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2 MONTHLY REVIEW, JANUARY 1970 Th e Business Situation Recent business statistics have continued to indicate some slowing in the economy’s rate of growth, although continued strength is expected in some key sectors. Industrial production has declined in each month since July, and residential construction activity has fallen since the beginning of 1969, In addition, consumer buying has been sluggish, and November retail sales were little changed from the levels of last spring. The price picture, however, shows no real slowing in rates of increase, and recent wage settlements are bound to result in significant boosts in unit wage costs. The outlook for the economy is rather mixed. Housing has been under downward pressure as a result of tight financing conditions, and auto production schedules have been cut back. Nevertheless, enactment of the tax reform bill, which includes a cut in the surcharge rate from 10 percent to 5 percent for the first six months of 1970 and elimination of the surcharge thereafter as well as an increase in social security benefits, will have a strongly stimulative influence on consumer income. Fur thermore, most recent capital spending surveys point to rapid increases in plant and equipment purchases well into 1970. PRODUCTION AND CONSTRUCTION The Federal Reserve Board’s index of industrial pro duction declined in November for the fourth consecutive month, dropping by 1.2 percent to a seasonally adjusted level of 171.1 percent of the 1957-59 average. This was the largest monthly decline since the 1960 recession, but approximately one half of the November fall was attribut able to the strike of about 150,000 workers at the General Electric Corporation. The cumulative decrease in output from the July peak amounts to about 2 percent, approx imately the same percentage decline that had occurred in the first quarter of the 1967 mini-recession. The General Electric strike had its major impact in the business equipment sector, where output fell in November after expanding at an annual rate of almost 7 percent in the first ten months of 1969. In view of the strength of near-term capital spending plans, however, growth of out put in this sector could well return to a rapid pace after settlement of the strike. After edging down from July to October, the production of materials registered a sizable decline in November. This largely reflected reductions in output of electronic components (General Electric) and auto parts included in the materials index. Iron and steel output, which grew rapidly in the first half of 1969, has remained about constant at the level it fell to in August. While seasonally adjusted data on steel ingot production indicate that output in December was up slightly, iron and steel industry observers say that production may soon be cut in response to reduced demand from the auto sector. Consumer goods output fell 0.7 percent in November chiefly because of a large drop in the output of automotive products. Several major auto producers cut overtime and shut down for several days in order to reduce inventories. On a unit basis, car assemblies dropped off sharply from a seasonally adjusted annual rate of 8.4 million in October to 7.9 million in November. Moreover, General Motors and Chrysler had additional shutdowns in December, and total domestic auto assemblies on a seasonally adjusted basis declined further to 7.2 million units. First-quarter 1970 production schedules of these two producers have also been cut back. The General Electric strike was an other important factor in the November decline of con sumer goods production. Residential construction has been under severe down ward pressure, as mortgage market conditions have be come steadily tighter. Private nonfarm housing starts in November at 1.27 million housing units, on a seasonally adjusted annual basis, were almost 15 percent below the 1968 average. Starts in all types of housing and in all re gions except the South decreased in that month. The short-term outlook is for continued downward pressure on the residential construction sector. The number of newly 3 FEDERAL RESERVE BANK OF NEW YORK issued local building permits for private housing units has dropped at about the same percentage rate as actual housing starts: the November level was almost 14 percent below the 1968 average; in addition, the dollar value of residential construction contracts, as reported by F. W. Dodge, dropped in November and the average level from June to November was 10 percent below the average in the first half of 1969. However, the increase in the legal ceil ing rate on mortgages insured by the Federal Housing Authority and those guaranteed by the Veterans Admin istration from IV i percent to 8 Vi percent, combined with a large backlog of unutilized building permits, may have a favorable effect on housing starts in the forty states that do not have legal maximum interest rates applicable to Government-backed mortgages. Chart i INVENTORY-SALES RATIOS Months of sales; seasonally adjusted ORDERS, INVENTORY ACCUMULATION, AND CAPITAL SPENDING New orders received by manufacturers of durable goods have, on the average, been trending upward, although during 1969 the growth rate was somewhat less rapid than in 1967 and 1968. Moreover, since prices have risen substantially, the 1969 increase in the volume of orders in real terms has been considerably less than the in crease in dollar volume. In November the orders series fell $0.7 billion despite an increase of $0.3 billion in defense bookings. Monthly figures are often volatile, but Novem ber declines were widespread, with electrical machinery, auto, and primary metals manufacturers experiencing exceptionally large reductions in the inflow of orders. Although total business inventories have been rising at rates which appear pretty much in line with total sales growth, this has not been true for all sectors (see Chart I). In October, total manufacturing and trade in ventories advanced $1.4 billion, with both manufacturing and retail levels continuing their rapid rates of accumula tion. At the manufacturing level, there was a sizable in crease in sales and the inventory-sales ratio registered a slight decline. November data on the manufacturing sec tor, however, indicate that sales fell 1 percent entirely because of a decline in durables shipments. Meanwhile, inventories rose $450 million, again all in the durables category, and the inventories-sales ratio increased but re mained well within the range of recent years. Moreover, at the wholesale level, inventory accumulation has been negligible and the inventory-sales ratio has been relatively low lately. Data for retail stores in recent months, how ever, suggest some imbalance between inventories and sales. For both durables and nondurables retailers, inven tories since the summer have been greater, relative to Note: The ratios for wholesale and retail are plotted through October. The ratio for total manufacturing is plotted through November. Source: United States Department of Commerce, Bureau of the Census. sales, than in the past few years. In the auto industry, where sales have been particularly weak, dealers’ stocks have been rising at a fast pace since July, and the inventory-sales ratio for other durables is higher than at the beginning of 1969. At retail outlets for nondurable goods the October surge in sales caused a fairly signifi cant drop in the inventory-sales ratio, but the ratio still suggests the existence of surplus inventories. Despite falling profits and exceptionally tight conditions in money and capital markets, businessmen are currently undertaking and planning for enormous amounts of plant and equipment investment. The Department of Commerce and the Securities and Exchange Commission revised up ward their estimate of fourth-quarter plant and equipment expenditures, and an increase from the third quarter is now indicated rather than the leveling expected earlier. Ac cording to this estimate, plant and equipment spending in 1969 was $71.3 billion, 11.2 percent above the 1968 rate. Furthermore, as the end of 1969 approached, suc cessive surveys of capital spending have tended to forecast increasingly higher plant and equipment outlays for 1970 (see Chart II). In August, the McGraw-Hill survey pro 4 MONTHLY REVIEW, JANUARY 1970 jected 1970 expenditures of $74.9 billion. Lionel D. Edie & Co., Inc. estimated, in September, that 1970 expenditures would average $75.5 billion. In October, the McGrawHill fall survey reported business plant and equipment purchases of $76.7 billion for 1970, and in December the latest Commerce-SEC survey projected $78.1 billion for 1970, a 9.7 percent increase over the 1968 level. An earlier Commerce-SEC report indicated that growth in the first half of 1970 would be particularly strong. While some of the increase in expenditures will undoubtedly be absorbed by the higher prices that are anticipated, this estimate never theless implies that plant and equipment purchases in real terms will be substantially above the boom levels of 1969. According to McGraw-Hill, the advance in real spending reflects businessmen’s desires to cut steeply rising unit production costs by modernization as well as their carry over of some unfulfilled 1969 plans into 1970. Of course, not all sectors are planning equally large expenditure in creases. Commerce-SEC indicated that it was the non- Chart II ACTUAL AND ANTICIPATED PLANT AND EQUIPMENT SPENDING Billions of d ollars Billions of dollars The November Commerce-SEC survey indicated that most of the growth is slated for the first half of the year rather than being spent evenly throughout the year as shown in this chart. Sources: United States Department of Commerce, Securities and Exchange Commission, McGraw-Hill, Inc., and Lionel D. Edie & Co., Inc. manufacturing sector that was planning a more rapid expansion, with public utilities— currently under severe capacity constraints— planning a 15 percent annual jump in plant and equipment expenditures. In the manufactur ing sector, purchases are expected to rise at a slower rate than they did in 1969, but record-level investment spend ing will still be undertaken. While manufacturers appear to have ample capacity, they report expectations of fast demand growth in 1970 and thereafter. EMPLOYMENT, PERSONAS. INCOME, AND RETAIL. SALES Although the unemployment rate in November and December at 3.4 percent was close to record-low levels, other indicators suggest some easing in labor market conditions. In November the percentage of covered per sons receiving unemployment insurance benefits rose and the index of help-wanted advertising fell. The decline in average hours worked also suggests eased conditions: the average workweek for factory workers fell 0.3 hours to 40.5 hours in October and edged up slightly in Decem ber, while overtime hours in November were down for the second consecutive month. Furthermore, according to the payroll survey, employment has been growing more slowly in recent months. Nonagricultural employment, which was increasing at the fast rate of 238,000 persons per month during the first half of the year, has been rising by only 57,000 persons per month since June. Personal income has been growing at a considerably slower rate in recent months, reflecting major work stoppages as well as easier labor market conditions and declining corporate profits. In the first half of 1969, personal income increased at an annual rate of 8 V2 percent, whereas since June the rate has been about 6 V2 percent. During November the General Electric strike reduced incomes by $1 billion and the net rise in total personal income was only $3.2 billion. However, even after adjustment for the effects of the strike, there appears to have been some slowing of the growth rate in OctoberNovember. Lately wage and salary income increases, in particular, have moderated, as gains in the number of payroll jobs have become smaller and the average work week has fallen. Another indication of slowing in the economy is the volume of retail sales, which has shown no significant change since the spring. Sales rose 1 percent in October, then declined a bit to $29.5 billion in November, a level only about V2 percent above that registered in the spring. Since December 1968, dollar volume has increased only 4.2 percent, less than the 5 percent rise in consumer goods FEDERAL RESERVE BANK OF NEW YORK prices. While the dollar volume of nondurables sales was about constant in November, durables sales turned down, with almost all the decline attributable to a fall in auto motive group sales. On a seasonally adjusted annual basis, domestic new car sales were 8.3 million units in November, down from 8.4 million in October, and the data show a further decline in new car sales to 7.7 million units in December. Preliminary December data for total retail sales indicate little change from November. The outlook for consumer demand is unclear. While the Michigan Sur vey Research Center reported the third consecutive quar terly decline in the index of consumer sentiment, the new tax and social security provisions will certainly bolster con sumer income and perhaps also consumer eagerness to buy. Despite the current slowing of economic expansion, prices have continued to increase rapidly at both con sumer and wholesale levels. Consumer price rises have been excessively large, averaging 6.0 percent (annual rate) in 1969 through November as compared with 4.7 percent in 1968 and 3.1 percent in 1967. There appears to be no real slowing of price increases, although some comparisons may suggest a moderation. From June to November, the consumer price index has risen at an aver age annual rate of 5.5 percent, lower than the 6.3 percent rate experienced in the first half of 1969. The average 5 annual rate of price increase in the last six months for which data are available (May through November), how ever, is about the same as in the first five months of 1969. Moreover, consumer prices were rising at a 6.5 percent rate in November. At the wholesale level, also, recent price advances have been large. Wholesale industrial prices rose at a 4.2 percent annual rate in December, resulting in an average annual rate of change in prices of 4.9 percent during the fourth quarter of 1969. The overall rise in 1969 was 4.0 percent, compared with 2.6 percent in 1968 and 1.8 percent in 1967. Meanwhile, rising wages and lagging productivity con tinue to put upward pressure on prices. In the manufac turing sector, labor cost per man-hour rose at an annual rate of almost 4 percent in November, while output per man-hour fell 4 percent; hence, the labor cost of producing a unit of output increased at an annual rate of 8 percent. Rapid rises in the labor cost of production have been common in recent months: from June to November, unit labor cost in manufacturing increased at a rate of 7 per cent, compared with only 2 percent in the first half of 1969. Moreover, recent and prospective large wage settle ments will undoubtedly result in a significant rise of unit labor costs in 1970. 6 MONTHLY REVIEW, JANUARY 1970 Th e Money and Bond Markets in December The pressure of monetary restraint continued to be felt subsequent new offerings, and these also met with success in the money and bond markets during December, when ful receptions. The rally subsided after about a week, and interest rates on many instruments climbed to record highs. yields once more began to rise. Rates did not reach the Quotes on prime four- to six-month dealer-placed paper levels set in the early part of the month, however, and were and ninety-day bankers’ acceptances rose % percentage again trending downward as December closed. In the taxpoint, and rates on most maturities of directly placed com exempt market, successively new record yields occurred mercial paper also advanced. The effective rate on Federal through midmonth, after which a somewhat better tone funds averaged 8.9 percent, up from its 8.7 percent level emerged that reflected in part the minimal supply of new in November, but net borrowed reserves declined somewhat offerings scheduled during the holiday period. during December. Following a brief rally in the first week of December, BANK RESERVES AND THE MONEY MARKET prices of long-term Governments fell sharply and broke through the previous record lows established the month Money market conditions remained firm during Decem before. Prices wrere also down on most other Treasury ber though no undue pressures resulted from the quarterly notes and bonds, but these remained above the low levels corporate tax payment date. Over the month as a whole reached in early October until unexpectedly heavy selling the effective rate on Federal funds averaged 8.9 percent, for tax losses developed throughout the Government bond somewhat above the 8.7 percent level in November. Trad market on December 29. Despite a rebound on the suc ing in Federal funds displayed the usual pattern of a ceeding two days, several of the high-coupon issues with buildup in rate at the start of each week, as money center intermediate maturities closed the month below their banks bid aggressively, and a decline at the close when October lows. The price declines on long-term issues in reserve pressures were reduced somewhat (see Chart I ). December were generally IYlq to 23 points, while most Daily average excess reserves of member banks increased A intermediate-term issues were down 1 to 2% points. The by $22 million, to $259 million, while borrowings at the only price rises among coupon issues during the month discount window wrere reduced by $87 million. As a re sult, nationwide net borrowed reserves averaged $867 were on maturities within eight months. The Treasury bill market also came under fire during million in December (see Table I ) , $108 million less than December, largely as a result of restrained investor interest in the preceding month. and a sizable amount of selling pressure which was par Both the eight New York City banks and the thirtyticularly intense toward the close of the month. The aver eight money center banks outside New York experienced age issuing rates on new three-, six-, and nine-month bills a deterioration in their basic reserve positions over the reached all-time highs during the period, climbing to 8.096, month, and the deficit of the forty-six together totaled 8.101, and 7.801 percent, respectively. Over the month as $4.9 billion at the end of December (see Chart II). The a whole, yields on Treasury bills generally increased by 8 deterioration was only partly seasonal and, to a large extent, reflected a sizable year-end increase in loans and to 58 basis points. On December 2 a triple A-rated corporate issue was investments outstanding. Despite a rise in United States Government and private priced to yield investors a record 9.10 percent, and the de bentures were not only a rapid sellout but also apparently demand deposits, the average basic deficit at the eight New sparked an interest in other new and outstanding issues. York City banks climbed by $766 million in the week ended Within two days underwriters began to raise prices on on December 3, as net loans to dealers increased some FEDERAL RESERVE RANK OF NEW YORK 7 Chart I SELECTED INTEREST RATES Percent M O N E Y M A RKET RATES O c to b e r N ovem ber O ctober-D ecem h er 1 969 D e ce m b e r B O N D M A RKET Y IE L D S O c to b e r N ovem ber Percent D e cem b er Note. Data ore rhown for business d ays only. M O N EY MARKET RATES Q U O TED : Bid rates for three-month Euro -d o llars in London; offering rates for directly p lace d fin an ce com p an y paper; the effective rate on Fed eral funds (the rate most representative of the transactions executed); closing bid rates (quoted in terms of rate of discount) on newest outstanding three-month and o ne-year Treasury bills. BO N D M ARKET YIELDS Q UO TED: Yield s on new A o a - and A a -ra te d p ublic utility bonds (arrows point from underw riting syndicate reoffering yield on a give n issue to market yield on the sam e issue im m ediately after it has been released from syndicate restrictions); $400 million and other loans and investments grew by about $750 million on average. A further deepening of the basic deficit at these banks occurred in the following week (see Table II), when the Treasury and private de mand depositors ran down their balances by substantial amounts while loans and investments remained at a high level. There was progressive improvement in the basic position of the eight New York City banks during the two weeks ended on December 17 and December 24, resulting chiefly from renewed inflows of United States Government and private demand deposits which more than offset the rising level of loans and investments. In the final statement week, however, the basic deficit of these banks increased despite an average inflow of al d a ily a v erage s of yields on seasoned A a a -ra te d corporate bon d s; daily a v erage s of y ie ld s on lo n g -term Governm ent; securities (bonds due or c a lla b le in ten years or more) and on G overnm ent securities due in three to five ye a rs , computed on the b asis of closing bid prices; Thursday a v erage s of yie ld s on twenty seasoned twenty-ye a r ta x -e x e m pt bonds (carrying M o ody’s ratin gs of A a a , A a , A , and Baa). Sources: Federal Reserve Bank of New York, Board of G overno rs of the Fed eral Reserve System, M oody’s Investors Service, and The W e e kly Bend Buyer. most $1.7 billion in private demand deposits. The worsen ing resulted from declines in all other liability items com bined with increases in all asset categories. Over the month as a whole the deterioration in the basic position of the New York City banks amounted to $891 million. In contrast to the pattern in New York City, the thirtyeight other money center banks did not increase their loans and investments until the middle of December when quarterly corporate tax payments came due. Nonetheless, their basic deficit showed a continued worsening until the final week of the month. Factors affecting the basic position varied from week to week, but over the month as a whole the primary sources of the deterioration were the increase in loans and investments, a decline in their Euro 8 MONTHLY REVIEW, JANUARY 1970 dollar holdings, and a rise in required reserves. System open market operations provided $632 million in reserves on a daily average basis during December pri marily through outright transactions and repurchase agree ments (see Table I). Market operating factors provided reserves totaling $536 million on a daily average basis, largely the result of an increase in float. A rise in required reserves, however, more than offset this supply of reserves from operating transactions. The money supply expanded at a seasonally adjusted annual rate of 1.8 percent in December, according to pre liminary data, following a rise of 1.2 percent in November. Over the fourth quarter as a whole the money supply grew at a rate of 1.2 percent, and at a rate of 2.5 percent for the year 1969. Total member bank deposits subject to reserve requirements and including Euro-dollar liabilities (the adjusted bank credit proxy) declined at a seasonally adjusted rate of 1.2 percent in December, resulting in a 0.3 percent contraction at an annual rate from the end of the third quarter. For the year as a whole the adjusted bank credit proxy fell by 1.7 percent. Chart II BASIC RESERVE POSITION OF MAJOR MONEY MARKET BANKS B illio n s of d o llars Billio n s of d o llars 1969 -5 O ctober Novem ber Decem ber Note: Calculation of the b asic reserve position is illustrated in Table II. THE GOVERNMENT SECURITIES MARKET Yields moved further upward in most sectors of the market for United States Treasury issues during Decem ber. Prices on long-term bonds fell to record lows, and rates on newly auctioned three-, six-, and nine-month bills climbed to all-time highs. Over the month as a whole, yields increased on all Treasury securities except short term coupon issues. The market was buffeted by a number of forces, however, and the upward pressure on yields was not unrelenting. During the first week of December, long-term Treasury bonds rose in price by as much as 2%2 in a spillover from the rally which developed in the market for corporate bonds. Notes and bonds with shorter maturities also showed some improvement at the start of the month. How ever, prices deteriorated after statements by Federal Re serve governors concerning the need for continued tight monetary policy as well as the unenthusiastic reception given a Federal National Mortgage Association offering. The market for Treasury notes and bonds underwent price declines in the early part of the next two weeks, establishing record lows for long-term bonds, but rallied at the close of each period. In the week ended on De cember 12 the market turned sharply lower, at first largely in reaction to selling pressures and to a state ment by Governor Robertson that tighter and more pain ful controls might be required in order to curb inflation. Announcement of another Federal agency offering and investor switching from Government securities into cor porates contributed further to the price declines. Toward the close of the week, however, some improvement occurred as a result of professional short covering and the report of a large rise in business inventories during Octo ber. Prices again declined in the early days of the week ended on December 19 in response to slackened investor interest and a resurgence of selling pressures from dealers and investors alike. A favorable interpretation of re marks by Chairman-appointee Burns, together with lessened seasonal tax-selling pressures and the report of a drop in orders for durable goods during November, brought about price rises as the week drew to a close. On balance, however, prices of notes and bonds were lower over the two-week period ended on December 19. Prices of coupon issues registered further declines dur ing the Christmas holiday week in quiet dealer trading with little investment demand. Then, on December 29, prices fell sharply in response to sizable, last-minute tax selling associated in part with changes in the Tax Reform Act awaiting the President’s signature. In the wake of the selling, most coupon issues fell to new lows, though a con- 9 FEDERAL RESERVE BANK OF NEW YORK Table I Table II FACTORS T E N D IN G TO INCREASE OR D ECREASE MEMBER BA N K RESERVES, DECEM BER 1969 RESERVE POSITIONS OF M AJOR RESERVE CITY BA NK S DECEM BER 1969 In millions o f dollars; (+ ) denotes increase (—) decrease in excess reserves In millions of dollars Daily averages—week ended on 17 Dec. 24 31 ! 4- 71 42 — 4— — — — 427 — 188 — 3 — 1 — 105 19S 118 136 16 135 — 135 — 25 — 498 — 151 — 434 444— — 4 -3 1 1 4 - 66 610 357 209 4 - 559 — 261 46 — 333 11 226 4 - 281 4- 95 + 377 4 - 176 — 546 44— — -f — 4 - 536 4-1,250 — 356 — 41 — 679 480 399 165 20 120 4- 4 - 144 — 698 66 — 360 Reserve excess or deficiency (— )* ............................. Less borrowings from Reserve Banks ............................... Less net interbank Federal funds purchases or sales (—■■).. Gross purchases ........................ Gross s a l e s .................... .. Equals net basic reserve surplus or deficit ( — ) ......... .. N et loans to Government securities dealers .................... .. N et carry-over, excess or deficit ( — ) t .................................... — 209 — 219 + 402 4 - 172 — 204 — 106 4- + 6 + 4- + 4- 3 — 2 + 259 + + — 6 4 - 10 46 5 9 14 8 30 1 — 81 — 12 — 11 4 - 51 4- 7 + 6 — 156 93 12 102 59 266 293 164 296 319 268 1,065 2,065 1,000 1,528 2,231 703 1,394 2,392 998 974 2,071 1,098 1,242 2,204 961 1,241 2,193 952 — 1,334 — 1,730 — 1,465 — 1,258 — 1,459 —1,449 822 6SS 516 679 768 670 17 16 58 30 31 4 - 286 — — outside N ew York Ctty ! 4- 632 19 4- 245 1 4- ii 4 -2 1 5 I - f 33 4 - 58 4 - 10 4 - 266 4- 39 471 — 103 ! — 30 I ! 1 + 197 + 577 90 162 ! i I 4 — sf — Reserve excess or deficiency (— )* ............................. Less borrowings from Reserve Banks ............................... Less net interbank Federal funds purchases or sales (— ) , . Gross purchases ........................ Gross s a l e s ................................. .. Equals net basic reserve surplus or deficit (— ) ................ Net loans to Government securities dealers ....................... Net carry-over, excess or deficit (— ) f .................................... — 6 — 2 40 — 60 — 9 21 — 307 264 297 356 334 312 2,397 4,424 2,028 2,864 4,850 1,987 3,140 5,017 1,877 3,576 5,067 1,491 3,076 4,895 1,819 3,011 4,851 1,840 — 2,706 —3,122 —3,477 — 3,993 — 3,419 — 3,343 269 121 97 60 128 135 5 23 28 1 61 ! 24 ! .......................................... + 563 4 - 203 — 375 — 158 4 - 296 | 4 - 529 Excess reserves .......................... -j- 65 4- — 199 4 - 219 4 - 230 -f Total Dec. 31 Eight banks in N ew York City Direct Federal Reserve c re d it transactions Open market operations (subtotal) Outright holdings: Government s e c u r it ie s ......... Bankers’ acceptances . . . . . Repurchase agreements: Government s e c u r it ie s ___ _ Bankers’ acceptances ......... Federal agency obligation?!. Member bank borrowings -------Other loans, discounts, and advances ............................................ Dec. 24 Dec. 17 Dec. 1 Total "m arket” factors___ Dec. 10 f “ Market” factors Member bank required reserves ............................................... Operating transactions (subtotal) ........................................ F ederal Reserve float ............. Treasury operations* . . . ----Gold and foreign account----Currency outside banka . . . . . Other Federal Reserve accounts ( n e t)t ........................ Dec. 3 Dec. 10 Dec. 3 Net changes F actors Dec. Average of five weeks ended on Dec. 31 Factors affecting basic reserve positions Changes in daily averages— week ended on 52 367 N o te: Because of rounding, figures do not necessarily add to totals. * Reserves held after all adjustm ents applicable to the reporting period reserves, t Not reflected in data above. required Daily average levels Member bank: Total reserves, including vault cash ........................................ Required reserves ...................... Excess reserves ............................... Borrowings ..................................... Free, or net borrowed (— ), reserves ..................................... .. Nonborrowed reserves .................. N et carry-over, excess or deficit (— )§ ................................... Table i i i 27,737 27,534 203 1,191 27,747 27,492 255 1,199 27,982 27,926 56 1,043 27,890 27,615 275 1,094 28,666 28,161 505 1,104 28,004? 27,746$ 2591: 1,126* — 988 26,546 — 944 26,548 — 987 26,939 — 819 26,796 — 599 27,562 — 867$ 26,878* 90 114 165 92 176 127* In percent Weekly auction dates— December 1969 Maturities Dec. 1 Three-m onth. S ix -m o n th .. . . Changes in Wednesday levels System Account holdings of Government securities maturing in: Less than one year .................... More than one year .................... Total ........................................ Dec. 8 Dec. 15 Dec. 19 Dec. 29 7.453 7.613 7.702 7.803 7.920 7.922 7.804 7.815 8.096 8.101 Monthly auction dates— October-December 1969 4-1,124 — 679 ~ + 1 ,1 2 4 4 -4 3 1 — — 679 4 - 431 4- 25 — 455 — 4- N o te : Because of rounding, figures do not necessarily add to totals. # Includes changes in Treasury currency and cash, t Includes assets denom inated In foreign currencies. % Average for fire weeks ended on December 31, 1909. § Not reflected in data above. in AVERAGE ISSU IN G RATES* AT R EGULAR TREASURY BILL AUCTIONS 4- 446 28 25 — 455 Nov. 25 Dec. 23 7.244 7.127 7.778 7.592 7.801 Oct. — 4 - 446 N in e-m on th .............................................. O n e-y ea r.................................................... 7.561 f Interest rates on bills are quoted in term s of a 360-day year, w ith the discounts from par as the return on th 8 face am ount of the b ills payable at m aturity. Bond yield equivalents, related to the am ount actually invested, would be slightly higher. 10 MONTHLY REVIEW, JANUARY 1970 siderable recouping occurred on the final two days of the month. Improved retail interest in the bill market and optimistic press reports combined to extend the late-November rally into early December. At the weekly auction on Decem ber 1 the average issuing rates on new three- and sixmonth bills were down 2 and 41 basis points, respectively, from their highs set on November 24. The improvement was short-lived, however, and rates on most bills increased from 3 to 16 basis points over the week. Factors con tributing to the weaker tone included some foreign ac count selling and attempts by dealers to pare their inventories in anticipation of the return of a large supply of bills under corporate repurchase agreements on the December 10 dividend date. There was sizable corporate demand for bills with December maturities, though, and these issues registered gains during the first week of the month. At the next two weekly auctions on December 8 and December 15, record rates were set on the new issues of three-month bills. Rates on the six-month bills also rose (see Table III), though they remained below the 8.027 percent high set on November 24. Additional foreign account selling emerged during this period, and the market also reacted negatively to Governor Robertson’s remarks. There was a temporary improvement in bill rates toward the end of the week of December 12, when some commer cial banks and state and local governments became purchasers and reinvestment demand from holders of maturing Government bonds also emerged. The rally was brief, however, and the market resumed its decline fol lowing the weekend. The weaker tone continued until good investor interest emerged on December 18, and par ticipants also interpreted Dr. Bums’ testimony in an optimistic light. Average issuing rates declined on both the three- and six-month bills in the auction held on Friday, December 19, giving a further lift to the market. Over the following holiday-shortened week, bill rates moved irregularly higher, as reinvestment demand from maturing tax anticipation bills proved somewhat disap pointing and the market faced the monthly auction. At this auction held on Tuesday, December 23, the average issu ing rate on the new nine-month bills was set at a record 7.801 percent but the rate on the new twelve-month bills was slightly below the high established in November (see Table III). Rates on outstanding bills edged upward over the remainder of the week, and then rose sharply following the weekend when substantial investor selling developed. Reflecting the pressures in the market, average issuing rates on the new three- and six-month bills jumped 29 basis points on December 29 from the previous auction and reached all-time highs. The higher bill rates attracted sub stantial investor interest, and rates improved at the close of the month. OTHER SECURITIES MARKETS The corporate bond market was still in the doldrums at the start of December and, when three slow-moving re cent issues were released from price restrictions, the up ward yield adjustments ranged as high as 40 basis points. On December 2, Pacific Telephone and Telegraph Company marketed $150 million of Aaa-rated debentures at a yield of 9.10 percent, the first Aaa-rated issue ever to reach a 9 percent level. The debentures quickly sold out on the first day. Small investors were the chief buyers of these bonds, which have five-year call protection, but some institutions also evinced interest in this offering. Crossing the 9 percent mark was apparently the stimulus that the market needed at the time, and the resulting rally extended into the succeeding week. Immediately following the tele phone offering, record returns were also made available on lower rated issues, and underwriters were able to move these quickly as well. By December 4, underwriters began to price new issues more aggressively and investor recep tion remained quite favorable. Thus, a double A-rated issue priced to yield 8.825 percent was about 90 percent sold on the first day. The rally in corporate bonds soon ended, with investor resistance to a new utility issue developing on December 10. Several public statements concerning the tenacity of in flationary pressures contributed to the cautious market tone which continued into the week of December 19. Postponements of some scheduled offerings occurred dur ing this period, and yields on the new issues which were marketed rose though they remained below the highs of early December. The corporate bond market registered some gains following Dr. Bums’ testimony on Decem ber 18, and showed some additional modest improvement over the remainder of the month when activity was very light and no additional issues of any consequence were marketed. Rates on tax-exempt bonds rose steadily over the first half of the month. Several new A-rated issues were priced to yield well over 7 percent, and a triple A-rated offering provided a record 6.60 percent return. The Weekly Bond Buyer's index of the average yield on twenty municipal bonds rose from 6.58 percent on November 27 to a new high of 6.90 percent on December 18. Once again there were a number of postponements, due to statutory interestrate ceilings and voluntary withdrawals, as this market experienced the effects of sizable tax selling and the con FEDERAL RESERVE RANK OF NEW YORK tinuing low level of commercial bank participation. More over, in the short-term tax-exempt area, the Department of Housing and Urban Development had to pay more than $900,000 in placement fees to underwriters in order to sell $317.9 million of local renewal project notes for which the bids exceeded the 6 percent interest ceiling. An additional $1.7 million was sold within the ceiling, result ing in an effective cost including the subsidy of about 6.45 percent. A month earlier the cost had been 5.49 percent for similar notes, which needed no subsidy. The tone of the municipal bond market improved con siderably after midmonth, however, and on December 18 a $125 million issue of State of Pennsylvania bonds was aggressively bid for and oversubscribed by investors. The 5.90 to 7.25 percent yield on the $75 million Aa-rated portion of these serial bonds was estimated to be, on aver age, some 20 basis points higher than the previous record on a comparable offering earlier in the month. However, the yields on the remaining $50 million portion rated A -l were lower than those on a similarly rated issue a week before. Reflecting the better market tone, the Bond 11 Buyer's index for December 24 declined for the first time in seven weeks to 6.79 percent, a drop of 11 basis points over the week, and remained at tills level on December 31. PERSPECTIVE ’69 Each January this Bank publishes Perspective, a brief, informative review of the performance of the economy during the preceding year. This booklet is a layman’s guide to the economic highlights of the year. A more comprehensive treatment is presented in our Annual Report, available in March. Perspective9 is available without charge from the 69 Public Information Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, N.Y. 10045. 12 MONTHLY REVIEW, JANUARY 1970 Money Creation in the Euro-Dollar M arket — A Note on Professor Friedman’s Views By F red H. Approximately a dozen years have passed since a few European banks began making a market for dollardenominated deposits, which came to be called the Euro dollar market. In that short time the market has attained a size of substantially more than $30 billion and has become the major channel for international short-term capital move ments. The market’s emergence and rapid expansion have fascinated many observers of the international financial scene, and a large number of analytical studies on its origins, evolution, and functioning have been published in recent years. Yet the market remains shrouded in mystery. As Federal Reserve Board Chairman Martin remarked not long ago, we do not fully understand the “wiring” of the Euro-dollar market. This is not entirely surprising. By any standard the market, though sophisticated, is still quite young. Its growth has been too recent to permit a full grasp of its workings. Moreover, governments and central banks have not yet developed the comprehensive statistical system required for a complete understanding of the intri cate linkages between the market and the flow of interna tional funds. While much is being done to fill data gaps, we remain ignorant of many aspects related to the ultimate origin and end use of funds handled by the market. This absence of basic data has given rise to many misunder standings about its workings. These misconceptions and many unresolved questions about the nature of the market are now catching the attention of some prominent members of the academic profession. Several have recently tried to supply ex planations of what the Euro-dollar market is all about. One of the latest efforts comes from a leading authority on money matters, Professor Milton Friedman of the University of Chicago. In a recent paper,1 he states that ♦Manager, International Research Department, Federal Reserve Bank of New York. 1 “The Euro-Dollar Market: Some First Principles”, The Morgan Guaranty Survey (October 1969), page 4ff. K lo pst o c k * the “market is the latest example of the mystifying quality of money creation to even the most sophisticated bankers, let alone other businessmen”, and notes that it is “almost complete nonsense” to explain the source of Euro-dollar deposits by pointing mainly to United States balance-ofpayments deficits, past and present. Euro-dollars, he says, are created in the same way as American banks’ deposit liabilities— “their major source is a bookkeeper’s pen”. He identifies the key to understanding the Euro-dollar market as the fact that “Euro-dollar institutions are part of a frac tional reserve banking system”, very much like Chicago banks. According to Professor Friedman, the failure to recognize “the magic of fractional reserve banking” is the chief source of misunderstanding about the Euro-dollar market. Many of Professor Friedman’s propositions confuse what is possible with what has happened in fact. Although in theory credit and deposit creation in the United States banking and Euro-dollar systems might be postulated to be similar, in actual practice the forces behind monetary expansion in the two systems differ in many important respects. In Professor Friedman’s exposition these differ ences are passed over lightly or not mentioned at all. Metaphors such as “the magic of fractional reserve bank ing” and deposit creation by “a bookkeeper’s pen”, though perhaps useful as expository devices for explaining mul tiple credit and deposit creation in the United States bank ing system, do not enhance our understanding of monetary processes in the Euro-dollar market. Applying the standard textbook treatment of credit and deposit creation to the Euro-dollar system is, of course, tempting. The lenders in the Euro-dollar market are commercial banks and like any system of banks should be capable of multiple credit and deposit expansion. But upon reflection it is apparent that Euro-banks (as we will call banks participating in the Euro-dollar market) bear a much closer resemblance to such financial intermediaries as savings and loan associations. Like these intermediaries, Euro-banks as a group can expect only a small fraction of their loans and investments to return to them as deposits; FEDERAL RESERVE BANK OF NEW YORK the deposit leakage from Euro-banks, as from nonbank intermediaries, is massive, while leaks from the American commercial banking system in the form of increases in the nonbank public’s holdings of coin and currency are quite limited and fairly predictable. Although Professor Friedman seems to recognize this in principle, he persists in suggesting that a “bookkeeper’s pen” is the major source of Euro-dollars as it is of the liabilities of United States banks. One might say that, because of the very large deposit leakages from the Euro-dollar system, the fountain pens of bookkeepers employed by Euro-banks run out of ink very quickly. It is evident that an explanation for the phenomenal rise of Euro-dollar liabilities must lie in monetary processes other than deposit creation in, and by, the Euro-dollar system. What then specifically are the differences between the deposit expansion processes in the United States banking and Euro-dollar systems? Perhaps the most important difference is this: When an American bank— say, in Chicago— acquires dollars and uses the resulting excess reserves to make new loans, the loan proceeds typically wind up in deposits in other American banks, while it acquires in its turn some of the deposits generated by loans made by other banks. But, when Euro-dollars are loaned by a Euro-bank, the loan proceeds rarely show up as deposits in other Euro-banks. In the United States, as borrowers disburse loan proceeds, the recipients have virtu ally no choice (and actually no desire) but to redeposit them in the same or another American bank which, as a result of the attendant reserve gains, may find itself in a position to make additional loans and investments. The banks’ ability and willingness to expand their asset port folios depend, of course, also on the public’s demand for bank deposits and on asset yields. Yet, in general, net reserve injections into the United States banking system tend to result in successive additions to outstanding bank credit though at a diminishing scale because each bank, as it obtains additional deposits, must retain some portion of its corresponding reserve gains in its required reserves. The distinguishing characteristic of United States banks is that, taken together, they do not lose cash reserves as they expand their outstanding credit and deposits, except to the modest extent that recipients of funds choose to add to their currency holdings rather than to redeposit these funds in their own bank accounts. Euro-banks as a group, on the other hand, cannot count on recapturing more than a relatively small fraction of their loan proceeds. As Euro-dollar borrowers spend the loan proceeds, the banks participating in the market, taken together, tend to lose most of the dollar balances employed in loan extensions. This becomes immediately n evident if we look at a typical asset portfolio of a Euro bank. Currently, a very large and often dominant portion of the assets of Euro-banks consists of deposits with United States banks’ overseas branches which pass most of the funds on to their head offices. Deposits taken on by the branches for this purpose are rarely returned to the Euro-dollar market, because the head offices of American banks and their borrowers employ virtually all these funds in the United States. Another sizable portion of a typical Euro-bank’s asset portfolio consists of dollar deposit placements in other foreign banks, including banks in Latin America and Asia, which bid for these funds to finance various busi ness transactions. For the most part, these banks utilize Euro-dollar credit lines for financing their customers’ payments obligations to the United States and third countries, the loan disbursements in both cases being typically credited to accounts in American rather than in Euro-banks. To an indeterminate extent, the banks sell the dollars to obtain those currencies that their customers re quire. But, even if the loans are denominated in dollars, the borrowers or their payees often sell the loan proceeds in the foreign exchange market in exchange for local or thirdcountry currencies. Few, if any, of the proceeds of such credits are redeposited by the borrowing banks or their clients in the Euro-dollar market. The same observation applies to the funds underlying other components of Euro-banks’ asset portfolios, such as loans and investments denominated in the banks’ own or third currencies. Euro-dollars borrowed for use in foreign currency loan markets or for financing investments in local money markets generally do not reappear in Euro-bank accounts unless the purchaser is one of the central banks that regularly shift reserve gains to the Euro-dollar market. One major characteristic of Euro-dollar banking for which there is no ready analogy in the American bank ing system is that balances placed in the market are con tinuously funneled into the foreign exchange market. It is true that in virtually all Euro-banks’ asset portfolios there are loans to European borrowers of the type described by Professor Friedman. In his article, he uses the example of a dollar loan by a London bank to a firm, called U.K. Ltd., which employs the loan proceeds to purchase timber from Russia. Suppose, says Professor Friedman, “Russia wished to hold the proceeds as a dollar deposit” in another bank in London. This could occur if Russia’s foreign trade bank acquires these dollars from the timber exporter and then deposits them with one of its London correspondent banks. Similarly, foreign central banks may acquire Euro-dollar loan proceeds in the foreign exchange market and redeposit them in the 14 MONTHLY REVIEW, JANUARY 1970 Eurodollar market. On occasion, notably during specula tive upheavals, some central banks have been known to purchase sizable balances originating in the Euro-dollar market and to reroute them through their own banking systems into the market. However, these and other examples of recaptures by Euro-banks of Euro-dollar loan proceeds are no more than exceptions to the general rule that in the aggregate only a small fraction of Euro-bank loan proceeds find their way to other Euro-banks. A full understanding of the difference between the deposit expansion processes of the two systems hinges on the fact that deposit liabilities of American banks serve as the principal means of payment while those of Euro-banks do not. Few Euro-banks provide dollar checking facilities. Only a small proportion of Euro-bank deposits consists of call and overnight deposits. Although these latter resemble demand deposits, their principal function is to provide their owners, virtually all banks, with quickly realizable reserves on which to fall back if they have to make unexpected dol lar payments at American banks. Call and overnight de posits held in Euro-banks by nonbanks are quite small. In fact, most of the deposit liabilities of Euro-banks are vis-a-vis other banks rather than nonbanks. Many Euro banks are essentially time deposit intermediaries in inter bank deposit markets. Liabilities of the Chicago banks in Professor Fried man’s example, on the other hand, consist for the most part of the public’s demand deposits, of which the major function is to serve as a means of payment. Individuals, corporations, financial institutions resident in Chicago, and innumerable out-of-town banks as well as Federal, state, and local government units find it convenient or even necessary to maintain demand deposit accounts with Chicago banks and to hold continuously adequate mini mum balances. No similarly compelling reasons for maintaining deposit accounts in Euro-banks exist for in dividuals and corporations abroad, let alone banks. Since its demand deposit liabilities serve as a means of payment and to compensate banks for a variety of ser vices, the LJnited States banking system in the aggregate may expect that the deposits created as it expands credit will stay in the system— again excepting some drain into coin and currency holdings of the nonbank public. The size of the American banking system may well remain stable even if the public should prefer to shift deposits to savings banks, savings and loan associations, or other nonbank financial intermediaries which merely rechannel such de posits when acquiring investments and making loans. Euro-banks in the aggregate, on the other hand, can expect no more than a modest rise in their deposit liabili ties as a result of their dollar loans and must rely on offering more attractive terms to holders of liquid assets than are available elsewhere if they wish to expand their dollar liabilities. United States banks, while by no means immune to the public’s preferences regarding the form in which it wishes to hold its assets, are much less dependent for deposit growth on the terms and conditions of the depository facilities that they offer to the public. Both United States banks and Euro-banks incur deposit liabilities which are a multiple of their cash reserves. In this sense, both systems engage in fractional reserve bank ing, as pointed out by Professor Friedman. But this char acteristic is common to all financial intermediaries, whether United States commercial banks, savings banks, life insurance companies, or Euro-banks. These institu tions convert all but a small part of the funds they receive into earning assets. Consequently, their cash reserves are only a fraction of their liabilities. This fact alone does not explain the striking differences in their credit-creating powers. Keeping fractional cash reserves is not the same as engaging in multiple credit expansion. The major question raised by Professor Friedman that still remains to be explained is how Euro-banks— notwith standing their inability to recapture as additional deposits more than a small fraction of the proceeds of their loans and investments— have been able to generate in fairly short order very impressive increases in their dollar liabili ties. The obvious answer is: By offering more attractive investment facilities and interest rates than provided by money markets and financial institutions in the United States and elsewhere, Euro-banks have been able to divert to themselves the local-currency cash reserves of in numerable banks and nonbanks in many parts of the world. Indeed, in recent years they have drained huge balances from major foreign money and loan markets. In addition, several central banks have for reasons of do mestic and international monetary policy placed large parts of their monetary reserves in Euro-banks. As foreign banks and nonbanks convert their own cur rencies into dollars in order to be able to make deposits with Euro-banks, and as central banks place monetary reserves in the market, they draw on dollars currently or previously accumulated abroad in consequence of our balance-of-payments deficits. In this particular sense, those who argue that the source of Euro-dollar deposits is “partly U.S. balance-of-payments deficits” and “partly dol lar reserves of non-U.S. central banks” are correct. This argument is valid in another sense: much of the liquidity of banks and nonbanks that has found a haven in the Euro-dollar market can be directly traced to balanceof-payments surpluses abroad, which are a counterpart of our deficits. This is also true of the reserve gains that FEDERAL RESERVE BANK OF NEW YORK a growing number of central banks are depositing in Euro banks. Other central banks, as they have accumulated dollar balances far in excess of amounts they desire to hold, have shifted these excess reserves to the Euro dollar market through sales of dollar balances at advan tageous swap rates. The buyers have been their own com mercial banks which have employed these funds for de posit and loan operations in the Euro-dollar market. In all these cases, a close relationship exists between our balance- of-payments deficits and additional Euro-dollar deposits. In summary, the traditional expository devices used in analyzing monetary processes in the United States are ill suited for the task of explaining monetary expansion in the Euro-dollar market. The sources, purposes, and func tions of dollar deposits in Chicago banks and Euro-banks have little in common. Dollars deposited in the Euro dollar market are, except for a small proportion, created by American banks rather than Euro-banks. Subscriptions to the m o n t h l y r e v i e w are available to the public without charge. Additional copies of any issue may be obtained from the Public Information Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, N.Y. 10045. 15
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