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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



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,


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


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
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-



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.


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.



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
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).
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



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 .


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


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.

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



C h art I



Per cent

Per cent


4.60 ■



December 30,1964



September 30,1964





3.40 -


3.20 .









J___ __ __
! I L
_ _



l_ l
10 1 12 13 14 15 32 34 36 38

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.


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 C R ED IT, M O N E Y S U P P L Y ,

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



C h a r t II

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


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




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 .




^x\Free reserves
SosNxv i



Net borrowed reserves




^ o r r o w 'n ss a t


®a n ^ s


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






P e rc e n t

P e rc e n t




-^maturing in 1-5 y e a rs t




Treasury securities m a t u r in g ^ \\


in less than 1 y e a r




Loans to brokers and dealers

















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).


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 .



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.

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

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



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
In millions of dollars
Daily averages week ended
Factors affecting basic reserve positions

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




46 — 11











-6 9 1

-9 7 6

-9 2 0

— 526

-7 7 8









Thirty-eight banks outside New York City

G ross p u rc h a se s ......................................
Gross s a le s ..................................................

Table T


Eight banks In New York City

Reserve excess or deficiency (—) * .....
Less borrowings from Reserve Banks
Less net interbank Federal funds pur­
chases or sales (—) ...............................



four weeks
Jan. 2 7

Net loans to Government securities
dealers ....................................................









-5 0 1

-5 9 2

-5 0 0

-1 2 3

-4 2 9








* Reserves held after all adjustments applicable to the reporting period less
required reserves and carry-over reserve deficiencies.

Daily averages—w eek ended





+ 589
— 238
— 473
— I ll
— 16
- f 228

4 - 207
4- 105
4- ioo
— 249
— 135

— 136

+ 134

4 - 61

4 - 24



— 166

4- 351

4- 312

4- 24



— 55

— 3

— 112

— 69



+ 177
+ 32
— 195

— 242
4 - 115

— 244
— 17
— 147
4- 9

4- 49
+ 17
— 74

— 260
— 301




“ 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 ....................


+ 131 4- 522
— 107 —
— 408 — 1,043
+ 17 —
+ 27 — 131
4- 232 4 - 1,142

Direct Federal Reserve credit

Open market instruments
Outright holdings:
Government securities ......................
Bankers’ acceptances ........................
Repurchase agreements:
Member bank borrowings..........................
Other loans, discounts, and advances...


— 36

— 116

— 510

— 73



— 202

+ 235

— 198

— 49







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.


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.



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.

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


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


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.

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



T he Changing Structure of the M oney M ark e t*

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.


S t o n e I*


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.



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.

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.



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 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.


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.

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


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

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

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.



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.



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


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.

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



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.