by concerns over the priorities of the gov
ernment’s economic policy and above-target growth of
money. But the British authorities had acted to address
these concerns prior to the period by permitting an
abrupt and sharp increase in short-term interest rates.
In Germany, where the pressures were far less acute,
market rates also tended to firm. But market participants
perceived the German authorities to be resisting the rise
out of concern that significant increases in interest rates
were not appropriate to the domestic economic situation.
These developments had disappointing implications for
other countries that had been maintaining favorable
interest rate differentials relative to Germany. The cen
tral banks in France, Italy, and Belgium, for example,
saw the opportunity for them to lower interest rates in
response to earlier improvements in their price per
formance as quickly slipping away.
Following the G-5 meeting in January most European
central banks participated in the coordinated interven
56
FRBNY Quarterly Review/Autumn 1985
tions that took place through early March. All of those
participating sold dollars, at times in sizable amounts.
Some supplemented their dollar sales with purchases
of marks and a couple of other currencies, either against
dollars or their own currencies.
From mid-March, when the dollar began to decline,
to end-June, sterling was the currency that rebounded
most strongly to lead the rise in European currencies
against the dollar. The Swiss franc also benefited more
than many others, while the German mark was not
particularly buoyant.
This pattern of exchange rate changes surprised
market observers who had anticipated that, once the
dollar started to fall, the mark would reassert itself as
the principal alternative for investment. But as it turned
out, the currencies to benefit most from the dollar’s ini
tial decline were, for the most part, those with assets
yielding relatively high interest rates. Foreign capital was
drawn into sterling, enticed by high yields on gilts and
other fixed income securities as well as the breadth and
liquidity of London’s financial markets. Residents in high
Chart 6
Selected Foreign Currencies against
the Dollar
Percent
35--------
5L I
J
I I I
F
I
I
I I I
M
A
I I I
I
I I I I
M
I
I I
J
I
I
I I I
J A
1985
Percentage change of weekly average bid rates for
selected foreign currencies from the noon rates
on February 28, 1985. Figures calculated from
New York noon quotations.
II
interest rate countries borrowed abroad where the cost
of funds was lower to finance trade and domestic
expenditures. The Swiss franc firmed against many
other currencies, even though Swiss interest rates
remained relatively low, because the impression spread
in the markets that monetary policy in Switzerland was
not likely to be eased. In Germany, interest rates were
also lower than in most other countries, and economic
indicators for the first quarter were being interpreted in
the market as disappointing. Expectations developed
that the Bundesbank would cut interest rates as soon
as exchange market conditions permitted and U.S.
interest rates declined.
Although the upward pressure on European interest
rates subsided as the dollar declined during the spring,
the European monetary authorities were slower to
reduce interest rates than many market observers had
expected.
In the United Kingdom, the authorities were intent on
reassuring markets of their commitment to strict financial
policies. A cautious budget, presented in March, called
for both a drop in the public sector borrowing require
ment and reductions of growth targets for Britain’s two
monetary target variables, MO and M3. As interest rates
in the United States declined and capital inflows into
sterling exerted upward pressure on the pound, the
Bank of England allowed interest rates to ease some
what. But the authorities were perceived as acting to
slow the decline—an approach that appeared reason
able as long as the economic outlook for the United
Kingdom was more optim istic than for most other
countries. By late June, short-term interest rates were
still above 12 percent and differentials v/'s-^-v/'s dollar
interest rates were even wider than they had been early
in February.
In Germany, also, the Bundesbank did not judge the
domestic situation as warranting a change in the course
of monetary policy. The central bank saw the underlying
trend of economic activity still pointing upward. Central
bank money stock was growing close to the top of its
target path, buoyed by an acceleration of domestic
credit growth early in the year. The public sector in
particular was tem porarily having an expansionary
impact on monetary growth. And by late spring a public
debate had emerged over accelerating proposed tax
cuts. The Bundesbank did not wish to suggest that an
easing of policy was appropriate by announcing reduc
tions of its official rates. But it was willing to provide
sufficient liquidity to the banking system mainly through
repurchase agreements. These operations reduced
banks’ use of Lombard credit and guided day-to-day
money rates cautiously lower. By the end of June, threemonth money rates had eased 75 basis points from
Chart 7
Selected Interest Rates
Chart 8
Three-month m aturities*
United Kingdom
Percent
Movements in exchange rate and official
foreign currency reserves
Dollars per pound
1 .5 0 ---------------
Billions of dollars
1.5
- 0 .5
1984
1985
Exchange rates shown in this and the following charts
are weekly averages of noon bid rates for dollars in
New York.
1984
♦W eekly averages of daily rates.
1985
* Foreign exchange reserves for the United Kingdom
and other members of the EMS, including Germany,
incorporate adjustments for gold and foreign exchange
swaps against European currency units done with
the European Monetary Fund.
FRBNY Quarterly Review/Autumn 1985
57
levels of end-February, less than half the decline for
comparable rates in the United States.
The relative stability of interest rates in Germany was
a factor limiting the scope for interest rate declines in
other European countries. The authorities there had
accepted that domestic interest rates would remain
considerably higher than those in Germany because
inflation rates were higher and current account positions
were not as strong. Yet their currencies were being
buoyed relative to the mark by the inflow of interestsensitive capital. Under the circumstances, these central
banks also looked to relatively subtle techniques to ease
money-market rates gradually, so as not to suggest that
a change in policy was underway. The Bank of France,
for example, lowered its money market intervention rate,
acting cautiously by moving in several small steps. In
this way, short-term interest rates in France declined
somewhat more than in Germany. A more substantial
change in technique occurred in Belgium where the
National Bank decided to adopt a more flexible and
market related practice for fixing the discount rate.
Henceforth the discount rate was to be linked to the rate
on three-month Treasury certificates. As a result, a
decline that had already occurred in market rates was
acknowledged and rates continued to ease modestly
through the end of June.
Against this background, the authorities in many
European countries also chose to respond to the
favorable exchange market environment for their cur
rencies by acquiring foreign currency reserves. During
the second quarter a number of central banks were
active buyers of dollars either in the market or from
customers. They also purchased substantial amounts of
other currencies, especially the German mark, because
it is a currency frequently used for intervention within
the EMS and is of increasing importance in the reserve
holdings of other European countries. As a result of
these operations, many countries restored the reserves
lost during their intervention operations in late January
through early March. France and Italy had among the
largest increases in reserves. Germany’s increase was
the greatest, even though it refrained from intervening
for much of the period.
Meanwhile, the Italian lira had broken stride with the
other European currencies. During February it had risen
against the dollar more slowly than the others. As a
result, it had moved from the top to the bottom of the
narrow EMS band between early February and midMarch and then traded consistently about 11/2 percent
below the bottom-most currency in the narrow band
during the second quarter. Fiscal policy in Italy had been
expansionary, with the government deficit expected to
grow to 17 percent of GDP in 1985. Moreover, Italy’s
inflation remained high relative to that of other countries
and successive increases in wage settlements eroded
the country’s competitiveness all the more. Accordingly,
the current account had deteriorated, with imports of
capital goods quickening. Under these circumstances,
market participants came to anticipate that the Italian
authorities might welcome a decline in their currency.
Sentiment toward the lira was briefly buoyed in May
and June when the government’s position strengthened
with a defeat of a referendum reinstating wage index-
Chart 10
Chart 9
France
Germany
Movements in exchange rate and official
foreign currency reserves
Movements in exchange rate and official
foreign currency reserves
Marks per dollar
Billions of dollars
------
Francs per dollar
Billions of dollars
2.0
1.0
0
-
1.0
-
2.0
- 3 .0
- 4 .0
J
A
S O
1984
N
D
J
F
M
A M
1985
J
See notes on Chart 8.
58
FRBNY Quarterly Review/Autumn 1985
J
1984
See notes on Chart 8.
1985
ation and a smooth transition to a new presidency. But
by July the lira had resumed its slide toward its lower
EMS limit. This depreciation helped to offset the com
petitive disadvantage resulting from accumulated infla
tion differentials but removed room for movement of the
exchange rate within the wide band available to the lira
in the EMS arrangement. The Italian authorities there
fore decided to seek a realignment of the lira’s central
rates. Thus, after the lira dropped to its existing lower
limit in hectic trading on Friday, July 19, the authorities
closed the foreign exchange markets in Italy after the
fixing. That weekend the EMS countries agreed to a
realignment that took the form of a 7.8 percent deval
uation of the lira’s bilateral central rates against all other
active EMS members. As a result, the lira’s European
currency unit central rate fell by 7.7 percent while the
others rose by 0.15 percent.
The July realignment of the EMS served to focus
market attention on the risks of further adjustments in
the exchange rate relationships among European cur
rencies. Market operators began to hedge their bor
rowings in low interest rate currencies and their
investments in high interest rate currencies. The mon
etary authorities in countries like France and Belgium
found the scope for letting interest rates ease or for
adding to official reserves more circumscribed than
before. At the same time the Bundesbank found that the
exchange rate environment, together with a reaffirmation
of the governm ent’s policy of fiscal consolidation,
afforded an opportunity to let short-term interest rates
decline more quickly. A similar development occurred in
the Netherlands.
About the same time in July sentiment toward sterling
began to soften as well. The pound had risen progres
sively against the mark to levels that brought into
question B ritain’s com petitive position vis-a-vis its
European trading partners. Moreover, the earlier opti
mistic assessment of the country’s economic prospects
gave way to a more guarded outlook in the face of a
weakening flow of new orders and a flattening of output
growth. Market participants came therefore to expect the
Bank of England to permit a more rapid decline in
interest rates, even if the pound were to weaken as a
consequence. Indeed, during the month, money market
rates in London declined toward the 11 percent level
and favorable interest rate differentials relative to the
dollar narrowed by about one and one-half percentage
points. In response, sterling gave up some of its gains
vis-a-vis the mark late in the month.
Thus, the decline in the dollar in July came to be
reflected in a somewhat more rapid rise in the German
mark than before. Even so, at the end of the six-month
period under review, the pound had still risen from the
February lows against the dollar by more than the other
Chart 11
Movements in exchange rate and official
foreign currency reserves
Lira per dollar
1500
Billions of dollars
1.5
1600
1700
1800
1900
2000
Exchange rate
------Scale
2100
J
A
S O
1984
N
D
M A M
-
2.0
1985
See notes on Chart 8.
Chart 12
Percent D eviation of Selected EMS
C urrencies from th e ir B ilateral
C entral Rates*
EMS
Percent
realignm ent
*W e e kly averages of daily 9 a.m. rates.
"^"The Italian lira may fluctuate i 6 percent from its
central rate with other participating currencies.
FRBNY Quarterly Review/Autumn 1985
59
European currencies. It closed the period up 38 percent
from the end-February lows at $1.4350. The mark rose
25 percent during the same period to DM2.7800, with
the Swiss franc and most EMS currencies moving
roughly in line with the mark. The lira rose 18 percent
to LIT1872.
Japanese yen
The yen generally moved in line with European curren
cies against the dollar during the six-month period, but
its fluctuations were narrower. As the period opened,
market sentiment toward the yen was relatively positive.
An annualized 9 percent rise in GNP in the fourth
quarter of 1984 and optimistic projections for calendar
1985 compared favorably with the experience and out
look of other countries. Inflation remained low, with the
effect of the yen’s depreciation against the dollar offset
by its rise against other currencies and by the weakness
of world commodity prices, particularly petroleum.
Japan’s current account surplus had grown to a record
$35 billion in 1984. Thus the yen did not fall as rapidly
against the dollar as the European currencies during
February.
Japanese fiscal policy continued to be one of grad
ually reducing the government’s fiscal deficit as a pro
portion of GNP. The Bank of Japan maintained its
accommodative monetary stance, but the central bank
refrained from reducing its official lending rates, citing
as its main reason the need to support the yen in the
exchange markets.
After March the yen did not rise as rapidly as other
currencies against the dollar. Attention was often
focused on Japan’s huge long-term capital outflows—
which had reached $50 billion in 1984—as a major
potential source of unpredictable pressure against the
yen. At times during the period, the yen’s performance
in the exchange market— as well as credit market
developments in both Japan and the United States—was
influenced temporarily by reports and rumors about
possible changes in rules or preferences governing
Japanese investment abroad. In any case, the yen did
not benefit, as did the European currencies, from a
favorable shift of capital flows late in the period under
review. Long-term capital outflows, as measured in
Japanese net purchases of foreign bonds, actually grew
larger to set new records in June and July. But since a
greater proportion of the outward investment by Japa
nese residents than before was thought to be hedged
through forward foreign exchange transactions and
short-term dollar borrowings, the resulting pressures
against the yen were substantially mitigated.
Rising foreign protectionist threats against Japan, and
demands that the Japanese government step up its
actions to reduce the trade imbalance, also attracted
60
FRBNY Quarterly Review/Autumn 1985
Chart 13
Japan
Movements in exchange rate and official
foreign currency reserves
Yen per dollar
Billions of dollars
235------------------------------------- -------------------------------------------- 0.8
Exchange rate
1984
1985
See exchange rate footnote on Chart 8.
attention in exchange markets at times as a potentially
negative background factor for the yen. Generally,
however, such pressures did not have im m ediate
exchange-rate influences. Announcements in April and
June of new Japanese government programs to open
domestic markets by reduced tariffs, liberalized invest
ment rules, and adm inistrative reform s had little
apparent impact on the yen rate at the time.
By the end of the period, Japanese foreign currency
reserves had risen by almost $1.2 billion to $2.38 billion,
largely reflecting interest earnings.
Canadian dollar
The Canadian dollar, like other currencies, weakened
considerably against the U.S. dollar early in the period.
The rise in U.S. interest rates during January and Feb
ruary fanned renewed debate over priorities for mone
tary and fiscal policies in Canada. Inflation in Canada
had stabilized under 4 percent on a year-on-year basis
but the unemployment rate had recently moved back
over 11 percent. Market participants, noting that Can
ada’s traditional interest rate advantage had dwindled
to about one percentage point by early February,
questioned the willingness of Canadian authorities to
permit increases in interest rates comparable to those
in the United States. Moreover, uncertainty developed
as to whether Canada’s newly elected government
would deal decisively with its plan to reduce the budget
deficit and improve the investment climate. At the same
time unease developed surrounding potential capital
outflows related to the acquisition by Canadians of
foreign-owned assets in the petroleum sector.
Chart 14
Chart 15
Canada
Interest Rates in Canada and the
Eurodollar Market
Movements in exchange rate, o fficia l foreign
cu rre n cy reserves, and in te re st d iffe re n tia l
Canadian dollars per dollar
Three-month m a tu ritie s*
Billions of dollars
2.0
Exchange rate
y T A •*------ bcaie
Percent
14
1.5
Foreign currency
1.0
^
S ca le ----- ►
0.5
B
0
- 0 .5
LI
I I I
I
I
IV
|
|
I
I
I
-
1.0
Percent
7
2
2
J
A
S
O
1984
N
D
J
F
M
A M
1985
*W eekly averages of daily rates.
1
0.
0
J
A
S O
1984
N
D
J
F
M
A M
1985
J
J
See exchange rate footnote on Chart 8.
♦C anadian finance paper minus Eurodollars.
Weekly average of daily rates.
Against this background, sentim ent toward the
Canadian dollar deteriorated sharply. Speculative selling
and an adverse shift in commercial leads and lags put
pressure on the exchange rate which fell to an all-time
low of Can.$1.4070 ($0.7107) early in March, a decline
of 6 percent from the end of January. The authorities
intervened heavily to moderate the decline, financing
their dollar sales by drawing on the government’s credit
lines with commercial banks and borrowing in the
Eurodollar market. Moreover, the Bank of Canada
allowed interest rates to rise more sharply than U.S.
rates, and the currency’s interest rate advantage wid
ened to 21/2 percentage points.
These developments helped to convince market par
ticipants that the authorities’ approach to the exchange
rate had not been changed. In addition, the Canadian
government announced plans for tax increases and
expenditure cuts to reduce the fiscal deficit together with
legislation to remove impediments to foreign investment
in Canada, thereby reducing uncertainty further. More
over, a strong external performance, signs of a pickup
in the domestic economy, and low wage settlements
provided a more encouraging outlook for the currency.
Thus, the Canadian dollar recovered after mid-March
most of the ground it lost earlier in the period to close
at Can.$1.3539 ($0.7386), down only 2 percent on bal
ance over the six months. Under these circumstances,
interest differentials eased back to fluctuate around
1 1/ 2 percentage points over the remainder of the period.
The Bank of Canada made net dollar purchases as its
currency rose, which it used to repay debt on its com
mercial bank credit lines and bolster reserves. In addi
tion, a further U.S. dollar borrowing in the U.S. market
served to boost the level of foreign exchange reserves.
By the end of July, foreign exchange reserves were up
$498 million over the period under review at $2.1 billion.
Selected Latin American currencies
During the six months under review, two major Latin
American countries, Mexico and Argentina, introduced
new economic packages that included, among other
measures, reforms to their respective foreign exchange
systems. In the case of Mexico, this package was
designed to get its stabilization efforts of the past three
years back on track. In the case of Argentina, the task
was to embark on major reforms to reverse long fes
tering economic imbalances that were being reflected in
spiraling inflation rates.
FRBNY Quarterly Review/Autumn 1985
61
Mexico
Mexico had posted a significant improvement in its trade
account, which had swung from a deep deficit into sur
plus in 1983 and 1984. However, the surplus had sub
sequently narrowed. During the first four months of this
year, the weakening of Mexico’s external position was
being accentuated by a nearly 10 percent fall in total
exports. Oil shipments dropped in the face of weakening
prices elsewhere, the competitiveness of non-oil exports
declined with a real appreciation of the “ controlled”
exchange rate, and the pressures of increasing internal
demand deflected production to the home market. Under
these circumstances, Mexico’s current account surplus
for all of 1985 was also expected to diminish, notwith
standing the reduction of interest payments stemming
from declining interest rates.
Meanwhile, Mexico’s fiscal deficit through June rose to
well above target levels. The budget overrun reflected the
lower-than-anticipated oil revenues and increased gov
ernment spending resulting partly from higher-thanexpected inflation and greater internal interest payments.
In response to these pressures, beginning in late May
the discounts widened between Mexico’s “ controlled”
exchange rate for licensed transactions and the two free
market rates—the internal “ free” rate and the “ superfre e ” rate across the M exican border. Thus, the
improvement in the foreign exchange position of the
Mexican peso, which had occurred in late March and
in April following announcement of new understandings
with the IMF on 1985 economic policies and the signing
62
FRBNY Quarterly Review/Autumn 1985
of the first phase of Mexico’s multi-year rescheduling,
quickly dissipated. By late spring the external market
was subject to recurring rumors of an impending peso
devaluation, an increase in the daily rate by which the
authorities adjusted the crawling “ controlled” rate, and
cuts in oil export prices. By mid-July, the gaps between
exchange rates for the peso were increasingly large.
Exporters had the incentive to delay or divert revenues
required to be converted in the “ controlled” market to
either the domestic “ free” market or the external,
“ super-free” market. Also, the volume of trading in the
internal “free” market diminished substantially. Thus, the
widening gap of peso rates was a source of growing
concern to the authorities.
To deal with this situation, the Mexican authorities
adopted a series of measures, starting in mid-June.
Under M exico’s procedures for licensing im ports,
exporters were granted certificates of importation rights
(called “ DIMEX” ), permitting them to import without
license a range of raw materials and inputs to make
their operations more efficient. Effective June 28, Mex
ican banks were allowed to operate in the foreign
exchange market at the “ super-free” rate by establishing
trading houses designed for this purpose. After the
Mexican banks were able to participate in the “ superfree” market via their trading houses, they became
major intermediaries in that market. Then, on July 11,
the Mexican banks, supported by the monetary author
ities, decided to stop trading at the internal “free” rate.
As a result transactions were switched from the “ free”
market, where the peso was trading at 247.3 pesos per
dollar the day before, to the “ super-free” market, where
the peso was at 312.0 pesos per dollar before the
announcement of this change. This switch constituted
a 26 percent devaluation for transactions not eligible for
the “ controlled” rate. Then on July 25, the Mexican
government announced additional economic reforms
including:
• A 17 percent devaluation of the ‘ ‘c o n tro lle d ”
exchange rate, from 232 to 279 pesos per dollar.
• The introduction of a “ regulated float” to replace the
earlier crawling system involving a fixed, daily slide
of the peso against the dollar for the “ controlled”
market.
• Elimination of import permits on goods accounting
for about 37 percent of its imports, thereby making
a total of over 60 percent of Mexican imports sub
ject to tariffs rather than non-tariff barriers, and a
further enlargement of the “ DIMEX” arrangements.
• A cut in c u rre n t g o vernm en t e x p e n d itu re s ,
Chart 17
Mexican In fla tio n Rate
Percent
1 20 ------------------------------------------------------
1982
1983
1984
1985
Sources: International Monetary Fund, International
Financial S ta tis tic s : and Banco de Mexico,
Informe Anual.
amounting to 150 billion Mexican pesos during
1985, that entailed a 20 percent cut in budgeted
expenditures on goods, the elimination of several
highly visible government positions, and major
cutbacks in expenditures by public enterprises.
The purpose of these reforms was twofold. First, they
were expected to relieve demand pressures in the
economy coming from the public sector. Second, they
were intended to improve competitiveness by adjusting
the exchange rate and by opening the domestic market
to lower-priced imports for raw materials, intermediate
products, and capital goods.
During the period between the announcement of the
abolition of the internal “ free” market and the rest of
the economic reforms, the peso weakened sharply as
Mexican residents rushed to buy dollars in anticipation
of a further devaluation. By July 24, the market rate in
Mexico and abroad had fallen a further 20 percent to
374 pesos per dollar, and the discount relative to the
“ controlled” rate widened to more than 60 percent. But
by the end of July, the peso recovered to 354.50 pesos
per dollar, and the discount from the “ controlled” rate
narrowed to about 27 percent.
Argentina
In Argentina a newly constituted democratic government
had been attempting to grapple with a debilitating wage/
price spiral without jeopardizing promised increases in
real incomes. But the domestic economy was in severe
disequilibrium. The central bank had monetized years
of oversized fiscal deficits. It found that, with public
sector wage increases and fiscal policy stimulating
demand, efforts to restrict excessive bank lending
through interest rate ceilings and credit allocation
schemes led to a diversion of financing to an informal
inter-company market.
Argentine officials had repeatedly spoken of the need
for programs to stabilize the economy over time by
tightening monetary and fiscal policies. As recently as
December 1984, Argentina had announced a 15-month
standby arrangement with the IMF. But the country was
from the start not in compliance with the standby pro
visions and the rise in Argentina’s inflation rate con
tinued to accelerate. In the process, the strategy of
gradual adjustment had lost credibility. By early 1985 the
internal chaos wrought by an economy reeling toward
hyperinflation provoked political demands for a new
approach that promised quicker results, even if the
approach involved immediate sacrifice.
Thus, in March President Alfonsin, with a new economic
team, began to adopt a series of new measures to
achieve rapid adjustment and a radical restructuring of the
economy. First, regulated deposit rates were raised to
levels comparable to the monthly inflation rate. Interest
rates were deregulated on some bank liabilities to attract
funds back into the banking system where the authorities
could exert more control on credit creation. Public utilities
also raised prices significantly to increase revenue.
On June 11, the government announced an 18 per
cent devaluation of the Argentine peso in the official
market. Previously, the government had implemented
“ mini-devaluations” rarely exceeding 4 percent, and
averaging about 1 percent per day to adjust for the
inflation differentials between Argentina and other
countries. Following this action, and amid rumors of
dramatic economic measures, the premium which
Argentine residents had to pay for dollars in the parallel
market widened to 35 percent.
Then on June 14, President Alfonsin announced a
package of bold economic reforms, centering on a
further, substantial cut in the fiscal deficit and a pledge
to stop monetizing the deficit. The deficit, which had
fluctuated in the range of 10 to 12 percent of GDP
since the end of 1983, was to be slashed to only 2.5
percent for the second half of this year. In support of
this plan, price and wage ceilings were fro ze n —
actions described as interim steps toward eliminating
the country’s price and wage indexation system that
FRBNY Quarterly Review/Autumn 1985
63
Chart 19
Chart 18
Argentine Inflation Rate
Argentine Currency
Dollar exchange
rate for p e s o *
Dollar exchange
rate for a u s t r a l *
Percent
1250 —
10 00
750
500
250
L......
1982
*O ne austral = 1,000 pesos (weekly observations).
was perpetuating Argentina’s inflation problem.
In addition, currency reform was instituted to replace
the Argentine peso with a new currency, the austral, at
a rate of 1000 pesos to 1 austral. Effective June 16, the
austral was given a fixed parity of 80 austral cents to
the U.S. dollar.
On the basis of these measures the government was
able to shore up Argentina’s external financing position
and reduce cash flow problems. It completed negotia
tions for reactivating the IMF program, which was
approved on August 9. It also took steps to reduce
interest arrears on public sector debt, using funds from
64
FRBNY Quarterly Review/Autumn 1985
I
1983
I
1984
I
1985
Sources: International Monetary Fund,
International Financial Statistics.
official reserves and drawing upon a multilateral bridge
financing facility backed by the monetary authorities of
the United States and 11 other participating countries.
The government’s actions also set the stage for com
pletion of a rescheduling agreement and a new lending
program with commercial banks.
The announcement of the government’s adjustment
program was generally well received in Argentina. In the
exchange market, too, the Argentine currency appeared
to have gotten a steadier footing by late July. Capital
inflows began to materialize, taking the form at least in
part of a reversal of commercial leads and lags.
NEW PUBLICATION
The Federal Reserve Bank of New York has issued a revised and expanded
version of its booklet, Open Market Operations.
The 48-page booklet by Paul Meek gives an insider's view of the mechanics
of open market transactions and the implementation of monetary policy. The
booklet evolved from four earlier editions by Mr. Meek. It is now directed at
undergraduate students of economics, participants in the financial markets,
and the general public.
Mr. Meek retired earlier this year as vice president and monetary adviser
in the New York Fed’s open market operations area.
Topics covered in the booklet include:
• How the New York Fed carries out open market operations on behalf of
the Federal Reserve System by purchasing securities to supply reserves to
the banking system and selling securities to withdraw reserves;
• The significance of Federal Reserve float, Treasury cash balances, and
currency in circulation in managing bank reserves; and
• The trading desk’s daily agenda, as well as Federal Open Market Com
mittee meetings with primary dealers and conferences with representatives of
the Treasury and Board.
Single copies of Open Market Operations are available free from the Public
Information Department, Federal Reserve Bank of New York, 33 Liberty Street,
New York, N.Y. 10045. Reasonable quantities are available upon request.
Subscriptions to the Quarterly Review (ISSN 0147-6580) are free. Multiple copies
in reasonable quantities are available to selected organizations for educational
purposes. Write to Public Information Department, 33 Liberty Street, New York, N.Y
10045 (212-791-5000). Single and multiple copies for United States and for other
Western Hemisphere subscribers are sent via third- and fourth-class mail, respec
tively. All copies for Eastern Hemisphere subscribers are airlifted to Amsterdam,
from where they are forwarded via surface mail. Multiple-copy subscriptions are
packaged in envelopes containing no more than ten copies each.
Quarterly Review subscribers also receive the Bank’s Annual Report.
Quarterly Review articles may be reproduced for educational or training purposes
only, providing they are reprinted in full, distributed at no profit, and include credit
to the author, the publication, and the Bank.
Library of Congress Catalog Card Number: 77-646559
@FedFRASER