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Federal
Reserve Bankof
NewYork
Quarterly Review

S p rin g 1979

V o lu m e 4 No. 1

D e fin in g M o n e y fo r a C h a n g in g
F in a n c ia l System
New Y o r k ’s In s u ra n c e In d u s try :
P e rs p e c tiv e and P ro s p e c ts

The E c o n o m y o f N ew Y o rk C ity

B u sin e ss T a x a tio n in N ew Y o rk C ity

A B a n k e r L o o k s at th e E x a m in a tio n P ro c e s s

31
34

T h e b us in e s s s itu a tio n
C u rre n t d e v e lo p m e n ts
P u b lic s e rv ic e e m p lo y m e n t: its ro le in a
c h a n g in g e c o n o m y

39
42
49

The fin a n c ia l m a rk e ts
C u rre n t d e v e lo p m e n ts
G lo b a l asset and lia b ility m a n a g e m e n t at
c o m m e rc ia l b a n k s
H ow w e ll are th e e x c h a n g e m a rk e ts
fu n c tio n in g ?

This Q uarterly Review is published by
the Research and S tatistics Function
of the Federal Reserve Bank of New
York. Among the members of the
function who contributed to this issue
are JOHN WENNINGER and CHARLES
M. SIVESIND (on defining m oney for
a changing financial system, page 1);
JANET SPRATLIN YOUNG (on per
spective and prospects of New York’s
insurance industry, page 9); RONA
B. STEIN (chart analysis on the
econom y of New York City, page 20);
MARK A. WILLIS (on business tax
ation in New York City, page 22);
DEBORAH JAMROZ (on the role of
p ublic service employm ent in a
changing economy, page 34); WARREN
E. MOSKOWITZ (on global asset and
lia b ility m anagement at com m ercial
banks, page 42).
Excerpts from a talk by DONALD C.
PLATTEN, Chairman, Chemical Bank,
on the bank exam ination process
appear on pages 29-30.
Remarks by SCOTT E. PARDEE on
how w ell the exchange m arkets are
functioning begin on page 49.
A report on m onetary p o licy and open
m arket operations in 1978 starts on
page 53.
A semiannual report of Treasury and
Federal Reserve foreign exchange
operations fo r the period August
1978 through January 1979 begins on
page 67.

Defining Money for a Changing
Financial System

In the past decade, major developments in this coun
try’s payments mechanism have raised the question of
whether the traditional definitions of the monetary ag
gregates are still appropriate. Many of the changes in
the form in which money is held and used have re
sulted from regulatory modifications designed to per
mit greater competition among banks and between
banks and other types of financial intermediaries.
These regulatory changes have allowed the devel
opment of a variety of new types of deposits. At the
same time, periods of historically high levels of interest
rates have increased the incentive for more efficient
cash management by both consumers and businesses,
resulting in the rapid growth of a variety of highly
liquid nondeposit assets. The pace of such develop
ments promises to accelerate in the future with in
creasing application of computer technology and elec
tronic funds transfers. As if to emphasize the changing
nature of the financial scene, conventional money de
mand equations, relating money balances to income
and interest rates, have not been able to account for
the movements in the narrowly defined money stock
since mid-1974. As a result, a redefinition of the
monetary aggregates is called for.
Defining the monetary aggregates appropriately is
critical because these aggregates have come to play an
increasingly important role in the formulation of mone
tary policy during the last decade. To be sure, the
monetary aggregates are by no means the only guides
The authors would like to thank Irving Auerbach, Edward C. Ettin,
Stephen Goldfeld, Richard D. Porter, and Thomas D. Simpson for
helpful comments. None of the foregoing bear responsibility for the
views expressed herein.

to policy. Developments in the credit markets, in the
foreign exchange markets, in business conditions, and
in prices all play an important role in policymaking.
It is against the background of analysis and projection
of these fundamental economic developments that the
Federal Open Market Committee (FOMC) establishes
annual targets for several monetary aggregates as in
termediate policy goals. The FOMC also sets short-term
tolerance ranges for the growth of two money defini
tions to guide System open market operations between
FOMC meetings. As regulations change and as the finan
cial system evolves, allowing the public to find new
forms in which to hold its financial wealth, relationships
among money, interest rates, income, and prices are al
tered as well. Without stability in these relationships, the
conduct of monetary policy is greatly complicated.
As the first step toward resolving these problems, a
set of redefined monetary aggregates was presented by
the staff of the Board of Governors in the January 1979
Federal Reserve Bulletin. Some of the details of these
proposals will be considered in this article. Briefly, the
suggested definitions would create improved, internally
consistent aggregates that can be estimated from cur
rently available data. They solve many of the problems
arising from regulatory changes by treating consis
tently deposits with similar liquidity characteristics,
regardless of whether they are located at commercial
banks or at thrift institutions— mutual savings banks,
savings and loan associations, or credit unions. For
example, all deposits subject to withdrawal by check
or other negotiable order, whether located at commer
cial banks or at thrift institutions, would be counted
in the narrowly defined money stock. However, the
proposals do not include aggregates that incorporate

Quarterly Review/Spring 1979

Table 1

Out-of-Sample Dynamic Errors in Projecting Mx
Quarterly average levels and growth rates 1970 to 1978
m +jc *# .

Period

........ to 1974-Q2
1970-Q1
Cumulative Growth
levels
rates
(billions
(per
of dollars)
cent)

1970:
Q 1 ...........
Q 2 ..........
Q 3 ..........
0 4 ...........

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

0.0
1.3
1.0

0.0
0.8
1.3
1.4

0.0

1971:
0.0
Q 1 .......... . . .
Q2 ........... .. .
0.2
0.0
Q 3 ........... . . .
Q 4 ........... . . . - 2 . 7

-2 .6
0.3
- 0 .2
-4 .7

1972:
0 1 ........... . . . - 3 . 9
0 2 ........... . . . - 5 .1
0 3 ...........
0 4 ........... . . . - 4 .1

- 2 .1
— 1.8
0.7
1.3

1973:
0 1 ...........
0 2 ..........
0 3 ...........
0 4 ...........

-3 .5
-4 .0
-2 .7
-2 .9

1.0
-0 .6
2.1
-0 .3

1974:
01 .......... .. . - 2 . 2
0 2 ........... . , . - 2 . 9

1.2
-0 .9

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

Average error — 1.9
Root mean squared
e r r o r .............
2.9

-0 .2
1.6

1974*03 10 1978-Q4

Period

Cumulative
levels
(billions
of dollars)

1974 (continued):
Q 3 .......... .. - 3.8
0 4 .......... . . - 6.2

Growth
rates
(per
cent)

— 1.3
- 3 .3
<f!

1975:
0 1 .......... .. — 11.6
0 2 .......... . . -1 5 .1
0 3 .......... .. - 1 7 .6
0 4 ..........

- I A
-4 .5
-2 .9
-7 .3

1976:
0 1 ..........
0 2 .......... . . - 3 2 .4
0 3 .......... . . - 3 7 .0
0 4 .......... . . - 3 9 .4

-6 .8
— 3.5
-5 .0
-2 .0
mmimamm

1977:
0 1 .......... . .
0 2 .......... ..
0 3 .......... ..
0 4 .......... , ..

- 4 2 .6
- 4 5 .5
- 4 6 .6
- 4 7 .5

1978:
0 1 .......... . . .
0 2 ........ . . .
0 3 .......... . . .
0 4 ..........

- 4 8 .7
— 49.4
- 5 0 .2
— 53.9

m m M
-0 .4
0.4
0.3
-3 .2

- 3 3 .3

-2 .9

37.0

3.8

- 2 .9
-2 .3
-0 .1
- 0 .1

The estimated parameters of the money demand equation
used to make these forecasts are shown below (t statistics
are shown in parentheses beneath the coefficients).
,040Dt + .173Y*
.261 + .750Mt_,
.019Rt
(4.00)
(5.46)
(.53)
(10.75)
(6.06)
where:
Pt :
GNP price deflator
M,:
In (Moneyt /P t )
Mt_j: In (Moneyt _i/P t )
Rt :
In (Commercial paper ratet )
Dt :
In (Effective passbook ratet )
Yt :
In (G N P ./P J
Estimation period: 195.7-02 to 1969-Q4
(The equation was corrected for first order autocorrelation with
p — .534.) The errors are calculated by subtracting the pre
dicted values from the actual values without any correction
for past errors.

iSISiSBiSililillll
2

FRBNY Quarterly Review/Spring 1979

highly liquid nondeposit assets such as repurchase
agreements (RPs) and shares in money m arket mutual
funds that have arisen out of the increased emphasis
on cash management in recent years. Including such
instruments would raise serious conceptual and mea
surement problems and, as the financial system con
tinues to evolve, new assets with sim ilar properties may
well be developed. In light of these problems, the Board
staff has lim ited the scope of its current proposals to
the deposit liabilities of banks and th rift institutions (in
addition to currency). But by leaving out highly liquid
nondeposit assets, the Board staff’s proposals do not
reestablish the ability of conventional money demand
equations to track movements in M! since mid-1974.1
What is money? For several thousand years, most
people would have answered gold and silver. Now the
answer has become more complex, and it continues
to change as new assets are developed w ith different
com binations of safety, liquidity, and interest-earning
properties. It is more useful to define money by w hat it
does than it is to list which assets should be included.
Money serves as a medium of exchange and as a store
of value. W hile most assets serve both these functions
to some extent, certain types serve prim arily as a me
dium of exchange; others, as a store of wealth. A
transactions-oriented definition of money attem pts to
measure those assets that perform the first of these
functions, while a wealth-oriented m onetary aggregate
is broadened to include assets that prim arily satisfy
the second. A great deal of em pirical research has
focused on estimating equations that explain the pub
lic ’s demand for a transactions-oriented aggregate,
and prior to mid-1974 these equations were able to
track movements in the money stock reasonably w ell.2
It is this relatively good perform ance in the pre-1974
period that makes the apparent mid-1974 breakdown
in the ability of this conventional money demand equa
tion to track movements in the money stock particularly
disturbing. For example, in the 1970 to mid-1974 period
the estimates show only a slight tendency to over
predict Mx (Table 1). The average error in predicting
the quarterly growth rate is only — 0.2 percent from
1970-Q1 to 1974-Q2. In the next four and a half years,
this error increases sharply to - 2 .9 percent per quarter,
1 These and other results are examined in an econometric study,
“ Changing the Money Definitions: An Empirical Investigation” ,
available from the authors on request.
2 See Stephen Goldfeld, “ The Demand for Money Revisited” ,
Brookings Papers on Economic Activity (Vol. 3, 1973) and “ The Case
of the Missing Money” , Brookings Papers on Economic Activity
(Vol. 3, 1976). Goldfeld’s equation links money balances to income,
the interest rate on three- to six-month commercial paper, and the
interest rate on savings deposits. The income variable captures the
transactions demand for money, while the two interest rate variables
measure the yield foregone in holding money balances.

resulting in a cumulative overprediction of $53.9 billion
by 1978-Q4. This poor performance after mid-1974 is
due, at least in part, to changes in regulations that gov
ern deposits at commercial banks and thrift institutions.
In addition, nondeposit assets have been developed
that are used for transactions purposes or that permit
the more efficient management of transactions bal
ances without much cost, inconvenience, or capital
risk. These assets account for part of this large error,
raising the questions of whether they are treated by
the public largely as transactions balances and whether
they should be included in a narrow definition of money.3
Current definitions of the monetary aggregates
The effects of regulatory changes and financial innova
tions are not consistently captured by any of the mea
sures of money currently published by the Federal Re
serve. These aggregates range from a narrow definition
that includes only currency and funds at commercial
banks used to settle everyday transactions to a far
broader measure encompassing most deposits at banks
and thrift institutions (Table 2). The aggregate most
commonly used in economic analysis (MJ, consisting
of currency in circulation and demand deposits at com
mercial banks, comes closest of the standard aggre
gates to measuring money as transactions balances.
Until recently, this series contained nearly all funds
commonly used for transactions purposes. As a partial
solution to the development of a variety of other
“ checkable” deposits, ranging from share draft ac
counts at credit unions to savings deposits subject to
automatic transfer at commercial banks (ATS), the Fed
eral Reserve has recently begun to publish a closely
related series (Mj+) that in addition to M, includes
demand deposits, interest-bearing negotiable order of
withdrawal (NOW) accounts and share drafts at thrift
institutions, and savings deposits (NOWs, ATS, and
conventional accounts) at commercial banks.
Still broader aggregates are frequently used in eco
nomic analysis by those who emphasize the role of
money more as a store of wealth than as a means of
payment. The most commonly used of these (M.J com
prises Mx plus time and savings deposits at com
mercial banks, excluding negotiable certificates of
deposit in denominations of $100,000 or more is
sued by large weekly reporting banks (CDs). Deposits
counted in M2 but not Mlf usually denoted as other
time and savings deposits, consist of three distinct
components: savings deposits, time deposits under
$100,000 (small time deposits), and large time deposits
3 For a technical discussion of this question, see P.A. Tinsley,
B. Garret, and M.E. Friar, “ The Measurement of Money Demand”
(Board of Governors of the Federal Reserve System, 1978).

of $100,000 or more (LTDs), which do not include CDs.
Savings deposits generally are readily available to the
depositor, whereas small time deposits are committed
for periods of time from thirty days to eight years or
more. Both savings deposits and small time deposits
are subject to interest rate ceilings, making deposit
inflows sensitive to market rates of interest paid on
money market instruments.4 However, LTDs and CDs
currently are not subject to interest rate ceilings, so
that their yields tend to move in tandem with other
market rates. LTDs consist of nonnegotiable certificates
of deposit and open time accounts5 at all banks and
a small volume of negotiable certificates of deposit is
sued by banks other than the large weekly reporters.
M;j contains all the items in M2 plus time and savings
deposits at thrift institutions. M3 is the narrowest
aggregate that is more or less consistent across
depository financial institutions in the sense that it
contains deposits with similar liquidity characteristics
located at both commercial banks and thrift institutions.
The addition of CDs at large weekly reporting banks to
M2 and M.„ respectively, yields M4 and M5.
Proposed redefinitions of the monetary aggregates
In redefining the monetary aggregates, the Board staff
has focused on five primary problem areas.
(1)
Included in the demand deposit component of
M, are certain foreign source deposits that are held
for official and semiofficial international purposes and
as clearing balances for foreign banks. These deposits
are held both at domestic commercial banks by foreign
commercial banks and foreign official institutions and
at the Federal Reserve by foreign official institutions
and international monetary institutions. Balances in
these accounts are not closely related to domestic
transactions and thus do not seem to belong in any of
the money definitions. Removal of these deposits was
recommended earlier by the Bach Committee.6
4 While small time deposits generally are subject to fixed rate ceilings
— until explicitly changed by the regulatory agencies, the relatively
new six-month money market certificates have a ceiling rate linked
to the average discount rate on six-month Treasury bills posted at
the weekly auction. Banks are able to match this rate, thrift institu
tions can pay an additional 0.25 percentage points, until the discount
rate on six-month Treasury bills exceeds 8.75 percent. For bill rates
between 8.75 and 9.00 percent, thrift institutions may offer 9.0 percent,
and for bill rates above 9.0 percent thrift institutions may offer the
discount rate on Treasury bills, the same rate that commercial banks
may offer.
5 An open time account is a deposit with a maturity of at least
thirty days for which a certificate is no-i -issued. These deposits
are subject to thirty days' notice before withdrawal.
4 Advisory Committee on Monetary Statistics, “ Improving the Monetary
Aggregates” (Board of Governors of the Federal Reserve System,
June 1976). Several other minor technical changes in the aggregates
recommended by the committee have also been incorporated in the
proposed redefinitions but are not discussed here.

FRBNY Quarterly Review/Spring 1979

(2)
Recent statutory and regulatory changes perm it
com m ercial banks and th rift institutions to offer “ check
able” deposits that are not included in the demand
deposit component of M t. Since 1972, various changes
in regulations by the Congress and state authorities
have extended the ability of commercial banks and th rift
institutions in the New England states and New York to
offer NOWs. Balances in NOW accounts are w ith
drawable by negotiable orders, which function sim i
larly to checks, but interest is paid on the balances
as well. These transactions-oriented balances are ex
cluded from the current definition of Ma and, indeed,
NOW accounts at th rift institutions are excluded even
from M2. In addition, in November 1978, revised banking
regulations permitted individuals to authorize their
comm ercial banks to transfer funds autom atically from
savings accounts into checking accounts, enabling

consumers to maintain transactions balances in
interest-bearing accounts until actually needed. As of
December 1978, there were about $3.9 billion in NOW
accounts and about $3.0 billion in savings accounts
subject to automatic transfers, relatively small amounts
when compared with an Ma level of $361.5 billion. Also,
in some states, th rift institutions offer demand deposits
and credit unions allow deposits to be w ithdraw n by
share drafts. Credit union share drafts are not in
cluded in
or M2i and demand deposits at th rift insti
tutions are not included in any of the current aggre
gates except 1 ^ + . The total volume of demand deposits
at th rift institutions and credit union share drafts is
small, but growing. All these new types of deposits tend
to distort Mi as a measure of transactions balances.
(3)
Additional changes have been made in the regu
lations governing savings accounts. In 1975, member

Table 2

Comparison of Current and Proposed Definitions of the Monetary Aggregates

Components
Currency in c irc u la tio n .............

M,
Current Proposed

M ,+
Current Proposed

M,,
Current Proposed

m3
Current Proposed

m4
Current

Current

At commercial banks:
X

NOW a c c o u n ts...........................

Savings subject to automatic
transfer ........................................

Demand deposits* ...............

Small time deposits .................

Large time deposits^ ...............

Other savings a c c o u n ts !........

CDs« ............................................
At th rift institutions:

Demand deposits .....................

NOW a c c o u n ts ...........................

Other savings a c c o u n ts !!........
Other time deposits .................
Credit union share d r a fts ........

* The definition of demand deposits differs between the current and proposed aggregates for technical
considerations such as the exclusion of deposits held by foreign institutions at domestic banks in the
proposed definitions. Precise definitions and historical data may be found in the Federal Reserve Bulletin.
t Excluding negotiable order of withdrawal (NOW) accounts and savings subject to automatic transfer.
$ $100,000 or more.
5 Negotiable certificates of deposit in denominations of $100,000 or more issued by large weekly reporting banks.
11 Excluding NOW accounts.

FRBNY Quarterly Review/Spring 1979

commercial banks and Federally chartered savings and
loan associations were authorized to make telephone
transfers from savings accounts to checking accounts
and to make preauthorized payments to a third party
from savings accounts. Also, state and local govern
ments in 1974, and corporations in 1975, were first al
lowed to hold savings deposits at commercial banks,
providing a convenient way for these depositors to earn
interest on funds that otherwise would probably have
been held as demand deposits. These accounts are often
used by smaller business and governmental units with
out sufficiently large amounts of funds to invest in
money market instruments on a short-term basis. This
is particularly true for state and local governments
because state laws governing eligible investments are
often very restrictive. At present, there are approxi
mately $15.0 billion in such accounts.
(4) Other time deposits at commercial banks and
thrift institutions in denominations under $100,000 have
become more distinct from savings deposits. This has
occurred not only because of increasing use of savings
deposits for transactions purposes, but also because
changes in regulations since 1973 have permitted
higher interest rates on time certificates with maturities
over ninety days while at the same time imposing sub
stantial penalties for early withdrawal. As a result,
while savings deposits have remained liquid and have
become more oriented toward transactions purposes,
small other time deposits have becomes less liquid and
less transactions-oriented than in earlier years. Thus,
these two types of liabilities probably should not be in
cluded at the same point in moving along the spectrum
from a very liquid, transactions aggregate to a broader
aggregate containing less liquid stores of value.
(5) There do not appear to be any economic rea
sons to separate demand, savings, or nonsavings time
deposits at thrift institutions from comparable cate
gories of deposits at commercial banks. In the current
definitions, M3 and M5 are relatively consistent
across institutions while Mlf Mx+, M2, and M4 are not.
To eliminate these shortcomings in the current defi
nitions, the Board staff has proposed four new mone
tary aggregates that would substitute, at least initially,
for the current six definitions (Table 2).
Proposed Mt and Mt+ : The proposed definition of
Mj equals the current definition of Mt (currency in
circulation outside banks and privately held demand
deposits at commercial banks), plus other deposits
subject to withdrawal by check or other negotiable
order at all commercial banks and thrift institutions,
together with savings subject to automatic transfer,
less demand deposits of foreign commercial banks and
official institutions. This aggregate is defined to include
only transactions balances at depository financial ir £er-

mediaries. On the proposed basis, M j+ would be equal
to the proposed definition of
together with all con
ventional savings deposits at commercial banks. This
aggregate, however, may only be used for a limited
period of time until the initial transition to ATS is com
plete. Unlike the other proposed aggregates, it is not
consistent across institutions; it includes savings de
posits at commercial banks but excludes savings
deposits other than NOW accounts at thrift institutions.
Proposed M2: M2 would be redefined to include the
proposed definition of Mx, together with savings de
posits at commercial banks and thrift institutions. This
measure includes transactions balances as well as
those deposits most readily convertible into trans
actions balances. Compared with the current definition
of M2, this aggregate reflects the changes proposed
for M1( while also excluding other time deposits at com
mercial banks and adding savings deposits at thrift
institutions.
Proposed Ms: M3 would be redefined as proposed M2
plus all time deposits at banks and thrift institutions
whether over or under $100,000. This aggregate mea
sures the deposits of the nonbank public at financial
intermediaries. Besides reflecting the changes in the
Mt component, this proposed definition of M3 differs
from the one currently used by including CDs at large
commercial banks. It is approximately equivalent to the
present definition of M3 (current M3+CDs).
The definitional changes proposed by the Board staff
correct many of the conceptual shortcomings of the
current monetary definitions stemming from lack of
consistency across institutions and the new types and
uses of deposits permitted by regulatory changes. By
including deposits with similar liquidity characteristics
at each level of aggregation, the proposed definitions
for M1( M2, and M3 are consistent across both com
mercial banks and thrift institutions. At the same time,
these proposed definitions recognize that regulatory
changes— which permit increased use of savings ac
counts for transactions purposes and which encourage
lengthening the average maturity of small time deposits
through higher ceiling rates for longer maturities—
have given savings and time deposits distinct liquidity
characteristics. Thus, it seems desirable to include
savings deposits in the more transactions-oriented M2
and to include small time deposits in the more wealthoriented measure, M3.
However, it is not clear that time deposits of
$100,000 or more— both CDs and LTDs— should be
treated in the same way as small time deposits under
$100,000. They have different liquidity characteristics
and different responses to changes in market rates of
Thterest. Smjll time deposits are subject to interest
’•ate ceilings and have maturities of up to eight years

FRBNY Quarterly Review/Spring 1979

Chart 1

Chart 2

O u ts ta n d in g R e p u rc h a s e A g re e m e n ts

M o n e y M a rk e t F u n d S h a re s

Billions of dollars
22

L u i l i.i 1111111 11111111111 i 1111111 1111 11
1970

Data for 1979 are plotted monthly; 1970 through 1978
plottings are quarterly.
Sources: Board of Governors of Federal Reserve System
and Federal Reserve Bank of New York.

or more, making them relatively illiquid because of the
substantial penalties fo r early w ithdrawal. In contrast,
LTDs and CDs are not subject to interest rate ceilings
and generally have relatively short maturities. More
over, negotiable CDs are traded in a secondary market,
making them highly liquid regardless of m aturity date
but also subject to capital risk.7 Thus, time deposits
of $100,000 or more present particular conceptual
problems, and it is not clear that they belong in M3
or in some aggregate that contains various money
m arket instruments.

Other issues in defining the aggregates
Conceptual problems of a different sort are raised by
the developm ent of a variety of nondeposit assets,
spurred by high levels of interest rates that have caused
individuals and corporations to seek new ways to
minimize noninterest-bearing transactions balances
while m aintaining liquidity. These nondeposit assets
are highly liquid, a characteristic of traditional trans
actions balances, yet they earn m arket rates of interest.
Chief among these are RPs, Eurodollar deposits, com
7 For more detail, see William C. Melton, “ The Market for Large
Negotiable CDs” , this Quarterly Review (Winter 1977-78), pages 22-34.

FRBNY Q uarterly R eview/Spring 1979

Sources: Donoghue's Money Fund Report (Holliston,
Massachusetts) and Investment Company Institute.

m ercial paper, and money m arket mutual funds. These
instruments either are “ checkable” or may have o rig i
nal m aturities as brief as one day, making them close
substitutes fo r demand deposits.
Repurchase agreements: Large corporations are able
to minimize their demand deposit balances by placing
excess funds each day in the short-term money market.
One way to do this is by arranging an RP— a secured
placem ent of imm ediately available funds in w hich the
borrow er sells securities to the lender and agrees to
repurchase them at a predeterm ined price at a future
date (often the next day).8 Such a transaction between
a corporation and a com m ercial bank would convert a
co rp oratio n ’s demand deposit asset into an interestbearing asset that would not be counted in any of the
current or proposed aggregates. Yet, since the funds
can be com m itted fo r periods of time as brief as just
overnight, they are still readily available fo r transac
tions purposes.
The RP m arket has grown very rapidly since 1970.
W hile the total volume of outstanding RPs is not
8 For more detail, see C.M. Lucas, M.T. Jones, and T.B. Thurston,
“ Federal Funds and Repurchase Agreements", this Quarterly Review,
(Summer 1977), pages 33-48.

known, such transactions at forty-six major money
center banks that report these transactions daily to
the Federal Reserve have increased since 1970 from
about $3.8 billion to about $20 billion. A survey in
December 1977 conducted by the Federal Reserve
S/stem indicates that 60 percent to 70 percent of these
RPs are arranged with nonfinancial corporations. While
these banks probably represent a large part of the
market, corporations may also arrange RPs with
smaller banks, with nonbank financial intermediaries,
or with other nonfinancial corporations. For example,
nonbank Government securities dealers use the
RP market to acquire funds from corporations and
others to finance their positions. At the end of 1978,
these dealers obtained about $2.0 billion each day
from corporations through RPs (Chart 1). Recognizing
the importance of RPs as an instrument for managing
demand deposits, the Board staff has proposed collect
ing data and estimating a series for RPs between all
commercial banks and money stock holders.
Money market mutual funds: These funds permit
investors to purchase shares in a portfolio of money
market instruments, thereby enabling them to earn
market rates of return without the large sums normally
needed for direct investment in such instruments.
Shares in money market funds also are highly liquid,
since they usually can be withdrawn by negotiable
orders— typically in $500 minimum amounts. Despite
the high degree of liquidity afforded by these shares,
they are not included in any of the current or proposed
aggregates. Assets of money market funds grew
from virtually zero prior to 1974 to $10.7 billion at
the end of 1978 (Chart 2). In the first three months of
1979, these funds increased another $7.2 billion.
Other liquid assets: Various short-term money market
instruments such as commercial paper or Eurodollar
deposits serve much the same cash management func
tion as RPs. Eurodollar deposits, in particular, probably
play an important role in the management of money
balances. As the financial system continues to develop,
other similar assets will undoubtedly become important.
All these instruments are potentially such close and
important substitutes for demand deposits that the
question arises whether some measure of them should
be included in the monetary aggregates, perhaps even
a fairly narrow definition. There are serious problems,
however, with including them. Reported data on these
instruments are not very complete. In particular, data
do not allow precise calculation of RPs between all
banks and nonfinancial corporations, or for that matter
among nonfinancial corporations. Adequate data for
short-term commercial paper and Eurodollars are not
available. Moreover, to include these instruments in a
definition of money, even if adequate data were avail

able, arbitrary guidelines would have to be established,
such as limiting the amount included to original ma
turities of one day or perhaps a few days at most.
Given these difficulties, the Board staff has limited the
scope of the proposed money definitions to the depos
its of banks and thrift institutions. But, even if these
liquid assets are not included explicitly in the mone
tary definitions, their impacts must still be recognized
to help explain the behavior of the current and pro
posed aggregates. The collection and publication of
more complete data on RPs, as proposed by the Board
staff, should greatly facilitate such analysis.
While the narrowest definition of money stresses its
role as a medium of exchange, the broader definitions
emphasize the store-of-value aspect of money. In this
role, there are many close substitutes for the liabilities
of depository institutions that are not included in the
definitions proposed by the Board staff. Not only in
struments of very short maturity, but also highly liquid
assets maturing after several days or even weeks, merit
consideration in defining the broader monetary aggre
gates. If the broad money stock is to be defined to
include large CDs, should not term RPs, bankers’
acceptances, Treasury bills, commercial paper, and
Eurodollar deposits be included at some point as well?9
A preliminary analysis, based on available data, sug
gests that the increased use of highly liquid nondeposit
assets could well be at least as important as the devel
opment of new types of deposits in explaining the
apparent shift in the money demand function since
mid-1974. For example, at the end of 1978, the total
volume of the new types of deposits and nondeposit
assets, shown in the top panel of Chart 3, was very
close to the estimated shortfall in the public’s demand
for money as measured by Goldfeld’s money demand
equation (Chart 3, bottom panel). Prior to mid-1974, the
errors from the money demand equation using the
current Mx definition were small, as was the total
volume of those various deposit and nondeposit items
that are close substitutes for demand balances. After
mid-1974, however, the errors from the money demand
equation began to cumulate to an unprecedented
extent— mirrored by the increased volume of near
* The question of including Eurodollar deposits in the definitions of
money is important but is surrounded by particularly difficult
measurement and conceptual problems. Eurodollar holdings of
United States resident individuals and corporations other than banks
have grown rapidly in recent years, but reliable data are not available
at present. Conceptually, very short-term Eurodollar deposits are
similar in many respects to RPs (although they are not collateralized).
Other Eurodollar deposits, probably representing the bulk of the
market, are similar to time deposits issued by domestic banks. There
seems plausible reason to suspect, however, that the proportion of
Eurodollars related to international rather than domestic transactions
must be substantially higher than is the case for the analogous
domestic instruments.

FRBNY Quarterly Review/Spring 1979

Chart 3

The Growth of Close Money Substitutes Has
Mirrored the Shortfall in Money Demand
Billions of dollars
60

_ f i n l I I I I I I I 1 I I I 1 I I I 1 I I I 1 I 1.1 I j - L
1970

* Sum of corporate and state and local government savings
deposits, NOW accounts, savings subject to automatic
transfers, credit union share drafts, and demand deposits
at thrift institutions.
t Sum of repurchase agreements (RPs) at nonbank Government
securities dealers with nonfinancial corporations, RPs at
forty-six large commercial banks, and assets of money
market mutual funds.
+ Post - 1969 errors from Goldfeld’s money demand equation
using the current definition of M1.

monies, stemming both from regulatory changes and
from innovations. The outstanding volume of substi
tutes fo r comm ercial bank demand deposits— resulting
from regulatory changes that perm it (1) the creation
of other “ checkable” deposits at commercial banks
and th rift institutions and (2) savings deposits fo r co r
porations and state and local governments at banks—
was only about two fifths of the m agnitude of the short
fall in Mi. But the total volume of the nondeposit assets
(Charts 1 and 2) was roughly equal to the remainder.
W hile the new types of deposits and nondeposit

assets shown in Chart 3 present a m irror image
of the estimated shortfall in the demand fo r money,
the result is to some extent fortuitous. On the one
hand, it is likely that the total amount of RPs out
standing is considerably more than the amount
shown for the forty-six banks fo r w hich data are avail
able. On the other hand, the total amount outstanding
cannot be expected to represent a d ollar-for-d olla r
reduction in demand deposits, inasmuch as some RPs
are arranged fo r periods longer than one day and even
some one-day RPs may not be perfect substitutes fo r
demand deposits. Also, some of the increase in money
m arket mutual funds undoubtedly has come from other
sources than demand deposits and, in fact, relatively
few checks have been drawn against fund shares.
At the same time, data lim itations preclude the
measurement of some highly liquid assets that are
very close substitutes fo r demand deposits. Further
more, not all the reduction in money holdings resulting
from cash management w ill necessarily be reflected
in the growth of nondeposit liquid assets. Part of it
may be reflected in other portfolio adjustments, such
as reduced business borrow ings at com m ercial banks
or in the com m ercial paper market. With all these
caveats, the available evidence nevertheless suggests
that the monetary aggregates w ill continue to be
d ifficult to forecast and to control unless allowance is
made not only for the new types of transactions de
posits resulting from regulatory changes but also fo r
highly liquid assets that have developed as a result of
the increased emphasis on cash management.
In summary, as a result of regulatory changes and the
continuing developm ent of the financial system, as well
as some conceptual problem s inherent in the current
money definition, it seems appropriate to redefine the
monetary aggregates. The Board staff has made a ma
jo r contribution in proposing definitional changes to
correct for shortcom ings stemming from regulatory
changes and from lack of consistency across deposi
tory institutions. The proposed definitions are restricted
to the deposit liabilities of financial interm ediaries and
do not incorporate highly liquid nondeposit assets.
There are, to be sure, serious conceptual and measure
ment problems with the inclusion of such assets in
monetary aggregates. Nevertheless, interpretation of
monetary phenomena would seem to require that ac
count be taken of developm ents in highly liquid non
deposit assets. The financial system is changing con
tinuously, and no one definition of the aggregates can
be w holly satisfactory fo r all purposes.

John Wenninger and Charles M. Sivesind

FRBNY Q uarterly R eview/Spring 1979

New York’s Insurance Industry
Perspective and Prospects
New York City is the home of some of the world’s larg
est life insurance companies and of the nation’s pre
mier market in commercial property-1 iability insurance.
Twenty years ago jobs in the city’s insurance industry
accounted for nearly half of all financial employment in
New York. Today this share has fallen to less than a
third. Moreover, since 1950 the fraction of the nation’s
insurance work force employed in New York City has
more than halved, from 16 percent to less than 7 per
cent or about 100,000 jobs. This decline stems from
many causes, among them the relatively slow growth of
local markets, laborsaving technological changes, the
decentralization of insurance operations, and burden
some taxes and regulations.
In terms of the future, there is evidence that some
of these negative influences are dissipating. The re
gional economy appears to be stabilizing, and New
York is becoming increasingly competitive with other
locations as business costs rise more slowly than in
the rest of the nation. An important element in the im
proving business climate has been governmental ac
tions taken in recent years. Changes have been made
to reduce regulatory and tax burdens on insurance.
Moreover, the brokerage and underwriting community’s
ability to compete worldwide has been strengthened by

This article would not have been possible without the assistance of
many individuals who shared their knowledge of the insurance indus
try. In particular, thanks are due to Bruce Abrams, William Berry,
Stanley Bron, Mario Carfi, George Conklin, John Cox, David Cummins,
John Gosden, Maurice Greenberg, Barry Greenhouse, William Halby,
Paul Klein, James Koehnen, Donald Kramer, Matthew Lenz, Dan McGill,
Wayland Mead, Joseph Murphy, Francis Schott, Richard Shinn,
Thomas Stapleton, Lee Vaughn, and John Verel, none of whom bear
responsibility for the opinions expressed herein.

the recently instituted Insurance Free Zone and the
prospective Insurance Exchange. These recent trends
lend hope that the decline in insurance-related jobs
can be arrested and might possibly be reversed.
Structure of the insurance industry: overview
By New York State law, individual companies are li
censed to sell life insurance or property-liability insur
ance, but not both types of policies.1 Life insurance
policies are long-term contracts to insure relatively pre
dictable risks. Property-liability policies are written for
shorter time periods (typically one year), and generally
cover less predictable risks. Many of the largest insur
ance corporations now have subsidiary companies in
both areas, but the individual companies remain opera
tionally distinct as required by statute. The types of
risks covered and the regulatory environment vary be
tween the two sectors, fostering differing sales tech
niques, investment strategies, and job skills.
Life insurance companies sell individual life and
individual accident and health insurance directly to
consumers and also sell group insurance plans, pri
marily through employers. Similarly, property-liability
insurance covers the so-called “ personal lines” that
insure homes and automobiles of ordinary consumers,
as well as “ commercial lines” that insure business
property and liability. These distinctions are important
1 An exception is accident and health insurance, which is sold by
'b&&M 3ropei^^jability companies and life insurance companies.
Property-/T« B te jpsuranee includes automobile liability and physical
damage i n ^ ^ k ; ^ homeowners and commercial multiple peril
insurance, fire and allied lines, inland and ocean marine, workers’
compensation, burglary and theft, surety, fidelity, glass, boiferarrd
mrchinery, and aviation insurance.

FRBNY Quarterly Review/Spring 1979

because the size and complexity of the policies issued
affect the types of marketing systems employed, which
in turn influence the location of insurance jobs.
Insurance is marketed through three distribution net
works that overlap somewhat. Much of the individual
insurance market is serviced by the American Agency
System which comprises thousands of independent
agents, each of whom typically represents a number of
companies and is reimbursed on the basis of the pre
miums received from policies sold. In most areas, how
ever, these independent agents and the “ agency com
panies” that they represent are in direct competition
with “ direct writers” — companies that employ their
own branch networks to sell directly to consumers.2
In addition, large commercial property-1 iabiIity risks
as well as a substantial fraction of the group life and
health plans are handled through a third network of
insurance brokers.
Brokers differ from agents in their authority to
“ bind” the company to an insurance contract. Brokers
submit their business to company underwriters who can
accept or reject it; it is the underwriter who binds the
company. Agents, however, have contracts with com
panies that allow them to commit the company on
certain types of policies, usually up to some specified
limit per policy.
Many insurance brokerage firms deal primarily in
large commercial risks. The largest brokerage firms
are national companies, with branch systems through
out the country. Their head offices, however, are lo
cated in the major insurance centers, where highly
skilled personnel put together complex insurance con
tracts. Since these risks are frequently shared among
several insurance companies, brokers benefit from
proximity to the companies’ underwriters. As a result,
they have remained fairly concentrated in cities such
as New York even when the ultimate market for their
services is widely dispersed. In contrast, agencies and
the branch offices of direct writers of individual insur
ance typically market standardized personal policies
to consumers in their local market.3 Because the sale
2 Direct writers, as used here, include both those companies that
employ salaried sales representatives and those companies that sell
through "exclusive agents” . Exclusive agents represent only one
company but are reimbursed on the basis of commissions.
The overwhelming majority of individual life insurance policies are
sold through exclusive agencies. The sale of personal lines propertyliability insurance is more equally divided between independent agents
and direct writers.
* Although the vast majority of individual insurance is sold through
agents or direct writers and nearly all large commercial policies are .
brokered, there is substantial overlap. Some agents do a itfk til?
sophisticated large-risk business, while many brokers s l^ ^ im a r ily
small personal-lines policies. In particular, in New York City, for
historical reasons virtually all property-liability insurance is purchased
through brokers.

FRBNY Quarterly Review/Spring 1979

of these policies does not require the same interaction
of insurance professionals, there is little reason to cen
tralize this activity. Consequently, jobs involved with
the sale of individual insurance tend to locate close
to the consumers.
The New York industry: early years
During the nineteenth century, the sales operations
and head offices of insurance companies were con
centrated in the nation’s urban centers. With travel
difficult, communications slow, and trade between re
gions limited, companies with large local markets had
decided advantages. At the same time, the infrastruc
tures of American cities facilitated home-office activi
ties. Trolleys and later subways enabled the office
district to draw workers from great distances, thus
increasing the available labor force. Elevator buildings
supported higher densities of activity, which made for
easy personal contact. Typewriters, adding machines,
and other office equipment made it technologically
feasible for commercial businesses to hire pools of
clerical workers to mass-produce outputs such as in
surance policies.
As the country’s largest, most developed urban
center, New York City provided special attractions for
the insurance industry. For example, because of the
commercial activity of the port of New York, the city’s
property-liability insurers gained special expertise in
large commercial risks. New York became the largest
commercial insurance market in the country; and, to
reach this market, property-liability companies that
were headquartered in other cities also established
major underwriting and administrative offices in Man
hattan.
The easy personal contact afforded by New York
City was especially important in the property-liability
industry. The early companies were clustered together,
making them readily available to brokers who typically
went from firm to firm to market their risks. This close
proximity also enabled companies to “ spread the risk”
by reinsuring with one another. When one company
reinsures business with another company, it assigns
all or part of the premium income from that business
to the reinsurer, in return for which the reinsurer as
sumes the corresponding proportion of the risk.
The investment activity of Wall Street drew early
life insurers to downtown Manhattan. Although they
were prevented by law from investing directly in spec
ulative ventures, prior to 1905 many New York life in
surers did so indirectly by holding interests in Wall
Street banks and investment houses— investments that
were relatively risky in those days.
By the turn of the century, New York insurers domi
nated the industry. In 1900, New York’s “ domestic” life

insurance companies— those chartered by (or dom i
ciled in) New York State— accounted for less than one
fifth of the nation’s life insurance companies, but they
collected more than half of the total United States life
insurance premiums. The p roperty-liability industry was
far less concentrated, but New York was still important.
Companies dom iciled in New York State accounted
fo r nearly one fifth of the nation’s p roperty-liability
premiums, although they were only a tiny fraction of
the country’s 2,000 fire, marine, and casualty com
panies. Most of New Y o rk’s dom estic insurance com
panies were headquartered in New York City, and the
concentration there of sales and head-office personnel
made the insurance industry one of the c ity ’s largest
employers of w hite collar workers.

The New York industry: maturity
Spurred by the growth of the New York m etropolitan
region, the relative importance of New Y ork’s property-

Chart 1

Share of Total United States Insurance
Premiums Received by New York
Domestic Companies
Percent
60

1900

1920

1940

1950

1960

1970

1976

Sources: New York Insurance Department, Statistical Tables
from Annual Statements: American Council of Life Insurance,
Life Insurance Fact Book: The Spectator Company New York,
Thejnsurance Yearbook 1901-1902. Life and Miscellaneous:
Insurance Information Institute, Insurance Facts: A.M. Best
and Company, Best’s Review. Propertv-Casualtv Edition
(December 1948) — property-liability data for 1898 were used,
since 1900 data on United States property-li.
were not available.

liability industry continued to increase during the early
part of this century. The share of total United States
property-liability premium income received by New
York-dom iciled companies increased from less than
20 percent in 1898 to more than 25 percent in 1940.
Moreover, since out-of-state companies traditionally
located m ajor underw riting activities in New York City,
it is likely that the insurance premiums received by New
York dom estic firm s understated the importance of the
c ity ’s pro pe rty-liab ility industry during this period.
In contrast to the growth of property-liability insurers,
in the first decades of the century New Y o rk’s life
insurance industry suffered a serious setback. In 1905,
public criticism of industry practices prompted the
New York State legislature to conduct a thorough
investigation of life insurance companies then operating
in the state. Widespread abuses were uncovered, and
the New York State legislature responded by severely
tightening its insurance regulations. Indeed, the 1906
New York Insurance Code has served as the model for
tw entieth century insurance regulations. The sharp
erosion in the m arket share of New York-dom iciled
life insurance companies— from nearly 60 percent of
United States premium income in 1900 to 40 percent in
1920— can in large part be attributed to the regulatory
restrictions as well as to the somewhat tarnished
image of New York companies immediately following
the investigation.
Between 1920 and 1940, the market share of New
Y ork’s dom estic life insurance companies stabilized
while that of the dom estic property-liability companies
continued to increase. Since 1940, however, New York
C ity’s importance as an insurance center— in both life
and property-liability business— has declined steadily
(Chart 1). This is evident from employment data as well
as premium income data.4 W hile total insurance em
ployment in New York City expanded from 1950 to
1957, the advance was slower than for the nation as
a whole. This disparity increased between 1957 and
1976, when insurance employm ent in the city fell by
19,000 jobs, a drop of about 15 percent, while insur
ance jobs in the nation rose by nearly 70 percent.
Over the entire period, from 1950 to 1976, New York
C ity’s share of the United States insurance w ork force
declined from 16 percent to less than 7 percent.
* In this article, employment is measured by the Bureau of Labor
Statistics series on “ covered employment” , that is, employees covered
by unemployment compensation. Covered employment data are
available for earlier years and with greater industry detail than the
more commonly cited payroll employment. In general, the trends of
the two employment series parallel each other. However, the covered
employment series does not follow exactly the payroll employment
series because the proportion of workers covered by unemployment
compensation has increased over the years. The increase in coverage
has probably affected the New York and United States series similarly.

FRBNY Quarterly Review/Spring 1979

Chart 2

Chart 3

Insurance Employment by Sector:
New York City

Insurance Employment by Sector:
United States

Thousands of employees
60 ----------------------------

Thousands of employees
500-------------------------------Life insurance

Accident and health
companies

o i^ r r r r

1950 52

Source:

68 70

74 7677

New York State Department of Labor.

Employment trends have varied somewhat among the
individual subsectors of New Y ork’s insurance industry.
Employment w ith life insurance companies, w hich ac
count for the largest number of insurance jobs in New
York City, advanced until the early 1970’s. Since then,
however, the New York life insurance companies have
sharply reduced their work force. Between 1972 and
1977, some 13,000 jobs were lost— 25 percent of the
1972 total (Chart 2). Nationally, the number of em
ployees of life insurance companies also declined in
the 1970’s, but the rate of decline was much slower
than in New York (Chart 3). By 1976, the city ’s share
of the co un try’s life insurance jobs had fallen to less
than 10 percent, down from 15 percent in 1950 (Chart 4).
In contrast to employment in the life insurance sec
tor, the number of jobs with property-liability com
panies, the second largest employer of insurance
w orkers in New York City, has declined almost every
year since the peak in 1957. Over the ensuing twentyyear period this sector lost 16,000 jobs, or nearly 40
percent of its 1957 work force. More recently, how
ever, employment in this industry appears to have
stabilized, and in 1977 property-liability companies
actually increased their work force a bit in New York.
With national employment in this sector expanding
virtually every year since 1950, New York C ity’s share
of United States jobs with property-liability companies
dropped from 18 percent in 1950 to 5 percent in 1976.
Jobs in New York with independent agencies and
insurance brokerage firm s and with accident and
health companies have actually increased over the last
tw enty-five years. But the employment growth has been

FRBNY Quarterly R eview/Spring 1979

1950 52

Source:

70 72

United States Department of Labor.

very modest relative to these sectors nationally. Con
sequently, in these sectors as well, New Y o rk’s share
of United States total employment has fallen.

Why has New York City lost insurance jobs?
More than 200 dom estic insurance companies are
headquartered in New York City. In addition, New York
is host to the regional sales and underw riting offices of
numerous out-of-state companies that are licensed to
sell in New York, as w ell as to the offices of the
independent agents and brokers that service the New
York market. In 1977 the New York insurance industry
employed nearly 100,000 w orkers and accounted fo r
about one third of New York C ity’s total financial em
ployment. Despite its size, New Y ork’s insurance
industry has failed to keep pace w ith the employm ent
gains elsewhere in the country. Indeed, if over the past
thirty years the c ity ’s insurance w ork force had kept
pace with the rest of the industry, there w ould be
225,000 insurance jobs in New York today— more than
tw ice the actual number.
M arket dispersal
Much of the relative decline in New Y o rk’s insurance
employment ultim ately can be traced to the shift
of insurance policyholders away from the traditional
home markets of New York companies. For example,
between 1940 and 1976, the fraction of total United
States life insurance premiums paid by New York State
residents fell from 17.7 percent to 7.0 percent. At the
same time, the fraction of total United States propertylia b ility premium income received fo r risks located in

New York declined from 17.3 percent to 9.4 percent.
Since insurance is one of the multitude of business
service industries that are attracted to headquarters
centers, these trends reflect the relocation of corpo
rate headquarters away from New York as well as the
nationwide dispersal of individual policyholders.
Faced with the relatively slow econom ic growth of
the New York region and the geographical dispersion
of the nation’s insurance market, New York companies
have had to compete fo r business in distant markets.
As a consequence, between 1940 and 1976, New Yorkheadquartered life insurance companies increased the
fraction of their total premiums received from out-ofstate residents from less than 50 percent to nearly 90
percent. Since insurance salesmen and the service
personnel who collect premiums and process claim s
and policy loans are closely tied to the local market,
the dispersal of business away from the New York
region has been accom panied by a decentralization of
m arketing-related jobs.
Com puterization
The slow growth of sales-related employment is only
part of the explanation. The home offices of New York
C ity’s dom estic insurance companies also provide a
substantial number of jobs, and these, too, have failed
to expand in recent years, prim arily because of produc
tivity increases resulting from automation.
Insurance was one of the first industries to use the
computer extensively in business operations. The sale
and production of an insurance policy had traditionally
involved the routine processing of numerous standard
ized form s by low-wage clerical workers— operations
that are highly amenable to com puterization. When the
life insurance industry began automating in the 1950’s,
computers were huge, m ultipurpose machines that
tended to be located in the head offices close to other
operations. Hence, although productivity increases as
sociated with automation reduced employment growth,
the jobs continued to be in New York.
In contrast to life insurance companies, the main
impetus to com puterize processing in the propertyliability industry did not occur until the 1960’s. By then,
computer technology had progressed sufficiently that
companies could locate expensive com puter hardware
in suburban areas to take advantage of lower wages
and to minimize the risks associated w ith centralizing
such activities in problem -plagued urban centers. In
deed, property-liability companies that were in the early
stages of com puterization in the 1960’s frequently
chose to locate their electronic data processing (EDP)
operations outside the city. As a consequence, employ
ment w ithin New Y o rk’s property-liability companies
fell both because of laborsaving com puterization and

because of the relocation of jobs outside New York.
Since many large life insurers had made substantial
investments in com puter hardware at th e ir headquar
ters, they were less inclined to decentralize these oper
ations in the 1960’s. But by the 1970’s, w ith further
advances in teleprocessing and developm ents in
sm aller less costly computers, the life insurance com
panies also had begun to relocate their EDP operations
outside the city.
Regulation
New York State insurance regulations have dissuaded
new companies from dom iciling in the state, and this
in turn has reduced the growth of headquartersrelated jobs in New York City. This has been particu
larly evident in the life insurance sector where, since
1906, the New York State Insurance Code has imposed
relatively conservative restrictions on investments,
commissions, salaries, and the amount of business that
can be w ritten. These regulations apply to all com
panies licensed to do business in New York, regardless
of their states of dom icile. Moreover, the so-called
Appleton Rule prohibits New York-licensed companies
from engaging in practices in other states that are not
allowed in New York State. Hence, all business of New
York-licensed companies is affected by the New York
Insurance Code— not just that in New York State.
As a result of New York State’s pioneering consumer
protection in the insurance field, New York life insur
ance com panies’ reputations for soundness and relia-

Chart 4

S h a re o f U n ite d S ta te s In s u ra n c e J o b s

Located in New York City
Percent
2 5 -------

Life
insurance
companies

Propertyliability
companies

Independent
agents and
brokers

Accident
and health
companies

Sources: New York State Department of Labor and
United States Department of Labor.

FRBNY Quarterly R eview /Spring 1979

bility have grown over the years and consumers have
undoubtedly benefited. Nevertheless, the regulations
have had adverse implications for the competitiveness
of New York-licensed companies and have served as
a disincentive to companies that might otherwise locate
in the state. A key example is the restriction on com
mission rates that New York-licensed companies can
pay to sales personnel. As a result of this regulation,
New York-licensed companies find themselves at a
competitive disadvantage in markets outside the state
because they cannot increase commissions to attract
and retain agents.
New York’s commission limitations are particularly
restrictive for new companies trying to establish them
selves in an area. Consequently, most new life insur
ance companies have chosen to become chartered in
other states and have avoided the New York market al
together. Others also have domiciled out of state but
have subsequently established a New York-domiciled
subsidiary company licensed only in New York. This
allows access to the New York market without expos
ing out-of-state business to New York regulations.
Because life insurance companies typically locate
their home offices in their state of domicile, New York’s
failure to attract new life insurance companies has
cost it jobs. Over the first fifty years of the century the
number of New York-domiciled life insurance com
panies grew from fourteen to twenty-three, an increase
of over 60 percent, but the number of companies
nationwide posted a sixfold increase from less than
100 to close to 650. While the growth of New York
companies has outpaced the nation since 1950, the
vast majority of the newly established New York com
panies simply represents New York subsidiaries of
major out-of-state insurers. As a result, the positive
impact of these increases on headquarters-related
employment in the region has been relatively small.
Although the number of New York domestic propertyliability insurers has actually declined by one third
since 1950, this has not caused an equivalent decline,
in New York property-liability insurance activity or in re
lated employment. Unlike life insurers, property-liability
companies frequently locate all or part of their
headquarters operations outside their state of domicile.5
Thus headquarters-related jobs in any state are only
loosely tied to the number of its domestic companies.
Much of the contraction in the number of propertyliability insurance companies has resulted from legal
reorganizations that have had limited effects on New
5 New York City has been the major beneficiary of this trend. Numerous
out-of-state companies maintain major underwriting operations in the
city to gain access to the New York market, and several companies
domiciled in other states also have their executive offices in New York.

FRBNY Quarterly Revi-ew/Spring 1979
Digitized for14
FRASER

York’s headquarters-related employment. Following
New York State’s decision in 1949 to allow multiplelines underwriting, a general consolidation took place
nationwide as property companies merged with
casualty companies.4 The ensuing reduction in the
number of New York companies was substantial. Be
tween 1948 and 1958, the New York domestic industry
contracted from 307 to 231 companies, a decline of
20 percent. There was not, however, a concurrent de
cline in insurance sales, and employment with New
York property-liability companies actually grew over
this period. Moreover, although the consolidation may
have resulted in some contraction of the work force
to eliminate duplication, merged companies did not in
general disappear from the New York insurance scene.
Even when a New York company was merged into a
company domiciled out of state, it typically continued
to do the same business out of the same New York
office as before.
Taxes
In addition to the regulatory burden, increases in New
York’s insurance taxes during the late 1960’s and early
1970’s also reduced the willingness of insurance com
panies to domicile in the state. High taxes are them
selves a disincentive. In insurance, however, the im
pact of high taxes imposed by any one state is magni
fied by the prevailing system of so-called interstate
retaliatory taxation.
Insurance companies are taxed by each state on the
policies they write on risks located within that state.
Furthermore, all states with domestic insurance com
panies also levy retaliatory taxes. Suppose, for ex
ample, that all states levy a standard premium tax of
2 percent, and that one state, say New York, chooses
to raise its rate to 3 percent. Companies domiciled out
side New York would pay the higher rate, but only on
the policies they wrote on risks located in New York.
In contrast, New York’s domestic companies would be
required to pay 3 percent, not only on the business
they wrote in New York, but also on their business in
any other state with retaliatory tax laws. Hence, the
burden of any general increase in a particular state’s
insurance tax falls more heavily on its own domestic
companies than on out-of-state companies licensed to
sell insurance in that state.
Retaliatory taxes were originally designed to pro4 Prior to this time, New York-licensed property companies were not
allowed to write casualty policies and vice versa. To be able to
provide their customers with a full range of insurance services, many
property (casualty) companies organized casualty (property)
subsidiaries and some even issued joint policies. When the legal
proscription on multiple-lines underwriting ended, many of these
subsidiaries were merged.

tect each state’s domestic companies from high taxes
in other states by penalizing the domestic companies
of any states charging the higher rates. They also have
had the effect of discouraging insurance tax increases
in general. For many years, 2 percent was the standard
premium tax throughout the country; and, even today,
most states continue to charge this rate.
In 1968, New York State raised property-liabiIity
premium tax rates from 2 percent to 2.25 percent, and
life premiums from 1.75 to 2 percent. However, to pre
vent retaliation, these increases applied to the New
York business of only New York domestic companies.
The tax on the New York premiums of out-of-state
companies remained unchanged.
By 1974, New York’s premium tax on domestic
property-liability companies and domestic life insur
ance companies had been raised to 2.6 percent and
2.25 percent, respectively. Some property-liability com
panies, which were members of insurance groups con
taining out-of-state companies, responded by trans
ferring their New York business to the out-of-state
companies to avoid paying the tax. Other companies,
unable to make this transfer, began to redomicile to
other states to reduce their tax burden.
In 1974, New York State acted to institute an insur
ance tax that did not discriminate against New York
State companies. The straight premium tax was re
placed by a combined income tax and premium tax.
Under the current system, the premium tax rate has
been reduced to 1.0 percent on life premiums and
accident and health premiums and to 1.2 percent on
property-liability premiums. But in both cases the pre
mium tax is supplemented by an income tax of 9.0
percent. In addition, each company’s total state tax
liability is limited by a “ cap” , or maximum, equal to
2.6 percent of total premiums.
When the 1974 tax changes were instituted, it was
hoped that other states would not retaliate against
income taxes and that the reduction in the premium tax
would solve the problem of retaliation. Neither hope
has been realized, however. Since the current tax is
applicable to the New York business of out-of-state
companies, many states seek to apply their retaliatory
provisions to the income tax. When the premium tax
equivalent of a New York company’s total New York
State tax exceeds the rate charged in another state,
the New York company is normally assessed the dif
ference in retaliatory taxes. As before, the New York
companies most affected are profitable firms with a
substantial proportion of their insured risks located
out of state.
The retaliatory squeeze on New York’s domestic
companies has been significantly lessened, however,
by the provision that allows them a credit against their

New York State taxes equal to 90 percent of the re
taliatory taxes that they pay to other states.7 Since their
institution in 1974, the credits granted by New York
State against retaliatory taxes have more than doubled
from $2 million to $5 million.
The 1974 tax changes reduced the tax burden on
New York’s domestic insurance industry but, by then,
a significant number of the state’s property-liability
companies had redomiciled. Nevertheless, the impact
on jobs and income has not been large. Redomiciling
is not the same as relocating, and the major commer
cial underwriting operations of nearly all the firms that
have obtained new charters from Delaware, Connecti
cut, or New Hampshire continue to be located in New
York City. Indeed, the majority of these remain in
downtown Manhattan. Hence, redomiciling has had
more impact on insurance companies’ tax liabilities
than it has had on their New York jobs.
Some of the states to which firms have redomiciled
have required that the insurance companies locate
certain jobs there in exchange for their charters. So
far, these requirements do not appear to have caused
the city to lose many jobs. In any case, the jobs that
have left appear to be concentrated in back-office
operations such as data processing— operations that
gradually have been relocating outside the city for
some years.
New York’s life insurance companies are also at a
tax disadvantage. Indeed, virtually all the state’s $5
billion in retaliatory credits have been paid to life
companies. But, unlike the property-liability companies,
no life insurance companies have chosen to redomicile,
in part because of fear of a challenge by the New York
State Insurance Department.8 Nevertheless, the new tax
indirectly constrains life insurance employment growth
by affecting product mix. Under the income tax portion

i To obtain the full 90 percent credit, a certain minimum fraction of a
company’s risks must be located in New York. Otherwise 90 percent
of the retaliatory taxes payable to other states could exceed the total
tax liability to New York State. In such a case, the company’s tax
payments to New York could fall to zero before offsetting the full
90 percent of the retaliatory taxes paid elsewhere.
Ironically, in such a case, redomiciling to a low tax state could
lower the tax liabilities of the company involved and at the same time
raise tax receipts to New York State. If the same number of employees
were to stay in New York, the premiums and income allocated to
New York State for tax purposes would remain the same, but
there would be no offsetting retaliatory credits.
Even in those cases where a company’s New York tax liability is
large enough to receive the full 90 percent credit, the remaining
10 percent of the retaliatory taxes is 10 percent that it would not be
required to pay if it redomiciled.
•Such a challenge could involve, among other things, the complicated
legal problem of how to allocate the liability of the New York Life
Insurance Guarantee Corporation for policies of any New York
domestic life company that would domicile elsewhere.

FRBNY Quarterly Review/Spring 1979

of the tax, investment income is taxed more heavily
than premium income. Because of the “ savings” com
ponent of individual whole life insurance, such policies
generate a larger portion of investment income per
dollar of premiums received than group or term insur
ance. Consequently, the switch from a straight pre
mium tax to a combination premium and income tax
creates incentives for New York companies to focus
increasingly on group and term insurance. Since these
areas are less labor intensive than individual whole
life business, the tax may be contributing to a further
reduction in New York City’s life insurance jobs.
The tax also increases the incentives for all in
surance companies to relocate jobs to other states.
In figuring its income tax liability, an insurance com
pany must apply the 9 percent rate to that portion of
its net income attributable to its business in New York
State— i.e., to its “ allocated entire net income” . The
proportionality factor is a weighted average of the
fraction of the company’s total premiums that are paid
by New York residents and the fraction of its total
payroll in New York.9
Even though the weight given to premiums in the
allocation formula is nine times the weight given to
payroll, the potential for reducing a company’s allo
cated net taxable income by relocating jobs could be
substantial. For example, assume one company pays
50 percent of its total payroll in New York while an
other pays only 10 percent of its wages there, and both
write 10 percent of their premiums in New York. In
this case, New York State levies its tax on 14 percent
of the net income of the company paying 50 percent
of its payroll in New York and on only 10 percent of
the net income of the other company. Hence, embodied
in New York’s tax laws is a definite incentive for
insurance companies to run their businesses from out
side the state.
What types of jobs continue to locate in New York?
As a result of the increased productivity of home-office
workers, the dispersal of sales personnel, and the re
location of data processing installations outside New
York, the size of the insurance work force in the city
has declined substantially over the past twenty years.
Yet, New York continues to be an attractive location
for many insurance operations. Indeed, for those com
panies headquartered in the city, New York continues
to house the major underwriting, investment, and legal
functions, as well as the senior administrative offices,
*A company’s entire net income that is allocated to New York State
is obtained by multiplying its total United States income by
9 p New York premiums
i ^
( 1 r New York payroll
^^
10 ^ United States premiums ^ / ^ ~ \ 10 ^United States payroll ^ /

FRBNY Quarterly Review/Spring 1979

and all the support facilities for these areas.
In particular, the sales and underwriting facilities
for large, nonstandard policies tend to be centrally
located in New York. This business requires sophisti
cated brokerage and underwriting expertise, and often
necessitates face-to-face communication. Thus, despite
the dispersal of other economic activity away from the
region, New York’s concentration of corporate head
quarters, insurance brokers, and insurance companies
has continued to attract this segment of the industry
to the city. In the life insurance sector, this includes
group insurance policies and pension management,
important products of New York companies. Similarly,
large commercial property-liability policies and rein
surance continue to be concentrated in New York.
New York—an international insurance center?
Large commercial property-liability risks are highly
mobile— not just within the United States but also
across national boundaries. Relative to other insurance
centers in this country, the New York market clearly
has a comparative advantage in this type of business.
The companies operating in New York together provide
sufficient underwriting capacity to absorb a substantial
fraction of the large risks. They also offer specialized
skills and services unavailable elsewhere in the coun
try. Worldwide, however, London is the primary insur
ance center, and, in the past, many risks that might
have been placed in New York instead moved on to
London. Consequently, New York’s continued growth
in these areas depends on its successful competition
with London for what is becoming an increasingly
international insurance business.
In the past, part of the problem of the New York
property-liability insurance industry reportedly has been
that large commercial risks were overregulated in New
York. The delay and added expense resulting from the
regulatory process may have motivated brokers and
customers to avoid placing risks in the New York
market and to opt instead for out-of-state and foreign
providers of insurance. Indeed, approximately half of
the premium income received by Lloyd’s of London
originates in the United States. A number of recent
changes in New York’s insurance law will improve the
national and international competitiveness of the New
York property-liability industry.
Regulation 20
The first move to improve New York companies’ ability
to compete for international risks was an amendment
to “ Regulation 20” . Adopted in 1977, this amendment
relaxed the legal restrictions on New York companies
that reinsure with “ nonadmitted” reinsurance com
panies— i.e., those not licensed in New York State.

Insurance companies are required by law to hold
reserves equal to their estimated losses, loss adjust
ment expenses, and unearned premiums.10 When a
block of business is reinsured, the reinsurer must in
crease its reserves to cover the assumed liabilities
while the direct insurer typically reduces its reserves
by a similar amount. Prior to the amendment to Regu
lation 20, New York-licensed primary insurers were not
able to take credit against their reserves for any busi
ness ceded to nonadmitted reinsurers. Obviously, if the
primary insurer cannot free reserves for new business,
reinsuring with nonadmitted reinsurers becomes
costly. Normally nonadmitted reinsurance companies
are willing to make additional arrangements to cover
the liabilities they assume: for example, they may grant
the primary insurer a letter of credit on a New York
bank. Moreover, to make it easier for American com
panies to reinsure with them, many foreign reinsurance
companies have established United States branches
that are licensed in New York State. Nonetheless, the
New York restrictions were viewed as limiting the
ability of New York companies to accept large risks
and causing some large risks to move directly to
London.
A t the same time, New York companies operating in
foreign insurance markets were at a disadvantage. If
they reinsured with admitted reinsurers, New York
State allowed them to credit their reserves. But by
reinsuring here rather than in the country where the
direct premium income originated, they increased their
foreign exchange exposure. In any case, foreign regu
lations often forbid reinsuring in the United States,
requiring instead that at least part of the reinsurance
be placed locally (in the foreign country) with
g o v e rn m e n t-co n tro lle d reinsurers. U nlike m any p riv a te ly

owned foreign reinsurers, these government reinsurers
have had no inclination to become licensed in New
York State. Consequently, New York companies dealing
in these countries were forced to reduce their capacity
to write new business because they could not credit
their reserves for this reinsurance.
The amendment to Regulation 20 relaxed these re
insurance restrictions. New York-licensed companies
can now automatically credit their reserves for 85
percent of most insurance ceded with nonadmitted
reinsurers. This should facilitate New York companies’
expansion of their activities abroad. It should also
heighten competition in the United States reinsurance

Property-liability premiums are typically paid one year in advance.
If a customer cancels the policy before the year is over, the
company refunds the ‘‘unearned" fraction of the premium paid;
hence, it must hold reserves to cover unearned premiums.

market as foreign reinsurers increase their activity
here."
An insurance “ free zone”
The amendment of Regulation 20 was followed in 1978
by major legislation that established a New York Insur
ance Free Zone as of September 1, 1978. In effect,
this amounted to a partial deregulation of large insur
ance contracts throughout the State of New York. Pre
viously, all commercial insurance policy forms had to
be submitted to the state insurance department for
approval— a process that resulted in increased costs
and delay. Under the Free Zone legislation, companies
that obtain special licenses are authorized to write
insurance contracts that are exempt from the New York
Insurance Department’s rate and policy filing require
ments so long as they carry annual premiums of at
least $100,000 for one kind of insurance or $200,000
for two or more kinds of insurance. Similarly exempt
from regulation are certain special, exotic, and difficultto-place risks such as kidnap and ransom or skydiving
insurance. However, Free Zone insurance must still
comply with the minimum standard policy provisions
of the New York Insurance Law. The Free Zone legis
lation also provides for income from risks located
outside the United States to be exempt from New York
States taxes.
This partial deregulation of large nonstandard insur
ance contracts should enable New York companies to
compete effectively for most United States risks that
brokers have, in the past, preferred to place in London.
Moreover, with the exemption of foreign risks from
New York taxes, it is expected that the New York in
surance industry will be able to attract an increasing
share of the in su ra n ce b u siness originating in other
countries. Early indications are promising. By February
1979 Free Zone licenses had been granted to sixtythree companies which in the aggregate have a capital
and surplus equal to $9 billion. Using the basic limita
tion of 20 percent of capital and surplus for Free Zone
writing, the Free Zone could provide a potential market
of $1.8 billion in insurance premiums.
The New York insurance exchange
The 1978 legislation also provided for the establish
ment in New York City of an insurance exchange— an
entirely new institution designed to attract risks from
" Many of the foreign firms that have recently opened branches in
New York are reinsurers who "domesticated” in response to restric
tions in the New York insurance law limiting the credit allowed
primary insurers on premiums reinsured abroad. Since these restric
tions have been eased, the rate of domestications of foreign branches
may fall, but the activity of foreign companies in the New York
market will probably increase.

FRBNY Quarterly Review/Spring 1979

around the world. Although the New York Insurance
Exchange is still in the organizational stages, the re
cently approved constitution and bylaws provide for
an institutional arrangement that is similar in many
respects to Lloyd’s of London.12 Underwriters, oper
ating on behalf of syndicates of investors, will locate
on an “ exchange floor” where member brokers will
come to market their risks. Because the exchange is
particularly suited for the writing of large insurance
and reinsurance contracts, it is envisioned that each
syndicate will accept only a small portion of any one
risk. Consequently, brokers are expected to follow the
Lloyd’s practice of presenting a risk to several different
syndicates in succession. Moreover, the member syn
dicates and brokers must maintain principal offices in
New York for the purpose of transacting insurance and
reinsurance business on the exchange.
The New York Insurance Exchange will differ in one
important respect from Lloyd’s of London. Lloyd’s syn
dicates are essentially unrestricted in the types of
property-liability risks they can underwrite. In New
York, however, most types of direct insurance risks
located in the United States will not be placed through
the exchange. Syndicates on the New York Insurance
Exchange will be constrained to underwriting: (1) re
insurance and (2) direct insurance on risks located
outside the United States. The only exceptions to these
restrictions will be on risks that have been refused by
Free Zone-licensed companies: these can be under
written directly by syndicates on the exchange. How
ever, syndicates will not be restricted to writing either
property-liability or life insurance. The same syndicate
can qualify to participate in both types of insurance
simply by increasing its capital from $3,550,000 to
$6,550,000.
By concentrating on reinsurance, the exchange will
be promoting a market that has been growing rapidly
in the United States. Since 1952, the total amount of
American premiums reinsured has increased by more
than 10 percent per year, and the fraction of that total
reinsured with American companies has grown even
faster. Before World War II, more than half of all
American reinsurance premiums was ceded to foreign
reinsurance companies; but, in 1976, only about one
fourth of American reinsurance was going abroad. To
some extent, this trend reflects the willingness of
foreign reinsurers to establish United States branches
and subsidiaries to obtain easier access to the Ameri

12 The constitution and bylaws that were approved by the state
legislature February 26, 1979 allow the New York Insurance
Exchange to begin functioning on or after March 1, 1979, but in all
likelihood the earliest it can begin business is in October.

FRBNY Quarterly Review/Spring 1979
Digitized for18
FRASER

can market. The activity of the reinsurance depart
ments of United States primary insurers has also grown
rapidly.
The New York Insurance Exchange is viewed as a
complement to the Insurance Free Zone. While the
New York Insurance Department will monitor the oper
ations of the New York Insurance Exchange, like
Lloyd’s of London it will be largely self-regulated. The
constitution establishes minimum capital requirements
for underwriting members. It also empowers the board
of governors of the Insurance Exchange to establish
procedures for ensuring the financial soundness and
ethical conduct of the exchange’s membership.
London’s preeminence in insurance is the result of
two factors: its huge capacity which enables it to
handle very large risks and its adaptability to the
world’s rapidly changing insurance needs. The New
York Insurance Exchange and the Free Zone together
should go a long way toward improving New York’s
relative competitiveness in the international insurance
market. The existence of a central market place, with
its easy interchange of brokers and underwriters, is
expected to foster competition and increase the ef
ficiency of the New York market to write reinsurance
and to place international risks. The insurance ex
change should also make the New York insurance
industry more accessible to individuals with capital to
invest, thereby expanding the capacity of the New York
market. In addition, the relaxation of certain statutory
controls applicable to large commercial risks within
the Free Zone and the self-regulation of the Insurance
Exchange should vastly increase the flexibility of New
York underwriters.
These regulatory and institutional changes will attract
business from other insurance centers and increase
the concentration of large nonstandard propertyliability insurance activity in New York— to the benefit
of the city’s employment and income. Although such
effects are difficult to project, the Governor’s economic
affairs cabinet has estimated that within two years
after their implementation, the Insurance Free Zone
and the New York Insurance Exchange will together
contribute between 1,100 and 2,500 new jobs to New
York City’s insurance work force. If one also con
siders the additional induced effect on noninsurance
employment, the city’s total job increase is projected
to be between 3,500 and 4,500 after two years and as
much as 8,000 after ten years. Clearly, the potential
contribution to the city’s economy could be significant.
Outlook for the future
Insurance employment in New York City is likely to
stabilize in the next few years. Some of the forces con
tributing to the past erosion of jobs appear to be eas

ing, and their negative impacts are likely to be offset,
at least in part, by new jobs attracted to the city by the
development of the Free Zone and Insurance Ex
change.
While total employment is likely to stabilize, the
composition of insurance jobs probably will continue to
shift. New York is likely to lose additional low-paid
clerical positions. Automation continues to reduce the
number of these jobs industrywide, and advances in
communications and computer technology have al
ready increased the geographical autonomy of insur
ance processing centers to the disadvantage of New
York City. There is little evidence that incentives for
dispersal of processing operations have been reduced
significantly. However, by now, this process may have
largely run its course.
The prospects for other headquarters-related jobs
depend on the relative costs of doing business in
New York. Sophisticated communications systems have
made it possible for many headquarters functions to
locate anywhere in the country, but at the same time
there have been more moderate increases in New York
City’s wages, consumer prices, office rents, and taxes
over the last two years than in most other cities. If
these trends continue, New York’s future as a head
quarters center can be expected to brighten.
Sales-related employment gains depend on the

growth of the market served. The growth of sales per
sonnel dealing in individual insurance in New York will
be closely related to the expansion in the local econ
omy, which is likely to lag the rest of the nation over
the next few years. In contrast, significant employment
gains are possible in the sales and underwriting of
large nonstandard policies. These activities continue
to be attracted by many of the same forces that origi
nally drew the industry to the city— the concentration
of corporate clients and the easy personal contact
made possible by New York’s well-developed office
infrastructure. In addition, the recently instituted In
surance Free Zone and forthcoming New York Insur
ance Exchange should enable the city’s propertyliability industry to increase its share of the worldwide
market in large commercial risks.
As clerical and processing jobs decline and insur
ance marketing personnel become more dispersed
nationally, New York’s insurance jobs are becoming
increasingly concentrated in the underwriting, broker
age, and management functions. This is the core of the
industry that most depends on what New York has to
offer— a market environment that encourages easy
face-to-face communication. By building on its ability
to provide such an atmosphere, New York should be
able to retain and promote this key sector of the in
surance industry.
Janet Spratlin Young

FRBNY Quarterly Review/Spring 1979

THE ECONOMY OF NEW YORK CITY
The labor market shows some improvement.
Index
110

Total employment
January 1977=100
—

United States

Employment is ex p a n d in g ,
although at a slower
than

rate

in the nation.

104 —

___^
Jem**00* '"’

102

New York City
100

I I I I I I I I I I I
1977

i l

i I i i I i i
1978

I I I
1979

Thousands
2760
Private employm ent
2740

The bulk of the job gains
are in the private

sector.

/ \

2720 —

—

2700 —

I I I II

2660

I II
1977

I II

I I I I I I M
1978

I M

I I I
1979

Percent
11.0 ------

New York City

United States

10.0

9.0 —

The rate of

local

has d e c l i n e d ,
a ser io us

joblessness

8.0

—

but remains

problem.

7.0 —
6.0

—

5.0 —

Q1/1977

All New York City employment data are seasonally adjusted by the Federal Reserve Bank of New York.

FRBNY Q uarterly R eview/Spring 1979

Q1/1978

Q1/1979

Other indicators of economic health point to
further progress.
Percent
72 ------H otel-m otel occupancy rate - January

Tourism

continues

grow

Thousands of units
14 -------------------------Housing starts

Housing
with
in

starts

most of

are

inc re asi ng

the a c tiv it y

—

Rest of the city
Manhattan

8—
6—

M a n h a tt a n .

4 —

2—

0—

1977

1978

Percent change
10

Consumer price index |
Change from twelve months earlier

While upward

price

are

inflation

bu il d in g ,

moderate

area than
a whole.

p r es s ur es

in the

remains
New York

c ou n tr y

New York-Northeastern
/ A \.
New Jersey

J_L
1977

I ll I I I I I I I
1978

1979

Prepared by Rona B. Stein.

FRBNY Q uarterly R eview /Spring 1979

Business Taxation in
New York City

New York City and New York State recently have
made serious efforts to improve their economies by
lowering business taxes. Some tax rates have been
reduced, many incentives have been added and
strengthened, and some taxes have been abolished.
However, much remains to be done. Businesses in New
York City still face a complicated system of state and
city tax laws which impose higher operating costs for
firms located here and reinforce the city’s reputation
as being inhospitable to business.
This article briefly reviews the present tax system
and notes some general ideas for restructuring it. The
article also points out two areas in particular need
of change— the heavier taxation of small firms relative
to that of la.rge firms and the limited tax relief given
to firms with competitors in lower tax jurisdictions.
The complexity of business taxation
New York City’s and New York State’s complicated
tax systems consist of franchise-type taxes assessed
according to the net income, total revenues, or some
measure of the value of the firm; other taxes assessed
on the value of goods and services used by businesses;
and tax incentives in the form of credits, deductions,
and exemptions which lower taxes for firms that qualify.
While a company or a single division of a company is
subject to only one franchise-type tax, it may be sub
ject to other business taxes and be eligible for any
number of the tax-incentive programs.
Franchise-type taxes. Both the city and the state
impose separate franchise taxes on banking corpora
tions, public utilities, and “ 9A” corporations— a broad
category which covers most corporations and is named

FRBNY Quarterly Review/Spring 1979

after the statute that created the tax at the state level.
A similar type of tax is imposed on the adjusted net
income of unincorporated businesses. (The state’s un
incorporated business tax is being phased out.) Insur
ance companies are subject to state franchise taxes.
The separate treatment at both the state and the city
levels of each of these five categories only hints at the
complexity of business taxes. Many of these franchisetype taxes, for instance, provide a number of alterna
tive methods of computing tax liability.1
Compounding the complexity of the tax systems is
the diversity in the rates of taxation (Table 1). For
New York State, income tax rates are 12 percent
for banking corporations, 9 percent for insurance com
panies, 10 percent for 9A corporations, and 4.5 percent
for unincorporated businesses.2 Insurance companies
are also subject to an additional tax on the amount of
their net premiums. The rates are 1 percent on net
premiums for accident, health, and life insurance poli-

1 For example, the state’s tax on 9A corporations specifies four
alternative methods for computing tax liability. The one yielding the
highest amount must be used. Two methods involve a tax on net
income applied either to the "entire net income” allocated to New York
State or to allocated income-plus-salary payments (designed to
prevent closely held corporations from avoiding this tax by paying out
profits as salary). A third method uses a different tax rate which is
applied to the firm ’s business and investment capital allocated to
New York State. The last method is simply a minimum tax of $250.
Almost 90 percent of the revenue from this tax is derived frofn the
income or income-plus-salary basis with an additional 8 percent
coming from corporations paying the minimum tax. Corporations are
also subject to a tax based on the capital of subsidiaries.
1 Public utilities are taxed on their gross income; however, these
taxes are not considered here.

Table 1

Rates for Selected Taxes on Business

Type of tax
Financial corporations:
Savings banks and savings and
loan associations .......................
Other banks ...............................
Insurance companies ..................... ....................
Other
"9A ” c o rp
o ra tio
n s .....................................
| g | | | | |5 |g fg if
r
'
Unincorporated businesses.............................
Property t a x ........................... - ..........................
Commercial rent tax ........................................
Sales and use taxes ....................... ................
Stock transfer tax......................... ......................
Occupancy taxes:
Commercial r e n ts ..............................................
Vending machines ............................................
Hotel ...................................................................

New York State
Recent
Current or
peak
scheduled

Tax base

Allocated net incomef
Allocated net incomef
Allocated net incomet
Allocated net incomef
Allocated net incomef
Assessed value
Rent per premises
Purchase price
Per share

12%

15.6% +
9% 5

12%*1J

■H

^ '-nr;.

12.134%
13.823%

4%
$

Per premises
Per vending machine
Per room

12.134%
13.823%

10.05%
4%
8.795%
7.5% **

New York City
Current or
scheduled

9%B

10%
0 (1981)

5.5%

Recent
peak

.0625+*

$12.00/year**
$ 2.00/year**
$ 1.00/day **

9%
4%
6% **

8.75%
(1981)

4%
0 (1981)
$12.00/year*
$ 2.00/year*
$ 1.00/day *

* All major taxes, except on public utilities and payroll, are included,
t Allocated net income is the amount of a firm’s total net income subject to New York taxes.
+ Includes tax surcharges.
5 Insurance companies also pay a tax on net premiums. The maximum tax liability for insurance
companies cannot exceed 2.6 percent (previously 2.65 percent) of net premiums.
# New York City used to impose a premium tax on all insurance policies written locally. The rates in 1974
were 0.6 percent for New York City insurance companies and 0.4 percent for non-New York city companies.
II The city imposes a premium tax on fire insurance policies written by non-New York City companies.
The amount paid can be credited against state taxes,
tl Omnibus (bus) corporations also paid an additional tax of 5.75 percent.
** Maximum rate.
Sources: Commerce Clearing House, Inc., and New York State Department of Commerce.

:
cies and 1.2 percent on net premium for other types
of insurance.
At the city level, tax rates on the net allocated in
come basis also differ between industries. Commercial
banks pay 13.823 percent, while savings banks and
savings and loan associations pay 12.134 percent. Most
other corporations pay 9 percent, and unincorporated
businesses pay 4 percent.
Three features of the franchise-type taxes are note
worthy. First, because of this plethora of tax laws,
different subsidiaries of the same company may be re
quired to pay taxes computed at different rates. Sec
ond, some of these taxes result, in effect, in double
taxation. The unincorporated business tax assesses
for a second time practically all the salaries paid to
partners and proprietors who also pay personal income
taxes on this same income. Similarly, part of the sal
aries paid by corporations to officers and to holders

of more than 5 percent of the company’s stock is taxed
twice under the income-plus-salary method, which
many small, closely held firms must use to compute
their tax liability.3 Third, while most of the tax rates
for these franchise-type taxes are still much higher
than before New York C ity’s fiscal crisis in the mid1970’s, many tax rates have recently been lowered.
For example, New York State’s 30 percent surcharge
on financial corporations, as well as other surcharges
imposed at the height of the fiscal crisis, has been
allowed to lapse. In addition, the tax base for insur
ance companies was shifted from exclusive reliance on
3 Over 90 percent of the firms having to compute their taxes on the
income-plus-salary basis paid less than $3,000 in corporation taxes
to the state in 1975-76. New York State Department of Taxation and
Finance, Statistical Supplement to the Annual Report of the
Department ot Taxation and Finance and New York State Tax
Commission, 1977-78, Table 3.

FRBNY Q uarterly R eview /Spring 1979

Table 2

Description of Tax Incentives
Requirements

How realized

Level

Investment in production facilities

Credit against corpora
tion or unincorporated
business taxes
Credit against corpora
tion or unincorporated
business taxes

4% of the value of the investment

The credit can be claimed for up to
ten years and is the average of two
ratios: qualified new investment in
the "eligible business facility" to
the firm’s total land, plant, and
equipment within the state; and
salaries and wages for the jobs
created or retained to the firm ’s
total salaries and wages within
the state.
Can deduct the whole cost in
one year

Incentive
New York State
Investment tax c r e d it.............
Employment incentive
tax c r e d it .................................

Received investment tax credit plus
increase in employment of 1% from
level in year before investment made

Job incentive c r e d it...............

Certification by job incentive board
as an “ eligible business facility”
(must sell product beyond local
market, have five or more em
ployees, and have a training
program)

Percentage reduction in
franchise-type taxes
otherwise owed

One-year w rite -o ffs .................

Investment in tangible business
property for research and develop
ment, industrial waste treatment,
and air pollution control facilities
Out-of-state sales, payroll, or
property

Deduction from taxable
income

Change in allocation
of income ru le s .......................

Sales and use tax
exemptions .............................

Fuel, machinery, and equipment
purchased for production; and
materials, machinery, and equip
ment purchased for research and
development, waste treatment, and
pollution abatement facilities

Reduces proportion of
income allocated to
New York State for tax
purposes
Exempt, or tax paid is
allowed as credit against
income tax.

2% in each of three years after
taking the investment tax credit

Sales factor given double weight
in allocation formula’

Eliminates tax

New York City
Double deduction for
depreciation ...........................

Investment in depreciable assets
used for production

Deduction from taxable
income

Up to twice Federal depreciation
allowances

One-year w rite -o ffs .................

Same as for state

Property tax e x e m p tio n s -----

New construction or reconstruction
of industrial and commercial
facilities, granted by Industrial and
Commercial Incentive Board

Increase in value exempt
from property tax

Moving cost credit ...............

Move into New York City from
out-of-state with ten or more
commercial or industrial job
opportunities

Credit against corpora
tion or unincorporated
business taxes

First year: 95% for all but
new construction of commercial
(initial exemption for it is 50% )
Following years: Decreases
5% per year until eliminated
Up to $300 per new commercial
job and $500 per new industrial job

Property tax stabilization . . .

Move into New York City from
out-of-state with 100 or more
industrial or commercial jobs and
rent space, eligibility determined
by the Industrial and Commercial
Incentive Board

Credit against corpora
tion or unincorporated
business taxes

Equal to any increase in property
taxes passed through under the
lease for a period of up to ten years

Machinery and equipment pur
chased for production; and mate
rials, machinery, and equipment
purchased for research and devel
opment, waste treatment, and
pollution abatement facilities.

Exempt, or tax paid is
allowed as credit against
income tax.

Eliminates tax

Sales and use tax

* For more detailed explanation of recent changes in New York State's allocation rules, see text.
Sources: Commerce Clearing House, Inc., and New York State Department of Commerce.

FRBNY Q uarterly R eview /Spring 1979

net premiums received to a less onerous combination
of premiums and income, with the maximum tax liability
lowered from 2.65 percent to 2.6 percent of net premi
ums. (For a discussion of the taxation of insurance com
panies, see the accompanying article on pages 9-19.)
Other business taxes. New York City and New York
State also impose several other taxes on the goods
and services used by businesses.4 State and city sales
taxes— each assessed at 4 percent— tax many of the
goods and services used by businesses. (Both levels
of government also impose a “ use” tax on purchases
made outside their jurisdictions but used within them.)
Although purchases of goods that become part of the
final product are exempt from the sales and use taxes,
other items such as computers, materials used in the
construction of new buildings, and machinery and
equipment used by service industries are all taxed.
New York City has a number of additional levies.
Rental payments on property used for business pur
poses are taxed under both the commercial rent tax
(the maximum rate is now 6.75 percent, down from 7.5
percent in 1977) and the general occupancy tax (the
maximum flat charge is $12 per rented premises per
year.) There are other occupancy taxes as well. Vend
ing machines and hotel rooms are taxed, respectively,
at maximum rates of $2 per machine per year and $1
per room per day. The stock transfer tax is being
reduced in stages and is scheduled to be phased out
in 1981. Real property, i.e., land and buildings, are
taxed at a rate of 8.75 percent on assessed value.
Tax incentives. New York City and New York State
offer a myriad of tax incentives. The proliferation of
these programs and the strengthening of existing ones
have been part of the city’s and state’s response to the
deterioration of their economies. Although fiscally in
capable of making substantial cuts in basic tax rates,
both levels of government have used their tax-incentive
programs to foster the development of the private
sector. These programs are well intentioned, and they
do reduce taxes for those firms that meet the eligibility
requirements. Unfortunately, they also contribute to the
overall complexity of the tax system by creating
a host of exemptions, deductions, and credits. (The
major features of the tax incentives are summarized
in Table 2.)
New investments may qualify for one of three differ
ent tax breaks. The state’s investment tax credit pro
vides a credit against taxes equal to 4 percent of the
value of any investment in production facilities. If
the same firm increases its employment 1 percent sub
* Omitted from the text are payroll taxes for unemployment insurance
and workmen’s compensation. The rates for these taxes vary among
firms within the state as well as between states.

sequent to this investment, then it also qualifies for
an employment incentive tax credit which is set at
one half the investment tax credit and may be taken in
each of the following three years. The city does not
offer any type of investment tax credit but does allow
firms to take depreciation deductions at up to twice
the Federal rate. An alternative credit (the job incen
tive credit) is available at the state level for firms in
vesting in either production or nonproduction facilities
such as office buildings. In contrast to the investment
tax credit, in which the amount of the credit varies with
the investment outlay, the amount of the job incentive
credit varies with the firm’s profits since it is set as a
percentage of the taxes otherwise owed. As a third
option for investments in facilities for research and
development, industrial waste treatment, or air pollu
tion control, firms can depreciate the entire amount
of these expenditures in one year.
New investments may also qualify for relief from sales
and use taxes and from property taxes. Most purchases
of machinery and equipment are exempt from sales and
use taxation, as are all purchases made to operate the
facilities eligible for the one-year write-offs.5
In New York City, investments in new construction
or reconstruction of buildings are eligible for exemp
tion for up to nineteen years from property taxation.
Large firms moving into the city from outside the state
and renting their space can be insulated from in
creases in property taxes passed through under their
leases, even if the increases result from building im
provements. Moreover, some firms moving in are also
eligible for tax credits to offset their moving costs.
Many businesses will benefit from two recent
changes in the state’s rules for determining the pro
portion of their net income subject to taxation by the
state. This proportion is related to the amount of
“ business” the firm does within the state by using
an allocation formula that takes into account how much
of a firm’s sales, payroll, and property are within the
state. One of the recent changes doubles the weight
given to the sales factor. This lowers taxes for a firm
whose percentage of sales inside the state is smaller
than its percentages of in-state payroll and property.
The other change now allows firms which do not have
a “ regular place of business” outside the state to allo
cate their income. The savings from these modifica
tions can be substantial (see chart).
5 New York City does not actually exempt the purchase of manufacturing
machinery and equipment from sales and use taxes but accomplishes
the same objective by allowing firms to claim these taxes as credits
against their franchise taxes. The reason for choosing this less direct
method is that these taxes cannot be altered because the legislature
has made their revenues allocable to the Municipal Assistance Corpo
ration to pay its debt obligations and operating expenses.

FRBNY Quarterly Review/Spring 1979

Illustration of the Reduction in Income Subject to New York State Tax
Due to Revised Allocation Rules*
Income su b je ct to New York State tax
Revised rules

Previous rules

Type of firm

s '—

s -------- \
No "regular place
of business”
outside state

Has "regular place
of business”
outside state

100%

r ? )

(^ r )

♦illu s tra tio n based on firm with 10 percent of sales, and essentially all property and payroll
within the state. For discussion of allocation rules see text. Revised formula allows firm
to allocate income even without a "regular place of business” out of state and gives double
weight to the sales factor. For example, the 55 percent is (2(10%) + 100% + 100%) /4.

Forging the tax system into an efficient tool to pro
mote the recovery of the local economy is a difficult
task. Nevertheless, even a simple overview can un
cover areas in particular need of change. At least two
stand out: the taxation of small firms relative to that
of larger firm s and the taxation of firms that sell some
or all of their product outside the state.

Small firms
Small firms are particularly hard hit under the present
tax system. Although both the city and state tax firms
of all sizes at a uniform rate, the effective tax rate de
clines with firm size because state and local taxes are
deductible from Federal taxable income. Those firms
paying at the highest marginal bracket on their Federal
corporation tax return end up with a net city and state
tax of about half the sum of the statutory rates,
whereas small firms pay a net tax of more than three
fourths the statutory rates.6 In addition, because many
6 The effective rate of state and local taxation depends not just on
their statutory rates but also on the Federal tax rate. For example,
most corporations are taxed at 9 percent by New York City and 10
percent by New York State. However, taking into account the inter
actions resulting from the deduction allowances by the state for local
taxes and by the Federal Government for both state and local taxes,
the total tax burden is only 55.774 percent for firms subject to the
maximum Federal rate of 46 percent and 32.023 percent for firms
subject to the minimum Federal rate of 17 percent which applies to

FRBNY Quarterly R eview/Spring 1979

small businesses are unincorporated or closely held,
much of their income is double taxed.7
Not only are small firms taxed at a higher effective
rate than larger firms, but they are excluded from
taking advantage of a number of tax incentives. For
example, e lig ib ility fo r New York C ity’s moving credit
is restricted to firms em ploying at least ten workers
and the property tax stabilization program requires a
firm to have at least one hundred employees.
The im position of a higher tax burden on small
firms seems inappropriate. While the exact number of
jobs provided by small firms is unknown, nearly 90
percent of the c ity ’s business establishments have
fewer than twenty employees and account for a sign ifi
cant fraction of output in the city. A further reason to
encourage small firms is the c ity ’s traditional role as
an incubator for small, innovative firms. The long-run
econom ic development of the city may depend on its

corporations with profits of less than $25,000. Thus, the state and
city taxes create an additional tax liability of 9.774 percentage
points for the large firms and 15.023 percentage points for the
small firms.
7 The unincorporated business tax
help firms with very small profits.
profits increase, there is a range
each additional dollar of profit is

contains a tax credit designed to
Because this credit decreases as
in which the effective tax bite on
twice the statutory rate.

ability to attract and hold firms from their earliest
stages of development.
Export-based firms
In addition to burdening small firms, the city’s tax
system, in particular, provides insufficient tax relief
to many of the firms selling some or all of their prod
uct outside the state. As a result, many of the jobs
provided by these so-called “ export-based” firms have
moved elsewhere. Originally, these firms were con
sidered the best ones to tax since it was presumed
that they could shift part of the tax burden to their
out-of-state customers in the form of higher prices.
However, advances in communications and transpor
tation have made it easier for many of the businesses
in New York City to be located elsewhere. While the
loss of jobs is not wholly attributable to taxes, for many
firms the relative level of taxation plays an important
role in their location decisions. Consequently, only
when the city offers relative cost advantages can it
impose higher taxes than other localities without los
ing its role as a major center of manufacturing activity
or even of legal, business, and financial services.
In this environment, New York City needs to change
its treatment of export-based firms. Under the city’s
rules for determining the amount of a firm’s income
which is subject to local tax, only those firms with a
“ regular place of business” outside the city can allo
cate their income. This prerequisite of an out-of-city
office is detrimental to the city’s economy since it
encourages firms to set up satellite offices which, once
established, provide an alternative location from which
a firm can easily expand. Furthermore, even firms
eligible to allocate their net income may not receive
sufficient tax relief to compete with firms located else
where because the city weighs payroll and property
equally with sales in its allocation formula.
Options for improving business taxation
In the near term, a complete revamping of New York
City’s and New York State’s tax systems is not possi
ble. Budgetary requirements and the enormity of the
task preclude changes that would significantly lower
the tax receipts of either level of government. Never
theless, small adjustments are feasible.
As a first step in tax reform, the effectiveness of the
current incentives in attracting or preserving jobs
needs to be assessed. How many firms have relocated
in the city because of these special tax relief pro
grams? How many firms would have expanded in the
city anyway? How many firms already located in the
city with no plans to leave are able to take advantage
of these programs?
Answering these questions is not easy. Even a tax

incentive that is initially well constructed may later
run into difficulties. New York City’s program of prop
erty tax exemptions for construction and reconstruction
of commercial and industrial properties illustrates this
problem. While the extent to which it spurs construc
tion is unknown, the bulk of the tax relief has gone for
new office buildings of large national corporations al
ready located in the city. More importantly, this tax
incentive may now be unnecessary for Manhattan in
view of the revival of construction activity.
A hard-headed reexamination of the tax incentives
would probably lead to the elimination of many of those
presently offered. All but the ones visibly contributing
to the recovery of New York’s economy should be
phased out, and no new tax incentives should be added
unless their net benefit is clear. A thorough overhaul
would yield two benefits. First, the complexity of the
system would be reduced, and the costs of confusion
produced by the present system would be diminished.
Second, the revenue saved could be devoted to other
forms of tax relief such as lowering some tax rates.
Here also, care must be taken in selecting which
taxes to reduce.®
Some taxes are being eliminated. Both the state’s
unincorporated business tax and the city’s stock trans
fer tax are now being phased out. The elimination of
more taxes in order to simplify further the tax system is
generally very costly in terms of revenue loss (see
Table 3 for the revenue raised by each of the major
taxes). However, the city’s occupancy taxes on com
mercial rents and vending machines— they raise a total
of only $1.5 million— can easily be removed. As a by
product of such a move, both the city and the business
community would realize savings on administrative and
paperwork costs. Eliminating the occupancy tax on
commercial rents may be even more significant due
to the symbolism of eliminating the duplicate taxation
of commercial rents, leaving only the commercial rent
tax. Since perception of the city’s attitude may be an
important factor in firms’ location decisions, a tax cut
that simplifies the tax system should yield the addi
tional benefit of counteracting the city’s past image as
a place inhospitable to business.
The bias against small firms should be examined.
8 A major portion of the revenues devoted by the city to tax relief
has gone recently to reduce the commercial rent tax. However, the
beneficial effects from cutting this tax may not have been as large
as expected. Although its reduction may help to placate those
business people who find its existence particularly onerous, the
actual cost savings to firms signing new leases may be marginal. In
the short run at least, the benefits most likely accrue to landlords
who can increase their rental charges in correspondence with the
fall in the tax rate. The competitive position of New York City as a
location for business may thus be unchanged. Of course, in the long
run, such an increase in the return to landlords may help prompt an
increase in the supply of rental space.

FRBNY Quarterly Review/Spring 1979

Table 3

Revenue From Business and Other Major Taxes

Type of tax

New York Stale revenue
Millions
of dollars
Percent

New York City revenue
Millions
of dollars
Percent

Corporation ("9A” ) t a x ......................................

1,005

8.7

479.4*

7.6

Financial corporation t a x .................................

169

1.5

150.0*

2.4

Unincorporated business tax .........................

0.4

Utilities tax ........................................................

480

4.2

Insurance ta x e s ..................................................

201

1.7

Commercial rent t a x ..........................................

70.6*f

1.1

109.1

1.7

200.7

3.2

1.5

Occupancy taxes:
Commercial rent and vending m ach in e s___
Hotel .....................................................................

10.8

$
0.2

Stock transfer t a x ..............................................

198.1

3.1

3,186.9

50.3

General property tax ........................................
4,894

42.4

710.8*

11.2

2,590

22.4

971.0

15.3

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

2,166

18.7

248.1

3.9

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

11,555

100.0

6,337.0

100.0

Personal income t a x ..........................................

Other

* Net of refunds.
t Unlike the state, New York City does not exempt professionals from this tax.
Sources: New York City Office of Management and Budget, Executive Budget— Fiscal Year 1979,
Supporting Schedules, pages 3R-4R, and New York State Division of the Budget, Fiscal Year 1979.

The tax rate for these firms could be lowered and
size requirements for tax incentives could be re
moved. Furthermore, the double-taxation feature in the
franchise-type taxes that small businesses generally
pay should be eliminated. The city’s unincorporated
business tax and the city and state taxes on 9A corpo
rations could be revised so that tax liability on salaries
is limited to the higher amount of that computed under
these taxes or of that computed under the personal
income tax. A m ajor benefit of such a change, par
ticularly in the case of the unincorporated business
tax, would be to reduce significantly the incentive for
the partners and proprietors of these companies to
live outside the city. Since the city’s unincorporated
business tax is 4 percent and the maximum personal
income tax on residents is 4.3 percent, the owners of
these businesses would pay essentially the same
amount of tax regardless of where they reside.
Export-based firms also need to be studied to de
termine which ones, with further tax relief, would be

t Less than 0.1 percent.

able to operate profitably in New York City. At a m ini
mum, the city should move toward the state’s new
income allocation rules, allowing firms to allocate net
income whether or not they have a “ regular place of
business” outside the city and to give double weight
to the sales factor.
The o u tlo o k

New York needs to overhaul its tax system. In the
short run, fiscal constraints lim it the extent of change
possible. Yet, despite these constraints, some m inor
taxes can be eliminated and tax incentives strength
ened. Greater tax relief needs to be directed to small
firms and those competing for market share outside
New York. In the long run, New York City and New
York State need to sim plify their tax systems as well
as to lower taxes. While the recent tax cuts have un
doubtedly aided business, further tax changes can
play an important role in spurring the econom ic re
covery of New York City.
Mark A. W illis

FRBNY Q uarterly R eview/Spring 1979

A Banker Looks at the
Examination Process
Excerpts from a talk given by Donald C. Platten, Chairman, Chemical Bank,
before a group of Federal Reserve Bank of New York examiners
on January 23,1979. His remarks should be of wide interest to bankers.

When I entered the banking business thirty-seven years
ago, there was a common saying that “ Nobody loves
his banker” . That statement wasn’t entirely true even
then, but there was some truth in it. A corollary was
that a banker was not exactly overjoyed to see the
examiners on his doorstep.
The stereotype of a banker then was a flinty-faced
naysayer, who asked embarrassing questions and then
didn’t believe the answers. The stereotype of a bank
examiner was a nitpicker in a green eyeshade who was
at best a nuisance, and at worst a threat. Neither
stereotype is valid in today’s complex, changing world.
Considering the pace of change in our industry over
the last ten years, it is fair to say that banks and their
examiners have been undergoing what could be called
a “ shared revolution” . As I reflect on the many changes
that have taken place, it occurs to me that one of the
most important has been a crucial shift in the relation
ship between the bank and its regulators. More than
ever before the regulator and the regulated are what
might be called “ friendly adversaries” , each with a
common interest in seeing the job well done, even
though they approach it from differing viewpoints.
As the banking industry has become increasingly
diversified and far-flung, and as the challenge of
managing it grows in geometric scale, the burden falls
ever more heavily on our internal systems, on our
external auditors, and most certainly on the examiners.
They must check and double-check procedures and

controls. They must alert us to danger signals and
let us know where we have blundered, as we some
times do.
Because of this rising challenge to the examination
process, I am very encouraged by the innovations I see
taking place in bank examination methods today. Devel
opments such as the Shared National Credit Program,
Uniform Country Risk Evaluation, and the Uniform Inter
agency Bank Rating System are altogether construc
tive and bound to save wasted motion on both sides.
Perhaps the most promising innovation of all is the
recent focus on the “ top-down” approach to bank
examination. This approach is not only cost effective,
in terms of both money and manpower, but also repre
sents a form of “ preventive medicine” . A careful
evaluation of systems and controls before trouble
occurs is the best method of preventing trouble. More
over, a “ systems” approach such as this will be
increasingly necessary, for banks and regulators alike,
if we hope to maintain effective control of far-flung,
complex, and diverse operations.
The expansion of United States banks overseas
means an increasingly widespread physical organiza
tion. These banks, operating in varying cultures,
employing growing numbers of foreign nationals, will
have a growing need to evaluate political and economic
risks as well as the managements of foreign companies
whose disclosure standards do not match our own. At
the same time, as banks become more heavily involved

FRBNY Quarterly Review/Spring 1979

in activities such as foreign exchange trading, where
risks are very high within a short time span, there will
be a much-heightened demand for tough, tight, and
sensitive controls.
If the barriers to interstate branching are lifted soon
— as many competent authorities predict— dozens of
banks will be expanding, perhaps too rapidly, into
unfamiliar territory. It seems certain this expansion will
change competitive relationships and market shares.
The pressures and temptations will be great and,
perhaps, push some managements and control systems
to the limit— or beyond.
At present, our entire society is going through a
revolution not only in its regulatory apparatus, but in
the whole relationship of the people to their govern
ment. It isn’t a very orderly revolution. In some areas
there has been deregulation or streamlining of existing
regulation. Witness the very promising deregulation of
airline fares. But there have also been too many cases
of clumsy or unworkable new regulations.
Proposition 13 in California, and the events related

FRBNY Quarterly Review/Spring 1979

to it, reflect the public’s ambivalence toward the role
of government in their lives. The people have made it
clear that they want their taxes cut. At the same time,
they want public services increased in areas such as
education and health. But this contradiction is only on
the surface. According to opinion analysts, what the
people really want from government is excellence.
And that, of couse, is what both sides want in bank
regulation— excellence, relevance, realism of the rules.
But, however much the regulation of banks may im
prove and adapt to changing realities, and no matter
how much both sides may share a commitment to,
and a desire for, excellence we will remain, and we
should remain, “ friendly adversaries” , each with our
separate priorities and points of view.
An ancient Greek philosopher once spoke of what
he called “ the harmony of tension” in an adversary
relationship. I think that expresses it very well. I hope
these remarks will serve to increase the harmony
between banks and examiners without entirely remov
ing that necessary tension.

The
business
situation
Current
developments
Chart 1

. . . even disregarding food and energy
prices, which were subject to
special influences.
Percent

15-

Consumer price index excluding food and energy

78 Jan Feb
79
Annual data are expressed as the change from December
of the preceding year to December of the year shown.
Data for 1979 are expressed at seasonally adjusted
annual rates.
1971

Source: United States Bureau of Labor Statistics
Index excluding food and energy calculated by
Federal Reserve Bank of New York.

Inflation flared up in early 1979 with an intensity not
felt since 1974. Some of the largest price increases
were related to special circum stances, such as disrup
tions of food supplies by severe w inter w eather and
the sharp increases in prices of imported petroleum
imposed by the Organization of Petroleum Exporting
Countries (OPEC). Moreover, fears of mandatory price
controls may have prompted some increases in posted
prices. More fundam entally, however, the acceleration
of inflation across a wide variety of goods appeared to
reflect the confluence of demand pressures and supply
constraints typical of the advanced stages of an eco
nomic expansion.
The acceleration of inflation actually began last
year, when the consumer price index for all urban
dwellers rose 9 percent, compared with increases
averaging just over 6 percent annually during the
three preceding years. The pace of inflation quickened
further early this year, with the consumer price index
rising at annual rates of more than 10 percent in
January and February (Chart 1). Prices of food rose
especially sharply during the winter, reflecting both
tem porary consequences of supply disruptions related
to severe w inter weather and also the longer run up
ward trend of beef prices as the slaughter continued
to decline. Consumers were also hit hard by sharply
rising gasoline and heating fuel prices in the wake of
the curtailm ent of petroleum supplies from Iran and
the subsequent large increases in oil prices by the oilexporting countries. Increases were more moderate
for the broad range of other finished goods and ser
vices, but those increases— taken as indications of
the underlying rate of inflation— also were distinctly
higher than in 1978.
Some more recent price developments may contain

FRBNY Quarterly R eview/Spring 1979

Chart 2

Shrinking Margins of Unused
Productive Capacity
Percent

gg ----------------------------------------C apacity u tilization in m anufacturing

6 0 ------------------------------------------------Employment - population ratio

Data for 1979 are plotted monthly; 1971 through 1978
plottings are quarterly.
Sources: Board of Governors of the Federal Reserve
System, Purchasing Management Association of Chicago,
and United States Bureau of Labor Statistics.

FRBNY Quarterly Review/Spring 1979

a glim mer of hope fo r the consumer. Thus, w hile pro
ducer prices of finished food products rose rapidly again
in March, prices of both crude foodstuffs and interm edi
ate food products edged up only slightly further fo llo w
ing extremely large increases during the two preceding
months. Spot prices of various agricultural goods
traded on com m odity markets have been declining
over the past several weeks as well. These price de
velopments in transactions at the earlier stages of pro
duction may well presage some m oderation of the rate
of increase in retail food prices during the spring.
Producer prices of finished goods other than food and
energy also advanced more slowly in March than
earlier in the year.
Unfortunately, this developm ent may not signal a
downturn in the underlying rate of inflation. The econ
omy is presently operating with a lim ited unused
productive capacity available to satisfy increased de
mands for goods and services (Chart 2). The rate of
capacity utilization in m anufacturing, at 86.3 percent
in March, was less than 2 percentage points below the
rate at the last cyclical peak in 1973, according to the
Federal Reserve index. Indeed, among the advanced
processing industries, factories were operating in March
at very close to the 1973 peak. In the prim ary process
ing industries— where most of the bottlenecks occurred
in 1973 and 1974— the rate of capacity utilization in
March was still substantially below the 1973 peak.
However, the explosive rise in energy prices since late
1973 has rendered some productive processes and
facilities obsolete, or at least inefficient. Consequently,
econom ically viable capacity may be less than the in
dexes indicate. Strains on productive capacity are being
reflected in some stretching-out of delivery times. For
instance, a larger percentage of the companies re
sponding to the m onthly survey of the Purchasing
Management Association of Chicago reported slower
deliveries from suppliers in March than at any time
since early 1974.
Constraints are more evident in the m arket for labor
as well. The unemployment rate of 5.7 percent in the
first quarter of 1979 was lower than at any time since
the m iddle of 1974. To be sure, much lower rates have
been attained in the past. However, dem ographic and
social trends, together with liberalization of various
programs for income maintenance, have tended to
raise the level of unemployment rates associated with
any given degree of tightness in labor markets. S ignifi
cantly, the proportion of the w orking-age population w ith
jobs rose to a post-W orld War II record in the first quar
ter. It is thus not surprising that reports of scarcities of
skilled workers have become increasingly frequent in
recent months, side by side with very high rates of
unemployment for the unskilled, and p articularly for

the minority, urban young.
The overall demand for labor remained strong in the
first quarter, despite indications of at least a tempo
rary softening of demand in a number of sectors. Total
civilian employment rose at a seasonally adjusted an
nual rate of 4.2 percent, matching last year’s unusually
rapid growth rate. Nevertheless, the growth of total
output as measured by real gross national product
(GNP) slowed to an anuual rate of only 0.7 percent,
compared with the 4 percent growth registered in
1978. At least part of the slowing of the growth of eco
nomic activity resulted from disruptions caused by
severe winter weather in various parts of the nation.
This was most notably true in construction activity,
where state and local government projects were cur
tailed and private housing starts plummeted in Febru
ary to the lowest level since the middle of 1976. But
bad weather also affected industrial production, fac
tory shipments, and retail sales— all of which rose
only slightly over the first two months of the year. The
pattern of developments suggests that productivity
moved sharply lower. While that quarterly movement
cannot be taken as a harbinger for 1979 as a whole, it
follows two years of exceptionally low productivity
growth that contributed to inflationary pressures.
While the growth of final sales was slowing in the first
quarter, inventory accumulation apparently increased,
especially at wholesale merchants and manufacturers
of durable goods. To some extent, book values of in
ventories were inflated by rapidly rising prices. To the
extent that adverse weather affected shipments more
than production, some of the inventory investment was
probably unintentional. The decline in retail inven
tories In February, which occurred in spite of very
sluggish sales, suggests that slow deliveries were re
sponsible for some of the buildup of stocks at factories
and wholesale outlets. There was also undoubtedly
some deliberate rebuilding of stocks after the surge

in sales during the closing months of last year. Some
of the buildup probably represented a hedge against
the possibility of a work stoppage in the trucking in
dustry, which came to pass on the first eleven days
of April. Finally, the possibility cannot be ruled out
that some part— probably a very small part— of the
January-February inventory bulge reflected a relaxa
tion of the cautious attitudes that have governed in
ventory policies of most businesses throughout the
current economic expansion.
By March it looked as though the economy was
recovering from the winter doldrums. Retail sales
posted a sizable advance in current dollars at least.
Sales were especially brisk in furniture, apparel, and
smaller domestic and imported automobiles. Industrial
production advanced vigorously in March, with sizable
gains widespread among products and materials,
especially motor vehicles and parts, steel, and coal.
Nonfarm payroll employment posted another large in
crease. Housing starts recovered but remained well
below the levels of last year.
These developments, in themselves, may merely rep
resent a rebound from two months of less buoyant
activity rather than presage new demand pressures. On
the other hand, new orders received by manufacturers
of nondefense capital goods, especially aircraft, rose
strongly in January and February, suggesting continued
growth of capital spending. But the present uncertain
ties in the outlook for total demand may persist for
some time.
In any event, supply limits are increasingly con
straining gains in output after the exceptionally rapid
rise in the final months of 1978. In the circumstances,
strong new demand pressures could have unfortunate
consequences for cooling the inflationary surge and for
future orderly growth which must be weighed against
the risk of some falling away from present levels of
activity.

FRBNY Quarterly Review/Spring 1979 33

Public service
employment: its role in
a changing economy
In recent years, the public service programs of the
Comprehensive Employment and Training Act of 1973—
more commonly known as CETA— have expanded
rapidly. In 1974, fewer than 100,000 workers were
employed under public employment programs. By April
1978, an estimated 755,000 people participated in these
Federal programs. In fiscal 1979, about $6 billion will
be spent to employ an expected 625,000 workers.
Due in part to the rapid expansion of public employ
ment as well as to the complexity of the CETA frame
work, public employment has been beset by problems
of mismanagement and abuse. As a consequence,
m a jo r steps re ce n tly have been taken to in cre a se the
program’s effectiveness. Most importantly, the program
has been restructured to insure that public service
jobs are provided for those most in need of assistance.
At the same time, increased emphasis has been put
on placing CETA workers in regular jobs through
greater coordination of public and private initiatives.
Toward this end, related private efforts, which expand
the number of private-sector job opportunities available
to the economically disadvantaged, are being encour
aged.
Legacy of the great depression
The Federal Government’s first significant involvement
with job training and public service employment began
during the 1930’s. The national economy was then in
the grip of a severe depression with one out of every
four workers jobless. In this environment, Federally
sponsored programs were developed to reduce unem
ployment and to provide temporary income support.
No other program generated as many public-sector
jobs as did the Works Progress Administration— later
renamed Work Projects Administration, or the WPA.

FRBNY Quarterly Review/Spring 1979

Established in 1935, before the advent of Federal un
employment insurance, the WPA provided a minimum
level of income for participants. The income support
afforded by the WPA was intended, however, to be
temporary. To encourage jobholders to seek nonsub
sidized work, participants’ wages were established
below those prevailing in the private sector. Moreover,
WPA employees enrolled for eighteen months were
required to leave the program for at least thirty days
before they could be rehired.
While the WPA was intended to provide temporary
jobs, the program was regarded initially as a boon
doggle wherein large numbers of participants did
limited work. Gradually, however, the program was im
proved. In the end, the WPA’s range of accomplish
ments was substantial. Roads, public parks, schools,
and stadiums were constructed under WPA auspices.
A variety of community services and cultural projects
were also completed with WPA funds. Indeed, the
experience demonstrated that public employment was
a viable method for employing large numbers of workers
with differing skill levels during long periods of high
unemployment. At the height of the program in 1938,
about 3 million persons, or approximately 30 percent
of the 10 million unemployed, were provided jobs.
Following the peak in WPA employment in 1938, the
number of participants declined steadily, and the pro
gram was abolished in 1943. By then, wartime labor
shortages had developed, and public service programs
were reoriented toward training in order to staff
defense-related industries. In the decade following the
end of World War II, public employment programs were
no longer necessary because of the relatively high
levels of employment and overall economic demand.
After these years of inactivity, public employment

programs were revived in the 1960’s. The principal
objective shifted from providing temporary economic
assistance to workers who were between jobs to im
proving the employment prospects of the “ hard-core”
unemployed— those workers who were chronically
unable to find jobs because of deficiencies in educa
tion, skills, or experience. This marked change in
Federal policy was attributable, in part, to the relatively
low levels of total joblessness that allowed the Federal
Government to focus on the deep-seated employment
problems facing relatively unskilled workers. Public
service jobs were created to supplement existing job
opportunities, but the emphasis was on job training and
temporary work experience. A host of manpower pro
grams aimed at minorities and the disadvantaged were
initiated. These included the programs authorized by
the Manpower Development and Training Act, as well
as the Job Corps, the Neighborhood Youth Corps, and
Operation Mainstream.1
In response to rising unemployment in 1971, the
Public Employment Program (PEP) was created.
Reminiscent of the work-relief initiatives of the 1930’s,
PEP’s primary aim was to counteract cyclical unem
ployment— unemployment attributable to inadequate
total demand in the economy. In a move toward decen
tralization of authority, PEP monies were distributed to
local governments that were responsible for designing
and conducting employment programs with minimal
Federal direction. At its peak in 1972, the program
employed an estimated 150,000 workers or about 3
percent of the total number of unemployed. PEP was
Intended as a two-year counter-recession program.
Under transitional provisions of the Comprehensive
Employment and Training Act, supplemental funding
became available in fiscal 1974, and the program did
not begin winding down until 1975.
Consolidation and decentralization: the CETA program
The Comprehensive Employment and Training Act of
1973 consolidated the operations of PEP and other job
training and public employment programs that had
been developed over the previous decade. The act also
formally decentralized authority for the design and
operation of public service programs. State and local
governments were delegated the responsibility for the
development and administration of public employment
activities. In this way, it was felt the programs would
’ The programs authorized by the Manpower Development and Training
Act initially focused on retraining workers who had been displaced by
automation. Later, these programs emphasized training unskilled and
inexperienced workers. The Job Corps and the Neighborhood Youth
Corps provided education, job training, and work experience for
young people. Operation Mainstream was aimed at older workers in
small communities and rural areas.

be tailored to local needs. The shift in responsibility,
however, transferred control from the Federal agencies,
which had acquired experience in the development
and operation of employment and training programs, to
relatively inexperienced state and local governments.
Initially, CETA was organized into four separate
programs— each with its own special goals. Title II,
the principal job-creation program, was aimed at
regions with disproportionately high unemployment.2
Funding was distributed according to the extent of un
employment in areas with jobless rates of 6.5 percent
or higher for three consecutive months. Unemployed
workers and persons from low-income families were
eligible to apply, and the first participants were hired
in July 1974. By the close of the year, nearly 100,000
persons were employed under public service programs.
In response to rising unemployment, a temporary
countercyclical Title VI program was appended to CETA
in December 1974. Applicants were required to have
been unemployed for at least thirty days, or fifteen
days if the local unemployment rate was above 7 per
cent. By December 1975, over 325,000 jobs were
financed by the combined CETA public employment
programs. With high rates of joblessness continuing
in 1976, funding for the Title VI program was extended
late in the year. At that time, stricter eligibility require
ments were introduced. The majority of new public
service positions was restricted to the low-income and
the long-term unemployed. In addition, emphasis was
put on placing CETA workers in special, short-term
projects that would not have been initiated without
Federal aid. The economic-stimulus package of 1977
allowed for more than a doubling of public service jobs.
Most of the increase was slated for public service jobs
under Title VI. By April 1978, an estimated 755,000 jobs
were funded under the CETA public employment Titles
II and VI. In addition, smaller scale CETA programs
provided public service jobs for youths, welfare recip
ients, and other disadvantaged workers.
As the economy expanded, steps were taken to dis
tinguish between countercyclical public employment
and public service programs aimed specifically at the
disadvantaged. In October 1978, the administrative
framework of public service employment was revised.
All public employment activities directed toward the
low-income and long-term unemployed were combined
under the Title II program. Eligibility for Title II jobs
2 Title I provided for the continuation of comprehensive employment and
training activities nationwide. Similar services were provided for
special groups of workers such as youth, migrants, and older workers
under Title III. The Title IV program authorized the extension of the
Job Corps for disadvantaged youth. In addition, a fifth title established
the National Commission for Manpower Policy to serve as an
independent advisory agency.

FRBNY Quarterly Review/Spring 1979

currently is limited to persons from low-income families
unemployed for at least fifteen weeks or receiving
welfare payments. These public service jobs are linked
directly with training and are intended to lead to regu
lar employment in the public or private sector.
In addition to introducing administrative changes, a
formula was adopted specifying the number of counter
cyclical jobs in a below “ full employment” economy.
According to this formula, when the overall jobless
rate exceeds 4 percent, the number of Title VI jobs
created equals 20 percent of the number of unemployed
in excess of 4 percent. Should the unemployment rate
exceed 7 percent, the number of public service jobs
created would equal 25 percent of the number of job
less workers above 4 percent. These positions are
intended to provide temporary work and income sup
port for those who are between jobs.
Using this formula, the current rate of joblessness of
under 6 percent means that the number of counter
cyclical jobs in 1979 will decline substantially from the
600,000 Title VI jobs authorized under the 1977
economic-stimulus package. The countercyclical pro
gram is scheduled to be cut even further in fiscal 1980.
What impact these reductions will have on total employ
ment remains to be seen. It may be that state and local
governments will use their own resources to fund some
of these public service jobs. In New York City, for ex
ample, the jobs of up to 7,800 of the city’s 25,000
CETA workers would be eliminated because of pro
posed funding reductions in 1980. However, the city’s
1980 budget plans provide funds to rehire about 3,000
of these CETA workers. Countercyclical funds may also
become available through other Federal programs.
Under a proposed urban-aid plan, cities with high
jobless rates may receive $400 million over the next
two years.
Although the number of countercyclical public ser
vice jobs is scheduled to be cut sharply, job oppor
tunities for the relatively unskilled are being stepped
up through greater coordination of public and private
programs. Toward this end, a new Federal initiative,
which seeks to involve the private sector explicitly in
CETA planning, is included in CETA’s 1978 reauthori
zation. Under this program, CETA agencies are
encouraged to develop programs meeting the employ
ment needs of private industry and to help CETA
participants find private-sector jobs. At the same time,
there are incentives for businesses to expand hiring
and training of unskilled workers, especially disad
vantaged youths.3 An estimated 80,000 private-sector
3 For a discussion of private-sector programs, see Jobs for the Hardto-Employ: New Directions for a Public-Private Partnership (Committee
for Economic Development, January 1978).

FRBNY Quarterly Review/Spring 1979

jobs are to be created under the new program by late
1980. In this vein, a revised tax credit program has also
been enacted which aims at promoting job creation in
the private sector by lowering the effective cost of
hiring and training disadvantaged workers. Taken
together, these programs are anticipated to offset most
of the proposed cuts in CETA’s countercyclical pro
gram. Nonetheless, because of the increased emphasis
on the private sector, public service funding will
decline significantly from the $6 billion authorized for
public service employment in fiscal 1979.
Important steps recently have been taken to
strengthen the Federal Government’s supervision of
CETA as a result of mismanagement and certain
abuses of the program in the past, such as political
patronage, fraud, and discrimination. In addition to
improving overall management and efficiency, a new
Federal program is designed to enhance the training
and technical assistance provided by the Federal
Government to local supervisory staff. This program
seeks to identify successful local programs and to
encourage the development of similar activities in
other regions. At the same time, independent monitor
ing agencies are being established to improve program
supervision at the local level. These agencies are
charged with insuring local compliance with CETA
rules and periodically evaluating local operations. In
light of past abuses of the CETA program, the United
States Department of Labor has been given expanded
authority to investigate and to take action against pos
sible misuses of CETA funds in order to prevent similar
abuses in the future.
The cyclical impact of public service employment
Jobs created under public employment programs play
an important role in a countercyclical policy. The sig
nificant expansion of CETA public employment between
mid-1977 and mid-1978 was aimed at reducing the high
rate of joblessness that resulted from the 1973-75
recession. In the twelve months ended April 1978,
about 450,000 additional jobs were funded under the
CETA programs. That increase represents roughly 12
percent of the gain in total employment during that
period. Whether the actual contribution of CETA public
employment was this large, however, depends on the
extent to which local agencies substituted Federally
financed jobs for positions they would otherwise have
funded themselves. Such “ job substitution” , of course,
reduces the effectiveness of public service programs
in directly creating jobs.
Estimating the rate of substitution is difficult. Analy
ses of the job-creation effects of public employment
programs report widely differing rates of job substitu
tion. Several statistical studies evaluated the job-

creation impact under PEP and the continuation of
public employment under CETA.4 In these studies, the
substitution rates were estimated to be 30 to 60 percent
one year later and, in several cases, to be substantially
higher thereafter. Based on interviews with CETA staff
and local fiscal data, two recent studies evaluated
CETA public employment as of July 1977 and Decem
ber 1977.5 According to these surveys, between 15 and
18 percent of CETA positions were substituted for jobs
that would have existed in the absence of Federal
funding. These analyses, however, employed a very
narrow definition of substitution. CETA jobs that main
tained services which might otherwise have been
curtailed were considered new jobs. Between 15 and
30 percent of the CETA jobs were involved with main
taining existing local services. Whether or not these
services would actually have been discontinued is
subject to question. If some of these positions had
been maintained with local funds, the substitution rate
would approach earlier estimates. Although the various
studies of substitution are based on differing assump
tions and are subject to limitations, the evidence
suggests that the substitution rate of public employ
ment programs is in the neighborhood of 40 to 50 per
cent about one year later and increases subsequently.
Although the estimates of earlier studies indicate
there are high rates of substitution, these estimates
may not be representative today, in light of new regu
lations. The maximum Federal contribution currently is
limited to $10,000 for each new CETA worker or $12,000
for each new employee in a high-wage area. Previously,
local agencies were allowed to supplement public ser
vice wages from their own budgets by any amount, but
current regulations limit local agencies to adding no
more than 10 percent of the maximum Federal wage
paid to workers in the countercyclical program.4 In
addition, the duration of public service jobs is now
4 For example, see the technical analysis papers of George E. Johnson
and James D. Tomola, prepared for the Office of the Assistant
Secretary for Policy, Evaluation and Research, United States Depart
ment of Labor; An Evaluation of the Economic Impact Project of the
Public Employment Program (Final Report, National Planning Associa
tion, May 1974); William Mirengoff and Lester Rindler, CETA:
Manpower Programs Under Local Control, (National Academy of
Sciences, 1978).
5 Richard P. Nathan and others, "Monitoring the Public Service
Employment Program— Preliminary Report", in Job Creation Through
Public Service Employment (Volume II, An Interim Report to the
Congress of the National Commission for Manpower Policy, March
1978), and Monitoring, the Public Service Employment Program: The
Second Round (Number 32, A Special Report of the National
Commission for Manpower Policy, March 1979).
*To insure that those workers with the greatest employment needs
participate, local agencies may not supplement wages under the
CETA program aimed at the disadvantaged. Moreover, the nationwide
wage goal for CETA public employment is $7,200.

generally limited to eighteen months. These regulations
may significantly change the composition of CETA
employment, especially in large cities where CETA had
often been used to pay the salaries of city workers who
would have been laid off in the absence of Federal
funding. Because of expected changes in personnel,
the level of community services may be affected. In
New York City, for example, a major portion of the
CETA work force must be replaced by October 1979
to comply with the new, stricter employment standards.
The city’s budget plans make allowance for problems
likely to be created by replacing experienced employ
ees with untrained CETA workers.
Public service employment and structural joblessness
In addition to creating further job opportunities, public
service programs attempt to reduce structural
unemployment— joblessness that reflects mismatches
of skills, inadequate education, institutional barriers to
employment, or geographical imbalances of job oppor
tunities. The principal goal of countercyclical public
employment is to provide jobs and income support to
persons who are temporarily without work. Most of the
unemployed are eligible. Structural public service pro
grams, in contrast, are primarily for those groups of
workers who suffer chronically high unemployment.
Even if substitution is extensive, public service pro
grams can be effective in reducing structural unemploy
ment if the composition of local employment is altered
to include those workers who are relatively disadvan
taged. The increasing focus of public service employ
ment on those workers most likely to face special diffi
culties in obtaining employment is reflected in CETA
enrollment. In fiscal 1978, over 75 percent of CETA
jobholders qualified as being economically disadvan
taged. About one third of CETA public employment
participants were members of minorities, considerably
more than their share of the unemployed population.
Just how effective are public employment programs
in reducing structural unemployment? One measure
of the near-term success of public service employment
is the extent to which participants secure nonsubsi
dized employment following enrollment in the program.
In fiscal 1977, only about one third of the participants
who left CETA public employment programs obtained
regular positions in the public or private sector.7 While
data are limited, the evidence suggests that CETA
workers tend to remain in public service programs. This
is due, in part, to the fact that generally the length
7 "Public Service Employment: An Overview of the Issues and the
Evidence” , in Job Creation Through Public Service Employment
(Volume I, An Interim Report to the Congress of the National Com
mission for Manpower Policy, March 1978).

FRBNY Quarterly Review/Spring 1979

of participation was unrestricted, and therefore move
ment to regular work was less of an immediate con
cern. Today, the emphasis in the structural public ser
vice program is on increasing skills to prepare partici
pants for transition to regular employment. Moreover,
the new limit on CETA participation allows a greater
number of disadvantaged workers to participate and
provides an incentive for workers to find regular
employment.
While steady work experience enhances the future
job prospects of participants, to be effective these
structural programs must impart knowledge and mar
ketable skills enabling workers to acquire long-term
employment. When participants in structural public
service programs are assigned to low-level positions
without the advantage of training, enrollment may not
help alleviate the disparities between job requirements
and participants’ skills. In the past, public service
participants have worked primarily in basic service
areas— such as fire and police protection, utilities, and
public works— but the work assignments have tended
to require relatively few skills. Moreover, there has
been only a minimal emphasis on job training. Under
CETA’s 1978 reauthorization, structural public service
employment now encompasses job training directly.
During the next four years, moreover, the proportion
of funds spent on skill development under the struc
tural program will more than double.
How successful this increased emphasis on training
will be in improving the long-term job prospects of
public employment participants remains to be seen. A
modest improvement in near-term earnings has been
found in evaluations of pre-CETA training efforts.8
• For example, see Orley Ashenfelter, “ The Effect of Manpower Training
on Earnings: Preliminary Results” , Proceedings of the Twenty-Seventh
Annual Meeting of the Industrial Relations Research Association
(December 1974), pages 252-60.

Participation in CETA’s public employment programs
can increase the current income level of workers.
Participation may also be effective in generating short
term gains. The long-run performance of CETA’s struc
tural public employment program, however, remains to
be thoroughly evaluated.9
Directions of public service employment
As a countercyclical policy tool, public service employ
ment provides temporary jobs and income support to
workers during periods of economic slowdown. Since
public employment can be instituted relatively quickly
and is likely to create more jobs per dollar spent than
other policies, it is an effective short-run counter
cyclical tool. However, its effectiveness declines over
time as local agencies come to rely increasingly on
Federal funds. With the economy entering its fifth year
of expansion, cyclical joblessness is not a problem
today. As a consequence, and in response to past mis
management and abuse, greater emphasis is being
placed on public employment programs for those
groups of workers who suffer chronic unemployment.
Combined with training, these jobs are being created
in an attempt to increase the future employment pros
pects of participants. A greater emphasis is also being
placed on engaging the private sector in the Govern
ment’s employment and training programs aimed at the
disadvantaged. At the same time, attempts are being
made to improve the management and efficiency of
these Federal programs.

9 The Bureau of the Census conducts an ongoing survey of CETA
participants following enrollment in the program. The data which are
available show a short-term improvement in earnings. An analysis on
the employment and earnings status of CETA participants three years
after entering the program is in progress.

Deborah Jamroz

FRBNY Quarterly Review/Spring 1979

The
financial
markets
Current
developments
Chart 1

Recent Changes in Interest Rates
Percent

Aaa-rated
state and local
government bonds

5 .5 0 r S ~
I I 1111111111 L.IJ 111111. l i-l-L-UN
J
A
S O

1978

1979

♦T h is yield is adjusted to twenty-year maturities and
excludes 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.

The w inter and early spring was a period of relative
stability in the credit markets. A fter rising throughout
most of 1978, interest rates generally came under
downward pressure as the new year began. Thereafter,
yields on shorter term securities remained at their
lower levels, while those on longer term instruments
retraced their earlier declines. The monetary aggre
gates continued to show little or no growth, as they had
during the closing months of 1978. Among the factors
contributing to these developments were a slackening
of the pace of econom ic expansion, continuing changes
in the p ub lic’s asset management practices, and greater
stability in the foreign exchange markets.
As the new year unfolded, money market interest
rates quickly reversed the sharp run-ups that had
occurred in the previous two months and then held
fairly steady over the balance of the w in te r and early
spring. Changes in the yield on three-m onth certificates
of deposit (CDs) are representative of these movements.
During January the secondary m arket rate on these in
struments fell by approxim ately 85 basis points to 10.15
percent, w hich is about where it stood in late October,
and subsequently moved very narrowly around this level
(Chart 1). These developments came against a back
ground of sluggish monetary growth and a Federal
funds rate that hovered close to 10 percent throughout
the period beginning in mid-December. In retrospect,
it appears that, as the w inter wore on, m arket partici
pants reevaluated their interest rate outlook and came
to view an additional firm ing move by the Federal
Reserve as unlikely to occur in the near term.
Yields on long-term securities tended to follow
short-term rates down during the latter part of January
but then reversed field in February. By late March, these
rates were also fluctuating w ithin narrow lim its and on

FRBNY Q uarterly R eview /Spring 1979

balance showed little net change for the period as a
whole. In the markets fo r Treasury and corporate
bonds, yields began the spring slightly higher than
where they were at the end of 1978. For example,
recently offered Aaa-rated utility issues were trading
around 9.65 percent, up some 15 basis points from their
levels in late December.
Sim ilarly modest rate increases were recorded on
long-term United States Government securities. Toward
the end of March, a delay in Congressional enact
ment of legislation raising the tem porary ceiling on
the national debt caused uncertainty over the
Treasury’s financing schedule. The delay led the
Treasury to postpone a number of securities auctions,
to suspend tem porarily the sale of savings bonds, and
briefly to interrupt the mailing of income tax refund
checks. Following enactment of the legislation on
April 2, the suspended services were resumed and the
Treasury announced a series of securities sales total
ing $26.7 billion over an eight-day period.
The tax-exem pt sector of the capital markets
benefited from a relatively strong technical position in
the early months of 1979, with inventories of unsold
securities generally remaining modest. Indeed, at times
dealer inventories, as measured by the Blue List,
reached their lowest levels in three years. As a result,
while yields on m unicipal bonds followed the same
general pattern as other long-term rates, they com
pleted the w inter somewhat below their initial levels.
Recently, an increasing number of m unicipalities
have been issuing a new type of tax-exem pt instrument,
revenue bonds backed by mortgages on single-fam ily
homes. Typically, a comm unity sells tax-exem pt securi
ties and then uses the proceeds to purchase mortgage
loans originated and serviced by local banks, th rift
institutions, and mortgage bankers. The loans go to
home buyers satisfying criteria set by the issuers (e.g.,
maximum income levels). State governments recently
have been issuing such securities at an increasing
rate, and in July 1978 Chicago became the first local
government to enter the market. The bonds are secured
by the mortgages, insurance on the mortgage pool, and
reserve funds equaling about 15 percent of the bond
issue. With these provisions, tax-exem pt bonds have
been sold at a cost of around 7 percent and mortgages
have been extended at rates of up to 81/2 percent, or
about 2 percentage points below open market rates. Pro
grams like these provide an additional means by which
governments may seek to stim ulate residential con
struction by subsidizing mortgage financing. Among
the questions raised by such efforts are whether the
people who obtain the funds need the subsidy and
what percentage of the funds contributes to additional
construction as opposed to other expenditures.

FRBNY Quarterly R eview/Spring 1979

Chart 2

Growth of Monetary Aggregates and Base
Seasonally adjusted
Percent
15-

10-

—
1 -

0
- 5IL .... I ... . L
15-

...... I

10 -

ot
15-

10 -

oL
15-

Monetary base *

10-

5-I----- 1—
1975

1976

1977

1978

III
1978

I
1979

The annual growth rates represent the percentage change
from the fourth quarter of one year to the fourth quarter
of the next. The quarterly growth rates represent the
percentage change from the preceding quarter expressed
at annual rates.
♦A d ju ste d for changes in Regulation D.
Source:

Board of Governors of the Federal Reserve System.

The unexpected, but prolonged slowing in the growth
of the monetary aggregates contributed to the generally
stable atmosphere in the cred it markets. The sharpest
deceleration was fo r
A fter advancing at roughly an
8 percent rate during most of 1977 and 1978, it rose at
a 4.4 percent rate in the fall and actually declined dur
ing the first quarter of this year (Chart 2). At its meeting
on February 6, the Federal Open M arket Com m ittee
(FOMC) anticipated some continuation of the sluggish
ness in Mv Hence, it projected the growth of this
aggregate at between V /2 and 41/2 percent for all
of 1979, down from the 2 to 6 percent range that had
been projected for the four quarters ending in 1979MI. Nevertheless, since the meeting, M x growth has
fallen short of the Com m ittee’s expectations.
The rates of advance of the broader monetary aggre
gates (M, and M ,) have also eased considerably since

last summer. At first, this was due largely to the
weakness in the Mx component of these measures.
However, in recent months there has been a marked
slowing in the growth of savings and smalldenomination time deposits, particularly those at
commercial banks. As a result, the first-quarter growth
rates of the broader aggregates, like that of M1( are
well below the ranges projected by the FOMC for all
of 1979. The range for M2 is 5 to 8 percent, while for
M3 it is 6 to 9 percent. Both of these are approximately
1 percentage point below the bands that had been
established for the four quarters ending in 1979-111.
The current 1979 growth ranges set by the FOMC
at its February meeting are the first monetary aggre
gate projections made under the Full Employment and
Balanced Growth Act of 1978 (“ Humph rey-Hawkins”
Act). The act requires the Board of Governors of the
Federal Reserve System to report in writing to the
Congress by February 20 and July 20 of each year on
its and the FOMC’s “ objectives and plans” for the
aggregates for that calendar year. In addition, the July
report is to include an early statement of objectives
and plans for the aggregates for the coming calendar
year. A key element of the legislation is that the oneyear growth ranges will no longer be adjusted forward
once a quarter. Instead, the ranges may be revised or
adjusted (with explanation), but the time periods are
calendar years.
Some slowing in monetary growth normally occurs
in the advanced stages of a business expansion. The
present decline is unusually large, though, and raises
questions of whether special factors are influencing
the public’s asset management practices. The Novem
ber 1 introduction of negotiable order of withdrawal
(NOW) accounts in New York State and automatic
transfer accounts throughout the country are such
factors. These developments caused a shift of funds
from checking accounts to savings accounts, without
having any apparent impact on the real economy. Thus,
there is general agreement that the reported growth of
M1 should be adjusted or “ corrected” for this effect.
On the basis of current estimates, such an adjustment
would increase Mj growth in the fall and winter quarters
by 1 and 3 percentage points, respectively.
The analysis of the monetary aggregates in the
article beginning on page 1 of this Review suggests
that it may also be appropriate to adjust the currently
reported data to take account of the public’s invest
ment in highly liquid nondeposit assets. Included
among these are overnight repurchase agreements,
overnight Eurodollar deposits, and money market mu
tual funds. It is unlikely, though, that every dollar

invested in these assets would otherwise have been
held in a checking account. Hence, the magnitude of
the latter corrections is open to further analysis.
The resulting uncertainties over the growth rates
of the monetary aggregates have led some observers
to focus more attention on the monetary base. Whether
the use of the base can help resolve these uncertain
ties is not clear. The Federal Reserve Bank of St.
Louis has published a measure of the monetary base
for some time and, on March 15, the Board of Gov
ernors of the Federal Reserve System began publishing
a slightly different series. Put simply, the monetary
base is an adjusted measure of the net monetary liabili
ties of the United States Treasury and the Federal Re
serve System held by the commercial banks and the
nonbank public. Specifically, it is the sum of member
bank deposits at the Federal Reserve, vault cash held
by all banks, plus currency held by the nonbank
public.
In recent months the growth of the monetary base
has slowed, like that of the other aggregates, but the
deceleration did not begin until this year and thus far
has been relatively modest. After rising at about a 9
percent rate through the fourth quarter of last year,
the growth rate of the monetary base dropped to slight
ly less than 6 percent in the first quarter.1 Such a slow
ing is comparable to some of the results obtained when
the growth rates of the conventional aggregates are
adjusted for various special factors influencing the
public’s asset management practices.
Sales of six-month money market certificates of
deposit continued at a rapid pace during most of the
first quarter, and this helped to moderate the slack in
the broader monetary aggregates. While the certificates
have been favorably received by depositors, there was
concern over their effect on the cost of funds to the
issuing institutions. Reflecting this concern, the Board
of Governors, the Federal Home Loan Bank Board, and
the Federal Deposit Insurance Corporation took joint
action, effective March 15, to lower the ceiling interest
rates payable on the certificates.
Subsequently, on April 13 the Board of Governors
proposed a 3 percent reserve requirement on Federal
funds and on repurchase agreements (RPs) on Trea
sury and agency securities made by member banks
or Edge Act units with any lenders except those subject
to reserve requirements imposed by the Federal Re
serve. The action is designed to establish more effective
control over the growth of bank credit.
1 The growth rates reported here are those published by the Board
of Governors and are adjusted for changes in Regulation D.

FRBNY Quarterly Review/Spring 1979

Global asset and
liability management at
commercial banks
A dramatic expansion of international banking in recent
years has led banks to reexamine the traditional
decision-making process. Many banks had found that
their international operations had grown in size and
complexity, particularly regarding funding and lending.
Additional effort was thus required to monitor and to
coordinate these activities, especially with domestic
money management. Accordingly, some banks have
adopted, or are presently considering, bankwide pro
cedures for coordinating their asset and liability de
cisions. Other banks have continued to rely consider
ably on decision making by branches and functional
units.
The variety of approaches currently used stems from
differences in views about the best practical approach
to funds management. There is no disagreement that
conceptually the consolidated balance sheet and over
all profit statement are key accounting elements for
bank decisions. Nor are institutional constraints an
impediment to global management. Until five years
ago, United States capital controls had limited the
movement of funds, between domestic and foreign
offices of banks, making it less necessary to have an
overall perspective. Today, however, dollar funds move
freely among major capital markets and the move
ment of other currencies is relatively unconstrained,
particularly in offshore markets. In principle, there is
no barrier to linking the activities of separate banking
units. Operationally, however, a global decision pro
cess may not be best for all banks. It requires that
senior management assimilate bankwide information
quickly, assess opportunities in world markets, and
communicate decisions within the organization. To
integrate these activities effectively may be costly.
Moreover, coordinating decisions may conflict with

FRBNY Quarterly Review/Spring 1979

other goals of bank management. The decision to
adopt a global management approach depends upon
the circumstances at an individual bank and the phi
losophy of its management. This article, based on
discussions in New York and other major money mar
ket centers, reviews the pros and cons of alternative
methods of asset and liability management.
Bank management in a nutshell
At the heart of the bank management process are
committees of high-ranking officers representing the
major functions of the bank. For asset and liability
management, for example, the most important areas
represented are investment, money market, and lending
activities, both domestic and foreign, supported by the
economic analysis function. The fundamental long-run
task of top management is to chart the probable course
of the bank, allowing for adequate funding and capi
talization to accommodate planned needs. Rarely, if
ever, will events proceed exactly as planned. Lending
opportunities may be greater or less than anticipated,
money market conditions may tighten or ease, or cur
rencies may come under upward or downward
pressures. Therefore, management’s objective is to
position the bank so that it can adapt profitably to
whatever conditions arise. One of the facts of life for
management is that a modern international bank is
dependent upon funds borrowed in the money market
for a large portion of its liabilities. A bank is able to
attract these funds at a favorable cost in part because
of the perceived safety and liquidity of its liabilities.
The guidelines set by management for sound oper
ations are, therefore, critical for maintaining the attrac
tiveness of the bank. A checklist of management con
cerns would include the following.

(1) Adequate capital. As the ratio of assets to capi
tal increases, the risk to shareholders and uninsured
depositors increases but, as the ratio declines, the rate
of return on capital falls off. The happy medium is hard
to find. When achieved, it is a blend of what com
petitors are doing, what supervisory authorities view
as appropriate, and what the bank’s own management
thinks is prudent. However an acceptable ratio is de
termined, it w ill affect management decisions. In the
planning process, the ratio signals the need to raise
additional capital in order to meet planned growth.
If the capital cannot be raised at an acceptable cost,
the expansion of the bank’s activities may be impeded,
in the long run, by the need to stay w ithin the range
of prudent capital coverage.
(2) Liquidity. It is the nature of banking to make
commitments to receive and to pay out funds. Some
commitments may be fixed in advance. The bank may
be required to make payment to the holder of a ce rtifi
cate of deposit or a Eurodollar account, to receive
payment on a maturing Treasury bill, or to hold funds
in its reserve account with the Federal Reserve. In
other cases, the tim ing and the amount of the flows are,
w ithin limits, at the discretion of the customer. He may
choose to draw down a deposit or a line of credit, to
roll over a loan, to make payments against an outstand

ing loan, or to put funds into a demand or time deposit
account. The liquidity problem fo r the bank is always
to be able to honor comm itm ents to make payments at
an acceptable cost and w ithout reliance on the Federal
Reserve discount window. To do this, banks chart fore
seeable inflows and outflow s of funds. They prepare
for anticipated outflows by arranging to obtain funds
at the time that the funds are needed. They also try to
reduce the likelihood of unforeseen shortfalls by using
stable sources of funds, such as custom er deposits
and funds with long m aturities, in order to reduce the
volatility of liabilities. As a cushion on the asset side,
they hold liquid assets. However, banks also rely upon
their capacity to borrow in money markets as an
im portant alternative to holding liquid assets. The
markets in Federal funds, repurchase agreements,
bankers’ acceptances, certificates of deposit, Euro
dollar deposits, and the comm ercial paper of the bank
holding companies are sources from w hich banks plan
to obtain funds as needed (Table 1).
(3)
Market exposure. Because banks depend so
heavily on the money markets for liquidity, it is im
portant for them not to exhaust their capacity to bor
row. They do this by remaining w ithin what they feel
is their share of each segment of the market. The
demand for funds beyond the custom ary level is an

Table 1

Selected Assets and Liabilities of Large Commercial Banks11
In billions of dollars

(1)

Year-end
1966
1969
1970
1972
1974
1976
1978

Net
Federal
funds
purchased!

(2 )
Certifi
cates
of
deposit

(3)
Other
liabilities
for borrowed
fundst

(4) I
Net
liabilities
to foreign
branches?

S if

(5)
Total
loans
and
investments

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

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

9.5

12.6

10.8
20.0

6.5
1.1
• 1.3
•15.5
-17.6

28.4
51.3
61.4

189.4
239.8
261.0
325.4
410.2
416.4
503.6

Ratio to
(1) to (5)
(percent)

4.0
4.1
6.1

6.9
12.3
12.2

Ratio to
(2) to (5)
(percent)
8.3
4.5

10.0

13.8
22.6
15.8
19.9

* Weekly reporting banks.
f Net of Federal funds sold to other commercial banks. Includes securities sold under agreements to
repurchase.
t Excludes borrowing from the Federal Reserve.
8 A negative number indicates net funding of foreign branches.
II Not available.
Source: Federal Reserve Bulletin.

FRBNY Quarterly R eview/Spring 1979

ambiguous indicator of a bank’s condition. The funds
may be wanted because of profitable opportunities or,
if the bank is having problems, to honor commitments.
Whatever the actual situation, there is the danger that
the financial markets will take the pessimistic view that
the bank is experiencing internal problems. Banks are,
therefore, reluctant to exceed their normal share of the
market for fear of tarnishing the value of their name
and thereby running the risk that all segments of the
market would then be closed to them.
(4) Foreign currency positions. A bank’s net position
in a foreign currency exposes it to the risk of fluctua
tion in the value of that currency. The bank may gain,
but it also risk's a loss. To limit potential losses, a
bank establishes rules concerning who will take such
risks and to what extent. The general practice is to
limit foreign exchange risk by hedging most foreign
currency positions. However, foreign exchange traders
may take positions within preset limits and subject to
review at a higher level.
(5) Maturity mismatches. Raising funds at a ma
turity different from that at which the funds are lent
gives rise to two concerns. One is the commitment to
provide funds, that is, the liquidity problem discussed
above. The other is the commitment to a particular
interest rate. Unexpected changes in market interest
rates may result in gains or losses in the bank’s port
folio. Losses may result if the bank finances its loans
with relatively short-term funds and market rates rise
or if relatively long-term funds are used and lending
rates fall. Correspondingly, profits can be earned if
interest rates move in the other direction. In practice,
much of this risk is mitigated by tying the lending rate
to the cost of funds. However, banks can profit
from the usual interest rate differential inherent in
borrowing short and lending long and from correctly
anticipating changes in interest rates. Hence, to an ex
tent, they try to harmonize the maturity structure of
the portfolio with likely interest rate developments.
If rates are expected to fall, for example, fixed rate
loans and short-term borrowings would be preferred.
As with foreign exchange positions, top management
must set limits on maturity mismatches and, especially,
it must see that these limits are consistent with ex
pected money market developments.
Having established general policy for the bank and
having set limits on discretionary decisions that can
be made at lower management levels, senior manage
ment leaves actual operations and market strategy to
officers with functional or regional responsibilities.
Adherence to the limits is frequently checked in the

FRBNY Quarterly Review/Spring 1979

asset and liability management process, but within the
limits managers are expected to maximize profits from
their activities. Typically, the performance of a funding
or a lending area is judged in relation to a standard
measure of the cost of funds to the bank. The threemonth London interbank offer rate or the three-month
certificate of deposit rate (adjusted for reserve require
ments and deposit insurance) are common choices,
although particular activities may be matched against
other rates. A money market function would try to raise
funds at a lower cost, whereas a lending function
would try to obtain a higher yield. The extent to which
each succeeds determines that unit’s profits.
Global management
The global approach to asset and liability management
shares all the features of traditional bank management
just described. The concerns of management are the
same. Operating responsibilities are still divided by
function and by region among profit center managers,
each with limits placed on his discretionary decisions.
At the same time, advocates of global management
recognize that in the 1970’s the world economy has
become more integrated and, in some ways, riskier.
The geographic division of responsibilities is seen as
an insufficient approach to both decision making and
risk management in worldwide markets. A unified ap
proach to funds management is thought to be a better
way to interface with today’s highly integrated markets.
Consequently, emphasis is placed on bridging the gap
between strategic planning and the bank’s day-to-day
currency and money market decisions. Efforts are
made to know aggregate bank positions on a timely
basis, to understand and to assess market conditions,
and to coordinate market positions in a way consistent
with an overall strategy.
The changing environment
The increased use of global management techniques
is a logical response to the changes that occurred
in the world economy during the early 1970’s. First,
United States capital controls were removed, allowing
free interactions between the domestic and interna
tional operations of banks. Second, the volume of
international banking transactions, particularly through
offshore offices, had grown into a major component of
the total business of United States banks. Last, fluctu
ating exchange rates and wider variations in interest
rates added to the risk of open currency and maturity
positions.
The removal of capital controls
In the 1960’s, United States authorities initiated three
programs that limited the ability of banks to move

funds internationally. In 1965, in the hope of alleviating
persistent balance-of-payments outflows, the United
States extended the coverage of its interest equaliza
tion tax (IET)— a tax on foreign equity and debt issues
purchased by United States residents— to include long
term bank loans to foreigners. At the same time, volun
tary limits on bank lending abroad were adopted under
the voluntary foreign credit restraint (VFCR) program.
In 1969, under Regulation M, the Federal Reserve
adopted measures to stem inflows of funds from for
eign branches of United States banks during the period
of tight monetary policy. As the result of these restric
tions, the domestic activities of United States banks
tended to be isolated from their international ones.
The IET and VFCR restrictions on banks were re
moved early in 1974, and the Regulation M reserve
requirement was reduced in stages between 1973 and
1978. The end of capital controls removed the main
institutional wedge that had segmented the dollar
financial markets. Consequently, the degree of inter
dependence between domestic and foreign operations
increased significantly. Domestic funds could, and did,
support foreign business; equally, foreign funds could
support domestic business. When capital controls lim
ited bank options, there had been no great cost in
compartmentalizing the bank decision process; but
with the end of these controls the cost of, and return
from, funds became the primary concern— the more
so with the increasing volume of business.
The growth of international banking
International banking, by United States banks and
banks of other countries, has grown very rapidly since
the 1960’s. Claims on foreigners of United States banks
(including their foreign branches) have increased 30
percent per year since 1969 (the earliest year for which
reliable foreign branch data are available), while liabil
ities to foreigners have grown 21 percent per year
during the same period. By comparison, assets of
domestic offices of large United States banks have
grown much more slowly, 9 percent per year. Abroad,
Bank for International Settlements statistics indicate an
eightfold jump in Eurocurrency deposits of banks in
eight reporting European countries (including branches
of United States banks located there) since 1969
(Table 2). The boom of United States banking abroad
has been very profitable for banks. In recent years
some United States banks have derived 50 percent or
more of their total profits from international activities,
compared with more modest earnings a decade ago.
The major factor behind the impressive growth of
international banking activities is the increasing inter
dependence of the world’s economies: the growth of
world trade, the global investment of multinational

corporations, the rapid economic growth of some de
veloping countries, and the imbalance in world pay
ments, particularly since the 1973 OPEC oil price
Increase. It is natural that much of the increased pay
ments flows associated with these events would occur
through banks.
Significantly, much of the growth of international
banking has occurred through offshore banking cen
ters. Claims of foreign branches of United States banks
on foreigners have grown at an annual rate of 33 per
cent since 1969, while their liabilities to foreigners
have increased at a 22 percent rate (Table 2). The use
of offshore centers is related mainly to the lower cost
of bank activities there. The restricted access to the
United States capital markets during the period of con
trols, helped to promote the use of offshore facilities
during that period. More important, though, has been
freedom from other regulations, particularly reserve
requirements, deposit insurance, and interest rate
ceilings. Alternative tax structures abroad also offer
some cost advantages to offshore banking. Moreover,
offshore centers offer a choice of location to some
depositors who are concerned that their accounts may
be blocked or expropriated.
As international activities grew, the impetus for top
level bank management to monitor the international
function increased. The consequence of errors was no
longer small. Moreover, in the mid-1970’s the risk from
international activities seemed less hypothetical than
before. Questions were being raised about the sound
ness of bank loans to tanker companies and to de
veloping countries, while the failure of a few prominent
banks underlined the need for sound management. The
environment was right for head offices to take a closer
look at their global operations.
Increasing risks in the marketplace
In the 1970’s exchange rates and interest rates have
become more variable than they had been in the recent
past. Central banks stopped pegging exchange rates
in 1973, allowing them to float (although some coun
tries, such as those in the European Community main
tained currency arrangements that provided for a de
gree of cohesiveness among their exchange rates).
Whipsawed by events— widespread inflation, an oil
embargo and price increases, recession in industrial
countries followed by an uneven recovery, and persis
tent trade imbalances among major countries— both
exchange rates and interest rates have moved by
wider amounts than in the past.
For banks, this movement has accentuated the risks
of foreign currency exposure and maturity mismatches
discussed above. Because potential gains and losses
have increased, the interest of bank management in

FRBNY Quarterly Review/Spring 1979 45

Table 2

Selected Measures of the Growth of International Banking
In billions of dollars

Year-end

Claims of United States banks
on foreigners
Head
Foreign
Adjusted
office*
branchf
totals

1962
1966
1969
1970
1972
1974
1976
1978

7.3
12.0
12.9
13.9
20.7
46.2
79.3
125.2

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

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

U
11
15.9
28.6
59.8
111.2
158.5
207.4

II
IT
28.1
41.8
79.5
151.6
218.1
302.7

Liabilities of United States banks
to foreigners
Head
Foreign
Adjusted
office’
branchf
to ta lf
22.0
29.1
42.6
43.5
61.7
96.1
110.7
166.3

II
II
27.8
35.7
61.0
106.0
135.6
168.9

II
11
59.2
71.9
120.6
197.6
241.9
323.0

Assets of
Gross
United States
Eurocurrency
offices of
deposits in
large banks§ eight countries!!
168.4
242.2
316.4
337.1
410.2
529.5
552.4
689.9

II
U
56.9
75.3
131.9
220.8
310.7
447.9“

* The figures include head-office claims on, and liabilities to, their own foreign branches. Custody
claims and liabilities are not separable from the bank’s own claims and liabilities prior to 1978.
In 1978, head-office claims and liabilities net of custody claims and liabilities items were $114.2 billion
and $77.8 billion, respectively.
t Net of claims on, or liabilities to, sister branches.
£ Net of head-office claims on, or liabilities to, its own foreign branches.
* Weekly reporting banks.
II The data do not include bank positions vis-a-vis residents of the country in which the bank is
located. The reporting banks are those located in Belgium-Luxembourg, France, Germany, Italy,
the Netherlands, Sweden, Switzerland, and the United Kingdom.
II Not available.
“ September 1978.
Sources: Federal Reserve Bulletin: Bank for International Settlements, Annual Report (“ External
Positions of Reporting European Banks in Dollars and Other Foreign Currencies'1).

managing these positions closely has also increased.
For the bank as a whole, risk stems from exposures
that do not net out from the overall balance sheet. In
this sense, the interest in global management is d i
rectly related to an interest in managing foreign cur
rency and m aturity exposures.

Pros and cons of central coordination
The growth of international banking and the greater
interdependence and riskiness of money markets and
foreign exchange markets increased the incentive for
some banks to use a global approach. Not all banks in
volved with international business have adopted global
asset and liability management, however. Bank man
agements differ in the assessment of the relative merits
of global management versus decentralized manage
ment. Some banks feel that central coordination en
ables them to manage better the flow of funds within
the organization and to initiate profitable transactions
that otherwise would not have been undertaken. Other

FRBNY Quarterly R eview/Spring 1979

banks feel that they are more effective if operated as
individual profit centers with the looser coordination
inherent in the traditional management review process.
Particularly, they are concerned w ith the way in which
central coordination shifts responsibilities to head of
fice personnel, reducing motivation at lower levels and
in foreign branches.
Much of the impetus for global management comes
from the desire for a unified approach toward sources
of, and uses for, funds in world markets, particularly
world dollar markets. The primary goal is for the bank
to be more effective in its use of the money markets.
To the extent that it succeeds, the bank will be more
profitable.
In practical terms, global management may help a
bank fund itself at the lowest rate and lend at the
highest. Since all banks compare rates in various mar
kets when seeking or placing funds, the advantage of
centralized information flow may be small under usual
circumstances. However, where timing is crucial— as

with an unexpected change in market conditions, for
example— the difference between the two banking
arrangements may be important. The authority to act,
as well as the information per se, may be critical. The
officer in charge of global management not only has
flexibility in his choice of markets, but generally has
wider limits on the positions he can take than his
counterparts at individual profit centers. By contrast,
the relative effectiveness of officers of branch profit
centers would depend in part upon the ease with
which they could obtain permission from the head
office to exceed their limits in special situations.
Global management may also enhance a bank’s
ability to arbitrage favorable rate differentials. For
example, six-month dollar funds may be available at
10.50 percent (adjusting for reserve requirements and
deposit insurance) in the New York certificate of
deposit market but may earn 10.75 percent in the
London Eurodollar market. By placing $1 million in
the London market financed from funds raised in New
York, the bank would earn a profit of $1,250. In the
process of bidding for funds in one market and offer
ing them in the other market, the bank helps to narrow
the arbitrage differentials between the rates in the
two markets. In that way, the degree of integration
between the two segments of the market is increased.
In some banks organized as separate profit centers,
the arbitrage function is handled by having funds man
agers deal at arm’s length with their counterparts in
other locations within the bank. Each manager could
initiate an arbitrage transaction. At most banks, how
ever, the decision to transact simultaneously in two
markets requires agreement between the managers
responsible for each market. Without central coordina
tion, they would have to decide on a means of splitting
the profits ($1,250 in the example) and each would
have to determine that the transaction is in the interest
of his profit center. Global management facilitates
arbitrage transactions by establishing a clear manage
ment responsibility to exploit such profit opportunities
in the interest of the bank as a whole. Moreover, the
close contact that the parent bank keeps with the
world market through its branches provides an impor
tant flow of information which helps spot arbitrage
opportunities.
Another way in which global asset and liability man
agement may be beneficial to banks is by increasing
their ability to net out opposing transactions before
they reach the market. Not uncommonly, a branch at
one location may need funds at the same time that
another branch wishes to supply funds. If they recog
nize their offsetting needs, they would transact with
each other. Otherwise, the transactions would be made
in the market, potentially at a cost to the bank of the

spread between the bid and offer rates for funds. With
global asset and liability management, the parent bank
maintains close contact with each branch. These com
munications increase the chance that the offsetting
transfers are handled internally, enabling the bank
to avoid the potential market cost.
Many banks take positions and earn profits on ex
pected fluctuations in market rates over time. Propo
nents of both the global and decentralized approaches
each regard their form of management as being the
better way of handling these positions. Advocates of
decentralized management take the view that there is
no monopoly on information in the market and that
local managers are as likely to exercise good judgment
as their counterparts in the head office. By managing
individually part of the total bank portfolio, they help
assure that the bank will respond, at least in part,
to favorable market opportunities. It is hoped that such
errors in judgment as occur will be more than offset
in other profit centers and that large mistakes will be
avoided. Thus, the decentralized approach is seen as
the best way to maximize the bank’s profits.
By contrast, the view of globally managed banks is
that it is better to formulate a single bank strategy.
Because contacts are maintained with personnel in
local markets, it is felt that the head office is not at a
disadvantage with regard to either information or ideas,
compared with the decentralized approach. If more
astute managers are at the head office, their judg
ment may be better than that of lower level of
ficers. Most important, however, is the greater control
of the total position inherent in global management.
Because the response to market events is closely
monitored by top management, some banks have been
more willing to take market positions after adopting
global management techniques than they had been
previously.
A major class of concerns about global asset and
liability management involve personnel management.
At a basic level, resistance to change from existing
managers often makes a shift to global management
awkward. People who have held important decision
making functions at various profit-making units tend
to resent new lines of authority, particularly if they
have less authority under the new arrangement. Re
luctance to alienate key staff people has sometimes
been a barrier to adopting the global view.
Lack of personnel who are generally familiar with
various bank functions has also acted as a barrier to
global management. Knowledge of both the domestic
and foreign sides of banking is a key ingredient to
coordinating global activities. Banks thin in personnel
with this experience have difficulty in shifting to global
management. The long-run solution is to rotate people

FRBNY Quarterly Review/Spring 1979

in various jobs so that they receive the proper training.
Beyond these initial barriers to change, though, there
are deeper reasons for questioning the viability of
global management. Coordination at the center is cru
cially dependent upon information on conditions in
diverse market locations. It requires tacticians who
continually probe the markets, execute trades, and re
port on events. The danger in central coordination is
that it could unintentionally supplant thinking and de
cision making on the periphery. If that were to happen,
global management would no longer get the informa
tion it needs to function effectively.
For this reason, some banks prefer decentralized
organization. The challenge to earn profits, the free
dom to manage a department or trading position with
out daily direction from superiors, and the feeling of
being trusted with responsibility motivates people to be
effective bankers. In this way, decentralized organiza
tion also helps train and select people for higher
positions. In the view of those who favor this approach,
it is the more effective way to run a bank.
Intermediate cases
The polar cases of global management of assets and
liabilities and decentralized decision making are not
the only possibilities. Intermediate cases exist. One
large bank, for example, has a policy of never inter
fering with the decisions of local managers. Nonethe
less, these managers report daily to the head office,

which can hedge market positions that, in the aggre
gate, appear to it to be unsound. In that event, the
offsetting transactions would be done at the head
office to maintain the spirit of local autonomy.
Centralized management need not be extended to
all of a bank’s operations. Eurodollar activity booked
in Nassau or the Cayman Islands is usually the first
international area to be coordinated with domestic
money market trading. London, because of its im
portance, is often next, followed by other Euromarket
centers. The movement to at least partial integration
of management at some banks is an indication of the
current strength of the shift to global management.
One interesting case is a bank whose highest level
officers strongly endorse the autonomy of local units.
Nevertheless, lower level officers in the domestic and
international areas at the head office and in London
have recognized the advantages of close central co
ordination. Informally, a supervisory unit at the parent
bank has become a vehicle for coordinating much of
their activities.
Thus, while there are grounds for debating the merits
for global management methods in their purest form,
banks continue to experiment with alternative ap
proaches. The reasons for doing so are clear. Banks
are adapting to their larger presence in world markets,
the tighter integration of domestic and foreign mar
kets, and increased risks inherent in the economic
environment.

W a rre n E. M o s k o w ltz

FRBNY Quarterly Review/Spring 1979

How well are the
exchange markets
functioning?
Foreign exchange is probably one of the most widely
discussed and yet least understood subjects of our
times. Nearly all newspapers now carry a daily article
reviewing the previous day’s events, and columnists
and editorial writers frequently elaborate on these
events in the broader context of their views on eco
nomic policies. Over recent years the academic liter
ature has been replete with articles on one aspect or
another of foreign exchange, often using highly sophis
ticated mathematical and econometric techniques. On a
more down-to-earth level, numerous corporate trea
surers have written books explaining how and when
they hedge their exposures. Governments have of
course always had a close interest in foreign exchange
policy, but it was traditionally a matter to be discussed
only by central bankers and finance ministers. Now
almost everyone in government seems to have an urge
to make his or her views known on foreign exchange
matters. In all this blare of public discussion, the ones
who seem to have been heard the least are the very
practitioners of the trade— the foreign exchange deal
ers themselves in commercial banks and central banks
around the world.
To be sure, traders disagree on everything of im
portance relating to foreign exchange. We only need
to look at those daily press stories which pick up bull
ish comments on a currency from one trader in Frank
furt and bearish comments from another in London.
Ask a group of traders how they feel the market should
be organized and you are sure to start an argument.
But then that is what a market is all about, meeting
Remarks by Scott E. Pardee, Senior Vice President, Federal Reserve
Bank of New York, before the FOREX Association of Canada in Toronto,
Canada, on Friday, January 26,1979.

the needs of a large number of people whose views
and interests vary. A market is not a mathematical
abstraction or a politician’s dream but very much a
part of the real world.
I think therefore it is time to focus on the exchange
market as it really is and address its real problems.
In laying out some of my own ideas to you, I run the
risk of showing my own biases, as an economist and
central banker as well as a market practitioner, but
my hope is at least to generate serious discussiorr on
market-related issues. Thus, my interest is on how well
the foreign exchange markets for major currencies—
including the Canadian and United States dollars—
are functioning, as distinct from whether exchange
rates should be fixed or floating or where they should
be.
Basically, it can be said that the foreign exchange
market fits very closely the ideal of a perfectly compe
titive market. There are numerous participants, as
actual and potential buyers and sellers in both the
interbank market and the more retail market between
banks and their commercial customers. Rates for all
major currencies are widely quoted, and deals can be
done virtually around the clock. There is a considerable
amount of information at traders’ disposal— again from
the news services, from government sources, from ad
visory services, and from the market itself as partici
pants talk to each other. Communications are rapid
and, if a trader cannot reach another by one means,
he has others he can turn to. Technology is evolving
rapidly.
Each day billions of dollars of transactions are con
ducted flawlessly through a set of conventions, of
common trading terminology among people of many
national languages, and of confirmation and payments

FRBNY Quarterly Review/Spring 1979 49

procedures consistent with the various national regu
latory structures and legal codes. Errors occasionally
occur, but they are normally resolved in an amicable
way. This achievement is to the credit of the many
thoughtful people in the exchange market who have
contributed to its evolution over the years and who are
adding to the market’s strength in these uncertain
times.
But many problems do exist. A smoothly functioning
market is said to have depth, breadth, and resiliency.
Depth means that a sizable amount of business can be
done without having a significant impact on the ex
change rate. In practice, this means that the market
makers in the interbank market are prepared to absorb
temporary excesses of supply and demand into their
own positions. While generally this is the case, it is not
always so. On occasion, they feel inhibited from taking
on large orders for a variety of reasons. These include
the very volatility of exchange rates which raises the
risk of loss in covering the position later on, internal
limits on positions that do not permit enough room
in a trader’s position to absorb a sizable transaction,
and external limits on the banks’ ability to deal as
with exchange controls. The problem of depth varies
with different currencies and over time. Whereas in the
“ good old days” many market-making banks were pre
pared to deal perhaps several hundreds of millions of
dollars against major currencies and carry the posi
tions overnight— if not longer— most are very likely
to give ground now after doing ten million dollars or
so, lest they get stuck with a position they cannot
u n w in d quickly. At tim es, th e market is so th in th a t th e
hint of a large possible transaction coming on the
market will cause traders to shrink back, leading to a
rate effect even if the transaction is not carried out.
Breadth means that many traders are willing to make
a market at any particular time. If you do not like one
trader’s rates, you can always shop elsewhere. On
some occasions, the markets may very well lack
breadth in this sense, particularly in the forward mar
ket. A few banks are still willing to make a commitment
to that market, accepting both the risks and the sub
stantial forward book it entails, while others have pulled
back to concentrate on dealing spot.
Aside from this, I would argue that the exchange
markets today have greater breadth than at any time
before. More banks than ever are prepared to deal,
within individual money centers as well as between
centers. This has led to changes in traditional trading
patterns, as in the United States last year when direct
dealing between banks became more prevalent and
international brokering was introduced on a wide scale.
The increase in numbers applies to the general
market as well as to the interbank market. There has

FRBNY Quarterly Review/Spring 1979

been a sharp increase in the number of corporations,
individuals, and even official institutions which turn
to the exchange market for their needs either as buyers
and sellers of goods internationally or as managers of
funds. And we have new markets such as those on
established commodity futures exchanges in the United
States. The volumes involved have scaled upward
sharply.
The question of breadth raises two potential issues.
First, the increasing cost of staffing and equipping a
modern trading room and back office could at some
stage give banks at the core of the market such a
competitive edge that others may retrench into corre
spondent banking relationships. So far at least, more
banks seem to be gearing up for the long haul than
pulling back. Second, the proliferation of institutions
related to the market— banks, brokers, advisory ser
vices— has already stretched thin the available pool of
foreign exchange talent, certainly in the United States.
The pressures on available talent heightens the risk of
serious mistakes, through a weakness in internal man
agement control systems, overwork, or inexperience.
Serious problems have been avoided in the last couple
of years but are entirely possible down the road.
Resiliency means that a large order to buy or sell
a particular currency can be absorbed in the market
without generating a cumulative movement in the rate.
If a currency declines, will it recover on its own or will
it continue to drop as a result of internal market dynam
ics? Here the record of recent years has been poor.
The most visible swings in rates have been under float
ing exchange regimes, but substantial one-way
pressures have built up under fixed rates as well, and
I have come to believe that the lack of resiliency in
exchange markets is an inherent characteristic of those
markets.
Too often, as soon as a currency comes under, say,
selling pressure, that pressure begins to cumulate. In
part this reflects the very speed of communications,
the facility with which trades can be entered into, and
the number of people prepared to act at a given
moment. But the responses are often quite out of pro
portion to the importance of an immediate event. Thus,
the fact that a particular currency is declining is
flashed around the world in seconds. Market commen
tary and the news services quickly provide an explana
tion for the decline, ascribing it to a statement by a
government official, release of an economic indicator,
a large sell order, or even a rumor. Sometimes these
explanations are far-fetched, but the conjunction of a
decline in a currency plus a plausible explanation for
that decline can trigger a widespread reaction in the
same direction as many market participants respond
virtually at once. This reaction itself adds credence

to the explanation and may draw in additional sellers.
It is not unusual to find situations in which hundreds
of millions of dollars are suddenly on the move.
The sellers may be risk-taking speculators, but they
may also be risk-adverse hedgers. The speculator of
course thrives on volatility, seeking to be the first to
buy on the way up and first to sell on the way down,
the longer the ride the better. The hedger fears vola
tility and may hasten to cover his exposures when he
sees a wide movement against him, lest he take bigger
losses by waiting longer. But once a rate begins to
move both the risk seeker and the risk avoider may
suddenly be on the same side of the market, adding
to the one-way pressure on the rate for the moment
and to general volatility once profit taking sets in. The
less the depth and breadth of the market, the wider the
amplitude of the swings. But, in a bearish or bullish
market, the one-way pressures may persist for some
time, pushing rates to levels that may overshoot by a
wide margin any conceivable equilibrium rate which
might be based on broader economic considerations.
The concept of equilibrium in the exchange market
is of course an elusive one. The exchange market is
always in equilibrium to the extent that supply and
demand coming into the market at a particular moment
are matched off at a going price. But the supply and
demand may have little or no relation to broader eco
nomic considerations, such as trade, current account
or basic payments balances, relative rates of inflation,
or even relative interest rate differentials. From an
economic policy point of view, however, it is important
that exchange rates over time do reflect a broader
economic equilibrium within and among countries and,
if not, policy adjustments have to be made. The policy
decisions are not always easy, given the trade-offs
among different economic objectives within a country
and between domestic and international objectives. So
it would be extremely dangerous for policymakers to
react to every swing in the exchange rate, lest the
volatility of exchange market sentiment be projected
into other sectors of the economy. Moreover, exchange
rate changes may give some unwelcome feedbacks
into the domestic economy. The best example is the
vicious circle in which domestic inflation leads to an
exchange rate depreciation which generates such a
bearish exchange market atmosphere that the rate is
pushed even further than could be explained by infla
tion differentials. To the extent that this excessive
decline of the rate persists, it ratchets up the cost of
imports and import substitutes and thereby aggravates
domestic inflation all the more.
It is under these conditions that central bank inter
vention plays a role. For the United States, since 1973
we have mainly intervened to counter disorderly con

ditions in the exchanges. Definitions of disorder vary,
but my definition includes several important elements.
At base is the unwillingness of market makers to cush
ion the pressures hitting the market by absorbing buy
or sell orders into their positions. This unwillingness
reflects their perception of the increased risks involved,
for whatever reason, in carrying a position if only for
hours or overnight. It is generally reflected in a widen
ing of bid-asked spreads traders quote to each other
and to customers, but wider spreads are not the only
piece of evidence. A trader may quote the same
spreads to a good customer and then unload his posi
tion in the market as quickly as possible. Or he may
go the other way and effectively refuse to quote at all.
When many traders shrink back, the market loses
depth and breadth, which in turn leads to a lack of
resiliency. Pressures in the market become increas
ingly one way; rate movements become cumulative
and volatile. Traders, including corporate treasurers,
portfolio managers, and even the man on the street
begin to respond to the rate movements alone rather
than to their judgment of the medium- or long-term
outlook for a currency. Under these conditions, central
bank intervention can play a smoothing or cushioning
role, limiting the length of the ride for the speculators
and reassuring the hedgers that they can remain on
the sidelines. But in the extreme, when one-way trading
prevails to the extent that rates overshoot, forceful
central bank action may well be needed to correct the
excessive swings of the rate. On November 1, for the
first time since the United States dollar was floated,
the United States authorities intervened precisely for
the purpose, as President Carter put it, to correct the
excessive decline of the dollar.
How can these inherent problems of the exchange
market be avoided? The responsibility is as great for
private market participants, including the individual
trader in a commercial bank, as it is for the authorities.
We are in a period in which exchange market matters
are unusually politically sensitive. At times of height
ened tensions in the exchange markets, ill-advised
actions by some market participants may not only be
costly to themselves but also to the market as a whole.
For the commercial bank trader, there are now a
variety of carefully considered codes of ethics and
internal management manuals to guide him. FOREX,
both at the national and international levels, is playing
a commendable role in seeking to improve the pro
fessionalism and expertise of its membership. To the
extent that these efforts are successful— and this
comes down to the conduct of each individual trader
— the market will be improved.
This does not absolve the authorities, particularly
the central bank, from responsibility to improve the

FRBNY Quarterly Review/Spring 1979

market. It is imperative that the central bank maintain
close contact with the market, not only for carrying
out intervention policies but also for gauging how well
the market is functioning. In the Federal Reserve Bank
of New York we have always sought to maintain such
contacts. We have recently enhanced that effort through
the sponsorship of a Foreign Exchange Committee
made up of senior foreign exchange officers of banks
in the United States and the heads of foreign exchange
brokerage firms.
One way in which the authorities can improve the
functioning of the exchange market is to avoid mech
anisms which inhibit competitive forces in the market,
such as arbitrary exchange controls. This is easy for
someone from the Federal Reserve to say, since the
United States lifted the remaining barriers to capital
outflows back in 1974, and presently there is little
stomach within the government to employ them again.
But most controls are essentially an effort to stifle
pressures coming from one side of the market. They
may work well in the short run. But over time they may
create serious distortions and trading problems, even
to the extent of favoring some market participants over
others. Moreover, they may encourage systematic eva

FRBNY Quarterly Review/Spring 1979

sion by some participants. Consequently, where such
controls are used, they should be relaxed as soon as
the opportunity arises.
Even intervention should be considered a limited
instrument, reserved mainly for calming nervous mar
kets and smoothing excessive fluctuations in rates.
As one’s time horizon lengthens, into periods of weeks,
months, and years which can more successfully be
analyzed by the standard tools of economic analysis
and econometrics, the exchange markets show through
as being reasonably efficient. Exchange rate move
ments over time tend to be consistent with the broader
movements of basic economic indicators, such as trade
and current account balances and relative rates of in
flation. Therefore, intervention to counter longer term
trends could easily be counterproductive in terms of
the efforts to achieve equilibrium in the exchange
market. At the same time, however, excessive depen
dence on the exchange rate as a means of adjustment
has many drawbacks. The lags are just too long and
the expectational effects too unpredictable. The focus
of longer term adjustment policy should rather be on
other basic policy tools, such as fiscal and monetary
policy and commercial policy.

Monetary Policy and Open
Market Operations in 1978

Monetary policy shifted increasingly toward restraint
in 1978, as the economy moved ahead strongly and
price inflation accelerated in the fourth year of the
current expansion. The Federal Reserve continued to
exert upward pressure on the interest rates at which
reserves are supplied to the banking system, forcing
the Federal funds rate up by about 31/2 percentage
points and raising the discount rate by the same
amount. However, the expansion of
exceeded de
sired growth rates until late in the year as economic
activity and credit demands often outran expectations.
Rising inflation and a continuing large international
payments deficit on current account sparked repeated
bursts of speculation against the dollar in the foreign
exch a n g e m arkets, and m o n e ta ry p o lic y in c re a s in g ly

took the implications of these developments for the
domestic economy into account.
Monetary expansion, already rapid in 1977, con
tinued high through most of 1978— with Mx growth
exceeding the Federal Open Market Committee’s
(FOMC) longer run range and M2 and M3 growth often
well up in their ranges. (The table on page 57 shows
the longer run ranges voted during the year.) Mx rose

Adapted from a report submitted to the Federal Open Market
Committee by Alan R. Holmes, Executive Vice President of the
Federal Reserve Bank of New York and Manager of the System
Open Market Account, and Peter D. Sternlight, Senior Vice
President of the Bank and Deputy Manager for Domestic Operations
of the System Open Market Account. Fred J. Levin, Manager,
Securities Department, and Ann-Marie Meulendyke, Chief, Securities
Analysis Division, were primarily responsible for preparation of this
report. Nancy Marks and Connie Raffaele, members of the Securities
Analysis Division staff, participated extensively in preparing and
checking information contained in the report.

at an 8.1 percent annual rate1 over the first ten months
and slowed thereafter, apparently reflecting a combina
tion of factors including the introduction of new trans
actions options. Thus Mx growth ran ahead of its 1977
pace for much of the year but turned out to be a bit
slower— at 7.3 percent— for the year as a whole
(Chart 1). Growth of M2 and M3 slowed considerably
on average from the previous two years. Interest rate
ceilings held down growth of the savings and time
deposit components, though both aggregates were
boosted after midyear by the introduction of money
market certificates on which ceiling rates were related
to weekly rates for new six-month Treasury bills. M2
and M3 grew 8.5 percent and 9.4 percent, respectively,
o v e r the fo u r q u a rte rs of 1978, within the upper halves
of the FOMC’s longer run objectives. The broader
measures that contain large negotiable certificates of
deposit (CDs)— M4 and M5— experienced rapid growth,
as an acceleration in CDs took up the slack from the
slowing of the smaller savings and time deposits. ,
Bank loans expanded rapidly during the year, and
bank credit rose by 11.3 percent from the fourth quarter
of 1977 to the fourth quarter of 1978, the same as in the
previous year. The strong growth of commercial and
industrial loans, evident the year before at regional
banks, spread to the money center banks during 1978,
with demand concentrated at the large New York City
banks late in the year. Commercial banks added a
moderate volume of tax-exempt securities to their
1 Data in the body of the report include the effects of seasonal and
bench-mark revisions published on February 9, 1979. The chrono
logical section makes use of data as published at the time, since
Federal Reserve decisions were based on them.

FRBNY Quarterly Review/Spring 1979

end 59.1 percent of the w orking-age population was
employed, an unprecedented rate for a peacetim e
period; a record 95.9 m illion persons had jobs. The
gains in employment were accom panied by a continued
rapid rate of entry into the labor force so that the
unemployment rate, after declining from 6.4 percent
of the labor force in December 1977 to 6.0 percent in
April 1978, fluctuated thereafter in a fa irly narrow band
averaging 5.9 percent. Still, because of structural
changes in the labor force, this unemployment rate
appeared to represent relatively full employment in the
economy, and there were reports of developing
shortages of certain types of skilled labor.
The expansion of econom ic activity during the year
was supported by heavy consumer spending, financed
to an unusually large extent by mortgage and instal
ment debt. Demand for housing and durable goods was
particularly strong, reflecting in part the buildup in
inflationary psychology. Business fixed investment also
expanded substantially during the year, although
growth of capacity still lagged relative to the im prove
ment posted in e arlier cycles. Surveys of investment
plans continued to suggest a sense of uncertainty
about expected pro fitab ility of such investment, be
cause of inflation and its distorting effects on tax
liabilities and because of the adverse im pact of the
1974 recession on profits.

Chart 1

G ro w th o f M o n e y S u p p ly M e a s u re s
a n d B a n k C re d it
Seasonally adjusted annual rates
Percent
10

Securities markets and interest rates

1973 1974

1975 1976 1977 1978

III

1978

portfolios but liquidated Treasury securities to meet
loan demand. Commercial paper outstanding expanded
at an increased pace during the year, attesting to the
strength of business needs fo r credit.

The economy in 1978
Real gross national product (GNP) expanded by an
estimated 4.4 percent over the four quarters of 1978,
down from 5.5 percent in 1977 but still above the postWorld War II average. Prices, as measured by the
GNP deflator, rose 8.3 percent over the four quarters
of 1978, the second consecutive speedup from the
recent low of 4.7 percent in 1976.
Employment expanded rapidly so that by the year-

FRBNY Q uarterly R eview/Spring 1979

Interest rates moved up throughout the m aturity spec
trum in the face of strong credit demands and rising
inflationary expectations. The most pronounced
increases were in the short- and interm ediate-term
areas where demand factors and monetary policy
initiatives combined to have their greatest impact. The
31/2 percentage point increase in the C om m ittee’s
Federal funds rate objective over the year was ac
companied by increases of sim ilar magnitude in most
other short-term rates. Yields on Treasury securities
m aturing in one to three years generally rose 21A to
3 1/2 percentage points. Yields on somewhat longer term
issues increased by 11A to 2 percentage points, w hile
those on long-term issues rose by % to 1 percentage
point. The overall upward movement and gradual fla t
tening in the yield curve during the first half of the year
were followed, after an extended summer rally, by a
dramatic shift to an inverse yield curve, w hich peaked
around the one-year maturity. (Charts 2 and 3 illustrate
the m ajor yield movements and changes in the yield
curve over the year.)
Borrowings by the Treasury were substantial during
the year. The Treasury added $21.4 billion to outstand
ing publicly held m arketable coupon issues, while re
placing $52.5 billion of pub licly held maturing coupon

securities. The Treasury’s ongoing program of regu
larizing and lengthening the public debt through
coupon offerings extended the average m aturity of the
debt by six months to three years eight months at the
year-end. Treasury bills held outside the Federal
Reserve and Government accounts, on the other hand,
increased by only $772 m illion over the year. The
demand of foreign official accounts for short-term bills
often contributed to a m arket scarcity of bills when
these accounts built up th eir holdings follow ing dollar
support activities. At such times, bill yields fell relative
to other short-term m arket instruments, and secondary
trading reflected resultant m arket shortages.
About one half of the net increase of $52.0 billion in
the Treasury debt held outside the Government was
financed through sales of Treasury issues to foreign
official accounts. These institutions added $29.3 billion
to their holdings, including $5.8 billion in nonmarketable securities. The Federal Reserve acquired $8.8

billion, and state and local governments bought $13.4
billion, largely of nonmarketable interest-arbitrage
bonds. Commercial banks liquidated a substantial
volume of securities, w hile the holdings of other finan
cial and corporate investors showed small changes.
Individuals made only slight additions to their mar
ketable and nonmarketable debt holdings, reducing
their share of the Treasury’s debt.
Federally sponsored agencies that support the
housing sector borrowed heavily during the year. Net
new borrowing by the Federal Home Loan Banks and
the Federal National Mortgage Association amounted
to $13.9 billion. Pass-through mortgage certificates also
continued to expand in volume. On the other hand, the
various farm credit agencies raised little net new cash
during the year.
The pace of business borrowing in the interm ediateand long-term sectors slackened somewhat, as busi
nesses turned increasingly to the banks and the
comm ercial paper market. Yields on long-term corpo
rate issues moved up by nearly 1 percentage point,
about the same as on long-term Treasury debt. Taxexempt entities again borrowed substantially, especially
through revenue-bond offerings. Tax-exempt yields
moved up about % percentage point in the long-term
area. The yield curve for tax-exem pt issues remained
upward sloping.

International developments relating to the dollar
While dom estic developm ents— especially the worsen
ing problem of inflation— were the main focus of mone
tary policy during 1978, foreign exchange develop
ments also came to bear increasingly on policy during
the year. Indeed, the position of the dollar in the fo r
eign exchange markets deteriorated sharply during the
latter part of 1977, and the dollar encountered fresh
sinking spells in 1978. This, together w ith dom estic
inflation, gave the Committee increasing cause for
concern, as it underscored fundamental dom estic as
well as international imbalances. As the year began,
a forceful response to dom estic developments, desir
able in its own right, bolstered the direct intervention
in the exchange markets undertaken by the Federal
Reserve and other central banks. The exchange mar
kets stabilized for a tim e thereafter but, as inflationary
pressures rose, participants became more and more
concerned about the adequacy of the United States
response. During the latter part of October, the situa
tion became critical. The d ollar dropped sharply as
participants became deeply concerned that prices in
the United States w ould continue to rise faster than
those of other industrial countries— and by a widening
margin.
On November 1, the Federal Reserve joined with

FRBNY Quarterly R eview /Spring 1979

the Adm inistration in a series of dramatic actions to
support the dollar and to dampen inflationary expec
tations. The Federal Reserve increased the discount
rate by 1 percentage point and raised its Federal
funds rate objective by about Vi percentage point. It
also raised reserve requirements on large time de
posits by 2 percentage points. These actions were
accom panied by jo in t Federal Reserve-Treasury ar
rangements to facilitate expanded dollar support oper
ations. Moreover, the Adm inistration pledged to reduce
the fiscal 1980 budget d eficit below $30 billion.
In reaction to the new program, the dollar immedi
ately rose sharply, as did prices of stocks and long
term bonds. Short-term interest rates rose, however,
as participants anticipated that further Federal Reserve
action m ight be necessary to defend the dollar. Sub
sequently, long-term interest rates resumed their climb.
Data becoming available during the final months of
1978 suggested the continuation of strong econom ic
growth and underscored how entrenched inflation had
become. The exchange markets remained very ner
vous, with the dollar under heavy pressure at times as
the resolve of the Federal Reserve and other central
banks to support the November 1 program in the
exchange markets was tested. Analysts noted the
slower growth of the monetary aggregates during the

final quarter, but were unsure w hether this represented
the impact of restraint or largely reflected institutional
changes occurring at the same time.

Monetary Policy and Its Implementation
In making policy in 1978, FOMC members confronted
a dom estic econom ic expansion plagued with more
inflation, and an international financial system whose
participants were becoming increasingly concerned
about the outlook for monetary growth and inflation
in the United States. The d o lla r’s key position as a
reserve currency and a major vehicle for financing
international trade meant that the United States econ
om y’s problems attracted w orld attention. Of course,
part of the continuing large deficit on current account
reflected the robustness of the United States economy
since 1975 relative to the other industrialized nations.
But the pickup of inflationary expectations in the
United States at a time when inflation rates were
slowing in other leading industrial countries kept mar
ket participants at home and abroad apprehensive
about this divergence. These fears culm inated in a
wave of pessimism in O ctober and a rush out of dol
lars into other currencies. The promise of more re
strained monetary and fiscal policy contained in the
November 1 package initiated a continuing reassess
ment of official resolve that restored a tentative but
hopeful sense of greater stability to the exchange
markets as the new year began.

Chart 3

Yield Curves for United States
Treasury Obligations

Policy objectives
■ ■ ■ ■

—
10.40 10.00 - J - \

9.60
-

Decemb er J 7, 1378
~
' i i

M
I

T
I

"
I

l luly. 12', 197.

I “

7.60 *[

— .
I
I
Decernber 28, 1977

- |

—©

z f
1
6.80 '/
J1

I
10

I -L
-J -

Number of years to maturity

August 23, 1978

FRBNY Q uarterly Review/Spring 1979

-a

The longer run objectives fo r monetary growth, ex
pressed in terms of four-quarter growth ranges based
on the level in the quarter just ended, changed little
during 1978, although the FOMC maintained, as an
ultimate goal, their gradual reduction to noninflationary
rates of growth. However, in view of previous over
shoots, Committee members each quarter tended to
place m ajor emphasis on achieving existing growthrate objectives. A m ajority felt that reductions of the
ranges before achieving existing goals would lack
cred ib ility and, if achieved, m ight impose too much
stringency on the economy. Indeed, at midyear, when
the Committee extended the earlier growth range fo r
Mj, it was recognized that, in light of the recent be
havior of money demand, growth of this aggregate
over the year ahead m ight well be around its upper
limit. Also, by moving forward the base period after
the rapid growth of the quarter before, it allowed in
effect somewhat faster growth than was consistent
with the ranges set in the previous quarter.
The Committee continued to establish four-quarter
growth ranges for Ma, M2, and M3, with an associated

Federal Open Market Committee’s Annua! Growth Ranges
for Monetary and Credit Aggregates
Seasonally adjusted annual percentage rates

Month
established

Period

Actual

j. .. . .
Adjusted
bank credit
proxy

Actual

March 1975 to March 1976.

April 1975

5 to

IVz

5.3

81/a to 10%

9.7

10 to 12

12,3

61/a to

9Vz

3.2

June

June 1975

5 to 7 Vz

4.4

81/2 to 10 V2

8.8

10 to 12

11.3

61/a to 91/s

3.2

1975 to June

1976.

July 1975

5 to 71/a

5.4

8Vz

to 10 V2

9.6

10 to 12

12.0

6 1/a to 9 Vz

3.1

1975-111 to 1976-111 ............. .

October 1975

5 to 71/a

4.6

7Vz

to 101/a

9.3

9 to 12

11.5

6 to 9

3.7

1975-tV to 1976-IV .............

January 1976

41/2 to 714

5.8

71/a to 101/a

10.9

9 to 12

12.7

6 to 9

4.3

6 to 9

5.0

1975-11 to 1976-11

1976-1

to 1977-1

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

April 1976

4 1/a to 7

6.5

71/a to 10

11.0

9 to 12

12.8

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

July 1976

4 1/a to 7

6.8

71/2 to 91/a

10.8

9 to 11

12.5

5 to 8

5.8

1976-111 to 1977-111 ............. . November 1976

41/2 to 6 V2

8.0

71/a to 10

11.1

9 to 111/a

12.7

5 to 8

11.4*

1976-iV to 1977-IV .............

41/2 to 61/a

7.9

7 to 10

9.8

8 1/a to 111/2

11.7

7 to 10

11.3*

to 6 V2

7.7

7 to 91/a

8.8

8 1/a to 11

10.5

7 to 10

11.3*

7 to 9 1/a

8.6

8 1/a to 11

10.0

Bank credit
7 to 10

12.0

8.6

81/ 2 to 1 0 1/a
7 1/2 to 10
71/a to 10

1976-11 to 1977-11

January 1977

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

April 1977

1977-11 to 1978-11

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

July 1977

4 to 6 Vz

8.2

1977-111
1977-IV
1978-1
1978-11
1978-JII

............. . October 1977
............. . February 1978
..............
April 1978
.............
July 1978
.............. . October 1978

4 to 6 V2
4 to 61/2
4 to 6 V2
4 to 6 V2
2 to 6

8.1

1977-1

to 1978-1

to
to
to
to
to

1978-111
1978-IV
1979-1
1979-11
1979-ill

4Vz

7.3

ey 2
6 1/a
6 V2
6 1/a
61/a

to 9
to 9
to 9
to 9
to 9

8.5

7 1/a to 10
to 10

IVz

9.6
9.4

7 to 10
7 to 10
7 1/2 to 10 V2
8 1/z to 11 Vz
8 Va to 11 Vz

11.9
11.3

The Board of Governors of the Federal Reserve System ceased publication of the credit proxy in
August 1977. Bank credit growth is given as a guide thereafter.

range fo r bank credit.2 The table presents a historical
summary of growth ranges established since 1975. The
existing objective for Mx was maintained until October.
At that time, the band of growth rates was reduced
and widened to allow for the expected though uncer
tain impact of automatic transfer services (ATS). The
new range was felt to be consistent with the same
rates of expansion as the one in effect before adjust
ment for ATS. For M2 and M3, which should have felt
little or no effect from ATS, the Committee extended
the previous growth ranges throughout the year, al
though the M3 range set in February was below that
set in the final quarter of 1977. The Committee lifted
the range fo r bank credit at its April meeting and
again in July in recognition of the greater share of
borrower demands being directed toward banks.

* Beginning with the October meeting, the Committee indicated it
would track MH-----defined as the sum of Mlt negotiable order of
withdrawal (NOW) accounts, credit union share drafts, and savings
deposits at commercial banks. An associated range of 5 to 7 1/ 2
percent was chosen.

Intermeeting instructions to the Account Manager
The directives given by the FOMC to the Federal Re
serve Bank of New York retained the form at of other
recent years. The Committee instructed the Manager
to raise or lower the Federal funds rate w ithin a band
of tolerance whenever growth rates of Mx and M2 for
the two-month period ending the month after the
meeting appeared to be going off course. For just
over half of the year the Committee used an “ aggre
gates” directive, w hich called for responding to sig
nificant deviations of the aggregates from the mid
points of their two-m onth ranges, giving approxim ately
equal weight to M t and M2. From December 1977
through February 1978 and again in July, the Com
mittee specified a “ money m arket” directive, calling
fo r a response only if projected growth was closely
approaching or moving beyond the upper, or lower,
bounds specified for M t and M2.
In October and November, the directives took ac
count of likely distortions to M x from autom atic trans
fers, giving prim ary consideration to M2, w ith Mj to be
considered only if its upper bound were exceeded.
In December, the Committee felt that the transition

FRBNY Q uarterly R eview /Spring 1979

was understood sufficiently to specify a range for Mx
and to resume giving it equal weight as a guide to
setting Federal funds rate objectives.
With the aggregates so strong for a large part of 1978,
the Committee frequently instructed the Trading Desk to
raise the Federal funds rate following the meeting with
out waiting for additional estimates of aggregate
growth. Also, the two-month ranges set on the aggre
gates more often than not led to further upward
adjustment in the Federal funds rate; indeed, it would
have taken a sizable shortfall in growth from expected
rates to have produced a reduction in the objective.
The width of the intermeeting range for Federal
funds variation generally was V2 percentage point. It
was twice widened at regular meetings to % percent
age point and twice narrowed to only Va percentage
point, the narrowest that had ever been specified. In
several months, use of the full range was subject to
prior consultation. Partly as a result, further guidance
was needed on eight occasions during the year and, as
the directive provides, involved interim instructions
from the Committee by telephone meeting or wire
vote. In one case, prior to announcement of the No
vember 1 program, a special meeting of the FOMC was
called in Washington.
While the Federal funds rate and the behavior of
the monetary aggregates remained the primary focus
of the instructions to the Account Manager, the be
havior of domestic financial markets and developments
in the foreign exchange markets also figured in the
directive. In January, and again in November and
D ecem ber, the C o m m itte e ’s decision to raise the
Federal funds rate responded, in significant measure,
to the weakness of the dollar in the foreign exchange
markets. (Of course, that weakness was, in itself, partly
a result of greater inflationary pressures in the United
States economy than abroad.) In these instances,
growth of the monetary aggregates appeared to have
slackened and by themselves would not have led to
restrictive policy moves. In January, the Federal Re
serve expressed the hope that the higher rates would
prove temporary. However, when the money measures
resumed their rapid growth, and the dollar remained
shaky over succeeding months, both domestic and
international considerations pointed toward the need
for additional restrictive steps.
Open market operations were conditioned to a sig
nificant degree by international developments. In
December 1977, the Committee inserted a phrase into
the domestic policy directive, instructing the Desk to
give specific attention to the unsettled conditions in
foreign exchange markets. Such an instruction was
included monthly except in May, June, and July, when
the exchange markets were relatively steady. Oper

FRBNY Quarterly Review/Spring 1979

ationally, this meant that the Committee was prepared,
in certain circumstances, to see somewhat tauter re
serve conditions than otherwise. At the time of the
January and November initiatives to support the dollar,
the Desk avoided drastic action to push the Federal
funds rate down to the stated funds rate objective.
When the dollar was under particular selling pressure,
aggressive actions to push the funds rate down, or
even an appearance of tolerating some downward
drift, could have risked aggravating the weakness in
the exchange markets.
Operations
The increase in the Federal funds rate objective from
6V2 percent at the start of the year to 10 percent or a
shade higher by the year-end was accompanied by an
overall upward adjustment in the discount rate from
6 percent to a record 91/2 percent. Discount window
borrowing tended to be sensitive to changes in the
spreads between the two rates. Whenever the Federal
funds rate moved more than about 1/2 percentage point
above the discount rate, borrowing rose substantially.
This variability occasionally made it difficult to estimate
the appropriate volume of nonborrowed reserves con
sistent with Federal funds rate objectives. It is pos
sible that such bulges in short-term use of the window
reflected some erosion of the discipline traditionally
associated with adjustment borrowing.
The forecasting of noncontrolled factors affecting
nonborrowed reserves, so called market factors, con
tinued to be difficult. Unexpected variation in the Trea
sury balance at the Federal Reserve persisted, and
Federal Reserve float became considerably more
variable. These factors were chiefly responsible for the
fact that the market factor estimates made at the
beginning of the week differed by about $900 million
on average from the final outcome. This compared
with an average difference of about $500 million in the
previous year. In most weeks, open market operations
were able to adjust to the bulk of the uncertainty and
to maintain reasonable stability in the Federal funds
rate. However, unexpected shortfalls or overshoots in
reserve availability did at times cause the Desk to
reverse the direction of its operations and the market to
experience wider than usual fluctuations in the funds
rate, particularly on settlement days.
In managing reserves, the Desk sometimes encoun
tered difficulty in making a sufficiently large volume
of repurchase agreements (RPs), particularly at times
when the Treasury balance at the Federal Reserve rose
sharply. For the most part, large reserve scarcities
tended to develop after quarterly tax-payment dates.
Government securities dealers and other market par
ticipants continued to hold small inventories, given

the negative carry on them and the expectations of
further interest rate increases. The Treasury assisted
on a number of occasions by reducing calls on the
comm ercial bank tax and loan accounts or making
occasional redeposits.
Reserve management was aided by the Treasury’s
implementation in November of the note investment
option that had been approved by the Congress late
in 1977.3 This gradually returned the bulk of variation
in Treasury cash balances to the commercial banks,
while leaving greater stability in the Treasury balance
at the Federal Reserve. However, some comm ercial
banks chose to remit their tax and loan receipts daily
to the Federal Reserve, while others imposed caps on
the amount of investment funds they would accept.
Predicting the amount of remittances, as well as the
rate at which checks clear against Treasury balances
at the Federal Reserve, remained somewhat trouble
some as the new system got under way. The new
system, however, held the promise of providing relief,
in time, to the earlier d ifficulties with sharply flu ctu
ating Treasury balances at the Federal Reserve.

Regulatory factors affecting monetary behavior
At the beginning of November, commercial banks were
permitted to offer autom atic transfer accounts to indi
viduals, and banks in New York State were authorized
to offer NOW accounts .4 Both options perm it house
holds to hold interest-bearing transactions balances
and thus to keep demand balances at or close to zero.
Their introduction reduced the growth rate of M, from
what it would have been otherw ise .5
During the latter part of 1977, market interest rates
began to exceed ceilings applied to small time and
savings deposits. In 1978, as in past periods when
such ceilings began to impinge, depositors gradually
redirected their funds into other instruments, which
tended to hold down the rate of expansion of M 2 and
M:1. As savings and time deposit growth slowed, banks
3 A description of the new procedures can be found in an article by
Joan E. Lovett, entitled “ Treasury Tax and Loan Accounts and
Federal Reserve Open Market Operations", this Quarterly Review
(Summer 1978), pages 41-46.
4 Automatic transfer accounts allow depositors to keep funds in a
savings account on which a bank may offer an interest rate of up to
5 percent, with the bank transferring these funds to the depositors’
checking accounts only when needed to cover clearings. NOW
accounts— previously only available in New England— permit drafts
directly against interest-bearing accounts.
5 In light of the distortions to Mi anticipated from the introduction of
automatic transfers, the Committee began to track M i+ (defined in
footnote 2), an experimental measure that attempted to capture all
transactions balances. The savings deposit component of this
measure declined very sharply in the final months of 1978, despite
the shifts into savings accounts because of the automatic transfer
option. Consequently, the behavior of M i+ was even weaker than
the traditional Mi.

stepped up their bidding for CDs, and depositors
sought out m arket instruments and money m arket mu
tual funds. In June, banks and th rift institutions were
authorized to issue money market certificates having a
$ 10,000 minimum, a m aturity of six months, and an
interest rate tied to average rates in the weekly sixmonth Treasury bill auction (with a 25 basis point
advantage to th rift institutions). Consequently, the pace
of M 2 and M:j expansion picked up sharply through the
summer and into the autumn. This regulatory change
also made it d ifficu lt to assess growth of the broader
aggregates relative to their behavior in the past.

Open Market Operations in 1978
January to mid-April
As the year opened, the value of the dollar in foreign
exchange markets was falling sharply in increasingly
disorderly m arket conditions. To check speculation
and to reestablish order, the Board of Governors of
the Federal Reserve System and the Treasury an
nounced on January 4 that the Exchange Stabilization
Fund of the United States Treasury would be used
actively in market intervention, together with the
$20 billion swap network linking the Federal Reserve
and foreign central banks. Late on Friday, January 6,
the Board approved a V2 percentage point increase in
the discount rate to 6 V2 percent at two Reserve Banks;
the other Reserve Banks quickly followed suit. The
follow ing Monday, the Account Manager, in accord
with the C om m ittee’s w ire instructions, began to seek
reserve conditions associated with a Federal funds
rate of 6% percent w ithin a newly adopted range of
6 V2 to 7 percent. Previously, the Manager had been
aiming fo r a Federal funds rate of about 6 V2 percent
w ithin the 6 1/4 to 6% percent range specified at the
December meeting, although funds had actually
traded above that rate at times, owing to holiday and
statement-date pressures in the money m arket around
the turn of the year (Chart 4).
The financial markets reacted q uickly to the Federal
Reserve’s moves. Money market rates jum ped by as
much as 45 basis points from the time the discount
rate increase was announced on January 6 to the
close of business January 9, while smaller, although
still substantial, advances were also registered in
interm ediate- and long-term yields. Subsequently, most
of these increases were retraced as market p artici
pants began to feel that the Federal funds rate would
stabilize at its higher level rather than rise further
over the near term.
In response to the early-January initiatives, the dol
lar had recovered somewhat by the time the Com m it
tee met on January 17, although the foreign exchange

FRBNY Q uarterly R eview /Spring 1979

Chart 4

FOMC Ranges for Short-run Monetary Growth and for the Federal Funds Rate, 1978
Percent

2 0 ------------------------------------- -----Narrow Money Stock (M1)*
Two-month growth rate
Mar &
Apr
Dec &
10 -Ja n
Jan & Feb
F®b &

Actual growth

15—

Apr &
May

Jun & Jul
May & Jun I
IJ u l & Aug Aug & S e p £ ^ j ^ ^ £ *
I-------------- ----- — ----- SL Mrtw Nov Oct
& & Nov

Dec
..
.
NOV s
Dec

&ja n l
.___

20-------------------------------- ------------------------------------------------------------------------------------------------Broad Money S tock (M 2 )*
__Two-month growth rate

Dec &
1Q Jan
Jan & Feb

_
Apr &
Au9 & SeP0 „ „ .
F jb 4 Mar & Apr May | May & Jun Jun & Jul Jul & Aug
" — ...-Sep & Oct Qct & Nqv

-V

Actual growth

Nov & Df C
pec

—— mmmmm

_=!
1 1 . 0 ------------------------

Federal Funds

Dec &:

Shaded bands in the upper two charts are the FOMC’s specified ranges for money supply growth over the two-month periods
indicated. No lower bound was established for M1 at the October and November meetings. In the bottom chart, the shaded
bands are the specified ranges for Federal funds rate variation. Actual growth rates in the upper two charts are based on
data available at the time of the second FOMC meeting after the end of each period.

*S easonally adjusted annual rates.

FRBNY Q uarterly R eview/Spring 1979

markets remained in a sensitive state. Information
available at that meeting presented a mixed economic
outlook for the year. Most members agreed with the
staff assessment that growth of economic activity
would be sustained at a good pace throughout 1978.
It was also felt that the unemployment rate would de
cline moderately further over the year, but prices were
expected to rise faster than in 1977. Growth of the
monetary aggregates had slowed somewhat in the
fourth quarter of 1977 from the very high rates regis
tered over the previous two quarters. Nevertheless, for
the year as a whole, the expansion of Mt had been
considerably above the FOMC’s projected range for
the period, set one year before, while growth of the
broader aggregates was near the upper bounds of
their corresponding ranges.6
Against this background, the Committee members
felt that any significant easing in money market condi
tions would be inappropriate, especially in view of the
continued weakness of the dollar in foreign exchange
markets. On the other hand, there was little sentiment
for further firming action unless the monetary aggre
gates appeared to be growing at rapid rates. Consis
tent with these views, the Committee directed the
Manager to continue aiming initially for a Federal
funds rate of 6% percent and to vary the funds rate
in an orderly fashion within a 6 V2 to 7 percent range
if growth of the aggregates over the January-February
period appeared to be approaching or moving beyond
the limits of their specified ranges. Growth ranges of
2 V2 to 71/2 percent for the two months were established
for Mx and 5 to 9 percent for M2.
In the weeks that followed, projected growth of Mj
and M2 in fact remained reasonably well within the
Committee’s ranges, and the Desk kept the Federal
funds rate unchanged at 6% percent. Open market
operations in the latter half of January and early
February were hampered by severe snowstorms. These
caused reserve management problems for banks and
large reserve projection errors for the Desk as a result
of unexpected bulges in float. The rise in float, along
with seasonal declines in required reserves and cur
rency in circulation, more than offset the reserves
absorbed by an increasing Treasury balance at the
Federal Reserve. Consequently, with few exceptions,
* At the time of the January meeting, M i was estimated to have
advanced by 7.4 percent from the fourth quarter of 1976 to the
fourth quarter of 1977, above the 4 1/2 to 61/2 percent range
announced by the Committee for the period. Over the same interval,
M2 growth was placed at 9.6 percent and M3 growth at 11.6 percent,
compared with the Committee’s ranges of 7 to 10 percent and
81/2 to 111/2 percent, respectively. Subsequent revisions boosted
growth over the four-quarter period to 7.9 percent for M i, 9.8 percent
for M2, and 11.7 percent for M3.

the Desk was in the position of draining reserves over
the period. To absorb reserves on a temporary basis,
the Desk arranged repeated rounds of matched salepurchase transactions in the market when the funds
rate tended to drift below the System’s objective. Since
the reserve excess was expected to persist for several
weeks, the Desk’s outright transactions were also
largely on the selling side. A substantial amount of the
System’s maturing Treasury bills was run off at the
regular weekly and monthly auctions. The Desk also
absorbed reserves by selling bills to foreign accounts,
which continued to acquire dollars through interven
tion in the foreign exchange markets.7
Starting in late January, the Desk became able to
pass through foreign account temporary investment
orders to the market as customer-related RPs.8 Thus,
it could choose to execute part or all of such orders
in the market under appropriate conditions of reserve
availability and cost. At other times, when there was a
need for the System to arrange its own RPs, the Desk
could adjust the amounts made in the market to take
account of the foreign orders which were arranged
as matched sale-purchase transactions with the Sys
tem. Over time, participants came to view the ar
rangement of customer-related RPs in the market
as suggesting that reserve conditions— rate and avail
ability— were reasonably close to those desired.
At both the February and March meetings, the Com
mittee retained the 6 V2 to 7 percent range for Federal
funds. Although economic activity had faltered in the
early months of the year, the sluggishness appeared
to reflect the unusually severe winter weather and a
lengthy coal strike. The staff expected the resultant
losses to be made up in the second quarter. Data

7 A System sale of bills to a foreign account absorbs reserves
indirectly. Dollars acquired by a foreign country in the exchange
markets are credited to the foreign account at the Federal Reserve
and deducted from member bank reserve accounts. If the foreign
account’s orders to buy bills are executed in the market, the payment
for the bills returns reserves to the banking system. Implicitly, this
is the standard assumption made in preparing reserve projections,
so that foreign countries’ gains or losses of dollars are considered
"neutral” in their impact on United States bank reserves. But if,
instead of executing the foreign orders in the market, the System
sells to the foreign account, bank reserves remain lower by the
amount of the sale. Similarly, System purchases from a foreign
account provide the deposits that are paid out by the account and
that add to member bank reserves.
8 During much of 1977, the Desk met such orders entirely through
matched sale-purchase transactions with the System Account. In
November 1977, the Internal Revenue Service ruled that income
from foreign account RPs arranged with the Federal Reserve Bank of
New York, which might have corresponding back-to-back RPs with
dealers, as well as from those arranged as matched sale-purchase
transactions with the System Account, was free of tax liability. This
ruling paved the way for the above-mentioned arrangements initiated
on January 23.

FRBNY Quarterly Review/Spring 1979

available at the February meeting suggested a decline
in Mx that month from its level in January and slow
growth of M2. The weakness in the monetary aggre
gates appeared to be related to the sluggishness in
the economy. In view of the uncertainties over the
economic outlook and the behavior of the aggregates,
the Committee continued to specify a money market
directive at the February meeting for the fifth consecu
tive month, reducing the likelihood that the Federal
funds rate would change. At the March meeting, after
new money stock estimates for the first two months
of 1978 showed significantly greater growth than pre
viously thought, the Committee returned to an aggre
gates directive, thus increasing the likelihood that the
funds rate would rise quickly in response to indica
tions of monetary strength.
Soon after the February 28 meeting, data and new
projections for the February-March period suggested
that growth of
and M2, taken together, would
closely approach the lower bounds of the Committee’s
tolerance ranges. Ordinarily, this might have prompted
the Desk to seek some reduction in the funds rate
within its specified range. However, the weakness of
the monetary aggregates still appeared temporary,
and the dollar meanwhile had come under another
heavy bout of selling pressure in the foreign exchange
markets after more than a month of relative calm.
Under these circumstances, the Committee decided at
a telephone meeting on March 10 to retain the 6% per
cent funds rate objective for the time being.
Projections of the monetary aggregates available
immediately after the regular March meeting showed
a pickup in growth, and for a short while estimates for
the March-April period were on the high side of the
Committee’s tolerance ranges. Subsequently, the un
expected strength evaporated, and the estimates fell
back to rates well within the specified ranges. The
Federal funds rate continued to hover close to 6% per
cent until mid-April.
Following the sharp advances in early January, most
interest rates fluctuated within a narrow range over
the remainder of the winter. Market participants were
encouraged by the stability of the Federal funds rate,
while the slowing in business activity and apparent
sluggish growth of the monetary aggregates tended
to offset concern over inflation and the weak perfor
mance of the dollar in foreign exchange markets. To
ward the end of March, however, intermediate- and
long-term yields resumed their climb, as market par
ticipants reacted to signs that the economy was re
bounding and inflationary pressures were strong. In
vestor concerns mounted following reports of a record
trade deficit in February and the significant upward
revisions to the monetary aggregates for the first two

FRBNY Quarterly Review/Spring 1979

months of the year. Expectations grew that monetary
policy would soon have to exert greater restraint.
Mid-April to mid-October
By the time the Committee met on April 18, it was
clear that the economy was recovering strongly from
the weather- and strike-plagued winter. Prices had
already advanced very rapidly in the early months of
the year. To some extent the acceleration of inflation
reflected special factors, such as curtailed food sup
plies associated with the harsh weather and the Jan
uary boosts in payroll taxes and the minimum wage.
But there was also evidence that inflationary expecta
tions had shifted upward, and the Committee was
deeply concerned about the prospects for prices. In
the financial markets, upward pressure on interest rates
appeared to be building. Households were continuing
to take on instalment and mortgage debt at a rapid
rate. Business borrowing at commercial banks had
accelerated from the already brisk pace of 1977. And,
to finance heavy loan demand, banks in turn were
stepping up their issuance of large CDs. Although the
expansion of the monetary aggregates had slowed in
the first quarter, it seemed likely to strengthen along
with the economy. There were already indications that
Mx would grow rapidly in April.
Under these circumstances, all the members agreed
that operations designed to achieve firmer money
market conditions needed to be undertaken promptly
if monetary growth were to be held in a path reason
ably consistent with the Committee’s long-run objec
tives. At the same time, they felt that any initial action
should be modest pending further evidence as to
whether the aggregates were growing at rapid rates.
Accordingly, the Committee established 7 percent as
the initial Federal funds rate objective. It also raised
the intermeeting range for funds to 6% to 7 Vz percent,
while instructing the Manager not to aim for funds
trading above 714 percent until the members had an
opportunity for further consultation. At this meeting,
the Committee restructured the language of the domes
tic policy directive, giving added weight to the objec
tive of restraining inflationary pressures by placing it
ahead of the objectives of encouraging continued
moderate economic expansion and contributing to a
sustainable pattern of international transactions.
After the Tuesday meeting, the Desk moved quickly
to signal the System’s firmer posture in advance of the
Treasury’s two-year note auction the next day and the
upcoming announcement of its May refunding a week
later. Early on Wednesday the Desk arranged matched
sale-purchase transactions in the market when Federal
funds were trading at 6% percent, a level at which
the Desk has passed through customer RP orders to

the market on some occasions earlier in the week. The
clear evidence of an increase in the funds rate caught
market participants by surprise. Although many had
been anticipating a rise for some weeks, they thought
it would be deferred since the statistics for the first
week in April— published on the thirteenth— had shown
no large jump in Mx.
While an objective of around 7 percent was kept
for the funds rate at the start of the April 26 week, the
Desk permitted expected reserve deficits to cause the
money market to firm somewhat further, given indica
tions that money growth in April and May was likely
to be strong. After it had passed through a portion of
foreign account RP orders to the market when funds
were at 7 percent before the weekend— thus indicating
some satisfaction with that rate— it arranged such or
ders as matched transactions with the System when
similar conditions prevailed later. Enlarged member
bank borrowings over the weekend had added to
reserves and, on Tuesday, the Desk was quick to
respond to a softening in funds to below 7 percent
by arranging matched sale-purchase transactions in
sufficient volume to generate some reserve need. By
the settlement day, with new data suggestive of greater
strength in the aggregates, the Desk began seeking
funds trading at 71/s percent, which became evident
when it let the rate move somewhat above that level
before providing reserves. With the auctions of Trea
sury refunding issues slated for the start of May and,
after appraising the strength in the projections of the
aggregates near the start of the May 3 statement week,
the Desk adopted an objective of VM percent for the
funds rate. While interest rates had been rising since
the initial firming move about two weeks earlier, sizable
adjustments had proceeded smoothly and demand for
the new securities was reasonably good.
On Friday, May 5, estimates of the aggregates were
even stronger, with Mx seen well above its specified
range of 4 to 81/2 percent and M2 close to the top of
its 51/2 to 91/2 percent range for April and May com
bined. A telephone meeting of the FOMC was held that
day to discuss whether the funds rate should be
permitted to rise above 71A percent. Staff analysis
suggested that the surge in the monetary aggregates
largely reflected the economic rebound, as well as
several transitory factors. The majority of the members
preferred to wait for additional evidence on the eco
nomic outlook and the behavior of the aggregates
before tightening further. Hence, the Committee voted
to retain the funds rate objective at VM percent,
but it indicated a preference for resolving doubt on the
high side of that objective.
At each successive meeting over the spring and
summer, the Committee sought a further firming in

money market conditions as the monetary aggregates
rose rapidly and inflationary pressures remained
strong. Growth of the aggregates came in spurts, mak
ing it difficult to determine the underlying trend. The
advances in April and September were particularly
sharp, with more moderate increases registered in the
intervening months. The Committee sought to provide
for a quick Desk response to evidence that the aggre
gates were accelerating. Except for the July meeting,
it adopted aggregates directives through September.
The allowable range for the Federal funds rate re
mained narrow, however, ranging from 1A to % per
centage point but most often at V2 percentage point for
the intermeeting periods.
With Mx and M2 rising rapidly, the Desk often found
itself operating in the upper portion of the intermeeting
ranges for Federal funds specified by the Committee.
On several occasions, available data suggested that
growth of the aggregates would approach or exceed
the upper limits of the Committee’s two-month toler
ance ranges at a time when the Desk was already
seeking Federal funds trading at the highest level
authorized without further instruction from the Com
mittee. In a wire vote in mid-June, the Committee
retained the existing Federal funds rate objective in
view of the proximity of the regularly scheduled June
meeting. In early September, however, the Committee
raised the objective further through a special telephone
meeting. By mid-October, the firming in the System’s
policy stance had brought the Federal funds rate up to
8% percent, 2 percentage points above the earlyApril level.
On five separate occasions over the spring through
the early fall, the Board approved actions by the
Reserve Banks to raise the discount rate. The cumu
lative effect of these actions was to increase the rate
by 2 percentage points to 81/2 percent by mid-October.
The Board stated that the actions were taken primarily
to bring the discount rate in closer alignment with other
short-term rates. In announcing the October boost, it
stressed its concern with continued high inflation, the
rapid rate of monetary expansion, and conditions in
the foreign exchange markets.
The April-October period was marked by wide shifts
in investor sentiment, and interest rates showed great
variation, particularly on intermediate- and long-term
issues. While rates rose across the maturity spectrum
during the spring and into the summer, a sharp price
rally emerged toward the end of July. Two successive
declines in the weekly money stock statistics, coupled
with the release of data suggesting a slowdown in the
pace of the economic expansion, convinced many
participants that the System was likely to maintain a
steady posture over the near term rather than to seek

FRBNY Quarterly Review/Spring 1979

additional firming in money market conditions. Feeling
developed in some quarters that yields in the capital
markets could be near their cyclical peaks. In this
climate, investors rushed to lock in current yields in
long-term securities, while Government securities
dealers scrambled to cover short positions— which had
become very large in the predominantly bearish atmo
sphere of the spring and early summer. Bidding interest
in the Treasury’s sale of three- and seven-year
notes and thirty-year bonds in early August was
especially strong, and average issuing yields set in the
auctions were well below the levels anticipated at the
time the offerings were announced in the previous
week.
The rally in the money markets was brief. After
dropping about 10 to 30 basis points over a two-week
period, short-term rates began to rise around midAugust when the Federal funds rate resumed its climb,
and they continued to advance through the remainder
of the summer and fall. In contrast, the capital markets
extended the rally until the middle of September. By
that time, longer term yields had fallen by 25 to 40
basis points from the levels of mid-July. At first, the
rise in money market rates appeared to have little
effect on the long-term sectors. However; in the face
of continued strong growth of the monetary aggregates
and the likelihood that short-term rates would have to
rise further, participants began to reassess the interest
rate outlook. A further revision in the money stock
measures, which boosted the growth of Mj over the
first eight months of the year, contributed to the more
bearish sentiment. The turnaround in long-term yields
occurred quickly. By the time the Committee met in
mid-October, most of the previous declines had been
retraced.
Mid-October to the year-end
The Committee faced more than the usual uncertainties
at its October meeting. In the first place, starting
November 1, commercial banks were authorized to
begin offering their nonbusiness customers a transfer
option that would allow funds to be shifted from sav
ings accounts to checking accounts automatically.
While ATS seemed certain to slow Mx growth relative
to that of GNP, the size and the speed of its effects on
Mx were difficult to estimate. Second, the precise shape
of President Carter’s new, anti-inflation program was
still to be announced. The members agreed, however,
that monetary and fiscal restraint would have to accom
pany the program if it were to succeed in reducing the
rate of inflation.
In this connection, concern was expressed about the
rapid growth of the monetary aggregates over the
previous calendar quarters, and most members agreed
64

FRBNY Quarterly Review/Spring 1979

that additional firming in System policy was necessary
to assure a slowdown in growth over the period ahead.
Accordingly, the Committee directed the Manager to
seek a Federal funds rate of around 9 percent— up
from its prevailing level of 8% percent— while increas
ing the intermeeting range for funds to 8% to 914 per
cent. To deal with the uncertainties involved in ATS,
primary weight was given to M2 as a guide to open
market operations in the intermeeting period, with Mj
entering only if its upper bound were exceeded. No
lower bound was specified. The staff also began, on an
experimental basis, to track Mx+ to provide the Com
mittee and the Desk with additional background on the
behavior of transactions balances until experience with
the effects of ATS could be obtained.
After the October meeting, the Desk sought an
increase in the funds rate to the 9 percent midpoint
of the FOMC’s range. In the October 25 statement
week, the Desk waited for a large projected reserve
need to show through in the money market but this
did not develop until relatively late. To meet large
reserve deficiencies, the Desk arranged repeated
rounds of RPs on the last three days— announcing
them in the afternoon before the day they were to be
executed and extending the time limit for receiving
propositions when offerings proved modest. With
interest rates rising and auctions of issues offered in
the Treasury’s November refunding slated to begin
October 31, dealer positions were very low. The Trea
sury assisted in easing the reserve scarcity on the
final two days by making redeposits with commercial
banks from its balances at the Federal Reserve. Still,
the funds rate rose by nearly 50 basis points that week
to just under 9% percent.
The firmness in the money market carried into the
next statement week, though the Desk became grad
ually more willing to tolerate this in view of the weak
ness evident in foreign exchange markets and mount
ing indications that new policies to aid the dollar were
being formulated. The higher level of funds trading—
in the area of 9Vs to 91A percent— imparted a sense
of impending higher interest rates and caution in the
market as it prepared to take on the Treasury’s new
offerings.
Meanwhile, the situation in the foreign exchange
markets was nearing crisis proportions. President
Carter’s anti-inflation program, announced on Octo
ber 24, had been greeted unenthusiastically in the
exchange markets, and selling pressure against the
dollar intensified. By the end of October, the dollar
had dropped in value from its beginning-of-the-year
levels by 36 percent against the Japanese yen, 35
percent against the Swiss franc, and 22 percent against
the German mark. The depreciation of the dollar

threatened to undermine the nation’s efforts to curb
inflation and to throw the international financial system
into disarray. Consequently, in the closing days of
October, Federal Reserve and Treasury officials, partly
in consultation with foreign officials, began to formu
late measures to deal with the situation, and by the
beginning of November a broad dollar defense program
was ready to be put in place.
The new program, announced jointly by President
Carter, the Treasury, and the Federal Reserve on the
morning of November 1, involved a series of concerted
actions designed, not only to halt the dollar’s slide in
foreign exchange markets, but also to correct the
excessive declines that had taken place. It featured a
marked tightening of monetary policy and the an
nouncement that the United States, in coordination
with other countries, was prepared to intervene force
fully and on a sustained basis in the exchange mar
kets. The discount rate at the New York Federal
Reserve Bank was raised immediately by 1 percentage
point— the steepest increase since 1931— to a record
91/2 percent. The other Reserve Banks joined the move
shortly thereafter. A supplementary reserve require
ment of 2 percent was placed on time deposits in
denominations of $100,000 or more to help moderate
the expansion of bank credit and increase the incen
tive for member banks to borrow funds abroad. In
line with Committee discussion the previous day, with
final activation of the decision left to Chairman Miller
following announcement of the full program, the range
for Federal funds was raised to 91/2 to 9% percent.
To finance United States intervention in the exchange
markets, a $30 billion package of foreign currencies
was mobilized. This included a $7.6 billion increase to
$15 billion in the Federal Reserve swap lines with
the central banks of Germany, Switzerland, and Japan.
The Treasury announced that it would draw $3 billion
from the United States reserve position with the Inter
national Monetary Fund, sell $2 billion equivalent of
special drawing rights, and issue up to $10 billion
equivalent of foreign currency-denominated securities.
Finally, the Treasury also announced that it would ex
pand its gold sales.
The announcements had immediate and dramatic
effects on financial markets. The dollar rebounded
strongly against other major currencies, the bond
markets rallied, and stock prices, as measured by the
Dow Jones industrial average, registered their largest
one-day gain on record. In the enthusiastic atmo
sphere, a 31/2-year Treasury note auctioned the day
before as part of the November refunding rose quickly
to a high premium. The remaining two auctions were
postponed for a day to allow the markets a little time
to adjust to the actions taken. The auction of ten-year

notes on November 2 encountered weak demand, as
some participants felt that the rally was being over
done, but strong interest developed for the thirty-year
bond sold one day later.
In the wake of the announcements, short-term inter
est rates increased sharply, and trading in Federal
funds on November 1 jumped immediately to the
9% to 10 percent area— somewhat above the Commit
tee’s newly adopted 91/2 to 9% percent range. In order
not to blunt the impact of the dollar defense program,
the Desk avoided aggressive action to push the funds
rate down to the new range, and trading in funds
hovered above 9% percent for several days. By the
end of the following week, market factors began releas
ing reserves in substantial volume, and the funds rate
eased down to a level within the specified range, but
again, consistent with the dollar defense program, the
Desk acted to keep trading largely in the upper portion
of the range.
Desk outright sales of Government securities to
foreign customers were unusually heavy in the first
three statement weeks of November, amounting to over
$4 billion. The sales helped absorb reserves released
by a sharp drop in Treasury balances at the Federal
Reserve, which arose partly because of the imple
mentation of the new cash management program. The
sales also helped meet foreign account demand for
Treasury bills at a time when market supplies of these
issues were scarce. On several occasions, to avoid
pressing further demands for short-term bills on a vir
tually depleted market and adding to the downward
pressure on rates, the Desk sold bills with short-term
maturities to foreign accounts while purchasing a simi
lar amount of longer term bills in the market.
At the final two meetings of 1978, the Committee
voted for additional tightening of money market con
ditions in recognition of the intensity of inflationary
pressures and in further support of the dollar defense
program. It moved cautiously, however, as incoming
economic and financial data presented conflicting
signals on the outlook. On the one hand, the pace of
business activity quickened in the closing months of
the year, suggesting underlying economic strength.
At the same time, however, growth of the monetary
aggregates slowed sharply, especially Mx which was
much weaker than could be attributed to the effects
of ATS alone. At the November meeting, the Committee
raised the intermeeting range for Federal funds from
the 91/2 to 93A percent objective set on November 1
to 9% to 10 percent, while instructing the Manager to
aim for an initial level of funds trading at 9% percent.
The Committee continued to deal with the uncertainties
involved with ATS in the same way that it had at the
October meeting— namely, by specifying only an upper

FRBNY Quarterly Review/Spring 1979

bound for the two-month growth of Mx and by directing
the Manager to place more weight than usual on the
behavior of M2 as a guide to open market operations.
At the December meeting, the range for Federal funds
was set at 9% to IOV2 percent and an initial objective
of 10 percent or slightly above was established. In
light of the experience obtained with the effects of
ATS by the December meeting, the Committee returned
to setting a range for
growth over the two-month
period and to placing equal emphasis on the behavior
of
and M2. However, the directive was structured
to make the Manager more responsive to relatively
high, than to relatively low, monetary growth rates.
In fact, the Committee later took action to avoid having
the funds rate decline when the aggregates weakened.
Money stock growth was sluggish over the final
months of the year, and the weakness continued into
early 1979. Following both the November and Decem
ber meetings, growth estimates for Mx and M2 were
progressively lowered to rates near or below the bot
tom of the Committee’s corresponding ranges, raising
questions about whether the Desk should modify its
approach to the Federal funds rate. Other factors,
however, argued for no change— including the still
fragile state of the dollar, the lack of evidence that
either inflation or economic activity was abating, and
uncertainty about the reasons for the slowdown in

FRBNY Quarterly Review/Spring 1979

monetary growth. In wire votes on December 8 and
again on December 29, the Committee agreed with the
Chairman’s recommendations to keep the funds rate
objective unchanged at-the prevailing level. As the
year ended, the objective remained at 10 percent or
slightly above.
Yields on fixed-income securities pressed higher
over the closing months of 1978. Most short-term rates
moved up in rough alignment with the advance in the
Federal funds rate. The rise in CD rates, however, was
initially more pronounced, as1 banks aggressively
sought to issue CDs during November. Prime lending
rates were boosted further in several steps to close
the year at 11% percent, only 1A percentage point
below the peak in 1974. The rally in the capital mar
kets that followed in the wake of the November 1
announcements soon faded. Yields in the long-term
sectors rose through most of December in reaction to
indications of greater than expected strength in the
economy and further evidence of the persistence of
inflation. Some encouragement was taken from the
moderation in the growth of the monetary aggregates,
but market analysts were not confident that it would
last. Toward the year-end, however, the markets sta
bilized as participants again debated whether long
term. yields might finally be nearing their cyclical
peaks.

August 1978-January 1979 Semiannual Report
(This report was released to the Congress
and to the press on March 8,1979)

Treasury and Federal Reserve
Foreign Exchange Operations
On November 1, 1978, President Carter, the United
States Treasury, and the Federal Reserve announced
a series of actions to correct what had become an
excessive decline of the United States dollar in the
exchange market. Between early August and endOctober, the dollar had fallen sharply against most
major foreign currencies, including net depreciations
of 18 percent against the German mark, 17 percent
against the Swiss franc, and 7 percent against the
Japanese yen. The renewed selling pressure on the
dollar, as with earlier periods of decline in 1977-78,
had largely been in reaction to the persistence of the
large United States trade and current account deficits,
compared with surpluses in several other industrial
countries, and to a quickening of inflation in the United
States, as against steady or slowing rates of inflation
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 Senior
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.
This is the first semiannual report on Treasury and Federal Reserve
foreign exchange operations to appear since the adoption on
September 1 of a new convention for quoting foreign exchange rates
in the New York market. To bring market practice here into line with
that in most other trading centers around the world, the market switched
to express exchange rates in terms of the number of foreign currency
units per dollar for currencies other than the pound sterling, which
continues to be quoted in terms of the dollar value per unit of currency.
In keeping with this shift in convention, all currency rates in this
report except sterling are expressed in terms of the number of foreign
currency units per dollar.

elsewhere. By late October the selling pressure had
gathered such force that dollar exchange rate move
ments had gone beyond what could be justified by
underlying economic conditions and were threatening
to undermine United States efforts to curb inflation.
In fact, the United States trade deficit had begun
to narrow, as manufacuring exports in particular were
expanding sharply, a trend that was expected to con
tinue. Economic growth in the United States was
expected to moderate in 1979, while more rapid expan
sion was already under way in several other major
countries. The sharp rise in United States interest
rates over the course of 1978, while interest rates else
where were steady or rising more slowly, had opened
up substantial interest differentials in favor of place
ments in the United States. But the market atmosphere
had become so extremely bearish that few expected
the dollar’s slide to stop or be reversed on its own.
The November 1 program, developed in close coop
eration with governments and central banks of three
major foreign countries, was linked closely to the
broader anti-inflation policies of the United States
Government. It featured a further tightening of mone
tary policy, including a 1 percentage point increase in
the Federal Reserve discount rate to a historic high
of 91/2 percent. Also, it provided for additional foreign
currency resources totaling up to $30 billion equivalent
to finance United States participation in coordinated
intervention in the exchange markets. For the Federal
Reserve, this involved a $7.6 billion increase in the
swap network through increases in the swap arrange
ments with the German Bundesbank, the Bank of Japan,

FRBNY Quarterly Review/Spring 1979

and the Swiss National Bank to a total of $15 billion.
For its part, the Treasury announced that it would draw
$3 billion in marks and yen from the United States re
serve position with the International Monetary Fund
(IMF) and sell $2 billion equivalent of special drawing
rights (SDRs) to m obilize additional balances of Ger
man marks and Japanese yen, as well as Swiss francs.
The Treasury also announced that it would issue
foreign-currency-denom inated securities up to $10 bil
lion equivalent. In addition, the Treasury announced it
would substantially increase the amounts of gold to be
offered at its m onthly auctions.
The United States authorities followed up the an
nouncements by intervening massively in the New
York m arket through the Foreign Exchange Trading
Desk of the Federal Reserve Bank of New York in
German marks, Swiss francs, and Japanese yen. These
operations were fully coordinated with intervention by
other central banks in their own markets and in some
cases in New York. The dollar rebounded sharply, and
reactions were sim ilarly favorable in United States
financial markets. Thereafter, the exchange m arket
gradually came into better balance with good two-way
trading at levels well above the late-October lows,
and the authorities were able to scale back their inter
vention. By late November-early December, the dollar
had advanced by nearly 12 percent against the German

mark, 15 percent against the Swiss franc, and 13 per
cent against the Japanese yen.
Despite the improved outlook, however, the d o lla r’s
recovery rested on fragile footing fo r the time being.
Many m arket participants remained pessim istic about
the prospects for bringing inflation under control in
the United States and continued to question whether
the authorities would succeed in their efforts to halt
the erosion of the d ollar’s value in the exchange mar
kets. The dollar therefore remained vulnerable to poten
tially adverse political and econom ic shocks around
the world. In early December the political upheavals
in Iran, coupled with a stoppage of that co un try’s pro
duction and export of oil, prompted a burst of dollar
selling. The mid-December announcement by the Or
ganization of Petroleum Exporting Countries (OPEC)
of a greater than expected rise in oil prices by some
14.5 percent over the course of 1979 triggered addi
tional selling of dollars. The United States authorities,
along with the other central banks, again intervened in
substantial amounts to blunt these selling pressures
on the dollar w ithout holding rates at any particular
level. But bearish sentiment deepened, and dollar
rates slipped back some 2 to 51/2 percent from their
early-Decem ber highs.
By the end of December, the United States author
ities had sold a total of $6,659.4 m illion of foreign cur-

Chart 1
Chart 2

T he D o lla r A g a in s t S e le c te d
F o re ig n C u rre n c ie s

S e le c te d In te re s t R ates

Percent

Three-month m aturities*

Percent
1 6 -----------------------------------------------

Euromark deposits
London m arket'
1978

1979

* Percentage change of weekly average of bid rates
for dollars from the average rate for the week of
January 3-6, 1978. Figures calculated from New York
noon quotations.

FRBNY Q uarterly R eview/Spring 1979

1
J

1 11__1 1 I
J
1978

‘ Weekly averages of daily rates.

F
1979

Federal Reserve Reciprocal Currency Arrangements
In millions of dollars
Amount of facility
January 1,1978

Institution
Austrian National B a n k ................................................
National Bank of Belgium ........................................
Bank of C a n a d a .............................................................
National Bank of D e n m a rk..........................................
Bank of England ..........................................................
Bank of France ............................................................
German Federal B a n k ..................................................
Bank of Ita ly ................................................................... .............. ........
Bank of Japan ...............................................................
Bank of Mexico ............................................................
Netherlands Bank ........................................................
Bank of N o rw a y ............................................................
Bank of S w e d e n ............................................................
Swiss National B a n k ....................................................
Bank for International Settlements:
■H m
Swiss francs-dollars ................................................
Other authorized European currencies-dollars ,
Total

Increases effective
during 1978

250
1,000
2,000
250
3,000
2,000
2,000
3,000
2,000
360
500
250
300
1,400

Amount of facility
January 31,1979
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
360
500
250
300
4,000

4,000*
3,000f

2,600f

600
1,250

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

20,160

9,600

29,760

* Increased by $2,000 million each on March 13 and November 1, 1978.
t Increased on November 1, 1978.

Table 2

Federal Reserve System Drawings and Repayments under
Reciprocal Currency Arrangements
In millions of dollars equivalent; drawings (+ ) or repayments (-- )
System swap
commitments
January 1, 1978

1978
I

1978
II

1978
III

1978
IV

1979
January

German Federal Bank ...............................

800.1

+1,008.5

f + 35.2
{ -800.1

f +360.8
|- 7 1 4 .9

( +4,154.3
( - 409.7

( +188.7
\ -42 8 .4

Bank of Japan ..............................................

-0-

156.5
50.0

-106.5

-0-

Swiss National B a n k ....................................

-0-

69.0

f + 4.8
\ — 69.0

+165.7

847.5
231.7

( + 33.8
\ -37 3 .4

446.7

+1,077.6

\ + 40.1
| — 869.1

f +526 5 f +5,158.2
( — 714.9 } - 691.4

\ +222.5
\ -90 8 .3

4,614.9*

Transactions with

Total

800.1

r -

System swap
commitmems
January 31, 1979
4,168.2*

Because of rounding, figures may not add to totals. Data are on a value-date basis with the exception of the last two columns,
which include transactions executed in late January for value after the reporting period.
* Outstanding commitments as of January 31, 1979 also include revaluation adjustments resulting from swap renewals,
which amounted to $26.3 million for drawings on the German Federal Bank renewed during January.

FRBNY Quarterly R eview /Spring 1979

rencies since November 1. Net of repayments, Federal
Reserve commitments under the swap lines with the
German Bundesbank, the Swiss National Bank, and the
Bank of Japan rose to a peak of $5,456.9 million in
early January. United States Treasury drawings under
its swap arrangement with the Bundesbank stood at
$889.4 million equivalent, and the Treasury had used
$1,820.4 million of the $4.4 billion equivalent of cur
rencies obtained through IMF and SDR transactions in
November and through the issuance of $1,595.2 million
equivalent of mark-denominated securities in the Ger
man capital market in December.
Though many market participants expected further
downward pressure on the dollar in January, renewed
selling failed to materialize and the dollar gradually
regained resiliency in the exchanges. In fact, the dollar
had been heavily oversold in late 1978. Moreover, on
those occasions when the dollar did come on offer, the
authorities quickly met the pressures, helping restore
a greater sense of two-way risk in the market. As
the market thus came into better balance, traders be
gan to respond more positively to the thrust of United
States policy. The Carter Administration opened the
new Congressional session by calling for austerity in
fiscal policy to deal with inflation and the dollar prob
lem. Federal Reserve spokesmen continued to empha
size the need for monetary restraint. The Federal Re
serve provided tangible evidence of this determination
by keeping domestic interest rates firm even as the
growth of monetary aggregates slowed. With the dol
lar taking on a firmer tone in the exchanges, the Ger
man Bundesbank was able to begin to absorb some
of the excess mark liquidity created in 1978 and
Switzerland and Japan lifted temporary barriers to
capital inflows.
In late January the demand for dollars picked up
further, as market participants began to view the
Iranian situation and possible oil shortages as a poten
tially serious problem for Western Europe and Japan as
well as for the United States. The dollar’s surge caught
some market participants by surprise, prompting a
sudden scramble for dollars toward the month end.
The central banks stepped in to avoid an outbreak of
disorderly conditions in the upward direction. On these
occasions, the United States authorities purchased a
total of $188.8 million equivalent of German marks,
Swiss francs, and Japanese yen. At end-January, dol
lar rates stood some 9 to 14 percent above the endOctober 1978 lows.
As the dollar improved in early 1979, the United
States authorities were able to step up efforts to clear
away swap indebtedness, repaying a net $1,118.3 mil
lion equivalent of commitments. These repayments were
effected by purchases of currencies mainly from corre

FRBNY Quarterly Review/Spring 1979

spondents but also in the market. By the end of Jan
uary, the Federal Reserve had reduced total swap
drawings outstanding to $4,615 million equivalent and
the United States Treasury had reduced its swap draw
ings in German marks to $613.0 million equivalent. Also,
in January, the Treasury issued in the Swiss market
$1,203 million equivalent of medium-term notes denom
inated in Swiss francs. Foreign currency securities
issued during the period were thereby increased to a
total of $2,798.2 million valued on the dates of issue. As
of January 31, 1979, the value of these liabilities
amounted to $2,821.8 million.
In all, during the six-month period from August 1978
to January 1979, the intervention sales of foreign cur
rencies by the United States authorities totaled $9,359.1
million. In German marks, sales over the six-month
period amounted to $8,122.9 million, of which $4,939.2
million was for the Federal Reserve and $3,183.7 mil
lion was for the Treasury. In Swiss francs, the Federal
Reserve sold a total of $1,029 million over the six-month
period. Sales of Japanese yen totaled $207.3 million, of
which $160.8 million was for the System and $46.5
million was for the Treasury.
In other operations, the Federal Reserve and the
United States Treasury continued to repay pre-August
1971 Swiss franc-denominated liabilities still outstand
ing with the Swiss National Bank. The Federal Reserve
bought sufficient francs directly from the Swiss National
Bank to liquidate $139.6 million equivalent of special
swap debt with the Swiss central bank. The Treasury
used Swiss francs purchased directly from the Swiss
central bank to repay $319.2 million equivalent of francdenominated securities. As of January 31, $139.3
million equivalent of System special swap debt and
$531.2 million equivalent of the Treasury’s obligations
still remained outstanding.
German mark
Since the mid-1970’s, the German mark had been
caught up in recurrent heavy inflows of speculative
and investment funds, leading to a sharp appreciation
of the rate against the dollar as well as against most
other major currencies. The mark’s underlying strength
reflected Germany’s large current account surplus.
German industry had successfully weathered the pre
vious substantial appreciations of the mark and had
maintained, if not improved, its competitiveness in
many markets. Moreover, the German government,
mindful of the broad public concern over inflation, had
been cautious about providing stimulus to the econ
omy. As growth in Germany lagged behind the expan
sion under way elsewhere, particularly in the United
States, the current account surplus mounted.
In fact, the mark’s appreciation had temporarily

added to the size of the current account surplus
through terms of trade effects. It also allowed Germany
to make further progress in curbing inflation, to the
extent that prices rose by only
percent in 1978.
Even so, the cumulative rise in the mark exceeded
relative inflation differentials with many trading part
ners, including the United States, and was clearly
having a depressing effect on the German economy.
By 1978, the German government had moved gradually
to provide more stim ulus to the domestic economy
through fiscal measures, but the market remained
doubtful that the underlying differences in econom ic
perform ance were likely to change very quickly.
Under these circum stances, trading conditions in
the exchange market between the mark and the dollar
had occasionally become extrem ely disorderly. In late
1977-early 1978, German and United States authorities
had intervened heavily in the exchanges to settle the
market and to reestablish a sense of two-way risk. For
the United States, the Federal Reserve and the Trea
sury had both intervened, mainly using marks drawn
under swap arrangements with the Bundesbank. In
March, the United States had announced its prepared
ness to sell SDRs to Germany and to draw marks from
the IMF, but such operations were not necessary at
the time. The dollar firmed over the next months, and
the United States authorities were able to unwind a
sizable part of the swap debt. By the end of July, the
Federal Reserve’s swap debt to the Bundesbank had
been reduced to $650.5 m illion equivalent and the
Treasury’s to $197.0 m illion equivalent. Meanwhile, in
view of the recurrent strains in the exchange markets,
the governments of the European countries decided
to work toward linking their currencies together under
common intervention arrangements. At a summit meet
ing in Bremen in July, the European Community (EC)
governments made a form al comm itment to establish
a European Monetary System (EMS) along these lines
with the specifics to be negotiated by the year-end.
A sense o f'd e e p frustration nevertheless prevailed
in the exchange markets about the kind of underlying
adjustments that would be necessary to establish sta
b ility in the dollar-m ark relationship. At the Bremen
and Bonn summit meetings in July, the German gov
ernment had promised to take additional stim ulative
measures which were subsequently implemented. But,
by early August, both the Swiss franc and the Jap
anese yen had come into strong demand and the un
settlement in those markets triggered renewed demand
for marks against dollars. The spot mark, which had
been trading at DM 2.0330 at the end of July, was bid
up to DM 1.9370 by August 15, a rise of 5 percent.
The Bundesbank and the Federal Reserve intervened
to temper the rise.

Chart 3

Germany
Movements in exchange rate and official
foreign currency reserves
Marks per dollar
1.60

Billions of dollars
6.0

1.70

5. 0

1.80

4. 0
w

1.90

Exchange ra te *
■*------Scale

2.00

A —/

2.30
2.40

2.0
1

2.10

2.20

3. 0

. 1

1.0

pf Foreign currency
rpsprvPR
Scale------►
t i l l
1 1
1 1 1 ... I I
J F M A M J
J A S O N
1978

0
1
I
D

F
1979

1.0

2.0

* Exchange rates shown in this and the following
charts are weekly averages of noon bid rates
for dollars in New York.

On August 16, President Carter expressed his deep
concern over the decline of the dollar, asking Secre
tary of the Treasury Blumenthal and Federal Reserve
Chairman M iller to seek ways to stem the decline.
Over subsequent days and weeks, the United States
authorities follow ed up with a series of measures. The
Federal Reserve tightened money m arket conditions,
hiked the discount rate % percentage point in two
stages to 8 percent by late September, and eliminated
reserve requirem ents on member banks’ Eurodollar
borrowings. The Treasury announced it would triple
the amount of gold at its m onthly auctions. Moreover,
the Adm inistration pressed the Congress to seek
means of reducing the budget deficit even further and
to resolve the remaining issues which held up passage
of an energy bill. The m arket responded favorably to
these initiatives, and the mark fell back to trade around
DM 1.9850 in early September.
The m arket’s extreme pessimism toward the dollar
did not lift completely, however, and trading remained
volatile. Consequently, the Bundesbank and the New
York Federal Reserve intervened on several occasions
in late August. For the month, the Desk’s sales of
marks for the Federal Reserve and the Treasury
amounted to $285.1 m illion equivalent and $277.9 m il
lion equivalent, respectively, financed partly out of
balances and partly by additional drawings under the

FRBNY Q uarterly R eview/Spring 1979

swap lines with the Bundesbank. At the same time, the
Desk was able to acquire marks, largely through nonmarket transactions with correspondents, to repay
swap drawings.
During September, a number of potentially favorable
developments emerged for the dollar. United States
trade figures showed that, following the bulge in the
deficit earlier in the year, import demand was begin
ning to slacken while exports were expanding rapidly.
With economic expansion in Germany and other coun
tries now more solidly based, official projections
pointed to a further and substantial narrowing of the
deficit for 1979. The Senate passed the long-awaited
energy bill. And the Camp David accord had gen
erated hopes of an easing of tensions in the Middle
East. But these developments were largely ignored by
the exchange markets, where traders were expressing
concern over the resurgence of inflationary pressures
in the United States.
By that time, the negotiations over the EMS were the
subject of extensive press and market commentary.
Many market participants came to expect that, before
the new arrangements could be introduced, scheduled
for January 1, a generalized realignment would be
necessary to revalue the mark substantially relative to
the other currencies. As these expectations spread,
heavy demand for marks built up, particularly before
weekends. The Bundesbank and the other EC central
banks had to intervene in progressively larger amounts
to maintain the 2 1/4 percent margin between partici
pating currencies. From the July Bremen summit to
mid-October, some $5 billion equivalent of marks was
pumped into the market by participating central banks.
Then on October 15 the mark was revalued by 2 percent
against the Netherlands guilder and the Belgian franc
and by 4 percent against the Norwegian and Danish
kroner. This stopped the immediate speculative pres
sure on the snake but did not generate significant
reflows.
Instead the bidding for marks continued. With the
focus now shifting back to the dollar, a massive
amount of hot money flowed out of dollars and into
marks. Corporate treasurers, investment managers,
central banks, and other dollar holders around the world
sought to diversify their portfolios by buying marks and
other currencies. The Federal Reserve’s decision on
October 13 to raise the discount rate another Vz per
centage point to 8V2 percent was ignored, as were the
generally favorable interest rate differentials for the
dollar. As the selling pressure on the dollar moved with
the time zones around the clock, intervention by the
German and United States authorities increased both
in size and scope. On the night of October 24, when
President Carter announced his new anti-inflation pro

FRBNY Quarterly Review/Spring 1979

gram calling for voluntary price and wage guidelines,
the Federal Reserve, operating through United States
banks with branches in Hong Kong and Singapore, in
tervened in marks in the Far Eastern market to counter
speculative pressure on the dollar. The market was
well aware of this very forceful approach by the au
thorities, but demand for marks continued to build,
and on October 31 the rate was pushed to an all-time
high of DM 1.7050. At this level, the mark had risen
almost 20 percent above early-August levels, 23 percent
since the beginning of the year and 34 percent since
late July 1976.
In all, the Trading Desk sold $1,641.4 million equiva
lent of German marks during September and October,
of which $976.7 million was in the last four trading days
in October. Of these totals, $1,033.2 million equivalent
was for the Federal Reserve and $608.2 million equiva
lent was done on behalf of the Treasury. Net of further
repayments during those months, swap drawings
on the Bundesbank had mounted to $1,256.1 million
by the Federal Reserve and $650.4 million by the Trea
sury. Meanwhile, net purchases of dollars, together with
the much larger intervention in EC snake currencies,
had swollen Germany’s international reserves by $8.4
billion since July to $49.5 billion by the end of October.
On November 1, President Carter announced, as a
major step in the United States anti-inflation program,
that it was now necessary to correct the excessive
decline in the dollar. In this connection, the Federal
Reserve’s swap line with the Bundesbank was raised
to $6 billion, along with increases in the System’s
swap lines with the Swiss National Bank and the Bank
of Japan. The Treasury announced it would draw
German marks on its reserve position in the IMF,
sell SDRs to Germany for marks, and issue markdenominated bonds in the German capital market.
The Desk followed up the announcements with a
highly visible and forceful intervention operation in
the New York market in German marks as well as in
Swiss francs and Japanese yen. These operations were
fully coordinated with those of other central banks in
their own markets. In response, many market profes
sionals moved quickly to dump their long mark posi
tions. As the dollar then rebounded, the spot mark
fell sharply to as low as DM 1.9030 on November 6,
down 10 1/2 percent from its record high just four trading
days earlier. But sporadic bidding for marks by the
banks’ commercial customers and by central banks
shifting funds out of dollars continued for some time.
Consequently, as the market sought to establish a new
trading range following the November 1 announce
ments, both the German and United States authorities
continued intervening openly and forcefully in their re
spective markets. These operations gradually brought

the market into better balance, and by November 20
the mark declined to as low as DM 1.94. In all, the
Desk intervened on twelve trading days during Novem
ber, selling $2,920.8 million equivalent of marks in the
market, of which $1,976.1 million equivalent was done
for System account and the remaining $944.7 million
equivalent was on behalf of the Exchange Stabilization
Fund (ESF). Meanwhile, Germany’s foreign currency
reserves increased by a further $500 million which,
together with the purchase of SDRs from the United
States Treasury and the increase in its reserve position
with the IMF resulting from the United States drawing,
contributed to the $2.8 billion increase in overall re
serves for the month.
During December, however, the dollar’s recovery
lost momentum. With the latest statistics showing the
United States economy even more buoyant than ex
pected just a month before— with prices, production,
and employment all expanding rapidly— the market
worried that the anticipated slowing of inflation and
narrowing of our trade deficit was now delayed. More
over, with economic activity in Germany picking up,
reports circulated that the Bundesbank was increas
ingly concerned over the buildup of mark liquidity in
domestic money markets. As a result, dealers watched
closely the Bundesbank’s weekly reserve figures for
any indication that it had acted to offset earlier inter
vention by selling dollars and grew cautious about the
implications of its December 14 announcement of a
reduction in commercial bank rediscount quotas and
a monetary growth target of 6-9 percent for 1979. In
addition, the approach of the starting date for the new
EMS was still a source of uncertainty as traders re
mained doubtful that even the new exchange rate
relationships would prevail in the proposed new joint
arrangement.
Against this background, the outbreak of a political
crisis in Iran and a larger than expected increase in
OPEC oil prices helped trigger another burst of de
mand for the German mark before mid-December. As
the mark advanced, many corporations joined in the
bidding to cover accounting as well as economic expo
sures before the rate rose too far. Moreover, some cen
tral banks of developing countries proceeded further
with their efforts to diversify portfolios by buying marks.
This demand for marks came at a time when many of
the dealing banks were reluctant to undertake new
transactions that would significantly alter their ac
counts for the year-end. Consequently, the market was
even less resilient than normal, and the heavy bid
ding for marks propelled the rate up to as high as
DM 1.8070 on January 2, almost 71/2 percent above its
November lows.
To moderate this advance, the United States and

German authorities again intervened forcefully through
out December. Operating on fourteen trading days the
Desk sold $2,796.5 million equivalent of marks including
$1,575.8 million equivalent for the System and $1,220.7
million equivalent for the Treasury. These operations
brought total United States intervention sales over the
last two months of 1978 to $5,717.3 million equivalent
of marks. As a result, total drawings outstanding on the
Federal Reserve’s swap line with the Bundesbank stood
at $4,558.0 million equivalent by the year-end. The
Treasury’s outstanding drawings on its swap line with
the German central bank stood at $889.4 million equi
valent. But the bulk of its intervention after November 1
had been financed out of ESF balances obtained from
the United States drawing on the IMF and out of
the proceeds of the Treasury’s first issue of markdenominated securities. This issue, which was floated
in the German capital market on December 15, was
comprised of $931.1 million equivalent of three-year
securities at 5.95 percent per annum and $664.1 mil
lion equivalent of four-year notes at 6.2 percent. The
$1,595.2 million of proceeds was warehoused by the
Treasury with the Federal Reserve.
Meanwhile, the surge in the mark ahead of the yearend had led many market participants to believe that
it would advance much further in early January. But,
in fact, the commercial demand for marks that had been
expected in January had largely been met. The Bundes
bank stepped in and intervened in size as soon as
trading resumed in the new year. Also rumors circu
lated that new dollar defense measures would quickly
be announced should the mark rise strongly against
the dollar. Traders then found they had few outlets for
the marks they had accumulated or had just received
from the German central bank, and some moved to
cover their positions. The mark thus fell bacK quickly,
to around DM 1.85, an unexpected turnaround which
had a sobering impact on market psychology. As a
result, after some initial nervousness, the market took
in stride the January 18 decision of the German
authorities to increase minimum reserve requirements
and to raise the Lombard rate V2 percentage point to
4 percent. Sentiment toward the dollar was also helped
by the stress on the need for fiscal restraint in the
President’s budget and State of the Union message
and by the Federal Reserve’s adherence to a restrictive
monetary policy. A scramble for oil by many countries
seeking to prepare themselves for a protracted disrup
tion of production in Iran prompted additional demand
for dollars.
The mark thus came increasingly on offer toward the
month end. It fell sharply on the final day of the period
under review, prompting the Desk to buy $70 million
equivalent of marks in the market to cover outstanding

FRBNY Quarterly Review/Spring 1979

Table 3

Federal Reserve System Repayments under Special
Swap Arrangement with the Swiss National Bank
In millions of dollars equivalent
System swap
commitments
January 1, 1978
506.5

1978
I

1978
II

1978
III

1978
IV

1979
January

System swap
commitments
January 31,1979

-9 5 .6

-6 2 .3

-18.1

139.3

Data are on a value-date basis.

Table 4

Drawings and Repayments by Foreign Central Banks and the Bank for International Settlements
under Reciprocal Currency Arrangements
In millions of dollars; drawings (+ ) or repayments (— )

Bank drawing on Federal Reserve System

Outstanding
January 1, 1978

1978
I

1978
II

1978
III

1978
IV

1979
January

Outstanding
January 31, 1979

Bank for International Settlements*
(against German marks) ...........................

-0-

( +295.0
I -29 5 .0

-0-

( +22.0
| -2 2 .0

-0-

Data are on a value-date basis.
* BIS drawings and repayments of dollars against European currencies
other than Swiss francs to meet temporary cash requirements.

Table 5

United States Treasury Drawings and Repayments under
Swap Arrangement with the German Federal Bank
In millions of dollars equivalent; drawings (+ ) or repayments (— )
Amount of
commitments
January 1, 1978
-0-

1978
I

1978
II

1978
III

1978
IV

1979
January

Amount of
commitments
January 31,1979

+964.8

( + 35.2
■) -53 3 .6

J +360.8
I -485.7

( +802.5
{ -25 4 .6

-26 4 .8

613.0*

Because of rounding, figures do not add to totals. Data are on a value-date basis with the exception of the last two columns,
which include transactions executed in late January for value after the reporting period.
* Outstanding commitments as of January 31. 1979 also include revaluation adjustments resulting from swap renewals,
which amounted to $11.6 million for drawings on the German Federal Bank renewed during January.

FRBNY Quarterly R eview/Spring 1979

Federal Reserve— Treasury “ Warehousing Arrangement”
D uring th e s ix -m o n th p e rio d , the Federal Reserve “ w a re
h o u s e d ” fo re ig n c u rre n c ie s by ta kin g fo re ig n e xch a ng e
a c q u ire d by th e T re a su ry th a t w as n o t im m e d ia te ly
needed to fin a nce fo re ig n e xch a ng e in te rve n tio n in
re tu rn fo r d o lla rs th a t w e re nee de d by th e T re a su ry
in its ow n d o m e s tic o p e ra tio n s. In ca rry in g o u t th is
e xch a ng e , th e F ederal R eserve o p e ra te d as it d id in th e
past to buy the fo re ig n c u rre n c y in a sp o t p u rch a se from
th e T re a s u ry and s im u lta n e o u s ly sell it b a ck to the
T re a s u ry at th e sam e e xch a ng e rate fo r a fu tu re
m a tu rity d a te — th re e m on th s o r even one ye a r la te r.
A key a s p e c t o f th is typ e of tra n sa ctio n is that, sin ce
bo th the F ederal R eserve and th e T re a su ry ag re e to
pay and to rece ive th e sam e am o u n t o f fo re ig n c u r
ren cy as s p e c ifie d by th e use of the sam e e xch a ng e
rate, n e ith e r p a rty in c u rs any fo re ig n e xch a ng e rate
ris k from th is tra n s a c tio n .
B etw een th e tim e o f th e in itia l tra n sa ctio n and the
m a tu rity date, th e T re a su ry has d o lla rs w h ich are
c re d ite d in itia lly to its a c c o u n t at the F ederal Reserve
B ank o f New Y o rk, w h ile th e F ederal Reserve has
fo re ig n c u rre n c y a ssets w h ich it pla ce s w ith its ce n tra l
b a n k c o rre s p o n d e n t a b ro a d to earn an in ve stm e n t re
turn. As the d o lla rs flo w in to th e U nited S tates ba n king
system , e ith e r by tra n s fe r to a T re a su ry ta x and loan
a c c o u n t at a c o m m e rc ia l b ank o r as th e T re a su ry

Federal Reserve and Treasury swap debt and to main
tain orderly trading conditions. The mark thus ended
the period at DM 1.8720, some 9 percent below its endO ctober peak but still up 8V2 percent over the sixmonth period under review.
Compared with the preceding two months, central
bank support for the dollar was modest during Jan
uary. The Federal Reserve Trading Desk intervened
to sell only $68.9 m illion equivalent of marks for the
System and $132.3 m illion equivalent for the Treasury
over the course of the month. Meanwhile, it took ad
vantage of opportunities to acquire marks, largely
through nonmarket transactions with correspondents,
which were used to repay swap debt. Thus, by endJanuary, the System’s outstanding swap indebtedness
to the Bundesbank was down $389.8 m illion net over
the month to stand at $4,168.2 m illion and that of the
Treasury had been reduced by $276.4 m illion to $613.0
million. These operations, repayments of swap debt by
the Bundesbank’s partners in the EC snake, and that
central bank’s own operations in the m arket were
reflected in the $1.8 billion net decrease in Germany’s
official reserves over the month to $52.1 billion by

fin a n ce s d o m e stic e xp e n d itu re s, m e m b e r ba n k reserves
in cre a se . H ow ever, u n d e r th e o p e ra tin g p ro c e d u re s the
d o m e s tic T ra d in g D esk uses to c a rry o u t o b je c tiv e s
set by th e Federal Open M a rke t C o m m itte e , it w o u ld
ty p ic a lly respond by a b s o rb in g an e q u iva le n t a m ount
o f reserves in its d a y-to -d a y open m a rke t o p e ra tio n s to
n e u tra lize any u n w anted e xp a n sio n a ry e ffe ct of the
use of th e T re a s u ry ’s b a la nce a t th e Federal Reserve
B ank o f New Y o rk.
A w a re h o u sin g tra n s a c tio n is reversed when the
F ederal Reserve repays th e fo re ig n cu rre n c y it has
a cq u ire d from th e T re a su ry and th e T re a su ry repays
d o lla rs . T h is co u ld o c c u r b e fore th e o rig in a l m a tu rity
d ate, if the T re a su ry d e cid e s th a t w areh o u se d fo re ig n
exch a ng e ba la nce s w ill be used to finance its in te rve n
tio n (in w h ich case th e T re a su ry ca rrie s any exch a ng e
risk th a t m ay be in vo lved ) o r upon m atu rity. W h e th er the
T re a su ry a cq u ire s d o lla rs to m ake the repaym ent to the
Federal Reserve by p u rch a sin g them in the fo re ig n e x
ch a n ge m arket, by b o rro w in g in the d o m e stic m arket, o r
fro m re c e ip ts from o th e r so u rce s, m em ber bank reserves
w ill d e clin e . In th is case, the d o m e stic T ra d in g Desk
w o u ld offse t any u nw anted d e clin e th ro u g h open m arke t
o p e ra tio n s. Thus, in p ra c tic e , th e re is no net e ffe ct on
m em b e r b a n k reserves as a re su lt of o p e ra tio n s un d er
th e w a reh o u sin g a rra n g e m e n ts.

January 31, 1979. But for the six-month period as a
whole, Germany’s reserves rose a net $11 billion.

Japanese yen
By late 1977-early 1978, the Japanese authorities faced
three m utually reinforcing problems: economic growth
had fallen short of the governm ent’s target, the current
account surplus remained excessive at an annual rate
of nearly $16 billion, and the yen was appreciating
rapidly, rising 30 percent in two years to ¥227.00.
Since each of these problems had significant inter
national implications, foreign authorities were pressing
Japan to hasten the adjustm ent process. In late 1977,
the government had provided more fiscal stimulus to
promote domestic growth and boost imports. In addi
tion, Japan encouraged imports by relaxing trade
restrictions on certain kinds of goods. But the impact
of these measures was blunted by the persistent rise
in the Japanese yen which exerted a drag on the
domestic economy. Moreover, the current account sur
plus widened even further as the yen rate appreciated.
This unexpected result reflected in good measure the
terms of trade effects of the yen’s rise. It also reflected

FRBNY Q uarterly R eview/Spring 1979

the fact that Japan’s exports remained highly com
petitive. With the yen’s appreciation serving as a
further brake to domestic inflation, Japanese firm s in
several key industries were able to take advantage of
declining costs of imported raw materials and other
products, such as oil. Moreover, because of the more
rapid inflation under way in many foreign markets,
Japanese exporters did not have to absorb the full
effect of the yen’s rise on their prices. By mid-1978
the underlying adjustm ent to the previous appreciation
of the yen was finally beginning to show through in
the trade figures, as export volumes started to decline
and im port volumes started to rise. But, in view of the
experience of the previous two years, the market was
still skeptical that Japan’s efforts to reduce its surplus
significantly— or the United States efforts to reduce
our current account d eficit— were likely to succeed in
the near future.
Against this background the yen had come into
demand, buoyed by heavy inflows of funds again in
late July-early August. The yen rate was bid up by
20 percent to ¥188.6 at the end of July and advanced
a further 3% percent to a peak of ¥181.8 in midAugust. By that time, selling pressure on the dollar
again spread to the markets for major European cur
rencies. On August 16, President Carter expressed
his deep concern over the d ollar’s decline, initiating
a series of actions by the Federal Reserve and the
United States Treasury to deal with the problem.
These included intensive discussions between the
United States and the Japanese authorities on means
of hastening the adjustm ent process. In late August,
the Japanese government introduced a supplementary
budget w hich included additional stimulus, mainly
through public w orks projects and credit availability
for housing, w hich was expected to increase GNP by
some ¥ 2 .7 trillion. The Japanese authorities also
pressed ahead on a program of emergency imports to
reduce the immediate current account surplus. The
market responded positively to these various official
actions, and the yen settled back in late August to
¥188, where it held steady in balanced trading through
m id-October.
By that time, Japan’s current account surplus was
more clearly on a narrowing trend. But the dollar had
again come under heavy selling pressure against
Western European currencies and that pressure again
spilled over into the yen, which rose to a new record
high of ¥176.45 by October 31. Under these circum
stances, the Japanese authorities became concerned
that the new appreciation of the yen m ight thw art even
the modest progress toward internal and external bal
ance that had just begun. The United States authorities
were also concerned that the decline of the dollar was

FRBNY Quarterly Review/Spring 1979

becoming excessive and threatened to undermine the
efforts to curb inflation in the United States.
Consequently, in further discussions in late October,
United States and Japanese authorities agreed that an
im portant element of any broader package of initiatives
to strengthen the United States dollar would be a com
m itment by the United States to intervene in Japanese
yen, backed up by substantial resources, along with
intervention in German marks and Swiss francs. For
sometime, the Federal Reserve Bank of New York
had been intervening in the New York m arket for
account of the Japanese authorities. It was agreed
that this would continue and that the United States
authorities would join in this intervention using their
own resources. As the $30 billion of foreign currency
resources was assembled, therefore, the Federal Re
serve swap arrangement w ith the Bank of Japan was
raised from $2 billion to $5 billion, and the United
States Treasury agreed to draw $1,000 m illion equiva
lent of yen from the IMF and to sell $641.7 m illion
equivalent of SDRs to Japan.
The announcement on November 1 of these mea
sures had a profound effect on yen trading in New
York, and the yen rate fell back sharply w ith only
modest intervention fo r the day. Heavy demand fo r yen
developed the next day in Tokyo. But the Bank of
Japan countered vigorously, and the Federal Reserve
Bank of New York maintained a forceful presence in

Chart 4

Japan
Movements in exchange rate and official
foreign currency reserves
Yen per dollar

* S e e footnote on Chart 3.

Billions of dollars

the New York market on that and subsequent days.
In response, the pressure quickly abated and there
was little need for further intervention. In all, sales of
yen by the United States authorities in early November
amounted to $196.7 million. Of the Federal Reserve
sales, $151.7 million equivalent of yen was financed by
drawings under the System’s swap arrangement with
the Bank of Japan and $2.8 million equivalent of Jap
anese yen was drawn from balances. United States
Treasury sales of $42.3 million of yen were financed
entirely out of proceeds of IMF drawings.
Once the sense of two-way risk was reestablished,
market sentiment began to shift against the yen.
Traders took account of the narrowing of Japan’s
current account surplus. Moreover, the wide interest
differentials favoring the United States dollar over the
yen generated capital outflows, as foreign governments
and international institutions stepped up new borrow
ings in the Tokyo market and nonresidents liquidated
earlier investments. Consequently, the yen rate dropped
back to as low as ¥202.45 in early December, some
13 percent below the late-October peak. By that time
the Federal Reserve began to acquire modest amounts
of yen to repay the swap drawings of early November.
The yen then became caught up in the renewed up
surge of the European currencies against the dollar in
mid-December. But, while regaining 5 percent to a
high of ¥192.45, the yen lagged behind the rise in the
other currencies. Consequently, intervention to check
the rise was relatively modest, with the United States
authorities selling a total of $10.6 million of yen. Of this
amount the Federal Reserve sold $6.4 million equivalent
financed by a $4.8 million equivalent drawing on the
swap line with the Bank of Japan and out of balances.
The remaining $4.2 million equivalent was sold by the
Treasury out of balances. By midmonth, market senti
ment turned hesitant toward the yen once again, as
major events of concern to the market at the time— the
political and economic disturbances in Iran and the jump
in OPEC oil prices— were viewed as potentially serious
to Japan as well as to the United States. Consequently,
the yen rate began to ease through the month end,
even as other currencies continued to advance.
In January, the yen softened further as Japanese
trading companies bid strongly for dollars. The Jap
anese authorities took the opportunity to dismantle
some of the barriers to capital inflows, cutting in half
the marginal reserve requirement on free yen deposits
and relaxing the restrictions on nonresident purchases
of Japanese securities. On several days the yen de
clined sharply enough in the New York market that
the Federal Reserve stepped in as a buyer of yen to
maintain orderly trading conditions. On this basis it
purchased $98.8 million equivalent for the account

of the United States authorities over the course of the
month. By the month end, the yen rate had fallen back
to ¥201.70, for a net decline of 6 V2 percent for the
six-month period under review. By that time, the Fed
eral Reserve had acquired sufficient amounts of yen
from transactions with correspondents and from the
market to repay in full the swap drawings on the Bank of
Japan. The Treasury’s purchases of yen were added to
ESF balances.
Swiss franc
By midsummer 1978 the Swiss franc was rising sharply,
reaching new highs against the dollar and other major
European currencies. Switzerland’s inflation rate was
running at 1.4 percent per annum, the lowest of all
industrial countries. Switzerland's current account for
the year, forecast to show a SF 9 billion surplus, was
expected to be second only to Japan’s. Also, many in
the market had come to question whether the authori
ties would continue to resist upward pressure on the
franc, since intervention in the exchanges earlier in
the year had already contributed to an explosion in the
monetary aggregates well above the central bank’s
5 percent target. Indeed, since midyear the Swiss
National Bank had been able to absorb some of the
excess liquidity through domestic monetary operations
and by selling dollars to nonresident borrowers under
the official capital export conversion requirement. As
a result, Switzerland’s reserves had declined somewhat
in July to $12.8 billion. But in the exchange market the
Swiss franc was swept up in a burst of bidding to
SF 1.7099 against the dollar and SF 0.8458 against
the German mark by August 2. At these levels, the
Swiss franc had gained since the beginning of the year
16 percent and 12 percent, respectively.
In view of the franc’s rapid advance, the National
Bank moved early in August to make more liquidity
available to the market by open market operations, the
placement of government deposits with commercial
banks, and one-year swaps against dollars. These oper
ations triggered a sharp decline in domestic and EuroSwiss franc interest rates and succeeded for a while
in blunting the franc’s rise. But, in the generally un
settled markets at the time, the franc was soon rising
again against the dollar, along with other major cur
rencies. It rose as high as SF 1.5451 by mid-August
before falling back by some 8 V2 percent in reaction
to President Carter’s expression of deep concern
over the dollar’s decline and the follow-up measures
by the Federal Reserve and the Treasury.
But by September the Swiss franc was again on the
rise. As before, the appreciation was for the most part
caused by commercial and official shifts of funds out
of the dollar. But the franc was also buoyed by flows

FRBNY Quarterly Review/Spring 1979

Chart 5

Switzerland
Movements in exchange rate and official
foreign currency reserves

*S ee footnote on Chart 3.

of funds out of other European currencies, including
the mark, in response to m arket concern that an ex
panded jo in t float arrangem ent to include all EC
countries would leave the franc isolated and hence
more vulnerable to even stronger upward pressures.
In this environment, the rate was propelled by late Sep
tem ber to a new record high of SF 1.4510 against the
dollar and SF 0.7547 against the mark. To moderate
this advance, the Swiss National Bank had gradually
increased its dollar purchases in Zurich and New York,
while the Federal Reserve joined in these operations
on twelve trading days in August and September, selling
$147.7 m illion equivalent of francs. These sales were
financed by drawings under the swap arrangement with
the Swiss National Bank, which raised the total from
$22.9 m illion equivalent to $170.5 m illion equivalent.
Meanwhile, the fra n c’s unrelenting advance in the
exchanges raised the risk of severe repercussions on the
Swiss economy. Producers of goods for both foreign
and dom estic markets were concerned about a loss of
competitiveness, falling profit margins, and declining
sales. But the trade balance remained strong because
of the favorable price effects of the fran c’s appreciation
on the terms of the trade. Concerned that an excessive
appreciation of the franc m ight drive the economy into

FRBNY Quarterly R eview/Spring 1979

recession, the Swiss authorities took the initiative in the
exchange markets in late Septem ber-early October. The
Swiss National Bank intervened massively to reverse
the rise in the rate both against the dollar and the
German mark. Although the bulk was done in Zurich,
the Federal Reserve follow ed up in New York, for the
account of the Swiss National Bank and fo r Federal
Reserve account. System sales of francs amounted
to $ 100.0 m illion equivalent.
Also, to signal a desire fo r the franc to decline
against the mark, the Swiss central bank bought mod
est amounts of snake currencies other than the mark
to give the mark more room to appreciate w ithin the
jo in t float. Finally, to increase the depth of the Swiss
franc market, the authorities raised the lim it on non
resident participation in foreign borrow ers’ Swiss franc
bond issues from 35 percent to 50 percent and allowed
50 percent of private nonresident borrow ings of francs
to be converted in the market.
In response to these actions, the franc initially fell
back sharply, dropping to a low of SF 1.63 against the
dollar and to SF 0.8350 against the mark. Later on,
however, as trading conditions deteriorated and the
dollar plummeted across the board, the franc rose
again, moving back to its record high on O ctober 31.
But, in the wake of the earlier intervention by the Swiss
National Bank and the highly publicized concern of
the Swiss authorities over the fran c’s relationship to
the mark, the Swiss franc lagged behind the rise in the
mark. As a result, although the Federal Reserve supple
mented its intervention in marks with sales of Swiss
francs, in late O ctober it sold only a m odest $46.5
m illion equivalent of francs financed by drawings on
the swap line with the Swiss National Bank. Mean
while, the heavy intervention by the Swiss National
Bank earlier in O ctober accounted largely for the $4.7
billion increase in Sw itzerland’s external reserves dur
ing August-October.
The fra n c’s advance was abruptly reversed in re
sponse to the November 1 announcement of steps to
correct the excessive decline of the dollar. These in
cluded an increase in the Federal Reserve’s swap line
with the Swiss National Bank from $1.4 b illion to $4
billion, indications by the Treasury that it w ould sell
SDRs for Swiss francs, and plans for the Treasury to
place franc-denom inated securities in the Swiss capital
market. On November 1, the franc fell sharply, drop
ping off some 8% percent below its highs of the pre
vious day. Thereafter, the franc, along with the mark
and the yen, came into heavy demand in a test of the
United States resolve to follow through on the Novem
ber 1 program. But the earlier forceful intervention by
the Swiss authorities had already made traders more
cautious, and the Swiss National Bank did not have to

intervene as heavily as before. For its part, the Federal
Reserve sold $351.6 m illion equivalent of francs in
the first half of November, financed entirely by
new drawings on the swap line with the Swiss cen
tral bank. This intervention helped settle the market,
and by November 20 the franc had declined another
9 percent to SF 1.7640. Thereafter, the rate fluctuated
fairly narrowly through early December, requiring only
occasional light support from the Swiss National Bank
and sales of just $29.0 m illion equivalent of francs by
the Federal Reserve on November 21 and 29 which
were financed by further swap drawings.
During December the franc came under renewed
upward pressure amid uncertainties ahead of the
scheduled introduction of the EMS at the month end,
growing political instability in Iran, and the announce
ment by OPEC of a larger than expected oil price in
crease. As the franc rose, many multinational corpora
tions sought to cover both econom ic and accounting
exposures. For a while the franc outstripped the mark
in its advance against the dollar, rising 9 percent by
the year-end. In response, the Swiss National Bank
intervened heavily and the Federal Reserve sold $354.3
m illion equivalent of francs through the month end, of
which $33.8 m illion was for value in early January.
These operations contributed to another $4.1 billion
equivalent rise in Sw itzerland’s external reserves since
October 31 to $21.6 billion at the year-end.
But this intense bidding tapered off quickly in early
January once it became clear that most companies

had satisfied their near-term need for francs before
the year-end. Also, tim ely and forceful intervention
by the National Bank left the m arket to expect that the
central banks would step in quickly to counter a re
newed rush into francs. Even so, the m arket was
aware that the heavy intervention by the Swiss National
Bank had generated a 16.2 percent increase in the
Swiss money supply in 1978, far above the targeted
rate of increase. To ease concerns that it m ight sud
denly tighten liquidity, the Swiss National Bank an
nounced that, since priority was still being given to
the stabilization of exchange rate relationships, it
would not set a money supply target for 1979. More
over, when the United States Treasury announced
plans to sell Swiss franc-denom inated bonds, the
Swiss National Bank follow ed up with an assurance
that the authorities would offset the liquidity drain
caused by this issue. At mid-January, the United States
Treasury placed a total of $1,203 m illion equivalent of
franc-denominated securities in the Swiss capital mar
ket. Of this amount $744.5 m illion equivalent was bor
rowed over 2 1/2 years at 2.35 percent per annum. The
remaining $458.5 m illion equivalent four-year place
ment was at 2.65 percent. The proceeds of these secu
rities were then warehoused by the Treasury with the
Federal Reserve.
In this better atmosphere for the dollar, traders be
gan to perceive a downside risk in the Swiss franc. In
view of the 10 percentage point differential between
United States and Swiss interest rates, it became im-

Table 6

United States Treasury Securities, Foreign Currency Denominated
In millions of dollars equivalent; issues (+ ) or redemptions (— )
Amount of
commitments
January 1,1978

1978
I

1978
II

1978
III

1,168.9

— 133.8

S w itzerland....................................................

-0-

G e rm a n y........................................................

-0-

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

1,168.9

Issues

1979
January

Amount of
commitments
January 31,1979

69.3

531.2

-0-

+1,203.0

1,203.0

+1,595.2

-0-

1,595.2

1978
IV

Government series:
Swiss National B a n k ....................................

—

167.1

—

Public series:

-13 3 .8

j + 1 jg £ J

{ +1 203 0

3'329'3

Because of rounding, figures may not add to totals. Data are on a value-date basis.

FRBNY Quarterly R eview /Spring 1979

mensely costly to remain short of dollars once the franc
began to ease. The franc thus fell back sharply from
its year-end highs, and this decline accelerated follow
ing the stress on anti-inflation policies in the United
States. With the exchange market now in better bal
ance, the Swiss government announced on January 23
the removal of the February 1978 ban on nonresident
purchases of foreign securities. Caught by surprise,
the market’s initial reaction was to bid heavily for
francs. But the Swiss National Bank reacted imme
diately with forceful intervention, and this flurry of
demand quickly subsided. Thus, the franc continued
to ease enabling the Swiss National Bank to sell some
of its earlier dollar purchases. The franc closed at
SF 1.700 on January 31, off 14 percent from the
late-October peak.
For its part, the Federal Reserve did not intervene in
the franc market during January. In fact, at one point
in which the franc was easing particularly sharply the
System was able to buy $20.0 million equivalent of
francs in the market. This purchase, together with
much larger amounts purchased directly from the Swiss
National Bank, enabled the System to repay $605.1
million of current System swap debt, leaving $446.7
million equivalent outstanding as of January 31. For
the period as a whole, the franc was virtually un
changed on balance, while Switzerland’s external re
serves rose a net of $8.9 billion over the six-month
period to $21.7 billion.
During the period, the Federal Reserve and the
United States Treasury continued with the program
agreed to in October 1976 for an orderly repayment
of pre-August 1971 franc-denominated liabilities. The
Federal Reserve repaid $139.6 million equivalent of
special swap indebtedness, while the Treasury re
deemed $319.2 million equivalent of Swiss francdenominated securities by the end of January. Most of
the francs for these repayments were acquired directly
from the Swiss National Bank against dollars. How
ever, francs were also bought from the National
Bank against the sale of $118.2 million equivalent of
German marks which were, in turn, either covered
in the market or drawn from existing balances. By endJanuary, the Federal Reserve’s special swap debt to
the Swiss National Bank stood at $139.3 million equiva
lent, while the Treasury’s Swiss franc-denominated
obligations had been reduced to $531.2 million equiva
lent.
EC snake
In the mid-1970’s, divergencies in the performances of
the major European economies had forced a number
of important currencies to drop out of the EC snake,
leaving the remaining currencies highly exposed to the

FRBNY Quarterly Review/Spring 1979

volatility of the exchange markets. As a result, over
the past three years the currencies remaining inside
the joint float had advanced more rapidly against the
dollar than those which had-left the band, even though
the differences in economic performance among all
EC countries had begun to narrow. Against this back
ground, the EC heads of state and government reached
agreement at Bremen last July to create a zone of
monetary stability via a new joint floating arrange
ment to include all EC members.
News of the agreement prompted some bidding for
the currencies outside the snake as the market took
the view that these currencies would henceforth trade
more in line with those now in the EC band. But within
that arrangement enough divergence between price
and trade performances remained to raise expecta
tions in the market that a realignment might take place
among those currencies prior to the introduction of
the EMS. Once the mark began outpacing the advances
of other major currencies against the dollar in late
July-early August, participants doubted that other par
ticipating currencies could keep pace with the German
mark. As a result, the Dutch guilder, Belgian franc,
Norwegian krone, and Danish krone all fell to the bottom
of the joint float.
Against this background, all four currencies were
subjected to outflows into the mark. In some cases, the
pressures were aggravated by local considerations. The
Norwegian krone was beset by commercial and profes
sional selling pressure as the market reacted to Nor
way’s loss of competitiveness vis-it-vis its major trading
partner, Sweden, whose currency had been withdrawn
from the EC band a year before. Evidence of deterio
ration in Belgium’s trade position during the summer
generated continued sizable selling of Belgian francs. A
large-scale buildup in commercial leads and lags also
weighed on the Netherlands guilder.
As the movement of funds into the mark gathered
momentum, the five EC central banks stepped up their
intervention to keep the joint float within its 21/4 per
cent limits, buying large amounts of guilders, Belgian
francs, and Danish and Norwegian kroner against sales
of German marks provided by the Bundesbank. By midOctober the total amount of marks created by the
Bundesbank to meet these pressures had mounted up
to $5.1 billion equivalent since end-June and was con
tributing to a strong expansion in Germany’s monetary
aggregates. By contrast, this intervention drained large
amounts of liquidity out of the other four snake cur
rencies. Interest rates rose steeply in each of their
money markets, while the respective monetary author
ities reinforced the squeezes still further by raising
official lending rates.
Finally, in mid-October, the EC monetary authorities

agreed to a realignm ent w hich upvalued the mark by
2 percent against the Dutch guilder and Belgian franc
and by 4 percent against the Danish krone and the
Norwegian krone. Following this announcement, the
heavy selling w ithin the snake came to an end and all
the jo in t float currencies advanced on their own to
record highs against the dollar at the month end. But
reversals of the comm ercial leads and lags or specu
lative positions in favor of the mark were modest. Con
sequently, part of the indebtedness built up w hile de
fending the snake was settled at the month end by trans
fers of dollar assets to Germany.
The November 1 announcement of the United States
measures to support the dollar triggered a sharp fall
in the mark, well in excess of the declines in the
other snake currencies. The mark thus dropped to the
bottom of the jo in t float, and strains on the band eased
generally. Under these conditions, market participants
began to reverse the highly expensive long mark posi
tions they had been maintaining against the weaker
snake currencies.
This unwinding proceeded slowly, however. Many un
certainties remained over the outlook for the snake in
view of the scheduled introduction of the new Euro
pean Monetary System on January 1. Some p artici
pants still wondered if another realignm ent m ight not
occur prior to the starting date now only a few weeks
away. Many traders thus continued to roll over short
positions against the mark. To clear the air, the mone
tary authorities of the EC snake countries let it be
known that the bilateral central rates presently in force
between the snake currencies w ould be maintained in
the new system. This announcement contributed further
to a reduction of tensions w ithin the snake. But Norway
decided it could not risk having its currency pulled up
further against the Swedish krona. Therefore, follow ing
Sweden’s decision not to enter the new system, Nor
way announced on December 12 it could not join the
arrangement and that the krone would be withdrawn
from the snake effective imm ediately.
The decision at the year-end to delay the implemen
tation of the new m onetary arrangement had no discern
ible impact on trading relationships w ithin the snake.
Instead, as the mark eased back against the dollar, the
process of unwinding positions taken up prior to the
m id-October realignment accelerated. Benefiting from
high domestic interest rates, the Dutch guilder and the
Danish krone became buoyed by these reflows and
traded firm ly in the snake. The comm ercial Belgian
franc was also bolstered by reflows but, amid con
cerns over the persistent sluggishness of the Belgian
economy and the size of the government deficit, the
return of funds took place more slowly and the franc
stayed near the bottom of the jo in t float.

French franc
During the spring of 1978, the French government had
reaffirmed its com m itm ent to give priority to the fight
against inflation and the maintenance of a sound bal
ance of payments, while boosting employm ent largely
through selective measures. By midyear, the economy
was beginning to respond to the modest stim ulus that
had been provided earlier, spurred by an upturn in
dom estic consum ption. Also, the current account had
settled into strong surplus. The French franc had
strengthened in the exchanges. It rose against the dollar
to trade around FF 4.36 by early August. It also gained
against the German mark, and the Bank of France had
taken in reserves. Progress on the inflation front, how
ever, had not yet met expectations. Looking ahead, the
m arket was uncertain about the prospect fo r an early
further decline in inflationary pressures since, as part
of its longer term strategy to reduce the growth
of public financing needs and to channel more per
sonal savings into business investment, the govern
ment had embarked on a program to increase charges
fo r public services and gradually to relax long-standing
controls on industrial prices. Also, by midsummer,
the m arket had become sensitive to the im plications of
any deterioration in econom ic perform ance relative to
that of Germany in view of the possibility that France
m ight join in an expanded EC currency arrangement

Chart 6

France
Movements in exchange rate and official
foreign currency reserves
Francs per dollar
Billions of dollars
4.1 0 -------------------------------------------------------------------------------- -- Exchanae ra te * 1 1
-«----- Scale
I \

4.20
4.30

— ' —

4.40

4.60

4.70
4.80

\ /

4.90

■

5.00 1

/ft]V
11 III 1
1|

4.50

Foreign currency
reserves
ocale
^

1 1
1 1 1------------------------------------I I I
I I I
1 J
--------—
J F M A M J
J A S O N D J F
1978
1979

See footnote on Chart 3.

FRBNY Q uarterly R eview /Spring 1979

which was scheduled for implementation on January 1,
1979.
Against this background, news during August of a
quick upsurge in consumer prices, an acceleration of
wage increases, and a temporary slippage in France’s
trade account back into deficit had a dampening effect
on market psychology for the French franc. Market
participants began to question whether the franc could
hold its own against the German mark, and commercial
leads and lags started to move against the franc. Also,
since short-term interest rates had been gently de
clining as the franc had strengthened during previous
months, some investors took advantage of a narrowing
of favorable interest differentials to shift funds into
other currencies. As a result, the fraric lost some of
its earlier buoyancy. Although at times it was bid up
as the dollar came on offer in August and September,
it posted little advance on balance over the two months
trading around FF 4.37. Meanwhile it eased back about
4 percent against the mark by end-September. Under
these circumstances, the inflows to France’s reserves
tapered off and the Bank of France provided some
support for the rate through sales mostly of German
marks but also of dollars.
In the increasingly unsettled markets that developed
during October, the French franc joined to a greater
degree in the rise in foreign currencies against the
dollar. By this time, also, the authorities had reinforced
the relatively restrictive monetary stance by reducing
to 11 percent the target for monetary growth in 1979
and by tightening somewhat the ceilings on bank
credit expansion. They also doubled the reserve re
quirements against sight deposits to 4 percent to ab
sorb liquidity generated by the balance-of-payments
surplus and the financing of the government deficit.
Thereafter, an abrupt tightening in the Eurofranc mar
ket prompted importers that previously had been
borrowing to bid instead for francs in the spot market
in order to meet their month-end payment needs. These
factors combined to push up the French franc, which
rose to a record high of FF 3.97 against the dollar on
October 31, some 9% percent above early-August
levels. But the franc continued to lag behind the Ger
man mark. As a result, the Bank of France at times still
provided occasional support for the franc by selling
marks while otherwise taking in dollars to limit the
franc’s rise.
Following the announcement of the November 1
package in support of the dollar, the French franc
plummeted along with other currencies, dropping back
below early-August levels to FF 4.3490 by midmonth.
Initially, it fell back less rapidly than the mark which
had been the center of speculation against the dollar.
But by late November, as the market focused on the

82 FRBNY Quarterly Review/Spring 1979

upcoming negotiation over the EMS at an EC Council
meeting December 5-6, the franc became subject again
to bouts of selling pressure on expectations that it
would decline against the mark before entering the
new joint floating arrangement. As a result, the franc
eased back against the mark to a low on December 4,
while moving back up to FF 4.45 against the dollar.
Before long, however, the earlier concerns about the
prospects for the French franc began to lift. Doubts
about France’s trade performance faded inasmuch as a
surplus of around FF 2.5 billion was emerging for 1978.
The market’s previous fears that price decontrol would
trigger an accelerated spiral of price increases no
longer seemed justified in view of the more moderate
rise in consumer prices reported for November. The
December announcement of an agreement that all
currencies coming into the EMS would enter at pre
vailing cross rates dispelled some of the uneasiness
about implementation of the new arrangement. Also,
inclusion of the Italian lira and the Irish pound in the
new arrangement alleviated concerns in the market
that the franc would be the only additional member.
Against this background, funds began flowing from the
mark back into the franc and the previously adverse
commercial leads and lags started to be reversed. More
over, since the dollar had started declining again,
market participants scrambled to cover exposures and
year-end needs in francs as well as in other currencies.
The franc thus recovered to as high as FF 4.1200 at the
Paris opening on January 2.
That day the decision not to proceed with the EMS
until EC members had concluded new agricultural
financing arrangements was announced. Also, forceful
intervention in other markets helped to blunt any
further rise in European currencies against the dollar.
Thereafter, the franc began to ease back, and this ten
dency continued as the dollar strengthened generally
during the month. Thus, the franc, closing at FF 4.2905
on January 31, was up only 1% percent on balance for
the six-month period. Against the mark, however, the
franc remained relatively firm during January with the
result that it recovered to just about the levels of six
months before. In view of the franc’s buoyancy gener
ally in December and against the mark during January,
the Bank of France continued to buy both dollars and
German marks in the market. These operations con
tributed to a further rise in France’s foreign exchange
reserves, which increased $1.6 billion over the
six months to $8.7 billion as of January 31.
Italian lira
Under Italy’s comprehensive stabilization program,
further progress was made during the first half of
1978 in strengthening the balance of payments and

reining in the rate of dom estic inflation. By midyear,
the inflation rate had been brought down to 12 percent,
and the current account had registered a com fortable
surplus of $2.1 billion over the first six months. Coming
into the summer, imports remained sluggish while ex
ports continued to be buoyed by the existence of
excess industrial capacity and by the com petitive
effects of the lira ’s decline of earlier years. With the
seasonal bulge in tourist receipts adding strength to
Italy’s current account, the stage was set for a further
widening of Italy’s surplus position. Also, interest rates
in Italy had been kept high, easing back less than the
slowdown in the inflation rate m ight have suggested,
in order to facilitate the financing of the large public
sector deficit. Consequently, Italian residents continued
to borrow abroad, and these capital inflows, on top
of Italy’s current account surplus, bolstered the lira
in the exchanges. As a result, the lira had come into
heavy demand for several months and the authorities
were able to buy substantial amounts of dollars to
rebuild Italy’s reserve position, w hile moderating the
rise in the spot rate. By the end of July the lira, trading
above LIT 841, was at its highest level against the
dollar since O ctober 1976. Moreover, Italy’s foreign
exchange reserves had increased to $9.3 billion, even
after the authorities had made sizable repayments of
official debt to the IMF, the EC, and the Bundesbank.
During August and much of September, the lira
continued to benefit from Italy’s strong balance-ofpayments position. The announcement on August 1
of a seven-month extension in the ceiling on the growth
of bank lending reassured the market that current
policies were to be m aintained. Against this back
ground and with the Bank of Italy continuing to take
large amounts of dollars into reserves, the authorities

Chart 7

Italy
Movements in exchange rate and official
foreign currency reserves
Lira per dollar
800 —
;urrency
Foreign currency
reserves
___Scale
825

Billions of dollars
-------- 2.0
1.0

850
875

Exchange ra te *
J

I 71scal'e 1

F M A M J

J
1978

*S ee footnote on Chart 3.

I___ I__ I__ L
S

F
1979

1.0

took the opportunity to follow through on initiatives
earlier in the year to ease exchange controls regarding
comm ercial payment terms. Meanwhile, the m inority
government announced its three-year econom ic stabili
zation program which, after extensive negotiation over
the summer months, had received the tacit approval
of the Communist Party. This program, w hich was to
reduce significantly the proportion of gross domestic
product taken up by the public sector deficit, included
a shift of government spending from current expendi
tures to the prom otion of investment, a freeze on real
labor costs together w ith a gradual phasing-out of
automatic wage rises under the scala-m obile program,
and improved incentives fo r labor m obility and a re
building of the financial condition of Italian enterprises.
At the same time, the authorities acted to absorb
some of the liquidity being created by Italy’s balanceof-payments surplus. This objective was accom plished
in part by extending the m aturities of new government
debt after the Bank of Italy confirmed an easing of
money market rates by lowering by 1 percentage point
to 10 1/2 percent its base rate for rediscounting and
advances. In addition, the government continued to
use some of its additions to official reserves to repay
outstanding debt to the IMF and the EC, both at and
p rior to m aturity. Moreover, to keep Italy’s inflation
rate more in line with its trading partners over the
longer run, the Italian authorities indicated they m ight
be receptive to some form of association fo r the lira
with the EMS, then under consideration w ithin the EC.
In October, however, the increasing unsettlement that
was developing in the exchange markets began to
affect the Italian lira as well. Although it, too, was
pulled up against the dollar by the rise in the strong
Continental currencies, the m arket began to question
whether the lira would not be allowed to weaken
vis-a-vis other EC currencies before being linked
to the EMS. As a result, com m ercial leads and lags
shifted m odestly against the lira. In addition, Italian
enterprises reacted to seem ingly favorable exchange
rates, together with the increases in Eurodollar interest
rates, by paying or prepaying their Eurocurrency debts
and switching back into lira financing. Consequently,
the lira lagged behind the mark during O ctober w hile
the Bank of Italy sold dollars to provide some support
for the rate. Even so, by October 31 the lira had
advanced 7 percent above early-August levels to LIT
787 against the dollar.
Then, follow ing the November 1 announcement
of United States measures to strengthen the dollar,
the lira declined along with other European curren
cies to trade around LIT 851.50. Meanwhile, new
figures showed that Italy’s current account, rem ain
ing strong even after the passing of favorable sea

FRBNY Quarterly R eview /Spring 1979

sonal factors, was amassing a surplus of some $6 bil
lion for the year. Also, the economy had begun to
expand more rapidly ahd, with financing needs grow
ing and interest rates still high, the inflows of capi
tal resumed. With regard to the EMS, the govern
ment had negotiated flexible terms for entry, whereby
the lira would be allowed to fluctuate as much as 6
percent around its central rate against each of the other
currencies. Moreover, the market was reassured once
prospects for a currency realignment prior to the in
troduction of EMS faded and numerous officials con
firmed that the exchange rate relationships of that
arrangement would be based on prevailing market
rates. Thus, the lira came into heavy demand as the
turn of the year approached, and the news on Jan
uary 2 of a delay in the implementation of EMS had little
apparent impact on the rate.
By January, the continuing strength of Italy’s exter
nal position was again showing through in the ex
change market. Although the lira tended to decline as
the dollar recovered across the board, it eased back
less rapidly than the German mark and other strong
European currencies. In mid-January the authorities
provided some relief to small firms with limited access
to the Eurodollar market, by raising slightly the ceiling
on domestic credit expansion applicable through March.
Nevertheless, funds continued to flow into the lira,
thereby keeping the rate buoyant even in the face of
increasingly vocal opposition from the trade unions to
the government’s anti-inflation program and the with
drawal of Communist Party support to the Andreotti
government at the month end. In fact, the lira closed the
six-month period trading steadily at LIT 843.50 to show
little net change on balance. Meanwhile, additional pur
chases of dollars by the Bank of Italy, again during Jan
uary, helped provide a further $2 billion increase in
foreign exchange reserves over the period to $11.3 bil
lion by January 31.
Sterling
In the United Kingdom, impressive progress had been
made in 1977 in bringing down domestic inflation,
swinging the balance of payments into surplus, and
bolstering the international reserve position. Also, by
late 1977, the British authorities had succeeded in
gaining leeway, under the agreements with the IMF,
for providing some modest stimulus to the economy.
But by late spring 1978 the markets were becoming
concerned that the sudden upsurge in demand in the
United Kingdom was beginning to generate additional
inflationary pressures and would weaken the payments
position. In June the authorities moved again to rein
force their broad anti-inflation effort through monetary
restraints, including a hike in interest rates, and

FRBNY Quarterly Review/Spring 1979

through a selective tightening of fiscal policy. Later,
the Government announced a 5 percent guideline for
wage increases over the coming year beginning in
August, down from the previous guideline of 10 per
cent. These measures helped to reassure the market.
Thus the pound had advanced to $1.95 against the
dollar by early August and had firmed against other
currencies as well. On the effective trade-weighted
basis used by the United Kingdom authorities, the
pound had reached 63 percent of its 1971 Smith
sonian parity.
By early August, however, the market was again be
coming concerned over the outlook for inflation in the
United Kingdom. The Trades Union Congress voted to
reject a continuation of an incomes policy, and highly
visible wage negotiations kept the exchange market
wary of a possible confrontation between the govern
ment and the unions over the 5 percent pay policy.
The pound fell back somewhat and traded unevenly
in the exchanges between early August and midOctober. But each time selling pressure mounted the
Bank of England responded quickly to show its resolve
in defending sterling, both through intervention in the
exchange market and through maintaining a taut money
market.
In October, as market participants increasingly
turned their attention to the accelerating slide of the
dollar, sterling started to advance on hot-money in
flows. Spot sterling soon moved above $2.00, and a
burst of buying in late October pushed the rate to as
high as $2.1050 by the month end. During this upswing
the Bank of England occasionally bought dollars to
keep the trade-weighted effective rate from rising much
above 63 percent.
In the wake of the United States measures of No
vember 1, sterling dropped back 6 percent to fluctuate
around $1.98 against the dollar, without any appre
ciable change on an effective basis. Meanwhile, union
opposition to the continuance of an incomes policy was
hardening. Interest rates abroad were rising sharply,
particularly in the United States. And, as sterling came
on offer, in response to these uncertainties the Bank
of England again provided support in the exchange
market to steady the effective rate. Short-term sterling
interest rates were allowed to rise and, on November 9,
the authorities hiked the minimum lending rate 7.Vz per
centage points to 12 1/2 percent, its highest level in two
years.
Thereafter, sterling was bouyed by inflows of interestsensitive funds. Also, with the spot rate holding firm
in December, many multinational corporations bought
pounds to cover accounting and economic exposures
and to satisfy year-end payment needs. The political
uncertainties in Iran and the mid-December increase

Chart 9
Chart 8

C a n a da

U n ite d K in g d o m

Movements in exchange rate and official
foreign currency reserves

Movements in exchange rate and official
foreign currency reserves
Dollars per pound
1.80--------------------

Canadian dollar per dollar

Billions of dollars

Billions of dollars
-------1.0

See footnote on Chart 3.
*S e e footnote on Chart 3.

in OPEC oil prices had little impact on sterling since
the United Kingdom, as an oil producer itself, was seen
as less vulnerable to a cutoff of oil supplies from Iran
and as perhaps even benefiting from the larger than
expected rise in oil prices. As a result, when the dollar
came on renewed offer during December, sterling was
bid up to a high of $2.0480 by early January. Mean
while, the government had announced it would not
join the EMS but would undertake, as it had in the past,
to keep sterling relatively stable vis-a-vis its principal
trading partners.
In view of the United Kingdom ’s com fortable reserve
position and the high level of interest rates, sterling
held firm in the exchanges in early 1979, despite a
spate of highly disruptive strikes. Sterling eased off
against the dollar as dollar rates generally improved,
but it held steady in effective terms. By the close of
the period the spot rate was at $1.9872, up 3 percent
on balance for the six-m onth period. Meanwhile, al
though the authorities had intervened on both sides
of the market, these operations had largely netted out.
Consequently, official reserves which were $17.6 b il
lion at end-January were unchanged on balance over
the six-month period.

Canadian dollar
By late summer, the Canadian dollar had been de
clining almost w ithout interruption fo r nearly two years.
Even so, the current account remained in substantial
deficit and long-term foreign borrowings by private
interests and provincial authorities were not sufficient
to close the overall payments gap. Moreover, the rate

of dom estic inflation remained high, aggravated partly
by the depreciating currency, and unemploym ent con
tinued to hold at uncom fortably high levels.
Earlier in 1978, the authorities had moved cautiously
to stim ulate employm ent through selective fiscal policy
measures w hile m aintaining a firm monetary policy
in light of concerns over inflation and the exchange
rate. The authorities had also arranged for some $7.7
billion of official long-term international borrowings
both to close the payments gap and to bolster reserves
which had been depleted through intervention to
cushion the decline of the exchange rate. Nevertheless,
the deep-rooted pessimism toward the Canadian dol
lar persisted in the exchange market, as the prospect
of a national election to be held sometime w ithin the
year left the m arket uncertain about the outlook fo r the
Canadian economy. Am idst these uncertainties, sudden
shifts of sentiment left the m arket subject to increased
volatility. In addition, selling pressures were aggravated
at times when the United States d ollar was declining,
because market participants would sell Canadian
dollars against United States dollars either to finance
acquisitions of currencies rising in the exchanges or to
offset for internal accounting short-dollar positions
against these currencies.
In August-September, after trading around the
Can.$1.14 level, the Canadian dollar again came under
heavy selling pressure in the exchanges follow ing some
disappointing trade and price figures. Also, the further
rise in interest rates in the United States had prompted
some outflows of interest-sensitive funds from Canada.
In response, the Bank of Canada raised its discount

FRBNY Quarterly R eview /Spring 1979

rate to 91/2 percent and announced a reduction of its
monetary growth targets for the coming year. The
authorities also arranged fo r a further $750 m illion bond
issue in the United States market. The selling pressure
continued, however, with the Canadian dollar slipping a
further 3 percent against the United States dollar.
Meanwhile, a sustained intervention effort contributed
to a decline in Canada’s external reserves by a net
$924 m illion in August-Septem ber to $3.7 billion.
In early O ctober the spot rate dipped to as low as
Can.$1.1958 before bottom ing out. In addition, the
Canadian authorities hiked the discount rate further
to 101/4 percent and operated in the bond m arket to
lift long-term Canadian interest rates. Interest-sensitive
funds thus began to move back into Canada. In addi
tion, the trade figures fo r September were back in
significant surplus and the rise in consumer prices
slowed, giving a boost to market sentiment toward the
Canadian dollar. Thus, the Canadian dollar moved back
up from its early-O ctober lows against the United States
dollar, and the Bank of Canada intervened to moderate
the rise. These official dollar purchases, combined with
the receipt of proceeds from the New York bond issue
and the takedown of additional credits on the fa cility
with the chartered banks, were reflected in a $1.4 bil
lion rise in external reserves to $5.1 b illion at the
month end.
On November 1, when the United States announced
its m ajor support package and the United States dol
lar rose sharply against the currencies of Western

Chart 10

In te re s t R ates in th e U n ite d S ta te s ,
C a n a da , and th e E u ro d o lla r M a rk e t
Three-month m aturities*
rcent
12

Eurodollars
London market

11
10

Canadian

9
8

Certificates of deposit
of New York banks
“ (secondary m arket)~

7
6

J
1978

*W eekly averages of daily rates.

FRBNY Quarterly R eview /Spring 1979

F
1979

Europe and Japan, the Canadian d ollar eased only
slightly vis-a-vis the United States dollar. But then, as
interest rates in the United States rpse by more than
rates in Canada, interest incentives favoring Canada
were nearly elim inated, even after the Bank of Canada
raised its discount rate to 10% percent on November 6.
Moreover, the latest figures on Canada’s price and
trade perform ance released during the month were
less encouraging. Bearish sentim ent resurfaced fo r the
Canadian dollar and, as selling pressure built up once
again, the rate drifted downward in November and
December.
In early January, the Canadian authorities announced
plans fo r a new official borrowing abroad, a $500 m il
lion equivalent issue denominated in yen, and the Bank
of Canada raised its discount rate by V2 percentage
point to 111/4 percent. These initiatives helped stabilize
the exchange rate, but the latest round of trade figures
announced in late January proved to be disappointing
to the market. The rate thus dipped to Can.$1.1989 at
the month end, down 51/2 percent fo r the six-m onth pe
riod, before firm ing somewhat in February. Meanwhile,
Canada’s reserves declined not only by $700 m illion from
end-October levels but also by $200 m illion on balance
over the six-m onth period to $4.4 billion as of January 31.

Profits and losses
The stepped-up intervention by the United States au
thorities beginning on November 1 involved a variety
of financing techniques. In addition to use of the swap
arrangements, the Treasury drew marks and yen on
its reserve position with the IMF and sold SDRs to both
Germany and Japan against their respective curren
cies. Also, the Treasury issued m ark- and Swiss francdenominated notes in the German and Swiss capital
markets, thereby raising foreign currency assets
against medium-term liabilities in those currencies.
The acquisitions or borrow ings of currencies and the
sale and repayment of currencies took place at varying
exchange rates. Thus the profit and loss im plications
became much more complex.
At the same time, at the end of 1978 the Federal
Reserve, in presenting its annual statement of condi
tion, shifted to accounting practices under w hich all
foreign currency assets and liabilities are periodically
revalued in dollars at current spot market rates. The
ESF had adopted this accounting practice in 1977. For
both institutions this meant that, in addition to profits
and losses actually realized on foreign exchange trans
actions, unrealized profits and losses are also reported.
New arrangements were also reached w ith foreign
central banks to revalue, beginning in January, matur
ing swap drawings that were being renewed at current
m arket rates. This practice generated realized profits

Table 7

Table 8

Net Profits (+ ) and Losses ( — ) on
United States Treasury and Federal Reserve
Current Foreign Exchange Operations

Net Profits (+ ) and Losses ( — ) on
United States Treasury and Federal Reserve
Liquidations of Foreign Currency Debts
Outstanding as of August 15,1971

In millions of dollars

in millions of dollars
United States Treasury
Exchange
General
Account

Period
1961-77

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

+51.2

Period

5.1

1971-77 .........................
First quarter 1978 ........

First quarter 1978 ...........

— 0.2

0.2

Second quarter 1978 . . . .

-1 7 .2

2.9

Second quarter 1978 . .

Third quarter 1978 ........... . .

-1 1 .0

0.1

Third quarter 1978 ___

Fourth quarter 1978 ........

5.0

-6 8 .0

+4.8

January 1979 ...................

+ 6.7

+ 1.2

+8.9

Unrealized profits and
losses on outstanding
assets and liabilities as of
January 31, 1979 .............

Data are on a value-date basis.

+ 2.5

+41.3
i

-7 .8

m m

Federal
Reserve
.......
-583.9
-

........

Fourth quarter 1978 . . .

Unrealized losses on
outstanding liabilities as of
January 31, 1979 ...............

Exchange
Stabilization
Fund
-51 6 .2

58.7

81.1

60.6

84.8

84.2

-11 7 .8

60.4

-156.7

16.3

-121.4

62.6

-462.9

Data are on a value-date basis.

mill
or losses depending on w hether the dollar rose or fell
over the period of the swap drawing.
Table 7 presents the profit and loss data for the
Federal Reserve and the United States Treasury, sepa
rating out the results between the Treasury General
Account and the ESF. Losses on pre-August 1971
Swiss franc debt, undertaken to protect the United
States gold stock, are presented separately in Table 8.
Table 7 covers all Treasury and Federal Reserve
purchases and sales in the foreign exchange market.
Federal Reserve operations m ainly reflect current swap
operations, while ESF data also reflect foreign cur
rency acquisitions from IMF drawings and SDR sales.

The Treasury General Account operations reflect the
issuance of foreign currency-denom inated securities
and sales of some of those proceeds in the market.
Foreign exchange operations are closely coordinated
between the Treasury and the Federal Reserve. The
incidence of realized profit and loss, however, falls
on the different participants in the operations depend
ing on the nature of the transaction and the exchange
rate at the p articular time. The ESF, the Treasury
General Account, and the Federal Reserve had both
profits and losses on individual transactions but, as
the table indicates, losses exceeded profits on bal
ance in 1978.

FRBNY Quarterly R eview /Spring 1979

FEDERAL RESERVE READINGS ON INFLATION
Inflation remains one of the most bedeviling phenomena of
our time. Despite being readily observed and easily measured,
inflation has been relatively impervious to containm ent and
the consequent damage to the social, econom ic, and political
fabric of our society is far reaching.
The Federal Reserve Bank of New York has compiled, in
one volume, a selection of speeches and articles by officials
and staff econom ists throughout the Federal Reserve System
which is designed to provide a comprehensive explanation of
the inflationary process, its effects and its policy implications.
This 272-page book is prim arily intended as a teaching
resource for college econom ics teachers and all interested
economy watchers. It w ill also be of use to high-school social
studies teachers.
The price for Federal Reserve Readings on Inflation is two
dollars ($2.00), prepaid. Checks and money orders (please do
not send cash) must be made payable to the Federal Reserve
Bank of New York and sent to:
Public Information
33 Liberty Street
New York, N.Y. 10045
Foreign residents must pay in United States dollars w ith a
check or money order drawn on a United States bank or its
foreign branch.

FRBNY Q uarterly R eview /Spring 1979

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