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194

MONTHLY REVIEW, DECEMBER 1961

T he Business Situation
Substantial economic gains during the past two months
suggest that the underlying forces of business expansion
continue to be strong and that the September slippage in
output and sales was merely temporary. Despite strikes in
the auto industry during the first half of October, industrial
production rose markedly during the month, completely
offsetting the previous month’s decline. Early reports for
November, moreover, point to further strength in steel
and automobile output. Retail sales, propelled largely by
a sharp advance in automobile sales, have recently shown
their first strong upward movement since the spring
turn-around in general business activity. The 2 Vi per cent
rise in October retail sales and further increases in auto
and department store sales in November suggest that the
business expansion is now receiving new impetus from the
consumer sector. The scheduled build-up in defense orders
and outlays should also continue to provide stimulus to
the economy in the months ahead.
Even before the first significant October figures had
reached the public, business sentiment had turned more
buoyant. This was reflected, among other things, in a Dun
and Bradstreet survey taken during the month, which
indicated that businessmen expected sales to reach an
all-time peak in the first quarter of 1962 and thought
that profits would rise well above present levels— adding
up to a more optimistic short-range outlook than reported
by this survey at any time since the second quarter of 1959.
P R O D U C T IO N

AND

CURRENT BUSINESS INDICATORS
S e a s o n a l l y a d ju ste d

Per cent

Pe r cent

120

120

!
In d u s t r i a l p r o d u c t i o n
•*****.
1957=100
^
1

! 1 1 !
o n s of d o lla r s

! . 1 . 1 . 1 . . . L . . . L ^ T “T a1.

1

no
I

!

i

i.

!

i

i

100

B illio n s o f d o

C O N S T R U C T IO N

With the end of the strikes in the auto industry in
mid-October and the disappearance of the other special
circumstances that had brought a hesitation in the eco­
nomic advance during September, the index of industrial
production returned in October to the record high of
113 per cent of the 1957 average attained in August
(see Chart I). All major groupings of the index increased,
with the largest gain occurring in the automotive sector.
Auto manufacturers that had suffered from strikes strove
to provide dealers with adequate supplies of 1962 models,
and other automotive firms stepped up production in
response to a general strengthening of consumer demand.
In November, automobile production continued to rise
strongly and steel output declined less than seasonally.
The rebound in auto production was also the major




factor underlying the sharp gain in sales by manufacturers
of durables in October, after the mild dip in September.
In addition, a number of other industries, including those
engaged in defense work, showed sales increases. This
helped to push up total sales by manufacturers of durables
by more than 2 per cent, to a 1961 high that was 16 per
cent above the low reached last January. New orders re­
ceived by manufacturers of durables also rose in October,
the ninth consecutive monthly advance, and the ninth
month in a row in which new orders have exceeded sales.
This gap, noticeably large since August (see Chart I), has
led to an appreciable rise in unfilled orders.
Total construction activity moved up in November,
following a slight dip in October. The gain was attributable
almost entirely to a 3 per cent rise in private residential
construction, the largest increase since the series turned
up in March. The improvement in housing outlays more
than offset the declines that occurred in most other sectors,

N e w o rd ers re ceived by
- d u ra b le s m a n u f a c t u r e r s
_
I I 1_ I M i l l

Sales by durables
manufacturers
I___l

M i ll i o n s of p e r so n s

M i ll i o n s of p e r so n s

551
----------------------

55

54 —

54

53

N o nagricuitural

1

P a y r o ll

em ploym ent'*
I 1 ! ! 1 !
__

l

I

!

i

I_ J__ L J _ L _ J _ L
_
_
_

survey.

S o u r c e s : B o a r d of G o v e r n o r s o f the F e d e r a l R e se r v e S y s te m ; U n ite d S t a te s
D e p a r f m e n t s o f Co m m e rce a n d L a b o r.

FEDERAL RESERVE BANK OF NEW YORK

195

Chart !l

PERSONAL INCOM E A N D RETAIL SALES IN THREE RECENT RECOVERIES
S e a so n a lly adjusted
Per cent

1

2

3

4

5

6

M onths after the trough

2

3

4

5

6

0

1

M on ths after the trough

2

3

4

5

6

M onths after the trough

Note: Trough month=10Q in each case. Trough months ere those indicated b y the N atio n al Bureau of Economic Research
chronology; A u gu st 1954, A p ril 1958, and February 1961.
^R eflects spe cial one-tim e paym ents: J u ly 1958, retroactive sa la ry increases for Federal em ployees; M arch 1961, prepaid
divide nds on N a tio n a l Service Life Insurance policies; an d Ju ly 1961, special d iv id e n d on such policies.
Source: United States D epartm ent of Commerce.

with military construction the major exception. It is note­ cent. The total of $18.6 billion (seasonally adjusted) fell
worthy that rental vacancies edged off during the third short only of the record $18.9 billion registered in April
quarter, after almost two years of uninterrupted rise, a sign 1960. Most of the gain was attributable to an increase in
new car sales, but there were also advances in sales of
favorable to the housing outlook.
Perhaps of more importance for the immediate prospects other durables as well as of many nondurables. During
of the housing industry, however, are conditions in the November, department store sales apparently moved
mortgage market; these have been responsible for much slightly above their October level, and new car sales
of the cyclical fluctuation in housing construction during jumped about 15 per cent over the October average. The
recent years. Despite a moderate tightening during the recent surge in auto sales has led some representatives of
third quarter associated with the higher yields that de­ the auto industry to predict a 7-million-car year in 1962,
veloped on other securities, mortgage interest rates remain
It is possible that the strength in retail sales during the
below the level which prevailed at the beginning of the last two months was only temporary, reflecting in some
current recovery. At the same stage in the 1958 cyclical measure purchases that had been postponed in the im­
upswing, mortgage rates had risen sharply from the re­ mediately preceding weeks because of hurricanes, un­
cession lows. Of course, even if mortgage rates show no seasonably warm weather, and shortages of the 1962further tendency to rise in the months ahead, this would model automobiles. That this is the complete explanation
not necessarily imply a substantial advance in construc­ of the rise, however, seems unlikely. The Federal Reserve
tion activity. It might mean, however, that residential Board’s latest quarterly survey of consumer buying plans,
construction will remain at fairly high levels for a while taken in October, pointed to a small increase in plans to
rather than dropping off sharply as had been the case at purchase automobiles (although little, if any, rise in plans
comparable stages of earlier periods of economic expan­ to purchase houses and major household durables). More­
sion.
over, the steady advance in personal income to a new
record level in October (see Chart II), together with other
R E T A IL S A L E S R EVIVE
evidences of improvement in consumers’ financial circum­
Retail sales in October shook off their lethargy of several stances, makes it reasonable to expect that consumers
months’ standing and advanced an impressive 2Vi per should at this stage of the cycle be ready to step up the




196

MONTHLY REVIEW, DECEMBER 1961

pace of their purchases. As Chart II shows, retail sales
had through September been slower to respond to the
gain in income in the current upswing than in comparable
periods of either of the two previous recoveries. Thus, the
October increase may be regarded as having brought such
sales more closely into line with personal income.
EMPLOYM ENT AND UNEM PLOYMENT

One factor that may have contributed to the October
increase in retail sales is the recent improvement in
employment, which in the nonfarm sector (as measured
by the Bureau of Labor Statistics payroll survey) rose by
160,000 persons in October to a level about one million
persons higher, seasonally adjusted, than last February’s low
(see Chait I). The October gains were widespread, with
only mining employment showing a slight decrease. Total
employment (as determined by the Census Bureau’s house­
hold survey) rose by 380,000, seasonally adjusted, largely
owing to a substantial increase in the agricultural sector
following the decline in September, when hurricane Carla
delayed harvesting in the Southwest.
The increase in the civilian labor force in October was
about as large as the advance in total employment. Seasonally adjusted unemployment remained virtually unchanged
at 4.8 million and the rate of unemployment also was un­
changed at 6.8 per cent of the labor force, only y10 of
a point lower than the 1960-61 high of 6.9 per cent.

However, an alternative seasonal adjustment technique
that differs somewhat from the one employed by the BLS
—the so-called “residual” method—did show a decline
in the unemployment rate, from 6.6 per cent in September
to 6.4 per cent in October.1
Although total unemployment, as determined by the
BLS seasonal adjustment, has not changed significantly
since the recovery began, unemployment in some important
categories has recently dropped. Between July and Octo­
ber, the number of unemployed adult males fell about 20
per cent and the number of “hard-core” unemployed
(those out of work a half year or more) decreased 30 per
cent. In addition, the number of persons working part time
in October but wanting full-time work was more than 20
per cent below the July figure. September-to-October
changes contributed to all of these movements, and
although seasonal factors were partly responsible, the im­
provement was to a significant extent attributable to the
business expansion.
1 Under the “residual” method, seasonally adjusted unemploy­
ment is calculated by subtracting seasonally adjusted employment
from the seasonally adjusted labor force. The BLS method is to
adjust each of the three series independently. Compared with the
BLS method, the residual technique tends to show higher unem­
ployment rates in the first three months of the year and lower
rates during the late summer and early fall months. Thus, unem­
ployment, adjusted according to the residual technique, reached
7.2 per cent at the business cycle trough in February, compared
with 6.8 per cent in the BLS series. The October figures, on the
other hand, show 6.4 per cent by the residual method and 6.8 per
cent by the BLS method.

International Economic and Financial D evelopm ents
B U S IN E S S C O N D IT IO N S A B R O A D

In many European countries, the rate of increase in
output has distinctly slowed in recent months. This
slackening— which followed the rapid expansion of
1959 and 1960— has, however, varied in degree from
country to country, and can be traced to a number of
factors. In some cases, supply limitations—combineds
at times, with official restraint measures— appear to be the
principal cause of the slowing down, while in others less
buoyant demand is of greater importance. Nowhere, how­
ever, can the current slackening be regarded as severe.
Indeed, consumer expenditures and foreign demand re­
main relatively strong in the majority of the industrialized
countries abroad. Actual declines in production have,




moreover, occurred only in a few cases (see Chart I).
In Canada, where economic developments are, of
course, closely linked to those in the United States, defi­
nite signs of a further acceleration of expansion could be
discerned this autumn. Some of the lift has come from the
upturn in the United States, and some from the wide range
of expansionary measures adopted by the Canadian au­
thorities over the past year.
In Japan the industrial production index in September
was some 22 per cent above a year earlier, and was still
rising rapidly in October. Some slackening in the rate of
growth may, however, be in prospect, for the inflationary
overtones of the domestic boom and the widening balanceof-payments deficit have been a growing source of concern.

FEDERAL RESERVE BANK OF NEW YORK

The authorities have sought to attack these problems with
monetary measures, including selective restraints on im­
ports of capital equipment, raw materials, and luxury
goods; the full impact of these measures on the Japanese
economy has yet to make itself felt. (In part, the new
restraints are designed to cushion the impact of scheduled
progressive reductions in quantitative import restrictions.)
The pattern of output changes in Continental Western
Europe has shown considerable variation from one coun­
try to another. For the six members of the European
Economic Community, according to the estimate made
earlier in the year by the Common Market Commission,
gross national product will increase by 5 per cent in 1961
and industrial production by 6-7 per cent, as against 7
and 12 per cent for 1960. In Germany the Economic Re­
search Institute predicted at the end of October that,

Chart I

INDUSTRIAL PRODUCTION IN SELECTED COUNTRIES
Se aso n ally adjusted, 1953=100
Per cent

Per cent

Note: Latest 1961 data p a rtially estimated.
^ B e lg ia n indexes for December 1960 and January 1961 affected by nation-w ide strikes.
Sources: Organization for Economic Cooperation and Development, General Statistics;
national statistics.




197

during the third and fourth quarters, GNP would be some
5 per cent higher (in real terms) than a year earlier; this
would make for the smallest quarterly increases (on a
year-to-year basis) since the spring of 1959, but is of
course still in line with the current Common Market aver­
age. German industrial output in the third quarter was
less than 4 per cent higher than a year earlier. In Italy,
by contrast, the expansion that resumed after a short
pause at the end of 1960 has lost only a little of its mo­
mentum, although the rise in Italy’s industrial output in
1961 will undoubtedly fall short of the exceptional 12
per cent gain achieved in the course of 1960. Industrial
output in Belgium, which was severely curtailed by strikes
last January, has more than regained its loss since then.
France’s third-quarter industrial production did not rise
so rapidly as it had a year earlier, but it is still possible
that the official growth target for 1961 will be reached.
In the Netherlands, the seasonally adjusted production
index dropped 9 per cent below the end-of-1960 level by
August, mainly because of a cut in the workweek, but
turned up again in September.
As far as any generalizations can be made, three factors
seem to be of major importance in the current slackening
of the rate of growth in Western Europe: labor short­
ages and other limitations on productive capacity;
official restraint measures, generally taken against this
“full employment” background; and slackening in invest­
ment demand, both for plant and equipment and for in­
ventories. The relative roles played by these factors varied
greatly from country to country, however, and only in
some have all three factors been at work simultaneously.
In a number of countries— including Austria, Denmark,
the Netherlands, Sweden, and the United Kingdom—
extremely strong demand pressures against limited re­
sources have increased the dangers of inflation. For these
nations, the problem in the past year has been to contain,
rather than sustain, the domestic boom and to repair its
effects on the balance of payments, particularly in the
United Kingdom. Thus, the Netherlands and, to a greater
extent, the United Kingdom have taken various and often
stringent measures to curtail domestic demand, while
some other countries have attempted to ease the strain
on resources by liberalizing imports, even at the risk of
a deterioration in their external positions.
The slackening in investment demand has in many
instances been attributable to various governmental meas­
ures. This appears to be notably true in Britain, where
fixed-capital formation in manufacturing industries is
likely to rise less rapidly from now on, partly because of
reduced investment outlays by the steel industry. Such
capital formation, to be sure, was 28 per cent higher in

198

MONTHLY REVIEW, DECEMBER 1961

the first half of this year than a year earlier, but its average
level in 1962 is expected to be no higher than the 1961
average. The current British housing boom also appears
to have reached its peak, and any further rise in public
investment will probably be very slow as a result of the
austerity measures adopted since April. The British dis­
tributive trades, on the other hand, expect to increase
their investment by about 8 per cent. In Japan, average
expenditures on capital goods during the fiscal year end­
ing March 1962 are expected to be about one-third above
the previous twelve months’ level, but they are likely to
turn down later in the fiscal year as a result of the govern­
ment’s restraint policy.
In some other countries, there has been a lessening in
the underlying demand for capital expansion, as in Den­
mark, the Netherlands, and Norway, where the growth of
fixed investment seems to have slowed down and inven­
tory accumulation has become more restrained. Canadian
expenditures on plant and equipment and on business in­
ventories have not yet turned appreciably upward, although
housing outlays have revived. In Italy, Sweden, and
Switzerland, on the other hand, the investment boom has
lost very little force and housing construction activity
continues to rise.
In contrast to investment, consumer demand has con­
tinued to grow at a high rate in the majority of foreign
industrial countries, and currently is the most important
factor of expansion. In Germany, for example, retail
sales in the third quarter were 9 per cent above a year
earlier, while in Sweden the National Institute of Eco­
nomic Research has forecast that consumption will rise
again in the second half of 1961 after having leveled off
in the first half. In Italy, the steady expansion of con­
sumer expenditures— especially for durable goods— quick­
ened after the summer holidays, and has helped offset the
effects, in a few industries, of reduced exports and a mod­
erate slackening of investment. Consumer expenditures
have also continued high in Denmark, Norway, and Japan.
Rising consumer demand has tended to be bolstered by
the pronounced increases in industrial wages that have
occurred so far in 1961, largely as a result of labor short­
ages. Gross hourly earnings of German industrial workers
at midyear had soared as much as 12.5 per cent over a
year earlier, while French industrial wages rose almost 4
per cent in the first half of 1961 and are expected to rise
by an additional 3 per cent in December as the result of
an increase in the minimum wage. The wage agreement
concluded in Denmark early in the year resulted in an
average increase of wages and salaries of about 10 per
cent. The steady emigration of Italian workers to Ger­
many, Switzerland, and other European countries has




tightened the Italian labor supply, and has begun to exert
pressure on wages; wage increases in Italy during recent
months have accordingly been more frequent than in the
last few years. British industrial wage rates rose by about
3 per cent in the first nine months of 1961, most of the
gain taking place before the recent wage and salary
“pause”.
Consumer prices in many industrial countries have*
shown a greater tendency to rise thus far in 1961 than dur­
ing the same period last year. However, only in Austria,
Germany, Norway, and the United Kingdom did con­
sumer prices rise more than 2 per cent during the
first three quarters. Only in Canada, France, Sweden,
and Switzerland has the advance in consumer prices
been somewhat smaller than in 1960. Due largely to
seasonal factors, moreover, food prices have recently
risen in most countries. The advance has in fact beer*
greatest in France, where it is possible that government
measures to aid the farm sector may lead to further price
increases. The March revaluation of the Deutsche mark
has helped to dampen the strong upward pressure on con­
sumer prices in Germany, while the Swiss authorities have
been aided in their stabilization efforts by an exceptional
expansion of imports. In the United Kingdom, the wage
and salary “pause” and other austerity measures have
apparently led to a stabilization of consumer incomes and
expenditures, and thus to an abatement of some of the
factors that had raised consumer prices by more than 3
per cent between January and September.
T H E I N T E R N A T IO N A L FIN A N C IA L. S C E N E

Continuing efforts to deal with the world’s payments
problems have highlighted the international scene in recent
months. In the United States a number of programs were
under way to help reduce the country’s balance-of-payments
deficit, and the United States Government also announced
new measures to maintain the strength of the dollar in
foreign exchange markets abroad. Britain reaped the first
fruits of its summer emergency measures: the speculative
pressure against sterling was reversed, and the government
promptly reduced the bank rate from the crisis level to
which it had been raised, and repaid a significant part of
its August drawing from the International Monetary Fund
(IMF). Other major European countries took new steps
to discourage inflows of short-term funds and to facilitate
the continued growth of domestic economic activity and
of trade.
The United States over-all balance-of-payments deficit
rose to a seasonally adjusted annual rate of somewhat
over S3 billion in the third quarter. This compared with

FEDERAL RESERVE BANK OF NEW YORK

a $1.9 billion deficit in the second quarter (exclusive of
nonrecurring debt-payment receipts). The chief cause
of the increased deficit in the third quarter was a signifi­
cant expansion of imports, along with a reduction in
investments by foreigners in the United States. While the
increase in imports stemmed essentially from the continu­
ing rise in demand associated with the domestic recovery,
it also reflected the settlement of the June dock strikes and
the delayed response of imports to improved business
conditions in earlier months. Noting that a further increase
in imports could be expected during the expansionary
phase of the domestic business cycle, Secretary Dillon
recently stated that “we face the probability of a reduction
in our commercial trade surplus over the coming year”.
As a part of the longer run program to bring the United
States international accounts into balance, the Treasury
has under study liberalized depreciation allowances and
tax credits on new investments, which would be designed
to stimulate investment and thereby improve the interna­
tional competitive position of United States industry. An
important step along these lines was taken in October,
when the textile industry was granted a general re­
duction of 40 per cent in the “life” of textile equipment
for tax purposes. The United States Government has also
announced that it will ask Congress for broader authority
to negotiate reductions in tariffs and other restrictions in
order that United States exporters may be in a position to
take full advantage of the opportunities emerging in West­
ern Europe and other markets. Important benefits for the
balance of payments should also flow from the Administra­
tion’s announced determination to bring the Federal budget
into balance in fiscal 1963 and to impress both industry
and labor with the need to avoid undue advances in prices
and wages.
In the meantime, other more immediate steps have been
taken to relieve the pressure on the balance of payments. A
new line of export credit insurance has been established,
and the Export-Import Bank’s system of guaranteeing
commercial bank loans to exporters has been broadened.
The United States and Germany are negotiating for Ger­
man purchases of United States military equipment,
supplies, and facilities, so as to offset some of the outflow
resulting from our heavy military commitments in Europe.
Actions taken simultaneously by the Board of Governors
of the Federal Reserve System and the Federal Deposit
Insurance Corporation on December 1 to increase the
maximum interest rates that United States commercial
banks may pay on savings and time deposits were de­
signed in part to enable the banks “to compete more
vigorously to retain foreign deposits that might otherwise
move abroad in search of higher returns”.




199

Moreover, the Stabilization Fund of the Treasury,
operated by the Federal Reserve Bank of New York as
fiscal agent of the United States, has broadened its ex­
change operations, which it had begun last March in close
consultation with the German central bank to combat
speculation against the dollar in the forward market for
Deutsche marks. Thus, in October the Treasury borrowed
$46.3 million worth of Swiss francs from the Banque
Nationale Suisse, acting as fiscal agent of the Swiss Con­
federation, so as to increase its Swiss franc balances to
support forward sales of Swiss francs and thus provide
itself with a desirable degree of operating flexibility. The
result of the operations was a strengthening of the dollar
vis-a-vis the Swiss franc in the spot as well as the forward
market.
Until late November, the dollar had also shown some
strength against other Continental currencies but had
weakened considerably vis-a-vis the pound. This weakness
represented a reversal of the situation that existed earlier
this year when funds were leaving London en masse for
the Continent by way of conversions into and out of the
dollar. Since August, in fact, funds had been returning to
London in reaction to the July 25 announcement by the
British Government of a new “austerity” program and the
assistance received by that government from the IMF.1
At first, the return flow of funds to London represented
mainly the liquidation of short sterling positions that had
been built up before August. By October, however, in­
vestment funds were being increasingly attracted by the
high short-term British interest rates that obtained follow­
ing the July increase in the Bank of England discount rate
to 7 from 5 per cent. The return flow of funds, together
with the drawing of $1.5 billion from the IMF, and the
improvement in Britain’s balance of payments on current
account swelled British reserves which permitted the
British government to make substantial debt repayments.
It voluntarily repaid during October-November $420 mil­
lion equivalent of its IMF drawing and, during AugustOctober, liquidated the bulk of the $910 million of
short-term credits extended by various central banks
under the March Basle arrangements.2 Despite these
special payments Britain’s reserves increased $1,103 mil­
lion in the four months ended November (see Chart II).
Availing itself of the long-standing United States policy of
selling gold to foreign monetary authorities at $35 per
ounce plus handling charges, the British government (which
1 For details, see Monthly Review, September 1961, pp. 152-53.
2 By the end of October, all of the Basle credits reportedly had
been repaid, except $50 million due to Switzerland. This amount
is to be funded by the year end into a 3 per cent loan, repayable
no later than in December 1964.

MONTHLY REVIEW, DECEMBER 1961

200

Chart II

OFFICIAL GOLD AND CONVERTIBLE
FOREIGN EXCHANGE RESERVES
En d of p e rio d
B illio n s of d o lla r s

B illio n s of d o lla r s

Sources: In te rn a tio n a l M o n e t a r y Fund; n a t io n a l statistics.

traditionally holds only a small proportion of its inter­
national reserves in foreign exchange) converted some of
its accumulated dollar balances into gold. This conversion
accounted for the bulk of the $300 million dip in United
States gold reserves during the week ended November 22.
In view of the restored confidence in sterling, the
British monetary authorities on October 5, and again on
November 2, reduced the discount rate by Vi per cent to
6 per cent. The rate thus had remained at the 7 per cent
“crisis” level for less than three months. According to the
Bank of England’s governor, however, the reduction did
not imply any less resolution in the application of the
government’s declared economic policy over the longer
run or of the other measures of monetary restraint. The
“credit squeeze” in particular, is still on. The Bank of
England has not lowered the special bank reserve require­
ments, which had been raised as part of the austerity
program announced in July, nor has it rescinded its re­
quest to the banks for credit restraint. Moreover, the
government has refused to commit itself to a date when it
will lift its appeal to labor and management for a pause
in new wage concessions. Full-scale wage negotiations are
currently under way in many important sectors of Britain’s
industry and civil service, but it is not clear how long the
unions will want to wait for the wage increases finally
agreed upon. The electric power unions have, in fact,
already obtained wage increases effective early next year.
The British authorities have also been devoting careful
attention to possible long-range programs to improve




Britain’s competitive position. Thus, the government has
announced that it is examining the possibility of an accel­
eration of depreciation allowances— a step that would
provide new incentives to exporters— as well as further
measures to improve export credit facilities. At the same
time, the government is seeking to establish a National
Economic Development Council, in which government,
labor, and management would participate. The Chancellor
of the Exchequer recently stated that the council will be
important in formulating economic policy in its early
stages, particularly as far as investment is concerned.
However, no decision seems to have been reached as to
whether the council should also concern itself with wage
policy.
While Britain’s foreign exchange reserves have been
increasing in recent months, German official reserves have
continued the decline that began earlier this year. The
$750 million decrease between June 30 and mid-November
was associated in good part with Britain’s August drawing
of marks from the IMF. In addition, there have been
increased government capital exports, as well as sizable
private capital exports, some of which reflected un­
certainty in August and September in the face of the
Berlin crisis. Moreover, speculation regarding a possible
new revaluation of the mark has disappeared, and con­
versions of foreign exchange into marks in excess of nor­
mal commercial considerations have consequently ceased.
The recent outflow of German short-term funds, to­
gether with a large government budget surplus and in­
creased note circulation, has tended to tighten German
financial markets. Had no official action been taken to
counter this tendency, German banks and industry would
probably have increased their foreign borrowing or would
have drawn down their overseas balances more rapidly.
The resulting inflow of foreign exchange, in conjunction
with Germany’s basic external-surplus position, would have
led to a renewed rise in Germany’s still very large holdings
of gold and foreign exchange. To avoid such a rise, the
German authorities have in recent months sought to ease the
financial markets by reducing the banks’ minimum reserve
requirements. These requirements, which had already been
reduced four times earlier this year, were again lowered
in five successive stages between July 1 and December 1.
Thus, reserve requirements for domestic sight, time, and
savings deposits are back to the levels of October 1959.
Moreover, the Federal Bank, in order to reduce the incen­
tive for exports of short-term funds, announced in midAugust that cover on forward dollar operations would
henceforth be made available at a discount of lA per cent
per annum. This was the second change this year in
German policy regarding forward operations, the first hav­

FEDERAL RESERVE BANK OF NEW YORK

ing occurred in February when the practice of furnishing
forward cover at a premium was dropped in favor of pro­
viding cover at par.
Japan, too, has been experiencing a loss of international
reserves this year but, in contrast to the German experi­
ence, this loss has essentially been due to heavy internal
demand. The decline in Japanese reserves, which began last
April, totaled $424 million between mid year and the end of
November, largely reflecting a record level of imports and
a cessation of short-term capital inflows. Lately, moreover,
there have been net capital outflows, due primarily to re­
payments of Euro-dollar deposits. To moderate internal
demand pressures and halt the loss of international re­
serves, the Bank of Japan on July 22 raised its discount
rate from 6.57 to 6.935 per cent, and on September 29 to
7.3 per cent. In addition, the penalty rate above the regu­
lar rate that banks must pay for borrowings in excess of
their discount ceilings was doubled in September, so that
borrowings in excess of the ceilings now cost 9.5 per cent.
Also in September, importers’ predeposit requirements
for many products were sharply increased from earlier
maximum levels of 1 per cent, to as much as 35 per cent
for some commodities. Finally, the authorities raised the
banks’ reserve requirements for the first time since their
imposition in September 1959, thereby adding to the
pressure being exerted on bank reserves by the loss of
foreign exchange. Effective October 1, requirements were
set at 1 and 3 per cent on large time and sight deposits.
In the meantime, Japan has obtained $200 million of
assistance from United States commercial banks to ease
its reserve position. Japanese officials now hope that equi­
librium in the nation’s balance of payments on current
account will be achieved by next September. They express
confidence that, despite current difficulties, they will by
then also have completed the recently announced program
of progressive removal of import quotas, under which
quota-free imports are to be raised from 65 per cent to
90 per cent of total imports.
Two Western European countries likewise have recently
taken measures to counter inflationary pressures. Last
August the Swiss National Bank, in continuation of its
policy of preventing an undue increase in the liquidity of




201

the Swiss monetary system, renewed a 1960 agreement
with the Swiss commercial banks directed at discouraging
the inflow of foreign funds into Switzerland.8 In France,
the authorities in September accelerated the tariff cuts that
Common Market members are committed to make by the
end of 1961 on their trade with each other. This move,
like a similar one in April, was designed to hasten the
exposure of French industry to foreign competition and
thus parry mounting inflationary pressures at home. The
September cut lowered French tariffs on industrial imports
from Common Market members by 5 per cent, and the
reduction was also extended to non-Common Market
members except where the cut would have reduced the
rate below the agreed level of the Common Market’s future
external tariff. These tariff reductions further confirmed
France’s strong external position, as witnessed by a virtu­
ally uninterrupted increase in reserves this year and the
prepayment in August of France’s remaining $303 million
of debt to the European Payments Union.
While individual countries were taking measures to
deal with their payments problems, many of them, acting
collectively, took longer range steps to strengthen the
international payments system. Agreement in principle
was reached at the annual meeting of the IMF in Vienna
to strengthen the gold-exchange standard through individ­
ual stand-by credits to the Fund.4 Moreover, on Septem­
ber 30 the Organization for Economic Cooperation and
Development (OECD) came into being. The OECD is
the successor to the Organization for European Economic
Cooperation, which since its inception in 1948 has been
a vital force in the development of intra-European co­
operation. The United States and Canada have now joined
as full members with eighteen European powers to form
the new organization, which will serve as a forum for reg­
ular discussion of the international payments mechanism,
aid to the underdeveloped areas of the world, and the
problems of growth and stability in the industrialized
countries.
8 For details of the agreement, see Monthly Review, September
1960, p. 162.
4 For details, see Monthly Review, October 1961, pp. 167-69.

202

MONTHLY REVIEW, DECEMBER 1961

The M oney M ark et in N ovem ber
The money market was moderately firm through most
of November. Reserve availability was concentrated
largely at country banks, while pressures generated by the
large Treasury refunding operation—through market
churning in the early part of the month and a continuing
heavy volume of dealer loans at the money market banks
thereafter— subsided only in the closing days of the pe­
riod. Federal funds consequently traded predominantly in
a 2Vi to 3 per cent range until late in the month, when
they traded as low as lA per cent. Rates posted by the
major New York banks on loans to dealers moved up
early in the month to a 3 to 3 Vi per cent range, and de­
clined in the final days to a 1Vi to 2Vi per cent level.
In the Government securities market, interest centered
on the Treasury’s successful refunding operation in which
holders of $6.5 billion maturing IV i per cent bonds ex­
changed their holdings for $3.6 billion of new 3V4 per
cent fifteen-month notes, $2.4 billion of reopened 3% per
cent bonds of May 15, 1966, and $517 million of re­
opened 3% per cent bonds of November 15, 1974. In
addition, the Treasury sold $800 million in strips con­
taining equal amounts of eight bills maturing in December
and January, which more than covered attrition on the
exchange of bonds, as the latter amounted to only $421
million.
The market for Treasury notes and bonds had a gen­
erally firm tone through November 8. In the following
week, prices declined sharply on news of favorable busi­
ness developments and a large balance-of-payments deficit
in the third quarter, market talk of a tightening of credit
policy, and sales by some weak holders of the reopened
3% per cent bonds of 1974. The market gained confi­
dence soon after midmonth, however, and prices rose
moderately until the last few days of the month when an­
nouncement of a large gold outflow again caused some
weakness in the market. In the Treasury bill market,
rates rose steeply over the first half of the month, as the
large investment demand expected to arise out of the
refunding did not materialize and the auction of strip bills
added to substantial inventories carried by dealers at
relatively high financing rates. Over the second half of the
month, the appearance of moderate bank and nonbank
demand brought a steadier trend in rates and permitted
some reduction of dealers’ heavy inventories. Three-month




bills closed at 2.55 per cent bid, up 26 basis points for
the month.
B A NK RESERVES

Market factors absorbed some $1.1 billion reserves
during four of the five statement weeks ended in Novem­
ber, the total net absorption for the entire period amount­
ing to some $1.0 billion. Reserve losses during the first
two statement weeks were due primarily to the unseasonally large drop in float and outflow in currency. The drain
over the final two weeks resulted largely from the sizable
gold outflow, stemming primarily from Britain’s large gold
purchase.
System open market operations more than offset these
drains from market factors, supplying some $1,055
million in reserves over the five-week period. On a
Wednesday-to-Wednesday basis, outright System holdings
increased by $818 million between October 25 and No­
vember 29, reflecting an increase of $3,893 million in
Government securities maturing within one year, and de­
creases of $3,014 million in issues in the one- to five-year
range and of $61 million in issues maturing in over five
years. In addition to open market operations, this reflected
the movement of some holdings into shorter maturity
categories. System holdings of securities under repurchase
agreements declined by $52 million over the period, but
substantial use was made of short-term repurchase agree­
ments within the month to relieve some of the pressure
concentrated at the central money market.
Borrowings from the Federal Reserve Banks increased
in each of the first three statement weeks, on a daily aver­
age basis, but leveled off thereafter to average $96 million,
compared with a $66 million average for the four state­
ment weeks ended October 25. Excess reserves averaged
$575 million for the five statement weeks ended November
29, $53 million higher than during the previous four state­
ment weeks, while free reserves averaged $479 million,
up $23 million from the four weeks ended October 25.
G O V E R N M E N T SE C UR IT IES M A R K E T

Attention in the Government securities market during
November focused on the Treasury’s refunding operation,

FEDERAL RESERVE BANK OF NEW YORK

in which holders of almost $7 billion in 2 V2 per cent
bonds maturing November 15 were offered a choice of
three issues: a new 3V4 per cent note, maturing February
15, 1963 offered at par, a reopened 33 per cent bond
A
maturing May 15, 1966 offered at 99%, and a reopened
3% per cent bond maturing November 15, 1974 offered
at 99. The refunding offer, announced on November 2
when the market was buoyed by news of the Vz per cent
reduction in the British bank rate, met an enthusiastic
response. After an initial downward price adjustment on
outstanding securities to levels in line with rates on the
new offerings, market prices firmed and held steady
through most of the November 6-9 period that books
were open for the exchange.
Beginning on the last day of the subscription period
and extending through midmonth, however, market senti­
ment shifted under the influence of favorable business

C hanges in F a cto rs T en d in g to Increase or D ecrease M em ber
B ank R eserv es, N ovem ber 1961
In m illions o f d o lla rs; ( + ) d en otes increase,
(— ) decrease in ex cess reserv es
Daily averages—week ended

Net
changes

r actor
Nov.
8

Nov.
15

Nov.
22

Nov.
29

4- 2
— 392
Currency in circulation........ 4 . 48
8
Gold and foreign account---- +
— 34

+
8
— 108
— 367
— 43
4 43

4 . 24
4- 56
— 255
4
5

— 40
4-557
— 128
— 148
— 150

4 . 50
— 251
— 153
— 116
4 . 39

4 - 44
— 138
— 655
— 288
— 97

— 369

— 268

— 158

4 . 90

— 429

— 1,134

4 427

— 86

+

81

4- 299

4-

969

4-

86

4-

46

Nov.
1
Operating transactions

Direct Federal Reserve credit
transactions
Government securities:
Direct market purchases or
s a le s ..................................... + 248
Held under repurchase
— 15
Loans, discounts, and
advances:
Member bank borrowings... + 19
Bankers* acceptances:

_

Under repurchase

+
+

16

+

+

87

+

4
1

— 13

t

+

3i

— 32
— 1

+_U

I7

_

4-

4

2

—

—

1

+

1

—

2

+

—

—

—

-

Total ..................... -f 252

4 - 464

4-

1

4- 91

4- 296

4- 1.104

Member bank reserves
With Federal Reserve Banks. — 117
Cash allowed as reserves!---- + 43

-f-196
— 274

— 157
-|- 224

4 . 181
— 26

— 133
4- 117

—
+

30

— 74

— 78

+

67

4-155

— 18

4.

54

«

— 143

4 - 88

4-

68

4-

122
.... ........

Effect of ohange in required reExcess reservest ........................
Daily average level of member
bank:
Borrowings from Reserve Banks
Excess reservest .....................

+
—

69

+

1
1

+

5

— 67

4 -110

4- 12

4 . 72

74
543
469

91
476
385

122
586
464

90
598
508

101
670
569

Note: Because of rounding, figures do not necessarily add to totals.
* Includes changes in Treasury currency and cash,
t These figures are estimated,
j Average for five weeks ended November 29, 1961,




96t
575$
479*

203

news, a rise in stock market prices, press discussion of a
possible advance refunding in December, and some sugges­
tions in the press that a tightening of System policy was in
progress. This reportedly brought some shift in sub­
scriptions away from the longest offering (the 3% per
cent bond) so that, while the total amount exchanged in
the refunding was quite high, with attrition at only 6 per
cent of the public holdings, subscriptions for the 3% per
cent issue amounted to only $517 million, of which $136
million came from Government Investment Accounts.
Some $3.6 billion was exchanged for the fifteen-month
note and $2.4 billion for the 4V^-year bond.
The heavy tone of the market was intensified after No­
vember 13 by news of the third-quarter increase in the
balance-of-payments deficit and announcement of a $225
million new-money offering by the Federal National Mort­
gage Association ($100 million in 10l/i-year obligations
and $125 million in three-year obligations). In this heavy
atmosphere, sales of shorter and intermediate issues by
investors preparing to switch into the new Treasury issues,
and a moderate volume of small-lot sales by weak holders
of the reopened 3% per cent bonds, caused a sharp price
reduction. The largest declines were in the reopened 3%
per cent bonds of 1974, which fell 2%2 during November
13-15 to close at 981%2 on the 15th. These declines were
extended on the morning of November 16, when a press
report indicated that the Treasury was concerned that
sizable speculative holdings of the new issues had been
built up and that distress selling was under way. Prices
fell sharply, particularly for the 3% per cent bonds, but
professional and retail buying soon appeared and the
market turned around, bolstered by a Treasury statement
denying the report of concern over speculative interest, so
that the V/s per cent bonds closed with a gain of %2 for
the day.
Thereafter, through most of the balance of the month,
prices moved upward as confidence was regained—partly
on the strength of higher free reserves figures for the No­
vember 15 statement week—and moderate investment
demand appeared. The Treasury’s November 17 exchange
offer of 3% per cent bonds of May 15, 1968 to holders
of $970 million Series F and G Savings bonds maturing
in 1962 had little market impact, the reopened issue rising
in price over the second half of the month to close at
992%2, compared with 992% 2 before the announcement.
In the final days of the month, however, the market weak­
ened once more, influenced in part by announcement of
the large gold outflow and by the favorable business
outlook. At the month’s close, prices of most short
and intermediate issues were down Mo to % for the
month, while longer bonds generally showed losses of

204

MONTHLY REVIEW, DECEMBER 1961

At these higher rate levels, some investor demand ap­
%6 tO %. Of the three securities offered in the refund­
ing, the 3lA per cent notes of February 1963, issued at peared, reinforced by some easing in the money market
par, closed at 100%2 bid; the 33 per cent notes of May and a calming of market apprehensions about a tightening
A
1966, issued at 992%2, closed at 992%2 bid; and the 3% of credit policy. In the face of continuing dealer offerings,
per cent bonds of November 1974, issued at 99, closed at however, and influenced by news of the gold outflow and
favorable business performance, rates moved irregularly
98%2 bid.
In the Treasury bill market, rates continued their late after midmonth. Average issuing rates on the three- and
October decline during the first few days of November, as six-month bills rose to 2.606 and 2.806 per cent, respec­
seasonal demands, strengthened by the effects of the Vi tively, in the November 27 weekly auction, the highest
per cent cut in the British bank rate, met scarcities in the levels in a year. Reflecting a more pronounced easing in
shorter maturities and spilled out to the three-month area. the money market in the final days of the month, the
This demand was supplemented by stockpiling purchases three-month bill closed at 2.55 per cent bid and the sixfrom dealers, who anticipated that a substantial demand month bill at 2.79 per cent; the 24-basis-point spread,
would arise out of the approaching Treasury refinancing compared with a 31-basis-point spread at the beginning
operation.
of the month, reflected the substantial addition to the
The rate decline was first slowed and then reversed, supply of bills in the three-month area.
however, by Treasury announcements that it would trans­
fer $100 million from the six-month to the three-month
O T H E R S E C U R IT IE S M A R K E T S
bill offering in the following weekly auction, and would
auction $800 million in strips combining equal amounts
The markets for corporate and tax-exempt bonds
of eight bills maturing December 7, 1961 to January 25, opened November on a firm note but soon weakened and
1962. Additional upward pressure on rates subsequently remained cautious over most of the month. Mixed recep­
developed from the market churning arising from the large tions were accorded most of the $400 million in new
refunding operation. This churning generated substantial public offerings of corporate bonds, which were greater
money market strains, which kept the Federal funds rate than the $330 million October total but less than the
close to 3 per cent, prompting commercial bank sales of $460 million of November 1960. New issues came at
bills and raising the dealers’ cost of carrying their swollen rising rate levels, and some high-grade corporate offerings
inventories. The anticipated demand for bills from holders met considerable investor resistance. Prices of seasoned
of the maturing issues did not materialize, moreover, as bonds were mixed, and at the month’s close Moody’s
expectations of higher rates and talk of imminent credit average of yields on seasoned Aaa-rated corporates stood
tightening led many potential bill purchasers to invest at 4.38 per cent, down 2 basis points for the month.
In the market for tax-exempt bonds, the rising price
in repurchase agreements bearing substantially higher
yields and some sellers of rights bought other short-term trend of the previous two months continued into early
issues. In the November 9 auction of strip bills, conse­ November. This trend was subsequently reversed, however,
quently, bidding was light and mainly professional. The as the heavy calendar of new offerings— $725 million for the
average issuing rate was 2.277 per cent, compared with a month, compared with $600 million in October and $435
2.08 per cent average bid rate for the eight reopened bills million a year before— and the poor receptions accorded
at the close the previous day. Later, with a substantial some issues brought the Blue List of advertised dealer
amount (over $500 million) of the strip bills added to offerings to a record $553 million around midmonth. This
their already large inventories and with carrying costs re­ led to some price cutting, and several syndicate agreements
maining high, dealers sought to lighten their holdings, on recent offerings were terminated. By the end of the
adjusting rates upward as offerings appeared. By mid­ month Moody’s average yield on seasoned Aaa-rated taxmonth, the three-month bill rate was at 2.58 per cent bid, exempts was at 3.31 per cent, up 6 basis points for the
29-basis-points higher than at the month’s start.
month.




FEDERAL RESERVE BANK OF NEW YORK

20S

Com pensating B alances*
balance requirements do, however, tend to be considerably
more common among large banks than among small ones,
and among large rather than small borrowers.
Sometimes balance requirements against lines of credit
are raised when the line is in use, while in other cases
the balance requirement does not change when the line is
activated. Actual balances in such cases may, indeed,
be at their lowest level when the credit line is being used
most fully, the small balances at such times being offset
by higher balances during periods when the line is being
used less intensively or not at all. Where loans are made
to borrowers who had not previously been required to hold
a balance against their line of credit, or who had not pre­
C H A R A C TE R ISTIC S A N D IM P O R T A N C E OF
viously had a line of credit at all, balance requirements
B A L A N C E R E Q U IR E M E N T S
frequently become effective at the time the loan is made.
Compensating balance requirements are usually ex­ The lending bank may, however, not ask for a compen­
pressed as a percentage of the line of credit extended. sating balance if the borrower had voluntarily carried
In a survey of 100 large banks taken in 1958 by the balances with it in the past— or gives strong promise of
Robert Morris Associates, the great majority of banks doing so in the future.
requiring compensating balances reported requirements in
This underscores the important fact that compensating
1958 of 10-20 per cent of the line of credit.1 The specific balance requirements often reflect an informal under­
percentage varied from bank to bank, and often from standing in which exact percentages are not discussed,
borrower to borrower. In almost all cases the required rather than a hard and fast agreement that spells out
volume of deposits is defined in terms of average balances the obligation of the borrower in precise detail. If the
held over a period, so that required balances may also customer, for example, voluntarily holds balances in
serve to meet customer working balance needs.2
excess of those the bank would ordinarily require, the
While it is impossible to estimate the dollar volume of subject of a compensating balance is not likely to be
deposits held by business borrowers as compensating brought up.
balances, the 1958 survey indicated that over 70 per cent
Informal and flexible arrangements are common where
of the banks covered made such balances a condition for there is a continuing relationship between the bank and its
extending lines of credit to all business borrowers. Other customer. Compensating balances and credit lines may be
banks required them against lines of credit in most, but merely one aspect of such a relationship; the bank often
not all, cases and for a few banks balances were required performs various services for the customer, in addition to
on lines of credit granted only to particular types of bor­ extending credit, and perhaps the customer will steer other
rowers, such as sales finance companies. Compensating business (that of its own customers or subsidiaries, for
example) to the bank. Where such relationships are
mutually satisfactory over the long pull, the exact nature
* Jack M. Guttentag, Chief, Domestic Research Division, and of the customer’s obligation with respect to the level of
Richard G. Davis, Economist, Domestic Research Division, had
his balance may never be explicitly spelled out.
primary responsibility for the preparation of this article.
X P. Gallot, “Why Compensating Balances? Part II”, Bulletin
F.
From the standpoint of the borrower, compensating
of the Robert Morris Associates, August 1958, pp. 309-19.
balances may be viewed as something of an informal “com­
2 See George Garvy, Deposit Velocity and Its Significance, Fed­
mitment fee”, i.e., as the price he pays for the bank’s
eral Reserve Bank of New York, November 1959, pp. 29-37.
Many banks expect business customers to hold minimum
average balances as a condition for extending loans or lines
of credit. There are indications, moreover, that the practice
of requiring such “compensating” balances has become
increasingly widespread during the past decade. One result
of this trend has been an increased interest in the effects
of compensating balance requirements on the loan volume
and interest earnings of individual banks as well as on
the general cost and availability of credit throughout the
banking system. Another result has been the growth of
a relatively new financial device, known as “link financ­
ing”.




MONTHLY REVIEW, DECEMBER 1961

206

commitment under the line of credit to extend a loan
when needed. At the same time these balances may also
serve to compensate the bank for other services. The cost
to the borrower of maintaining balances for these pur­
poses largely depends on whether the balances needed
exceed those the customer would voluntarily hold to carry
on his business, even in the absence of any requirement.
Comparison of the 1958 Robert Morris survey with a
similar survey taken by that organization in 1954 suggests
that banks were tending to extend compensating balance
requirements to a wider group of business borrowers.
There are indications that the practice has become even
more widespread since 1958. The 1958 survey indicated,
moreover, that the requirements had been raised since
1954 and were being enforced more vigorously. Customer
failure to fulfill requirements is usually met, in the first
instance, with persuasion. If this does not work, the bank
may have recourse to higher interest rates, reduction of
credit lines, or even outright cancellation of borrowing
privileges, depending upon the persistence of the de­
ficiency, the customer’s current and potential value to
the bank, and the general state of credit conditions.

Balance Sheet of Individual Bank
No

C o m p e n s a t in g B a l a n c e s R e q u ir e d

Liabilities

Assets
Required reserves
Credit .........................

$ 210
840

Initial deposits ............

$1,050
$1,050

$1,050

C o m p e n s a t i n g B a l a n c e s R e q u ir e d

Liabilities

Assets
Required reserves
Credit .........................

$ 250
1,000
$1,250

Initial deposits .............. $1,050
Deposits held as com­
200
pensating balances .
$1,250

or $210, as required reserves. The remaining $840 can be
made available as loans to borrowers who, we assume,
Banks generally look at compensating balances as an immediately withdraw these funds to make payments. But
aspect of bank-customer relations— indeed, as one means if the bank requires compensating balances of 20 per cent
of fostering such relationships and thereby encouraging it can, based on the same $840, extend $1,000 in loans
borrowers to use various banking services. Some banks because the balance requirement assures the bank that
also feel that compensating balances can moderate fluc­ only $800 will actually be withdrawn. (The bank must
tuations in deposit balances and that, in the event a loan hold the rest of the $840, or $40, as required reserves
goes into default, such balances might offset part of the against the $200 in deposits maintained by the borrower
as a compensating balance.) The $1,000 in loans repre­
loss.
Much of the recent interest in the effects of compensat­ sents a $160 increase, compared with the case where no
ing balance requirements, however, has centered on their compensating balances are required, and interest earnings
influence over the volume of deposits, lending capacity, are correspondingly higher. At the same time, however,
and the effective interest rate on loans. From the stand­ the amount of withdrawable funds is reduced from $840
point of the individual bank, compensating balance re­ in the no-requirements case to $800 when balances are
quirements can increase both deposits and loans, and required, the difference being equal to the additional re­
thereby swell interest earnings. These requirements, how­ quired reserves that must be held against the compensating
ever, actually reduce the volume of withdrawable funds balance.
Although the individual bank can increase its deposits
which the bank can make available to borrowers because
part of the bank’s funds are tied up as required reserves by requiring compensating balances, the ability of the
held against borrowers’ compensatory deposits.
banking system as a whole to create deposits is limited
These points are illustrated by the example in the table.3 by total reserves, which are not influenced by balance
Assume that a bank obtains a deposit of $1,050 from the requirements. However, to the extent that compensating
public and that it must hold 20 per cent of this amount, balance requirements tend to concentrate deposits in city
banks, which have higher required reserve ratios, total
deposits may tend to be somewhat reduced. On the other
3 For simplicity, the example assumes that requirements are hand, in so far as balance requirements reduce the day-tobased on the loan amount rather than the line of credit. The
alternative assumption leads to the same results.
day volatility of deposits, they may make some banks
EFFECT O N D E P O S IT S A N D C R E D IT




FEDERAL RESERVE BANK OF NEW YORK

willing to remain more fully invested than otherwise,
thereby tending to increase deposits.
Aside from these possibly minor influences, compen­
sating balance requirements have no effect on total de­
posits. A bank that increases its own deposits by requir­
ing compensating balances reduces deposits of other banks
by the same amount. This is obviously the case where the
borrower obtains the compensating balance by withdraw­
ing funds deposited in other banks. But it is also the case
where the compensating balance is obtained directly from
the lending bank as part of the loan, as illustrated in the
table. In the example, the $200 compensating balance
absorbs $40 of reserves that otherwise would have been
available to support $200 of deposits by credit expansion
elsewhere in the banking system.
RE LATIO N TO W O R K IN G B A L A N C E N E E D S

Where the borrower must hold balances that cannot be
withdrawn, it might be concluded that the loan amount (or
line of credit) overstates the actual volume of funds that
can effectively be used. By the same token, it may seem
that the effective interest rate (i.e., the interest payment
figured as a proportion of usable funds) is higher than the
contract rate. Even in cases where such conclusions do
ftold, the higher cost would have to be set against the
value to the customer of the informal guarantee of loan
accommodation under the line of credit, as well as the
value of any other bank services rendered to him.
But even aside from these collateral benefits, the com­
pensating balance requirement may not increase the effec­
tive cost of credit to the borrower. Most business borrowers
have substantial working balance needs. They must main­
tain an average level of deposits sufficient to bridge
day-to-day gaps between payments and receipts as well as
to meet those special contingencies (emergencies and
opportunities) that require immediate cash. Actual bal­
ances held for this purpose may fluctuate markedly, but
since compensating balance requirements are usually
stated in terms of average balances over a period, they
serve in part, at least, to satisfy working balance needs.
Where required balances are equal to or less than the
average balances borrowers would hold to meet working
balance needs, the requirement does not reduce the effec­
tive availability of funds to the borrower, nor does it
mean that the effective interest cost of credit to him is
higher than the contract rate.
Thus, in the example cited above, a borrower who seeks
to hold working balances of $200 is not adversely affected
by the $200 balance requirement. The balance require­
ment merely obliges him to hold his working balance at the




207

lending bank rather than elsewhere. From the point of
view of the lending bank, the arrangement assures a con­
tinuing bank-customer relationship. The customer’s de­
posits add to bank earnings, and may encourage the bank
to offer him a larger loan or lower contract rate than it
offers to nondepositors. (The latter, in fact, may not
obtain accommodation at all.) Indeed, where a potential
borrower with heavy working balance needs does not
already have a compensating balance arrangement with
his bank, another bank might be able to solicit his business
by offering a relatively low contract rate of interest on
condition that the borrower transfer a balance large
enough to meet that bank’s balance requirement. Where
borrowers already have a compensating balance arrange­
ment that is reflected in loan rates lower than those
charged to nondepositors, the scope for this inducement
is of course limited.4
When balance requirements exceed the borrower’s
working balance needs, however, the requirement does
force him to pay interest on balances he does not need.
Thus, if the borrower in the example above has working
balance needs of only $100 but is nevertheless obliged to
hold $200 of his $1000 loan as a compensating balance,
he is provided with only $900 of effective funds, and the
effective rate of interest he pays rises correspondingly.
(If the borrower uses his line of credit only part of the
time but must hold average balances that are $100 higher
than those he needs over the full year, the effective rate
he pays is still higher.)
In cases of this type, the effective yield to the bank theo­
retically could be raised and, at the same time, the effective
cost to the borrower reduced by an appropriate combina­
tion of reduced balance requirements and increased con­
tract rates of interest. The potential benefit arises from
the elimination or reduction of the required reserves that
must be held against the compensating balance. The cus­
tomer may of course feel that he receives full value for
these balances in the form of “commitment insurance”
and other bank services. Nevertheless, in principle, direct
payment for these services could be beneficial to both
parties, since it would eliminate the reserve requirement
against the compensating balance.
For example, if the recipient of the $1,000 loan in the
compensating balance case shown on the table needs no
working balances at all so that the loan provides him with
only $800 of funds that he can use effectively, he would
be just as well off with a loan of $800 at a contract inter­
est rate one-fourth higher and no required balance. The
4 See Donald R. Hodgman, “The Deposit Relationship and
Commercial Bank Investment Behavior”, Review of Economics
and Statistics, August 1961, p. 262.

208

MONTHLY REVIEW, DECEMBER 1961

bank, however, would be better off in the latter case,
because its interest earnings on this specific loan transac­
tion would remain the same while $40 of required reserves
would be “freed” and could be used to make additional
loans. In principle, this benefit could be shared between
borrower and lender, although in practice much depends
on the relative bargaining positions of the two parties.
The burdensomeness of compensating balance require­
ments where they exceed borrower working balance needs
may account for the fact that balance requirements are
sometimes waived or set at comparatively low levels for
certain types of borrowers, such as builders, whose normal
balance needs are small; in such cases, the lower require­
ments may be offset by higher contract rates of interest.
Indeed competition may exert pressure toward keeping
requirements low in cases where working balance needs
are relatively small just as it encourages the development
of compensating balance arrangements where such needs
are heavy.
Nevertheless, in some cases, compensating balance
requirements in excess of customer working balance needs
do, for various reasons, persist. Banks may have a special
incentive to maintain compensating balances in order to
solidify bank-customer relations, from which they often
obtain collateral advantages. Compensating balances,
moreover, may be administratively the most convenient
way of compensating the bank for services, despite the
added cost to the bank of holding reserves against idle
deposits. Some banks, furthermore, may strive to make
their deposits as large as possible, even if this causes some
reduction in earnings— especially when the impact on
earnings is not clearly visible. In addition, balance require­
ments may be rendered inflexible by the bank’s desire to
maintain uniformity of requirements or contract rates of
interest among different borrowers of the same general
type. Finally, the upward adjustments in the contract rate
needed to offset any reduction or elimination of compen­
sating balances may be restrained in some cases by legal
or traditional ceilings on contract interest rates. If bor­
rowers are generally satisfied with their banking relation­
ship, competitive pressures that might otherwise overcome
some of these obstacles and spark downward adjustments
in requirements may not develop.
How important are cases where compensating balance
requirements exceed borrower working balance needs?
The necessity felt by many banks to educate their cus­
tomers to an acceptance of compensating balances, as well
as the problems sometimes encountered in enforcing the
requirements, strongly suggests that it is more than an
occasional and isolated phenomenon. There are indica­
tions, moreover, that such cases may have grown in-




SHORT-TERM LOANS FROM BANKS AND CASH
PLUS DEPOSITS OF ALL MANUFACTURING CORPORATIONS
Per cent

Per cent

* Loans with o rigin al maturity of one year or less.
Sources: Federal Trade Commission; Securities and Exchange Commission.

creasingly important in recent years. Since 1952, for
example, cash holdings of manufacturing corporations
(consisting very largely of demand deposits) have hardly
changed at all while short-term bank loans to such corpo­
rations, although subject to sharp cyclical fluctuations,
have nevertheless tended upward (see chart). If it is
assumed that deposits subject to compensating balance re­
quirements have risen in line with loans (a reasonable
assumption in view of the fact that lines of credit, against
which compensating balances are usually set, tend to move
in the same direction as loans), it would appear that such
deposits now comprise a large proportion of total
deposits, and may therefore exceed working balance needs
in a proportionately larger number of individual cases.6
5 Some observers have concluded that, because the ratio of cash
holdings to short-term bank loans for manufacturers has generally
been well in excess of typical required balance ratios, the require­
ments have not been burdensome for this group of firms as a
whole. This evidence is far from satisfactory, however, since
compensating balances are most often required, not against loans
themselves, but against lines of credit. Since at any given time
many lines of credit are not being used, or not very fully used,
total credit lines greatly exceed outstanding loans. The ratio of
deposits to lines of credit is thus smaller, and perhaps considerably
smaller, than the ratio of deposits to loans. Even aside from this
consideration, moreover, the totals for manufacturing borrowers
as a whole may conceal a significant number of individual firms
for which a burden does exist.

FEDERAL RESERVE BANK OF NEW YORK

This, along with the increased prevalance of compensating
balance requirements, may explain the recent development
and growth of a new financing device known as “link
financing”. Although this device is not yet widespread, it
has been used by some firms for which required balances
exceed working balance needs.
L IN K F IN A N C IN G

209

he requires. Even if the bank is willing to increase the
size of the loan by an amount sufficient to cover the bal­
ance requirement, the added charge could exceed the cost
to the borrower of obtaining the deposit through a link
financing arrangement. Where the bank is unwilling to
increase the size of the loan, the only alternative to link
financing may be even more costly borrowing from other
nonbank sources. Link financing can thus reduce, but
cannot eliminate, the cost imposed by compensating bal­
ance requirements in excess of working balance needs.
From the standpoint of the lending bank, a compen­
sating balance in the form of a time certificate has the
advantage of reducing the volume of required reserves that
must be held against the deposit. On the other hand,
some banks express opposition to link financing on the
ground that it does not encourage close bank-customer
relations.

While many variants of link financing exist, the gen­
eral nature of this technique may be illustrated by the
following example: A borrower receiving a $100,000 loan
is required by the bank to keep a compensating balance
of 20 per cent (or $20,000) but wishes to withdraw the
full amount of the loan to make payments. Both the bor­
rower and the bank may be satisfied if the borrower can
find a supplier of funds, such as an insurance company,
mutual fund, or pension fund, that will deposit $20,000 of
C O M P E N S A T IN G B A L A N C E S D U R ING THE
its own money in the borrower’s bank— such deposits
B U S IN E S S CYCLE
typically taking the form of time certificates of deposit. In
There is considerable evidence that compensating bal­
this way, the lending bank obtains the compensating bal­
ance of $20,000, the borrower gets the use of the entire ance requirements are responsive to cyclical changes
$100,000 loan, and the supplier of deposits receives a in general monetary conditions. Thus in periods of declin­
certificate of deposit on which it receives interest paid by ing interest rates, when money is plentiful and banks are
the borrower.6 In some cases, the supplier may subse­ seeking to expand loans, banks often reduce compensating
quently sell part or all of his time certificates to other in- balance requirements as one more way of making borrow­
vestors. Finance companies are important users of link ing more attractive and meeting competition. Similarly,
financing, but the technique has been employed by con­ during periods of stringency, pressures may be generated
struction and manufacturing firms as well. Some link to raise balance requirements. In the 1958 study referred
financing deals are arranged by middlemen who have been to above, slightly over half the bankers interviewed stated
quick to discover a profitable brokerage opportunity. that they adjusted their policies in the light of general
These brokers may sometimes obtain funds for an in­ monetary conditions, and effective flexibility may be even
dividual borrower from several participating suppliers more widespread. Even a bank which aims at a fixed ratio
of compensating balances to lines of credit, regardless of
(frequently in units of $5,000).
The supplier of deposits in a link financing deal is paid monetary conditions, may enforce the policy more vig­
by the borrower, but he may, in addition, receive interest orously in periods of rising interest rates and loan demand
on the certificate of deposit directly from the lending bank. than in periods of comparative slack. Such variations in
The fact that the total return from both sources has gen­ the vigor of enforcement may indeed provide a more flexi­
erally exceeded the legal maximum that banks are per­ ble means of adjusting to changing market conditions than
mitted to pay on time deposits has perhaps been the major changes in nominal requirements or in contract rates.
inducement to the flow of funds into this market. In
Cyclical flexibility in the application of compensating
cases where the deposit is noninterest bearing, the payment balance requirements thus can be a mechanism through
by the borrower normally exceeds the legal maximum rate which changes in the cost and availability of credit are
on time deposits.
transmitted to the market for business loans. On the avail­
Although link financing requires the borrower to make a ability side, increases in balance requirements or in the
supplemental payment to the supplier of the compensating vigor of enforcement tend to immobilize a larger part of
balance, it may nevertheless be the least expensive means loans and deposits in cases where required balances
for the borrower to obtain use of the full amount of funds already equal or exceed working balance needs. On the
cost side, increases in the required balance ratio will raise
6 Some cases have been reported where the supplier has pro­ effective interest rates, over and beyond increases in con­
vided deposits equal to the full amount of the loan, rather than
tract rates, to borrowers with small working balance
merely the compensating balance.




21-0

MONTHLY REVIEW, DECEMBER 1961

needs. It is impossible to estimate the quantitative sig­
nificance of the cost and availability effects of cyclical shifts
in compensating balance policies, but they may have a
definite importance. One study of finance company bor­
rowing suggests that decreases in compensating balance
requirements between 1953 and 1954 may have reduced
borrowing costs by about as much as reductions due to
declines in the contract rate of interest itself.7
C O N C LU D IN G C O M M E N T

When the effects of compensating balance requirements
are taken into account, cyclical swings in effective bank
interest rates and credit availability are larger than is indi­
cated by conventional statistical measures. This does not




imply, however, that these swings in effective rates and
availability have been larger than they would have been
in the absence of compensating balance requirements, la
its conduct of monetary policy, the Federal Reserve Sys­
tem takes into account all influences bearing on the supply
of credit that are outside the System's immediate control,
of which compensating balance requirements is one,
Changes in the supply of credit from this and other acwxcs
that are inappropriate to the prevailing economic shuiA-oti
may therefore be neutralized by offsetting adjustments in
monetary policy,
7 See Robert C. Holland, Bank Lending to Finance Companies,
December 1951 -June 1956, unpublished doctoral dissertation, Uni­
versity of Pennsylvania, 1959.