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FEDERAL RESERVE
BANK

OF MEW Y®MK

MONTHLY R E V I E W
MAY

1976

Contents
Our Changing Financial System
An Address by Richard A . Debs ................

119

The Strategy of Monetary C ontrol ................

124

The Business Situation .....................................

136

The Money and Bond Markets in A p ril .........

141

FEDERAL RESERVE BANK OF NEW YORK

119

Our Changing Financial System
By R i c h a r d A. D e b s
First Vice President and Chief Administrative Officer
Federal Reserve Bank of New York

A n address to the eighteenth Annual Forecasting Conference of the
New York Chapter of the American Statistical Association in
New York City on April 30,1976

The topic for this session— our changing financial sys
tem— is most timely. Of course, it might be said that it
would be timely at any point in our history. Change is
always with us, and our financial system has always
been changing— more or less. But there are periods when
change in some areas of our lives and institutions is more
rapid, more pervasive, more forceful, than at other times,
and it seems to me that our financial system is now and
has been in the midst of such a period.
These changes, and the problems and prospects they
have created, have been the subject of a good deal of pub
lic attention in recent months. There is no doubt that the
attention is warranted and that there should be concern
about the future course of change in the financial system.
Perhaps what is not as well recognized, however, is
that where we are today is the result of a profound, but
subtle, process of change that began at least ten years ago.
More recently, national and international economic de
velopments of the last few years have had a particularly
strong impact on our financial system. Only by under
standing these changes in their longer perspective can we
assess the implications of our present state of affairs for
the future.
Anyone looking back over the period of the 1960’s
cannot fail to be impressed by the rapidity of the growth
of the banking industry during these years and the speed
and scope of the banking innovations that were introduced.
The incentives for such growth, change, and experimen
tation are not hard to identify. The expansion of world
wide production and trade required increased financial
services. Even more significant were the gathering forces

of inflation, fueled in part by rising levels of governmental
expenditures. Those inflationary pressures greatly magni
fied the underlying demand for bank credit.
Further, during these same years, the level of financial
sophistication of bank customers advanced considerably.
On one side, corporate treasurers— spurred by rising
interest rates and competitive pressures— developed more
sophisticated techniques in the utilization of bank services.
On the other, consumers increased their demands for
financial services and astute bankers recognized that con
sumer finance was a vast and growing market.
In the face of expanding demand for financial services,
the concept of liability management gradually took hold
among many of the nation’s banks. With traditional
sources of deposits past their peak of growth, these insti
tutions turned to new instruments, new sources of funds,
and new approaches to money management. The nego
tiable certificate of deposit provided banks with a
marketable instrument to compete for interest-sensitive
funds at fixed maturities tailored to specific investor needs.
Federal funds activity swelled, as the nation’s large banks
sought to mobilize and put to work idle pockets of cash
that were available throughout the country. The Euro
currency markets, with their huge pools of dollars accu
mulated in part from United States payments deficits,
were viewed as a viable source of liquidity.
It was only natural, with the increasing internationaliza
tion of world production and markets, especially the
growth of United States multinational corporations, that
United States banks would become increasingly interna
tional minded in their operations. United States banks

120

MONTHLY REVIEW, MAY 1976

developed sources of funds abroad, actively sought the of debt or equity, that the securities industry had con
overseas business of firms they served at home, and ex sidered its own province since the passage of the Glasspanded their lending to foreign firms and governments. Steagall Act.
They greatly expanded their networks of foreign branches
In many respects, the new dynamic posture of banking
and subsidiaries, forging new links with the Euro-dollar was a positive development. It engendered increased flexi
and foreign currency markets. At the same time, foreign bility in our banking system, helping to ensure that
banks responded, though to a lesser degree, to the attrac financial resources would be allocated efficiently over a
tion of opportunities in the United States.
wide range of economic and financial activities. But I
While these developments were rooted in the expanding think it is also fair to say that the expansive philosophy
financial needs of the world economy, the response of our on the part of a number of banks during the 1960’s
major banking institutions also began to be influenced by reflected an overexuberance born of an inflationary
certain attitudes that were relatively new to banking. The psychology that should have been recognized as unsus
rapid growth of the banking industry was accompanied tainable. In many cases, inflation helped to bail out both
by the accession to managerial authority of a new breed lenders and investors who, in earlier times, would have
of banker. Often these were individuals, trained in modern had to pay a price for the inefficiencies and cost overruns
business management methods, who were willing to ex of those they financed. From this point of view, one of
periment aggressively to improve the profit performance the most pernicious aspects of the inflation was the num
of their organizations and who, for better or worse, had ber of apparent success stories it created and the lure it
no personal exposure to the banking traumas of the set out for expansion plans that might best have been left
1930’s. Moreover, these changes and experiments occurred in the drawer.
at a time when the bank regulatory atmosphere was con
Most bankers recognized that rapid expansion would
ducive to expansion and wider competition.
greatly increase demands on the managerial skills and
The combination of expanding markets, a more aggres financial resources of their organizations. Many of those
sive bank management philosophy, and generally accom that became active in liability management, therefore,
modative regulation during the 1960’s sparked a new sought to develop expertise in money management. Those
dynamism in banking, as banking organizations expanded that engaged in the more specialized forms of finance
both their markets and their products. Banks were faced such as factoring, leasing, and foreign exchange lending
with increased competition from the commercial paper and trading sought experts in those fields. Many of our
market, which provided a direct channel for short-term nation’s large banking organizations established staffs of
borrowing and investment by nationally known firms. In economic and financial experts to aid in management
this environment, banks ventured further into term lend decisions. And, while these changes met some of the new
ing. Perceiving expanded possibilities for lucrative lending demands that expansion placed on bank management,
in real estate, many bankers enlarged their real estate they also contributed to overconfidence. They fostered
activities, some by sponsoring REITs or otherwise form the expectation that the timing and depth of economic
ing relationships with these rapidly growing, new financial reverses could be anticipated accurately and that neces
intermediaries. Seeking new opportunities to diversify, sary remedial measures could be taken in time to avert
the more aggressive banking institutions formed one-bank severe damage. Yet, as the 1960’s came to a close and
holding companies which, until the 1970 Bank Holding inflation began to outrun even the most pessimistic fore
Company Act Amendments, were not subject to the re casts of a few years earlier, it seems clear, in retrospect,
quirements of Federal bank holding company laws.
that the expansionary wave of the prior ten years was
As the bank holding company movement took hold, beginning to impose strains on bank liquidity, capital,
the possibilities were soon recognized for expansion into and management that could not go on indefinitely.
such financially related fields as consumer and commer
Inflation also hurt other members of the financial com
cial finance, equipment leasing, and mortgage banking. munity and the investing public. The thrift industry, which
These activities could be pursued by nonbank affiliates became increasingly exposed to disintermediation as in
without the geographic limitations that apply to commer terest rates soared, sought relief through wider deposit
cial banking. The momentum of expansionary forces and lending powers. The securities industry underwent up
introduced added competition to a number of areas of heaval, as antiquated back-office facilities collapsed and
finance. Moreover, it has carried banks to the outer edge inadequate capital forced retrenchment or merger for
of activities, such as automatic investment and dividend several well-known firms. Insurance company portfolios
reinvestment plans, private placements, and syndications declined in value, as sharply higher interest rates exacted

FEDERAL RESERVE BANK OF NEW YORK

a heavy toll of both stock and bond prices. The investing
public, including many individuals that could ill-afford it,
suffered substantial losses from investments in common
stock that they had hoped would provide better protection
against inflation than fixed-dollar claims such as bonds or
life insurance.
As we entered the 1970’s, our financial system began
to be buffeted by a succession of shocks and strains that
few observers would have thought possible in so short a
span of time. In 1970, the Penn Central crisis seriously
disrupted the commercial paper market and unsettled our
financial system. In 1973, the failure of the United States
National Bank of San Diego, followed shortly afterward
by a forced merger of the Beverly Hills National Bank,
was a disturbing sign. Then, in 1974, the failure of the
Franklin National Bank dealt a heavy blow to confidence
in our financial system. The failure of the Herstatt Bank
in Germany at around the same time suggested that bank
ing difficulties had infected the international markets.
Meanwhile, the $20 billion United States REIT industry,
which was heavily indebted to banks, began to sustain
large losses and was soon on the brink of collapse. And
the drastic jump in oil prices threatened major, adverse
economic and financial consequences. All of these events
raised serious doubts about the ability of the free world’s
financial institutions to continue to function effectively.
It must be remembered, too, that this very adverse se
quence of events struck our economy and financial sys
tem at a time when accelerating inflation and then reces
sion were having a pervasive and profoundly negative
effect on economic activity both at home and abroad.
Many borrowers, especially those in the real estate indus
try, were severely hurt by increases in production costs
and soaring interest rates, as well as energy scarcities—
all of which served to undermine the economic foundations
of their ventures. It is no wonder that the quality of bank
credit deteriorated throughout the nation. And, I might
add, more recently the crisis in New York municipal fi
nance caused new and unforeseen pressures for our bank
ing system.
That the financial difficulties did not culminate in an
even more severe economic setback than we had is
a tribute to the effectiveness of our built-in stabilizers in
cushioning the impact of recession. It also speaks well for
the monetary and fiscal measures that were taken to end
the decline as swiftly as possible. The responsible actions
of bankers to avoid a cascade of customer failures sig
nificantly contributed to economic and financial stability.
It seems clear to me that the shocks and strains of the
past few years have constituted the most serious threat
to domestic and international financial stability we have

121

experienced in a long time. But I also think it would be
a mistake to use these difficulties either to generalize about
weaknesses in our nation’s banking institutions or as evi
dence of a need for radical changes in our financial sys
tem. It should be recognized, first of all, that our financial
institutions have proved to be extraordinarily resilient
and durable. The number of banking failures has been
quite small, and the consequences of each have been kept
within reasonable bounds. Overall, our banking institu
tions have held up well despite the nation’s recent steep
slide into recession.
It is true, of course, that the past few years have seen
some serious problems emerge for the United States bank
ing industry, problems that merit the careful attention of
both bank supervisors and the banking industry. Infla
tion and recession have created many more problem
loans in our banking system than would be healthy for
the long run. Yet, in viewing the credit situation at banks
across the nation, we believe that the problems are far
from insurmountable and many, if not most, of them are
on the way to being resolved. In my view, the banking
industry has reacted responsibly and constructively to get
its problem loans on the right track. I feel reasonably sure
that efforts to work out problem loans will keep the losses
to a minimum that is well within the capacity of our
banking system to absorb.
I believe that many bankers have gained a deeper un
derstanding of the circumstances and decisions that led
to the present state of events. The extremely difficult few
years we have just come through represent an important
watershed for bankers. The extravagances and excesses
of earlier years have left a deep impression, and I doubt
that those mistakes will soon be forgotten.
Nonetheless, it is understandable that the Congress, the
public, and the bank regulatory agencies should scrutinize
and take stock of our present position to determine what,
if any, structural or regulatory changes may be desirable
in our banking system as we approach the 1980’s. Several
proposals for change have already been brought before
the Congress. One thrust of those proposals is to assist
the thrift industry by expanding its powers, thus eliminat
ing many of the present differences between the powers
of banks and thrift institutions. In my personal view, a
change of this type might be desirable. However, any such
change should be approached gradually and phased in
over time, so as to minimize the transitional effects, while
at the same time ensuring that management attention is
not diverted from the pressing current problems of work
ing out the difficulties that have developed over the past
several years. Some proposals would revise the role and
structure of the Federal Reserve System to reduce its inde

122

MONTHLY REVIEW, MAY 1976

pendence from the day-to-day pressures of the political
arena. I think that there are serious risks to our economy
in making monetary policy susceptible to recurring politi
cal pressure. It seems to me that far-reaching changes
should not be made without a searching appraisal of their
impact on our financial system and economy.
There are, fortunately, many promising signs today of
economic recovery. We should not overreact to our prob
lems and saddle our nation’s banking system with new
adjustment burdens while recovery is still under way. Our
financial institutions, thanks in part to the protective leg
islation enacted during the 1930’s, have stood the test
of the recent past. We can and should afford ourselves the
opportunity to probe and analyze the soft spots in our
financial system and to implement considered changes
based on convincing evidence of need.
I would like to turn now to an issue that has been the
subject of intense interest on the part of investors and
the general public in the past few months. That is the
disclosure of confidential information concerning the fi
nancial position of certain of our nation’s major banks
and the ongoing reporting of bank financial information
that hitherto has been unavailable. There is, I might say,
a certain irony in the attention focused recently by the
press on a relatively few “problem” banks at a time when
the peak intensity of the difficulty had already passed.
It is no accident that many temporary difficulties have
been resolved without shock to public confidence. In ap
proaching the question of financial reform, I would hope
that we would avoid the kind of oversensitivity to bank
ing problems that could work to discourage unduly the
vital function of risk taking by banks. To do so would
rob our national economy of the venture capital that is
essential for the enlargement of our productive potential
and the growth of our job markets.
Yet, we fully understand and appreciate a legitimate
need for insight by the public into the current and pro
spective financial condition of our nation’s banking insti
tutions. We believe the public is entitled to relevant, upto-date information on the financial condition of banks
and bank holding companies. However, I think these
needs will be met through the very considerable increase
which is now being made in the frequency and degree of
detail in the regular bank and bank holding company re
ports that must be provided to the bank regulatory agen
cies and the public. There is a substantial job to be done
in evaluating how this information can best be employed
to appraise the financial condition of banks and bank
holding companies. In the meantime, I think it would be
advisable to move cautiously with respect to new require
ments or procedures for the reporting by banks of finan

cial information. There have recently been growing pres
sures in the accounting field to require banks to make
substantial loss provisions in connection with certain
types of loans that have been revised, restructured, or
exchanged for underlying assets to ease financial pressure
on the borrowers, in many cases to improve the prospects
for repayment. I would hope that these accounting ap
proaches are subjected to wide discussion before any hard
and fast rules are established.
I believe the lessons of the financial storms of the
past few years suggest how we ought to revise and im
prove our financial system. I think most bankers would
agree that a strengthening of bank capital, liquidity, and
earnings should get top priority as we approach the
1980’s, and it is already evident that progress is being
made in these areas. The resolution of difficulties at in
dividual institutions is getting prompt attention. Retrench
ment and regrouping to strengthen bank management and
financial positions seem to be in progress throughout the
banking industry, as we would expect during a period of
slack demand for loans.
Bankers will face a dilemma, however, as the economy
picks up momentum and the demand for credit increases.
A new acceleration in the rate of bank growth could
bring with it a renewed stretching of bank capital and
liquidity. Commercial banks, I think, must balance their
expansion plans against tightened standards of financial
prudence. There will need to be explicit recognition that
there are limits on the extent to which expanding loan
demand can be financed through increased dependence
on interest-sensitive funds and that a new upsurge in
loans requires growth of capital in a balanced manner.
The strategy and tactics of the renewed commercial bank
expansion that may lie ahead should include a careful
appraisal of dividend policies and plans for infusions of
capital through new issues of stock and subordinated debt.
It seems to me that a much tougher stance by bankers
with respect to loan commitments and other contingent
liabilities will be in order, despite customer demands for
accommodation.
I think the last few years suggest that it may pay in the
long run to pass up some opportunities for expansion or
short-term profits in order to avoid undue additional risks.
This will not be easy to do, especially if competitive pres
sures increase. For example, powerful new competition in
banking could be expected to emerge from the granting
of checking powers to thrift institutions throughout the
nation. Even if the thrift industry does not obtain check
ing powers, electronic payments technology will probably
erode whatever remains of the traditional distinctions be
tween demand and savings accounts.

FEDERAL RESERVE BANK OF NEW YORK

In an environment in which the traditional boundaries
for banking functions become blurred, it would be natural
for banks to attempt to maintain their forward momentum
by further expanding and diversifying into new markets,
new products, and new technologies. Yet, the limits on
expansion and diversification for an industry in which the
public has so large a stake must be given careful study in
light of the consequent demands on management and the
necessary supporting resources. I would question the wis
dom of most new incursions into nonbanking areas where
banks have little knowledge or expertise and certainly
into financial areas where past incursions have brought
grief, such as the securities activities of the 1920’s.
Bank supervisors have an important job of assisting in
the development of realistic and widely acceptable stan
dards that can be used to evaluate bank capital, liquidity,
and overall risk. Wide agreement on those standards will
help banks to avoid the danger zone of excessive risk.
Bank supervisors also have a responsibility to assist the
Congress in developing a means for measuring supervisory
performance. This is not an easy task. For example, effec
tive supervision does not necessarily mean the preserva
tion of all financial institutions whatever the circumstances.
It seems clear to me that good supervisory performance
should not be measured primarily by the extent to which
bank failures are prevented. If there were no failures over
a period of years, it could mean that banks were not
serving the needs of business firms and consumers.
We certainly do not want to constrain banking organi
zations to the point of preventing them from providing
for the vital credit needs of our economy. This means
that banks should be expected to have an improved
capacity for measuring and managing risk. And we should

123

be prepared to tolerate some bank failures or consolida
tions in cases where bank management persistently has
proved ineffective and the damage is too great to repair.
At the same time, widespread bank failures clearly would
be damaging to public confidence and would be an un
desirable consequence of market discipline. In any case,
the Federal Reserve is intensifying its efforts to expand
the scope and improve the effectiveness of supervisory and
examination procedures. Our aim is to increase our
capacity to spot deterioration at an early stage and to
suggest corrective measures that could help banking insti
tutions remain effective and viable. In addition to its
regulatory responsibilities, the Federal Reserve has a
strong interest in a sound and resilient banking system
because monetary policy operates on and through banks.
Monetary policy must always be formulated with con
sideration for the consequences of policy actions on banks
and other financial institutions. For the present, the easing
of inflationary pressures in our nation’s economy has
enabled the Federal Reserve to pursue a generally accom
modative monetary policy which, along with the respite
from strong inflationary pressures, has provided commer
cial banks with an opportunity to strengthen their capital
and liquidity.
Maintaining this strength as the nation’s economy ad
vances further and as loan demand develops renewed
vigor will require banks to keep a close watch on their
lending policies and on their ability to handle reasonable
risks. This attitude of prudence on the part of the nation’s
banks would do much to improve the effectiveness of
monetary policy in adjusting flexibly to changing economic
conditions and thus help to keep our economy on a sus
tainable path of growth.

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MONTHLY REVIEW, MAY 1976

The Strategy of Monetary Control

Editor’s Note: The following is adapted from the annual report for 1975 sub
mitted to the Federal Open Market Committee by Alan R. Holmes, Executive
Vice President of the Federal Reserve Bank of New York and Manager of the
System Open Market Account, and by Peter D. Sternlight, Vice President of the
Bank and Deputy Manager for Domestic Operations of the System Open Market
Account. Sheila Tschinkel, Adviser, and John S. Hill, Senior Economist, were
primarily responsible for the preparation of the report. The authors are indebted
to Ann-Marie Meulendyke, Anne Rowane, and Eleanor Martin for their assistance.

Monetary policy in 1975 sought to promote a sustain
able economic recovery while at the same time helping to
damp down inflation and to reduce fears of its rapid re
appearance. It succeeded in establishing the financial pre
conditions for a long-lasting expansion and complemented
the vigorous stimulus of Federal tax actions to increase
personal disposable income. The economy, after suffering
the deepest recession in the postwar era, began to recover
as consumer buying rose and inventory liquidation tapered
off. By the year-end, the recovery was well along a normal
trajectory and the rate of inflation had been reduced sig
nificantly. Confidence was growing that the expansion
could continue for an extended period without reigniting
more severe inflation, provided monetary and fiscal policy
continued to be shaped toward that objective.
The course of monetary policy during the year was
influenced importantly by the unwinding of the accumu
lated strains of the preceding boom and by massive shifts
in financial flows that reflected the recession itself. The
size of the Federal Government’s financing— which ulti
mately reached $85 billion in the year— periodically led
to concern among observers that market congestion might
impede the recovery at some stage. The financing was in
fact accomplished without undue difficulty, as an accom
modative monetary policy and slack private loan demand
enabled banks to rebuild their high-quality assets. Corpo
rate business worked to restore its strained liquidity by
borrowing heavily in the bond market and repaying bank
loans, as its inventories were sharply reduced in the first
half of the year. The banking system emerged with a sig

nificant volume of problem loans and placed increased
emphasis on credit quality. A number of state and local
government instrumentalities were unable to borrow in
the markets at all because of the lack of confidence in
their financial strength. Consumers continued to save at
a high rate, and it was hard to assess the significance for
monetary policy of changes in their distribution of savings
among money and other liquid assets especially after the
Federal tax rebates of May.
Early in the year, the Federal Open Market Committee
(FOMC) began a practice of focusing explicitly on a
longer time horizon in formulating its policy approach, in
response to a Joint Resolution of the Congress (House
Concurrent Resolution 133). In April, the Committee
adopted annual growth ranges for the monetary and
credit aggregates. In recent years it had used such ranges
for some of the aggregates, specified for six-month time
horizons, to quantify the leverage it wished to exert on
the economy. The Committee’s announcement of its
choice of a 5 to IVi percent growth for Mx and related
ranges for M_>, M3, and the bank credit proxy helped to
focus the national discussion of policy. While some critics
believed that these ranges were too low, the economy’s
rebound— accompanied by an especially large rise in
money velocity— tended to mitigate such criticism by the
year-end. Also, the FOMC’s observed efforts to imple
ment its broad goals contributed importantly to the less
ening of inflationary expectations during the year.
In the early part of the year, monetary policy con
tinued to encourage a resumption of moderate monetary

FEDERAL RESERVE BANK OF NEW YORK

growth, contributing to a sharp fall in interest rates in
the process. (Rates of growth of monetary and credit
aggregates are presented in Chart I.) By mid-March, such
expansion appeared in progress. Short-term interest
rates leveled off temporarily, while long-term rates began
to rise as concern mounted that huge Treasury financing
demands would compete with other demands and force
higher rates all around. A substantial bulge in bank de
posits emerged in the second quarter. When growth
strengthened substantially beyond earlier expectations, it
appeared to reflect more than just the temporary and

Chart I

M O N E Y SUPPLY A N D A D JU S TED B A N K CREDIT P R O XY
Seasonally adjusted a n n u a l rates

Percent
10

125

anticipated impact of tax refunds and transfer payments.
By June, it appeared that excessive monetary expansion
would indeed continue if current bank reserve and money
market conditions were maintained in the face of the
expansive forces then at work in the economy, and the
FOMC permitted some firming in such conditions.
In the course of the third quarter, interest rates rose,
growth in the aggregates decelerated, and other infor
mation on the economy suggested that the recovery itself
was gaining momentum. Meantime, the New York City
fiscal situation was causing widespread concern in the
financial markets. Some felt that spending by some
municipalities would be affected if they were to en
counter difficulty in borrowing. Renewed concern over
the viability of financial markets and institutions began to
diminish the benefits of stronger liquidity positions. While
the atmosphere in the credit markets weakened, the slow
down in money growth alleviated worries about inflation.
Starting in October, the Federal Reserve adopted a some
what more accommodative reserve policy which con
tributed to a fairly rapid decline in short-term rates of
interest. Late in the year, a Federal program to provide
seasonal aid to New York City relieved the problem
immediately facing that city and reduced market concern.
T H E S TR A TE G Y OF POLICY FORM ULATION

Jig

ADJUSTED CREDIT PROXY

tlllllll-l]
1970

1971

1972

1973

1974

1975

III

1975
Ml = Currency plus adjusted demand deposits held by the public.
M2 = Ml plus commercial bank savings and time deposits held by the public,
less negotiable certificates of deposit issued in denominations of $100,000
or more.
M3 = M2 plus deposits at mutual savings banks and shares at savings and
loan associations plus credit union shares.
Adjusted bank credit proxy = Total member bank deposits subject to reserve
requirements plus nondeposit sources of funds, such as Euro-dollar
borrowings and the proceeds of commercial paper issued by bank
holding companies or other affiliates.
Source: Board of Governors of the Federal Reserve System.

t h e e v a l u a t i o n o f l o n g -r u n o b j e c t i v e s . The experi
ences over the year illustrated the complexities of mak
ing policies and of formulating strategies for their im
plementation. Since 1970, the FOMC has made use of
the money supply measures to define the general out
lines of its policy objectives and to guide open market
operations between Committee meetings. The Commit
tee’s decision-making and policy-implementation process
pays particular attention to the variables over which
monetary policy has the most direct control and examines
the degree to which they influence the timing and shape
of economic developments. The Committee seeks to take
account of shifts in economic behavior, whether arising
from policy actions or other forces, which may be altering
previously observed relationships. These behavioral rela
tionships are part of a generalized economic framework
which can be used to examine incoming data to obtain
information on the economic outlook and changes in the
framework itself.
Monetary policy influences the economy by affecting the
cost and availability of money and credit. In formulating
a policy strategy, the Committee considers the expected
relationships among monetary growth rates, credit condi
tions, the liquidity of key economic sectors, and output,

126

MONTHLY REVIEW, MAY 1976

employment, and prices. The FOMC then has to account of the forces already in motion and their likely
devise an operational strategy for carrying out its impact on money over the period ahead. Unexpectedly
policy. When the Committee chooses a strategy of im rapid, or slow, growth could suggest that modification of
plementation, it weighs how System actions that affect the current operational posture is needed to lead toward
reserve availability will, in turn, affect the assets and liabili desired long-run objectives. The Committee’s instructions
ties of financial institutions and the public demand for them. to the Manager specify a stance with respect to reserve
The resultant responses to System policy are related to past, provision and how the Desk should vary it in response
present, and expected movements in interest rates. The to deviations in money growth.
effects of changes in policy are then transmitted to monetary
In its operating instructions the Committee tended for
and credit flows and, ultimately, to resource utilization.
most of the year to place the most emphasis on M1? though
A complex economy has many sectors and developed the broader money stock measures were also used. The
and M2
markets, which interact to affect economic activity. There FOMC established ranges of tolerance for
are feedbacks between sectors and markets that take time to growth that reflect influences on their behavior in the
work through the financial and economic system. A change short run and serve as reference points against which in
in System posture with respect to reserve provision affects coming data on these aggregates can be gauged. The
the behavior of money, the level and term structure of ranges cover growth in each measure over a two-month
interest rates, and economic activity with a lag. The reaction period, consisting of the month of the meeting and the
of participants in the economic process to changes in policy ensuing month. When there is uncertainty about the
and other developments involves consideration of the costs economic factors that are affecting money growth, the
of making adjustments in behavior. The timing and magni Committee has often used a fairly wide band of 3 to 4
tude of these responses often differ from historical patterns. percentage points on an annual-rate basis. This may also
Past data serve only as a guide to the significant relation be done when past growth has been unusually slow or
fast and some deviation in the opposite direction is ac
ships that constitute the economic structure.
Some shifts in the demand and supply functions for ceptable. When the direction of reserve behavior and
money seem to have been under way during 1975. Changes interest rates over the long run is deemed clear, the Com
in attitudes toward the liquidity of financial assets and the mittee often raises or lowers the bounds of the ranges for
development of alternative money substitutes seem to have the aggregates to reduce the likelihood of responses by
affected the way that transactions volume and interest the Manager that are not in keeping with these expecta
rates fed through to the demand for money. Uncertainty tions.
Incoming data on, and projections of, the aggregates
about behavioral relationships and the magnitudes
of the forces that drive them makes it neces are compared with their ranges each week to determine
sary to sift incoming data for its potential information the Desk’s posture with respect to reserve provision and the
content. The greater the uncertainty, the larger a diver Federal funds rate. The Manager’s response to undesired
gence relative to expectations has to be to make the de behavior is constrained by a range of permissible variation
cision maker willing to act on the basis of what appears in the weekly average Federal funds rate. The range usually
to be new information. When data are volatile or the centers around a rate believed at the time of the meet
degree of confidence in postulated relationships is low, ing to be consistent with the long-run objectives for the
unexpected deviations can contain very little information aggregates. In addition to the range on the Federal funds
in a short time period. In these circumstances, the data rate, the Committee guides the Desk on the emphasis it
have to be collected and tracked for a longer period of should place on other policy considerations, such as con
time than otherwise. As 1975 wore on, policymakers ditions in domestic and/or international financial markets.
became increasingly concerned that the relationship Information received between Committee meetings may
of Mi to economic activity was becoming less dependable. indicate inconsistencies among the group of policy specifi
cations or reveal significant new developments. When
s h o r t -r u n o p e r a t i o n a l s t r a t e g i e s . The Committee’s
this occurs, the FOMC may modify its original instruc
operational strategy is designed to be responsive to in tions to produce a stronger or weaker response to the
coming information in a way that fosters the long-run behavior of the aggregates.
objectives. At each meeting, the Committee examines
In implementing open market policy, the Manager
patterns for bank reserves and interest rates that are assesses and responds to new data, chiefly financial flows.
expected, over time, to be consistent with the intended Since such data are highly disaggregated and cover short
growth in the money stock measures. It seeks to take periods of time, it is often difficult to extract useful

FEDERAL RESERVE BANK OF NEW YORK

information from them. Information on the aggregates
is used to develop objectives for the Trading Desk.
The time horizon at the Desk is short, as the aims
for reserve availability in the banking system are
framed in terms of the statement week. In deciding
on the manner and timing of open market operations, the
Desk evaluates a broad range of data on and projections
of reserve demands and supplies. It combines these statis
tical estimates with information revealed by a continuous
monitoring of the market for bank reserves. The Desk’s
procedures involve an understanding of underlying shortrun behavioral relations which make up a framework for
evaluating its observations.

127

Chart II

M O N E Y M AR KET C O N D ITIO N S A N D G R O W TH IN M l
Percent
9.00

M illions of dollars
~

8.50

8.00
7.50
7.00
6.50

6.00
5.50
5.00

M O N ETAR Y POLICY IN 1975

4.50
4.00

The following discussion highlights significant develop
ments over the past year and focuses on the information
available to the FOMC at several key points to provide
examples of the Committee’s policymaking procedures.

Percent
15

10
5

0
-5

1
8 15 22 29 5
12 19 26 5 12 19 26
2
9
16
When the year began, monetary
January
February
M arch
A p ril
1975
policy was in the midst of a stimulative phase in order to
$ Shaded bands are the Federal Open-Market Committee's specified ranges
counter the built-up forces of recession. Real gross na
of tolerance.
tional product (GNP) was declining, and projections sug
gested that economic activity would continue to recede in
the first half of the year. Information on the behavior of
prices suggested some moderation in the rate of increase,
but unemployment was rising.
To encourage faster monetary and credit expansion, the M2 and M3 began to increase at relatively rapid rates. At
discount rate was reduced from 13A percent to 6 V4 percent that point, the Account Manager under normal circum
in three steps during the first quarter and reserve require stances would have permitted the Federal funds rate to
ments were also cut. The narrowly defined money sup begin rising, but the Committee on March 27 instructed
ply (MO had expanded at a 4.7 percent rate in the fourth him to treat 5 V2 percent as the approximate upper limit
quarter of 1974. While the System acted to increase the for the weekly average for the time being, in view of weak
availability of nonborrowed reserves and the Federal ness in the economy and of sensitive conditions in the finan
funds rate fell from about 8 V2 percent at the end of De cial markets, especially the bond markets. Still, at the end
cember to 5 V2 percent by mid-March, money growth of the first quarter, it was generally believed in the market
slowed a bit further in the first quarter of the year.
place that the scope for further interest rate declines was
The decline in the funds rate prompted other short limited.
term market rates to fall substantially as well, and growth
in the broader money supply measures accelerated over
m i d -a p r i l t o m i d - s e p t e m b e r . The information available
this interval. Bond yields fell for a while, but greatly en for the Committee meeting in April showed a mixed pic
larged public and private borrowings and concern about ture. This meeting is reviewed more intensively in this
the creditworthiness of some state and local government report, because it provides an interesting illustration of
how a broad range of information can be used to deal
instrumentalities worked to limit these declines.
By March, M 1 was beginning to grow at a substantial with the conflicts and uncertainties inherent in policy
pace (see Chart II). While expansion had initially ap making.
Data for the first quarter indicated that the rate of
peared to be below or within the tolerance ranges set at the
first two FOMC meetings of the year, M3 then seemed to decline in industrial production was slowing, that economic
be exceeding the ranges agreed upon at the March meeting. activity was likely to recede only a little further, and that

Ja n u a r y

t o m i d -a p r i l .

128

MONTHLY REVIEW, MAY 1976

the rise in the price level was moderating. Inventory liqui
dation had remained rapid, but it seemed likely that the
reduction in stocks would taper off and provide a boost
to the expected recovery. However, the near-term outlook
for a substantial improvement in the unemployment rate
was bleak, and strong upward pressure on wages was
still evident.
On the financial side, business demands for short-term
credit continued weak, though corporate bond financing
to strengthen liquidity was exceptionally large. As busi
ness loans were repaid, banks absorbed a sizable volume
of new Treasury issues. Growth in M t and M2 appeared
to be strengthening markedly. Apparently, the effects on
money demand of earlier declines in interest rates were
being bolstered by the accelerated payments of tax refunds,
which were adding to income flows. There was widespread
concern in the securities markets about the ability to meet
the very heavy financial needs of the Treasury without
crowding out the private borrowing that was likely to
develop as the economy moved strongly into recovery.
Taken together, the range of information suggested that
the economy was likely to begin to recover soon but that the
turning point had not yet been reached. It appeared that the
recovery could be sluggish because demand in several
important sectors, such as automobiles and housing, was
likely to remain weak for some time. Moreover, there
was considerable uncertainty about how much stimulus
would arise from the recently enacted program of Federal
tax rebates and increases in transfer payments and about
how soon consumer spending would begin to respond.
The Committee wanted to encourage the expanded finan
cial flows necessary to facilitate an upturn, but it was also
mindful that overly rapid monetary growth, if sustained,
could revive inflationary fears and be detrimental to the
economy in the future.
To frame policy over a longer horizon, the Committee at
this time began formulating objectives for four measures
of the aggregates in terms of growth ranges for annual
periods. The ranges selected were 5 to IV 2 percent for M1?
SV2 to lO1^ percent for M2, 10 to 12 percent for M3, and
6 V2 to 9 V2 percent for the bank credit proxy. In the near
term, growth in money was expected to be more rapid even
if prevailing money market conditions were to be main
tained. The Committee was prepared to accept a tempo
rary acceleration in monetary expansion, adopting toler
ance ranges of 6 Vi to 9 percent and 9Vi to 11% per
cent for Mj_ (see Chart III) and M2, respectively, over the
two months ending in May. The range of variation
specified for the Federal funds rate was 4% to 5% per
cent, roughly surrounding the prevailing money market
conditions.

The implementation of the policy directive adopted in
April illustrates how the Manager assesses and responds
to data available after FOMC meetings. While estimates of
Mi showed adequate growth in the first few weeks after
the meeting, by early May it appeared that expansion
for April and May combined would be at a rate that was
close to the bottom of the tolerance range. Projected
growth in M2 was revised steadily lower over the inter
meeting period, and by the final week it fell somewhat
below the range.
Against this background the System sought to provide
nonborrowed reserves somewhat more readily, but acted
cautiously awaiting further data to confirm the initial signs
of monetary weakness in order to avoid exaggerated market
effects during a period of heavy Treasury financing. Par
ticipants were preparing to bid for a sizable volume of
issues in the quarterly Treasury refunding, and an aggres
sive easing of reserve objectives during such a period could
have had a stronger influence than warranted by the in
formation available to the Desk.
The Desk encountered difficulty in achieving some eas
ing in the money market, and the Federal funds rate rose
after the April meeting rather than declining as was
expected. There was the usual uncertainty about the pro
jected impact on the supply of nonborrowed reserves
from the market factors not under the System’s control.
At one point these uncertainties were compounded by an
interruption in the wire transfer systems for funds and
securities. The Desk made record volumes of transactions
over the period, buying $1.1 billion of Treasury coupon
issues and $2.6 billion of bills outright and adding $2.8
billion of reserves, on average, through repurchase trans
actions in the market.1 Bank demands for nonborrowed
reserves were increasing, partly because of the growth of re
quired reserves, and the System wanted at least to meet
such needs. At the same time, the supply of nonborrowed
reserves was being drastically reduced by inflows of cash
to Treasury balances at Federal Reserve Banks.2

1 On days when the Desk was arranging repurchase agreements,
its transactions took into account short-term investment orders of
customers. It made matched sale-purchase transactions between
the System and their accounts, rather than arrange two types of
repurchase contracts in the market at the same time.
2 In 1975 massive open market operations were needed to offset
the impact of intramonthly swings in Treasury cash balances at
Reserve Banks. The Treasury had been intensifying its efforts
to minimize its cash holding at commercial banks. Generally,
balances at Reserve Banks rose sharply toward the end of each
month. The buildup in balances was particularly large just after
the mid-April tax date.

FEDERAL RESERVE BANK OF NEW YORK

The average effective Federal funds rate increased from
5.44 percent in the April 16 week to a peak of 5.71 per
cent in the final week of the month. It began to decline
thereafter, and trading generally fell into the 5 to 5X
A per
cent preferred range just before the May FOMC meeting.
Desk actions were also guided by the FOMC concern
about developments in the financial markets. Interest rate
expectations had reflected some anticipation that Treasury
borrowing needs would exert upward pressure and that
the more rapid money supply growth toward the end of
the first quarter would be followed by a tightening of
System policy. The yield increases were particularly appar
ent in the municipal bond market in view of the financial
troubles of New York City and the Urban Development
Corporation of New York State. As both the slowdown

129

in money growth and the Desk’s encouragement of a
lower Federal funds rate became evident, the securities
market began to improve dramatically. The Treasury’s
disclosure that its near-term borrowing needs were turn
ing out lower than anticipated earlier gave the rally a
strong boost, particularly in the Government securities
market. The refunding and other recent Treasury issues
encountered good demand, partly because banks contin
ued adding to portfolio holdings as loans were repaid in
volume. Nevertheless, the schism between issues of differ
ent quality in the municipal market became more pro
nounced and some local instrumentalities began to have
difficulty in raising needed cash.
Over the period, the Desk had responded to weaker
than anticipated growth in money supply though its actions

C hart III

M O N E Y M A R K E T C O N D IT IO N S A N D G R O W T H IN M l
M illio n s of d ollars

■
m ilf t i i i s t e l f e l l
■
1

NARROW M O NE Y STOCK (Ml)
Two-mont h growth rate

Percent

il-June

■

NARRO W M O NEY STOCK (M l)*
Two-month growth rate

JuneAugust
1

1
M ay-July

M illio n s of d ollars

Marc h-May

23
30
A p r il

...... 1 .......J ..... L . .
7
14
21
28
M ay

. 1... J ....... _L
11
18
25
June
1975
4

1
2

9
Ju ly

-5
16

* Shaded bands are the Federal Open Market Committee’s specified ranges of tolerance.

1
I
23
30
Ju ly

I
6

!
I
1
I
1
I -5
13
20
27
3
10
17
August
S e p te m b e r
1975

130

MONTHLY REVIEW, MAY 1976

were conditioned by the desire to avoid exaggerated re
actions to a modest change in System objectives. It was
not clear whether the deceleration in the aggregates indi
cated a significant weakening in the economy, a shift in
money demand, or a temporary aberration in the data.
The cautious response by the Desk would work to counter
a slowing in money growth, but given its limited nature
it would not be difficult to offset should growth soon
rebound.
Later on in the quarter, data showed that expansion
of Mt was accelerating to a greater degree than had been
expected to result from the impact of tax rebates and
stepped-up Government transfer payments. When Mi con
tinued to run substantially above expectations, the System
acted in late June to restrain reserve growth. The Federal
funds rate had been fluctuating around 5Vx percent in an
FOMC prescribed range of 5 to 6 percent. Following a
rise in this rate, yields in the securities markets adjusted
sharply upward.
The funds rate rose to about 6 percent in early July
and, though the FOMC agreed on June 26 to amend the
upper constraint on this rate from 6 to 6 Vi percent, the
Manager did not need to use the additional leeway as
incoming data suggested some weakening in the aggre
gates. At the July meeting, an analysis suggested that
growth in money and credit was likely to slow consider
ably but this could be temporary, given an apparent
strengthening of the economy. There were some differ
ences within the Committee about how best to respond
to incoming monetary data in view of its erratic behavior
and the difficulty of assessing the special factors that were
continuing to distort the observed growth. There were
uncertainties about the underlying strength of the econ
omy and the impact of relatively high levels of market
interest rates at the current stage of the business cycle.
While the Committee retained the earlier annual longer
run growth ranges for the aggregates, it placed them on
a quarterly average basis for the year ending in the sec
ond quarter of 1976 in view of the erratic movements of
monthly figures on money balances. For the near term, the
FOMC agreed to maintain prevailing money market con
ditions provided that growth in monetary aggregates
appeared to be slowing substantially from the bulge in the
second quarter.
While the Manager responded to initial indications of
higher than desired monetary expansion after the July
meeting, newer data soon suggested a deceleration to rates
of growth within the ranges specified by the Committee,
and the Desk sought steady conditions of reserve avail
ability. Federal funds traded generally in a 6 Vs to 6 V4
percent range until early September. At that time, growth

was relatively slow, compared with the short-run ranges
specified at the August meeting. But the FOMC agreed on
September 5 that the Manager should be instructed to
maintain current money market conditions in view of the
likelihood of a strengthening in demands for money and
credit and the prospect that any decline in the Federal
funds rate might have to be reversed shortly.
m i d -Se p t e m b e r t h r o u g h DECEMBER. The economic data
available at the September FOMC meeting contained sev
eral indications that a vigorous recovery was in prospect.
At the same time the outlook for price inflation had
worsened somewhat. It was expected that the relatively
strong expansion in nominal GNP would add to demands
for money and credit over coming months. Conditions in the
securities markets had become somewhat unsettled, partly
because of the escalating problems of New York City and
worries about the difficulties facing some other municipal
borrowers.
In view of this outlook, the Committee adopted aggre
gate specifications that were likely to be consistent with
little change or a possible firming of money market con
ditions over the ensuing month (see Chart IV ). Some
members advised action to achieve a modest firming
whenever feasible without disrupting markets, as it would
help restrain monetary growth later on. But others pre
ferred not to firm policy on the basis of projections that
such growth would exceed desired rates over the long
run, though they would act promptly if and when actual
growth accelerated substantially. The FOMC established
a 6 to 7 percent allowable range of variation for the
Federal funds rate at this meeting, compared with
a 53A to 7 percent range set in August.
Initial data received after the September meeting seemed
to suggest that Ma was indeed strengthening and the Man
ager sought to encourage a slight firming in money market
conditions with the objective of moving the Federal funds
rate up toward the midpoint of its range of tolerance. But
the estimates were revised down, and by early October it
appeared that growth would again fall below desired rates.
In view of the pronounced weakening and the unsettled
conditions in the municipal bond market, the Committee
on October 2 instructed the Manager to aim immediately
to reduce the funds rate to 6 Vs percent and then to 6 per
cent shortly thereafter. The FOMC also agreed to reduce
the lower constraint on this rate to 5% percent.
This response reflected the recognition that emerging
strains in the financial sector could jeopardize the eco
nomic recovery. Investor concern about the safety of assets
was growing, including a measure of market concern about
the New York City banks because of their close associa

FEDERAL RESERVE BANK OF NEW YORK

tion with New York City and State problems. Even though
prospects for loan growth continued weak and further
interest rate declines seemed in store, the New York City
banks bolstered liquidity by selling additional certificates
of deposit (CDs), sometimes at rates equal to or ex
ceeding those paid by other major money center banks,
in contrast to the usual pattern in which major New York
banks pay slightly lower rates than most others.
Over the closing months of the year, interest rates fell
to lower levels than had been anticipated earlier though
money growth remained sluggish. At the same time, the
short-run behavior in Mi was even more volatile than
usual. Incoming deposit data were difficult to interpret, and
the outlook for the two-month growth rates was often
revised significantly.
At its October meeting, the Committee retained its
longer run annual growth rate range for Mi, which now
extended through the third quarter of 1976. It also
reduced the bottom end of such ranges for M2 and M3 by
1 percentage point to allow for pressures on market

Chart IV

M O N E Y M AR KET C O N D ITIO N S A N D G R O W T H IN M l

1975
^Shaded bands are the Federal Open Market Committee's specified ranges
of tolerance.

131

interest rates stemming, in part, from heavy Treasury
borrowing which might serve to moderate inflows of time
and savings deposits. At that and the subsequent meeting,
the FOMC reduced the allowable range of variation for
the Federal funds rate. While growth in monetary aggre
gates fell short of the two-month ranges, this was not
evident until late in the period after the October meeting
and the decline in the funds rate was slowed. The funds
rate then hovered around 5 X
A percent over the last part
of November before edging down to 53/ie percent in midDecember.
At the December meeting, evidence suggested that flows
of money into corporate savings accounts, as a result of a
recent regulatory change, were depressing growth in Mx.
There was considerable uncertainty about the size of this
effect on demand deposits and whether it would alter the
public’s demand for money. In view of these problems,
many members preferred to make the Manager’s response
less sensitive to incoming data on monetary aggregates.
The Committee instructed the Desk to maintain prevailing
bank reserve and money market conditions, with the
Federal funds rate around 5 V4 percent, unless growth in
the aggregates deviated significantly from the midpoints of
their ranges. Subsequent data suggested that growth in
M2 was falling well short of its range of tolerance, and the
Manager again moved to seek a more accommodative re
serve climate as the year drew to a close.
The Manager’s actions in the closing months of 1975
were attuned to the developing strains in the banking sys
tem. Investors became sensitive to the quality of bank
assets— especially bank holdings of certain municipal se
curities and categories of loans that involved perceived risks
of loss. The bankruptcy of W. T. Grant focused ad
ditional attention on loan quality, and many banks
bolstered their reserves for potential loan losses. For a
while, CD rates rose considerably relative to rates on Trea
sury bills as some investors sought to place funds in the
safest of financial assets. While the rate differentials later
narrowed to a more typical spread, investors remained
selective in their CD holdings. Bank desire to improve
liquidity in the latter part of the year may have affected
their willingness to make loans. In turn, this may have
contributed to the slow growth of demand deposits.
Programs were enacted for New York City in December
that enabled it to reduce interest payments on outstanding
securities and to refund maturing bonds. Plans included
seasonal loans by the Federal Government for a threeyear period. While the immediate problems were resolved,
the markets were concerned that the moratorium that had
been adopted for some New York City notes could affect
the demand for municipal securities more generally.

132

MONTHLY REVIEW, MAY 1976

SUM MARY AND CONCLUDING C O M M EN TS
Chart V

Developments in 1975 illustrated the difficulties of con
trolling the aggregates and raised some questions about
how objectives for these measures should be established and
evaluated. Expansion in M 1 for the full year decelerated
to a 4.4 percent rate as its behavior was unusually sluggish
in the first and final quarters. The annual growth was
slower than might have been expected based on past
experience in similar stages of the business cycle. But
looking at broader deposit aggregates, financial flows, and
markets, the expansion of liquidity in the economy ap
peared ample. Growth in consumer-type deposits was
relatively strong and M2 increased by 8.2 percent, up from
7.7 percent in 1974. Declines in interest rates gave rise to
substantial deposit inflows to thrift institutions so that
growth in M3 accelerated from 7.1 percent to 11.1 percent.
While there was much concern that the financial needs
of the Treasury would thwart private efforts to rebuild

SELECTED B A N K CREDIT C O M P O N E N TS
S easonally adjusted ann ua l rates on a q u a rte rly average basis
30

TOTAL BANK CREDIT*

-m

-10 ......... 1...
50

i l i..
ti

m
1

.........1 ...... 1

1
1

1 m
1

0
-1 0

BUSINESS L O A N S *

_ 1 i
i i i t ™ 0—0
0 I I
111 i i i
100

-10

.—

]

.....

..........

UNITED STATES GOVER NMENT SECURITIES

80
60
40

■j

Table I
TOTAL DEBT RAISED IN CREDIT MARKETS, BY SECTOR
1970

1971

1972

1973

-2 0

1975

1974

12.9
8.2

25.6
3.8

17.4
6.2

9.7
19.6

12.0
21.4

85.2
10.1
15.4

State and local governm ent ..............

11.2

17.6

14.4

13.7

17.4

23.8

24.8

20.2

12.5

23.3

34.5

..............................................

26.4

48.9

68.8

71.9

54.5

54.6

Short-term and all o th ert ................

17.9

28.4

58.4

Total .........................................................

100.4

149.1

185.4

103.9

83.9 -

231.3 i 212.5
1

1974

1975

13
8

17
2

9
3

I
i
5 !
8

Source: Board of Governors of the Federal Reserve System.

2.7
197.1

Percentage of total raised

6
10

43
5

State and local governm ent ..............

C orporate and foreign bonds .........

M ortgages ..............................................

Short-term and all o th ert ................

Total ........................................... .............

100

28
-

2
100

N o te: Because of rounding, figures may not add to totals.
* Includes nonm arketable debt, savings bonds, loan p articipations not else
w here included, and financing of budget agency debt. G overnm ent N ational
M ortgage A ssociation (G N M A )-g u aran teed securities backed by m ortgage
pools are included in the agency securities category,
t Includes consum er credit, business loans, other loans not elsewhere classi
fied, open m arket paper, and repurchase agreem ents.
Source: Estim ated from flow-of-funds d ata of the B oard of G overnors of the
Federal R eserve System.

“["Adjusted to reflect the sale of Franklin National Bank's $1.5 billion of loans
and investments to the Federal Deposit Insurance Corporation.

C orporate and foreign bonds .........

U nited States G overnm ent
Treasury securities* ......................
Agency securities .............................

||
■■

♦ Adjusted for loans sold to affiliates.

Billions of dollars

M ortgages

1973

Sector

U nited States G overnm ent
Treasury securities* ......................
Agency securities .............................

-4 0

■" | I

liquidity, this did not occur. The Federal Government
borrowed a record $85 billion over the year, compared
with $12 billion in 1974 (see Table I ) .3 At the same time,
corporations sold an unprecedented $30 billion of bonds.
But these increases in supplies were absorbed more
readily than had been expected, in part because net de
mands on the credit markets and the banking system
were reduced (see Chart V ). Internal corporate cash
flows were strong, and this enabled corporations to reduce
short-term borrowing substantially. The $10 billion net

3 Relative to the size of the economy, Treasury borrowing was
much smaller in 1975 than in some years during World War II.

FEDERAL RESERVE BANK OF NEW YORK

paydown of private short-term debt, due entirely to a re
duction in business borrowing, stood in marked contrast to
the $70 billion rise in such obligations the year before.
Banks also took steps to improve their liquidity. As
business loans were repaid in substantial volume and other
loan demand was weak, banks acquired sizable amounts
of Treasury securities (see Chart V and Table II). They
bought $29 billion, compared with a net liquidation of $3
billion in the previous year, as the stimulative monetary
policy induced deposit inflows. Aside from rebuilding
their investment portfolios, banks reduced their reliance
on funds purchased in the CD market for the first time in
six years. The drop in CDs was reflected in a slowing of
growth in the bank credit proxy. Savings and loan associ
ations repaid advances to the Federal Home Loan Banks,
thereby enabling this agency to repay debt. Thrift institu
tions increased their holdings of Treasury securities and
mortgages in response to good deposit inflows.

133

Table II
ACQUISITIONS OF FEDERAL GOVERNMENT SECURITIES,
BY SECTORS
1970

1971

1972 I 1973

1974

1975

Sector
Billions of dollars
I

Federal Reserve System
Treasury securities* .......................
Agency securities .............................

5.0

6.8
0.5

0.8
0.8

3.0
2.8

5.7
1.4

C om m ercial banks
Treasury securities ...........................
Agency securities ...........................

6.9
3.5

3.1
3.8

2.4 — 8.8 — 2.6
4.1
7.6
3.6

29.1
1.2

O ther financial
Treasury securities ...........................
Agency securities ...........................

1.1 2.7

1.7
4.3

2.3 — 1.1
4.8
2.0

18.8
8.0

Private domestic nonfinancial
Treasury securities ........................... —11.1 2.1 Agency securities ...........................

8.6
5.4

1.6 j
0.1 |

7.4
11.4

26.3

8.4

0.3

3.6

1.7

1.3 -

0.7

2.4

33.5

95.4

Foreign! ................................................

9.1

All other ................................................

1.8

Total* .......................................................

21.1

0.3 29.4

23.6 j

8.7
0.6

29.4

2.5
3.2

6.7
21.6
11.4 — 0.6
7.8

1
Percentage of total acqusitions of
Federal Government securities

Chart VI

SELECTED M O N E Y RATES
W eekly

Federal Reserve System
Treasury securities* ......................
Agency securities .............................

23
2

3
3

30
2

9
8

6
1

C om m ercial banks
T reasury securities ...........................
Agency securities .............................

33
17

10
13

10
17

— 30
26

— 8
11

31
1

Other financial
Treasury securities ...........................
Agency securities .............................

5
13

— 6
15

10
20

— 4
7

7
10 1

20
8

Private domestic nonfinancial
Treasury securities ........................... Agency securities ............................. S

53
10

— 29
— 18

7
1

25
39

20
34 -

23
1

Foreignt ................................................

— 7

— 2

100

All other ................................................. !
T o tali ...............................

8
100

N ote: Because of rounding, figures may not add to totals.
* See Table I for explanation of T reasury securities category,
t B reakdow n between Treasury and Federal agency securities not available.
I F o r breakdow n betw een Treasury and agency securities, see U nited States
G overnm ent sector on Table I.
Source: Estim ated from flow-of-funds data of the B oard of G overnors of the
F ederal R eserve System.

1975
Sources: Board of Governors of the Federal Reserve System, Federal Reserve
Bank of New York, and Moody's Investors Service, Inc.

Interest rate movements over the year (see Chart VI
and Table III) were influenced by the shape of credit
flows and by responses to System policy. The decline in
the Federal funds rate and its temporary rise over the
summer was followed by similar changes in other short
term rates. The Federal funds rate declined from around
IV a percent in early January to about 5% 6 percent in the
final week of the year. Treasury bill rates declined by
about 13A percentage points to 5.18 percent for the threemonth issue. Rates on private short-term investments

134

MONTHLY REVIEW, MAY 1976

declined by even more as supplies shrank. The yield
curve became steeply upward sloping, particularly for
Treasury issues, as financing in the intermediate to longer
term area was relatively heavy (see Chart V II). While
rates on Treasury issues due in five years or longer ended
the year slightly higher on balance, those on Federal
agency issues declined somewhat, mostly reflecting the
relative behavior of supplies of these issues. In private
debt markets, yields generally declined, though the extent
of the drops depended on investor attitudes toward the
safety and quality of the securities.
Events in 1975 once more demonstrated that there are
no simple rules for formulating and implementing a policy
strategy. Policymakers continually seek to take into ac
count the effect of new developments on the relationships
among monetary aggregates, interest rates, and ultimate
economic objectives in framing policy. While an under
standing of these important interactions develops over
time, the implications of incoming data and the kinds of
responses they should generate in the short run remain a
critical question in formulating policy strategies.
It is often not possible from month to month to isolate

Table III
SELECTED INTEREST RATES
In percent
1974

1975

Rates
Dec.
31

Feb.
19

Apr.
23

June
IS

Oct.
1

Dec.

F ederal funds— weekly average
effective rate
..............

7.35

6.29

5.54

5.31

6.36

5.18

Three-m onth T reasury bill:
A verage bond yield equivalent .......

7.34

5.56

5.83

4.91

6.77

5.36

D iscount rate— Federal Reserve
Bank of New Y ork ............................

7.75

6.75

6.25

6.00

Three-m onth certificates
of deposit
.....................

9.25

6.49

6.25

5.55

7.01

5.68

Short-term

Long-term
U nited States G overnm ent
securities (3- to 5-year)

7.26

6.71

7.90

7.14

8.21

7.28

Treasury bond due 1993-98

............

7.75

7.59

8.30

7.85

8.43

7.93

Recently offered A aa-rated
utility bonds

9.67

9.08

9.71

9.14

9.70

9.10

6.45
6.30
7.20 | 7.40

6.92
8.05

6.45
7.76

State and local governm ent bonds:
A aa-rated ................................................
A -rated
................................................

t
6.70
6.00
7.20 ■ 6.55

Sources: Board of G overnors of the Federal R eserve System, F ederal Re
serve B ank of New York, and M oody’s Investors Service, Inc.

Chart VII

SELECTED YIELDS O N UNITED STATES
G O V E R N M E N T SECURITIES
Y ield to m aturity
8.80

O ctob er 1, 1975

8.40 ~

—

7.60 _ /

6.80
6.40
6.00
5.60
5.20

8.40

A p ril 23, 1975

8.00

7.20

Yield to m a turity
8.80

-/7

„ ------------

//j/
\

June 18, 1975

___,>»'

___^

December 31, 1975

Decem ber 31, 1 9 7 4 ___________________
---------February 19, 1975

8.00

—
_ 7.60
_ 7.20
6.80
6.40

w
(

6.00
5.60

1 1 1 1 1 1 1 1 1 ! I 1 1 ! I 1 1 ! 1 1 /. 1 1 5.20
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 2224 26
Years to m aturity
Note: The curves chosen represent selected peaks and troughs in the
United States Government securities market during 1975.

the impacts of particular supply and demand forces which
are affecting the behavior of the several monetary aggre
gates. In 1975,, Mi growth was at times dominated by
short-run influences, such as the massive tax rebate and
refund program. It was not clear at the time whether the
rapid expansion in the spring suggested an upturn in trans
actions demand or if demand deposit balances were tem
porarily boosted by the pattern of the Treasury’s payments
to the public. When the New York City fiscal crisis came
to the fore, changes in attitudes about the quality of
money and credit market instruments seem to have af
fected the desired composition of portfolios of liquid assets
as well as the willingness of banks to supply loans and to
acquire interest-bearing deposits.
Over a longer horizon, institutional and regulatory
changes affect the properties of monetary assets. Using
1975 again as an example, a change in Regulation Q that
permitted banks to issue savings deposits to small busi
nesses appears to have altered the way that some firms
manage cash balances and the amounts of demand deposits
needed to finance their transactions. Over the near term, it
probably retarded the growth of Mx relative to that of M2.
In situations like these, it becomes difficult to assess the
appropriateness of a particular long-run objective for a
monetary aggregate and how the Desk should respond
to incoming data on money when it diverges from expecta
tions.

FEDERAL RESERVE BANK OF NEW YORK

As the year drew to a close, these uncertainties led the
Committee to take steps that reduced the responsiveness
of the Manager’s stance to short-run changes in
growth. In early 1976, the FOMC also began to place
additional emphasis on M2 as one of the determinants of
open market actions. These refinements in policy strategies
constituted part of a response to changes in underlying
economic relationships. At the same time, uncertainties
about the long-run significance of developments affecting
the demand for, and supply of, money and its relationship
to economic activity are likely to persist.

135

It seemed evident, as the year drew to a close, that the
performance of the economy was improving and that the
relatively slow growth in Ma had probably been due to a
downward shift in the public’s demand for this aggregate.
Thus, the behavior of a particular monetary measure
cannot substitute for an appraisal of the economy as a
whole in the formulation and implementation of policy.
And 1975 seemed to confirm that policymakers’ judg
ment, based on an extensive range of information, is more
effective than invariant rules for guiding the behavior of
policy instruments.

136

MONTHLY REVIEW, MAY 1976

The Business Situation
Economic activity in the United States has risen at a
brisk pace in recent months. Real gross national product
(GNP) advanced at a robust 7.5 percent annual rate in
the first quarter, marking the fourth consecutive increase
since its low point in early 1975. A major impetus to the
economy’s first-quarter growth was provided by consum
ers who bought substantially larger quantities of various
goods and services, sharply increasing their purchases of
new cars. In addition, a sizable thrust was provided by
a turnaround in inventory investment, as businesses be
gan to replenish their stock of inventories. Looking to
ward the future, many economists expect residential con
struction activity to pick up further as employment
increases and consumer incomes continue to rise. Moreover,
it is unlikely that there will again be a sharp deterioration
in the net export position, as occurred in the first quarter
when the United States upswing outpaced that in other
countries. Changes in conditions in the labor market during
the first quarter reflected the rapid expansion in the level of
production. Compared with the previous quarter, about 3A
million more workers held jobs in the nonfarm sector and
the unemployment rate dropped almost a full percentage
point. Employment showed further strong gains in April but,
due to a large increase in the size of the labor force, the un
employment rate remained at 7.5 percent. Other indicators
of labor market conditions such as the average duration of
unemployment, however, have continued to improve.
Accompanying the first-quarter rebound in economic
activity was an unexpectedly dramatic deceleration in the
rate of increase in prices. The GNP implicit deflator, the
broadest measure of prices in the economy, rose at the
lowest rate in nearly four years. Moreover, the behavior
of the wholesale and consumer price indexes confirmed
the marked slowing in inflation. Most of the recent de
crease in inflation, however, resulted from drops in food
and energy prices. Since these declines are not expected
to continue, some acceleration in the rate of inflation
would seem likely over the near term. Indeed, at the
wholesale level, April data show a sizable increase in farm
prices. Nevertheless, worries about a possible return to the
inflation rates seen in 1974 have largely disappeared.

From a somewhat longer term perspective, the rate of
wage gain is important for the price outlook. Some of
the recent news on wage increases has been mildly encour
aging, but most of the major wage contracts scheduled for
1976 have yet to be negotiated.
GNP AND R ELA TE D D EVELO PM EN TS

According to preliminary estimates, output of final
goods and services in physical terms increased at a
rather sharp 7.5 percent annual rate during the first quarter.
This solid advance marked the fourth consecutive gain in
real output and dispelled remaining doubts about the sus
tainability of the recovery. The level of economic activity
has now regained almost all of the ground lost in the steep
recession. However, since both the labor force and capacity
have grown in the interim, the potential level of output is
well above the current level, leaving room for further
sizable increases in production. The first-quarter expan
sion largely reflected a sharp increase in inventory
investment and a sizable advance in consumer purchases
of both durable and nondurable goods and services.
Although most other components also showed gains (see
Chart I), net exports declined.
In the first quarter of this year, many business firms
began to refurbish their depleted stocks of inventories
and the swing from liquidation to accumulation accounted
for half of the growth in real GNP. The Commerce De
partment’s preliminary estimates, which are based on
incomplete inventory data, indicate that the shift toward
accumulation was attributable to businesses which pro
duce nondurable goods (see Chart II). It appears that
the excessive inventories held by producers of nondu
rables in 1974 had been worked off by the end of 1975.
In fact, in some industries producing nondurable goods,
modest accumulation had begun in the second half of
1975. It is not surprising that the nondurable goods
sector, which was the first to begin liquidation of excess
stocks, would be the earliest to resume inventory accumu
lation. In contrast, firms manufacturing durable goods
began their inventory reductions somewhat later, and

FEDERAL RESERVE BANK OF NEW YORK

liquidation continued into the early part of the first quar
ter. The latest monthly data, however, indicate that in
February and March durables manufacturers began to
build inventories once again. As a result of the massive
inventory reduction during 1975 and the pickup in final
sales, the overall ratio of inventories to final sales has
declined significantly and, by the first quarter of 1976,
the ratio of nonfarm business inventories to final sales
had fallen close to pre-recession levels. With inventory
stocks now at a fairly comfortable level, inventories will
have to grow at about the same rate as sales for firms to
have large enough stocks of materials, goods in process,
and finished goods to operate efficiently.
Consumer spending, which has provided the major
stimulus in the upturn, continues to contribute strength
to the rebound of production. In the first quarter, con
sumer purchases of goods and services in real terms ad-

137

Chart II

REAL N O N F A R M IN VEN TO R Y INVESTM ENT
A N D REAL INVENTO RY-SALES R ATIO
Seasonally adjusted annual rates
Billions o f 1972 dollars
!—
15

, "1- ...... ■ i1 ■ ' -.......
NONDUR/^BLES INVEfnITORY INVEiSTMENT

Billions of 1972 dollars
15

■ I I I

l l l l

III.

Ii1

l l i l

,_ L 1__L.

L _ L .1__

.L 1. I .... 1 _L .1 ..

DURABLES INVENTOR’Y INVESTME

1, 1..J ...

-5

_ill

■

«l-....I■IIII.ll
1. 1 J

... 1..1 1

i_i

-10

1 1 i . _ L ,J_. 1 .

II"

Chart I

RECENT C H A N G E S IN REAL G R O S S N A T IO N A L
P R O D U C T A N D ITS C O M P O N E N T S
S easonally a dju sted
| Change from fourth q ua rte r
' 197 5 to first quarter 1976

1 Change from third quarter to
^ fourth q u a rte r 1975

Source:

-1 0

-5

B illions of constant (1972) dollars
Source:

U nited S tates D e p a rtm e n t o f Com m erce, Bureau o f Econom ic A n a ly s is .

United States D epartm ent o f Commerce.

vanced at a 7.5 percent annual rate, the largest rate of
increase posted since late 1972. Much of the recent
surge in consumption has been accounted for by the
rebirth of buyers’ interest in new cars. Unit sales of do
mestic models rose to an average of 8.7 million in the
January-March period, about 10 percent above the aver
age sales in the final quarter of 1975 and some 22 percent
over 1975 as a whole. In April, sales of domestic cars
advanced again, reaching a seasonally adjusted 9 million
unit annual rate. The resurgence of auto demand has been
primarily for standard- and intermediate-size domestic
models. The industry, having misjudged the demand mix
this year, is apparently near capacity production of these
models, and the inventories of autos, which overall are
now low relative to sales, are reportedly even lower
for these suddenly popular models. Sales of the gener
ally smaller imports, on the other hand, have been very

138

MONTHLY REVIEW, MAY 1976

sluggish, holding steady at an annual rate of 1.3 million
units, and their share of total United States auto sales has
ebbed to about 13 percent, down sharply from the over
20 percent share they had early in 1975. While the re
surgence in automobile demand shows every sign of con
tinuing, a production bottleneck could conceivably arise
this summer, if the United Rubber Workers’ strike against
the tire producers becomes prolonged. Automakers say
their stocks of rubber-related products could sustain pro
duction for only several weeks.
The pickup in sales of autos and other big-ticket items
provides tangible evidence of improving consumer con
fidence. The slowing of inflation, recovery in employ
ment and incomes, and the rebound of equity prices all
have fostered a more optimistic outlook and have encour
aged spending. The consumer sentiment index of the Uni
versity of Michigan jumped sharply in the first quarter and
now stands close to the level reached before its plunge
during the recession-inflation environment of 1974-75.
Undoubtedly, the improvement in consumer sentiment
has also played a role in the demand for new houses.
Residential construction activity increased at an annual
rate of 14.4 percent in the first quarter of 1976. More
over, since work on new housing units continues for
several months and is typically heaviest in the three
months after the unit has been started, the recent rate of
housing starts and new permits issued suggests that further
gains can be expected in the second quarter of this year.
Housing starts rebounded sharply in February and re
mained close to this higher level in March. At 1.44 million
units annually, housing starts in March were more than
50 percent above their low point in early 1975. Neverthe
less, the industry is operating far below its pre-recession
level, with construction of multifamily dwellings particu
larly depressed. Multifamily housing starts (each apart
ment is counted as a unit) fell substantially during the first
quarter, though several factors suggest that building may
strengthen during coming months. Permits for new
units, particularly multifamily units, showed gains in the
first quarter. In addition, the rate of absorption of new
units has picked up recently. Mortgage commitments at
savings and loan associations, one of the leading indicators
of future building activity, have risen 4.4 percent since the
final quarter of 1975, reaching their highest levels since
mid-1973. In general, the current and near-term outlook
on mortgage money availability is favorable, as savings
and loan deposit flows have remained high.
Though business investment in fixed capital remains
well below its previous peak, there was a significant in
crease in real expenditures on business equipment and
structures during the first quarter: business fixed invest

ment in real terms grew at a 7.7 percent annual rate.
Surveys of planned plant and equipment expenditures
carried out earlier in the recovery had indicated that little
or no growth in real expenditure could be expected during
1976, but some of these surveys did predict a firstquarter surge. The McGraw-Hill spring survey shows that
firms have revised upward spending plans, and other new
surveys may show upward revisions as a result of a
brighter outlook for demand and improved financial
conditions. The early months of 1976 saw rising equity
prices, coupled with moderating long-term interest rates,
and a resurgence of internally generated funds. With the
economy’s solid performance reducing many uncertainties
about future demand, the likelihood of an advance
in capital outlays appears to be improved. Although
capacity utilization rates remain relatively low in most
industries, firms may begin to undertake modernization
expenditures. During the past few years, the types
of equipment and structures that business firms find best
suited to their needs have been radically altered by the
changing relative price of energy as well as by the impact
of environmental legislation. It has been argued that firms’
responses to these changing conditions were delayed by
the recession and that the next few years may find them
modernizing their stocks of plant and equipment, thus
adding to investment demand.
The sharp deterioration in net exports in the beginning
of 1976 reflected a surge in imports at the same time that
exports declined. The strong rise in imports was largely
attributable to the rapid expansion in economic activity
and personal incomes in the United States which increased
the demand for all types of goods and services including
those produced abroad. In explaining the fall in exports,
some analysts point to the fact that the timing of grain
shipments to the Soviet Union accounted for some of the
declines and that much of the remaining fall was concen
trated in the highly volatile civilian aircraft and parts
category. Others note that last summer’s appreciation of
the dollar may have contributed to the decline in exports
as well as to the strong rise in imports. Looking to the
near future, there are some indications that economic
growth of some of the major American trading partners is
picking up. This coupled with a more normal rate of
expansion in the United States makes it unlikely that
further sizable declines in net exports will occur.
Government purchases of goods and services contrib
uted little to the latest rise in aggregate demand. Federal
expenditures actually edged down in real terms, as the
increase in nondefense expenditures failed to offset the
decline in defense spending. The latest information on
orders for defense goods indicates that defense spending is

FEDERAL RESERVE BANK OF NEW YORK

likely to be up in the near future so that the level of Fed
eral spending will probably be more stimulatory in coming
months. At the state and local levels, spending increases
were substantially smaller than in the final quarter of
1975. Apparently reacting to taxpayer resistance to higher
levies, state and local payroll employment grew at less
than one third of its recent rate. With long-term financing
costs high and voter resistance to new bond issues wide
spread, municipal construction dropped.
As personal incomes are continuing to grow rapidly
and the outlook for business expenditures is brightening,
there now seems little doubt that the recovery will persist.
PRICES

By virtually every broad measure of price change,
inflation has slowed markedly in recent months. As mea
sured by the implicit GNP price deflator, prices of goods
and services advanced at a 3.7 percent annual rate in the
first quarter, down sharply from the 6.8 percent increase
recorded in the previous three-month period and the 8.8
percent rise in 1975 as a whole. The rate of growth of the
fixed-weight price index for GNP— which, unlike the
GNP deflator, is unaffected by shifts in the composition
of output— also showed a sharp deceleration. The fixedweight deflator rose at an annual rate of 3.9 percent in the
initial quarter of 1976, compared with 7.2 percent in the
final quarter of 1975.
Consumer prices, as measured by the overall consumer
price index, increased at a moderate 4.5 percent pace
on a quarterly average basis during the first quarter, com
pared with a 6.5 percent rate of increase in the fourth
quarter of last year. The first-quarter rate of inflation was
the lowest recorded since the end of 1972. A closer look
at the behavior of the components, however, suggests
that temporary factors helped to retard inflation in recent
months. During the first quarter, food prices declined for
the first time in more than eight years, falling at an annual
rate of 2.4 percent. At the same time, consumer energy
prices dropped at a 5.4 percent annual rate, reflecting in
part the impact of recent legislation. Excluding these
items, the behavior of prices has been less favorable. The
price of consumer services rose at a 10.5 percent annual
pace, while the prices of commodities other than food and
energy grew at a 5.4 percent rate. While inflation has
cooled significantly from its 1974 rate, the magnitude
of price increases for services and commodities other
than food and energy during recent months makes it clear
that the underlying trend rate of inflation remains above
the first-quarter experience. If, as widely expected, the
outright declines in food and energy prices are replaced

139

by modest increases, the overall rate of inflation will
certainly accelerate in the near term. Such movements
will not signal an increase in the trend rate of inflation
but rather the absence of large, temporary rates of de
cline in the prices of food and energy.
In April, wholesale prices of farm products and of
processed foods and feeds rose 2.8 percent, thereby
recovering half the decline of the past five months. This
turnabout caused the overall wholesale price index to
rise 0.8 percent despite the sustained decline in power
and fuel prices, which fell 0.4 percent. The wholesale
prices of industrial commodities continued to advance,
climbing a relatively moderate 0.3 percent in April. During
the first four months of the year, wholesale industrial
prices rose at an annual rate of less than 3 V2 percent,
down substantially from the 9.2 percent rate in the last
half of 1975. The surge in prices of farm products and
of processed foods and feeds in April suggests that the
slide in retail food prices is probably near an end. Whole
sale prices of consumer goods other than food, however,
edged down in April for the second consecutive month.
This development suggests a near-term continuation of
relatively modest rates of increase in consumer prices of
goods other than food.
WAGES, P R O D U C TIV ITY , AND EM P LO YM E N T

The recent data indicate that there was some modera
tion in wage pressures in the early months of 1976. The
average hourly earnings of private nonfarm production
and other nonsupervisory workers, adjusted to exclude
the impact of interindustry shifts and of overtime in
manufacturing, rose at a 6.2 percent annual rate during
the first quarter, the smallest quarterly increase in the last
three years. And the first-quarter major collective bar
gaining settlements indicate a slight reduction in the rate of
increase of wages and benefits. The average first-year
wage and benefit gain negotiated in the first-quarter settle
ments covering 5,000 or more workers was 9.5 percent,
down from last year’s 11.4 percent increase, and the team
ster settlement reached in April, which covered 450,000
workers, called for a first-year increase in wages and
benefits of slightly over 9 percent. To be sure, a substantial
part of the 4.2 million workers whose contracts are slated to
expire in 1976 have yet to negotiate new agreements, so
that bargains struck in the coming months will be more im
portant for overall wage costs. There are a few signs that
these wage increases may be moderate. High unemploy
ment in some sectors has apparently altered several unions’
bargaining strategy. For example, in the depressed construc
tion industry, wage increases have been moderate and,

140

MONTHLY REVIEW, MAY 1976

indeed, a few unions have even accepted pay cuts in order to undesired inventory and they began layoffs, causing em
be more competitive with nonunion workers. In addition, ployment to drop rapidly. Since its low point in the first
the United Auto Workers, who are involved in the largest quarter of 1975, however, the recovery in employment has
settlement of the year, have announced that job security been very similar to typical postwar recession experience.
rather than wage increases will be the primary bargaining In the early part of previous recoveries, however, high
issue.
unemployment rates induced a falloff in the rate of labor
Productivity, as measured by output per hour worked in force growth. This phenomenon appears to have been
the private nonfarm economy, increased at a 3.3 percent largely absent during the recent cycle. It is not clear why
annual rate in the first quarter of this year after declining labor force growth has remained so strong. Perhaps the
in the fourth quarter of 1975. Over the last four quarters, decline in real wages that many nonfarm wage earners ex
productivity has risen at a rapid 4.9 percent rate. In perienced led additional family members to seek jobs, or
creased productivity usually occurs at the beginning of maybe extended unemployment benefits have kept individ
an economic upturn, so that the recent pattern was ex uals in the labor force who would otherwise have dropped
pected. The brisk increase in productivity, coupled with out in discouragement. In any event, the large increase in
moderate increases in labor compensation per hour the size of the work force in this recovery has meant that
worked, has greatly reduced cost pressures. Over the four the unemployment rate has fallen more slowly than it had
previous quarters, unit labor costs in the private nonfarm in past postwar upturns.
economy rose just 2.4 percent.
The rapid upturn of economic activity has resulted in
a marked increase in employment. Compared with the
final quarter of 1975, 3A million additional workers were
employed in the nonfarm sector. Some had been recalled
C hart III
from layoff, and others had found new jobs. This led to
THE LABO R M AR KET IN RECESSION A N D RECOVERY
a dramatic 0.9 percent fall in the percentage of the labor
INDEXED AS A PERCENTAGE OF TROUGH-OUARTER LEVEL*
force who were unemployed. In April, labor market con
Percent
Percent
ditions overall continued to improve. Nonfarm payroll
employment climbed by 350,000 persons, as most sectors
of the economy expanded their work forces. According to
the survey of households conducted monthly by the Bureau
of Labor Statistics, total civilian employment rose 700,000
in April. A roughly equal spurt in the civilian labor force
prevented the strong employment gains from being re
flected in the unemployment rate, which remained at 7.5
percent. However, other measures did show further im
provement in labor market conditions. For example, the
percentage of the labor force unemployed for more than
fifteen consecutive weeks fell another 0.2 percentage point,
continuing the sharp decline in extended unemployment
that began in January.
The conditions in the labor market over the course of
the recent downturn and recovery have been somewhat
different from the experience in other recessions (see
Chart III). Early in the downturn, many firms felt that
the decline in economic activity would be mild. They
therefore retained a relatively large fraction of their work
force and maintained production, allowing inventories to
build up. Thus, early in the recession, employment held
N ote: The N a tio n a l Bureau of Economic R esearch-dated recession trou g hs occur
in fourth quarter 1949, second qu a rte r 1954, second quarter 1958, first qua rter
up well when compared with typical postwar recession
1961, fourth quarter 1970 The trough quarter fo r the latest recession has not yet
been dated by the NBER. The first q u a rte r o f 1975 was selected as the te ntative
experience. Then, as events made it clear that a sales re
trough qua rte r.
* F o r each reference cycle the trough-quarter level equals 100 percent.
covery was not going to materialize as quickly as expected,
Source: United States D epartm ent o f Labor, Bureau of Labor Statistics.
firms found themselves faced with a massive overhang of

FEDERAL RESERVE BANK OF NEW YORK

141

The Money and Bond Markets in April

Interest rates in the money and bond markets declined
through most of April but posted sharp increases near
the end of the month. According to market analysts, good
news on inflation played a part in the declines in long
term rates in March and early April. In mid-April, how
ever, new reports confirmed that a brisk economic recovery
was under way, and long-term rates began to rise. There
after, underwriters encountered difficulty distributing some
new corporate debt issues, which had been priced when
market conditions were more favorable. Toward the end of
the month, amid reports of substantial growth in the mone
tary aggregates, many investors came to believe that the
Federal Reserve might have adopted a less accommodative
stance and money market rates rose sharply. Yields on state
and local government debt declined on average for the
second straight month.
On April 28, the Treasury announced plans for its cur
rent quarterly refinancing. The amount of new cash to
be raised and the maturity composition of the offerings
were in line with what investors had expected and had
little effect on yields in the debt markets. The Treasury
ultimately raised $3.4 billion in new cash and refunded
$4.1 billion of maturing publicly held debt.
Preliminary estimates of the narrowly defined money
stock (M2) indicate a rapid acceleration in its growth
during April. Growth in the more broadly defined money
stock (M2) also increased sharply. Further declines in
large negotiable certificates of deposit (CDs) outstand
ing, however, held the bank credit proxy to a modest
advance.
T H E M ONEY M AR K ET AND T H E
M O NETAR Y AGGREGATES

Interest rates on money market instruments ended April
little changed on balance, as downward movements during
most of the month were reversed by sharp increases in
the final week. The effective rate on Federal funds
averaged 4.82 percent over the month as a whole. While
this was 2 basis points below the average of the previous
month, in the final statement week the average rate rose 15

basis points over its average in the previous week to 4.93
percent (see Chart I). At the end of April, yields on 90- to
119-day dealer-placed commercial paper were 5Vs percent,
about the same as at the end of March. Rates on 90-day
bankers’ acceptances fell by 15 basis points during April
to 5.03 percent. The average yield in the secondary
market on 90-day CDs closed the period at 5.13
percent, down 6 basis points. Member bank borrowings
from the Federal Reserve during the month continued at
about frictional levels (see Table I), as other money mar
ket interest rates remained well below the discount rate.
The demand for business loans was again weak in April,
and commercial paper outstanding increased only mod
erately. Commercial and industrial loans at large com
mercial banks, including loans sold to affiliates, fell
by $1.3 billion over the four statement weeks ended
April 28. The average increase in these loans during April
was about $1 billion in the previous five years. Even in
comparison with other postwar economic recovery
periods, the demand for business loans has been very
weak. Usually business loans increase in the upturn,
but since April 1975, about when this recovery
started, business loans have declined by 3.8 percent.
Some economists attribute this weakness to the large
volume of internal funds currently available to corpora
tions. Others point to the fact that inventory accumu
lation, which is frequently financed by bank loans,
has begun rather late in this recovery. The decline in
business loans has led, in turn, to the substantial runoff in
large negotiable CDs observed in recent months and to an
increase in bank holdings of Government securities. Most
banks have not, however, responded to the weak bank loan
demand by lowering the prime lending rate, which re
mained at 6% percent through the end of April. One ma
jor bank did lower its prime rate to 6 V2 percent on May 3.
Preliminary data indicate that growth in the monetary
aggregates accelerated sharply in April. During the fourweek period ended April 28, seasonally adjusted Mi—
private demand deposits adjusted plus currency outside
commercial banks— grew at an annual rate of 9.8 percent
over its average in the four-week period ended thirteen

142

MONTHLY REVIEW, MAY 1976

C hart I

SELECTED INTEREST R ATES
F e b ru a ry -A p ril 1976
Percent

N o te :

M O N E Y MARKET RATES

BOND MARKET YIELDS

Percent

D a ta a re show n fo r b usiness d a y s o n ly .

M O N E Y MARKET RATES Q UO TED: P rim e c o m m e rc ia l loan rate a t m ost m a jo r b a n ks;
o ffe r in g ra te s (q u o te d in term s o f ra te o f d is c o u n t) on 90- to 119-day p rim e co m m e rc ia l
p a p e r q u o te d b y th re e o f the fiv e d e a le rs th a t r e p o r t th e ir ra te s , o r the m id p o in t o f
the ra n g e q u o te d if no consensus is a v a ila b le ,- the e ffe c tiv e ra te on F e d e ra l fu n d s
(the ra te m ost re p re s e n ta tiv e o f th e tra n s a c tio n s e x e c u te d ); c lo sin g b id ra te s (q u o te d
in te rm s o f ra te o f discount) on ne w e st o u ts ta n d in g th re e -m o n th T re a su ry b ills .
B O N D MARKET YIELDS Q UOTED: Y ie ld s on new A a a - r a te d p u b lic u tility b o n d s a re b a sed
on p ric e s a s k e d b y u n d e rw ritin g s y n d ic a te s , a d ju s te d to m ake th e m e q u iv a le n t to a

weeks earlier. This brought M 1 growth to 6.2 percent
over its four-week average level ended fifty-two weeks
earlier (see Chart II). The recent high rate of money
stock growth has been in part attributable to exception
ally rapid expansion of currency in circulation. In the fourweek period ended April 28, currency grew at an annual
rate of 14.6 percent from its four-week average level
ended thirteen weeks earlier whereas demand de
posits adjusted, the other component of M 1? rose at an
8.1 percent annual rate. Growth in M2— M 1 plus time de
posits other than large negotiable CDs— grew at an
annual rate of 12.8 percent from the four-week period
ended thirteen weeks earlier. Over the same period, the
bank credit proxy— total member bank deposits subject to

s ta n d a rd A a a -r a te d b o n d o f a t le a s t tw e n ty y e a rs ' m a tu rity ; d a ily a v e ra g e s o f
y ie ld s on s e a so n e d A a a -r a te d c o rp o ra te bonds,- d a ily a v e ra g e s o f y ie ld s on
lo n g -term G o v e rn m e n t s e c u ritie s (b o n d s d u e o r c a lla b le in ten y e a rs o r m ore)
a n d on G o v e rn m e n t s e c u ritie s d u e in th re e to fiv e y e a rs , co m p u te d on th e b a s is
o f c lo s in g b id p ric e s ; T h u rsd a y a v e ra g e s o f y ie ld s on tw e n ty s e a s o n e d tw e n tyy e a r ta x -e x e m p t b o n d s (c a rry in g M o o d y ’s ra tin g s o f A a a , A a , A , a n d Baa).
S ources: F e d e ra l R eserve B a n k o f N e w Y ork, B o a rd o f G o v e rn o rs o f th e F e d e ra l
R eserve S ystem , M o o d y ’ s In ve sto rs S e rvice , Inc., a n d The Bond B uyer.

reserve requirements plus certain nondeposit sources of
funds— rose by only 2.2 percent at an annual rate, as the
volume of CDs continued to decline.
T H E GOVERNM ENT SECUR ITIES M AR K ET

Yields on most Federal Government securities closed
the month at about the same levels as at the end of March,
after declining through midmonth and then reversing course
toward the end of the month. Early in April, the market
rallied in response to news of continued moderation in in
flation and to downward revisions of projected Treasury
borrowing in the months ahead. The optimistic price infor
mation released in April included the relatively modest first-

143

FEDERAL RESERVE BANK OF NEW YORK

quarter increase in the GNP deflator as well as continued
moderation in the rate of rise of the wholesale and consumer
price indexes. The Treasury’s need for new cash in the
remainder of the fiscal year is slated to be lower than
originally anticipated because expenditures had been over
estimated. Later in the month, many investors began to
believe that the Federal Reserve had adopted a less ac
commodative policy stance and this prompted price
declines throughout the market.
Treasury bill rates declined during most of the month.
The average accepted rates on three- and six-month bills
at the regular weekly auction on April 19 were 4.76
percent and 5.09 percent, respectively (see Table II). At
the last auction in March, the three-month bill yield had
been 17 basis points higher and the six-month bill yield
had been 24 basis points higher than at the April 19 auc
tion. Market sentiment was bolstered by the redemption
without replacement of $4.7 billion of bills maturing on
April 22, including $2.5 billion of fourteen-day cash man
agement bills. However, with firmer Federal funds trading
near the end of the month, rates in the secondary market
climbed and three- and six-month bills were sold at yields of
4.91 percent and 5.23 percent in the month’s final auction.
At the regular monthly auction on April 29, the Treasury
raised an additional $750 million in new cash with an
offering of $3.2 billion of 52-week bills. The issue sold
at an average rate of 5.65 percent, down 14 basis points
from the rate obtained on March 31. Interest rates on
three- and six-month bills ended the month at 4.91
percent and 5.29 percent, respectively, about 6 and 7
basis points below their levels at the end of the previous
month.
Returns on Government coupon issues moved down
over the first half of April and then increased in the
last half, a pattern similar to that shown by the rates on
private debt. The upturn of long-term interest rates prior
to any rise in short-term rates was attributed by some mar
ket observers to news on the recent brisk pace of eco
nomic recovery. They argued that this unexpectedly high
rate of economic recovery caused upward revision in esti
mates of what short-term interest rates would be in the
near future and thus made investors demand a higher
return for holding long-term issues.
In early May the Treasury sold the three coupon issues
which comprised its May refunding package. Auctions were
conducted on May 4 for $2 billion of 23 Vi -month notes
and on May 7 for $800 million of the reopened issue of
23% -year bonds with 7% percent coupons. Yield bids on
the notes averaged 6.61 percent, and a 6Vi percent coupon
was provided on the issues sold. The average price in the
auction of bonds resulted in a yield of 8.19 percent.

Table I
FACTORS TENDING TO INCREASE OR DECREASE
MEMBER BANK RESERVES, APRIL 1976
In m illions of dollars; (+ ) denotes increase
and (—) decrease in excess reserves

Changes in daily averages—
week ended

Net
channes

Factors
April

April
28

April
21

April
14

“ Market” factors
Member bank required reserves ................ +
Operating transactions

(subtotal)

.................................

Federal Reserve float
Treasury operations*

371 —

........... + 3 ,6 3 9

...................................

I ll

+ 1 ,1 5 8

453 —

—

715

— 4,377
+

480 -

— 3,546

—

627

850

946

+ 1 ,9 0 2

Currency outside banks ............................. _

436

— 829

— 1,105

+ 1 ,0 1 5

213

—

231

277

+ 3 ,4 4 0

Gold and foreign account ........................

434

— 189

— 1,355

Other Federal Reserve lia b ilities
and

capital

..................................................... +

236

+ 1 ,0 4 7

— 5,092

168

......... — 4,396

— 1,273

+ 4 ,8 4 4

-f

138

...................................... — 2,379

— 1,592

Total “ m arket” factors ............................. + 4 ,0 1 0

3
203

Direct Federal Reserve credit
transactions
Open market operations

(subtotal)

687

Outright holdings:
Treasury

securities

Rankers'

acceptances

Federal

agency

.................................

obligations

7 —

—

....................

—

+ 2 ,7 9 1

+ 1 ,2 3 0

—

16
—

Repurchase agreem ents:
Treasury

securities

...................................... — 1,513

297

Bankers’ acceptances ...................................

—

289

296

—

Federal agency obligations

—

208

101

—

......................

Member bank borrowings ............................... —
Seasonal

borrowings!

.................................

Total

129

.................................................................... — 4,280

Excess reservest§

.......................................... — 270

851

395

190

159

—

138

261

613

— 973

+ 5 ,0 8 3

111

—

9 -

262

Other Federal Reserve assets! .................... +

+ 1 ,6 7 2

263

Monthly
averages||

Daily average levels

Member bank:
Total reserves, including vault casht§ . . .

33,580

33,775

34,481

34,403

34,060

Required reserves

..............................................

33,449

33,560

34,275

34,254

33,885

Excess reserves§ ...................................................

131

215

206

149

175

.................................

......................................

33,556

33,713

34,442

34,350

34,015

Net carry-over, excess or deficit (— )fl . . .

157

Total

borrowings

Seasonal

..............................................

borrowings!

Nonborrowed reserves

N ote: Because of rounding, figures do not necessarily add to totals.
* Includes changes in Treasury currency and cash,
t Included in total member bank borrowings.
t Includes assets denom inated in foreign currencies.
§ Adjusted to include waivers of penalties for reserve deficiencies in
accordance w ith the Regulation D change effective November 19, 1975.
|| Average for four weeks ended April 28, 1976.
If N ot reflected in data above.

144

MONTHLY REVIEW, MAY 1976

From April 29 through May 5, subscriptions were ac
cepted for ten-year notes with 7% percent coupons at par.
All subscriptions for under $500,000 made with a 20
percent cash downpayment were accepted. A total of $4.7
billion of these notes was sold. This ten-year note issue
was the first under recent legislation extending permissible
note maturities from seven to ten years.
Spreads between the interest rates on Government
agency issues and those on Treasury issues have remained
quite narrow. In explaining this, market analysts pointed
to the small supply of agency issues, reflecting the highly
liquid position of thrift institutions which reduced the need
of these institutions to sell mortgages in secondary markets.
Near midmonth, the Federal Intermediate Credit Banks
(FICB) placed $1,044.5 million of consolidated bonds
maturing February 1, 1977 at 5.60 percent, raising $157.0
million in new cash. The Banks for Cooperatives (BC)
issued $409.5 million of short-term consolidated bonds
maturing May 3, 1976 at 5.20 percent. On April 15, the
Government National Mortgage Association issued $335.9
million in mortgage-backed thirty-year securities, of which

Chart II

G R O W T H O F SELECTED M O N E Y STO C K MEASURES

Table II
AVERAGE ISSUING RATES
AT REGULAR TREASURY BILL AUCTIONS*
In percent
Weekly auction dates— April 1976
Maturity
April
5

April
12

April
19

April
26

4.957

4.830

4.763

4.909

5.293

5.068

5.089

5.230

Monthly auction dates— February-April 1976

F ifty-tw o weeks ......................................

February
4

March
3

March
31

April
29

5.572

6.010

5.781

5.645

•Interest rates on bills are quoted in terms of a 360-day year, with the discounts from
par as the return on the face amount of the bills payable at m aturity. Bond yield
equivalents, related to the amount actually invested, would be slightly higher.

$175.3 million of IVa percent pass-through securities was
issued at 7.85 percent and $160.6 million of IV 2 percent
pass-through securities was sold at 7.87 percent. In addi
tional farm credit financing around midmonth, the BC
issued $410 million of six-month bonds at 5.2 percent and
the FICB issued $1,045 million of nine-month bonds at
5.6 percent. The rate on the FICB issue was down from
6.1 percent on the March issue and lower than any
such issue in the past year. The Department of Housing
and Urban Development placed $271 million of notes to
finance urban renewal projects at an average interest rate
of 2.92 percent, the lowest rate for such a financing since
November 1972.
OTHER SECUR ITIES M AR KETS

1974

1975

N ote: G ro w th rates are com puted on the basis of four-w eek averages of d a ily
figures fo r periods ended in the statem ent week plotted, 13 weeks e a rlie r and
52 w eeks ea rlie r. The latest statem ent week p lo tte d is A p ril 28, 1976.
M l - Currency plus a d ju ste d demand deposits held by the public.
M 2 = M l plus commercial bank savings and time deposits held by the public, less
ne g otia ble certificates of deposit issued in denom inations of $100,000 or more.
Source: Board of Governors o f the Federal Reserve System.

In the corporate bond market, the sharp rally that
began in the previous month continued through mid-April.
During the first half, corporate obligations benefited from
the reports of slower inflation, the outlook for less Trea
sury borrowing, and a small number of new corporate
issues. The rally extended to medium-quality issues, as
news of strong economic recovery reduced investors’ wor
ries about risk. In the latter part of the month, prices
declined and some issues, which had been priced earlier
and remained in syndicate, did not sell well. Rates on
municipal bonds continued to decline over most of the
month but stabilized late in the period.
In new issue activity, the bellwether financing of the
month was a $450 million issue of Aaa-rated telephone

FEDERAL RESERVE BANK OF NEW YORK

debentures. The forty-year securities were priced shortly
after midmonth to yield 8.29 percent. Reflecting the
extent of the rally, this return was 27 basis points below
a similar issue sold the month before. Distribution of the
large offering began successfully, but corporate bond prices
fell while some of the bonds were still in underwriters’
hands. Syndicate price restrictions were removed shortly
thereafter, and the bonds sustained a sharp price drop
in the secondary market, bringing the return to 8.47
percent about one week after the issue date. In a key
industrial offering, $250 million of Aaa-rated thirty-year
debentures was quickly placed with investors just after
midmonth at a yield of 8.02 percent. Another Aaa-rated
offering in March provided an 8.57 percent return, al
though that issue had been very generously priced and had
a longer effective maturity.
A sizable amount of new tax-exempt obligations of

145

state governments was sold at competitive bidding during
April. Two $125 million bond issues rated A aa/A A
(Moody’s/Standard & Poor’s) met good receptions. State
of Oregon bonds provided returns from 4.1 percent in
1981 to 5.6 percent in 1994, while State of Tennessee
bonds yielded from 3.2 percent in 1977 to 5.6 percent in
1996. Both issues were placed at rates well below an Aaarated state offering in mid-February, which returned from
4.20 percent in 1979 to 5.90 percent in 1991. Bond obli
gations of the State of Ohio, rated A a/A A and totaling $45
million, were reoffered at yields ranging from 3.5 percent
in 1977 to 6.75 percent in 2001. The Bond Buyer index of
twenty bond yields on twenty-year tax-exempt bonds fell
14 basis points over the month to 6.55 percent, continuing
the declines posted over March. The Blue List of dealers’
advertised inventories rose by $48 million to close the
month at $797 million.

Full text of Economic Policy Review (Federal Reserve Bank of New York) : May 1976, Vol. 58, No. 5

FRASER