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Federal
Reserve Bankof
NewYbrk
Quarterly Review
Spring 1977
1
Volume 2
New Directions for the Federal Budget?
11
14
The business situation
Current developments
Capital spending— a lack of dynamism
17
19
The financial markets
Current developments
Financing the Federal deficit in 1975 and 1976
23
29
37
50
On the monetary aggregates
I A Broader Role for Monetary Targets
II Monetary Objectives and Monetary Policy
III The Implementation of Monetary Policy
in 1976
Treasury and Federal Reserve Foreign
Exchange Operations
New Directions for the
Federal Budget?
The Federal budget reflects much of the history of the
nation. Changes both on the revenue side and the
spending side highlight 200 years of conflicts and
compromises about the economic, political, and social
priorities of the country. Within the past half century,
moreover, the Federal Government has become one of
the major influences on the nation’s life. Much of the
time, the changes have been evolutionary and gradual.
Sometimes, however, as during the depression of the
thirties, a compass change is clearly evident. Is the
nation now on the threshold of another significant
budget shift?
The recent Presidential campaign indicated that both
candidates favored a curb on the expansion of the Fed
eral Government and an improvement in its effective
ness. These objectives seemed to reflect the sentiments
of a substantial portion of the electorate. The Congress,
for its part, has instituted new budget procedures to as
sert control over spending. Altogether, forces to hold
down the size of the budget seem to be at work.
Despite these auguries, the prospects for significant
restraints on spending are uncertain. Developments
since World War II point the other way: Federal spend
ing has increased more than twelvefold since fiscal
1947. Even after adjusting for inflation, Federal spend
ing is almost three times higher than in 1947. More
over, the current state of public opinion suggests that
there is considerable ambiguity about how conflicting
pressures on budget making will be reconciled. While
the citizenry seems to favor less government, the na
tional government is increasingly asked to tackle prob
lems that used to be the responsibility of the private
sector, or of state and local governments, or that had
previously not been viewed as problems. The growth
of the economy, which often helped to solve problems
in the past, is a less certain solution today for two
reasons. One is the question of whether satisfactory
levels of economic growth can now be attained as
easily as before. The other is the difficulty of making
growth compatible with improved practices in regard
to the environment.
Whenever the economy operates below capacity,
there is bound to be pressure to use stimulative fiscal
policy in order to promote greater economic activity
and to reduce unemployment. However, spending mea
sures and temporary tax cuts for countercyclical pur
poses tend to undercut the prospects for curtailing
outlays and for permanent tax reductions. At present,
the spending problem is accentuated because there are
strong pressures to do more about newer concerns
with respect to energy, pollution, and health. At the
same time, some older concerns, such as the structural
problems of high unemployment among teenagers, Viet
nam veterans, and workers in urban areas as well as the
pressure to relieve poverty, give little sign of abating.
The wish to reduce taxes clearly collides with the
demand for new or expanded programs. It is not
very likely that this conflict can be resolved by the
new Congressional budget techniques and by proposed
new procedures, such as sunset laws and zero-base
budgeting. Sunset laws automatically terminate exist
ing programs at specified dates; zero-base budgeting
requires that spending for existing programs be justi
fied each time an additional appropriation is under
consideration. Techniques can only lead to efficient
decision making after a consensus on priorities has
been reached. Consensus is elusive because wellorganized special interest groups can often mount
heavy pressures to continue or to expand particular
programs. What the new budget procedures can do is
to pose for the Congress in unavoidable form the
central question of economics: how to allocate scarce
FRBNY Quarterly Review/Spring 1977
1
means— in this case Government revenues— among
alternative uses— in this case Government outlays.
Budget processes old and new
As the size of the budget grew, a general dissatisfac
tion with the Congressional budget process became
increasingly evident by the late sixties and seemed to
pick up momentum in the seventies when inflation ac
celerated. In 1969, a New York Times story carried the
headline “ Treasury Secretary Warns of Taxpayers Re
volt” . A recent Brookings Institution study reported
that “ Ten years ago, government was widely viewed as
an instrument to solve problems; today government
itself is widely viewed as the problem” .1 Solutions for
the varied fiscal maladies were many, but there was
one that cut across political, economic, and social dif
ferences— the Congress should get the budget under
control. In hearings held on proposals for improving
Congressional control over revenues and spending,
support for such legislation was widespread and in
cluded members of the Congress, business leaders,
university professors, and public interest groups. Con
gressman Al Ullman, chairman of the House Ways and
Means Committee, testifying in 1973, said:
. . . the clear intent of the Constitution is that the Congress
does have the power of the purse, that Congress does levy
the tax and determine the expenditures . . . . Yet, under
the procedures we follow today [1973] we have virtually
handed all of this over to the Office of Management and
Budget— something not intended by the Constitution.
At the same hearing, Roy L. Ash, the incumbent Direc
tor of the Office of Management and Budget (OMB),
said:
Congressional actions that affect the budget are taken
piecemeal and are uncoordinated for the most part.
Until the passage of the Congressional Budget and
Impoundment Control Act on July 12, 1974, the budget
process in the Congress was fragmented; indeed, there
was virtually no satisfactory Congressional control over
total Federal spending. In addition, the Congress
had no committees charged with consolidating the
various pieces of budget legislation into a meaningful
whole as they entered the legislative hopper. Nor did
it have a staff that could have provided it with such an
overview. The new budget control act established a
Budget Committee in the House and in the Senate to
coordinate budget policy. It also established a Con
gressional Budget Office (CBO) to provide information
and analysis comparable to that which the OMB pro
1 H. Owen and C.C. Schultze, eds., Setting National Priorities, the Next
Ten Years (Washington, D.C.: Brookings Institution, 1976), page 7.
2 FRASER
FRBNY Quarterly Review/Spring 1977
Digitized for
vides the executive branch. The new structure op
erated on a preliminary, nonbinding basis during fiscal
1976. The new arrangements became mandatory be
ginning with the fiscal year 1977 that started on Octo
ber 1, 1976 and that will run through September 30,
1977.2
The 1974 budget act sets up a timetable for the Con
gressional budget process. This timetable is designed
to insure that all appropriation bills for a new fiscal
year are completed before a current fiscal year ends.
In recent years, it was common for some appropriations
to be passed after a new fiscal year had begun— oc
casionally as long as six months after. The act also
requires the Congress to set an appropriate level of
Federal receipts and outlays, determine budget priori
ties, and review any decisions by the President to
impound any funds for programs already under way.
The new budget timetable is summarized in the ac
companying box. In addition to setting new require
ments, the act integrates previously existing executive
and Congressional schedules. This integration should
enable the Congress to exercise better control over
spending and taxation and to assess the impact of
the emerging budget on the economy. Under the new
procedures, the President still submits his budget at
approximately the same time in January as in the past;
the present schedule specifies it be done by the fif
teenth day after the Congress convenes. The actual
budget process, of course, begins well before the
President submits his budget, for that document repre
sents the culmination of budget making within the
executive branch. A new part of the whole budget
process is the requirement laid down by the Congress
that the President submit to it a “ current services
budget” much earlier— by November 10.
The current services budget
The current services budget is meant to provide a
bench mark or baseline against which any changes
later proposed by the President or by the Congress
can be measured. A current services budget is one
that estimates Federal tax and spending programs on
the assumption that they are continued without any
change in policies. These estimates are presented
for the current fiscal year and also for the fiscal year
ahead. This budget must also take into account the
effects of expected changes in economic activity or
2 Starting with the current fiscal year, fiscal years will run from
October 1 through September 30 of the succeeding year. Fiscal
years are identified by the year in which they end. From 1921
through fiscal 1976, the fiscal year of the Federal Government
began on July 1 and ended on the following June 30. The shift
from fiscal 1976 to the current fiscal year, 1977, left the July 1September 30, 1976 quarter unattached to any fiscal year, and
the period is officially known as “ the transition quarter” .
of other trends. Examples of such changes are higher
or lower levels of unemployment or inflation, variation
in the number of social insurance beneficiaries, or
variation in the number of recipients under programs
that are mandated by existing legislation, such as
those for veterans.
In the document submitted to the Congress last
November, the Ford administration chose to submit
four alternative current services budgets based on
four alternative sets of economic assumptions or
paths. These alternatives for calendar 1977 projected
a gross national product (GNP) ranging from $1,874
billion to $1,905 billion, an unemployment rate ranging
from 6.4 percent to 6.9 percent, and an increase in
the GNP deflator (a measure of the general inflation
rate) ranging from 5 percent to 6.5 percent. Total bud
get revenues under the four paths varied by almost
$20 billion, but total spending varied by only about
$6 billion. Under the new budget procedures, the
Joint Economic Committee of the Congress (JEC)
must evaluate whether the President’s current services
budget is reasonable. The range of estimates sub
mitted for the fiscal 1977 and 1978 current services
budgets was judged to be reasonable by the JEC.
The standard appropriation process
Following the usual practice, President Ford presented
a budget message in January accompanied by docu
ments that gave a detailed and comprehensive view
of Federal spending and receipts. It contained revi
sions for the current 1977 fiscal year and a proposed
budget for the next year, fiscal 1978. The fiscal 1978
document also contained budget projections through
fiscal 1982. The revenue and spending estimates for
fiscal 1978 and subsequent years, of course, combined
the continuance of existing programs, the phasing-out
or elimination of other existing programs, and pro
posed programs for which new legislation would have
to be enacted.
The standard procedure has been and continues to
be that each new activity of the Federal Government—
or the expansion of an old activity— must be authorized
by a bill which has been passed by both houses of
the Congress and has been signed by the President.3
Such bills are considered first by the appropriate legis
lative committee (in both the House of Representatives
and the Senate) responsible for the subject the bill
addresses. If necessary, the bill includes an authoriza
tion to appropriate up to a specified amount of money
3 Some bills, of course, are passed over a Presidential veto, and a few
bills have become law without Presidential signature under the
Constitutional provision that, if the President does not sign or veto a
bill, it becomes law after ten days provided that the Congress is then
in session.
Timetable for budget action
On or before:
Action to be completed:
November 1 0 ................. President submits current services budget
Fifteen days after the
Congress con ve ne s___ President submits official budget
March 15 ....................... Committees and joint committees sub
mit reports to budget committees in
House and Senate
April 1 ............................. CBO submits report to budget commit
tees
April 1 5 ........................... Budget committees report first concur
rent resolution on the budget to their
respective houses
May 1 5 ........................... Legislative committees report bills and
resolutions authorizing new budget au
thority
May 1 5 ........................... Congress completes action on first con
current resolution on the budget
Seventh day after
Labor Day ..................... Congress completes action on bills and
resolutions providing new budget author
ity and new spending authority
September 1 5 ................. Congress completes action on second
required concurrent resolution on the
budget
September 2 5 .................If necessary, the Congress completes
action on reconciliation bill or resolution,
or both, implementing second required
concurrent resolution
October 1 ....................... New fiscal year begins
for the program. If the committees approve, the bill
is brought to a vote before the full membership of
each branch of the Congress. If the bills passed by
the two houses differ in any respect, these differences
must be resolved by a conference committee com
posed of members of the two houses. If there is an
acceptable resolution, then identical bills are resub
mitted for passage in each house and transmitted to
the President for signature.
Actual authority to spend funds typically involves a
further step— the passage of the appropriation bill,
again by both houses of the Congress. (The stated
amount on the appropriation bill may be no more, but
may be less than, the amount in the authorization bill.)
The appropriation bill must also be signed by the
President. An appropriation specifically permits a Fed
eral agency to order goods and services and to draw
funds from the Treasury to pay for these goods and
services as well as to meet payrolls up to some
stated amount. Other spending may take the form of
transfers of funds to state and local governments,
to individuals, or to governments abroad and inter
FRBNY Quarterly Review/Spring 1977 3
national agencies.4
Spending in any single fiscal year is always made
up of a combination of spending from some appropria
tions carried over from previous years as well as from
appropriations newly legislated. For example, the
Ford administration’s January budget document esti
mated that $129.2 billion would be spent in fiscal 1978
from the pool of previously authorized appropriations
and that an additional $310.7 billion would come from
new appropriations for new programs or to continue
existing programs.
Since World War II, a practice has developed
whereby the President may instruct the Bureau of the
Budget (now the OMB) to hold spending for a par
ticular activity below the amounts the Congress had
appropriated. The Congress has increasingly viewed
this practice as an infringement on its Constitutional
prerogative to determine the appropriate amount of
spending by the Federal Government, and the Congress
has now passed legislation to assert its control. If a
President wishes to withhold or postpone funding for
an existing program, under the new Congressional
control system he must send a special message to the
Congress. The House and the Senate must approve
such a rescission bill within forty-five days if the
rescission is to become effective. In contrast, if the
President wishes to defer spending temporarily, Con
gressional approval is not required, but the deferral
can be denied if one house passes a resolution against
the proposal.
Steps to the first concurrent resolution
Under the new timetable for Congressional action on
a proposed budget, the various committees with re
sponsibilities for particular segments of budget legisla
tion must report to the budget committee of their house
by March 15. These reports give dollar estimates for the
programs in their jurisdictions, for instance, social
security, transportation, taxes. At the same time, the
CBO and the budget staff in each of the houses are
busy analyzing the President’s proposals, drafting pre
liminary budget resolutions, and preparing reports
that answer questions on the budget that are posed by
various Congressional committees. By April 1, the CBO
is required to present to each budget committee a
report on alternative budget possibilities with re
spect to total revenues and expenditures and their
major categories, as well as a discussion of national
budget priorities. At the same time, each budget com
mittee is preparing a similar budget package. By
4 For ongoing programs, many of which represent long-term national
commitments, the appropriations process is somewhat different from
the one described above. A prominent example is the funding
of the social security programs.
Digitized for
4 FRASER
FRBNY Quarterly Review/Spring 1977
April 15, the budget committee in each house must
submit its suggested first concurrent resolution on the
budget for the next fiscal year. The committees, of
course, take into account the material sent to them
by the CBO on April 1.
After April 15, within the guidelines of the proposed
first concurrent resolutions— they are really prelim
inary budgets— the contours of the Congressional
budget begin to take on more specific form. Between
April 15 and May 15, the first concurrent resolution
must be debated and passed by both houses. Any
differences between the two must be resolved in con
ference, and the final conference report must be
passed by both houses before May 15. In addition, by
May 15 the legislative committees in both houses are
required to have reported out all programs requiring
authorizations. The first concurrent resolution estab
lishes the target for total receipts and outlays and for
the deficit or surplus that the Congress aims to
achieve. Moreover, the spending total must be broken
down into seventeen major categories.
Steps to the second concurrent resolution
After May 15, all the Congressional committees con
tinue to work on the proposals within their jurisdic
tions. They keep in mind the dollar limits set in the first
concurrent resolution and aim to complete action on
the necessary individual bills by the seventh day after
Labor Day. During this period, a committee might seek
to raise its tentative target, which would then create
adjustment problems for the total budget. These prob
lems can be resolved in a variety of ways, including
the cutting of other spending programs or even by in
creasing revenues.
Action on the second concurrent resolution must be
taken by September 15. This resolution sets final totals
on the major categories of revenue and spending.
Given the spending total and the revenue total, there
should then exist a specific deficit or surplus that the
Congress is deliberately identifying as its goal for that
budget. This is most noteworthy, since until last year
there had been no requirement for such an explicit
decision by the Congress. The second concurrent reso
lution changes the spending targets of the first resolu
tion to spending ceilings and the revenue targets to
revenue floors.
If the Congress cannot reach agreement by Septem
ber 15, the legislation provides only a ten-day period
for it to iron out its differences. However accomplished,
joint agreement on a second concurrent resolution must
be achieved no later than September 25. Consequently,
when the coming fiscal year begins on October 1, the
budget totals for that year are already set. There can
still be changes made if the Congress decides that
there is a need for new initiatives or for modification
of existing programs after the fiscal year begins. Such
changes would require further concurrent resolutions.
Among the more important reforms of the budget act
is a built-in antifilibuster device. To prevent delays by
filibuster in the Congressional budget process, the re
form legislation not only sets deadlines for each step,
but also sets specific time limits for debate. In the case
of the Senate, for example, the law states that “ Debate
in the Senate on any concurrent resolution on the bud
g e t .. . shall be limited to not more than 50 hours. . . .”
Experience with the new process
The effectiveness of the new procedures was illus
trated by the way the timetable operated to shape
the budget for the current fiscal year. Last May, the
first concurrent resolution for fiscal 1977 placed total
expenditures at $413.3 billion, some $20 billion higher
than the proposed spending total for fiscal 1977 in the
budget President Ford presented in January 1976.
The larger expenditures proposed by the Congress, ac
cording to an analysis by the staff of the House budget
committee last spring, would have increased employ
ment by about one million persons more than was im
plicit in the President’s budget. The $413.3 billion total
itself represented a compromise between differences
that had existed earlier between the House and Senate
over the size of the proposed jobs programs. The
House had proposed higher outlays, including more
spending on public works.
As with the first resolution, the proposed second
concurrent resolutions passed by each house were
not identical. But the differences this time were rela
tively minor and easily reconciled. A few weeks earlier,
however, there had been considerable concern over
the substantial divergences between the Senate and
the House on the proposed tax legislation. The Senate
wanted tax cuts much larger than the House did, not
only for fiscal 1977 but also for succeeding years. Even
tually, the reconciliation kept revenues, and therefore
the deficit, close to the totals that had been set in the
first resolution.
The disappointing course of the economy after pas
sage of the second concurrent resolution last fall con
vinced President Carter by the time he took office
that it was prudent to try to stimulate the economy
further. He therefore proposed a $31 billion package
of tax cuts and job creation programs, mostly for
fiscal 1977 and 1978. Consequently, the Congress had
to work on a third concurrent resolution incorporating
these changes. Once again the versions passed by
the House and the Senate differed, for the two bodies
augmented President Carter’s proposals by different
amounts. Passage of the third concurrent resolution
was achieved on March 3. It added $4.4 billion to
spending and reduced expected revenues by $14.8 bil
lion. The estimated deficit for fiscal 1977 was thereby
raised to $69.8 billion, $19.3 billion above that of the
second concurrent resolution, although the stimulus
package itself had not been passed.
Assessment of the new budget controls
Any assessment of the new budget controls must take
into account a loophole in the coverage of the budget.
Some Governmental agencies, such as the Postal
Service and some of the lending agencies, are not
included in the budget. Outlays by these agencies were
$7.2 billion in fiscal 1976, and the estimate for fiscal
1977 is $10.8 billion.5
If Congressional control over Federal Government
activities is to be comprehensive, these off-budget
organizations should be put into the budget. Under
current arrangements, the financing of existing offbudget agencies is exempt from the provisions of the
Congressional Budget and Impoundment Control Act
of 1974, but there is no bar to prevent the Congress
from putting them into the budget. Until the off-budget
agencies are brought explicitly under budget control
procedures, a significant and perhaps widening gap in
spending control will remain.6
When the new budget control system was adopted,
it was viewed with considerable skepticism. Previous
attempts to control spending had little impact. The
spending ceilings in effect for a few years contained
too many exceptions. The ceiling on outstanding Trea
sury debt that is still in existence has proved to be
ineffective. More significantly perhaps, the new system
interposed another layer within the existing Congres
sional structures. The new budget committees, with
their responsibilities to set and to monitor binding
ceilings on spending and to implement desired goals
for revenues, encroach on the domains of existing com
mittees. Political observers wondered whether these
s These agencies finance some of their operations from funds obtained
by borrowing, chiefly from the Federal Financing Bank (FFB), which
in turn obtains its funds from the Treasury. Consequently, Treasury
borrowing from the public is higher than the amount required to
finance the recorded budget deficit.
4 As defined in the budget document, “ off-budget entities are federally
owned and controlled, but their transactions have been excluded from
the budget totals under provision of law". Some agencies are
completely off-budget, such as the Pension Benefit Guaranty
Corporation. Only a portion of the activities of some agencies are
off-budget, such as the programs for the housing of the elderly and
of the handicapped in the Department of Housing and Urban
Development (HUD). Off-budget agencies must be differentiated
from Government-sponsored agencies, such as the Federal Home
Loan Banks (FHLB) and the Federal National Mortgage Association
(FNMA), which are privately owned and operated and therefore
completely excluded from the budget. These agencies borrow in
the capital market by issuing their own debt instruments.
FRBNY Quarterly Review/Spring 1977
5
committees would allow their strongly entrenched
powers to be eroded. After the first year of operation,
however, the consensus was that the new system had
been successfully launched. Continuing success, never
theless, is far from a foregone conclusion. A tradition
of solid achievement in Congressional budget control
must be built to help safeguard the integrity of the new
procedures. They should not become empty rituals.
Perspectives on the budget
The bulk of spending under any new budget is based
on legislative programs that have been in existence for
years, even though in many cases new appropriations
are required annually. Any new initiatives on spending
and taxation are just the tip of the total budget ice
berg. New initiatives, however, are likely to affect
future budgets significantly. To understand any new
budget, it is therefore helpful to review how it has
evolved in size and in composition. Such a perspective
Chart 1
Federal Budget
Billions of dollars
4 0 0 ---------------------------------
can be gained by examining data from two related,
though different views of the Federal Government—
the view provided by the unified budget and the view
provided by the Federal sector of the national income
accounts (NIA).7
Taking the span of years since World War II, total
unified budget Federal receipts and expenditures
broadly trace a similar growth trend, although reve
nues move more erratically. After 1946, revenues
typically fell short of spending; there have been only
eight years of surpluses. For many years the deficits
were generally small— under $5 billion (Chart 1). But
beginning with fiscal 1971, deficits in the unified bud
get— with the exception of two years— were larger
than $23 billion, and they reached a historic peak of
$66.5 billion in the last fiscal year.
The cumulative deficit for the fiscal years 1947 to
1976 is more than $238 billion, which raised outstand
ing Federal debt on June 30, 1976 to $620 billion. A
sizable portion of this debt, $150 billion, was held by
the Government itself. Another sizable portion, $95
billion, was owned by the Federal Reserve System.
Privately held net Federal debt has increased from $230
billion in calendar 1946 to $446 billion in 1975. The
share of this debt in relation to all outstanding debt in
the economy, nevertheless, has dropped from about
50 percent in the late forties to about 15 percent.8
Trends in spending
It is convenient to look at Federal spending by the
categories used in the NIA. Total NIA Federal spending
has increased from $29.5 billion in fiscal 1947 to $373.0
billion in fiscal 1976. All of the broad categories of
spending identified in the NIA have grown almost
steadily. Much of this increase simply reflects the
growth of population and the economy, as well as the
effects of rising prices. In addition, however, Federal
expenditures have been pushed ever higher by the
adoption of newly developed programs plus the addi
tion of new functions to previously existing programs.
Surplus
10
■
0-
-
A
10-
20-
-3 0 -4 0 -5 0 -
Deficit
-6 0 -7 0 1 I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I. I
1946
50
55
60
65
70
76
Fiscal years
Source: The Budget of the United States Government, 1978.
6 FRBNY Quarterly Review/Spring 1977
7 For the purposes of this article, it proved most helpful to discuss
Federal Government spending using the NIA categories and Federal
Government receipts using the unified budget categories.
The unified budget is the official budget of the United States
Government. The Federal sector in the NIA is a statistical estimate
of Federal Government activities recalculated from budget data to
provide a picture of the Federal Government consistent with the
accounting system used to estimate total output of the economy— GNP.
The estimate of total GNP is based on a comprehensive set of data—
the NIA— made up of a number of subsectors, such as government,
business, and consumers. While broadly similar, the unified budget
of the Federal Government and the NIA Federal sector differ in
agencies covered, in accounting techniques, and in the various
descriptive categories into which programs are combined.
8 These debt data, compiled to cover in a consistent accounting
framework all debt in the nation by major sector, are available only
on a calendar-year basis. The latest data are for 1975.
Since World War II the Federal Government has
grown larger not only in absolute terms but also in
relation to other sectors of the economy. The typical
test of relative size is to calculate how the Federal
Government sector has grown by comparing it with
the growth of GNP, the measure of total output of
goods and services in the economy. On this basis, the
Government sector has grown from 14 percent of
GNP in fiscal 1947 to 23 percent in fiscal 1976. This
growth has been somewhat erratic: a large upward
thrust was associated with the Korean war, another
not quite so large was associated with the Vietnam
war, and a third was associated with the recent re
cession (Chart 2).
Chart 2
Federal Government Expenditures as a
Share of Gross National Product
Percent
2 4 -------
Outlays by sector
Although they have exhibited very different patterns
over the years, two components of Federal outlays,
spending for goods and services and spending for
transfer payments, account for the bulk of outlays.
Federal purchases of goods and services increased
from $13 billion in fiscal 1947 to $127.2 billion in fiscal
1976. Nevertheless, as a share of GNP these purchases
are now only 2 percentage points higher than in 1947.
They peaked at more than 15 percent during the
Korean war and are currently down in the neighbor
hood of 8 percent. Defense spending is responsible for
this relative decline and now accounts for about two
thirds of all Federal purchases, compared with a peak
of 87 percent during the Korean war.
Transfer payments, which consist of the various
social insurance and the other general welfare and
assistance programs, have expanded almost contin
uously. These payments have increased from $10 bil
lion in fiscal 1947 to $156.7 billion in fiscal 1976, a
more than fifteenfold growth. As a percentage of GNP,
they have about doubled— from less than 5 percent
to almost 10 percent. By fiscal 1975, transfers exceeded
total Federal purchases of goods and services and
became the largest component among all the NIA
Federal spending categories.
There has, of course, been substantial growth of
other spending as well. The increase in Federal grantsin-aid to state and local governments, which include
revenue-sharing payments, has been important. Grants
to state and local governments have climbed from 0.7
percent of GNP in fiscal 1947 to 3.6 percent in fiscal
1976. They now provide more than 20 percent of state
and local revenues. Interest payments on Federal debt
have registered a sixfold rise in absolute dollar
terms, and Federal subsidies have advanced eight
fold from the end of fiscal 1946 through fiscal 1976. Still,
both have remained relatively small in percentage
terms, and together amount to only 2 percent of GNP.
Federal Government expenditures are based on
national income accounts.
Sources: Economic Report of the President, 1977i
The Budget of the United States Government, 1978.
Trends in receipts
Despite frequent deficits, Federal receipts tended to
increase at almost the same pace as spending until
1970. Most recently, due to the very deep 1973-75 re
cession, receipts have lagged behind spending by
much wider margins than before. Consequently, deficits
have widened substantially. Viewed over the long
term, all categories of receipts in the unified budget
have grown greatly, though some have risen faster
than others. There were only temporary interruptions—
due sometimes to slowdowns in economic activity,
sometimes to changes in tax laws.
The individual income tax has been, and remains,
the backbone of Federal Government revenues, ac
counting for about 45 percent of total receipts every
year. Apart from the steady share from the income tax,
the composition of Federal revenues has changed
FRBNY Quarterly Review/Spring 1977
7
markedly since 1946 (Table 1). Starting with a share
of less than 8 percent of the total in 1946, employer
taxes and individual contributions to social security
and related programs now account for almost 31 per
cent. The jump reflects increases in contribution rates
and the tax bases on which contributions are figured,
broadened coverage, and the introduction of new types
of coverage, such as for hospital bills and disability
pay. In all, almost 75 percent of total Federal revenues
is now collected from the individual income tax and the
social insurance taxes. By contrast, the corporation
income tax, which in 1946 constituted more than 31
percent of total revenues, has dropped to about 14
percent, even though its dollar contribution has been
growing (Table 2). All other revenue sources now con
tribute only about 12 percent of the total, compared
with 20 percent in 1946, because excise taxes have
been reduced or eliminated.
The government sector in the economy
There is no simple way to assess the impact of the
Federal Government sector— or the budget— on the
nation’s economic system. Federal Government spend
ing as a percentage of GNP provides only the roughest
measure of the importance of the Government in the
economy. From one point of view, saying that Federal
Government spending amounts to 23 percent of GNP
overstates its importance. The amount of the total out
put of goods and services that the Government pur
chases is down to about 8 percent of GNP. As Gov
ernment purchases as a percentage of GNP have been
declining, Government transfer payments to individuals
and state and local governments have been rising rela
tive to GNP. Since Federal Government transfer pay
ments do not involve actual Federal purchases of
goods and services, it has been said that their inclu
sion in an evaluation of the Federal sector leads to
overstating the Federal Government’s role. However,
these transfers inevitably alter private spending. Had
the Federal Government not received taxes from some
people and transferred them to others, a different pat
tern and level of private spending would have pre
vailed.
Other budget practices suggest that the budget may
well substantially understate the role played by the
Federal Government in the economy and in the nation’s
noneconomic affairs. One understatement of the extent
of Government influence results from the size of “ tax
expenditures” . Tax expenditures— or tax subsidies—
represent revenue losses arising from special provi
sions of the Internal Revenue Code (some of them are
the “ loopholes” about which there is a great deal of
popular discussion). These special provisions make the
tax liability of an individual or a business firm smaller
http://fraser.stlouisfed.org/
8 FRBNY Quarterly Review/Spring 1977
Federal Reserve Bank of St. Louis
Table 1
Federal Budget Receipts: Distribution by Source
In percent
Fiscal
1946
Fiscal
1968
Fiscal
1972
Fiscal
1976
Individual incom e taxes . .
41.0
44.7
45.4
43.9
Corporation incom e taxes .
31.1
18.7
15.4
13.8
contributions ........................
7.8
22.5
25.8
30.9
Excise taxes ........................
16.9
9.2
7.4
5.7
Estate and gift ta x e s ...........
1.7
2.0
2.6
1.7
Customs d u t ie s ....................
0.9
1.3
1.6
1.4
M iscellaneous receipts . . .
0.5
1.6
1.7
2.7
Total receipts ........... ..........
100.0
100.0
100.0
100.0
D escription
Social insurance taxes and
Table 2
Federal Government Budget Receipts by Source
In billions of dollars
Fiscal
1946
Fiscal
1968
Fiscal
1972
Fiscal
1976
Individual incom e taxes . .
16.1
68.7
94.7
131.6
Corporation incom e taxes .
12.2
28.7
32.2
41.4
contributions ........................
3.1
92.7
6.6
34.6
14.1
53.9
Excise taxes ........................
15.5
17.0
Estate and g ift taxes .........
0.7
5.4
5.2
Customs d u t ie s ....................
0.4
3.1
2.0
3.3
4.1
M iscellaneous receipts
0.2
2.5
3.6
8.0
39.3
153.7
208.6
300.0
D escription
Social insurance taxes and
,.
Total receipts ......................
Source: The Budget of the United States Government.
than it otherwise would have been. Tax expenditures
are simply another way by which public policy can
attempt to promote particular types of economic activi
ties or moderate undue tax burdens on persons or
firms who are seen as facing special circumstances.
Estimates of tax expenditures now must be included in
the budget by law. The official estimate is that tax
expenditures amounted to $95.4 billion in fiscal 1976.’
Identification of the cost of specific tax expenditures
should facilitate the evaluation of whether the benefits
to the nation are worth the revenues lost.
Another form of Government influence which is often
not recognized is the effect of the Government’s credit
programs. In fiscal 1976, direct loans outstanding had
risen by $14.4 billion to $64.2 billion, and guaranteed
*A n y estimates of tax expenditures are subject to a w ide range of
uncertainty because of the technical issues and am biguities involved
in calculating them.
or insured loans outstanding rose by $11.3 billion to
$169.8 billion. Of course, loans that are guaranteed by
the Government do not add to budget outlays unless
borrowers default; consequently, these loans represent
only a contingent, though large, liability of the Federal
Government. In addition, about $10 billion of loans
made by off-budget agencies also are excluded from
budget spending totals, even though these disburse
ments increase the amount of Treasury borrowing.
Understatements about the budget also arise from
accounting practices. The unified budget records cer
tain kinds of receipts not as such, but as offsets to
spending. This practice does not affect the size of the
surplus or deficit, but it does lower the level of total
receipts and total expenditures. Offsetting receipts from
the public in fiscal 1976 amounted to $13.9 billion, thus
reducing outlays from a gross level of $380.4 billion to
$366.5 billion and reducing receipts to $300.0 billion,
the figures that are cited in the total budget for fiscal
1976.
Finally, in recent years there has been a large in
crease in the number and in the scope of the regu
latory functions of Government. They require relatively
small numbers of governmental personnel and rela
tively small amounts of Federal spending. Neverthe
less, these regulatory functions affect a wide range of
activities. It sometimes seems as if more discontent
with Government is generated from the regulatory and
standard-setting functions than is generated from dis
satisfaction with the levels of taxation or spending.
While there are efforts to reduce Government regula
tion, reasons to introduce new ones seem constantly
to arise— right now there is a good deal of pressure
to introduce more regulations to protect consumers.
Questions of budget policy
Fundamental conflicts with respect to budget policy
can be expected to continue for years to come. The
charge that Government is too big is commonplace.
At the same time there is a strong pressure to raise
spending for defense and for health and social needs.
There is a similar dichotomy about Government regu
lation. It is said to be stifling private competition,
initiative, or prerogative, but recent calls to reduce
regulation have met a mixed response from the in
dustries involved.
Fiscal policy has become more controversial of late.
For much of the postwar period, the fiscal prescription
to combat a recession was simple: cut taxes and in
crease spending. In recent years, however, the per
sistence of inflation even during recessions has
complicated the application of this standard policy
prescription. Moreover, structural problems of the
economy now seem to require policy measures to deal
with specific concerns, such as teenage unemploy
ment or the plight of the inner city. In brief, reliance
on broad fiscal policy to solve national difficulties is
being questioned. At the same time, the economy has
seemingly become harder to manage. This is the con
text in which the principal budget issues that are
likely to be concerning the President, the Congress,
and the citizenry at large must be viewed.
(1) Tax policy. Federal Government taxes are a
perennial center of controversy, with income taxes—
individual and corporate— bearing the brunt of the
criticism. Broadly viewed, there are three types of
complaints: rates are too high, the tax structure is too
complex, the structure is shot through with too many
inequities. While almost everyone favors reform and
rate reductions, there is difficulty in reaching a con
sensus on specific proposals. Nevertheless, the time
for a fundamental reconstruction of the income tax
seems to be coming. Former President Ford proposed
some revisions in his January budget presentation,
and the Carter administration announced that it will
send to the Congress this fall recommendations cov
ering both individual and corporate income taxes.
The basic problem underlying any attempted re
vision of the individual and corporate income taxes
is the need to ensure that tax treatment of all forms
of income is as uniform and equitable as possible.
To do so properly requires a comprehensive approach,
since piecemeal reform can give rise to new loopholes
or to new forms of unequal treatment.
The merits of a tax reform are generally examined
solely on the basis of tax considerations. Because gov
ernment spending ultimately must be paid for by tax col
lections, a formidable constraint is placed on reforms
that would reduce revenues in any major way. Another
constraint is that broad-ranging changes in taxes and
spending inevitably have important consequences on
the overall operation of the economy. Finally, some tax
arrangements are specifically designed to implement
desired social policies. This results in tax complexity
rather than simplicity, as well as favored treatment for
selected categories of taxpayers. Consequently, the
task of actually achieving the general objective of a
simple and equitable income tax system has proved
elusive— yet in a democracy this objective must con
tinue to be pursued.
(2) Energy shortages and environmental protection.
New complexities in budget making have arisen be
cause of the increasing role that the Federal Govern
ment is playing in connection with energy and the
protection of the environment. Legislation to cope with
these issues will be a continuing concern of President
Carter and his successors and of the Congress. Such
legislation can be expected to be a combination of
FRBNY Quarterly Review/Spring 1977
9
spending programs, tax changes, special incentives
or subsidies, and new regulations. They are likely to
have an enduring effect on the budget, and over the
long run could materially affect the existing composi
tion of spending and revenues. Even more important,
they may well bring marked changes in the structure
of the whole economy.
The nation’s economy, both on the production and
the consumption sides, developed on a foundation of
cheap energy. The Organization of Petroleum Export
ing Countries (OPEC) ended that era, and the resulting
higher energy prices have been working their way into
the entire price structure. Moreover, the persistent ef
forts by OPEC to maintain the price relationships be
tween oil and other products that were set immediately
after petroleum prices were quadrupled late in 1973,
if successful, will tend to exert upward price pres
sures. Standard fiscal measures cannot deal ade
quately with inflation arising from such unusual de
velopments.
The resolution of the nation’s energy problems
inevitably involves environmental considerations. Dam
age to the environment from all sources has already
been responsible for the adoption of a variety of regu
lations. These clearly involve money costs. Yet lack
of environmental regulation can involve social costs
that are not so easily perceived. It is now obvious that
environmental pollution can no longer be treated with
benign neglect. In fact, abuse of the environment
itself has become a major contributing factor to price
and supply pressures, as illustrated by the increasingly
expensive search for clean water. There is little ques
tion that the present generation faces difficult deci
sions about how the bountiful natural heritage be
queathed to them should be handed on to their
successors.
(3) Is government too big? With so many major prob
lems facing the nation, will it continue its practice of
shifting problems onto the lap of the Federal Govern
ment when all else fails? This results in Government
taking on social and economic tasks that might more
properly be taken care of by states and localities or by
the private sector. Any such misdirection of efforts
and resources cannot be fully corrected until the na
tion’s priorities are more thoroughly reassessed and a
new consensus forged.
Whatever is done about major priorities, there is at
least a potential for better control over Federal spend
ing. The budget control act and its procedures are
already in place. And two proposals for further im
provements are now being discussed: sunset legisla
tion and zero-base budgeting (ZBB). A bill has already
10 FRBNY Quarterly Review/Spring 1977
been introduced into the last Congress, the Government
Economy and Spending Reform Act of 1976, which
combines the sunset and ZBB concepts.
The sunset principle states that all programs must
contain a specific and automatic termination date.
After that date, it is necessary to reauthorize the pro
gram, presumably after searching reexamination. ZBB
requires spending programs to be grouped according
to objective and then arranged by priority in order to
allocate available budget resources among them. Strict
application of ZBB requires that spending for each
program must be justified each time an appropriation
for it is under consideration. A fully effective ZBB
process should eliminate any need for the sunset
principle. Given the relative newness of both concepts
and the likelihood of the less than perfect implementa
tion of any set of procedures, sunset laws are probably
useful adjuncts to ZBB.
The sunset and ZBB procedures have been used in
some state governments, and similar procedures have
been in use by business. Stated as general principles,
the goals are laudatory; implementation, however, runs
the danger of greatly proliferating paper work. Expecta
tions for each of these proposals should be tempered
by government experience with cost-benefit analysis,
a system that was adopted during the Johnson admin
istration but one that was later abandoned in most
Federal agencies because of very limited success.
Whatever techniques may be used to control Govern
ment spending, they cannot solve the basic dilemma of
what the proper role and the proper size of the gov
ernment sector should be in a free democratic society.
The question of size does not merely involve the pos
sibility of overwhelming the individual or his initiative.
It may also bear on the problem of controlling infla
tion. There is a belief, held particularly widely in
Europe, that big government itself can be a major con
tributor to inflation.
In the end, it is the citizenry that will have to come to
grips with the issue of what tasks should be allocated
to government and what tasks should be allocated
to the private sector— business, families, foundations,
or voluntary associations. To a substantial extent, the
shift to the Government of duties that once were the
responsibility of other organizations or the family
stems from a perception that certain necessary tasks
were not adequately being carried out. To prevent a
further diminution of the responsibilities allotted to
the private sector, as well as to recapture some that
it has lost, will undoubtedly require new private initia
tives and innovations. Simply railing at “ big govern
ment” will not do the trick.
Joseph Scherer
The
business
situation
Current
developments
Chart 1
Employment and Production
Seasonally adjusted
M illions of persons
85
Payroll em plo ym ent
Ratio scale
80
75
b jliiliiliiliiliiliiliili iliiliiliiliiliiliiin liiliiliiliiliil
Index: 1967=100
140In du strial p ro d u ctio n
130
125
120
115
^
110 L i l l i 1.I..L1111 u i n . l i 1..111 I j J l l i 11111 l l l l l l l l l l l i i l u l l i l i i i l l
1972
1973
1974
1975
1976
1977
Sources: Bureau of Labor S tatistics and Board of
Governors of the Federal Reserve System.
The economy recovered quickly from the disruptions
caused by the bitter weather that plagued much of
the eastern half of the country early in the year. That
weather made it difficult to interpret what was hap
pening in the economy: first came the retarding effects
of the cold spell, and then came the stimulating effects
of business’ efforts to recoup earlier losses in output
and sales. As spring arrived, however, the economy’s
renewed vitality began to take on a solid look.
Consumer spending has contributed a great deal to
that vitality. After retail sales were crippled by the
weather in January, they rebounded to a record high
level in February and rose sharply again in March.
Sales of autos during March reached a seasonally
adjusted annual rate of 12 million units, including
imports, the best rate since the spring of 1973.
Consumer confidence, according to private surveys
taken in February, was virtually unchanged from the
comparatively high level it had reached prior to the
onset of the freezing weather. Consumers’ willingness
to spend is also suggested by large increases in con
sumer credit.
Vigorous buying at retail reflects the consumers’
improving income position. Personal income, which
was depressed by the weather and other factors in
January, rose at a high rate in February. Further
sizable increases in incomes probably occurred in
March as payrolls continued to swell. Consumer buy
ing power will, of course, be enhanced to the extent
that any kind of tax cut may be granted to individuals
this year.
Housing continues to be an important sector sus
taining economic activity. Residential construction
picked up handsomely during the lull in the general
economy last summer and fall, and it quickly recov
FRBNY Quarterly Review/Spring 1977
11
ered from the effects of extreme cold this year. Build
ing of single-family homes has been particularly
active; February starts reached the highest level since
the record peak of January 1973.
Apartment house construction, in contrast, remains
relatively subdued. Notwithstanding the almost steady
recovery from the extreme recession low, multifamily
housing starts are below previous highs by about
half. Yet, there appear to be some encouraging signs.
The rental markets have been tightening; vacancy
rates, for example, are down significantly and now
stand at five-year lows. In the condominium market,
too, sales have improved somewhat, suggesting that
a slow turn for the better may have begun. Increased
activity under the various Federal housing assistance
programs helped to push multifamily housing starts
up in the latter part of last year, and there is wide
spread expectation that such assistance will be ex
panded further. For both single and multifamily hous
ing, the immediate outlook is further buttressed by the
continuing inflow of deposits at thrift institutions that
is keeping mortgage money in ample supply. All in
all, the consensus that the rate of total home building
will at least stay at current levels for the whole of
1977 looks reasonable.
The business capital investment situation still shows
no great improvement. As discussed in the following
article, outlays have remained relatively sluggish in
this recovery and significantly lag the pace during
previous upswings. All the latest government and pri
vate surveys of plant and equipment spending confirm
earlier expectations that business intends to increase
such outlays only moderately in 1977.
Business’ additions to its stock of goods and mate
rials may lend further impetus to the upturn. The sharp
slowdown in inventory accumulation in the closing
months of last year, together with an increase in final
sales, has brought inventory-sales ratios to low levels.
By March, inventory buying appeared to be advancing
with vigor, according to the survey of the National
Association of Purchasing Management.
The pickup in the tempo of consumer and business
demands is mirrored in the trend of industrial pro
duction as well as in the behavior of payroll employ
ment, which has risen at a monthly average of 300,000
starting last November (Chart 1). The production index
more than regained its January loss in February and
made another significant gain in March. By March the
index exceeded last December’s level by 1.5 percent.
Auto makers were responding to healthy sales rates by
raising their production schedules for March and April
to the highest rates for those months in recent years.
A look at the business picture as a whole shows a
different pattern from that generally prevailing after
12 FRBNY Quarterly Review/Spring 1977
Chart 2
Trends in Wages
Percentage changes at seasonally adjusted annual rates
14-------------------------------------------------------------Average hourly earnings:
Private nonfarm economy
E ffects of overtim e and interindustry shifts are eliminated
12
L lj. l Lll 1.1.1 u h 111111111111111ii 1111111111
Effective wage increases in m ajor collective
bargaining agreements
1 2 -C ost-of-living adjustm ents are included-----------
1086-
42
1968
Source:
69
70
71
72
73
74
75
76
J___ I
77
Bureau of Labor Statistics.
eight quarters of expansion. While the overall recovery
has been as vigorous as the average of previous re
coveries, it has been chiefly propelled by the con
sumer. Capital spending hasn’t caught fire, capacity
utilization has risen only modestly, inventories remain
relatively low, and unemployment is still a major
problem.
The unemployment rate averaged 7.9 percent in the
fourth quarter of last year and declined to 7.4 percent
in the first quarter of this year. This is a welcome im
provement from the recession peak of near 9 percent,
but the rate is nevertheless unacceptably high. Insur
ing that many more of the unemployed get jobs is
likely to command high priority for some time.
The unemployment problem continues to run in tan
dem with the inflation problem. Wholesale prices,
which had already begun to rise more rapidly during
the autumn of last year, jumped 1 percent (seasonally
adjusted) in both February and March. Not only did
food and farm prices increase faster, but more sig
nificantly, industrial wholesale prices accelerated.
Similarly, the rise in consumer prices, which had been
contained to a monthly average of 0.4 percent in 1976,
climbed 0.8 percent in January and 1 percent in
February.
The resurgence of prices can in part be explained
as the special effect of cold weather. Nevertheless, it
is disturbing and is contributing to a revival of infla
tionary psychology, with all the attendant adverse
impact on confidence. Still there are reasons to think
that the recent speedup in price increases is only
temporary. The economy’s resources seem ample.
There are no serious shortages, except perhaps for
natural gas. There are no real signs of excessive pres
sure on industrial capacity. And there is of course no
shortage of labor.
While unemployment and prices claim a great deal
of attention, another crucial element in the health of
the economy is coming under scrutiny. That element
is the growth of productivity. Gains in output per manhour in the private nonfarm business sector fell away
after hitting an unusual high in the first quarter of last
year. Since compensation per hour continued to grow
at a fairly rapid pace, the increase in unit labor costs
accelerated. If the present rate of growth in output
continues, productivity should speed up once again. To
what extent the gain will be translated into an im
provement in labor costs, however, will depend a
great deal on how moderate wage settlements turn out
to be.
This year’s bargaining calendar is relatively heavy.
Major collective bargaining agreements covering some
5 million workers expire or can be reopened during the
year, including contracts in the steel, communications,
railroad, textile, and construction industries. Most con
tracts that will be negotiated or can be reopened in
1977 already incorporate provisions for cost-of-living
adjustments, so that there need be few major wage
“ catch ups” written into contracts in order to restore
the real income positions of workers. Effective wage
increases in collective bargaining agreements have
come down gradually in the past two years (Chart 2),
but it is far from certain that another step down will
be taken this year.
To sum up, most economic news suggests that the
recovery is in rather strong stride. Whether that stride
proceeds at a pace strong enough to lower unem
ployment significantly but not so strong as to feed
inflation is the economic question of the day.
FRBNY Quarterly Review/Spring 1977
13
Capital
spending—
a lack of
dynamism
Although the growth of real GNP in the present re
covery has been in line with growth during previous
recoveries, real capital spending has been disappoint
ing. Why has investment been so sluggish? Some of the
weakness must be accounted for by the large amounts
of excess capacity still so evident. Given such a situ
ation, businessmen are especially unlikely to invest
in new capacity unless they can anticipate the invest
ment will be a profitable one. One indication that the
profitability of new investment has not been particularly
enticing is the relationship of the prices paid to build
capacity to the prices received for the goods or
services that capacity will produce. From 1958 through
1974, the prices of capital goods went up at a slightly
faster pace than did product prices. In 1975 this un
favorable differential widened significantly. Although
the differential remained virtually stable in 1976, the
high level of capital goods prices is still apparently
one of the significant deterrents to investment.
There are a number of other deterrents affecting the
climate for investment, and many are related to the
actions or inactions of the Federal Government. Busi
nessmen would apparently like to see the Government
resolve their uncertainties about price monitoring, ease
some environmental and safety regulations, and allow
a larger investment tax credit. Any help on the tax
front would be particularly welcome now because cor
porations are paying taxes on book profits— profits
which are not adjusted downward for the much higher
costs of replacing inventory and capital goods in an
era of inflation. Another important concern of execu
tives is inflation itself, for major increases in prices
would in the end bring on a recession. Since some
businessmen fear an inflation-recession sequence,
they don’t want to add capacity that would be redun
dant within a comparatively short time.
14 FRBNY Quarterly Review/Spring 1977
There has been widespread concern on all sides,
business included, about the lackluster performance
of capital spending. Much of the worry relates to the
long-run effects of this performance on the stock of
fixed business capital. If that stock grows, the
potential level of employment as well as the potential
volume of output increases. If that growth is below
par, employment opportunities appear more slowly
and increases in the volume of output are held down.
Moreover, if there is insufficient production capacity,
demand for some products may outstrip supplies, thus
creating bottlenecks and putting upward pressure on
prices. Since it takes time to construct and to complete
new capital projects, a significant advance in the level
of real investment may be needed this year if production
bottlenecks are to be avoided in late 1978 and beyond.
Some measures of weakness
In the 1973-75 recession the decline in real capital
spending, as well as the decline in the economy as
a whole, was the steepest since before World War II
(Table 1). The decline was also longer than usual. In
four of the five previous recessions, the low in real
capital spending— nonresidential fixed investment—
coincided with the low in the economy as a whole. In the
latest cycle, however, the low in capital spending came
two quarters after the economy had begun to improve.
Real capital spending finally did advance beginning
with the fourth quarter of 1975, but not vigorously. The
annual rate of growth in the five quarters following the
third quarter of 1975 was 5.6 percent, about equal to
that in the first five quarters of recovery following the
1970 recession. In contrast, in the four other recoveries
between 1950 and 1970, the growth rate of capital
spending in the first five quarters was considerably
larger— 9.0 percent or more (Table 2).
All in all, in the current expansion only 33 percent of
the drop in real capital spending during the recession
was recouped within five quarters of the upturn in
such spending. In all previous postwar expansions,
74 percent or more of the loss had been regained
within five quarters (Table 2).
The latest Department of Commerce survey of
planned expenditures for plant and equipment suggests
an increase of roughly 7 percent in real spending for
1977, compared with 1976. At this rate, the level of real
investment will still not have surpassed its previous
peak at the end of this year. It is sometimes claimed
that the Commerce survey understates future expendi
tures when capital outlays are increasing during a
recovery and that such an understatement is taking
place now. But there is no clear historical evidence
for this presumption.
Table 1
Declines in Real Capital Spending*
D eclines in
real capital spending
(percent)
Recessions
1948-49
16.0
4
3.9
3
1953-54 .................................
1957-58
1960-61
Number of
quarters
of decline
14.8
4
4.5
3
..
1970 ........................................
8.0
5
1973-75 .................................
17.5
6
* Capital spending is nonresidential fixed investm ent. The d e
clines are measured from the peaks to the troughs of capital
spending itself.
Source: Calculated from Department of Comm erce data.
Table 2
Determinants of capital spending
Apart from all the general uncertainties holding back
capital spending, there are a number of more quanti
fiable reasons that help account for the lack of robust
ness. Certainly one such reason is the rate at which
presently existing production facilities are being uti
lized. Although plant and equipment expenditures by
manufacturing industries comprise less than half of
all nonresidential fixed investment, capacity utiliza
tion in manufacturing is useful as a rough indicator
of demand pressures on the economy’s total capacity.
It is rough in any case because the figures on capacity
utilization in manufacturing are, at best, only approxi
mations of the actual rate of utilization.
There are several different estimates of capacity
utilization in manufacturing, and perhaps the most
widely used is the series published by the Federal
Reserve Board.1 As one would expect, the Board’s—
and other— measures of the ratio of actual output to
the capacity for output go down during recessions.
The most recent decline was particularly severe; the
drop, according to the Board’s estimate, came to 16.9
percentage points from the previous quarterly peak,
and capacity utilization hit a new postwar low of
70.9 percent during the first quarter of 1975 (Table 3).
As a result, there is more excess capacity left now
after eight quarters of expansion than at comparable
stages of other recoveries (Table 3), even though the
increase in the manufacturing utilization rate during
the 1975-76 upswing has been equal to the average
pace during the past five recoveries. This fact alone,
however— the large amount of excess capacity— is not
1 For a full description of the four most w idely used measures of
capacity utilization in manufacturing, and further details on the recent
capacity situation, see “ Measuring Capacity Utilization in
M anufacturing” in the W inter 1976 issue of this Review.
Recoveries in Real Capital Spending*
Annual percentage
rate o f growth during
first five quarters
Recoveries
Percentage of decline
regained w ithin
first five quarters
1949-50
15.0
100
1954-55
11.9
over 100
1958-59
10.1
74
1961-62
9.0
over 100
1970-71 ................
5.5
79
1975-76 ................
5.6
33
* Capital spending is nonresidential fixed investment. The gains
are measured from the troughs of capital spending itself.
Source: Calculated from Department of Commerce data.
Table 3
Cyclical Comparisons of Capacity Utilization
in Manufacturing
In percent
Recession
Q uarterly
level at
trough*
Quarterly
level after
eight quarters
o f expansion*
............................................ ............ 72.4
83.5
1953-54 ............................................ ............ 79.1
86.5
1948-49
1957-58
............................................ ............ 72.4
81.3
1960-61
.........................................................73.8
82.3
1970 ................................................... ............ 76.3
85.8
1973-75
80.2f
............................................ ............ 70.9
* The troughs referred to in the first colum n are those of
capacity utilization in m anufacturing. The quarterly levels
in the second colum n are those fo r the eighth quarter after
a trough in the econom y as a whole.
t Estimated.
Source: Board of Governors of the Federal Reserve System.
FRBNY Quarterly Review/Spring 1977
15
enough to explain the sluggishness of capital spend
ing last year. In previous recoveries, when utilization
reached about 79 percent, real capital spending rose
by annual rates of 8.5 percent to 12.5 percent in the
next three quarters. In the first quarter of 1976 the
utilization rate stood at 79 percent of capacity, yet
in the next three quarters capital spending rose at an
annual rate of only 6.3 percent. The more modest in
crease in spending in the present recovery confirms
that excess capacity only partially accounts for the
lack of dynamism in capital spending.
A substantial recovery of corporate profits would
normally be expected to facilitate capital spending.
Profits, of course, fell precipitously in the recent re
cession. The domestically earned aftertax profits of
nonfinancial corporations plummeted 73 percent. They
went from a seasonally adjusted annual rate of $36.3
billion in the third quarter of 1973 to $9.6 billion in
the third quarter of 1974. (Profits, as used here, are
corrected for the higher replacement costs of inventory
and of plant and equipment.2) Profits began climbing
thereafter. They came to $42 billion for all of 1976,
about equal to the profit highs of 1966. However, since
corporate output is a good deal larger than a decade
ago, profit margins, by any measure, are substantially
lower now than in the mid-1960’s.
A look at cash flow
Businessmen, of course, don’t only look at the size
of their profits when they plan investment spending.
They also look at their internal cash flow, i.e., their
retained earnings plus their set-asides for depreciation
(or capital consumption). Capital spending has been
modest when measured against this figure, quite pos
sibly because of the changed attitude of businessmen
to the state of corporate balance sheets. During the
last recession, corporations suffered from a severe
liquidity squeeze. Consequently, they took steps to
strengthen their financial positions by paying off bank
loans and by floating more bonds. As a result, cor
porate balance sheets have improved considerably,
laying the groundwork for a faster growth of capital
spending.
2 These aftertax profits include inventory valuation and capital con
sumption adjustments. The inventory valuation adjustment is the
difference between the original cost of inventory and the
cost of replacing it. When replacement cost is greater than
original cost, as it has been for a number of years, this adjustment
lowers profits. If replacement costs should be declining, this
adjustment would raise profits. The same effects apply to the capital
consumption adjustment, which converts the depreciation based
on tax returns to a measure reflecting uniform depreciation formulas
as well as the present cost of replacement.
16 FRBNY Quarterly Review/Spring 1977
Another significant factor that also determines how
much businessmen are willing to spend for more ca
pacity is the movement of the prices of plant and equip
ment relative to the prices of the products those same
capital goods produce. Each company has the data to
make such a comparison for itself and thus can as
certain whether additional capacity would produce
sufficient earnings. In fact, some have emphasized
that the increase in capital replacement costs has
been relatively so rapid as to become a major impedi
ment to capital spending. For business as a whole,
there is no measure of this relationship, but there is a
proxy: how the index of capital goods prices moves
in relation to the price of corporate output.3
The problem of prices
From 1958 through 1974 the price of capital goods
rose only a little faster than the advance in the price
of corporate output. In 1975, however, the gap be
tween the rate of increase in the prices of capital goods
and those of final products widened substantially and
was twice as large as in any of the preceding sixteen
years. This widening indicates a further significant
decrease in the expected rate of return on new invest
ment. In 1976, the prices of capital goods and of their
products rose about equally.
Of course, there are other factors related to the
cost of new plant and equipment apart from the prices
of the goods themselves. Clearly, the energy costs
associated with operating both old and new equipment
have risen greatly. At the same time, expenditures for
antipollution equipment, while helping to improve the
quality of life, have significantly increased the effec
tive costs of capital goods.
The factors explored here— the business climate
and inflation, excess capacity, new caution about
balance sheets, the flow of profits and retained earn
ings, and the uncertainty about whether future product
prices will justify the present costs of installing new
capacity— do much to explain why capital spending
has come along rather slowly. As these factors become
more conducive to higher capital spending, and some
of them, such as profits and capacity utilization rates,
have already begun to do so, capital spending should
begin to gather momentum.
3 The price of corporate output referred to here is the im plicit price
deflator for the gross domestic product of nonfinancial corporations;
the index of capital goods prices used is the implicit price deflator
for business fixed investment. Both deflators are drawn from the
national income accounts.
Marjorie Schnader
The
financial
markets
Current
developments
Recent Changes in Interest Rates
gPercent
50----------------------------------------------
1976
1977
*T h e s e yields are adjusted to five- and tw enty-year
maturities and exclude bonds with special estate
tax privileges.
Sources: Federal Reserve Bank of New York, Board of
Governors of the Federal Reserve System, and Moody's
Investors Service, Inc.
A significant change took place in the financial markets
near the turn of the year. At the end of 1976, a buoyant,
practically euphoric, atmosphere pervaded the stock
market and the various sectors of the bond market.
The pace of the economy had been somewhat subdued
in the last half of the year, and inflationary pressures
seemed to have abated. Underwriters and investors
alike were therefore expecting the kind of moderate
and restrained economic growth that would limit both
inflation and upward pressure on interest rates.
Developments early in the first quarter of 1977, how
ever, caused a rapid, almost overnight, change in ex
pectations. Prior expectations proved to be wrong on
several counts. Underwriters had anticipated a further
decline in the Federal funds rate which would spur
demand by investors, but the rate did not decline. The
slower growth in economic activity came to be recog
nized as having been only temporary. And the be
havior of the various price indexes— consumer, whole
sale, and spot commodity— raised the possibility of
more inflation than had generally been forecast for
1977 and beyond.
The reaction to these changed perceptions had its
major effect very soon after the year opened. Securities
underwriters and dealers began unloading the exces
sive inventories they were carrying. Underwriters and
dealers also began to believe that investors would
demand higher interest rates to compensate for the
possible increase in inflation. In addition, investors
started to focus on the likelihood that the new admin
istration’s budget deficit could be too stimulating for
the economy and could also enlarge Government bor
rowing in the credit markets. All these factors caused
FRBNY Quarterly Review/Spring 1977
17
prices of debt instruments to fall sharply during most
of January; only near the month’s end did prices be
come steady, and they have remained fairly stable
ever since. The drop in prices, of course, meant a
rise in interest rates.
The abrupt change in the atmosphere of the finan
cial markets occurred in the absence of any change in
the thrust of monetary policy. Indeed, the Federal
funds rate was steady throughout the first quarter,
fluctuating narrowly around December’s average of
4.65 percent. Beyond the shortest term sector of the
money market, however, the change was pervasive.
For example, the monthly average of rates on threemonth Treasury bills reached 4.60 percent in March
after they had fallen to 4.35 percent in December. In
terest rates in other short-term markets followed much
the same pattern. The advance in yields on intermediateterm Government securities was particularly sharp (see
chart). This reflected the adverse swing in sentiment
about the medium-term outlook for inflation and the
prospect of sales in this maturity range by banks to
accommodate greater loan demand. Accordingly, the
yield on a five-year Government issue climbed to a
6.93 percent average in March from the recent low of
6.10 percent in December.
Interest rates on long-term Government and cor
porate bonds also declined before the year-end and
then rebounded sharply. When yields moved down,
more corporate issues to raise new funds and to re
finance appeared. When yields went up again, some
corporate issues were postponed to await better mar
ket conditions.
Rates in the municipal bond market did not reverse
course as much as those in other long-term markets.
There has been a general downward movement in
municipal yields over the past eighteen months, re
flecting the improved financial conditions in New York
and other cities. Another event important to the muni
cipal market was a court decision in November that
prohibited New York City from continuing its mora
torium on repayments of principal to holders of certain
18
FRBNY Quarterly Review/Spring 1977
of the city’s notes. This prompted a considerable im
provement in the status of lower rated municipals
generally, and their yield spreads from prime-rated
municipals consequently fell. The spread between Baa
and Aaa municipal yields, as reported by Moody’s,
was 187 basis points at the end of November and
narrowed to 115 basis points at the end of March.
Because of the trend to lower yields on tax-exempt
issues, commercial banks on the whole limited their
accumulation of these securities. Banks did choose,
however, to increase their holdings of bankers’ ac
ceptances by sizable amounts before their end-of-year
financial statements were due. They ran off most of
these acceptances as the new year began. (Banks did
much the same around the previous year-end.)
During the first quarter of this year, commercial
banks added substantially to their Government securi
ties portfolios— rather more than they usually do in that
quarter. Lending to businesses, however, continued to
rise only very slowly, with demand for these loans at
money market banks lagging demand elsewhere, as is
typical in a cyclical upswing. Corporations have on the
whole reduced their bank borrowings substantially over
the past two years, and they have bought a consider
able volume of liquid assets. Their stronger cash
position allowed them to make sizable income tax pay
ments in March without borrowing a great deal from
commercial banks.
The recent improvement in corporate liquidity is one
of the determinants governing the outlook for the credit
markets over the balance of 1977. The fundamentals
indicate some cyclical upturn in private demand for
credit, and the Federal deficit may add more to credit
demands than is usual for this stage of the cycle. With
economic activity and income growing strongly, how
ever, the level of private saving will rise and thereby
increase the already ample supply of investable funds.
The outlook for inflation will be important to the credit
markets this year, and these markets will remain very
sensitive to any change in perceptions about how well
inflation is being kept in check.
Financing
the Federal
deficit in
1975 and 1976
The Federal deficit reached historic highs in 1975
and 1976. As a result, in those two calendar years the
United States Government had to borrow a massive
amount of funds— a record two-year total of $155 bil
lion net.1 Despite widespread fear that so large an
amount would be difficult to raise, all the funds were
obtained without strain and in a time of generally
steady to declining interest rates. In retrospect, it
appears that the unusual conditions accompanying
the recent severe recession and the recovery that
followed did a great deal to facilitate the smooth
financing of the deficits.
During part of the recession and the latter stages of
the preceding boom, the rate of inflation was unusually
rapid and short-term interest rates climbed to the
highest levels in history. At that time, inflationary ex
pectations and the prospect of shortages contributed
to substantial inventory accumulation by business.
This accumulation led to a great deal of short-term
borrowing and, as the recession wore on, a serious
excess in inventories.
Against this background, the financial soundness of
a number of corporations came into question and,
understandably, investors became more quality con
scious about securities for a time. Quality conscious
ness benefits Government securities, the least risky
in the market. Furthermore, as the economic recovery
developed, corporate cash flow increased greatly.
Businesses seized this opportunity to restructure
balance sheets: they substituted long-term for short
1 All data in this article are drawn from the flow-of-funds accounts
of the Board of Governors of the Federal Reserve System.
The figures on yearly net purchases of Treasury securities by
sector are summarized in Table 1; total holdings at the year-end are
summarized in Table 2.
term liabilities and they added to their holdings of
liquid assets, particularly Treasury obligations.
Businessmen’s policies became much more cautious
after their chastening experiences during the reces
sion. They were quite conservative in their accumula
tion of inventories. They increased their investment in
fixed assets at a modest rate, in part because the
previous severe contraction of economic activity left
them with a large amount of excess capacity. These
restraints on spending caused the demand for bank
loans to be unusually weak. Because commercial
banks were faced with such weak loan demand, Trea
sury securities became an attractive investment for
them. This was particularly true since the banks, too,
wanted to build up their liquid asset holdings. Other
investors— namely, thrift institutions, insurance com
panies, pension funds, state and local governments,
and foreign official institutions— also substantially in
creased their purchases of Treasuries.
The Treasury’s offerings
In raising the considerable sums required in 1975 and
1976, the Treasury adopted several policies designed
to improve the market’s reception of its issues. It kept
the market informed of its estimates of financing
needs and offered a wider spectrum of maturities on
a regular basis. This procedure enabled dealers and
investors to anticipate forthcoming offerings and work
them into their portfolio strategy. The Treasury also
took advantage of the legislation passed in 1976 that
provided it with additional flexibility in financing the
deficit. For many years there had been a Federal law
setting a 41A percent interest rate ceiling on United
States Government bonds, but bonds could not be
sold at 4Va percent when interest rates began to rise
FRBNY Quarterly Review/Spring 1977
19
in the 1960’s. In 1971, therefore, $10 billion of the
total amount of Government bonds was exempted
from the ceiling. In 1976, the amount of exempt bonds
was increased to $17 billion.2
Around the same time in 1976 that the amount of
Government bonds exempt from the interest rate ceil
ing was increased, the maximum maturity of notes—
which are not subject to interest rate ceilings— was
extended from seven to ten years. Given the favorable
environment in the debt markets, the Treasury under
took to sell relatively more coupon securities than bills.
Thus, 1976 was the first year since 1964 in which the
average maturity of the Government debt was ex
tended.
Much of the hew borrowing was accomplished by
regular offerings of coupon securities. Monthly offer
ings of two-year notes began in February 1975 and
later quarterly sales of four-year and five-year notes
were added as ordinary parts of the financing sched
ule. The Treasury also added to its offerings of bills,
particularly in 1975.
In 1976, for the first time in six years, the Treasury
also made use of fixed price subscription issues. In
these issues, coupon rates are set by the Treasury
and the obligations are sold at par. The technique was
used for one issue of seven-year notes and two issues
of ten-year notes offered in minimum denominations of
$1,000. These were extremely successful in attracting
a greater diversity of buyers. In fact, the obligations
were so popular that they were heavily oversubscribed.
The Treasury was therefore able to increase the total
volume of funds raised through the subscription issues
to $18.5 billion, $7.5 billion more than the amount
originally planned.
Buyers of debt: nonfinancial corporations
and commercial banks
Rising sales and improved profit margins swelled
corporation cash flows as the recovery proceeded. In
ternally generated funds sufficed to cover a major por
tion of the modest expenditures on plant and equip
ment.3 And, of course, inventory accumulation was for
the most part also cautious.
Corporations have issued a substantial quantity of
long-term debt and of equities ever since the present
recovery began. The funds raised were largely used
to repay short-term borrowing— particularly bank
loans— and to purchase liquid assets. In the process,
corporations acquired a sizable volume of Treasury
securities; they bought a net $17.2 billion of Govern
ments in 1975-76. These purchases raised their total
holdings from $5 billion at the end of 1974 to $22.5 bil
lion at the end of last year. The rise in their holdings
of Governments along with their repayment of short
term debt improved the liquidity of nonfinancial cor
porations: the ratio of liquid assets to short-term
liabilities increased from a low of 26.6 percent at the
end of 1974 to 34 percent at the end of 1976.
Since corporate demand for bank loans was weak,
commercial banks were drawn to Treasury securities.
Acquiring them also enabled commercial banks to re
build their own liquidity. Data for weekly reporting
banks show that their ratio of liquid assets to liabilities
rose from a low point of 8.6 percent during October
1974 to a high of 13.9 percent by December 1976. Over
the two-year interval, commercial banks bought a net
$46 billion of Treasury securities, thus bringing their
portfolio of Governments to $103 billion by the end of
last year.
Annual Changes in Treasury
Securities Outstanding
Billions of dollars
9 0 -----------------------807060504030 -
2 The exem ption now applies to the am ount of Government bonds
outstanding apart from holdings by the Federal Reserve System
and Government investm ent accounts. This means that the am ount
of Governm ent bonds that can be issued under the
$17 b illion ceiling can change when the Federal Reserve or
Governm ent investm ent accounts purchase outstanding issues that
carry a coupon rate of more than 4 1A percent. When this happens,
additional bonds can be sold to the public. As of January 31, 1977,
the Federal Reserve Banks and United States Government
accounts held $11 billion of the $23 billion outstanding Govern
ment bonds with coupons in excess of 4 Vi percent.
3 For further details, see "C ap ita l S pending— A Lack of D ynam ism ",
page 14.
Digitized20
for FRASER
FRBNY Quarterly Review/Spring 1977
20-
10
-
Q- i— I, I
__ L66
-10l_1965
L
67
68
69
70
71
72
73
74
J___ I___ I
75
76
Source: Board of G overnors of the Federal R eserve System.
Buyers of debt: households and thrift institutions
Households4 provided funds to finance the Federal
deficit in 1975 and 1976 in two ways. They did so
directly through their purchases of Treasury debt. They
also did so indirectly through deposits in thrift institu
tions that used part of the inflow of such deposits to
buy Government securities.
Households shifted from being large net purchasers
of Treasury securities in 1975 to being net sellers in
1976. This shift stemmed from changes in the rates of
interest on marketable Treasury securities in relation
to the rates available on time and savings accounts.
Rates on time and savings deposits do not change
very often, and these rates may not exceed specified
ceilings. Thus, whenever the yield on Treasury securi
ties rises above the rate on savings deposits, house
holds tend to increase direct purchases of Treasury
issues and to reduce the flow of deposits to savings
accounts (at times, they may even make net with
drawals). When the yields on Treasury issues fail
toward or below the rates on savings deposits, the
flow tends to shift back toward savings accounts.
In the period under consideration, households had
occasion to do both. Toward the end of 1974 and the
beginning of 1975, rates on Treasury securities de
clined sharply from the extremely high levels attained
in mid-1974. Households therefore started to increase
their deposits at commercial banks and thrift institu
tions and were net sellers of Treasury securities. In
the remainder of 1975, households were net buyers of
marketable Treasury issues, particularly during the third
quarter when market rates rose temporarily. Over 1975
as a whole, households acquired a net $6.4 billion of
marketable Treasury obligations.
During 1976, in contrast, holdings of marketable
Government issues by households actually declined a
net $7.7 billion. The reason was that market rates of
interest were relatively low and stable in 1976. Indeed,
by December, some short and intermediate rates were
at their lowest levels in four years. Households there
fore were net sellers of Treasury issues in all quarters
of 1976 except for the second, when market rates of
interest rose briefly. Most of the proceeds appear to
have been deposited in time and savings accounts.
However, over 1975-76 combined, households also
bought a net $8.7 billion of savings bonds. As a result,
household holdings of all Treasury debt rose by $7.5
billion to $111 billion.
By the end of 1976, thrift institutions had also en
larged their holdings of Governments. While mar
ket rates remained high during the first half of the
4 The category "households", as used here, includes not only
households but also personal trusts and nonprofit organizations.
recession, the deposit gains of thrift institutions
slowed down. The subsequent fall of market rates
made savings deposits competitive again in 1975 and
1976. With these reflows, both savings and loan associ
ations and mutual savings banks restored their liquid
ity as they acquired Treasury securities with some of
these deposits. In the two years, thrift institutions took
on a net total of nearly $8 billion of Treasury securi
ties. In addition, savings and loans repaid borrowings
from Federal Home Loan Banks, while savings banks
(which generally are not members of the Federal Home
Loan Bank system) increased their purchases of cor
porate bonds. As thrifts rebuilt their liquidity, they
also began to expand their mortgage portfolios more
rapidly.
Other buyers of debt
As the economy expanded in 1975-76, pension funds5
and insurance companies received sizable inflows of
funds. Previously, these institutions had not been par
ticularly heavy investors in United States Government
securities and, indeed, had been net sellers in recent
years. The availability of large new issues of these
securities during the past two years, however, pro
vided a welcome outlet for the investment of a por
tion of the large inflows of funds. Thus, pension funds
and insurance companies added considerably to their
holdings of these securities in 1975-76. Pension fund
portfolios of Government securities grew by $11.3 bil
lion, and insurance company holdings increased by
$6.5 billion. These investments amounted to 16 per
cent of the financial assets added to the portfolios of
these institutions during the two years, as their pur
chases of other securities also rose. On the other hand,
acquisitions of mortgages by life insurance companies
slowed markedly since the availability of attractive in
vestments was constricted by the reduced construc
tion of commercial buildings and multifamily residen
tial units.
State and local government general funds also sub
stantially increased their net purchases of Treasury
issues in 1975-76. Some purchases— although it is not
clear how much— involved using Treasuries as a ve
hicle for advance refunding of the municipalities’ own
obligations issued when interest rates were high. The
decline in rates encouraged municipalities to under
take such refunding to the extent possible. This can be
done, even though the obligations themselves are not
yet eligible to be called, by selling new debt at the
current lower rate of interest and investing the pros The term “ pension funds” , as used here, includes private
pension funds and employee retirement funds of state and
local governments.
FRBNY Quarterly Review/Spring 1977
21
Table 1
Table 2
Net Annual Purchases of Treasury Securities
Holdings of Treasury Securities
In b illions of dollars
In billions of dollars, at the year-end
1972
Sector
1973
1974
1975
1976
1975
1976
3.2
5.3
59.2
56.6
14.3
85.4
102.8
3.3
Thrift in s titu tio n s ................
9.2
6.2
5.6
10.1
13.4
2.2
Savings and loan
associations ....................
5.7
3.2
3.1
5.4
7.5
Mutual savings
banks ...............................
2.1
9.0
C om m ercial b a n k s ___
2.4
-
8.8
-2 .6
28.8
8.2
17.4
Thrift in s titu tio n s .........
-0 .3
-
2.9
-0 .6
4.5
Savings and loan
associations .............. - 0 . 5
0.2
3.0
—
—
3.3
-0 .2
2.4
-0 .2
2.3
22.5
8.5
5.3
Other Treasury . . . .
1974
68.0
-
Savings b o n d s .........
1973
Com m ercial banks ...........
— 2.6
H o u s e h o ld s ....................
1972
Nonfinancial corporate
N onfinancial corporate
business ........................
Mutual savings
banks ........................
Sector
0.5
-0 .4
2.2
1.1
17.0
9.2
10.5
2.7
3.0
4.0
- - 3.0
4.7
14.3
6.2
6.4
- - 7.7
business ...................... ..
Households
........................
3.5
3.0
2.6
4.7
5.9
77.6
94.6
103.9
111.4
Savings bonds
.............
57.7
60.4
63.3
114.3
67.4
Other Treasury
.............
19.9
34.2
40.5
47.0
39.3
6.5
5.6
4.7
10.1
16.0
6.7
6.3
6.2
9.5
12.6
41.3
72.0
Private pension funds
and state and local
governm ent retire
ment funds ....................
0.5
—
0.9
-0 .9
5.4
5.9
Private pension funds
and state and local
governm ent retire
ment funds ........................
Insurance c o m p a n ie s ..
-0 .3
-
0.5
-0 .1
3.3
3.2
Insurance c o m p a n ie s ___
26.2
26.1
54.4
54.8
24.3
58.4
30.6
.................................
66.5
76.6
Federal Reserve ................
Other* ...................................
69.9
78.5
80.5
87.9
97.0
4.5
5.0
5.9
8.6
13.0
331.5
339.4
351.5
437.3
506.4
State and local govern
ment general funds . . .
0.1
— 1.8
6.3
10.7
State and local governm ent
general funds ....................
0.3
3.7
8.1
10.1
Foreign
8.6
2.0
7.4
9.1
-1 .0
0.5
0.9
2.7
4.4
14.3
7.9
12.0
85.8
69.1
4.4
Foreign ...........................
8.4
Federal Reserve ......... - 0 . 3
O t h e r * .............................
Total
...............................
-
Total
......................................
* The category “ O ther” consists of investm ent com panies, money market funds, securities brokers and
dealers, cre dit unions, and Federally sponsored credit agencies.
Source: Board of Governors of the Federal Reserve System.
ceeds in special Treasury securities. The municipality
generally earns enough on the Treasury securities
to cover its new interest payments. As soon as the
old municipal obligations carrying the high rates ma
ture or can be called, the municipality pays them off
with the proceeds from the special Treasury issues—
issues that were designed to mature at the same time.
In this way, the municipality has substituted new, lower
interest debt for older, higher interest debt. Of course,
until such a switch can be made, the municipality must
continue to service the original higher interest debt.
Purchases of Treasury securities by foreign official
institutions and international organizations provided a
major source of funds for financing the 1975 and 1976
Federal deficits. Over that period, foreign holdings of
Treasury issues rose $18 billion, nearly five times the
rate of acquisition in the 1973-74 period. Major groups
of foreign purchasers in order of importance were:
(1) central banks and governments of industrial coun
tries, (2) OPEC governments, and (3) international or
22 FRBNY Quarterly Review/Spring 1977
ganizations, particularly the World Bank. Acquisitions
by industrial countries, which accounted for one third
of total foreign purchases over the two-year period,
were especially heavy in 1976 and resulted from the
large amount of dollars obtained through exchange
market operations by central banks, particularly those
of Germany, Switzerland, and Japan. Purchases by
OPEC members, which were more than one fourth of
total foreign acquisitions in 1975-76, grew steadily
over the period, reflecting the continued strong sur
plus position of those countries. At the same time
there was a marked shift in the OPEC portfolio toward
longer term Treasury obligations.
During 1975 and 1976, the Federal Reserve acquired
a net $16.5 billion of Treasury securities. These pur
chases reflected the Federal Reserve’s policy of pro
viding enough bank reserves to support a growth of the
money supply compatible with the System’s aim of
helping to achieve stable and noninflationary eco
nomic growth.
Arline Hoel
On the Monetary Aggregates
Remarks before the
Toronto Bond Traders’ Association in
Toronto, Canada, on
Tuesday, February 22, 1977
A Broader Role for
Monetary Targets
Paul A. Volcker
President, Federal Reserve Bank of
New York
I suppose that anyone from the United States who
prepares to deliver a speech to a Canadian audience
thinks about some of the striking similarities— and
some of the striking differences— between our two
countries. After reflecting on the matter for a while, I
began to be increasingly certain that, in the context
of my subject for this evening, the similarities are
vastly more important than the differences. Recent
thinking about the problems of economic stabilization,
and particularly about the objectives and techniques
of monetary policy, seems to me to have run along
parallel paths in Canada and the United States.
As far as bond traders are concerned, I suspect
it’s part of the instinct of a Canadian bond man—
more so, even these days, than of an American— to
recognize that economic stabilization has an increas
ingly international dimension. In that respect, there
has been a radical change in the game since the
final breakdown of the Bretton Woods system nearly
four years ago.
Following the lead set by Canada, the major indus
trial countries came to conclude that, like it or not,
we would have to live within a context of flexible
exchange rates. Bitter experience had demonstrated
that the earlier arrangements were too rigid and
brittle to contain the pressures that build up in mar
kets as a result of the divergent economic perfor
mances of countries.
it was not the first time that a highly structured
system finally fell by the wayside under the pressure
of events and new needs. In the decade following
World War I, restoration of the gold standard and
fixed parities, designed to provide the substance
and the symbol of renewed international stability, was
the goal of almost every central bank and government.
In domestic policy, the simple rule was that an
annually balanced budget had a high order of political,
as well as economic, priority. But, under the impact of
the Great Depression and the international monetary
crises related to it, neither fixed exchange rates nor
balanced budgets survived for long.
Following that dismal experience, strong new efforts
to achieve stabilization were made after World War II.
Internationally, a new par value system, freed of some
of the rigidities of the gold standard, was installed at
Bretton Woods. Domestically, the changes were more
striking, drawing heavily on the ideas of Keynes. And
for roughly two decades— particularly supported by
close cooperation among the industrial countries—
the new arrangements were able to support unprece
dented growth and prosperity in a framework of a
high degree of price stability.
But the turbulence of the 1970’s brought that period
to a close. We have coined some cumbersome and
ugly new words— “ stagflation” , for instance— to de
scribe the domestic dilemmas of many countries.
Externally, we have seen some exchange rate gyra
tions almost as large as those of the 1930’s. In this
perplexing situation, theorists and policymakers alike
have had to grope for new approaches and standards
to guide economic management.
As a result, internationally accepted doctrine has
obviously and radically changed. The current ap
proach, as reflected in the new articles of the Interna
FRBNY Quarterly Review/Spring 1977
23
tional Monetary Fund, has two basic premises: first,
that exchange rate changes should play a more con
tinuous and active role in the process of international
adjustment; second, that the basis for any stabilization
of exchange rates must lie primarily in the efforts of
individual countries to achieve growth without inflation
at home. It is not much of an exaggeration to say
these concepts stand on its head the old doctrine—
the concept that fixed exchange rates, by imposing a
strong external discipline on governments and cen
tral banks, would force stability at home.
One practical implication is to place an even heavier
burden on domestic policies. In a world of floating
exchange rates, inflationary or deflationary forces
arising in one country are less readily diffused among
its trading partners. Instead, in recent experience
there have been occasions when the sharp deprecia
tion of an exchange rate aggravated domestic infla
tion.
The irony is that, as the support which the fixed rate
system provided for internal stabilization weakened,
so did confidence in the capacity and will of govern
ments to achieve stability through domestic policy.
Some of the old rules just no longer seemed very
relevant.
Take one example. For more than a generation
every economics textbook has taught us that the con
cept of an annually balanced national budget is out
moded. But somehow the more sophisticated ideas of
“ cyclically balanced” and “ full employment” budgets
seem, in practice, to have opened the way to more or
less perpetual— and seemingly ever larger— deficits.
Take another example. Early in the postwar period the
idea developed that a “ trade-off” between unemploy
ment and prices could be carefully calculated, that it
It is neither possible nor desirable to attempt close
control over the growth of the monetary aggregates
during short periods of time, a point which has not
yet been convincing to the bond traders as they
attempt to interpret, and often overinterpret,
the money supply figures we release in New York
late every Thursday afternoon.
could be a guide to policy. But that trade-off has
turned out to be neither stable nor meaningful in a
world characterized by both high unemployment and
high inflation. It has turned out that the efforts at
“ fine tuning” monetary, fiscal, and other policies have
sometimes been as confusing as helpful in a world
in which the future is never known, the lags between
action and response are long and uncertain, and mar
24 FRBNY Quarterly Review/Spring 1977
kets adjust to current expectations as much as to
current facts.
It is in this context of doubt and disillusionment
that some ideas espoused by the so-called monetarist
school have attracted new attention in the United
States and elsewhere. Their main point of emphasis—
that money matters— is hardly new. Indeed, the thought
that there is a relationship between the supply of
money and the general level of prices is one of the
I have become increasingly convinced that the
experiment in “practical monetarism” can play a
part in restoring a sense of greater stability and
confidence in monetary policy and in our economic
performance.
oldest propositions in all of economics. Few econo
mists— and almost no central bankers— have ever
disputed it. Nevertheless, for a variety of reasons,
beginning in the 1930’s and continuing through most
of the postwar period, the emphasis in policymaking
was focused on the short run, where the relationship
between money and prices is less clear. While the
effects of the money supply on credit markets and
interest rates were generally recognized, the effects
on the economy were thought not to be terribly power
ful in periods of depression or recession. Attention
turned elsewhere— to fiscal action, to the process of
wage bargaining, and to other forces as the main
determinants of economic activity and prices.
I am not about to argue that these other forces are
not important, and— in some circumstances— even cru
cial. There is a lot of evidence that the relation be
tween money and prices is not very close in the short
run. But there is also a hard core of truth in the central
theme of the monetarist school: over time, an excess
supply of money contributes nothing to employment,
nor to real income, nor to real wealth, but only to
inflation.
In its modern dress, monetarism has also helped
clear up a good deal of confusion in other respects.
We have become more conscious of the difference
between rates of interest as observed in the market
place and the “ real” rate of interest— that is, the
return after adjustment for expected changes in pur
chasing power. We recognize to a greater degree the
importance of expectations in explaining behavior in
financial markets and in economic life generally. We
have learned that lenders and borrowers have come
to anticipate inflation and that they are sensitive to
policies they interpret as contributing to inflation.
Consequently, they sometimes may react in unac-
customed ways— for instance, by selling securities out
of fear of inflation when the money supply is rising
exceptionally fast, instead of using the larger supplies
of money to add to their holdings. As a result, a grow
ing money supply is no longer seen to be as closely
associated with sustaining real economic growth as it
used to be.
In a sense, the long run of which the monetarists
speak has caught up with us. The lessons have not
been lost on central banks, in the United States or
elsewhere. They have responded, in their policies and
policy pronouncements, by putting new emphasis on
the behavior of the money supply and its related
monetary aggregates. In particular, it has become the
practice in the United States, in Canada, and in a
number of other important countries to specify quite
precisely the growth ranges, or projections, or targets
— the nomenclature differs— for certain monetary ag
gregates over a period of a year or so ahead.
In the United States and elsewhere, there was a
certain initial reluctance to adopt this approach. Given
that the relationship between money and other eco
nomic variables is imperfect, the reasons are under
standable. Central bankers share a human desire to
want to hedge against an uncertain future. They also
want to retain the ability to respond flexibly as new
developments emerge, to probe experimentally with
new policy measures, to test market reactions, and
to learn from those reactions before fully committing
themselves to follow a set course. Indeed, this flexi
bility to act and react has long been considered a
great strength of monetary policy.
After two years of experience with projecting mone
tary growth ranges, the Federal Reserve still takes
care to note that it does not focus exclusive attention
on the monetary aggregates, and that the projections
are always subject to change in the light of subsequent
economic and financial developments. Moreover, the
Federal Reserve has pointed out time and again that
it is neither possible nor desirable to attempt close
control over the growth of the monetary aggregates
during short periods of time, say, a few weeks or even
months— a point which I am afraid has not yet been
convincing to our own bond traders as they attempt to
interpret, and often overinterpret, the significance of
the money supply figures we release in New York late
every Thursday afternoon.
All these qualificatons and reservations are impor
tant. Yet, I have become increasingly convinced that
this experiment in “ practical monetarism” is proving
useful. Over time, I believe it can play a part in
restoring a sense of greater stability and confidence
in monetary policy and in our economic performance.
Within our Federal Reserve councils, the longer
range money supply projections have already pro
vided a useful discipline for our debate. Any monetary
authority faces a constant flow of new information—
and thus a decision about whether to react or not.
Obviously, there are dangers in reacting too fast and
too much. The results of any new action may not be
evident for many months, when the situation may be
quite different. But equally, there are dangers in react
ing too slowly or not at all. The risks in either direc
tion are reduced when each new piece of information
must be taken into account in relation to an earlier
judgment and a longer perspective about the appro
priate growth in the money supply.
Potentially as important is the communication of our
specific ranges for monetary growth clearly to others—
whether to the political authorities in the Congress
and the Administration, or to business, labor, and the
marketplace. It is one thing to repeat again and again,
as central bankers are apt to do, our dedication to
If the new approach to aggregates proves useful in
helping to achieve stability in our domestic economies,
the benefits should be reflected in an increased
degree of stability in our international economic
relationships as well.
the general proposition that, while encouraging
growth, we also want to encourage a gradual return
to price stability. It is quite another thing to present,
defend, and stick to specific numbers for monetary
growth consistent with that objective.
Obviously, credibility in that respect is crucial. It
can only be earned over time. That process will be
speeded if we continue to specify clearly our objec
tives and to defend our approach in public debate.
I suspect this kind of thinking has influenced other
central banks that have also adopted some form of
monetary “ targeting” for periods of a year or so
ahead. Of course, the details differ.
You are more familiar than I am with the particular
policies instituted late in 1975 by the Bank of Canada.
Unlike the Federal Reserve, the Bank of Canada
targets only one of the monetary aggregates— the
narrowly defined money stock,
The targets have
generally not been reviewed publicly as frequently as
in the United States. The projected range for
in
this country is higher. But these differences must all
be interpreted in the light of a different institutional,
economic, and political setting. The similarities in
approach are much more striking than the differences,
including the fact that both central banks have empha-
FRBNY Quarterly Review/Spring 1977
25
sized that money growth will gradually have to be
reduced below presently specified ranges if price
stability is to be restored.
Among European countries, Germany and Switzer
land now set annual targets— single points rather than
ranges— for monetary aggregates. Germany uses cen
tral bank money— a variation of high powered money
or the monetary base— as the primary target of its
operations. Switzerland, like Canada, uses the narrow
ly defined money stock as the single target. But again,
the similarity in concept is more striking than the
variants in detail.
Other countries appear to be moving in the same
direction. The British authorities have recently been
drawn, little by little, into setting a monetary target,
recognizing the value of clarifying the aims of monetary
policy at a time of great domestic and exchange rate
uncertainty.
Late last year, the authorities in France announced
their target for the growth of a broadly defined money
stock during 1977. On the other side of the world,
Japan appears to be moving cautiously in the same
direction. While the Bank of Japan currently does not
make public announcements, we know that every
quarter it sets targets for the broadly defined money
stock.
It is of course too soon to pronounce any final
judgment on the success of these experiments in
“ practical monetarism” ; whether they will turn out to
be only a passing fad or a really significant change in
the way we approach and implement monetary policy.
Certainly, we will need to recognize and deal with
some potential pitfalls that could arise if the concept
is applied too rigidly.
We must constantly be aware that, whatever the
stability in the relationship between money and in
come or gross national product in the long run, there
is considerable instability in the relationship over the
shorter runs that are relevant to the policymaker. For
instance, we in the United States found that the tax
rebates we gave to individuals in 1975 pushed mone
tary growth substantially higher for a month or two
because the money was at first deposited in checking
accounts. The impact proved temporary. Similar be
havior can be anticipated as a result of the rebates
that seem almost certain to be given this year. Per
haps more significant is that, over much of the past
year and longer, the relationship between money,
interest rates, and nominal income has not always
been in line with earlier cycMcal patterns. That helps,
among other things, to explain why most forecasts of
rising interest rates went awry.
In circumstances like these, central bankers need
to take account of other information beyond the sta
Digitized for
26 FRASER
FRBNY Quarterly Review/Spring 1977
tistics on monetary growth from week to week or
month to month in shaping their policy actions. As we
do, we are in the position of constantly balancing the
danger of failing to react in a timely way to changes
in monetary growth against the danger of reacting too
fast and too aggressively. If we choose wrongly, we
are forced to retrace our steps as more or better
information becomes available.
Clearly, there are risks in not responding in a timely
way to bulges or shortfalls in the money supply rela
tive to specified objectives. If a new turn in the statis
tics turns out to be significant, delays may make it
much more difficult to get back on the track of the
longer term objective. Moreover, unexpected changes
may be telling us something important about economic
developments that we would ignore at our peril.
But the danger of overreacting to deviations in the
aggregates from targets is just as real. Statistically, in
our experience there is a high probability that any
deviation from the established trend over a month or
two— even of considerable size— will prove temporary.
In the United States, at least, most week to week
fluctuations can be close to meaningless. Attempts to
respond immediately by tightening or easing the sup
ply of reserves will probably only slowly effect the
money supply, but in the attempt the market can be
whipsawed. More confusion than light might be thrown
on our intentions if our short-term gyrations in open
market operations serve to confuse what our long
term strategy continues to be.
The importance of this point is reinforced at times
when market conditions may deserve attention in their
own right. There have been a number of occasions
You will have to try to make sense out of all those
monetary data that central banks pour out in ever
greater volume, and you will have to learn how
the central banks themselves are likely to respond.
when markets were unusually sensitive or disturbed—
so much disturbed that a potential impact on business
sentiment and financial availabilities could not be
ignored. At such times, even relatively small changes
in the apparent posture of the Federal Reserve may
trigger expectations in the market that are entirely out
of proportion to any presumed gain in tracking mone
tary targets.
More broadly, I think the intellectual emphasis on
monetary aggregates has sometimes gone too far in
implying that credit market conditions “ don’t count” .
In the view of some monetarists, market conditions
don’t count in the sense that they do not consider
market conditions an independent source of disturb
ance in the economy, or a legitimate concern of policy.
My experience has been to the contrary. There have
been a number of occasions in the 1970’s when the
Federal Reserve had to pay the closest possible atten
tion to particular financial problems and to the potential
vulnerability of various credit markets. The recurrent
concerns in my country about the capacity of thrift
institutions to perform their role as intermediaries
between savers and the mortgage market is one ex
ample. The potential disturbances growing out of the
Penn Central Railroad and the Franklin and the Herstatt
Bank affairs are another class of examples. The strain
on the municipal bond markets and the concerns
about the rising level of losses commercial banks were
taking on loans a year or so ago are other cases in
point. Those problems had to be dealt with— actually
or potentially— by techniques that cannot be encom
passed by any simple monetary rule.
All of this presents important questions of approach
and tactics in pursuing monetary objectives. Each
central bank will have to develop techniques shaped
to its own institutions and needs.
But, even after taking account of other policy re
quirements, the record in adhering to specified mone
tary targets has so far been fairly good. Here in Canada,
as you know, growth in the narrowly defined money sup
ply, despite sharp monthly variations, has been gener
ally consistent with the established target range
despite the slippage down to and below the bottom
of the range in recent months. Among European coun
tries which have announced single point targets rather
than ranges, no central bank has scored a bull’s-eye.
But the performances have been reasonably close to
the mark.
In the United States, too, growth of the monetary
aggregates during 1976 was broadly consistent with
the Federal Reserve’s long-run projections. Measured
from the fourth quarter of 1975 to the fourth quarter of
1976, Mj advanced by 5.5 percent— well within the
range announced for that period. At the same time,
growth rates of the broader aggregates were close to
the upper ends of their respective ranges.
I recognize that the point can be made that this
record has been achieved, at least in my country, in a
rather favorable environment. Specifically, we were
able to realize our monetary objectives within a con
text of economic growth, some abatement of inflation
ary pressures, and generally stable interest rates. In
this view, the real test will come only when financial
pressures, or concerns about the course of economic
activity, become greater and, therefore, generate strong
new demands for money creation as the solution for
such problems.
i would agree that the strength of the commitment
of central banks to the new approach remains to be
challenged in adversity. But perhaps it would also be
correct to suggest that monetary policy has to some
degree facilitated achieving the improvement in eco
nomic conditions.
In the end, the new approach will have to stand or
fall on the basis of how well it is rooted in reality,
on the validity of the basic proposition that excessive
growth in the money supply can only feed inflation,
and that it will not assist us in meeting our underlying
I think the intellectual emphasis on monetary
aggregates has sometimes gone too far in implying
that credit market conditions “don’t count”.
goal of sustained prosperity. My own judgment is that
we already have ample evidence that strong infla
tionary forces, and a renewal of inflationary expecta
tions, will damage rather than help our prospects for
employment and growth. What remains to be seen is
whether those propositions have become so widely
and clearly understood that the old temptations to
turn to the printing press in the effort to reach our
objectives can be resisted.
In recent years, some of the old hallmarks of
sound and responsible policies— particularly fixed ex
change rates and balanced budgets— have been
weakened or destroyed. They broke down at least in
part because, applied too rigidly, they no longer fit the
realities of the time. But I suspect that the loss of
those anchors for policy— however understandable
and justifiable— has something to do with the sense of
uncertainty and instability that has been so prevalent
in this decade.
I hope the new focus on containing monetary growth
can fill some of that void. In substance, the concept is
relatively straightforward and readily understood. It
embodies an essential truth in a manner that can be
clearly communicated. Performance can be readily
monitored. In that sense, both the symbols and sub
stance of effective monetary policy can be brought
together in a comprehensible way.
If the new approach in fact proves useful in helping
to achieve stability in our domestic economies, the
benefits should be reflected in an increased degree of
stability in our international economic relationships as
well. To be sure, economic, political, and social condi
tions vary from country to country. Among other con
sequences of that fact, we can expect different rates
of inflation to persist for some time. And, faced with
FRBNY Quarterly Review/Spring 1977
27
unique circumstances, different central banks will
choose different goals for monetary growth.
All of this will influence exchange rates. Indeed,
changes in exchange rates should not be resisted—
ultimately they cannot be resisted— when they reflect
deep-seated changes in relative economic circum
stances.
What we can reasonably seek is an environment in
which those exchange rate changes take place rela
tively smoothly, without the exaggerations and sense
of turbulence, uncertainty, and crisis that have been
so common in recent years. It seems to me evident
that that basic objective will be served as the domestic
intentions of the monetary authorities become more
predictable, and as confidence in the domestic mone
tary framework grows. As I see it, the practice of
specifying monetary targets will contribute to that end.
But, of course, we need to do more than simply set
targets. We will need to demonstrate our ability to
adhere to the targets. And we will need to act to bring
monetary growth targets gradually down to noninflationary levels.
We still have a long way to go before we can claim
Digitized28
for FRASER
FRBNY Quarterly Review/Spring 1977
success. Those of us responsible for monetary policy
will need to develop the new techniques and to resolve
many problems of tactics as well as strategy. In our
own actions, we will need to justify and make credible
our claims that inflation can be brought under control.
Those of you dealing in financial markets will also
need to adjust and to learn. First, you will have to try
to make sense out of all those monetary data that central banks pour out in ever greater volume, and you
will have to learn how the central banks themselves
are likely to respond. Ultimately, as you gain confi
dence, I hope you will also see the profit potential in
taking a longer view about securities prices and ex
change rates. I also hope that you will come to appre
ciate the risks and dangers of following the crowd in
response to the latest fad or fears.
I welcome this process of adjustment and learning.
I have high hopes that the new approaches toward
money management I have discussed tonight can
help point us toward greater stability in both our
domestic economies and in the exchange rate system.
With a little patience and fortitude, I believe those
present hopes can be converted to firm expectations.
On the Monetary Aggregates
II
A talk given at
Fairleigh Dickinson University,
Hackensack, New Jersey, on
Wednesday, March 2,1977
Monetary Objectives and
Monetary Policy
Richard G. Davis
Senior Economic Adviser
Federal Reserve Bank of New York
Since the spring of 1975 the Federal Reserve has been
announcing projected growth ranges for several mea
sures of money and bank credit. The use of such
monetary “ targets” raises a wide range of issues in
monetary economics, from the rather narrowly technical
to the more broadly philosophical. Since the subject
is vast and time is limited, I shall have to be content
with a terse and selective summary of some of the main
issues posed by the use of monetary targets. Specifi*
cally, I want to (1) describe the procedures for setting
projected monetary growth ranges currently in use,
(2) try to suggest some historical reasons for the evo
lution of these procedures, (3) describe the broad
strategic considerations that enter into the setting of
the monetary growth ranges, (4) discuss some general
problems in determining just what numerical values
should be chosen under given circumstances, and (5)
discuss some problems in realizing projected growth
ranges once they are set.
Under the current procedure, the Chairman of the
Federal Reserve Board announces projected growth
ranges for the coming four-quarter period in quarterly
presentations to (alternately) the House and Senate
banking committees. These presentations are made in
response to a joint Concurrent Resolution of the House
and Senate passed in March 1975.
At the outset I should perhaps note that the term
“ targets” , often applied to these monetary growth
ranges, actually has no particular official standing.
Indeed in some respects the term is misleading since
it may seem to imply that particular numerical values
for the money supply, rather than the general health
of the economy, is the “ target” of policy. And it may
seem to imply a degree of rigidity with regard to the
pursuit of these money supply ranges that does not
exist. Notwithstanding these difficulties, I will fre
quently use the term “ target” for lack of a more
convenient alternative.
The ranges themselves are defined in terms of
upper and lower limits for growth rates in three defini
tions of the money supply (and one of bank credit) as
measured from the most recent quarterly average levels
to the prospective levels four quarters ahead. The cur
rent target period thus covers growth over a one-year
period ending with the fourth quarter of 1977. The group
of monetary measures that are targeted at the moment
includes Mx (currency plus demand deposits), M2 (Mx
plus commercial bank time and savings deposits other
than large negotiable CDs), and M3 (M2 plus deposits
and shares at mutual savings banks and savings and
loan associations). Chart 1 shows the current growth
rate ranges for Mx and M2 and compares them with
actual growth rates over some recent past periods.
While the targets are stated in growth rate terms, given
the base period levels, these growth rates can of
course also be translated directly into upper and lower
limits on the dollar levels four quarters hence. A trans
lation into dollar levels is sometimes useful as a means
of following how the aggregates may be tracking rela
tive to the targets. Chart 2 shows the growth path of
Mx over the four quarters of 1976 relative to the upper
and lower limits implied by the target growth rates at
the beginning of 1976.
FRBNY Quarterly Review/Spring 1977
29
C hart 2
Chart 1
M1 Levels Relative to Projected
One-Year Range
Money Supply Growth Rates
Percent
10---------------------------------------
B illio ns of dollars
3 2 0 ------------------- 1------------------------ ----------------------Actual M1 level
------------- 1975-IV to 1976-IV
(Range established in January 1976)
8
6
315
4
2
S
\
\
\
\
4%%
305
\
P rojecte d
ranges
1976-IV to
1977-IV
/
/
\
0
/
/
/
\
310
/
/ ' 7%%
/
\
\
\
\
L
300
\
\
\
295
q U---------U _---- -LUL---- _LLL---1955-641965-71 1972
(averages)
1973
III
1974
1 1 1---- 1 1 1. . . .
1975
1976
Historical evolution
Quite apart from the immediate impetus to publicly
announced monetary targets provided by the Congres
sional Concurrent Resolution, the present targeting pro
cedure represents the product of a long evolution in
thinking over the postwar period. When active counter
cyclical monetary policy first got under way in the
postwar period, the Federal Reserve faced a new
situation and new objectives for which the experience
of earlier decades really offered little guidance. Clearly,
one of the main objectives of policy was to provide
countercyclical ballast. This meant “ tightening” when
expansion threatened to become unsustainably exuber
ant and “ easing” when the economy became soft. At
first, it was pretty much universal practice both inside
and outside the Federal Reserve to calibrate policy in
terms of money market conditions or the behavior of
short-term interest rates. Policy was said to be “ eas
ing” or “ easy” when short-term rates were falling or
low and to be “ tightening” or “ tight” when rates were
rising or high.
After some experience with this framework, however,
it became evident that the behavior of interest rates
30 FRBNY Quarterly Review/Spring 1977
290
was not always a good way to calibrate the impact
of policy. The trouble was that, even in the short run,
interest rate movements depend only in part on what
the Federal Reserve does and much more on what the
economy itself does by way of generating demands for
money and credit. As a result, interest rates can give
off misleading signals of policy’s impact at crucial junc
tures in the business cycle, with the movements in rates
reflecting the effect not of policy but of cyclical devel
opments in the economy itself.
Perhaps the locus classicus of such situations oc
curred in early 1960 when the economy went into re
cession and interest rates fell even though bank
reserves and the money supply continued to contract
until the middle of the year. The conjunction of a falling
money supply and bank reserves along with falling
interest rates made it quite clear that declining rates
reflected weakening credit demands at a time when
the economy was going into recession. Under such
conditions, it didn’t seem to make much sense to de
scribe monetary policy as “ easy” simply because
interest rates were falling. The feeling spread in the
1960’s that this kind of situation might not be at all
rare and indeed might be a systematic feature of
business-cycie behavior. As a result, wariness about
identifying monetary “ tightness” and “ ease” with
interest rate movements increased. At the same time,
the advantages of identifying policy directly by the
behavior of movements in the money supply and bank
reserves seemed to become more apparent.
This trend in thinking was clearly also spurred by
a roughly concurrent increase in the popularity of
“ monetarism” — a view that claims a dominant impor
tance for the behavior of the money supply in determin
ing a wide range of short and longer run economic
developments. Nevertheless, there is little intrinsic
connection between the question of what indexes to
use in measuring and guiding monetary policy and the
larger issues posed by monetarism about the behavior
of the economy as a whole.
In any case, the accelerating rates of inflation we
began to experience in the late 1960’s undoubtedly
further undermined confidence in the use of interest
rates and increased the appeal of monetary aggregates
as measures of policy. With the relatively high rates
of inflation that emerged in the late 1960’s, an old
idea resurfaced, namely, that actual market rates of
interest really consist of two parts: (1) a so-called
“ real” rate of interest which equals the market rate
adjusted for any depreciation in the purchasing power
of the principal over the life of the loan and (2) an
inflationary component to compensate for this depre
ciation.
With high and variable rates of inflation, given
market interest rates obviously will not have a constant
meaning in terms of the real “ tightness” or “ ease”
they imply about financial markets. Under these con
ditions the behavior of market rates becomes a rather
elastic measuring rod. Moreover, even if the monetary
authorities could in theory control at least some nom
inal interest rates by pegging the prices of some debt
instruments, they have no control at all over the “ real”
interest rate, i.e., the nominal rate adjusted for infla
tion. Finally, the emergence of inflation over recent
years as an absolutely first-rank economic problem
has tended to reemphasize the long-run strategic im
portance of monetary growth rates.
The strategy of setting monetary targets
To return to the current practices regarding monetary
targets, it is easy, at least on one level, to describe how
the numerical monetary target ranges are set. Procedurally, the result is the outcome of a vote by the
Federal Open Market Committee (FOMC). In choosing
among alternatives, the individual Committee members
obviously vote for that set of target numbers they think
is most likely to produce good results for the economy
over the coming year given the information at hand.
For each member, this decision depends upon two
elements: (1) his preferences among possible out
comes for the economy and (2) his views about what
outcomes are in fact likely to result from the choice
of particular target ranges. The economics staffs at the
Board of Governors of the Federal Reserve System
and at the Reserve Banks try to provide some assis
tance on this latter aspect of the problem by try
ing to project the consequences for the economy of
alternative target ranges. These projections may be
made in a variety of ways, ranging from the use of
econometric models to purely judgmental projections,
with various combinations in between. Obviously, how
ever, the various staff judgments will not always agree,
will not always be right, and will not always be ac
cepted by the Committee members.
Immediate circumstances aside, Chairman Arthur F.
Burns and other senior Federal Reserve officials, in
cluding President Paul A. Volcker of the New York
Reserve Bank, have frequently emphasized that the
overall process of setting monetary aggregate targets
has been influenced since its inception by a longer
run strategy: This strategy is one of gradually bring
ing down growth rates in money to levels that in the
long run may prove compatible with price stability.
The linkage suggested by this strategy between the
longer run behavior of money and price stability, how
ever, does not necessarily imply a “ monetarist” view of
inflation— certainly not in the sense of believing, as
Milton Friedman has put it, that inflation is “ always
and everywhere a purely monetary phenomenon” . The
events of the past few years, it seems to me, should
have made it clear that, in the short run, inflation can
lead a life of its own quite independent of current or
past monetary development. The 12 percent inflation
of 1974, for example, was clearly traceable in a large
part to special factors and cannot be explained by
monetary growth alone.
But on a longer term basis, it doesn’t take much
massaging of the data to suggest a general if imperfect
parallelism between monetary growth and inflation
(Chart 3). Even over this longer run, there is a serious
question under present day conditions as to whether
the causality doesn’t run as much from prices to
money as from money to prices. Central banks and
governments all over the world have often found
themselves under intense pressure to validate price
increases stemming from nonmonetary sources be
cause the short-run alternatives have seemed to be
pressures on interest rates and employment. Conse
quently, although in a narrow, purely economic view
of the inflation problem, rapid monetary growth might
be regarded as the “ cause” of long-run inflation, a
FRBNY Quarterly Review/Spring 1977 31
more comprehensive view of the entire process must
put the blame on a multitude of political, social, and
economic pressures. These pressures have given an
inflationary bias to modern economies, one that has
often been accommodated by monetary expansion
simply because in the short run this has seemed to be
the least undesirable among available alternatives.
Yet despite reservations about purely monetary
theories of inflation, economists do generally agree
that avoidance of excessive monetary growth is at least
a necessary— though not necessarily a sufficient—
condition for long-run price stability. Thus, it was evi
dent by 1972 that a long-term strategy of gradually
slowing monetary growth rates had become desirable.
As Chart 1 shows, growth rates did in fact slow in 1973
and 1974 but, beginning in 1975, the pressing immedi
ate problem of ensuring an adequate economic recov
ery became a factor. Nevertheless, the longer term
objective of gradually lowering monetary growth rates
has continued to be reaffirmed— most recently in Feb
ruary by Chairman Burns in his regular quarterly
testimony to the Congress. As Chart 4 shows, all but
one of the eight individual changes in monetary target
C hart 4
M1 and M2 Ranges for One Year Ahead
Percent
7 .0 0 -
6.00-J
5.00
6 . 00 '---------------- 1---------------- 1---------------- 1---------------- 1---------------- 1---------------- 1---------------- 1--------------Chart 3
Money and Price Changes in the Long Run
1975-1
to
1976-1
75-11
75-111 75-IV
76-1
76-11
76-111
to
to
to
to
to
to
76-11
76-111 76-IV
77-1
77-11
77-111
Periods covered by the o n e -ye a r ranges
76-IV
to
77-IV
Changes at annual rates, measured from 12 quarters ea rlier
Percent
32 FRBNY Quarterly Review/Spring 1977
ranges for Mj and M2 that have been made over the
past two years have been in the direction of modest
downward adjustments in the upper or lower ends of
the ranges of one or more of the money supply
measures.
The current targets are clearly still well above the
levels that would be likely to prove consistent with
long-run price stability. To be sure, no one can say with
certainty just what these growth rates are, but the his
torical record seems to suggest rough estimates of
about 1 to 2 percent for Mi and about 3 to 4 percent
for M2.
Movements to such levels could not be made all
at once, however. Inflation, once set in motion, tends
to be extremely persistent under modern conditions,
even after demand pressures have disapppeared. Thus
at least some inflation seems inevitable, no matter what
monetary policy does, for a certain period ahead. If
monetary growth rates do not take this fact into ac
count, they risk being insufficient to finance adequate
growth of real economic activity. This consideration
provides a strong reason for setting monetary targets
under these conditions above levels appropriate for
long-run price stability, moving down to those levels
as inflation recedes.
Problems in setting targets
A major problem in setting targets is that there
can be slippages in the relationship between money
and the economy over periods of time and in orders of
magnitude substantial enough to be important to
policymakers. To the extent that such slippages exist,
determining target levels needed to achieve any given
economic result will have to involve a significant
amount of judgment. The existence of slippages means
that appropriate target ranges simply cannot be me
chanically deduced from past behavior— as would be
implied, for example, by a literal and uncritical use
of projections from an econometric model.
The relationship between the growth of money and
the growth of GNP can deviate from past patterns, for
example, if the public’s desire to hold money balances
under given conditions— the “ demand for money func
tion” in the parlance of economists— changes. No one
thinks the demand for money under given conditions
is absolutely stable, but there are substantial differ
ences of opinion as to just how important shifts in
money demand may be. We have recently had highly
suggestive (to me) evidence that the demand for money
can in fact deviate far enough from the norm to have
quite significant policy implications. Thus, over the first
year of the current economic expansion, the income
velocity (turnover) of Mi balances rose very rapidly,
by almost 8 percent. It is normal for velocity to rise at
above-trend rates the first year of economic expansion,
but the 1975-76 rise was abnormally rapid even so—
the rate of increase exceeded the average for the four
preceding upturns by nearly 60 percent. What is most
striking about this abnormally rapid rise in velocity is
that it occurred despite some net downward drift in the
yields on a wide range of financial instruments (includ
ing common stocks) that are alternatives to holding
money. Economists assume that declines in such
yields ought to reduce the incentive to economize on
noninterest-bearing Mi balances. Thus they would nor
mally expect interest rate declines to reduce velocity
or at least slow its growth, not to produce the unusually
rapid increase that actually occurred.
That velocity did, nevertheless, increase so rapidly
suggests a weakened desire to hold money balances
under given conditions. And there have been some
institutional developments recently that could explain
a shift of funds out of Mx balances. These developments
— including the spreading use of NOW accounts and
the opening-up of savings accounts to business, for
example— could explain the apparent reduction in the
demand for IV^ balances that the figures on velocity
seem to imply. The point of all of this is simply that
anyone looking ahead at the very beginning of the
recovery and trying to guess an appropriate rate of
Mx expansion for the year ahead would have had a real
problem. Relying on past statistical relationships alone
would have led him to a serious overestimate of the
Mx growth needed to finance the rather vigorous 13
percent growth of nominal GNP that actually occurred.
A second technical problem that complicates setting
aggregate targets has to do with the changing relation
ships among the various monetary measures that are
targeted. Over the years, M2 and M3 have on average
grown more rapidly than Mx (Chart 5). Thus under
normal circumstances we would expect the M2 and M3
target ranges to be above the corresponding Mi ranges
— as they have over the past two years. Complicating
the problem, however, is the fact that the differentials
between the growth rates of Mx and the other two
measures have at times varied sharply.
The explanation for these shifting relative growth
rates lies mainly in the sensitivity of the time and
savings deposits included in M2 and M3 (but not in MJ
to competition from open market instruments, such
FRBNY Quarterly Review/Spring 1977
33
Chart 6
Behavior of M1: Narrow Money Supply
Changes from previous month
Annual rates, seasonally adjusted
Percent
to Mx. These movements clearly can create some di
lemmas in setting targets. Over the past year, for
example, Mj grew 5.5 percent, about the middle of
the 41/2 to 71/2 percent target range set early in the
year, while M. grew by about 10.9 percent, somewhat
above the upper end of its 71/2 to 101/2 percent range.
The unusually wide spread between Mx and M2 growth
in 1976 undoubtedly did reflect in large part the un
usual declines in open market interest rates during the
year. These declines clearly encouraged massive flows
of funds out of market instruments and into the various
types of time and savings deposits.
What is the proper attitude to take toward the
unusually rapid growth rates of M2 and M3 in these
circumstances? One possibility is simply to make some
allowances for the fact that interest rate relationships
between deposits and market instruments are out of
line with their long-run equilibria and adjust upward
the target ranges for M2 and M3 relative to Mx. This
in fact is what the FOMC did at its October meeting.
(The change was subsequently modified in January as
bank time and savings deposit rates seemed to be
adjusting downward to a more normal relationship with
market rates.)
Problems in hitting targets
as Treasury bills and commercial paper. This sensitivity
in itself might cause no particular problem if interest
rate differentials between time and savings deposits
and open market instruments were roughly constant.
But, in fact, these interest rate differentials show
rather sizable changes. These changes, in turn, follow
roughly the overall average level of interest rates
as it varies with the business cycle. In part, the changes
in interest rate differentials result from Regulation Q,
which puts limits on deposit interest rates and thus
may prevent them from following market rates up when
the latter are rising. But Regulation Q is only part of
the story. For various reasons, deposit rates tend to be
slow to adjust to changes in competing market rates
even when market rates are relatively low and the
legal ceilings are not a consideration.
The result of the sluggish adjustment of bank de
posit rates to rising open market rates is often a flow
of funds out of interest-bearing deposits along with a
corresponding slowdown in M, and M3 growth relative
to Mx. Conversely, when market rates are falling, funds
tend to flow back into time and savings accounts, re
sulting in abnormally rapid M2 and M3 growth relative
FRBNY Quarterly Review/Spring 1977
Digitized34
for FRASER
Not only are there difficult problems in setting targets,
there are equally difficult problems in achieving them
once set. The trouble starts from the fact that the
Federal Reserve does not control the money supply
directly. Its direct influence is limited to the volume of
reserves supplied through its open market operations,
the terms and conditions on which it permits banks to
obtain reserves through the discount window, and the
level at which it sets required reserve ratios. Obvious
ly, these tools are very important influences on the
level of the money supply. Indeed, over a sufficiently
long time horizon, they may be essentially determining.
Nevertheless, the short-run slippage can be— and
often is— enormous.
Week-to-week and even month-to-month figures on
the seasonally adjusted annual growth rates in any of
the monetary measures represent little more than
statistical “ noise” (Chart 6). These short-run move
ments are often heavily influenced, if not dominated,
simply by problems of seasonal adjustment. It is hard
to overemphasize the influence that seasonal adjust
ment procedures alone, with their inevitable uncer
tainties, can have over short-run annual growth rates
computed for the monetary aggregates. Last year,
for example, the difference between seasonally ad
justed and unadjusted monthly changes at annual
rates in M1 varied from 4.5 percentage points (in
March) to as high as 38.4 percentage points (in Feb
ruary). Even on a quarterly average basis, seasonality
is critical, with differences between adjusted and
unadjusted annual rates of growth amounting to as
much as 6.4 percentage points (in the fourth quarter).
Obviously, uncertainties about the appropriate sea
sonal adjustment factors can translate into large un
certainties about annualized growth rates even over
periods as long as a quarter.
Seasonality aside, other important short-run influ
ences on monetary growth rates include flows between
the public and the Treasury and shifts in the volume
of trading on financial markets. These factors can
have a substantial impact, at least temporarily, on the
public’s holdings of demand deposit balances. As a
result, monetary growth rates tend to fluctuate sharply
and erratically in the short run. To get a meaningful
feel for how monetary growth rates are developing,
it is really necessary to look at time horizons of six
months or longer (Chart 7).
The erratic character of short-run monetary move
ments greatly complicates the task of deciding
whether corrective actions are needed to achieve
longer run targets. If no action is taken, there is a risk
that the errors will cumulate and that temporary devia
tions will turn into long-run misses. If, however, action
is taken prematurely to offset a random movement that
would have corrected itself, the action will soon have
to be reversed. In this case the end result may be
unnecessary disturbances in reserve supplies and
money market conditions.
There is, unfortunately, no really good way to detect
when short-run deviations in monetary growth from
longer run targets are truly temporary and when they
reflect more fundamental developments. Judgment,
and the concomitant risk of error, is unavoidable in
these situations. To avoid overreacting to short-term
developments, the Federal Reserve has in practice
tended to “ tolerate” short-run swings in monetary
growth rates over fairly wide ranges. The limits to
such “ toleration” have usually been expressed as
upper and lower limits on two-month average growth
rates— known, obviously enough, as “ tolerance
ranges” . These ranges are set at levels that reflect
the Open Market Committee’s estimates of the various
short-run influences that may be impinging on the
monetary aggregates at any given time. As a result,
Chart 7
Growth of M1: Narrow Money Supply
Annual rates, seasonally adjusted
Percent
1972
1973
1974
1975
1976
1977
FRBNY Quarterly Review/Spring 1977
35
the short-term tolerance ranges for any particular
two-month period may differ significantly from the
underlying one-year target ranges (Chart 8). More
over, reflecting the highly unpredictable nature of
short-term movements, the percentage point spreads
embodied in the two-month tolerance ranges have
normally been set wider than the spreads contained
in the one-year target ranges.
The Federal Reserve is constantly looking for ways
to improve its forecasts, and therefore its potential
control, of short-run movements in the monetary ag
gregates. It is possible that over time, better data,
changed institutional arrangements, more refined
forecasting procedures, and improved tactical methods
could lead to better short-run control. My own view,
however, is that much of the problem of erratic shortrun movements is likely to prove rather intractable.
Some economists have suggested that improved shortrun control could be achieved by making forecasts
of the (nonborrowed) reserve-deposit multiplier* over
the month ahead, then simply supplying nonborrowed
reserves in line with the desired level of deposits.
While such a procedure may have some attractions,
I have seen nothing to suggest that this technique
would by itself significantly reduce the inherent diffi
culties of short-term monetary control.
To put the problem of short-term control in per
spective, however, there seems to be little or no evi
dence that short-run fluctuations in monetary growth
rates, even over periods of up to six months, have
major impacts on the economy. Thus, it may be that
* That is, the multiple that the total of banking system deposits is
of total banking system nonborrowed reserves.
36for FRBNY
Digitized
FRASER Quarterly Review/Spring 1977
the problem of short-run control is really not intoler
ably serious, however vexing it may be to those that
have to try to deal with it.
Conclusion
Even this short review of monetary aggregate targets
clearly indicates that there are many problems con
nected with them: problems in setting the targets,
problems in hitting the targets, and indeed limits to
what the approach can accomplish in improving the
performance of the economy. In no sense has the use
of monetary targets been able to turn what used to
be called the “ art” of central banking into a rigid
mechanical process for controlling and monitoring
the flow of money and credit. Judgment is required
in determining at what levels the targets should be
set and under what conditions and in what ways they
should be changed. Judgment is also required in
making the week-to-week and month-to-month deci
sions with regard to open market operations appropri
ate to achieving the targets. And, finally, judgment
is required in deciding how to respond when monetary
performance seems to be getting out of line with
what had been expected and intended.
Nevertheless, despite all these caveats, the setting
of monetary objectives covering fairly long time spans
— however provisional and subject to change— seems
to me one of the more constructive innovations in
macroeconomic policymaking of recent years— not
just in this country, but in others as well. It is a
development, moreover, that seems especially useful
in a period when high and variable rates of inflation
have become one of our most serious problems.
On the Monetary Aggregates III
The Implementation of
Monetary Policy in 1976
The Federal Open Market Committee (FOMC), in set
ting open market policy in 1976, sought to foster eco^
nomic expansion following the 1974-75 recession and to
achieve further moderation in the rate of inflation. The
dampening of inflationary expectations that emerged
contributed to a considerable decline in long-term
interest rates and, over the course of the year, the
credit markets financed another large Federal deficit
more readily than had been generally anticipated.
The Committee’s decisions were heavily influenced
by its perception of the tempo of the economic
recovery, which first speeded up and then slowed
down. A surge in activity early in the year generated
expectations of continued strong economic expansion
that might necessitate actions to restrain growth of
the monetary aggregates. When the aggregates grew
strongly in the spring, the Committee began limiting
the extent to which it accommodated the demand for
member bank reserves. As the summer progressed,
however, the rate of economic expansion moderated
and growth of the labor force began to exceed growth
of employment. The rate of monetary expansion also
receded. Gradually, the FOMC shifted emphasis to
A report by Alan R. Holmes and Peter D. Sternlight.
Mr. Holmes is Executive Vice President of the Federal Reserve
Bank Of New York and Manager of the System Open Market Account.
Mr. Sternlight is Senior Vice President of the Bank and Deputy
Manager for Domestic Operations of the System Open Market
Account. John S. Hill, Senior Economist, and Christopher J. McCurdy,
Economist, were primarily responsible for the preparation of this
report, which is adapted from the Annual Report on Open Market
Operations for 1976 submitted to the Federal Open Market Committee.
promote a step-up in the growth of the aggregates
through a more accommodative approach to the pro
vision of reserves. By the year-end the pace of eco
nomic advance seemed to be quickening once more.
In formulating its broad policy approach, the Com
mittee continued to focus on a one-year time horizon
for growth of the monetary and credit aggregates.
It also adopted short-run instructions that prescribed
a Trading Desk response, through open market oper
ations, to indications of undesired strength or weak
ness in the monetary aggregates. The Committee’s
instructions to the Account Management were in
essentially the same format as in recent years. In
implementing its instructions, the Trading Desk found
market participants in 1976 acutely sensitive to move
ments in the monetary aggregates as well as to the
conduct of open market operations. At the same time,
recent changes in the Treasury’s cash management
policies increased the volatility of Treasury cash bal
ances and thereby posed difficult operational chal
lenges to the Desk.
This report focuses on the Trading Desk’s imple
mentation of the FOMC’s directives during the year.
After presenting an overview of the Committee’s pol
icy decisions in 1976, it describes the procedures used
by the Desk to bring reserve supplies into line, with
the Committee’s objectives. It discusses particularly
interesting periods in detail in order to illustrate how
the Desk carried out operations against the back
ground of the sensitive financial environment that pre
vailed over much of the year.
FRBNY Quarterly Review/Spring 1977 37
Monetary Policy and the Financial Markets
Establishing growth ranges
In seeking both sustainable economic expansion and
a reduction of price inflation, the Committee on bal
ance lowered its ranges for annual growth of the
major monetary aggregates (see table). At its October
1975 meeting, the Committee had set a range of
5 to 71/2 percent for growth of M*— demand deposits
plus currency in the hands of the public— over the
four-quarter period ended in the third quarter of 1976.
In January 1976, it reduced the lower limit of this
longer run range by V2 percentage point. Later it
narrowed the range through two V2 percentage point
reductions in the upper end. Thus, the range adopted
for Mj in November 1976 for the annual period ending
in the third quarter of 1977 was AV2 to 6 1/2 percent.1
The annual range for M 2— Mx plus time and savings
deposits at commercial banks other than large negoti
able certificates of deposit (CDs)— had been set at 7 1/2
to 1 0 1/2 percent at the October 1975 FOMC meeting and
the range was reduced, on balance, through subse
quent modifications, to 7 V2 to 1 0 percent for the annual
period ending in the third quarter of 1977. At the
October 1975 meeting the Committee had adopted
a range of 9 to 12 percent for M3— M2 plus deposits
at thrift institutions. A range of 9 to 1 1 1/2 percent was
established about a year later in November 1976.2
The Committee, in assessing the growth of the
monetary aggregates early in the year, expected the
demand for money to pick up in view of projected
gains in economic activity. There had been an unusu
ally rapid increase in the income velocity of Mi in
the second half of 1975. However, there was uncer
tainty whether innovations in the management of cash
would continue to depress the rate at which demand
balances would grow, given the expected gains in
income and prevailing interest rate levels. After a
slow start, Mx growth strengthened markedly during
1 One factor influencing the C om m ittee’s decision to reduce the growth
range in Novem ber was increasing efficiency in the use of cash
balances. The growth of transactions balances held in the form of Mx
was curtailed by the grow ing use of overdraft facilities, NOW accounts,
savings accounts that perm it telephonic transfers to checking
accounts or settlem ent of m onthly bills, and savings accounts by
businesses and state and local governm ents. One study by John
Paulus and Stephen H. A xilrod (Board of Governors of the Federal
Reserve System, “ Recent Regulatory Changes and Financial
Innovations Affecting the Growth of the Monetary A ggregates” )
indicated that, w ithout these developm ents, the growth of M i in
the year ended in the third quarter of 1976 m ight have been roughly
1V2 to 2 percentage points higher than actually occurred.
2 The upper ends of the ranges for M2 and M3 were reduced around
midyear, but they were raised slig htly in November because tim e and
savings deposit inflows appeared likely to remain heavy, given that
market interest rates had declined relative to those paid by banks
and th rift institutions.
FRBNY Quarterly Review/Spring 1977
Digitized38for FRASER
Chart 1
Growth of Money Stock and
Adjusted Bank Credit Proxy
Seasonally adjusted annual rates
the spring and reached an average annual rate of
7 percent, seasonally adjusted, over the first five
months of the year. Its expansion moderated there
after, and only in October did it again display signifi
cant strength.
Measured from the fourth quarter of 1975 to the
fourth quarter of 1976,
increased 5 1/2 percent.
Commercial bank time and savings deposits other than
large CDs grew rapidly during the year, as the interest
rates on passbook accounts proved attractive in com
parison with market rates. Consequently, M2 grew by
11 percent (see Chart 1).
Implementation of the FOMC’s policy objectives
Efforts
longer
on the
supply
of the Open Market Committee to achieve its
run objectives required continuing judgments
extent to which open market operations should
nonborrowed reserves in relation to the de
trading level for Federal funds declined in three stages
from about 5 1/2 percent at midyear to around 4%
percent at the year-end.
mand for them. After a brief move toward augmenting
reserve availability and lowering the Federal funds
rate during the first two weeks in January, the Com
mittee was content to see Federal funds continue to
trade around 4% percent through the winter. Policy
directives issued following the January and February
meetings instructed the Account Management to main
tain prevailing money market conditions unless the
growth rates of the monetary aggregates appeared to
be deviating significantly from the midpoints of their
specified short-run ranges. Indications of strong growth
of the aggregates at the end of February led to a very
slight shift toward a less accommodative stance, but
this was reversed soon afterward on the basis of fur
ther information.
The Committee continued to hold to a steady course
until mid-April. Then, rapid growth of the aggregates,
especially in Mlt and evidence of a vigorous economic
expansion prompted a shift toward a less accommoda
tive stance that had been long expected in the finan
cial markets. The System provided nonborrowed re
serves less freely, and the Federal funds rate rose by
% percentage point over the next six-week period to
51/2 percent by the end of May.
During the second half of the year, as evidence
developed that overall economic growth had slowed,
the thrust of open market operations was toward easier
money market conditions. The initial approach of the
Committee was relatively cautious. At the June meet
ing it set a narrower than usual range for movements
in the Federal funds rate, and at the August meeting
it stressed the maintenance of stability in money mar
ket conditions. As concern about the economic out
look increased, however, at its September meeting
the Committee opted for a Federal funds rate range
that provided more room for downward than for up
ward movement. Thereafter, the Committee acted to
promote a more accommodative financial climate. The
Behavior of financial markets
Expectations of market participants were greatly re
sponsible for the sharp rise in interest rates that de
veloped during the spring. Even though interest rates
had declined substantially since the previous autumn,
market participants generally anticipated a cyclical up
turn in rates during the year. Their expectations were
based on a presumption that expanded private credit
demands would compete with heavy Federal borrowing
in a period when the Federal Reserve was likely to be
taking steps to restrain growth of the money stock.
When reserve conditions did tighten briefly in late
February, market interest rates rose sharply and re
turned to previous levels only gradually, even after the
tightening in reserves proved to be temporary. When
the Federal funds rate rose 75 basis points between
mid-April and late May, other short-term rates advanced
by as much as 80 to 10 0 basis points; long-term yields
rose roughly 40 basis points. In the market for Trea
sury securities these rate increases were larger than
the declines that had developed earlier in the year
(see Chart 2).
These expectations that interest rates would rise
over the rest of the year proved wrong. Economic
growth decelerated in the second half, while the Fed
eral deficit turned out to be smaller than had been
anticipated. Domestic corporations reduced their bor
rowings in the bond market in the second half as
capital spending recovered slowly. This environment
led investors— flush with cash and encouraged by the
progress being made in dampening inflationary forces
— to push yields significantly lower over the final seven
months of the year. By December, rates on Treasury
bills were as much as 125 basis points below the levels
Federal Open Market Committee’s Annual Growth Ranges for
Monetary Aggregates and Adjusted Bank Credit Proxy
Seasonally adjusted annual percentage rates
Period
Month established
m2
Mx
Ms
C redit proxy
1975-111 to 1976-111
October 1975
5 to 7 1/a
7 Vs to 10Vs
9 to 12
1975-1V to 1976-1V
January 1976
4 Vs to 7 1/z
7 Vs to 101/2
9 to 12
6 to 9
1976-1
A pril 1976
4 Vs to 7
7Vs to 10
9 to 12
6 to 9
1976-11 to 1977-11
July 1976
4Vs to 7
7 1/2 to
9 to 11
5 to 8
1976-111 to 1977-111
Novem ber 1976
4Vs to 6 Vs
7 1/2 to 10
9 to 11 Vz
5 to 8
to 1977-1
9 1/z
6 to 9
FRBNY Quarterly Review/Spring 1977
39
that had prevailed at the beginning of the year. Yields
on long-term Treasury issues were down by about 75
basis points, while those on corporate and tax-exempt
issues showed substantially larger declines. In some
markets, long-term interest rates were at their lowest
levels in about three years.
During 1976 the Treasury raised $58 billion of new
cash, second only to the record amount raised in
1975. It also extended the average maturity of its
debt for the first year since 1964. It continued to regu
larize its debt offerings and to reduce uncertainty
about prospective financings by keeping the market
informed about its borrowing plans. The Treasury filled
the remaining maturities in its monthly two-year note
cycle and established quarterly four- and five-year note
cycles. New Federal legislation aided the Treasury’s
debt extension program by extending the maximum
maturity of Treasury notes from seven years to ten
years and by increasing from $10 billion to $17 billion
the amount of long-term bonds that could be issued
without regard to the 4 1/4 percent interest rate ceiling.
The Treasury took advantage of this added flexibility
by offering an intermediate-term note and a long-term
bond in each of its quarterly refundings as well as a
short-term two- or three-year note. In the first three
refundings the Treasury sold one seven-year and two
ten-year notes, with fixed coupons and prices, through
subscription. All other securities were sold on an auc
tion basis. The subscription sales drew heavy demand
for the attractively priced notes, enabling the Treasury
to increase the total size of the subscription issues to
$18.5 billion, $7.5 billion more than the amounts ini
tially offered.
The volume of secondary market trading in United
States Government securities expanded considerably
in 1976; flurries of speculative activity contributed to
periods of unusual price volatility. The increase in
trading activity stemmed partly from the large volume
of Treasury financing. But there was also a surge in
the trading activity of portfolio managers who sought
to outperform the rate of return provided by more con
servative investment strategies. Traders necessarily
sought to anticipate the future course of rates by ana
lyzing economic and monetary data as they appeared
and by projecting the data yet to be published. In this
environment, participants were often quick to react,
or to overreact, to new data that they thought might
presage shifts in monetary policy and credit conditions.
Most sectors of the economy added further to their
liquidity, continuing the rebuilding process that had
dominated credit markets in the previous year. Corpo
rate borrowers flocked to the bond market during the
first half, reducing their short-term debt and seeking
to secure long-term funds before the expected rise
40 forFRBNY
Quarterly Review/Spring 1977
Digitized
FRASER
C hart 2
Selected Interest Rates
Percent
10.0----------------------------------------------R ecently offered
Aaa-rated corporate bonds
J F M A M J J AS ON
1975
DJ
F M A M J J A S O N D
1976
in interest rates. At the same time, favorable cash flows
generated by the rebound in corporate profits allowed
businesses to finance a substantial portion of their
capital needs internally. As a result, the pickup in
short-term business borrowing from banks and in the
commercial paper market over the second half of the
year fell short of participants’ anticipations. Moreover,
the entire rebound in the aggregate of business loans
at banks reflected acquisitions of bankers’ acceptances.
Commercial banks, disappointed by the slack de
mands of their business customers, turned to buying
intermediate-term Treasury coupon securities in order
to take advantage of the higher returns available to
ward the longer end of the upwardly sloping yield
curve. Thrift institutions easily accommodated the
rising demand for mortgages as their deposits con
tinued to expand rapidly. In addition, they continued
to rebuild their liquidity, although not by so much as in
1975.
Long-term t^x-exempt issues posted larger yield
declines over the year than taxable securities. Investors
largely overcame the acute fears that had been trig
gered by New York City’s financial problems in late
1975— although New York City itself did not regain
access to the market for its own obligations. In addi
tion, with an improved earnings position, fire and casu
alty insurance companies expanded their interest in
tax-exempt securities, and commercial banks also
showed some renewed interest in such issues as the
year progressed.
Techniques of Policy Implementation
The FOMC’s instructions to the Manager of the Sys
tem Open Market Account regarding the management
of bank reserves provide— to a considerable extent—
for the accommodation of the public’s demand for
money in the short run, while at the same time pre
scribing a response when growth of money appears
inconsistent with the Committee’s long-term objec
tives. At each meeting the Committee specifies condi
tions to be achieved for bank reserve availability as
measured by the Federal funds rate. It also specifies a
procedure for changing the Federal funds rate within
designated limits if current projections of growth in
the monetary aggregates indicate significant weakness
or strength relative to ranges specified by the Com
mittee for the two-month period covering the month
of the latest meeting and the following month (see
Chart 3).
In 1976, the Committee instructed the Desk to assign
approximately equal weight to Mi and M2 in evaluating
the short-run behavior of the aggregates, rather than
placing primary emphasis on Mx as it had in the past.
The Committee continued to include in its directive
an instruction that the Manager take account of de
velopments in the domestic and international financial
markets.
Following each FOMC meeting, the Account Manager
seeks to achieve the Committee’s current objectives
through operations in Treasury and Federal agency
securities and bankers’ acceptances. Decisions about
the size and type of operations and their timing are
based partly on projections of reserve availability. The
Manager also looks to the behavior of the Federal
funds rate for additional information on factors affect
ing the supply of, and demand for, bank reserves. But
participants in the Federal funds market have become
more reluctant to trade at rates which they perceive
to be out of line with the System’s objective. Thus, the
role of the funds rate as a short-run objective for open
market operations tends to reduce its usefulness as
a guide to reserve availability. Furthermore, the Man
ager, in shaping open market operations, has to take
into account the sensitivity of market expectations to
the behavior of the funds rate.
In evaluating the prospective behavior of the Federal
funds market, the Manager and his staff seek to ap
praise the demand for, and supply of, bank reserves
over the statement week ending on Wednesday. Mem
ber banks must meet their reserve requirements on
average each week, and in addition they hold some
margin of excess reserves as the result of the rapid
shift of balances within the banking system. Required
reserves are determined by deposits on the banks’
books two weeks earlier and are thus known by each
bank and the Federal Reserve at the start of the state
ment week. The Manager estimates the excess reserves
that banks are likely to hold, taking into account sea
sonal deposit flows, the size and distribution of reserve
excesses (or deficiencies) carried over from the previ
ous week, the presence of holidays or statement
publishing dates, and interest rate movements. The
Manager then has in hand an estimate of the total
reserves likely to be demanded by the banking system
in the current week.
With these demand considerations in mind, the Man
ager reviews projections of the supply of nonborrowed
reserves in the banking system for the week. These
projections estimate the impact on reserves of “ market
factors” , such as Federal Reserve float, currency in
circulation, and the Treasury’s balance at the Federal
Reserve Banks. The Manager will then have an esti
mate' of nonborrowed reserve levels stretching out four
to six weeks into the future, based on the assumption
that the Trading Desk takes no action to affect re
serves.
The Manager is thus able to compare the projected
level of nonborrowed reserves over the week ahead
with estimates of total reserves demanded. He can
then determine the appropriate volume of reserves to
be added or subtracted on a daily average basis if
open market operations are to maintain the existing
rate on Federal funds. In doing this, account is taken
of the expected addition to reserves likely to arise from
borrowings at the discount window.
The Manager’s approach to operations each week
is shaped partly with an eye on the extent to which
nonborrowed reserves in subsequent weeks are ex
pected to fall short of, or exceed, projected reserve
requirements. If reserve deficits extend into future
weeks, the Desk is more likely to use outright pur
chases of securities to meet a reserve need. If the need
is temporary, greater reliance on repurchase agree
ments is likely. Conversely, when reserve surpluses
are projected over several weeks, outright sales and
redemptions of maturing securities may be appropriate.
FRBNY Quarterly Review/Spring 1977
41
Chart 3
FOMC Ranges for Short-run Monetary Growth and for the Federal Funds Rate, 1976
Percent
20 -
Narrow Money Stock (M1)4t
Two-month grow th rate
15—
.Actual growth
Broad Money Stock (M2) 4*
Tw o-m onth grow th rate
- A r tiia l g ro w th
Feb & Mar
6.0
5.5
Shaded bands in the upper two charts are the FOMC’s s pe cified ranges fo r money supply grow th over the two-m onth periods
indicated; in the bottom chart they are the s pe cified ranges fo r Federal funds rate variation. Actual qrow th rates in the upper
two charts are based on data available at the tim e of the second FOMC meeting after the end o f each period.
* Seasonally adjusted annual rates.
http://fraser.stlouisfed.org/
42 FRBNY Quarterly Review/Spring 1977
Federal Reserve Bank of St. Louis
Dec
&—
If there is only a temporary need to absorb reserves,
matched sale-purchase transactions are employed.3
The Manager also relies on the behavior of trading
in Federal funds as a source of additional information
on the supply and demand forces affecting the money
market. The Desk may defer putting its program into
effect until the trading level of Federal funds in the
money market confirms the statistical estimates of
reserve availability. Care is taken to avoid actions that
might lead to misinterpretation of the System’s inten
tions by market participants. Thus, when a need to
supply reserves is anticipated, the Manager may wait
for the funds rate to edge up at least to or above the
operational objective before entering the market. When
an overabundance of reserves is projected, the Man
ager may wait for the funds rate to edge down at least
to or below the objective before entering the market
to absorb reserves.
At times, the money market may not reflect the pro
jected conditions of reserve abundance or scarcity. In
this case the Manager may merely delay carrying out
his plans to affect reserves. However, when reserves
are estimated to be abundant (scarce) and the funds
rate threatens to rise (fall) significantly above (below)
the desired level, that situation calls into question the
accuracy of the estimates of the supply of, and the
demand for, reserves. The System’s absence from the
market in that event could be misleading, and the
Manager is likely to enter the market to counteract
undesirably firm (easy) conditions.
The value of the Federal funds rate as an indicator
of the conditions of reserve availability probably has
diminished in recent years. Large shifts in the Trea
sury’s balances at the Reserve Banks have led to
much greater day-to-day volatility in the level of non
borrowed reserves. Exposed to such volatility, money
position managers at the banks are less likely to
3 The System temporarily adds reserves through repurchase agreements
and withdraws reserves through matched sale-purchase transactions.
In making repurchase agreements, the Desk enters into a contract
under which dealers sell United States Government securities, Federal
agency issues, and bankers’ acceptances to the System and agree to
buy them back at a specified time, usually one day to a week later,
at the same price plus a competitively determined rate of return. The
Desk generally permits dealers to offer customer securities as well as
the dealers' own holdings. Repurchase agreements either may allow
dealers to buy securities back at a date earlier than specified initially
or may not allow such early withdrawals— an alternative form intro
duced in 1976. The Manager’s decision on the amount of securities to
be purchased is partly based on the statistical estimates of reserve
supplies. The volume and aggressiveness of the dealers' offerings
provide additional information on the size of the reserve need. Under
matched sale-purchase transactions the System sells Treasury bills to
the market, and at the same time contracts to buy them back on a
certain day, usually up to a week later. The rate at which bills are sold
and repurchased is set through competitive bidding by the dealers.
Matched sale-purchase transactions cannot be terminated before
maturity.
react to the immediate ebb and flow of funds because
they expect the Federal Reserve to compensate for
these massive surges. They appear to be willing to
accumulate larger reserve deficits or surpluses before
taking offsetting actions in the Federal funds market.
Thus, the actual Federal funds rate tends to remain
close to the market’s perception of the System’s ob
jective for the rate until rather late in a statement week.
The primary source of the large shifts in the Trea
sury’s balance has been the Treasury’s cash manage
ment policy of holding the bulk of its balances at the
Federal Reserve Banks rather than in its tax and loan
accounts at commercial banks. The Treasury’s balance
at the Federal Reserve tends to fall early in the month
as social security and other regular payments are made
and then to rise later in the month when taxes and other
revenues are received. The average weekly change in
the Treasury’s balance at the Reserve Banks amounted
to $2 billion in 1976, a 45 percent increase from 1975
and a fourfold increase from 1974. In fourteen weeKs
in 1976 the change exceeded $3 billion. As a result,
the Trading Desk undertook substantially enlarged op
erations just to counteract short-run swings in bank
reserves (see Chart 4).
Faced with shifts in reserves of this magnitude, the
Manager often needs to enter the market very early in
the week to take offsetting action. But the reserve
estimates available at the start of a week are often in
error— by about $490 million on average in 1976, a
55 percent increase from the year before. Since Federal
funds tend to trade close to the market’s perception of
the Desk’s objective, it is difficult to get confirmation
from the money market of the magnitude of the re
serve need or surplus before the calendar weekend.
To deal with this situation the Manager may seek to
compensate for a major part of the reserve swings by
announcing, on Wednesday, intentions to supply or to
absorb reserves on the first day of the forthcoming
statement period.4 Even so, the scale of operations
needed after the weekend often remained quite large.
The Account Management often has the option of
engaging directly in transactions with foreign accounts
to carry out System reserve objectives rather than
acting as agent to execute these foreign orders with
dealers in the market. For example, when the Desk
receives foreign orders to buy securities, it may elect
* Reserve operations affecting an entire week have been employed with
increasing frequency. The Manager arranged six- or seven-day
operations either to add or to absorb reserves during twenty-eight
weeks in 1976. Furthermore, nine of the week-long repurchase
operations were announced to the dealers on Wednesday afternoon
and executed on Thursday morning to allow the dealers additional
time to round up securities from customers. Preannouncing also
diminished any significance that might be attached to the funds rate
prevailing when the transactions were completed the next day.
FRBNY Quarterly Review/Spring 1977 43
Open Market Operations in 1976
C hart 4
Effect on Bank Reserves of Changes in
Treasury Balance at the Federal Reserve
1976 and 1974
B illions of do llars
6------------------------------------------------------------
C um ulative change in w eekly average from final w eek
of previous year.
to meet such orders by selling directly from the Sys
tem’s own portfolio at prevailing market prices. Similar
ly, when the foreign order is to sell securities, the
Desk may buy for the System Account. When the Desk
arranges foreign transactions with the System Account
in this way, the transactions have the same effect on
bank reserves as System operations through dealers
in the market.
Foreign acounts often also have funds available for
overnight investment. When this is the case, the Desk
may arrange matched sale-purchase transactions with
the System Account to drain reserves overnight rather
than act as agent and place these funds in the market
as repurchase agreements with dealers. When a reserve
abundance is projected, System matched sale-purchase
transactions made directly with foreign accounts can
help to reduce the excess. Moreover, when the reserve
levels are expected to be approximately satisfactory, or
in somewhat short supply, and the Federal funds rate
is below the desired level, transactions directly with
foreign accounts can sometimes be used to encourage
a firming of conditions in the money market.
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44 FRBNY Quarterly Review/Spring 1977
Federal Reserve Bank of St. Louis
January to mid-April
The FOMC’s view at the beginning of the year was that
the economy was expanding in an orderly manner, as
industrial production, retail sales, and employment
all displayed good-sized gains. Although growth in the
money supply was expected to rebound from the slow
rate that had developed during the second half of 1975,
there were significant uncertainties in the forecast. It
was difficult to assess the impact on growth of
likely
to result from continued technological change in busi
ness and household management of cash balances and
from the further growth of savings accounts recently
authorized for businesses. Moreover, seasonal adjust
ment of the money supply was problematical, with
alternative adjustment techniques producing different
results.
Against this background, the Committee preferred
not to allow modest deviations in the projected growth
of the aggregates relative to the Committee’s short-run
ranges to prompt changes in the Desk’s Federal funds
rate objective. The directives issued after the January
and February meetings instructed the Manager to main
tain prevailing money market conditions unless growth
of the aggregates deviated significantly from the mid
points of their specified ranges .5 Such a “ money mar
ket” directive places primary emphasis on maintaining
prescribed money market conditions .
At the January 1976 meeting, the Committee speci
fied ranges for the aggregates that were somewhat
wider than usual. This specification reduced the likeli
hood that the Federal funds rate would change. The
behavior of the money stock measures was divergent in
the weeks that followed, but taken together the esti
mates for the two months ended in February did not
warrant a change in reserve conditions. Mx remained
near the bottom of its range, while M 2 was at or above
the top of its range.
A money market directive was also adopted in
February. But the aggregates showed strength shortly
thereafter, with estimates of both Ma and M 2 moving
well up in their ranges. Accordingly, the Trading Desk
sought to hold back slightly on supplying nonbor
rowed reserves relative to the emerging demand by
banks. On Friday, February 27, it began seeking con
ditions consistent with Federal funds edging up from
4% percent to a 4% to 4% percent range. That after
noon, when Federal funds were trading at 4’% per
cent, the Desk entered the market as agent to arrange
repurchase agreements for customer accounts. This
5 When significant weakness had developed in the aggregates
during late Decem ber and early January, the Desk had lowered
the Federal funds rate objective to 4% percent.
was contrary to market expectations that the Desk
would enter to provide reserves on behalf of the Sys
tem when funds were trading at that level. It was
interpreted by participants as indicating a change in
the System’s previous stance. The funds rate moved
swiftly to 4% and 5 percent that afternoon, though
this occurred when it was too late for the Desk to
make any significant volume of repurchase transac
tions for its own account for payment that day. By
Monday, funds were trading at 5 percent and above
and the Desk provided reserves in volume. The money
market remained unduly tight until shortly before the
end of the statement week even though the banking
system held a substantial volume of excess reserves
at the week’s end.
The financial markets had expected interest rates
to move higher in view of the improvement in the
economy, but the late-February evidence of firming by
the System occurred sooner than had been expected.
Interest rates moved up sharply: the rate on threemonth Treasury bills rose by around 30 basis points
over the week, while long-term bond yields moved
about 15 basis points higher.
During the following statement week, new data
suggested that the aggregates were not, in fact, mov
ing outside the Committee’s tolerance ranges, and the
Desk returned to the 4% percent Federal funds rate
objective. A surfeit of reserves was being provided
by a declining Treasury balance, but the surfeit had to
be reinforced by additional System reserve injections in
order to put enough downward pressure on the funds
rate to bring it close to 4% percent by the week’s end.
Other markets were somewhat slower to settle back.
Participants in these markets continued to view under
lying economic conditions as suggesting a rise in
short-term rates.
At its March meeting the Committee favored essen
tially little change in conditions of reserve availability
but expressed greater willingness at that point to resist
any strengthening that might develop in the monetary
aggregates. Consequently, the Committee voted for
an “ aggregates” directive, the more common form
of its operational instructions. Such a directive places
primary emphasis on the behavior of the aggregates,
thereby establishing a somewhat greater likelihood that
conditions of reserve availability will be altered be
tween meetings. The aggregates, in fact, behaved about
as expected over the next month, and thus the Fed
eral funds rate remained around 4% percent through
mid-April.
Mid-April through May
At the April and May meetings the recovery appeared
to be proceeding at a vigorous pace, with preliminary
estimates indicating that real gross national product
(GNP) had expanded at a 71/2 percent rate in the
first quarter. The outlook for economic growth ap
peared bright, with prospects of further inventory accu
mulation and continued sizable advances in consumer
spending. Also the underlying demand for money ap
peared to be strengthening. Mj growth in February and
March had averaged about 6 percent at an annual rate,
and the staff projected very rapid growth in April.
Expansion in M2 and M3 was also quite fast. Most
members preferred to restrain such strong growth
of the aggregates and were willing to tolerate some
firming in money market conditions after both the
April and the May meetings.
At the April meeting the Committee directed the
System Account Manager to seek reserve conditions
consistent with Federal funds trading around 4%
percent— within a tolerance range of 41/2 to 51/t
percent. In addition, the Committee’s directive allowed
the Desk to respond further to indications of undesired
strength in the money supply. Throughout the interval
between the two meetings, expected growth in the
aggregates was high relative to the Committee’s spe
cified ranges, prompting the Account Management to
continue to hold back on nonborrowed reserves in re
lation to demand. By the time of the May meeting,
Federal funds were trading at 51/4 percent, the top
of the range. The Committee called for an immediate
increase in the Federal funds objective to around
5% percent, and by the end of May the Federal funds
objective had been raised to 51/2 percent under an
aggregates directive.
At the time of the April Committee meeting, interest
rates on short- and long-term debt had fallen to the
lowest levels reached thus far in the year. Threemonth Treasury bills traded at rates as low as about
4.70 percent in mid-April, and long-term Government
bond yields were down to around 7.80 percent. Still,
participants in the markets were cautious about the
interest rate outlook as they prepared to face a large
volume of offerings during the approaching quarterly
Treasury refunding. Indications of vigorous economic
growth strengthened market expectations that the Sys
tem might well resist the rapid growth of the monetary
aggregates that was emerging.
During the six weeks from mid-April to late May, when
the Desk pursued a less accommodative policy toward
reserve provision, the yield curve for Treasury securi
ties moved substantially higher and flattened out a bit.
Rates on Treasury bills due in three and six months in
creased by about 90 basis points; yields on coupon
issues maturing in three to seven years moved up by
about 55 to 70 basis points; yields on long-term bonds
advanced about 35 basis points. During this period bond
FRBNY Quarterly Review/Spring 1977
45
quotations became especially volatile, particularly on
Thursday afternoons following publication of the week
ly money stock series, as participants sought to
anticipate future System actions. About three quarters
of the overall increase in yields on long-term Treasury
bonds over the period was concentrated in market trad
ing late on Thursdays and during the day on Fridays.
One episode during this period provides an inter
esting setting for examining the methods that the
Trading Desk uses to implement System policy as
well as the market’s response to the Desk’s actions
and other influences. Operations during the bank
statement week running from Thursday, May 6, to
Wednesday, May 12, posed a particularly difficult
challenge: how to effect a change in the System’s
posture while contending with volatile reserve flows
and sensitive securities markets in the midst of a
Treasury refunding operation. Prior to the start of that
statement week the System’s operations had already
led to a rise in the Federal funds rate from about 4%
percent in mid-April to a 5 percent level in early May.
On the first day, Thursday, May 6, reserve projec
tions indicated that a fall in the Treasury’s balance at
Federal Reserve Banks would release about $3 billion
of reserves, on average, to the banking system during
the statement week beginning that day, although there
would be some offsetting reserve absorption by other
factors. These estimates thus pointed to an overabun
dance of about $1 billion of nonborrowed reserves that
week. Federal funds were trading at 4% percent,
only slightly on the comfortable side of the 5 percent
level sought at that time.
In these circumstances the Desk sought initially to
absorb reserves unobtrusively, limiting its operations
to transactions directly with foreign accounts. The
System sold Treasury bills outright to these accounts
and also arranged overnight matched sale-purchase
transactions with them, thereby meeting overnight
investment requirements of the foreign accounts. Since
overnight customer orders were not placed in the
market on Thursday, participants concluded that the
Desk was draining reserves to a certain extent. By
early afternoon, however, the weight of the reserve
excess began to tell in the money market, with funds
threatening to trade at 4% percent. The Desk then
entered the market to drain reserves by arranging a
moderate amount of four-day matched sale-purchase
transactions. These efforts did not affect the expec
tations of market participants because the Treasury
balance typically declines near the start of each month
and the need to drain reserves was widely expected.
Through most of Thursday, prices of United States
Government securities had been edging lower in quiet
activity as the market adjusted to the previous rise in
Digitized 46
for FRASER
FRBNY Quarterly Review/Spring 1977
the Federal funds rate. There was also some nervous
ness because the market was still awaiting the results
of the Treasury’s offering of ten-year 7% percent notes
— the centerpiece of the May refinancing— on which
subscriptions had been taken on the preceding day.
In this atmosphere, the announcement of a large in
crease in the wholesale price index added to the
market’s concern about renewed Inflationary pres
sures. Then, late in the day, the weekly money stock
data were released, showing a decline of $800 million
in the level of M1 for the statement week ended
April 28. However, this decline was smaller than some
market participants had expected and did little to offset
the substantial growth recorded in previous weeks.
Consequently, market observers grew more concerned
that the System might continue to press for a higher
trading level of the Federal funds rate. In this uneasy
market atmosphere, securities prices continued to
decline.
Market weakness persisted on Friday morning after
the Treasury announced that it would increase the
size of the ten-year note issue by $1.2 billion to $4.7
billion because of heavy subscriptions from investors.
While dealers and others subscribing for large amounts
had been allotted 15 percent of their subscriptions,
some of these subscribers by that time were hoping
to receive few, if any, of the new notes. Dealers felt
uncomfortable with their awards, and there was further
downward pressure on prices in advance of the final
refunding auction that day of an additional $750 mil
lion of 7% percent bonds, due February 15, 2000.
From the time just prior to the release of the money
stock data to the close of trading on Friday, Treasury
bill rates rose about 5 to 12 basis points, while prices
of intermediate-term Treasury issues fell about 1A to
% point. Prices of long-term bonds fell about 11/s
points, as the market grew less willing to take on addi
tional bonds in the auction.
On Friday morning the new projections of the mone
tary aggregates continued to show undesirable
strength. The data suggested that growth of Mx would
be well above the Committee’s 41/2 to 8 V2 percent
range specified for the April-May interval, while M2
was running well up In the 8 to 12 percent range. This
information indicated that it would be appropriate for
the Desk to seek conditions of reserve availability
consistent with the Federal funds rate moving up from
about 5 percent to around 51/s percent by Wednesday,
the end of the statement week.
In view of the sensitive state of the securities mar
kets in the midst of the Treasury’s refunding, the Desk
proceeded cautiously in seeking this adjustment. Re
serve projections on Friday, May 7, suggested ade
quate reserve availability because of the System’s
operations on the previous day and a substantial down
ward revision in the estimate of reserves likely to be
released by a decline in the Treasury balance. Federal
funds traded at 4% percent and then at 5 percent. In
an effort to achieve a firmer money market by Wednes
day, the Desk again drained reserves unobtrusively
by selling Treasury bills outright and arranging overthe-weekend matched sale-purchase transactions, in
both cases with foreign accounts. Given the sensitive
state of the securities markets and the Treasury’s long
bond auction that day, no overt action to drain reserves
was taken in the market.
By Monday, new estimates of reserve availability
suggested the need to add about $1 billion to the
weekly average, reflecting another large downward
revision in the estimates of reserves expected to be
provided by the decline in the Treasury balance and
other factors. With Federal funds opening at 5 percent,
the Desk confined its initial action to a modest pur
chase of Treasury bills from foreign accounts. When
the funds rate began to rise above 5 percent, the Desk
entered the market to fill a good portion of the pro
jected reserve deficit by arranging three-day repur
chase agreements.
The securities markets remained apprehensive. The
bonds sold in Friday’s auction had an average yield of
8.19 percent, higher than many had anticipated. Trea
sury bill rates rose an additional 5 basis points or so
during the day, while prices of longer maturity coupon
issues fell by nearly V2 point. The corporate market
also reflected supply pressures, as unsold issues piled
up in dealers’ inventories and a heavy forward calen
dar grew even larger.
On Tuesday, reserve estimates indicated adequate
availability for the week, due to the Desk’s injection
of the previous day and an upward revision in the
effect of market factors on reserves of about $350
million for the week. Federal funds traded predom
inantly at 5Xt percent during the day. The Desk took
no action in the market to affect reserve supplies but
did drain reserves through matched sale-purchase
transactions with foreign accounts to establish condi
tions that would promote a slightly firmer money mar
ket on the following day.
Federal funds traded at 5Va percent on the morning
of Wednesday, May 12, and reserve projections indi
cated a moderate need to add reserves for the state
ment week ended that day. With conditions in the
money markets about as desired, the Desk arranged
temporary investment orders from foreign accounts
in the market and awaited further developments. Funds
traded steadily at 5Va percent until the noon hour and
then moved higher. The Desk entered the market at
this point to provide reserves through overnight re
purchase agreements. The funds rate thereafter moved
back to about 5Va percent. The credit markets, still
digesting the recent Treasury offerings, remained quite
sensitive to the Desk’s toleration of higher trading
levels in Federal funds. Treasury bill rates moved up
about 5 to 12 basis points, and prices of coupon issues
generally fell by Va to % point.
The Desk’s caution during the week stemmed from
the fragile state of the securities markets. Until recent
years, the System typically tried to avoid changes in
its posture with regard to reserve management while
the Treasury was formulating its offering and while
underwriters were taking on and distributing Treasury
securities on a large scale. Such “ even keel” consid
erations have diminished considerably in the past
few years. The use of the auction technique for selling
coupon securities since 1970 has substantially in
creased the ability of underwriters to adjust their ex
pectations of future rate levels up to the time of the
Treasury’s sale. The regularization of the Treasury’s
debt offerings has also reduced uncertainty regarding
the size and timing of the Treasury’s borrowings. Fur
thermore, given the increased frequency of the Trea
sury’s sales of coupon issues, the System could no
longer maintain an even keel if it were to retain flexibil
ity in pursuing an open market policy consistent with
its long-term objectives. Nonetheless, the sharp rise in
interest rates during the May 1976 period had not
been fully anticipated in the market, and underwriters
incurred significant losses on this occasion.
June to mid-October
In early June, with projections of the aggregates show
ing a somewhat more moderate growth than in late
May, the Manager continued to seek a Federal funds
rate of around 5 V2 percent.
By the June FOMC meeting, economic growth ap
peared to be slowing from the rapid pace seen earlier
in the year, and most members viewed this decelera
tion as a healthy development. In addition, monetary
growth appeared to be settling back to a more accept
able rate. Therefore, while awaiting further information
on the economic situation, the Committee favored
relative stability in money market conditions, preferring
to avoid both a significant easing, which might have to
be reversed shortly, and also a significant firming. It
adopted an aggregates directive but specified a rela
tively narrow Federal funds rate range of 5Va to 5%
percent, thus limiting the potential response to devia
tions in the aggregates. As it turned out, the estimates
of Mx and M2 weakened in early July, prompting the
Manager to provide reserves more readily, and the
Federal funds rate fell from around 51/2 percent to
about 51/4 percent by mid-July.
FRBNY Quarterly Review/Spring 1977
47
The Committee retained a steady posture with re
spect to reserve availability over the rest of the summer.
While there were signs of hesitation in the pace of
the economy, data on consumer and business spending
at times suggested that the deceleration could be
temporary and similar to those observed in the recov
ery phases of previous business cycles. At the July
meeting, the Committee selected a wider Federal funds
rate range as part of the specifications for an aggre
gates directive, though several members still favored
keeping the range narrow in view of the uncertainties
in the outlook. These concerns were more widespread
in August, and the Committee voted for a money mar
ket directive at that time. The aggregates remained well
within the specified ranges after both meetings, and
the thrust of open market operations was not altered.
During the summer the financial markets began a
prolonged rally, which gained considerable momentum
in August. The short-term markets were buoyed by the
moderation in the growth of the money supply and
the overall stability of Federal funds trading. Long-term
markets were aided by growing confidence that in
flationary pressures were waning and by a cutback
in demand from corporate borrowers. From the begin
ning of June to mid-September, three-month Treasury
bill rates fell by about 50 basis points and long-term
bond yields declined around 35 basis points. With
commercial banks and others extending the maturities
of their purchases of Treasury coupon securities, yields
on intermediate-term issues registered the largest de
clines— about 65 basis points.
At the September meeting, FOMC members noted
the significant interest rate declines that had been
registered in the debt markets. While growth in Mx
had slowed, M2 was expanding at a relatively rapid
pace. As the pause in economic growth persisted,
however, more attention was given to the possibility
that future growth would fall below expectations.
Against this background, the Committee in September
voted for an aggregates directive, structuring the Fed
eral funds rate range to permit greater room for
easing than for firming. The range was established at
4% to 51/2 percent with the focal point at 5!4 percent,
thus allowing the possibility of a 50 basis point decline
should growth in the aggregates turn out lower than
expected at the time of the meeting.
In the statement week that followed the meeting,
the week ended September 29, the Federal funds
objective remained at 5Va percent. However, the Ac
count Management experienced considerable difficulty
in achieving this objective, as the Treasury’s opera
tions drained a larger than expected volume of re
serves. Initially, the Desk faced a sizable estimated
reserve deficit of $31/2 billion to $4 billion (daily aver
48 FRBNY Quarterly Review/Spring 1977
age), mainly due to the continuing buildup in the
Treasury’s accounts at the Federal Reserve Banks
after the September 15 tax date. On the first day of
that week, the Desk arranged $3.8 billion of sevenday repurchase agreements, an operation that had
been announced to the market on the previous after
noon. While the reserve injections that day about met
the week’s need, the Manager expected that with
drawals from the repurchase agreements would neces
sitate further reserve injections late in the week.
Indeed, early terminations of such contracts, which
came to $1.3 billion on a daily average basis, substan
tially eroded the net reserve injection. Furthermore,
upward revisions in the estimates of the Treasury’s
balance, amounting to $1.1 billion on average, en
larged the reserve deficit. Consequently, the money
market became quite firm beginning on Monday, Sep
tember 27, and the Desk arranged five additional
rounds of repurchase agreements over the rest of
the statement week. Despite taking virtually all propo
sitions for repurchase agreements on the final two days,
the Desk still was unable to depress the Federal funds
rate from around 5% and 51/2 percent to the 51/4 per
cent objective. On Wednesday night, holdings in the
repurchase account, including bankers’ acceptances,
reached a record $8.7 billion.6 The securities markets
seemed to show little reaction to the tight conditions
after the weekend, partly because they could observe
the Desk making every effort to counteract the money
market firmness.
To prevent a repetition of the money market strains
and the uncertainties associated with sizable early
terminations of repurchase agreements, the Desk in
stituted an alternative form of repurchase contract in
the week of October 6, one that did not permit termi
nation before maturity. On the first day of the new
statement period, the Desk arranged about $1.4 billion
of such agreements in addition to $4.6 billion of fourday contracts that carried the right of early termina
tion. As expected, most of the securities involved in
the nonterminable contracts came from the portfolios
of banks and other institutions while the dealers them
selves, both bank and nonbank, exhibited a preference
for the terminable contracts.
In early October the projections of the monetary
aggregates began to indicate a substantial weakening
in the growth of demand deposits for the SeptemberOctober interval, although M2 growth remained near
the middle of its range. In view of this, the Desk began
to seek Federal funds trading in a range of 51/s to 51/»
percent instead of the previous 51/4 percent objective.
When subsequent projections confirmed this picture,
4 This record was eclipsed on D ecem ber 29 when such holdings built
up to $10.7 billion.
the Desk became steadily more accommodative, and by
the time of the October meeting funds were trading
around 5 percent.
Mid-October to the year-end
Most FOMC members favored a slight easing in money
market conditions at the October meeting. The econ
omy’s lackluster performance continued; the growth
of real GNP had slowed a little further in the third
quarter from the rather modest pace of the second
quarter. Moreover, the risks of a shortfall from expecta
tions had increased, since it appeared that the slow
growth of personal income, the protracted sluggishness
in consumer spending, and the decline in stock market
prices could, if extended, dampen business confi
dence and adversely affect investment plans. The
Committee voted an aggregates directive and decided
to seek a decline in the Federal funds rate from 5 per
cent to 4% percent (the middle of a 41/z to 51A per
cent range) during the first full statement week after
the meeting.
A few days after the meeting, however, the outlook
for the monetary aggregates displayed surprising
strength, with both Mx and M2 projected near the
upper limits of their tolerance ranges. Moreover, it
was apparent that, unless later data contradicted this
outlook, an easing move would only have to be re
versed one week later. Accordingly, the Committee
concurred in the Chairman’s recommendation that the
Manager should hold the System’s posture unchanged.
Data received in the following week continued to
indicate unexpected strength, and the Manager again
consulted with the Chairman who advised that any
significant increase in the Federal funds rate objective
would be inconsistent with the Committee’s intent. The
Desk continued to seek reserve conditions consistent
with Federal funds trading around 5 percent until the
November meeting.
At rts November meeting, the Committee concluded
after its review of economic and financial develop
ments that a decline in the Federal funds rate to about
4% percent would be appropriate within the first week
after the meeting, followed by a further decline to
around 4% percent during the second week. The Fed
eral funds rate range was set at 41/2 to 51A percent.
Subsequent changes in the objective would depend
on the outlook for the aggregates. This time the
monetary growth rates remained closer to expecta
tions, although Mx growth was slowing. In these cir
cumstances, the Desk held to the 4% percent objective
through early December and then shifted to 4% per
cent when it appeared that Mx was weakening further.
The deliberations at the December meeting struck
a more optimistic chord as most members agreed that
the business situation had strengthened. Indications
of strong gains in personal consumption and residen
tial construction suggested that, once the decline in
inventory accumulaton had run its course, economic
growth would soon accelerate. The Committee pre
ferred to maintain the prevailing money market con
ditions in the weeks ahead. In part, this reflected the
difficulties in assessing the significance of monetary
growth rates over the December-January period. Also,
improvement in the economy and substantial interest
rate declines strengthened expectations for the future.
The Committee voted a money market directive and
the Desk continued aiming for conditions of reserve
availability consistent with Federal funds trading at
4% percent through the year’s end.
The securities markets extended the summertime
rally through the end of the year. Over the last three
months, interest rates fell considerably, with both
short- and long-term Treasury securities posting de
clines of about 70 basis points. The economy’s slug
gish advance through most of the fourth quarter had
suggested that two of the markets’ major concerns,
the possibility of heavy demands from borrowers and
a rebound in inflationary pressures, would not prove
troublesome for the time being. In addition, very sharp
price gains were recorded in the markets during those
intervals when the System had shifted toward a more
accommodative interest rate stance. In late November
and December the markets’ perceptions of the Desk’s
moves toward ease, in conjunction with a reduction in
the Federal Reserve discount rate from 51/2 percent to
5Va percent, and a flow of news that emphasized the
economy’s slow growth generated expectations in the
markets of further accommodative steps. The markets
also reacted bullishly to the Federal Reserve’s re
duction in reserve requirements in December. Specu
lative enthusiasm was widespread among market
participants, and dealers built up inventories of
Government securities to record levels in December.
Against this background, the retreat in the securities
markets that followed in the first few weeks of 1977
was especially pronounced. New economic data indi
cating a strengthening in business activity, the ab
sence of further accommodative steps by the System,
and participants’ attempts to capture profits all gave
rise to heavy selling pressure. Moreover, there were
anxieties over the inflationary pressures that might
arise out of the severe winter conditions and the new
administration’s proposed fiscal stimulus program. By
the end of January, the backup in yields on Treasury
issues had eliminated a substantial portion of the de
clines posted in the fourth quarter of 1976; the sell-off
in the corporate and tax-exempt sector was less pro
nounced.
FRBNY Quarterly Review/Spring 1977
49
August 1976-January 1977 Semiannual Report
Treasury and Federal Reserve
Foreign Exchange Operations
During the August 1976-January 1977 period under
review, market participants remained sensitive to the
possibility of further sharp rate movements for major
currencies, as wide disparities in economic performance
persisted among industrial countries. With the pace of
economic expansion slowing in several countries dur
ing the summer and early fall, many traders became
concerned that individual governments might not suc
ceed in achieving greater price stability and payments
equilibrium in the face of historically high unemploy
ment rates and mounting political pressures to stimulate
domestic demand. Consequently, as the market sought
to anticipate both economic developments and possible
policy changes, swings in sentiment generated largescale shifts of funds into and out of some curren
cies. Among those that had weakened early in 1976, the
pound sterling and the Italian lira came under renewed
pressure, while other currencies— such as the Mexican
peso and the Canadian dollar— were also heavily on
offer at various times during the period. Meanwhile,
speculation over a realignment within the European
Community (EC) currency arrangement put the “ snake”
margins under renewed pressure. And the Japanese
yen was also subjected to reversals in market assess
ment.
The authorities of several countries moved to bring
about internal and external balance in their economies
A report by Alan R. Holmes and Scott E. Pardee.
Mr. Holmes is the Executive Vice President in charge of the
Foreign Function of the Federal Reserve Bank of New York and
Manager, System Open Market Account. Mr. Pardee is
Vice President in the Foreign Function and Deputy Manager for
Foreign Operations of the System Open Market Account. The
Bank acts as agent for both the Treasury and the Federal
Reserve System in the conduct of foreign exchange operations.
50 FRBNY Quarterly Review/Spring 1977
and to restore order in the exchange markets. The
United Kingdom authorities adopted a program of fis
cal and monetary restraint tied to agreement on im
portant medium-term credits. These included a $3.9
billion standby arrangement with the International
Monetary Fund (IMF) and a $3 billion arrangement with
the major central banks and the Bank for International
Settlements (BIS) to deal with the official sterling bal
ances. The governments in France and Italy also intro
duced broad-based stabilization programs, including
fiscal and monetary measures and direct controls. In
late October, the governments participating in the
snake arrangement agreed on a parity realignment in
which the German mark was adjusted upward by 2 to 6
percent against its partner currencies. Although many
disparities in economic performance remained in early
1977, these various corrective measures were inter
preted by the market to be steps in the right direction
and therefore helpful in alleviating many of the tensions
in the exchanges.
During the period, the dollar was again caught up in
the crosscurrents affecting the European markets. But,
in addition, sentiment toward the dollar shifted in re
sponse to the pause in the United States recovery,
which spurred a gradual reassessment of the outlook
for interest rates. As United States short-term interest
rates declined while comparable rates elsewhere held
steady or advanced somewhat, the narrowing in inter
est rate differentials prompted flows out of dollars. At
times, other uncertainties— over the United States elec
tion, over our widening trade deficit, and over a po
tentially large Organization of Petroleum Exporting
Countries (OPEC) price hike— had an adverse effect on
market psychology. By early January 1977 the dollar
had therefore declined by some 10 percent from late-
July levels against the German mark and the other cur
rencies linked to it. Much of the dollar’s decline was
gradual and trading in New York was generally orderly.
But on those days when the market here became un
settled, the Federal Reserve countered with moderate
offerings of marks to stabilize trading conditions. There
after, however, the market’s attitude toward the dollar
was buoyed by economic indicators that suggested the
United States economy was picking up steam once
again and by a reversal in interest differentials as
United States rates firmed while those abroad eased.
The dollar then came into demand and firmed against
the main Continental currencies through end-January.
In exchange market intervention during the August
1976-January 1977 period, the Federal Reserve sold
$175.6 million equivalent of marks, of which $160.7 mil
lion was from balances acquired before and during the
period and $14.9 million was drawn in December under
the swap line with the German Bundesbank. That swap
drawing was quickly repaid in January when the dol
lar’s buoyancy enabled the System, by purchases in the
market and from correspondents, to rebuild balances
once again. In all, the System bought $205.0 million of
marks during the six-month period.
Moreover, pursuant to an agreement in late-October
between the United States authorities and the Swiss
National Bank for repayment in three years of Federal
Reserve and United States Treasury debt in Swiss francs
outstanding from August 1971, the System repaid $154.6
million equivalent and the Treasury repaid $86.1 million
equivalent through end-January. Most of the francs
were purchased directly from the Swiss National Bank
against dollars. But, in addition, $7.9 million of Swiss
francs was acquired from correspondents, while addi
tional francs were bought from the Swiss National Bank
against the sale of $48.1 million equivalent of German
marks, $4.8 million of French francs, and $0.4 million
of Dutch guilders. The marks and French francs came
from balances acquired in the market during the period,
while the guilders came from existing holdings. Finally,
by November, using Belgian francs acquired from cor
respondents and in the market, the Federal Reserve
liquidated the last $82.4 million equivalent of swap debt
to the National Bank of Belgium outstanding since
August 1971.
Also during the period the Bank of England drew
in September a further $100 million each on the Fed
eral Reserve and United States Treasury, which was
in proportion to British drawings on other participants
in the June 1976 standby credit facility. Total drawings
on the System and the Treasury were thereby in
creased to $300 million each. These drawings were re
paid in full at their maturity when the facility terminated
on December 9, along with drawings on other partici
pants. The Bank of Mexico repaid an earlier swap draw
ing of $360 million on the Federal Reserve and drew a
further $150 million, which it arranged to repay at ma
turity in February. The Bank of Mexico also drew and
Chart 1
Table 1
Selected Exchange Rates*
Federal Reserve Reciprocal Currency Arrangements
In m illions of dollars
Institution
* Percentage deviations of w eekly averages of New York
noon offered rates from the average rate fo r the w eek
of January 2-9, 1976.
Am ount of fa cility January 31, 1977
Austrian National Bank .....................................................
National Bank of Belgium .................................................
Bank of Canada ..................................................................
National Bank of Denmark ..............................................
Bank of England ..................................................................
Bank of France ....................................................................
German Federal Bank .......................................................
Bank of Italy .........................................................................
Bank of Japan ....................................................................
Bank of M e x ic o ....................................................................
Netherlands Bank ................................................................
Bank of Norway ..................................................................
Bank of Sweden ..................................................................
Swiss National Bank .........................................................
Bank for International Settlements:
Swiss francs-dollars .......................................................
Other authorized European c u rre n c ie s -d o lla rs ------
$
Total
$20,160
........................................................................................
250
1,000
2,000
250
3,000
2,000
2,000
3,000
2,000
360
500
250
300
1,400
600
1,250
FRBNY Quarterly Review/Spring 1977
51
Chart 2
Selected Interest Rates
Three-m onth m aturities *
1976
1977
* W eekly averages of daily rates.
repaid a total of $365 million under a special short-term
credit facility initiated in September with the United
States Treasury. In addition, that central bank subse
quently drew a further $300 million under the Exchange
Stabilization Agreement, of which $150 million was out
standing at end-January 1977.
German mark
During most of early 1976 the exchange markets were
bullish for the German mark. By that time, the economy
was expanding smartly. Export growth continued strong
enough to keep Germany’s trade and current accounts
in substantial surplus even though imports were on the
rise. And Germany’s rate of inflation, at around 5 percent
per annum, remained one of the lowest among industrial
countries and was continuing to moderate. This pic
ture contrasted sharply with that for many of Germany’s
trading partners in Europe, where more rapid economic
activity was leading to a deterioration in current
account balances and upward pressure on wages and
prices. Although by early summer the markets had
settled down somewhat after the strains of JanuaryMarch, expectations remained that sooner or later the
mark would appreciate against the currencies of other
European countries with significantly higher rates of
inflation. Thus, the mark held firm at the ceiling of the
EC band while the other currencies in the arrangement
remained clustered near the bottom.
Meanwhile, against the dollar, the mark leveled off
below $0.3900 in the late spring and early summer, as
the market considered the German and United States
economies to be broadly in phase, even to the extent
52 FRBNY Quarterly Review/Spring 1977
of entering the pause in growth at roughly the same
time. Traders nevertheless remained concerned that
changing money market conditions might at any time
generate a reversal of the heavy volume of funds Ger
man banks had previously placed abroad in dollars and
other currencies. Moreover, persistent expectations of
a mark revaluation against the other EC currencies
sometime before or after the German general elections
in early October left traders poised to buy marks at the
first sign that it was strengthening once again.
Against this background, market speculation over
a realignment within the snake was quickly reignited
when sizable orders to buy marks triggered a sharp rise
in the spot rate late in July. The mark moved quickly
to its upper intervention limit against several of the
other snake currencies. There it came under recurrent
waves of heavy demand during August, as dealers built
up mark positions and commercial leads and lags
shifted in Germany’s favor. The Bundesbank and the
other snake central banks intervened forcefully in one
another’s currencies to keep their exchange rates with
in the prescribed limits. At the same time the dollar
again became caught up in the pressures of the snake
and, as the mark strengthened, the Bundesbank pur
chased sizable amounts of dollars in Frankfurt. To
maintain orderly conditions in New York, the Federal
Reserve followed up by selling $15.9 million equivalent
of marks from balances on August 16-17, the System’s
first intervention sales since March.
By September, in the wake of the large-scale offi
cial intervention and monetary measures taken in
Europe, the immediate pressures within the snake
had temporarily tapered off. But sentiment toward the
mark remained bullish. News of increased foreign
orders on top of an already large trade surplus for
July provided an optimistic outlook for Germany’s fu
ture trade performance. In addition, reports suggesting
a continued pause in the United States recovery gen
erated expectations of a protracted decline in United
States money market rates, while German rates were
expected to hold steady or rise somewhat. Moreover,
as sterling dropped sharply in the exchanges early in
September, the shift of funds out of sterling into marks
magnified the demand for the German currency all the
more. Consequently, the market remained fearful that
speculation could resurface at any time and that Ger
many’s exchange rate policy might once more emerge
as a campaign issue in the final days of a close con
test for the upcoming general elections. As a result,
trading remained nervous, the Bundesbank made further
large purchases of dollars, and the Federal Reserve
sold a further $16.3 million equivalent of marks in New
York on two days, September 16 and 24.
With the approach of the October 3 German elec
tions, the mark came into renewed speculative demand
late in September. The snake again became fully ex
tended and the Bundesbank intervened heavily, along
with other participating central banks, to maintain the
limits. As these tensions resurfaced, the mark also ad
vanced against the dollar following news of another
large United States trade deficit and a decline in lead
ing economic indicators for August. After the election,
no parity changes were announced but the market was
kept on edge by the possibility of a mark revaluation.
Thus, the mark remained in demand through midmonth
— advancing to $0.4117, over 6 percent above the levels
of late July. The Federal Reserve sold an additional
$20.9 million equivalent of marks from balances when
trading became unsettled in New York on October 5-6.
Meanwhile, the Bundesbank purchased dollars to mod
erate the mark’s rise. Intervention in snake currencies
and in dollars was largely responsible for the $2.8 bil
lion increase in German reserves during the three
months, July-October.
On Sunday, October 17, the EC finance ministers and
central bank governors meeting in Frankfurt agreed
on a realignment of parities within the joint float to
avoid a repetition of the speculative pressures of pre
vious months. The German authorities announced a
2 percent revaluation of the mark which, together
with the parity changes by Scandinavian members of
the EC monetary arrangement, resulted in a parity ad
justment of 2 percent to 6 percent between the mark
and other snake currencies. After some initial hesi
tancy in the market, the mark soon dropped to the
bottom of the realigned joint float and, against the
snake currencies, it began to trade below levels pre
vailing before the realignment was announced. By
end-October a substantial unwinding of commercial
leads and lags was under way. The other central banks
participating in the EC monetary agreement quickly took
advantage of these reflows to buy marks in the market
to repay their indebtedness stemming from previous
interventions. These official purchases of marks also
had the effect of absorbing some of the liquidity created
in Germany as a result of the huge currency inflows of
preceding months. To bring the pace of monetary ex
pansion back closer to the target levels for 1976 as a
whole, the Bundesbank reinforced the process by sell
ing large amounts of German government securities in
the open market.
As a result, the mark did not ease against the dollar
as it did against other snake currencies but rose to
around $0.4150. In general, though, trading was wellbalanced from the time of the EC realignment to midNovember. Only infrequently did particularly large
demands for marks come into the market in a way that
put pressure on the mark during the New York trading
day. In particular, the mark became well bid on Octo
ber 19 and 26, in response to heavy shifts out of ster
ling, and on November 22 following publication of
disappointing economic indicators for the United
States. On these occasions of market unsettlement, the
Federal Reserve offered marks, selling a total of $22.9
million equivalent from balances. At other times the
Trading Desk was able to purchase modest amounts of
marks for System balances mostly from correspondents
but also in the market when trading was quiet.
Over the rest of the year, however, the market be
came increasingly sensitive to the relative progress of
the economic recoveries in Germany and the United
States. Reports of a steep rise in German industrial
output in October gave rise to expectations that money
market conditions in the two countries would continue
to diverge. To the market, these expectations seemed
to be confirmed by the 1A percentage point cut in
Federal Reserve discount rates on November 19 and
a technical reduction in reserve requirements an
nounced on December 17. These moves contrasted
with the Bundesbank’s announcement of an 8 percent
target for the growth of central bank money in 1977—
a target interpreted as restrictive in view of the much
more rapid growth of the preceding months. As a
result, interest differentials favorable to the dollar were
squeezed out by early December. At the same time,
the possibility of a sizable hike in oil prices at the up
coming OPEC talks weighed on the dollar.
Thus, the mark was in demand throughout Decem
ber, and this demand intensified as German banks
Chart 3
Germany
Movements in exchange rate
Dollars per mark
t
op
t
•
1
J
F
1
1
M A
I I I
M J J
1976
I
I
A
I
S
O
I I
N
D
J
I
F
1977
i
♦E x c h a n g e rates shown in this and the follow ing charts are
w eekly averages of New Y ork noon offered rates.
"•"Central rate established on June 29, 1973.
^ N e w central rate established on O ctober 18, 1976.
FRBNY Quarterly Review/Spring 1977
53
sought to satisfy year-end needs by acquiring marks in
the exchange market. Most of this bidding for marks
was concentrated during the European trading day and,
to provide resistance to a cumulative rise in the mark
rate, the Bundesbank bought substantial amounts of
dollars in Frankfurt. When these pressures spilled
over into the New York market, the Federal Reserve
followed up with sales of marks on four days during
December, for a total of $74.5 million equivalent. Of
this, $59.6 million equivalent was financed from System
balances and $14.9 million equivalent was drawn under
the swap arrangement with the Bundesbank. Never
theless, the mark had firmed to $0.4249 by the end of
the year, a rise of 31/2 percent since the snake realign
ment of October.
With the dollar declining, dealers had tended to
ignore several recent reports pointing to a pickup in
United States economic activity— a substantial increase
in November’s leading economic indicators, a surge in
durable goods orders, and strong Christmas retail
sales. Instead, after the passing of the year-end and par
ticularly in the light of the mark’s recent strength, mar
ket professionals began building new long mark-short
dollar positions on the expectation that United States
interest rates would go still lower and that the United
States trade deficit would worsen this year while Ger
many’s trade surplus would increase. Consequently,
the mark extended its advance against the dollar,
reaching $0.4274 in Europe on January 4, fully 10!A
percent above late-July 1976 levels. To avoid an even
sharper rise, the Bundesbank made sizable dollar pur
chases. The Federal Reserve followed up by selling
$7.3 million equivalent of marks out of balances before
the market turned around.
The shift in sentiment in favor of the dollar followed
wire service reports of a 1 percent fall in German in
dustrial production in November. In addition, after the
liquidity pressures of the year-end had passed, Ger
man short-term interest rates began to ease. Con
sequently, the mark began to move back on some
professional covering. The decline soon gathered
momentum as United States interest rates edged some
what higher, the market reacted favorably to the in
coming Carter administration’s fiscal stimulus pro
posals, and substantial amounts of funds flowed out
of marks back into sterling. By late January the
mark eased back 4 percent to $0.4101. In cushioning
the mark’s decline, the Bundesbank sold modest
amounts of dollars in Frankfurt while the Federal
Reserve bought $90.1 million equivalent to repay in
full its recent swap drawing and to replenish System
balances. On January 31, however, widespread publicity
about the disruptive economic effects of severe winter
conditions in the United States triggered a burst of de
54 FRBNY Quarterly Review/Spring 1977
mand for marks and other European currencies, and the
Federal Reserve sold $17.8 million equivalent of marks
from balances to stabilize trading conditions. The mark
thus closed the period at $0.4157, some VM percent
above late-July 1976 levels. Meanwhile, by end-January
1977 German reserves had fallen $1.3 billion from endOctober 1976 for a net rise of $1.5 billion since July
1976.
Sterling
For some time the British economy has been plagued
by one of the highest inflation rates in Europe, disap
pointingly slow economic growth, and a persistently
large deficit in its balance of payments. To address
these underlying problems, during the spring of 1976
the authorities successfully secured trade union agree
ment to a second, one-year phase of wage restraint
in exchange for some tax relief. For the longer term,
the government announced a shift in priorities toward
stimulating key industries and away from broad social
welfare programs, while seeking to restrain both pub
lic and private consumption to make room for export
growth. But the delicate balance upon which the gov
ernment’s strategy for gradually achieving economic
stability rested was brought into question last spring.
Between March and early June, the pound fell by more
than 15 percent to $1.7065 against the dollar and nearly
12 percentage points to 41.9 percent below the Decem
ber 1971 Smithsonian agreement level on an effective
basis against the major currencies. This drop left the
market badly shaken. Following announcement of a
$5.3 billion package of standby credits from the Group
of Ten countries plus Switzerland and the BIS, the
pound recovered some 4 percent from its June low to
trade between $1.77 and $1.78. The market neverthe
less remained volatile, and the British authorities con
tinued to intervene at times in sizable amounts. To
replenish reserves, the Bank of England drew late in
June $1.03 billion on the standby facility, including
$200 million under the Federal Reserve swap line and
$200 million from the United States Treasury’s Ex
change Stabilization Fund.
During the summer the sterling market was in better
balance, with the spot rate still above $1.77, until
latent uneasiness about Britain’s economic prospects
resurfaced in late August. The immediate catalyst for
reassessment was the highly publicized water shortage
in Britain, resulting from a record drought, which
raised the possibility of production and employment
cutbacks in several parts of the country. And by then
the evident pause in other industrial economies had
dimmed hopes that the United Kingdom would be
pulled out of recession by rising export demand. At
home the economy was stagnant, unemployment was
Table 2
Federal Reserve System Drawings and Repayments under
Reciprocal Currency Arrangements
In m illions of dollars equivalent; draw ings (+ ) or repayments (— )
..............
Transactions with
System swap
com mitments,
January 1, 1976
1976
I
1976
II
1976
lit
1976
IV
1977
January
System swap
com m itm ents,
January 31, 1977
National Bank of B e lg iu m .............
297.6
— 86.5
— 83.7
-1 0 0 .0
-
27.4
-0-
-0-
German Federal B a n k ......................
-0-
j^ 2 6 4
“ 107.5
-0-
+
14.9
-1 4 .9
-0-
Netherlands Bank .............................
-0-
( + 19 6
-j
ig g
-0-
-0-
-0-
-0-
-0-
Swiss National B a n k ........................
567.2
j — 620 0
-0-
-0-
Bank fo r International Settlements
(Swiss francs) ...................................
600.0
Total .....................................................
1,464.8
-0-
-0-
-0-
-0-
-0-
“ 191-2
— 100.0
f+
14.9
|-1 ,1 7 4 .6
-1 4 .9
-0-
— 600.0*
} + 752 6
-1 .1 4 7 .2 f
-0-
D iscrepancies in totals are due to rounding.
* C onsolidation of Swiss franc debt.
| The Federal Reserve repaid the outstanding $1,147.2 m illion equivalent of its pre-August 1971 Swiss franc swap indebtedness
and took down the same am ount on the newly created special swap line designed to refund the short-term obligation into
a medium -term obligation, w hich is being reduced as draw ings are repaid over a three-year period (see Table 3).
Table 3
Federal Reserve System Drawings and Repayments under
Special Swap Arrangement with the Swiss National Bank
In m illions of dollars equivalent; draw ings (+ ) o r repayments (— ) -
Transactions with
System swap
com mitments,
January 1,1976
Swiss National Bank ......................
-0*
Total .....................................................
-0-
1976
I
-0-
1976
II
-0-
1976
III
-0-
1977
January
System swap
com m itm ents,
January 31, 1977
(+1,147.2
j96.2
-5 8 .4
992.5
f +1,147.2
|96.2
-5 8 .4
992.5
1976
IV
Discrepancies in totals are due to rounding. Data are on a value date basis with the exception of the last two colum ns
w hich include transactions executed in late January for value after the reporting period.
FRBNY Quarterly Review/Spring 1977
55
still increasing, and the inflation rate was beginning to
edge upward again, in large part because of spiraling
import costs. In addition, the market focused increas
ingly on the size of Britain’s large public sector deficit
— even after the government’s announcement in July
of planned cutbacks in government expenditures for
the next fiscal year— as well as on the potential threat
of a ballooning in money supply should the debt not be
financed through sales of government bonds. The ag
gregates already had increased rapidly in July, and
this was seen not only as a potential source of inflation
but also as an indication of large-scale British financing
of adverse leads and lags against sterling.
In the face of these various uncertainties, the pound
came on offer again in late August. Market sentiment
soured further over subsequent weeks on reports of
strikes and wage demands beyond the bounds of the
government’s incomes policy, as well as in reaction
to official figures showing a £905 million reduction
in foreign official holdings of sterling balances in the
second quarter. In response, sizable commercial sell
ing (including outflows to finance third-country trade),
several large sell orders thought to have been from
the Middle East, and outright dealer positioning
against sterling weighed heavily on the pound. At first,
the Bank of England provided substantial support to
keep the pound around the $1.77 level. But, when the
selling pressure persisted, the authorities cut back on
intervention to conserve official reserves. Instead, the
Bank of England hiked its minimum lending rate by
V/2 percentage points to 13 percent, issued a call for
special deposits to drain bank liquidity, and announced
a new long-term government bond issue yielding close
to 15 percent.
56 FRBNY Quarterly Review/Spring 1977
Nevertheless, heavy commercial and professional
selling continued, and by late September the pound
had been pushed down nearly to $1.70. At that point,
the Labour Party’s annual conference provided a plat
form for sharp criticism of the government’s planned
public expenditure cuts as well as for demands for
import controls to protect British jobs. Following wide
spread press coverage of these disputes, the pound
came under further pressure and was driven below
$1.70. Once the rate moved through this bench mark
without meeting any market resistance, the slide
quickly gathered momentum, and by September 28 it
had plunged to a low of $1.6320 before steadying
somewhat.
To “ buy time for the market to give a more positive
assessment of government economic policy” , Chancel
lor Healey announced on September 29 that Britain
intended to apply for $3.9 billion in further credits
from the IMF to repay borrowings under the June
$5.3 billion standby credit facility scheduled to
expire December 9. Also, to offset recent reserve
losses, the British authorities again drew on the
standby facility, obtaining another $ 1 0 0 million each
from the Federal Reserve and the United States
Treasury— amounts which were in proportion to draw
ings on other countries participating in that facility.
Shortly thereafter, the authorities moved further to
tighten liquidity and to drive up the cost of financing
short sterling positions. The Bank of England raised
the minimum lending rate another 2 percentage points
to an unprecedented 15 percent, called a second
round of special deposits to absorb additional liquidity,
and operated forcefully in the market for short-dated
swaps.
These policy initiatives drew favorable comments
both in the market and from foreign government offi
cials. In addition, the resulting squeeze in the do
mestic and Euro-sterling money markets helped the
pound to steady around $1.65 during early October.
Nevertheless, sterling’s 7 percent depreciation from
the $1.77 level left the market fearful that pressure
could reemerge at any time. In addition, a disagree
ment within the Labour Party over the degree of re
strictiveness the government should accept in negoti
ating terms and conditions of the IMF loan introduced
another layer of uncertainty into the market.
In this atmosphere, a London newspaper article—
alleging that the IMF and the United States Treasury
had proposed that the pound be allowed to depreciate
to $1.50 as a precondition for IMF credit— touched off
widespread selling of sterling as soon as markets
opened on Monday, October 25. Even though the re
port was firmly denied by IMF, United States, and
British officials, the pound dropped precipitously, de
six months. In addition, the Bank of England reintro
duced the supplementary deposit scheme— the socalled “ corset” regulation— whereby banks place with
the central bank a rising proportion of the increase in
interest-bearing deposit liabilities above specified
levels.
The pound’s turnaround in November also reflected
growing market expectations that the government was
reaching an accommodation over the terms of a new
IMF package, even if that were to involve severe fiscal
restraints. As the market awaited the announcement of
new budgetary measures, these expectations solidified
and sterling advanced to $1.6857 by December 15,
while the Bank of England bought dollars in the market
to moderate the rise. In the budget message that day,
the Chancellor announced public spending cuts over
the next two fiscal years, increased indirect taxation,
and the sale of part of the British government’s hold
ings in British Petroleum— measures expected to re
duce the public sector borrowing requirement as a
share of gross domestic product from 9 percent to 6
percent for the 1977-78 fiscal year. The Chancellor also
revealed targets for domestic credit expansion over
the next three years that would meet IMF conditions
for keeping a tight rein on monetary expansion. In
addition, to prefinance IMF drawings, he announced
standby swap facilities of $350 million with Germany
and of $500 million with the United States (of which
the Federal Reserve and the Exchange Stabilization
Fund would each provide $250 million). Finally, he
indicated that there was a general desire among the
major countries to achieve a satisfactory arrangement
dining almost 5 percent in early trading. In an attempt
to restore order in the market, the Bank of England
intervened forcefully. But this quick and unprecedented
plunge in the rate left the market thoroughly confused
over the appropriate level for sterling and kept the
pound vulnerable to every rumor or press report about
the IMF loan conditions. Thus, when reports came
over the news services that the Labour Party National
Executive had voted to oppose further public spending
cuts, the pound fell to an all-time low of $1.5550 on
the morning of October 28. At this level, the pound had
sunk some 13 percent below end-July levels and to
48.8 percent on a trade-weighted average basis. Mean
while, during the three months to end-October, reserves
dropped over $600 million, even after the $515 million
of drawings on the June standby facility and the
receipt of more than $500 million in public sector
borrowings abroad.
By early in November, however, the pound had
bounced back above $1.60, following the first reports
that negotiations might be under way with Germany,
Japan, and the United States for major new credits to
deal with the problem of official sterling balances. The
pound then advanced to the $1.65 level by midmonth
in a turnaround that was partly triggered by new moves
by the government to curb outflows and credit expan
sion. In particular, on November 19, the authorities
sealed off a gap in exchange control regulations,
through which sizable amounts of funds had flowed out
during the summer, by restricting the use of the pound
in financing third-country trade— a measure expected
to generate a substantial reflow over the subsequent
Table 4
Drawings and Repayments by Foreign Central Banks and the Bank for International Settlements
under Reciprocal Currency Arrangements
In m illions of dollars; draw ings (+ ) o r repayments (— )
Banks drawing on
Federal Reserve System
Drawings on
Federal Reserve
System outstanding
January 1,1 9 7 6
1976
I
1976
II
1976
III
1976
IV
-0-
+200.0
+ 100.0
-0-
+ 500.0
-0-
-5 0 0 .0
Bank of England ...................................
Bank of Italy ..........................................
Bank of Mexico .....................................
1977
January
D rawings on
Federal Reserve
System outstanding
January 31, 1977
-3 0 0 .0
-0-
-0-
-0-
-0-
-0-
-0-
150.0
-0-
+360.0
-0-
(+ 1 5 0 .0
{- 3 6 0 .0
Bank for International Settlements
{against German marks) ...................
-0-
-0-
( + 14.0
14.0
( + 37.0
37.0
-0-
-0-
-0-
T o t a l...........................................................
-0-
+ 500.0
\ +574.0
14.0
(+ 1 3 7 .0
|- 5 3 7 .0
(+ 1 5 0 .0
{- 6 6 0 .0
-0-
150.0
FRBNY Quarterly Review/Spring 1977
57
Table 5
United States Treasury Securities, Foreign Currency Series
In m illions of dollars equivalent; issues (+ ) or redem ptions {— )
Am ount of
com m itm ents
January 1, 1976
Issued to
1976
I
1976
fl
1976
III
Swiss National B a n k ......................
Total ...................................................
-0-
-0-
-0-
1976
IV
1977
January
Am ount of
com m itm ents
January 31, 1977
-5 3 .6
-3 2 .6
1,513.1
-5 3 .6
-3 2 .6
1,513.1
Data are on a value date basis w ith the exception of the last two colum ns w hich inciude transactions
executed in late January for value after the reporting period.
.
for the sterling balances.
After some initial hesitancy in the market, the pound
was then buoyed by an extreme shortage of funds in the
London money market that was only partially alleviated
by the Bank of England. As settlements for the growing
sales of British government gilt-edged securities
drained liquidity from the banking system just before
the year-end, the banks bid for balances in the ex
changes. In addition, some fairly sizable commercial
orders came into the market, also for year-end pur
poses or for covering open positions taken up earlier
in the year. Accordingly, the rise in the pound gradually
accelerated during December, and the rate reached
$1.7080 by the month end, some 10 percent above its
late-October low. Meanwhile, the Bank of England re
paid, upon maturity, its drawings of $300 million each
on the Federal Reserve and the Exchange Stabilization
Fund as part of its total $1,545 billion repayment of
outstanding credits on the standby facility. Partly as a
result, British reserves fell to $4.1 billion by the yearend, their lowest level in six years.
In early January, announcement of the IMF’s official
approval of the $3.9 billion standby facility for Britain
further reassured the market. Moreover, following dis
cussions in Paris and Basle, the central banks of the
major industrial countries reached agreement on a plan
to deal with the sterling balances. Under this plan,
eleven countries (the United States, Germany, Japan,
Switzerland, Belgium, the Netherlands, Canada, Aus
tria, Sweden, Norway, and Denmark) would provide up
to $3 billion to the BIS to back up British drawings for
financing net reductions in official sterling holdings be
low December 1976 levels. Of this, the Federal Reserve
and the United States Treasury would provide $1 bil
lion. For their part, the British authorities would offer
medium-term foreign-currency-denominated securities
to official holders to fund part of the total sterling bal
http://fraser.stlouisfed.org/
58 FRBNY Quarterly Review/Spring 1977
Federal Reserve Bank of St. Louis
ances and to achieve an orderly reduction in the reserve
currency role of the pound. The Managing Director of
the IMF was also requested to assist in the implemen
tation of the agreement.
Announcement of these agreements early in January
triggered a sharp jump in the sterling rate to as high
as $1.7350, before it subsequently leveled off at about
$1.7150. Then, the long process of reversing previ
ously adverse commercial leads and lags and of un
winding sterling credits used in third-country trade
financing generated a steady demand for sterling. At
the same time, British interest rates moved progres
sively lower, as reflected in the six cuts in the Bank of
England’s minimum lending rate from the 15 percent
level of mid-November to 1 2 1/4 percent on January 28.
In addition, the central bank scaled back its earlier
calls for special deposits. Under these circumstances,
prospects of capital gains spurred some flows of for
eign funds into British securities. Late in the month
the authorities announced a $1.5 billion Euro-dollar
loan with a syndicate of European and North American
commercial banks, which gave a further boost to the
pound. As a result, spot sterling traded firmly during
January while the Bank of England took the opportunity
to buy dollars in the market and to rebuild its official
reserve position. At $1.7149 by the month end, the
pound was up 1 0 1/2 percent from its October low and
only 4 percent below late-July 1976 levels. On a tradeweighted average basis, sterling’s depreciation since
the 1971 Smithsonian agreement had narrowed 6 per
centage points from the record reached in October to
42.8 percent, compared with 38.8 percent at end-July
1976. Meanwhile, the Bank of England’s large-scale
purchases of dollars in January had, along with the
initial takedown on Britain’s IMF standby, contributed
to a $3.1 billion increase in reserves for the month. As
a result, Britain’s foreign exchange reserves stood at
$7.2 billion on January 31, $1.8 billion more than six
months before.
Swiss franc
During the first half of 1976, the Swiss franc was pro
pelled progressively higher against all major cur
rencies. Switzerland’s inflation rate declined to about
3 1/2 percent, the lowest among the industrial coun
tries, while an unprecedented trade surplus swelled
the Swiss current account surplus to nearly 10 percent
of GNP. Moreover, large amounts of funds were drawn
into francs as market participants sought protection
against the severe uncertainties plaguing many other
European currencies at the time. At home, however, the
Swiss economy was stagnant, with overall economic
activity only a little higher than at the trough of the 1975
recession. While the appreciation of the franc helped
to reduce import costs significantly, it also led to a de
terioration of profitability in Switzerland’s export indus
tries and in turn exerted a drag on investment.
Consequently, the Swiss authorities moved to limit
the franc’s rise in the exchanges. They intervened to
buy large amounts of dollars, both in Zurich and
through this Bank in New York, offsetting enough of
these purchases with sales to foreign borrowers— re
quired to convert the proceeds of their borrowings in
Switzerland at the central bank— to avoid jeopardizing
the monetary target for the year. Moreover, the Swiss
authorities imposed additional exchange controls, re
stricting the importation of large foreign bank notes
in April and adopting quotas in June to curtail forward
sales of Swiss currency to nonresidents while entering
into a gentleman’s agreement whereby Swiss banks
would refrain from accepting franc deposits abroad.
In addition the Swiss National Bank reduced its dis
count and Lombard rates to the lowest levels in ten
years to bring down domestic interest rates, and it
Chart 5
Switzerland
Movements in exchange rate *
D ollars per fra nc
.42
N
*S e e footnote on Chart 3.
D
J
F
1977
indicated a willingness to continue to provide tempo
rary liquidity through dollar swaps with the commercial
banks to maintain a comfortable money market.
By late July, these various measures had begun to
take effect. The Swiss franc eased back 51A percent
from its peak levels of early June to $0.3981, while slip
ping some 5 1/2 percent lower against the German mark.
In contrast to previous periods of turbulence in the
exchanges, trading in Swiss francs remained rela
tively quiet as renewed tensions built up in the EC
snake during August. Now that interest rates in
Switzerland were well below those elsewhere in Eu
rope and were expected to decline further as the Swiss
authorities pursued their accommodative monetary
policy, funds flowed increasingly back out of francs
into marks. In addition, a move into deficit in the trade
accounts during the summer led some market partici
pants to question whether Switzerland would continue
to show the unusually strong trade performance of
recent months. As a result, the franc gradually dropped
back against the mark throughout the fall, declining
by some 4 percent between end-July and late Novem
ber. Against the dollar, however, the franc was pulled
up by the rise in the mark to trade around $0.4100
through late November, with the National Bank inter
vening frequently to moderate daily movements in the
rate.
By late 1976, the Swiss economy was still failing
to show any signs of expansion. The continued soft
ness in domestic demand was reflected in a further
reduction in inflation to just 1 percent at an annual
rate, its lowest since the mid-1960’s. The current
account remained in large surplus, totaling some $3.5
billion for the year as a whole. In the absence of any up
ward pressures on domestic prices and with growth of
the monetary base lagging, the Swiss authorities stepped
up their efforts to provide liquidity to the banking
system. While continuing to accommodate the banks’
temporary needs with large amounts of dollar swaps,
the National Bank announced that they were prepared
to inject substantial Swiss francs on a permanent
basis through dollar purchases in the exchange mar
kets. Over November-December, these outright pur
chases amounted to nearly $ 2 billion, well in excess
of the dollar sales under the capital export conversion
program. As a result, the Swiss franc continued to
drop back further against the German mark and other
European currencies while trading narrowly against
the dollar. Then in January 1977, with economic
stagnation in Switzerland contrasting sharply with
the improved outlook emerging in the United States,
the franc eased back in the generalized decline of
European currencies against the dollar to end the
period at $0.3990. At this level, from the record highs
FRBNY Quarterly Review/Spring 1977
59
of June 1976, the franc had declined by a net 5 percent
against the dollar and fully 1 1 % percent against the
mark.
In October, the Federal Reserve and the United
States Treasury reached agreement with the Swiss
National Bank on an orderly procedure to repay over
three years the Swiss franc indebtedness remaining
from August 1971. This included $1,147.2 million
equivalent of drawings under the Federal Reserve
swap line, as well as the $1,599.3 million equivalent
of United States Treasury Swiss franc-denominated
notes. In this connection, the Federal Reserve’s draw
ings on the original swap agreement with the National
Bank were repaid on October 29, using Swiss francs
drawn under a newly established special swap facility
which, in turn, will be reduced as the swap is repaid
over the three-year period. The System then began to
liquidate its obligations in accordance with the new
arrangement, primarily using francs purchased directly
from the Swiss National Bank against dollars and other
foreign currencies. By the end of the period, the Fed
eral Reserve repaid $154.6 million equivalent, leaving
$992.5 million outstanding as of January 31, 1977.
During this same period, the United States Treasury
purchased sufficient francs directly from the Swiss
National Bank to repay $86.1 million equivalent of
franc-denominated securities, leaving $1,513.1 million
equivalent outstanding as of January 31.
French franc
Last year, the French authorities faced particularly dif
ficult policy choices. Although domestic demand had
recovered briskly from the recession of 1974-75, this
pickup led to a greater rise in imports than in exports
and a sharp widening of the current account deficit.
At the same time, domestic inflation continued to hover
at a rate of nearly 1 0 percent per annum, almost
double that of countries such as Germany and the
United States. Early in the year, the franc came under
heavy selling pressure within the EC arrangement on
the expectation that sooner or later it would have to be
adjusted downward within the EC snake or otherwise
depreciated against the currencies of countries that
had lower rates of inflation. In mid-March, when the
governments participating in the arrangement failed
to agree on a realignment of parities, the French au
thorities decided to allow the franc to float indepen
dently. Although the franc rate initially dropped by
some 5 1/4 percent, it subsequently settled at about 2
percent below its previous EC parity and traded around
$0.2125 against the dollar through early summer.
During the summer, however, France was hit by a
severe drought, which threatened to push up food
prices, cut agricultural exports, and increase oil im
http://fraser.stlouisfed.org/
60 FRBNY Quarterly Review/Spring 1977
Federal Reserve Bank of St. Louis
Chart 6
France
Movements in exchange ra te *
Dollars per franc
.t o ■
22
-
. J i l l
J
F
M
A
I I I
M
J
J
1976
I I I
A
S
O
II
N
D
I I
J F
1977
* S e e foo tnote on C hart 3.
ports to compensate for lost hydroelectric power.
By that time also, the domestic economic expansion
had slowed and, with rates of unemployment and
inflation remaining uncomfortably high, the debate
over economic policy choices in France had heated
up considerably. Consequently, market concern over
the outlook for the franc resurfaced, and in late July
and early August the franc came under renewed
selling pressure. Although the authorities countered
by sharply raising interest rates, the franc slipped
back to a 2 1/ 2 -year low of $0.1986 by August 13, while
easing a further 8 percent against the EC snake cur
rencies. The spot rate then steadied after the gov
ernment indicated it was working on a new economic
stabilization program. Following a cabinet reshuffle in
late August, the new Prime Minister, Raymond Barre,
stressed his intention to give priority to curbing infla
tion and defending the franc. Consequently, trading
quieted down and the rate rose to around $0.2030
through mid-September as the market awaited the
new program.
On September 22, Premier Barre announced a wideranging set of measures designed to balance the
budget, to reduce the French inflation rate, and to re
store equilibrium to the balance of payments. These
measures included increases in income taxes to offset
proposed reductions in value-added taxes and to
finance aid to drought-stricken farmers. Moreover, to
curb cost inflation, the government imposed a threemonth price freeze on most goods other than oil and
called upon trade unions to keep 1977 wage increases
within the anticipated rise of retail prices. At the same
time the monetary authorities lowered ceilings and
reactivated reserve requirements on bank lending in
order to achieve a 12.5 percent monetary growth target
during the next year. Finally, to discourage further
adverse shifts in commercial leads and lags while
these longer term measures were taking hold, the Bank
of France hiked its discount rate a further 1 percentage
point to 1 0 1/2 percent and imposed a modest tightening
in foreign exchange controls.
The market’s initial response was cautious, in part
because of the potentially controversial nature of the
tax increase and the call for wage restraint, and the
franc was marked down somewhat. Over subsequent
weeks, as strains emerged within France’s ruling coa
lition of parties, the market atmosphere became more
uncertain. In addition, talk of another large OPEC oil
price increase in December raised concern that such
a move would undercut France’s domestic antiinflationary effort and widen the trade deficit further.
As a result, the franc came on offer during the late
fall and early winter, with selling particularly strong
at times of tension within the EC snake or pressures on
sterling. The franc held generally above $0.2000
vis-a-vis the dollar but declined, in parallel with the
dollar, a further 6 percent from mid-August against the
mark and other EC snake currencies. To avert a
steeper decline, the Bank of France kept a tight rein
on domestic monetary conditions, thereby encourag
ing inflows of interest-sensitive funds by both nonresi
dents and French companies.
Late in the year, signs began to appear of an
improvement in the French economic outlook. The
trade deficit narrowed significantly in response to a
sharp decline in French imports. The OPEC oil price
increase was not so large as feared. Moreover, the
domestic price freeze clearly was containing the rise
in price indexes. Although market sentiment toward
the franc remained cautious, the closing-out of posi
tions taken earlier in the year and a reversal of previ
ously adverse commercial leads and lags contributed
to a 1 percent rise in the franc rate before the year-end.
In early 1977, the market atmosphere improved even
further. Several of the strikes which had been threat
ened in response to the anti-inflationary measures
failed to materialize. The release of retail price figures
showing a slowdown in the inflation rate in December
for the third consecutive month confirmed to the mar
ket that the government’s price and wage restraints,
resting heavily on voluntary compliance, were proving
more effective than many traders had expected. More
over, although interest rates in France eased somewhat,
they did not decline as much as in other financial
centers and the Bank of France did not join several
other European central banks in lowering its official
lending rate. Thus, the franc remained relatively firm
throughout January, holding at $0.2012 against the
dollar by the month end while recovering some 2-3
percent against the German mark and other Continen
tal currencies. The Bank of France was therefore
able to add to reserves, with the result that official
exchange holdings rose a net $264 million during
the August 1976-January 1977 period.
Italian lira
The Italian lira was under severe pressure from the
beginning of 1976, dropping as much as 26 percent
through early spring in response to deep-rooted eco
nomic and political strains in Italy. Recovery of the
domestic economy, though still tentative, stimulated a
rapid rebuilding of inventories which, together with
the rise in raw materials prices, swelled Italy’s import
bill and turned the trade account into deep deficit.
In the political impasse which developed, moreover,
fiscal policy remained expansionary, threatening to
blunt the effectiveness of the restrictive monetary
measures adopted during the spring to support the
lira. To halt the slide of the rate in early May, the
authorities therefore resorted to a set of tough foreign
exchange restrictions. The most important was a tem
porary 50 percent deposit requirement on the lira
countervalue of virtually all foreign-currency purchases
by Italian residents, which mopped up some $5 billion
equivalent of domestic liquidity over the next three
months and stimulated sizable capital inflows. Mean
while, as efforts to reach a political compromise to deal
with Italy’s economic and social problems evaporated,
new elections were set for late June.
The outcome of those elections, a narrow but
clear-cut plurality for the Christian Democratic Party
over the Communist Party, gave an immediate boost
to market sentiment. Delicate political compromises
had to be struck, however, and several weeks passed
before a minority government under Prime Minister
Andreotti was formed and confirmed by the Parliament.
Meanwhile, until broader policy measures could be
taken, the authorities maintained a squeeze on
Chart 7
Italy
Movements in exchange ra te *
Dollars per lira
.0015------------------------------------------------.0014
.0013
.0012
.0011
1977
* S e e footnote on Chart 3.
FRBNY Quarterly Review/Spring 1977
61
domestic liquidity by extending the import deposit
requirement for a further three months. This squeeze
continued to draw funds in from abroad which, coupled
with seasonally high tourist receipts and reversals of
pre-election outflows, kept the lira firm around
$0.001197 (Lit 835). The Bank of Italy took advantage
of the lira’s buoyancy to absorb large amounts of
dollars in the market. Using these acquisitions, that
bank not only repaid external indebtedness— including
in late July the full $500 million drawn under the swap
line with the Federal Reserve earlier in the year— but
was able to add substantially to reserves. Although the
pace of reflows began to slow late in August, the Bank
of Italy was still able to repay $500 million of its
$2 billion gold collateral loan with the Bundesbank,
while extending the arrangement itself for another
two years.
By mid-September, the Andreotti government had
begun to negotiate the components of a stabilization
program with various political factions. By that time,
however, Italy’s inflation rate was accelerating again,
partly reflecting a surge in import costs. In response,
the trade unions maintained their resistance to the
government’s efforts to slow wage increases by modi
fying or eliminating the cost-of-living indexation sys
tem. Meanwhile, the scheduled expiration of the import
deposit requirement in November was approaching.
The market was concerned that, as these deposits ran
off, new liquidity would be injected into the money
market at a time when the Italian Treasury was still
borrowing heavily from the Bank of Italy to finance the
public sector deficit. Also, with the tourist season over,
many market participants were again expecting a de
terioration of Italy’s current account.
In this uncertain atmosphere, a gradual buildup of
commercial selling by Italian oil companies and other
firms pushed the lira progressively lower in late Sep
tember. In response, the Bank of Italy supported the
lira in the market and the government arranged to
phase out the import deposit requirement gradually
over six months beginning in November. In addition,
the authorities imposed a V2 percent levy on commer
cial bank deposits to reduce liquidity by Lit 550 billion.
Nevertheless, as speculative pressure in other Euro
pean markets broadened to envelop the lira, the spot
rate fell off to as low as $0.001146 (Lit 873), down A V a
percent fom late July.
To check this pressure on the lira while the govern
ment completed negotiating its package of economic
stabilization measures, the authorities imposed a tem
porary 10 percent tax, effective October 1-15, on most
resident foreign currency purchases to supplement
the import deposit requirement still in force. In addi
tion, they hiked the discount rate a full 3 percentage
http://fraser.stlouisfed.org/
62 FRBNY Quarterly Review/Spring 1977
Federal Reserve Bank of St. Louis
points to 15 percent and raised cash financing re
quirements on exports invoiced in foreign currencies
from 30 percent to 50 percent. In response, the spot
rate was immediately marked up by as much as 4 per
cent to trade at $0.001190 (Lit 840).
On October 13 the government announced its pro
posals for increased taxes and sizable public spending
cuts for 1977. In addition, regulated prices for
gasoline and for many public services were in
creased, while cost-of-living-linked wage increases
for certain high income groups were ordered to
be invested in government securities. The market
response was hesitant, however, as the limited
change in wage indexation was interpreted as under
scoring the government’s difficulty in resolving this
highly charged political issue. Thus, sentiment toward
the lira remained bearish, and the authorities again
found it necessary to tighten exchange controls in an
effort to avoid an outburst of speculative selling when
the special foreign exchange tax terminated on October
15. Ceilings on Italian banks’ spot and forward posi
tions were cut. Moreover, in a sweeping restriction,
the authorities prohibited until further notice nearly all
nonresident drawings on existing credit lines with
Italian commercial banks. In addition, in order to bring
credit growth back within the limits agreed with the
EC, a ceiling on the growth of loans was reintroduced
on October 15. Even after these measures were im
posed, however, the removal of the foreign currency
tax released a flood of pent-up foreign currency de
mand that drove the lira back down to $0.001147 (Lit
872). To cushion the decline in the rate, the Bank of
Italy again had to intervene heavily. Consequently, in
a matter of days the authorities reimposed the tax
on foreign exchange transactions— this time at 7 per
cent for four months beginning in October— to bridge
the period until the new economic measures could
start to improve the balance of payments.
As a result of all the restrictions then in force, the
lira again came into demand. To avoid incurring the
deposit and tax requirements on spot purchases of
foreign exchange, Italian importers sought additional
short-term trade credits abroad. At the same time, high
domestic interest rates forced Italian commercial banks
and other market participants to shift an increasing
amount of their borrowing into the Euro-dollar market.
Moreover, the risk of severe penalties on breaching
nonresident credit limits prompted foreign banks to
build up working balances in lire. In addition, the lira
also benefited from a return flow of funds placed il
legally abroad earlier in the year after the authorities
extended their amnesty program to encourage further
repatriations. On the strength of these various inflows
of funds, the lira remained in demand through mid-
December, fluctuating narrowly around $0.001156 (Lit
865). The Bank of Italy took the opportunity to buy
sizable amounts of dollars virtually every day, thereby
rebuilding official reserves by some $1.4 billion during
October and November. Early in December, the Bank
of Italy repaid the $486 million portion of the EC credit
provided by Britain, while borrowing an additional
$236 million on its gold collateral loans with the
Bundesbank.
By late in the year, the Italian balance of payments
was beginning to show signs of improvement as some
of the restrictive measures adopted in October began
to take effect. With the public sector deficit under more
effective control, the government forecast a reduction
in the Treasury’s borrowing requirement for 1977. In
addition, the authorities took the opportunity to re
duce compulsory commercial bank investments in pub
lic sector securities, while at the same time the central
bank was able for the first time since 1975 to sell
Treasury bills in the open market to absorb commer
cial bank free reserves.
In this improved atmosphere, the government was in
the position late in December to announce its decision
to cut the currency tax in half, effective December 27,
and to reduce the remaining levy in successive Vz
percentage point cuts, phasing it out entirely by Feb
ruary 21, 1977. Initially, the lira was marked down, as
Italian firms— especially oil companies— came into the
market to satisfy postponed foreign currency needs. By
December 28 the lira had slipped over 1 percent to
$0.001143 (Lit 875) even as the Bank of Italy inter
vened to moderate the decline. With market partici
pants still delaying their foreign currency purchases
in anticipation of further relaxation of the restrictions,
however, the lira steadied after that burst of selling
pressure had passed. In January, the continuing domes
tic money squeeze stimulated further inflows from the
Euro-currency market, which offset much of the demand
for currencies that emerged as both the foreign cur
rency tax and the import deposit requirement were pro
gressively reduced. Thus, the lira eased only a further
% percent to $0.001134 (Lit 882) by the month end, a
net decline of 5 1/4 percent for the six months since
July 1976.
Netherlands guilder
During 1976 the Dutch guilder was caught up in wide
swings in market sentiment. In the speculative atmo
sphere that emerged in European currency markets
early in the year, the guilder was bid up on the ex
pectation that it would be revalued along with the Ger
man mark. Following a showdown over EC parities in
March, however, the guilder came suddenly on offer
when the market learned that the Dutch authorities
C hart 8
Netherlands
Movem ents in exchange ra te *
Dollars per guilder
4 1 -------------------------------i
l
-----
T
■
J
<i
ii
F
ii
i i
M
A
M
i
»
i
«
J
ii
J
i
A
i
i
S
m
—
i---- 1-------i______ ji_____
i---------1--------1
O
N
D
1976
J
F
1977
* S e e footnote on Chart 3.
Central rate established on Septem ber 17, 1973.
were unwilling to revalue. Subsequently, the market
grew increasingly bearish toward the guilder. To be
sure, the economy was moving gradually into recovery
and the current account continued in substantial sur
plus. But the rise in domestic prices was still more
rapid than in Germany, and the market questioned the
prospects for any reduction of inflationary pressures.
Thus, the guilder fell to near the bottom of the snake,
where the central bank intervened heavily by selling
dollars until a tightening of conditions in the Amster
dam money market helped bring the guilder market
into better balance in early summer. Meanwhile, the
guilder had joined in the general decline against the
dollar to trade around $0.3675 by end-July.
In early August, when speculation reemerged over
a possible parity realignment within the EC snake, funds
were shifted into marks and the guilder came under
attack once again, dropping to the bottom of the EC
band where heavy intervention by the Netherlands
Bank was required. To demonstrate a determination to
maintain the guilder within the EC snake at prevailing
rates, the authorities brought about an intense squeeze
in the money market by successively raising the dis
count rate to 7 percent by August 20 and by imposing
increasingly stiff penalties on commercial banks’ bor
rowings in excess of their quotas at the central bank.
By late August, the combined effect of the heavy cen
tral bank intervention, the penal interest rates, and resi
dent demand for balances to meet tax payments had
sent overnight money rates in Amsterdam soaring to
unprecedented levels. Dealers, faced with a sharply
FRBNY Quarterly Review/Spring 1977
63
increased cost of financing short guilder positions,
rushed for cover. Dutch commercial banks liquidated
some of their short-term foreign assets to meet liquidity
needs, while adverse commercial leads and lags dating
back to the spring were reversed. As a result, the guil
der snapped sharply higher in late August and then
kept pace with the mark’s rise against the dollar except
for a temporary setback just prior to the October 3
German elections. The Netherlands Bank was therefore
able to purchase sufficient German marks in Septem
ber and early October to repay the remaining indebted
ness resulting from its previous intervention.
In the October 17 realignment of snake parities,
the mark was adjusted upward by 2 percent against
the guilder. As a substantial reflux of funds and un
winding of adverse leads and lags developed within
the arrangement, the guilder remained in demand. In
this atmosphere, the Netherlands Bank moved progres
sively to ease domestic liquidity. It continued its pur
chases of German marks and dollars in the exchanges,
reduced penalty rates on commercial bank borrowings
from the central bank, entered into swaps against
dollars before the year-end, and lowered the official
discount rate in two steps to 5 percent by January 7.
In December the Dutch capital market, closed since
the previous May, was reopened for selected foreign
issues.
These various measures helped to keep the guilder
just below the upper limit of the snake, where it fol
lowed the rising trend of the mark through the fall and
early winter. By early January, the spot guilder reached
an eighteen-month high of $0.4102. Thereafter, as
United States interest rates firmed and sentiment toward
the dollar improved, the guilder settled back to $0.3965
at the month end, for a net rise of 7 percent since endJuly 1976. In the meantime, the sizable central bank
purchases of marks and dollars since August 1976 had
contributed to a substantial increase in official ex
change reserves so that in the year from January 1976
external holdings declined only marginally on balance.
Belgian franc
During the various episodes of exchange market tur
bulence in early 1976, the Belgian franc was vulnerable
to selling pressures, partly on market concern over
Belgium’s relatively high rate of inflation. Whenever
tensions flared up in the exchanges, the Belgian
authorities vigorously defended the franc by raising
short-term interest rates and squeezing domestic
liquidity. At the same time, even though the economic
recovery was slower than in most other countries, they
took other anti-inflationary measures. The market ex
pected only slow progress toward price stability, how
ever, in view of Belgium’s system of indexing wage
64 FRBNY Quarterly Review/Spring 1977
Chart 9
Belgium
Movements in exchange ra te *
Dollars per franc
J
.0 2 7 ----------------------------------------------------------------
ojiLLLI
1 III
J F M A M J J
IA I SI
O
-------
I ID J I I FI
N
1976
1977
* See footnote on Chart 3.
"^C entral rate established on February 12, 1973.
increases to the rise in prices, and this concern became
even stronger when the serious drought last summer
threatened to push domestic food prices up sharply.
Under these circumstances, when strains on the EC
band resurfaced in late July and early August, adverse
shifts in leads and lags put renewed pressure on the
Belgian franc at the snake’s lower limit. Therefore, the
National Bank of Belgium was obliged to intervene in
large amounts, along with the other participating cen
tral banks. But the generalized flow into marks was
great enough to pull the franc up against the dollar to
$0.025750 by mid-August.
Meanwhile, the Belgian authorities publicly re
affirmed their commitment to defend the franc’s exist
ing EC parity, expressing the view that a devaluation
of the franc within the snake would have serious infla
tionary consequences while complicating the tasks of
promoting economic recovery and reducing unem
ployment. Moreover, the authorities reimposed a
severe credit squeeze, hiking the official discount rate
in two steps to 9 percent, raising interest rates on
other official advances and short-term Treasury certi
ficates even more, and cutting back on commercial
bank credit limits with the central bank.
As Belgian liquidity tightened early in September,
dealers began to cover some of their now expen
sive short positions and pressure against the Belgian
franc subsided. After mid-September the commercial
franc moved away from the snake’s floor and, apart
from a brief speculative outburst before the German
elections, the franc required only limited additional
support against the mark through mid-October. In
fact, on a few days, the franc firmed sufficiently within
the joint float to enable the National Bank to buy small
amounts of marks in the market to begin repaying the
mark debt it had accumulated from earlier interventions.
Nevertheless, disparities in economic performance
between Belgium and Germany continued to raise
expectations of an eventual realignment between the
currencies of the two countries. Thus, the market’s
initial reaction to the announcement on October 17
that the Belgian franc’s snake parity— like the guilder’s
— would not be independently lowered in the realign
ment of the snake was one of disappointment, and the
franc was marked down sharply the next day at the
opening in Europe. But almost immediately thereafter
the franc began moving back up against the dollar and
within the snake.
Then, as short positions and adverse commercial
leads and lags built up since mid-July were progres
sively reversed, the franc joined the other EC curren
cies in a steady advance against the dollar which
continued through the year-end. By early January
1977 the franc rate had firmed to $0.028000, 91/2
percent above midsummer levels. During this period
the National Bank occasionally purchased dollars to
moderate the rise. At the same time, with the franc
holding firm within the EC snake, the National Bank
bought sizable amounts of German marks in the mar
ket, initially to repay the remaining mark debt and
later to build up dollar reserves by converting mark
purchases at the Bundesbank. As a result, Belgian
reserves increased from end-October to end-December
by about $700 million, enough to offset losses during
the preceding three months. Meanwhile, the substan
tial injections of Belgian franc liquidity arising from
the central bank’s purchases of dollars and marks
helped to ease strains in the Belgian money market,
and the authorities followed up by lowering official
lending rates on various advances and loans in line
with the easing in market rates of interest.
By January, official figures showed that Belgium’s
current account had moved roughly into balance and
that Belgium’s inflation rate was moderating once
again. Domestic economic activity remained slack,
however, and the unemployment rate seasonally ad
justed had risen to nearly 6 .2 percent of the labor force.
Under these circumstances and with the franc remain
ing steady within the EC snake, the Belgian authorities
followed other European central banks in cutting
domestic interest rates further. The National Bank re
duced its discount rate for the first time since August
to 8 percent, lowered a variety of other official lending
rates by as much as 2 percentage points, and raised
commercial banks’ rediscount quotas to increase the
availability of credit. During the remainder of January,
the commercial franc eased back along with the mark
against the dollar to $0.027040 by the month end, a
net rise of 6 percent in the six months from end-July
1976.
During the period under review, the Federal Reserve
completed its program of regular purchases of Belgian
francs to repay swap debt outstanding since August
1971, acquiring sufficient francs from correspondents
and in the spot and forward market to liquidate the
remaining $82.4 million of drawings by November 12.
Japanese yen
Following the economic dislocations of previous years
— inflation, payments deficit, and recession— the Japa
nese authorities were seeking to revive the domestic
economy through fiscal stimulus and accommodative
monetary policy without rekindling domestic infla
tion. When early in the year, however, the United
States and other industrial countries experienced a
sharp expansion of demand, particularly in rebuilding
inventories, Japanese exports surged without an im
mediate rise in imports and Japan’s trade and current
accounts moved into substantial surplus. This gen
erated more positive expectations toward the yen
which, combined with favorable interest arbitrage
incentives, led to substantial capital inflows to Japan.
Consequently, in the early months of 1976 the yen
rebounded by some 2 percent from its lows of late
1975. Although the market camo into better balance
over the late spring, the possible persistence of a large
trade surplus for Japan became a matter of official
concern abroad and was one of the subjects discussed
at the economic summit meeting among major nations
in Puerto Rico in late June. Moreover, the Japanese
press carried reports that, in the economic policy
debate emerging in Japan, some leaders expressed a
readiness to accept a gradual rise in the yen to contain
domestic inflation.
As the market reacted to reports of these policy dis
cussions, the yen came into heavy demand from late
June through August. Foreign importers of Japanese
goods advanced their yen purchases in the spot and
forward markets to cover future needs, nonresident
investors shifted funds into Japanese securities, and
Chart 10
Japan
Movements in exchange ra te *
Dollars per yen
0032*----- 1----- 1___ I____ I___ I___ I____ >___ I___ I____ I___ >____
I__
J F M A M J J
A S
O N D J
F
1976
1977
* S e e footnote on C hart 3.
FRBNY Quarterly Review/Spring 1977
65
market professionals both in Tokyo and abroad shifted
into long or longer yen positions. The spot rate reached
a high of $0.003504 (¥285.4) by September 9, some
5 1/4 percent above midyear levels. To maintain an
orderly market, the Bank of Japan bought moderate
amounts of dollars in August-September before the
yen eased back somewhat late in September.
In early October, however, the balance of market
sentiment shifted back against the yen. Talk of a siz
able OPEC oil price rise in December had become a
major concern in view of Japan’s dependence on oil
imports for the bulk of its energy needs. With the
approach of the national election in Japan in early
December, political uncertainties also weighed on
market psychology toward the yen. Moreover, the
economic pause in the United States and Europe
during the summer had been reflected in a deceleration
of Japanese export growth which, coupled with a
delayed rise in imports to rebuild stocks run down
earlier in the year, had led to a narrowing of the trade
and current account surplus. Since the Japanese
economy was also sluggish, the market came to expect
that interest rates in Japan might eventually decline,
and market rates softened somewhat even as the Bank
of Japan kept its discount rate unchanged.
In this atmosphere, the yen came increasingly on
offer in the exchange market during October and No
vember, as professional traders shifted out of yen and
into dollars while previously favorable leads and lags
were unwound. Selling pressures increased on the days
before and after the December 5 election, in which the
ruling Liberal Democratic Party almost lost its absolute
majority in the lower house of the Diet. By December
the yen rate slipped to as low as $0.003359 ( ¥ 297.7),
some 41A percent below its September high, with the
Bank of Japan by then intervening forcefully to main
tain orderly market conditions.
Over the next few days, however, the market atmo
sphere improved markedly. The smooth transition of
authority to a new government under Prime Minister
Fukuda had a reassuring effect, particularly as the new
administration in Japan reasserted the policy of cau
tious stimulus to the economy. In addition, the outcome
of the OPEC meeting in midmonth with a smaller than
expected increase in OPEC oil prices also came as a
relief to the market. Consequently, the yen turned
upward once again, bolstered by seasonal conversions
of exports receipts.
By early 1977, figures had been released showing an
overall Japanese trade surplus of $10 billion for 1976
and a current account surplus of about $3 1/2 billion, or
nearly 1 percent of GNP. Moreover, the revival of
demand in the United States and elsewhere was
reportedly again generating a rise in Japanese exports
http://fraser.stlouisfed.org/
66 FRBNY Quarterly Review/Spring 1977
Federal Reserve Bank of St. Louis
which outpaced import growth. Amid renewed expres
sion of concern over the size of Japan’s trade and
current account surplus, funds again began to flow
heavily into Japan. The yen thus continued to advance
through most of January, reaching a high at the month
end of $0.003469 (¥288.3), some 31A percent above
the early-December low, with only modest intervention
by the Bank of Japan.
Canadian dollar
By midsummer 1976, the Canadian authorities had
made significant progress in reducing inflation from
the levels of 1974-75, partly as a result of a broad antiinflationary program which included price and wage
restraints as well as a restrictive monetary policy. At
the same time, however, the pace of expansion of the
domestic economy was sluggish, unemployment was
still high, and Canada’s current account remained in
sizable deficit. During the first half of 1976, this deficit
had been more than offset by Canadian borrowings
abroad, amounting to some $4.5 billion. Thus, while the
market remained hesitant about the longer term pros
pects, the conversions of these borrowings had pushed
the Canadian dollar rate up strongly in the exchanges.
The broader interest in the Canadian dollar that these
borrowings had generated, together with the impres
sive rise in the rate, had attracted sizable professional
position-taking that left the currency more exposed to
volatile swings in market sentiment. When the pace
of new borrowings and conversions slowed during
midsummer, the Canadian dollar dropped about 3
percent from its June highs to below $1.01 early in
August.
In August and September, however, several new for
eign borrowings were announced that generated a
reversal of professional positions and reportedly at
tracted renewed flows of OPEC funds into Canadian
dollars. Buoyed also at times by seasonally strong
commercial demand, the Canadian dollar advanced
again to above $1.03 by late October. The Bank of
Canada continued to intervene on both sides of the
market to maintain orderly trading conditions, with the
net result that by end-October Canada’s official re
serves were almost back up to end-June levels.
Meanwhile, some long-standing concerns over pros
pects for the Canadian economy began to weigh on
market sentiment. Opposition was building up, within
both the labor unions and the business community, to
an extension of the government’s year-old wage-price
control program. Also, the latest economic statistics
indicated a further slippage in the already disappoint
ing pace of recovery, raising the possibility of higher
unemployment especially in Quebec and the maritime
provinces,. At the same time, the growth of monetary
aggregates was slipping below the Bank of Canada’s
target range. Under these circumstances, the market
became wary of significant declines in Canadian inter
est rates relative to those in the United States.
Thus, sentiment toward the Canadian dollar was al
ready turning more hesitant when reports spread that
the Separatist Party of Quebec might make severe in
roads in the Liberal Party’s majority in the upcoming
November 15 elections for the Quebec provincial leg
islature. In response, the Canadian dollar came on offer
and the spot rate began to soften even before the
elections. Nevertheless, market participants were
caught by surprise when the Separatist Party won
by a sizable majority. In reaction, the Canadian dollar
was marked down sharply in London the day after the
election, before temporarily recovering somewhat in
the New York and Canadian markets.
Over subsequent days, as the market tried to assess
the broader political and economic implications of the
Chart 12
Interest Rates in the United States,
Canada, and the Euro-dollar Market
Three-m onth m a tu ritie s *
Percent
12-------------------------------------------------Canadian finance paper
8 -C e rtific a te s of deposit of New Y o rk ---------------------banks (secondary m arket)
Euro-dollars
election results in Queoec, the selling pressure gath
ered force. Professional dealers in both Europe and
North America scrambled to cut back their Canadian
dollar positions or to take up short positions. As the
rate fell, commercial demand for Canadian dollars vir
tually dried up, United States corporations brought
forward their normal year-end conversions of earnings
by Canadian subsidiaries, and Canadian borrowers
postponed their conversions of new foreign issues.
Meanwhile, interest rates in Canada also began to
ease. On November 19, after a Va, percentage point
cut in Federal Reserve discount rates, the Bank of
Canada announced a reduction in its lending rate of
1/2 percentage point to 9 percent. With the Canadian
dollar increasingly on offer, the spot rate tumbled
through the $1.00 level over our Thanksgiving Day
holiday and, in record turnover, continued to slide
over the next few days. By Tuesday, November 30, it
had reached $0.9587 in London, the lowest level since
June 1970. The Bank of Canada provided substantial
resistance to the sharp fall in the rate, and Canadian
official reserves fell $759 million in November.
The Canadian dollar began a tentative recovery in
early December, when some participants began to feel
that the selling had been overdone. Reports of new for
eign borrowings scheduled for early 1977 tended to
provide some reassurance that, even after the Quebec
election, Canadian borrowers could continue to tap the
international credit markets. As the atmosphere im
proved, there were renewed borrowing conversions
in the market, and some short positions were covered.
In addition, reports circulated that the proceeds of
Canadian wheat sales to China were being converted.
Thus, even after the Bank of Canada cut its discount
rate another I/2 percentage point on December 21,
the exchange rate was marked down only briefly, and
by January 5 it had recovered to $0.9984, over 4 per
cent above its November 30 low. The Bank of Canada
intervened about as heavily to moderate the rise as it
had to cushion the decline, adding $764 million to
official reserves during December.
Nevertheless, the market remained cautious toward
the Canadian dollar and the rate generally fluctuated
lower during the rest of January. By this time, market
participants held firm expectations of a further easing
of short-term interest rates in Canada, while in con
trast United States money market rates were tending to
rise. Uncertainties over the timing of future borrowing
conversions dampened professional bidding for Cana
dian dollars. In addition, the market reacted adversely
to Quebec Premier Levesque’s speech to businessmen
in New York, in which he reaffirmed his party’s objec
tive of an independent French-speaking Quebec. By
end-January, therefore, the Canadian dollar rate had
FRBNY Quarterly Review/Spring 1977
67
slipped back to $0.9825, for a net decline of 41A
percent over the six-month period. During that time,
Canadian official reserves declined by $115 million
on balance.
Mexican peso
For nearly two decades, Mexico’s impressive economic
growth largely reflected the authorities’ efforts to
mobilize domestic savings and attract funds from
abroad to finance the development effort. Externally,
this approach resulted in a current account deficit
which was normally offset by sufficient capital inflows
to achieve at least overall balance and, in most years,
to allow for some accumulation of international re
serves. Throughout this period, the Mexican authorities
successfully maintained a fixed rate of $0.08 to the
peso, meeting with only occasional bouts of selling
pressure. This stability nevertheless rested on a deli
cate balance of economic forces. Beginning in the
early 1970’s, ambitious social and economic programs
at home led to growing fiscal deficits which eventually
generated rates of inflation well above those in the
United States and other major countries. At the same
time, Mexico was caught up in the backwash of world
wide inflation, particularly after the oil price rise of
1973-74, and the subsequent recession in the United
States and other industrial countries. The Mexican
authorities managed to avoid an economic downturn
in 1974-75, but at the expense of a sharp widening in
the current account deficit that required even greater
foreign borrowings than before. By early 1976, the
authorities had recognized the need for restoring inter
nal and external balance and had made a start toward
that objective. Nevertheless, market participants re
mained cautious in view of the large economic
imbalances which remained, the increasing wage
demands of Mexican trade unions, and election-year
uncertainties in Mexico.
Against this background, the Mexican peso came
under heavy selling pressure on several occasions in
early 1976. By April, rumors of a forthcoming devalua
tion of the peso had led to outflows of resident funds
as well as to hedging by nonresidents of peso claims
and receivables. To help finance its intervention at that
time, the Bank of Mexico drew the full $360 million
available under the swap arrangement with the Federal
Reserve. Some reflows subsequently developed but not
in sufficient volume for the Bank of Mexico to liquidate
the swap drawing quickly, as it had with earlier
drawings in 1974 and 1975.
The market remained edgy throughout the spring and
early summer. After former Finance Minister Lopez
Portillo was voted to succeed President Echeverrfa
in the July 4 election, many market participants ex
68 FRBNY Quarterly Review/Spring 1977
C hart 13
Mexico
Movem ents in exchange ra te *
Dollars per peso
------------------------------.080
.070
...........
.0 6 0 ---------------------------- ' 1
.U O U
............. .
.U 4 U
0„0I I I I
J
F
M
I I I
A
M
J
J
1976
I I
I
A
S
I I
O
N
l J
D
J
F
1977
* S e e footnote on Chart 3.
pressed concern over the possible need for a change
in the exchange rate either before or after the Decem
ber 1 inauguration. Although Mexico’s imports had
steadied, the growth of exports was falling well below
expectations, halting progress in reducing the current
account deficit. Yet, the authorities were unable to
step up the pace of foreign borrowings to offset fully
both the widening current account deficit and the
continuing hot money outflows. The Bank of Mexico
continued to support the peso at the $0.08 level, but
at a heavy loss of international reserves.
On August 31 the Mexican authorities announced
that, as part of an overall strategy of economic adjust
ment, the peso would be allowed to float, with the Bank
of Mexico intervening only to prevent “ erratic and
speculative fluctuations” in the spot rate. Other mea
sures included steps to cut the public sector deficit,
price controls on raw materials, and taxes on ex
ceptional profits that exporters might receive from, the
peso’s depreciation.
Immediately after these announcements, the spot
peso was marked down almost 39 percent before re
covering slightly in thin trading. To help steady the
rate, official intervention was soon resumed and the
peso traded around $0.0505 through late October.
Meanwhile, in conjunction with these new policies, the
Mexican government had entered into negotiations
with the IMF. In that context, the United States Trea
sury and the Federal Reserve agreed to a special ar
rangement with the Bank of Mexico on September 20,
making available to that bank up to $600 million of
interim financing. On that basis, the Bank of Mexico
drew early in October $365 million on the United States
Treasury, an amount that was fully repaid when Mexico
made its first drawing on $963 million in credits the IMF
made available beginning in November. In Octo
ber the Bank of Mexico also repaid the $360 million of
swap drawings on the Federal Reserve outstanding for
six months.
In the exchanges, however, the attitude toward the
Mexican peso remained bearish. Although wage in
creases were substantially below levels originally de
manded by the labor unions, domestic prices had
nevertheless risen sharply following the floating of the
peso. Moreover, the market had come to expect that
implementation of new measures in connection with
Mexico’s eligibility for drawing on the Fund would have
to await the installation of a new administration on
December 1. In this atmosphere, a variety of rumors, of
capital controls or freezes on resident bank accounts,
began to appear in the market, triggering renewed
movements of funds out of Mexico in early autumn.
Later on, in mid-November, reports of seizures of
privately held land in northern Mexico generated fur
ther uncertainty. In response, capital outflows inten
sified and Mexican residents rushed to convert more
pesos into United States dollars, including dollar
currency notes.
In an effort to maintain an orderly market for the
peso, the Bank of Mexico at first stepped up its official
dollar sales. But, after sustaining a further loss of re
serves, the authorities permitted the peso to sink a
further 25 percent to $0.0380 on October 27, before
resuming support for the rate. Among other credits
to augment reserves, the authorities drew in November
$150 million on the swap line with the Federal Reserve
and a total of $300 million under the Exchange Stabili
zation Agreement with the United States Treasury.
Later that month, in the face of massive selling pres
sure on the peso and the likelihood of even more
capital outflows before December 1, the authorities
announced over the November 20-21 weekend that
they were withdrawing temporarily from the market. To
deter additional speculative selling of pesos, commer
cial banks and other credit institutions were prohibited
from trading for their own accounts, except to cover
existing commitments. Instead, stockbrokers were
authorized to act as foreign exchange dealers for the
purpose of executing essential transactions. Following
these measures, the immediate selling of pesos stopped
and a technical shortage of peso balances quickly
developed in both Mexico and abroad. Thus, the peso
bottomed out at $0.0345 on November 22— fully 57
percent below the prefloat level— and rose to as high
as $0.0526 by December 1.
That day, in his inaugural address, President L6pez
Portillo called for national unity, austerity measures,
and a productivity improvement program to strengthen
the Mexican economy. The speech was well received
in Mexico and abroad, and over the following days a
substantial reflux of funds into pesos developed.
Thereafter, the new administration began implemen
tation of the policy measures embodied in the agree
ment with the IMF and gained agreement for more
modest than expected wage increases in the January
round of wage talks. Moreover, on December 20, the
authorities lifted the prohibition against commercial
bank trading for their own account. Even as more
normal trading resumed, the peso held firm at around
the $0.05 level through the year-end and into early
1977. When some selling pressure emerged briefly
after mid-January, the rate dropped to as low as
$0.0444 before firming in good two-way trading. By the
month end, the peso was trading at $0.0463, some 42
percent below the prefloat level. Meanwhile, the Bank
of Mexico’s reserve position had improved sufficiently
to repay in December $150 million of the $300 million
drawn on the United States Treasury and to schedule
repayment of the $150 million in swap drawings on the
Federal Reserve at maturity in February.
FRBNY Quarterly Review/Spring 1977
69
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