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246 MONTHLY REVIEW, OCTOBER 1973 The Business Situation Recent developments suggest that economic expansion continues to be constrained by shortages and capacity limi tations arising under the pressures of strong aggregate de mand. Industrial production declined in August because of a sharp drop in the output of automobiles and trucks, in part resulting from materials shortages. With backlogs of unfilled orders still rising rapidly and the inventory-sales ratio for manufacturing continuing low, it is apparent that demand is straining productive capabilities. The latest Government survey indicates that businesses now anticipate even larger increases in expenditures on plant and equip ment for the final quarters of 1973 than were previously reported. Retail sales remained high in August, as rapid increases in personal income helped to bolster consumer demand. Some buying, however, seemed to be related to attempts to beat expected post-freeze price increases. Only the housing sector has shown clear signs that a con siderable slackening in activity is under way. While the unemployment rate held steady in September, the high level of job vacancies and increasing complaints that cer tain types of labor are in short supply suggest a tight labor market. Soaring inflation in recent months has been marked by especially rapid increases in food prices. In August, the consumer price index rose at its most rapid rate in over twenty-five years, with food prices exploding at a 74 per cent annual rate. At the wholesale level, prices dropped in September, as sharp declines in the prices of certain agri cultural commodities led to a drop in the overall index at an 18.3 percent seasonally adjusted annual rate. Never theless, over the three months ended in September, whole sale prices rose at a 12.6 percent annual rate because of the overwhelming increase in prices of farm products, processed foods, and feeds. There are also indications that wholesale industrial prices have begun to rise rapidly again, especially in areas where demand is pressing strong ly against capacity. At this point, the effects of rapidly rising wholesale food and other prices in earlier months are probably not fully reflected at the retail level. Moreover, while wage increases appear modest by comparison with the acceleration in prices, there are some tentative signs that the size of wage changes may be picking up. PRODUCTION, ORDERS, AND INVENTORIES During August, the Federal Reserve Board’s index of industrial production edged down at a seasonally adjusted annual rate of 2.8 percent, registering its first decline since October 1971. This downturn was primarily the result of a substantial fall in the output of motor vehicles and parts. Such production, which accounts for about 5 per cent of the total index, dropped 12 percent in August, the sharpest one-month decline since the 1970 automobile strike (see Chart I). Originally scheduled to exceed 10 million units at an annual rate, actual August output of domestic-type autos turned out to be at a much slower 8 million unit rate. The shortfall reflected the simultaneous occurrence of several unusual developments. Intensely hot weather covered much of the United States during portions of the month and hampered production by prompting scattered layoffs and plant shutdowns. The Canadian rail strike had an adverse impact on the output of domestic-type passenger cars, since there is a substan tial amount of integration of auto production facilities between the United States and Canada. However, the major portion of the August setback resulted from short ages of a wide variety of automotive parts. Although production was proceeding at a brisk clip in early Sep tember, the seven-day strike at Chrysler held total Septem ber output to a 9 million unit annual rate, compared with rates of production averaging around 10 million units dur ing the first half of 1973. Excluding motor vehicles and parts, industrial produc tion advanced at a 5.7 percent seasonally adjusted annual rate in August. Over the past six months, nonautomotive industrial production has advanced much more slowly FEDERAL RESERVE BANK OF NEW YORK C h a rt I INDUSTRIAL PRODUCTION S e a s o n a lly a d ju s te d ; 1967 = 1 0 0 S ource: Board o f G o ve rn o rs o f the Federal Reserve System. than during the previous half year. Some of this modera tion probably represents the impact of capacity constraints and supply bottlenecks in many important sectors of the economy. In any event, output of intermediate products rose sharply in August and output of business equipment increased modestly despite a decline in truck production. Firms are planning to increase their plant and equip ment spending in 1973 by 13.2 percent according to the Commerce Department survey taken during July and August (see Chart II). This was the same increase as reported in the April-May survey. Since actual outlays fell more than %IV2 billion short of anticipated levels in the second quarter— at least partly as a result of supply problems— the most recent findings imply a substantial step-up in spending during the second half of this year. The April-May survey projected a 10 percent annual rate of growth over the last two quarters but the more recent estimates envision a 14 percent climb. If realized, the 13.2 percent rise in plant and equipment spending would make this the largest increase since 1966, when outlays surged 16.7 percent. Spending in nonmanufacturing industries is slated to rise by 9.9 percent, compared with the rapid 19.4 percent increase expected for manufacturing. A num ber of the industries that are facing capacity constraints, such as primary metals, textiles, and paper, have revised 247 their plant and equipment spending plans upward. Orders placed with manufacturers of durable goods fell by $0.4 billion (seasonally adjusted) in August, marking the second consecutive monthly decline. In July the cut back was centered in orders for defense goods, but book ings for these products rebounded substantially in August. A sizable increase in bookings for primary metals helped offset declines in other areas. Most of the August slowing in new orders occurred in nondefense capital goods in dustries, where bookings were unchanged from June to July. Over the first six months of 1973, orders for capital goods increased rapidly, however. The backlog for non defense capital goods rose considerably in August and accounted for over 25 percent of the large advance in un filled orders. More than 30 percent of the total existing backlog is centered in the primary metals industries where supply problems have persisted, nearly doubling the back log during 1973. In August, shipments of durable goods declined following a rather large July increase, so that the ratio of unfilled orders to shipments increased to a new 1973 high of 2.61 months. An indicator of broader coverage, the book value of seasonally adjusted business inventories, including all manufacturing and trade, increased $1.4 billion in July. In comparison, the average monthly increment in total business inventories was $1.9 billion over the first half C h a rt II PLANT AND EQUIPMENT EXPENDITURES A C T U A L A N D A N TIC IP A TE D S e a s o n a lly a d ju s te d a n n u a l rate B illio n s o f d o lla rs B illio n s o f d o lla rs Note: Figures shown fo r the th ird and fourth quarters o f 1973 are estim ates o f intended spending from the Ju ly-A ugust survey. Source: United States D epartm ent o f Com m erce, Bureau o f Economic Analysis. 248 MONTHLY REVIEW, OCTOBER 1973 of 1973. The magnitude of these changes has been affected, of course, by the sharp intensification of inflation over the past seven months, and it appears that the physical volume of inventories has increased little. For example, during the first half of this year, the monthly book value increase in business inventories was well above the $1.2 billion increase averaged in the second half of 1972. How ever, the physical or real increase in inventories for the first half of 1973, as recorded in the national income ac counts, was about half that of the earlier period. Another aspect of the current inventory situation which stands out is the persistently low level of the inventorysales ratio by historic standards. Business sales advanced strongly during July, and the ratio of inventory to sales fell to 1.410, the lowest level since the early days of the Korean war. Preliminary data indicate that manufacturing inventories rose by nearly $1 billion in August, a slightly larger in crease than those registered on average over the first seven months of the year. At the same time, manufactur ers’ shipments dropped, in part because of the problems that plagued automobile producers in August, so that the inventory-sales ratio for manufacturing increased modestly. CONSUMER SPENDING AND RESIDENTIAL CONSTRUCTION Consumer spending has remained strong in recent months, with demand fueled in part by relatively large increases in personal income. Personal income rose $8.5 billion in July and $10.6 billion in August after registering average monthly gains of just over $7 billion during the first half of the year. While wage and salary disbursements have continued to advance strongly, farm proprietors’ income increased by an unusual $0.8 billion in both July and August because of higher farm prices. In addition, transfer payments spurted in August in part through a cost-of-living adjustment applied to pensions of retired Federal civilian employees. Retail sales rose by a very sharp 3.7 percent in July to $42.7 billion, following a decline between March and June, and remained at the high July level in August ac cording to the advance report. In perspective, retail sales during August were 3.2 percent above the average of the second quarter, which had in turn shown virtually no increase from the January-March average. In August, sales of nondurable goods remained at the high July pace. Recent strong demand for home food freezers, undoubt edly connected with food stockpiling, has helped to boost sales in the furniture and appliances category which spurted sharply upward in August. Sales of new domestic- type autos slowed to a 9.7 million unit annual rate in August but rebounded to a very strong 10.6 million unit rate in September. Over the first nine months of the year, sales of domestic cars have been at a 10.1 million unit pace. The strong September pickup in sales is of note in view of the fact that dealer inventories were quite low, according to industry observers, with supplies of the popu lar small models especially tight. Sales of imported autos moderated to 1.7 million units (seasonally adjusted annual rate) in August and 1.5 million units in September, down from the previous two months and well under the historic high of 2 million units attained during February and March of this year. Retail purchases have been facilitated, in part, by con tinued sizable expansion in consumer credit. In August, consumer credit outstanding rose by $2 billion, somewhat less than advances averaged over the first seven months of the year but still substantially above the average month ly increases of 1972. Increases in nonautomotive instal ment credit and in automobile paper have been large in recent months, while the growth of noninstalment credit has moderated relative to its performance earlier this year. The pace of housing activity continues to slacken. Housing starts dipped ,to 2 million units at a seasonally adjusted annual rate in August, off sharply from the his toric peak of 2.5 million units achieved this past January. The August decline, which reduced starts to their slowest pace in almost two years, was concentrated primarily in single-family units. Newly issued building permits fell in August to an annual rate of 1.7 million, well below the December 1972 peak of 2.4 million. This marked the sev enth decline in new building permits issued in the past eight months. Sales of mobile homes, which had been a rapidly growing component of the housing stock, have fallen for four consecutive months with seasonally ad justed July shipments of 569,000 at an annual rate, the lowest since last October. July sales of new one-family homes dropped well below the June pace, while inventories of unsold singe-family, homes rose sharply to a record 8.8 months of sales. All of these data were gathered before the Administra tion’s mid-September announcements of proposed changes in national housing and home financing programs. Some of these proposals, such as lifting the interest rate ceilings on Federal Housing Administration (FHA) mortgages and instituting a tax credit for financial institutions on mortgage lending, require Congressional approval and thus are not likely to have an impact on housing in the very near term. However, the two major initiatives which can be implemented without further legislation— the ex pansion of the Government National Mortgage Associ FEDERAL RESERVE BANK OF NEW YORK ation’s capacity to purchase FHA-insured mortgages and the establishment of a $2 Vi billion program of forward commitments to savings and loan associations by the Fed eral Home Loan Bank Board—might help bolster housing activity in the future. PRICES AND WAGES The economy continues to feel the effects of the price advances originating in the agricultural sector. Consumer prices rose at a seasonally adjusted annual rate of 23.1 percent in August, the fastest increase in more than twenty-five years. Over the year ended in August, the consumer price index jumped 7.5 percent. This is much faster than the most rapid twelve-month increase recorded during the late 1960’s and early 1970’s— the rise of 6.4 percent over the year ended in February 1970. The index for food consumed at home exploded at a 92 per cent annual pace in August, lifting such prices to a level 23.3 percent above that of a year earlier. Increases regis tered for poultry, eggs, and pork contributed substantially to the August advance. Even prices of fresh fruits and vegetables, items now in season, rose considerably on a seasonally adjusted basis, although they declined on an unadjusted basis. A substantial rise in consumer food prices had been widely anticipated in light of previously announced in creases at the wholesale level, but the August behavior of prices of nonfood consumer items, while less dramatic, is probably more surprising and complicated to assess. Non food commodity prices increased at a rapid 5.8 percent annual rate on a seasonally adjusted basis but only a 2.9 percent annual rate before seasonal adjustment. In view of the many changes in the Economic Stabilization Pro gram over the past two years, it is possible that some usual seasonal patterns have been disturbed so that the unadjusted data should also be closely watched. Prices of services, which the Department of Labor does not adjust for seasonal fluctuation, rose at a rapid 7.8 percent an nual rate in August, the sharpest advance since April 1970. An increase in mortgage interest costs accounted for a substantial portion of the upswing. Nevertheless, prices of other services, such as rents, medical costs, and telephone charges, also contributed to the increase in this measure. Extraordinary variations in the wholesale price index have resulted over the past several months in part in re sponse to changes in the controls program. Following a decline of about 17 percent in July, wholesale prices sky rocketed in August at a record 75 percent annual rate and then plummeted 18 percent in September, the largest an nual rate of decline for any month since March 1946. 249 The amazing August increase was propelled by the more than 200 percent (annual rate) rise in wholesale prices of farm products, processed foods, and feeds. Declines in prices of major foodstuffs such as grains and livestock caused the September index to reverse direction and plunge at a record 62 percent annual rate. While the September decline may ease the severity of some price advances faced by the consumer, substantial retail food price pressures undoubtedly still exist. Despite the declines in July and September, prices of farm products, processed foods, and feeds have climbed at an annual rate of 32 percent since June to a level almost 40 percent higher than a year ago. Wholesale industrial prices were essentially unchanged in July as a result of the freeze. They then rose at a 4.7 percent seasonally adjusted annual rate in August, and this was followed by a 7.9 percent jump in September. (Data unadjusted for seasonal variation show much the same pattern.) September’s large advance brought the rise over the past year to nearly 8 percent. The hike in whole sale industrial prices in both August and September re flected increases in prices of metals, textiles, and lumber and wood products—industries in which supply constraints have been reported. Wages have shown a comparatively modest response to the protracted acceleration in consumer price changes. However, there are some tentative signs that the size of wage increases is beginning to pick up. The index of average hourly earnings for private nonfarm workers is probably the closest approximation to basic wage rates available because it eliminates the effects of interindustry employment shifts and manufacturing overtime hours. Although the index is very volatile on a month-to-month basis, an examination of changes over the most recent six months shows that hourly earnings have increased at an annual rate of 7.4 percent, compared with a slower rise of 5.7 percent during the previous half year. LABOR MARKET DEVELOPMENTS Conditions in the labor market remain basically strong although, as is often the case with monthly statistics, some of the most recent evidence has been mixed. Ac cording to the survey of households, the civilian labor force and employment registered very large increases in September on a seasonally adjusted basis after contracting slightly in both July and August. Because data based on samples— even one as large as the household survey which encompasses some 50,000 households— can move some what erratically on a month-to-month basis, comparisons over longer time spans often help to give a clearer picture MONTHLY REVIEW, OCTOBER 1973 250 of the underlying situation. Over the year ended in Sep tember, the civilian labor force expanded by a very rapid 2.7 percent, while the total civilian population of working age increased by a considerably smaller 1.8 percent. The overall unemployment rate edged up from 4.7 percent in July to 4.8 percent in August, and this rate was main tained in September. However, the decline in the unem ployment rate from the 5.5 percent level prevailing a year C h a rt Itl HELP-WANTED ADVERTISING IN NEWSPAPERS S e a s o n a lly a d ju s te d Source: The C onference Board, Inc. ago in the face of very rapid labor-force growth is signifi cant both from the narrow technical standpoint and from the broader vantage point of assessing underlying econom ic developments. The separate survey of establishments revealed that the number of persons on nonagricultural payrolls rose by about 200,000 workers in both August and September following a small decline in July. This brought the ad vance over the past year to 2.6 million jobs. During the third quarter, employment growth in the major industries was particularly strong in services. Manufacturing employ ment, however, was essentially unchanged over the quarter after having increased by more than 900,000 over the pre ceding twelve months. According to the Labor Department, the number of seasonally adjusted unfilled job vacancies in manufactur ing was 191,000 in August, up sharply from 170,000 at the start of this year and 131,000 a year ago. This is con sistent with reports of shortages of certain types of skilled labor developing in recent months. Over the past year the number of long-term job vacancies— those which have gone unfilled for a month or more— has risen 64 percent, compared with the 39 percent increase in shorter term vacancies over the same period. The Conference Board’s index of the volume of newspaper help-wanted advertising is the closest available approximation to an all-industry gauge of job vacancies. In July the index jumped to a rec ord 131 percent of the 1967 base and, while it slipped to 127 in August, it remained well above rates posted earlier in 1973 or in previous years (see Chart III). The ratio of this index to the number of unemployed persons, also indexed on a 1967 base, may be more suitable for comparisons spanning several or more years as it adjusts for labor-force growth. Since its trough in the first half of 1971, this ratio has risen rather steadily. Although the August ratio fell off somewhat from its July peak, it is higher than it has been in recent years but substantially below levels reached in the late 1960’s. FEDERAL RESERVE BANK OF NEW YORK 251 The Money and Bond Markets in September After edging up early in the month, interest rates gen erally declined dramatically during the second half of September as market pressures cooled and evidence mounted that the growth of the monetary aggregates was slowing. During the final two weeks of the period, partic ipants became convinced that monetary policy was turning toward a less restrictive stance and, against this back ground, rates on most money market instruments moved lower. Rates on most maturities of commercial paper de creased by to % percentage point over the month and rates on large-denomination certificates of deposit (CDs) fell significantly toward the end of the period. The aver age effective rate on Federal funds remained about un changed from the previous month. Earlier in the month, the Federal Reserve raised marginal reserve requirements on large CDs, bank-related commercial paper, and finance bills in a further step to control the rapid expansion of bank credit. This measure increased the cost of such funds to banks and was followed by a boost in the prime lending rate to large business borrowers to 10 percent from 93 A percent. The rally in the United States Government securities market which began in the middle of August continued throughout September, except for one brief but sharp downturn in conjunction with the announcement of the increase in reserve requirements. Treasury bill rates de clined sharply over the second half of the month to levels that had last prevailed in June. Prices of Treasury coupon securities advanced considerably over most of the month. Inventories were light, and reactions to shifting expectations were dramatic. Prices of Federal agency securities also increased during September despite a con tinued heavy calendar of new issues. New issue activity in the corporate and municipal bond markets was modest, and prices of older outstanding corporate and tax-exempt securities also rose over much of the month. In September, the narrow money supply (M i)— demand deposits adjusted plus currency outside banks— contracted for the second consecutive month. M2, which includes time and savings deposits other than large CDs, expanded con siderably less rapidly in September than it had in August. The slowing in the growth of these deposits together with a slackening in the rise of large CDs contributed to the moderation in the growth of the adjusted bank credit proxy compared with its growth over the past few months. BANK RESERVES AND THE MONEY MARKET Short-term interest rates generally held steady during the first three weeks of September, but dropped rapidly late in the month (see Chart I). The rate on 90- to 119day commercial paper fell % percentage point to close the month at 95 percent. Rates on bankers’ acceptances /s also moved lower in September, falling 3 percentage A point over the month. The average effective rate on Fed eral funds was fairly steady throughout September. In the statement week ended September 26, the effective rate on Federal funds averaged 10.84 percent in comparison with the 10.79 percent average of the August 29 statement week. However, member bank borrowings from the Fed eral Reserve, although still sizable, declined from the very high $2.14 billion averaged in August to $1.94 billion in September (see Table I). With corporate cash needs seasonally high in Septem ber, reflecting tax and dividend payment dates, the de mand for bank credit continued strong. A large volume of CDs held by corporations matured on or before Sep tember 15, providing some of the necessary liquidity. Rates on large CDs remained high over the first half of the month but declined thereafter. At the month’s end, three-month CD rates in the secondary market were around 9Vi percent, down about IV 2 percentage points over the month. However, the effective cost to commer cial banks of acquiring funds through CDs was increased as a result of a boost in marginal reserve requirements applicable to such deposits. In a further effort to curb the rapid expansion of bank credit, the Board of Gov ernors of the Federal Reserve System on September 7 announced an increase in the marginal reserve require ments on large-denomination CDs, bank-related com mercial paper, and finance bills. The action raised the reserve requirement on increases in the level of these 252 MONTHLY REVIEW, OCTOBER 1973 liabilities since the week ended May 16 from 8 percent to 11 percent, effective September 20. Member banks are required to maintain the additional reserves in the state ment week beginning October 4. A 5 percent reserve requirement continues to be applied to CDs and com mercial paper up to the quantity outstanding in the state ment week ended May 16. The 11 percent marginal reserve requirement does not apply to banks with a com bined total of less than $10 million of CDs and bankrelated commercial paper outstanding. This is the second time this year that the Federal Reserve has resorted to in creasing the marginal reserve requirements on these lia bilities. Commercial banks increased their prime lending rate for large business borrowers by lA percentage point to 10 percent in the statement week ended September 19. With the gap between the prime rate and commercial paper rates slowly narrowing, corporations began to find the commercial paper market a more attractive source of funds. The volume of dealer-placed nonbank-related com mercial paper outstanding, after declining steadily over the year to a low of $7.5 billion in mid-August, rose modestly throughout September. The latest data confirm that the growth of most of the monetary aggregates has slackened considerably in recent months after a prolonged period of rapid expansion. Pre- C h art I SELECTED INTEREST RATES Percent M O NE Y MARKET RATES July - S e p te m b e r 1973 1973 N o te : BOND MARKET YIELDS Percent 1973 D a ta a r e s h o w n f o r b u s in e s s d a y s o n ly . M O N E Y M A R K E T RATES Q U O T E D : B id ra te s fo r th r e e - m o n th E u r o - d o lla r s in L o n d o n ; o f fe r in g s ta n d a r d A a a - r a t e d b o n d o f a t le a s t tw e n ty y e a r s ’ m a t u r i t y ; d a ily a v e r a g e s o f r a te s ( q u o te d in te rm s o f r a te o f d is c o u n t^ o n 9 0 - to 1 1 9 - d a y p r im e c o m m e r c ia l p a p e r y ie ld s o n s e a s o n e d A a a - r a t e d c o r p o r a te b o n d s ; d a i l y a v e r a g e s o f y ie ld s o n lo n g q u o t e d b y th r e e o f th e fiv e d e a le r s t h a t r e p o r t th e ir ra te s , o r th e m id p o i n t o f th e r a n g e te rm G o v e r n m e n t s e c u r itie s ( b o n d s d u e o r c a l la b le in te n y e a r s o r m o re ) a n d q u o t e d if n o c o n s e n s u s is a v a ila b l e ; th e e f f e c t iv e r a te o n F e d e r a l fu n d s (th e r a te m o s t o n G o v e r n m e n t s e c u r itie s d u e in th re e to fiv e y e a r s , c o m p u te d o n th e b a s is o f r e p r e s e n t a t iv e o f th e tr a n s a c tio n s e x e c u t e d ) ; c lo s in g b id r a te s ( q u o te d in te rm s o f r a te o f c lo s in g b id p r ic e s ; T h u r s d a y a v e r a 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 t y - y e a r d is c o u n t) o n n e w e s t o u t s t a n d in g th re e - m o n th T r e a s u r y b ills . B O N D M A R K E T YIELD S Q U O T E D : Y ie ld s o n n e w A a a - r a t e d p u b l ic u t i l i t y b o n d s a r e b a s e d o n p r ic e s a s k e d b y u n d e r w r it i n g s y n d ic a te s , a d ju s t e d to m a k e th e m e q u i v a le n t to a ta x - e x e m p t b o n d s ( c a r ry in g M o o d y 's r a tin g s o f A a a , A a , A , a n d B a a). S o u rc e s : F e d e r a l R e s e rv e B a n k o f N e w Y o rk , B o a r d o f G o v e r n o r s o f th e F e d e r a l R e s e rv e S yste m , M o o d y ’ s In v e s to r s S e rv ic e , In c ., a n d T h e B o n d B u y e r. FEDERAL RESERVE BANK OF NEW YORK liminary estimates indicate that M ± declined in September for the second consecutive month. During the past three months, Mx has shown virtually no growth (see Chart II). Over the twelve months ended in September, Mx increased by 5Va percent. The growth of time deposits other than large negotiable CDs slowed in September, after hav ing been buoyed in August by the increase in interest rate ceilings on consumer time and savings deposits and the abandonment of ceiling restrictions on deposits of maturi ties of four years or more. The combined effect of the expansion of these time deposits and the decline in Mx resulted in an advance of the broad money supply (M2) at an annual rate of about 2 V2 percent in September. This is well under the pace of expansion experienced over the twelve months ended in September. The adjusted bank credit proxy— which consists of daily average member bank deposits subject to reserve requirements and certain nondeposit liabilities— expanded at an estimated 5V2 percent seasonally adjusted annual rate in September. This is considerably slower growth than the 13 percent advance over the last twelve months. The growth of large CDs decelerated markedly in Sep tember, as such deposits increased at a rate of less than 4 percent. In comparison, over the first eight months of 1973 large CDs expanded at an explosive 82.6 percent annual rate. Reserves available to support private non bank deposits advanced at an annual rate of about 13 Vi percent in September. 253 Table I FACTORS TENDING TO INCREASE OR DECREASE MEMBER BANK RESERVES, SEPTEMBER 1973 In millions of dollars; (+ ) denotes increase (—) decrease in excess reserves Changes in daily averages— week ended Net changes Factors Sept. Sept. 19 Sept. 12 5 Sept. 26 “ M arket” fa c to rs Member bank required reserves .................. + Operating transactions (subtotal) ............... — 34 29 231 — 305 — 350 — 395 4 2 ,9 1 3 — 300 — 1,703 + 876 + 525 4- Federal Reserve float ................................... — 282 4-1,652 + 414 — 1,259 Treasury operations* ...................................... + 570 + 1 ,1 0 2 — 343 — 978 + 351 Gold and foreign a c c o u n t ............................. + — — — 9 — 87 Currency outside banks ............................... — 204 545 — 14 15 65 — 211 28 — 144 + Other Federal Reserve liabilities and capital ....................................................... — 133 4- 435 — 199 — Total “ market” factors ............................... — 5 + 3,1 4 4 — 605 —2,053 + + 530 — 2,683 + 356 + 1,4 3 8 — 359 Treasury securities .......................................... + 300 — 2,345 + 494 + 1,339 — 212 Bankers' a c c ep ta n c e s...................................... — 2 + 101 481 D irect F ederal R eserve cred it tr a n sa c tio n s Open market operations (subtotal) ............. Outright holdings: 2 — — — 3 6 + — Federal agency o b lig a tio n s .......................... 6 11 131 + — 14 — — — — 15 — 137 11 — — 40 — Repurchase agreements: Treasury securities ........................................ 4- 162 288 — 116 + 170 — Bankers’ a c c e p ta n c e s ................................................... — 11 — 18 — 3 + 24 — 8 Federal agency o b lig a tio n s ........................... 4- 92 — 143 — 7 + 42 — 16 Member bank b o rro w in g s ............................................. THE GOVERNMENT SECURITIES MARKET Seasonal borrowings! ................................................ Other Federal Reserve a s s e t s j ................................. Treasury bill rates declined over much of September, and fell dramatically in the latter days of the month. Throughout the period, the market was very sensitive to actions of the Federal Reserve. Early in the month, market sentiment was jolted by the Federal Reserve’s announcement of an increase in reserve requirements on large CDs, bank-related commercial paper, and finance bills. Rates rose sharply and, in fact, new interest rate peaks for some issues were established. The rise in yields was short-lived, however, as a much firmer tone developed around midmonth. Shortly thereafter, the rally gained momentum when market participants interpreted a pur chase of bills by the Federal Reserve for both customer and System accounts as an indication that monetary policy was becoming less restrictive. In a flurry of spirited activ ity, the rate on three-month bills declined by about 177 basis points over the second half of the month. For the month as a whole, secondary market rates on most Trea sury bills were about 76 to 170 basis points below their opening levels. These sharp declines contrast with the Total§ ......................................................................................... E xcess reserves! ....................................................... — 876 72 — 194 + 219 + 484 — 17 — 23 — 6 + 11 — 4- 33 + 53 + 67 + 39 + 192 4 366 —3,504 4 361 — 360 — 367 35 + 642 + 1.960 — 536 + — 93 — 55 37 Monthly changes Daily average levels M ember bank : Total reserves, including vault cash! . . . . 34,128 33,537 33,879 34.136 33,92011 Required reserves ................................................ 33,644 33,413 33,718 34,068 33,711|| Excess reserves§ ................................................ Total borrowings ................................................ 484 124 161 68 20911 2,364 1,488 1,707 2,191 1,938|| Seasonal borrowings! ................................... 168 145 139 150 Nonborrowed reserves ........................................ 31,764 32,049 32,172 31,945 31,98311 157 92 27 24 75!! Net carry-over, excess or deficit ( — ) J 151! Note: 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 $112 m illion of certain reserve deficiencies on which penalties can be waived for a transition period in connection with bank adaptation to Regulation J as amended effective November 9, 1972. The adjustm ent amounted to $450 m illion from November 9 through December 27, 1972, $279 m illion from December 28, 1972 through March 28, 1973, and $172 m illion from March 29 through June 27. 1973. I Average for four weeks ended September 26. I # Not reflected in data above. 254 MONTHLY REVIEW, OCTOBER 1973 more modest reductions in some other short-term rates in September. After a record yield was established for the three-month bill in the September 10 weekly auction, rates declined sharply (see Table II). In the September 24 auction, aver age issuing rates on the three- and six-month issues were 145 and 107 basis points lower, respectively, than the rates set in the auction of August 31. The yield on 52week bills in the monthly auction held September 19 was 8.06 percent, about 33 basis points below the rate estab lished at the previous month’s auction. Prices of Treasury coupon securities advanced during much of September. Good technical position and im proved investor demand served to support the longer term market. The evident slowing in the growth of the monetary aggregates led to expectations that monetary policy would become less restrictive and consequently that interest rates were at or near their peaks. The im provement in the United States balance of payments and the dollar’s better performance in the exchange markets contributed to the firm market atmosphere. Over the month, yields on most three- to five-year issues declined by an average of 58 basis points, while yields on longer term issues generally fell by about 36 basis points. Prices of Federal agency securities rose appreciably during September despite a substantial volume of new issues. Investor demand was strong in this sector, in part because the positive spread between yields on agency and Treasury issues has widened. Federal agency financ ing, particularly from the housing support agencies, has been heavy throughout 1973. During the first eight months of the year, agency financings were 87 percent above the level of the comparable period a year earlier. In Septem ber, the market for agency issues benefited from the good overall technical position of the capital markets and from the sentiment that interest rates had peaked. Early in the month, the Federal Home Loan Bank Board announced an offering consisting of $500 million each of fourmonth, seventeen-month, and 56-month securities. The three maturities were priced to yield 9.38 percent, 8.70 percent, and 7.60 percent, respectively. These securities, which raised $1.5 billion of new money, experienced good initial investor demand but subsequently traded at dis counts during the weakening market of the second week of the month. Also during the second week, the farm credit agencies announced a $1.5 billion financing, con sisting of $306 million of five-month bonds, $302 million of six-month bonds, $200 million of 42-month deben tures, and $699 million of nine-month bonds. These issues, priced to yield 9.90 percent, 9.85 percent, 7.70 percent, and 9.75 percent, respectively, quickly rose to C h a rt II CHANGES IN MONETARY AND CREDIT AGGREGATES S e a s o n a lly a d ju s te d a n n u a l rate s P e rce n t P e rc e n t 0 1 I I 1 I 1 1 I I 1 I I 1 I I 1 I I 1 I I 1 1 I 1 11 I I I 1 I I . J o 0 1 1 1,1. L -i-jJ— .l L-L_L.J 1971 1 1 1 I 1 11 I 1 I 1 I 1 1 I I I IJ 0 1972 197 3 N o te : D ata fo r September 1973 are p re lim in a ry. M l = C urrency plus adjusted dem and deposits held by the public. M2 = M l plus com m ercial bank savings and tim e deposits held by the p ub lic, less neg o tia b le certificates of deposit issued in denom inations o f $100,000 o r more. A djusted bank c re d it pro xy = Total m em ber bank deposits subject to reserve requirem ents plus nondeposit sources o f funds, such as E uro -d o lla r borrow ings and the proceeds of com m ercial p a p e r issued by bank h o ld in g com panies or other a ffilia te s . Sources: Board o f G overnors of the Federal Reserve System and the F ederal Reserve Bank of New York. premiums. Later in the month, the Federal National Mortgage Association marketed $500 million of fiftymonth debentures priced to yield 7.55 percent and $400 million of 83-month bonds priced to yield 7.50 percent. These issues met a favorable reception. OTHER SECURITIES MARKETS Prices of corporate and municipal securities increased on balance during September. The advance was inter rupted briefly by the additional measures instituted by the Federal Reserve to curb the expansion in bank credit. Thereafter, the corporate bond market was aided by the strength of the Treasury coupon sector, and prices moved higher. The technical condition of the corporate sector was excellent, and the price increases in this sector un doubtedly stemmed, in part, from the prolonged scarcity of new issues. Thus far in 1973 there has been about a 40 FEDERAL RESERVE BANK OF NEW YORK percent reduction in the volume of new corporate securi ties offered publicly by comparison with the 1972 level. Most new issues marketed in September carried yields well below similar securities offered in August. On Sep tember 5, $25 million of A-rated public service bonds priced to yield 8.13 percent sold out quickly. The same day, however, an A-rated power company issue attracted only modest interest when aggressively priced to return 8.10 percent. This yield was 70 basis points less than that of a similar issue marketed one-month earlier. On Sep tember 11, $150 million of forty-year Aaa-rated Bell System debentures encountered a lukewarm reception. The issue was originally priced to yield 7.85 percent, Table II AVERAGE ISSUING RATES* AT REGULAR TREASURY BILL AUCTIONS In percent Weekly auction dates— September 1973 Maturities Sept. 10 Three-month ........................................ Sept. 17 Sept. 24 9.016 8.921 8.786 8.832 7.331 7.661 Monthly auction dates— July-September 1973 July 24 Fifty-two weeks .................................. Aug. 22 Sept. 19 8.393 8.388 8.057 * 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 maturity. Bond yield equivalents, related to the amount actually invested, would be slightly higher. 255 35 basis points lower than a similar issue marketed three weeks earlier; however, when syndicate price restrictions were removed, the yield rose 17 basis points. In sub sequent trading later in the month, the issue recovered virtually all of this price loss. During the middle of the month $75 million of Aaa-rated first mortgage bonds, priced to yield 8.02 percent in thirty years, was initially afforded only a fair reception, but subsequently the bonds were swept up in the rally which pervaded the capital markets. Several aggressively priced smaller issues mar keted later in the month experienced heavy investor de mand. Prices of tax-exempt securities also moved higher dur ing the month. The stable tone experienced throughout the period was attributed, in part, to a relatively light sup ply of new issues. Of course, this market also reacted to changes in the participants’ views of Federal Reserve pol icy. Prior to the increase in reserve requirements, a $75 million issue of Aa-rated bonds attracted excellent de mand when priced to return from 4.50 percent in 1977 to 4.65 percent in 1984. The buoyant atmosphere which developed in the capital markets during the final two weeks of September helped to generate good demand for several high-quality issues. On September 26, $292.7 million of Aaa-rated bonds was reoffered to yield from 4.20 percent in 1974 to 5.15 percent in 2014— about 15 to 20 basis points below the returns provided by the same borrower in June. On the same day, a power author ity offered $110 million of A -l rated debentures scaled to yield from 4.85 percent in 1986 to 5.44 percent in 2010. These issues were quickly sold. The Bond Buyer index of twenty tax-exempt bond yields fell from 5.34 percent on August 30 to 5.00 percent on September 27. The Blue List of dealers’ advertised inventories rose $226.5 million over the month to $711.5 million. 256 MONTHLY REVIEW, OCTOBER 1973 Reserve Requirements Abroad By G eo r g e G arvy Economic Adviser, Federal Reserve Bank of New York The United States is the only important country in which not even all commercial banks are subject to reserve regu lation by one central monetary authority. For members of the Federal Reserve System, significant changes were in troduced last year (through amendments to Regulation D that became effective in November 1972) to formalize the break with the inherited geographic basis. However, the basic ingredients of the system of reserve requirements have remained, in fact, unchanged for almost forty years, in spite of deep and manifold changes in banking and in the structure of the demand for credit, credit instruments, and their uses. In this article, the use of reserve ratios in leading industrial countries is surveyed and an attempt is made to extract from this experience some general con clusions regarding their place as a routine tool of mone tary control. Other uses, such as the control of undesirable inflows of foreign funds, are also noted.1 In some instances, it seemed desirable to refer to the policies and practices of some less developed countries as well. A review of foreign experience with fractional reserve ratios is timely because, even after the recent changes in the structure and average level of reserve requirements in the United States, further improvements in the system of variable reserve requirements remain on the agenda and continue to be discussed within as well as outside the Federal Reserve System.2 1 An appendix in which the uses of reserve requirements in eleven individual major industrial countries are reviewed is avail able on request. 2 See, for instance, Deane Carson, “Should Reserve Requirements Be Abolished?” The Bankers Magazine (Winter 1973), the Report of the President’s Commission on Financial Structure and Regu lation (Hunt Commission Report, December 1971), and “The Structure of Reserve Requirements”, an address by Arthur F. Burns, Chairman of the Board of Governors of the Federal Re serve System, before the Governing Council Spring Meeting of the American Bankers Association, April 26, 1973 (Federal Reserve Bulletin, May 1973, pages 339-43). VARIABLE RESERVE REQUIREMENTS AS A TOOL OF MONETARY POLICY To be sure, in each country the specific aspects of frac tional reserve ratios and the role which these requirements play within the range of tools actually used by the mone tary authorities depend on a number of historical and traditional factors. Preferences of the central bank and, possibly, political constraints are other relevant influences. As with so many other monetary tools, the use of reserve ratios as a means of implementing policy objectives varies from country to country and, within each country, over time. The effectiveness of the regulation of the deposit mul tiplier depends basically on the ability of the monetary authorities to control the supply of reserves and the differ entiation of deposits into separate categories to which dif ferent ratios apply. Adjustments in the supply of bank credit can be achieved either by modifying the credit mul tiplier (the relationship between a given reserve base— primary reserves— and the credit superstructure) or by providing a fulcrum against which other policy tools de signed to control the availability of reserves can be ap plied. The effects of changes in reserve ratios on the structure of bank costs and profits are important elements in monetary control. However, the creation of domestic reserve assets (through monetization of domestic public and/or private debt) may be the result of public policy decisions not directly related to monetary policy. Also, changes in reserves of foreign origin may result from ex change flows that are triggered by speculation rather than rooted in trade or service transactions or in international migration of capital. Thus, regulation of the monetary system through the manipulation of reserve ratios might be complicated by limitations affecting a central bank’s ability to control the availability of reserve assets. The introduction in the United States in 1935 of vari able reserve ratios on a regular and permanent basis was followed by many foreign countries which passed similar FEDERAL RESERVE BANK OF NEW YORK legislation or provided for such requirements when under taking a general revision of banking laws. Peter Fousek found that by October 1957 thirty-three foreign countries had adopted variable reserve requirements, usually for time as well as for demand deposits.3 In the sixteen years following 1957, the use made of this new tool has varied widely among individual countries, as has its coordination with other tools of monetary policy, such as open market operations and liquidity ratios. These variations bring into relief the considerable differences in banking systems and banking policies throughout the world. Since World War II, reserve requirements have been a preferred tool of monetary control in most industrially ad vanced countries, even those which, for historical or other reasons, had hesitated for a long time to introduce such requirements on a statutory basis. In several leading industrial countries where reserve requirements were intro duced relatively recently,4 they have been integrated with the existing fairly complex systems of monetary control, notably liquidity ratios.5 Liquidity ratios, prescribing the holding of a specified amount of cash and liquid assets related to total or selected bank liabilities, have not altogether disappeared as a means of controlling bank credit expansion. In most countries they have been relegated to, or maintained in, the role of a safeguard for depositors, and in that case are usually administered (as in Switzerland) by a separate authority in charge of bank supervision rather than monetary policy. Variable reserve requirements now play a key role in implementing monetary policy in the three main countries of Western Europe— the United Kingdom, France, and West Germany— and also in Canada. In West Germany, reserve requirements became the main tool of monetary control following the reconstruction of its bank ing system after World War II. The system of reserve ratios was subsequently refined and modified to achieve additional objectives, such as controlling undesirable short term capital flows. In the United Kingdom and in France, reserve ratios are reinforced by related liquidity ratios, and in recent years they have been used decisively to cope with mounting inflationary pressures. 3 Peter G. Fousek, Foreign Central Banking: The Instruments of M onetary Policy (Federal Reserve Bank of New York, 1957). 4 France in 1967 and Sweden in 1962. 5 While regulation of reserves is primarily a tool of quantitative control over the cash base of the banking system, in some countries it is also used as a qualitative instrument. 257 VARIATIONS IN PRACTICAL APPLICATION The way in which reserve requirements have been folded into the existing framework of monetary control differs from country to country. The usefulness of reserve re quirements as a control tool depends to a certain extent on the alternative control mechanisms they replace or supplement. To the extent that generalizations can be made, in those industrially advanced countries in which reserve requirements have been introduced only recently, their attractiveness was in providing a fulcrum for con trolling total multiple deposit creation as well as in pro viding a more powerful means for achieving specific pol icy goals. Such goals range from selective control— “di rection” in the terminology of some foreign countries— to dealing with undesirable inflows of foreign short-term capital. In some instances, reserve requirements have been introduced or revitalized as a result of disenchantment with direct controls, or because the political parties that favored such controls lost power. Indeed, by and large, reserve requirements have now come to be widely regarded abroad as an alternative to the system of quantitative controls which set absolute or formula ceilings for total or specified categories of loans or bank assets. Introduction and variation of reserve requirements usually pose difficult questions of policy and equity. The first encompasses questions such as the proper differentia tion of deposit liabilities, the differential treatment of deposits of nonresidents, exemption of certain deposit liabilities, and compliance procedures. Problems of equity frequently arise because not all banks acquire reserves in the same manner and at comparable rates, especially when the balance of payments is the main source of additional reserves. Usually some banks have less difficulty than others in complying with any change in the level and structure of reserve ratios. Increases in reserve ratios must fre quently be cushioned by other central bank actions to facilitate adjustment to the new levels, sometimes by lengthening the time available for portfolio adjustments beyond the effective date of the new provisions or by other means. Bank reserves are now normally stipulated by law or regulation. Prior to the 1930’s, they were usually main tained to satisfy a bank’s liquidity needs under standards set by custom or determined by each institution in the light of its business experience. The detailed definition of categories of institutions and liabilities (or assets) subject to reserves may be stipulated in the law or left to the de termination of the monetary authorities. Setting and modi fication of reserve ratios within legal limits is usually delegated to the central bank or, where it exists, to a 258 MONTHLY REVIEW, OCTOBER 1973 monetary authority which establishes broad policy guide lines for the central bank, or to the Minister of Finance. In countries in which legal authority to impose reserve requirements was lacking, central banks found it sometimes necessary to obtain the cooperation of commercial banks (in some cases, by indicating that, if it were not forth coming, binding legislation would be sought) to observe “voluntarily” agreed-upon reserve ratios, either in cash (as in Sweden and Switzerland) or in cash and/or specified assets (as in the United Kingdom). Several central banks preferred to continue operating for some time on the basis of such agreements even after obtaining legal powers to impose reserve requirements (Canada prior to 1967, Sweden prior to 1969); the Bank of England, which has been in a position to set obligatory reserve ratios since 1971 and, as a matter of fact, even as far back as 1946, continues to seek voluntary cooperation. Reserve requirements normally apply to various cate gories of deposit liabilities (in a few cases, other than interbank deposits) as they are differentiated by maturity. The degree of any further differentiation in reserve re quirements depends on a variety of factors, such as the institutional structure of an individual country’s financial sector and the nature and importance of foreign currency deposits. Only a few countries differentiate ratios by geo graphic location or size of bank. In countries in which nationwide branch banking systems predominate, there is little, if any, room for differentiation of reserve require ments by either size or location. In industrially advanced countries, with the exception of the United Kingdom, reserves are normally held in the form of deposits with the central bank, with allowance for including vault cash up to a certain limit. In the less advanced countries, specific provisions range from the requirement that all reserves be held in the form of cash deposits with the central bank to complex formulas in which a specified part of the reserves may, or even must, be held in the form of a variety of stipulated assets. The range of assets qualifying as reserves depends on whether they have been issued to achieve certain qualitative objec tives and/or are used to finance the government or some specific institutions created or controlled by it. When reserve requirements do double duty as a tool of mone tary control and as a means of achieving specific aims of economic policy, such as stimulating growth of selected economic activities or achieving socially desirable goals, their average level is typically high. In the less developed countries, the experience with reserve ratios has been quite varied. During most of the time since World War II, many of these countries have been experiencing pressures on their balance of payments, resulting in chronic shortages of international reserves. Some of these countries— frequently following the advice of experts from the United States or other advanced coun tries or international organizations— have introduced or revised banking laws to include authority for sophisti cated versions of monetary tools. The use of these tools was usually limited by the undeveloped character of the countries’ financial structure and markets. Reserve ratios were frequently vitiated by attempts to combine their use as tools of monetary control with efforts to foster economic development, typically by using them as a means of selec tive credit controls. Reserve requirements in several countries of Latin America offer some of the most extreme examples of qualitative control use. In several countries, a prescribed proportion of reserves must be held in the form of specified obligations, including mortgages and/or loans to specified categories of borrowers, or for stipulated purposes. Such provisions lighten the reserve burden by reducing the share of reserves which yield no income. At times, it becomes difficult to determine whether reserve requirements are used primarily as a means of controlling monetary expan sion or to influence the composition of bank portfolios. The latter is clearly the case when a reduction in reserve ratios is conditioned on using the funds released to make loans that would foster production (Bolivia) or benefit small- and medium-size industry (Brazil). A more frequent provision requires or permits holding of specified govern ment securities. In some countries, interbank deposits qualify as reserves (up to a stipulated percentage), but in some instances only government-owned commercial banks qualify as reserve depositories. The experience of less developed countries also under lines the basic fact that the effectiveness of variable reserve requirements as a monetary control tool hinges importantly on the scarcity character of primary reserves and the ability of the authorities to preserve this quality by closely controlling the creation of reserves of domestic origin. More broadly, it illustrates the proposition that the transfer of any control technique to a country with a different economic, financial, and social structure and po litical climate is fraught with many difficulties. In several countries, one or more “central institutions” exercise supervisory power over specialized credit institu tions and/or provide certain services to them, such as lending or rediscounting. Transactions between these cen tral institutions and their members are frequent and sizable, and the latter tend to hold the bulk of their redundant funds with these central institutions. In some instances, as in Italy and Sweden, the affiliated credit institutions (such as credit cooperatives) may keep part FEDERAL RESERVE BANK OF NEW YORK PRINCIPAL RESERVE REQUIREMENTS IN LEADING INDUSTRIAL COUNTRIES In percent Country Demand deposits* Savings and other time deposits* Austria! ................ 25 7-11$ 15 6.5-9 for time and savings deposits of up to one year; 6.5-8 for time and savings deposits of over one yearj Belgium ................. 20§ None 7 None Canada .................. 12 12 4 4 Francell ................. None 10 30 10.5-19.55# 10 for savings deposits; 20 for other time deposits 7.75-9.25 for savings deposits; 9-13.55 for time deposits# Italyf ..................... 221/2** 22 Vi 221/2 221/2 Japan .................... 2 0 tt 2-3.5n 20 2 15 I I I 2 15 2 or all of the required reserves with their respective central institutions. Since the latter must redeposit an equivalent amount with the central bank, this arrangement amounts to a two-tier system in which specialized institutions act as a conduit for adjustments required of their members to fulfill reserve requirements. Similarly, in some coun tries certain categories of credit institutions are permitted to keep all or part of their legal reserves with Giro offices or similar organizations, which in some countries perform a key role in operating the national payments mechanism. None Germanyf ............. 259 Netherlands §§ Sweden §§ ............... 5 50 24-30## 50 20-30## 40 28 0-5 for savings deposits; 0-30 for time deposits 3.5 for savings deposits and bank bonds maturing within five years None 121/2 None 121/2 Switzerland*** United K ingdom ftt ......... Note: For some countries, not all of the ratios applying to specific institutions and/or situations are mentioned in the following footnotes. * The first line indicates the legal maximum, the second line the reserve requirements in force on July 1, 1973. f Some form of marginal requirements also in effect. $ Lower ratios apply to institutions with liabilities of under 40 million schil lings. § Deposits with a maturity of one month or less. I Higher reserve ratios apply to demand and time deposits held by non I residents. Also, a separate reserve ratio on assets applied concurrently. # Depending on location and other criteria. ** Applies to the excess of deposits over capital funds; a specified portion may be held in income-yielding assets, other than deposits at the central bank which earn interest. Different reserve ratios apply to various deposit-accepting institutions other than commercial banks. f t But 50 percent for free yen accounts held by nonresidents. tt Depending on bank’s total deposits. §§ Authority to set legal requirements was not used; ratios shown are based on agreements concluded with the banks. I II Applies to deposits in excess of 15 million guilders, or about $5.7 million I at the exchange rate in effect on June 29, 1973. # # Depending on size and type of bank: 30 percent for the five largest com mercial banks, 24 percent for other commercial banks, 27 percent for the Post Office Banks, and 20 percent for savings banks and rural credit societies. *** Indicated ratios apply to growth in deposit liabilities to residents above July 31, 1971 levels. Lacking legal power, the Swiss National Bank ne gotiated in 1969 a gentleman’s agreement with the Bankers’ Association. In December 1972, it obtained, for a three-year period, powers to impose both average and marginal requirements on liabilities to both banks and nonbank financial institutions and higher ratios against liabili ties to nonresidents. In addition, special cash deposits may be required against the excessive growth of certain assets. f t t The United Kingdom has a fixed reserve assets ratio, of which a small part is held as balances with the Bank of England by London clearing banks only; other reserve assets are various public debt securities, call money placed with discount houses, and a limited amount of commercial paper. Different reserve requirements apply to discount houses and finance houses. At times, special deposits in the form of interest-earning deposits must be held with the Bank of England. On July 1, 1973 special deposits amounted to 3 percent. BROADENING THE SCOPE OF RESERVE RATIOS The scope of application of reserve requirements has tended to be widened as the range of near moneys has grown and as the effectiveness of reserve requirements as a monetary tool tended to become impaired because of the significant changes which have taken place in the financial structure as well as in banking procedures and processes. In some countries, the scope of reserve requirements was widened primarily in order to tighten selective credit con trols. Indeed, since World War II, in most of the advanced countries compartmentalization of financial services has tended to be reduced by greater competition, mainly from institutions which until quite recently had no legal author ity to engage in activities directly competing with those of commercial banks. Banks have developed new ways of raising funds to supplement deposit liabilities to which frac tional reserve requirements originally applied. The amounts of such nondepository funds have increased rapidly and, in some countries, more rapidly than deposits of commer cial banks. Furthermore, since reserve requirements raise the cost of funds to (and therefore total expenses of) banks, in some countries competing institutions have been able to offer services (including loans) at lower rates. To meet competition, commercial banks in some countries have sponsored, or made greater use of, institutions able to take over some of their business on a basis that would reduce the reserve costs and yet permit them to recapture the revenue (or profits) on business so trans ferred. At the same time, changes in savings, payments, and money management patterns have tended to blur, and even extinguish, what originally was— or appeared to be— a clear demarcation between money and near money. All advanced countries have experienced such developments in various degrees. Most advanced industrial countries have endeavored to meet the problem of ever-growing proliferation of financial institutions and the significant changes in the scope of their activities by subjecting a widening range of financial insti 260 MONTHLY REVIEW, OCTOBER 1973 tutions to reserve requirements which originally had been applicable to commercial banks only.6 The tendency is quite general to make reserve requirements applicable to additional types of institutions which begin to accept de posits or that have become important factors in the short term credit market. Where, in the absence of statutory re quirements, cash balances with the central bank are held in stipulated amounts as a result of gentleman’s agree ments, such agreements now usually encompass (as in the Netherlands) various deposit-accepting and creditgranting institutions other than commercial banks. There are, of course, many smaller and less developed countries which, because their institutional framework still consists essentially of commercial banks only or because the volume of near money is very small, have not needed to extend the range of institutions subject to reserve re quirements. As a matter of fact, in some of these countries, currency rather than deposits constitutes the bulk of the money supply, so that control of the volume of deposit money is less significant than in the advanced countries. Some countries have been searching for a more direct means of influencing the distribution of bank credit than making selected categories of assets eligible—within the stipulated limits— as reserve assets, or giving such assets preferential treatment at the discount window. Differen tiated reserve requirements on assets offer such an alterna tive. The imposition of separate reserve requirements against assets rather than, or in addition to, reserves on liabilities is a relatively new technique (first applied in France in 1971). It is designed to give monetary authori ties a measure of control over the portfolios of financial institutions by stimulating (or deterring) holding of cer tain types of assets. It is thought that reserve requirements related to specific categories of assets can achieve policy objectives more directly than similar requirements im posed on liabilities, or than reserve ratios on liabilities differentiated by type of institution, on the assumption that such variations can be related to institutional preferences for specific categories of assets (such as mortgages, foreign acceptances, etc.). Currently, credit institutions in France subject to reserve requirements must comply with stipu lated ratios applicable to assets as well as to liabilities. In some countries reserve ratios are used primarily as a fulcrum. Relative tightness or, alternatively, ease in monetary conditions is achieved by manipulating the avail ability of reserves— through open market operations or other means, such as debt management—in relation to aggregate reserves required by the applicable reserve ratio structure. Since all growing economies must increase their reserve base over the longer pull, the monetary authorities can influence credit conditions without resorting to cyclical changes in reserve ratios by regulating the availability of additional reserves and the conditions under which they are supplied. Reserve requirements may also be made more or less stringent merely by varying the range of eligible assets, by changing the mode of computation of liabilities subject to reserves, or by a more rigid enforce ment of compliance rules. Thus, relative stability of reserve ratios over protracted periods of time is not necessarily an indication of a diminished role which fractional reserve requirements play in a given country. The use of reserve requirements as a fulcrum is subject to serious limitations in situations where commercial banks hold excess reserves in amounts above those deemed desirable to protect their liquidity, or when banks (and, in some cases, other financial institutions as well) dispose, typically or occasionally, of large amounts of foreign exchange that can be automatically converted into domes tic cash (as in the case of the Netherlands, for example). A similar limitation arises in countries where a large part— or even the bulk— of reserves is created by redis counting operations of the central bank and the additional reserves needed to meet an increase in reserve ratios are provided almost automatically. Indeed, in several Latin American countries, for instance, the value of the reserve tool—whether used as a fulcrum or a means of making frequent changes in the monetary multiplier—is greatly diminished, and in most instances neutralized, by cen tral bank policies which normally provide reserves almost automatically to banks to meet increases in reserve ratios (in particular when they are made primarily to affect the composition of portfolios rather than the credit multiplier). In such situations, compliance with minimum reserve re quirements has become a formality, which may involve costs and inconvenience, but does not, in fact, prevent banks from pursuing expansionary policies. Actually, in some Latin American countries (and in other countries as well) reserves provided at the discount window equal or exceed the total amount of required reserves. Another type of limitation has at times arisen in some less devel oped countries in which branches of foreign banks are an important component of the banking structure. Branches can usually offset the restraining effects of increased re 6 In at least one country (Japan) reserve requirements have been serve ratios by obtaining additional funds from their extended to funds held by trust departments of commercial banks. head offices. In a few countries, reserves must be maintained against overdrafts. FEDERAL RESERVE BANK OF NEW YORK 261 In a few countries, where alternative control techniques such as open market operations are not available, fre quent changes in reserve requirements have been utilized to offset seasonal fluctuations in reserve availability. One conspicuous example is Colombia, where sales of its main export product, coffee, used to result in seasonal bulges of bank reserves. To cope with this situation, the reserve ra tios were frequently raised temporarily during end-ofyear periods, and subsequently were restored to the original level. Another example is New Zealand, where massive transfers from private accounts occur on several tax pay ment dates. Until recently no mechanism existed to cushion the effect on the liquidity of banks, and for many years reserve requirements had been changed often to offset the impact on the New Zealand banking system of the pay ment of income taxes.7 On the other hand, some central banks have pursued a policy of making only infrequent changes in reserve re quirements, in part to avoid undesirable “announcement effects”. They have endeavored to mop up excess liquidity by requiring commercial banks to acquire from the central bank stipulated amounts of nonmarketable certificates of deposit as an alternative to raising reserve requirements (as in Austria). A similar technique is to require banks and other specified deposit institutions to make temporary deposits with the central bank. Interest may be paid on such deposits. Such arrangements may rest on a statutory basis (as in the United Kingdom) or be negotiated with the banks and embodied in a “gentleman’s agreement” (as in Belgium since July 1972). In countries in which liquidity ratios serve monetary control purposes (though in some countries, as in Austria and until July 19 in the Netherlands, on a standby basis only), they are used mainly to reinforce legal reserve re quirements by further reducing the monetary multiplier but permitting the additional reserves to be held in specified income-yielding liquid assets. The most conspicu ous examples are the United Kingdom and Canada. When the United Kingdom authorities recently abandoned direct credit ceilings and interest rate controls in favor of in creased reliance on liquidity ratios, the Bank of England found it necessary to focus its regulatory concern beyond the clearing banks (large institutions in the city of London, A relatively new use of reserve requirements has been to sterilize or reduce the effect on reserves of speculative inflows of foreign short-term funds and to protect the country from the effects of turbulence in the international monetary field by imposing higher reserve requirements on nonresident than on resident accounts. During the period of international monetary unsettlement that has existed since the floating of the pound in June 1972, changes in reserve requirements have been used exten sively as part of moves by several European countries to achieve monetary restraint and, more specifically, to mop up liquidity resulting from central bank purchases of foreign exchange.8 7 New Zealand and Colombia were identified by Fousek in 1957 as examples of frequent use of changes in reserve ratios (op. cit., pages 51-53). In New Zealand the reserve ratio was changed 251 times between November 1957 and November 1972. In Colombia, 27 changes were made between 1962 and 1969. 8 For example, the German Bundesbank raised, effective March 1, 1973, reserve ratios on demand and time deposits 15 percent across the board, and by half this percentage on savings deposits for residents; for nonresidents they were already 100 percent at the margin. but with nationwide branch networks). While the Scottish banks and those in Northern Ireland were expected to observe liquidity ratios comparable to those expected of city banks, other financial institutions were not. Even earlier, in July 1961, the Bank of England found it neces sary to address its informal requests, designed to achieve a moderation of credit expansion, to an ever-widening range of financial institutions, in addition to those that had al ready observed liquidity ratios. Subsequently, British over seas banks, branches of foreign banks, merchant banks, acceptance houses, finance houses (which specialize in consumer finance), and discount houses were all added to the list of institutions required to observe stipulated re serve ratios, although not necessarily as high as those ap plying to the core of the financial system— the city banks. Canada alters the liquidity ratio from time to time mainly to complement debt management operations and to support open market operations by forcing the banks to liquidate assets other than Treasury bills when squeezed for cash, thus spreading the effect of open market opera tions more quickly to other financial sectors. Other coun tries, such as Belgium, apply the ratio occasionally to neutralize excess liquidity. However, France, the country which after World War II had placed liquidity ratios in the center of its monetary policy, has been phasing them out since 1967 in favor of reserve ratios and other tools of monetary control. USE TO CONTROL INFLOWS OF FOREIGN FUNDS 262 MONTHLY REVIEW, OCTOBER 1973 When separate or additional reserve ratios on deposits by nonresidents are used to control the inflow of short term funds, usually marginal requirements are applied. In such cases, typically some historical base period rather than a uniform absolute amount is used to determine the exempt base. Foreign experience also includes examples of the temporary imposition of supplementary require ments in a form different from the normal reserve ratios authorized by permanent legislation. Such requirements may apply to borrowers rather than to lenders, as in the case of Germany and Australia which established cash deposit requirements for long-term borrowing abroad as emergency measures in 1972 and 1973, respectively. SUMMARY Among the major industrial countries, the United States remains unique in that the responsibility for setting re serve requirements for commercial banks is split between the Federal Reserve System and the fifty state banking au thorities, which define independently the assets that qualify to satisfy these requirements. The United States is the only major country in which the central bank does not have the power to regulate reserves of depository institutions other than commercial banks, even though the bulk of savings and other time deposits is kept with such institutions. Also, in no other country is the effectiveness of the cen tral bank limited by making membership, and thus com pliance with its reserve regulations, voluntary for a sig nificant segment of commercial banks. In most of the advanced countries, central banks have at their disposal a number of policy tools which can be used either simultaneously or as substitutes. Skillful use by some central banks of variable reserve requirements has induced several other leading countries in recent years to add this tool to those already available to their mone tary authorities. In countries in which the legal basis has been lacking, informal agreements with bankers’ organiza tions were used to provide for holding specified cash reserves. The flexibility of the reserve tool and the useful ness of marginal requirements has been demonstrated in several situations, including the current period of inter national monetary tensions. The mere existence of reserve requirements as well as extension of the range of financial institutions subject to them is by no means, by itself, an indication that the re serve tool is continuously and skillfully used, or even that it is indispensable as a monetary control tool in a given country. In some less advanced countries, the richness of monetary instrumentation borders on unnecessary gadgetry which, in effect, disguises unwillingness or inability to use the simpler available mechanisms. One important lesson of foreign experience is the observable widening of controls through reserve ratios. The need for this widening has arisen from changes in fi nancial structure, in the money market, and in the chan nels through which credit flows, as well as in the scope of activities of the various credit-granting institutions. In most advanced countries, it has resulted in successive ex tensions in the range of institutions subject to reserve requirements and, in some cases, in the range of liabilities as well. This, in turn, has led to greater differentiation of requirements. In countries which typically gain nonresident deposits in times of international monetary turbulence, it has been found useful to impose higher reserve ratios— frequently in the form of marginal requirements— on de posits of nonresidents (together with other measures to neutralize their effect on the domestic reserve base). Another important conclusion is that periodic changes in reserve ratios must be coordinated with open market and discount operations. Such coordination is required to avoid situations in which the intended restraining or stimu lative influence on the money supply (or on a specified collection of deposit liabilities) fails to materialize because reserves are provided (or absorbed) through other policy actions, thus permitting banks to avoid portfolio adjust ments. On the other hand, coordinated use of other tools for a limited period might be required to facilitate individ ual bank adjustments to changes in the level and struc ture of applicable ratios.