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FEDERAL RESERVE BANK OF NEW YORK 19 Our international P aym ents Deficit: A Continuing Challenge* By A l f r e d H a y e s President, Federal Reserve Bank of New York sterling fills both of these roles. Also, the severity of this sterling crisis may have been enhanced by the fact that it was one of a series of crises affecting sterling over the postwar period. Let me take this occasion to register a dissent from the contention that such crises demonstrate an inherent weak ness in our whole reserve currency— or gold exchange— system. It is not the system itself or any lack of early enough knowledge of trouble that is to blame, but rather the all-too-human tendency, observable by no means in the United Kingdom alone, to underestimate the difficulty of the payments problem to be dealt with and the rigor of the discipline needed to correct it. It is always easier to detect the flaws in another country’s methods than in one’s own, and the United Kingdom did not lack warnings from abroad that decisive measures needed to be taken— any more than we have lacked foreign advice on the im portance of meeting our own payments problem. While domestic and international objectives complement one another in the long run, there is all too often a genuine conflict in the short run between international and do mestic priorities, and there are frequently political prob lems involved in taking the needed remedial measures. The fundamental soundness of a currency is based ulti mately on the strength and stability of the domestic econ omy, but the balance of payments is the most important factor determining its market strength at any given time. And a chronic payments problem for a major trading currency can of course be greatly accentuated by large temporary swings reflecting so-called “leads and lags” or a natural desire of traders and investors, including bank ers, to hedge their present or prospective holdings of the currency in question. This type of action is far more im portant, for a country like the United Kingdom, than the * An address before the thirty-seventh annual midwinter meet ing of the New York State Bankers Association, New York City, deliberate raids of outright speculators, so dear to the January 25, 1965. hearts of some journalists. Of course, a change in the atti It is always pleasant and stimulating to meet with this fine group and discuss some of the important issues facing us as commercial and central bankers. As commercial bankers, you are of course the principal channel through which monetary policy has its impact on the economy— and I am delighted to say that your help over the years in working toward our common goals has been invaluable and much appreciated. In the period ahead, I believe that close cooperation and mutual understanding will be more essential than ever. On several past occasions I have stressed in this gather ing the international payments problems that have assumed growing importance in our policy considerations in recent years. Unfortunately, those problems are still very much with us despite all the efforts of the past four or five years; and the sterling crisis of last November, together with other developments in the exchange and gold markets growing out of that crisis, has focused world attention on these matters. The dollar, as the leading world currency, widely used both for reserve purposes and as a medium of international trade and payments, could hardly expect to escape some of this attention; so it seems especially appropriate today to dwell on this side of our continuing problem, although I shall also have something to say on domestic developments. Exchange crises are of course not new. We have had several in the last two or three years, of various origins, and they have all been met successfully through timely measures of international cooperation. But naturally a crisis is more serious when it involves a reserve currency or a currency used widely for trade and investment— and 20 MONTHLY REVIEW, FEBRUARY 1965 tudes of the principal holders of a currency as an inter national reserve could, in itself, further accentuate the temporary pressures; but this appears to have been a minor element in the recent sterling troubles. Crises are never welcome, but looking back on the re cent sterling experience even with the brief perspective now available I can find much that is heartening. First, the $3 billion credit arrangement was a dramatic demon stration of the solidarity of the major financial nations, when they saw a threat to the whole international financial system, and of their ability and willingness to act with great dispatch. Second, there is a firm understanding among the financial authorities of these same nations— in contrast to the views of some academicians and financial writers— that devaluation of a major currency is not a workable solution to monetary ills; and that a successful attack on one major currency could have serious conse quences for most others and for the international financial system in general. Third, the United Kingdom authorities recognized the threat to their currency and were willing to take actions which in the aggregate constitute a much more effective package than has been generally appreciated as yet in the market. Once the exchange markets become unsettled there is a natural susceptibility to all kinds of unfounded rumors which tend to perpetuate or even compound the market uncertainty. Thus, in the case of the dollar, the initial re ports about the possible elimination or modification of the 25 per cent gold reserve requirement gave rise to a misinterpretation abroad which was the exact opposite of the correct understanding. Obviously the purpose of changing the requirement would be not to weaken the fixed tie between gold and the dollar at $35 per ounce, but to make crystal clear that all our gold stock is avail able to fulfill its primary purpose, i.e., to enable the United States to meet its international obligations and preserve the dollar’s strength. There should be no illusion that the soundness of the dollar depends on maintenance of this or any other arbitrary reserve ratio. Rather it de pends on the staunch pursuit of noninflationary domestic growth policies and the reestablishment of equilibrium in our balance of payments. Taking the latter point first, and looking back over the past year, we may find that there has been some modest im provement in our payments position, but not nearly enough in view of the persistent large deficits from 1958 on. All the data for last year are not yet available, but it is sobering to bear in mind that the cumulative deficit in the six years from 1958 to 1963 reached some $21.6 billion. Essentially what happened in this past year was that our trade surplus grew faster than anyone expected, but most of the gains from this and other sources were offset by a sharp rise in private capital outflows. Bank lending abroad has played a large role, especially in the past few months, and much of this lending has gone to the industrial coun tries of Europe. Direct investment has also increased in the past year—both to Europe and in the aggregate. No doubt the rising trade surplus and increased capital out flow are in some degree interdependent, but this does not mean we can be complacent about the capital outflow or about any other element of our total payments position. It is the net result that counts and that net result has been one that we cannot tolerate much longer. As I have said so often, time is working against us, as long as deficits are accumulating, even if at a diminishing pace, for the cumulative effect of past deficits is to increase the threat of conversions of dollars into gold. In 1964 there were very significant mitigating factors, notably the desire of private foreign interests to increase their dollar holdings sharply and the unusually heavy flow of gold into the London market. It may be that the statistical treatment of certain items in our deficit presents a picture of somewhat unwarranted gloom; for example, the sta tistical deficit is enlarged by the operations of agencies of Canadian and some other foreign banks as intermediaries in our own markets, when they receive United States dol lar deposits from Americans and lend or invest them in the United States. Yet we must bear in mind that develop ments in other countries, such as a tightening in their own local credit conditions, can draw dollars out of private holdings and into the central banks. We must also recog nize that no statistical rearrangement alters the fact that liquid claims against us are very large indeed. As the leading world currency the dollar has a special obligation to observe high standards of behavior, especially as to the maintenance of its internal value. By meeting this goal, and reducing or hopefully eliminating our pay ments deficit, noninflationary adjustments in other coun tries will be greatly facilitated and solid support will be provided for our system of fixed exchange rates. Needless to say, we are also very much interested in furthering ex panded world trade and investment by maintaining a high level of domestic economic activity. Parenthetically, I might add that, while we should— and in fact must— do more to eliminate our payments deficit, I would certainly not subscribe to the thesis that we should let the deficit automatically bring about a sharp decline in domestic liquidity and credit availability. No nation today can afford to permit any such automatic response; but each country must give due weight to international factors in deciding what constitutes appropriate liquidity. The “fruit ful tension” between domestic and international objectives, FEDERAL RESERVE BANK OF NEW YORK to use the phrase of Dr. Emminger of the German Bundes bank, has itself been an important influence toward better international cooperation and coordination of policies. The attack on our payments deficit must be many pronged. There should of course be a continuing effort to stimulate exports— especially through keeping our costs and prices stable so that American products are fully com petitive both abroad and at home— and the Government should redouble its efforts to reduce the net drain of for eign military operations and foreign aid. But the spotlight at the moment would seem to be on capital movements. And this brings us squarely to the question of how far capital outflows can and should be influenced by general credit availability and to what extent by selective meas ures. To my mind there are strong advantages in the former approach—that is, one based on general credit availability—to the degree it can be used without unduly impeding domestic objectives. Certainly this approach is more in keeping with our long-range objective of maxi mizing freedom of international trade and investment, and also with our tradition of favoring impersonal, nondiscriminatory controls whenever possible. And we cannot overlook the fact that, despite increases in the discount rate and in short-term market rates in 1963 and late 1964, there is still ample credit availability to accommodate a large aggregate of foreign lending by domestic banks. At the same time, we must recognize that the subject of short- and long-term capital movements among major industrial countries is highly complex, and that our own position must be developed in a world that is already crisscrossed by infringements on the free movement of capital imposed by many, if not most, other countries. For example, several European countries with strong balanceof-payments positions are still placing severe restrictions on foreign bond flotations and other capital exports. On the other hand, we must face the fact that United States capital inflows are by no means always welcome in Europe. In several instances the authorities in some European countries have acted to restrict inflows, whether in the form of bank loans or of longer term investments, because they sought to avoid the corresponding increase in do mestic liquidity— or in some cases because of serious con cern over the prospect of increasing American ownership of key national industries. In the light of these complex factors, and the importance of achieving a rapid improvement in our balance of pay ments, I am reluctantly coming to the conclusion that we must face the possibility of a more direct approach on certain components of this problem, even if it involves some compromise with our basic philosophy of complete freedom to lend and invest abroad, Of course the interest 21 equalization tax already represents one such compromise, and the extension of this tax to certain types of bank loans, as permitted in existing legislation, is one possible line of approach that has received attention. Another and to my mind a preferable possibility would be to enlist the support of our commercial banks in voluntarily reducing the heavy outflows of bank credit. But whatever may be done in the area of selective measures, whether through the tax route or otherwise, should be regarded as a tem porary expedient, to be eliminated at the earliest oppor tunity. Moreover, I believe that any selective measure must be backed by a posture on general credit availability that is not so easy as to encourage excessive leakages that would thwart the purpose of the selective approach. Turning now to the domestic side, let me say forthwith that I consider domestic aspects of our economy’s devel opment no less important than the international side to which I have given attention in my remarks thus far. It hardly needs reiteration that these two aspects are in extricably connected—that we cannot gain the full fruits of our domestic economic potential without achieving a viable international position, but also that the dollar’s in ternational strength ultimately rests on a healthy domestic economy. Looking at the economy’s recent record I believe there is much cause for satisfaction. Despite the disruption caused by the autumn automobile strikes, business was moving ahead at the year end and the outlook is for fur ther gains this year, provided we can avoid costly work stoppages. So far the threat to price and cost stability embodied in the automobile labor settlements remains only a threat, and the cost-price structure remains reason ably stable, although there have been some scattered signs of upward price pressures. Unfortunately, the generally well-balanced growth of the past four years is now en dangered by a sharp steel inventory buildup in anticipation of a strike this spring, which could lead to increased price pressures, as well as subsequent slackening of business; but this unhappy outcome is not a foregone conclusion. The outlook for the second half of the year is even less clear than for the first half; much depends on the size of the first-half steel buildup, and on success in avoiding either an extended work stoppage or a wage settlement that might engender fresh price pressures. The outlook also depends importantly on the extent to which Federal fiscal policy may provide an added stimulus. From our current vantage point, it seems likely that the net budget ary stimulus could be a good deal stronger in the second half of the year than in the first; this might arise both be cause of possible excise tax cuts and increases in planned expenditures and also because of eliminating the first- 22 MONTHLY REVIEW, FEBRUARY 1965 hall drag arising from the catch-up with 1964 personal income tax payments. As for developments in the credit area, the most striking feature of 1964 is that bank credit has grown at about the same substantial rate as in 1963 and indeed at about the same rate as in 1961 and 1962— roughly 8 per cent each year. A year ago I was inclined to question whether this continuing rate was not a bit excessive, particularly in the light of our balance-of-payments problem. This is still a relevant question, especially as we enter a new year with a smaller margin of unused resources than was available a year ago. If we look at the money supply (currency plus demand deposits), we find that it grew as rapidly in 1964 as in 1963, and somewhat more rapidly than in the two preceding years. To be sure, total nonbank liquidity rose a little more slowly last year than in 1963, mainly because of a slowdown in growth of time deposits, which had surged ahead in 1962 and 1963 under the stimulus of changes in Regulation Q and the development of certifi cates of deposit. Even so, nonbank liquidity fully kept pace with total activity last year so that the ratio of liquid hold ings to gross national product remained at the high level reached at the end of 1963. Commercial banks, it is true, are now more heavily loaned up than they were a year ago, but not to the point where we can detect any lessened desire to seek additional loans, either at home or abroad. We can find satisfaction in the relatively steady level of stock market credit and in some reduction in delinquency rates on consumer and mortgage loans, although there has been some concern about the quality of credit in a num ber of areas. As we look ahead, we undoubtedly face another year of perplexing crosscurrents and challenging problems for monetary policy. The challenge at home is to assure con tinued growth of the economy in a noninflationary atmos phere; and with manpower and productive resources now somewhat more fully utilized than in the last four years it may be more difficult to maintain earlier growth rates without courting price and cost pressures. The need for a “noninflationary atmosphere” can hardly be overem phasized, with respect to both our domestic and interna tional objectives— and I wish I felt more confident that its critical importance is recognized throughout the country. I feel encouraged by the growing recognition that fiscal policy can be used more actively and more flexibly than in the past as a stimulative force. Indeed, if the economy should show signs of lagging growth later in the year, the burden of providing further stimulation could hardly be assumed by monetary policy, in the present international setting, although monetary policy will obviously have to see that credit remains sufficiently available for all essen tial needs. Rather the burden would have to rest largely on fiscal policy and other types of Government and pri vate actions. In other words, the proper composition of the so-called “policy mix”, which has emerged as a basic element in national economic policy in the last few years, will remain highly important in 1965. As for the international challenge, I have said already that we can no longer afford to temporize with our balance-of-payments problem. The first order of business of the United States authorities in the financial area should be a combined attack— not merely to gain time, but to solve the problem. I am confident that the wholehearted cooperation of bankers and other private interests will be forthcoming, for all of us have an equally large stake in a successful solution. T H E N E W Y O R K F O R E IG N E X C H A N G E M A R K E T A thoroughly revised and updated version of The New York Foreign Exchange Market, written by Alan R. Holmes and Francis H. Schott, has just been published by the Federal Reserve Bank of New York. (The original booklet, written by Alan Holmes, ap peared in March 1959.) In his foreword to the 64-page booklet, Alfred Hayes, President of the Bank, notes that: “The United States dollar and its relationships with other currencies play a vital role in the international flow of goods, services, and investments and in a stable international financial system. I hope that a study of the New York foreign exchange market, facilitated by this booklet, will help the reader toward a fuller appreciation of these matters of genuine importance.” Copies of the booklet are available from the Pub lications Section, Federal Reserve Bank of New York, 33 Liberty Street, New York, N. Y., 10045, at 50 cents each. Educational institutions may obtain quantities for classroom use at 25 cents per copy. FEDERAL RESERVE BANK OF NEW YORK 2S T he B usiness Situation The economy closed out its fourth full year of sustained fare would have their initial impact at that time. In addi growth with activity still moving ahead vigorously. Official tion, an excise tax cut has been proposed, which would tabulations have confirmed that, due to the October- amount to $1.75 billion per year when fully effective. November strikes in the automobile industry, over-all activity registered only a moderate advance in the fourth RECENT P A T T E R N S OF D E M A N D quarter as a whole, but various monthly and weekly indi cators pointed to renewed widespread gains in Decem According to the preliminary estimates of the Com ber and January. Thus, industrial production, payroll merce Department, gross national product in the final employment, and durables new orders were all up strongly quarter of 1964 (measured at a seasonally adjusted an in December. Preliminary January data suggest that auto nual rate) rose by $5.1 billion to $633.5 billion (see chart), mobile assemblies were maintained a shade below Decem bringing the total for the year to $622.3 billion. This rep ber’s record rate and that steel ingot production continued resented a 6.6 per cent increase over the 1963 figure and at the very high December level. Retail sales in January brought the nation’s total output to a level 24 per cent apparently moved past the high mark set in December. The above that prevailing at the start of the current business drop in the unemployment rate to 4.8 per cent in January expansion. As had been expected, the figures for the was a most encouraging development. fourth quarter were depressed, owing to the strikes that All major labor disputes in the railroad industry are re took place in the automobile industry in October and No portedly settled. However, in a strike that has already had vember. As a result, the rise in total GNP in the quarter was considerable adverse effects, East and Gulf Coast dock the smallest since early 1961. workers continue to be absent from their jobs despite con In a reflection of the shortage of the new models in the last tract agreements at most of the ports. The crucial labor- several months of the year, consumer spending for automo management negotiations in the steel industry are about to biles and parts dropped by $2.9 billion. Consumer outlays be resumed. Meanwhile, despite the late 1964 flurry of for other durables and for nondurables and services, on the announcements of selective price increases, the broad price other hand, rose by $4.5 billion in the quarter. With new indicators have continued to show relative stability. Con cars once again in ready supply in dealers’ showrooms, auto sumer prices rose less in 1964 than in 1963, while industrial mobile sales surged to a record in the final month of the wholesale prices last year inched up by just over Vz of a per quarter and moved even higher in January. Trade reports cent. With the economy operating at a high level, restraint in indicate a high degree of optimism about near-term auto wage-price decisions will be necessary to avoid a resurgence sales prospects. Moreover, retail sales in general appear to of the inflationary atmosphere characteristic of the mid- have continued to advance in January, as they did in De cember (even after allowance for seasonal factors). 1950*8. One key factor affecting the course of over-all activity The fourth quarter also witnessed the third consecutive during the months ahead will be the actions taken by Con quarterly decline in outlays for residential construction, gress on the Administration’s fiscal 1966 budget and other There is, however, some evidence that the downtrend in economic proposals. The proposed Administration budget residential construction activity may have leveled out. In will stimulate the economy significantly, particularly in December, nonfarm housing starts rose by 7 per cent, and the second half of calendar 1965, and would thus serve as the dollar value of residential construction contract awards a counterbalance to any weakening that might develop in moved up markedly in the final two months of 1964. Business fixed investment showed an increase in the some sectors of demand. Most of the suggested expenditure increase in such areas as education, health, and social wel fourth quarter of 1964, although the gain was estimated to 24 MONTHLY REVIEW, FEBRUARY 1965 GROSS N A T IO N A L PRODUCT A N D SELECTED COM PONENTS S e a s o n a lly a d ju s t e d a n n u a l r a t e B illi o n s o f d o l l a r s B illi o n s o f d o l l a r s reflected the enforced partial deferment of truck and auto mobile buying plans— in many cases involving whole fleets of vehicles— because of strike-induced shortages. With normal supply conditions restored, and with commercial and industrial contract awards up strongly in the final quarter of 1964, the prospects appear bright that capital spending will move to new records in the months ahead. Government expenditures for goods and services ex panded following a very slight third-quarter decline. State and local government spending, up for the tenth consecu tive quarter, provided most of the strength, while Federal purchases rose only slightly. Indeed, the average quarterly increase in Federal purchases in calendar 1964 was $0.2 billion as against a $0.6 billion average in the 1962-63 period. (Under the proposed budget, the quarterly average advance in purchases of goods and services during fiscal 1966 would be about the same as in calendar 1964. Most of the stimulative impact of the budget arises from pro jected larger expenditures on social programs that do not in volve direct purchases of goods and services.) PR O D U C T IO N , O R D E R S, A N D E M P L O Y M E N T The Federal Reserve Board’s seasonally adjusted index of industrial production chalked up a 2.2 percentage point increase in December, following an even larger gain the month before. This rise brought industrial output to a level 8 per cent higher than at the end of 1963 and 32 per cent above the level that prevailed at the beginning of the current upswing. As in November, a large part of the December increase in total output was attributable to the automobile industry where most workers clocked a con siderable amount of overtime in an effort to alleviate short ages of new cars in dealer showrooms. At the same time, however, good gains were recorded by producers of most other consumer goods— there was an especially sharp rise in the output of television sets—while production of business equipment also showed strength. Among the widespread gains in materials output was a further rise in iron and steel production, which brought operations in that industry to near the record rates reached just before and after the long strike in 1959. The total flow of new orders received by manufacturers of durable goods rose by 6.3 per cent in December, as new orders for motor vehicles and parts and primary and fabricated metals surged forward. Moreover, the backlog of unfilled orders on the books of durable goods manu facturers moved up for the twelfth consecutive month and reached the highest level since 1957. Weekly data at hand be smaller than those recorded in most of the quarters of the for January point to continuing strength in production in current business upswing. In large part, the slower advance that month. Automobile assemblies were again responding N o te : T o ta l G N P in c lu d e s n e t e x p o rts o f g o o d s a n d s e rv ic e s n o t sh o w n s e p a r a t e ly . ♦ G ro s s n a t io n a l p r o d u c t e x c lu d in g b u s in e s s in v e n to r y in v e s tm e n t. + In c lu d e s in v e n t o r y in v e s tm e n t n o t s h o w n s e p a r a t e ly . 4 In c lu d e s o u tla y s fo r p r o d u c e rs ’ d u r a b le e q u ip m e n t a n d n o n r e s id e n t ia l c o n s tru c tio n . S o u rc e : U n it e d S ta te s D e p a r tm e n t o f C o m m e r c e . FEDERAL RESERVE BANK OF NEW YORK to the favorable reports of dealer sales, while demands for steel— apparently mainly for current consumption but partly also for inventory building as a hedge against a possible strike— continued to stimulate high production of steel ingots, putting pressure on steel-finishing capacity. The strong upward movement in industrial production helped materially in raising seasonally adjusted nonfarm payroll employment by 226,000 persons in December. All major industry groups shared in the increase, but par ticularly strong gains were registered in manufacturing and construction as well as in the number of persons at work for state and local governments. The employment rise in manufacturing brought total employment in that sector up 25 to 17.6 million, the highest level in more than ten years and nearly 500,000 persons more than at the end of 1963. Average hours worked in manufacturing also rose further in December and, at 41.1 hours per week, were the high est since 1953. In January, the seasonally adjusted unemployment rate dropped to 4.8 per cent from the revised December level of 5.0 per cent. This represents the lowest monthly reading since October 1957 and continues the gradual but marked improvement in unemployment that took place last year. In 1964, the unemployment rate averaged 5.2 per cent, which represented considerable progress over the 5.7 per cent average for 1963. Recent Banking and M onetary D evelopm ents Federal Reserve policy actions taken in late November in defense of the nation’s balance of payments had a sig nificant impact on United States short-term interest rates in the fourth quarter of 1964, but did not, on present evi dence, lead to any appreciable curtailment in the flow of funds through the banking system and the long-term credit markets. With banks amply supplied with reserves, bank credit and deposits continued to expand substantially, both before and after the policy change. Although there were re ports of a slight firming in some bank lending terms, the prime rate remained unchanged after an abortive attempt by a few banks late in November to initiate an increase, and indications are that borrowers still found banks ready to ac commodate their loan demands. The continued growth of the banks’ over-all loan portfolios led to a further rise dur ing the quarter in the loan-deposit ratio for commercial banks as a group. SE LE CTED IN TE R E S T RATE C H A N G E S IN T H E F O U R T H Q U A R T E R The raising of the Federal Reserve’s discount rate from 3V2 per cent to 4 per cent in late November, as was indi cated at the time, was largely a precautionary move fol lowing the rise in the British bank rate from 5 per cent to 7 per cent. It was aimed at offsetting a part of the increased differential between United States and foreign short-term interest rates as well as at discouraging potential speculation against the dollar. There was a marked response of United States short-term rates to the policy change. For example, after having fluctuated in a narrow range above the 3.55 per cent level from late September through most of Novem ber, the average issuing rate on three-month Treasury bills rose by about 25 basis points in the period immediately fol lowing the discount rate change (see Chart I on next page). Similarly, rates charged by major banks on new loans to Government securities dealers worked higher over the final six weeks of 1964, closing the year in a 4Vs to 4% per cent range, compared with an average of around 3.80 per cent in most earlier weeks of the year. Secondary market rates on negotiable time certificates of deposit also adjusted upward following the discount rate change. Long-term interest rates remained generally stable throughout the fourth quarter, as they did earlier in the year. Yields on five-year United States Government mar ketable securities moved up only about 4 basis points over the quarter and those on ten-year maturities were up only about 2 basis points. Yields on corporate bonds and on secondary mortgages were also stable over the period, while yields on municipal bonds declined to their lowest levels of the year. This stability in long-term rates, com bined with the increase in rates in the shorter term market, brought about a general flattening in the yield-maturity curve for Government securities during the quarter. As 26 MONTHLY REVIEW, FEBRUARY 1965 C h art I SELECTED INTEREST RATES 4.40 Per cent Per cent YIELDS O N UNITED STATES TREASURY OBLIGATIONS tiV 4.80 4.60 ■ 1.80 4.60 4.40 4.40 December 30,1964 4.20 4.00 4.20 4.00 September 30,1964 3.80 3.80 3.60 3.60 3.40 - _L 3.20 . 1 2 3 4 I L J______ 5 6 7 8 9 J___ __ __ ! I L _ _ 3.40 -LaJ— 3.20 l_ l 10 1 12 13 14 15 32 34 36 38 1 N u m b e r o f y e a r s to m a tu r ity * C e rtific a te s o f d e p o s it — ra n g e o f W e d n e s d a y o ffe rin g rates in se co n d a ry m a rke t. 9 0 - d a y b ills — a v e r a g e issuing ra te . D e a le r lo a n ra te — w e e k ly a v e r a g e o f d a ily m id p o in t o f ra te s q u o te d on new d e a le r loans. t Y ie ld versus m a tu rity curves w e re d e v e lo p e d a tth is B ank b y d ra w in g sm ooth lines th ro u g h th e s c a tte r o f a c tu a l m a rk e t y ield s on U n ited S tates G o v e rn m e n t o b lig a tio n s on th e d a te s shown. shown in Chart I, the very short-term end of the curve for December 30, 1964 was up about 30 basis points from that for September 30; yet, the long-term end was vir tually the same in both curves. earlier months of the past year. Business loans, in particu lar, continued their relatively fast growth (10.8 per cent during the year as a whole). Holdings of securities other than Governments advanced in the fourth quarter at the relatively modest pace of earlier months of 1964, follow ing a more rapid rate of increase during the preceding year. Bank holdings of Government securities, on the other hand, turned down again in the fourth quarter following a third-quarter pickup, though the net decline in such hold ings for all of 1964 was smaller than in 1963. The strength shown by bank credit in the fourth quarter was also reflected in the money supply and in commercial bank time deposits. To be sure, the $1.4 billion rise in the seasonally adjusted daily average money supply from September to December was less than the rather unusual bulge in the preceding three months. Variations in the rate of change in this series over such short time spans are not unusual, however, and have to be evaluated cau tiously in light of the many other factors involved. In 1964 as a whole, the increase in the money supply amounted to 4 per cent, virtually the same as in 1963. Commercial bank time deposits, on the other hand, showed a smaller rate of gain in 1964 as a whole than in 1963, despite some acceleration in the fourth quarter. To add to their loan potential, a few banks began late in the third quarter to attract funds through the issuance of new short-term unsecured negotiable notes. The amount of such notes outstanding was estimated to be in a range above $100 million by the time of the November change in Regu lation Q. Following the increase in time deposit rate ceilings, the outstanding volume of these instruments appears to have declined somewhat as banks began to raise their offering rates on time certificates of deposit. It is still too early to judge fully the effects of these higher rates on time deposits, but time deposit growth did accelerate toward the end of December and through January. B A N K LIQ U ID IT Y B A N K C R ED IT, M O N E Y S U P P L Y , A N D T IM E D E PO S IT S Total loans and investments at all commercial banks rose by $4.3 billion (seasonally adjusted) in the fourth quarter of 1964, and there was no clearly discernible slackening in the pace of the advance following the shift in Federal Reserve policy. The fourth-quarter advance brought the increase in bank credit for the year as a whole to 7.9 per cent, essentially unchanged from the 8.0 per cent rise in 1963. The general pattern of changes in individual com ponents of total bank credit was roughly the same as in The relatively rapid growth of bank loans over the last two years has resulted in a gradual but widespread reduc tion in bank liquidity positions. All indicators of bank liquidity are, of course, somewhat arbitrary and difficult to interpret. The implications for the banks’ liquidity of the widely used loan-deposit ratios, for example, may change with a different “mix” of demand and time deposits. Over the last few years, the relative proportion of time deposits— which are on average less subject to unexpected withdrawals than demand deposits—has increased for the banking sys tem as a whole and for most individual banks. High loandeposit ratios therefore may not be so much of a restraint 27 FEDERAL RESERVE BANK OF NEW YORK C h a r t II BANK LOAN-DEPOSIT RATIOS * P er cent Per cent Reserve Banks, plus vault cash, in excess of the legal re serve requirements— are the most liquid source of funds for member banks, and the absolute amount of such re serves in the fourth quarter of last year averaged $406 million, compared with $451 million a year earlier and $549 million in the final quarter of 1962 (see Chart III). At the same time, member bank borrowings from the Fed eral Reserve increased, so that member bank free reserves (excess reserves less borrowings) declined from an aver age of $387 million in the fourth quarter of 1962 to $79 million in the final quarter of 1964. Since deposits at member banks were growing fairly rapidly over this pe riod, the ratio of free reserves to deposits declined even more rapidly. Treasury securities maturing in less than one year are another asset category that is generally considered part of C h a r t III INDICATORS OF BANK LIQUIDITY N o te : S h a d e d a r e a s re p r e s e n t rece ss io n p e rio d s , a c c o rd in g to N a t io n a l B u re a u o f Eco n om ic R e s e a rc h c h ro n o lo g y . * M i l l i o n s o f d o lla r s R atio s c o m p u te d b y this B a n k (see fo o tn o te 1). M illio n s o f d o lla r s EXCESS RESERVES A N D BORROW INGS OF ALL MEMBER BANKS ^ ~ 1 1 So u rc e: B o a rd o f G o v e rn o rs o f th e F e d e ra l R es erv e S ystem . 1500 . \ 1500 ^ ^x\Free reserves SosNxv i H nnn\ . Net borrowed reserves \ ^ 1 / ^ o r r o w 'n ss a t X ®a n ^ s 1000 on further loan expansion as they previously were. Never theless, it appears fairly certain from most reasonable in dicators that bank liquidity has been reduced somewhat over the last year or two. The loan-deposit ratio was up to 59.5 per cent at the end of 1964 for all commercial banks as a group, com pared with 58.5 per cent at the end of the third quarter and 57.3 per cent at the close of 1963.1 At weekly reporting member banks, both in and outside New York City— a group of banks which includes the larger and more aggres sive lenders in the major cities across the country—the loandeposit ratios reached 64 per cent in December (see Chart I I ). This was a four-year high for the New York City banks and a postwar record for banks outside the money center. When measured in relation to deposits, there has also been a downward movement in a number of asset cate gories that are generally considered to be part of bank liquidity positions. Excess reserves— deposits at Federal 1000 500 500 0 0 P e rc e n t P e rc e n t RATIO OF SELECTED ASSETS TO TOTAL DEPOSITS*AT ALL WEEKLY 20 REPORTING MEMBER BANKS ^ ^ ^ ~ -^maturing in 1-5 y e a rs t A 15 15 Treasury securities m a t u r in g ^ \\ 10 10 in less than 1 y e a r ~~ 5 5 Loans to brokers and dealers 0 | | j 0 1953 54 55 56 57 58 59 60 61 62 63 64 N o te : S h a d e d a r e a s re p r e s e n t re ce ss io n p e rio d s , a c c o rd in g to N a t io n a l B u rea u o f Eco n om ic R es ea rch c h ro n o lo g y . * 1 Loan-deposit ratio equals loans (adjusted), less loans to brokers and dealers, as a percentage of total deposits (less cash items in process of collection). 20 Treasury notes and bonds T o ta l d e p o s its le ss cash item s in p ro cess o f c o lle c tio n . 1”D a ta n o t a v a i la b l e p rio r to Ju ly 1 9 5 9 . S o u rc e : B o a rd o f G o v e rn o rs o f th e F e d e r a l R e s e rv e S y stem . 28 MONTHLY REVIEW, FEBRUARY 1965 One noteworthy liquid-asset category that has not shown a general downtrend relative to deposits over the past two years is composed of call loans to brokers and dealers for the purpose of purchasing and carrying securi ties. Such loans amounted to 2.8 per cent of deposits in the fourth quarter of 1964, compared with 2.5 per cent two years earlier. While bank liquidity positions have been declining, the Federal Reserve has continued to provide the reserves necessary to support substantial deposit and credit expan sion. Perhaps this policy stance of the System has been reflected in bankers’ willingness to accept some decline in their liquidity positions. In any event, to all appear ances, borrowers have continued to be able to obtain new loans readily. However, what the decline in liquidity posi tions probably does mean is that, with portfolios them selves offering little room for further reallocation to meet 2 It should be noted, however, that comparisons over time of future loan demands, the banking system may now be bank holdings of Treasury securities may be distorted by the varying timing and amounts of Treasury financings— a dis more sensitive to System policy in supplying reserves than tortion that cannot always be eliminated by statistical pro earlier in the current business expansion. cedures. a bank’s liquid reserve position.2 For all weekly reporting member banks, such holdings amounted to 6.1 per cent of deposits in the fourth quarter of 1964, about un changed from the 5.7 per cent level prevailing in the final months of 1963 but considerably below the 8.7 per cent figure at the end of 1962 (see Chart III). While holdings of intermediate-term Treasury securities may be less rele vant in assessing bank liquidity, it is interesting to note that these too have declined relative to deposits. In the fourth quarter of 1964, holdings of Treasury issues matur ing in one to five years amounted to 7.8 per cent of total weekly reporting bank deposits, compared with an 11.1 per cent share two years earlier. T he M oney and Bond M ark ets in January The money market during January readily accommo dated the substantial financial flows set in motion by the Treasury’s advance refunding. Banks in the money centers experienced heavy reserve pressures in the first half of the month, but managed to fill the bulk of their reserve needs in the Federal funds market where reserves were in fairly good supply at a 4 per cent rate. With the completion of the refunding, these special pressures subsided and the money market became somewhat more comfortable in the latter part of January. The Treasury’s advance refunding operation dominated activity in the Government securities market during the month. The offering was accorded an excellent reception. The exchange of $9.7 billion of shorter term securities for intermediate- and long-term bonds resulted in a significant lengthening of the average maturity of the marketable debt. Market participants took the unexpectedly large re sponse as a manifestation of investor confidence in the viability of current interest rates, and prices of most out standing Treasury coupon issues rose through much of the month. An element of caution crept into the market near the end of the month as concern about the balance of pay ments led to profit-taking in the securities recently issued. In the market for Treasury bills, demand was strong early in the month when sellers of the eight coupon issues eligible for conversion in the advance refunding operation sought other outlets for their funds. Bill rates generally receded through midmonth, but edged irregularly higher thereafter as offerings expanded. In the markets for corporate and taxexempt bonds, demand for new issues was good and prices generally advanced, in part because participants were en couraged by the favorable reception accorded the Treasury refunding. THE M O NEY M ARKET A N D BANK RESERVES The money market had quite a firm tone through midJanuary, and then became a bit more comfortable over the remainder of the month. Rates posted by the major New York City banks on call loans to Government securities 29 FEDERAL RESERVE BANK OF NEW YORK dealers were in a AVa to AV2 per cent range in the first half of the month, and in a 4 to 4Vi per cent range thereafter. As the month opened, offering rates for new time certifi cates of deposit issued by leading New York City banks were at the upper end of the range prevailing since the November increase in the Federal Reserve discount rate, but these rates edged lower on balance during the month. The range of rates at which such certificates traded in the secondary market also tended lower in January. Dealers’ inventories of bankers’ acceptances expanded during the month in the face of steady sales by commercial banks, while the investment demand for acceptances was generally light. Acceptance rates remained unchanged throughout the period. In early January, the money market handled smoothly the unwinding of transactions connected with the year-end statement publishing date, and the credit demands ocea- Table n RESERVE POSITIONS OF MAJOR RESERVE CITY BANKS JANUARY 1965 In millions of dollars Daily averages week ended Factors affecting basic reserve positions Jan. 6 Reserve excess or deficiency (—) * ..... Less borrowings from Reserve Banks Less net interbank Federal funds pur chases or sales (—) ............................... G ross p u r c h a s e s ...................................... G ross s a le s .................................................. Equals net basic reserve surplus or Net loans to Government securities dealers .................................................... Equals net basic reserve surplus or In millions of dollars; (+ ) denotes increase, (—) decrease in excess reserves Jan. 27 4 61 14 161 46 — 11 72 156 13 113 635 829 970 335 1158 330 810 443 1167 356 943 500 1060 380 -6 9 1 -9 7 6 -9 2 0 — 526 -7 7 8 799 750 685 575 702 9 45 27 98 679 Thirty-eight banks outside New York City G ross p u rc h a se s ...................................... Gross s a le s .................................................. Table T Jan. 20 Eight banks In New York City Reserve excess or deficiency (—) * ..... Less borrowings from Reserve Banks Less net interbank Federal funds pur chases or sales (—) ............................... CHANGES IN FACTORS TENDING TO INCREASE OR DECREASE MEMBER BANK RESERVES, JANUARY 1965 Jan. 13 Average four weeks ended Jan. 2 7 Net loans to Government securities dealers .................................................... 16 137 380 29 155 466 55 55 500 88 359 939 559 1128 662 1120 620 -5 0 1 -5 9 2 -5 0 0 -1 2 3 -4 2 9 270 524 632 394 455 858 770 1011 653 * Reserves held after all adjustments applicable to the reporting period less required reserves and carry-over reserve deficiencies. Daily averages—w eek ended Factor Net changes Jan. 13 Jan. 20 405 239 262 289 7 355 + 589 — 238 — 473 — I ll — 16 - f 228 4 - 207 4- 105 4- ioo — 249 — 135 4-327 — 136 + 134 4 - 61 4 - 24 + 83 — 166 4- 351 4- 312 4- 24 + 521 — 55 + 5 — — 3 — 112 + 1 — 69 — — + 236 » + 177 + 32 — 195 — — 242 4* 4 - 115 + 5 — 244 — 17 — 147 4- 9 4- 49 + 17 — 74 + 4 — 260 + 40 — 301 418 Jan. 6 Jan. 27 “ Market” factors Member bank required reserves*............ Federal Reserve float ............................ Treasury operations! ............................ Gold and foreign acc o u n t.................... Currency outside banks* ...................... Other Federal Reserve accounts (net)$ ...................................... Total “market” factors .................... — + — -f — + + 131 4- 522 — 107 — 1 — 408 — 1,043 54 + 17 — + 27 — 131 4- 232 4 - 1,142 Direct Federal Reserve credit transactions Open market instruments Outright holdings: Government securities ...................... Bankers’ acceptances ........................ Repurchase agreements: Member bank borrowings.......................... Other loans, discounts, and advances... 8 — 36 — 116 — 510 — 73 — 735 — 202 + 235 — 198 — 49 — 214 22,199 21,846 353 30© 44 21,890 21,845 21,257 588 424 164 21,421 21,440 21,050 390 277 113 21,163 21,260 20,919 341 203 138 21,057 Daily average levels of member bank: Total reserves, including vault cash*. . . Free reserves* .............................................. Nonborrowed reserves* .............................. Note: Because of rounding, figures do not necessarily add to totals. * These figures are estimated, t Includes changes in Treasury currency and cash, i Includes assets denominated in foreign currencies. S Average for four weeks ended January 27, 1965. 21.686S 21,268§ 418§ 303§ 115§ 21,3835 sioned by the Treasury’s advance refunding. Banks in the major money centers, particularly those in New York City, were called upon to meet a sizable part of the enlarged fi nancing needs of Government securities dealers at a time when repayments of other loans fell short of normal sea sonal expectations. In such circumstances, the basic reserve deficiencies of these banks rose to very high levels.1 The major money center banks were able, however, to recap ture most of the reserves dispersed outside the money centers through expanded purchases of Federal funds at 4 per cent. System open market operations helped facilitate the increased turnover of money and securities by allow ing marginal reserve availability to remain somewhat greater than had prevailed before the onset of seasonal pressures in December. Thus, although borrowings from the Reserve Banks rose from the low average level of Decem 1 Data on basic reserve positions of these banks—included in this article for the first time — may be found in Table II. A detailed description of these data appeared in the August 1964 issue of the Federal Reserve Bulletin. 30 MONTHLY REVIEW, FEBRUARY 1965 ber, they remained roughly in line with other recent months. The special tensions associated with the refunding abated after January 19, the settlement date for the opera tion. Bank loans to securities dealers contracted sharply as the dealers exchanged the “rights” for the new is sues and delivered securities sold earlier in “when-issued” trading. The basic reserve positions of the major money market banks improved, and member bank borrowing from the Reserve Banks dropped back. Contributing to the more comfortable atmosphere was the release of re serves through a sharper-than-expected decline in deposits at “country” banks. Over the month as a whole, market factors provided $521 million of reserves while System open market opera tions absorbed $453 million. The weekly average of Sys tem outright holdings of Government securities declined by $236 million from the final week in December through the last week in January, and average System holdings of Government securities under repurchase agreements con tracted by $260 million. Average net System holdings of bankers’ acceptances, both outright and under repurchase agreements, rose by $43 million during the period. From Wednesday, December 30, through Wednesday, January 27, System holdings of Government securities maturing in less than one year declined by $40 million, while holdings of issues maturing in more than one year were unchanged. TH E G O V E R N M E N T SE C U R IT IE S M A R K E T During the first half of the month, interest in the market for Government securities focused upon the Treasury’s January advance refunding operation, the terms of which were announced on December 30.2 Demand developed quickly for the refunding issues, and the operation built up momentum as it proceeded. Prices of outstanding obliga tions in the intermediate- and long-term maturity area— where market supplies would be enlarged by the refunding — adjusted downward immediately following the financing announcement but subsequently edged higher. Meanwhile, prices of shorter term securities not involved in the Treas ury’s offering rose as sellers of the refunding rights—the eight note and bond issues eligible for exchange— switched into other issues of comparable maturity. Considerable commercial bank interest also continued for low-coupon discount issues, extending the gains made in December. Participants paused briefly on January 7 to assess the im plications of impending Treasury gold sales to foreign coun 2 For details, see this Review, January 1965, page 7. tries, but an improved tone quickly reappeared following the Treasury’s January 8 warning that the London gold market remained under firm control and that “any specu lation against the basic price of gold would inevitably end on the losing side”. Market activity tapered off somewhat with the closing of the refunding subscription books on January 8, and prices of outstanding notes and bonds fluctuated narrowly in anticipation of the announcement of the outcome of the operation. The very favorable results released on January 12 indicated that public subscribers converted approxi mately $9.0 billion, or almost 41 per cent of their holdings, of the eligible short-term securities into the three longer term bonds offered by the Treasury, and that official ac counts subscribed for $702 million. Subscriptions from all sources totaled $4.4 billion for the new 4 per cent bonds of 1970, $3.1 billion for the new 4V& per cent bonds of 1974, and $2.3 billion for the reopened AVa per cent bonds of 1987-92. The size of the conversion far surpassed the expectations of most observers and was widely interpreted as reflect ing considerable confidence in current interest rate levels, although it was generally realized that the market would take some time to digest the enlarged supply of longer term maturities. Reports that the British trade gap had narrowed considerably in December and the firmer tone of sterling also buoyed the market during subsequent trading sessions. Furthermore, Government securities became relatively more attractive when aggressive under writer bidding for a new Aaa-rated corporate bond issue pushed its reoffering yield to 4.37 per cent, only about 14 basis points above the highest yield then avail able on long-term Government obligations. In this opti mistic setting, prices of notes and bonds generally moved higher from January 13 through January 22. Subsequently, participants interpreted the President’s Budget Message as giving promise that the Treasury’s financing needs would not bear heavily on the capital markets in the coming fiscal year. Nevertheless, prices of coupon issues edged lower over the remainder of the month, partly in reaction to earlier gains and partly because the market focused once more on the balance-of-payments problem and the possible steps that might be taken to deal with it. After the close of business on January 27, the Treasury announced the terms of its routine February refunding operation— an offering of approximately $2.2 billion of 21-month 4 per cent notes, dated February 15, 1965 and maturing on November 15, 1966. The proceeds will be used to redeem in cash a comparable amount of 2% per cent bonds coming due on February 15. Subscription books for the new notes— which were priced at 99.85 to yield FEDERAL RESERVE BANK OF NEW YORK 4.09 per cent—were open for one day, February 1. After the close of business on February 3, the Treasury an nounced that subscriptions for the new notes totaled $10.6 billion of which $2.3 billion was accepted. Subscriptions from various official institutions aggregated $537 million and were allotted in full. Subscriptions from other sources were allotted in full up to $100,000, while larger subscrip tions were subject to a 15 per cent allotment but were assured of a minimum award of $100,000. The Treasury bill market opened the year with a favor able atmosphere. Rates on a few short-dated bills edged higher in the early days of 1965, as banks and corporations sold off securities that had been purchased in the final days of 1964 for year-end statement purposes, but rates on most other issues declined through January 13. Reinvestment demand for bills was widespread from sellers of rights in the Treasury’s refunding operation, and scarcities for some bill issues began to develop. The rate declines, however, were limited by the expectation that bill demand would contract after the refunding, and by the Treasury’s an nouncement on January 6 that it would sell an additional $1% billion of June tax anticipation bills on January 12. (Since banks were permitted to make 50 per cent of their payments for the special issue through credit to Treasury Tax and Loan Accounts, the auction attracted good com mercial bank interest, and an average issuing rate of 3.711 per cent was set.) The January 12 news of the substantial size of the refunding conversion had bullish implications throughout the short-term maturity area, where market sup plies would be reduced. However, the favorable reaction of the bill sector to this news was tempered when the Treas ury revealed on January 13 that it planned to add $100 mil lion of bills to the regular weekly auctions in coming weeks, commencing January 18. The Treasury’s announcement noted that this action would be “helpful in counteracting a technical shortage of shorter term bills in the market, in maintaining international short-term interest rate rela tionships, and in covering some of the Treasury’s remaining first-quarter cash needs”. Against this background, a more cautious tone emerged in the market for outstanding bills around midmonth. To ward the end of the month, increased discussion of this country’s balance-of-payments problem and of the likeli hood of further action to deal with it reinforced the hesitant atmosphere. Bill rates in this latter period edged slightly higher on balance. Demand tapered off while of ferings expanded modestly, particularly in the shorter ma turity areas where scarcities had previously existed. At the last regular weekly auction of the month, held on January 25, average issuing rates were 3.848 per cent for the new three-month issue and 3.946 per cent for the new 31 six-month bill, 2 and 1 basis points lower, respectively, than the average rates at the final weekly auction in December. The January 26 auction of $1 billion of new one-year bills resulted in an average issuing rate of 3.945 per cent, as against a rate of 3.972 per cent on the comparable issue sold a month earlier. The newest outstanding three- and six-month bills closed the month at bid rates of 3.87 per cent and 3.96 per cent, respectively. OTH E R SE C U R IT IE S M A R K E T S Prices of corporate and tax-exempt bonds edged higher in moderately active trading during January. Both sectors were bolstered by indications of a recovery of sterling as well as by the excellent investor response to the Treasury’s advance refunding operation. The continuing light cal endar of scheduled flotations also was a factor in the strong tone of the corporate sector, and substantial commercial bank demand developed during the month in the market for tax-exempts. Underwriters thus bid aggressively for several new corporate and tax-exempt bond issues marketed during the month, and sales from dealers’ shelves were sub stantial. Over the month as a whole, the average yield on Moody’s seasoned Aaa-rated corporate bonds declined by 1 basis point to 4.42 per cent while the average yield on similarly rated tax-exempt bonds fell by 3 basis points to 2.96 per cent. (These indexes are based on only a limited number of issues and therefore do not necessarily reflect market movements fully.) The volume of new corporate bonds publicly floated in January amounted to an estimated $160 million, compared with $305 million in December 1964 and $335 million in January 1964. One large new corporate bond flotation early in the period consisted of $40 million of A-rated sinking fund debentures maturing in 1990. The issue, which will not be refundable for five years, was offered to yield 4.57 per cent and was well received. Later in the month, a $40 million issue of A-rated first mortgage bonds maturing in 1993 was reoffered to yield 4.44 per cent. The bonds, which had no call protection, encountered con siderable investor resistance. New tax-exempt flotations in January totaled about $735 million, as against $975 million in December 1964 and $915 million in January 1964. The Blue List of tax-exempt securities advertised for sale closed the month at $679 million, compared with $693 million on December 31. The largest new taxexempt bond flotation during the period was a $124 mil lion issue of A-rated municipal various-purpose bonds. Reoffered to yield from 2.25 per cent in 1966 to 3.45 per cent in 1995, the bonds were accorded a good investor reception. 32 MONTHLY REVIEW, FEBRUARY 1965 T he Changing Structure of the M oney M ark e t* By R obert Perhaps the most striking characteristic of the perform ance of the money market during the past few years has been the unusual stability of interest rates on a day-to-day and week-to-week basis. During the past two years, in particular, there have been stretches of many weeks in which three-month Treasury bills, for example, moved within as narrow a band as 2 or 3 basis points. A broad view of the market reduction in short-run rate fluctua tions in recent years may be obtained by noting the av erage issuing rates emerging from the weekly auction of three-month Treasury bills over the past several years. As shown in the upper panel of the accompanying chart, the average issuing rate on these bills in successive weekly auctions has gradually but consistently recorded smaller changes since 1960. The average absolute week-to-week change was only 3 and 2 basis points in 1963 and 1964, respectively, compared with average changes of 18 basis points in 1958 and 23 basis points in 1960. What is the explanation for the extraordinary short-run stability of rates in recent years? The most fundamental part of the explanation, I believe, is to be found in the stable behavior of the economy itself. But also of great importance in this connection are certain changes that have emerged in the money market mechanism, and the response of the monetary and debt management authori ties to our persisting balance-of-payments problem in a context of interdependent national money markets. I shall deal with these factors in turn. W. S t o n e I* R ATE F L U C T U A T IO N S A N D TH E B EH A V IO R OF THE ECONOM Y We have experienced, in the nearly four years since early 1961, a generally steady, orderly, and noninflationary rise in economic activity. Business forecasts have alternated from moderately bullish to mildly bearish to more of the same, but no matter how forecasters have behaved, the economy has worked its way more or less steadily upward, generating credit demands that by and large appear to have been attuned to current needs and generating simultaneously a substantial flow of savings. At the same time, monetary policy, both responding to and reinforcing the stable character of the economic ad vance, has been generally stimulative and has remained unchanged for extended periods during the last four years. Moreover, abstracting from the two discount rate in creases over the past eighteen months, the few changes in monetary policy that have occurred have generally taken the form of subtle, delicate shadings that have avoided the setting-off of sharp expectational reactions— and subse quent corrections—in financial markets. The steady economic advance since early 1961 is in sharp contrast to the path of the economy during the pre ceding four years. After reaching a peak in 1957, the economy entered upon the short but sharp recession of 1957-58; that recession, in turn, evolved into the eco nomic spurt of 1958-59; and in 1960 the economy under went another recession, the low point of which was reached in early 1961. Monetary policy changed with the economy during those years, moving to a more stimulative posture in several steps in late 1957 and the first part of * An address delivered at the meeting of the American Finance 1958, then moving in stages toward restraint in late 1958 Association, Chicago, December 29, 1964. and 1959 before turning once again toward a stimulative t Vice President, Federal Reserve Bank of New York, and Manager, System Open Market Account. The views expressed in posture early in 1960. this paper are the responsibility of the author, and do not neces The broad pattern of interest rate behavior in the two sarily represent the views of the Federal Reserve Bank of New periods 1957-60 and 1961-64— quite apart from shortYork or the Federal Open Market Committee. FEDERAL RESERVE BANK OF NEW YORK 33 ISSUING RATES ON THREE-MONTH TREASURY BILLS, 1 9 57 -64 B a s is p o i n t s B a s is p o i n t s S o u r c e : A v e r a g e is s u in g r a t e — F e d e r a l R e s e r v e B u l l e t i n . run, day-to-day, and week-to-week fluctuations— was sig nificantly different, reflecting in large part the marked differences in the behavior of the economy and the asso ciated differences in the course of monetary policy. Thus during 1957-60, three-month Treasury bill rates—to use that rate again as a proxy for short-term rates generally —moved between a low of 0.64 per cent and a high of 4.67 per cent, a range of 403 basis points. (See the lower panel of the chart.) Intermediate- and long-term rates also moved within rather wide limits. In contrast, during the period 1961-64, three-month bills moved between a low of 2.19 per cent and a high of 3.89 per cent, or a range of only 170 basis points;1 and intermediate- and long-term rates also moved within a considerably narrower band than in the earlier period. Given the broad pattern of rate stability during the past few years and the generally stable economic conditions that produced it, there has been considerably less scope for significant short-run fluctuations in rates than form erly, when rapid cyclical change in the economy produced considerable volatility in rate expectations and in demandsupply conditions affecting rates. But while the broad pattern of rate stability associated with the generally stable performance of the economy in recent years is a highly important reason for the relative absence of significant short-run fluctuations in rates, it is by no means a suf ficient reason. Fairly wide short-run fluctuations around a generally stable rate level are easily conceivable, and have occurred in the past. But they have not occurred this time. Why? As suggested earlier, an important part of the answer to this question may be found in some sig nificant structural changes that have occurred, and are still occurring, in the money market mechanism itself. S T R U C T U R A L C H A N G E S IN T H E M O N E Y M A R K E T What I refer to as structural changes in the money market consist essentially of a growth in the kinds of 1 Until the discount rate increase of late November 1964, the money market instruments and the volume of each, and an associated growth in the number and the degree of range had been only 140 basis points. MONTHLY REVIEW, FEBRUARY 1965 34 aggressiveness and sophistication of money market par ticipants. This combination has tended to damp shortrun movements in rates on individual money market in struments relative to changes in rates on other money market paper and also, within the framework of the broad pattern of rate stability associated with the stable per formance of the economy, to damp such fluctuations in all money market rates together as might nevertheless have occurred. I should add that, while some of the market changes discussed below are new, most of them consist of refinements and extensions of earlier practices. What are these changes? THE GROWTH AND DEVELOPMENT OF THE FEDERAL FUNDS The Federal funds market has undergone in re cent years a rapid process of growth that as yet shows little sign of abatement. Currently published data on the transactions of 46 major banks across the country which tend to be the largest participants in the Federal funds market offer a partial glimpse of the volume of funds that passes through that market. Gross purchases and sales of Federal funds by those 46 banks during the eighteen state ment weeks ended in July through October of 1964, for example, averaged about $3.0 billion per day.2 The stagger ing sums that move through the market daily reflect not only the more active, aggressive use of it by large banks, but also the participation of a growing number of medium sized banks and even some relatively small ones. Indeed, several large regional money market banks across the nation have developed arrangements with their “country” correspondent banks under which they acquire and pool the excess reserves of the latter and keep them employed in the Federal funds market.8 The size and efficiency of the funds market have helped make possible some of the highly aggressive and flexible market practices that in turn have tended to damp short term fluctuations in rates on individual money market instruments. One of the more significant of these practices is the use by many bank money position managers of Federal funds and Treasury bills as virtual substitutes in the employment of money at short term. It is not new, of course, for banks with a margin of liquid resources available for investment to put those resources into bills when that rate is attractive relative to the funds rate and m arket. 2 Federal Reserve Bulletin, September 1964, p. 1150, and No vember 1964, p. 1430. 3 This practice has probably been an important factor in pro ducing the generally lower levels of country bank excess reserves that have emerged in the past year or so. into Federal funds when the reverse is true. But the number of banks engaging in this “arbitraging” practice has increased markedly in recent years; and, in particular, there has been a sharp narrowing of the rate differentials that activate such switches of money between bills and Federal funds. To illustrate, a few months ago, when threemonth Treasury bill rates were moving closely above and below the 3.50 per cent level at which the Federal funds rate was almost always to be found, officials of several large banks informed me that it was their practice to move sizable amounts of money out of Treasury bills into sales of Federal funds when the three-month bill rate declined to 3.47 or 3.48 per cent and to pull their money out of the Federal funds market and put it back into the bill market when the latter reached 3.52 or 3.53 per cent.4 Furthermore, any particular bank’s use of the Federal funds and Treasury bill markets in this way is not limited by the amount of its own resources that it may have available. A great many banks will buy Federal funds and imme diately reinvest those funds in bills (and in other outlets, including loans to Government securities dealers) when worthwhile rate differentials appear. This kind of active money management tends to damp short-term fluctuations in Treasury bill rates. The interaction that has developed between the Federal funds and Treasury bill markets is, of course, closest when the funds rate is generally stable— as it is when bank credit demand in relation to reserve availability is such as to put it at the discount rate most of the time. But it should be noted that the relationship between the Federal funds rate and the Treasury bill rate tends to be relatively close even when the funds rate is somewhat below the discount rate, as evidenced particularly by the experience of 1962 and early 1963, when the two rates seldom di verged by much, or for long, despite the fact that the funds rate was most often below the discount rate. While the Treasury bill and Federal funds rates tend to move closely together when the latter is at or somewhat below the discount rate, they have diverged for extended periods when the bill rate was above the discount rate. Under the reserve conditions that tend to prevail at such times, Federal funds are not a reliable source of supply of re sources to carry a bill position— as they generally are under easier reserve conditions. Moreover, the discipline exercised at the “discount window” insures that Federal 4 Costs involved in paper work, deliveries, etc., are such that transactions within the narrow limits indicated here must be of large size to be profitable. Smaller banks engaging in such “arbi trage” activity have somewhat wider limits in mind. FEDERAL RESERVE BANK OF NEW YORK Reserve advances are also not a source of supply that is on call repeatedly. Very recently, some banks have begun to bid for Federal funds at rates above the discount rate, primarily for the purpose of acquiring a larger volume of resources for lending and investing. It is likely that such additional funds as are obtained by individual banks in this way will, in part, be re-loaned to Government se curities dealers, who must, of course, borrow to carry their inventories of securities. If the banks willing to pay above the discount rate for Federal funds should develop fairly reliable sources of supply at that higher rate, it is likely that they will also use such funds to reinvest in bills if the spread in favor of the latter is attractive. This would tend to damp rate fluctuations in bills even when they are trading at levels above the discount rate. THE GROWTH AND DEVELOPMENT OF OTHER MARKET IN Banks and other money market participants have long undertaken “arbitrage” operations in which they have switched money back and forth among the various short-term instruments, and rates on those instru ments have therefore been linked and the markets for them interconnected. In recent years, however, the links have become stronger and the interconnections tighter. The strong urge of a growing list of economic units— banks, corporations, states, and municipalities, to name only the more prominent of them—to keep cash balances fully employed at the maximum return compatible with risk and liquidity considerations has, under the economic con ditions that have obtained in recent years, produced an active demand for a large volume of short-term instru ments and for efficient markets in which they can be traded. And those same economic conditions— and policy efforts to deal with our persisting balance-of-payments problem—have resulted in a larger and larger supply of liquid debt instruments to meet that demand. Thus the aggregate volume of Treasury bills has expanded by 39 per cent to $55 billion since the end of 1960 (the volume held by the public increased by 32 per cent to $47 bil lion). The volume of commercial paper outstanding has grown by 87 per cent to $8.4 billion;5 bankers’ accep tances have grown by 57 per cent to $3.2 billion; short term (within one year) paper of Government agencies has risen by 62 per cent to $7.1 billion; and time cer tificates of deposit, which were relatively small at the end of 1960, have burgeoned to the point where the STRUMENTS. 35 weekly reporting banks alone now have nearly $13 bil lion outstanding. This impressive growth in the volume of money market instruments outstanding, and the rise in the number and level of sophistication of the economic units investing in them, have been accompanied by an increase in the efficiency of the markets in which the instruments are bought and sold— and, in the case of certificates of de posit, by the development of a broad new market. There are, of course, great differences in efficiency among the various markets, but each is more efficient than formerly., Hence, a given volume of any short-term instrument can now move through the market for that instrument with a lesser change in prices and rates than was formerly the case; or, to state the proposition inversely, for a given change in prices and rates, the amount of securities that can be traded is now larger than formerly.6 The growth of market efficiency, in the sense just indicated, has made it possible for market participants who wish to move funds back and forth among the various short-term instru ments in response to shifting rate differentials to do so without encountering the kinds of frictions that would produce unacceptable price changes or undue delays. The result is an increasing volume of such “arbitrage” opera tions among the various market instruments and, of course, a concomitant tendency for short-term rate fluc tuations in each of those instruments to be damped.7 THE SPECIAL CASE OF NEGOTIABLE CERTIFICATES OF DE Since early 1962, banks have had leeway under Regulation Q interest rate ceilings to post rates on time deposits that are more fully competitive with other money market rates than formerly. Given that greater leeway, acceptance of time deposits from virtually all sources, in cluding nonfinancial corporations, and the issuance of negotiable certificates evidencing such deposits have been major factors in producing the accelerated growth in POSIT. 6 It may be noted in this connection that there has occurred a general narrowing of spreads between bid and asked prices in recent years, partly because investors, having become more so phisticated and aggressive, do more “shopping around” in the market, and partly because competition has become intensified with the increase, in the past few years, in the number of dealers in money market instruments. 7 Directly placed commercial paper generally does not move through the market from one holder to another in any direct way. But it does so indirectly. It is common for many finance companies to take their paper back from a buyer before maturity if the buyer so desires. Unless the finance company had excess 5 Paper placed through dealers has risen by 63 per cent to $2.2 cash balances at the time, it would likely issue new paper to an billion, while paper placed directly has increased by 98 per cent other buyer, thus in effect transferring the paper from the first holder to the second. Here the issuer is an intermediary as well. to $6.2 billion. 36 MONTHLY REVIEW, FEBRUARY 1965 commercial bank time deposits since the end of 1961 ;8 in particular, they have been major influences underlying the fact that a significant part of the recent time deposit growth has been in negotiable form. The rapid rate of growth of time deposits, and the development of a sub stantial margin of such deposits that is negotiable, have been accompanied by an increase in the interest sensi tivity of such deposits. This is evidenced not only in the fact that ownership of existing deposits is actively trans ferred through the market from one owner to another as small shifts in rate differentials with other instruments appear; it is also evidenced by the ability of a bank to in crease or decrease its volume of time deposits by very small adjustments in the rate it will pay to acquire such deposits. There have been several cases, for example, in which banks have attracted tens of millions of dollars of time deposits in less than a day merely by shortening by two or three months the maturity of deposits for which they were willing to pay a given nominal rate. Similarly, banks have been able to reduce their time deposits by making very slight downward adjustments in the rates they were willing to pay to renew maturing deposits. The development of the time certificate of deposit, and the fact that banks can increase and decrease their time deposits with small shadings in rate, have significantly in creased the flexibility with which the aggregate stock of money market instruments can expand and contract. The impact on rate fluctuations of this increased flexibility, however, depends on the nature of the factors that moti vate banks to increase or decrease the supply of nego tiable certificates of deposit. Let us assume, for example, that there occurs a given increase in the demand for money market instruments, perhaps in response to an in crease in corporate cash flow. Other things being equal, this increase in demand would exert downward pressure on money market rates. At the lower rate level, there would presumably be some banks willing to issue negoti able certificates of deposit that would not have been pre pared to issue such certificates at higher rates. The in creased demand for money market instruments would thus elicit an increase in the stock of them; and the rate decline involved in the satisfaction of the increased de mand would be less than if that demand converged upon the existing stock of money market instruments (or a less readily expansible stock). In cases of this kind, therefore, the time certificate of deposit has tended to reduce short- run fluctuations in rates in response to changes in demand for money market instruments. The question may be raised whether there is any dif ferent impact on short-run rates when banks undertake to change the level of their negotiable time deposits in response to upward and downward movements in sea sonal loan demand— as many banks do— as an alternative to changing their portfolios of money market instruments. If banks were to rely exclusively on changes in holdings of money market instruments as a response to seasonal changes in loan demand, they would, when faced with a rise in such demand, redistribute short-term instruments through the market to the nonbank sector. The desire of the banks to sell such instruments may be viewed as a reduction in demand for them; and other things being equal, some price decline, and rate increase, would be necessary to effect the redistribution.9 To the extent that banks choose to increase their negotiable time deposits in response to a seasonal rise in loan demand, they increase the supply of money market instruments, and this too in volves some decline in their prices and increase in their rates. But the reduction in demand for such instruments that would have occurred had banks chosen the alterna tive of reducing their short-term portfolios does not, in this case, occur. Therefore, unless one is prepared to make asymmetrical assumptions with respect to the elas ticities of supply and demand for money market instru ments, one may conclude that whether banks choose to meet a seasonal rise in loan demand through liquidating short-term investments or through issuing new time cer tificates of deposit makes little difference in respect of the extent of the rate change associated with the rise in loan demand. To put the point another way, there seems to be no a priori reason for expecting an important difference in rate impact whether the rise in loan demand elicits an increase in the supply of money market instruments or a decrease in the demand for them. To sum up the points made concerning negotiable cer tificates of deposit, the growth and development of these instruments have added an extra dimension of flexibility to the size of the stock of money market paper; and on balance it appears that the negotiable time certificate has tended, in some degree that cannot be quantified, to re duce short-run fluctuations in money market rates.10 9 This, of course, assumes that the central bank does not step in and simply take at going rates all the paper that banks wish 8 Such deposits (excluding interbank deposits) have risen by to sell. 50 per cent over the past three years, compared with 27 per cent 10 All the observations made here in connection with certificates over the preceding three years. Federal Reserve Bulletin, No of deposit apply equally to the recently introduced short-term un secured bank notes. vember 1964, p. 1438. FEDERAL RESERVE BANK OF NEW YORK THE M O NE Y M ARKET A N D THE BALANCE OF PA Y M E N T S There is no need to review here this country’s balanceof-payments problem, nor is it necessary to detail the rapidly developing interconnections between national money markets in a world of convertible currencies. Nor indeed is it necessary to restate the proposition that in such a world differentials in interest rates, and particularly in short-term rates, have an impact on the size and di rection of international capital movements. This has for some years been the conclusion of the monetary and debt management policy makers, and they have taken account of that conclusion in framing and executing their policies. The Treasury has increased the supply of Treasury bills on occasions when bill rates seemed to be moving down ward to levels that would open up significant spreads in favor of money rates abroad. The Federal Reserve, on similar occasions, has sold Treasury bills into the market or, in periods in which reserves were being supplied, has at times provided the reserves through purchases of securi ties other than bills. The 1962 reduction in reserve re quirements was undertaken in good part to make reserves available to the banks without buying short-term securi ties in the open market and exerting direct downward pres sure on short rates. The market, observing these developments, quickly came to try to anticipate the points at which official re sistance would be offered to rate declines. In consequence, the market came increasingly to generate its own resist ance to rate fluctuations in the sense that dealers and other market participants would become more reluctant buyers and would begin to offer their holdings into the market as rates moved downward toward the expected official resistance point; and such offerings of course tended to slow down, and sometimes even reverse, the rate decline that activated them. As rates moved back up, a number of market participants, feeling that the authorities had no wish to see the rise continue substantially beyond the point at which the decline started, would undertake to rebuild their holdings. This pattern of market behavior, based on assumed official attitudes and anticipated actions, has been another major factor in damping short-run fluctuations in rates on money market instruments. It is, of course, true that the concern of policy makers over the balance of payments has caused them to watch the level of short-term rates closely. But it does not follow from this that the concern over short rates has taken or should take the form of holding such rates within the ex ceedingly narrow range in which they have moved. There are at least three reasons why any rate limits the authori 37 ties may have in mind at any point of time should be relatively wide and flexible. The first is that what matters with respect to international capital flows is not the abso lute level of rates in this country but their level relative to rates abroad— and ultimately, whether any given set of relationships between domestic and foreign money rates seems to be producing actual, adverse flows of funds. Secondly, fluctuations of some reasonable magnitude are desirable in a market that is performing an important eco nomic function— as the money market does in facilitating the policy actions of the authorities and the immense volume of transfers of money and debt instruments from one holder to another that is generated by the economy daily. Given an awareness of the extent to which short term fluctuations in money market rates have been damped by the factors outlined earlier, policy makers have had no desire to suppress within even narrower limits such short-term fluctuations as might naturally occur. The third reason why any rate limits that policy makers may have in mind should be rather wide and flexible is that the behavior of rates has been a helpful, although by no means an infallible, indicator of developing cyclical eco nomic change. It would obviously be possible for a sharp expansion or contraction of bank reserves and the money supply to occur while rates were being officially pinned to some rigid upper or lower limit. Given the authorities’ awareness of this fact, there has been no desire to put up fences that would prevent a movement in short rates asso ciated with an emerging cyclical change in the economy from showing through. C O N C LU D IN G C O M M E N T S Three major factors have been cited as limiting the amplitude of short-run fluctuations in money market rates during recent years: the remarkably stable character of the economic expansion and the concomitant moderate growth of credit demands and persisting large flows of savings, the further growth and development of the market mechanism itself, and the response of policy makers to the problem of short-term capital flows (and of the market to the policy makers) in a context of interdependent na tional money markets. It would be quite futile to attempt to assign any precise weights to these factors according to their order of importance in the damping of short-run rate fluctuations. I think it is clear, however, as I indicated at the outset, that the first—the stability of the economy itself—is fundamental. As for the second and third, it is hard to say which has had the greater influence in damping short-run rate fluctuations. Suffice it to say that both are important. However one may judge the question of relative im 38 MONTHLY REVIEW, FEBRUARY 1965 portance among the factors discussed earlier— and judg sonal, or purely random causes, would tend to be damped ments will differ widely—I think it can be said that the by the market mechanism itself, which obviously has no changes that have occurred in the money market in recent way of distinguishing among such causes. Moreover, if years have made the performance of that market an in the rate movement nevertheless proceeded further, it might creasingly useful indicator of developing cyclical change be damped by official action. But this does not vitiate the in the economy. Broadly construed, the money market’s point that the performance of the money market has be essential role is to provide the machinery through which come an increasingly useful indicator of emerging cyclical those seeking to acquire cash balances can obtain them change in the economy. If the rate movement in question in exchange for short-term obligations and through which were a response to purely random or seasonal changes in those seeking to employ cash balances can do so in return demand for cash balances, the movement would soon be for such obligations. Demands for cash balances by many reversed without official action, or in response to some thousands of economic units emerge from the economic modest dose of such action. A rate movement associated process daily; supplies of cash balances temporarily in with a cyclical change in demand for cash balances, how excess of the needs of thousands of other economic units ever, would not be quickly reversed. Rates would stub also develop daily. The machinery of the money market bornly persist in pressing against, or perhaps break out passes enormous amounts — measuring several billions of, the upper or lower limit of the band that the market each day— of these cash balances from those who have had regarded as acceptable to policy makers. And, if the them to those who want them, and it does so with ex authorities themselves then offered resistance, the cyclical traordinary efficiency. That machinery is now used by a pressure being exerted on rates would be reflected else very large number and variety of important economic where— in more-than-seasonal changes in nonborrowed units; and this large and growing list of market partici reserves and the central bank’s portfolio, or in quick pants is actively engaged not only in keeping cash balances changes in the aggregate of Treasury bills outstanding as fully employed but, consistent with risk and liquidity the Treasury moved, perhaps in the weekly bill auctions, considerations, in keeping each dollar employed at maxi to increase or decrease the supply of bills. Thus the mum yield by streams of “arbitrage” operations. With tendency for short-term rate fluctuations to be substan the market’s reach now extending broadly and deeply into tially damped would not prevent cyclical rate pressures every sector of the economy, any cyclical change in the from rather quickly exerting visible effects, which could economy’s demand for cash balances would be reflected be taken into account in framing subsequent policy ac in the market in a stubborn tendency for short-term rates tions. Indeed, it can be argued that, with the market to move; and this tendency would, I think, show through mechanism itself largely damping short-run rate fluctua more quickly than formerly, when the market was less tions, a tendency for rates to move for cyclical reasons well developed in the sense that it was used by a lesser would show through more clearly than ever, since it would number and variety of economic units, who were employ not, in nearly the same degree or for such extended pe ing their cash balances in a less active and sophisticated riods as earlier, be entangled with and obscured by the way. It is of course recognized that any movement in wide fluctuations that formerly occurred in response to short-term rates, whether stemming from cyclical, sea purely seasonal and random influences.
