Full text of Economic Policy Review (Federal Reserve Bank of New York) : Autumn 1988, Vol. 13, No. 3

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Federal
Reserve Bank of
NewYbrk

Quarterly Review




Autumn 1988

Volume 13 No. 3

1 Strengthening International Economic
Policy Coordination
6

A Review of Federal Reserve Policy
Targets and Operating Guides in
Recent Decades

18 The Globalization of Financial Markets
and the Effectiveness of Monetary
Policy Instruments
28

Interest Rate Divergences among the
Major Industrial Nations

45

Estimating the Funding Gap of the
Pension Benefit Guaranty Corporation

60

In Brief
Economic Capsules

67

Treasury and Federal Reserve
Foreign Exchange Operations

This Quarterly Review is published by
the Research and Statistics Group
of the Federal Reserve Bank of New
York. Remarks of E. GERALD
CORRIGAN, President of the Bank,
on strengthening international
econom ic p olicy coordination begin
on page 1. Among the staff members
who contributed to articles in this issue
are ANN-MARIE MEULENDYKE (on a
review of Federal Reserve p olicy targets
and operating guides in recent decades,
page 6); LAWRENCE J. RADECKI and
VINCENT REINHART (on the globalization
of financial markets and the effective­
ness of monetary p olicy instruments,
page 18); BRUCE KASMAN and CHARLES
PIGOTT (on interest rate divergences
among the m ajor industrial nations,
page 28); and ARTURO ESTRELLA,
BEVERLY HIRTLE, and JOHN A. BREHM
(on estimating the funding gap of
the Pension Benefit Guaranty
Corporation, page 45).
Among the staff members who contributed to
In B rief —Economic Capsules are
SUSAN HICKOK and THOMAS KLITGAARD
(on U.S. trade with Taiwan and
South Korea, page 60).
A quarterly report on Treasury and
Federal Reserve foreign exchange
operations for the period August
through O ctober 1988 starts on
page 67.




Strengthening International
Economic Policy Coordination
Good evening, ladies and gentlemen. I am delighted
and honored to have this opportunity to address you as
a part of the ongoing Olin Fellowship Program here at
Fairfield University.
The subject I would like to peruse with you is the
rapidly changing character of the global economic and
financial system. My principal message is that the
changes we are seeing in the global economy make it
important that we strengthen the process of multilateral
economic policy coordination and cooperation.
For the typical citizen here in the United States,
symptoms of the changed character of the world econ­
omy surround us. When our clock radio —which is
probably imported —awakes us, the morning news will
usually include a report on overnight stock market
developments in Tokyo, the dollar-deutsche mark
exchange rate in Frankfurt and the London gold price
fixing. Many drive to work in imported cars and even
those driving domestic cars probably know that their
car is better and cheaper because of the competition
of imports. Once in the work place, elements of inter­
national trade and finance now have a significant direct
or indirect bearing on virtually any type of business
enterprise I can imagine —small or large. Indeed,
whether it is gyrations in the world price of oil, changes
in the dollar exchange rate, or changes in interest rates
in a major foreign capital, none of us is insulated from
economic and financial developments occurring far
beyond our national boundaries.
The extent to which these symptoms of the changed
Remarks by E. Gerald Corrigan, President of the Federal Reserve
Bank of New York, before the Olin Fellowship Program of the Fairfield
University School of Business, October 11, 1988.




character of the world economic and financial system
abound in our daily lives is, in some respects, a more
recent phenomenon in the United States than in most
other countries of the world. This is so in part because
our economy is so large relative to others and in part
because we are more economically self-sufficient than
are most of the other nations of the world. But, to para­
phrase the English poet John Donne, no nation is an
island, even a nation as large, as dynamic, and as rich
as ours. The energy shocks of the 1970s, the behavior
of world equity markets last fall, and our large trade
and payment imbalances remind us of that in blunt
terms.
Whether it is gyrations in the world price of oil,
changes in the dollar exchange rate, or changes in
interest rates in a major foreign capital, none of
us is insulated from economic and financial
developments occurring far beyond our national
boundaries.

One consequence of this, of course, is that to a
greater extent than was once the case our economic
well-being is more closely tied to the economic well­
being of others, just as theirs is even more tightly
bound up in how we manage our affairs. This, of
course, is why each nation of the world, but especially
the major nations of which the United States remains
the most important, must increasingly view its pros­
pects and its problems in a global context and in a
manner that guards against the dangers of myopic

FRBNY Quarterly Review/Autumn 1988

1

approaches to economic policy. Let me cite an example
or two of the dangers I have in mind.
• First, we all know that one of the pillars of growth,
prosperity, and rising standards of living on a
worldwide basis is to be found in free, open, and
fair trade between nations. Yet, as we look around
the world, it is quite apparent that the maintenance
and strengthening of practices and policies that
are consistent with the principle of free trade can­
not be taken for granted. For example, protection­
ist sentiments are lurking in the shadows here in
the United States; the further economic and finan­
cial integration of Europe planned for 1992 is
viewed by some as a move toward a “ fortress
Europe” that will be open internally but closed
externally; finally, several nations in the Pacific
Basin continue to record very large trade and pay­
ment surpluses in a context in which there is at
least a question as to how open those economies
are to imported goods and services.
I cite these examples not because I believe any

One of the pillars of growth, prosperity, and rising
standards of living on a worldwide basis is to be
found in free, open, and fair trade between
nations. Yet, as we look around the world, it is
quite apparent that the maintenance and
strengthening of practices and policies that are
consistent with the principle of free trade cannot
be taken for granted.
one of them represents a clear and present danger
to the world trading system that has flourished in
the postwar period. Rather, my point is that each
of them reflects concerns and attitudes in one
country or group of countries that, at least in part,
reflect conditions or perceived attitudes in other
countries. Protectionism is at work in the United
States partly because of concerns about imports
but more so because of perceptions of foreign
markets being closed to U.S. goods and services.
Similarly, at least part of the motivation for Euro­
pean economic integration seems to be spurred by
concerns about protectionism in the United States,
the Canadian-United States trade agreement, and
the apparent technological gap between the
United States and Japan on the one hand and
Europe on the other.
This linkage in attitudes — however loose and
imprecise it may be —is potentially of great impor­
tance since it implies that if one nation or group of

2 FRBNY Quarterly Review/Autumn 1988




nations begins to slip into a more protectionist
mode, retaliatory actions by others could follow
swiftly. Should that begin to occur, we would find
ourselves confronting not only a clear and present
danger to world trade, but also a major threat to
growth and prosperity on a worldwide scale.

If one nation or group of nations begins to slip
into a more protectionist mode, retaliatory actions
by others could follow swiftly. Should that begin
to occur, we would find ourselves confronting not
only a clear and present danger to world trade,
but also a major threat to growth and prosperity
on a worldwide scale.

• Seoond, we all know that the United States trade
deficit is unsustainable, but what is not always
clear is the recognition that there are limits as to
how and how quickly that deficit can be eliminated
in a context of noninflationary growth in the United
States and the world economy. For one thing, we
in the United States simply do not have the indus­
trial capacity or the slack in labor markets needed
to generate the output of manufactured goods that
would be needed to eliminate the trade deficit in
the near term. Partly for that reason, but also
because of the nature and size of the adjustments
required in the surplus nations, the elimination of
the trade deficit in the context of growth must be
viewed over a time horizon of several years and in
a context in which success depends not just on
what we do but also on the policies and perfor­
mance of trading partners. Fortunately, the initial
phases of the adjustment process are now well
underway, but we still have a very long way to go.
The elimination of the trade deficit in the context
of growth must be viewed over a time horizon of
several years and in a context in which success
depends not just on what we do but also on the
policies and performance of trading partners.

• Third, the fact that it will take some time to wind
down our trade deficit points to another area in
which we must exercise vision and patience, and
that relates to the growth of foreign investment in
the United States. One does not have to look very
long or very hard to find expressions of concern
about the speed with which foreigners are accu­
mulating assets —both securities and hard invest-

merits — in the United States. Those concerns are,
in some respects, understandable, but the hard
fact of the matter is that as long as we have cur­
rent account deficits, foreign investment in the
United States must increase.
The hard fact of the matter is that as long as we
have current account deficits, foreign investment
in the United States must increase.

Stated differently, current account deficits —like
all deficits —must be financed and, one way or
another, the financing of the current account deficit
will manifest itself as a net increase in foreign
holdings of United States assets. Indeed, it is pre­
cisely the cumulative effects of the string of large
current account deficits over recent years that —in
a proximate sense —account for the substantial
change in our net financial position with the rest of
the world over that period.
That is, if we go back to 1981, which was the last
year in which the United States had a current
account surplus, the stock of U.S.-owned foreign
assets exceeded the stock of U.S. assets owned
by foreigners by about $140 billion. At the end of
this year, the stock of U.S. assets —stock, bonds,
government securities, factories, farm land, real
estate, and so forth —owned by foreigners will
exceed the stock of U.S. foreign assets by some­
thing close to $500 billion. As a very rough approx­
imation, that swing in balance sheet terms from a
net foreign asset position of $140 billion to a net
liability position of about $500 billion reflects the
cumulative sum of the current account deficits we
have incurred since 1981. In addition, because
those net foreign obligations must be serviced, we
now face a situation in which the current account
deficit is larger than the trade deficit.
Looked at somewhat differently, even if we
assume a straight-line adjustment to current
account balance over the next few years, we are
still looking at prospective current account deficits
that will almost surely aggregate to at least a cou­
ple of hundred billion dollars. But, whatever the
precise amount, net holdings of U.S. assets by for­
eigners will increase by about that amount. The
issue, therefore, is not whether we are happy with
that outcome —which, by the way, brings with it
many beneficial results. The issue is how do we
and others manage our affairs so that the prospec­
tive deficits are financed in the most painless way
possible and that we and others follow through on




the policy initiatives needed to better insure that
the underlying imbalances in trade and payments
will be rectified.
The examples I have just cited, bearing as they do
on the persistent and large international trade and pay­
ment imbalances in the world economy, are illustrations
of why it is so important that policies are aimed at the
causes, not the symptoms, of these problems and why
it is so very important that we find even more effective
ways to cope with these problems in a framework of
international cooperation and coordination.

The issue is how do we and others manage our
affairs so that the prospective deficits are
financed in the most painless way possible and
that we and others follow through on the policy
initiatives needed to better insure that the
underlying imbalances in trade and payments will
be rectified.

That, of course, has not been, and will not be, easy
because the underlying causes of these imbalances
reflect both national and international considerations
and because they reflect both macroeconomic and
structural or microeconomic forces that have built up in
the global economy over a long period of time. In the
United States, for example, the heart of the problem
lies with the combination of large budget deficits and a
very low rate of net private savings. But those macro
elements in the United States have been compounded
by other factors such as cost and quality deficiencies in
at least some sectors of U.S. manufacturing industries.
In Europe, sub-par growth in domestic demand, rela-

The underlying causes of these imbalances reflect
both national and international considerations and
they reflect both macroeconomic and structural or
microeconomic forces that have built up in the
global economy over a long period of time.

tively high rates of unemployment, and various struc­
tural rigidities have also contributed to these imbal­
ances over time. In Japan and the Pacific Basin, very
high savings rates, the historic orientation to export
industries, and the visible and invisible barriers to
imports have also played a role, as has the debt crisis
in much of the developing world. And all of these fac­
tors have, to a degree, been amplified by the extreme
gyrations and volatility in exchange rates that have

FRBNY Quarterly Review/Autumn 1988 3

characterized the last decade or so.
Fortunately, and reflecting in part the efforts of the
G-5 and G-7 Ministers of Finance and Central Bank
Governors, the last few years have witnessed an inten­
sified effort to attack these problems on both a national
and an international scale. And those efforts are
clearly bearing fruit. The composition of output in
Japan, the United States, and much of Europe has
shifted in the right direction even as growth has been
maintained; inflation has been reasonably well con­
tained; the U.S. trade deficit in real GNP terms has
fallen from a peak of $157 billion in the third quarter of
1986 to $90 billion in the second quarter of 1988; bilat­
eral and multilateral efforts aimed at more open mar­
kets abroad are having a measure of success even if
the going is tough and slow; productivity and quality
gains in U.S. manufacturing are clear and impressive;
and the general pattern of behavior in exchange mar­
kets in recent months is distinctly more constructive.
But, as I said earlier, we still have a long way to go.
To successfully complete the transition to a more bal­
anced world economy surely means that each country
must address its own problems. But, in my view, it also
means that we must redouble efforts aimed at greater
elements of international policy cooperation and coor­
dination, including broad-based financial, political, and
moral support for the key multilateral official institutions
such as the International Money Fund, the World Bank,
and the General Agreement on Tariffs and Trade.

To successfully complete the transition to a more
balanced world economy surely means that each
country must address its own problems. But, in
my view, it also means that we must redouble
efforts aimed at greater elements of international
policy cooperation and coordination.
In urging this, I recognize that there are skeptics who
question how much has been, or can be, achieved
through the efforts of, say, the G-5 or G-7. The skeptics
point out that governments are not prepared to cede
sovereignty; that is true. They point out that the pro­
cess is inevitably confronted with conflicting objectives;
that is true. They point out that the tools available for
coordination are imperfect at best; that is true. They
point out that some aspects of the process —perhaps
especially the economic summits of the heads of state
—appear to be short on substance and long on cere­
mony; that may also be true. But what they fail to point
out is the alternative.
I, for one, don’t really see an alternative other than
each country slowly but inexorably drifting in the direc­

4 FRBNY Quarterly Review/Autumn 1988




tion of beggar-thy-neighbor attitudes and policies that
can only work to the detriment of all. More importantly,
on the positive side of the ledger, I also believe that
efforts to date have played a distinctly positive role in
getting the necessary adjustment process moving in
the right direction. Indeed, even if the process has
done nothing more than help each country see its own
economic problems and prospects as others see them,
the process has value.

Efforts to date have played a distinctly positive
role in getting the necessary adjustment process
moving in the right direction. Indeed, even if the
process has done nothing more than help each
country see its own economic problems and
prospects as others see them, the process has
value.

Since I believe the process has done that and more,
I believe we should build on our success and seek out
ways to further strengthen the spirit, and the sub­
stance, of international economic policy coordination.
In saying this, I am mindful that we must guard against
inflated expectations as to what can be achieved. Sim­
ilarly, we surely must guard against the illusion that
policy coordination can take individual countries —
including the United States —off the hook in terms of
the things they must do in their own right. Looked at in
this light, policy coordination is not, nor can it ever be,
a substitute for sound and disciplined policies on the
part of individual countries. But, at the very least, inter­
national communication, cooperation, and coordination
can help to provide a framework that supports the dic­
tates of discipline on the part of individual countries
while at the same time reinforcing the mutuality of
interests among nations. In addition, the process as a

Policy coordination is not, nor can it ever be, a
substitute for sound and disciplined policies on
the part of individual countries. But, at the very
least, international communication, cooperation,
and coordination can help to provide a framework
that supports the dictates of discipline on the part
of individual countries while at the same time
reinforcing the mutuality of interests among nations.

whole breeds familiarity among the participants, a
familiarity that can be absolutely invaluable when
adversity strikes suddenly, as for example when the
debt crisis exploded in the summer of 1982 or when

worldwide equity markets collapsed last fall.
To put this in a slightly different perspective, let me
share with you an excerpt from a letter written by one
leading international economic statesman to another.
The excerpt reads as follows:
“ I have always taken the position that both you
and we had three possible courses in our relations
with each other. One was to deal wholly indepen­
dently with our respective problems, without any
relations, and in complete ignorance of what the
other was doing, in other words to ignore each
other; another might be to pursue a wholly selfish
policy, each disregarding completely the interests




of the other, and possibly pursuing a policy antago­
nistic to the other; and the third might be to adopt
a policy of complete understanding, and exchange
of information and views, and to cooperate where
our respective interests made it possible. How can
there be any choice between these three, nor any
ground of complaint, so long as we are right and
not afraid of our critics?”
That letter, ladies and gentlemen, was written by
Benjamin Strong, Governor of the Federal Reserve
Bank of New York, to Montagu Norman, Governor of
the Bank of England, on March 21,1921. Perhaps there
really is nothing new under the sun.

FRBNY Quarterly Review/Autumn 1988 5

A Review of Federal Reserve
Policy Targets and Operating
Guides in Recent Decades
In March 1951, the Federal Reserve regained the
power to conduct an active monetary policy that it had
relinquished during the Second World War. The occa­
sion was the signing of the Treasury-Federal Reserve
Accord permitting a move away from the pegged inter­
est rates that had helped to hold down the cost of Trea­
sury financing. The Accord made it possible for the
Federal Reserve to make adjustments to its monetary
policy stance in pursuit of its ultimate goals of eco­
nomic expansion and price stability. While those goals
have not changed in the ensuing three and a half
decades, the intermediate and operational targets of
policy have been subject to several significant shifts.
This article traces the development of Federal Reserve
monetary policy and operating targets since the Accord
and discusses the modifications that were made to
them.
The Federal Reserve needs intermediate targets and
indicators of policy because it does not have the
means to achieve the ultimate goals directly. The Fed-

This article draws heavily on the annual reports prepared by the
Manager of the System Open Market Account for the FOMC and on
policy records and directives. Beginning with the 1962 report, large
portions of the Manager’s reports have been published. The annual
report for 1962 appeared in the Federal Reserve Bulletin (as did
some of the reports for the 1970s). The reports for 1963 through 1969
appeared in the Annual Report of the Board of Governors of the
Federal Reserve System. Subsequently, the reports appeared in the
New York Reserve Bank’s Monthly Review or Quarterly Review.
Additional information was obtained through conversations with
John Larkin, Fred Levin, Paul Meek, Robert Roosa, Irwin Sandberg,
Peter Sternlight, and Robert Stone, who were at the Desk during
many of the years covered. Stephen Axilrod and Donald Kohn of the
Board of Governors also provided insights. Other source material is
listed in footnotes and in the Appendix.

FRBNY Quarterly Review/Autumn 1988



eral Open Market Committee (FOMC), which directs
monetary policy for the Federal Reserve, developed
intermediate targets that were linked, at least indirectly,
to the ultimate goals and subject to indirect Federal
Reserve control. Because the FOMC lacked the tools
to realize even the intermediate objectives over short
periods of time, it also developed reserve operating
targets that it could achieve promptly, using the policy
tools available to it. The Board of Governors of the
Federal Reserve System had the authority to affect the
banks’ demand for reserves through the policies it
established with respect to reserve requirements, the
discount rate, and the rules of access to the discount
window. The FOMC had the means to affect the supply
of bank reserves by instructing the Trading Desk at the
Federal Reserve Bank of New York to carry out open
market purchases or sales of securities. These policy
tools could be manipulated to bring about some
desired behavior of the operating targets.
Overview
In the 1950s and 1960s, the behavior of bank credit
generally served as the primary intermediate objective.
It was joined by money beginning in the latter part of
the 1960s. Various monetary aggregates became the
primary intermediate targets in the 1970s. Money
received its greatest emphasis in the late 1970s and
early 1980s. During the 1980s, as the demand for
money seemed to change in a fundamental way, the
Committee treated its monetary targets more flexibly
and sought to supplement them with other indicators.
The immediate operating targets have, in a sense,
come full circle since the 1950s: the FOMC initially tar­

geted free reserves and then shifted to federal funds
rates, to nonborrowed reserves, and most recently to
borrowed reserves, a measure similar in many ways to
free reserves.1
All of the target variables and indicators that have
been used over the years are interrelated. Whenever
reserve measures have been the primary operating tar­
get, interest rates have played a role in modifying the
policy response, and vice versa. But the existence of
such relationships does nothing to diminish the impor­
tance of the principal target; the selection of this target
influences how the Federal Reserve will respond to
price behavior and to new developm ents in the
economy.

encourage the return of an efficiently functioning Gov­
ernment securities market with “ depth, breadth, and
resiliency.” The subcommittee made its recommenda­
tions at the end of 1952.4 It emphasized that the secu­
rities markets would function better if policy operations
were conducted in ways that showed the public that the
Federal Reserve was no longer setting interest rates,
and that gave a large number of dealers the oppor4“ Federal Open Market Committee Report of Ad Hoc Subcom m ittee on
the Government Securities Market,” reprinted in The Federal Reserve
System after Fifty Years, Hearings before the Subcom m ittee on
Domestic Finance of the House Committee on Banking and Currency,
88th Cong., 2d sess. (Washington, D.C.: GPO, 1964), vol. 3,
pp. 2005-55.

1953-65: bank credit and free reserves
The Federal Reserve gradually resumed its pursuit of
monetary policy goals a fter the Treasury-Federal
Reserve Accord freed it from the obligation to support
a pattern of pegged rates on Treasury debt issues.
Before the Accord, the Treasury had insisted that the
Federal Reserve continue the practice, begun during
World War II, of standing ready to buy or sell Treasury
securities at posted rates. By 1950, the FOMC was
convinced that rates were being held too low, partic­
ularly in view of the stimulus to economic growth and
to speculative buying associated with the Korean War.
The low rates were contributing to excessive provision
of reserves and s ig n ific a n t in fla tio n . The FOMC
believed that a return to an independent monetary pol­
icy was essential if inflation were to be contained. It
negotiated with the Treasury for a number of months to
reach the Accord.2
After the Accord, the Federal Reserve gradually with­
drew its support of rates.3 The FOMC created a sub­
committee to investigate how the Federal Reserve
could best carry out an active monetary policy and
’ Mechanically, the behavior of free and borrowed reserves only differ
when excess reserves change. The various reserve measures are
defined in the Box.
2Allan Sproul, who participated in the negotiations as President of the
Federal Reserve Bank of New York, offered an interesting
com m entary on the process in “ The ‘A c c o rd ’ — A Landm ark in the
First Fifty Years of the Federal Reserve System ," in Lawrence S.
Ritter, ed., Selected Papers of Allan Sproul, D ecem ber 1980;
reprinted from the Federal Reserve Bank of New York Monthly
Review, November 1954.
3The Federal Reserve followed a so-called even keel policy during
Treasury financing periods through the early 1970s. Until that time,
most Treasury coupon securities were sold as fixed -price offerings.
Around the financing periods, the Fed avoided changes in policy
stance and tried to prevent changes in money market conditions.
Major financing operations occurred four times a year, around the
middle of each quarter. However, extra unscheduled financing
operations occurred when the Treasury found itself short of money.
Debt issuance was put on a regular cycle in the 1970s.




Box: Reserve Measures
Free reserves are defined as excess reserves less
borrowed reserves, or alternatively, as nonborrowed
reserves less required reserves. Free reserves are
derived from two reserve identities. Total reserves of
the banking system equal required reserves plus
excess reserves. Total reserves also equal borrowed
reserves plus nonborrowed reserves. Total reserves are
reserve balances held by depository institutions (DIs) at
the Federal Reserve and vault cash that is applied
toward meeting requirements. (Before the Depository
Institutions Deregulation and Monetary Control Act of
1980, only banks that were members of the Federal
Reserve held reserves. Now any Dl that accepts trans­
actions accounts can be subject to reserve require­
ments.) Required reserves are total reserves that DIs
must hold to comply with Federal Reserve regulations.
They are specified in Federal Reserve Regulation D
and are fractions of various maintenance period aver­
age deposit levels. Excess reserves are reserve bal­
ances that DIs hold that are not needed to meet
requirements. Since DIs do not earn interest on excess
reserves, they attempt to limit their holdings. However,
DIs cannot hit reserve targets precisely, and they can
be penalized for failing to meet their requirements on
average or for ending the day with their reserve account
overdrawn. Hence it is hard to avoid holding some
excess reserves. Excess reserves moved in a relatively
narrow range for long periods of time, then became
more variable in the 1980s, and consequently became
harder to estimate. Borrowed reserves are reserve bal­
ances acquired from the Federal Reserve's discount
window facility. (Extended credit borrowing by banks in
d iffic u lty is often treated as akin to nonborrow ed
reserves.) Nonborrowed reserves are all reserves aris­
ing in other ways, primarily through open market opera­
tions and through changes in other factors on the
Federal Reserve balance sheet.

FRBNY Quarterly Review/Autum n 1988

7

tunit'y to make markets with minimal interference from
the Fed. To achieve these goals, the subcommittee rec­
ommended that open market operations be confined to
the short-term Treasury bill market, where the price
impact of an operation ought to be the smallest. That
would give the securities dealers the opportunity to
make active markets in a range of securities and allow
the forces of supply and demand to determine the
structure of rates. Only if the market for coupon securi­
ties were clearly disorderly, and not just adjusting to
new information, would the Fed step in to buy or sell
coupon securities.
The report also expressed dissatisfaction with the
Desk’s operating technique. During the interest rate
pegging period, the Trading Desk had often used one
of a group of 10 dealers as a broker or agent to
arrange orders in the market. The dealers that were not
part of that group complained that they were unfairly
excluded from dealings with the Federal Reserve. The
dealers that did act as agents were also dissatisfied
because they could not transact business with the Fed
for their own portfolios when they were acting as
agent. Both groups of dealers felt it was difficult to
make two-way markets as long as the Federal Reserve
was willing to buy or sell securities at known rates in
response to public demand.
The FOMC adopted most key recommendations of
the subcommittee. It actively pursued a countercyclical
policy using an array of measures to evaluate eco­
nomic activity and inflationary forces. Between 19§3
and 1960, it pursued what came to be known as a “ bills
only” policy, confining its open market operations to the
bill sector except when the coupon market was “dis­
orderly.” Throughout the 1950s, there was considerable
debate within the System about whether coupon opera­
tions should be reintroduced to promote orderly mar­
kets or whether coupon markets should be left to
function as much as possible without interference from
the Fed. On only two occasions during this period were
market conditions formally judged to be sufficiently dis­
orderly to justify the Desk’s purchase of Treasury cou­
pon issues.
To create a climate where the dealers could make
markets on an equal footing, the Trading Desk devel­
oped the competitive "go around” technique, still in
use today, in which all of the dealers were contacted
simultaneously and given the opportunity to make bids
or offers. It also increased the number of dealers with
which it would trade and specified criteria that dealers
had to meet to qualify for a trading relationship.
During these years the FOMC took longer-term guid­
ance from a number of indicators in choosing an
appropriate policy stance. It gave special emphasis to
the behavior of bank credit (commercial bank loans
8 FRASER
FRBNY Quarterly Review/Autumn 1988
Digitized for


and investments) as an intermediate policy goal. It
sought to speed up bank credit growth in periods when
economic activity showed weakness and slow it down
in periods of rapid growth. Bank credit statistics were
available just after the end of the week for large banks
but were only available with a lag of several weeks for
small banks. Thus, bank credit was not suitable for
day-to-day operating guidance.
The instructions for the Desk’s day-to-day operations
focused on free reserves —referred to as net borrowed
reserves when borrowed reserves are greater than
excess reserves —and money market conditions. By
money market conditions, the FOMC meant not only
short-term interest rates but also indications of the
ready availability of funding to the securities dealers.5
The written directive provided by the FOMC to the
Desk was deliberately nonspecific, avoiding even a hint
of targeting interest rates. For example, in November
1957, the FOMC directed the Desk to conduct opera­
tions “with a view to fostering sustainable growth in the
economy without inflation, by moderating pressures on
bank reserves.” The Manager of the System Open Mar­
ket Account surmised from the discussion at the FOMC
meeting what the Committee wanted.6
Free reserves were targeted in order to provide some
anchor to the policy guidelines. A relatively high level
of free reserves represented an easy policy, with the
excess reserves available to the banks expected to
facilitate more loans and investments. Net borrowed
reserves left the banks without unpledged funds with
which to expand lending; they were viewed as fostering
a restrictive policy stance. It was assumed that banks
would adjust loans and investments when reserve
availability changed.
sThe FOMC took into account that the level of the discount rate would
influence interest rates and the banks’ perception of reserve
availability. However, it did not (and does not) have the authority to
change the discount rate and took the rate as a given within the
context of short-term policy making.
•At that time, there was no provision for the Trading Desk to make
modifications to the policy stance between meetings in the event of
unexpected developments. The FOMC met very frequently — generally
every two weeks through the middle of 1955 and every three weeks
subsequently. They often had telephone meetings between regular
meetings.
The Committee members were kept informed of what was
happening through written reports describing the reserve forecasts,
money market conditions, Trading Desk operations, weekly lending
patterns of large banks, and background information on other
securities markets. Reports were prepared in the open market
operations area at the end of each statement period and before each
FOMC meeting. An FOMC member also had the opportunity to
participate in a daily conference call at which Desk personnel
described recent developments affecting reserve demands and
supplies and the behavior of the money markets. A wire summarizing
the daily conference call was sent to the FOMC members. The
written and oral reports have continued through the years, although
the topics emphasized have changed as the priorities of policy have
changed.

The linkages between free reserves and bank credit
were viewed at the time as somewhat complex.7 High
rather than rising free reserve levels were believed to
foster rising bank credit since banks would perpetually
have more excess reserves than they wanted and
would continually expand lending. High net borrowed
reserve levels would, in a parallel manner, encourage
persistent loan contraction. However, defining the point
where free or net borrowed reserves were neutral —
that is, fostering neither rising nor falling bank credit
levels —was believed to be possible conceptually but
not empirically. Other factors complicating the linkage
were the distribution of reserves, loan-deposit ratios,
the maturities of bank portfolios, the strength of loan
demand, and the stage of the business cycle. Still, the
Federal Reserve did not consider any of these diffi­
culties to be fatal to the procedure so long as bank
credit growth was monitored over time.
Operationally, the Trading Desk worked with a free
reserve target that had been implied by the discussion
at the most recent FOMC meeting. Research staff
members developed and refined techniques during the
1950s and 1960s for forecasting each day what free
reserves would be over the reserve maintenance
period by forecasting both nonborrowed and required
reserves. Maintenance periods were one week long for
reserve city banks (member banks with offices located
in cities with Federal Reserve banks or branches) and
two weeks long for country banks (all other member
banks). Computation and maintenance periods were
essentially contemporaneous. The reserve factor esti­
mates, which affected nonborrowed reserves, were
subject to sizable errors, even though considerable
resources were devoted to obtaining timely information
about past and likely future behavior of the more vol­
atile factors. Forecasts of required reserves were a
problem initially but were improved in the 1960s as
data flows were accelerated. Furthermore, reserves
were not always well distributed across classes of
banks, a condition that sometimes contributed to dispa­
rate behavior of free reserves and interest rates. These
forecasts guided the Desk in making the appropriate
reserve adjustments. It could buy or sell Treasury bills
when forecasts suggested that free reserves were
below or above the objective. Temporary reserve injec­
tions could be made with repurchase agreements
(RPs), although the agreements were not used nearly
as much as they were later.
7See (Peter D. Sternlight), "The Significance and Limitations of Free
Reserves,” Federal Reserve Bank of New York Monthly Review,
November 1958, pp. 162-67; and “ Free Reserves and Bank Reserve
Management,” Federal Reserve Bank of Kansas City Monthly Review,
November 1961, pp. 10-16. A critique of free reserves and a survey
of the literature are provided by A. James Meigs in Free Reserves
and the Money Supply (Chicago: University of Chicago Press, 1962).




Because of the uncertainties in the forecasts of free
reserves, and because the FOMC was also interested
in money market conditions, the Desk watched “ the
tone and feel of the markets” each day in deciding
whether to respond to the signals being given by the
reserve forecasts. Reading the tone of the markets was
considered something of an art. Desk officials watched
Treasury bill rates and dealer financing costs. They fac­
tored in comments from securities dealers about diffi­
culties in financing positions. Desk officials were
primarily concerned with the direction in which interest
rates were moving, rather than their level, and with the
availability of funding. The tone of the markets might
suggest whether the free reserve estimates were accu­
rate. If the banks were short of free reserves, they
would sell Treasury bills, a secondary reserve, and put
upward pressure on bill rates. The banks would also
cut back on loans to dealers, thus making dealer
financing more difficult.
The federal funds rate played a limited role as an
indicator of reserve availability in this period, but it
began to receive increased attention during the 1960s.
The interbank market was not very broad as the 1960s
began, but activity was expanding.8 During the 1960s,
the reports of the Manager of the System Open Market
Account increasingly cited the funds rate in the list of
factors characterizing money market ease or tightness.
Until the mid 1960s, the funds rate never traded above
the discount rate. During “tight money periods,” when
the Desk was fostering significant net borrowed
reserve positions, funds generally traded at the dis­
count rate, and the rate was not considered a useful
indicator of money market conditions. When free
reserves were high, funds often traded below the dis­
count rate and showed noticeable day-to-day variation.
At such times, they received greater attention as an
indicator of reserve availability.
There was considerable surprise when funds first
traded above the discount rate, briefly in October 1964
and more persistently in 1965. Why, it was asked,
would any bank pay more for overnight funding than
the Federal Reserve charged? In fact, large banks
were becoming more active managers of the liability
side of their balance sheets. Borrowing from other
banks, away from the Federal Reserve, played a role in
this management. Though it was not noted at the time,
the changes in liability management techniques were
making free reserves an increasingly uncertain predic­
tor of bank credit growth. The relationship between
bank credit and free reserves depended upon banks
■Mark H. Willes, “ Federal Funds during Tight Money,” Federal Reserve
Bank of Philadelphia Business Review, November 1967, pp. 3-11; and
"Federal Funds and Country Bank Reserve Management,” Federal Re­
serve Bank of Philadelphia Business Review, September 1968, pp. 3-8.

FRBNY Quarterly Review/Autumn 1988 9

responding passively to reserve availability. In 1961,
banks developed negotiable Certificates of Deposit
(CDs), which they could use to accom m odate
increased loan demand without having unused free
reserves. Interest rate ceilings on CDs under Regula­
tion Q occasionally brought a sudden halt to this kind
of expansion. The next logical step was to finance loan
demand by purchasing overnight federal funds and
renewing the contract each day. Takings in the funds
market were not subject to reserve requirements or
Regulation Q interest ceilings. (Such ceilings were
dropped for most large CDs in 1970.) The discount win­
dow could not be used on such a steady basis. The
Federal Reserve actively discouraged frequent or pro­
longed borrowing, thus reinforcing banks’ longstanding
reluctance to borrow.
In 1961, several developments led the FOMC to
abandon its “ bills only” restrictions. The new Kennedy
Administration was concerned about gold outflows and
balance of payments deficits and at the same time
wanted to encourage a rapid recovery from the recent
recession. Higher rates seemed desirable to limit the
gold outflows and help the balance of payments, while
lower rates were wanted to speed economic growth.
To deal with these problems simultaneously, the Trea­
sury and the FOMC attempted to encourage lower
long-term rates without pushing short-term rates down.
The policy was referred to in internal Federal Reserve
documents as “ operation nudge” and elsewhere as
“ operation twist.” The Treasury engaged in advance
refundings and maturity exchanges with Trust accounts.
The Federal Reserve attempted to flatten the yield
curve by purchasing coupon securities while simul­
taneously selling Treasury bills. The procedure contin­
ued for another year and then ceased to be discussed
after short-term rates rose in 1963. The Manager’s
reports focused mostly on operational difficulties in
purchasing coupon issues after a long period of
absence from that sector and reached no judgment on
the effectiveness of the policy. Academic economists’
studies have suggested that the effect on the yield
curve was minimal, while practitioners had mixed views
of its success.
Second half of the 1960s: transition to new targets
and indicators
The formal policy procedures were changed only mod­
estly over the latter half of the 1960s, but the period
was marked by questioning and a search for alternative
intermediate targets and techniques for achieving
them. Inflation, which had been low over the previous
decade, was a growing problem, and the annual
reports expressed considerable concern about the lack
of tax increases (until late 1968) to finance the

10FRASER
FRBNY Quarterly Review/Autumn 1988
Digitized for


Vietnam War involvement and the “Great Society” pro­
grams. Interest rates rose and became more variable.
Economists, both within and outside the Federal
Reserve, questioned the assumed linkages underlying
the policy process, including the connections of free
reserves and bank credit to the ultimate policy goals of
economic expansion and price stability. Quantitative
methods were increasingly applied to test the hypothe­
sized relationships among operational, intermediate,
and ultimate policy objectives. Some studies suggested
that more attention should be paid to money growth
and to the behavior of total reserves or the monetary
base.
In response to these developments, the FOMC
expanded the list of intermediate guides .to policy. The
directives continued to focus on bank credit but added
money growth, business conditions, and the reserve
base. Free reserves continued to be the primary gauge
for operations. When excess reserve behavior proved
difficult to predict, borrowed reserves received increas­
ing weight.
As the federal funds market became more active, the
funds rate gained more prominence as an indicator of
money market conditions. The annual report for 1967
explicitly cited the funds rate as a goal in itself rather
than merely an indicator of the accuracy of free
reserve estimates. It said that daily open market opera­
tions “focused on preserving particular ranges of rates
in the federal funds market and of member bank bor­
rowings from the Reserve Banks.” 9 The report
expressed concern that reserve forecast errors might
lead to unintended money market firmness that market
participants could misinterpret.
Although the FOMC met every three to four weeks, it
was concerned that developments between meetings
might alter appropriate reserve provision. Conse­
quently, in 1966 it introduced a “ proviso clause” that
set forth conditions under which the Desk might modify
the approach adopted at the preceding meeting. The
FOMC would have preferred to use bank credit as the
trigger to change money market conditions, but data
still were available only with a lag. Hence, it used a
proxy for bank credit in the proviso clause. After some
experimentation, it adopted what it called the bank
credit proxy, which consisted of daily average member
bank deposits subject to reserve requirements.
•"Open Market Operations during 1967,” a report prepared for the
Federal Open Market Committee by the Open Market Operations and
Treasury Issues Function of the Federal Reserve Bank of New York,
February 1968, p. 4. The published version of this report, "Review of
Open Market Operations in Domestic Securities in 1967,” in Board of
Governors of the Federal Reserve System, 54th Annual Report, 1967,
(1968), pp. 208-75, had a somewhat different introduction. It omitted
the discussion of operational complications that had contained the
reference to the funds rate.

Logically the bank credit proxy, which represented
most of the liability side of the banks’ balance sheets,
should have moved in a similar fashion to bank credit,
which was most of the asset side of the banks’ balance
sheets (other than reserves), but they often differed.
One source of distortion was the growing use of nonreservable liabilities to finance credit extension. Banks
encountered rising interest rates as inflation heated up,
and the rate ceilings mandated by Regulation Q often
limited the banks’ ability to raise rates enough to
attract deposits. Furthermore, higher interest rates
made reserve requirements more burdensome. Conse­
quently, banks raised money in the Eurodollar market
to finance lending. In 1969, the bank credit proxy was
expanded to include liabilities to foreign branches, the
largest nondeposit liability. Nonetheless, the proxy con­
tinued to deviate from bank credit as reserve ratios
changed.
If the bank credit proxy moved outside the growth
rate range discussed at the FOMC meeting, the Desk
would generally adjust the target level of free or net
borrowed reserves modestly, on the order of $50 mil­
lion or so according to rough recollections of officials
participating at the time. Sometimes the proviso clause
permitted either increases or decreases in the objec­
tive for free reserves. Frequently it allowed adjustments
only in one direction.
To decide each day on its operations, the Desk
looked at the reserve forecasts, short-term interest
rates, and availability of financing to the dealers. If the
need for reserves was confirmed by a sense of tight­
ness in the markets, the Desk generally responded
soon after the 11:00 a.m. conference call. During this
period it used a larger share of outright transactions
than it currently does, partly because it engaged in
less day-to-day fine tuning, but it did make active use
of RPs and, after their introduction in 1966, of matched
sale-purchase transactions. In 1968, the Board of Gov­
ernors adopted a system of lagged reserve accounting
under which reserve requirements were based on aver­
age deposit levels from two weeks earlier, with all
member banks settling weekly. The change made it
easier to hit free reserve targets —ironically, shortly
before free reserve targeting ended.
1970 to 1979: targeting money growth and the
federal funds rate
In 1970, money growth formally replaced bank credit as
the primary intermediate target of policy, and the fed­
eral funds rate replaced free reserves as the primary
guide to day-to-day open market operations. The tran­
sition was gradual, with the first few years of the
decade characterized by frequent experimentation and
modification of the procedures. Nonetheless, the



framework until October 1979 generally included
setting a monetary objective and encouraging the
funds rate to move gradually up or down if money were
exceeding or falling short of the objective.
Bank credit and its proxy continued for a while in the
list of subsidiary interm ediate targets, but they
received decreasing attention. The Desk also contin­
ued to watch the behavior of both free and borrowed
reserves, mostly as indicators of how many reserves
were needed to keep the federal funds rate at its
desired level. The procedures exploited the positive
relationship between borrowing and the spread
between the funds rate and the discount rate. The rela­
tionship was imprecise, but it gave the Desk an idea of
how many free or net borrowed reserves were likely to
be consistent with the intended funds rate. The Desk
used the forecasts of reserve factors to gauge the
appropriate direction and magnitude for open market
operations.
Initially in 1970, the FOMC selected weekly tracking
paths for M1, which were generally the staff projections
of likely behavior. It simultaneously continued to
specify desired growth of the bank credit proxy and
indicated preferred behavior for M2, but those mea­
sures received less weight than M1.10 It instructed the
Desk to raise the federal funds rate within a limited
band if the monetary aggregates were well above the
tracking path or to lower the funds rate within that band
if the aggregates were below the tracking path.
In 1972, a number of significant modifications were
made. The weekly tracking path for M1 was supple­
mented (and was later replaced) by two-month growth
rate ranges that used the month before the FOMC
meeting as a base. The change was designed to
reduce the weight given to the rather volatile weekly
money numbers and to quantify significant deviations.
At the end of that year, the Committee also sharpened
the distinction between targeting desired money growth
and targeting expected money growth. Initially, the M1
tracking path had been based on Board staff expecta­
tions. Setting the desired growth path equal to the
projection ran the risk of aiming for money growth that
was too high or too low to be consistent with noninflationary growth. By late 1972, the Committee took note
of that problem. It developed independent estimates of
monetary aggregate growth that were expected to be
consistent with moving gradually toward lower inflation.
It introduced six-month growth targets designed to
achieve these goals. Econometric models, supple10At the time, M1 consisted of currency and privately held demand
deposits. Other checkable deposits were added to the definition in
1980. M2 consisted of M1 plus time and savings deposits other than
large CDs at commercial banks. Thrift institution deposits, overnight
RPs, Eurodollars, and money market funds were not included until 1980.

FRBNY Quarterly Review/Autumn 1988 11

merited by the judgments of the staff, were used to
develop the six-month and one-year estimates. The
models allowed money growth to respond to economic
activity and interest rate behavior. The weekly and twomonth estimates were derived judgmentally, allowing
for a range of technical factors.
The FOMC also introduced a reserve operating
mechanism in 1972 that was designed to influence the
supply of money. It was to be used simultaneously with
the interest rate guideline, which worked through the
demand for money. The FOMC made the addition to
address a weakness in the existing procedure, namely,
the need to rely on staff estimates of the funds rate
required to achieve desired money growth. The funds
rate worked by affecting the interest rates banks both
paid and charged customers and hence the demand for
money. But the demand for money was also a function
of nominal income and anticipated inflation (which was
only partially captured by the behavior of nominal inter­
est rates). The Board staff built models of money
demand, as did other Federal Reserve research
departments. There was much debate throughout the
decade about these models and their accuracy. Some
observers felt that the models would have done well
enough over periods judged to be of meaningful length
(six months to a year) if the FOMC had really allowed
interest rates to move as much as the models required.
Others felt that it was not practical to control money
adequately by working through the demand side, either
because the models were not reliable enough or
because the interest rate consequences could be too
disruptive to markets.
The development of a reserve guideline to aid in
achieving monetary targets was based on the reservemoney multiplier model of money control. The model
implied that controlling total or required reserves would
constrain money growth through the operation of the
reserve requirement ratio. The FOMC was concerned,
however, that a pure reserve provision strategy would
cause undesired short-run volatility of interest rates.
The FOMC briefly tried reserve targeting in 1972 but, to
limit money market volatility, it put a constraint on the
funds rate.
A technical problem complicated the use of a reserve
guideline. Controlling total or required reserves was
considered the best means of affecting deposits, yet
these measures were subject to change for reasons
unrelated to the behavior of money. In particular, inter­
bank and federal government deposits were excluded
from all the money definitions but were subject to
reserve requirements. Government deposits at the time
varied far more than they have in recent years. All tax
and loan account monies were kept in commercial bank
demand deposits subject to reserve requirements until

12FRASER
FRBNY Quarterly Review/Autumn 1988
Digitized for


1977 when a legal change permitted note option
accounts that pay interest and are not subject to
reserve requirements. To take account of the reserve
requirements on deposits not in the money definitions,
the Federal Reserve developed a measure that
excluded reserves against government and interbank
deposits. It was called reserves on private deposits or
RPD. While RPD behavior was closer to that of M1 than
was total reserve behavior, the linkage was not very
close because reserve requirements differed widely
according to the size and membership status of the
bank. Movements of deposits between large and small
banks or member and nonmember banks changed the
ratio of RPD to M1. Changes in the ratio of currency to
deposits also affected the relationship between RPD
and M1.
Using staff estimates of the various ratios, the FOMC
set two-month growth target ranges for RPD designed
to be consistent with the desired growth in M1, and
instructed the Desk to alter its reserve provision in a
way that was intended to achieve them. The actions
were also supposed to be consistent with achieving a
specified federal funds rate each week, which could be
moved within a band between meetings. Usually the
specified band was 1 to Vk percentage points wide
over the intermeeting period and somewhat narrower
each week. Intermeeting intervals were four to five
weeks long. As it turned out, the relatively narrow
funds rate constraints often dominated, and the Desk
frequently missed the RPD target. RPD targets were
declared unachievable, although the funds rate con­
straint precluded a true test. In 1973, the Committee
changed RPD’s status from operational target to inter­
mediate target, placing it in the same category as M1
and M2. Since information on the behavior of M1 was
about as good as information on RPD, RPD gradually
fell into disuse. It was dropped as an indicator in 1976.
Subsequent modifications to techniques mostly
related to the nature of the monetary targets. In 1975,
in response to the requirement of a congressional res­
olution, the Federal Reserve adopted annual monetary
target ranges and announced them publicly. A growth
cone was drawn from the base period, which was the
calendar quarter most recently concluded. Every three
months, the target range was moved forward one quar­
ter. The procedure meant that by the time the annual
target period was completed, the target had long since
been superseded. Frequently, the targets were over­
shot, and complaints about upward base drift were
legion. The Full Employment and Balanced Growth Act
of 1978, known as the Humphrey-Hawkins Act, estab­
lished the current procedure requiring the Federal
Reserve to set targets for calendar years and to
explain any misses.

In addition to setting the annual targets in February
and reviewing them in July as required by the
Humphrey-Hawkins Act, the Committee continued to
set two-month ranges. In theory, the two-month money
growth targets were supposed to be consistent with
returning to the annual target range if the money mea­
sures were outside the range, and with holding the
aggregates within the ranges if they were already
there. However, the Committee was often skeptical of
staff forecasts. Furthermore, the Committee sometimes
felt that the estimated changes in the funds rate
needed to get money back on target were unacceptably
large. It sometimes approved growth rates that
stretched out the period for bringing money back on
track, and on occasion it acknowledged that target
growth probably would not be achieved within the year.
During most of the 1970s, the FOMC was particularly
reluctant to change the funds rate by large amounts at
any one time. Part of that reluctance reflected a wish to
avoid short-term reversals of the rate. Keeping each
rate adjustment small limited the risk of overdoing the
rate changes and then having to reverse course. Those
priorities restricted the options available to search for
the appropriate rate at times when the FOMC was
uncertain about the correct rate. The adjustments in
the funds rate often lagged behind market forces,
allowing trends in money, the economy, and prices to
get ahead of policy.
The FOMC usually made only small changes in the
funds rate at the meeting; frequently, the rate was not
changed and the range surrounded the most recent
rate target. The Committee also put relatively narrow
limits on the range of potential adjustments that could
be made between meetings if money growth went off
course. In the early 1970s, the intermeeting funds rate
range was generally % to 1 1/2 percentage points wide.
By the latter part of the decade, its width was usually
about V2 to 3A percentage point, and on a couple of
occasions only 74 percentage point. In addition, the
specifications for the aggregates were often set in a
way that made it likely that the funds rate would be
adjusted in one direction only, effectively cutting the
range in half.
In implementing the funds rate targeting procedure,
the Desk became increasingly attuned to preventing
even minor short-term deviations of the funds rate from
target. It felt some constraint not to make reserve
adjustments in an overt way unless the funds rate
moved off its target. When reserve estimates sug­
gested that a large adjustment was needed but the
funds rate did not confirm it early in a statement week,
the Desk would worry about delaying its market entry
because it might not be feasible to do a very large
open market transaction late in the week. To provide



needed reserves without an announcement effect, the
Desk increasingly used internal transactions with for­
eign accounts. A fter the introduction in 1974 of
customer-related RPs —agreements on behalf of offi­
cial foreign accounts —the Desk used the agreements
when the funds rate was on target but a reserve need
was projected. (Market participants had routinely
assumed that outright transactions for customers had
no policy significance, and they initially regarded
customer-related RPs the same way.)
If the estimated need to add or drain reserves was
too large for these techniques, the Desk often pounced
on very small funds rate moves off target to justify an
operation. For instance, if estimates suggested that
additional reserves were needed, the Desk would often
enter the market to arrange an RP when the funds rate
rose Vie percentage point above the preferred level. If,
on the other hand, the funds rate fell despite the esti­
mated need to add reserves, the Desk typically would
allow a 1/b percentage point deviation to develop before
it would arrange a small market operation to drain
reserves. There was an operational limit to how late in
the day transactions could be done for same day
reserve effect. The cutoff was supposed to be 1:30
p.m., but if the desired funds rate move occurred just
after that time, the Desk often responded if it was
anxious to do an operation. The end of its operating
time was close to 2:00 p.m. by 1979.
The Desk’s prompt responses to even small wiggles
in the federal funds rate led banks to trade funds in a
way that tended to keep the rate on target. Except near
day’s end on the weekly settlement day, a bank short of
funds would not feel the need to pay significantly more
than the perceived target rate for funds. Likewise, a
bank with excess funds would not accept a lower rate.
Rate moves during the week were so limited that they
provided little or no information about reserve availabil­
ity or market forces. Probably few, if any, in the Federal
Reserve really believed that brief small moves in the
funds rate were harmful to the economy. The tightened
control developed bit by bit without an active decision
to impose it.
1979 to 1982: monetary aggregates and nonbor­
rowed reserves
In October 1979, the FOMC radically changed the oper­
ating techniques it used for targeting the monetary
aggregates. It explicitly targeted reserve measures
computed to be consistent with desired three-month
growth rates of M1. The constraint on the federal funds
rate applied only to weekly averages, not to brief
periods during the week. Its width was 4 to 5 percent­
age points, wide enough to allow the adjustments
needed to achieve the monetary target. Persistent

FRBNY Quarterly Review/Autumn 1988 13

overshoots of money targets and severe inflation had
changed priorities. Interest rate volatility, so feared
when the RPD targets were developed in 1972,
seemed more tolerable.
Operationally, the FOMC chose desired growth rates
for M1 (and M2) covering a calendar quarter and
instructed the staff to estimate consistent levels of total
reserves. The process resembled that used to estimate
RPDs. The staff estimated deposit and currency mixes
to derive average reserve ratios and currency-deposit
ratios. The estimation technique employed a mix of
judgment and analysis of historical patterns. From the
total reserve target, the Desk derived the nonborrowed
reserve target by subtracting the initial level of bor­
rowed reserves that had been indicated by the FOMC.
The initial borrowing level was intended to be consis­
tent with the desired money growth. If it were incon­
sistent, money and total reserves would exceed or fall
short of path. If the Desk only provided enough
reserves to meet the nonborrowed reserve path, bor­
rowing would automatically rise if money growth (and
total reserve demands) were excessive, or fall if such
growth were deficient. The borrowing move would
affect reserve availability and the funds rate and would
encourage the banks to take actions that would accom­
plish the desired slowing or speeding up of money
growth. If the pace of adjustment implied by the mech­
anism did not seem appropriate, instructions were
occasionally given to accelerate or delay the borrowing
adjustment. The FOMC could make alterations to the
basic mechanism at a meeting or direct the Desk to
make them under specified conditions between
meetings.
To reduce overweighting of weekly movements in
money, the total and nonborrowed reserve paths were
computed for intermeeting average periods, or two
subperiods if the intermeeting period were longer than
five weeks. (In 1979 the FOMC met 9 times and in 1980
it met 11 times; in 1981 it moved to the schedule of 8
meetings a year in use today.) A consequence of this
averaging technique was that errors in the early part of
the period had to be offset by large swings in borrow­
ing in the final week. Informal adjustments were some­
times made to smooth out those temporary spikes or
drops in borrowing that were deemed inconsistent with
the longer term pattern. While the adjustments were
considered necessary to avoid severe swings in
reserve availability and interest rates, they gave the
appearance of “fiddling” and have led to considerable
confusion in the literature. Each week the total reserve
path and actual levels were reestimated, using new
information on deposit-reserve and deposit-currency
ratios.
In implementing the policy, the Desk emphasized that
Digitized 14
for FRASER
FRBNY Quarterly Review/Autumn 1988


it was targeting reserves and not the funds rate by
entering the market at a standard time to perform its
temporary operations. It confined outright operations to
estimated reserve needs extending several weeks into
the future. It arranged them early in the afternoon for
delivery next day or two days forward. The federal
funds rate was not ignored; it was used as an indicator
of the accuracy of reserve estimates, although it was
not always that reliable. On the margin, it could accel­
erate or delay by a day or so the Desk’s entry to
accomplish a needed reserve adjustment, but its role
was much diminished.
Wide swings in the federal funds rate had been
anticipated, although there was some surprise at the
degree of volatility. Swings in the short-term growth
rates of the monetary aggregates also were wider than
generally had been expected, although the risk of
some overadjustment of money had been recognized
from the beginning. Some observers saw it as a neces­
sary antidote to the earlier procedure, which often
moved the funds rate too little too late. In part, the
sharp movements in both interest rates and money
probably reflected the underlying conditions. The effort
to end the inflation that had built up over one and a
half decades and had come to permeate economic
relationships forced major adjustments. Expectations
about inflation and economic activity were very fluid
during those years; they fluctuated sharply as people
evaluated new information and judged whether the
anti-inflation policies were likely to succeed.
The control mechanism itself almost assured that
money growth would cycle around a trend unless the
FOMC intervened in the process. If money rose above
its desired level, required reserves would rise by a
fraction of the overshoot determined by the reserve
ratio. Following the procedures would cause borrowed
reserves to rise as well. They would not decline until
money growth, and hence total reserve growth, slowed.
The higher borrowing would slow money growth, but
with a lag. By the time the procedures called for lower
borrowing, it would have been high too long, assuring
that money growth would fall below the desired level in
what appeared to be a “ damped cycling process.” Bor­
rowing would then fall short too long, setting up the
next round of acceleration of money growth.
1983 to the present: monetary and economic objec­
tives with borrowed reserve targets
A breakdown in the relatively close linkage between M1
and economic activity, rather than dissatisfaction with
the procedures, led to the next set of changes,
although there was also some sentiment that short­
term rate volatility had been excessive. By the latter
part of 1982, it was becoming apparent that the

demand for money, particularly M1, was strong relative
to income, so that growth within the target range would
have been more restrictive than seemed desirable
under the circumstances. Some of the increase in the
demand for money was attributed to the ongoing
deregulation of interest rates on various classes of
deposits. In particular, NOW accounts were making it
more attractive to hold savings in M1. In addition, the
maturing of a large volume of special tax-favored “all
savers” deposits in October of that year was expected
to add substantially to M1 holdings. The FOMC had
hoped that M2 would continue to be a reliable indica­
tor, and for a few months at the end of 1982 it
attempted to use it as a guide to building total and
nonborrowed reserve targets. However, money market
deposit accounts (MMDAs), authorized beginning in
December 1982, proved very attractive, and the
demand for M2 rose sharply.
In the absence of a stable relationship between
money and economic activity, the FOMC followed ad
hoc procedures for guiding reserve provision, hoping
that the distortions to the relationship would prove to
be short-lived. The FOMC focused on measures of
inflation and economic activity to supplement the
aggregates. Instead of computing total and nonbor­
rowed reserve levels linked to some aggregate and
deriving a level of borrowing that moved with the devia­
tions of the aggregate from target, it chose the bor­
rowed reserve level directly. It intended to adjust it up
or down whenever money seemed to be deviating from
path in a meaningful way (after making allowance for
distorting factors and taking account of the supplemen­
tal indicators).
The monetary aggregates did not quickly resume
their prior relationship with economic activity. Declining
inflation made holding money more attractive, and
interest rate sensitivity increased, since rates on some
components of M1 were close to market rates but slow
to change. Policy decisions continued to be guided by
information on economic activity, inflation, foreign
exchange developments, and financial market condi­
tions. In time, money growth was moved from a pre­
dominant position in the directive to join the list of
factors shaping adjustments to the borrowing level.
What apparently started out as a temporary procedure
has persisted, with modifications, for six years.
Under current procedures, forecasts of reserve avail­
ability are compared to a maintenance period average
objective for nonborrowed reserves that is believed to
be consistent with achieving the desired amount of bor­
rowing. The decision each day whether to provide or
drain reserves is guided to a considerable extent by
the estimated difference between the forecast volume
of nonborrowed reserves and the objective for the two-




week maintenance period. The Desk uses money mar­
ket conditions, this time specifically the funds rate, to
supplement the reserve forecasts, particularly in
choosing the days on which operations are conducted
and the instruments used to make the reserve adjust­
ments. For instance, if the funds rate is significantly
above the range that is expected to correspond to the
intended borrowing level (based on the discount rate
that is in place), the Desk is more prompt in meeting an
estimated reserve need to indicate that the funds rate
probably is out of line. But it generally continues to
intervene at a standard time and accepts more varia­
tion in the funds rate than in the 1970s. Particularly,
there are opportunities for market sentiment concern­
ing the likely course of interest rate pressures to exert
an influence on those pressures.
Summary
Over the post-World War II period, the FOMC made
several significant changes in both the intermediate
and operating targets of policy. Concerns about infla­
tion were often a driving force for change. The inflation
that accompanied the Korean War led the Federal
Reserve to negotiate with the Treasury a means to
resume an active monetary policy. The techniques
developed after the 1951 Accord reflected the predomi­
nant Committee view that bank credit cost and avail­
ability played a major role in determining economic
activity and that inflation resulted when the economy
overheated. Free reserves and money market condi­
tions were adjusted to influence bank credit. Some
FOMC members believed that a strong link existed
between interest rates and economic activity, but most
members, recalling their experience with forced rate
pegging in the 1940s, were disinclined to target interest
rates directly. The procedure adopted in the early
1950s appeared to work in a generally satisfactory way
for a time, and its use persisted for more than one and
a half decades.
The change from bank credit to a monetary aggre­
gate as an intermediate target began to evolve in the
late 1960s. It was made because observers came to
see the relationships between Federal Reserve actions
and ultimate outcomes as more complex than previ­
ously thought, and because of distress about rising
inflation. Some academic research suggested that the
behavior of money was a better leading indicator of
economic activity and prices than were bank credit or
interest rates. Reliance on the federal funds rate rather
than free reserves developed as the federal funds mar­
ket became more active and as the passage of time
made associations between funds rate targeting and
the rate pegging episode of the 1940s less likely. The
changes were formally implemented at the start of the

FRBNY Quarterly Review/Autumn 1988 15

1970s.
In 1979, the FOMC shifted operating targets dramati­
cally. It did so because the monetary objectives had
been overshot repeatedly and inflation had accelerated
to unacceptable rates. Use of the funds rate as the
operational target was thought to be partly to blame
because, as the adjustment tool, rates were changed
too cautiously. The monetary aggregates remained the
intermediate target, but additional efforts were made to
avoid persistent overshooting. Nonborrowed reserves,
which were more directly linked to M1, became the
operating target.
By contrast, the 1982 adjustments primarily stemmed
from problems with M1, and to some extent with the
broader money measures, as intermediate targets. By
that time, considerable progress had been made in
slowing inflation. The modifications were motivated by
an apparent breakdown in the traditional relationship
between the monetary aggregates, especially M1, and
economic activity. Although operating targets had to be
modified when the monetary aggregates were de­

emphasized, the primary operating target, borrowed
reserves, was a variant of the previous nonborrowed
reserve target.
Since 1982, the Committee has watched what might
be called intermediate indicators rather than targets. It
has continued to monitor the aggregates and to set tar­
gets for M2 and M3. The target setting has been
guided by insights that have been gained about how
interest rate deregulation and changing expectations of
inflation have altered the relationship between the
monetary aggregates and the economy and prices.
Nonetheless, the relationships are not sufficiently pre­
cise to support close short-run targeting of the aggre­
gates at this stage. In the absence of a reliable
intermediate target, the Committee has followed devel­
opments of the economy and prices directly and has
observed a variety of economic statistics, in addition to
the monetary aggregates, that point to future moves in
the goal variables.
Ann-Marie Meulendyke

Appendix: Selected Readings on Monetary Policy Implementation
Readers interested in knowing more about Federal
Reserve policy targets and operating guidelines since
the 1950s will find the following sources helpful:

“ Free Reserves and Bank Reserve Management.” Fed­
eral Reserve Bank of Kansas City Monthly Review,
November 1961, pp. 10-16.

Axilrod, Stephen H. “ Monetary Aggregates and Money
Market Conditions in Open Market Policy.” Federal
Reserve Bulletin, February 1971, pp. 79-104.

Madigan, Brian F., and Warren T. Trepeta. “ Implementa­
tion of Monetary Policy.” In Changes in Money Market

Axilrod, Stephen H. “ U.S. Monetary Policy in Recent
Years: An Overview.” Federal Reserve Bulletin, January
1985, pp. 14-24.
“ Federal Funds and Country Bank Reserve Manage­
ment.” Federal Reserve Bank of Philadelphia Business
Review, September 1968, pp. 3-8.
“ Federal Open Market Committee Report of Ad Hoc
Subcommittee on the Government Securities Market.”
Reprinted in The Federal Reserve System after Fifty
Years, Hearings before the Subcommittee on Domestic
Finance of the House Committee on Banking and Cur­
rency. 88th Cong., 2d sess. (Washington, D.C.: GPO,
1964), vol. 3, pp. 2005-55.
Federal Reserve Study — New Monetary Control Pro­
cedures, vols. 1 and 2. Board of Governors of the Fed­
eral Reserve System, February 1981.

16 FRASER
FRBNY Quarterly Review/Autum n 1988
Digitized for


Instruments and Procedures: Objectives and Implica­
tions. Bank for International Settlements, March 1986.
M eek, Paul. “ Open M arket O p e ra tio n s .” Federal
Reserve Bank of New York, editions of 1963, 1969,
1973, 1978, and 1985.
Meek, Paul. U.S. Monetary Policy and Financial Mar­
kets. Federal Reserve Bank of New York, October 1982.
Meigs, A. James. Free Reserves and the Money Supply.
Chicago: University of Chicago Press, 1962.
Poole, W illiam . “ Federal Reserve O perating Pro­
cedures: A Survey and Evaluation of the H istorical
Record since October 1979.” Journal of Money, Credit
and Banking, vol. 14, no. 4 (November 1982, part 2),
pp. 575-96.
Roosa, Robert V. Federal Reserve Operations in the
Money and Government Securities Markets. Federal
Reserve Bank of New York, July 1956.

Appendix: Selected Readings on Monetary Policy Implementation (continued)
S pindt, Paul A., and Vefa Tarhan. “ The Federal
Reserve’s New Operating Procedures, A Post Mortem.”
Journal of Monetary Economics, vol. 19, no. 1 (January
1987), pp. 107-23.
Sproul, Allan. “The Accord’ —A Landmark in the First
F ifty Years of the Federal R eserve S yste m .” In
Lawrence S. Ritter, ed., Selected Papers of Allan
Sproul. December 1980, pp. 51-73. Reprinted from
Federal Reserve Bank of New York Monthly Review,
November 1954.
(Sternlight, Peter D.) “The Significance and Limitations
of Free Reserves.” Federal Reserve Bank of New York
Monthly Review, November 1958, pp. 162-67.




Wallich, Henry C. “ Recent Techniques of Monetary Policy.” Federal Reserve Bank Kansas City Economic
Review, May 1984, pp. 21-30.
*
W allich, Henry C. “ Techniques of M onetary Policy.”
Remarks before the Missouri Valley Economic Association, Memphis, Tennessee, March 1, 1980.
Wallich, Henry C., and Peter M. Keir. “ The Role of
Operating Guides in U.S. Monetary Policy: A Historical
Review.” Federal Reserve Bulletin, September 1979,
pp. 679-91.
Willes, Mark H. "Federal Funds during Tight Money.”
Federal Reserve Bank of Philadelphia Business Review,
November 1967, pp. 3-11.

FRBNY Quarterly Review/Autum n 1988

17

The Globalization of Financial
Markets and the Effectiveness
of Monetary Policy Instruments
Since the early 1970s financial markets around the
world have been moving toward fuller integration. At
least in principle, this trend could have significant impli­
cations for each country’s financial markets and the
workings of its domestic monetary policy. In the case of
the United States, the globalization of financial markets
could at times diminish the compatibility of the Federal
Reserve’s goals for inflation, employment, and external
balance. Moreover, the closer integration of domestic
and foreign financial markets could conceivably impair
the Federal Reserve’s ability to implement a change in
its monetary policy. This article focuses on this last
aspect of globalization and monetary policy. More spe­
cifically, we seek to determine whether globalization
has loosened the linkage between the instruments of
monetary policy— the discount rate and open market
operations— and short-term interest rates.
Intuition suggests that closer integration makes the
total demand for dollar-denominated money market
instruments more interest-rate elastic. The domestic
component of this demand would be more elastic
because debt instruments issued by foreigners are
more readily available to U.S. investors and hence pro­
vide closer substitutes for domestic instruments than
ever before. The foreign component of this demand
would also be more elastic because U.S.-issued instru­
ments appear more often in foreign portfolios. Sim­
ilarly, the supply side of the market would be more
elastic since the issuers of short-term debt instruments
have more options. Consequently, a change of a given
magnitude in a policy instrument and the correspond­
ing movement of the federal funds rate— other things
equal— would have a smaller proximate impact on
FRBNY Quarterly Review/Autumn 1988
Digitized 18
for FRASER


domestic short-term rates; and a smaller impact on
short-term rates implies, according to virtually all
descriptions of the monetary transmission mechanism,
a diminished effect on the ultimate goals of policy. So,
changes in bank reserves would need to be larger than
before to alter the three-month interest rate by, say,
half a percentage point and thereby tighten policy.
By increasing the participation of foreign investors in
U.S. financial markets, globalization may also have
made the U.S. money market more sensitive to devel­
opments in foreign credit markets and the foreign
exchange markets. As a result, the effect of any
change in a monetary policy instrument may now be
less certain, in the sense that the financial markets’
response to discount rate changes or open market
operations may not be anticipated as well as before,
when the reactions of only the domestic credit markets
had to be considered. In these other terms, the effec­
tiveness of monetary policy may also have been dimin­
ished because policymakers might turn more cautious
when the impact of their actions cannot be gauged in
advance.
But the changes brought about by globalization need
not be as substantial as such speculation might sug­
gest. It may be argued that globalization has deeply
affected the determination of U.S. capital and money
market rates and has altered the linkages between
money market and capital market rates; nevertheless,
its effects may not have significantly reduced the size
or the predictability of the proximate impact of policy
instrument changes on domestic short-term interest
rates. The overnight rate is determined by the supply of
nonborrowed bank reserves and this rate is insulated

from any open-econom y impacts. If the linkage
between the overnight rate and three-month money
market rates is essentially unchanged, monetary pol­
icy’s proximate impact on the money market would be
preserved and could be anticipated much as before.
To address these issues, we present a general
framework that assumes that assets are not generally
perfect substitutes either domestically or interna­
tionally. Empirical research has usually rejected the
assumption of perfect substitutability of assets. But the
framework is also consistent with the view that the sub­
stitutability of various types of assets has increased
over time. Thus, the trend of the past several years
toward globalization has the potential to alter the way
the markets set U.S. short-term interest rates. Next, we
describe the role of the federal funds market, where
policy instrument changes are first felt. Its special func­
tion leads us to focus our statistical analysis on the
spread between a market-determined short-term inter­
est rate (the three-month Treasury bill rate) and the
federal funds rate.
Finally, we specify and estimate an econometric
model of that spread in order to gauge the effect of
foreign economic conditions on the U.S. money market.
On the basis of our regression results, we evaluate the
impact of financial market integration on the effective­
ness of domestic reserve operations. We find, as antici­
pated, that foreign econom ic variables exert a
statistically significant influence on U.S. short-term
interest rates and that their collective influence has
been expanding somewhat relative to domestic eco­
nomic variables. Such a development would, of course;
be consistent with increasing international capital
mobility and greater integration of national financial
markets. Nevertheless, our results suggest that the
expanding significance of foreign economic variables is
more directly traceable simply to a relative rise in their
volatility compared with the volatility of domestic vari­
ables (although the absolute volatility of both has
declined). These comparatively greater movements in
the foreign variables affecting domestic credit markets
have apparently made the outcome of instrument
changes (open market operations and discount rate
changes) less certain, and consequently, less effective
in a qualitative sense.
Surprisingly, however, the growing influence of for­
eign factors seems to be associated with a larger
impact on the money market from a given change in
the supply of bank reserves. We find limited evidence
that domestic reserve operations are actually gaining
potency: a somewhat smaller open market operation
can be conducted to achieve a given impact on short­
term interest rates. This is the opposite of the antici­
pated effect from globalization. Thus, in this quantita­




tive sense, it can be said that despite globalization,
policy actions may not be any less effective.
In summary, our results suggest that while the impact
of a given reserve change has possibly become larger
in the face of international financial integration, the
predictability of the response of domestic short-term
interest rates has declined. The latter development has
occurred principally because the relative importance of
movements in foreign economic variables, which may
be essentially unpredictable ex ante, has increased.
The framework for the econometric model
One might reasonably suppose that the globalization of
financial markets has had a significant and direct
impact on both the U.S. capital and money markets.1
That is, globalization may well have altered the deter­
mination of domestic long-term interest rates and their
spreads relative to short-term rates. To be sure, the
volume of nonborrowed reserves, as determined by
open market operations in conjunction with market fac­
tors, retains close influence on the overnight federal
funds rate. But notwithstanding this influence, it is logi­
cal to ask whether globalization has hampered the
Federal Reserve’s ability to implement monetary policy
changes (as measured by nominal short-term interest
rates) using its instruments, the discount rate and open
market operations.
To look into this matter, we will construct and esti­
mate a single-equation econometric model. This model
fits within a general framework for credit markets with
cross-country linkages. It relates the spread between
the overnight federal funds rate and the three-month
Treasury bill rate to domestic and foreign economic
factors. The empirical results obtained from this model
may provide some insight into the potentially declining
efficiency of monetary policy instruments.
A general model of the financial sector
In the most general case, the demand for a particular
U.S. financial asset depends on: (a) its own rate of
return relative to those of all other domestic assets; (b)
the return in dollars on foreign assets, equal to their
own rates of return, plus the expected change in the
exchange rate; (c) the level of financial wealth and the
flow of saving, both here and abroad; and (d) other
relevant macroeconomic variables that affect percep­
tions of risks and the future value of the various
assets.2 These relevant variables include foreign’ See Bruce Kasman and Charles Pigott, “ Interest Rate Divergences
among the Major Industrial Nations,” in this issue of the Quarterly
Review.
2This follows from James Tobin, “A General Equilibrium Approach to
Monetary Theory,” Journal of Money, Credit, and Banking, February
1969, pp. 15-29.

FRBNY Quarterly Review/1988

19

sector indicators such as the volatility of the exchange
rate and the current account position.
Each financial asset substitutes to some extent for
every other financial asset. Some pairs of assets are
nearly perfect substitutes foF each other, such as com­
mercial bank negotiable certificates of deposit and
bank holding company commercial paper (provided
that they have similar maturities and are issued by sim­
ilarly rated institutions). Other assets are weak substi­
tutes: for example, low-grade corporate bonds and
overnight Eurodollar deposits. The extent to which
domestic and foreign assets are substitutes for one
another is a function of their similarity in terms of li­
quidity, maturity, default risk, and other characteristics,
as well as the importance the market attaches to dis­
tinctions of nationality and currency denomination.3
Generally, domestic and foreign assets will tend to be
more closely substitutable the more open the national
financial markets and the lower the barriers to interna­
tional flows.
The influence of foreign economic factors on U.S.
interest rates could be growing through any of several
routes, each related to the globalization of financial
markets and the increasing openness of the U.S. econ­
omy. First, and most important, the reduction of bar­
riers to international capital flows, a key element of the
globalization of financial markets, by itself tends to
make domestic and foreign assets closer substitutes by
allowing investors greater freedom to choose among
alternatives. Consequently, movements in foreign
demand and supply, other things equal, should exert
through either interest rates or exchange rates greater
influence on domestic financial conditions, and vice
versa. Second, the real sector of the U.S. economy is
more open than before, with the result that the scale of
certain variables, such as the volumes of exports and
imports and the associated financial transactions, has
increased relative to the economy as a whole, and the
impact of the exchange rate bn the real economy has
increased. Third, there may be more variation in impor­
tant international economic variables (for example, the
U.S. exchange rate), such that they are the s o u rc e relative to domestic economic factors— of more of the
shifts in the demand for financial assets. Greater vari­
ability of international economic factors would be likely
to increase the number and size of unpredictable shifts
in domestic credit demand or supply.
Much of the empirical research on interest rate deter­
mination is not particularly helpful in addressing
whether and how foreign factors are becoming more
important. This research has tended to concentrate
mostly on testing the expectations theory of the yield
3See Kasman and Pigott, "Interest Rate Divergences.”

FRBNY Quarterly Review/Autumn 1988
Digitized20
for FRASER


curve and theories of international interest rate parity.
Econometric models of domestic interest rate deter­
mination have tended to be constructed on the joint
assumptions that all assets (or all assets within a par­
ticular class) are perfect substitutes and that expecta­
tions of future interest rates are formed “ rationally” ;4
the models of international rate determination have
most often been based on the assumption of perfect
capital m obility. Under these assum ptions, the
demands for domestic financial assets are infinitely
sensitive to differentials in expected rates of return,
and hence, we should never observe persistent differ­
entials over the same holding period because the mar­
ketplace would quickly arbitrage them away. Nor should
we observe persistent differentials in yields between
similar foreign and domestic assets after adjustment
for expected currency changes; the marketplace should
arbitrage away differentials across currencies.
Empirical research usually rejects the expectations
theory of the yield curve.5 Instead, systematic devia­
tions between the actual three-month Treasury bill rate
and that predicted by the yield curve are observed.
Similarly, perfect substitutability among assets that dif­
fer only with respect to currency denomination has
been tested and generally rejected; significant differen­
tials in ex ante (uncovered) yields have been found.6
Unfortunately, researchers have had little success in
identifying the factors causing these differentials. Thus,
we do not have much to build on when we address how
the trend toward globalization may have changed the
connection between policy instruments and money
market rates.
The independence of the federal funds rate
Before describing the econometric model used in this
paper and discussing our regression results, it is useful
to clarify the special role of the federal funds rate in
the money market. The overnight market for federal
funds is largely independent of, but not disconnected
4That is, investors base their expectations on all information
economically available about the future behavior of interest rates.
5For a summary of this line of research, see Robert J. Shiller, John Y.
Campbell, and Kermit L. Schoenholtz, "Forward Rates and Future
Policy: Interpreting the Term Structure of Interest Rates," Brookings
Papers on Economic Activity, 1:1983, pp. 173-217; and N. Gregory
Mankiw, "The Term Structure of Interest Rates Revisited,” Brookings
Papers on Economic Activity, 1:1986, pp. 61-96. For a collection of
papers on the domestic and international determinants of interest
rates, see Nominal and Real Interest Rates: Determinants and In­
fluences, Bank for International Settlements (Basle, Switzerland, 1985).
•Paul Boothe and others, International Asset Substitutability: Theory
and Evidence for Canada, Bank of Canada, 1985; and M.A. Akhtar
and Kenneth Weiller, “ Developments in International Capital Mobility:
A Perspective on the Underlying Forces and the Empirical
Literature," Federal Reserve Bank of New York, Research Paper
no. 8711, in International Integration of Financial Markets and U.S.
Monetary Policy, December 1987.

from, the rest of the money market. As a practical mat­
ter, if we look at the average funds rate calculated over
intervals longer than a month, we find that it is set
within a range by the demand for and supply of bank
reserves independently of other short-term rates, and
thus it is subject to the influence of open market opera­
tions. Changes in other interest rates do feed back
onto the fed funds rate, but only to a limited extent. In
the opposite direction, the federal funds rate is con­
nected to the rest of the money market, such that
domestic operations set off a chain reaction affecting
other money market rates. Thus, in the classification
scheme for economic models, the financial sector is
not a fully simultaneous system. Instead, it is block
recursive, the funds market constituting the first block
and the rest of the financial markets the second and
main block.7
The demand for bank reserves is created by (a)
reserve requirements and (b) each bank’s need to post
a positive reserve balance in its account at the Federal
Reserve every night. The supply of bank reserves is
essentially determined by (a) the actions of the Man­
ager for Domestic Operations and (b) the administra­
tion of the discount window. “ Market factors” such as
float and Treasury fiscal operations cause unintended
fluctuations in supply to the extent that the open mar­
ket Desk does not perfectly foresee and allow for them.
The funds market thus redistributes reserves among
banks so that they can meet reserve requirements and
avoid overnight overdrafts.
The specialized nature of the federal funds market is
manifested in rate movements that take place late in
the trading day. When a significant shortage or surplus
of reserves appears on a settlement day, the fed funds
rate will soar or plunge far outside of its recent trading
range. These movements, typically occurring after
4:00 p.m., do not correspond to changes in the closely
related markets for overnight repurchase agreements
(RPs) and overnight Eurodollars, because by that time
these markets are effectively closed for the day. Move­
ments in the fed funds rate can also occur if the Fedwire is down or if some large bank is having computer
problems.8
As noted, however, the funds rate is not totally dis­
connected from the rest of the money market in the
short run— its independence can be overstated. The
federal funds rate trades within a range even when no
policy moves are being made. Developments in the RP
market or very short-term Eurodollar market can spill
over and affect the overnight funds rate, particularly
7ln such a system, the endogenous variables are determined in
sequence, either individually or in groups.
•There are also quarter-end and year-end effects.




within a single two-week reserve maintenance period.
Expectations of an imminent policy move will also
cause overnight funds to trade high or low relative to
other money market rates.
In sum, by virtue of the conservation of reserves in
the domestic banking system, there is no reason to
presume that globalization has directly had any mea­
surable effect on the determination of the overnight
federal funds rate— except perhaps within the reserve
averaging period. Within such periods, the possibility
exists that the increasing integration of world financial
markets may have had some minor effects on the
behavior of the overnight funds rate. For example, glob­
alization may have increased the size and depth of the
overnight Eurodollar market and made overnight Euros
a better substitute for overnight fed funds. In addition,
by increasing the volume or variance of clearings of
money-center banks, globalization may have raised the
demand for excess reserves.9
The connection to other interest rates
Immediately available funds are lent to the banking
sector by private firms and municipalities through RPs,
and by thrift institutions and credit unions through fed­
eral funds purchases. (Transactions in “ immediately
available funds” are those in which the transfer of
money is made during the same business day and not
at the end of the day or on the next day.) Moreover,
immediately available funds are channeled downstream
from small banks to large banks through the federal
funds market. To some extent, these participants can
shift to or from other instruments (term fed funds, term
RPs, very short maturity Eurodollar deposits, “short”
Treasury bills) if the overnight fed funds rate is out of
line with slightly longer-term rates. The possibility of
substitution creates a connection between the over­
night funds rate and other money market rates. (In a
generalized model of the financial sector, the federal
funds rate would appear in the demand equations of
other short-term instruments.) Thus, open market oper­
ations can influence money market rates directly by
affecting the federal funds rate and indirectly by
changing the markets’ expectations of the future values
of this rate.
All this implies that the spreads between the federal
funds rate and other money market rates can be quite
variable from one month to the next. The Treasury
yield curve may be upward sloping, and yet the over­
night federal funds rate may be well above the one- or
three-month bill rate because monetary policy is plac9No increase in the clearing banks’ demand for excess reserves has
been detected, however, during the past several years as the volume
of transactions handled by CHIPS (Clearing House Interbank
Payments System) has grown rapidly.

FRBNY Quarterly Review/1988 21

ing considerable pressure on banks’ reserve positions;
or the funds rate may be below the Treasury bill rates if
modest reserve pressure is being imposed.
Moreover, because federal funds and Treasury bills
are imperfect substitutes, there is some scope for the
internationalization of financial markets to have an
effect. The rate spread between them is not deter­
mined exclusively by the expected future path of
domestic short-term interest rates; other factors matter.
So, since the overnight fed funds rate is influenced by
changes in the supply of nonborrowed reserves, move­
ments in the spread between the fed funds and Trea­
sury bill rates reflect changes in the stance of mone­
tary policy— as well as developments in domestic and
foreign credit markets.10 Whether movements in the
rate spread now reflect changes in Federal Reserve
instruments to a lesser degree because of globaliza­
tion is the focus of the remaining sections of this
article.
Estimation and analysis of the model
To investigate the effect of the globalization of financial
markets on the linkage between open market opera­
tions and domestic short-term interest rates, we esti­
mated a single-equation econometric model based on
the generalized framework of the preceding section.
This model explains the movements in the spread
between the overnight federal funds rate and the threemonth U.S. Treasury bill rate.
The spread is most obviously and directly affected by
changes in the instruments of monetary policy. The
overnight federal funds rate is expected to rise relative
to the three-month Treasury bill rate as the supply of
bank reserves is tightened; the funds rate is expected
to fall relative to the bill rate when reserve supply is
easing. Thus, on average the spread widens as reserve
supply tightens, and narrows (and may even turn nega­
tive) when supply eases. Of course, the spread can
narrow or widen without any policy-related change in
the supply of reserves; many other factors influence
the spread between these two interest rates. In any
10That the slope of the Treasury yield curve, measured from three or
six months to 10, 20, or 30 years, is an indicator of the stance of
monetary policy is a view held by many participants in the credit
markets, including economists working in the area. For example, see
Drexel Burnham Lambert Government Securities Inc., “ Treasury
Market Comment: October 1987." A variation is Laurent’s use of the
spread between the long-term bond rate and the federal funds rate
as an indicator of policy. See Robert D. Laurent, "An Interest RateBased Indicator of Monetary Policy,” Federal Reserve Bank of
Chicago Economic Perspectives, January-February 1988, pp. 3-14.
The spread used in this paper is still another variation. As the next
section will show, this spread is affected by many factors, only some
of which are identifiable by statistical analysis, and thus is far from
an unambiguous indicator of policy changes. First, the long-term
bond rate and foreign factors affect the spread; second, short-term
shifts in the demand for Treasury bills— as in a "flight to quality" by
investors— distort it.


22 FRBNY Quarterly Review/Autumn 1988


case, the best choice among possible measures of the
influence of policy actions on the funds rate is clearly
borrowed reserves (or the related measure, free
reserves).11
Another important factor affecting the federal fundsTreasury bill rate spread is the U.S. bond rate (the long
end of the domestic yield curve). Changes in the bond
rate, through arbitrage up and down the yield curve,
should be positively correlated with changes in the bill
rate. The bond rate, though labeled a domesticeconomy variable, may be an im portant channel
through which foreign financial shocks or impulses are
transmitted to the domestic credit markets. In the past
few years, the foreign demand at some auctions of U.S.
Treasury bonds has been estimated by primary dealers
to be on the order of 40 to 50 percent. It would seem
then that the influence of economic developments out­
side the country can be introduced by variables that
are nominally labeled domestic; and it is probably futile
to categorize variables as purely domestic or purely
foreign.
In addition to these two “ domestic economy” vari­
ables, any number of explicitly foreign economic fac­
tors could also affect the federal funds-Treasury bill
spread:
• First, movements in foreign interest rates would be
expected to be correlated with movements in
domestic interest rates, especially as foreign
assets become increasingly substitutable for
dom estic assets; more than one connection
between foreign and domestic rates could be imag­
ined. Thus, weighted averages of foreign short- or
long-term interest rates were included in the
regressions as explanatory variables.
• Second, the exchange rate would be expected to
influence the spread directly or indirectly. The
anticipated change in the exchange rate is a com­
ponent of the anticipated total return from assets
denominated in a foreign currency. Moreover, with
a much longer lag, a significant change in the
exchange rate affects the competitiveness of an
economy’s products in world markets and thus
adds or subtracts from its aggregate demand. Such
shifts would in turn affect the demand and supply
of credit. Through these channels domestic finan­
cial markets could be affected by actual or antici­
pated exchange rate movements. To capture these
uBecause policy changes can be accomplished through changes in
the discount rate instead of, or in conjunction with, open market
operations, one would expect the discount rate to be one of the
factors appearing in the regression equation. The discount rate,
however, is omitted for several reasons: a discount rate change is
often widely anticipated before it is announced, a surcharge was
imposed during 1981, and additional multicollinearity would be
introduced.

effects, we tried two proxies as explanatory vari­
ables: changes in the exchange rate and its for­
ward premium. The actual change in the exchange
rate, besides altering competitiveness, represents
the realized currency gain or loss; since expecta­
tions are not measured well, the actual change may
have to substitute for the anticipated change in the
exchange rate.
• Third, the amount of currency risk incurred by
investing in foreign assets— the risk that an inves­
tor takes by later having to convert the return from
a foreign-currency-denominated asset into dollars
— should be relevant. The greater the risk, the less
attractive the foreign assets. Thus, the variance of
the exchange rate was used as a measure of vol­
atility in the foreign exchange market.
• Fourth, the closer integration of U.S. financial mar­
kets with those in the rest of the world may affect
the spread by enhancing international capital
mobility as well as asset substitutability. Increased
capital mobility and the process of financial market
integration may be reflected in the growing volume
of international financial and nonfinancial transac­
tions. We tried two proxies to capture this trend
toward greater internationalization: the sum of all
private financial inflows and outflows and direct
investments, and the sum of U.S. merchandise
exports and imports (both scaled by nominal GNP).
Regression results
In each of the regressions in the first set, we added
one of a number of foreign factors to an equation that
otherwise contained only domestic-economy variables.
Thus, the spread between the federal funds rate and
the Treasury bill rate was initially explained by (a) dis­
count window borrowing, (b) the domestic bond rate,
and (c) one of the foreign variables. In these regres­
sions, with ajl variables appearing in first-difference
form, statistically significant coefficient estimates were
found for discount window borrowing, for the domestic
bond rate, and among the foreign variables, for foreign
short-term interest rates; but none of the other foreign
variables proved significant. Thus, insignificant esti­
mates were found for foreign long-term rates, for for­
eign trade (the ratio of U.S. exports and imports to
GNP), for foreign financial transactions (the ratio of
financial inflows and outflows to GNP), and for the
exchange rate, its forward premium, and its volatility.
The coefficient for the foreign trade variable came clos­
est to achieving the usual significance levels and
hence it was included in later regressions.
The regression results for the equation that included
foreign short-term rates but not foreign trade are
reported in column 1 of Table 1. The estimated long-run




impacts of borrowed reserves, the bond rate, and for­
eign short-term rates on the spread are in the
expected direction and seem reasonable in magnitude:
• If borrowed reserves rise $100 million while the
domestic bond rate and foreign money market
rates are constant, the spread between federal
funds and Treasury bills immediately grows 4 basis
points and eventually widens by a total of 11 basis
points.12 Intuition suggests that the bill rate should
rise more and the spread should widen less than
the model indicates. But it must be remembered
that the bond rate is held constant so that pressure
is being placed on the bill rate only from shorter
maturities. On average, a tightening of policy would
also cause the domestic bond rate to rise; pressure
would then be applied to the bill rate from the long
end of the market as well (and if foreign short-term
rates rise, from the international money market too).
• If the bond rate falls by 100 basis points with mon­
etary policy unchanged and foreign short-term
rates constant, then the spread of the federal funds
rate over the Treasury bill rate widens by 50 basis
points in the same month, but later narrows, ending
with a net increase of 23 basis points.13 Essen­
tially, the bill rate moves down less than the bond
rate, and the Treasury yield curve flattens; with the
funds rate nearly constant and a lower bill rate, the
spread between the overnight and three-month
rates widens.
• When foreign short-term interest rates fall while
domestic long-term rates and discount window bor­
rowing are constant, the spread between the fed­
eral funds rate and the bill rate initially widens, as
would be expected. According to the equation,
given a 100 basis point fall in foreign short-term
rates, the bill rate falls by 36 basis points. In the
longer run, though, the spread is relatively
unaffected. The coefficient estimates imply that the
spread will eventually be a little narrower than it
was initially but the effect may be too small to be
significant.14 In any event, it is difficult to interpret
the coefficient on foreign short-term rates in a con­
ventional fashion. Changes in foreign rates may
12The short-run effect is the sum of the two borrowed reserves
coefficients (-4 .7 8 + 26.66) divided by a scaling factor ($58.7
billion, total reserves as of December 1987); the long-run effect is
the sum of the simple change in the bond rate plus 2.5 times the
change in the bond rate from its average over the four previous
months (-4 .7 8 + (2.5)(26.66)) divided by a scaling factor.
13These effects are calculated in the same way as those for the
borrowed reserves variable.
14The effects are again calculated in the same way as for the
borrowed reserves.

FRBNY Quarterly Review/1988 23

well be a response to U.S. rates or may reflect, at
least to some extent, industrial countries’ efforts to
coordinate monetary and exchange rate policies.
Having found that foreign short-term rates contrib­
uted significant explanatory power to the equation, we

Table 1

Regression Results for the Model
S am ple Period: November 1979 to D ecem ber 1987
C oefficient Estimates
(t-statistics in parentheses)
Independent
Variables:
Constant
BRi-BR,.,
BRt-BR4M
BOND,-BOND,.,
BOND.-BOND4,.,
FST,-FSTm
FST,-FST4m
FRTRD,-FRTRD4m

Version 1

Version 2

0.019
(0 5 )

0.019
(0.5)

-4 .7 8
( - 0 .7 )

-6 .5 4
(- 1 .0 )

26.66
(4.6)

28.35
(4.8)

-0 .6 8
(-3 7 )

-0 .5 6
( - 2 .9 )

0.18
(1 3 )

0.10
(0.8)

-0 .7 0
( - 2 .2 )

-0 .7 9
( - 2 .5 )

0.34
(2.0)

0.35
(2.0)
148.0
(1.7)

—

Summary S tatistics
R2

Durbin-W atson
Standard error

0.42
2.51
0.54

0.44
2.51
0.53

Note: All variables entered the regression in first-difference
form.
D ependent
variable
BR

= Federal funds rate less the three-month
Treasury b ill rate.
= Borrowed reserves (in hundreds of m illions of
dollars), d iv id e d by total reserves (in billions).

BR4

= The average of borrowed reserves (d ivid ed by
total reserves) over the previous four months.

BOND

= The 10-year Treasury bond rate.

BOND4

= The average of the bond rate over the
previous four months.

FST

= An average of foreign short-term interest rates.

FST4

= The average of foreign short-term rates over
the four previous months.

FRTRD

= The sum of nominal exports and imports,
d ivide d by GNP (all in billions of dollars).

FRTRD4

= The average of FRTRD over the previous four
months.

A com plete de scription of the variables is provided in the
A ppendix.

24FRASER
FRBNY Q uarterly R eview/Autum n 1988
Digitized for


then reestimated the regression equation by adding the
other foreign variables one at a time. In this second set
of regressions, none of the additional foreign variables
was significant. The variable coming closest to signifi­
cance was foreign trade (t-statistic of 1.72). The results
of this regression are reported in column 2 of Table 1.
A rise in foreign trade is correlated with an increase in
the spread between federal funds and Treasury bills.
In sum, foreign variables do seem to be playing a
role in determ ining the federal funds-Treasury bill
spread. Foreign short-term rates clearly contribute; for­
eign trade, as a proxy for international activity gener­
ally, may also. To be sure, the inclusion of foreign
short-term rates, with or without a foreign trade vari­
able, only modestly improves the equation’s fit (R2).
The degree of improvement in the overall fit, however,
is likely to be a deceptive indicator of the role of for­
eign factors and may be a poor way to measure the
effect of globalization. In the presence of a high degree
of multicollinearity, as is the case here, the marginal
increase in the regression’s explanatory power should
not be interpreted as meaning that only a negligible
share of the movements in the spread can be attrib­
uted to foreign sources. The marginal increase is
biased toward understating the contribution of the for­
eign factors.
Gauging the impact of globalization
The next step was to apportion the explained variability
in the spread between the domestic and foreign factors
and to make an inference regarding the importance of
globalization. But before taking this step, we calculated
the actual and predicted variability of the spread, mea­
sured by the standard deviation, within 12-month inter­
vals, moving through the sample one month at a time
from January 1980 to December 1987. The predicted
variability is the degree of variability expected given
the movements in the factors incorporated in the
model; it is derived using the coefficient estimates of
the regression model (version 2, which includes the
foreign trade variable). Chart 1 compares predicted
variability with actual variability. (The predicted vari­
ability is shown by the dashed line, the actual vari­
ability by the solid line.)
The period from late 1979 to mid-1982, when the
Domestic Trading Desk used a nonborrowed reserves
operating target, clearly coincides with a high degree
of volatility in the spread. Moreover, the larger move­
ments in borrowed reserves, the bond rate, and the
foreign variables in that period are the sources of
much, but by no means all, of this higher variability;
some of the variability cannot be attributed to factors
identified in the model. This increase in residual vari­
ance could be the by-product of the monetary policy

tactics of the period, or the effect of atypically large
real or financial shocks to the economy, such as the
credit control program. Thus, besides greater variability
of the right-hand side variables in the regression, there
is a larger element of unexplained variation— variation
that cannot be attributed to factors explicitly included
in the regression model.
We next calculated the relative contributions of
domestic and foreign factors to the variability of the
spread, as predicted by the equations, and plotted the
results in Chart 2. This statistical procedure does not
allow precise attribution, but it does seem that (a) for­
eign factors introduce less variability than domestic
factors into the spread, but (b) the share introduced by
foreign forces is grad ua lly increasing over time,
although with a highly irregular trend. In the early
1980s, foreign factors were responsible for about 25
percent of the spread’s variability; most recently, about
40 percent on average. This increase is one indication
that, relatively speaking, foreign economic factors are
having a greater effect than before on the determina­
tion of U.S. short-term interest rates.
If one channel of influence for monetary policy is its

C h a rt 1

The Actual and P red icted Standard
Deviation of the Change in
the Rate Spread

impact on short-term interest rates, and if this impact,
in turn, operates in part through the effect of open mar­
ket operations on the market for reserves and the
funds rate, then any nonpolicy factor that may influence
the spread between the funds rate and the bill rate can
be an impediment to policy if its influence is not easily
forecastable. Thus, a growing influence of foreign fac­
tors on this rate spread may represent a problem for
policy if these foreign influences are hard to predict
and hence hard to allow for. Foreign influence on the
spread may be difficult to estimate for several reasons:
despite improved communications, developments in for­
eign economies are not as well understood as those in
the domestic economy; the actions of foreign central
banks are not known in advance; and foreign investors
respond somewhat differently from domestic investors
to changes in the economic outlook. Under these cir­
cumstances it can be argued that the effectiveness of
policy has declined as the role of foreign factors has
increased.
The procedure used in our regression analysis to
this point does not perm it us to say whether the
increased variability in the rate spread attributable to
fo re ig n fa c to rs re fle c ts the d ire c t im pact of the
increased globalization of financial markets. Indeed,
the use of a constant coefficient model automatically
rules out the possibility of any such inference. One way
to test for an increased impact of rising international
financial integration would be to see if the estimated

O v e rn ig h t F e d e ra l Funds Rate v e rs u s the T h re e -M o n th
U.S. T reasu ry B ill Rate
C h a rt 2

P erce ntag e p o in ts




The C o ntrib u tio n s of D om estic and
Foreign V ariab les to the Standard
Deviation of the Change in
the Rate Spread
O v e rn ig h t F e d e ra l Funds Rate versu s the T h re e -M o n th
U.S. T re a su ry B ill Rate
P erce nt
100

0
1980

1981

1982

1983

1984

1985

1986

1987

FRBNY Q uarterly Review/1988

25

coefficient on the foreign factors rises over time. In
another set of regressions, one coefficient in each
equation was allowed to rise or fall steadily through the
sample period.15 These time-varying regression results
do not indicate increasing foreign-variable impacts on
the spread. The hypothesis that the coefficient for for­
eign short-term interest rates has remained essentially
constant is not rejected on the basis of conventional
statistical tests. This may simply mean that globaliza­
tion of the money markets was substantial by the early
1980s and progressed more slowly thereafter, while still
occurring apace in the capital markets. For the foreign
trade variable, however, a constant coefficient can be
rejected, but surprisingly, the coefficient is declining,
15A llow ing all coefficients to vary through time in a single regression
consum es too many degrees of freedom and introduces too much
collinearity.

Table 2

Testing for Changing Coefficient Values
Sam ple Period: November 1979 to D ecem ber 1987
C oefficient Estimates
(t-statistics in parentheses)
Independent
Variables:

Equation Equation
1
2

Constant

0.018
(0.5)

B R fB R j^

45.08
(2.1)

(BRt-BRM )
‘ Time
BR,-BR4m
(BR,-BR4m )
’ Time
BOND.-BOND,.,
BOND,-BOND4 m
f s t ,- f s t m

FST,-FST4m
FRTRDt-FRTRD4t.1
(FRTRD,
-FRTRD4t.1)*TIME

- 0 .4 4
( - 2 .4 )
26.71
(4.7)

0.011
(0.1)
-4 .4 5
(-0 7 )
-

57.26
(3.1)

Equation
3

Equation
4

0.017
(0.1)

0.020
(0.1)

43.96
(2.0)
-0 .4 5
( - 2 .5 )
28.44
(5 0 )

- 6 .1 7
( - 0 .9 )
-

26.75
(4.6)

-0 .2 9
( - 1 .7 )

-

-

-

-

-

-0 .6 9
( - 3 .9 )

-0 .6 4
( - 3 .5 )

-0 .5 6
(-3 0 )

-0 .5 6
(- 2 .9 )

0.15
(1.2)

0.17
(1.3)

-0 .8 5
( - 2 .7 )

-0 .8 1
( - 2 .5 )

-0 .9 4
( - 3 .0 )

-0 .8 1
(- 2 .6 )

0.43
(2.5)

0.37
(2.2)

0.44
(2.6)

0.27
(1.5)
854.6
(2.2)
-5 .3 8
( - 1 .9 )

-

0.078
(0 6 )

-

-

-

-

151.8
(1 8 )

-

-

-

0.15
(1.1)

Summary Statistics
R2
Durbin-W atson
S tandard error

0.46
2.52
0.52

0.44
2.51
0.53

0.46
2.53
0.52

FRBNY Q uarterly R eview/Autum n 1988
Digitized26
for FRASER


0.46
2.50
0.52

not rising as anticipated. (See column 4 of Table 2.)
On the domestic side, a constant coefficient for the
bond rate can not be rejected. Because globalization of
capital markets has supposedly been progressing rap­
idly this decade, it might have been expected that this
coefficient would have increased over time. In the case
of the borrowed reserves variable, a constant coeffi­
cient can be rejected, but the regressions indicate that
the coefficient falls during the sample period. For the
change in borrowed reserves from the previous month
(but not for the change from the average over the pre­
vious four months), a constant coefficient can be
rejected at the 95 percent level. The results appear in
the first three columns of Table 2.
If the finding of a declining coefficient is correct, the
implication is that a given increase— in, say, the level
of borrowings induced by open market operations—
may produce approximately the same upward pressure
on the funds rate as in earlier years but may now have
a larger effect on the other short-term rates presumed
to affect the economy at large. That is, the rise in the
funds rate is now more nearly matched by a rise in the
bill rate, so that the impact on the spread is smaller
than in earlier years. Even if this finding is true, how­
ever, its practical significance is doubtful since it simply
means that a smaller volume of open market opera­
tions is needed, other things equal, to produce a given
impact on bill rates and other short-term rates.
In any case, the power of the test used is unknown; it
may have the tendency to indicate incorrectly a chang­
ing coefficient value more often than the test’s signifi­
cance level suggests. Moreover, this finding could also
be the product of mixing two somewhat different time
periods, 1979-82 and 1983-87. The earlier period cor­
responds to the time when the path for nonborrowed
reserves was directly tied to the growth of the money
supply. Finally, greater coordination of monetary poli­
cies may invalidate the “ other things equal” assump­
tion underlying this analysis. That is, domestic and
foreign monetary policies may now be changed in con­
cert, causing the location of the shift in the regression
equation to be misidentified.

Conclusion
Our study provides some empirical evidence indicating
that an increased impact of foreign developments on
the U.S. money markets may have loosened the link­
age between changes in the supply of bank reserves
and U.S. money market interest rates, and perhaps to
some extent complicated the use of monetary policy to
influence these rates. According to our results, foreign
economic factors have been making a greater contribu­
tion to the determination of U.S. short-term rates in
recent years. A greater role played by foreign factors in

the domestic credit markets makes for more uncer­
tainty in anticipating the proximate impact of a policy
instrument change. Whether the greater contribution by
foreign economic factors indicated by the regression
model has been precipitated by globalization is debata­
ble; but a case can be made that the greater volatility
in the financial and real sectors of the world economy
is attributable to tighter connections among financial
markets worldwide.
One indication that globalization has loosened the
linkage would be regression estim ates showing an
increasing effect of foreign economic factors on the

spread between the federal funds rate and the Trea­
sury bill rate, or a decreasing effect of domestic factors
on that spread. Such changes in the effects were not
observed, however. Instead, we found some statistical
evidence suggesting that the potency of monetary pol­
icy instruments may be greater, in the limited sense
that a given change in borrowed reserves may have a
larger impact on money market rates than in the past.

Lawrence J. Radecki
Vincent Reinhart

Appendix: Description of the Variables Used in the Regression Equations
Variables appearing in reported results
The dependent variable, SPREAD, equals the overnight
federal funds rate (monthly average of effective daily
rates) less the three-month Treasury bill rate (monthly
average of daily rates in the secondary market, bank
discount basis). Source: Board of Governors of the Fed­
eral Reserve System.
BR equals the sum of adjustment and seasonal bor­
rowing from the discount window, in millions of dollars.
Source: Board of Governors of the Federal Reserve
System.
BOND equals the 10-year T reasury bond rate
(monthly average of daily rate in the secondary market).
Source: Board of Governors of the Federal Reserve
System.
FST equals the weighted average of the short-term
interest rates in 10 countries (Switzerland and the G-10
countries excluding the United States); the weights are
the same as those used for the exchange rate. Source:
INTMAC database of the Board of Governors’ staff.
EXP is the merchandise exports of the United States,
seasonally adjusted. Source: Department of Commerce.

Variables appearing in unreported results

States, seasonally adjusted. Source: Departm ent of
Commerce.
Foreign long-term interest rates equal the weighted
average of the long-term interest rates in 10 countries;
the w eights are the same as those used fo r the
exchange rate.
U.S. exchange rate is the index of the weighted aver­
age exchange value of the U.S. dollar against curren­
cies of other G-10 countries plus Switzerland. March
1973 = 100 (weights based on the 1972-76 global trade
of each of the 10 countries). Source: Board of Gover­
nors of the Federal Reserve System.
Volatility of the exchange rate equals the standard
deviation of the change from the previous day in the
logarithm of the U.S. exchange rate, calculated monthly.
Source: INTMAC database of the Board of Governors’
staff.
The forward premium of the exchange rate equals the
difference between the yen-dollar or mark-dollar spot
rate and th e th re e -m o n th fo rw a rd rate. S o u rce : B ank fo r

International Settlements.
The dollar volume of U.S. governm ent securities
(Treasury and agency) bought by foreign private inves­
tors was obtained from the Treasury Department.

Imports are the merchandise imports of the United




FRBNY Quarterly Review/1988

27

Interest Rate Divergences among
the Major Industrial Nations
The international integration of financial markets has
increased dramatically during the last decade. Government-imposed barriers to international capital flows were
gradually relaxed throughout the 1970s and by now have
been substantially eliminated in the major industrial
countries. More recently, the development and growth
of currency and interest rate swaps, options, and other
new financial instruments have further stimulated inter­
national financial integration by giving investors and
borrowers a wider range of choices than that traditionally
available from purely domestic channels. Distinctions
between domestic and foreign financial markets are
fading rapidly as major corporations can gain access to
New York, London, and other international financial
centers nearly as readily as their home markets.
It is widely presumed that financial integration reduces
interest rate divergences among similar credit instru­
ments and increases the degree to which yields in dif­
ferent markets move together over time. Historical
experience with integration of domestic financial markets
would seem to support this presumption. For example,
the development of national money and capital markets
in the United States during the latter part of the 19th
century reduced regional disparities among interest rates
and made the rates increasingly responsive to national,
as opposed to purely local, conditions. This experience
suggests that growing international financial integration
should reduce interest differentials across countries and
possibly lim it the autonomy of national monetary
authorities in controlling domestic financial yields. The
actual record of the last two decades, however, raises
doubts about these propositions. In particular, interna­
tional interest divergences during much of the 1980s

28 FRBNY Quarterly Review/Autumn 1988



have been as great or greater than those observed
during most of the 1960s and 1970s.
This article examines interest rate divergences imong
the United States and other major industrial countries
from the 1960s through the present. As the next section
shows, interest rate disparities among nations can arise
from differences in currency denomination and national
jurisdiction as well as from factors that cause yields to
diverge domestically. Expected exchange rate changes
and their associated risks, together with institutional
barriers to financial flows across national borders, are
potentially important sources of international interest
disparities. The analysis also shows that increased
financial integration unambiguously reduces one source
of international interest rate divergences, that arising
from institutional barriers. Whether integration actually
leads to interest rate convergence, however, depends
critically on the nature of other economic changes
occurring at the same time and their effect upon currency
expectations and risks.
These points are underscored by our empirical anal­
ysis of interest divergences. Neither nominal nor real
interest rates have shown any systematic tendency
toward convergence during the past 25 years. However,
the factors underlying interest rate disparities apparently
have changed significantly. Currency expectations and
associated risks are now the primary sources of diver­
gence, while the importance of overt barriers to capital
mobility has declined markedly. These changes can be
attributed to the historical association of increased
financial integration with the shift from fixed to flexible
exchange rates that has resulted in increased volatility
in currency values.

Causes of interest divergences
In general, disparities among yields on alternative assets
reflect differences in their underlying characteristics.
Within a given nation, liquidity, credit risk, tax treatment,
and other related attributes determine the relative yields
on various instruments. Differences in these character­
istics also contribute to interest variations across
countries— indeed, the international diversity in these
attributes is often greater than the diversity within any
single nation. In a world composed of many countries,
however, interest rates may also diverge because of
currency distinctions and jurisdictional differences, the
latter reflected largely in capital controls and other
institutional barriers to financial flows across borders.
The existence of different national currencies is a
fundamental source of international interest rate diver­
gences. To compare yields on assets denominated in
different currencies, an investor requires an estimate of
their exchange rate at maturity. For example, the dollar
return on an instrument denominated in German marks
(DM) depends upon how much the DM is expected to
appreciate (or depreciate) over the holding period. This
means that yield differentials among assets denominated
in different currencies implicitly reflect market forecasts
of future exchange rate changes. In addition, investing
in one currency as against another involves potential
risks because exchange rates cannot be predicted
exactly. This currency risk, resulting from uncertainty
about future exchange rates, is also a potential source
of interest divergences across countries.1
International interest divergences also reflect nation­
ality distinctions arising from a variety of government
policies and institutional imperfections that effectively
impede financial flows across national jurisdictions. Until
fairly recently, most industrial countries explicitly
restricted or otherwise regulated international capital
flows; these restrictions have been substantially removed
in the United States, Canada, Japan, the United
Kingdom, and Germany, but remain important in many
other nations.2 Interest divergences based on nationality
can also arise from differences in tax systems or other

’ Currency risk thus arises from the variances of the perceived
distribution of exchange rates rather than their means. From a
market perspective this risk reflects the potential loss to an investor
in a currency from an unanticipated change in that currency’s value.
d e re g u la tio n of capital flows generally has proceeded furthest in
shorter-term markets. See M. A. Akhtar and Kenneth Weiller,
“ Developments in International Capital Mobility: A Perspective on the
Underlying Forces and the Empirical Literature,” Federal Reserve
Bank of New York, Research Paper no. 8711, in International
Integration of Financial Markets and U.S. Monetary Policy, December
1987. Note that even the prospect of the imposition of capital
controls can affect interest rates. Risks arising from the possible
inability to repatriate funds are generally referred to as ‘‘sovereign"
and "p olitical” risks.




policies not explicitly aimed at capital flows, as well as
from private market imperfections such as incomplete
information or monopolistic restrictions on market access
and pricing.
The effects of these various factors on interest diver­
gences across countries can be summarized in the fol­
lowing identity:
(i) i - i* = %s + DOM + CRISK + BAR,
where i and i* are, respectively, the interest rates on
U.S. assets and foreign-currency-denominated assets of
a given maturity while %s is the expected (annualized)
rate of dollar depreciation to maturity. The remaining
terms represent the effects of “ domestic” distinctions
among the assets (DOM), currency risk factors (CRISK),
and official and private barriers to capital flows (BAR).3
The difference in asset returns expressed in a common
currency, that is, adjusted for expected exchange rate
changes, is a reflection of these last three elements:4
(ii) i - i* - %s = DOM + CRISK + BAR.
Furthermore, an investor can in some cases avoid the
risk associated with uncertainty about future exchange
rates by “ hedging” (selling) the proceeds of a foreign
currency investment in the appropriate forward market.
The return differential on this hedged (or “ covered” )
basis is simply the interest differential (i - i*) less the
forward premium on the dollar (fp), defined as the
annualized difference between its forward and spot
values:
(iii) i - i* - fp = DOM + BAR.
The covered return differential is not (directly) affected
by currency distinctions since it is adjusted for both the
expected level and uncertainty of future exchange rates.5
Thus, for assets that are comparable in terms of their
domestic characteristics (DOM = 0), the covered dif­
ferential is essentially a reflection of barriers to capital
flows (BAR).
3The substitutability of different countries’ assets is essentially a
function of the importance of the factors summarized by BAR and
CRISK. In reality, the factors underlying these terms are often
closely related, even if distinct in theory.
4The common currency differential as we have defined it is also
known as the "uncovered” differential, denoting that the relative
return is not hedged in the forward market.
5However, currency distinctions may be im plicit in the covered
differential when, for example, official regulations treat foreign
currency investments differently from investments in domestic
currencies (the effect would be captured in BAR). Generally, formal
forward markets exist only for certain short-term assets, although
recently developed currency swap facilities provide comparable
arrangements for some longer-term assets.

FRBNY Quarterly Review/Autumn 1988 29

It is also useful to express the yield differential in
terms of the traditional expected inflation (%p) and real
interest (r) components of nominal interest rates:
(iv) i - i* = (%p - %p*) + (r - r*).
Nominal interest divergences among countries also can
be expressed as the sum of differences in expected
inflation rates and in their real interest rates (where the
real interest rate measures an asset’s return in goods
rather than money). Furthermore, the real interest dif­
ferential is itself partly a reflection of expectations about
the future real exchange rate (x), defined as the nominal
rate deflated by the ratio of home to foreign prices (p
and p*):
x = s -j- (p/p*).
The real exchange rate effectively measures the value
of a country’s goods in terms of its foreign counterparts.6
Using the last two expressions, we can write the real
interest differential in terms analogous to relation (i) for
the nominal difference,
(v) r - r* = %x + CRISK + BAR + DOM.
To summarize, observed nominal interest divergences
across countries can be accounted for by four sets of
factors: expected changes in nominal exchange rates
(which in turn reflect differences in anticipated inflation
and expected changes in real exchange rates); currency
risk; the effects of barriers to capital mobility; and
domestic characteristics summarized in DOM. These
factors are the proximate determinants of international
interest differentials and will provide a useful framework
for our later analysis of the actual behavior of interest
rate divergences among the United States and other
countries.
Fundamental determinants
These proximate sources are not, however, the most
basic causes of international interest divergences, but
rather the reflection of more fundamental exogenous
economic conditions. In thinking about these funda­
mental causes, we can make a distinction between fac­
tors directly affecting particular financial markets and
those determining the transmission of their effects
among countries.
•The real exchange rate is essentially an extension of the "terms of
trade” to include nontraded goods as well. Changes in the nominal
exchange rate can be expressed as the sum of the change in the
corresponding real exchange rate plus the inflation differential. The
traditional theory known as "purchasing power parity” essentially
asserts that real exchange rates are constant in the long run.

FRBNY Quarterly Review/Autumn 1988
Digitized30
for FRASER


In principle, virtually any disturbance that affects one
country’s financial markets more than another’s may lead
to international interest rate differentials. Of particular
importance historically have been divergent national
inflation rates, which normally have been associated with
disparate monetary policies. A country that has a higher
inflation rate than abroad must generally maintain nom­
inal interest rates above those of its trading partners in
order to compensate for the decline in the value of its
currency that typically results from the inflation.7 Diver­
gences in real as well as nominal interest rates have
also resulted from shorter-term fluctuations in monetary
policy that affect domestic liquidity, from disparities in
fiscal policies, and even from commodity supply shocks
such as the oil price increases of the 1970s.8
All of these conditions can create pressures for interest
rates to diverge across countries. Nonetheless, the
extent to which such divergences actually occur, as well
as the way in which they are reflected in currency
expectations and other proximate components, depends
upon the nature and strength of the transmission of such
disturbances from one country to another. Particularly
critical to this transmission mechanism are the mobility
of capital and the exchange rate regime.
In its broadest sense, capital mobility refers to the
degree to which international financial flows tend to
respond to changes in asset yields.9 Key aspects of
international capital mobility are the extent and severity
of explicit official and private barriers to capital flows
and the degree to which assets that are similar
(DOM = 0) but issued in different countries or currencies
are viewed as close substitutes by investors. Generally,
the greater the mobility of capital, the larger the com­
bined effect of a change in a country’s interest rates on
foreign interest rates and exchange rates. An increase

7To the extent that a rise in the inflation rate simply leads to a
compensating increase in domestic interest rates and depreciation
in the nominal exchange rate (leaving the real exchange rate
unaltered), it need not lead to any further divergence in real interest
rates or yields expressed in a common currency. Typically, however,
inflation has indirect effects on real interest and exchange rates and
may affect the BAR and CRISK components as well.
•For example, the mid-1970s oil price rise led to the following
consequences in most importing countries: an acceleration of
inflation, sharp increases in nominal and real interest rates, and a
subsequent downturn in real economic activity. Because the
magnitude and timing of these effects varied greatly across
countries, depending on their reliance on oil imports and other
factors, international interest divergences increased markedly during
this episode.
•This is the traditional broad definition of capital mobility. Under a
narrower definition, capital mobility refers only to the severity of
explicit barriers and other market imperfections that impede
international financial flows. Thus currency risk is a determinant of
the degree of capital mobility under the broad definition but not
necessarily under the narrower one.

in capital mobility can be thought of as a reduction in
the average size and variability of the BAR and CRISK
terms defined earlier. It follows that a given disturbance
is apt to produce smaller divergences in asset yields
expressed in a common currency when capital mobility
is high than when it is low.
Equally important to the international transmission of
interest rate changes, however, is the flexibility of
exchange rates. Unlike a fixed rate regime where
exchange rates (at least in principle) are not free to vary,
a floating rate system allows changes in interest rates
to affect present and future currency values. Conse­
quently, for a given amount of capital mobility, a change
in one country’s interest rates will have more impact on
actual and expected exchange rates (and possibly
CRISK), and less on foreign interest rates, when
exchange rates are flexible than when they are fixed.
In this sense, the current flexible exchange rate regimes
may allow greater scope for international interest rate
divergences.

Implications of reduced barriers to capital mobility
International financial integration has risen consid­
erably over the last two decades, in large part because
of a dramatic reduction in overt barriers to capital flows
among the major industrial nations. The discussion in
the preceding section shows that this development, of
itself, should reduce international interest rate diver­
gences, whether expressed in national currencies, a
common currency, or in real terms. Historically, however,
changes in international financial integration have not
occurred in isolation but have been accompanied by
other complex economic changes, some with potential
effects on interest rate determination. For this reason,
the implications of increased financial integration are apt
to be less clear-cut in an international context than within
a single nation.
In a national market, the use of a single currency
precludes variations in nominal exchange rates as well
as any persistent disparities in inflation rates across
regions. The domestic sources of interest divergences
are therefore significantly fewer than the international
sources; consequently, there is a fairly strong pre­
sumption that increased financial mobility and integration
will lead to closer alignment of interest rates across
markets.
In an international economy comprising many nations
and currencies, however, whether increased capital
mobility leads to convergence of interest rates depends
upon the nature of the changes in exchange rate
behavior and government policies that are occurring at
the same time. During the postwar era, increased
financial integration has been accompanied by a tran­




sition from fixed to highly variable exchange rates and,
as documented in the next section, greater disparities
in national inflation rates. In effect, as the importance
of factors reflected in BAR has declined, the potential
importance of currency expectations and risk factors may
well have increased. Accordingly, interest rates have
been subject to conflicting pressures: easing of restric1ions on capital flows has tended to push the rates
toward convergence, while greater exchange rate vol­
atility and inflation disparities have increased pressures
for the rates to diverge. As we show in the empirical
analysis that follows, this configuration of economic
changes over the last three decades has led to a fairly
complex and variable pattern of interest rate divergences
among the major industrial nations.
Evidence on interest rate divergences
We now examine the historical pattern of interest rate
divergences and their proximate determinants for five
major industrial countries—the United States, Germany,
Japan, the United Kingdom, and Canada. Divergences
among both short-term money market rates and longerterm government bond yields are considered.10 We first
show that these nations’ nominal interest rates exhibit
no consistent trend toward convergence over the last
two decades, although the impact of barriers to capital
mobility (BAR) has declined markedly. This implies that
currency factors are now the main source of observed
international interest rate divergences. We then go on
to consider the extent to which expected exchange rate
changes can account for interest differentials across
countries, asking whether asset yields expressed in a
common currency have converged over time. Finally, we
examine the nature of the currency expectations them­
selves, in particular the degree to which they appear to
be a reflection of anticipated inflation differentials or of
fluctuations in real exchange rates.
Nominal interest rate divergence
Interest rate dispersion can, in principle, be measured
in several ways. In most of the analysis below, we focus
on an indicator of the aggregate level of interest rate
divergence for the group as a whole— the average
absolute deviation of individual rates from the group
mean. This indicator measures the collective impact of
the proximate sources of interest differentials identified
earlier: expected exchange rate changes, currency risk,
10The short-term rates used in this study are: three-month certificate of
deposit (CD) rate for the United States; three-month interbank rate
for Germany; two- to three-month interbank (call) rate for Japan; the
one-month financial paper rate for Canada; and the three-month
interbank loan rate for the United Kingdom. The long term rates are
government bond yields of greater than five-year maturities. These
are generally the most comparable rates available for the entire
period.

FRBNY Quarterly Review/Autumn 1988 31

and barriers to capital mobility, as well as any domestic
comparability distinctions among assets. For assets that
are reasonably comparable, this measure indicates the
degree to which international interest rates diverge in
a given period and their tendency towards convergence
over time.
Of course, the assets considered here are not perfectly
comparable, and thus interest rate divergences need not
disappear across countries even as currency and juris­
dictional differences subside. Our analysis will suggest
that domestic comparability distinctions are generally
in sig n ifica n t among short-term instrum ents. More
important differences in average maturity and other
characteristics are, however, reflected in long-term rates.
Nonetheless, these distinctions have remained relatively
stable and hence are unlikely to have had a substantial
impact on changes in the pattern of interest rate dis­
persion over time. For this reason, a comparison of
average levels of interest rate divergence across relevant
periods should provide a reasonable indication of trends
in their proximate determinants.

Further insight into the nature of international interest
rate divergences is provided by examining bilateral
interest rate relations. We present evidence concerning
one important component of our aggregate dispersion
measure, U.S.-foreign bilateral interest rate differentials.
In addition, the tendency for U.S. and foreign interest
rates to move together is analyzed in the accompanying
Box. While not directly measuring the size of diver­
gences, this analysis provides some indication of the
strength of linkages between domestic and foreign asset
markets during different historical periods.
Chart 1 presents our measure of the degree of dis­
persion of nominal interest rates from the 1960s onward.
The chart shows clearly that nominal interest rates often
have diverged widely. The average absolute deviation
of short-term interest rates from the group mean has
frequently exceeded 200 basis points and has only rarely
fallen below 150 basis points during this decade. Long­
term rates, although typically less widely dispersed than
the short rates, have generally diverged by more than
150 basis points.

Chart 1

Nominal Interest Rate D ispersion*
Percent
S h o rt-te rm rates

Long-term rates

Sources:

Interest rates are taken from the countries' central bank publications.

Note: Figures with arrows indicate period averages fo r 1961-72, 1973-79, and 1980-88:111.
♦ The mean absolute deviation of quarterly average in te re st rates from the simple average of the group. The group includes the
United States, Canada, the United Kingdom, Germany, and Japan. Short-term interest rates are three-month money market rates.
Long-term in te re st rates are yields on government bonds with maturities of five years or more.

FRBNY Quarterly Review/Autumn 1988
Digitized32
for FRASER


earlier.
The impression that interest rates have not converged
is further supported by evidence on the correlation of
U.S. and foreign yields (see the accompanying Box).
Specifically, the response of foreign interest rates to a
given change in U.S. rates was generally smaller during
the 1980s than the average response over the 1970s
and 1960s.
These results are particularly striking in view of the
clear evidence that the component of interest diver­
gences attributable to explicit barriers to international
capital flows (BAR) has declined markedly over time.
These barriers were fairly stringent in Japan and Europe
for much of the postwar period and effectively helped
insulate domestic interest rates from changes in financial
conditions abroad.11 Beginning in the mid-1970s these
impediments were largely removed in the major industrial
countries as part of a larger move toward financial
deregulation.
An indication of the effect of these changes can be
seen from the fall in the dispersion of covered short­
term interest rates shown in Chart 2.12 The identity (iii)
discussed in the previous section shows that, for com-

It is also apparent that the degree of nominal interest
rate divergence has tended to increase over time.
Interest rates were most closely aligned during the years
1966-71: both short- and long-term rates generally fell
within 100 basis points of the group mean during this
period. Since 1973, however, divergences among the
rates have become increasingly pronounced. Average
rate deviations over 1973-79 exceeded 200 basis points
on short-term and 170 basis points on long-term rates,
roughly double the levels of the 1960s and early 1970s.
The dispersion of nominal interest rates reached its peak
in 1981. Nonetheless, for the 1980s as a whole, interest
rate divergence has exceeded that of the two preceding
decades.
This trend towards greater nominal interest rate dis­
persion among industrial countries can also be observed
in U.S.-foreign bilateral interest rate relations. The
average absolute interest differential between U.S. rates
and those abroad has risen steadily during the past two
decades, increasing roughly by 100 basis points for both
short- and long-term rates (Table 1). Underlying this
trend have been particularly sharp increases in the size
of U.S. interest differentials with Germany and Japan.
U.S. rates, uniformly the lowest among industrial nations
during the 1960s, began to rise relative to those in
Germany and Japan during the 1970s; by the 1980s both
short- and long-term U.S. interest rates had increased
on average to more than 300 basis points above their
German and Japanese counterparts. In contrast, the gap
between U.S. interest rates and their typically higher
Canadian and U.K. counterparts exhibits no systematic
tendency to increase over time. In nearly all cases,
however, the volatility of the U.S.-foreign interest dif­
ferentials has been substantially higher since 1973 than

11The United States also im posed barriers to cap ital flow s during parts
of the 1960s and 1970s, although they w ere usually less restrictive
than those im posed by other m ajor industrial countries. An exam ple
is the interest equalization tax of the late 1960s.
12Because of lim itations on forw ard rates and other required data, our
analysis is largely confined to short-term interest rates over the
1970s and 1980s. To reduce com p a ra b ility differences, we have
used the Japanese Gensaki (bond repurchase) rate for this section
and the append ix rather than the two- to three-m onth call rate
referred to elsew here in the article (and in all other charts and
tables). The Gensaki rate is most com para ble to the short rates for
the other countries but was only ava ila ble on a regular basis from
the early 1970s on.

Table 1

U.S.-Foreign Bilateral Nominal Interest Differentials
(Period Average of Q uarterly O bservations in Percentage Points)

Average
Absolute Deviationf
Period

Short

Long

Germany
Short

______Japanj_____

_____ Canada_____

United Kingdomj|

Long

Short

Long

Short

Long

Short

Long

- 1 .8 2
(0.82)

- 2 .8 6
(2.53)

- 0 .8 5
(0.75)

- 0 .6 6
(0.75)

- 0 .7 2
(0.37)

-1 .9 5
(1.18)

- 1 ,8 8
(0.52)

1960-72

1.78

1.19

0.60
(1.54)

1973-79

2.57

2.16

1.32
(2.81)

-0 .0 1
(2.01)

0.31
(3.38)

- 0 .0 4
(1.51)

- 1 .1 5
(1.53)

-0 .6 2
(0.44)

-3 .3 1
(2.26)

- 4 .9 3
(1.49)

1980-88§

2.81

2.17

3.23
(1.25)

3.03
(1.02)

3.68
(2.64)

3.77
(1 3 4 )

- 1 .4 9
(1.09)

-0 .7 1
(0 7 1 )

- 1 .7 6
(2.56)

- 0 .7 2
(1.33)

Note: Figures in parentheses are standard deviations.
fS im p le average of the four absolute bilateral interest differentials.
^Ja p a n ’s long-term interest rates begin in 1967.
||United K ingdo m ’s long-term interest rates begin in 1961.
§1988 data through third quarter.




FRBNY Quarterly Review/Autumn 1988

33

Box: Foreign Responses to U.S. Interest Rate Changes
The analysis of interest rate dispersion presented in the
text focuses on cumulative levels of interest rate diver­
gence across countries. Our aggregate indicator— the
average absolute deviation of rates from the group
mean— provides a good summary measure of the overall
size of interest rate divergences that arise from currency
and jurisdictional differences. It is also useful, however,
to examine whether the tendency for national interest
rate movements to be associated with each other has
been affected by financial integration. Accordingly, in this
section we present evidence concerning the average
response of foreign interest rates to movements in U.S.
and German rates.
The correlation and average response measures in
Table A identify the strength and magnitude of interest
rate linkages between national asset markets, thus pro­
viding some indication of the nature of the transmission

of disturbances from one country to another.t No clear
relationship exists, however, between these measures of
responsiveness and the degree of interest rate disper­
sion. An increase in the response of foreign to U.S.
interest rate changes, for example, does not necessarily
imply a narrowing of interest differentials or consequently
our measure of rate divergence. The extent to which rates
will diverge also depends upon the size of the original
disturbance and its persistence over time.
An examination of Table A suggests that only Canadian
interest rates respond in a consistent and strong manner
to movements in U.S. rates. Responses of other foreign
tL ik e the dispersion indicator, these m easures provide a
purely statistical indica tion of the degree of a sso cia tio n — in
this case between cha nges in U.S. and foreign rates. They
provide no d ire ct m easure of causal relations or the strength
of interest rate transm ission in any fundam ental sense.

Table A

Transmission of Interest Rate Movementst
Nominal

Real

Short-Term

1960s
United States
Germany
Japan:}:
Canada
United Kingdom§

P

Long-Term

0.64
0.02
0.88
0.47

b2
0.10
—
0.08
0.13
0.86

0.35
NA
0.63
-0 .0 2

—
0.56
0.21
0.69
0.38

0.45
—
0.16
0.34
0.29

—

0.66

B,

—

—

0.25
0.01
0.60
0.25

Short-Term

0.45
NA
0.91
0.57

b2
0.27
—
NA
0.26
0.16

0.20
-0 .0 7
0.15
0.34

—
0.41
0.15
0.72
0.22

—
0.52
0.16
1.10
0.58

0.34
—
0.47
0.42
0.82

0.34
-0 .2 2
0.43
0.41

—
0.61
0.42
0.89
0.47

—

1.05

0.36
0.21
1.05
0.41

P
—

B,
—

P
—

Bt
—

0.01
-0 .2 5
0.17
0.83

b2
0.00
—

-0 .0 6
0.11
-0 .2 6

1970s
United States
Germany
Japan
Canada
United Kingdom

—

0.50
0.28
0.78
0.28

—

—

0.38
-0 .2 6
0.37
0.98

0.31
—

-0 .1 6
-0 .1 1
1.06

1980 to 1988-11
United States
Germany
Japan
Canada
United Kingdom

—

0.33
-0 .3 6
0.77
0.14

0.17
-0 .2 0
0.80
0.12

—

-0 .1 0
1.31
0.01

—

0.40
1.21
0.65

—

0.29
-0 .1 8
0.69
0.13

—

0.19
-0 .1 3
0.81
0.17

0.45
—

-0 .2 2
0.86
0.09

fT h e colum n headings:
p = correlation of U.S. with foreign interest rate.
B ,, B2 = average response, in pe rcentage points, of foreign interest rates associated with a one pe rcent cha nge in
U.S. (B ,) and German (B2) rates.
^Jap an's long-term interest rates begin in 1967.
§United K ingdo m ’s long-term interest rates begin in 1961.

Digitized34
for FRASER
FRBNY Q uarterly Review/Autumn 1988


Box: Foreign Responses to U.S. Interest Rate Changes (continued)
rates to U.S. yields have been much more variable and
generally very modest. In addition, movements in German
interest rates seem to elicit only a weak response from
all countries.
Overall, these response measures support the con­
clusions in the text that financial integration has not been
associated with a closer alignment of interest rates across
countries. At the least, there appears to be no systematic
tendency for foreign rates to become more responsive
to U.S. yields over time; this result also applies generally
to the responses of foreign rates to German yields.
Indeed, a one percent change in U.S. nominal interest
rates was generally associated with a smaller response

parable assets (DOM = 0), the level of the covered
U.S.-foreign yield differential— with asset proceeds
hedged in the forward markets to compensate for
expected exchange rate changes and currency risk
factors— provides a direct measure of the contribution
of nationality distinctions (BAR).
Divergences in covered yields clearly have become
both substantially smaller and less variable over the past
decade. Most notably, since 1982 the average (absolute)
deviation of short-term covered interest rates from the
group mean has fallen to roughly 25 basis points, a level
representing only about 10 percent of the dispersion of
short-term nominal interest rates. This reflects a sharp
decline when compared to the 90 basis point dispersion
in covered yields over the 1974-79 period, which rep­
resents more than 40 percent of the total dispersion of
unadjusted rates during this period.
Further insight into this apparent decline in barriers
to capital mobility is presented in the Appendix, where
we consider the determinants of U.S.-foreign bilateral
covered interest differentials. The analysis suggests that
the closer alignment of covered yields during the 1980s
is the result of a general dismantling of official barriers
to capital flows— both abroad and in the United
States— as well as other developments promoting the
integration of short-term financial markets across
industrial nations.13

in corresponding European and Japanese rates during
the 1980s than during the 1970s or 1960s4 Similarly,
associations among short-term real interest rates were
generally weaker for the 1980s as a whole than for the
prior decade. Thus, statistical linkages among national
interest rates do not seem to have become stronger over
time— a pattern clearly consistent with the evidence cited
earlier.
^C orrelations am ong long-term interest rates w ere som ewhat
greater during the 1980s than the 1970s. This find in g is
largely a reflection of the higher va ria b ility of interest rates in
the latter period. C orrelations, however, do not d ire ctly
measure the qu antitative change in one interest rate
associated with a cha nge in another.

C hart 2

Covered Interest Rate Dispersion*
P erce nt

18----------------------------------------------- -

S o u rce s: In te re s t ra te s are ta k e n fro m th e c o u n tr ie s ’
c e n tra l bank p u blication s.
Note: F ig ures w ith a rro w s in d ic a te p e rio d a ve ra g e s fo r
1974-79, 1980-82, and 1983-88:111.

13The extent of integration among longer-term markets (or its change
over tim e) is much more d iffic u lt to gauge, in part because forw ard
or other exp lic it mechanism s for hedging longer-m aturity investm ents
have not been available until the last several years. A recent
analysis by Helen Popper (“ Long-Term Covered Interest Parity: Two
Tests Using C urrency Swaps,” unpublished paper, D epartm ent of
Economics, U niversity of C alifornia at Berkeley, August 1987) does
suggest fairly close alignm ent of covered yields as calcula ted from




* The mean ab solute d e v ia tio n of q u a rte rly average
s h o rt-te rm a s s e t yie ld s (c o n v e rte d to d o lla r te rm s by the
fo rw a rd e xch a n g e ra te p re m ia ) from the sim p le ave ra g e
of the five c o u n trie s . S h o rt-te rm in te re s t ra te s are
th re e -m o n th money m a rke t ra tes.

FRBNY Quarterly Review/Autumn 1988

35

Differentials expressed in common currency
The fact that interest rates have not converged even
as barriers to capital mobility have fallen has one rea­
sonably unambiguous implication: currency-related fac­
tors, as reflected in forward exchange premia, are now
the primary source of international yield divergences.
What then is the nature of these currency factors and,
more specifically, how do we assess the relative impor­
tance of exchange rate expectations and currency risk?
One common view is that eliminating barriers to
financial flows across countries necessarily means the
near equalization of asset yields expressed in a common
currency, that is, adjusted for expected exchange rate
changes. This would imply that anticipated exchange
rate movements are now the primary source of observed
interest differentials across countries on comparable
assets and that currency risks have a fairly limited role,
at least at the margin. This view is implicit in several
recent analyses that link the rise in U.S. interest rates
above those abroad over 1981-85 to the concurrent
“ overvaluation” of the dollar relative to its (presumed)
long-run equilibrium. Given the high and increasing
exchange rate volatility over the last 15 years, however,
it is far from obvious that currency risk factors are so
unimportant. Indeed, it is at least conceivable that cur­
rency risk premia have increased enough to offset the
tendency toward convergence in interest rate levels
arising from the reductions in barriers to capital flows.
The main problem in resolving these questions is that
neither exchange rate expectations nor currency risk
premia are directly observable. Indeed, exchange rate
expectations have been notoriously difficult to measure
because of the high volatility of currency values. Any
concrete analysis must be based upon proxies (pref­
erably several) for expectations. One possibility is to use
actual exchange rate changes over a given period as
an approximation of the anticipated change during the
same period in order to gauge the common currency
yield differential. Conceptually, this indicator, which can
be thought of as the ex post yield differential, is equal
to the actual ex ante differential (reflecting currency risk
as well as any remaining DOM and BAR) plus the mar­
ket’s forecast error in predicting the future exchange
rate. If market forecasts are not systematically biased
and forecast errors are roughly comparable among
periods, this proxy will indicate the broad trends in actual
common currency interest differentials.
Chart 3 shows the dispersion of the short-term interest
rates expressed in dollars using the ex post measure.
Divergences in ex post dollar yields have risen dra­
matically over time. The average divergence has exFootnote 13 continued
currency swap quotes (essentially futures prices) for high-quality
bonds issued in the Euromarkets.

36for FRASER
FRBNY Quarterly Review/Autumn 1988
Digitized


ceeded 1000 basis points over the last decade, more
than twice that recorded before 1973. Furthermore, the
divergences have been somewhat greater during the
1980s than over 1973-79.
It is doubtful that these trends reflect increasing cur­
rency risk premia alone. In particular, the magnitude of
the dispersion of ex post differentials seems implausibly
large to represent risk premia. (Note that typical gaps
between yields on very high risk junk bonds and AAA
rated bonds are smaller than the differentials shown in
Chart 3.) The fact that the dispersion of the ex post
yields is nearly five times that of the unadjusted interest
rates also suggests that forecast errors are largely
responsible for the observed pattern in ex post yield
dispersion. Thus, the increasing divergences shown in
the chart are most likely the reflection of increasing
currency volatility and unpredictability; they provide no
conclusive evidence whether ex ante common currency
interest differentials have converged.
Possibly more informative are various surveys of the
exchange rate expectations of market observers and
participants that have only become available during the
1980s.14 Estimates of dollar depreciation based on a
survey reported in the Economist Financial Review are
presented in Table 2 along with the corresponding for­
ward discount on the dollar quoted at the time of the
survey. Recall that the forward discount on the dollar
is equal conceptually to its expected depreciation plus
the currency risk premium (CRISK). Thus the difference
between the forward discount and the market survey
expectations figure can be taken as a proxy for the cur­
rency risk.
As the table shows, survey estimates of dollar depre­
ciation typically exceeded the forward discount for most
of the 1980s, suggesting that investors viewed dollar
assets as generally less risky than similar assets
denominated in foreign currencies. The average size of
these risk premia proxies is quite large, exceeding 500
basis points in many cases. Nonetheless, the survey
measures and forward exchange premia do tend to vary
together. As the table shows, both 3-month and 12month forward discounts on the dollar are largest for
those currencies against which the dollar is expected
to depreciate most. Moreover, the expected depreciation
and forward discount rates show a positive and statis14See the work of Jeffrey Frankel and Kenneth Froot: "Using Survey
Data to Test Standard Propositions Regarding Exchange Rate
Expectations,” American Economic Review, vol. 77, no. 1, pp.
133-53; and “ Interpreting Tests of Forward Discount Unbiasedness
Using Survey Data on Exchange Rate Expectations,” NBER Working
Paper no. 1963, July 1986. See also Kathyrn Dominiquez, "Are
Foreign Exchange Forecasts Rational?: New Evidence from Survey
Data," Board of Governors of the Federal Reserve System,
International Finance Discussion Papers, no. 241, May 1986. Here
we use the Economist Financial Review survey data provided by
Ken Froot.

Table 2

Survey Data and Foreign Exchange Rate Premia: June 1981-May 1987
(Period Average in Percent)

Forward exchange prem ia
on the do lla r
( + = discount)
S urvey-based estim ates
of d o lla r d e p re c ia tio n t
E stim ated currency risk
prem ia ( + = discount)
Memo: correlation of survey-based
estim ates of do lla r deprecia tion
and forw ard exchange prem ia

______German Mark______

______Japanese Yen______

3-Month
12-Month
Horizon______ H orizon

3-Month
12-Month
Horizon_______ Horizon

______British Pound
3-M onth
H orizon

12-Month
Horizon

3.86

3.78

3.95

3.97

- 0 .9 4

-0 .4 7

11.47

9.00

11.70

9.14

2.88

2.38

-7 .6 1

- 5 .2 2

- 7 .7 5

- 5 .1 7

- 3 .8 2

- 2 .8 6

0.50

0.72

0.53

0.53

0.41

0.63

Source: Data provided by Ken Froot from data base used in Frankel and Froot, “ U sing Survey Data to Test S tandard Propositions
R egarding E xchange Rate E xpectations," A m erican E conom ic Review, March 1987.
tS u rve y -b a s e d data are from the E conom ist Financial Report.




FRBNY Quarterly Review/Autumn 1988

37

tically significant association over time. 15
As a whole, the survey evidence suggests that both
expected exchange rate changes and currency risk
premia are important components of forward premia and
interest differentials across countries. This conclusion
is consistent with the findings of most other recent
studies of these questions. 16 But the data are too limited
to draw more specific conclusions concerning the relative
importance of currency expectations and risk premia or
to assess the extent to which ex ante common currency
yield differentials have changed over time.
Nature of expectations
Finally, to clarify the nature and importance of the
exchange rate expectations, we ask whether they reflect
differences in anticipated inflation rates, expected
changes in real exchange rates, or both. Our earlier
conceptual analysis implies that this question essentially
concerns the behavior of real interest rates and their
relation to the corresponding nominal rates. In particular,
a comparison of relations (i) and (v) shows that real
interest differentials reflect expectations of real exchange
rate changes (as well as DOM, CRISK, and BAR) and,
unlike their nominal counterparts, are not directly
affected by anticipated currency movements arising from
inflation differentials. Thus, comparing the dispersions
of real and nominal interest rates should help to clarify
the relative importance of expectations about inflation
and about real exchange rate movements. Admittedly,
real interest rates and the expected inflation rates
underlying them are not directly observable; they can,
however, be approximated using past inflation as a proxy
for anticipated future rates. 17
Chart 4 presents the dispersion of short-term and long­
term real interest rates calculated in this manner. As a
comparison of Charts 1 and 4 reveals, the dispersion
18ln “ Using Survey Data to Test Standard Propositions,” Frankel and
Froot also compare the forecast errors (prediction less actual
change) implied by the survey data and corresponding forward
premia. These errors are closely related, suggesting that
expectations, at least as measured by the surveys, are an important
element of the forward premia and corresponding interest
differentials. The errors are also large, both absolutely and relative
to the risk premia implied by the survey data. This result is
consistent with our contention that forecast errors are largely
responsible for the pattern of ex post nominal interest divergences.
'•Most evidence suggests that currency risk premia exist, but
considerable controversy remains over their empirical importance.
The strongest evidence that currency risk premia play a major role
in interest differentials across countries has been provided by
Eugene Fama, “ Forward and Spot Exchange Rates,” Journal of
Monetary Economics, November 1984, pp. 319-38; his results
suggest that currency risk premia are more variable than exchange
rate expectations and show a strong negative correlation with them.
17Here we use the past year’s inflation (in the GNP deflator) to
measure short-term real interest rates and the past two years’
inflation for the long-term yields.

38for FRBNY
Digitized
FRASER Quarterly Review/Autumn 1988


of real interest rates remained relatively close to that
of nominal yields during the 1960s and early 1970s and
rose above that of nominal rates by well over 1 0 0 basis
points during 1973-75.18 After 1975, however, the dis­
persion in real rates declined, dropping to roughly its
pre-1973 average. In contrast, the dispersion of nominal
yields continued to increase and during the 1980s has
averaged nearly twice its pre-1973 level.
The clear implication that can be drawn from this evi­
dence is that expectations concerning inflation (that is,
differences in the rate anticipated for various countries)
have been a significant source of interest differentials
across countries during the era of floating exchange
rates and indeed were the primary cause of the
increased divergence in nominal rates observed after
1975. Consequently, it appears that currency expecta­
tions arising from inflation differences have been a sig­
nificant contributor to international interest divergences,
at least over the past 10 to 15 years. This result is not,
of course, entirely surprising in view of the substantial
increase in the variability and disparity of national infla­
tion rates that occurred during the 1970s.
More striking, however, is that the average dispersion
of real interest rates has been both substantial (generally
above 1 0 0 basis points) and roughly constant over time.
This relative stability in the average level of real interest
rate dispersion is remarkable in light of the clear evi­
dence that financial integration has virtually eliminated
one of its most significant sources. The earlier analysis
strongly suggests that barriers to capital mobility prob­
ably were the main contributor to real (as well as nom­
inal) interest dispersion prior to 1973 and an important
contributor during the latter 1970s. The role of capital
controls, however, became minor during the 1980s. Thus,
currency factors—currency risk premia and expectations
about real exchange rates— have increased in size and
now appear to be the main source of real interest
divergences among the countries.
Furthermore, there is reason to believe that expec­
tations about real exchange rate movements have been
a significant contributor to real interest rate divergences,
particularly in recent years. The evidence for this con­
clusion stems from the conceptual nature of real
exchange rates and their actual behavior in the 1970s
and 1980s. This same evidence also suggests, although
only tentatively, that interest rate divergences adjusted
for expected movements in real exchange rates were
in fact smaller on average during the 1980s than in the
18ln Japan and the United Kingdom during the mid-1970s, government
controls sharply restricted the flexibility of nominal interest rates in
adjusting to the severe fluctuations in inflation occurring at the time.
This led to dramatic swings in real interest rates and largely
explains the exceptionally large dispersion in these rates among the
countries in the mid-1970s.

1970s.
As indicated earlier, the real exchange rate for a given
country measures the average level of its product prices
relative to those of its trading partners; hence real
exchange rates are a key determinant of the nation’s
international competitiveness. It is therefore reasonable
to suppose that at any time there is a long-run equilib­
rium real exchange rate level (consistent with a sus­
tainable external payments position) toward which the
actual exchange rate tends to move over time. This
notion is the basis for the traditional and widely accepted
notion of “ purchasing power parity” (PPP), which in its
strictest form implies that the equilibrium real exchange
rate is constant in the long run. More realistic interpre­
tations of PPP allow for some evolution in the long-run
equilibrium arising from differences in productivity,
demand, and other relevant trends across countries.
Either interpretation implies, however, that short-term
variations in real exchange rates represent, at least in
part, departures from long-run values that tend to be

reversed over time.19
Before the 1971 Smithsonian agreement to devalue
the dollar, real exchange rates of the dollar and other
major currencies were fairly stable, at least relative to
their long-term trends. Fluctuations in the real value of
the dollar became more considerable during the 1970s
and, as Chart 5 reveals, became highly pronounced in
the 1980s. The chart also shows that deviations of the
real dollar from its past trend and period average, which
can be viewed as very rough proxies for the long-run
equilibrium , have also been quite large during the
present decade, both in absolute terms and relative to
19Several recent studies of exchange rate behavior during the 1970s
and 1980s im ply that the long-run e q uilibrium real exchange rate
changes fairly continuously. Some in fact sug gest that actual real
exchange rate cha nges largely reflect fluctu ation s in their long-run
eq uilibrium and that there is virtually no tendency for current real
exchange rate movem ents to be reversed in the future. See, for
exam ple, John C am pbell and R ichard C larida, "The Dollar and Real
Interest Rates," p a per presented at the 1986 C arnegie-R ochester
C onference on Public Policy, N ovem ber 21-22, 1986.

C hart 4

Real Interest Rate Dispersion*
P erce nt

8 --------------------------Short-term rates

0
4

Long-term rates

S o u rc e s :
Note:

In te re s t rates are ta ke n fro m the c o u n trie s ’ ce n tra l bank p u b lic a tio n s .

F ig ures w ith a rro w s in d ic a te p e riod ave rage s fo r 1961-72, 1973-79, and 1980-88:11.

♦ The mean a b s o lu te d e v ia tio n of q u a rte rly ave rage real in te re s t ra te s from the sim p le a v e ra g e of the group. The group in clu d e s
th e United S tates, C anada, the U nited Kingdom , Germ any, and Japan. Real s h o rt-te rm in te re s t ra te s a re th re e -m o n th money
m a rke t ra te s , le s s the infla tio n in the GNP/GDP d e fla to r over the p a st ye a r. Real lo n g -te rm rates are y ie ld s on go vernm ent bonds
w ith m a tu ritie s of five ye a rs o r m ore, less the in fla tio n in the GNP/GDP d e fla to r ove r the p a st tw o y e a rs .




FRBNY Quarterly Review/Autumn 1988

39

the 1970s.
PPP theory strongly suggests that this behavior indi­
cates a substantial “ overvaluation” of the dollar relative
to its long-term equilibrium during the first half of the
1980s. Similarly, the theory would attribute the sharp
decline in the dollar after 1985 to a “ correction” of this
overvaluation. From this interpretation of the dollar’s
movements— which is supported by the unprecedented
rise in the U.S. trade deficit after 1982— we can infer
that anticipated changes in the real value of the dollar
(at least over the medium term) have been sizeable and
have contributed significantly to the divergences in real
interest rates observed during the decade. The evidence
from Chart 6 provides some support for this supposition:

the real long-term interest differential between the United
States and the four major foreign countries rose with
the appreciating real dollar over most of 1980-84; the
real interest differential and the dollar also fell together
after 1985.20
On balance these arguments suggest that expected
movements in real exchange rates have been a signif­
icant source of real interest divergences during the
20There is, of course, no rigid linkage betw een real interest rates and
exchange rates, either in theory or practice. As Chart 6 also shows,
the dollar continued to rise over 1984-85 even when U.S. real
interest rates fell relative to abroad. N onetheless, the pattern evident
before and after that period does su p p o rt the hypothesis that
expectations about future d o lla r m ovem ents were an im portant
proxim ate source of real interest d iffe ren tials ob served at the time.

C h a rt 5

Real Value of the Dollar
Index 1972=100
140

Real dollar v a lu e *

B o U - L J—I—L

P e rc e nitt
3 0 ------D e v ia tio n fro m fiv e -y e a r m o v in g average"!"

3 0 1 i i i 11 i i I i i i I m i 11 i i 11 11 1 1 1 1 1 1 1 i L i i i 1 i i i I i i 11 i i i 11 i i 1 1 1 1 1 1 1 i 1 1 1 1
1970
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85

S ource:
Note:

1 1 1 . 1 1 111 L u j J
86
87
88

M organ G uaranty T ru s t Com pany, W orld F in a n cia l M a rk e ts .

F ig ure w ith a rro w in d ic a te s p e riod ave rage .

* R e a l tra d e -w e ig h te d value of the d o lla r a g a in s t 15 in d u stria l c o u n trie s co m p u te d using do lla r e x c h a n g e ra te s d e fla te d by the
ra tio of fo re ig n to U.S. m a nufa cturing w h o le s a le p ric e s .
t D eviation of the re al tra d e -w e ig h te d e xch ange ra te fro m its fiv e -y e a r m oving average.

FRBNY Quarterly Review/Autumn 1988
Digitized40
for FRASER


1980s; the role of real exchange rate expectations during
the 1970s is less clear, but very likely less important
than after 1980. More generally, this behavior provides
further evidence of the major role that currency expec­
tations, apparently reflecting perceptions about both the
real and inflation components of exchange rates, have
played in interest differentials across countries in recent
years.
More speculatively, the apparent increase in impor­
tance of real exchange rate expectations may also mean
that interest rates expressed, ex ante, in a common

currency were more closely aligned in the 1980s, when
international financial integration was greater than earlier.
By definition, the real interest differential is equal to the
expected change in the real exchange rate plus the
common currency differential (see relations ii and v).
Hence, the fact that the dispersion in real interest rates
did not rise in the 1980s over the latter 1970s, while
the magnitude of expected real exchange rate changes
apparently did, suggests a possible decline in the dis­
persion of common currency differentials. Of course, the
very rough and preliminary nature of our analysis makes

C h a rt 6

U.S.-Foreign Real Interest Differential and Real Exchange Rate*
P e rc e n t
4 --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Real long-term interest differential

S o u rc e s : In te re s t ra te s a re ta k e n fro m th e c o u n trie s ’ c e n tra l ba nk p u b lic a tio n s . The GNP/GDP d e fla to rs are ta ke n fro m
p u b lic a tio n s of the c o u n trie s ’ c e n tra l s ta tis tic s o ffic e s . E xch a n g e ra te s are ta ke n fro m In te rn a tio n a l F in a n cia l S ta tis tic s .
* W e ig h te d a v e ra g e of b ila te ra l U .S .-fo re ig n re a l lo n g -te rm in te re s t d iffe re n tia ls and o f real d o lla r e x c h a n g e ra te s a g a in st
C anada, th e U n ite d K ingdom , G erm any, and Ja p a n . Real lo n g -te rm in te re s t ra te s a re y ie ld s on g o v e rn m e n t b o n d s w ith
m a tu ritie s o f fiv e y e a rs o r m ore, le s s th e in fla tio n in th e GNP/GDP d e fla to r o v e r th e p a st tw o yea rs. R eal e x c h a n g e ra tes
a re c a lc u la te d u s in g n o m in a l d o lla r exch a n g e ra te s d e fla te d by th e ra tio o f fo re ig n to U.S. GNP/GDP d e fla to rs . W e ig h ts are
c a lc u la te d u s in g OECD e s tim a te s o f GNP a d ju s te d fo r p u rc h a s in g po w e r p a rity .




FRBNY Quarterly Review/Autumn 1988

41

this conclusion especially tentative.

Conclusion
It seems reasonably clear that international financial
integration has increased considerably over the last
decade. However, the effect of integration on the rela­
tionship of interest rates across countries has been
somewhat different from that suggested by prior expe­
rience with the integration of domestic financial markets.
Interest rates in the major U.S., European, and Japanese
money markets now move very closely with their coun­
terparts in the corresponding “ offshore” Eurocurrency
markets. Yet divergences among national interest rates,
even for instruments with very similar characteristics,
have often been very large in recent years.
As our analysis has shown, these patterns are not
paradoxical; cross-country interest rate disparities are
the natural consequences of differing currencies and
jurisdictions that, while irrelevant or negligible within a
single country, are potentially very important in an
international context. In particular, in an environment of
flexible exchange rates and divergent national economic
conditions, interest differentials across countries can be
expected to arise even when capital mobility and finan­
cial integration are “ perfect.” Of themselves, reductions
in barriers to financial flows may be expected to reduce
in ternatio n al interest rate divergences, but not if
accompanied by increased exchange rate fluctuations
and greater disparities in national economic policies.
These observations are reasonably consistent with the
evidence cited in this article. There appears to be no
systematic tendency for interest differentials to abate
across countries over time; indeed nominal interest
divergences during the 1980s have been greater on

average than those observed during the previous two
decades. Nonetheless, this analysis provides clear evi­
dence that the sources of international interest differ­
entials have changed. During the 1960s, interest rate
divergences were sustainable under a fixed exchange
rate regime in large part because of fairly stringent lim­
itations on financial flows across national jurisdictions.
With the substantial reduction in such barriers over the
last 15 years, interest differentials across countries have
become primarily associated with expected exchange
rate changes— apparently reflecting both increased
divergences in national inflation rates and greater real
exchange rate fluctuations— and currency risk premia.
More fundamentally, this analysis has implications for
the conduct of monetary policy in a financially integrated
world economy. Our results suggest that the ability of
monetary authorities to influence domestic interest rates
independently of rates abroad has not declined signif­
icantly over time. In this narrow sense, the independence
of national monetary policies may not have been
appreciably reduced by international financial integration.
Nonetheless, the reduction in barriers to international
capital flows has strengthened the overall linkages
among domestic interest rates, exchange rates, and
foreign interest rates. As a result, domestic monetary
policy actions influence and are influenced by foreign
economic conditions more now than in the past. In a
broader sense, therefore, increased international finan­
cial integration has led to greater interdependence
among national monetary policies.

Bruce Kasman
Charles Pigott

Appendix: The Determinants of U.S.-Foreign Covered Interest Differentials
The closer alignment of covered interest rates across
countries that has been documented in the text may
reflect changes in several factors related to national
jurisdiction. In addition to explicit restrictions on capital
flows, perceived differences in U.S. and foreign assets
arising from domestic tax systems, default risk, trans­
action costs, or political and sovereign risk are embedded
in covered interest differentials. In this section we attempt
to identify more clearly the role that factors specific to
U.S. and foreign markets have played in the decline of
covered interest differentials. To this end, we decompose
each U.S.- foreign covered interest differential into the
sum of the onshore-offshore differential for each country’s

FRBNY Quarterly Review/Autumn 1988
Digitized42
for FRASER


assets and the offshore differential on U.S. and foreign
assets:t
Covered differential = USDE + FORDE + USFORE
The first term, USDE, measures the interest differential
between comparable dollar assets in domestic markets
and Euromarkets. Since the United States has had virf ln more precise terms, any covered diffe ren tial [(1 + i) (1 + i* ) f] can be seen to equal ( i - i E ) + ( iE * - i* ) f + [(1 + iE )
- (1 + iE *f)], where i, i*. iE and IE* are U.S. onshore, foreign
onshore, U.S. Euromarket, and foreign Eurom arket rates,
respectively, and f is the forw ard exchange rate premium .

Appendix: The Determinants of U.S.-Foreign Covered Interest Differentials (continued)
In the table, this d e co m position of U .S .-foreign covered
interest d iffe re n tia ls is presented fo r a num ber of periods
d u rin g th e past 15 ye a rs. F ocusing firs t on o u r b ila te ra l
covered d iffe re n tia ls w ith Japan and the United Kingdom ,
we see th a t c a p ita l c o n tro ls, re fle cte d in th e la rge size
and v a ria b ility of FO R D E , w e re a m a jo r d e te rm in a n t of
interest rate variations before 1980. A fte r 1979, however,
s h a rp d e clin e s e m e rg e in the size and v a ria b ility o f the
FO R DE co m p o n e n t fo r Ja p a n and th e U n ited K in g d o m ,
a fin d in g c o n s is te n t w ith o th e r e vid e n ce in d ic a tin g th a t
th e se co u n trie s d is m a n tle d th e ir c o n tro ls at ro u g h ly th a t
tim e. For G e rm a n y and C an a d a, tw o c o u n trie s th a t lo o s ­
ened ca p ita l co n tro ls earlier, th is co m p o n e n t o f th e c o v ­
ered d ifferential has been relative ly sm all thro u g h o u t our
s a m p le .§
T he sm all size (g e n e ra lly b e lo w 20 b a sis p o in ts) and
va riability of these d iffe re n tia ls fo r all the foreign countries
sin ce 1982 su p p o rt th e c o n clu sio n th a t fo re ig n b a rrie rs

tu a lly no ca p ita l c o n tro ls from the e a rly 1970s o nw ard
(with the exception of several m onths in 1980), this term
c a p tu re s th e role o f d o m e stic U.S. re g u la tio n s in g e n ­
e ra tin g c o ve re d in te re s t d iffe re n tia ls. The second term ,
FOR DE, is a sim ilar m easure for foreign assets and again
re fle c ts the im p o rta n ce of fo re ig n reg u la tio n s, in clu d in g
the in flu e n c e of a n y fo re ig n ca p ita l co n tro ls.
T he th ird te rm in th is d e co m p o sitio n , U S F O R E , ca p ­
tu re s the c o ve re d d iffe re n tia l in E u ro m a rke ts b etw een
d o lla r a sse ts and a sse ts d e n om in a te d in fo re ig n c u rre n ­
cie s. S in ce c o n tro ls in th e se m arkets are in s ig n ific a n t
and identical across the assets com pared, th is differential
p ro v id e s a m ea su re of th e im pact of p o litic a l risk co n ­
sid e ra tio n s . M ost stu d ie s have found th e se d iffe re n tia ls
to be rather s m a ll— indeed not significantly diffe re n t from
z e ro on a v e ra g e .t
tF o r a recent exam ination of covered interest diffe ren tials in
Euromarkets, see Vincent Reinhart and Kenneth Weiller, "W hat
Does Covered Interest Parity Reveal about C apital M o bility?"
Federal R eserve Bank of New York, Research Paper no. 8713,
in Interna tiona l Integration o f Financial M arkets an d U.S.
M onetary Policy, D ecem ber 1987.

§There is substantial evidence, however, that at least until the
m id-1970s cap ital controls in G erm any were a sig n ifica n t
com ponent of covered interest differentials.

Decomposition of U.S.-Foreign Covered Interest Differentials
(In Percentage Points)

Total C overed
D iffe re n tia l!

USDE

FO R D E

U S FO R E

Germany
Jan.
Sep.
Dec.
Jan.

74
77
79
83

-

Aug.
Nov.
Dec.
Sep.

77
79
82
88

-0 .7 8
-1 .0 6
-1 .6 5
-0 .4 3

(0.50)
(0.43)
(0.40)
(0.40)

-0 .6 1
-0 .6 0
-0 .8 9
-0 .2 5

(0.40)
(0.25)
(0.29)
(0.22)

-0 .3 5
-0 .4 0
-0 .4 8
-0 .2 0

(0.30)
(0.27)
(0.30)
(0.17)

0 .1 9
-0 .0 6
-0 .2 9
-0 .0 1

(0.20)
(0.19)
(0.20)
(0.16)

-

Aug.
Nov.
Dec.
Sep.

77
79
82
88

-0 .3 0
-2 .2 0
-0 .8 2
-0 .5 0

(5.17)
(1.72)
(1.67)
(1.15)

-0 .6 1
-0 .6 0
-0 .8 9
-0 .2 5

(0.40)
(0.25)
(0.29)
(0.22)

NA
NA
- .1 .8 3 (1.76)
0 .3 2 (0.72)
0 .13 (0.25)

NA
NA
0.2 2 (0.92)
- 0 . 2 6 (1.57)
- 0 . 4 1 (1.16)

-

A ug.
Nov.
Dec.
Sep.

77
79
82
88

-0 .3 2
-0 .6 9
-0 .8 7
-0 .1 5

(0.72)
(0.74)
(0.92)
(0.68)

- 0 .6 1
-0 .6 0
-0 .8 9
-0 .2 5

(0.40)
(0.25)
(0.29)
(0.22)

NA
NA
- 0 . 0 9 (0.16)
- 0 . 1 8 (0.35)
- 0 . 1 3 (0.13)

NA
NA
0 .0 0 (0.68)
0 .1 9 (0.89)
0 .2 0 (0.64)

1.92
0 .15
-1 .0 5
-0 .2 7

(1.77)
(0.92)
(0.62)
(0.33)

-0 .6 1
-0 .6 0
-0 .8 9
-0 .2 5

(0.40)
(0.25)
(0.29)
(0.22)

1.62
0 .5 6
-0 .0 8
-0 .0 7

Japan
Jan.
Sep.
Dec.
Jan.

74
77
79
83

Canada
Jan.
Sep.
Dec.
Jan.

74
77
79
83

United Kingdom
Jan.
Sep.
Dec.
Jan.

74
77
79
83

-

Aug.
Nov.
D ec.
Sep.

77
79
82
88

(1.2 5 )
(0.78)
(0.43)
(0.11)

0 .9 2
0 .1 9
-0 .0 8
0 .0 8

(0.83)
(0.28)
(0.53)
(0.23)

Note: Figures in parentheses are standard deviations.
fT h e total covered differential equals the sum of the other three differentials. Period averages may not sum e xa ctly due to rounding errors.




FRBNY Q uarterly Review/Autumn 1988

43

Appendix: The Determinants of U.S.-Foreign Covered Interest Differentials (continued)
to capital m obility, while quite im portant in the past, have
n o t b e e n a s ig n ific a n t p ro x im a te fa c to r d e te rm in in g
in te re s t rate d iffe re n tia ls d u rin g the 1980s.
A s im ila r cla im can be m ade reg a rd in g the im p orta n ce
o f U.S. c o n tro ls and p o litic a l risk, fa cto rs e m b o d ie d in
the o ther com ponents of the covered interest differentials,
f o llo w in g 1 9 8 2 . E x a m in in g th e in te r e s t d iff e r e n t ia l
be tw e en d o m e s tic U.S. and E u ro d o lla r a sse ts su g g ests
that actions taken in U.S. m arkets m ight account, in part,
fo r th e la rge and v o la tile (un co ve re d) real in te re st d if­
fe re n tia ls o b s e rv e d d u rin g 1980-82. C hanges in Federal
R eserve operating procedures in O ctober 1979, com bined
w ith n u m e ro u s re s e rve re q u ire m e n t sh ifts and th e im p o ­
s itio n o f “ v o lu n ta r y ” c r e d it c o n tro ls in 1 9 8 0 , le d to
increased interest rate divergence between these assets.
In te re s t d iffe re n tia ls on d o lla r a sse ts here and in E u ro ­
m a rke ts rose a b o ve 100 b a sis po in ts d u rin g a lm o st all
o f 1980, rea ch in g a le ve l th a t w as d o uble th e ir ave ra g e

Digitized44
for FRASER
FRBNY Quarterly Review/Autumn 1988


fo r th e 1974-79 period.|| A t th e sam e tim e, E u ro m a rke t
co ve re d d iffe re n tia ls betw e en d o lla r a sse ts and a sse ts
d e n o m in a te d in fo re ig n c u rre n c ie s b e ca m e m ore vo la tile
d u rin g 1980-82, re fle ctin g in crea se d p o litic a l u n c e rta in ty
in the w ake o f the se co n d oil p rice sh o ck and th e LDC
debt crisis. However, w ith the possible exception of d o lla ryen rates, E u ro m a rke t co ve re d d iffe re n tia ls ha ve been
in s ig n ific a n t sin ce 1982. In te re st d iffe re n tia ls b e tw e en
d o m e stic U.S. and E u ro d o lla r a sse ts have a lso fa lle n
c o n sid e ra b ly sin ce 1982, re fle c tin g both th e rem o va l of
c o n tro ls (N o ve m b e r 1980) and th e c lo s e r in te g ra tio n of
do m e stic and E u ro d o lla r m a rke ts in re ce n t ye a rs.

||For a detailed discussio n of the links betw een E urodollar and
U.S. dom estic money m arkets during this period, see
Lawrence L. Kreicher, “ E urodollar A rbitrage,” this Quarterly
Review, Summer 1982.

Estimating the Funding Gap of
the Pension Benefit Guaranty
Corporation
The Pension Benefit Guaranty Corporation (PBGC), a
self-financing government corporation created to insure
private defined benefit pension plans, has experienced
net losses in all but two years since its creation in
1974.1 When a pension plan with a large funding defi­
ciency is terminated, the PBGC is obligated to take on
a well-defined portion of the net liability of the plan.2
The cumulative effect of these net liabilities is a stated
funding deficiency that stood at $3.8 billion as of the
end of fiscal year 1986.3 Although the stated funding
deficiency of the PBGC fully reflects the plan termina­
tions that have already taken place since 1974, it fails
to take into account expectations about future termina­
tions or about future premium income. The purpose of
this article is to develop and apply a framework for
evaluating the effects of expected future income and
outflows.
The PBGC’s main source of noninvestment income is
the collection of insurance premiums from corpora­
tions. The chronic funding problems experienced over
the years have prompted Congress to raise the pre­
mium rates on several occasions and, effective in 1987,
1The accompanying glossary provides definitions of pension terms
used in this article.
2The PBGC’s share is the liability for guaranteed benefits minus the
sum of the assets of the plan and 30 percent of the sponsor’s equity.
3As of the end of fiscal year 1987, the deficiency had declined to $1.5
billion, mainly because of a reversal in the LTV case, which is still
being contested. We use the 1986 deficiency because the most
recent company data available for use in the empirical part of the
article covers this period. The stated deficiency represents the net
worth position of the PBGC rather than a cash flow deficit. The PBGC
has experienced cash flow deficits in only two of the seven fiscal
years from 1980 to 1986. For a brief history and analysis of the
PBGC, turn to Appendix A.




to make the rates sensitive to the level of underfunding
of each p a rticu la r plan. These measures have
improved the situation somewhat but have fallen short
of stemming the rising trend in funding deficiencies.
Because this picture only looks at the past, however,
it actually understates the true funding problems of the
PBGC. If the corporation were a private pension fund
subject to the Employees Retirement Income Security
Act (ERISA), it would have to make some provision for
the funding of projected future acquisitions of net lia­
bilities .4 The general principle behind such funding
practices is that, even if future outflows are not known
with certainty at present, the fund is liable for any
future outflows that result from current plan provisions
and should fund them as they accrue on the basis of
the best available expectations.
In the case of past plan terminations, PBGC account­
ing adheres to this principle. The assets acquired from
terminated plans and their sponsors are earmarked for
the payment of future benefits corresponding to those
plans. The net liabilities that may be expected to arise
from future pension plan terminations, however, are
ignored in current financial statements, as are future
premium payments. This means that even if Congress
were to provide the approximately $4 billion it would
take to restore the PBGC to momentary solvency, the
burden of future plan terminations could undo the
effects of such provisions.
In this article, we estimate the current level of fund4A pension plan’s “ accrued liability" is defined in ERISA as “ the
excess of the present value...of the projected benefit costs and
administrative expenses...over the present value of future contribu­
tions for the normal cost" (ERISA, Title I, Subtitle A, Section 3(29)).

FRBNY Quarterly Review/Autumn 1988 45

ing necessary for the PBGC to provide for future plan
terminations. Our estimates suggest that the present
value of PBGC liabilities resulting from future termina­
tions is more than $30 billion. Our estimate of the value
of future premium payments is only $14 billion, how­
ever, resulting in an additional net PBGC liability of
nearly $17 billion. This projected shortfall represents a
further burden to the PBGC beyond its stated account­
ing deficiency of $4 billion. While our estimates are
sensitive to a variety of assumptions made in the spec­
ification of our model and its parameters, we give
extensive consideration to the real world behavior of

corporations and pension funds in making our assump­
tions. We incorporate in our model both the actual reg­
ulatory restrictions on pension fund activity and the
basic c h a ra cte ristics of pension fund assets and
liabilities.
If the PBGC were a private insurance company with
bottom line motivations, it would be essential that it set
its premiums according to such actuarial calculations.
Only the public nature of the institution and its pre­
sumed access to public revenues make it possible for it
to operate without reliance on explicit estimates of
future net liabilities.

Glossary of Pension Terms
Accrued pension benefits:
V ested p e n s io n b e n e fits plus b e n efits e a rn e d but not
ye t ve ste d by active em ployees.

Defined benefit pension plan:
A p e n sio n plan in w h ich b e n e fits take th e fo rm o f a
p ro m ise d an n ua l p a ym e n t to retire e s, u su a lly based
on le n g th of s e rv ic e and average salary.

Defined contribution pension plan:
A p e n s io n p la n in w h ich b e n e fits ta k e th e fo rm of
p e rio d ic c o n trib u tio n s to an in v e s tm e n t fu n d d e d i­
ca te d to the w o rke r and tra n sfe rre d to the w o rke r at
re tire m e n t.

ERISA:
T he E m p lo y e e s R e tire m e n t In co m e S e c u rity A ct of
1974. T h is le g is la tio n e sta b lish e d the P ension B enefit
G u a ra n ty C o rp o ra tio n and m a n d a te d ru le s fo r th e
fu n d in g a n d te rm in a tio n o f d e fin e d b e n e fit p e n s io n
p la n s.

Full funding:
The level of p e n s io n p la n a ssets th a t ju s t eq u als the
level of p e n s io n p la n lia b ilitie s .

Funding ratio:
T h e ra tio o f p e n s io n fu n d a sse ts to p e n s io n fu n d
lia b ilitie s .

Maximum funding limitation:
The m axim u m ta x -d e d u c tib le pe n sio n p la n c o n trib u ­
tio n p e rm itte d by th e IRS and ERISA. E ssentially, ta xd e d u c tib le e m p lo ye r c o n trib u tio n s m ay not push p e n ­
sio n p la n a ssets beyond th e fu ll fu n d in g level.

Minimum funding requirement:
T h e m in im u m p e n s io n p la n c o n tr ib u tio n re q u ire d
u n d e r the te rm s of ERISA. It e quals the sum of n o r­
m a l c o s ts and a m o rtiz a tio n of any u n d e rfu n d in g .

Normal cost:
T he p re s e n t va lu e of p e n sio n plan b e n e fits e a rn e d by
active w o rke rs d u rin g th e year. A co m p o n e n t of the
p e n s io n c o n trib u tio n m ade by the p e n s io n p la n s p o n ­
so r, it re p re se n ts th e a m o u n t th a t the sp o n so r w ould
have to c o n trib u te to m a in ta in th e c u rre n t le ve l of

FRBNY Q uarterly Review/Autum n 1988
Digitized46
for FRASER


o v e rfu n d in g o r u n d e rfu n d in g if all a c tu a ria l and m a r­
ket a ssu m p tio n s w ere m et.

Overfunding:
T h e a m o u n t by w h ic h p e n s io n p la n a s s e ts e x c e e d
p e n s io n p la n lia b ilitie s .

Pension plan assets:
The m arke t va lu e of all s e c u ritie s held by th e p e n sio n
fund. It eq u als th e cu rre n t va lu e of all p a st p e n s io n
p la n c o n trib u tio n s and in v e s tm e n t e a rn in g s, net o f all
past p e n s io n p la n b e n e fit p a y m e n ts and a d m in is tra ­
tive exp e nse s.

Pension plan benefit payments:
C ash pa ym e n ts m ade to re tire d w o rke rs d u rin g the
year.

Pension plan contribution:
T he ca sh va lu e o f c o n trib u tio n s m ade by th e p e n s io n
p la n s p o n s o r d u rin g th e year. It e q u als th e sum of
n o rm a l c o s ts and th e a m o rtiz a tio n of any o v e rfu n d in g
or u n d e rfu n d in g .

Pension plan liabilities:
T he p re se n t va lu e of fu tu re p e n s io n p la n b e n e fit p a y ­
m en ts m in us the p re se n t va lu e o f fu tu re n o rm a l costs.

Pension plan participants:
A ctive w o rkers w ith b oth ve ste d and u n ve ste d p e n ­
sion benefits, and re tire e s and fo rm e r e m p lo ye e s w ith
ve ste d p e n sio n be n efits.

Pension plan sponsor:
T h e c o m p a n y w h o s e e m p lo y e e s a n d f o r m e r
e m p lo ye e s (both re tire e s and fo rm e r e m p lo ye e s w ith
ve ste d b e n efits) are co ve re d by th e d e fin e d b e n e fit
p e n s io n p lan.

Underfunding:
T he a m o u n t by w h ich p e n s io n p la n asse ts fa ll s h o rt of
p e n s io n p la n lia b ilitie s .

Vested pension benefits:
F uture b e n e fit p a ym e n ts ow ed to re tire e s and fu tu re
b e n e fit p a y m e n ts th a t a re g u a r a n te e d to a c tiv e
w o rke rs even if they leave th e firm .

The PBGC funding problem:
definition and methodology
Our primary goal here is to determine the appropriate
level of current funding for the PBGC. Since the PBGC
is essentially a provider of insurance, we turn for guid­
ance to the methods used by actuaries to value insur­
ance policies and pension funds .5 These methods
provide a framework for modeling the assets and lia­
bilities of the pension funds insured by PBGC and for
describing their behavior over time. The evolution of
the funding status of these plans, together with the
changing financial condition of the firms sponsoring
them, determines the size of the net liabilities that will
accrue to the PBGC from future plan terminations.
In adopting the research strategy suggested by the
actuarial approach to valuing PBGC liabilities, we use
tools developed in the field of finance. First, we apply
the mathematical tools devised in the theory of contin­
gent claims, since insurance is a special case of such
claims.6 Second, we draw on the theory of business
failures in analyzing pension fund terminations. By law,
terminations of underfunded pension plans should
occur only when the sponsor firm is in grave financial
distress. This has been the de facto approach since
the PBGC was created, even though it became a legal
requirement only recently.
The next few sections present the various portions of
the model. The fund and its sponsor firm are modeled
as separate but related entities. The value of the PBGC
insurance is determined by six variables associated
with the fund and its sponsor, and the analysis focuses
on the evolution of these variables over time. This evo­
lution is determined by a series of dynamic relation­
ships that describe the growth of firm assets and debt,
the number of plan participants, the assets and lia­
bilities of the fund, and the normal cost associated with
the fund.7 These relationships specify that the value of
each of these variables in one time period is deter­
mined by its own value in the previous time period, as
well as by the lagged values of other model variables,
5A useful mathematical exposition of these actuarial principles is
found in Howard E. Winklevoss, Pension Mathematics (Homewood,
Illinois: Richard D. Irwin, Inc., 1977).
•The literature on this topic is extensive. An early (and rudimentary)
example of the use of option pricing theory in the context of PBGC
insurance is William F. Sharpe, “ Corporate Pension Funding Policy,”
Journal of Financial Economics, vol. 3 (1976), pp. 183-94. A more
recent example, with a more detailed framework, is Alan J. Marcus,
“ Corporate Pension Policy and the Value of PBGC Insurance," in
Zvi Bodie and others, eds., Issues in Pension Economics (Chicago:
University of Chicago Press, 1987).
7These equations and a mathematical discussion of the model are
presented in Appendix B. For a complete analysis of the model, see
A. Estrella and B. Hirtle, “ The Implicit Liabilities of the Pension
Benefit Guaranty Corporation," Federal Reserve Bank of New York
Research Paper (forthcoming).




by institutional elements such as PBGC premium rules,
and by unpredictable random shocks. In each case,
assumptions are based on empirical research and on
theoretical considerations.
These dynamic relationships are simulated over time
by generating values of the random disturbances and
"ro llin g ’’ the equations forward. This process is
repeated a large number of times, and averages are
taken over all the individual realizations. Simulations
are useful in handling complicated dynamics such as
those involved in valuing PBGC insurance. They allow
for precise and realistic modeling of the various
aspects of pension funding and of the relationship
between the fund and the sponsor. For example, in our
analysis, the sponsor’s contribution to the pension
plan, as well as the PBGC premium, is charged to the
firm in the model, potentially affecting cash flows and
Ihe firm’s solvency. Although in general not very large,
these effects may be central to the issue in some
cases, as they were in the solvency problems of LTV
and Chrysler.
Pension fund dynamics
The model of PBGC insurance used in the estimates
differs from previous models of PBGC insurance in
several important respects. In contrast to earlier formu­
lations that make somewhat ad hoc assumptions about
funding strategies, this model employs the legal and
regulatory restrictions that actually govern pension
plan contributions. It takes explicit account of ERISA
minimum funding rules and of the PBGC premium rate
structure. In addition, the model imbeds funding restric­
tions imposed by the IRS to limit tax-deductible contri­
b u tio n s to o v e rfu n d e d pen sio n funds. These
assumptions mean that the modeled behavior of pen­
sion funds more closely follows the actual behavior of
pension funds under existing law.
We assume that each firm sponsors a single pension
fund for all of its workers. This pension fund is financed
by contributions from the firm and by the investment
return on the fund’s assets.
Contributions
The contribution made by the firm to its pension fund
during each period is based on minimum and maximum
funding guidelines established in ERISA and amended
by subsequent legislation. The minimum contribution
under the funding requirements consists of the normal
cost and a payment to amortize any funding deficiency.
The normal cost component of the contribution rep­
resents the present value of pension plan benefits
earned by workers during the year. As such, normal
costs will vary across firms according to the composi­
tion of the work force, the distribution of the length of

FRBNY Quarterly Review/Autumn 1988 47

employment of workers at the firm, and the terms of the
pension plan. Firms with a high ratio of active workers
to retirees will tend to have normal costs that are a
larger proportion of pension plan liabilities than firms
with a low ratio of active workers to retirees.
The second component of the firm’s contribution to
its pension fund is the amortization of underfunding.
This component is determined by a combination of
ERISA funding rules and firm discretion. If the fund is
underfunded at the beginning of the year, then the rate
at which the firm must amortize this underfunding is
determined by a complex set of guidelines imposed
under ERISA. For purposes of the model, we assume
that the firm amortizes each period’s underfunding over
a 2 0 -year horizon using the expected rate of return on
the pension fund assets as the discount rate.8 On the
other hand, if the firm is overfunded at the beginning of
the year, then no amortization payment is required.
The maximum (tax-deductible) contribution is deter­
mined by the “ full funding limitation” in ERISA, as
amended in 1987.9 The firm cannot contribute on a taxdeductible basis an amount that would push the assets
of the plan, including the employer’s contribution,
beyond the sum of the plan’s liabilities plus normal
cost. If the normal cost exceeds one half the liabilities,
the allowable tax-deductible contribution is further
restricted to be less than the excess of 150 percent of
liabilities over assets .10 If the minimum contribution
exceeds this full funding limitation, only the full funding
amount is required. The firm may choose to make a
contribution in excess of the full funding limitation on a
non-tax-deductible basis, but our model assumes that
firms do not do so. We assume that the sponsor’s con­
tribution to the pension fund is the lesser of the mini­
mum funding amount specified in ERISA (assuming a
2 0 -year amortization horizon) and the maximum fund•The 20-year amortization horizon was chosen as a rough average of
the amortization horizons specified by the ERISA for underfunding
arising from various sources. For instance, underfunding arising from
past service credits (increases in benefits of ongoing plans or
startup of plans in an underfunded condition) may be amortized over
a 30-year horizon, while underfunding arising from actuarial gains
and losses (when actual returns deviate from expected returns or
when actuarial assumptions are not met) may be amortized over a
10-year horizon. On average, the 20-year assumption is probably on
the low side. This would make our estimates of PBGC liabilities
conservatively lower.
•Omnibus Budget Reconciliation Act of 1987, Subtitle D, Part 1,
Section 9301.
i®The 150 percent of liabilities restriction is additionally binding only if
the normal cost exceeds one half the liabilities, a condition that is
generally unlikely. Only companies that are growing at exceptionally
fast rates would be subject to this further restriction. In the
empirical part of the article, the assumed range of normal cost to
liability ratios falls in the region in which the 150 percent constraint
is nonbinding. Data on actual normal costs for individual firms are
not conveniently accessible.

FRBNY Quarterly Review/Autumn 1988
Digitized48
for FRASER


ing amount specified by the IRS.11
Investment returns
The investment return is assumed to consist of two
components: an expected return, which is realized with
certainty during each period, and a random unex­
pected return, which varies from period to period and
may be positive or negative.
Liabilities
Withdrawals from the fund are made during each
period to cover pension plan benefit payments. The
relationship between normal costs, pension plan bene­
fit payments, and pension plan liabilities produces the
dynamic behavior of liabilities. Normal costs and pen­
sion benefit payments are assumed to grow at the
same rate per period. This growth reflects an increase
in the number of pension plan participants rather than
an increase in real benefit provisions over time. Partici­
pants are defined as active workers and retirees, and
we assume that the number of plan participants grows
at the same fixed rate per year as normal costs and
pension benefit payments.
Benefit payments can also be expressed as the sum
of normal costs and the expected return on the full
funding level of pension plan assets (the level of assets
that just equals pension plan liabilities). Combining
these three relationships implies that pension fund lia­
bilities grow at the same rate as benefit payments and
normal costs.
Dynamics of the sponsor firm
This section discusses the dynamics of the sponsor
firm and delineates the links between the firm and its
pension fund. There are three principal links between
the dynamics of the fund and those of the firm: the
pension contribution, the PBGC premium, and the plan
termination decision.
The pension contribution, which was discussed in the
previous section, is modeled explicitly as an expense
to the firm. The second link, the PBGC premium, is
also modeled as a direct expense of the sponsoring
firm. Following legislation adopted in 1987, the PBGC
premium varies according to the funding status of each
pension fund.12 The PBGC charges a flat rate of $16
per plan participant. In addition, the PBGC levies an
underfunding fee of $ 6 per $ 1 0 0 0 of underfunding per
participant. The total premium is capped at $50 per
11The maximum funding provision is analogous to a requirement to
amortize any overfunding. In fact, this amortization is faster for
overfunding than for underfunding, especially since the portion of the
normal cost that may be used to offset the overfunding is limited to
50 percent of liabilities. This asymmetry has the effect of producing
an underfunded status in long-run equilibrium.
120mnibus Budget Reconciliation Act of 1987.

participant. Under these regulations, the total premium
cost to the plan sponsor is the premium rate times the
number of plan participants.
Based on these pension-related expenses and gen­
eral considerations, the final set of dynamic relation­
ships used in the model concerns the debt and assets
of the sponsoring firm. Firm debt is assumed to grow at
a fixed rate per period and is unaffected by pension
plan activity. The growth in firm assets is assumed to
consist of two components. Like pension fund assets,
firm assets have a return consisting of an expected
return and a random component that varies across
periods. The firm’s contribution to its pension fund and
the PBGC premium payment are subtracted from firm
assets during each period.
Model summary
Six dynamic relationships describing the movement
of the model variables over time emerge from the pre­
ceding discussion. These relationships are:
(1) Normal cost =
in year t

normal cost x
growth factor

normal cost
in year t -1

(2) Fund liabilities = normal cost x fund liabilities
end of year t
growth factor end of year t -1
(3) Fund assets = fund assets end of year t-1
end of year t
+ expected plus random x
rates of return

fund assets
end of year t -1

+ pension contributions - pension benefit payduring year
ments during year
(4)

Plan
=
participants
in year t

plan
x
participant
growth
factor

(5)

Firm debt
=
firm debt
end of year t
growth factor

plan
participants
in year t - 1
x
firm debt
end of year t -1

(6 ) Firm assets = firm assets end of year t-1
end of year t
+ expected plus random x
rates of return

firm assets
end of year t-1

lished, we may proceed to construct the final link
between the fund and the firm, the firm failure/pension
termination event. Under legislation adopted in 1986,
underfunded pension plans may be terminated and
PBGC insurance drawn upon only if the sponsoring
firm is in a “ distress situation.” 13 Essentially, the PBGC
limits terminations of underfunded plans to firms facing
bankruptcy or severe economic distress. For purposes
of this model, we assume that underfunded pension
plans terminate only when the sponsoring firm enters
formal bankruptcy.
The difficulty with this assumption is determining
what conditions signal firm bankruptcy. One such con­
dition is the technical insolvency of the firm, when the
face value of the firm’s debt exceeds the value of the
firm’s assets.14 In many cases, however, a firm will
declare bankruptcy before it has become technically
insolvent. In these instances, the decision to declare
bankruptcy may be related to cash-flow difficulties or to
the inability to meet a scheduled debt payment. In
order to model bankruptcy under these conditions, the
simulation model superimposes a criterion of firm fail­
ure based on flows. This criterion is developed on the
basis of an empirical bankruptcy model using financial
statement data.
The basic premise of the empirical model is that flow
variables— specifically, the determinants of changes in
firm assets— affect the probability that the firm will
enter bankruptcy. Firm asset growth may be financed
by two sources: retained earnings, which reflect the
operating profitability of the firm, and external financing
(debt and equity issuance), which reflects balance
sheet growth. In order to measure the impact of these
two sources of asset growth in predicting bankruptcy
probability, we estimate a statistical model using
annual data on assets, debt, and retained earnings
between 1973 and 1981 for a sample of 174 failed and
ongoing firms.15 Using the results of this estimation, we
are able to generate a “critical level” for the change in
assets for any given probability of bankruptcy. This crit­
ical level represents the change in firm assets neces­
sary to generate the specified bankruptcy probability.
Our PBGC insurance model fixes a target bankruptcy
probability P* and assumes that if the probability of
bankruptcy implied by the model simulation equals or
exceeds this level, then the firm declares bankruptcy.
This target bankruptcy probability is set at 95 percent,
13Single Employer Pension Plan Amendments Act of 1986.

- pension contributions during year

PBGC premiums
during year.

Plan termination conditions
Now that the basic dynamics for the firm are estab­




14This formulation has been adopted in previous studies. For example,
see Marcus, “ Corporate Pension Policy.”
15The statistical model chosen is a probit model. The results of this
estimation and the data used are discussed fully in Estrella and
Hirtle, "Im plicit Liabilities."

FRBNY Quarterly Review/Autumn 1988 49

which is associated with a critical asset-change level,
%RV*, of approximately - 3 6 percent. Although the
critical level is a function of time-dependent flow vari­
ables and varies over time, this value is representative
of the magnitude of the one-period change in assets
necessary to generate a significant bankruptcy
probability.
In the simulation, the procedure to check for firm
bankruptcy is to calculate %RV* at the end of each
period and to compare it to the actual percent change
in firm assets, %RV. Any value of %RV smaller (more
negative) than %RV* will produce a predicted proba­
bility of failure greater than 95 percent. If the actual
change in firm assets is less than or equal to %RV*,
then the firm is assumed to be bankrupt.
Data and parameter assumptions
In the case of the PBGC insurance estimates (and
probably in general), the selection of data and parame­
ter values is as important to the estimation procedure
as the development of the model’s equations. Earlier
work on PBGC insurance has generally adopted typical
parameter values from the literature on options without
giving proper consideration to the specific nature of
pension fund and corporate assets and liabilities. Since
the model is quite sensitive to some of the assump­
tions, it is worthwhile to invest some time in the selec­
tion process.
In order to simulate the PBGC insurance model, it is
first necessary to assign initial period values to the
variables whose behavior is described by the six
dynamic relationships dicussed above. The data
needed consist of firm-level information about pension
plan assets, liabilities, normal costs, and participants
as well as information about firm assets, debt, and
equity. These data are derived from information in the
COMPUSTAT annual data tapes. The COMPUSTAT
tapes contain balance sheet information on approx­
imately 6000 publicly held firms that file reports with
the SEC.
To obtain a comprehensive sample, we included all
firms reporting complete data on firm assets, retained
earnings, long-term and short-term debt, number of
employees, and pension plan assets and liabilities for
1985, 1986, or 1987.16 The final sample consists of
1586 firms from a wide variety of industries. These
1586 firms have aggregate pension fund assets of $437
billion and aggregate pension fund liabilities of $288
billion. Seventy-four of the 100 largest private pension
funds in 1987 are represented in the sample. The sam1#The final sample contained 63 firms with information from 1985, 1287
firms with information from 1986, and 236 firms with information from
1987.

FRBNY Quarterly Review/Autumn 1988
Digitized 50
for FRASER


pie contains nearly 19 million workers, a number which
represents approximately two-thirds of the 30 million
pension plan participants covered by the PBGC single­
employer plan. This number may overstate the cover­
age of PBGC single-employer plan participants in the
sample, however, since all employees of a given firm
may not be covered by a PBGC-insured pension
plan.17
For each of the 1586 firms in the sample, data on
firm assets, retained earnings, and debt and pension
plan assets and liabilities are taken directly from the
COMPUSTAT tapes. Liabilities are reported as both
vested and accrued liabilities.18 The funding require­
ments imposed by ERISA are written in terms of
accrued liabilities, but the benefits guaranteed by the
PBGC more closely resemble vested liabilities. Hence,
both liability figures are included in the data set. Dur­
ing model simulation, accrued liabilities are used in
determining the funding status of a pension plan, and
vested liabilities are used in calculating the value of
the insurance at termination.
Pension plan assets and liabilities are reported on an
aggregate basis for each firm on the COMPUSTAT
tapes. That is, firms with multiple pension plans for
their employees report only total assets and liabilities
summed across all plans at the firm. Since a given firm
could have both overfunded and underfunded pension
plans, this procedure means that some underfunded
plans will go undetected.19

17For instance, the pension plans of highly-compensated workers are
not necessarily insured by the PBGC. In addition, certain workers at
the firm could have pension plans covered by the PBGC multi­
employer fund. These workers would be primarily production workers
covered by certain collective bargaining agreements. Finally, some
workers could be enrolled in defined contribution pension plans,
which are not insured by the PBGC.
18Vested pension liabilities are liabilities arising from vested pension
benefits. Vested benefits are benefits owed to retirees and benefits
that are guaranteed to active workers even if they leave the firm.
Accrued pension liabilities are vested liabilities plus the liabilities
corresponding to nonvested but accrued benefits of active
employees.
19To the degree that underfunded plans are hidden by aggregation at
the firm level, the value of the total PBGC insurance liability could be
underestimated. Consider a firm with two pension plans, one
overfunded by $20 million and one underfunded by $10 million. On
an aggregate basis the firm's plans are overfunded by $10 million,
and the PBGC insurance would appear to be “ out of the money.” In
fact, however, the underfunded plan might represent a liability for the
PBGC, depending upon the net worth of the firm. Assuming that the
$20 million of overfunding from the first plan is “ returned” to the firm
if the plans are terminated, the value of the PBGC’s claim against the
net worth of the firm is at least $6 million (30 percent of the $20
million of overfunding). If the remaining net worth of the firm is at
least $13.3 million (so that the 30 percent claim is worth $4 million),
then the $10 million of underfunding from the second pension plan is
covered by the 30 percent of net worth claim against the firm and
the insurance is out of the money. To the extent that the remaining

The remaining variables necessary for the simulation
of the insurance model are not available directly from
the COMPUSTAT tapes. The tapes contain neither the
normal cost nor the number of pension plan partici­
pants. In order to arrive at initial period values for
these variables, we make estimates using available
information about pension plan liabilities and the
number of firm employees. Pension plan normal costs
in the initial period are estimated as a share of pension
plan liabilities. The number of pension plan participants
is similarly calculated as a ratio to the number of
employees at the firm. The ratios used in these calcu­
lations are taken from simulations performed by Winklevoss of hypothetical “ model” pension plans.20
Since the relationships between pension plan lia­
bilities and normal costs and the number of pension
plan participants and employees will change during the
life cycle of a firm, the adjustment ratios are varied
according to the growth characteristics of the firm.
Firms in the sample are designated as either “ stable"
or “ growing” based on the increase in employment at
the firm over the five years before the year of the
observation. Firms experiencing rapid employment
growth over this period are assigned to the “ growing”
category while all other firms are designated as “ sta­
ble.” Firms less than five years old at the time of the
observation are assumed to be “ growing.” 21 Growing
firms are assumed to have a higher percentage of new
workers than stable firms; consequently they will have
both a lower ratio of pension plan participants to firm
employees and normal costs that are a higher share of
pension plan liabilities.22
Footnote 19 continued
net worth of the firm is less than $13.3 million, however, the PBGC
insurance associated with the underfunded plan will have some value
and the aggregation of the two plans will understate the value of the
insurance.
“ Winklevoss, Pension Mathematics. The ratios are based on the
simulations reported by Winklevoss in Table 4-7.
**A cutoff value of 20 percent for the five-year growth in employment is
used to determine whether or not a firm is "growing." The 20 percent
level was chosen after an analysis of the employment growth rates
for the firms in the sample. Of the 1586 firms, 441 (28 percent) had
employment growth rates greater than or equal to 20 percent, 858
(54 percent) had growth rates less than 20 percent, and 298 (18
percent) were less than five years old. The median employment
growth rate was approximately 10 percent for the sample as a whole,
which reflects the rapid economic expansion over the 1982-87 period.
“ If N is the number of employees at the firm, NC normal cost,
P pension plan participants, and L plan liabilities, the calculations
are:

Category

Nq/N-s

Calculations

Stable

Less than 20 percent

Growing

More than 20 percent

NC0 = .15 l_o
P0 = 1.427 N0
NC0 = .25 Lq
P0 = 1.103 N0




The remaining information necessary to simulate the
PBGC insurance model consists of the expected
growth rates associated with the various difference
equations and the nature of the random disturbances
to firm assets and pension fund assets. In order to
make the behavior of the model variables during the
simulation as realistic as possible, we derive these
parameter values from the behavior of real world
proxies for the various model variables. For instance,
the basic growth rates characterizing the path of the
sponsor firms over time are chosen so that several
diagnostic model statistics— including the long-run
aggregate funding ratio and the firm failure rate—
produce reasonable values.
As part of the attempt to reflect real world behavior
in the pension model, asset growth rates are assigned
according to the growth categories described earlier.
Stable and growing firms are allotted real "base”
growth rates of 0 and 1/z percent per period, respec­
tively. Pension plan benefits, the number of plan partic­
ipants, and firm debt are all assumed to grow at this
base growth rate. Firm assets grow at the base rate
plus the rate of growth of productivity, which is
assumed to be 1 percent per period.23
The random disturbances to fund assets and firm
assets are assumed to be jointly normally distributed
with mean zero and standard deviations aA and av,
respectively. Since economy-wide events could affect
firm assets and pension fund assets in similar ways,
the disturbances are assumed to be correlated. The
random characteristics of the pension fund are based
on the performance of a portfolio of common stocks
and bonds over the years from 1973 to 1987.24 The
60/40 mix of stocks and bonds in the portfolio reflects
the average relative shares of these securities held by
pension funds according to the Federal Reserve
Board’s Flow of Funds Accounts. An analysis of the
behavior of the inflation-adjusted returns on this portfo­
lio suggests that aA = .12 is a reasonable value. In
addition, the analysis suggests that the expected real
rate of return on pension fund assets should be set to
2.5 percent per year.
We base the value for crv on estimates of the unex­
pected growth of real balance sheet assets of a sam­
ple of firms on the COMPUSTAT tapes. A sample
consisting of all firms on the COMPUSTAT tapes
reporting complete asset and debt data between 1977
and 1987 was collected. For each of the firms in this
sample, the unexpected growth in firm assets on a year
“ Note that the model is expressed completely in real (inflationadjusted) terms.
a4The basic returns are obtained from the Ibbotson Associates data
base.

FRBNY Quarterly Review/Autumn 1988 51

over year basis, VGROWt, is calculated as follows:25
VGROW, = (Vt-VM - (Dt- D,..,))/V,.,,

where Vt and Dt are the firm’s assets and debt, respec­
tively, in year t. The standard deviation of VGROW is
calculated for each firm over the 1 0 observations in the
sample. Using these results as a guide, we set the
standard deviation of real firm assets, av, to .10.26 The
correlation between the firm’s assets and the return on
the 60/40 portfolio is set at .25. This value is based on
both theoretical and empirical considerations.27
To summarize, we assume that pension assets pro­
vide a real expected return of 2.5 percent per annum
with a standard deviation of 12 percent. The expected
value of 2.5 percent serves as the constant discounting
rate for future real flows in the model or, more gener­
ally, as the constant interest rate. The assumption of a
constant interest rate is reasonable in the present con­
text, since we are most interested in present values
calculated over the very long run. Although it is possi­
ble to experiment with other assumptions about the
future course of interest rates and to examine the
short-run implications of such scenarios on the PBGC’s
acquisition of new liabilities, such experiments lie
beyond the scope of this article.
The real return on firm assets is either 1 or 1.5 per­
cent, depending on the particular firm’s recent growth
performance, with a standard deviation of 1 0 percent.
The correlation between the returns on firm assets and
pension assets is 0.25. The return on firm assets is
essentially a measure of earnings after interest as a
proportion of the firm’s assets. Thus, for a firm with a
debt-to-assets ratio of one half (which is roughly the
recent aggregate level in the United States28), the
“ Since the parameter <xv is meant to represent the standard deviation
of unexpected firm asset growth and since debt growth is planned
for and controlled by the firm, the growth in firm debt, Dj-D,.,, is
removed in the asset growth calculation.
“ The range of values for the standard deviation of VGROW is
extensive, probably on account of the limited number of observations
per firm. The median standard deviation is .13 and almost half of the
observations fall into the range from .05 to .15, leading to the
selection of .10 as a representative value.
^ T h e lack of information about the market value of a firm's assets
makes it difficult to estimate this correlation precisely. However, since
the liabilities side of the balance sheet is similar in composition to
the fund's assets, we would expect the correlation to be positive. In
addition, if the average firm is more volatile than the diversified fund,
the correlation should be less than perfect. Test simulations of the
model suggest that the results are not very sensitive to changes in
the correlation between 0 and 0.5, and we chose the midpoint of this
range. Empirically, the median correlation with the firm’s
capitalization (a somewhat different measure) over the 1978-87
period was 0 .1 1 .
“ Board of Governors of the Federal Reserve System, Flow of Funds
Accounts.

FRBNY Quarterly Review/Autumn 1988
Digitized52
for FRASER


return on assets should be about one half of the return
on equity. Our assumptions for the expected returns on
firm assets (1 or 1.5 percent) and pension assets (2.5
percent) are consistent with the foregoing relationship.
Finally, firm liabilities as well as pension liabilities are
assumed to grow at rates of 0 and 0.5 percent for sta­
ble and growing firms, respectively.
Model simulation and results
Simulation procedure
The six dynamic relationships describing the behav­
ior of the six variables of the model (firm assets, debt,
pension plan assets and liabilities, normal costs, and
the number of pension plan participants), together with
the plan termination conditions discussed earlier, are
the basic elements necessary to evaluate the PBGC
insurance. We perform this evaluation by dynamic sim­
ulation. After assigning period 0 values for the vari­
ables and sp ecifying the nature of the random
disturbances, we roll the difference equations forward
over a fixed horizon of 100 periods.29 At the end of
each period, the conditions that signal the termination
of the pension plan are checked.
When the pension plan is terminated because of
technical insolvency or bankruptcy, the PBGC insur­
ance is valued according to the procedure specified by
ERISA and subsequent amendments. These pro­
cedures require that the PBGC assume the assets and
guaranteed liabilities of any underfunded plan upon
termination. In return for accepting the net liabilities of
the underfunded plan, the PBGC is granted a claim of
up to 30 percent of the net worth of the sponsoring
firm .30 This additional claim may not exceed the total
amount of plan underfunding. Thus, for firms with overfunded pension plans at termination, the insurance is
worth nothing. For firms with underfunded plans, the
insurance is valuable only to the extent that the PBGCguaranteed liabilities exceed the fund’s assets plus 30
percent of the net worth of the firm. For plans terminat­
ing because of the technical insolvency of the firm, the
“ Theoretically, the simulation should proceed for an infinite number of
periods. Since discounting reduces the present value of liabilities
that occur in the distant future, a finite period generally produces a
reasonable approximation. The choice of period here is dictated by
the size of the discount factor and by practical computer time
constraints.
aoRecent changes in PBGC regulations make the firm liable for 100
percent of the underfunding with respect to guaranteed liabilities in
terminated pension plans. However, the part of the PBGC claim
exceeding 30 percent of firm net worth has a lower status in
bankruptcy court than the portion of the claim falling within 30
percent of net worth. This more-than-30 percent portion has the
same status as other unsecured creditors, and it is unclear whether
this portion of the PBGC’s claim has significant value. For purposes
of our model, this part of the claim is assumed to be valueless. To
the extent that the assumption is incorrect, our estimate of the value
of the PBGC insurance will be reduced.

net worth portion of the PBGC’s claim against the firm
has no value. Once the net termination liability is deter­
mined, its present value is used as the value of the
PBGC insurance under the particular sequence of ran­
dom events.
In order to obtain a precise estimate of the value of
the PBGC insurance for each firm, we repeat the entire
simulation procedure a significant number of times and
calculate an average present value for the insurance.31
Results
The basic results of this estimation are presented in
Table 1. The aggregate value of the PBGC insurance is
calculated at about $31 billion, which is within the gen­
eral bounds of previous estimates.32 This is the amount
that firms would have to contribute now to prepay fully
the PBGC insurance. Under the current premium struc­
ture, however, the expected present value of future pre­
mium payments is just $14 billion. Thus, the current
funding deficiency of the PBGC with respect to future
terminations is about $17 billion. Adding this figure to
the stated underfunding of $4 billion for past termina­
tions yields a total funding deficiency of $21 billion.
Future terminations represent a major burden for the
31Tests sug gest that 1,000 repetitions produce statistica lly stable
results.
3*For instance, Marcus (“ C orporate Pension Policy” ), operating on a
sam ple of the 100 largest private pension funds in 1982, finds
a g gregate values ranging between $5.6 billion and $22 billion.

Table 1

Aggregate Simulation Results
Currently Active Firms
Fiscal Year 1986
(In Billions of Dollars)
Future term inations
Present value of PBGC insurance
Present value of PBGC prem ium s
U nderfunding
Memo:
Past term inatio ns— PBGC underfunding
Total PBGC underfunding
Net new liabilities (annual rate)
Average
Maximum (15th year)

Table 2
3.8

Validation Statistics

20.6
0.6
1.9
29.2 years

Duration}:

21.5 years

average time to incurring of net new liability,
by am ount of net new liability.
average time to incurring of net new liability,
by present value of net new liability.




Model diagnostics
To establish the plausibility of the basic results, we
compute several additional statistics. Overestimation of
the PBGC liabilities could result if either the frequency
of terminations or the net liability per termination was
overstated. The statistics in Table 2 help to clarify
whether either of these problems is encountered in the
simulations.
The assumed firm dynamics produce ex post firm
failure rates that average 0.9 percent over the course
of the simulations. On an annual basis, failure rates run
from a low of .2 percent in the 2d year to a high of 1.3
percent in the 25th year (see Figure 1). A higher failure
rate im plies a greater level of underfun ding with
respect to the PBGC insurance. The average of the
simulated rates is somewhat below the 1.1 percent rate
observed over the last four years, a finding which indi­
cates that the estimate of the PBGC’s underfunding
tends to be conservative in this respect.
The aggregate long-run funding ratio can be used as

30.5
13.7
16.8

Average life f

fW e ig h te d
w eighted
^W eighted
w eighted

c o rp o ra tio n re la tiv e to the c u rre n t a c c o u n tin g
obligations.
The new net liabilities of the PBGC are projected in
our simulations to accrue at an average rate of $600
million per year and to peak after 15 years at about $2
billion. The precise timing of the liabilities is more diffi­
cult to estimate than their present value, which is in
essence an average over time. Thus, the results relat­
ing to the time pattern of liabilities are of a lower order
of certainty than those concerning present values. A
couple of summary measures of timing may be useful,
however. The liabilities occur over a period whose aver­
age length is 29 years and whose (Macaulay) duration
is 22 years. These statistics suggest that the problems
of the PBGC are long-run, rather than acute, in nature
since the burden of the net liabilities incurred by the
PBGC falls over a fairly long horizon.

Percent
Firm failure rate
(Equals plan term ination rate)
Average
Minimum
Maximum
A ggregate funding ratio
(Plan assets/accrued liabilities)
Initial
Long-run (after 100 years)

0.9
0.2
1.3

122
78

FRBNY Q uarterly R eview/Autum n 1988

53

an indication of the relative size of the net liability per
termination. Holding the size of the guaranteed lia­
bilities fixed, the higher the funding ratio, the lower the
potential cost to the PBGC of assuming the pension
plan upon termination. The comparatively low value of
78 percent generated by the simulation results in large
part from the tendency of the rules to amortize overfunding more quickly than underfunding. Although this
value is lower than levels observed currently in most
active pension plans, it is fully consistent with actual
amortization rules.
Table 3 contains analysis of the model’s sensitivity to
parameter values. The results tend to be quite sensi­
tive to the choice of the growth rate of plan benefits
(and, in the model, of the firm’s debt). The table shows
that PBGC underfunding increases by over 20 percent
in response to an increase of one percentage point in
the growth rate. The two percent growth case leads to
a long-run funding ratio that seems low compared to
actual experience. On the other hand, the no growth
case produces the most favorable results for the PBGC
but is unrealistic as a long-run average scenario since
it allows for no employment growth over an extended
period of time.

P r e m iu m s t r u c t u r e

In order to investigate the effects of the latest round
of PBGC premium increases, we repeated the base
case simulation using the previous flat premium struc­
ture of $8.50 per participant per year. The results
appear in Table 4. Under the flat premium structure, the
present value of future premium payments falls to $5
billion. Given that premiums currently range from $16
to $50, it is not surprising that the present value of the
$8.50 constant rate premiums is less than half the
$13.7 billion value under the current variable rate reg­
ime. Although the value of the insurance is about the
same under the two structures, the value of the pre­
miums is higher by about $8 billion when variable rate
premiums are imposed, reducing the underfunding by
about one third.
The impact of the change in the PBGC premium
structure can also be seen by comparing the path of
future liabilities implied by our model with the PBGC’s
own projections as presented in its 1986 annual report.
The PBGC estimates are made under the constant pre­
mium rate structure and can be contrasted with esti­
mates from our model assuming both constant and
variable premium rates.

Figure 1

Annual Failure Rates
B ase C ase S im ulatio n
P e rce n t

pi I I I I I I I I I I I I I I I I I I I I I I I I l I I I I I I I I I I I I I I l I I l I l I I I I I I I I I I I I I I I I I I l l l I I I I I I I I I I I I I l I I I I I I I l j I I I I I I I I I I
0

5

10

15

20

25

30

35

FRBNY Q uarterly R eview/Autum n 1988
Digitized54
for FRASER


40

45
50
55
S im ulation yea r

60

65

70

75

80

85

90

95

100

To generate its projections, the PBGC report simply
extrapolates recent trends in the growth of its assets,
liabilities, and operating costs. It provides two sets of
estimates, one (Forecast A) based on the trends since
the creation of the agency in 1974 and the other (Fore­
cast B) based on the trends over the most recent fiveyear period. The two sets of estimates are reproduced
here in Table 5.
The average year-by-year results of our simulations
may be used to produce alternative estimates of the
PBGC’s net liabilities as they would appear in future
annual reports. These liabilities would change from
year to year for three basic reasons: they would
increase by the interest due on outstanding liabilities
as well as by the net new liabilities incurred, and they
would decline by the premium income received.
Since our model is estim ated in real terms, the

Table 3

Sensitivity Analysis
Liabilities from Future Terminations

No Growth

Base Case
.5 Percent
Growth

2 Percent
Growth

Alternatives for the future

In Billions of Dollars
Present value of PBGC
insurance
Present value of PBGC
prem ium s
U nderfunding

results must be adjusted for expected inflation in order
to make them comparable to the current-dollar PBGC
projections. This may be done by multiplying the result­
ing estimates by a factor representing the expected
cumulative effect of inflation from 1986 to the year of
the estimate. The PBGC forecasts assume a discount
rate of 7.25 percent. Since our estimates are based on
a real discount rate of 2.5 percent, we set the expected
inflation rate at a level of 4.75 percent, which is consis­
tent with both of these assumptions.
The PBGC estimates in Table 5 correspond to con­
stant premium rates of $8.50 per employee per year.
Hence, estimates from our model using this premium
structure also appear in the table. In general, these
estimates are close to the lower of the two PBGC pro­
jections for the early years and fall between the two
projections for the later years.
When estimates based on the new variable-rate pre­
mium structure are used, the impact of the change in
premiums becomes apparent. Because premiums are
currently higher for all firms, the estimated future lia­
bilities are all lower than in the constant premium case.
In fact, the liabilities are generally lower than both of
the PBGC projections, although they continue to grow
significantly over time, more than tripling over the 10year horizon.

28.0

30.5

40.3

13.0
15.0

13.7
16.8

16.9
23.4

According to our estimates, the funding status of the
PBGC is significantly worse than its financial state­
ments would indicate. If liabilities arising from future
terminations are taken into account, its total funding

Percent
Average failure rate
Long-run funding ratio

0.9
79

0.9
78

0.9
68
Table 5

Year-by-Year Projections of PBGC Reported
Liabilities
(In Billions of Dollars)
Table 4

Year

Alternative Premium Structures
Base Case Growth (.5 Percent)
(In Billions of Dollars)
Previous
Premium
Structure

Current
Premium
Structure

($8.50
Per Participant
Per Year)
Present value of PBGC insurance
Present value of PBGC prem ium s
U nderfunding




30.3
5.4
24.9

30.5
13.7
16.8

1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996

PBGC
Forecast A f
3.8
4.2
4.6
5.2
5.8
6.5
7.4
8.3
9.3
10.5
11.8

PBGC
Forecast B4:
3.8
4.6
5.5
6.7
7.9
9.4
11.0
12.9
14.9
17.3
19.9

Constant
Premiums§
3.8
4.0
4.2
4.8
5.5
6.4
7.6
9.2
11.2
13.5
16.4

Current
Premiums!
3.8
3.8
3.8
4.0
4.5
5.0
5.8
6.8
8.2
10.0
12.2

fB a s e d on growth trends from 1974 to 1986.
^B ased on growth trends from 1982 to 1986.
§Our estim ates, prem ium rate of $8.50.
||Our estim ates, variable prem ium rates of $16 to $50.

FRBNY Q uarterly Review/Autum n 1988

55

deficiency is more than five times the value reported.
Thus, if the coverage of the insurance is to remain at
current levels, additional funding is necessary. Since a
deficit has already developed, the problem is partic­
ularly pressing.
Who should provide these new funds? When Con­
gress created the PBGC, it intended the corporation to
be self-financing. Perhaps the simplest way to resolve
the funding problem while adhering to this legislative
intent would be to raise the premiums to a level that
makes their present value equal to the value of the
future insurance provided to the plan participants. This
approach is investigated in Table 6 using the results of
the simulations. The ratio of the estimated value of the
PBGC insurance to that of present value of the pre­
mium payments leads to a simple but usable approx­
imation of the premium rate that would solve the
current imbalance. The result is not exact in that the
greater premiums could affect the financial integrity of
the firms and alter the pattern of failures and termina­
tions. In addition, a large increase in premiums could
induce some firms to terminate their defined benefit
pension plans in order to avoid the additional cost.
However, since premiums tend to be small relative to
other firm variables, these effects are likely to be of
second order.
The simulation of the pre-1987 regime with premiums
at a constant rate (Table 4) provides an estimate of the
constant premium level that would be required for ben­
efits to match costs. These calculations suggest that a
contribution of $48 per employee per year would be
necessary. The problem with this type of setup, how­
ever, is that it creates disincentives to full funding for
sponsors whose plans are substantially underfunded.
The variable rate structure was introduced precisely to

deal with this kind of moral hazard problem.
An alternative is to retain the current structure that
makes contributions dependent on the funding status
of the plan— and therefore dependent on the risk to
the PBGC— but to raise each of the components of the
rate structure by the same proportion. As shown in
Table 6, this change would imply premium rates rang­
ing from $36 for fully funded plans to $111 for plans
with serious underfunding. This scheme would produce
the same present value of premiums as the constant
$48, but the burden would be redistributed to reflect
the individual risk of the given pension plan.33
A different way of dealing with the underfunding
problem is related to the negative amortization of overfunding analyzed above. We argued that pension plans
tend to be underfunded in the long run because,
according to the present rules, overfunding tends to be
amortized more quickly than underfunding. Liberalizing
the full funding limitation could reduce or eliminate this
asymmetry, thus raising the long-run funding level and
reducing the PBGC’s risk exposure.
The elimination of the full funding limitation would
give an incentive to sponsors to contribute more
heavily by m aking a d d itio n a l c o n trib u tio n s ta xdeductible. Table 7 reports simulation results for a sce­
nario in which firms are always allowed to contribute
the normal cost on a tax-deductible basis regardless of
the funding status of the plan. The effects are dramatic
in that the underfunding is reduced by $16 billion rela­
tive to the base case to only $1 billion. A somewhat
33This adjustm ent to the variable rate structure is not unique, in that
many com binations will produce the same present value of prem ium s
as the fixed premium system . The adjustm ent discussed here fixes
(at $5667) the maximum per-worker level of underfunding for w hich
the plan sponsor is penalized in the form of a higher PBGC
premium . Other system s are possible. In particular, if reducing moral
hazard in funding is the goal of the prem ium structure, a lower
"penalty ra te” than the $13 im posed by this adjustm ent could be
com bined with a higher maxim um underfunding level in a way that
would maintain the same prem ium present value.

Table 6

Self-Financing Premium Rates
(D ollars per Participant per Year)
Im plied
SelfFinancing
Actual
Premium Premium

Table 7

No Full Funding Limitation
Base Case Growth
(In Billions of Dollars)

Fixed rate (To end of 1987)
(Factor = 30.3/5.4 = 5.61)

8.50

48

Variable rate (1988)
(Factor = 30.5/13.7 = 2.23)
Fixed portion
In cre m e n tf
Maximum rate

16
6
50

fP e r p a rticipan t per $1000 of underfunding.

FRBNY Q uarterly Review/Autum n 1988
Digitized 56
for FRASER


36
13
111

Present value of PBGC insurance
Present value of PBGC prem ium s
U nderfunding

11.7
10.7

Present value of ad ditional contributions
Tax revenue loss

74.0
25.2

Average failure rate
Long-run funding ratio

1.0

0.9 percent
1071 percent

unrealistic feature of these results is that the long-run
funding ratio increases to a level of more than 10 to 1.
It seems unlikely that such levels would be reached in
the aggregate, particularly since such gross overfund­
ing could reasonably be expected to lead to a surge in
voluntary plan terminations.34 Such terminations would
both reduce the aggregate funding level and weaken
the position of the PBGC by removing the healthiest
plans from the pool covered by PBGC insurance. High
aggregate funding ratios are observed in this simula­
tion at least in part because the pension model makes
no provision for such voluntary terminations.
If the results are so attractive for the PBGC, what are
the real costs of such an alternative? Aside from the
voluntary terminations issue, one drawback is that tax
revenues would be lost by making the additional contri­
butions tax-deductible. In the example, the present
value of the tax losses would amount to $25 billion.35
Since this alternative involves a loss of general reve­
nues, it may be compared to the benefits of providing
the additional funding directly from general tax reve^ T h e sponsor of an overfunded pension plan has the option to
term inate the plan voluntarily and replace the pension coverage for
its workers with annuities. In such term inations, the sponsor is able
to recover a large share of the overfunding, since the firm is legally
responsible to cover only accrued pension benefits at the time that
the plan is term inated. For a more com plete discussion of the
motives and issues involved in voluntary term inations, see Arturo
Estrella, “ C orporate Use of Pension O verfunding," this Quarterly
Review, Spring 1984.
asMost of this loss is experienced in the first year, and further losses
are incurred for about a dozen years.

nues. Bringing the underfunding down to $1 billion
through a direct capital infusion would cost taxpayers
$16 billion, an amount which is $9 billion less than the
cost of eliminating the full funding limitation.
Thus our results suggest that raising the premium
rates may be the best current alternative in dealing
with the PBGC’s funding problems. Relaxing funding
limitations appears to be an expensive and ineffective
way to keep the PBGC solvent. Even at the exagge­
rated level reached by the funding ratio when full fund­
ing limitations are liberalized, PBGC insurance has
significant value and PBGC liabilities exceed assets by
$1 billion. Moreover, a provision that bases the individ­
ual insurance premiums on the risks involved for the
PBGC is the clear choice in handling the moral hazard
issue. The present system of making rates dependent
on the level of funding is a simple and effective first
step. Further progress could be made by taking into
account such factors as the riskiness of the fund’s
portfolio and of the firm’s own equity.
In the short run, some stopgap measure may be nec­
essary to prevent cash flow deficiencies resulting from
a further deterioration of the PGBC’s financial status.
Any short-term public funding could be provided in the
form of a loan if premium rates are raised to levels that
w ould u ltim a te ly s u ffic e to cover the expected
liabilities.

Arturo Estrella
Beverly Hirtle

Appendix A: Historical Sketch of the PBGC
T he PBG C w as fo rm e d in 1974 un d er T itle IV of the
E m p lo y e e R e tire m e n t In c o m e S e c u rity A ct (E R IS A ).
E s ta b lis h e d as an in d e p e n d e n t, s e lf-fin a n c in g , w h o lly
ow n e d g o v e rn m e n t c o rp o ra tio n , th e PBG C p ro te cts the
p e n sio n b e n e fits o f w o rke rs in p riva te d e fin e d be n efit
p e n sio n plans.
By y e a r-e n d 1986, n e a rly 40 m illio n A m e ric a n s , or
a p p ro x im a te ly o n e o u t of e v e ry th re e w o rke rs, w ere
e n ro lle d in p e n sio n p la n s in su re d by one of th e tw o p ro ­
g ra m s th a t th e P B G C o ffe rs . O ne p la n , w h ic h is th e
fo c u s o f th is paper, c o v e rs s in g le e m p lo y e r p e n s io n
p la n s; the o th e r c o v e rs m u lti-e m p lo ye r p e n sio n plans.
O f th e 40 m illio n w o rke rs e n ro lle d in PBG C plans, 30
m illio n in 110,000 p la n s w e re c o v e re d by th e s in g le
e m p lo y e r p ro g ra m in 1 9 8 6.f
tP ension Benefit Guaranty C orporation, Annual Report to the
Congress, FY 1986.




In the event th a t a co ve re d p e n sio n plan te rm in a te s
w ith o u t s u ffic ie n t a sse ts to m ee t lia b ilitie s , th e PBG C
g u a ra n te e s th e e n ro lle d w o rkers' “ b a s ic ” be n efits. B e n ­
e fits c o n s id e re d b a sic are all ve ste d re tire m e n t be n efits,
in clu d in g q u a lifie d p re re tire m e n t s u rv iv o r a n n u itie s and
c o st of livin g a d ju s tm e n ts (C O L A s) th a t b e ca m e e ffe c ­
tive p rio r to plan te rm in a tio n . T h e se b e n e fits are su b je ct
to a m axim u m p a ym e n t c o n s tra in t d e fin e d as th e le sse r
of a p a rtic ip a n t’s a ve ra g e m o n th ly e a rn in g s d u rin g the
h ig h e s t p a id c o n s e c u tiv e fiv e y e a rs o r a d o lla r lim it
based on the 1974 lim it of $750, a d ju ste d p ro p o rtio n a lly
w ith the S o cia l S e c u rity ta x a b le w age base. In 1986,
th is d o lla r lim it w a s $ 1 7 8 9 .7 7 p e r m o n th . A lth o u g h
a u th o rize d to do so, th e PBG C has not in su re d “ nonb a sic” b e n e fits such as re tire e m e d ica l in su ra n ce , lum p
sum paym ents, and C O L A s th a t b e ca m e e ffe c tiv e a fte r
the te rm in a tio n d a te o f th e plan.

FRBNY Q uarterly R eview/Autum n 1988

57

Appendix A: Historical Sketch of the PBGC (continued)
A p re re q u is ite fo r th e P B G C ’s fu ll g u a ra n ty o f all
b a sic b e n e fits is th a t the plan m ust have been in su re d
fo r at le a st five ye a rs p rio r to te rm in a tio n . In a d d itio n,
a n y p la n a m e n d m e n ts th a t ch a n g e th e b a s ic b e n e fit
m akeup of a plan m ust be in e ffe ct fo r at le a st five
y e a rs b e fo r e th e y a re fu lly in s u re d . A m e n d m e n ts
a d o p te d less th a n five ye a rs b e fo re plan te rm in a tio n are
c o ve re d at a rate o f 20 p e rc e n t of the in cre a se per ye a r
from th e tim e o f th e change.
If a p la n q u a lifie s fo r P B G C c o v e ra g e , th e p la n ’s
s p o n s o rs pay a pre m iu m to the c o rp o ra tio n in o rd e r to
p a rtic ip a te in th e pro g ra m . T his prem ium is a v a ria b le
rate equal to a fla t rate of $16 p er w o rker p er ye a r plus
a fu n d in g c h a rg e o f $6 p e r $1000 of “ fu n d in g ta rg e t
in su fficie n cy.” A fu n d in g ta rg e t in su fficie n cy is de fin ed
as the d iffe re n c e b e tw e e n 125 p e rce n t of the p re se n t
va lu e o f a p la n ’s ve ste d b e n e fits and the va lu e of the
p la n ’s assets. In o rd e r to lim it a sp o n s o r’s co sts should
a plan be v e ry u n d e rfu n d e d , th e PBGC im p ose s a cap
o f $50 p e r w o rk e r p e r year. P lans w ith fe w e r than 100
w o rke rs are e xe m p t from th is fu n ding ch a rg e and are
o n ly su b je c t to the fla t rate. T he va ria b le rate prem ium
s tru c tu re w as a d o pte d by th e PBGC in J a n u a ry 1988.
B e fo re th is change, plan s p o n so rs w ere c h a rg e d a flat
rate p e r p a rtic ip a n t p er year. In 1974, th is co st was $1;
in 1977, $ 2 .60 ; and in 1986, $8.50.
Plan s p o n s o rs can te rm in a te a plan o n ly un d er c e r­
ta in circ u m s ta n c e s . T he S in g le Em ployer P ension Plan
A m e n d m e n t A ct of 1986 (SEPPAA) d e ta ils the c o n d i­
tio n s u n d e r w h ich a plan m ay be te rm in a te d . T he re are
th re e ty p e s o f te rm in a tio n s : sta n d a rd , d is tre s s , and
in v o lu n ta ry . T he s ta n d a rd te rm in a tio n o c c u rs w h e n a
te rm in a tin g plan is fu lly fu n d e d or o ve rfu n d e d . In th is
situ a tio n , plan a sse ts m ust be used to p u rch a se a n n u ity
c o n tra c ts fro m a lic e n s e d in s u ra n c e c o m p a n y . A n y
exce ss a sse ts from an o ve rfu n d e d plan m ay be re c o v ­
e re d by th e em ployer.
T he s e co n d ty p e of te rm in a tio n is a d istre ss te rm in a ­
tio n . A te rm in a tio n is so d e s ig n a te d if a co m p a n y m eets
at le a st one of th e fo u r fo llo w in g c rite ria :


58 FRBNY Quarterly Review/Autum n 1988


1. It is in b a n k ru p tc y liq u id a tio n .
2. It is re o rg a n izin g u n d e r th e B a n k ru p tc y Act.
3. It c a n n o t pay its d e b ts and w o u ld be u n a ble to
c o n tin u e in b u sin e ss u n le ss th e plan te rm in a te s.
4. It is e x p e rie n c in g u n re a so n a b ly b u rd e n so m e p e n ­
sion co sts d ue s o le ly to a d e clin in g w o rk force.
T he first tw o c a te g o rie s a re o b je ctive . T he se co n d tw o
c rite ria are s u b je c tiv e and req u ire PBG C ap p ro va l.
T he th ird ty p e of te rm in a tio n is an in v o lu n ta ry te rm i­
na tio n. In such cases, th e PBG C in itia te s a plan te rm i­
na tio n if th e s p o n so r is u n a b le to pay b e n e fits w hen due
o r to s a tis fy m inim um fu n d in g re q u ire m e n ts.
In b o th in v o lu n ta r y a n d d is tre s s te rm in a tio n s , th e
PBG C a ssu m e s o w n e rsh ip o f th e p la n ’s a sse ts and lia ­
b ilitie s. S p o n so rs are a lso lia b le to th e P B G C fo r th e fu ll
am o u n t of u n fu n d e d g u a ra n te e d b e n efits. T h is lia b ility is
se p a ra te d into tw o p a rts. Im m e d ia te ly pa ya ble to the
PBG C is th a t p o rtio n o f th e lia b ility eq u al to th e le sse r
of th e va lu e of th e u n fu n d e d g u a ra n te e d b e n e fits o r 30
p e rce n t of the firm ’s net w o rth . T he se co n d p a rt is th a t
p o rtio n , if any, o f u n fu n d e d g u a ra n te e d b e n e fits in
excess of 30 p e rc e n t of net w o rth . T he PB G C n e g o ti­
ates w ith th e s p o n so r a p a cka g e in w h ich th is re m a in in g
lia b ility is d e fe rre d and paid u n d e r m ore c o m m e rc ia lly
fa vo ra b le c ircu m sta n ce s. If an e m p lo ye r is in b a n kru p tcy
p ro ce e d in g s, then th e firs t p a rt of th e P B G C ’s cla im is
g ive n th e p rio rity sta tu s of a fe d e ra l ta x lien. T he s e c ­
ond p a rt has th e sta tu s of an u n se cu re d g e n e ra l c re d i­
tor. H isto rica lly, the PBG C has re co ve re d an ave ra g e of
ju s t 8 ce n ts fo r e ve ry d o lla r o f u n fu n d e d g u a ra n te e d
b e n e fits co ve re d by b oth c la im s a g a in st plan s p o n s o rs 4
S in ce its in ce p tio n in 1974, th e PBG C has run d e ficits
in 11 of 13 ye a rs as o f ye a r-e n d 1986. By ye a r-e n d 1986,
the a ccu m u la te d d e ficit of th e PBG C sto o d at $3 .8 b il­
lion, an in cre a se of $ 2 .5 b illio n from ye a r-e n d 1985.

John A. Brehm
^Pension Benefit Guaranty C orporation, Promises A t Risk
(Washington, D.C., A pril 1987), p. 18.

Appendix B: The PBGC Insurance Model
This appendix presents the difference equations that
compose the PBGC insurance model discussed in the
text. The model consists of six equations that describe
the dynamic behavior of firm assets and debt, pension
plan normal costs and number of participants, and pen­
sion fund assets and liabilities. The equations contain
the following variables (stock variables are measured at
the end of the year):
= Pension fund assets in year t
A,
= Pension fund liabilities in year t
L,
= Guaranteed pension fund liabilities in
year t
= Pension fund benefit payments during
B,
year t
= Pension fund contributions during
year t
NC,
= Normal cost portion of pension fund
contributions during year t
m,
= Am ortization rate of pension fund
overfunding/underfunding during year t
= Firm assets in year t
v,
= Firm debt in year t
D,
= Number of pension plan participants
P.
during year t
= PBGC premium per plan participant
•fft
during year t.
Given the discussion in the text, the difference equation
describing the movement of pension fund assets can be
expressed as:
A,
= (1 + a A + Za ^A,.,
C, - B,t
where aA is the expected return on pension fund assets
(assumed to be constant across time) and zAt is the
random return on fund assets during year t.
The pension fund contribution is the sum of normal
costs plus the a m o rtiz a tio n of any o v e rfu n d in g or
underfunding:
Ct = NC, + mt.1(Lt1-At1).
Under the guidelines established by ERISA, when a
pension fund is underfunded, the sponsoring firm must
am ortize the funding shortage over a period of years.
For the purpose of this model, we assume that the
am ortization horizon is 20 years and that the sponsor
uses the expected return on fund assets as the dis­
count rate. These assum ptions imply that for under­
funded plans,
m, = aA + aA/[(1 + aA)20-1].
Sponsors of overfunded plans, on the other hand, are
limited by the IRS in the size of the contribution that
they may make. Specifically, the firm cannot contribute
an amount that will push the assets of the plan beyond
the lia b ilitie s plus norm al c o s ts .f These restrictio ns
imply that:

Lp

c,

fT h ts lim itation has been tightened by legislation adopted in
1987 that further lim its the assets of the fund, including the




m, = 1
if L,ssA,<L, + NC,
m, = NC,/(A,-Lt) if A ^ L t+ N C ,.
The other com ponent of the pension contribution is
the normal cost of the pension plan. We assume that
pension benefits and and norm al costs grow at the
same rate, aB, per year:
B, = (1 + otB)B{_1( and
NCt = (1 + aB)NCM .
Benefits may also be expressed as the sum of normal
c o s ts p lu s th e e x p e c te d re tu rn on p e n s io n fu n d
liabilities:
B,
= NC, + qa L,_i ,
which leads to the difference equation for pension fund
liabilities:
L, = (1 + a B)LM .
The sponsor firm ’s dynamic behavior is described by
the movements of firm debt and assets. As noted in the
text, firm assets can be expressed as:
V, = (1 + otv + Zv,t)Vt-i — C, “ TT,Pt,
where av is the expected return on firm assets and zv i
is the random return component. According to ERISA
regulations, the PBGC premium is related to the funding
status of the pension plan as follows:
77t = 16 + M IN[34,MAX[0,6(L,-At)/(1000 P,)]].
The number of pension plan participants is assumed to
grow at a constant rate, ap, per year:
P, = (1 + ap)PM .
Finally, firm debt is also assumed to grow at a constant
rate, aD, per year:

D, = (1 + aci)DM.
After substitution and sim plification, these difference
equations may be sum marized as follows:
(1) NC, = (1 + a B)NCM
= (1 + a B)Li-1
(2) L,
(3) At = (1 + Z a . .) A m + (aA-m,.1)(A,.1-LM)
= (1 + ap)P t.-i
(4) P,
(5) D,
= (1 + aoJD,.,
(6) Vt
= (1 + a v + Zv,t)V,_-t-NCt-mt_1(Lt.1-A,.1)-TT,P,
These equations correspond exactly to those in the text.
W hen the plan term inates, the value of the PBGC
insurance is determ ined by these six variables. If the
pension plan is underfunded at term ination, the PBGC
assum es the a sse ts and lia b ilitie s of the plan and
assesses the firm sponsor a fee equal to 30 percent of
the net worth of the firm. This fee may not exceed the
amount of underfunding, however. Under these rules,
the value of the PBGC insurance can be expressed as:
PBGC = M A X [0,Lf-A t-.3MAX[0,Vt-Dt]].
Footnote f continued
em ployer's contribution, to no more than 150 percent of the
plan’s liabilities. This restriction is binding only if the normal
cost exceeds one half of the liabilities. Because of assum p­
tions made in the em pirical part of the paper, this constraint
is never binding in our model. For a more detailed discussion
of this issue, see Estrella and Hirtle, "Im p licit Liab ilitie s."

FRBNY Q uarterly Review/Autum n 1988

59

In Brief
Economic Capsules
U.S. Trade with Taiwan
and South Korea
The United States has been running large trade deficits
with the two Asian economies of Taiwan and South
Korea. By 1987 the combined U.S. trade deficit with
these economies alone reached $27 billion, equal to
17 percent of the total U.S. trade deficit worldwide
(Table 1). Although the U.S. deficit with these econ­
omies improved during the first half of 1988, it still
remains very high. This note looks at U.S. trade with
Taiwan and South Korea. It discusses both the composition
of this trade and its recent growth path, giving particular
attention to the factors behind the 1988 improvement in
the U.S. trade position. The note ends by briefly con­
sidering the outlook for U.S. trade with the two econ­
omies in light of the current trade performance.
To summarize the main points, the United States
exports primarily capital goods and industrial supplies
to Taiwan and South Korea. Recent export growth has
been across all commodity categories. The United
States imports primarily consumer goods and capital
goods components from Taiwan and South Korea. The
slowdown in imports has been mainly in the consumer
goods area. Appreciation of the Asian currencies,
import liberalization measures undertaken particularly
by Taiwan, and special circumstances in some key
trade industries appear to explain most of the recent
improvement in U.S. trade with these two economies.
Even with this recent improvement, however, the U.S.
trade deficits with both Taiwan and South Korea remain
large. Further trade improvement with these economies
will most likely require significant additional changes in
some of the underlying trade determinants.
The Taiwanese and South Korean economies
There are some broad similarities in the Taiwanese and

FRBNY Quarterly Review/Autumn 1988
Digitized 60
for FRASER


South Korean economies. Neither is endowed with a
large natural resource base, but both have a welleducated, skilled labor force. As a consequence, the
dominant industries in the two economies focus on
manufacturing, both of capital and consumer goods.
Both economies have, furthermore, relied on export
growth to maintain a rapid pace of development, with
exchange rates kept at levels necessary to insure the
competitiveness of local products in world markets.
Productivity growth in the manufacturing sectors of
both Taiwan and South Korea has been extremely rapid
(Table 2). Supported by a very strong investment per­
formance, this growth has kept unit labor costs com­
petitive while wage rates have risen sharply.
Taiwan and South Korea differ somewhat in the com­
position of their output. Taiwan has tended to concen­
trate more on the production of consumer goods, while
South Korea has devoted a greater percentage of its
energy to producing capital goods and automobiles. In
part because consumer goods production requires less
investment expenditure, Taiwan has not relied as
heavily as South Korea on foreign funds to finance
development. In fact, while South Korea’s foreign debt
totaled about $35 billion at the end of 1987, Taiwan
was actually a net creditor to the world.
An even sharper distinction between the two econ­
omies lies in the area of foreign trade. Taiwan has run
current account surpluses since the middle 1970s.
South Korea, in contrast, only began to run a current
account surplus in 1986. Consequently, although recent
surpluses have led both economies to appreciate their
currencies, the New Taiwan dollar has appreciated
more strongly against the U.S. dollar than has the
South Korean won. The New Taiwan dollar rose 27 per­
cent against the U.S. dollar between the first quarter of
1985 and the third quarter of 1988; the South Korean
won rose 1 2 percent during this period. Adjusted for
relative inflation rates, the New Taiwan dollar rose

IN BRIEF-ECONOMIC CAPSULES

17 percent in real terms against the U.S. dollar, the
South Korean won 12 percent (Chart 1).1
1These changes are calculated in term s of movement in the Asian
currency/U.S. dollar exchange rate. Real rates are calculated by
deflating with wholesale price indexes. The Asian currency
movements com pare with nominal rises against the U.S. dollar of
43 percent for the German mark and 48 percent for the Japanese
yen over the same period. In real term s the mark rose 38 percent
and the yen 36 percent.

Taiwan has taken greater steps to remove import
restrictions than has South Korea. Although Taiwanese
tariffs still remain high on a number of goods, notably
automobiles and agricultural products, recent mea­
sures have significantly reduced tariff rates for most
items. South Korea continues to maintain relatively
high tariff rates on a broad range of goods while con­
centrating recent import liberalization efforts on reduc­
ing the number of import items that require restrictive
im port licenses. Taiwan has no sig nificant im port
licensing requirements.

Table 1

U.S. Trade Balances with Taiwan and South
Korea

Table 2

(Billions of Dollars, BOP Basis)
1985

1986

1987

19 8 8 f

Taiwan
(Percent of total
U.S. trade deficit)

-1 1 .2 1

- 1 4 .6 4

-1 7 .5 0

-1 0 .8 3

(9.2)

(10.1)

(10.9)

(8.3)

Korea
(Percent of total
U.S. trade deficit)

-4 .2 5

- 6 .9 8

- 9 .3 9

- 8 .8 9

(3.5)

(4.8)

(5.9)

(6.8)

Growth in Productivity, Real Investment,
Unit Labor Costs, and Wages in Manufacturing
(Averaged Annualized Percent Change 1985-87)

Taiwan
South Korea

fF irs t half 1988 values, seasonally adjusted and annualized.

Productivity
Growth

Increase
in
Investment

Growth in
Unit Labor
Costs

C hange in
Average
Hourly
Wage

10.4
12.7

14.2
14.5

-1 .9
1.5

9.5
11.5

C h a rt 1

Asian Exchange Rates versus U.S. Dollar
Q u a rte rly A v e ra g e s
N ew T a iw a n d o lla r p e r U.S. do lla r
5 0 --------------------------------------------------------------------------------------------

S o u th K o re a n w on p e r U.S. d o lla r

Real

2 5 1i n 1 1 1 1 1 1 1 1 11 i i 11 1 1 11 1 1 11 1 1 1i n
1978

79

80

81

82

83

84

85

I in
86

11 i l L u j J
87

88

4 0 0 L U .L .l.1 l I 1,1.1.] 1 I 1.1.1.11 1 1 1 1 I J.1.11 111-L.l I I I 1 I I I 1 1 1.1 1
1978 79
80
81
82
83
84
85
86
87
88

N o te : Real exch a n g e ra te s a re c a lc u la te d as nom inal e x c h a n g e ra te s m u ltip lie d by th e ra tio o f U.S. to A sia n w h o le s a le
p r ic e in d e x e s w ith 1980:1=100 fo r all th re e p ric e in d e x e s .

N BRIEF-ECONOMIC
CAPSULES



FRBNY Q uarterly Review/Autumn 1988

61

Composition and growth of U.S. trade with Taiwan
and South Korea
U.S. trade with Taiwan and South Korea has grown rap­
idly during the 1980s, on both the export and the
import side. However, U.S. imports have until recently
outpaced U.S. exports, leading to growing U.S. bilateral
trade deficits with both economies (Chart 2).

The United States exports primarily capital goods
and industrial supplies to Taiwan and South Korea
(Table 3). Agricultural sales are the next largest U.S.
export category despite strong agricultural import pro­
tection by both Asian economies. U.S. automobile
exports are effectively limited by high tariff rates in
both Taiwan and South Korea.

C h a rt 2

U.S. Trade with Taiwan* and South Korea
B illio n s o f d o lla rs

B illio n s o f d o lla rs
2 5 -------------------------S o u th K o re a

1978

79

80

81

82

83

N ote: The 1988 p o in t re p re s e n ts the fir s t tw o q u a rte rs ’ va lu e a n n u a liz e d and s e a s o n a lly a d ju s te d .
f.o .b . b a s is and im p o rts a re on a c u s to m s basis.

84

85

86

87

88

E x p o rts a re on a

* E x c lu d in g g o ld .

Table 3

Composition of U.S. Exports to Taiwan and South Korea in 1987

Autos

Other
Consumer
Goods

A gricultural
Products

2 .6 t

0.2

0.4

0.9

2.5

3.6

0.2

0.2

0.9

6

9

2

3

8

Total

Capital
Goods

Industrial
Supplies

Taiwan
(In billions of dollars)

6 .5 t

2.2

South Korea
(In billions of dollars)

7.5

6

Exports to Taiwan and
South Korea as a percent
of total U.S. exports
fE x c lu d in g gold.

62FRASER
FRBNY Quarterly Review/Autumn 1988
Digitized for


IN BRIEF-ECONOMIC CAPSULES

U.S. export growth to Taiwan and South Korea has
been remarkably fast over the last few quarters. In part
this reflects an artificial boost to exports in 1988 from
transshipment of foreign gold through the United States
to Taiwan, a development that caused a sharp increase
in reported U.S. sales to Taiwan. Even abstracting from
gold sales, however, U.S. exports to Taiwan grew at an
average annual rate of 47 percent and to South Korea
at an average annual rate of 33 percent over the last
half of 1987 and the first half of 1988. These rates con­
trast with average annual U.S. export growth rates of 9
and 13 percent to Taiwan and South Korea respectively
from the beginning of 1985 through mid-1987. Recent
growth was spread across most export categories
(Table 4).
U.S. imports from Taiwan and South Korea are pri­
marily consumer goods, although capital goods and, in
the case of South Korea, automobiles are becoming
increasingly important (Table 5). Clothing and footwear

are still the largest consumer goods imports, followed
by consumer electronics. Capital goods imports are
mainly parts and'components such as semiconductors.
U.S. imports from Taiwan and South Korea grew rap­
idly through mid-1987 before slowing significantly in
pace by year end and through the beginning of 1988
(Table 6). After growing at an average annual rate of 28
percent over the previous two and a half years, imports
from Taiwan actually fell 3 percent during the four quar­
ters ending 1988-11. Imports from South Korea grew
only 10 percent over these last four quarters, after
growing at an average annual rate of 34 percent during
the previous period. Although imports of industrial sup­
plies and agricultural products declined recently, these
commodity imports are relatively small; the marked
slowdown in total imports from mid-1987 until mid-1988
was prim arily the result of weakness in consumer
goods and automobile sales.
Overall, the U.S. trade deficits with Taiwan and South

Table 4

U.S. Export Growth to Taiwan and South Korea 1988-11/1987-11
(In Percent)

Autos

Other
Consumer
Goods

A gricultural
Products

37.9 f
(37.9)

292.5
(6.8)

93.8
(6.8)

54.6
(14.7)

42.6
(51.4)

- 2 5 .0
(1.3)

70.4
(3.0)

46.4
(10.6)

A gricultural
Products

Total
Growth

Capital
Goods

Industrial
Supplies

Taiwan
(Export share})

47.2 f
(100)

29.8
(31.2)

South Korea
(Export sh a re t)

33.5
(100)

18.2
(30.7)

tE x c lu d in g gold.
tP erce ntag e share of each com m odity category in total U.S.exports to each Asian economy in 1988-11.

Table 5

Composition of U.S. Imports from Taiwan and South Korea in 1987

Total

Capital
Goods

Industrial
Supplies

Autos

Other
Consumer
Goods

Taiwan
(In billions of dollars)

24.6

5.8

1.9

0.4

15.6

0.5

South Korea
(In billions of dollars)

16.9

3.0

1.6

2.5

9.3

0.3

10

10

3

3

Imports from Taiwan and
South Korea as a percent
of total U.S. imports


IN BRIEF-ECONOMIC
CAPSULES


28

3

FRBNY Quarterly Review/Autumn 1988

63

Korea, at $11 billion and $9 billion respectively in the
first half of 1988,2 still remain exceptionally large rela­
tive to the size of the actual export and import flows
between the United States and these two economies.
U.S. imports from Taiwan are still three times the level
of U.S. exports to Taiwan while U.S. imports from
South Korea are more than double the level of U.S.
exports to that economy.

Factors behind the recent strength in U.S. exports
and moderation in U.S. imports
Several factors lay behind the recent strength in U.S.
exports to Taiwan (abstracting from gold sales) and to
South Korea and the moderation in U.S. imports from
these economies. Policy decisions, general economic
developments, and special circumstances in some key
trade industries all played a role. Econometric analysis,
described in the Box, suggests the relative importance
of these various factors in improving U.S. trade with
Taiwan and South Korea over the four quarters ending
1988-11 (Table 7).
The Taiwanese and South Korean policy decisions to
let their currencies appreciate relative to the U.S. dollar
and to undertake im p ort lib e ra liz a tio n m easures
appear to have been the most important factors boost­
ing U.S. export sales to Taiwan and South Korea during
this period. The fall in U.S. prices relative to Taiwanese
and South Korean prices that resulted from New Tai­
wan dollar and won appreciation significantly increased
demand in both Asian economies for U.S. products.
Import liberalization measures, along with some spe­
cial policies to promote purchases of U.S. products,
apparently had an even larger impact on Taiwanese
demand for U.S. goods. Much weaker liberalization
efforts in South Korea had a correspondingly smaller
impact.
2These figures are seasonally adjusted and annualized.

The two other major factors raising the dollar value
of U.S. exports to Taiwan and South Korea were Asian
economic growth and a rise in U.S. export prices.
Domestic economic growth in Taiwan and South Korea,
entailing heavy investment expenditure, was partic­
ularly beneficial to U.S. exporters concentrated in capi­
tal goods and industrial supplies. U.S. export prices
were up because of a significant rise in commodity
prices as well as U.S. inflation in general. The com­
modity price factor was important because industrial
supplies are a major U.S. export item to Taiwan and
South Korea. U.S. export prices also appeared to be
up because the dollar prices of competing Japanese
products rose with yen appreciation, providing U.S.
producers a little leeway to raise their own prices.
On the import side, currency appreciation and prob­
lems in specific consum er goods industries were
apparently the main factors behind the slowdown in
Asian sales to the United States. Foreign currency
appreciation has two effects: it raises the price of
imports while reducing the volume of demand. The
price effect occurs first. In the case of Taiwan, the vol­
ume effect of appreciation over the four quarters end­
ing 1988-11 appears to have been greater than the price
effect. Thus, Taiwanese currency appreciation signifi­
cantly depressed the value of U.S. purchases from Tai­
wan.3 For South Korea, whose appreciation timing
pattern was different, the price effect apparently offset
the volume effect during this period (although further
volume effects are presumably yet to come). South
Korean appreciation, therefore, seem ingly did not
change the value of U.S. import purchases over these
3During this period Taiwanese and South Korean prices rose relative
to Japanese prices because of the tim ing of new Taiwan dollar, won,
and yen appreciation. This relative price movement depressed the
volume of U.S. demand for Taiwanese and South Korean goods as
some purchasers sw itched over to Japanese items. This sw itch is
included in the volume effect de scribed above.

Table 6

U.S. Import Growth from Taiwan and South Korea 1988-11/1987-11
(In Percent)
Total
Growth

Capital
Goods

Industrial
Supplies

Autos

Other
Consumer
Goods

A gricultural
Products

Taiwan
(Im port s h a re f)

-2 .9
(100)

14.7
(26.9)

-6 .6
(8.0)

4.3
(2.0)

-9 .0
(60.2)

-8 .0
(1.7)

South Korea
(Im port sh a re f)

10.5
(100)

36.4
(20.2)

20.1
(9.8)

-4 .2
(15.0)

6.6
(52.8)

-3 .6
(1.7)

-[•Percentage share of each com m odity category in total U.S. im ports from each Asian economy in 1988-11.

Digitized for
64FRASER
FRBNY Q uarterly Review/Autumn 1988


IN BRIEF-ECONOMIC CAPSULES

four quarters.
Special industry factors clearly depressed U.S. pur­
chases from both Taiwan and South Korea. The
1987-88 slump in U.S. clothing demand significantly cut
apparel imports from the two Asian economies. Finan­
cial difficulties of two U.S.-owned toy companies manu­
facturing in Taiwan lowered Taiwanese toy sales to the
United States. An automotive industry strike in South
Korea dramatically cut U.S. imports of South Korean
cars. The saturation of demand in the United States for
microwave ovens and VCRs also hurt sales from both
Asian economies.
Appreciation and special industry factors depressing

U.S. imports were balanced against two factors pro­
moting U.S. purchases from Taiwan and South Korea —
robust U.S. economic growth and growing Asian supply
capacity.4 For Taiwan, currency appreciation and spe­
cial industry problems more than offset these latter fac­
tors supporting U.S. im port growth, producing the
outright decline in imports noted earlier. For South
Korea, special industry factors cut the growth in U.S.
import purchases to about half the rate suggested by
these import-supporting factors alone.
4Growing Asian supply capacity is used here to refer to the rapid
econom ic developm ent of the two Asian econom ies that has enabled
them to increase their share in world markets substantially over the

Box: Estimating the Impact of the Various Factors Affecting U.S. Export and Import Growth
Rates with Taiwan and South Korea
The te x t a ss e s s m e n ts o f the im p o rta n ce of the va riou s
fa c to rs u n d e rlyin g b ila te ra l tra d e g ro w th rate s b e tw e en
th e U nited S ta te s and Taiwan and South K orea were
p rim a rily b ased on re g re ssio n analysis. R e g re ssio n s for
e x p o rt and im p o rt p rice and vo lum e w ere run fo r U.S.
trad e w ith Taiwan and S outh K orea over the p e rio d 1979
to 1987. On the w hole, th e reg re ssio n re su lts are fa irly
robust, but in som e ca se s th e y are se n sitive to s ig n ifi­
ca n t c h a n ge s in the sa m p le pe rio d .
The reg re ssio n c o e ffic ie n ts fo r the m a jo r fa cto rs m en ­
tio n e d in the te x t are show n in the table. T he t-s ta tis tic s
are g iven in p a re n th e se s.

Regression Coefficients
U.S. Export Growth
Growth in
Asian
Industrial
Production

C hange in Change in
U.S./Asian
U.S.
Relative
Wholesale
Prices
Price Index

Change in
Japanese/
Asian
Relative
Prices

To Taiwan

1.16
(3.5)

- 1 .1 5
(2 8 )

0.83
(3.7)

-.2 0
(1.0)

To South
Korea

0.37
(1.1)

-1 .4 5
(3.0)

0.81
(3 .9 )

-.4 4
(2.4)

U.S. Import Growth

Growth in
U.S.
Industrial
Production

C hange in
Asian
Supply
C apacity
Change in
and Other Asian/U.S.
Trend
Relative
Effects
Prices

C hange in
Japanese/
Asian
Relative
Prices

From Taiwan

1.09
(3.3)

12.22
(5.5)

-1 .0 7
(3.7)

0.53
(2.4)

From South
Korea

1.21
(4.9)

13.78
(2.9)

-0 .7 2
(2.3)

0.51
(2.9)


IN BRIEF-ECONOMIC
CAPSULES


The fa cto r la b e le d “ C h a n g e in A sian S u p p ly C a p a city
and O th e r Trend E ffe c ts ” w as run in the re g re s s io n s as
a sim p le trend g ro w th te rm . The reason is th a t m a n u ­
fa ctu rin g ca p a c ity in Taiwan and South K orea has been
gro w ing fa irly ste a d ily o ve r the re g re ssio n p e rio d and is,
c o n s e q u e n tly , d iffic u lt to s e p a ra te fro m o th e r tre n d
e ffe cts. The o th e r fa cto rs are fa irly sta n da rd . Som e fa c ­
to rs w ere e n tere d w ith a lag in the re g re ssio n s, w ith
t-s ta tis tic s used to ch o o se the a p p ro p ria te lag length.
T h e e s tim a te d im p a c t o f o th e r im p o r ta n t fa c to rs
a ffe ctin g U.S. tra d e flow s w ith Taiwan and S outh K orea
w as d e rive d se parately. T he e ffe ct of A sia n im p o rt lib e r­
a liz a tio n w as d e te rm in e d by a p p ly in g th e re g re s s io n d e rive d p rice co e ffic ie n ts to th e average ch a n ge in ta riff
rate s and to o th e r p o lic y -in d u c e d p ric e ch a n g e s in each
A sia n econom y. B e ca u se ta riff and o th e r p rice ch a n g e s
did not a p p ly to all p ro d u ct c a te g o rie s equally, th e se
e stim a te s sh o u ld be vie w e d m ore as o rd e r of m a g n itu d e
fig u re s than as p re cise n u m e rica l results. In c o m b in a ­
tio n w ith the re g re ssio n an a lysis, th is e stim a tio n p ro ­
ce d u re w o rks well in e x p la in in g U.S. e x p o rt g ro w th over
d iffe re n t q u a rte rs in the re ce n t past.
E s tim a te s o f th e im p a c t o f s p e c ia l in d u s try fa c to rs
w ere b ased on d e via tio n s in U.S. im p o rt g ro w th in the
a ffe c te d in d u s trie s fro m ra te s e x p e c te d g iv e n o v e ra ll
U.S. im p o rt g ro w th from Taiwan and South Korea. S p e ­
c ific a lly it w as a ssu m e d that, in the a b se n ce o f sp e cia l
in d u s try problem s, th e im p o rt g ro w th rate s fo r clo th in g ,
to ys, a nd a u to m o b ile s w o u ld have s lo w e d re la tiv e to
th e ir 1986-87 g ro w th rate s by th e sam e p e rce n t as to ta l
im p o rt g ro w th rate s slow ed. T he d e rive d g ro w th rate s
based on th is a ssu m p tio n w ere then c o m p a re d to actual
g ro w th rates fo r th e se in d u s trie s to ga u ge th e m a g n i­
tude of s p e cia l pro b le m s.

FRBNY Quarterly Review/Autumn 1988

65

The outlook for U.S. trade with Taiwan and South
Korea
The U.S. trade balance with Taiwan and South Korea
has improved significantly in recent quarters. However,
given the still large discrepancy between the size of
U.S. exports and U.S. imports with these two econ­
omies, trade improvement can only be sustained if U.S.
exports continue to grow rapidly while U.S. import
growth remains more subdued.
In the absence of further policy adjustment this
required growth pattern may be difficult to achieve.
Some of the key factors behind the recent strength in
U.S. exports and moderation in U.S. imports are apt to
diminish over time. The effect of past currency appre­
ciation on trade growth rates fades with time. The

same holds true for the effect of import liberalization
measures. The effects of special industry factors that
were favorable to trade adjustment appear to have
begun to dissipate already —for example, the South
Korean automobile industry strike is over.
On the positive side, at least two possible develop­
ments favorable to trade adjustment are on the horizon.
Current U.S. discussions with Taiwan and South Korea
may lead to further Asian trade liberalization, while
U.S. demand growth may moderate as the U.S. econ­
omy slows from its very strong recent rate of expan­
s io n . T he fo re s e e a b le im p a c t o f th e s e tw o
developments by themselves, however, is unlikely to
prove sufficient to eliminate, or perhaps even reduce
substantially, the U.S. trade deficits with Taiwan and
South Korea.

Footnote 4 continued
last decade. In the regression analysis, the contribution that Asian
econom ic developm ent has made to U.S. import growth is estim ated
by a trend growth rate (see Box).

Susan Hickok
Thomas Klitgaard

Table 7

Accounting for U.S. Trade Growth with Taiwan and South Korea
(Percentage Point Contributions over the Period 1987-11 to 1988-11)
Due to:

Asian Trade
Policy Changes

Asian
Economic
Growth

U.S. Price
Increases
Including Special
Price Factors

10

15

8

7

7

10

5

7

7

4

O th e rt

Total

Relative
Price
Changes

To Taiwan
(E xcluding gold sales)

47

To South Korea

33

U.S. Export Growth

O th e rf

Due to:

U.S. Import Growth
From Taiwan
From South Korea

Total

Relative
Price
Changes

S pecial Clothing,
Toy, and
Autom obile
Factors

U.S.
Economic
Growth

Increased Asian
Supply C apacity
and Other Trend
Factors

-3

-1 0

-5

7

13

-7

-2

-7

7

17

-6

10

fT rend and unexplained residual.
^M arket saturation in specific consum er goods products and unexplained residual.


66 FRBNY Q uarterly Review/Autumn 1988


IN BRIEF-ECONOMIC CAPSULES

Treasury and Federal Reserve
Foreign Exchange Operations
August-October 1988

During the early weeks of the period under review, the
dollar continued the generally upward trend that had
prevailed throughout the summer, moving higher
against all major foreign currencies but especially the
German mark. At times during August and to a lesser
extent during September, there were episodes of
upward pressure whereupon the U.S. authorities inter­
vened, selling dollars to restrain the dollar’s rise. As
the period progressed, shifts in expectations about the
U.S. economic outlook, about the prospects for further
increases in U.S. short-term interest rates, and about
the progress of external adjustment led to a more cau­
tious attitude toward the dollar, and the currency
started to ease. During October selling pressures
intensified, and late that month the U.S. authorities
intervened in the foreign exchange market to support
the dollar. On balance, the dollar ended the threemonth period about 5 V2 percent lower against the
Japanese yen and 5 percent lower against the German
mark from end July levels.
In the opening weeks of the period, the dollar was
buttressed by the release of economic statistics indi­
cating continued strength in the U.S. economy. The
August 5 announcement of preliminary employment
data for July, together with an upward revision to June
employment data and evidence of increasing capacity
utilization, suggested that U.S. economic growth was
proceeding at a pace that could give rise to new inflaA report presented by Sam Y. Cross, Executive Vice President in
charge of the Foreign Group at the Federal Reserve Bank of New
York and Manager of Foreign Operations for the System Open Market
Account. Cathy McHugh was primarily responsible for preparation of
the report.




tionary pressures. Market participants interpreted these
economic statistics as increasing the likelihood that the
Federal Reserve would tighten its monetary policy
stance. Some observers already claimed to see signs
of Federal Reserve tightening and were attracted by
the prospects of rising short-term interest rates and the
relatively high yields available on dollar-denominated
assets. Even so, market participants were somewhat
surprised when the Federal Reserve raised the dis­
count rate by V2 percentage point to 6 V2 percent on
August 9. Subsequently, short-term interest rate differ­
entials favoring the dollar against both the German
mark and the Japanese yen widened. On August 10,
the dollar reached its period high of DM 1.9245 against
the mark while trading as high as ¥ 135.20 against the
yen. At that time, the dollar was 2 V2 percent higher
against the mark and 1 1/2 percent higher against the
yen from the start of the period. From its low point
around the turn of the year, the dollar had moved up
more than 23 percent against the mark and more than
1 2 percent against the yen.
For several weeks thereafter the dollar traded firmly
as market participants adjusted commercial leads and
lags and implemented other hedging strategies to take
account of the dollar’s renewed strength. Sentiment
toward the dollar remained bullish, with traders inter­
preting even potentially unfavorable news as favorable
for the dollar. In these circumstances, market partici­
pants questioned the degree of the Administration’s
concern over the dollar’s rise.
Perceptions that external adjustment was proceeding
on track encouraged positive sentiment toward the dol­
lar. Market participants noted that the trade deficit had

FRBNY Quarterly Review/Autumn 1988 67

narrowed with each of the prior three monthly reports,
setting in place a trend of improved performance
based on varying combinations of strong export perfor­
mance and slower growth of imports. The August 16
report that the U.S. trade deficit for June had widened
to a seasonally adjusted $12.5 billion from a revised
$9.8 billion in May initially disappointed the market,
and the dollar briefly declined. But strong upward pres­
sure on the dollar soon reemerged as some market
participants seemed to view the widening of the deficit
— and in particular the rise in imports —as yet another
indication that the Federal Reserve might further
tighten its policy stance to counter inflationary pres­
sures. Meanwhile, others noted that the substantial rise
in imports of capital goods had favorable implications
for increasing U.S. industrial capacity.
The dollar moved as high as DM 1.9230 against the
mark on August 22 and ¥ 134.70 against the yen on

C h a rt 1

After rising gradually in August, the do llar
declined later in the period.

August 24, almost matching the highs reached earlier
in the month. Between August 5 and August 23, the
U.S. monetary authorities at times intervened heavily in
the foreign exchange market to resist the tendency for
the dollar to advance, selling a total of $1,806 million
against marks in operations often coordinated with
other central banks. The intervention operations, rein­
forced by official commentary both in the United States
and abroad expressing concern that any further rise of
the dollar against the German unit might impede
improvement in the trade balances, were, by the end of
August, beginning to be viewed as a forceful demon­
stra tio n th a t in te rn a tio n a l agre e m e n ts to fo s te r
exchange market stability remained intact.
Then on August 25, in a move prompted by develop­
ments in the foreign exchange market as well as
domestic conditions in the individual countries, the
German Bundesbank and several other European cen­
tral banks raised their official interest rates. As German
interest rates edged higher following the Bundesbank’s
announcement of a V2 percentage point rise in the dis­
count rate, interest rate differentials favoring the dollar
against the mark narrowed, diminishing the relative
attractiveness of dollar-denominated assets.

P e rce n t
25------------------------------------------------------

C h a rt 2

Data reported in the period showed
continuing high levels of capacity
utilization.
P erce nt
84

83

82

81

80

1988

0
Jan

The c h a rt s h o w s th e p e rc e n t change of w e e k ly a v e ra g e
rates fo r th e d o lla r fro m Ja n u a ry 8, 1988. A ll fig u re s
are c a lc u la te d fro m New Y o rk noon qu o ta tio n s.

68FRASER
FRBNY Quarterly Review/Autum n 1988
Digitized for


Feb

Mar

A pr

May
1988

Jun

Jul

Aug

Sep

The c h a rt sho w s the d e g re e of c a p a c ity u tiliza tio n in
U.S. in d u stry.

Table 1

Federal Reserve
Reciprocal Currency Arrangements
In Millions of Dollars
Amount of Facility
O ctober 31, 1988

Institution

250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000

Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
German Federal Bank
Bank of Italy
Bank of Japan
Bank of Mexico
N etherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements:
Dollars against Swiss francs
Dollars against other
authorized European currencies

600
1,250
30,100

Total

C hart 3

S hort-term in te re s t rate d ifferentials
favo rin g the dollar w id en ed in August
and again in O ctober.
P e rc e n ta g e p o in ts
4 .4 ------------------------------------------------------------------------------------4 .2 ------ E urom ark ---------------------------------------------- —---------

2 8 1

I

I

May

I

I

I

I

Jun

I

1

I

I

I

1

1

Jul

I

I.

Aug

I

I

I

I

I

S ep

1

I

1

1988
The c h a rt sh o w s w e e k ly a v e ra g e in te re s t ra te
d iffe re n tia ls b e tw e e n th re e -m o n th E u ro d o lla r ra te s
and th re e -m o n th E u ro m a rk e t d e p o s it ra te s fo r
G erm an m arks and J a p a n e s e yen.




1..J—

O ct

I

That day the dollar declined almost 1 percent against
the mark, bringing the dollar to about the same level as
at the opening of the period. The yen declined even
more against the mark on that and subsequent days
because the Bank of Japan was not expected to follow
actions by the other central banks to raise official inter­
est rates. As the yen weakened, the dollar moved to its
period high against the yen of ¥ 137.25 on September 2.
Throughout much of September, the dollar traded
within a relatively narrow range. Market participants
expressed renewed confidence in the official commit­
ments to promote exchange rate stability and per­
ceived that monetary authorities would not welcome
any further rise of the dollar. Many of the factors that
had contributed to the upward pressure during late
summer also had become much less evident. In partic­
ular, a new round of statistics suggested that U.S. eco­
nomic growth was slowing to a more sustainable pace.
While that development was viewed as generally favor­
able for long-run economic prospects, it weakened
some of the short-term demand for dollars by contribut­
ing to expectations that upward pressure on dollar
interest rates was likely to subside. The financial mar­
kets took special note of the September 2 release of
U.S. nonfarm payroll figures for August that showed
slower employment growth than the market had previ­
ously anticipated. Inflation concerns were also allayed
by the outlook for declining oil prices and the report of
unchanged average earnings during August.
As the upward pressures on the dollar eased and as
market participants perceived prospects for greater
exchange rate stability, investors were increasingly
attracted to certain relatively high-yielding currencies,
such as the Canadian dollar. The Canadian dollar also
benefited from early public opinion polls in advance of
the Canadian elections showing strong support for the
incumbent Conservative party that favored the enact­
ment of the U.S.-Canadian free trade agreement. The
U.S. dollar declined steadily against the Canadian unit
from early September through mid-October.
Although the positive outlook that had prevailed dur­
ing the summer tended to erode during September,
there were episodes of upward pressure on the dollar.
One occasion followed the September 14 announce­
ment of a smaller-than-expected U.S. trade deficit for
July that provided reassurance to the market that the
co rrection of global im balances was co n tinuin g.
Another occurred following the release of a statement
by the Group of Seven (G-7) finance ministers and cen­
tral bank governors attending a meeting in Berlin over
the weekend of September 24. Although that statement
reaffirmed the basic objectives of previous commit­
m ents re g a rd in g co o p e ra tiv e e ffo rts , in clu d in g
exchange rate stability, it contained no precise refer­

FRBNY Q uarterly Review/Autum n 1988

69

ence to dollar exchange rates. Some market partici­
pants, therefore, concluded that the G-7 was prepared
to tolerate further dollar appreciation.
During these episodes, the dollar moved up smartly,
and the U.S. authorities intervened to resist these pres­
sures. Between September 14 and September 22, the
Desk sold $230 million against marks. On September 26,
the first business day after the G-7 meeting, the Desk
sold an additional $100 million against marks, and a
substantial number of other central banks intervened
forcefully to sell dollars at the same time. The visible,
concerted intervention operations provided a clear sig­

nal to the market that the G-7 had not changed its
exchange market objectives.
At the end of September, market participants noted
that there was significant concerted intervention to sell
dollars against the mark when the dollar, at about
DM1.89, was still well below the levels reached the
previous month. Furthermore, subsequent official state­
ments from various sources pointed to the economic
risks of a further dollar rise and gave new weight to the
September 24 statement.
During October, market sentiment toward the dollar
turned negative. For one thing, the prospect of upward

Table 2

Drawings and Repayments by Foreign Central Banks under Reciprocal Currency Arrangements
with the Federal Reserve System
In Millions of Dollars; Drawings ( + ) or Repayments ( - )
g
Central Bank Drawing on the
Federal Reserve System
Bank of Mexico

Amount of
Facility

O utstanding as of
July 31, 1988

August

Septem ber

O ctober

O utstanding as of
O ctober 31, 1988

700.0

0

+ 700.0

- 7 0 0 .0

0

0

Data are on a value-date basis.

Table 3

Drawings and Repayments by Foreign Central Banks under Reciprocal Currency Arrangements
with the U.S. Treasury
In Millions of Dollars; Drawings ( + ) or Repayments ( - )
Central Bank Drawing
on the U.S. Treasury
Bank of Mexico

Amount of
Facility

O utstanding as of
July 31, 1988

August

Septem ber

O ctober

O utstanding as of
O ctober 31, 1988

300.0

0

+ 30 0.0

-3 0 0 .0

0

0

Data are on a value-date basis.

Table 4

Drawings and Repayments by Foreign Central Banks under Special Swap Arrangements
with the U.S. Treasury
In Millions of Dollars; Drawings ( + ) or Repayments ( - )
Central Bank Drawing
on the U.S. Treasury
National Bank of Yugoslavia
Central Bank of Brazil
C entral Bank of the
A rgentine Republic

Amount of
Facility

O utstanding as of
July 31, 1988

August

Septem ber

O ctober

O utstanding as of
O ctober 31, 1988

50.0
250.0

33.8
232.5

0
-2 3 2 .5

- 3 3 .8
0

0
0

0
0

265.0*

-

-

-

0

0

Data are on a value-date basis.
•Arrangem ent was in effect as of O ctober 20, 1988.

70FRASER
FRBNY Quarterly Review/Autum n 1988
Digitized for


pressure on short-term dollar interest rates appeared
to diminish further. Release of a series of economic
reports indicated that U.S. economic activity, while still
showing strength, was moderating even more. News of
sm aller-than-forecast increases in U.S. employment
during September (later revised upward) and prelimi­
nary third-quarter U.S. GNP figures reinforced the view
that a further tightening of U.S. monetary policy was
less likely in the near term.
Moreover, market participants, having seen repeated
evidence of coordinated central bank sales of dollars
during the summer and early autumn, remained con­
vinced that the monetary authorities would firmly resist
any further substantial rise of the dollar.
In addition, concerns were aroused about the pace of
adjustment of global imbalances by the October 13
release of U.S. trade data for August showing a widen­
ing of the trade deficit to $12.2 billion. Despite com­
ments of U.S. officials cautioning that wide fluctuations
in monthly trade data were of little significance and
noting the clear trend of improvement in the U.S. trade

accounts over a longer period, the market continued to
focus closely on these monthly trade releases. Partici­
pants expressed growing concern about the sus­
tainability of U.S. progress in reducing its external
deficit.
The dollar’s decline against the yen during October
was particularly noteworthy. Over the course of the
month, the dollar moved approximately 6 percent lower
against the Japanese unit. Widespread reports circu­
lated of substantial sales of dollars against yen by

Table 5

Net Profits (+ ) or Losses ( - ) on
United States Treasury and Federal Reserve
Foreign Exchange Operations
In Millions of Dollars

Period
August 1, 1988 to
O ctober 31, 1988
C h a rt 4

The monthly U.S. trade d efic it figures
continued to show fluctuations against a
background of a declining trend.

Valuation profits and losses on
outstanding assets and liabilities
as of O ctober 31, 1988

Federal
Reserve

U nited States
Treasury
Exchange
Stabilization
Fund

0

0

+ 1,536.9

+ 1,258.9

Data are on a value-date basis.

B illio n s o f do lla rs
16 ------------------------------------------------------------------------------------------

Trade deficit
15

C h a rt 5

During the period, the U.S. econom y grew at
a slightly less vigorous pace.
P erce nt

1988
The c h a rt s h o w s the m onthly and th re e -m o n th m oving
a ve rage U.S. m e rc h a n d is e tra d e d e fic it, s e a s o n a lly
a d ju s te d and re p o rte d on a c e n s u s b a sis. The tra d e
fig u re s fo r June, July, and A ugu st w e re re le a s e d on
A ugu st 16, S e p te m b e r 14, and O c to b e r 13, re s p e c tiv e ly




I

II

III

IV

I

1987

II
1988

III

The c h a rt s h o w s the annualized change in
U.S. G ro ss N ational P roduct.

FRBNY Q uarterly Review/Autum n 1988

71

Japanese institutional investors and U.S. investment
banks seeking to hedge an increasing proportion of
their dollar portfolios in anticipation of further dollar
declines. Furthermore, the yen’s strength seemed to
reflect a relatively favorable market assessment of
Japan’s progress in adapting to the rise in its currency
since 1985. Selling pressure intensified as the dollar
moved below important technical and psychological
levels, reaching the period lows of about ¥ 124.50
against the yen and DM 1.76 against the mark at one
point on October 31. Under these circumstances, the
U.S. authorities entered the market to buy dollars for
the first and only time in the period, purchasing that
day $ 2 0 0 million against yen to support the dollar.
As the period ended, the dollar was underpinned by
a widely held market view that the authorities would act
to prevent any sharp fall in the dollar at least through
early November in advance of the U.S. presidential
election. In addition, interest rate differentials favoring
the dollar widened slightly as Japanese money market
rates eased by a modest amount. However, market
sentiment toward the dollar remained distinctly nega­
tive as skepticism deepened that the policy initiatives
needed to keep the international adjustment process
intact, both here and abroad, would be undertaken
promptly enough.
The dollar closed the three-month period at ¥ 125.50
against the yen, barely 4 1/2 percent above its record
low of ¥ 120.20 recorded on January 4, 1988. Against
the mark, the dollar closed the reporting period at
around DM 1.79, more than 141/2 percent above its
record low of DM1.5615 in January. On a tradeweighted basis, as measured by the index of the Fed­
eral Reserve Board staff, the dollar declined by
4 V2 percent in terms of the other Group of Ten curren­
cies during the period.
The U.S. monetary authorities sold a total of
$2,136 million against German marks and purchased a
total of $200 million against Japanese yen during the
three-month period. The Federal Reserve and the Trea­
sury’s Exchange Stabilization Fund (ESF) participated
equally in the financing of all intervention operations.
During the period, there were several other foreign cur­
rency transactions of the ESF and the Federal Reserve:
• On August 1, the Bank of Mexico activated its

Digitized72
for FRASER
FRBNY Quarterly Review/Autumn 1988


reciprocal arrangements with the Federal Reserve and
the U.S. Treasury, drawing $700 million and $300 mil­
lion, respectively. On September 15, both amounts
were fully repaid.
• On August 26, the Central Bank of Brazil repaid an
outstanding $232.5 million drawing on a $250 million
short-term ESF financing facility. The remaining
$17.5 million was not drawn during the period.
• The National Bank of Yugoslavia repaid $17.2 mil­
lion to the U.S. Treasury on September 26 and
$16.6 million on September 30, thereby liquidating the
$50 million ESF facility. This facility was provided to
Yugoslavia in June along with a $200 million facility by
the Bank for International Settlements, acting for a
number of central banks.
• On October 20, the U.S. Treasury through the ESF,
together with a number of other monetary institutions,
agreed to establish a facility to provide up to $500 mil­
lion in short-term financing to Argentina. The ESF’s
share was $265 million. No drawings were made as of
October 31.
As in previous periods, the U.S. authorities acquired
foreign currencies through sales of dollars to other offi­
cial institutions and through receipt of principal repay­
ments and interest payments received under the
Supplementary Financing Facility of the International
Monetary Fund. Such foreign currency acquisition
totaled $2,103.4 million equivalent.
As of end October, cumulative bookkeeping or valua­
tion gains on outstanding foreign currency balances
were $1,536.9 million for the Federal Reserve and
$1,258.9 million for the ESF. These valuation gains rep­
resent the increase in the dollar value of outstanding
currency assets valued at end-of-period exchange
rates, compared with the rates prevailing at the time
the foreign currencies were acquired.
The Federal Reserve and the ESF regularly invest
their foreign currency balances in a variety of instru­
ments that yield market-related rates of return and that
have a high degree of quality and liquidity. A portion of
the balances is invested in securities issued by foreign
governments. As of end October, holdings of such
securities by the Federal Reserve amounted to
$2,540.1 million equivalent, and holdings by the Trea­
sury amounted to the equivalent of $2,816.9 million.




Recent FRBNY Unpublished Research Papers*
8821. Sofianos, George. “A Comparson of Market-Making Struc­
tures.” September 1988.
8822. Rodrigues, Anthony, and Charles Engel. “A Test of Interna­
tional CAPM.” September 1988.
8823. Sofianos, George. “ Description of Margin Requirements.”
October 1988.
8824. Fons, Jerome S. “ Default Risk and Duration Analysis.”
November 1988.
8825. Bell, Linda A. “ The Causes of Rising U.S. Industrial Wage
Dispersion.” December 1988.
8826. Frydl, Edward J., and Dorothy M. Sobol. “ Prospects for LDC
Debt Management: Debt Reduction versus Debt Forgive­
ness.” December 1988.
‘ Single copies of these papers are available upon request. Write to
Research Papers, Room 901, Research Function, Federal Reserve
Bank of New York, 33 Liberty Street, New York, N.Y. 10045.

FRBNY Quarterly Review/Autum n 1988

Single-copy subscriptions to the Quarterly Review (ISSN 0147-6580) are free.
Multiple-copy subscriptions are available for an annual cost of $12 for each
additional subscription. Checks should be made payable in U.S. dollars to the
Federal Reserve Bank of New York and sent to the Public Information Department,
33 Liberty Street, New York, N.Y. 10045. (212-720-6134). Single and multiple
copies for United States and for other Western Hemisphere subscribers are sent
via third- and fourth-class mail, respectively. All copies for Eastern Hemisphere
subscribers are airlifted to Amsterdam and then forwarded via surface mail.
Multiple-copy subscriptions are packaged in envelopes containing no more than 10
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

FRBNY Quarterly Review —Autumn 1988





Federal Reserve Bank of New York

33 Liberty Street
New York, N.Y. 10045