Full text of Economic Policy Review (Federal Reserve Bank of New York) : Spring 1982, Vol. 7, No. 1

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Federal
Reserve Bankof
KewYork
Quarterly Review




S p rin g 1982
1

V o lu m e 7 No. 1

S h o rt-ru n M o n e ta ry C o n tro l: An
A n a ly s is o f S om e P o s s ib le D a n ge rs

11

T he E u ro d o lla r C o n u n d ru m

20

M o rtg a g e D esig ns, In fla tio n ,
and Real In te re s t R ates

30

C u rre n t e c o n o m ic d e v e lo p m e n ts

34

M o n e ta ry P o lic y and O pen M a rk e t
O p e ra tio n s in 1981

54

T re a s u ry and F ed era l R eserve F o re ig n
E x c h a n g e O p e ra tio n s

The Q uarterly Review is published by
the Research and Statistics Function
of the Federal Reserve Bank of New
York. Among the members of the staff
who contributed to this issue are
LAWRENCE RADECKI (on an analysis
of some possible dangers of short-run
monetary control, page 1); EDWARD J.
FRYDL (on the E urodollar conundrum,
page 11); MARCOS T. JONES (on m ort­
gage designs, inflation, and real
interest rates, page 20).
A report on m onetary p o licy and open
m arket operations in 1981 begins on
page 34.
A semiannual report of Treasury and
Federal Reserve foreign exchange
operations fo r the p eriod August 1981
through January 1982 starts on
page 54.




Short-run Monetary Control
An Analysis of Some Possible Dangers

While the Federal Reserve has been setting annual
targets for several years, there continues to be a ques­
tion of the time horizon the Federal Reserve should
use in attempting to control money. Some analysts
contend that the Federal Open Market Committee
(FOMC) can and should extend control to the very
short run. But there could be costs in so doing: the
pursuit of monthly monetary targets could transmit an
unacceptable degree of instability to the financial mar­
kets and to economic activity. The purpose of this
article is to show under what circumstances such
considerations are important and then to review some
empirical evidence relevant to these matters.
Currently, the Federal Reserve’s monetary targets
are set on an annual basis, measured from the fourth
quarter of one year to the fourth quarter of the next.
During the course of the year, the FOMC also sets
shorter run monetary objectives consistent with attain­
ing the annual targets. These shorter run targets usu­
ally extend over a period of a few months, for example,
December to March.
Some analysts argue that tight control over such
short periods or even shorter periods is both desir­
able and feasible. Others are concerned that sharp
movements in nonborrowed reserves would be re­
quired to achieve such precise control. To hit the
monetary targets in the very short run it might
become necessary to adjust the level of nonbor­
rowed reserves substantially every period to offset
the lagged effects of the Federal Reserve's own policy




actions in previous periods. This is because the total
response of the public’s money holdings to a change
in nonborrowed reserves occurs partly in the same
period as the change in nonborrowed reserves and
partly in the next and succeeding periods. Conse­
quently, a change in nonborrowed reserves bringing
the money stock quickly back to target from, for in­
stance, a level below target may later cause the money
stock to rise above target, as the lagged effects take
hold. It would thus be necessary to make further ad­
justments to the level of nonborrowed reserves to keep
the money stock on target in every period.
Roughly speaking, if the lagged effects of past
actions are large, the movements in nonborrowed
reserves from period to period required to keep the
money stock on target in each period could turn out
to be sizable initially and diminish only slowly through
time. If the lagged effects are particularly large, the
required offsetting movemehts in subsequent periods
could increase through time; such a situation is known
as “ instrument instability” .1 Explosive oscillations in the
movement of the policy instrument would be untenable.
Furthermore, even substantial although gradually mod­
erating oscillations in nonborrowed reserves might be
judged to be undesirable, not because of the required
shifts in open market operations per se, but because

1 See Robert S. Holbrook, "Optimal Economic Policy and the Problem
of Instrument Instability” , American Economic Review (March 1972),
pages 57-65.

FRBNY Quarterly Review/Spring 1982

1

of the associated effects on financial markets and
the general economy.2
In the first section of this article, the timing of the
public’s adjustment of its money holdings to changes
in interest rates is shown to be important in selecting
a control horizon for the monetary aggregates that will
avoid or minimize such problems. This is true even
though interest rates are not controlled by the Federal
Reserve under the new operating procedures. In the
second section, empirical estimates of the demand
for money from previous research are examined. The
evidence indicates the possibility that monetary con­
trol over periods of less than six months could have
destabilizing effects. Some readers may wish to pass
over the mathematical treatment of the problem in the
first section and proceed directly to the review of
earlier empirical research and its implications, begin­
ning on page 4.

Simulations of the monetary sector under
monetary targeting
In this section, some simple examples are used to il­
lustrate how strict short-run monetary targeting can
precipitate cycles in nonborrowed reserves and in­
terest rates. Initially, it is assumed for sim plicity that
the level of income is given and is invariant to
changes in the money stock and interest rates; there­
fore, only the monetary sector of the economy is rele­
vant. Later this assumption will be dropped; changes
in the money stock and interest rates w ill then be
allowed to affect aggregate demand, which in turn
will have feedback on the demand for money. At that
time, the model w ill be expanded to include an equa­
tion representing aggregate demand.
To begin, let the monetary sector consist of the de­
mand and supply of money, which are specified as:
(demand) M(t) = a - b0r(t) - b j ^ t - l ) + cY(t)
(supply) M(t) = d + eNBR(t) + f[r(t) - DISC(t)]
where
M = the money stock,
r = the interest rate,
Y = income,
NBR = nonborrowed reserves,
DISC = the discount rate, and
t represents a specific period of time.
2 Attention was called to these potential problems first by Richard G.
Davis, “ Implementing Open Market Policy with Monetary Aggregate
Objectives” , Monetary Aggregates and Monetary Policy (Federal
Reserve Bank of New York, 1974), pages 7-19, and more recently by
Bryon Higgins, "Should the Federal Reserve Fine Tune Monetary
Growth?’’, Economic Review (Federal Reserve Bank of Kansas City,
January 1982), pages 3-16. Also see John H. Ciccolo, "Is Short-run
Monetary Control Feasible?", Monetary Aggregates and Monetary
Policy (Federal Reserve Bank of New York, 1974), pages 82-91.

2

FRBNY Quarterly Review/Spring 1982




That is, the quantity of money demanded is determined
by the current period’s income and the current and
previous period’s interest rate, so that the total re­
sponse to a change in the interest rate occurs partly
in the same period and partly in the following period.
The quantity of money supplied is determined by the
current period’s level of nonborrowed reserves and the
spread between the interest rate and the Federal Re­
serve’s discount rate. Banks are assumed to respond
completely in the same period to changes in these
factors. Hence, no lagged effects are included in the
supply-of-money equation.
If the goal of monetary policy is to keep the money
stock on target in every period, the level of nonbor­
rowed reserves— the Federal Reserve’s main policy
instrument— must be changed every period (at least
early on) after a change in income or a shift in the
demand for money.3 Nonborrowed reserves must be
changed enough in the first period to offset the. effect
of the income or money demand disturbance on money
holdings. In the second period and all periods there­
after, nonborrowed reserves must be adjusted to offset
the lagged effects of earlier changes in nonborrowed
reserves.
The relative magnitude of the current and the oneperiod lagged interest rate effects on money demand
determines whether the oscillations of nonborrowed
reserves and the interest rate will be explosive or
stable if period-by-period control over the money stock
is maintained. It can be shown that the cycles are
explosive— the case of instrument instability— if the
lagged effect ( b j'is greater than the current effect (b0).
If the current effect is greater than the lagged effect,
the cycles eventually die out. Generally the greater the
current effect is relative to the lagged effect, the more
rapidly the cycles dampen.4
Chart 1 shows the simulated behavior of nonbor­
rowed reserves and the interest rate when a targeted
value of the money stock is to be maintained despite
a permanent 4 percent reduction of income. Three
sets of values for the current and lagged interest rate
effects were selected to illustrate explosive, slowly
damped, and rapidly damped cycles. The qualitative
s Recognizing that the Federal Reserve does not have perfect control
over either the Federal funds rate or nonborrowed reserves, some
economists refer to one or the other as the operating target rather than
the policy instrument. The term "policy instrument” then refers to
open market operations, the discount rate, and reserve requirements.
For example, see Gordon H. Sellon, Jr., and Ronald L. Teigen, "The
Choice of Short-run Targets for Monetary Policy: Part One” , Economic
Review (Federal Reserve Bank of Kansas City, April 1981), pages 3-16.
4 If the current and lagged effects are exactly equal, constant oscillations
occur; however, this special case will not be considered. See
William J. Baumol, Economic Dynamics (New York: Macmillan, 1970),
page 164.

character of the cycles would be the same if the in­
come disturbance is transitory, provided the ratio be­
tween the current and lagged effects of the interest
rate on money demand is kept constant.
In the example shown in Chart 1, the lagged interest
rate effects on money are confined to the previous
period, but lagged interest rate effects on the demand
for money may in the real world extend for several
periods. If so, the resulting cycles will be one of two
types: (a) cycles repeating themselves every two pe­
riods or (b) cycles taking longer than two periods to
repeat themselves. To distinguish between these two
cases, it is customary to refer to (a) as oscillations
and to (b) as fluctuations or trigonometric oscillations.
Whether they are oscillations or fluctuations, the cycles
can be either explosive or damped.5
Besides lagged interest rate effects on the quantity of
money demanded, there may be lagged income effects.
Their presence generally does not change the char­
acter of the cycles, although it does affect the par­
ticular path. For example, suppose a lagged income
effect is introduced so that the quantity of money de­
manded is determined by the current and previous
period’s level of income, as well as the current and
previous period’s interest rate. The demand-for-money
equation therefore becomes:
M(t) = a - b0r(t) - b ^ t - 1 ) + c0Y(t) + c ^ t - l ) .
Let the weights of the interest rate effects be the same
as those used to produce the slowly damped cycles
shown in Chart 1. In the first four columns of Table 1,
a comparison is made between the paths that non­
borrowed reserves and the interest rate take when the
demand for money does and does not have a lagged
income effect; the long-run income elasticity is the
same, however. In both cases, slowly damped cycles
occur; with the lagged income effect present, the
amplitude of the cycles is smaller.
Although the character of the cycles is generally the
same whether lagged income effects are present or
not, there is an important exception. No cycles what­
soever occur following a change in income if the cur­
rent and lagged effects from income and the interest
rate are exactly parallel, that is:
(b „/c 0) = (bi/C j) = (b2/ c 2) = • ■

5 With a two-period lag, fluctuations will occur rather than oscillations
if (b j/b o )2 < (4b2/ b J . With a two-period lag, the conditions for
damped cycles are:
(b2/b 0) J < 1 and
(bl /b 0) 2 < [1 + (b2/b * ) ]2
These conditions are derived in Baumol, op. cit., page 248.




If income decreases in period 1 when money demand
is in equilibrium, nonborrowed reserves w ill be moved
in period 1 to its new equilibrium level if the money
stock is to be kept on target, and nonborrowed re­
serves will be kept at that new equilibrium level in
all subsequent periods. The last two columns of
Table 1 are an example of this. What happens is
that the level of nonborrowed reserves is moved in
period 1 to offset exactly the change in the quantity
of money demanded due to the change in income. No
further adjustments of the policy instrument are neces­
sary to keep the money stock on target, because the
lagged interest rate effects precisely cancel the lagged
income effects in subsequent periods.
Exactly parallel income and interest rate effects may
seem to be a very special case, but this restriction
often appears in empirical studies of the demand for
money. One way this restriction is imposed is through
the “ partial adjustment” model, which is frequently as­
sumed, mostly for convenience, as the mechanism de­
termining the lagged income and interest rate effects
in the demand for money.6 Implicit in the partial ad­
justment model is the way all factors influencing the
long-run demand for money have parallel lagged ef­
fects in the short run.
Looser short-run monetary targeting
The simulation results (Chart 1) illustrate how lags
in the demand for money can cause troublesome
cycles in nonborrowed reserves and interest rates
when the money stock is immediately brought back to
target following a disturbance. The problem can be
averted by relinquishing some control over the money
stock in the short run. Suppose that only the current
and previous period’s interest rate affects the quantity
of money demanded; again let the weights of these
two effects equal those used to generate the slowly
damped cycles in Chart 1. In period 1, let income de­
crease permanently by 4 percent. If the level of non­
borrowed reserves is changed so that the interest rate
is moved to its new equilibrium value in period 1 and
kept there subsequently, the money stock will be back
on target in period 2 and will remain there. Cycles are
thus avoided but at the cost of having the money stock
below target for one period.
This result can be generalized for more complicated
cases. If the quantity of money demanded is affected
by the level of the interest rate as far back as n
periods ago, the money stock w ill be back on target
in period n + 1, provided the interest rate is moved to
•T he partial adjustment model is discussed in detail by Stephen M.
Goldfeld, "The Demand for Money Revisited” , Brookings Papers on
Economic Activity (1973, 3), pages 576-638.

FRBNY Quarterly Review/Spring 1982

3

its new equilibrium value in period 1 and subsequently
kept there. The money stock, however, w ill be off target
from period 1 through period n.7
Another strategy, that of bringing the money stock
back to target gradually, would also m itigate cycles,
provided they were damped to start with. In Table 2,
a com parison is made between the paths nonborrowed
reserves and the interest rate take with the immediate
and gradual return of the money stock to target. If the
money stock is brought one half of the way back to
target in the first period and com pletely back to
target in the second period, the am plitude of the
damped cycles is greatly reduced. This strategy fails
nevertheless in the case of instrument instability; if
immediate return of the money stock to target causes
explosive cycles, likewise gradual return to target
causes explosive cycles. This occurs because the
money stock must eventually be put on target in one
period.8

Chart 1

S im u la te d Paths o f N on bo rro w e d Reserves
and the In te re s t Rate
Assuming Period-by-Period Control of Money
Billions of dollars
13.40Nonborrowed reserves
____________________________ Slowly
13.20
damped
13.00

E x p lo s iv e

Rapidly
damped

Results from empirical research on the
demand for money
The sim ulations presented earlier suggest that the
lag structure in the demand for money is critica l fo r
the behavior of nonborrowed reserves and the in­
terest rate under monetary targeting. In this section,
the results from three econom etric studies of the
dem and-for-m oney equation are examined to see what
types of cycles are im plied according to the analysis
in the previous section. Although the models are based
on the same general theory of money demand, there
are differences in the ways they are form ulated and

damped

Period
Demand fo r money: M(t) = a—b0 r(t) —b-jr(t —1) + cY (t)
E xplosive case: b0 = 0.7, bi = 0.8
Slowly damped case: bD = 0.8, b^ = 0.7
Rapidly damped case: b0 = 1.3, b-| = 0.2

then estimated, so that the im plications of tig h t mone­
tary targeting vary considerably.
7 This was pointed out by Holbrook, op. cit., page 60.
8 This can be shown with the example below. The demand for money is:
M(t) = 19 — (0.5)r(t) — (1.0)r(t— 1) + (0.5)Y(t); this specification
leads to instrument instability if period-by-period control is attempted.
If the money stock is gradually returned to target after four periods,
however, instrument instability still occurs because the money stock
must be put back on target in period 4.
Simulated Paths of Nonborrowed Reserves and the Interest Rate
In billions of dollars

Period

Y

M

NBR

r
(percent)

0
1
2
3
4
5
6
7

100
96
96
96
96
96
96
96

45.0
43.5
44.0
44.5
45.0
45.0
45.0
45.0

12.60
12.75
12.60
13.05
12.30
13.80
10.80
16.80

16
15
16
13
18
8
28
-1 2

oo

96

45.0

—

—

Digitized for
4 FRASER
FRBNY Quarterly Review/Spring 1982


Goldfeld. Stephen Goldfeld form ulated and estimated
a model of the demand fo r money using quarterly
data.9 He found that the quantity of money demanded
in a particular quarter was determ ined by the level of
the com m ercial paper rate as fa r back as six quarters
previous and by the level of income as far back as
eleven quarters previous. The mean lag— the tim e it
takes fo r one half of the long-run effect resulting from
a change in income or interest rates to occur— was
calculated to be 9.2 months fo r the com m ercial paper
rate and 6.8 months fo r income. The estimates of the
regression equation’s coefficients im ply that adjusting
the policy instrum ent to keep the money stock on ta r­
get every quarter would precipitate cycles that dampen
rather rapidly. For example, starting in equilibrium
w ith the money stock on target and the interest rate
9 See Goldfeld, op. cit., pages 604-5.

Table 1

Simulated Paths of Nonborrowed Reserves and the Interest Rate
Assuming Period-by-Period Control of Money
In billions of dollars

Period

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

Nonparallel income
and interest rate lags
(Co = 0.35, Ci = 0.15)
NonInterest
borrowed
rate
reserves
(percent)

No income lag
(Co = 0.5, cx = 0.0)
Non­
Interest
borrowed
rate
reserves
(percent)

Parallel income
and interest rate lags
(Co = 0.267, Cx = 0.233)
NonInterest
borrowed
rate
reserves
(percent)

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

12.60
12.98
12.65
12.93
12.68
12.90
12.71
12.88

16.00
13.50
15.69
13.77
15.45
13.98
15.27
14.14

12.60
12.86
12.75
12.85
12.76
12.84
12.77
12.83

16.00
14.25
15.03
14.35
14.95
14.42
14.88
14.48

12.60
12.80
12.80
12.80
12.80
12.80
12.80
12.80

16.00
14.67
14.67
14.67
14.67
14.67
14.67
14.67

00 .............................

12.80

14.67

12.80

14.67

12.80

14.67

0
1
2
3
4
5
6
7

Income equals $100 billion in period 0, $96 billion in subsequent periods.
Demand for money: M(t) = a — (0.8)r(t) — (0.7)r(t— 1) + c0Y(t) + cxY(t - D .
Supply of money M(t) = d + eNBR(t) + f[r(t) - DISC (t)].

Table 2

Simulated Paths of Nonborrowed Reserves and the Interest Rate
Immediate Versus Gradual Return of the Money Stock to Target
In billions of dollars

Immediate return
Money
stock

Nonborrowed
reserves

Interest
rate
(percent)

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

45
45
45
45
45
45
45
45

12.60
12.98
12.65
12.93
12.68
12.90
12.71
12.88

OO .............

45

12.80

Period
0
1
2
3
4
5
6
7

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

Gradual return
Money
stock

Non­
borrowed
reserves

Interest
rate
(percent)

16.00
13.50
15.69
13.77
15.45
13.98
15.27
14.14

45
44
45
45
45
45
45
45

12.60
12.79
12.81
12.79
12.81
12.79
12.81
12.80

16.00
14.75
14.59
14.73
14.61
14.72
14.62
14.70

14.67

45

12.80

14 67

Income equals $100 billion in period 0, $96 billion in subsequent periods.
Demand for money: M(t) = a — (0.8)r(t) — (0.7)r(t—1) 4- cY(t).
Supply of money: M(t) = d + eNBR(t) + f[r(t) - DISC(t)].
Target for money stock: $45 billion.




FRBNY Quarterly Review/Spring 1982

5

Chart 2

Chart 3

Sim ulated Paths of the Interest Rate under
Monetary Targeting: G oldfeld Equation

Simulated Paths of the In te re st Rate under
Monetary Targeting: MPS Equation

Interest rate in percent
1 7 -----------------------------------------------------------------------------------------

Interest rate in percent
17 ---------------------------------------------------------------

Price level
disturbance----------------------------------------------------------

disturbance

3

ll I l l l l I I I II

4

6

7 8 9
Quarters

10

11 12 13 14 15

at 16 percent, suppose the demand fo r money falls by
1 percent. (A 1 percent deviation of the money stock
from its targeted value would seem to characterize
s o m e of the problem s the FOMC c o n fro n ts .) C hart 2
shows the values of the interest rate that result quarter
by quarter when the target is attained by changing
nonborrowed reserves. Two cases are exam ined: (a) a
fall in money demand due to a drop in the price
level and (b) a fall due to a decline in real income.
(These two cases are different since a change in the
price level, unlike a change in real income, has no
lagged effects.) Because the interest rate ela sticity in
the current quarter was estimated to be rather small, a
very sharp rise in nonborrowed reserves— and a con­
current fall in the short-term interest rate— is necessary
in the first period to offset a price level disturbance.
MPS. A second equation examined is that used in
the MPS model of the m acroeconom y.10 This regression
equation was also estimated using quarterly data;
however, the dependent variable is demand deposits.
The lagged effects of short-term interest rates were
10 This equation is described in a mimeograph obtained from the
Board of Governors of the Federal Reserve System. MPS refers to
the MIT-Penn-Social Science Council econometric model.

6

FRBNY Quarterly Review/Spring 1982




121

4
5
Quarters

J _____I_____I

estimated to go back three quarters; the mean lag is
only 1.8 months, considerably shorter than G oldfeld’s
estimate. The interest rate ela sticity fo r the current
q u a rte r was constrained to —0.05, w hich is about 3.5
tim es as great as G oldfeld’s estimate. The lagged ef­
fects from income were also estimated to go back
three quarters. Since the interest rate’s current period
effect is large relative to its lagged effects, the esti­
mated coefficients of the MPS equation im ply very
rapidly damped cycles if the money stock is kept on
target every quarter follow ing either a price level or
real GNP disturbance. Chart 3 shows the values of the
interest rate obtained when the two sim ulations per­
form ed with the G oldfeld equation are repeated w ith
the MPS equation.
Thomson-Pierce. This equation representing money
demand was estimated using m onthly, instead of quar­
te rly data." The lagged effects of the short-term inter­
est rate were estimated to go back nine m onths and
fo r income four months. In contrast to the two m odels
already investigated, the estim ates of this regression

11 The Thomson-Pierce model is described in Robert S. Pindyck and
Steven M. Roberts, "Optimal Policies for Monetary Control", Annals of
Economic and Social Measurement (January 1974), pages 207-38.

equation’s coefficients imply that hitting monetary tar­
gets either month by month or quarter by quarter
would cause explosive cycles. This result is obtained,
in part, because it was estimated that the interest rate
from five months previous had the greatest effect on
the current m onth’s money demand. The shortest time
period over which monetary targeting would be fea­
sible w ithout explosive cycles appears to be six
months.
In summary, the estimates of these three models
have vastly different im plications fo r monetary target­
ing: i.e., rapidly damped cycles in nonborrowed re­
serves and interest rates if monetary targets are hit
quarterly in contrast to explosive cycles if monetary
targets are hit on anything shorter than a semiannual
basis. The wide range in findings is not so surprising,
given the wide variation in estimates of the lagged ef­
fects that changes in income and interest rates have on
the demand for money. To illustrate how diverse the
estimates of the lagged effects are, the mean lag has
been computed from several studies on the demand for
money (or demand deposits). According to these esti­

mates (Table 3), the mean lag in some cases is less
than a month, and in other cases more than 2 V2
years. The mean lag by itself is insufficient to deter­
mine the im plied behavior of nonborrowed reserves
and the interest rate under monetary targeting since
the pattern in the relative sizes of the lagged effects
is also important. Still, from this wide range of esti­
mates of the lagged effects (as characterized by the
mean lag), a wide variation in the implied behavior
of the monetary sector under m onetary targeting could
be expected.
Furthermore, very small changes in the estimates
of the lagged effects can significantly influence the be­
havior of nonborrowed reserves and the interest rate
under precise m onetary targeting. Consider, fo r ex­
ample, an alteration of the Goldfeld equation in which
the long-run interest rate elasticity remains un­
changed, but the mean lag is lengthened from the
existing 6.8 months to 7.3 months. To do this, let the
elasticities take on the values shown on page 8; these
hypothetical values are all w ithin one standard devia­
tion of G oldfeld’s estimates.

Table 3

Estimates of the Mean Lag in the Demand for Money

Name

structure

Lag
Income

Mean lag (in months)
Market interest rate

Quarterly models:
Goldfeld ....................................................................
Goldfeld .....................................................................
MPS* .............................................................. ..........
MPS ............................... ...........................................
Hamburger* ..............................................................
Lieberm an§................................................................

geometric
polynomial
geometric
polynomial
geometric
geometric

7.6
9.2
10.0
t
31.0
0.9

7.6
6.8
10.0
1.6
31.0
0.9

polynomial
polynomial

2.5
1.3

1.9
4.8

Monthly models:
Board of G overnors||................................................
Thom son-Pierce........................................................

* See Jared Enzler, Lewis Johnson, and John Paulus, ‘‘Some Problems in Money Demand” ,
Brookings Papers on Economic Activity (1976,1 ), pages 261-80. MPS refers to the MIT-Penn-Social Science
Research Council econometric model.
t Cannot be computed.
$ Michael J. Hamburger, "Behavior of the Money Stock: Is There a Puzzle?” , Journal of Monetary
Economics (July 1977), pages 265-88.
§ Charles Lieberman, "The Transactions Demand for Money and Technological Change",
Review of Economics and Statistics (August 1977), pages 307-17.
I! See Helen T. Farr, “ The Monthly Money Model", mimeograph (Washington, D.C.:
Board of Governors of the Federal Reserve System, 1980).




FRBNY Quarterly Review/Spring 1982

7

pended in em pirical research on the demand fo r
money, no firm conclusion can be made concerning
the precise cyclical behavior of nonborrowed reserves
and short-term interest rates under quarter-by-quarter
o r month-by-month monetary targeting. A ccording to
this analysis, slow ly damped cycles are a distin ct pos­
sibility and explosive cycles cannot be elim inated
entirely from the set of potential outcomes.

Chart 4

Sim ulations of the Interest Rate with
G oldfeld’s Estim ates and Assumed Values
Interest rate in percent
2 2 - ------------------------------------------------------------------------------------------------------------- -—

_____________________

\ With assumed
\
elasticities

Simulations of the monetary sectpr and aggregate
demand under monetary targeting

I

<

S

*7

j
H j _____ I

—

\ \

I

i/ T \ v

■

| I
I With estimated
1 0 —t t - l --------------------------- e lasticities--------------------------------------

M

-L-L
L L I I II II II II JI. I I II II II II II II II II
0

1

2

3

4

5

6

7 8 9 10
Quarters

11 12 13 14 15 16

In this section, a sim ple three equation model of the
economy is constructed. The model is used to illus­
trate how, under fa irly believable conditions, feedback
on the money market from the production side of the
economy can reinforce the lagged interest rate effects
on the demand fo r money, thereby aggravating the
cycles in nonborrowed reserves and the interest rate
caused by period-by-period monetary control and, at
the same time, creating cycles in income itself.
M odel sim ulations
The model consists of three equations: (1) the demand
for money, (2) the supply of money, and (3) aggregate
demand:
(1) M(t) = a - b0r(t) - b j ( t—1) + cY(t)
(2) M(t) = d + eNBR(t) + f[r(t) -

In te re s t ra te e la s tic itie s
Lag (in q u a rte rs )...........
Goldfeld’s estimates . . .
Hypothetical values . . . .

DISC(t)]

(3) Y(t) = g - h0r(t) - hxr(t—1)
0
1
2
3
4
5
6
0.014 0.014 0.012 0.011 0.009 0.006 0.003
0.0100.012 0.014 0.014 0.010 0.006 0.003

This slight change in the interest rate’s lagged effects
from what Goldfeld estimated causes the cycles to
dampen much more slow ly (Chart 4).
In a paper written for the Federal Reserve staff
study of the New Monetary C ontrol Procedures, Tinsley
and Others [1981] make a sim ilar observation. The co­
efficient estimates of the model they investigate im ply
that damped, rather than explosive, cycles would re­
sult from tig ht monetary targeting. They note, though,
“ the margin between sta bility and instability is ex­
trem ely small, especially in light of the standard errors
of the coefficients” .12
Thus, the high sensitivity of interest rate behavior to
the estimates of lagged effects, combined with the wide
variation in the estimates of lagged effects, leads to
vastly different im plications. Despite all the effort ex­

12 See Appendix C of Peter Tinsley and Others, "Money Market Impacts
of Alternative Operating Procedures” , New Monetary Control Procedures, Federal Reserve staff study, Volume 2 (Washington, D.C.:
Board of Governors of the Federal Reserve System, 1981).

FRBNY Quarterly Review/Spring 1982



The demand and supply of money are form ulated
in the same manner as before. Aggregate demand
is affected by the current and previous p eriod’s interest
rate. The relative magnitudes of the current and lagged
interest rate effects in the demand fo r money and
aggregate demand, as well as the sensitivity of the
demand for money to changes in income, determ ine
the type of oscillations nonborrowed reserves, income,
and the interest rate w ill exhibit if absolute control
over the money stock is maintained. Specifically, the
cycles w ill be explosive if (b0 + ch0) < (bx + c h j and
damped if (b0 + ch0) > (bx + c h j).13 Thus, the more
the current p erio d ’s interest rate affects money de­
mand and aggregate spending, the more likely the
cycles w ill be stable; the more the previous peri­
o d ’s interest rate affects money demand and aggre­
gate spending, the more likely the cycles w ill be
unstable.
Table 4 reports the simulated behavior of the model

13 Constant oscillations occur if (b0 + ch0) = ( bx + ch i); as before,
this special case will not be considered. Another special case occurs if
b0hj = bihoi then income exhibits no cycles whatsoever.

Table 4

Simulated Paths of Nonborrowed Reserves, the Interest Rate, and Income
Assuming Period-by-Period Control of Money
In billions of dollars

Period

........

Explosive (h0 = 0.5, h* = 4.0)
NonInterest
borrowed
rate
reserves
(percent)
Income

Slowly damped (ho = 1.5, h j = 3.0)
NonInterest
borrowed
rate
reserves
(percent)
Income

Rapidly damped (h0 = 4.0,
NonInterest
borrowed
rate
(percent)
reserves

= 0.5)

Income

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

12.60
12.79
12.52
12.91
12.36
13.14
12.03
13.61

16.00
14.71
16.54
13.94
17.63
12.39
19.83
9.28

100.00
97.65
101.81
94.86
103.42
91.23
108.51
84.05

12.60
12.75
12.63
12.73
12.64
12.71
12.65
12.70

16.00
15.02
15.83
15.16
15.72
15.26
15.64
15.34

100.00
97.46
99.18
97.76
98.93
97.96
98.77
98.10

12.60
12.69
12.68
12.68
12.63
12.68
12.68
12.68

16.00
15.39
15.48
15.47
15.47
15.47
15.47
15.47

100.00
98.42
98.40
98.40
98.40
98.40
98.40
98.40

00 ...........

_

_

_

12.68

15.47

98.40

12.68

15.47

98.40

0
1
2
3
4
5
6
7

Demand for money: M (t) = a — (1.3 )r(t) — (0.2)r ( t —1) + cY(t).
Supply of money: M(t) = d + eNBR(t) + f[r(t) — DISC( t ) ].
Aggregate demand: Y (t) = g — h0r(t) — h1r(t —1).

when the targeted value of the money stock is to be
maintained despite shifts in aggregate demand. Three
sim ulations are conducted. The demand-for-money
function is the same in each of the three cases; if
looked at in isolation, a relatively large current period
effect (b0 = 1.3, b* = 0.2) would imply rapidly damped
cycles. The purpose of these simulations is to reveal
how critica l are the sizes of the current and previous
period’s interest rate effects on aggregate demand.
The procedure used to perform the sim ulation is
sim ilar to what was follow ed in the simulation of the
monetary sector alone. Initially the money stock is on
target. Then, aggregate demand (rather than income)
decreases permanently by 4 percent, and the level of
nonborrowed reserves is adjusted period by period to
keep the money stock on target. Given a dem and-formoney equation, the interest rate effects on aggregate
demand determ ine the type of cycles that occur. Thus,
concentrating on the current and lagged interest rate
effects in the demand fo r money by themselves could
lead to the wrong conclusion concerning the outcome
of period-by-period control of the money stock.
With this model as with the model consisting solely
of the monetary sector, explosive o r slow ly damped
cycles can be avoided by relinquishing some control
over the money supply and setting the interest rate
at its new equilibrium value. Slowly damped cycles



can also be m itigated by bringing the money stock
back to target only gradually.14
The lagged effects on aggregate demand
It is beyond the scope of this article to survey the
large volume of em pirical w ork on the lagged effects
on aggregate demand, p articularly investment spend­
ing. It is fair to say, however, that all m acroeconom ic
models of the economy feature lagged interest rate
effects on residential construction and business fixed
investment. Current rates alone may influence the
decision to begin construction of housing units or
expansion of plant capacity, but actual expenditures
follow with a lag.
Although it seems certain that the lagged effects
on investment spending exist, there is no consensus
on the pattern of the lagged effects or the number of
periods they extend beyond the previous period. There
does seem to be a considerable im pact on residential
housing construction one and two quarters after a
change in the level of interest rates. (In term s of the
model used in this section, this delayed impact would
be reflected by hx being equal to or greater than h0.)

14 Many of these same points were illustrated with a similar model
by Kevin Hurley in "How a Tight Monetary Policy Can Destabilize
the Economy’’, Money Manager (March 9, 1981), page 3.

FRBNY Quarterly Review/Spring 1982

9

Thus, the pattern of lagged interest rate effects on
aggregate demand could to some extent intensify
cycles caused by tight control of the money supply.
In another paper written for the Federal Reserve
staff study of the New Monetary Control Procedures,
Enzler and Johnson construct a consensus model of
the macroeconomy that would give results which are
“ qualitatively representative of a wide range of models
of similar but more elaborate structure (for example,
the MPS model)” .15 This model consists of four equa­
tions; besides aggregate demand and the demand for
money, they include an equation describing FOMC be-

15Jared Enzler and Lewis Johnson, "Cycles under Monetary Targeting” ,
New Monetary Control Procedures, Federal Reserve staff study,
Volume 1 (Washington, D.C.: Board of Governors of the Federal
Reserve System, 1981).

havior and a “ Phillips curve” inflation rate equation.
They then use this model to perform a series of simu­
lations of the economy’s performance. In several simu­
lations, explosive or slowly damped cycles with a
period of fourteen quarters are obtained for income;
these simulations imply explosive or damped cycles
for the interest rate and nonborrowed reserves as well.

Concluding remarks
Some critics of monetary policy assert that the FOMC
should control the money stock in the very short run.
These critics generally do not confront the possibility
that overly close monetary control could destabilize
the economy. In fact, empirical research suggests that
the adoption of a very short control horizon could
inject instability into financial markets and the level
of economic activity.

Lawrence Radecki

10

FRBNY Quarterly Review/Spring 1982




The Eurodollar Conundrum

Transactions in the Eurodollar market can complicate
Federal Reserve monetary policy. Most dollars held
abroad are not counted in the U.S. target aggregates,
but they may substitute for deposits in domestic banks.
Unpredictable changes in Eurodollars, then, can reduce
the usefulness of currently defined money stocks as
targets. The slippage is not too important now, since
Eurodollars are relatively small compared with the ag­
gregates. But overseas deposits are growing much
faster than domestic money stocks: for example,
Eurodollar deposits of U.S. residents not counted in
the aggregates increased more than 35 percent in
1981. With this pace of expansion, the Euromarket
could in the future become an important snag in
monetary control and the problems it poses merit
closer attention.
This article looks at the complications the Eurodollar
market creates for monetary policy and examines some
solutions. The best approaches from a U.S. viewpoint
involve international agreements that are hard to
achieve. U.S. authorities could take some steps on
their own that would reduce the monetary control
problem, but these would be less effective or would
have disruptive side effects. The options surveyed
here do not, by and large, imply changing the central
feature of monetary policy: the use of a monetary
aggregate as an intermediate target. Current practices
in the Eurodollar market, however, do pose a conun­
drum that is part of a broader problem— the emerging
conflicts among policies on monetary control, financial




deregulation and innovation, and the lender-of-lastresort role.1

The Eurodollar market and monetary control
The availability of Eurodollar deposits provides a way
for investors to place funds outside the domestic bank­
ing system without limiting its capacity to generate
deposits. In this regard, the Euromarket acts like other
alternatives to domestic bank deposits, such as re­
purchase agreements, money market funds, or even
commercial paper. These nonbank instruments are
avenues for the growth of credit that are not directly
constrained by the supply of reserves to U.S. banks.
Although Eurodollar deposits are bank liabilities, they
produce effects similar to the nonbank instruments
because they are generally free from reserve require­
ments.
Federal Reserve policy seeks to control the growth
rates of target monetary aggregates, but most Euro­
dollars are not counted in these aggregates.2 There­
fore, growth of Eurobank operations can expand global
dollar credit for a given reserves base and convention-

1 On aspects of this issue, see Betsy Buttrill White, "Monetary Policy
Without Regulation Q” , this Quarterly Review (Winter 1981-82),
pages 4-8.
2 Overnight Eurodollar deposits held by U.S. nonbank residents at
Caribbean branches of U.S. banks are a component of M-2. Term
Eurodollars held by U.S. nonbank residents are part of L, a broad
liquidity measure. Eurodollars held by foreigners are not included in
any aggregate.

FRBNY Quarterly Review/Spring 1982

11

ally defined money supply. Insofar as Eurodollars sub­
stitute for usual money balances and sustain more
spending in the United States, the measured monetary
aggregates will show increased velocities. But the
extent of the substitution cannot be easily gauged and
that is the crux of the monetary control problem:
changes in Eurodollar deposits that cause unantici­
pated velocity swings for the monetary aggregates
make the latter less reliable as intermediate policy
targets.
The chief determinant of investor preference for
Eurodollars is their risk-adjusted interest rate differ­
ential against domestic deposits. Eurobanks operate
on a narrower margin between their cost of funds and
their return on loans than do domestic banks— and
hence can offer depositors higher yields— because
they are free from certain costs. Specifically, Euro­
banks are free from reserve requirements and are not
prohibited from offering very short-dated time deposits.
The Eurodollar sector is linked to the domestic
banking market through arbitrage: banks will fund at the
lower cost, thereby tending to equate the costs of funds
in both sectors. Under “ normal” market conditions, do­
mestic rates adjusted for reserve requirements (and
other relevant costs, such as deposit insurance) will
just about equal Eurorates.3 As a corollary of such
arbitrage, depositors get most of the benefit of the
lower operating margin in the form of higher Euro­
market rates. This yield advantage for Eurodollars
widens in basis points when the level of dollar interest
rates rises.
Such behavior meshes with the incentives banks
face. If U.S. banks have to hold more noninterestbearing reserves than they desire, they have a strong
motive to encourage shifts of funds to reserve-free
Eurodeposits. In a competitive market, then, banks
will price Eurodeposits as attractively as they can.
This is why most of the gain is passed on to depositors
as a higher yield on Eurodollars.4
Offsetting the yield gain is a higher risk that deposi­
tors assign to Eurodollars. Three principal elements
make up this risk: (1) Eurodollar deposits are not in­
sured; (2) they are booked at banking offices that do

not have direct access to the Federal Reserve discount
window, and (3) they are outside the legal jurisdiction
of the United States. The element of country risk in the
last feature can cut two ways. While many depositors
will view the United States as a relatively low country
risk, others may prefer to hold dollars outside the
reach of American law. These risk features are a chief
reason why domestic banking system deposits are
held in the face of a yield disadvantage.5
In a market without constraints on flows of funds,
investors would be expected to shift deposits into the
Euromarket until the risk-adjusted yields in the two
sectors are equated. Then there would be no clear
reason for one sector to grow more rapidly than the
other. Nevertheless, the removal of U.S. capital con­
trols in 1974 did not get rid of the gap in growth rates
between the overseas and domestic dollar banking
sectors. Since then, the Eurodollar market has consis­
tently grown much faster than the domestic aggregates
(table). This rapid growth has raised concerns that the
Eurodollar market may act to limit the effectiveness of
U.S. monetary policy in the control of inflation.

Growth of the market
Increased demands for Euromarket credit, particu­
larly by sovereign borrowers for balance-of-payments
financing, are frequently cited as the driving force
behind the expansion of the market. What complicates
monetary policy, however, is the growth of the deposit
side of the market. Credit extensions in the Euromarket
can be funded up to a point without new deposits
by interbank borrowings from domestic banking sys­
tems— for example, the overseas branch of a U.S. bank
may make a Eurodollar loan and fund it with borrow­
ings from its head office. Although this process— a
kind of “ pure” intermediation— can have important
implications for the distribution of bank lending, it
does not automatically produce growth on the deposit
side of the Euromarket.
What factors, then, account for the relatively high
rate of Eurodollar deposit growth since 1974? There
is no simple satisfactory explanation, but at least three
ideas that focus on important economic trends of the
post-1974 period merit some attention.6 The first of

3 The complete arbitrage conditions are more complicated, but they
show that in an efficiently arbitraged market the differential between
Eurorates and domestic rates adjusted for reserves will be small. A more
elaborate analysis of arbitrage conditions appears in R.B. Johnston,
“ Some Aspects of the Determination of Euro-currency Interest Rates” ,
Bank of England Quarterly Bulletin (March 1979).

5 Of course, demand and small time deposits are not available in the
Euromarket. And even an unconstrained risk-neutral large depositor
may hold a domestic certificate of deposit because of its superior
liquidity, compared with a Eurodollar time deposit or a Eurodollar
certificate of deposit.

4 Federal Reserve pronouncements, the so-called Martin-Burns letters,
seek to dissuade U.S. banks from soliciting Eurodollar deposits from
domestic residents through their overseas branches. Such cautions
probably have limited the marketing efforts of some banks. Neverthe­
less, recent growth of resident Eurodollar deposits has been strong
both at foreign banks and at overseas branches of U.S. banks.

4 The lengthy and disputatious literature about the size of the Eurodollar
m ultiplier does not shed much light on the problem of why the market
grows so fast. If the m ultiplier is a stable parameter, the growth of the
market must still be explained by whatever determines the initial deposit
inflows. If the m ultiplier is not stable, as appears to be the case, it is
best to drop that framework altogether.

Digitized for12
FRASER
FRBNY Quarterly Review/Spring 1982


Growth Rates of Eurodollar Deposits and U.S. Monetary Aggregates
Percentage change over period, at annual rates

Market sector

1974

1975

1976

1977

1978

1979

1981
1980 (Jan.-Sept.)

28.9
t
33.2

38.0
21.8
7.4

24.3
30.9
23.6

19.6
17.1
17.5

24.6
24.6
39.0

27.4
29.1
35.7

27.4
23.5
27.3

20.2
22.6
26.8

4.4
5.6
8.5
9.3

4.8
12.7
9.6
10.2

6.6
14.1
12.0
11.3

8.0
10.9
12.4
12.7

8.2
8.3
11.4
12.6

7.1
8.2
9.3
11.1

6.5
9.0
10.3
10.1

2.2
9.2
10.8
10.7

Eurodollar deposits*
Gross ...................................
Net ........................................
Nonbank ...............................

U.S. monetary aggregates};
M-1 ........................................
M-2 ........................................
M-3 ........................................
L ............................................

* Percentage changes in the outstanding end-of-period levels,
f Not available.
$ Percentage changes in the monthly average levels for the last month of the period.




FRBNY Quarterly Review/Spring 1982

13

these explanations, and the most important, hinges on
factors that have changed the risk-adjusted rate differ­
ential between domestic deposits and Eurodeposits;
the other two look to shifts in international payments
patterns that altered the worldwide distribution of
financial wealth.
Changes in the risk-adjusted rate differential. The
risk-adjusted interest rate differential between Euro­
dollar deposits and domestic bank deposits is the most
important element affecting depositor decisions. Two
developments have made this differential move in favor
of Eurodollar deposits in recent years. The first has
been the trend increase in the level of dollar interest
rates. This resulted in an increased basis points ad­
vantage for Eurodollar deposits (Chart 1). If the per­
ceived risk differential in favor of domestic deposits
was unchanged in terms of basis points, an incentive
emerged to shift funds into the Euromarket.
On top of this, however, the perceived riskiness
of Eurodeposits has almost certainly declined over
time. In part, the very success of the market brought
this about. Since 1974 no crisis of confidence on a
par with the Herstatt affair has occurred. Following
the Herstatt episode, bank managements upgraded
their internal controls and authorities in many coun­
tries improved their monitoring of banking activities
and tightened their prudential supervision. Despite
repeated warnings from many quarters about the in­
capacity of the market to handle the volume of recy­
cling related to higher oil prices, no specific incident
can be pointed to as a failure of an institution to func­
tion. As a result, the Euromarket was seen as more
robust and less of a risk to depositors.
Enhancing this perception were widely held views
about the extent of agreement among major central
banks on lender-of-last-resort roles and supervisory re­
sponsibilities. In September 1974, following the Franklin
National and Herstatt troubles, the central bank gover­
nors of the major countries meeting at the Bank for
International Settlements (BIS) in Basel stated they
were satisfied that means exist to provide liquidity
assistance to the Euromarket should the need arise.
Later, in the autumn of 1975, the Committee on
Banking Regulations and Supervisory Practices pre­
sented to the BIS governors a set of guidelines on the
division of supervisory obligations among national
authorities, widely known as the Concordat.7 These
guidelines were more detailed than the Basel declara­

7 See Peter Cooke, “ Developments in Cooperation Among Banking
Supervisory Authorities” , presented at a Conference on the Inter­
nationalization of Capital Markets, International Faculty for Corporate
and Capital Market Law, New York City, March 19-21,1981.

FRBNY Quarterly Review/Spring 1982
Digitized for14
FRASER


tion on lender-of-last-resort activity. They placed the
primary burden for supervising the liquidity positions
of Eurobanks with the host authorities. The duty of
supervising the solvency position of subsidiaries and
joint ventures was also placed chiefly, but not ex­
clusively, with the host authorities, while that for
branches was held to belong clearly to the home
authority of the parent banks.
The Concordat covers just supervisory duties; the
Basel declaration is the only public notice of any
international agreement on emergency assistance.
Nevertheless, together they had a reassuring effect on
market views about the extent of central bank cooper­
ation regarding support for the Euromarket. This, in
turn, contributed to the continuing erosion of perceived
risks in the Euromarket, prompting more deposits and
faster growth.
U.S. balance-of-payments deficits. A view that has
achieved some standing is that deficits in the U.S.
balance of payments have fed the growth of the Euro­
market since 1974. The line of argument here is often
hard to follow. In some versions, the U.S. deficit on the
official reserves transactions basis, roughly the total
of current account and private capital transactions,
has been cited as a cause of Euromarket expansion.
U.S. payments deficits and Eurodollar growth may be
observed together, but a logical case for a causal link
is absent. A simple example shows why. A Eurobank
may make a dollar loan to a foreigner and fund it by
borrowings made in or by deposits that have been
induced to shift from the United States. If the loan
substitutes for borrowing the foreigner would have
done anyway in his domestic market, what shows up
is a net private capital outflow in the U.S. accounts
and expansion in the Euromarket.8 But the former
cannot be said to cause the latter. Indeed, the Euro­
market may play a purely intermediary role, as in a
case where the foreigner could have borrowed the
dollars directly within the United States. Eurodollar
transactions and U.S. capital flows are both set by a
complex interaction of borrower and lender prefer­
ences worldwide.
A variant of the argument looks to deficits on the
U.S. current account instead of the overall balance of
payments. The factors that determine the current ac­
count picture— international competitiveness and rela­
tive business cycles, for example— are independent of
8 This example assumes that the central bank of the foreign country
intervenes in the exchange market to acquire the dollars as reserves.
Under a purely floating exchange rate, of course, no deficit on the
official reserves transactions account would appear, since there would
be an offsetting current account or private capital inflow to the
United States.

Euromarket transactions. U.S. current account deficits
shift financial wealth from U.S. residents to the rest
of the world. Since changes in financial wealth affect
the demand for all assets, including Eurodollars, cur­
rent account deficits can shift up the demand for
Eurodollars, but only if foreigners always have a
greater preference fo r Eurodollar deposits, at the
margin, than U.S. residents. But there is no theoretical
reason to assume this kind of systematic tilt in asset
preferences. Some factors, such as convenience, w ill
w ork in favor of foreigners holding dollar deposits in
overseas banks, w hile others, such as the Eurom arket’s
lack of direct access to the Federal Reserve discount
window, w ill cut the other way. Whether a shift of
wealth arising from U.S. current account deficits was
a force behind high Eurodollar growth is an em pirical
question that can be answered correctly only by a
detailed model of w orldw ide portfolio behavior. A
rough look at the numbers, however, shows that the
effect, if it exists, is too subtle to be assigned much
importance. In fact, the United States had a tiny
cumulative current account surplus over the period
1974-80. Furthermore, annual swings in the deficit ap­
pear to be correlated with a broad measure of Euro­
dollar growth in just the opposite direction (Chart 2).
O il-exporter surpluses. The most striking interna­
tional wealth transfer of the period was the growth
of oil-exporting-country current account surpluses.
Here again the pattern of current accounts would
have affected Euromarket growth only if oil-exporting
countries had a stronger preference for Eurodollars
than did oil-im porting countries. This presumption,
however, is not unreasonable. Many commentators
have depicted the financial behavior of the oil ex­
porters as very cautious, at least in the initial years
of large surplus, and marked by a desire for invest­
ments with a high degree of liquidity. Such prefer­
ences would favor the Eurodollar banking sector,
which offers time deposits of very short m aturities not
available from U.S. banks. Thus, a shift of wealth to
a group of countries with a relatively high liquidity
preference could have plausibly fueled Eurodollar
growth. Member states of the Organization of Petro­
leum Exporting Countries (OPEC) had a total cum ula­
tive current account surplus between 1974 and 1980
of nearly $325 billion. But, as with the U.S. current
account, yearly changes in the OPEC surplus do not
appear to match up closely with variations in the Euro­
dollar growth rate (Chart 2).
In summary, different factors have at various times
contributed to relatively high Eurodollar growth. Cer­
tainly, a m ajor fa cto r behind sustained high growth of
the market in recent years has been the rise in the



risk-adjusted yield advantage for overseas deposits
relative to dom estic deposits. This reflects the com ­
bined effects of trend increases in the level of dollar
interest rates and trend reductions of the perceived
riskiness of Euromarket deposits. But the ballooning of
the OPEC surplus may have played a p articularly im­
portant role in 1974-75, a tim e when dollar interest
rates were declining and perceptions of risk in the
Euromarket were aggravated.

What can be done?
If the high rate of Eurodollar deposit growth poses a
problem fo r a policy of monetary aggregates target­
ing, what steps can be taken to address the problem?
The range of policy options covers three broad
classes: (1) do nothing; (2) take account of Eurodollars
in the monetary targeting process; (3) put the Euro­

FRBNY Quarterly Review/Spring 1982

15

dollar and dom estic banking sectors on a more equal
footing by measures that change the risk-adjusted
rate differential.
Do nothing
The prescription that policym akers can safely ignore
the Eurodollar m arket rests on the view that the size
of the problem it poses is small and is likely to remain
so in the near future. As a percentage of M-3— the
aggregate that includes large dom estic bank tim e de­
posits, the principal alternative to Eurodollars— over­
seas dollar deposits held by U.S. residents amount to
only about 3 percent (Chart 3). And, as dom estic re­
serve requirements on nonpersonal time deposits fall
to 3 percent under the provisions of the Monetary
Control Act, Eurodollars w ill have much less of an
edge in the future.
The counterpoint to that view is that Eurodollars are
fast becoming a big problem. In fact, focusing on a
broader Eurodollar measure— those held by all non­
banks w orldw ide— reveals that overseas dollar de­
posits exceed 10 percent of M-3 (although most
observers think that such a measure overstates the
amount of Eurodollars that should be compared with
dom estic aggregates).
The Euromarket is becoming a more active and sig­
nificant alternative to dom estic banking deposits. Be­
tween December 1980 and December 1981, term
E urodollar deposits held by domestic nonbank resi­
dents other than money market funds grew at an an­
nual rate of over 35 percent to $66.2 billion. Should
these trends continue, the Eurodollar m arket w ill grow
to a significant size relative to M-3 in a number of
years. While reduction of dom estic reserve require­
ments on nonpersonal time deposits w ill work to slow
this process, it w ill not remove all incentives for Euro­
m arket growth. A 3 percent reserve requirem ent can
still result in a significant yield differential at current
levels of interest rates. Additionally, a large part of
Eurodollar deposits is fo r very short-dated m aturities
(less than fourteen days) not allowable for dom estic
deposits. These short-term Eurodollars may continue
to substitute to some extent for domestic transactions
accounts. There are, therefore, reasons not to neglect
Eurodollars in setting monetary policy.
Take account of Eurodollars
The second policy option is to take account of Euro­
dollar developments in some way. This can be done
form ally or informally. To account form ally for changes
in Eurodollars in setting policy means revising the
target monetary aggregates to include some classes
of overseas deposits. The problem with this approach
is a basic one: econom ic analysis at present cannot

16 FRBNY Quarterly Review/Spring 1982



answer very well what shares of Eurodollar holdings
by dom estic residents or by foreigners should be
counted or to w hich aggregates they should be added.
Using a sim ple criterion to construct a mone­
tary aggregate can be misleading. The location of
deposits, for example, is frequently irrelevant to the
purposes the deposits serve. U.S. residents may hold
dollars overseas that are closely connected with their
dom estic business operations. While a residence-ofdepositor rule may appear more satisfying, it also has
some drawbacks. For example, some of the Eurodollars
held by foreigners may support their transactions
w ithin the United States. Furthermore, these simple
rules do not address the question of how many Euro-

dollars should be put in an M-1 aggregate, how many
in M-2, and so forth.
Statistical evidence in this area is limited, but one
study has been done using a familiar methodology in
research on the empirical definition of money.9 It
compared the out-of-sample forecasting properties of
standard money demand equations and reduced form
income-money relations fitted to different definitions
of money, including and excluding various categories
of Eurodollar deposits. The findings are mildly con­
sistent with the inclusion in the narrow monetary
aggregate of some part of Eurodollars— specifically,
overnight deposits booked anywhere in the world held
by U.S. residents. The methodology itself, however,
does not determine what proportion of Eurodollars
should be added to the monetary aggregates. The
study makes the interesting point that, once some ac­
count has been taken of U.S. resident Eurodollar hold­
ings, the inclusion of Eurodollars held by foreigners
does not improve the statistical or forecasting proper­
ties of the money demand equation. On the question
of which categories of and how many Eurodollars
should be put in the broader (M-3) aggregate, the
results are inconclusive.
An informal way of taking account of Eurodollars
is to study their behavior and make changes when
needed, for example, by altering the speed of adjust­
ment to monetary target paths or even by changing
the target ranges themselves. One can argue that the
scope for this kind of adjustment currently exists, but
it is applied only rarely and in an uneven way. An
informal approach is really useful only if it includes a
more systematic procedure to analyze Eurodollar de­
velopments when constructing monetary policy options.
Both the formal and informal approaches share a
serious drawback: most data are not available on
a timely basis. In fact, this was a major reason why
only selected Eurodollar items were put in the new
aggregates. For the most complete information series
— the BIS Eurocurrency statistics— the lag ranges from
three to six months. This lack of timely data has nat­
urally led to considering options that would tend to
put the Eurodollar and domestic banking sectors on a
more equal footing. Such approaches would seek to
change the relative cost structure of the two sectors
in a way that would reduce or eliminate the incentive
to shift funds into the Euromarket.
Put the sectors on an equal footing
Measures that seek to put the sectors on an equal
footing are especially useful from the perspective of
* Laurie Goodman, "Eurodollars and the U.S. Money Supply” , Federal
Reserve Bank of New York Research Paper No. 8001 (January 1980).




U.S. monetary control goals. If investors do not have
much reason to hold deposits in one sector rather
than the other, the two should grow at similar rates.
Therefore, the elements left out of the aggregates
will tend to grow at the same rate as those which
are included and the problem of how many Eurodollars
to count in a “ true” money measure is lessened.10
Putting the sectors on an equal footing involves
changing the factors behind the risk-adjusted yield
differential. This can be done in two ways: (a) closing
the gap between the margins on which banks in the
two sectors operate and thereby making the rates on
deposits converge or (b) affecting the perceived rela­
tive risk of the two sectors.
The first way includes the larger number of options.
Some actions can even up the two sectors by adjust­
ing costs in the domestic market, and U.S. authorities
can take these steps unilaterally.
Eliminate or further reduce domestic reserve re­
quirements. This step goes to the heart of the matter,
since getting rid of reserve requirements on non­
personal time deposits at domestic banks would ease
some of the monetary control problems posed by the
Euromarket. Some problems would remain, however,
as a large share of Eurodeposits is very short
dated and this would still be a potential substitute for
domestic transactions accounts.
Pay interest on the required reserves of domestic
banks. Instead of eliminating reserve requirements,
the cost disadvantage they impose on domestic banks
could be reduced through interest payments on re­
quired reserves. The closer such payments are to
market rates, the smaller will be the yield difference
between Eurodollars and domestic deposits. However,
this option is at present excluded under the condi­
tions of the Monetary Control Act.
Other policy steps are possible that would even up
the two sectors by changing cost structures in the
Euromarket.
Impose reserve requirements on Euromarket de­
posits. In principle, this could be done unilaterally:
the Federal Reserve could impose reserve require­
ments on Eurodeposits at overseas branches of U.S.
banks. Such a move would be largely ineffective since
deposits would be shifted to other Eurobanks. Non10 That problem is eliminated only if Eurodollars as a whole substitute
for M-3 as a whole. If Eurodollars substitute only for the domestic large
time deposit component of M-3 and if that component is growing more
rapidly than other parts of M-3, the weight given to the fast-growing
component in the broad aggregate will depend on how many Euro­
dollars are included.

FRBNY Quarterly Review/Spring 1982

17

dollar Eurobanks may not be willing to take over the
entire dollar book of U.S. branches immediately. But
in the longer run the U.S. banking system’s loss of
market share would be enormous and little effect
would occur on the total market.
The alternative to unilateral actions is to negotiate
an agreement among the major international banking
countries (the Group of Ten and Switzerland) to im­
pose reserve requirements on the Eurodeposits of
their banking systems worldwide. This was proposed
by the United States at the BIS in 1980 but was not
adopted. A major problem impeding agreement was
the imbalance that such an agreement would create
between the domestic and Euromarket operations of
foreign banking systems. Putting reserve requirements
on Eurodollar deposits only would not be sufficient.
These could be avoided by booking, say, a reservefree Euromark deposit while at the same time selling
the marks forward against dollars, thereby creating the
equivalent of a reserve-free Eurodollar deposit. These
redenomination incentives can be stopped only by
putting reserve requirements on Eurodeposits in all
currencies. To do this, however, would create compli­
cations for foreign countries that do not use reserve
requirements on their domestic banks but would wind
up with them on the Eurodeposits of their home cur­
rency. The impasse stems from differences among
countries in the techniques used for monetary control
and domestic financial regulation. Breaking the im­
passe would seem to require a closer harmonization
of national banking systems.
Impose capital-assets ratios. That dilemma led to
suggestions that perhaps an agreement on Euromarket
regulation could be reached by focusing on capitalassets ratios. This approach is also full of pitfalls. A
basic one is that capital-assets ratios serve principally
as a prudential yardstick for supervision purposes, not
as a monetary policy tool. They can limit the growth of
banking system balance sheets, but they are not a
very flexible instrument for monetary policy when com­
pared with open market operations that affect reserves
availability.
And there are other problems. Definitions of accept­
able bank capital vary across countries, and the capitalassets ratios on which different national banking sys­
tems operate span a wide range. Unlike the United
States, many foreign banking systems have a large
public-sector element, which raises a question of
whether infusions of new capital would be made on an
equivalent commercial basis in all countries. Finally,
under a system where capital is the effective constraint
on balance-sheet growth, banks might face an incentive
to add to earnings by taking on riskier loans, since

18 FRBNY Quarterly Review/Spring 1982


institutions that show higher earnings growth might be
able to issue new equity at higher price-earnings
ratios.
Impose a mixed regulation system. These difficulties
bring up the question of whether agreement could be
reached on a mixed system of regulations where some
countries place reserve requirements on the Eurooperations of their banking systems and others impose
capital-assets ratios. Can such a system be designed
that would limit the growth of the Euromarket but not
distort Euromarket shares among different banking
systems simply because different types of regulations
are used? One theoretical study answers yes.11 At any
time there are levels of reserve requirements and of
capital-assets ratios that do not distort market shares.
However, the relative value of those ratios must be
changed continually in response to changes in the
cost of capital to avoid a distortion of market shares.
Such a system would be complicated to design and
run, perhaps too complicated to be practical. If interest
payments on required reserves were allowable, vari­
ations in that rate of interest could be used as a tool
to keep an equitable cost structure in the face of
varying capital costs. Of course, such a mechanism
runs up against the familiar objections to paying inter­
est on reserves.
Even an international agreement, of whatever de­
sign, is subject to the criticism that nonagreeing bank­
ing systems would be at an advantage and would
take over business. However, if an agreement were
broadly enough based to cover the major international
banking countries and if lender-of-last-resort assistance
were not available to nonagreeing banking systems
(as would surely be the case), the capability of those
banks to take over any significant part of the market
could be limited. Highly capitalized banks operating
outside the agreeing countries would be the biggest
loophole.
Increase the perceived risk of the Euromarket. A
final approach would be to increase the perceived
relative riskiness of the Euromarket, making Eurodollar
deposits less attractive for any given yield differential.
In practice, this would involve limiting the guarantee
of lender-of-last-resort assistance to the Euromarket
in a way that would have a convincing effect on market
views of risk. Obviously, such a step is drastic. Lim­
iting lender-of-last-resort support for the Euromarket

11 Stephen E. Usher, “ A Mixed Policy Approach to Euromarket Regula­
tion” , Federal Reserve Bank of New York Research Paper No. 8002
(February 1980).

would have a large one-time effect on perceptions and
would shrink the size of the market. It would not,
however, clearly improve the monetary control prob­
lem stemming from shifts of funds between the over­
seas and domestic sectors.

Conclusion
All the options considered have drawbacks as well as
points in their favor. What, then, is the most sensible
line to follow? No single approach w ill provide an
entirely satisfactory solution; it is best to try to make
small progress on many fronts. From the U.S. perspec­
tive, an international agreement on Eurocurrency re­
serve requirements remains an attractive approach to
a solution of the monetary control problem. But, to
be practical, such an agreement would have to be
structured more carefully with differences among na­
tional banking systems in mind. It would be useful to
study further the prospects for an international agree­
ment on a mixed system of regulations to see if a
relatively simple arrangement could be worked out
that would be roughly equitable. A reason, though not
the only one, for the failure to agree on Euromarket
reserve requirements was that the proposal was




geared principally to U.S. concerns. Trying to design
an agreement that would have short-run monetary con­
trol benefits for the United States while addressing the
interests and concerns of other countries would be
helpful. It would build on the basically sympathetic
view that some foreign authorities have of an inter­
national agreement on Euromarket regulation.
Other avenues are open. Reserve requirements on
domestic nonpersonal time deposits could be phased
out when appropriate. Taking systematic account of
Euromarket developments could play a greater role
when deciding whether to aim high or low in the
monetary aggregates target ranges. Clearly, work
should continue on trying to determine the extent to
which Eurodollars substitute for domestic instruments
counted in the aggregates. Finally, the somewhat try­
ing multilateral efforts to obtain better and more timely
data should go on. While this item may be the least
controversial, it is not the least important, since the
inadequacies of current data prevent specific answers
to many of the important empirical questions about
the role that Eurodollars play and limit the extent to
which changes in the Euromarket can be factored into
short-run policy decisions.

Edward J. Frydl

FRBNY Quarterly Review/Spring 1982

19

Mortgage Designs, Inflation,
and Real Interest Rates
The economic trends of the last decade have dimin­
ished the usefulness of the fixed-rate mortgage. High
interest rates, substantial inflation, and the variability
of both have created problems for borrowers and
lenders. Prospective mortgage borrowers face pay­
ment obligations that have been raised dramatically
by the rise in mortgage rates. Lenders, on the other
hand, have experienced large reductions of net worth
as the rise in interest rates has reduced the market
value of their portfolios of long-term fixed-rate loans.
Both sides of the mortgage market could benefit from
the use of a different mortgage design.1 Each of the
alternatives to the fixed-rate mortgage has its advan­
tages and disadvantages. This article reviews the eco­
nomics of the fixed-rate mortgage and alternative
designs, focusing on how each one deals with the
problems of housing finance in the present environment.
On the lending side of the market, the major re­
sponse to the developments of the last several years
has been the adoption of mortgage designs that per­
mit rate adjustments. Such loans protect lenders from
the risk of unanticipated changes in interest rates. But
borrowers may face the same difficulties with adjust­
able mortgages that they have had with fixed-rate
loans. By itself, the rate-adjustment feature does not
i New mortgage designs are not the only method of coping with the
problems of the fixed-rate mortgage. Mortgage investors might resort
to hedging in the futures market, for example, to reduce the interest
rate risk associated with a portfolio of long-term fixed-rate assets.
Alternatively, mortgage investors might benefit from the establishment
of an insurance facility in which they could buy protection from these
risks. Either of these devices could be used to support continued
lending in fixed-rate loans, provided there were institutions or indi­
viduals (other than the lender) willing to accept the risks.

20

FRBNY Quarterly Review/Spring 1982




reduce a mortgage borrower’s payment burden. Indeed,
the adjustable mortgage presents borrowers with the
additional problem of an unknown series of future
payments.
There are two ways in which the mortgage contract
can be altered to protect lenders from interest rate
risk while at the same time presenting borrowers with
initial payment requirements smaller than those of
the long-term fixed-rate loan. One is the use of
inflation-linked contracts, or indexed loans. In con­
trast to adjustable mortgages, on which rates are
periodically raised or lowered to reflect changes in
(nominal) market yields, indexed loans have their out­
standing balances raised or lowered to reflect move­
ments in some measure of prices. The interest rate
on an indexed mortgage would not contain an inflation
premium. Thus, in an inflationary environment, an in­
dexed loan would impose a substantially smaller pay­
ment burden on mortgage debtors in the early years
of a loan agreement. An alternative approach would
be to reduce required mortgage payments of ad­
justable loans during the early years of the loan by
adopting more flexible schedules for the repayment
of loan principal. In some cases, the two schemes are
approximately equivalent. Both designs2 achieve the
twin goals of smoothing the borrower’s real payment
burden and allowing lenders to adjust mortgage re­
turns in response to changes in economic conditions:
indexed mortgages respond to inflation, while adjust2 These and other mortgage designs are discussed at length in New
Mortgage Designs tor Stable Housing in an Inflationary Environment,
a collection of papers edited by Franco Modigliani and Donald Lessard
(Federal Reserve Bank of Boston Conference Series No. 14).

able mortgages reflect changes in nominal interest
rates.
When variations in nominal interest rates are due
largely to variations in (actual and expected) inflation,
the two main alternatives to the standard mortgage
design serve the purpose of reducing or elim inating
inflation-induced risks and distortions. But, recently,
higher and more volatile real interest rates have be­
come im portant factors in the mortgage market. Each
of these mortgage designs leaves one or both sides of
the m arket exposed to the risk of variations in the real
rate of interest. Moreover, when real interest rates
remain at high levels, neither of the alternatives to
the long-term fixed-rate loan can reduce the costs of
homeownership.

Shortcomings of the fixed-rate mortgage
The standard lending instrument in the housing finance
industry has been the long-term fixed-rate m ortgage.3 It
is characterized by equal periodic payments. Part of
each payment is interest on the loan, calculated by
applying the contract rate of the loan to the unpaid
balance. The remainder of each payment constitutes
repayment of principal, or amortization of the loan.
The term of the loan— the length of the amortization
period— can be set at any number of years, but o rig i­
nal m aturities of twenty, twenty-five, and th irty years
are commonly used.
M onthly payments on a mortgage loan are deter­
mined by the size of the loan, the contract rate, and
the length of the am ortization period. Other things
remaining equal, the m onthly payment required to
amortize a mortgage loan is higher with a higher con­
tract rate, a shorter am ortization period, or a larger
loan amount. Although all the monthly payments on a
fixed-rate loan are fo r the same (nominal) dollar
amount, their allocation between principal and interest
varies considerably over the life of the loan. Early pay­
ments are devoted alm ost entirely to the payment of
interest. But, as the relatively small repayments of
principal accumulate and the loan balance declines,
the proportion of the fixed payment that needs to be
allocated to interest declines, and amortization pro­
ceeds more rapidly. Interest payments are tax deduct­
ible. Thus, the increase in the proportion of each
payment that is allocated to repayment of loan principal
raises the aftertax cost of the mortgage.

The effects of inflation
In the absence of inflation, the level payments required
to repay a standard mortgage loan would impose a
constant real payment burden on the borrower. This
burden is illustrated by the solid horizontal line in the
upper panel of the chart. With a stable price level,
the 4 percent contract rate on the loan fo r which
these payments are made produces a real return of
4 percent. The amount of the loan is $50,000. The
m onthly payments are $238.71.
But, when inflation and interest rates rise in tandem,
the real cost of loan repayment is redistributed, with
a higher real cost in the early years of the loan being
offset by a reduced real cost in later years. When
lenders expect inflation to continue throughout the
life of a fixed-rate loan, they must raise the rate at
w hich such loans are offered by the expected rate of
inflation. The inflation premium, as this rate increase

3 In June 1981, for example, Federally insured savings and loan asso­
ciations held $430 billion in mortgage loans on one- to four-family
residential properties, of which less than $35 billion was subject to rate
adjustment. If recent trends continue, however, the fixed-rate loan may
be the exception, not the rule. Roughly one third of new conventional
mortgage commitments made in the last half of 1981 were for adjustable
loans.




FRBNY Quarterly Review/Spring 1982

21

is called, compensates lenders for the decline in pur­
chasing power of their nominally fixed debt claims.
The effects of the inflation premium on mortgage
borrowers are substantial, as can be seen by compar­
ing the real values of mortgage payments for several
loans that produce the same real return to the investor.
The loans, all for $50,000, differ only in the size of the
inflation premium contained in their nominal rates.
They all produce a 4 percent real return. An 8 percent
loan (associated with expectations of 4 percent infla­
tion) requires monthly payments of $366.88, while the
payments for the 12 percent loan (with expectations of
8 percent inflation) and the 16 percent loan (at 12 per­
cent inflation) are $514.31 and $672.38, respectively.
While these payment obligations are fixed in nominal
terms for the life of the mortgage, the cumulative
effect of inflation reduces their real values as time
progresses. The real value of the payments on the
8 percent loan, for example, declines by 4 percent per
year, while that of the payments for the 16 percent
loan declines by 12 percent per year. In general, higher
inflationary expectations produce a higher initial real
and nominal payment requirement. The real values of
'these payments, however, decline more rapidly the
higher the rate of inflation. The effect of inflation on
the real value of the remaining mortgage balance is
similar. As shown in the lower panel of the chart, in­
flation increases the rate at which the real value of
the mortgage debt is reduced.
Some analysts4 have described these features of the
fixed-rate mortgage in an inflationary environment as
the mislabeling of principal and interest components
of the level monthly payment. In the case of the
12 percent loan, for example, the real value of the out­
standing loan balance at the beginning of the second
year is 8 percent less than it would have been without
inflation. But this reduction of the value of the lender’s
asset has been offset by the payment of an 8 percent
inflation premium in addition to the 4 percent real
return on the original balance. Since the 8 percent
inflation premium is a deductible interest expense, the
fixed-rate mortgage borrower receives a tax subsidy
for what is essentially the repayment of principal.
The large payments produced by high nominal rates
give rise to the “ affordability problem” — the inability
of many households to qualify for mortgage loans.
Using customary underwriting standards, the annual
income required for approval of a mortgage loan ap­
plication rises proportionately with the monthly pay­

4 See, for example, Milton Friedman, "How to Save the Housing
Industry” , Newsweek (May 26,1980), page 80. An earlier, more formal
treatment is in D. Tucker, “ The Variable-Rate Graduated-Payment
Mortgage” , Real Estate Review (Spring 1975).

Digitized for
22FRASER
FRBNY Quarterly Review/Spring 1982


ment. As shown in the chart, an increase in the ex­
pected rate of inflation from zero to 8 percent, assum­
ing a 4 percent real return is to be obtained, raises the
income threshold by 115 percent. (This is the per­
centage increase in the required monthly payment
associated with a move from a 4 percent loan to a
12 percent loan.) As payment requirements have in­
creased faster than household incomes, there has been
a decline in the proportion of households able to
qualify for mortgage loans.5 In recent years, however,
the relaxation of loan approval standards has mitigated
the impact of rising mortgage rates. Thus, the rule of
thumb that mortgage and other housing costs should
be less than 25 percent of household income has given
way to current limits that approach 40 percent at some
lending institutions.
Interest rate risks
The fixed-rate mortgage contract also suffers from
its inability to protect lenders from interest rate risks.
Until recently, this sort of risk was associated with the
occurrence of higher than expected inflation rates. But
the rate of inflation has declined fairly steadily since
early 1980, while nominal interest rates have remained
high. This more recent experience has awakened bor­
rowers and lenders alike to the existence of real inter­
est rate risks.
The difficulties caused by unanticipated inflation
are easily explained. In the examples discussed so
far, it has been assumed that inflation turns out to be
what had been expected when the mortgage rate
was set. But the actual rate of inflation experienced
during the life of the mortgage loan may be dif­
ferent from the inflation premium included in the
nominal mortgage rate. When inflation exceeds this
premium, borrowers benefit from a faster than antici­
pated reduction of the real value of payments on the
mortgage loan. And, when the actual rate of inflation
falls short of the inflation premium, borrowers are
faced with a slower than expected reduction of the
real value of mortgage payments. Lenders face the
opposite results, benefiting when actual inflation is
less than the inflation premium and losing when actual
inflation exceeds expectations.
The fixed-rate mortgage also leaves borrowers and
lenders exposed to the risk of variations in the real
rate of interest. This risk may arise in conjunction
with— or apart from— the failure of actual inflation to
match expectations. Assume, for example, that a mort­
gage loan was made at a 15 percent contract rate

5 It should be noted, however, that an increase in the real rate of interest,
with the inflation premium unchanged, would have the same effect,
reducing the proportion of qualifying households.

when both borrower and lender expected inflation of
10 percent per year for the entire term of the loan.
They implicitly agreed to a real interest rate of 5 per­
cent. Even if their inflationary expectations are correct
— that is, if prices rise by 10 percent per year— the
prevailing nominal (and hence real) rate of interest
might rise (benefiting the borrower) or fall (providing
the lender with a windfall). Alternatively, with the
nominal level of interest rates constant, there could
be an increase or decrease in the rate of inflation
expected to prevail in the economy, reducing or in­
creasing the real cost of the long-term mortgage loan.
The long-term fixed-rate mortgage offers protection
from neither real nor inflation-based interest rate risks.
Thus, for very different reasons, mortgage borrowers
and lenders face strong incentives to find alternatives
to the standard mortgage contract. Borrowers’ primary
concern is to minimize the cash flows required to
repay mortgage debt, particularly in the early years
of the loan. Lenders, on the other hand, are con­
cerned mainly with the nominal yield flexibility of the
mortgage instrument. For both groups, the long-term
fixed-rate mortgage is largely incapable of coping
with interest rate risks, whether they are due to
changes in inflationary expectations or to changes in
the real rate of interest.4

Alternative mortgage designs
The mortgage designs that have been used or pro­
posed as replacements for the fixed-rate loan are
variants or combinations of two basic alternatives—
adjustable and indexed loans. An adjustable mortgage
is a loan agreement under which the contract rate,
monthly payments, and remaining maturity of the loan
all may be changed in response to the movement of
a predetermined interest rate. These changes in the
mortgage loan are made at the end of each adjustment
period. (In practice, adjustment periods have been as
short as six months or as long as five years.) The ad­
justable mortgage can thus be viewed as a series of
short-term loan agreements based on a single longer
amortization period or as a single long-term loan with
provisions for rate adjustments. Several adjustable
mortgage designs have been introduced in recent
years (Box 1).
As a response to inflation-induced interest rate vari­
ations, the indexed mortgage seems to be fundamen­
tally different from the fixed-rate loan and its adjust­
able variants. The contract rate on an indexed loan
*The single exception is the borrower's ability to refinance mortgage
debt at lower nominal rates. Refinancing is sensible when the present
value of the reduction in mortgage payments exceeds the trans­
actions costs of the new mortgage loan.




contains no inflation premium and is, therefore, lower
than the nominal interest rate in an inflationary period.
This rate is not subject to periodic adjustment. In­
stead, the outstanding balance of an indexed loan is
periodically raised or lowered in line with movements
in some measure of housing prices or the general
level of prices. If the series used to adjust an indexed
loan is an accurate measure of inflation, and these
adjustments are made frequently enough, the real
value of mortgage payments will be constant through­
out the life of the loan.7 While the basic features of an
indexed mortgage loan are fairly simple, the selection
of an appropriate price index might pose a problem.
Among the candidates for use in adjusting the remain­
ing balance on indexed loans are such general mea­
sures of price changes as the consumer price index
or the gross national product price deflator, nationwide
measures of housing prices, similar measures aggre­
gated on a regional or local basis, and individual
house prices.
There are a number of factors that might impede the
widespread introduction of the indexed mortgage con­
tract. Chief among these is the unwillingness of finan­
cial institutions to hold indexed assets that are not
hedged by indexed liabilities.8 It is a useful reference
device, however, because it eliminates the distortions
that characterize a fixed-rate mortgage in an infla­
tionary environment.
Suppose, for example, that lenders desire a real
return of 4 percent and expect inflation to proceed at
a 12 percent rate over a thirty-year period. Under
these conditions, long-term fixed-rate loans and adjust­
able loans would be offered at a 16 percent rate and
indexed loans would be offered at 4 percent. In the
first year of a thirty-year loan for $50,000, payments
on the standard loan and the adjustable loan would
be $672.38, while those on an indexed loan would be
$238.71— roughly 35 percent of the payments on the
competing fixed-rate loan. The payments on the fixedrate loan would remain at $672.38 throughout the life
of the loan. But, if the price index rose by 12 percent
in the first year of the indexed loan, its balance would
be raised (from $49,119.45 to $55,013.79) at the end of
the first year. The monthly payments on the indexed

7 In practice, these adjustments might be made at annual intervals,
creating the possibility of significant deviat;ons from a constant real
payment burden.
8 In New Mortgage Designs for Stable Housing in an Inflationary
Environment, several authors advocated the issuance of indexed
deposits at commercial banxs and thrift institutions. More recently,
Michael Lovell has proposed indexed annuities, which would be the
appropriate liability hedge for a different group of mortgage investors.
See “ Unraveling the Real-Payments Twist", Brookings Papers on
Economic Activity (1981:1).

FRBNY Quarterly Review/Spring 1982

23

Box 1: Adjustable Mortgage Instruments
In the last three years, Federal and state regulators
of mortgage lending institutions have authorized a
variety of adjustable mortgages. The successive designs
have allowed lenders increasing discretion in selecting
the features of adjustable loans. They also have relaxed
or removed the limits on interest rate changes that can
be made on adjustable loans.
Table 1 summarizes the features of five different
mortgage designs authorized by the Federal Home Loan
Bank (FHLB) Board, the agency that regulates Feder­
ally chartered savings and loan associations. The first
four columns describe different kinds of adjustable
mortgages. The last column describes a hybrid design,
the shared-appreciation loan.
The first design listed in the table, the California
variable-rate mortgage, allowed Federally chartered
thrift institutions in that state to issue loans with fea­
tures identical to those being offered by state-chartered
lenders in the state. Under these regulations, the con­
tract rate on an outstanding loan could be changed at
six-month intervals in response to changes in the aver­
age cost of the funds in the eleventh FHLB district.
Limits on the rate adjustments were imposed to protect

mortgage borrowers from sudden large increases in
required mortgage payments. The maximum allowable
rate increase was set at 50 basis points per year, and
a limit of 250 basis points was imposed for the cumu­
lative total of rate increases. To assure the continued
availability of long-term fixed-rate loans, lending institu­
tions were barred from issuing more than 50 percent
of their mortgage loans in the variable-rate instruments.
In the California mortgage design and other early
mortgage plans, limits on rate adjustments were viewed
as an important consumer protection device. A bor­
rower that signed a variable-rate contract with an
initial interest rate of 8 percent, for example, was cer­
tain that the rate on the loan could never exceed
10.5 percent. The limits on rate increases, however,
could have the effect of converting a variable-rate loan
to a fixed-rate loan after the maximum interest rate
increases have been applied. Not surprisingly, subse­
quent designs have included higher limits on interest
rate adjustments, expanding the range of interest rate
risk that could be assigned to mortgage borrowers.
The California and nationwide variable-rate mort­
gages each called for rate adjustments tied to move­

Table 1: New M ortgage Instruments Authorized by the Federal Home Loan Bank Board
California
variable-rate
mortgage
(VRM)

Nationwide
variable-rate
mortgage
(VRM)

Index ..................................

Average cost of
funds, San Fran­
cisco FHLB
district

Average cost of
funds, all FSLIC
insured savings and
loan associations

FHLB average
contract rate on
existing homes

Any index that is
“ readily verifiable”

Net appreciation is
based upon net
sales price
appraisal

Adjustment period ...........

6 months

12 months

3, 4, or 5 years

Any period up to
5 years

10 years or less

50 basis
points per year

50 basis
points per year

50 basis
points per year

No limitations

40 percent of net
appreciated value

Life of lo a n ...................

250
basis points

250
basis points

500
basis points

No limitations

Effective date ...................

January 1979

July 1979

April 1980

April 1981

September 1980

Minimum adjust­
ment of 10 basis
points
50 percent
portfolio limitation
Authorized for
Federally chartered
thrift institutions
in California

Maturity exten­
sion up to one third
of original maturity
50 percent
portfolio limitation

No maturity
extensions

Replaced FHLB
regulations for
VRMs and RRMs
Negative amorti­
zation without limit
30-year loan term
may be extended
to 40 years

Guaranteed (and
mandatory)
refinancing of re­
maining balance
and contingent
interest at end of
appreciation
period

Instrument

Maximum adjustments:
Individual .....................

Renegotiable-rate
mortgage
(RRM)

Adjustable-rate
mortgage

Sharedappreciation
mortgage

Other features or

FSLIC = Federal Savings and Loan Insurance Corporation.

Digitized for
24FRASER
FRBNY Quarterly Review/Spring 1982


Box 1: Adjustable Mortgage Instruments (continued)
Table 2: Adjustable M ortgages in the Secondary M arket
Maximum
interest rate
adjustmen!
(percent)

Interest
rate
index*

Interest
rate
adjustment
period

Payment
adjustment
period

FHLB*
FHLB*

6 months
6 months
1 year
2 1/2 years
21/2 years
5 years
1 year
1 year

6 months
3 years
1 year
2'h years
2 Vs years
5 years
1 year
1 year

—
—
2

Federal Home Loan Mortgage Corporation
1 ..........................................
FHLB*
FHLBrf:
2 .......... .............................

1 year
1 year

1 year
1 year

2

Plan

Maximum
payment
adjustment
(percent)

Federal National Mortgage Association
2
3
4
5
6
7
8

t ........
t ........
t .........
...........
...........
........... .............................
.............................
..

7 Vs
—
—
—
5

—
7 Vs
18%
—
—
—
—

~
* Treasury yields for Federal National Mortgage Association plans 1 through 6; Federal Home Loan Bank Board
conventional mortgage rate for others,
t Negative amortization permissible, so long as the loan balance does not exceed 125 percent of the
original loan amount.
$ FHLB average contract rate on existing homes.

ments in the average cost of funds at savings and
loan associations. In subsequent regulations, the FHLB
authorized the use of a current mortgage rate as an
index, reflecting the concerns of many lenders that
yields on outstanding mortgages should be kept in line
with those of newly originated loans.
In principle, the adjustable-rate mortgage authorized
by the FHLB Board satisfies both concerns that seemed
important to lenders. It imposes no limits on the size
of contract rate adjustments, satisfying lenders’ con­
cerns with yield flexibility. In addition, the regulations
for adjustable-rate mortgages do not specify a par­
ticular index for contract rate adjustment. The rules
allow lenders to choose virtually any interest rate
series as the basis for mortgage rate adjustments.
The regulations for adjustable-rate mortgages may
provide substantial benefits for mortgage borrowers as
well. They permit, but do not require, the use of nega­
tive amortization. This provision allows lenders to
reduce the increases in monthly payments associated
with any given contract rate increase. Similarly, the
regulations permit lenders to extend the remaining
maturity of a loan, thus providing another means of
reducing required increases in monthly payments.
In the short run, the use of adjustable mortgages
promises to benefit consumers by increasing the w ill­
ingness of lenders to provide mortgage loans. In­




deed, a secondary market for adjustable-rate loans has
already materialized. In July 1981 both the Federal
National Mortgage Association (FNMA, or Fannie Mae)
and the Federal Home Loan Mortgage Corporation
(FHLMC, or Freddie Mac) announced plans to purchase
adjustable-rate mortgage loans in the secondary mar­
ket. Fannie Mae will accept eight different loan designs,
while Freddie Mac will buy only two. Table 2 sum­
marizes the main features of the acceptable loan de­
signs. Both agencies announced that nonconforming
loans will be considered for purchase on a case-bycase basis.
FNMA will buy loans that have adjustment periods
ranging from six months to five years. Many of the
FNMA plans include limits on interest rate changes
and monthly payment increases. Four of the eight
plans allow for negative amortization. In none of these
cases, however, will the loan balance be allowed to
exceed 125 percent of the original loan amount.
The designs that are acceptable to Freddie Mac are
identical to two of the Fannie Mae options. Both use
the FHLB mortgage-rate index and have annual ad­
justment periods. Unlike most of the other plans that
FNMA will accept, both of the plans approved for
FHLMC purchase prohibit negative amortization.
Catherine S. Ziehm
Marcos T. Jones

FRBNY Quarterly Review/Spring 1982

25

loan would also rise by 12 percent, to $267.36. This
larger nominal amount, however, would have only the
same purchasing power as the original payment of
$238.71.
If in subsequent years the price index continued to
rise at a 12 percent annual rate, the outstanding bal­
ance and monthly payments on the indexed loan would
continue to be raised by 12 percent each year. This
pattern of price increases would produce large nomi­
nal payment requirements— $7,151.73 per month in the
thirtieth year, for example. Presumably, however, a
borrower’s nominal income would also have risen in
line with the price level, allowing these large nominal
payments to be handled as easily as the initial pay­
ments of $238.71.9
With an annual adjustment period for the adjustable
mortgage loan, payments in the second and subse­
quent years would depend on the change in the in­
terest rate to which the loan was tied. Thus, changes
in market conditions— whether due to a change in
the inflation premium or in the underlying real rate of
interest— would be transmitted through the mortgage
contract.
The treatment of inflation and risk
The differences in payment schedules reflect differ­
ent arrangements for the sharing of interest rate risk.
At one extreme, the fixed-rate loan saddles mortgage
lenders with the entire risk of variations in nominal
rates. Because of the asymmetry established by the
borrower’s option to refinance, changes in nominal
interest rates can work only to the disadvantage of
lenders. Moreover, since the fixed-rate loan can as­
sign only nominal interest rate risks, it exposes both
borrowers and lenders to the risk of offsetting changes
in the real rate of interest and the inflation premium.
At the other extreme of risk-sharing arrangements,
adjustable mortgages assign all the risk of variations
in nominal rates to borrowers. Like fixed-rate loans,
they entangle the risks of real and inflation-based
variations in interest rates. Thus, adjustable loans
guarantee lenders that their mortgage yields will al­
ways reflect the prevailing level of real interest rates
as well as the current inflation premium.
In contrast to fixed-rate loans, indexed mortgage
contracts disentangle the real and inflationary com­
ponents of nominal interest rate risk. They assign all
the risk of inflationary developments to the borrower,
while forcing lenders to bear the risk of variations in
the real rate of interest. In an environment of rapid
and variable inflation, perfectly indexed contracts are
? This is too generous a presumption for those households whose
incomes fail to keep pace with inflation.


26 FRBNY Quarterly Review/Spring 1982


economically equivalent to fixed-rate loans in a world
of stable prices.
The three designs thus have very different implica­
tions for risk sharing. But all of them accommodate
inflation. The indexed mortgage, however, has two
distinct advantages over the fixed-rate and adjustable
designs. First, since it allows the inflation adjustment
to be based on the price changes experienced during
the life of the contract, it does not require borrowers
and lenders to commit to a specific inflation forecast.
In addition, since its payment schedule is based only
on the real component of the prevailing level of inter­
est rates, it avoids the inflation-induced distortions—
and the associated affordability problem— of the fixedrate loan.
Adjustable mortgages suffer from some of the basic
shortcomings of the standard fixed-rate loan. During any
particular adjustment period, the payments on an adjust­
able loan are identical to those of a long-term fixed-rate
loan with the same contract rate, outstanding balance,
and remaining maturity. Since the contract rate on an
adjustable loan is a nominal rate, the payments re­
quired for its amortization are subject to the same
inflation-induced bias. In fact, if there is no change in
the interest rate to which an adjustable mortgage is
tied, the associated payments would be identical (in
nominal terms) to that of a fixed-rate loan. Moreover,
if the real and inflationary components of this constant
rate on the adjustable mortgage do not vary over time,
the real value of the series of payments would also
be identical to that of a fixed-rate loan made at that
rate. Under these circumstances, adjustable mort­
gages would not alleviate the inflation-induced distor­
tion of the mortgage borrower’s payment burden .
From the lender’s point of view, the attractiveness
of adjustable loans may be deceptive. While such loans
offer lenders protection from the risk of variations in
interest rates, they may raise the default risk of mort­
gage assets. This default risk is the analogue of the
affordability problem: just as prospective mortgage
borrowers can be disqualified by rising payment re­
quirements, holders of adjustable mortgage loans fac­
ing substantially increased payment requirements might
be forced into delinquency and default.
An approximation of the indexed loan
The adjustable mortgage contract can be respecified
in a manner that redistributes the allocation of interest
rate risks and avoids the possibly severe initial pay­
ment requirements of the fixed-rate design. Federal
regulations for adju stab Ie-rate mortgages include two
provisions that would allow lenders to reduce or to
eliminate the increase in monthly payments associated
with an increase in the contract rate of the loan. One

of these provisions permits negative amortization.10
For intervals as long as five years, mortgage lenders
may set the monthly payment on a loan below the
amount required to pay interest on the outstanding
balance. The difference between these amounts is
accumulated as an increase in the loan’s outstanding
balance— hence the term negative amortization.
When negative amortization is used, the size of re­
quired payments is independent of the rate of interest
that is applied to the outstanding loan balance. As a
result, lenders may be able to increase the proportion
of prospective mortgage borrowers that qualify for
mortgage loans by maintaining low payment require­
ments. Under these arrangements, the loan balance
would be increased by the difference between actual
payments and those required by strict application of
the mortgage contract rate.
In an inflationary environment, the results could be
qualitatively similar to the use of an indexed mortgage.
The real interest rate that would apply to an in­
dexed loan would be significantly below the nominal
rate on a competing fixed-rate loan, producing much
lower monthly payments. Similarly, the monthly pay­
ments on an adjustable loan would be reduced sub­
stantially by the negative amortization feature. The
outstanding balance of an indexed loan would be
raised periodically to reflect increases in the chosen
measure of inflation. In a similar fashion, the out­
standing balance of an adjustable loan with negative
amortization would be raised periodically to reflect the
difference between actual and required payments. But,
when the pretax cash flows involved in the two loan
designs are similar, the deductibility of interest pay­
ments— including deferred interest when it is paid—
10 The other provision allows the remaining maturity of an outstanding
loan to be extended, so long as the entire term of the loan does not
exceed forty years. After the first year of a thirty-year adjustable-rate
mortgage, for example, the remaining maturity can be increased from
twenty-nine to thirty-nine years.




would make the adjustable loan less costly on an
aftertax basis (Box 2).

The outlook
The economic characteristics of indexed mortgage
loans and adjustable loans with negative amortization
can be similar. The difference in the mechanisms they
employ to reduce the risks and distortions of inflation
are more apparent than real. In comparison to the
standard fixed-rate loan, however, both of these de­
signs reduce the cash receipts of mortgage lenders
in the early years of a mortgage loan. In view of the
sizable losses they have incurred in recent years, it
may be unreasonable to expect mortgage lenders
quickly to exploit the negative amortization feature to
the extent required to replicate the indexed contract.
The preceding analysis, however, underscores the
point that the more fundamental problem in the mort­
gage market may be the persistence of high real rates
of interest. In markets of all kinds, high real rates of
interest discourage leveraged purchases of long-lived
assets by raising financing costs {e.g., the cost of bor­
rowed money) and opportunity costs (e.g., the purchas­
ing power of foregone interest earnings). New mort­
gage designs may remove the inflation-induced distor­
tions that have disrupted the mortgage market. But, if
high real rates of interest persist, they will continue
to encumber the housing market.
Beyond the immediate future, there is a more san­
guine prospect for the allocation of interest rate risks.
With sufficient flexibility in the construction of pay­
ment schedules— that is, with negative amortization—
adjustable mortgages permit the separation of real and
inflation-induced interest rate risks. The direction of
recent changes in the design of mortgage contracts
suggests a reasonable allocation of these risks, with
borrowers absorbing the risk of variable inflation, while
lenders— in their basic role as financial intermediaries
— absorb the risk of variations in real interest rates.

Marcos T. Jones

FRBNY Quarterly Review/Spring 1982

27

Box 2: Cash Flows and Tax Consequences
For the sake of simplicity, the analysis in the text of
the article ignores the tax treatment of mortgage debt.
The deductibility of interest payments reduces the bor­
rower’s cost of debt repayment in all the mortgage
designs. In the cases of adjustable and indexed loans,
these arrangements mean that the tax authorities absorb
some of the impact of increases in interest rates or
the price level. Indeed, the sensitivity of household
aftertax costs to changes in interest rates or the price
level is a declining function of the marginal tax rate.
Lenders face an additional complication. When taxes
are paid on interest earnings accrued (rather than
interest earnings received), negative amortization
schemes confront lenders with taxable incomes that
exceed their interest receipts. Thus, accrual-basis
lenders have a strong incentive to avoid the use of
loan designs that involve negative amortization.
Consider a twenty-year mortgage loan for $50,000.
The four panels of Table 3 illustrate the cash flows and
aftertax costs associated with each of four agreements
that might be used to effect the transaction.1 At the
time any one of these contracts is written, the prevailing
fixed-rate mortgage rate is 15 percent and includes
a 9 percent inflation premium. The variations in interest
rates that are assumed to follow are all due to changes
in inflationary expectations. The real before-tax interest
rate remains at 6 percent.
Two measures of the aftertax cost of the loan appear
in Columns 5 and 6. They apply to borrowers with
marginal tax rates of 50 and 20 percent, respectively.
Each is calculated as the sum of interest payments
(net of tax benefits) and amortization. Since loan re­
payment is actually a form of saving, these figures
overstate the economic cost of the loan payments.
Fixed-rate mortgage
In the simplest case, equal annual payments of
$7,988.07 (Column 1) amortize the loan over its twentyyear term. In the first year, $7,500 of the payment is
allocated to interest (0.15 x $50,000, Column 2), leaving
only $488.07 for the repayment of principal. By the

1 For illustrative purposes, all the figures in the table are based
on a schedule of annual payments made at the end of each year.
Complete tables and a mathematical summary of the calcula­
tions are available from the author on request.

28

FRBNY Quarterly Review/Spring 1982




twentieth year, however, only $1,041.92 of the payment
is allocated to interest.
Adjustable mortgage
In its unconstrained form, the adjustable mortgage is
equivalent to a series of one-year loans made at the
values of the reference rate listed in Column 7. In the
example provided, the reference rate rises to 21 percent
in the third year of the loan, making the required pay­
ment one-third more than the first annual payment.
Aside from the irregularity of the series of annual pay­
ments and relatively minor changes in the amortization
pattern, the adjustable mortgage shown here maintains
all the cash flow and tax features of the fixed-rate loan.
Adjustable mortgage with negative amortization
Any number of schemes can be devised to achieve
negative amortization. One such method establishes two
mortgage rates— a payment rate used to calculate
periodic payments and a debit rate used to compute
interest due on the ioan. Whenever the payment rate is
less than the debit rate, negative amortization occurs.
The figures in panel C arise from such a dual-rate
scheme. The payment rate is set at a constant 6 percent,
while the debit rate is the hypothetical reference rate.
The tax consequences of the negative amortization
scheme are somewhat different from those of the first
two designs. Loan payments are allocated first to cur­
rent interest {i.e., interest accrued during the period),
then to deferred interest, and finaljy to principal. As a
result, for each year in which the loan balance remains
above the original $50,000, the entire loan payment is
tax deductible.
Indexed mortgage
The series of payments and the amortization pattern
of the indexed loan are very much like those for
the adjustable mortgage with negative amortization.
But differences in the composition of loan balance
changes (recall the mislabeling of principal and inter­
est, page 22) have a dramatic effect on the aftertax cost
comparisons. While most of the payments on the
adjustable loan with negative amortization are fully
deductible, only a portion of each payment on the in­
dexed loan qualifies as an interest expense. Thus, in
the mortgage market, the tax code’s treatment of
indexation constitutes an important barrier to the intro­
duction of indexed contracts.

Box 2: Cash Flows and Tax Consequences (continued)
Table 3: Cash Flows and A ftertax Costs in Four M ortgage Designs
Nominal dollar amounts; loan amount is $50,000 and loan term is 20 years
Aftertax
cost
50%

Aftertax
cost
20%

Hypothetical
reference rate (R)
or inflation rate (I)
(7)

Payment

Interest

Amortization

End-ofyear
balance

(1)

(2)

(3)

(4)

(5)

(6)

1
2
3

7,988.07
7,988.07
7,988.07

7,500.00
7,426.79
7,342.60

488.07
561.28
645.48

49,511.93
48,950.64
48,305.16

4,238.07
4,274.68
4,316.78

6,488.07
6,502.72
6,519.55

19
20

7,988.07
7,988.07

1,947.94
1,041.92

6,040.13
6,946.15

6,946.15
0.00

7,014.10
7,467.11

7,598.49
7,779.69

Year

A. Fixed-rate imortgage

1
2
3

7,988.07
9,765.62
10,667.33

7,500.00
9,407.27
10,322.25

488.07
358.35
345.08

49,511.93
49,153.58
48,808.50

4,238.07
5,061.98
5,506.20

6,488.07
7,884.16
8,602.88

R*
0.15
0.19
0.21

8
9
10

6,364.92
5,754.79
6,325.31

4,521.23
3,469.49
4,108.33

1,843.69
2,285.31
2,216.98

43,368.58
41,083.27
38,866.29

4,104.30
4,020.05
4,271.15

5,460.67
5,060.90
5,503.64

0.10
0.08
0.10

19
20

7,170.62
7,106.02

1,350.78
646.00

5,819.83
6,460.02

6,460.02
0.00

6,495.23
6,783.02

6,900.46
6,976.82

0.11
0.10

C. Adjustable mortgage with negative amortization
(3,140.77)
4,359.23
7,500.00
1
10,096.75
(5,334.22)
4,762.52
2
(6,879.20)
5,400.55
12,279.75
3

53,140.77
58,475.00
65,354.20

2,179.61
2,381.26
2,700.27

3,487.38
3,810.02
4,320.44

R*
0.15
0.19
0.21

B. Adjustable mortgage

8
9
10

9,340.25
9,734.75
9,941.72

8,268.63
6,529.17
7,840.91

1,071.62
3,205.58
2,100.81

81,614.65
78,409.07
76,308.26

4,670.13
4,867.38
4,970.86

7,472.20
7,787.80
7,953.38

0.10
0.08
0.10

19
20

21,589.16
24,580.83

4,353.96
2,234.62

17,235.21
22,346.21

22,346.21
0.00

19,412.19
23,463.52

20,718.37
24,133.91

0.11
0.10

O. Indexed mortgaget
1
2
3

4,359.23
4,751.56
5,369.26

3,000.00
3,181.11
3,488.17

1,359.23
1,570.45
1,881.09

53,018.44
58,136.23
64,693.41

2,859.23
3,161.01
3,625.17

3,759.23
4,115.34
4,671.63

I*
0.09
0.13
0.15

8
9
10

9,105.33
9,469.54
9,658.94

4,836.40
4,763.47
4,570.73

4,268.93
4,706.07
5,088.21

79,391.19
76,178.82
73,934.23

6,687.13
7,087.81
7,373.57

8,138.05
8,516.85
8,744.79

0.04
0.02
0.04

19
20

18,747.69
19,685.08

2,062.31
1,114.25

16,685.38
18,570.83

18,570.83
0.00

17,716.54
19,127.95

18,335.23
19,462.23

0.05
0.04

The values of the reference rate in years 1 through 20 are 0.15, 0.19, 0.21,0.21,0.18, 0.13, 0.13, 0.10, 0.08, 0.10,
0.12, 0.14, 0.16, 0.17, 0.15, 0.14, 0.13, 0.12, 0.11, and 0.10.
f End-of-year balances for the indexed loan include an adjustment for inflation. This adjustment is not shown in the table.
t The inflation rate is assumed to be the difference between the reference rate and 0.06.




FRBNY Quarterly Review/Spring 1982

29

Current
economic
developments

Chart 1

I n d u s t r ia l P r o d u c t io n
Percent

Business activity declined further in the first quarter,
and inflationary pressures continued to subside. Inter­
est rates, which had backed up near the end of the
year, continued to rise in January and did not change
significantly through the balance of the quarter. Look­
ing ahead, two main factors are w idely cited to support
a view that a turnaround in econom ic a ctivity w ill
begin by the second half of the year. First, inventory
liquidation appears to be w inding down. Also, dis­
posable incomes w ill receive a large boost in July
from a 7.4 percent increase in social security pay­
ments and a 10 percent reduction of income taxes.
Nevertheless, many believe that whether the economy
can sustain a recovery fo r an extended period of tim e
may depend in large measure on the future course of
interest rates. Despite the improvement in the inflation
outlook and the weakness in the economy, concerns
continued that rates would remain high, in part because
of the Federal budget outlook.

Inventories and the first-quarter decline in GNP

Sources: Board of Governors of the Federal Reserve
System and United States Department of Labor,
Bureau of Labor Statistics.

30

FRBNY Quarterly Review/Spring 1982




In each of the recessions in the postwar period, in­
ventory liquidation has been the prim ary fa cto r in the
decline of gross national product (GNP) in at least one
of the quarters during the recession. Com pletion of the
liquidation has generally occurred near the turning
point in econom ic activity. According to prelim inary
estimates, real GNP declined in the first quarter at
an annual rate of about 4 percent. Industrial produc­
tion plunged in January, as severe weather conditions
interfered with production schedules, and fell back
again in March (Chart 1). This decline in production

facilitated a large runoff of inventories. A ccording to
prelim inary estimates by the Department of Commerce,
a drop in business inventories of $17.5 billion, by itself,
more than accounts for the estimated decline in real
GNP in the first quarter.
If the inventory adjustm ent is nearly over, it w ill re­
move a large negative factor from the measured change
in GNP and may set the stage fo r a recovery in the
second half of the year. Evidence is mounting that
the auto inventory adjustm ent is about over. Stocks
changed little in March. However, retail sales (ex­
cluding autos) were weak throughout the quarter,
declining by approxim ately 4 percent in real terms.
This casts some doubt on w hether the inventory co r­
rection in the nonauto sectors has been completed
as of yet, although the rate of decline should be more
moderate in any event. In fact, even if the reduction
of stocks were to continue but at a slow er rate, it
would represent a positive contribution to GNP growth.

The persistence of high interest rates: January
money growth and budget deficit projections
The prospects fo r a strong and sustained recovery that
w ill last more than a few quarters depends on a num­
ber of factors, ranging from energy prices to business
and consumer response to the recent tax cut. One
of the most im portant factors is the future course
of interest rates. Despite weakness in the economy
and a decline in the inflation rate, nominal interest
rates increased early in the quarter and remained high
throughout. An im portant backdrop to the run-up in
short-term rates early in the quarter was a surge in
the growth of the money stock in December and Jan­
uary. In these two months, M-1 grew at an annual rate
of about I 6V2 percent and, by the end of January,
was well above the upper bound of the target range
(Chart 2). In February and March, M-1 declined slightly
on balance. This helped alleviate some of the fears of a
further rise in rates, although as the quarter ended the
markets began to focus on the prospects of a surge
in money growth in April.
Another sustaining factor for high interest rates, es­
pecially in the interm ediate- and long-term m aturity
areas, has been market concern over the Federal bud­
get outlook. The President’s February budget proposal,
as anticipated, forecast a $100 billion deficit for 1982.
However, fo r 1983 and 1984, the enactment of deficitreduction measures of $56 b illion and $84 billion would,
according to the budget proposal, reduce the deficits to
only about $90 billion and $80 billion, respectively.
Subsequent analysis by the Congressional Budget Of­
fice (CBO) and others suggested that, on the basis of
technical inaccuracies alone, even these deficit figures
m ight be understated by $25 b illion fo r 1983 and $35



Chart 2

M -1 :

L e v e ls a n d T a r g e t s

Billions of dollars

5 .5 %
S

8 .5 %
>
/

/
s

/

/
2 .5 % -

/
/

6.0% i

/

*/

l\

y

y Actual1
^

A/
' r

I i
1 1 1 1 1 1 II 1 1 1 _ u
I 1 1 1 11 1 11
O N D J F M A M J J A S O N D J FMAMJ J A S O N D
1980
1981
1982

1

Source: Board of Governors of the Federal
Reserve System.

billion to $45 billion fo r 1984, and less optim istic eco­
nomic assumptions would raise the number even fu r­
th er .1 It has now become clear that, w ithout additional
spending cuts and tax increases like those contained
in the President’s budget or those proposed by others,
the markets could be faced with financing a 1983 defi­
cit in excess of $180 billion and a 1984 deficit of at
least $220 billion.
Assuming an end to the recession by the second
half of this year, an increase in the deficit in fiscal
1983 during the first year of recovery would not be
w ithout precedent. In five of six recessions in the post­
w ar period, the deficit as a percentage of GNP peaked
after the end of the recession (Chart 3):
• Some tax payments, such as corporate and
individual income tax final payments, are
lagged and, in contrast to w ithheld taxes, show
their greatest response to a recession in the
year follow ing the resumption of econom ic
growth.

1 See “ An Analysis of the President’s Budgetary Proposals for Fiscal
Year 1983” , Congressional Budget Office (February 1982) and state­
ment of James R. Capra before the Senate Committee on the Budget
(March 5, 1982).

FRBNY Quarterly Review/Spring 1982

31

Chart 3

The G overnm ent D eficit as a Percentage of GNP
Percent
7

-2

1950
Shaded areas represent periods of recession, as defined by the National Bureau of Economic Research.
Source: Congressional Budget O ffice , An Analysis of the P resident's Budgetary Proposals fo r Fiscal Year 1983.

• Also fiscal stimulus, in the form of tax cuts
o r discretionary spending increases has usu­
ally been put into place just before or slightly
after the resumption of real growth and con­
tinues to affect the budget figures fo r some
tim e afterward. This factor appears to be part
of the fiscal outlook fo r 1983. For example,
the July cut in individual income taxes w ill re­
sult in an increase in fiscal stimulus, more
than offsetting the net spending cuts enacted
to date.

cline only slightly as a percentage of GNP (as shown
by the President’s budget). It is this pattern that has
been cited by market participants as an im portant fac­
tor sustaining the high level of interest rates. An in­
ability of the Congress and the Adm inistration to enact
changes that would significantly cut the size of the
1983 deficit is not necessarily viewed as an im portant
problem for 1983 per se as it is a signal that the
figures fo r 1984 and 1985 in Chart 3 may become a
reality.

In the past, the deficit as a percentage of GNP gen­
erally continued to rise until real GNP reached its
pre-recession peak. What is different this tim e is that
well into what is supposed to be a recovery period
(1984 and 1985) the d eficit could continue to rise both
in absolute terms and as a percentage of GNP (as
shown by the adjusted CBO baseline in Chart 3).2 At
best, the deficit would rise in absolute terms and de­

The prospects of large budget deficits in the future
may be affecting both the real and inflation com po­
nents of nominal interest rates. Measured against either
the current inflation rate or a short-run forecast of the
inflation rate, real interest rates have been at a postwar
high— between 6 and 8 percent when measured on a
basis unadjusted for taxes. High budget deficits, com­
bined with a Federal Reserve policy of not accom m o­
dating such deficits, are generally considered to affect
not only short-term rates but more im portantly also the
longer maturities. The reason fo r this is that, despite a
potential rise in personal and business saving rates as
a result of the tax cut, the quantum jum p in the deficit

The Government deficit and interest rates

2 The CBO baseline is a budget projection that shows what the budget
would look like with no changes in the laws and policies in effect at the
end of calendar year 1981. For the purposes of analysis, an adjustment
has been made to the baseline to make it reflect the real growth of
defense in the Administration’s budget proposal.

Digitized 32
for FRASER
FRBNY Quarterly Review/Spring 1982


over the next few years would, on balance, result in a
smaller share of savings being available for private
borrowers. However, assuming the economy sustains
some kind of recovery (in part because of stimulative
fiscal policies), private credit demands are expected to
increase. A confrontation between rising private credit
demands and a reduced availability of savings for pri­
vate investment would mean continued high real inter­
est rates in the future. The credibility of the Federal
Reserve’s commitment to its money growth targets is
critical to this line of reasoning. Expectations are said
to be keeping real rates in the longer maturities high
right now, precisely because the market believes the
Federal Reserve will not cushion the effects of the
future deficits on funds availability by absorbing signif­
icant amounts of Government debt. A reinforcing ef­
fect is that the expected high real rates also may add
to risk premiums because of the fear of the financial
failure of corporations that are forced to borrow at
high rates both now and in the future.
The deficit also might be affecting that part of cur­
rent nominal interest rates related to inflation expecta­
tions. Although current inflation rates are low, the
inflation component of interest rates is actually com­
prised of market participants’ expectations about future
inflation. Some analysts suggest that the market fore­
sees higher inflation because large deficits could
generate irresistable pressure on the Federal Reserve
to accelerate money growth with an accompanying
increase in inflation and inflationary expectations. A
competing explanation is that market participants be­
lieve that large deficits during an economic recovery




are inherently inflationary, irrespective of what the
Federal Reserve is doing.
Although projections of future deficits may be an
important reason for the current high level of rates,
there are limits to how fast or by how much interest
rates would decline if projections of future budget def­
icits were reduced. First, the fiscal outlook is not the
only factor holding up interest rates. For example,
for long-term rates, it is possible that, even in the
absence of the deficit problem, there would be consid­
erable market skepticism about the likelihood of a
longer term slowing of inflation, given the record of
progressively higher upward ratchets of inflation after
temporary improvements over the past fifteen years
and the accompanying deterioration of the long-term
bond market. This may limit somewhat the size of the
reductions of long- and intermediate-term rates that
would result from enactment of a deficit-reduction
program. In addition, Federal outlays have been con­
sistently underestimated and Congressional and Ad­
ministration budget targets have been far from the
mark over the past few years.3 Consequently, it may
take some time and possibly even some actual experi­
ence with lower Treasury borrowing to counteract
market skepticism about the ultimate effects of an
agreed-upon set of deficit-reduction targets.

3 In testimony before the House Budget Committee on March 16, 1982,
Henry Kaufman, citing previous overruns of budget resolution targets,
suggested that it would take more than enactment of Congressional
budget resolution targets to convince the financial markets that the
outlook for the deficit had been improved substantially.

James R. Capra

FRBNY Quarterly Review/Spring 1982

33

Monetary Policy and Open
Market Operations in 1981

The Federal Reserve System pursued a policy of mon­
etary restraint in 1981 as part of a sustained effort
to break the inflationary momentum that had built up
over the years. Economic activity was expanding rap­
idly as the year began, but the economy then leveled
off in the second and third quarters before declining
in the closing months. Meantime there were encour­
aging reductions in the measured rates of price in­
crease and significant progress in blunting inflationary
expectations. Signs of slower labor cost increases
offered hope of further gains on the price front in
1982.
The Federal Open Market Committee’s (FOMC)
policy of restraint involved a slowing in the pace of
expansion planned for its money and credit objectives.
For M-1B, adjusted for shifts into negotiable order of
withdrawal (NOW) accounts, the FOMC sought growth
of 31/2 to 6 percent from the fourth quarter of 1980 to
the fourth quarter of 1981, 1/2 percentage point below

Adapted from a report submitted to the Federal Open Market Committee
by Peter D. Sternlight, Senior Vice President of the Bank and Manager
for Domestic Operations of the System Open Market Account. Fred J.
Levin, Manager, Securities Department, and Ann-Marie Meulendyke,
Research Officer and Senior Economist, Open Market Operations
Function, were primarily responsible for preparation of this report, with
the guidance of Paul Meek, Monetary Adviser. Connie Raffaele, Robert
Van Wicklen, and Catherine S. Ziehm, members of the Securities
Analysis Division staff, participated extensively in preparing and
checking information contained in the report.


34 FRBNY Quarterly Review/Spring 1982


the range set for M-1B for 1980.1 Since M-1B had come
out above the upper bound in 1980, the new range
implied a greater deceleration than the Vz percentage
point change in the range. For M-2, M-3, and bank
credit, the growth ranges were 6 to 9 percent, 6 V2 to
91/2 percent, and 6 to 9 percent, respectively, un­
changed from those set for 1980.2 As with M-1B, the
ranges for M-2 and M-3 implied a deceleration from
actual 1980 growth rates since both measures had
exceeded their ranges that year. Furthermore, the
growing importance of money market mutual funds
(MMMFs) was expected to add to the growth of the
broader measures, which meant that similar growth
rates would have more restrictive implications than
previously.

1 The shift adjustment for M-1B was an estimate of the extent to which
NOW account deposit growth in excess of the previous trend came
from sources other than demand deposits and, hence, represented an
increase in M-1 B that would not have occurred in the absence of
legalization of nationwide NOW accounts. The estimates were made
from survey data. The adjustments assumed 77.5 percent of NOW
accounts came from demand deposits in January and 72.5 percent in
the remaining months of 1981. It was estimated that the remainder of
the transferred funds came from M-2 components, so that no shift
adjustment was needed for that measure.

2 The FOMC also established a range of 3 to 51/2 percent for M-1 A
(shift adjusted) at its February meeting. However, by midyear, the
bulk of the initial transfers of funds into NOW accounts appeared to
have taken place, and the measure was given no further emphasis in
policy deliberations. For the year, it expanded 1 Vz percent.

Chart 2

Chart 1

Targeted and Actual Growth of M-1B

Targeted and Actual Growth of M-2

Adjusted for NOW account shifts
Billions of dollars

Billions of dollars

1980




1981

1980

1981

Chart 4

Bank Credit: Levels and
Associated Range
Billions of dollars
1360

FRBNY Quarterly Review/Spring 1982

35

It turned out that the various monetary aggregates
in 1981 diverged more than had been expected. The
narrow measures were weak, compared both with their
performance of other recent years and with the
FOMC’s objectives. The broader measures meantime
grew about as much as in 1980, or even more, and
they tended to be high relative to the objectives. M-2
hugged the upper bound of the Committee’s fourquarter range and slightly exceeded it for the year.
M-3 was above the upper boundary of its four-quarter
range throughout the year. Bank credit generally
fluctuated around the upper bound of its associated
range, ending slightly within the range. Charts 1 to 4
illustrate the behavior of the various measures relative
to their ranges.3
Faced with such different signals from the various
monetary measures, the Committee gave weight to
both M-1B (shift adjusted) and M-2. Operationally,
this meant that it was often willing to accept some
of the shortfall in M-1B when M-2 was around the
upper bound of its range. The 71/2 percentage point
spread between their growth rates was unprecedented
for a period of cyclically high interest rates. Chiefly
responsible appeared to be the public’s alacrity in
economizing on low-return deposits in favor of those
offering market-related interest rates. All the com­
ponents of M-1B are subject to some type of interest
rate ceiling, while many elements in M-2 and M-3
provide market-related rates. These latter components
grew very rapidly during the year, continuing a trend
of recent years. In some cases, they drew funds
that might otherwise have been invested directly in
market instruments. In its midyear review of the
long-run targets, the Committee recognized these
developments, indicating that it would accept M-1B
around the bottom of its range and M-2 around the top
of its range for the year. By the year-end, the diver­
gence was even greater than anticipated at midyear,
with M-1B ending below its range and M-2 slightly
above its range.
The FOMC continued to pursue the reserve-oriented
approach to controlling money growth begun in
October 1979. A review of the procedure completed

3 The figures in this report are based on the seasonal and benchmark
data that applied during 1981 and the definition of M-2 in effect at the
time. In February 1982, M-2 was redefined to include retail repurchase
agreements (RPs) and to exclude institutional MMMFs. Benchmark
and seasonal revisions were also made. Net revisions to the growth
rates of the various monetary aggregates were very small. The new
data show that, for the four quarters of 1981, M-1B (shift adjusted)
grew 2.3 percent. M-1B not shift adjusted— now referred to as M-1—
grew 5 percent over the four quarters of 1981, compared with 4.9 per­
cent on the unrevised basis. M-2 expanded 9.5 percent, and M-3 grew
11.4 percent after revision. Changes in the quarterly patterns also were
small. Table 1 displays growth rates before and after the revisions.

Digitized for
36 FRASER
FRBNY Quarterly Review/Spring 1982


early in the year concluded that quicker changes in
the path for nonborrowed reserves and the discount
rate were probably desirable to speed up the response
to large deviations of total reserves and money from
path. This approach was followed in April when
money expanded rapidly. The Federal Reserve lowered
the nonborrowed reserve path and raised the dis­
count rate and the surcharge. During much of the
rest of the year, the FOMC gave weight to the strength
of M-2 as well as to the weakness in M-1B. In the
face of such divergent signals, path adjustments of
the above-noted kind were avoided. It was not until
early November, in the context of a visibly slowing
economy and continued apparent weakness in M-1B,
that a second adjustment was made to the nonbor­
rowed reserve path specifically to speed a return of
total reserves to path. Around this time, the surcharge
on the discount rate was also reduced and then elimi­
nated and the discount rate lowered.
The maintenance of a restrictive monetary policy
in the face of embedded inflationary expectations
meant that interest rates tended to be high during
much of the year. Rates were also volatile. At times,
market participants concentrated on factors tending
to boost rates, including estimates of large and
prolonged Federal deficits and substantial growth
of broad money aggregates. At other times, partici­
pants were heartened by the slow growth of the nar­
row monetary measures, the weakening in economic
activity, and signs of slowing inflation. Interest rate
volatility itself probably also contributed to somewhat
higher rates than might otherwise have prevailed, as
lenders and dealers sought additional protection
against the greater risks.
The capital markets continued to function reasonably
well during the year despite adverse conditions. A
large volume of Government, corporate, and municipal
debt issues was sold. For much of the year, short-term
rates were higher than long-term rates, as is typical
in periods of monetary restraint. Potential long-term
investors were reluctant to extend the maturities of
their portfolios unless substantial rate declines ap­
peared to be a near-term prospect. Rallies tended
to be short-lived.
In these circumstances, many corporate borrowers
chose to sell intermediate- rather than long-term
issues, as the risks seemed less and the buyers more
receptive. Deep discount securities offering low, or
even zero, coupons also came into vogue as investors
sought to lock up high yields for the life of the issue.
By the year-end, with the economy having weakened,
short-term rates had come down below long-term
rates and were somewhat below those of a year
earlier. Long-term rates were well above the levels where

they had started the year, although generally below
the Septem ber-October peaks. Long-term municipal
rates, though, reached record levels late in the year.
The Economy and Financial M arket Developments

The economy
The pace of econom ic activity slackened as 1981
progressed. At the start of the year, the economy was
expanding rapidly, extending the recovery begun in
the second half of 1980. Real gross national product
(GNP) in the first quarter grew strongly at an 8.6 per­
cent seasonally adjusted annual rate. The m iddle two
quarters were essentially flat— a slight decline in the
second quarter and a slight rise in the third. The econ­
omy weakened notably in the final quarter, with real
GNP falling at a 4.5 percent rate. For much of the year,
many observers felt that the economy was surprisingly
resilient, given the extent of monetary restraint and the
depressed levels of the autom obile and housing sec­
tors. Still, the drop, when it occurred, was steeper
than many had expected, particularly as it came soon
after the enactment of large tax cuts. The unemploy­
ment rate was virtually steady through midsummer but
then climbed in the final months.
The inflation rate, as measured by the various in­
dexes, slowed irregularly over the year. The greatest
improvement was in wholesale prices. The producer
price index rose at a 12 percent annual rate through
A pril and at a 4.5 percent average over the balance
of the year. For the year the increase was 7.1 percent,
compared with 11.9 percent during 1980. The rise in
consumer prices also slowed between the first and
second quarters but speeded up again in the third
quarter before m oderating to a 5.2 percent annual
rate in the fourth quarter. For the year the consumer
price index rose 8.9 percent, compared with 12.4 per­
cent in 1980. Some of the slowing in both wholesale
and consumer price advances reflected developments
in the volatile energy and agricultural sectors, but
there also was deceleration in other components. The
im p licit GNP price deflator, w hich is less volatile, rose
8.9 percent from the fourth quarter of 1980 to the fourth
quarter of 1981, m odestly below the 9.9 percent in­
crease a year previous.

The financial markets
Interest rates during the year were volatile and fre­
quently higher than seemed consistent with a weak­
ening pattern of econom ic activity and some slowing of
inflation (Chart 5). A fter peaking in May, short-term
rates fluctuated in a high range and then began to fall
in September. They declined sharply in the fourth
quarter, reflecting the weak economy, slowing infla-




FRBNY Quarterly Review/Spring 1982

37

tion, and the Federal Reserve’s provision of reserves
in the effort to meet money growth objectives. Long­
term rates, on the other hand, peaked somewhat later
and remained above the late-1980 levels at the year-end.
Long-term rates were held up by concerns about
ongoing Treasury deficits, as well as uncertainty about
whether there would be more permanent gains in the
battle against inflation than after earlier episodes of
restraint during the last decade and a half.
During the year, investor expectations responded to
changing evidence concerning monetary growth, the
state of the economy, the size of prospective Federal
deficits, and the outlook for inflation. During the first
quarter, slow growth of M-1B led to a marked decline in
short-term interest rates, as the Reserve System sup­
plied nonborrowed reserves while the demand for total
reserves fell. Long-term rates changed little as the
economy remained strong, so that the yield curve on
Treasury issues, which had been steeply inverse through
mid-February, became virtually flat by the end of March
(Chart 6). In early April, short-term rates began to rise
sharply, first as market participants discovered that
the FOMC had not lowered the Federal funds rate
range even though funds had traded below the lower end
of its range for a couple of weeks. More importantly, the
pickup in M-1B growth in late March and April against
the background of a strong economy was troubling,
while the System’s rapid response to the overshoot
generated strong upward pressure on the Federal funds
rate. There was also growing concern that large bud­
get deficits would result from the President’s economic
program, and the steeply inverted yield curve that de­
veloped by mid-May stood significantly above that of
six weeks earlier (Chart 6).
Rates in all sectors stayed high through the summer.
Long-term rates rose more than short-term rates, as
concerns about Treasury deficits and prospective sup­
plies of corporate debt weighed heavily. By August,
money market conditions began to ease in response
to the persistent weakness in M-1B. With long-term
rates still holding up, or rising, the yield curve de­
veloped a humpbacked shape. Continued declines in
short rates relative to long rates and the mildly ac­
commodative monetary policy stance produced, by the
end of October, a positively sloped yield curve for
the nearby years. A major rally was touched off at
that time by cumulating evidence of economic weak­
ness. This lowered the yield curve and steepened its
slope. The rally came to a halt in late November, with
short-term rates at their lows for the year and long­
term rates well below their September-October highs.
Rates backed up again through the year-end. A sense
of caution returned as budget deficits and strengthen­
ing money growth came into focus.

38

FRBNY Quarterly Review/Spring 1982




Debt issuance
With a substantial deficit to be financed and a large
volume of maturing issues to be rolled over, the Trea­
sury was a major borrower during the year. Marketable
debt held outside the Federal Reserve and Govern­
ment accounts rose a net $88.4 billion in 1981, similar
to the $90 billion increase the year before. (A net
pay down of $10.3 billion of publicly held nonmarketable issues, including $2.4 billion denominated in
foreign currencies, contributed to the cash need.) The
Treasury raised a net of $23.2 billion from the public
through bills and $65.2 billion through coupon issues.
In addition, it replaced $68 billion of maturing coupon
issues and continued rolling over the $172 billion of
publicly held bills that was outstanding at the end
of 1980.
The Treasury maintained its regular cycles of Trea­
sury bill and coupon sales during the year. In view of
the large cash needs, it added a quarterly seven-year
note cycle beginning with an auction on December 30,
1980. It also substituted a twenty-year bond for a
fifteen-year bond at the start of 1981. Some considera­
tion was given to the possibility of eliminating the
offering of long-term bonds, on the grounds that the
Treasury should not make a commitment to pay high
interest rates for an extended period when the Ad­
ministration was resolved to end inflation. However,
given the huge financing needs and the desirability of
maintaining a balanced debt structure, the Treasury
decided to continue to sell bonds on a regular basis.
With this ongoing commitment to debt extension, the
average maturity of the outstanding debt was length­
ened over the year by two months to fifty months.
The market for issues of Federally sponsored agen­
cies was subject to considerable strain during the
year. During the summer, investors became wary of
the issues of the Federal National Mortgage Asso­
ciation (FNMA) and to a lesser degree the Federal
Home Loan Banks (FHLBs). The prevailing high in­
terest rates caused the costs of FNMA and the thrift
institutions that rely on FHLBs to rise well above the
yields on their mortgage portfolios. Market participants
became concerned by June about their sustained via­
bility, and interest rate spreads between the debt of
these agencies and the Treasury widened significantly.
The spreads increased through August, especially for
FNMA issues, for which the spreads widened to well
over a full percentage point compared with a more
normal Va to V2 percentage point. Later in the year,
as short-term yields declined, spreads fell back toward
more usual levels.
Net new cash raised by various Federal agencies
during the year amounted to $33.3 billion, compared
with the $24.9 billion raised the year before. (These

figures do not include Government National Mortgage
Association pass-through certificates.) Most borrowing
was by FNMA, FHLBs, and the farm credit agencies,
with FHLBs accounting fo r the stepped-up issuance in
1981. Debt was issued in m aturities ranging from six
months to ten years.
Corporate bond issuance was again heavy in 1981,
with a total of $37 b illion of public offerings, although
this was below the record level of almost $42 billion
in 1980. Many corporations faced weakening liquidity
positions and were eager to extend the m aturities of
th e ir outstanding debt. However, they tended to wait
for declines in bond yields to rush their offerings to
market. A large portion of the year’s debt issuance
took place during rallies in the spring and toward the
year-end.
Given interest rate vo la tility and the high degree of
uncertainty about the future, investors tended to favor
intermediate-term issues increasingly in 1981. Indeed,
according to an estimate by Salomon Brothers, about
half of the nonconvertible debt issuance by domestic
corporations in 1981 was in intermediate-term issues,
compared with only about one quarter in the late
1970s. Another m ajor change was the active issuance
of debt with coupons well below current rates, offered
at an initial discount. Some investors found these is­
sues attractive because they offer certain advantages
should interest rates fall. They are less likely to be
called early and a part of the return is, in effect, al­
ready invested at the high rates prevailing when the
bonds were issued. Issuers found their costs lower on
such offerings and also gained a tax advantage since
the accrued interest obligations can be treated as an
expense before the actual payment must be made.
Sales of tax-exempt bonds amounted to $46 billion
in 1981, about 70 percent of which were revenue is­
sues. In 1980, total borrowing had been $47 billion,
with 65 percent consisting of revenue bonds. (These
figures do not include borrowings with m aturities of
one year or less.) During the latter part of the year,
the yields on tax-exem pt issues had to rise to new
highs to attract investors, in part because the changes
in the tax laws reduced the importance of tax-free
income fo r the traditional purchasers of these issues.
Also, there was a year-end surge in offerings by state
housing authorities to fund relatively low-rate m ort­
gages. The tax-exem pt sector shared in the early
stages of the November rally but reversed course
before the taxable sector, with rates in some cases
ending at their highs fo r the year.




Monetary and Credit Aggregates and Monetary Policy
Behavior of the aggregates
Growth rates of the narrow and broad aggregates
diverged to an unusual extent in 1981. The narrow
measures generally were w eaker than intended, while
the broader aggregates expanded at a more rapid
pace than was sought by the FOMC. In responding to
developments over the year, efforts were made to
interpret this divergence, with w eight being given to
both M-1B (shift adjusted) and M-2.
M-1B (shift adjusted) grew just 2.1 percent between
the fourth quarter of 1980 and the fourth quarter of
1981. (Figures do not allow for the benchm ark and
seasonal revisions made in February 1982. The re­
vised figures are given in Table 1.) This was well
below the Com m ittee’s target range of 3 1/2 to 6 per­
cent. Except when growth accelerated in April, M-1B
(shift adjusted) was below the range through the year
(Chart 1). The perceived extent of the weakness de­
pends somewhat on the choice of dates. Measured
from December 1980 to December 1981, it grew 3.3
percent, and inclusion of January 1982 would bring
M-1B w ithin an extension of the 1981 “ growth cone” .
Measures of v o la tility of M-1B also depend on one’s
vantage point, although the vo la tility was less than in
1980. While quarterly average growth rates in 1981
showed alternating strength and weakness, growth
rates computed from the Iasi month of the previous
quarter to the last month of the new quarter were rea­
sonably steady fo r the first three quarters, then more
rapid in the final quarter (Table 1). In any event, there
seems little reason to believe that short-run variations
in money growth rates— say from one quarter to the
next— are significant fo r the perform ance of the econ­
omy so long as they do not cumulate in one direction
or the other fo r a long period.
M-1B itself showed considerably more growth than
the shift-adjusted measure in the early part of the
year, as individuals opened NOW accounts with funds
transferred from savings and other accounts as well
as from demand accounts. Initially it was expected
that there would be about a 2 to 3 percentage point
difference in the growth rates over the year as a
whole. By December 1981, the shift adjustment cumu­
lated to $12.4 billion, which meant a 3 percentage
point difference in the growth rates. Much of the shift
took place early in the year, causing the adjustment
fa cto r to reach $9.8 billion by A pril. The differences
then moderated though they widened somewhat in the
final two months. Demand deposits also dropped dra­
m atically in January and were decidedly weaker than
other transactions accounts through April. Thereafter
the differences generally were modest.

FRBNY Quarterly Review/Spring 1982

39

M-2 generally was close to or slightly above the
upper bound of its 6 to 9 percent range during 1981
and increased 9.5 percent over the four quarters
(Chart 2), about the same rate as the year before. It
accelerated rapidly in the three months ended in April,
at a 13.5 percent pace, moving above its target range
by March. A sharp deceleration in May and June
brought it back within its range. M-2 then fluctuated
around the upper bound of its range for some months
before a two-m onth spurt at the close of the year once
again took it slightly above its range.
The non-M-1B components of M-2, as a group, ex­
panded rapidly on average although their accelera­
tions and decelerations showed a sim ilar pattern to
M-1B. The individual nontransactions components
showed a wide range of growth rates. MMMF shares
grew extrem ely rapidly through most of the year, in­
creasing from $75.8 billion in December 1980 to
$184.5 b illion in December 1981. Six-month money mar­
ket certificates (MMCs) also expanded rapidly through
August but declined thereafter, posting a net increase
of 9 percent. The 21/2-year small savers certificates
grew fa irly rapidly early in the year, slowed when the

rate cap kept yields well out of line during the spring
and early summer, then accelerated dram atically when
the interest rate cap was removed at the start of
August. Overall they increased about 88 percent. On
the other hand, overnight RPs (issued by comm ercial
banks) and Eurodollars (issued by Caribbean branches
of member banks), which served as short-term invest­
ment media for excess corporate cash, changed little
over the year. Savings deposits and traditional types
of small time deposits subject to below-m arket interest
rate ceilings declined over the year.
M-3 expanded 11.2 percent from the fourth quarter
of 1980 through the fourth quarter of 1981 (Chart 3),
well above the upper bound of the 6 V2 to 91/2 percent
target range. It moved above that range in January
and stayed above throughout the year, even though
there was a modest deceleration after April. Large
time deposits expanded at a 21 percent average rate
over the four quarters. Sharp variations in the rates
of change of large time deposits appeared to be re­
lated to the behavior of bank credit (Chart 4). When
that measure decelerated from January to April, large
tim e deposits decelerated as well. When bank credit

Table 1

Monetary Aggregates in 1981
Seasonally adjusted annual rates

Period
Growth from previous quarter:
Quarter 1 .................................................................................
Quarter 2 ................................................................................. ...........
Quarter 3 .................................................................................
Quarter 4 .................................................................................

M-1B*
Unrevised

5.2

Growth from three months earlier:
March .....................................................................................

M-2
Unrevised

M-2
Revised

M-3
Unrevised

M-3
Revised

—0.9
5.8
- 0 .4
4.7

8.2
10.6
7.2
10.6

7.5
12.0
8.3
8.8

12.4
10.6
10.3
9.8

11.2
12.2
11.2
9.2

11.7
7.2
8.6
12.2

10.8
9.3
8.6
10.0

12.6
10.3
10.5
10.0

12.4
11.5
10.8
9.3

M-1 B*
Revised

September ............................................................ ................
December ............................................................................... ...........

8.3

2.2
1.9
1.8
7.6

Growth from December 1980 to December 1981 ............. ..........

3.3

3.4

10.3

10.0

11.3

11.4

2.1

2.3
7.3
7.4
8.2
8.2
6.2

9.5
9.6
8.8
8.3
11.5
13.7

9.5
9.2
8.4
8.2
11.5
13.6

11.2
10.2
9.8
11.2
12.6
11.4

10.0
9.8
11.3
12.5
11.3

Growth from four quarters earlier:
1981-Quarter 4 ....................................................................... ...........
1980-Quarter 4 ...................................................................
1979-Quarter 4 ..............................................................
1978-Quarter 4 ...................................................................... ..........
1977-Quarter 4 ....................................................................... ...........
1976-Quarter 4 .......................................................................

8.2
8.2

* Data for 1981 are adjusted for the estimated impact of shifts into NOW accounts.

FRBNY Quarterly Review/Spring 1982
Digitized40
for FRASER


11.4

growth picked up again between May and October,
large tim e deposits resumed a relatively rapid pace
of growth. When bank credit growth slackened in
November, large time deposits declined.
The divergence in the average rates of expansion
of the narrow and broad aggregates in 1981 was un­
precedented fo r a period of cyclically high interest
rates. The growth of M-1B, adjusted, slowed m arkedly
for the year as a whole, as businesses and con­
sumers economized on transactions balances with a
low rate of return. M-2 growth, however, continued
at a rapid clip, reflecting the growth of the com po­
nents that offered m arket-related interest rates.4
Through 1978, in contrast, M-2 had typ ically slowed
more than M-1 during periods of rising rates because
interest rate ceilings caused a shift to market instru­
ments whenever market rates were above the ceilings
(Chart 7). In those days, M-2 also accelerated earlier
and more sharply when interest rates fell below the
ceilings.
Sensitivity of M-2 to interest rate moves began to
change during 1978. As the economy entered an ex­
tended period during which interest rate ceilings were
binding, the incentives to find substitutes strength­
ened, and regulatory changes permitted the marketrelated components to develop. The im portance of
instruments that paid market rates grew dram atically.
By the final quarter of 1981, about 45 percent of M-2
consisted of instruments that could pay m arket rates,
compared with 2 percent at the start of 1978. Some
of these funds came out of the M-2 components sub­
je ct to ceilings, leaving total M-2 unchanged. But, in
other cases, funds were attracted that were previ­
ously invested, or would have been invested, directly
in market instruments rather than being intermediated
through banks, th rift institutions, and MMMFs.
Some of the shift into m arket-rate-based instruments
in M-2 reflected a transitional adjustment in response
to the existence of new options. This probably raised
the average growth rate for M-2 relative to M-1B by
more than would be expected to occur during future
interest rate cycles. The transition still appears to be
in progress. The changes in M-2 com position sug­
gest that M-2 growth w ill no longer be so severely
constrained by rising interest rates as that of M-1.
Indeed, it seems possible that M-2 m arket-related
components could attract funds from longer term
4 "Market-related rates” means either completely unrestricted rates,
such as on overnight RPs and Eurodollars and on MMMF shares, or
rates that are tied to a market rate such as six-month MMCs.
MMCs were first permitted in June 1978. The 21/2-year small savers
certificates were introduced at the start of 1980. From March 1980
until August 1981, however, they were subject to a rate cap which
often was below market rates. All savers certificates paying a marketrelated tax-exempt rate were introduced in October 1981.




instruments whenever short-term rates rise above
long-term rates. Conversely, funds might move out of
M-2 when the yield curve shifts to a positive slope.
At the same time, savings and other low -interest com­
ponents of M-2 could behave in an opposite fashion,
and the net result on M-2 as a whole is uncertain. In
1981, the conflicting forces served to maintain growth
that was well above the rates recorded in earlier
periods of high interest rates but well below the peak
growth rates associated with reinterm ediation in times
of declining rates.

Implementation
During 1981 the FOMC continued to fo llo w the supplyoriented procedures adopted in October 1979. As
before, the Committee provided, on occasion, for
speeding up the adjustm ent process through path or
discount rate changes when the demand fo r total re­
serves departed significantly from path. Given the fre­
quent divergence between M-1B and M-2, the Commit­
tee gave somewhat greater e xp licit attention to M-2
than in the previous year. (In the remaining sections,
all reference w ill be to the shift-adjusted version of
M-1B which form ed the basis of policy during 1981.)

FRBNY Quarterly Review/Spring 1982

41

The Committee reaffirmed its support for making
adjustments to the nonborrowed reserve path on oc­
casions when total reserves and money were far
above or below their objectives. Targeting nonbor­
rowed reserves means that intended discount window
borrowing will adjust automatically to satisfy the dif­
ference between total reserve demand and nonbor­
rowed reserve supply. Studies of the first year’s ex­
perience with the new procedures suggested that, to
speed the response when a large discrepancy devel­
oped, adjustments should probably be made to the
nonborrowed reserve path. This in fact had been done
on six occasions during 1980.
In practice, however, supplemental adjustments were
made only during two reserve periods in 1981, as most
episodes of reserve divergence from path involved
shortfalls of M-1B that coincided with overshoots of
M-2. In a mechanical sense, the reserve paths by
themselves give much more weight to M-1B than to
M-2. This arises because most of the deposits in M-1B
are subject to relatively high reserve requirement ra­
tios, while those in M-2 are subject either to low re­
serve requirements or to none at all. When total re­
serves and M-1B were well below path but M-2 was
strong, the path was not lowered. This had the effect
of giving more weight to M-2 than would have occurred
automatically. Downward path adjustments were made
in April when both measures were above path, and an
upward adjustment was made in early November when
M-1B was far below path and M-2 had slowed.
Although explicit changes in the nonborrowed re­
serve path aimed at speeding the return of total re­
serves to their track were limited in number, there
were frequent path adjustments of a more technical
nature. For the most part, they were made to both the
total and nonborrowed reserve paths to incorporate
new information about reserve multipliers. In addition,
there were instances where borrowing had been quite
different from anticipated levels early in the inter­
meeting period, and path adjustments were made to
avert abrupt changes in conditions of reserve availa­
bility deemed inconsistent with the thrust of policy.
The FOMC continued to set broad bands around the
Federal funds trading range. These bands served to
trigger consultation when funds traded persistently
outside these ranges. This occurred during the early
part of the year and led to Committee discussions. In
the latter part of February, M-1B had weakened suffi­
ciently so that total reserves were well below path and
the funds rate was pushing below the 15 percent lower
bound. In a telephone consultation, the Committee
indicated willingness to see funds trade below the
range (although it was also inclined to tolerate some
shortfall in reserves, given the strength in the broader
Digitized42for FRASER
FRBNY Quarterly Review/Spring 1982


aggregates). No formal change was made in the funds
rate range. During April, money growth was exception­
ally strong, and the Federal funds rate was allowed to
trade above the range during the latter part of the
April-May intermeeting period. A Committee telephone
consultation confirmed that and other responses to
the bulge in money. No further conflicts arose between
the reserve objectives and the Federal funds rate
bands over the balance of the year.
Estimating the impact on reserves of so-called oper­
ating factors continued to be a challenge. In 1981, the
average absolute projection miss was about $600
million from the first day of the statement week. (The
standard deviation was $735 million.) Even by the final
day of the week the average absolute error was $120
million (and the standard deviation was $165 million).
Large errors are most likely to occur in winter, when
weather has a greater impact on check clearing. Weeks
containing partial holidays are often troublesome as
adjustments between open and closed banks need to
be worked out.
Revisions to reserve estimates from the start of the
week were smaller on average in 1981 than in the
previous year when the absolute average had been
around $750 million. The gain came primarily as a
result of the reduction of both the mean and variance
of float. The reorganization of the interdistrict check
transportation system in September 1980 played a key
role in these changes.
With considerable uncertainty and variability remain­
ing in the behavior of the operating factors, the Trading
Desk continued to employ RPs and matched salepurchase agreements to affect reserves on a temporary
basis. Helped by the lower variance in float, the vol­
ume of temporary transactions arranged in the market
did decrease to $269 billion in 1981, compared with
$370 billion the year before.5 The decline might have
been greater had it not been for the need to offset
the reserve absorption from the transfer of funds to
the Federal Reserve in early July associated with the
special Iranian accounts. Since it was not known when
the funds would be paid out, it was not practical to use
outright securities purchases as an offset. The funds
finally were transferred in mid-August, returning the
reserves to the banking system.
Outright transactions during the year amounted to
$25.9 billion. Of these, $11.4 billion was arranged in the
market, $12.6 billion with foreign accounts, and the
remainder consisted of redemptions of maturing issues.
The net increase in the portfolio was $8.5 billion to a

5 These figures include customer-related RPs as well as RPs and
matched sale-purchase agreements on behalf of the Reserve System.

level of $139.8 billion at the year-end. As usual, most of
the increase supported the rise in currency outstand­
ing. Nonborrowed reserves increased modestly, w hile
foreign currency holdings declined somewhat.
Conducting Open M arket Operations

January through March
A pattern that was to characterize much of the year
emerged near its start, as the narrow aggregates fell
below the C om m ittee’s path w hile M-2 was in line with
its path or somewhat above. As the demand for re­
serves weakened along with the narrow money mea­
sures, the nonborrowed reserve-targeting procedure
led to declines in borrowing and a fa irly steep drop in
short-term interest rates. The strength in M-2 had little
offsetting impact on reserve demands, since much of
it was concentrated in MMMF shares w ith zero reserve
requirements.
About midway through the quarter, after the Federal
funds rates had declined to about 15 percent from the
19 to 20 percent range prevailing in December, the
Committee decided to accept some shortfall in the
growth of the narrow aggregates in view of the
strength in the broad aggregates. The nonborrowed
reserve path was lowered tem porarily relative to the
total reserve path to maintain borrowing pressure on
banks and thus reduce the likelihood that short-term
rates would drop precipitously. Subsequently, the nar­
row aggregates showed additional weakness for a
time, and the funds rate eased a bit further before firm ­
ing at the period’s close.
At the December 1980 meeting, the Committee had
specified growth objectives fo r the December-March
period at annual rates consistent with the m idpoints
of the tentative annual ranges for growth for all of
1981 adopted the previous July. These ranges centered
on 41/4 percent fo r M-1 A, 4% percent fo r M-1B, and
7 percent for M-2, after allowing fo r the im pact of the
introduction of nationwide NOW accounts on Decem­
ber 31 (Table 2). In light of the rapid advance in
the aggregates since the summer of 1980, the Commit­
tee was w illing to accept some shortfall from these
rates if that developed in the context of reduced pres­
sures in the money market. The Committee had agreed
upon an initial level for adjustm ent and seasonal bor­
rowing of $1.5 billion to be used to construct the non­
borrowed reserve path. The Federal funds rate range
had been placed at 15 to 20 percent, w ith the end
points serving as potential triggers fo r a Committee
consultation if funds were to trade persistently out­
side the range.
Operations early in the year were com plicated by
the d ifficulties in measuring the impact of NOW ac­




counts on money growth, the effects of seasonal pres­
sures in the money market, and the transfer of funds
related to the settlem ent of the hostage crisis with
Iran. Following the December FOMC meeting, the staff
had built reserve paths fo r the intermeeting period,
using its December projections fo r the monetary ag­
gregates at the tim e and the growth rates for January
consistent w ith the Com m ittee’s three-m onth objec­
tives. The aggregates in December turned out well
below path, w ith the narrow aggregates actually de­
clining sharply and M-2 showing only modest growth.
January estimates were erratic from week to week
and thus highly uncertain. The staff had to gauge the
proportion of funds that were flowing into the newly
authorized NOW accounts from demand deposits
versus other interest-bearing assets in order to com ­
pute the adjusted measures fo r M-1 A and M-1B. These
flows proved much stronger than had been envisioned,
so that even slight revisions to the estimated propor­
tions from one week to the next had large impacts on
their estimated growth. Overall, incoming data sug­
gested some pickup in money growth in January, but
the levels remained below those built into the path.
With the narrow aggregates weak and the Desk
supplying nonborrowed reserves in line with the path,
the im plied weekly borrowing levels consistent with
the path gradually moved downward in December and
averaged about $1.1 billion in January. Actual discount
window borrow ing, however, did not begin to recede
until after the turn of the year. Even then, it fluctuated
w idely from week to week and remained generally
above expectations (Chart 8). The average weekly
effective rate on Federal funds reached a record of
20.06 percent in the week of January 7, and trading
remained in the 19 to 20 percent area over the next
two weeks. Late in December and early in January,
banks’ demands fo r excess reserves were persistently
higher than allowed fo r in the path so that nonbor­
rowed reserves tended to be scarce. Heavy dealer
financing demands and the lingering effects of cor­
porate and bank year-end positioning activity tended
to keep the funds rate from declining appreciably
until late in the month.
Meanwhile, in the week of January 21, the Desk
faced special problems relating to the transfers of
Iranian funds. As the week began, negotiations be­
tween the United States and Iran to resolve the hos­
tage situation were proceeding actively. It was clear
that resolution would entail the unfreezing of Iranian
assets held at com m ercial banks and the New York
Reserve Bank, but the tim ing of the transfer and its
effect on bank reserve availability were in question.
On Friday of that week (and again on Monday), the
Desk provided reserves by arranging custom er RPs in

FRBNY Quarterly Review/Spring 1982

43

Table 2

Specifications from Directives of the Federal Open Market Committee and Related Information

Date
of
meeting

12/19 /8 0 ...........

2 /3 /8 1 ...............

Specified short-term
annualized rates of
growth for period
mentioned (percent)
M-1B*
M-2

Range for
Federal
funds rate
(percent)

Associated
initial
assumption for
borrowed
reserves
(millions of
dollars)

December to March
4%
7

15-20

1,500

13 + 3 surcharge

December to March
5-6
8

15-20

1,300

13 + 3 surcharge

10%

13-18

1,150

13 + 3 surcharge
14 + 4 surcharge
on 5/5

April to June
6

16-22

2,100

14 + 4 surcharge

3/31/81,

5V2

March to June

(or somewhat
less)

5 /1 8 /8 1 .............
3
(or lower)

44

FRBNY Quarterly Review/Spring 1982




Basic
discount rate
and surcharge
on day of meeting
and subsequent
changes (percent)

Notes

The short-run specifications
also included an objective of
41A percent growth for M-1A
(adjusted for NOW account
shifts). The Committee indi­
cated some shortfall in growth
would be acceptable if that
developed in the context of
reduced pressures in the
money market.

The short-run specifications
also included an objective of
5 to 6 percent for growth of
M-1 A (adjusted for NOW
account shifts). In a telephone
conference on February 24, the
FOMC modified the directive
to accept some shortfall in
growth of M-1 A and M-1 B from
the rates specified at the
February meeting.

For simplification, the Committee
decided to focus on M-1 B as
the measure of transactions
balances and to omit any refer­
ence to M-1 A in its statement
of monetary objectives for the
short run. In a telephone con­
ference on May 6, the FOMC
agreed that the reserve paths
should continue to be set on the
basis of the short-run money
growth objectives set at the
March meeting, recognizing that
the Federal funds rate might
continue to exceed the upper
end of the range indicated for
consultation at that meeting.

Table 2 (continued)

Specifications from Directives of the Federal Open Market Committee and Related Information

Range for
Federal
funds rate
(percent)

Associated
initial
assump­
tion for
borrowed
reserves
(millions of
dollars)

Basic
discount rate
and surcharge
on day of meeting
and subsequent
changes (percent)

June to September
7
see
notes

15-21

1,500

14 + 4 surcharge

June to September
7
see
notes

15-21

1,400

14 + 4 surcharge
14 + 3 surcharge
on 9/22

September to December
7
10
(or slightly
higher)

12-17

850

14 + 3 surcharge
14 + 2 surcharge
on 10/13
13 + 2 surcharge
on 11/2
13 on 11/17

11-15

400

13
12 on 12/4

10-14

300

12

Specified short-term
annualized rates of
growth for period
mentioned (percent)
M-1 B*
M-2

Date
of
meeting

7 /7 /8 1 ...............

8 /1 8 /8 1 .............

1 0 /6 /8 1 ............

11 /1 8 /8 1 ........

1 2 /2 2 /8 1 ..

October to December
7
11

November to March
4-5
9-10
(M-1)

•

Notes

The 7 percent objective for
M-1B growth was set provided
that growth of M-2 remained
around the upper limit of, or
moved within, its range for
the year.

The short-run specifications for
M-1 B was again made provi­
sional on M-2 growth remaining
around the upper limit of, or
moving within, its range for
the year.

In setting the objective for
growth of M-2, the Committee
recognized that its behavior
would be affected by recent
regulatory and legislative
changes, particularly the
public’s response to the
availability of the all savers
certificate.

The transactions measure of
money was redesignated as M-1
with the same coverage as
M-1B. The target no longer
reflected the shift adjustment
for conversion of outstanding
interest-bearing assets into
NOW accounts.

• Abstracting from the effects of deposit shifts connected with the introduction of NOW accounts on a nationwide basis on December 31,1980.




FRBNY Quarterly Review/Spring 1982

45

the m arket when the funds rate was firm, even though
estimates suggested a surplus of nonborrowed re­
serve supplies relative to the objective for the week.
(These estimates assumed that all funds transferred
from banks to Iran would flow back to the banking
system the same day, which was not certain.) Later
on Friday, after receiving instructions to sell Iran’s
$1.1 b illion of Treasury bill holdings, the Desk pur­
chased these fo r the System Account. The proceeds,
along with the $1.4 billion of Iran’s balances held at
the New York Reserve Bank, were invested by arrang­
ing matched sale-purchase transactions w ith the Sys­
tem Account. The reserve effects of these two opera­
tions were offsetting.
The funds transfers were supposed to take place
over the weekend, but it was not until the wee hours
of Tuesday that com m ercial banks were instructed to
transfer $5.5 billion to the New York Reserve Bank for
payment to Iran. The funds were placed at the Bank
of England and returned to the banking system late
that day. The result left a large surplus of reserves,
augmented by the discount window borrowing of
one bank involved in the transfer (which the Desk
treated as nonborrowed reserves fo r path-setting pur­
poses). After the transfer on Tuesday, the funds rate

Chart 8

M oney M arket C o n d itio n s and
B orrow ed Reserves
P e rc e n t

22.0
20.0

Federal funds weekly
Discount rate
-average effective rate — ---------- plus surcharge-

18.0

V __________ _________________ ^ ________

16.0
14.0
12.0
ia o

I I I ] i I I I i j ; I ! i I ■I I i , ■i i I , . I I I , i i 1 i 1I i I 1 i I , . I . ■, , I i 11

Millions of dollars
3000
2500

2000
1500
1000

500

0

J

F

M

A

M

J

J

A

S

O

N

D

1981
* Excludes extended credit borrowing by thrift institutions
(and a small amount of emergency credit borrowing)
starting in the week of August 19 which was treated
as nonborrowed reserves for path purposes.

46 FRASER
FRBNY Quarterly Review/Spring 1982
Digitized for


plummeted, dropping to 10 percent. The Desk ab­
sorbed the glut of reserves on Wednesday by arranging
nearly $7 b illion of matched sale-purchase transac­
tions in the market.
The week encompassing the Iranian funds transfers
was the start of the second reserve subperiod (three
weeks ended February 4) follow ing the December
meeting. In the last two weeks of that subperiod, the
Desk encountered a problem involving discount window
borrowing that has occurred from tim e to tim e since
the beginning of the reserve-targeting approach in
O ctober 1979. Borrowing through Tuesday of the Jan­
uary 28 statement week was averaging about $1.8 b il­
lion, well above the $1.2 billion level expected to be
associated with the nonborrowed reserve objective for
that week. If the Desk acted to achieve the objective,
banks were likely to end up holding about $600 m illion
more excess reserves than th eir estimated demand.
The glut of reserves would then result in a sharp
easing in money market conditions on the settlem ent
day, perhaps disrupting the markets and giving a mis­
leading impression about System policy intentions.
Faced with this situation, the Desk deliberately sought
to undershoot the nonborrowed reserve objective that
week by about $500 m illion, somewhat less than the
overshoot in borrowing.
Given the shortfall in nonborrowed reserves in the
January 28 week, a relatively large increase would
have been needed in the February 4 statement week
to achieve the average path level fo r the three-week
period as a whole. In turn, this would have im plied a
sharp drop in expected borrowing for that week, down
to about $250 m illion. To avoid an abrupt easing in
financial m arket pressures likely to be generated by
such a reduced borrowing level, and given the prox­
imity of a m ajor Treasury financing, it was decided
to lower the nonborrowed reserve path by $280 m illion
relative to the total reserve path. This left projected
borrowing fo r the week at $1.1 billion, about the same
as in the previous week. Nonborrowed reserves fo r the
three-week subperiod ended February 4 were virtually
equal to the revised path, according to final figures.
Reflecting the weakness in the narrow aggregates,
total reserves averaged $390 m illion below path, with
most of the shortfall in required reserves.
At the February 3 meeting, the Committee sought
a near-term pickup in money growth to make up for
the shortfalls in the narrow aggregates that had oc­
curred in December and January. Accordingly, it
adjusted upward the December-to-M arch growth ob­
jectives for both M-1A and M-1B to 5 to 6 percent and
raised the M-2 objective to 8 percent. The Federal
funds rate range continued at 15 to 20 percent.
During the first subperiod that follow ed the Febru­

ary meeting (four weeks ended March 4), incoming
data for February suggested that the narrow aggre­
gates were growing well below path. M-2 growth, on
the other hand, appeared to be picking up strongly
that month and was projected to be on or above
path. Reflecting the weakness in the narrow aggre­
gates, implied discount window borrowing associated
with achieving the nonborrowed reserve path gradu­
ally moved lower. Actual borrowing also trended down,
though it fluctuated widely from week to week, and
the Federal funds rate eased substantially. By the
February 25 statement week, estimates before the
weekend suggested that achievement of the average
nonborrowed reserve path for the subperiod implied
borrowing of $770 million over the remaining two
weeks. Meanwhile, the funds rate dipped below 15 per­
cent on Friday and continued to edge lower after the
weekend. It became evident that pursuit of the non­
borrowed reserve path was inconsistent with funds
trading remaining within the Committee’s specified
range.
At a special telephone conference on Tuesday, Feb­
ruary 24, the Committee discussed the strength of M-2
and M-3 and the easing in money market conditions,
as well as the uncertainties over the behavior of the
narrow aggregates. It decided to accept some shortfall
in growth of the narrow aggregates, implying a reduc­
tion of the nonborrowed reserve path. While the funds
rate range was not formally changed, it was recog­
nized that pursuit of the nonborrowed reserve path
might lead to further declines in the funds rate, de­
pending on subsequent growth of the aggregates. In
the final week of the first subperiod, the Desk chose
not to offset an undershoot in nonborrowed reserves
and an overshoot in borrowing in the previous week.
Nonborrowed reserves for the subperiod thus came out
$70 million below the downward revised path. Total
reserves were $220 million below path.
At the start of the second reserve subperiod, growth
of the monetary aggregates did indeed appear to be
weaker. Accordingly, it was decided not to continue
with the downward adjustment of the nonborrowed
reserve path in the second subperiod that had been
applied in the first subperiod. Estimated borrowing
consistent with achieving the nonborrowed reserve
path in the second subperiod (four weeks ended April 1)
dropped to $800 million. Subsequently, the narrow
aggregates began to show renewed strength. As the
second subperiod progressed, weekly borrowing levels
consistent with the path gradually moved upward,
climbing back to around $1.1 billion by the final week.
The funds rate continued to edge lower for a while,
briefly touching as low as 13 percent in mid-March, but
returned to the 15 percent area by the end of the month.




Nonborrowed reserves for the second subperiod were
very close to path, while total reserves averaged $320
million below path.

April through June
The Federal Reserve responded quickly and force­
fully to a surge in money growth in April. The Desk’s
pursuit of the nonborrowed reserve path in line with
the Committee’s aggregates objectives automatically
forced banks to step up their discount window bor­
rowing, putting upward pressure on short-term rates.
To apply further restraint, the nonborrowed reserve
path was lowered substantially in early May, forcing
even higher borrowing, and the Board of Governors
approved increases in both the basic discount rate
and the surcharge on frequent borrowing by large
banks. Following these actions, growth of the monetary
aggregates began to slow. At first, the Committee was
willing to tolerate the slowdown to make up for the over­
run in April. Later, as the money stock weakness
continued through June, reserve pressures on banks
were gradually relaxed.
The Committee’s targets for second-quarter growth
of the monetary aggregates, set at the March 31
meeting, were formulated to take into account the
disparate trends in the money stock measures and
their relationship to the Committee’s annual ranges.
The objective for growth of M-1B of 51/2 percent or
somewhat less was set with recognition that a portion
of the first-quarter shortfall apparently reflected the
rapid expansion of MMMF shares which were being
used, to some extent, as transactions balances. The
objective for M-2 growth of about 101/2 percent gave
weight to the staff’s projection that the expansion of
MMMF shares would remain strong in the second
quarter. At this meeting, the Committee stopped
specifying short-run objectives for M-1 A; after adjust­
ment for the effects of flows into NOW accounts,
growth of the two narrow measures would be similar.
Initial estimates of monetary aggregates growth fol­
lowing the March meeting were in line with path rates
for April, set equal to the Committee’s objectives.
As the intermeeting period progressed, however, esti­
mates for April M-1B growth were repeatedly revised
upward to rates well above path. In turn, estimated
discount window borrowing consistent with achieving
the nonborrowed reserve path rose sharply from the
initial $1,150 million level. By the final week of the
first reserve subperiod (four weeks ended April 29),
implied weekly borrowing needed to achieve the
nonborrowed reserve path had climbed to $1.7 billion.
Nonborrowed reserves for the first subperiod were
close to path. Reflecting the strength in the aggre­
gates, total reserves averaged $160 million above
FRBNY Quarterly Review/Spring 1982

47

path, with required reserves $310 million above path.
At the start of the second reserve subperiod (three
weeks ended May 20) the demand for total reserves
was projected to be about $550 million iabove path.
Given this large gap, it was decided, in consultation
with the Chairman, to reduce the nonborrowed reserve
path relative to the total reserve path by $250 million.
Average borrowing associated with the nonborrowed
reserve path over the second subperiod rose to nearly
$2 billion. The following Monday, on May 4, the Board
approved Reserve Bank requests to raise the basic
discount rate from 13 to 14 percent and to lift the
surcharge on frequent borrowing by large banks from
3 to 4 percentage points.
Although the gap between projected reserve de­
mands and the total reserve path narrowed a bit in the
following week, it was still quite wide. Consequently,
the nonborrowed reserve path was reduced by an
additional $120 million and by a further $114 million to
offset an overshoot in borrowing in the April 29 week.
(Discount window borrowing on the settlement day
of that week was a record $8.6 billion, as the Desk had
difficulty in hitting the weekly nonborrowed reserve
objective because of sizable revisions to reserve pro­
jections and a shortage of collateral in the market.)
These adjustments followed a Committee telephone
consultation on May 6, at which it instructed the Desk
to continue aiming for reserve paths consistent with
the money stock objective set at the March meeting,
recognizing that Federal funds in the days remaining
before the May meeting were likely to trade in ranges
that exceeded somewhat the 13 to 18 percent con­
sultation band. Nonborrowed reserves for the sec­
ond subperiod averaged close to the downward re­
vised path, while total reserves came out $450 million
above path.
As banks were forced to borrow increasing amounts
at the discount window beginning in early April, the
Federal funds rate began to climb. At first, the rise
was delayed a bit as banks seemed content to hold
unusually low excess reserves or to run deficiencies.
Funds traded in the 15 to 151/2 percent range over the
first three weeks of April and then shot up to 20 per­
cent in the wake of the extreme reserve stringency in
the April 29 week. Thereafter, the funds rate seemed
to be settling down in the 17 to 18 percent area, but
the announcement of the discount rate actions on May 4
pushed the rate up almost immediately to around
19 percent where it remained in the days preceding
the May Committee meeting.
When the Committee met on May 18, the members
agreed about the importance of maintaining a posture
of restraint to reduce growth of the monetary aggre­
gates rather quickly. The economy had expanded well

48 FRASER
FRBNY Quarterly Review/Spring 1982
Digitized for


above expectations in the first quarter, and the velocity
of the narrow money stock had grown at an unusually
raqjd rate. Indications of continuing strength in the
economy, coupled with a possible turnaround in the
velocity of money, posed the risk of excessive growth
of the aggregates as the year unfolded. Although the
major price indexes were rising at somewhat reduced
rates, there was little indication of a reduction of the
underlying inflation rate or an abatement in inflationary
expectations. Accordingly, and also in light of the
rapid money growth in April, the Committee sought a
substantial deceleration in growth for the April-June
period to rates of 3 and 6 percent for M-1 B and M-2, re­
spectively. Moreover, given the overshoot in April, the
Committee indicated that it was willing to accept some
shortfall of M-1B growth from the two-month rate
specified. An initial borrowing assumption of $2.1
billion was established, and the funds rate range was
lifted to 16 to 22 percent.
A few days after the May meeting, staff projections
of the aggregates for May were considerably weaker
than those available at the time of the meeting. Projec­
tions suggested essentially no growth for M-1B for the
month and only modest growth of M-2. Given the Com­
mittee’s preference for such a slowdown, following the
April bulge, the reserve paths were constructed using
the staff’s revised forecasts for May and the implied
growth rates for June consistent with the Committee’s
two-month objectives. Hence, at the start of the first
reserve subperiod (four weeks ended June 17),
achievement of the nonborrowed reserve path was
expected to imply the same $2.1 billion of discount
window borrowing that the Committee had accepted
as the initial assumption.
During the first week of the subperiod, borrowing
bulged to $2.9 billion, as banks borrowed heavily
over the three-day Memorial Day weekend— perhaps
because many thought that another increase in the
discount rate might be imminent. Under these cir­
cumstances, the Desk deliberately sought a level of
nonborrowed reserves for the week that was well be­
low the objective. To have achieved the weekly
objective, given the high borrowing, would have
meant an overabundance of total and excess reserves
and a sharp easing in money market conditions at
the end of the week— a result that seemed inconsis­
tent with the thrust of policy.
In the weeks that followed, estimates of M-1B for
May were repeatedly revised downward, although
projected M-2 growth remained close to, or only
somewhat below, path. As M-1B weakened, both the
total and nonborrowed reserve paths were adjusted
lower each week, for a total downward adjustment of
$180 million, in keeping with the Committee’s willing­

ness to accept some shortfall from the aggregates
growth targets specified at the May meeting. (The
nonborrowed reserve path was lowered an additional
$206 million in the second week to offset the impact
of the unusually high borrowing over the Memorial
Day weekend.) The effect of these adjustments was to
keep implied weekly borrowing levels consistent with
hitting the nonborrowed reserve paths from falling
sharply below the $2.1 billion level. Reflecting these
adjustments, both nonborrowed and total reserves
averaged close to path.
By mid-June, estimates showed that M-1B had de­
clined in May at a 5 percent annual rate, and little
or no growth was projected for June. (Projected M-2
growth for the two-month interval, on the other hand,
was only a touch below path.) Given the extent of the
M-1B growth shortfall from the Committee’s two-month
objective, it was decided that no further downward
adjustments to the reserve paths were warranted. The
paths for the second subperiod (three weeks ended
July 8) were redrawn on the basis of 31/2 percent
growth of M-1B from March to June, the staff’s pro­
jection of growth at the time.
During the second subperiod, incoming data for
M-1B in June indicated even further weakness than
earlier. This time, however, the reserve paths were
not reduced to accommodate the shortfall. As a result,
the demand for total reserves fell increasingly below
path. In turn, achievement of the nonborrowed re­
serve path implied lower and lower borrowing levels.
By the final week of the subperiod, the weekly borrow­
ing level consistent with hitting the nonborrowed re­
serve path had dropped to $1.4 billion. Total reserves
for the subperiod averaged $100 million below path.
Nonborrowed reserves were also about $100 million
below path according to final figures, although pre­
liminary numbers indicated that they were fairly close
to path.
With the Desk supplying nonborrowed reserves
more generously over the second subperiod, this
should have led to some easing in the Federal funds
rate over late June and early July. Instead, funds con­
tinued to trade around 19 percent, the same level that
had prevailed since the beginning of May. One factor
that apparently accounted for the firm money market
over the period was that banks had been forced to
borrow heavily over an extended time. Hence, even
though borrowing pressures eased starting in late
June, there was greater reluctance to resort to the
window. Still another factor was that banks became
increasingly disappointed when the funds rate failed
to ease beginning in early June as many had expected,
given the weakness in M-1B. In the week of June 17,
in particular, banks made only light use of the dis­



count window through Tuesday and thus accumu­
lated large reserve deficiencies, expecting funds to
break on the settlement day. Instead, funds shot up
to as high as 30 percent at the close on Wednesday
as banks were forced to borrow $6.4 billion to meet
reserve requirements. The caution engendered by
this experience tended to keep the funds rate firm
well into July.
Interest rates varied over a wide range in the second
quarter, as the markets were buffeted by the rapid
changes in the money stock, shifting views on the
economic and Federal budget outlook, and uncertainty
over System policy intentions. Yields rose sharply
through early May, reaching near-peak levels in the
short-term markets and setting new records in rrjany
longer term sectors. (The records were eclipsed in the
third quarter.) The markets were disturbed at the out­
set when the February FOMC policy record, released
on April 4, was interpreted to mean that the System
had not deliberately sought the trading in Federal
funds below the 15 percent that had emerged in midMarch. Rapid money stock growth in April and the
firming trend in the funds market put strong upward
pressure on rates, as did the discount rate actions
taken on May 4. While some participants were en­
couraged by Congressional actions to restrain Federal
spending, many worried about the interest rate impli­
cations of a large tax cut and resulting high Federal
budget deficits.
Around mid-May sentiment began to change. The
markets rallied strongly over the next month, and
yields retraced a large portion of their earlier in­
creases. A series of statistics suggested that the
economy was not so robust as previously thought and
that inflationary pressures were waning. Reports indi­
cated that the Administration might be willing to com­
promise on its tax-cut proposals. At the same time,
the weakness in M-1B in May and early June con­
vinced many participants that the money market would
soon begin to ease. By mid-June, however, partici­
pants had grown impatient with the continued firm­
ness in the funds market. Many began to appreciate
that policy was also being significantly affected by the
strength in M-2. As the quarter ended, yields were
on the rise again.

July through September
The third quarter was marked by continued divergent
trends in the narrow and broad monetary aggregates.
Except for a brief time early in the quarter, growth of
M-1B fell increasingly below the Committee’s objec­
tives; M-2 growth, on the other hand, was roughly in
line with its corresponding objectives. As the Desk
pursued the nonborrowed reserve path, the reserve

FRBNY Quarterly Review/Spring 1982

49

approach automatically generated less borrowing pres­
sures on banks, and the Federal funds market eased
substantially by the quarter’s end. Given the sustained
strength in M-2, however, no steps were taken to rein­
force this process either by raising the nonborrowed
reserve path or by cutting the basic discount rate.
At the July meeting, the Committee affirmed its in­
tention to seek growth of M-1B for the year near the
lower bound of its specified range, recognizing that
growth of the broader aggregates might be high in
their annual ranges. M-1B had so far been growing
well short of this pace, advancing at an annual rate of
2!4 percent through the second quarter. The 7 percent
objective chosen at this meeting for expansion of M-1B
from June to September, if continued in the fourth
quarter, would bring growth up to the lower bound of
the annual range by the year-end. At the same time,
though, it was made conditional on M-2 remaining
around the upper end of, or moving within, its growth
range for the year.
The initial borrowing level for the intermeeting period
was established at $1.5 billion. Early in the first re­
serve subperiod (three weeks ended July 29), incom­
ing data suggested that growth of both aggregates
in July was exceeding path rates— set a bit higher for
M-1B than the Committee’s three-month objective be­
cause of the expected impact of an early mailing of
social security checks that month. Later in the first
subperiod, and continuing through the second reserve
subperiod (three weeks ended August 19), estimated
M-1B growth for July was repeatedly revised down­
ward to rates well below path. Consequently, after
edging higher at first, implied weekly discount window
borrowing consistent with the nonborrowed reserve
path gradually moved downward in the second sub­
period to the $1.4 billion level or below. Actual bor­
rowing also fell, although it varied sharply from week
to week. The Federal funds rate declined gradually
from the 19 percent level at the time of the July
meeting to around 18 percent by mid-August. Non­
borrowed reserves were $90 million and $40 million
below path in the first and second subperiods, respec­
tively. Total reserves were $80 million above path in
the first subperiod, reflecting an overshoot in excess
reserves, but $200 million below path in the second
subperiod.
Starting in the August 19 statement week, the Desk
began to include thrift institution borrowing at the dis­
count window under the extended credit program as
nonborrowed reserves for path purposes, since such
borrowing does not imply the same reserve pressures
in the money market as adjustment borrowing. The
amount of extended credit borrowing each week was
treated as a market factor that supplied nonborrowed

FRBNY Quarterly Review/Spring 1982
Digitized 50
for FRASER


reserves. (The same procedure was followed with re­
spect to special borrowing by one particularly large
regional bank in 1980.) In this way, as the Desk aimed
to achieve the nonborrowed reserve path, the reserves
supplied through the extended credit program did not
lead to an overabundance of total reserves.6
System open market operations between the July
and August meetings were substantial. The Desk pur­
chased for the System Account over $3 billion of Trea­
sury bills ($1.4 billion in the market and the rest from
foreign accounts) and nearly $1 billion of Treasury
coupon securities in the market. These outright trans­
actions were needed to counter the effect of seasonal
factors that were draining reserves. In addition, the
Desk arranged an unusual volume of temporary trans­
actions stemming from the second phase of the settle­
ment with Iran. As part of that settlement, $2 billion of
funds was transferred from commercial banks to the
New York Reserve Bank on July 10. Because of the
uncertainty over when the funds would flow back to the
banking system— as it turned out, not until August 17
— they were placed in the foreign temporary invest­
ment pool. To offset the effects on reserve availability,
the Desk engaged in repeated rounds of System RPs
in the market or passed through to the market portions
of the enlarged foreign investment orders.
When the Committee met in August, it retained the
7 percent target for M-1B growth over the June-toSeptember interval, subject to the same provision
that M-2 remain around the upper bound of, or move
within, its range for the year. Since the expansion of
M-1B had fallen well short of path in July, achievement
of the three-month objective meant that a substantial
pickup in growth was needed for the August-September
period. Data available at the time of the meeting
showed rapid increases in the first couple of weeks
of August, and the paths were constructed to reflect
the strength that was projected and also desired for
the month in view of the earlier shortfall.
A few days after the meeting, however, estimates
of M-1B growth for August were revised downward
sharply. Although estimates were subsequently boosted
as the period progressed, growth remained well below
path. Incoming data for September suggested that
M-1B was remaining weak in that month as well.
In contrast, M-2 growth for the two months was
generally estimated to be close to, or only slightly
below, path. Moreover, flows of funds into retail RPs

6 The volume of extended credit borrowing was fairly modest over the
year. In late October, it reached a weekly average peak of $464 million
(largely accounted for by the borrowing of one institution) and there­
after dropped back to the $125 million area.

at thrift institutions (not captured in the M-2 series)
were artificially depressing its growth. After making
allowance for this distortion, M-2 appeared to be ex­
panding at rates somewhat above path.
Reflecting the shortfall in M-1B growth from the
Committee’s objectives, total reserves in the first re­
serve subperiod (four weeks ended September 16)
averaged $160 million below path. (Nonborrowed re­
serves were $70 million below path.) At the start of the
second subperiod (three weeks ended October 7), the
gap between the total reserve path and the projected
demand for total reserves swelled to around $370 mil­
lion. Ordinarily, such a large gap would call for an
upward adjustment of the nonborrowed reserve path
relative to the total reserve path to speed money
growth back to path. However, given the behavior of
M-2, no adjustment seemed warranted. Even so,
implied weekly borrowing consistent with the nonbor­
rowed reserve path dropped from the initial level of
$1.4 billion specified by the Committee to below
$900 million by the end of the second reserve period.
Total reserves for the second subperiod averaged
$370 million below path, while nonborrowed reserves
were $60 million above path. With borrowing pres­
sures on banks easing, the Federal funds rate fell
sharply, down from about 18 percent in mid-August to
around 15 percent in mid-September. On September 21,
the Board approved Reserve Bank recommendations
for a reduction of the discount rate surcharge on
frequent borrowing by large banks from 4 to 3 per­
centage points. By this time, though, very little bor­
rowing was actually subject to the surcharge, and thus
the action had no observable effect on the funds rate.
Indeed, if anything, market participants seemed dis­
appointed that no cut was made in the basic discount
rate.
Despite the sharp drop in the Federal funds rate over
the third quarter, other short-term rates edged higher
in July and August before turning down in September.
Although most rates finished the quarter lower on bal­
ance, the declines were much less than registered in
the funds market. Indeed, rates on Treasury bills be­
yond the shortest maturities ended the period some­
what higher, reflecting continued heavy Treasury
issuance.
Meanwhile, yields on intermediate- and long-term
securities were on a generally upward trend over the
quarter in extremely volatile markets. New record-high
yield levels were established in all the key sectors.
The mood was one of deep pessimism, dominated by
concern over the prospect of continued large Treasury
deficits in the wake of the Federal tax cuts. Although
participants responded favorably to the economic sta­
tistics showing a weakening economy and moderating



inflation, this nourished only sporadic rallies. Investors
remained largely on the sidelines, preferring to chan­
nel their funds to short-term instruments. Corporate
borrowers avoided the capital markets in favor of bank
loans and commercial paper. Trading activity was
largely confined to dealers and trading accounts, who
were hesitant to take sizable positions, and the mar­
kets were thin. Daily price movements of 2 to 3 points
(25 to 40 basis points in long-term yields) were not
uncommon. In the Treasury’s August refunding, all
three issues set new record yields in their maturity
categories, with the auction average on the reopened
thirty-year bond at 14.06 percent. At its peak in late
September, the yield on Treasury long-term bonds in
the secondary market touched as high as 15.29 percent.

October to the year-end
Growth of the monetary aggregates picked up sub­
stantially in the fourth quarter, but the strength was
not apparent until the final month. Earlier in the period,
estimates suggested that the narrow money stock
measure was continuing to come in below path. Conse­
quently, borrowing pressures on banks eased and
money market rates fell considerably, spurred on by
cuts in the basic discount rate. The sharp rebound in
money growth that followed, however, went well be­
yond the Committee’s objectives. The strength in the
aggregates was unusual, as interest rates were still
historically high and the economy was in the midst of
recession with no recovery in sight. Nevertheless, the
reserve approach automatically began to apply in­
creasing pressures in the money market— pressures
that were intensified as money growth accelerated fur­
ther early in the new year.
When the Committee met in October to consider its
fourth-quarter objectives, it weighed the risks of in­
adequate versus excessive money growth against the
background of continued divergent trends in the ag­
gregates. M-1B had advanced little in the third quarter,
and its expansion for the year thus far was well below
the lower bound of the Committee’s annual range.
Growth of the broader aggregates, on the other hand,
had remained close to, or somewhat above, the upper
bounds of their respective ranges. The Committee
agreed upon annual growth objectives for the
September-to-December period of 7 percent for M-1B
and 10 percent or slightly higher for M-2. It was noted
that the behavior of M-2 would depend, in part, on the
public’s response to the availability of all savers cer­
tificates starting October 1.
The staff built the reserve paths for the intermeeting
period on the basis of essentially straight-line money
growth for the individual months of the quarter, but
with some allowance for a one-time jump in M-2 in

FRBNY Quarterly Review/Spring 1982

51

October to reflect anticipated shifts of funds from
retail RPs into the new all savers certificates. Over the
first reserve subperiod (three weeks ended October 28),
the monetary aggregates projections for October were
fairly close to path. (Total reserves for the first sub­
period ended up $60 million below path, while non­
borrowed reserves were $50 million above path.)
Hence, expected discount window borrowing implied
by the nonborrowed reserve path remained around the
$850 million initial level agreed to by the Committee.
Starting in the second subperiod (three weeks
ended November 18), however, estimates of the aggre­
gates began to fall below path. M-1B was especially
weak, but M-2 growth was also somewhat below path
for October, as there was less switching of funds into
the all savers certificates than had been anticipated.
As money growth weakened, borrowing consistent
with achieving the nonborrowed reserve path moved
lower. To encourage a bit quicker response in money
growth back to path, while also avoiding a precipitous
easing in money market conditions, the nonborrowed
reserve path was raised modestly— by about $50
million— in the November 11 statement week. Expected
borrowing associated with the nonborrowed reserve
objective that week was about $500 million. However,
actual borrowing was well above this level, which
would have meant only modest borrowing in the final
week of the subperiod if the nonborrowed reserve path
were to be achieved. To avoid an abrupt reduction of
reserve pressures only a few days in advance of the
November FOMC meeting, it was decided to aim for
reserve supplies a little below the nonborrowed re­
serve path, consistent with borrowing of $400 million
in the final week. Nonborrowed reserves in the second
subperiod averaged slightly below path, according
to preliminary data, but $60 million above path after
subsequent revision. Total reserves were $30 million
below path, with required reserves $140 million be­
low path.
Meanwhile, on October 30, the Board announced a
reduction of the basic discount rate from 14 to 13
percent. Earlier, on October 9, the discount rate sur­
charge on frequent borrowing by large banks had
been lowered from 3 to 2 percentage points; on
November 16, it was removed altogether. The reduc­
tion of the basic discount rate and the lessening of
borrowing pressures on banks was reflected in a con­
siderable easing in the money market. The Federal
funds rate dropped from about 151/2 percent at the
time of the October FOMC meeting to around 13 per­
cent by the third week in November.
The securities markets rallied dramatically begin­
ning in late October. Investors responded enthusi­
astically to mounting evidence of a slowdown in the
Digitized 52
for FRASER
FRBNY Quarterly Review/Spring 1982


economy and further moderation in inflation. Reports
of continued weakness in the narrow money stock
measure also buoyed sentiment, as did the cut in the
basic discount rate and the general easing of money
market conditions. Over the course of a month, rates
on three- and six-month Treasury bills dropped about
3 percentage points to their lowest levels in over a
year. Strong investor demand was evident in the Trea­
sury’s November refunding, with the thirty-year bond
auctioned at an average yield of 14.10 percent. In
the latter part of November, the yield on Treasury
long-term bonds in the secondary market got as low as
12% percent. In the improving climate, corporate
borrowers rushed offerings to market that had been
deferred earlier. The volume of gross corporate issues
in November swelled to over $7 billion, nearly twice
the average monthly volume recorded over the first
ten months of the year.
By the time the Committee met in November, it
was clear that the downward drift in the economy
observed earlier had developed into a recession.
The Committee continued to agree on the desirability
of seeing more rapid growth of M-1B over the re­
maining months of the year, taking account of the
strength in the broader aggregates. In this light, they
chose growth objectives for the October-to-December
period of 7 percent for M-1B and 11 percent for M-2.
Given the shortfall of M-1B in October, it was under­
stood that more rapid growth, consistent with the
fourth-quarter objectives set at the October meeting,
would be acceptable if the demand for transactions
balances proved to be strong. It was also understood
that a modest shortfall of M-1B growth from path
would not be unacceptable, particularly if the broader
aggregates continued to expand rapidly.
On December 4, the Board announced a further
1 percentage point reduction of the basic discount
rate to 12 percent. In the meantime, the monetary
aggregates were showing mixed trends early in the
intermeeting period, with estimated M-1B growth for
November sJightly below path and M-2 growth slightly
above. As the period progressed, however, estimates
for M-1B in November were revised sharply upward.
(A further large upward revision to M-1B in November
was made late in December, reflecting new deposit
information from a sample of quarterly reporting
banks.) Preliminary data for the first couple of weeks
in December suggested that the strength was con­
tinuing that month. Projected total reserve demand
for the reserve period (five weeks ended December 23)
thus rose above the total reserve path and average
borrowing consistent with achieving the nonborrowed
reserve path moved up to about $500 million from
the $400 million initial level chosen by the Committee.

At the same time, actual borrowing in the first two
weeks of the reserve period fell well below expecta­
tions, which would have implied sharply higher bor­
rowing in the remaining weeks if the original non­
borrowed reserve path were to be achieved. It was
decided, however, to accommodate the borrowing
shortfalls in the first two weeks and to set the objec­
tives for nonborrowed reserves for the remaining
weeks in line with the estimated average borrowing
for the period. This approach recognized the Com­
mittee’s willingness to tolerate somewhat above-path
growth of M-1B over the November-December interval
to make up for the October shortfall. Nonborrowed
reserves for the period averaged $90 million above
path, while total reserves were $210 million above path.
Many banks apparently misjudged the Federal Re­
serve’s policy stance in late November and early
December, believing that the System’s objectives for
nonborrowed reserves implied only frictional levels of
borrowing. Hence, they were reluctant to pay higher
rates for Federal funds than the prevailing discount rate
or to borrow from the discount window. Funds thus
traded around 121/2 percent in late November and very
early December when the basic discount rate was 13
percent. After the announcement of a reduction of the
discount rate to 12 percent on December 4, funds
traded for a while around 11% percent. Discount win­
dow borrowing was extremely light early in the state­
ment weeks of November 25 and December 2. While
this should have resulted in sharply higher borrow­
ing on the settlement day of those weeks, this did not
happen, largely because of reserve projection errors.
Even in the week of December 9, when borrowing did
bulge on Wednesday after remaining low earlier
in the week, participants tended to shrug this off as an
aberration. By mid-December, however, the funds rate
began to move higher as expectations changed, in




part owing to the reported strength in the monetary
aggregates.
Over the remainder of the year and into early 1982,
the monetary aggregates continued to grow very rapid­
ly. M-1 bulged in the first week of January and, as
the month unfolded, little of the strength washed out.
Growth rates for the aggregates were thus well above
the Committee’s objectives for November to March set
at the December meeting of 4 to 5 percent for M-1 and
9 to 10 percent for M-2. (M-1 has the same coverage
as M-1B, but the target was set for the measure with­
out adjustment for the impact of NOW account shifts.)
As the aggregates strengthened, projections of the de­
mand for reserves began to rise well above the total
reserve path, forcing banks to borrow increasing
amounts at the discount window and putting upward
pressure on the funds rate.
The rally in the securities market faded soon after
the November FOMC meeting. Interest rates across
the maturity spectrum backed up sharply in December
and continued to rise through January. While long­
term yields in the Government and corporate sectors
remained somewhat below their peak levels of late
September, yields in the municipal sector set new
record highs in early January before receding late
in the month as the technical situation in that market
improved. The rapid growth of the monetary aggre­
gates and the firming trend in the money market in
December and January were the principal factors
responsible for the turnaround in yields, while the
prospects for continuing large Federal deficits re­
mained a major concern. At the same time, though,
market participants took encouragement from sta­
tistics showing weakness in the economy and modera­
tion in inflation. The rise in yields was thus tempered
by the view that money growth would not remain strong
with signs pointing to continuing recession.

FRBNY Quarterly Review/Spring 1982

53

August 1981-January 1982 Semiannual Report
(This report was released to the Congress
and to the press on March 4,1982.)

Treasury and Federal Reserve
Foreign Exchange Operations
There were two key turning points for the dollar in the
exchange market during the August-through-January
period under review. In early August, the year-long
advance of the dollar against major foreign currencies
came to an end. Then, after a four-month decline, dollar
rates started to firm at the beginning of December, a
trend which continued through the remainder of the
period.
Several factors supported the long advance of the
dollar through early August. U.S. inflation had begun to
moderate even as the economy withstood recessionary
tendencies longer than most forecasters had expected.
The Reagan administration’s leadership in translating its
economic policy into action was greeted positively in the
exchange markets, particularly as the program gained
support in the Congress. At the same time, the U.S. cur­
rent account continued to post a surplus. Meanwhile,
the demand for credit in the United States remained
strong and, with the Federal Reserve continuing to re­
strain monetary expansion, interest rates stayed high.
Thus, although differentials favoring the dollar were well
below their peaks of late 1980, they were widening again
during the summer, attracting interest-sensitive funds
into dollar-denominated assets once again.
Most other industrial countries, by contrast, con­
tinued to show disappointingly slow progress in pulling
out of the difficulties associated with the prolonged ad-

A report by Sam Y. Cross. Mr. Cross is Senior Vice President in
charge of the Foreign Group of the Federal Reserve Bank of New
York and Manager of Foreign Operations for the System Open
Market Account.


54 FRBNY Quarterly Review/Spring 1982


justment to the 1979-80 oil price increases. In many
countries there was public debate over the appropriate
course of fiscal and monetary policy in the face of
unacceptably high inflation and mounting unemploy­
ment. In this context, foreign governments expressed
open concern over the high level of U.S. interest rates
and the inflationary consequences of the depreciation
of their currencies against the dollar. Furthermore, po­
litical developments in Eastern Europe and the Middle
East clouded the outlook for many countries abroad,
leaving traders and investors with the view that the
United States was a relatively attractive outlet for
investment.
As the dollar continued its advance in early August,
however, sentiment became more cautious. Market par­
ticipants were aware that major European central banks
had stepped up their dollar sales and, in view of the
rapid run-up of the dollar in late July-early August, be­
gan to expect a correction. Consequently, once the up­
ward momentum broke, dollar rates fell back sharply in
mid-August and then declined irregularly through late
November.
The August turnaround in the exchange markets coin­
cided with a shift in focus in the U.S. financial com­
munity from the immediate issues surrounding the
passage of the Administration’s program to its implica­
tions for the fiscal deficit and U.S. capital markets. As
market attention turned to estimates of the fiscal gap,
skepticism deepened that the Administration’s program
could proceed without having the government’s bur­
geoning financing needs exert renewed strains on the
credit markets. In this environment, there was growing

concern over the potential fo r conflict between fiscal
and monetary policy, leading market participants to
question whether the Federal Reserve m ight back away
from its anti-inflation stance.
At the same time, the economy began to show signs
of weakening. U.S. short-term interest rates were there­
fore easing, even though the Federal Reserve contin­
ued its policy of restraining monetary expansion. Re­
flecting the slow growth of the narrowly defined money
supply, the Federal funds rate dropped about 600 basis
points over the four months to end-November. The
Federal Reserve progressively eliminated its 4 percent
surcharge on large banks that frequently borrowed at
the discount window, and by early December it reduced
its basic discount rate 2 percentage points to 12 per­
cent. Already by November evidence was mounting that
the U.S. economy was in a sharp recession, leading to
expectations that private-sector credit demands would
decline substantially. These expectations contributed
to a rally in the bond m arket which brought long-term
rates down more than 200 basis points by the end of
the month.
The four-m onth decline of short-term interest rates
in the United States was reflected in a narrowing of
interest differentials favorable to the dollar vis-a-vis most
other currencies. At least initially, monetary authorities

abroad fe lt they had little room to respond to the lower
U.S. interest rates by easing their own money market
rates. They were concerned about entrenched inflation­
ary pressures at home, and in some countries, notably
France, Switzerland, and the United Kingdom, the cen­
tral banks acted to raise interest rates. In addition,
some countries felt constrained by the pressures
against their currencies w ithin the European Monetary
System (EMS).
Beginning in October, however, as U.S. interest rates
continued to decline, monetary authorities in some
countries began to allow an easing of th eir own short­
term interest rates. Their econom ies were making
little headway in recovering from recession, and unem­
ployment was rising rapidly. Government deficits were
already large relative to historical standards and in
many cases were placing strains on the dom estic finan­
cial markets. Consequently, the authorities in several
countries felt there was only lim ited scope fo r further
fiscal stimulus. The current account deficits of a number
of countries were beginning to decline so that the au­
thorities fe lt they no longer needed such high interest
rates to attract capital from abroad. There were w ide­
spread forecasts of a U.S. move from current account
surplus to deficit in 1982; Japan’s current account
had already swung from a deep deficit into surplus;

Table 1

Federal Reserve Reciprocal Currency Arrangements
In millions of dollars

Institution
Austrian National Bank ...................................................................
National Bank of Belgium .............................................................
Bank of Canada .............................................................................
National Bank of D enm ark.............................................................
Bank of England ...........................................................................
Bank of F ra n ce .................................................................................
German Federal Bank ...................................................................
Bank of Ita ly ...........................................................................
Bank of Japan .................................................................................
Bank of M e x ic o ...............................................................................
Netherlands Bank ...........................................................................
Bank of N o rw a y...............................................................................
Bank of Sw eden...............................................................................
Swiss National B a n k .......................................................................
Bank for International Settlements:
Swiss francs-dollars ...................................................................
Other authorized European currencies-dollars.......................




Amount of facility
January 1, 1981

Decrease effective
May 23, 1981

200

Amount of facility
January 31,1982
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
1,250

200

30,100

FRBNY Quarterly Review/Spring 1982

55

and a German export surge had led officials and p ri­
vate forecasters alike to predict an elim ination of
that country’s current account deficit in 1982. More­
over, strains in the EMS were relieved by a m ultilateral
realignm ent of parities on O ctober 5. As a result, fo r­
eign monetary authorities felt they had greater scope
fo r easing their dom estic interest rates. Even so, with
the drop in short-term U.S. rates accelerating, par­
ticu la rly in November, interest differentials favoring the
d o lla r continued to narrow.
Meanwhile, other factors lent support to the dollar.
Orders to buy dollars emerged repeatedly whenever
the dollar moved substantially lower, as comm ercial
interest in a number of centers sought to take advan­
tage of what they considered favorable rates for cur­
rent payments or investments. From time to tim e there
were also substantial purchases of dollars by the
monetary authorities in Organization of Petroleum Ex­
porting Countries (OPEC) and other countries outside
the Group of Ten. In addition, there was a continuing
inflow of funds into dollars from Japan, where residents
were taking advantage of a recent relaxation of ex­
change controls or were for other reasons seeking to d i­
versify th eir portfolios internationally. Furthermore, the
November rally in the U.S. bond market reportedly at­
tracted capital from abroad, as investors sought to lock
in high yields and position themselves for capital
appreciation. Moreover, the increasingly fragile situa­
tion in the M iddle East and Poland depressed sentiment
toward those countries seen as more vulnerable than
the United States to heightened geopolitical tensions.
The recession in the U.S. economy led forecasters to
expect less deterioration in this country’s current ac­
count than previously. Even so, by end-November the
dollar dropped from end-July levels by 61/4 percent
against sterling, about 11 percent against the Japanese
yen and the German mark, and as much as 18 percent
against the Swiss franc.
Early in December the dollar turned around once
more and began an advance that carried through endJanuary. This second turning point was triggered by
a reappraisal of the view that a continuing drop in
econom ic activity in the United States would lead to
further substantial declines in U.S. interest rates and,
therefore, to further movements adverse to the dollar in
interest rate differentials.
That reappraisal was based on a number of devel­
opments. In the United States, the Federal Reserve
was perceived as moving cautiously to reduce its dis­
count rate and to supply bank liquidity. Although output
was falling and unemployment was clim bing, credit
demands were not fading. In fact, comm ercial financing
needs were heavy, with corporate issues flooding the
bond m arket in December and commercial demand for
Digitized for
56FRASER
FRBNY Quarterly Review/Spring 1982


bank credit remaining strong. Also, estimates of the
Federal deficit fo r current and future fiscal years had
undergone repeated and large upward revisions, and

Chart 1

The D ollar A g a in st S e le cte d
F oreign C urren cie s
Percent
40

o

_5l 11111i,i 111111i i i 1111il 1111mil,mil iiLu 1111111u ill 1111iii
J

F

M

A

M

J

J
1981

A

S

O

N

D

J

F
1982

Percentage change of weekly average bid rates
for dollars from the average rate for the week of
December 29, 1980-January 2, 1981. Figures calculated
from New York noon quotations.

Chart 2

S e le c te d In te re s t Rates
Three-month m atu ritie s*
Percent
22
Eurodollars
London market
—

' “v - . - V

N-

London interbank
sterling

Euromark deposits
London market
J

F

M

A

M

J

J

A

1981
* Weekly averages of daily rates.

S

O

N

D

J

F
1982

the prospective borrowing requirement for the first quar­
ter of 1982 was seen as likely to be greater than previ­
ously had been estimated. Moreover, the release of
figures showing no letup in a series of large weekly
increases in the monetary aggregates began to generate
expectations of a substantial tightening of money market
conditions. Under these circumstances, U.S. money
market rates rose in December and even more rapidly
in January.
Abroad, by contrast, persistent weakness of do­
mestic economies had led to near-record levels of
unemployment, and in some countries official financial
policies were coming under domestic criticism. As
pressures for measures to boost employment intensi­
fied, expectations strengthened that some countries
in Europe might ease their restrictive monetary pos­
tures even if U.S. interest rates did not decline further.
In fact, during January, the central banks of many
major industrialized countries either reduced their offi­
cial lending rates or facilitated some easing of local
money market rates.
As interest rate differentials once more moved
strongly in favor of the dollar, they began to attract
funds into dollar-denominated assets. The dollar was
bid up across the board during the final two months
of the period. By end-January it was about 6 percent
higher against the European currencies and 8 percent
higher against the yen from the levels of end-November.
As a result, the dollar closed the six-month period
down on balance about 1 percent against sterling, 4
percent against the yen, 51/2 percent against the
German mark, and 13 percent against the Swiss franc.
The trade-weighted value of the dollar in terms of ten
major currencies declined 31/2 percent during the
period.
During the six-month period, there were occasions
when the market experienced unusually sudden and
sharp exchange rate movements during a single day.
Some of these episodes were associated with major
political events, such as the assassination of Egypt’s
President Anwar Sadat on October 6 and the imposi­
tion of martial law in Poland over the December 12-13
weekend. Other episodes were less dramatic and were
not associated with such identifiable events. The
U.S. authorities were prepared to intervene on some
occasions had the market disturbances persisted or
cumulated during the U.S. trading session; as it turned
out, the Federal Reserve undertook no intervention
operations on behalf of the U.S. authorities. The Trad­
ing Desk continued its long-standing practice of coop­
erating with other central banks by intervening as their
agent from time to time in the New York market.
On September 1 and December 15 the U.S. Treasury
paid off the two maturing tranches equivalent to



$1,611.4 million of its German mark-denominated se­
curities. After those redemptions, the Treasury had
outstanding $4,080.8 million equivalent of the foreign
currency notes, public series, which had been issued
with the cooperation of the German and Swiss authori­
ties in connection with the dollar-support program of
November 1978. Of the notes outstanding as of Janu­
ary 31, 1982, a total of $3,622.3 million is denominated
in German marks and $458.5 million is denominated in
Swiss francs. The maturity dates for the remaining se­
curities range between May 12, 1982 and July 26, 1983.
In the seven months through January 1982, the
Federal Reserve had gains of $0.1 million on its for­
eign currency transactions. The Exchange Stabilization
Fund (ESF) gained $15.2 million in connection with sales
of foreign currencies to the Treasury general account
to finance interest and principal payments on foreign
currency-denominated securities. The Treasury’s gen­
eral account gained $42.5 million net. This gain re­
flected $94.8 million of profits on the redemption at
maturity of Swiss franc- and German mark-denominated
securities, partly offset by $52.3 million of losses as a
result of annual renewals at current market rates of
the agreement to warehouse with the Federal Reserve
Swiss franc and German mark proceeds of Treasury
securities. As of January 31, 1982, valuation losses on
outstanding balances were $374.8 million for the Fed­
eral Reserve and $1,102.1 million for the ESF. The
Treasury’s general account had valuation gains of
$826.4 million related to outstanding issues of securi­
ties denominated in foreign currencies.

German mark
In early August the German mark was subject to di­
vergent tendencies— weak against the dollar but strong
against European currencies.
With respect to the dollar, market sentiment toward
the mark remained bearish. Domestically, the German
economy was relatively weak, unemployment was ris­
ing, and inflation was high by historical standards.
Moreover, the government deficit remained large, cap­
ital markets continued under strain, and fiscal policy
was under heated discussion publicly and within
Germany’s coalition government. Internationally, Ger­
many had experienced substantial deterioration in its
terms of trade because of the increase in oil prices
and the depreciation of the mark. The current account
was in heavy deficit, and there were wide interest rate
differentials favoring investment in the United States.
On top of these economic considerations, the mark
was seen in the exchanges as more exposed than the
dollar to international political tensions. This vulnera­
bility reflected Germany’s strategic position, its ties to
Eastern Europe, and its greater reliance on the Middle

FRBNY Quarterly Review/Spring 1982

57

Table 2

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
Bank of Sweden .............................

Outstanding
January 1, 1981

1981
I

1981
II

1981
III

1981
IV

1982
January

Outstanding
January 31,1982

-0-

+ 200.0

- 200.0

-0-

-0-

-0-

-0-

1981
III

1981
IV

1982
January

Amount of
commitments
January 31,1982

Data are on a value-date basis.

Table 3

United States Treasury Securities, Foreign Currency Denominated
In millions of dollars equivalent; issues ( + ) or redemptions { — )
Amount of
commitments
January 1, 1981

Issues

1981
I

1981
II

Public series:
G e rm a n y ................................................

5,233.6

-0-

-0-

-

680.3

-93 1 .1

-0-

3,622.3

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

1,203.0

-0-

-0-

-

744.5

-0-

-0-

458.5

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

6,436.6

-0-

-0-

-1 ,4 2 4 .8

-9 3 1 .1

-0-

4,080.8

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

Table 4

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

Period

Federal
Reserve

United States Treasury
Exchange
Stabilization
General
Fund
account

First quarter 1981 ......................................................................

+

6.2

-

0.7

Second quarter 1981 ...................................................... ..

-

1.4

-

3.8

Third quarter 1981 ............................................. ......................

+

0.1

Fourth quarter 1981

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

January 1982 ...........................................................................
Valuation profits and losses on outstanding assets and
liabilities as of January 3 1, 1982 ...........................................
Data are on a value-date basis.

FRBNY Quarterly Review/Spring 1982
Digitized for58
FRASER


-0 -0 -3 7 4 .8

+

-1 4 4 .3
-0-

-0 -

+

85.9

-0 -

-

39.2

15.2

-

4.2

-1 ,1 0 2 .1

+826.4

East for energy resources and export markets. In con­
sequence, the mark was subject to capital outflows,
all the more as market sentim ent toward the dollar
became increasingly bullish. On August 10 the rate
plunged to a five-year low of DM 2.5773, a decline
of some 45 percent since mid-1980.
Against other EMS currencies, however, the mark
remained strong. It benefited from the m arket’s view
that the authorities in Germany were still placing p ri­
ority on correcting the external imbalance and on fi­
nancing the current account deficit in the interim by
inflows of private and official capital. The federal gov­
ernment continued the practice, unusual fo r Germany,
of placing Deutsche mark-denominated debt instru­
ments directly with foreign official institutions. Follow­
ing the move in February 1981 to introduce a special
Lombard facility, German interest rates increased so
that adverse interest rate differentials vis-a-vis other
EMS currencies were either narrowed or elim inated.
The Bundesbank had announced its intention that be­
cause of the inflation problem it would aim at the
lower part of the 4 to 7 percent target range for the
growth of central bank money. Thus, with the market
apprehensive about prospects fo r other EMS curren­
cies, the mark had moved toward the top of the EMS,
at times hitting its upper intervention limit.
As a result of these crosscurrents in the exchanges,
the Bundesbank had frequently bought French and
Belgian francs to ease pressures w ithin the EMS w hile
selling dollars, at tim es heavily, to support the mark
against the dollar. Through end-July, Germany’s fo r­
eign currency reserves had increased to stand at
$43.4 billion. During August, however, as the Bun­
desbank stepped up its dollar sales to support the
mark, German foreign currency reserves fell by $1.5
billion.
Once the mark came close to its lows, m arket par­
ticipants became wary of a shift in market direction
and professionals moved quickly to cover their short
positions. The mark bounced back sharply and, as the
d ollar fell lower in the exchanges, market sentim ent
toward the German currency became more favorable.
In part, the turnaround reflected developments in the
United States, where the initial euphoria surrounding
the adoption of the U.S. A dm inistration’s econom ic
program gave way to skepticism that the program
would achieve all its goals. At the same tim e in
Germany, trade and current account figures fo r July
were released, pointing to a dram atic improvement in
export sales and providing the first concrete evidence
that the earlier surge in export orders was finally show­
ing through. Official commentary about this improve­
ment gave rise to expectations that Germany’s current
account deficit would continue to narrow in subsequent



Chart 3

G erm any
Movements in exchange rate and official
foreign currency reserves
Marks per dollar

Billions of dollars

Exchange rates shown in this and the following
charts are weekly averages of noon bid rates for
dollars in New York. Foreign currency reserves
shown in this and the following charts are drawn
from IMF data published in International
Financial S tatistics.
* Foreign exchange reserves for Germany and other
members of the European Monetary System
include adjustments for gold deposited with the
EMS and for foreign exchange swaps.

months— a tim e when most forecasters were expecting
the U.S. current account to deteriorate. Furthermore,
the government finalized a 1982 budget proposal ac­
cording to which nominal expenditure growth would
be slowed to 4 percent and the net financing require­
ment of the federal government would be cut to DM 27
billion o r 1.6 percent of gross national product (GNP),
down from a revised estimate for 1981 of DM 34.3
b illion or 2.2 percent of GNP. As the dollar eased,
therefore, the German mark moved up to trade around
DM 2.3195 by end-September.
Meanwhile, the strengthening of the mark added to
strains w ithin the EMS. The markets became vulner­

FRBNY Quarterly Review/Spring 1982

59

able, especially prior to weekends, to repeated rumors
of an imminent realignment of the participating cur­
rencies. Speculative bidding for marks against the
French and Belgian francs frequently stretched the
EMS to its limits, generating sizable intervention in
several centers and pushing the mark up against the
dollar as well. The Bundesbank responded to these
pressures by purchasing both dollars and EMS cur­
rencies in the exchanges so that, by the end of Sep­
tember, German foreign exchange reserves increased
by $1.1 billion.
Over the weekend of October 3 and 4, the EMS
finance ministers announced a realignment of parities
to take effect October 5. The mark, as well as the
Dutch guilder, was revalued by 51/2 percent against
those currencies whose parities remained unchanged
and in effect by 8 V2 percent against the French franc
and the Italian lira. Immediately thereafter, the mark
traded in the lower portion of the new band, reflecting
reflows of speculative investments as well as a re­
versal of commercial leads and lags. Accordingly,
other central banks began purchasing marks in the
exchanges so as to cover the liabilities within the EMS
that had built up over preceding months. Against the
dollar, however, the realignment was seen as freeing
the mark to strengthen further, and in subsequent
days the mark moved up to DM 2.1815, 151/2 percent
above its August low.
Following the realignment of the EMS, the Bundes­
bank confirmed the easing of interest rates that had
already begun in Germany’s money and capital mar­
kets by cutting the special Lombard facility rate from
12 percent to 11 percent effective October 9. The
Bundesbank felt able to take action to support the
domestic economy because of the overall strength of
the mark, the improving outlook for the balance
of payments, and the achievement of a compromise
on fiscal policy. Even so, the Bundesbank was careful
not to signal more forceful action, since at home in­
flation continued to accelerate to an annual rate of
7 percent year on year and in the United States interest
rates remained high so that interest rate differentials ad­
verse to the mark remained large. Later the same day
the Federal Reserve lowered its surcharge on discount
window borrowing by large banks from 3 percent to
2 percent, the second 1 percentage point cut in this
rate in three weeks. Thus, the Bundesbank’s action
did not contribute to any further widening of interest
rate differentials versus dollar assets.
After mid-October a number of developments within
Germany weighed on the mark. Unemployment was
increasing as declining corporate profits forced many
firms to move aggressively to economize on labor. As
a result, market participants came to expect that the

60 FRBNY Quarterly Review/Spring 1982


Bundesbank would take advantage of whatever oppor­
tunity developed to allow German interest rates to fol­
low U.S. rates down. In addition, the earlier optimism
over a quick and sustained improvement in Germany’s
balance of payments faded, as first August and then
September monthly trade figures disappointed market
expectations. Late in October the government revised
its budget estimates for 1982 to take account of climb­
ing unemployment and lower than expected revenues,
thereby eliminating virtually all the planned drop in
the borrowing requirement. Although this new budget
gap was later covered, largely by an expected increase
in Bundesbank profits available to be transferred to
the government, the episode underscored the differ­
ences that still existed within the government coali­
tion on major issues of economic policy. Also, political
tensions abroad adversely affected sentiment toward the
mark. The assassination of Egyptian President Anwar
Sadat pointed out the potential for instability in the Mid­
dle East and Germany’s reliance on that region for oil
supplies. Repeated reports of military maneuvers
around Poland were also an unsettling reminder of
Germany’s vulnerability to potential Soviet interference
in Eastern Europe.
Under these circumstances, the mark did not
strengthen even though interest differentials adverse
to the mark were narrowing sharply. Also, the Bundes­
bank moved cautiously to provide some short-term
liquidity to the banking system through swaps and re­
purchase agreements and did not change official inter­
est rates again until December 4, when it cut its spe­
cial Lombard rate V2 percentage point to 10.5 percent.
By contrast, in the two months to early December, the
Federal Reserve had twice lowered its discount rate
by 1 percentage point to 12 percent and also elimi­
nated the remaining 2 percentage point surcharge
on frequent borrowers. Short-term interest rates in
the United States had fallen sufficiently to cut in half
— from about 5 percentage points to 2 V2 percentage
points— the short-term differentials vis-it-vis the mark.
During the six weeks to end-November, the mark
occasionally came into demand, especially at times
when U.S. interest rates were declining. But the mark
did not keep pace with currencies outside the EMS
that were continuing to strengthen against the dollar.
Instead, movements of the rate above the DM 2.20
level regularly prompted commercial and investor sell­
ing of marks against dollars. On occasion, the mark
came sharply on offer, especially in the wake of politi­
cal developments in Eastern Europe or the Middle
East. At these times, the Bundesbank intervened
promptly and forcefully to sell dollars while EMS central
banks were also buying marks. These operations
contributed to better market balance.

In December and January the mark was adversely
affected by developments abroad. On December 14,
martial law was declared in Poland, triggering a
brief scramble for dollars against marks and sending
the rate as low as DM 2.3650 for a few hours. Prompt
intervention by the Bundesbank and other central
banks, together with commercial activity and profes­
sional profit taking, quickly restored balance to the
market, and the rate almost fully recovered in just a
matter of hours. Yet the Polish situation remained a
matter of market concern. In the United States, interest
rates stopped declining, disappointing market expecta­
tions that the deepening U.S. recession would continue
to ease credit demands. Indeed, U.S. money market
rates moved strongly higher, casting doubt that the
strengthening of Germany’s external position would
show through in the mark exchange rate.
This development focused attention anew on the
dilemma facing the German authorities. With the level
of unemployment heading to a record two million per­
sons, political pressures mounted, not only from labor
unions but also within parties in the governing coali­
tion, for more action to deal with the deteriorating
unemployment situation. But the government was
concerned about actions that either would increase
taxes and thereby hamper a recovery or would in­
crease government borrowing and thereby add to
inflation. There were also pressures to ease monetary
conditions. But the Bundesbank remained concerned
that a renewed easing in interest rates would ex­
acerbate the decline in the mark which would exert
a further upward push on costs and prices.
In the event, the government presented to Parlia­
ment a compromise program, approved shortly after
the close of the period, that was designed to stimulate
jobs through investment subsidies, lending programs
for small companies, and modest direct government
spending on energy-saving projects— financed mainly
by a 1 percentage point increase in the value-added
tax in 1983. Meanwhile, new figures showed that an
export surge late in the year had boosted Germany’s
trade account and helped pull its current account
deficit for 1981 as a whole down to DM 17.5 billion,
significantly lower than had been forecast. The im­
proving external position gave the Bundesbank scope
to lower its special Lombard rate a further Vz per­
centage point to 10 percent on January 21 and ensure
a similarly modest easing in money market rates.
At the end of January the mark was trading at
DM 2.3420, down about 61A percent from the lateNovember levels while up about 9 percent from its
lows of early August. The Bundesbank was at times
active in the markets during December and January,
selling dollars in support of the mark, while other



central banks within the EMS continued to acquire
marks. Reflecting Bundesbank dollar sales during the
two months, German foreign currency reserves fell
$3.0 billion to close the period at $37.5 billion, down
$5.9 billion for the period as a whole.

Swiss franc
In mid-1981, Switzerland was faced with a resurgence
of inflationary pressures. Part of the inflationary im­
pulse stemmed from the buoyancy of the domestic
economy— in contrast to the stagnation in other Euro­
pean countries— led by strong consumption and con­
struction activity. Shortages developed, in the housing
market, and domestic house prices and rents exhibited
sharp increases, contributing to a strong rise in con­
sumer prices. In addition, the decline of the Swiss
franc in the exchanges substantially boosted the cost
of imports, particularly by raising the domestic price of
oil and other dollar-denominated raw materials.
Though Swiss interest rates had risen progressively,
they were still well below those in other industrial coun­
tries. At midyear, interest differentials adverse to the
franc were about 9-10 percentage points vis-it-vis the
dollar and more than 3 percentage points vis-k-vis the
German mark. Consequently, foreign official and corpo­
rate borrowers continued to place heavy demands on
the Swiss franc money and capital markets. The Swiss
authorities did not seek to restrain these outflows.
They hope.d to avoid the development of sizable
external markets in Swiss franc-denominated assets,
particularly for longer maturities, and in any event the
current account had moved into surplus, estimated to
be $2.0-2.5 billion for 1981. Nonetheless, the pressure
of outflows of capital pushed the Swiss franc down in
the exchanges. At end-July the franc was trading
at SF 2.15 against the dollar and SF 0.87 against the
German mark. Along with other major currencies, it
declined further against the rising dollar to a fouryear low of SF 2.2095 on August 10, a decline of some
39 percent since its peak of 1980. On July 31, Switzer­
land’s foreign exchange reserves stood at $9.9 billion.
The Swiss authorities continued to pursue a policy
of monetary restraint to combat inflationary pressures.
Increasingly, however, the authorities had reason to
question whether policy was as restrictive as develop­
ments in the monetary aggregates would suggest or,
in view of the inflationary situation, whether policy
was as tight as circumstances warranted. For some
time the monetary base was below the 4 percent annual
growth target for 1981. However, as in many other coun­
tries, continuing financial innovations in Switzerland,
coupled with unusually high interest rates by historical
standards, had altered the behavior of banks and the
public, making the monetary base as well as the broader

FRBNY Quarterly Review/Spring 1982

61

m onetary aggregates less reliable than in the past as
a guide to policy. Questions about the adequacy of
monetary restraint were highlighted by the release of
consum er price numbers for August, showing inflation
rising 11.3 percent at an annual rate in the most recent
quarter and 7.4 percent year on year.
Early in September the authorities began taking ag­
gressive action to tighten monetary policy and thereby
underscore the prim acy of the anti-inflation struggle.
Effective September 2 the Swiss National Bank boosted
its discount rate to 6 percent from 5 percent and its
Lombard rate to 7.5 percent from 6.5 percent, the fourth
rise in 1981 in those official lending rates. The authori­
ties also made the refinancing of credit through foreign
exchange swaps with the central bank more expensive.
Following these actions, Swiss franc interest rates
shot up tem porarily before settling down around 11
percent.
The rise in Swiss interest rates during September
and October, which occurred at a tim e when in­
terest rates in other centers were easing, meant
that differentials adverse to the franc either narrowed
dram atically, as in the case of the dollar, or were
reversed, as in the case of the German mark.
Nonresidents therefore found incentives to begin re­
paying th eir Swiss franc-denom inated debt, w hile in­

Chart 4

Switzerland
Movements in exchange rate and official
foreign currency reserves
Francs per dollar

Billions of dollars

See exchange rate footnote on Chart 3.


62 FRBNY Quarterly Review/Spring 1982


vestors sought out higher yielding franc investments,
and these actions helped propel the franc sharply
higher in the exchanges. As the franc strengthened,
the view developed in the market that the Swiss author­
ities might allow the franc to appreciate beyond SF 0.80
against the mark— a level considered an upper bound
in the market since Septem ber 1978 when the Swiss
National Bank had intervened forcefully at that rate. In
addition, many European countries were regarded as
more vulnerable than Switzerland to p olitical tensions
in Eastern Europe and the M iddle East, and this con­
cern over the prospects for other currencies continued
to benefit the Swiss franc. In these circum stances, the
franc became exceptionally well bid. By m id-November
the rate advanced 18 percent from early-Septem ber
levels to a high of SF 1.7475 against the dollar and
some 10 percent to SF 0.7935 against the German
mark.
The strong appreciation of the franc, w hile welcome
as a contribution in the fight against inflation, was
nevertheless a matter of concern to the authorities.
Of special w orry was the rapid rise against the Ger­
man mark, the currency of S w itzerland’s main foreign
trade partner and m ajor com petitor in third markets,
since it threatened to put Swiss exporting and tourist
industries in a difficult position. Still, the authorities
made clear in public statements that large-scale in­
tervention sim ilar to that undertaken in 1978 would be
inappropriate. Sizable sales of Swiss francs would lead
to an expansion in Sw itzerland’s money supply, and
large purchases of dollars would push the dollar higher
in the exchanges— both developments that would
exacerbate inflationary pressures.
In the event, by November the economy showed
clear signs of flattening out and some private fore­
casters began to express fears that econom ic activity
would weaken to the point where unemployment
might rise. In addition, the need to avoid liquidity
strains from developing with the approach of the yearend argued fo r some relaxation in monetary restraint.
A ccordingly, the Swiss National Bank progressively
reduced the rate charged to dom estic banks for Swiss
franc swap credit against dollars and provided some­
what more liqu id ity than it absorbed via maturing
swaps. On December 4 the authorities reduced the
Lombard rate from 7.5 percent to 7.0 percent— an
action taken in coordination with interest rate reduc­
tions in other industrial countries and designed to bring
the Lombard rate more closely in line w ith prevailing
Swiss money market rates. But at the same tim e the
Swiss National Bank was anxious to avoid the impres­
sion of a fundamental shift in policy course and
consequently left the discount rate unchanged at 6
percent. In the exchange market the franc lost its

upward momentum as domestic and Euro-Swiss money
market rates eased downward. Against the dollar the
franc slipped back to trade around SF 1.80 by endDecember. Against the mark, however, the franc
remained well bid around SF 0.7985, principally in re­
sponse to market concerns over the foreign and do­
mestic implications for Germany of the declaration of
martial law in Poland.
By January the need for such a tight monetary policy
in Switzerland appeared to have passed, particularly
with the release of inflation figures showing a marked
deceleration in consumer prices to around 6 percent.
The 3 percent monetary growth target announced by the
authorities for 1982 was generally viewed as consistent
with the policy of fighting inflation, while also pro­
viding sufficient liquidity so as not to exacerbate the
developing weakness of the economy. Even so, the
Swiss authorities were thought to be under less pres­
sure than others in Europe to ease credit conditions,
given Switzerland’s low unemployment rate and the
still relatively favorable performance of the economy.
In fact, the Swiss National Bank did not lower its
official lending rates following the reduction by the
Bundesbank on January 21 of its special Lombard
rate. In these circumstances the franc, though fluctu­
ating widely at times, remained firm against the Ger­
man mark. But vis-a-vis the dollar, the franc con­
tinued to ease as money and capital market rates in
the United States firmed substantially and were gen­
erally expected to remain high despite the weakness
of the U.S. economy.
By the end of January the franc was trading at
SF 1.8680 against the dollar and at SF 0.7976 against
the German mark. At these levels the franc was up
151/2 percent against the dollar since its August low.
Over the six months under review the franc gained 131/2
percent against the dollar and 8 percent against the
German mark. Between end-July and end-January,
Switzerland’s foreign exchange reserves rose $600 mil­
lion to $10.5 billion in response to foreign currency swap
operations, the net purchase of dollars in intervention
operations, and interest earnings on outstanding re­
serves.

Japanese yen
By mid-1981 the Japanese economy had made im­
pressive adjustments to the second round of oil price
increases of 1979-80. Changes in production processes
in many of Japan’s largest enterprises had substan­
tially reduced Japan’s dependence on oil imports.
These developments, together with a continuing im­
pact of the 1979-80 depreciation of the yen, had led
to a sharp improvement in Japan’s current account,
which swung from deep deficit to moderate surplus in



just one and a half years. The rate of inflation at the
wholesale level, which at one point in 1980 had
reached 24 percent, had slowed to just about 1 per­
cent. Meanwhile, restrictive monetary and fiscal poli­
cies had helped limit the extent to which rising
material prices were passed on in the economy so that
inflation at the consumer level, which had never ex­
ceeded 9 percent, was around 5 percent per annum.
The process of adjustment had been uneven, how­
ever, and domestic demand remained weak. Impor­
tant sectors of the economy remained severely de­
pressed. Moreover, consumer expenditures were slow
to recover from the deflationary impact of rising energy
prices, despite the moderation of inflation. The slug­
gishness of domestic demand cast doubt that a firm
basis for sustained recovery had been established,
and domestic pressures on the authorities intensified
to adopt reflationary measures. Moreover, it height­
ened anxieties that the weakness of demand at home,
in combination with the legacy of the yen’s earlier*
depreciation, would provoke another surge of exports
and exacerbate protectionist reactions in Japan’s ma­
jor markets overseas.
As a result, the authorities had already begun to
provide stimulus to the economy. The government
had announced measures to aid small companies and
to speed up expenditures for public works. But the
scope for further expansionary fiscal policies was
limited by virtue of the fact that the levels of the
government’s overall deficit and borrowing require­
ment continued to be considered excessive by many
Japanese and were already exerting pressures in the
local capital markets. Thus, the larger source of stimu­
lus came from an easing of monetary policy. During the
spring, the Bank of Japan lowered its discount rate,
eased banks’ reserve requirements, and substantially
relaxed “ window guidance” ceilings on the growth of
bank lending.
In the exchange markets, the yen had benefited from
Japan’s improving economic performance to recover
from its 1980 lows against most European currencies.
Relative to the German mark, it had risen nearly 40
percent to trade at 97 yen to the mark by early August.
Against the dollar, however, a tentative recovery late
in 1980 had given way to a renewed and protracted
decline. With interest rates in Japan lower than in
any other industrialized country, Japanese residents
had taken advantage of newly liberalized foreign ex­
change controls to make long-term investments
abroad. Then during midsummer, when a long-awaited
decline in U.S. interest rates failed to materialize,
market participants lost hope that the large interest
differentials adverse to the yen would soon narrow so
as to permit Japan’s improving competitiveness to

FRBNY Quarterly Review/Spring 1982

63

Chart 5

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

Billions of dollars

1981

1982

See exchange rate footnote on Chart 3.

show through in the yen-dollar exchange rate. Thus, as
Japanese im porters sought to lim it th eir losses dur­
ing the August vacation period, they accelerated their
yen sales to hedge remaining future dollar needs.
In addition, foreign corporations continued short-term
yen borrow ings to meet financing needs in other cur­
rencies. As the selling of yen gathered force, it pushed
the spot rate down to ¥ 246.10 by the first business
day in August— a level only about 6 percent above its
1980 low.
At this point, many m arket participants felt that the
yen’s decline had been overdone in view of Japan’s
steadily improving current account position. With
banks generally in an oversold position, the market
was ripe for a reversal of sentiment toward the yen
when the dollar began its general decline during
August. Reports that some Middle Eastern investors
had been attracted in size by the rally in Japan’s
securities markets and purchases on the International
M onetary M arket helped spur the turnaround in de­
mand for the currency in early August. The yen’s rise
initia lly outpaced that of other currencies against the
dollar, bringing the exchange rate to ¥ 228.20 against
the dollar and to a high of ¥ 91.64 against the German
m arkon August 18.
A sense of caution soon overcame the yen market,

64 FRBNY Quarterly Review/Spring 1982


however. Participants recalled the disappointm ent
earlier in the year when the yen’s appreciation had
not gone as far as expected. They w orried about the
p ossibility that new protectionist barriers m ight be
erected in markets where Japan’s exports were pen­
etrating rapidly. Moreover, pressures built up over the
summer and autumn for the government to introduce
further monetary and fiscal stimulus to the still flagging
domestic economy. In this atmosphere, the yen’s rise
seemed to stall after m id-August at around the ¥ 230
level against the dollar even as the European cur­
rencies continued rising.
In September, the monetary authorities announced
that w indow guidance ceilings on com m ercial banks’
lending would be further increased for the fourth quar­
ter, even though monetary growth, running close to 10
percent at an annual rate, was just w ithin the Bank of
Japan’s projections. Further, the government an­
nounced on O ctober 2 a four-point program of fiscal
and other measures intended to stim ulate dom estic
demand and imports w hile assisting Japanese indus­
tries and regions that were experiencing particularly
severe structural difficulties. The M inistry of Finance
also set w ider lim its on Japanese banks’ foreign lend­
ing fo r the half year beginning in October, in keeping
with the projected financing needs accom panying the
growing surplus on the current account and reflecting
the continuing policy of allowing the country’s banks
to maintain th e ir overall share of lending in the Euro­
markets.
Long-term capital outflows from Japan remained
large even though interest differentials favoring dollar
investments narrowed during the late summer and
autumn. Using their new freedom under the 1980
Foreign Exchange Law, Japanese institutional in­
vestors continued programs begun earlier in the year
to diversify internationally. Also, some Japanese
firm s with large im port requirements had experienced
significant losses earlier in the year on their uncovered
future dollar commitments and were now adopting
more conservative policies regarding the hedging of
forward obligations in foreign currency. In the case
of firm s in some structurally depressed industries, such
as oil refining, the need to protect weak financial posi­
tions by hedging more of their future im port require­
ments was encouraged as part of the governm ent’s ef­
forts to support long-term adjustment. Under these in­
fluences, the yen-dollar rate wavered around the ¥ 230
level through Septem ber and October. Against the
German mark, whose continuing rise against the dollar
was partly influenced by the pressures building for
realignment w ithin the EMS, the yen declined steadily
to reach a low point of nearly ¥ 105 per mark on
October 30.

During November the yen became well bid again, as
U.S. interest rates declined further and hopes became
widespread that this trend would continue. Market
participants felt that, despite renewed arguments be­
ing heard in Japan for a further easing of monetary
policy, Japan’s already low interest rates offered less
scope for the monetary authorities in Japan as com­
pared with those in Europe to match U.S. interest rate
reductions. Therefore, further drops in U.S. rates were
expected to be reflected in a significant narrowing of
the differentials adverse to yen investments. Foreign
transactions in Japan’s securities markets, including
purchases of bonds under short-term repurchase ar­
rangements, reversed direction in November to become
sizable net purchases. Market participants were also im­
pressed by trade figures released for September and
October that showed a further strong improvement in
the current account surplus, even though the October
figures on export letters of credit already gave some
warning that the growth of exports might be slowing
in subsequent months. Under these positive influences,
the yen rose some 8 percent against the dollar during
November, reaching its high for the six-month period
of ¥ 213.40 on November 30 while recovering to
¥ 96.80 against the German mark.
Toward the end of the year there still was no clear
evidence of recovery in the domestic economy and
predictions of a very large current account surplus
in 1982 became widely accepted. Statistics on con­
sumer and wholesale prices continued to show the
lowest rate of inflation among industrial countries.
Information released about the real economy indicated
that growth of the third quarter had been heavily
concentrated in the foreign sector. Public-sector
spending and domestic consumption were virtually flat,
while private investment actually declined slightly for
the third quarter in a row. Investment by small- and
medium-sized firms showed an especially large drop,
continuing the trend which had been a concern to
policymakers for sometime. After the third quarter,
monthly trade statistics revealed that even export
growth had slowed at least temporarily in November
under the influence of government-imposed restraints
as well as sluggish demand in major export markets.
While welcome from the point of view of mitigating
trade frictions, this development lent further emphasis
to the need for recovery in the domestic economy.
The new budget, announced in December for the
fiscal year beginning in April 1982, retained the rela­
tively restrictive stance that had been adopted for fis­
cal year 1981 in keeping with the long-range objective of
containing and eventually reducing the size of the gov­
ernment's deficit and borrowing requirement. In these
circumstances and with the yen exhibiting more



strength than it had in the earlier part of the year, the
monetary authorities took further action to help spur
the faltering recovery. On December 11, the Bank of
Japan reduced its discount rate for lending to com­
mercial banks by % percentage point to 51/2 percent
following similar actions in the United States and
other industrial countries. This step was supplemented
later in the month by the announcement that overall
credit ceilings limiting loans extended by Japan’s
leading commercial banks, already progressively eased
in previous quarters, would be lifted entirely for the
calendar quarter beginning in January 1982.
In announcing the cut in the official lending rate,
the authorities made it clear that they had confined the
reduction to less than 1 percentage point so as not to
interfere with the recent rising tendency of the yen
and that they were prepared to counter any short-term
effect on the yen-dollar rate by intervening in the ex­
change markets. Nonetheless, when the U.S. and Euro­
dollar interest rates began to rise during December,
the relative unattractiveness of yields on yendenominated assets showed through in the exchanges
once again and the yen began moving down. When the
upward movement of U.S. interest rates continued into
January, rather than reversing with the new year as
many had hoped, the depreciation of the yen con­
tinued. Potential yen holders became increasingly im­
pressed with the discrepancy between the pressures
building for sustained high interest rates in the United
States, as new statistics were released showing higher
than expected growth of the U.S. monetary aggregates,
and the situation of Japan’s monetary authorities, who
faced a continuing need to ease credit policy to stim­
ulate the flagging domestic economy. Hope that wide
interest differentials might soon be reversed thus
faded in the first weeks of the new year. Pressure
against the yen intensified, bringing the exchange rate
against the dollar to ¥ 230.00 by the close of Janu­
ary, down 8 percent from the November 30 high but up
61/2 percent above the low of August 1981. The
yen’s cross rate in terms of the German mark had
changed even less on balance, to ¥ 98.21 by endJanuary as compared with ¥ 97.00 six months earlier.
The Bank of Japan continued its policy of inter­
vening in the exchange markets to smooth erratic
fluctuations in the exchange rate, intervening to sup­
port the yen at various times when the rate moved
down rapidly. Such dollar sales contributed to net
declines recorded in Japan’s foreign exchange re­
serves for December and January. For the six months
as a whole, however, Japan’s foreign exchange re­
serves rose $600 million to $24.6 billion by endJanuary, mainly reflecting interest earnings on Japan’s
outstanding holdings.

FRBNY Quarterly Review/Spring 1982

65

Sterling
In mid-1981, deep-seated concerns over the prospects
for the economy of the United Kingdom continued to
weigh on market sentiment toward the pound. While
the worst of the 2 1/2 -year-old recession appeared over,
evidence of an econom ic upturn had not yet mate­
rialized and, with United Kingdom interest rates lower
than earlier in the year, there was concern that the
government m ight be easing its stringent financial poli­
cies prematurely. It appeared likely that the United
Kingdom share in world export markets was falling—
inasmuch as persistently high rates of inflation and the
earlier appreciation of the exchange rate had severely
eroded the competitiveness of British industry. The
trade and current accounts remained in surplus. How­
ever, softening world oil prices prompted worries that
the substantial benefits B rita in ’s oil self-sufficiency had
provided to the balance of payments m ight dim inish.
Moreover, in other m ajor industrial countries interest
rates had increased, particularly over the summer. But
in the United Kingdom the pressures of high and rising
unemployment were seen in the exchange market as
lim iting the rationale, as well as the scope, for the
authorities to raise dom estic interest rates, and inter­
est differentials in fact moved adversely to sterlingdenominated assets. By end-July the pound had
dropped 24 percent from the highs registered in
January of last year to $1.84 against the dollar. It also
declined 101/2 percent to DM 4.55 against the German
mark and 10 percent in effective terms to 92.5
on a trade-weighted basis. The Bank of England,
acting to smooth fluctuations in the exchange rate,
had maintained its policy of intervening modestly on
both sides of the market. Nonetheless, mainly due
to the repayment of outstanding loans, B ritain’s foreign
exchange reserves had declined to $13.6 b illion by
end-July.
The pronounced drop of the dollar in August was
reflected in only a tem porary rebound of sterling in the
exchanges. Indeed, bearish sentiment toward the
pound deepened in September and O ctober so that,
w hile other European currencies were advancing
against the dollar, the pound declined in the ex­
changes. In part, renewed downward pressure on
sterling stemmed from fears that the monetary authori­
ties had relaxed the restrictive stance of monetary pol­
icy before inflationary expectations had been firm ly
laid to rest, thereby threatening the progress already
under way in bringing inflation under control. In the
view of many, the growth of the targeted aggregate
sterling M-3 substantially above its 6-10 percent annual
range could not be fu lly explained by tem porary dis­
tortions, such as the delay of tax payments caused by
a civil servants’ strike or by technical factors, such

66 FRBNY Quarterly Review/Spring 1982


as a shift in housing finance from the building soci­
eties to the banks. A fter allowing for these considera­
tions, the “ underlying” rate of sterling M-3 growth re­
mained high. The banking data released fo r August
were particularly discouraging in this respect, reflect­
ing a rapid expansion of bank lending to finance
personal consumption and to satisfy growing needs of
the corporate sector.
The downward pressure on sterling also resulted
from nervousness ahead of the publication of trade
figures for September and O ctober— the first fu ll fig ­
ures since February 1981 when the civil service pay
dispute interrupted the com pilation of data. In the
interval, expectations for a reduction of the trade
surplus had developed. Weakened competitiveness
was thought likely to restrict the volume of exports,
while im port volume was expected to rebound as the
previous sharp rundown of dom estic stocks abated
and was gradually reversed. The decline of sterling
during 1981 was also presumed to have weakened the
terms of trade. In the event, the actual trade figures
confirmed a fall in the trade surplus from the excep­
tional level of the w inter of 1980-81, though gaps in the
data posed greater than usual problems of interpreta­
tion. Looking ahead, crude oil price reductions, which
had taken place on a selective basis follow ing the
breakdown of OPEC price discussions in late summer,

Chart 6

U n ite d K in g d o m
Movements in exchange rate and official
foreign currency reserves
Dollars per pound

Billions of dollars

o c n ----------------------------------------------------------------------------------------------------------------------------------------------------1 0

Foreign currency
reserves

0.5

0
-0 .5
-

1.0

-1 .5
-

2.0

-2 .5
J

F M A M J

J
1981

A

S

O N

D

See exchange rate footnote on Chart 3.

J

F
1982

added to the unfavorable outlook for Britain’s balanceof-payments trends.
As broad-based selling pushed the pound precipi­
tously lower, the rate dropped in September to $1.7695
against the dollar and to DM 4.10 against the mark.
In effective terms it traded as low as 86, repre­
senting a trade-weighted drop in sterling to the lowest
levels since March 1979. At this point British policy­
makers faced a choice. On the one hand, the depre­
ciation of the exchange rate improved competitive­
ness and brightened the outlook for a recovery of
depressed profit margins and of investment activity.
But, on the other hand, the fall in the exchange rate
following the decline that had already taken place
earlier in 1981 threatened anti-inflationary goals at a
time when wage and price inflation was showing
improvement. Inflation had already fallen to around
10 percent, close to rates prevailing among Britain’s
major trading partners. Moreover, a sharp drop in
average wage settlements had occurred which, coupled
with productivity gains, had stabilized unit labor costs
for the first time in a decade. A failure by the authori­
ties to respond forcefully to the rapid buildup of selling
pressures might risk accelerating sterling’s fail given
the development of a severely adverse market psy­
chology. Furthermore, domestic monetary develop­
ments, particularly the expansion of bank lending,
suggested that policy action was appropriate to avoid
a further buildup of domestic liquidity. Thus, on bal­
ance, both external and internal considerations pointed
to the desirability of increasing United Kingdom money
market rates.
Accordingly, in mid-September the authorities raised
short-term interest rates sharply, under new monetary
control arrangements that came into effect the previous
month, first through the discount window and then by
their operations in the bill market. In addition, the au­
thorities began operating more actively in the exchange
market as a seller of dollars. Meanwhile, interest rates
moved lower in the United States and, as a result, Brit­
ish interest rates stood above comparable U.S. in­
terest rates for the first time since November 1980.
Then, immediately following the realignment within the
EMS, interest rates softened in a number of continental
European countries as well so that interest differentials
moved generally more favorably for sterling. These
developments prompted widespread demand for ster­
ling, which gathered momentum in November when the
rally in the U.S. bond market carried over to the giltedged market and attracted foreign investors seeking
to benefit from capital gains in addition to exchange
rate returns. By late November the pound had recov­
ered 11 percent from its lows to trade around $1.98
against the dollar and 91.9 on an effective basis.



During December, domestic debate over the state of
the economy intensified against the background of in­
creased labor unrest. On December 2, Chancellor Howe
announced a £5 billion increase in projected public
spending for the 1982-83 fiscal year (April-March), mainly
for the local authorities and for spending on employ­
ment and training programs. But these measures were
generally seen as no more than a passive adjustment
by the government to rising unemployment and con­
tinued low levels of economic activity since they did
not imply a significant shift in the already restrictive
stance of fiscal policy. Most private forecasters re­
mained relatively pessimistic concerning the strength
of any recovery given the lackluster prospects for gov­
ernment expenditure, consumer spending, and exports.
The rebuilding of inventories was thought to compensate
only partly for the weakness in other areas of eco­
nomic activity. In these circumstances, exchange mar­
ket participants remained concerned that the govern­
ment would have to relax its restrictive policies after
all and the pound again came under selling pressure,
with the rate slipping back 6 percent from its lateNovember highs to $1.8690 by mid-December before
steadying around the year-end.
Sentiment toward sterling turned more optimistic
during January. The labor situation improved, particu­
larly following the unexpected decision of the miners
not to strike and instead to accept the management
pay offer— a development which seemed to validate
the perseverance of the government in its overall strat­
egy. The miners’ decision brightened the outlook for
inflation to abate, and in the exchange market this
boosted sentiment for sterling. Domestically, this
prospect gave a lift to the capital markets and gen­
erated hopes that conditions in the money markets
would ease. In fact, a softening in short-term interest
rates materialized and was not resisted by the authori­
ties. Even so, the decline in short-term United Kingdom
interest rates was less than reductions on the Conti­
nent where the monetary authorities were taking
advantage of some improvement in their external posi­
tions to allow interest rates to decline and thus support
their economies. As a result, interest rate differentials
favoring sterling investments over those denominated
in Continental currencies widened. At the same time,
trade figures released for December were better than
expected and the pound also benefited from oil com­
pany demand. As a result, sterling held generally
firm against the rising dollar and advanced strongly
against the Continental currencies. By end-January the
pound was trading at $1.8670 for a net rise of 11/2
percent against the dollar since end-July. On an effec­
tive basis, sterling stood at 91.8 for a % percent de­
cline over the six-month period under review.

FRBNY Quarterly Review/Spring 1982

67

Between end-July 1981 and end-January 1982 the
foreign exchange reserves of the United Kingdom de­
clined by $1.0 billion to $12.6 billion. The authorities’
intervention operations in the exchange market had a
small im pact on reserves as compared with other influ­
ences, such as the repayments and accruals of ex­
ternal public-sector borrow ings and the revaluation
losses of gold and dollar swaps against European
currency units (ECUs) done with the European Fund
for Monetary Cooperation (FECOM).

Chart 7

France
Movements in exchange rate and official
foreign currency reserves
Francs per dollar
4 .4 0 —-----------------------------

Billions of dollars

4.60
4.80

French franc
During late summer 1981, m ajor elements of the eco­
nomic strategy adopted by Francels new government
were under exchange m arket scrutiny. The government
had moved aggressively to reduce burgeoning unem­
ployment through monetary and fiscal measures to
stim ulate consum ption and investment, and it was
pledged to a program to redistribute income and to
nationalize m ajor banks and industrial groups. In other
European countries the case for a shift toward policy
stim ulus was under intense political debate, but most
governments opted for continued monetary and fiscal
restraint. Consequently, pessimism deepened in the
exchange markets over the outlook for the French
franc, since the divergence in policies was expected
to produce a deterioration in inflation and the current
account d eficit in France w hile improvements were
anticipated in some other European countries. The
franc fell in these circum stances more rapidly than
other European currencies against the rising dollar.
From FF 5.8775 at end-July it plummeted to a record
low of FF 6.1870 on August 10, while also dropping
to the floor of the EMS. Moreover, in subsequent
weeks as the dollar declined in the exchanges, the
franc had d ifficulty keeping pace with the advance
of the German mark and other EMS currencies against
the U.S. currency.
The French government sought to contain the selling
pressures on the franc during August and September
so as not to jeopardize its domestic program. The
Bank of France intervened heavily in the exchange
markets, selling mainly dollars as well as European
currencies, to keep the franc within the mandatory
21/4 percent trading lim it against the German mark
and occasionally also against other currencies which
traded at the top of the join t float. The government
also tightened exchange controls to lim it further the
scope fo r leading and lagging of commercial payments
by tem porarily suspending the fa cility for im porters to
purchase foreign currency forward. Previously, onemonth forw ard cover had been permitted except for
importers of raw m aterials who were allowed up to three
months to purchase forward exchange ahead of deDigitized for68
FRASER
FRBNY Quarterly Review/Spring 1982


5.00
5.20
5.40
5.60
5.80

6.00
6.20

J

F M A M J

J
1981

A S O N D J

F
1982

See exchange rate footnote on Chart 3.

livery. In addition, the Bank of France raised on
Septem ber 21 its money m arket intervention rates by
1 percentage point— to 191/2 percent fo r seven-day
m aturities— thereby reversing the previously easier
tendency in dom estic interest rates. However, the
authorities did not wish to undercut the basic p olicy aim
of reducing the high interest rate burden on French
industry, and thus the government requested that the
increase in banks’ costs be financed out of profits and
not by raising base lending rates.
Otherwise, with respect to dom estic policy, the
government continued to address the problem s of an
economy showing only lim ited signs of recovery from
more than sixteen-eighteen months of recession. Late
in September the government presented its 1982 bud­
get proposals, aimed forem ost at increasing em ploy­
ment by supporting econom ic activity. The budget
provided fo r the creation of 70,000 new public-sector
jobs, increased spending on private and p ublic invest­
ment, raised aid and financial incentives to industry,
and hiked outlays on education and various social
welfare programs. On the revenue side the im position
of new taxes, higher tax rates, and steps to reduce
tax evasion fell short of the nearly 27 percent increase
in expenditures, leaving the government w ith a pro­
jected fiscal deficit of FF 95 billion, roughly equivalent

to 3 percent of GNP, compared with about FF 70 bil­
lion in 1981 or about 2.4 percent of GNP. The govern­
ment also approved a bill nationalizing five industrial
groups and a large segment of the private banking
sector, with the takeover shifting approximately 750,000
workers from private industry to the government sector.
In the exchange market, participants continued to
be concerned about the direction of economic policy.
They feared an adverse impact on already depressed
business spending plans of the government’s efforts
to nationalize and restructure industry. They were
troubled by the prospect of a sharp rise in the fiscal
deficit, which seemed likely if an economic recovery
did not materialize. They worried that an expansion
in the deficit in a short period could compromise the
government’s growth target for the monetary aggre­
gates and, thereby, risk substantially increasing infla­
tionary pressures. These concerns prompted large
flows of funds to move out of France amid growing
speculation that the franc would be devalued within
the EMS. The outflows of funds were reflected in a
$3 billion decline in French foreign exchange reserves
from $22.6 billion at end-July to $19.6 billion by endSeptember.
On October 5 the central EMS parity of the French
franc, along with the Italian lira, was adjusted down­
ward 3 percent against the Danish krone, Irish pound,
and the Belgian franc— whose central rates remained
unchanged— and in effect by 8 V2 percent against the
German mark and the Netherlands guilder, currencies
whose central rates were moved upward within the
joint float. Immediately after the EMS realignment,
the franc traded at the top of the new band amid a
reflow of funds that took the form of a reversal of
commercial leads and lags and also represented a
reflux of speculative and investment capital. As a
result, the franc rose in tandem with the mark against
the dollar to trade around FF 5.56 by mid-October.
In the weeks that followed, French government
officials stated that henceforth the government would
give the same priority to fighting inflation as to unem­
ployment to ensure maximum positive effects from
the currency realignment. The authorities acted on
several fronts to blunt the inflationary impact of the
devaluation of the franc. The government imposed
temporary price controls or freezes on a wide range
of services and food items, where prices had shown
marked acceleration, and introduced an 8 percent
guideline on annual increases for industrial products.
Regarding wages, the government began discussions
with the country’s main unions to alter cost-of-living
provisions in future wage negotiations so as to stabi­
lize real earnings. In addition, the government froze
FF 15 billion in budgeted 1982 expenditures, while



also raising employer and worker contributions to the
social security fund. These various measures helped
improve the atmosphere in the domestic bond market,
and the government, for sometime previously unable
to issue new bonds, began to borrow successfully on
a large scale. The government’s access to the bond
market in financing its deficit made it possible for
'monetary growth to decelerate and enhanced pros­
pects for the monetary aggregates to stay within the
1982 range.
With the realignment in place and with policies in
France appearing to move toward greater balance
between the goals of combating unemployment and
curbing inflation, the franc remained firm within the
EMS. The impact of stimulative policies on France’s
inflation and trade performance remained a source of
concern. However, these issues became somewhat
less acute, as other countries moved cautiously to
provide stimulus to their flagging economies through
an easing in monetary conditions and as they came
under growing pressure to adopt programs of fiscal
stimulus. With the divergence in policies somewhat
less pronounced, some forecasters began to look for
a smaller deterioration than previously expected in
the 1982 French current account.
Moreover, nominal French interest rates remained
relatively high— commanding a 6-7 percentage point
premium over German interest rates— even though the
authorities had renewed their efforts to reduce French
money market rates in the aftermath of the EMS
realignment. French firms sought foreign currency
loans to finance domestic expenditures, while foreign
official and private investors maintained and even
increased their holdings of franc-denominated assets.
In these circumstances, the French authorities were
able to ease the ban on forward purchases of foreign
currencies, allowing importers of selected basic com­
modities to purchase foreign exchange up to three
months ahead of delivery. Otherwise, exchange con­
trols remained intact, limiting the scope for resident
outflows. Moreover, France continued to be seen in
the exchanges as less vulnerable than other Con­
tinental countries to political disruptions in the Middle
East and in Eastern Europe, a perception that helped
bolster the franc particularly following the declaration
of martial law in Poland in December.
For all these reasons, the franc remained firm at
the top of the joint float even as EMS currencies as
a group weakened against the dollar during December
and January. By end-January the franc was trading at
FF 5.96 against the dollar, a net decline of about VA
percent over the six-month period under review but a
rise of more than 3 V2 percent from its August lows. The
relative strength of the franc enabled the Bank of France

FRBNY Quarterly Review/Spring 1982

69

to acquire sufficient marks in the market to reimburse in
advance the main part of its very short-term obligations
to FECOM stemming from earlier exchange market in­
tervention in 1981. The outstanding amount was fully
repaid by early January in ECUs, foreign currency, and
special drawing rights. By end-January, France's for­
eign exchange reserves stood at $18.3 billion. At this
level, France’s foreign exchange reserves were $4.3
billion lower over the six-month period under review,
in part reflecting these repayments as well as the re­
valuation losses of gold and dollar swaps against ECUs
done with FECOM.

Italian lira
At the beginning of August the Italian lira had fallen
against the strongly rising dollar to stand at LIT 1,227.50.
However, it was trading comfortably near the top of the
EMS, holding its position firmly in relation to other Euro­
pean currencies following its earlier downward adjust­
ment within the joint float. The Bank of Italy had recently
taken advantage of the lira’s position within the EMS
to rebuild foreign currency reserves to a level of $16.5
billion.
The relatively firm performance of the lira at that
time reflected sizable tourist inflows which offset the
adverse impact of Italy’s deteriorating terms of trade
following the sharp increase in dollar prices for energy
and other products as well as a weakening of demand
in Italy’s principal export markets. In addition, a tight
control on liquidity and credit at home helped shield
the lira from high interest rates abroad. The Bank of
Italy, as part of its continuing struggle against inflation,
had tightened monetary policy progressively by widen­
ing the scope of its ceilings on bank lending, raising
reserve requirements, and hiking its discount rate to
19 percent. In addition, the monetary authorities were
changing their procedures for issuing Treasury bills
so that the Bank of Italy could vary its purchases of
bills according to its assessment of domestic liquidity
needs rather than buy all unsold Treasury bills at auc­
tion. Moreover, a deposit scheme had been imposed
in May for a four-month period on purchases of foreign
exchange for imports. This scheme, which required
the placement with the Bank of Italy for ninety days of
a noninterest-bearing lira deposit equal to 30 percent
of the exchange transaction, had the effect of increas­
ing the cost of payments in foreign currency as well
as cutting into credit available for domestic purposes.
Nevertheless, there were continuing problems. In­
flation was still running at a rate of 18 percent, con­
siderably higher than most of Italy’s trading partners.
The public-sector debt had continued to exceed ex­
pectations despite persistent attempts at expenditure
control. A collapse in the stock market had seriously

FRBNY Quarterly Review/Spring 1982
Digitized for70
FRASER


threatened the authorities’ long-standing efforts to
rebuild the financial structure of Italy’s industrial
sector. Evidence then available indicated that the
domestic economy was weak, with industrial produc­
tion still declining. The terms of trade were falling,
as the U.S. dollar continued to climb in the exchanges
and the traditional surplus on service income was con­
tracting because of growing international debt service.
To deal with these problems, a new coalition gov­
ernment led by Republican Giovanni Spadolini an­
nounced that it would not rely on any further sharp
contraction of economic activity to curb inflation.
Instead, it would seek to contain inflationary pressures
through a series of negotiations with business, labor,
and various political interests aimed foremost at ad­
justing Italy’s wage indexation system, the scala mo­
bile. For the first time, two of the three major labor
unions indicated a willingness to negotiate limited
adjustments to the system. Furthermore, proposals
were put forth for “ receding targets” and “ norms” for
prices, wages, and public utility rates. At the same
time, the government decided to extend the fourmonth-old import deposit scheme until end-February
1982. In an agreement with the European Community,
however, it announced a phased reduction of the pro­
portion of foreign exchange purchases held in
noninterest-bearing deposits and increased somewhat
the products exempted from the deposit requirement.
During August-September, the lira remained firm
within the joint float even as seasonal tourist inflows
tapered off. Italy’s trade balance was beginning to
improve, as export volumes picked up in response to
the earlier devaluation and as softness in the domestic
economy held import volumes down. Although the
weakness of the EMS bloc had pushed the lira to a
new record low of LIT 1,268.50 against the dollar on
August 10, the Bank of Italy was able to purchase
sizable amounts of dollars to rebuild its reserve posi­
tion through early September. These purchases were
reflected in the $1.0 billion increase in foreign cur­
rency reserves over the two months.
Late in September the lira dropped from the middle
to the bottom of the joint float. Rumors began to cir­
culate in the market that an EMS realignment would
be broad enough to include the lira, whereas pre­
viously only a limited adjustment focusing on other
currencies was thought likely. New estimates, putting
the public-sector borrowing requirement as large as
12.5 percent of gross domestic product, also generated
concern that the escalating deficit would undermine
the efforts to curb inflation. As Italian importers moved
to accelerate foreign currency purchases, sizable in­
tervention by the Bank of Italy was required to steady
the rate.

On O ctober 5 the lira was, in fact, devalued along
with the French franc by 3 percent against the cur­
rencies whose official parities remained unchanged
and, in effect, by 8 V2 percent against the German
mark and Dutch guilder. In public statements after the
realignment, the Italian government stressed that it had
not taken the initiative for the change and that the
effect of the revaluation of the mark versus the lira,
w hile insufficient to reestablish the com petitive posi­
tion of Italian exports to West Germany, would make
German exports to Italy more* expensive and thereby
add to Italian inflation in the short run.
After the EMS realignm ent and through endNovember the lira, although generally trading around
the m iddle of the EMS band, firmed against the dollar.
Italian interest rates remained high w hile those in other
centers were generally declining so that favorable
interest rate differentials fo r the lira widened against
most currencies. Concern remained, however, that the
new government w ould not win quick agreement from
unions and business on approaches to reduce price
and wage pressures. Sim ilarly, in November a record
rise in the sca/a m obile underscored the risk that the
gains in international com petitiveness resulting from

Chart 8

Italy
Movements in exchange rate and official
foreign currency reserves
Lira per dollar
8 5 0 -----------------

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

the two devaluations would be q uickly eroded by
inflation. Thus, at tim es the lira came on offer and the
Bank of Italy prom ptly intervened to resist declines in
the rate, as reflected in the two-m onth drop of $469
m illion in foreign currency reserves.
Beginning in late December and continuing through
the end of January, the lira firm ed to trade at or near
the top of the EMS, even though it fell back in relation
to the U.S. dollar along w ith other currencies in the
jo in t float. The Italian trade and current accounts had
made considerable and sustained improvement. Export
and im port volumes, as well as service income, were
responding favorably to the depreciation of^ the lira,
declining real incomes in Italy, and inventory liquida­
tion. Moreover, long-term capital continued to flow
into Italy, mainly in the form of Eurodollar borrowings,
as cred it availa ility at home remained tight. To rein­
force the slow t jw n in inflation under way, the Bank
of Italy extende J in late December the 1981 ceilings on
growth of ban lending until the end of 1982. These
ceilings were < ctremely restrictive in that they required
a reduction c lending in real terms. Nevertheless, the
lira came on >ffer on occasion, fo r example, when a
bunching of )reign currency purchases entered the
market follov ig reductions in the proportion of trans­
actions cove d by the im port deposit scheme. But in­
tervention b} the Bank of Italy helped the lira remain
near the top 1 the EMS. By end-January the lira was
trading at LI" 1,250.00 against the dollar, up 11/2 percent
from its Aug st lows. However, over the six-m onth pe­
riod under ri iew, the lira declined 1% percent against
the dollar ar I 71/4 percent against the mark, in part re­
flecting the esults of the O ctober EMS realignment.
Meanwhile, a ly’s foreign exchange reserves advanced
$1.3 billion >ver the period to stand at $17.8 b illion at
end-Januar

European f Dnetary System
1050

1—3.0

See exchange rate footnote on Chart 3.




The persis nee of serious recession and high inflation
provoked i a jo r policy debates in most countries in
the EMS o ir the summer of 1981. Com plaints intensi­
fied that f gh U.S. interest rates were exacerbating
the alread d ifficu lt process of adjustm ent by forcing
a choice
etween accepting the inflationary conse­
quences c depreciation of th eir currencies against
the rising < ollar or by raising interest rates in defense
of home c rrencies and accepting a loss in econom ic
output. Do lestically, pressures built up fo r a relaxation
in monetar policy, fo r fiscal expansion— through some
com binatk 1 of increased expenditures and tax cuts—
or otherwi e fo r a change in policy emphasis. In some
countries, such as Germany, the com m itm ent to re­
strictive p ilicies already in place remained firm. In
other nati< ns, including Belgium and the Netherlands,

FRBNY Quarterly Review/Spring 1982

71

the debate made it difficult for newly elected legisla­
tures to reach agreement on a ruling government or
on a common program. In France there was an explicit
shift in strategy, under new leadership elected in the
spring, in favor of reducing unemployment through
domestic stimulus and specific job-creating measures.
In the exchange markets, expectations intensified
during the summer and early autumn that divergent
policies and economic trends among participating
EMS countries— particularly Germany and France—
would force a realignment of the joint float. These
expectations gained strength, particularly after the
turnaround of the dollar in August, since market par­
ticipants felt that tensions within the joint float would
more readily show through once there was greater
scope for the mark to rise in the exchanges. In the
event, large speculative flows emerged, imposing major
strains on the joint float arrangement. To contain the
selling pressures, the monetary authorities in many
countries raised domestic interest rates. Moreover,
EMS central banks intervened heavily during August
and September to keep their currencies within agreed
limits. In contrast to the spring, the intervention
largely took the form of sales of dollars rather than
EMS currencies. Then, on October 5 the EMS cur­
rencies were realigned with the German mark and
Dutch guilder each revalued 51/2 percent and the
French franc and the Italian lira each devalued 3 per­
cent in relation to the Belgian franc, Danish krone, and
the Irish pound whose bilateral central rates against
each other remained unchanged.
The new exchange rate structure and the lessening
of strains within the EMS provided more countries than
previously with the scope to begin lowering interest
rates and thereby provide some monetary stimulus to
their economies. France and Denmark permitted money
market rates to ease, while Germany and the Nether­
lands lowered official lending rates in the OctoberDecember period. However, the reduction of European
interest rates lagged behind the decline of rates in
the United States and partly for this reason EMS cur­
rencies advanced against the dollar by as much as
11 to 16 percent from their August lows. In December
when U.S. interest rates moved higher, the currencies
of the EMS started to decline against the rising dollar
in the exchanges. Although there were rather wide
exchange rate fluctuations against the dollar, the con­
figuration of currencies within the EMS remained com­
paratively stable.
The French franc, which moved to the top of the
band immediately after the realignment, was soon
joined by the Dutch guilder in the upper part of the
EMS. The guilder was supported by a current account
surplus and improving inflation prospects in the Neth­

72 FRBNY Quarterly Review/Spring 1982



erlands. From a deficit in 1980, the current account
moved to a surplus of about NG 7 billion last year,
with further improvement expected this year. The turn­
around in the current account reflected delayed in­
creases in the price of natural gas exports and the
effect on imports of weak domestic investment and
consumer demand. In addition, direct incomes policies
pursued by the authorities in 1980 and 1981 improved
competitiveness, with labor costs per unit of output
lagging behind those of most other countries. Also
contributing to the guilder’s strength in the EMS was
the formation of a government in the autumn after
many false starts since the general elections in May.
The government was pledged to a program of reducing
the fiscal deficit as a proportion of GNP, while also
directing part of the country’s substantial gas rev­
enues to specific employment-creating projects.
Even though Denmark in contrast to the Netherlands
was running a current account deficit, the Danish
krone also traded firmly in the upper portion of the
joint float. Gains in export market shares and the
depressed level of imports supported the krone by
narrowing Denmark’s current account deficit over the
course of 1981. The central bank also made sizable
foreign currency payments on behalf of the govern­
ment from official reserves, thereby helping maintain
balance in the exchange market.
Trading around the middle of the EMS band was the
Italian lira, bolstered by a contraction in Italy’s cur­
rent account deficit and a tight monetary policy which
induced long-term capital to flow in from abroad.
Meanwhile, the Irish pound tended to fluctuate some­
what below the middle of the joint float even as Irish
domestic interest rates rose significantly. Although
conversions of private- and public-sector foreign bor­
rowings helped underpin the pound, the inflows of
capital had difficulty keeping pace with the widening
of the current account deficit, as a recovery in stock
building and fixed investment from earlier depressed
levels began to draw in imports.
The German mark, after having initially moved to
the floor of the EMS following the October realign­
ment, remained near the bottom of the joint float
through end-1981. Accordingly, EMS central banks
were able to purchase marks in the exchanges to cover
liabilities incurred earlier in the year to FECOM.
Together with the mark at the bottom of the EMS was
the Belgian franc, pushed lower by concerns over
Belgium’s large and protracted budget and current
account deficits. After elections in November, expec­
tations built up that a downward adjustment of the
franc within the EMS would occur. As selling pres­
sures intensified in late November-early December,
the Belgian National Bank supported the franc at the

floor of the 2!4 percent band through increasingly
heavy sales of foreign currency. The authorities also
raised the discount rate and the Lombard rate each by
2 percentage points to 15 percent and 17 percent,
respectively, effective December 11 and enforced other
measures making it prohibitively expensive for non­
residents to speculate against the franc. Then, over
the December 13-14 weekend, a new government was
formed, pledged to restrain wage increases under the
wage indexation system and to curtail the budget defi­
cit. With the new government providing grounds for a
more effective approach than previously to reducing
government expenditures and lowering the costs of
industry, market sentiment toward the Belgian franc
improved.
After the new year, as the currency bloc declined
against the dollar, the configuration of currencies
within the EMS shifted somewhat, but without imposing
new strains on the joint-flbat mechanism itself. As
before, the Dutch guilder and the French franc re­
mained strong within the joint float, and the authorities
in both countries were able to lower interest rates in
line with reductions in Germany. The Italian lira also
traded at the top of the band as the authorities kept
interest rates high. The Danish krone slipped lower in
the middle of the band in response to projections of a
widening in Denmark’s current account deficit in 1982,
and the authorities, unable to take advantage of the
tendency for major European interest rates to come
down, tightened money market conditions instead.
The German mark moved higher in the joint float
even as the Bundesbank, acting to stimulate domestic
demand, lowered on January 21 the special Lombard
rate for the third time in six months. As the mark
moved higher and as debate within Ireland over eco­
nomic policy intensified, the Irish pound came under
modest pressure and moved into the lower half of the
EMS band. For its part, the Belgian franc traded
steadily at the bottom of the EMS and the authorities
cut the discount rate effective January 7 by 1 percent­
age point to 14 percent and the Lombard rate by 2 per­
centage points to 15 percent. The authorities did not,
however, further reduce lending rates when the
Bundesbank acted on January 21 to cut its official
lending rate. By the end of January the EMS currencies
had relinquished much of the gains recorded against
the dollar in the autumn months to end the six-month
period about 11/2 percent to 101/4 percent higher against
the U.S. currency from their August lows.

Canadian dollar
The Canadian dollar was heavily on offer in mid-1981,
dropping on August 4 to a fifty-year low of Can.$1.2445
(U.S.$0.8035). The decline reflected market concerns



over the balance-of-payments implications of Canadian
energy policy, constitutional issues, and persistent in­
flation.
The main focus of exchange market attention was
Canadian energy policy announced in autumn 1980,
especially the establishment of incentives for explora­
tion and development of domestic energy which favor
Canadian ownership, and an ensuing dispute between
the federal government and Alberta over energy pricing
and taxation. By mid-1981, the “ Canadianization” pol­
icy had stimulated sales of foreign-owned energy com­
panies and outflows of capital. Moreover, the policy
was seen as threatening the inflows of investment capi­
tal needed to offset the traditional current account
deficit and to provide capital required to develop Ca­
nadian energy reserves and other economic resources.
Also, to press their position in the dispute with the
federal gr ^eminent, the provincial authorities in Al­
berta ha i cut oil production temporarily within the
provincr, increasing Canada’s short-term dependence
on impeded crude oil.
Other factors beyond the energy problems weighed
on marl et sentiment in early August. Strong upward
pressure on Canadian prices and wage costs had con­
tinued through the first half of 1981 in contrast to the
United States where improvement on the inflation front
had begun to appear. The move to “ patriate” the Ca­
nadian constitution by the federal government led to
legal challenges by provincial governments at a time
when relations were already strained by the energy
issues. Earlier in the summer, the traditional interest
rate differentials in favor of the Canadian currency
nearly disappeared at times when short-term U.S. rates
climbed sharply.
Against this background, the Canadian dollar had
become increasingly vulnerable, dropping sharply at
the end of July and the first week of August. The
authorities took several actions in response. The Bank
of Canada intervened heavily to support the rate and,
by end-July, Canadian foreign currency reserves had
declined to $748 million. It also drew $700 million in
July and $500 million in August under the $3.5 billion
standby facility with domestic chartered banks to re­
plenish reserves. At the end of August total borrowings
under the facility stood at $1.5 billion. Beginning in late
July, the Bank of Canada aggressively pushed up in­
terest rates. In roughly three weeks, short-term rates
jumped by about 3 percentage points, restoring sub­
stantial interest rate differentials in favor of Canadian
assets by early August. In addition, the Canadian Min­
istry of Finance asked commercial banks to reduce
their lending to corporations for purposes of financing
buyouts involving foreign currency conversions.
In the wake of these actions, the Canadian dollar re-

FRBNY Quarterly Review/Spring 1982

73

Chart 9

Canada

Chart 10

Movements in exchange rate and official
foreign currency reserves

Interest Rates in the United States,
Canada, and the Eurodollar M arket

Canadian dollars per dollar
1. 1 -

Billions of dollars
3.0

Three-month m atu ritie s*
Percent

-0 .5
J F
1982

-

1.0

* Weekly averages of daily rates.
See exchange rate footnote on Chart 3.

bounded in the exchanges. Also during August, expec­
tations developed that a compromise would soon be
reached between the federal and provincial govern­
ments on the troublesom e issues of pricing, taxation,
and revenue sharing in the energy field. On Septem­
ber 1, an agreement was in fact announced which pro­
vided for the rapid move of dom estic oil prices toward
w orld market levels, helping alleviate exchange mar­
ket concern that the governm ent’s policy would lim it
future energy development. With agreement now
reached, chances increased that several m ajor oil
exploration projects that had been suspended in earlier
months would be resumed. Also, Alberta moved to re­
store oil production cutbacks, easing Canadian needs
fo r imported crude. A compromise on revenue sharing
was also achieved, providing for increases in federal
revenues. Under these circum stances, and w ith the
U.S. dollar generally in decline, the Canadian dollar re­
covered substantially after mid-August to Can. $1.1929
by September 3. The Bank of Canada was a net pur­
chaser of U.S. dollars during August-Septem ber and
repaid $700 m illion of the $1.5 billion in credits drawn
during the summer.
The Canadian d ollar then steadied to trade in a
fa irly narrow range, easing back slightly on balance
through the rem ainder of September and October.
The Bank of Canada, stressing its view that reduction
of inflation was crucial to a return to healthy econom ic
growth and external balance, resisted declines in Ca­


74 FRBNY Quarterly Review/Spring 1982


nadian interest rates as large as those then developing
in the United States. Nevertheless, a sudden increase
in unemploym ent in September and other signs of de­
veloping econom ic slack led to questions in the m arket
as to how much longer the authorities could maintain
th e ir policies of restraint even though there was no
evidence of a slowing of inflation. Moreover, the Cana­
dian trade surplus had weakened through the summer,
pushing the current account more deeply into deficit.
The Bank of Canada was a net purchaser of U.S. dol­
lars during these two months. It paid down $200 m illion
in borrow ings from dom estic banks, and by the end of
O ctober foreign currency reserves stood at $1,270
m illion.
During November, the Canadian d o lla r clim bed
about 2 percent as the U.S. dollar declined against
most m ajor currencies and as several factors shifted
in favor of the Canadian dollar. The Bank of Canada
responded to the continued decline in U.S. interest
rates by lim iting the fall in Canadian interest rates.
As a result, interest rate differentials favorable to the
Canadian dollar widened, spurring borrow ings abroad
especially by p ublic authorities. As the exchange rate
rose, borrowers moved to accelerate conversions of
foreign currency. The governm ent also introduced a
generally restrictive 1982 federal budget to Parlia­
ment. The exchange market was impressed that mone­
tary and fiscal policy in Canada continued to be
directed toward control of entrenched inflationary pres­

sures. At about the same time, new oil and gas
finds in the Beaufort Sea seemed to improve the
chances of achieving the Canadian goal of energy
self-sufficiency by 1990. Also, Prime Minister Trudeau
announced in early November a compromise agree­
ment, with all provinces except Quebec approving
“ patriation” of the Canadian constitution.
By November 30, the Canadian dollar had reached
Can.$1.1761 (U.S.$0.8503), its highest level in over a
year. With the Canadian dollar strengthening sharply,
the Bank of Canada bought U.S. dollars in the ex­
change markets. During November, the government
finalized a $300 million medium-term loan from the Saudi
Arabian Monetary Agency. In total, Canadian foreign
currency reserves rose $1.75 billion during the month
and stood at $3.0 billion at the month end. In November
and December the Bank of Canada repaid the final
amounts borrowed to finance intervention during the
summer.
In December and January, with U.S. interest rates
rising, concern developed that Canadian interest rates
would not increase sufficiently to maintain interest rate
differentials. Successive monthly figures on unemploy­
ment confirmed the weakness of the Canadian econ­




omy and triggered a debate over fiscal and monetary
policy. The restrictive tone of the 1982 budget had
generated substantial domestic criticism, and many
analysts were predicting that the Canadian economy
had by then entered its worst recession of the postwar
period. Yet inflation had not decelerated and wage
settlements continued above 12 percent at a time when
the United States was showing progress in both of
these areas. In the event, Canadian interest rates
drifted slightly lower, and favorable differentials, which
at their peak had been over 5 percentage points, nearly
evaporated by the end of January. Capital inflows ta­
pered off and the Canadian dollar dropped back to
Can.$1.1988.
Thus, by the end of January, the Canadian dollar
was trading about 2 percent below its end-November
highs but still nearly 3 percent above its lows reached
just after the opening of the period. The Bank of
Canada was a net seller of U.S. dollars, so that
Canadian foreign currency reserves declined in Janu­
ary to stand at $2.9 billion. Even so, over the sixmonth period, Canadian foreign currency reserves in­
creased $2.2 billion and all drawings on the standby
facility with domestic chartered banks were repaid.

FRBNY Quarterly Review/Spring 1982

75

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FRBNY Quarterly Review/Spring 1982