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FINANCIAL INNOVATION IN THE UNITED STATESBACKGROUND, CURRENT STATUS AND PROSPECTS*
Alfred Broaddus

The purpose of this paper is to describe recent
financial innovation in the United States, outline its
principal implications with regard to (1) the structure
and behavior of financial markets and (2) the conduct
of monetary policy, and speculate on the likely character of further innovation in the near-term future.
In the United States as elsewhere, financial innovation has been a continuous but uneven process, where
the rate of innovation has varied substantially from
one period to the next depending on a variety of
circumstances. In particular, there have been a
number of periods of accelerated innovation in U. S.
financial history, frequently during or following
periods of great social and political upheaval such as
the Civil War and the Great Depression. It seems
clear in retrospect that the 1970s and early 1980s
have been years of relatively rapid innovation due
largely to (1) higher inflation and its impact on
interest rates and (2) rapid technological progress
that has significantly reduced the real costs of carrying out financial transactions. This accelerated innovation has already had a profound effect on the
competitive structure and risk characteristics of
American banking and financial markets, on the way
these markets are regulated, and on the conduct of
U. S. monetary policy. Further, while there is some
reason to believe that the pace of innovation may
diminish in the United States in the years immediately ahead, the full impact of the innovations that
have already occurred probably has not yet been felt.
The paper is organized as fol1ows.l Section I provides background information on the structure and
regulation of American financial markets, with
*This paper was delivered at the First International
Symposium on Financial Development sponsored by the
Korea Federation of Banks in Seoul on December 4, 1984.
The views expressed in the paper are the author’s and do
not necessarily reflect the views of the Federal Reserve
Bank of Richmond, the Federal Reserve System, or the
Korea Federation of Banks.
1
The paper is organized roughly along the lines of the
framework suggested by M. A. Akhtar. See Akhtar,
“Financial Innovation and Monetary Policy: A Framework for Analysis,” in Bank for International Settlements
(1984), pp. 3-25.

2

special attention to the regulation of banks and other
depository institutions. Section II describes the
forces that appear to underlie the accelerated rate of
financial innovation in recent years. Sections III and
IV discuss the impact of this innovation on financial
markets and the conduct of monetary policy, respectively. Finally, Section V speculates briefly on
future prospects. In view of the breadth of the topic
and the purpose of the symposium for which this
paper was prepared, the paper will seek to synthesize
available information on recent financial innovation
in the United States rather than to break new analytical ground.
I.
BACKGROUND INFORMATION ON THE STRUCTURE
AND REGULATION OF U. S. FINANCIAL MARKETS

This section provides background information on
the general structure of U. S. financial markets and
the regulation of these markets. This perspective is
essential to an understanding of the nature of recent
financial innovation and the forces underlying it.
A. Structure of U. S. Financial Markets
As is well known, the money and capital markets
in the United States are among the largest and most
highly developed in the world. Tables I and II
provide a general idea of the size, scope and structure
of these markets. Table I is a flow of funds table
that shows total net new demands for and supplies
of funds in U. S. credit markets in recent years in
both dollar and percentage terms. In addition, the
final column on the right side of the table shows total
amounts outstanding at the end of 1983. 2 A S t h e
table indicates, total new credit flows in 1983
amounted to $515.5 billion. On the demand side,
2

Table I includes only debt instruments and therefore
excludes equity funds. The net issuance of corporate
stock in 1983 was $46.2 billion. Total corporate stock
outstanding at the end of 1983 was $2,151.4 billion. See
Kaufman, McKeon and Blitz (1984), Table 3C, p. 33.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

Table I

DEMAND FOR AND SUPPLY OF CREDIT IN U. S. CREDIT MARKETS
1978

1979

1980

1981

1982

$73.7
33.9

$12.4
38.8

1983e

Amount
Outstanding
December 1983 e

A. NET DEMAND
1. Annual Net lncreases in Amounts Outstanding ($ billions)
Privately Held Mortgages
Corporate and Foreign Bonds
Total Long-Term Private

$117.7
34.4

$113.1
31.9

152.1 144.9

$1,319.5
617.5

-102.3 51.1

1,937.0

118.6
35.1

147.3

77.4

153.7

78.6
27.8

119.5
31.9

128.9
29.2

106.5

151.3

158.2

274.5

318.5

1,978.9

$415.7 $398.7 $351.9 $419.4 $405.0 $515.5

$5,344.8

92.2
52.4

98.0
49.3

Total Short-Term Private

144.6

Privately Held Federal Debt
Tax-Exempt Notes and Bonds

86.5
32.5
119.0

TOTAL

123.2 107.6

$67.0
35.3

67.6
9.8

Short-Term Business Borrowing
Short-Term Household Borrowing

Total Government Debt

$84.2
39.0

55.5
23.9

44.9
49.9

853.5
575.4

79.4

94.8

1,428.9

210.9
63.6

265.9
52.6

1,504.2
474.7

2. Percentages 1
Privately Held Mortgages
Corporate and Foreign Bonds

28.3
8.3

28.4
8.0

23.9
11.1

17.6
8.1

Total Long-Term Private

36.6

36.4

Short-Term Business Borrowing
Short-Term Household Borrowing

22.2
12.6

24.6
12.4

19.2
2.8

35.0 25.7
38.3
8.4

3.1
9.6

13.0
6.8

24.7
11.6

12.6

19.8

36.2

13.7
5.9

8.7
9.7

16.0
10.8

Total Short-Term Private

34.8

36.9

22.0

36.6

19.6

18.4

26.7

Privately Held Federal Debt
Tax-Exempt Notes and Bonds

20.8
7.8

19.7
7.0

34.0
9.1

30.7
7.0

52.1
15.7

51.6
10.2

28.1
a.9

28.6

26.7

43.0

37.7

67.8

61.8

37.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

$174.5 $175.7 $152.0 $199.9 $178.5 $267.3
27.2
30.6
126.2
72.8
56.7
54.9

$2,423.2
949.5

Total Government Debt
TOTAL
B. NET SUPPLY

1. Annual Net Increases in Amounts Outstanding ($ billions)
Total Nonbank Finance
Thrift Institutions
Insurance, Pensions, and
Endowments
Investment Companies
Other Nonbank Finance
Commercial Banks
Nonfinancial Corporations
State and Local Governments
Foreign Investors
Residual: Households Direct
TOTAL
2. Percentages

72.4
6.6
22.7

62.0
29.3
27.8

68.2
15.9
12.9

72.4
72.4
28.0

91.0
52.3
4.6

109.1
8.0
24.1

998.8
213.2
261.7

126.1
-0.9
16.0
38.0
61.8

122.2
7.5
7.1
-4.6
90.6

101.8
-3.8
1.8
23.2
76.9

108.9
5.4
0.5
16.0
88.7

108.5
15.5
6.4
17.6
78.5

146.3
13.6
15.2
12.8
60.3

1,600.3
120.2
77.1
238.5
885.1

$415.7 $398.7 $351.9 $419.4 $405.0 $515.5

$5.344.8

1

Total Nonbank Finance
Thrift Institutions
Insurance, Pensions, and
Endowments
Investment Companies
Other Nonbank Finance

42.0
17.5

44.1
14.2

43.2
15.6

47.7
6.5

44.1
7.6

51.9
24.5

45.3
17.8

17.4
1.6
5.5

15.6
7.3
7.0

19.4
4.5
3.7

17.3
17.3
6.7

22.5
12.9
1.1

21.2
1.6
4.7

18.7
4.0
4.9

Commercial Banks
Nonfinancial Corporations
State and Local Governments
Foreign Investors
Residual: Households Direct

30.3
-0.2
3.8
9.1
14.9

30.6
1.9
1.8
-1.2
22.7

28.9
-1.1
0.5
6.6
21.9

26.0
1.3
0.1
3.8
21.1

26.8
3.8
1.6
4.3
19.4

28.4
2.6
2.9
2.5
11.7

29.9
2.2
1.4
4.5
16.6

100.0

100.0

100.0

100.0

100.0

100.0

100.0

TOTAL
e

Estimated.

1

Details may not add to totals due to rounding.

Source: Kaufman, Henry, James McKeon and Steven Blitz, 1984 Prospects for Financial Markets, New York: Salomon Brothers, Inc.,
December 1983, p. 28.

FEDERAL RESERVE BANK OF RICHMOND

new government debt accounted for approximately
62 percent of the total, and new private debt made up
the remainder. As section A2 of the table makes
clear, the principal development affecting the structure of the demand for credit in the years shown has
been the disproportionate growth of government debt
and especially the growth of federal debt. The net increase in privately held federal debt rose from a little
over 20 percent of total net demand in 1978 to almost
52 percent in 1983. Although part of this increase
reflected normal cyclical developments,3 the substantial increase in federal expenditures over the last two
decades has produced a strong secular increase in the
growth of federal demands for credit. Section B2 of
the table shows the breakdown of the supply of funds
across various categories of lenders. In 1983, commercial banks provided slightly less than 30 percent
of new funds. All depository institutions (commercial banks plus thrift institutions) provided somewhat
more than half of all funds.
Table II looks more specifically at the relative size
of various classes of financial institutions using data
on the stocks of financial assets held in 1983. As the
data indicate, depository institutions as a group accounted for over half of the total; commercial banks
held approximately a third.
Tables I and II focus on the structure of U. S.
financial markets in terms of dollar flows and stocks.
To appreciate fully the nature of the American financial system, however, one must take account of the institutional and geographic character of these markets.
In general, financial markets are less centralized in
the United States than in most other industrial countries. While New York City is clearly the financial
center of the country, there are important regional
market centers, including regional stock exchanges,
in several other major cities. Nowhere is the relative
decentralization of U. S. markets more apparent,
however, than in the case of commercial banks.4 A s
of the end of 1983 there were 14,454 insured commercial banks in the United States of which 4,751
were national banks chartered by the federal government and the remainder were state banks chartered
by the various state governments. Although several
major international banking organizations are based
in the United States, overall banking resources are
3

1978 was the fourth year of the business expansion that
followed the recession that ended in the first quarter of
1975. 1983 was the first year of the recovery from the
recession that ended in the fourth quarter of 1982.
4

The historical and regulatory factors that have influenced the structure of the U. S. banking industry are
discussed below.

4

Table II

FINANCIAL ASSETS HELD BY U. S.
FINANCIAL INSTITUTIONS
1983

$ Billions

Percent
of Total

$2,526.3

53.4

1,496.3
67.7

31.6
1.4

703.8
169.4
89.1

14.9
3.6
1.9

Life Insurance Companies

514.4

10.9

Private Pension Funds

276.6

5.9

State and Local Government
Retirement Funds

216.1

4.6

Finance Companies

254.8

5.4

Total Depository Institutions
Commercial banks and
affiliates
Foreign banking offices
Savings and loan
associations
Mutual savings banks
Credit unions

54.1

1.1

Money Market Mutual Funds

102.4

2.2

Sponsored Credit Agencies

236.2

5.0

Mortgage Pools

244.9

5.2

Federal Reserve System

161.2

3.4

Other

141.2

3.0

$4,728.2

100.0

Mutual Funds

TOTAL

Source: Board of Governors of the Federal Reserve System.

considerably less concentrated than in most other
countries. In December 1982, the 10 largest banking
organizations based in the United States held only
about 18 percent of total domestic deposits.
B. The Regulation of U. S. Markets
A thorough review of the regulation of the U. S.
financial system is beyond the scope of this paper.5
The extent and intensity of regulation vary greatly
across markets, from the minimal regulation of the
market for U. S. government securities to the comprehensive regulation of commercial banks. It is
the regulatory system applied to banks and other
depository institutions that is most relevant to recent
financial innovation in the United States. Therefore,
the remainder of this section focuses primarily on
banking regulation.

1. Evolution of banking regulation in the United
States Banking has been systematically regulated in
the United States throughout the nation’s history.
The character of this regulatory apparatus has
changed significantly from one period to the next,
5

For a comprehensive recent survey see George J. Benston, “The Regulation of Financial Services,” in Benston
(1983B), pp. 28-63.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

and it has been a major source of political controversy
since the earliest days of the republic. Indeed, one of
the principal political debates in the years immediately following the Revolution centered around the
question of whether the federal government or the
respective state governments should predominate in
the regulation of banks.
This issue has never been fully resolved. The
period from the Revolution until 1836 was one of
constant tension. The majority of banks were chartered and supervised by the states. The federal
government chartered only two banks in this period,
the First Bank of the United States (1791-1811) and
the Second Bank of the United States (1816-1836).
These two banks, however, had branches nationwide,
exercised some central banking functions, and, as a
result, became principal targets for those who sought
to restrict the growth of the power of the federal
government.
When President Andrew Jackson vetoed the legislation that would have renewed the charter of the
Second Bank, the states temporarily gained ascendancy in banking regulation. Further, between 1837
and 1860 a number of states adopted so-called “free
banking” laws under which banks could be freely
established as long as certain minimum, well-defined
conditions regarding capital and collateralization of
notes were met. This period has usually been regarded as an unsuccessful experiment with “laissezfaire” banking during which the absence of regulation
led to abuses (by so-called “wildcat” banks) that
demonstrated the need for greater regulation.6 T h e
extent of regulation began to increase gradually in the
1860s, and the federal government slowly but surely
reestablished its participation with the passage of the
National Banking Act in 1863 and the Federal Reserve Act in 1913.7
2. Foundation of the present regulatory system
Although the history of banking regulation prior to
the early 1930s has an important bearing on the
present regulatory system, especially with regard to
geographic restrictions on branching, the major force
that shaped the current system was the reaction to
6

This view of the Free Banking Era has been challenged
in an important recent article by Rolnick and Weber
(1983).
7

For more detailed discussions of banking regulation in
the nineteenth and early twentieth centuries see Thomas
C. Huertas, “The Regulation of Financial Institutions: A
Historical Perspective on Current Issues,” in Benston
(1983B). See also McCarthy (1984). The standard works
on the period are Friedman and Schwartz (1963) and
Hammond (1957).

the traumatic banking crisis that accompanied the
Great Depression. Some monetary historians now
attribute the crisis to the failure of the Federal Reserve System to provide adequate reserves to the
banking system in the face of an international financial panic and a major worldwide economic contraction. 8 At the time, however, the upheaval was blamed
mainly on (1) excessive competition in the provision
of banking services and (2) speculative activity and
conflicts of interest that resulted from the active
participation of commercial banks in investment
banking activities in the 1920s. The comprehensive
banking legislation of the early 1930s, which is the
foundation of the present regulatory system, was
designed to correct these perceived weaknesses.
The main elements of this legislation were as
follows :
(a) Separation of commercial and investment
banking. The Banking Act of 1933, known popularly
as the Glass-Steagall Act, prohibited commercial
banks from engaging in most underwriting and other
investment banking activities. The idea was that
commercial banks would invest primarily in shortterm, “self-liquidating” commercial loans and other
liquid assets in accordance with the real-bills doctrine
that was influential at the time. This effort to keep
commercial banking separate from the securities
industry and other commercial activities has been
extended by more recent legislation, particularly the
Bank Holding Company Act of 1956 and the 1970
amendments to that Act.
(b) Restrictions on the payment of interest on
deposits. Banks were prohibited from paying interest
on demand deposits, and the Federal Reserve was
given the authority to set ceiling rates on time deposits. The Fed has regulated time deposit rates over
the years through its Regulation Q.
(c) Deposit insurance and restrictions on entry.
The Banking Act of 1933 established the Federal
Deposit Insurance Corporation to administer a national deposit insurance system. It set specific and
generally restrictive conditions for the granting of
national charters and indirectly set standards for state
charters through the conditions imposed for admission to the insurance system.
(d) Maintenance of geographic restrictions on
branching. The banking legislation of the 1930s left
the restrictions on branching contained in the Mc8

See Friedman and Schwartz (1963), chapter 7.

FEDERAL RESERVE BANK OF RICHMOND

5

Fadden Act of 1927 unchanged. Under these restrictions, interstate branching was prohibited, and
nationally chartered banks had to conform to any
further restrictions imposed by state law in the states
in which they operated.
The general thrust of this regulatory system is
clear. Commercial banking was to be insulated from
other financial and commercial activities. In order
to promote stability, entry into the industry, entry
into particular geographic markets, and price competition were to be severely limited. In the Hegelian
dialectic, thesis generates forces producing antithesis,
and the tension is eventually resolved through synthesis. In U. S. financial markets, the regulatory
system established in the 1930s is the thesis, and the
extensive financial innovation of recent years is the
antithesis. The synthesis of these opposing forces is
presently being formed.
II.
FORCES UNDERLYING RECENT FINANCIAL
INNOVATION IN THE UNITED STATES

As suggested at the end of the preceding section,
recent financial innovation in the United States is
largely a reaction to the restrictive and essentially
anti-competitive regulatory system established in the
1930s. The forces motivating this innovation have
existed since the system came into being, but they
have been greatly strengthened over the last 25 years
by two essentially external developments: (1) accelerated technological progress in the computer and
communications industries and (2) a secular increase
in the rate of inflation accompanied by high and
volatile interest rates. This section briefly describes
these developments.

and for business firms and households to use, sophisticated cash management techniques to reduce the
proportion of liquid assets held in deposits or other
instruments subject to interest rate ceilings. This
same technology has made it feasible for nonbank
financial institutions such as securities firms to offer
financial products that combine their traditional investment services with transactions services that
closely resemble those formerly provided exclusively
by commercial banks. The Cash Management Account offered by Merrill Lynch, for example, which
combines a conventional securities account with a
credit line and a money market fund that has a thirdparty payments capability would not have been feasible in the absence of the ability to process, record
and store large volumes of data relatively inexpensively. The same is true of a myriad of other cash
management services now offered by both banks and
other financial institutions and of the infrastructure
that supports them such as electronic funds transfer
systems and automated clearinghouses.
B. Inflation and Interest Rates
The technological developments described above
would have had a substantial impact on cash management practices in any event, but the incentive to
develop these techniques has been greatly increased
by the behavior of inflation and interest rates in the
United States since roughly 1965. As indicated by
Chart 1, the inflation rate was below 3 percent during
most of the period between the Korean War and the

A. Technological Advances
Technological progress in the computer and communications fields in recent years has led to a truly
phenomenal reduction in the real cost of processing
and transmitting data. It has been estimated that
between the mid-1960s and 1980 computer processing
costs declined at an average annual rate of 25 percent,
and communications costs fell at a rate of 11 percent. 9
The impact of these developments has been especially
great in banking and financial markets. In particular,
the quantum reduction in real transactions costs has
made it both feasible and profitable for banks to offer,

1950

1960

1970

1980

Source: U.S. Department of Labor, Bureau of Labor
9

See Kaufman, Mote and Rosenblum (1983), p. 9.

6

Statistics.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

mid-1960s. After 1964, the expansive fiscal and
monetary policies associated with enlarged domestic
social programs and the financing of the war in Vietnam and subsequently the petroleum shocks of the
1970s produced a steady if irregular increase in inflation to a peak rate exceeding 13 percent in 1980.
While not particularly high by world standards, this
was the highest peacetime inflation in modern American history.
The rise in inflation was accompanied by corresponding increases in the level and volatility of interest rates, which can be seen in Chart 2. Through
most of the 1950s and early 1960s, the opportunity
cost of holding non-interest-bearing demand deposits
and savings or other time deposits subject to Regulation Q ceilings was either relatively low or nonexistent. The so-called credit crunch of 1966, however, was the first of a series of tight credit episodes
during which market rates rose significantly above
the Regulation Q ceilings. Initially, these episodes
occasioned massive but generally temporary transfers
of funds from accounts subject to the ceilings to
market instruments such as Treasury bills. This
“disintermediation” of funds was both costly and
disruptive. In particular, because the majority of
mortgage credit in the 1960s and early 1970s was
provided by savings and loan associations and other
thrift institutions that derived most of their funds
from time deposits subject to the ceilings, disintermediation led to severe periodic restrictions of the
availability of credit to support residential construc-

tion. The housing and building trades lobbies are
powerful political forces in the United States, and
the disruption of these industries by disintermediation
was an important factor leading to the reevaluation of
banking regulation discussed below.
As Chart 2 shows, market interest rates have exceeded the Regulation Q passbook ceiling both substantially and continuously since the end of 1976.10
As a result, the temporary disintermediation that
characterized the period between 1965 and 1977 has
been supplanted by the more comprehensive and
permanent innovations described in the next section.
Aside from the higher level of interest rates and
the incentives it has created, Chart 2 shows that the
variability of rate movements has also increased
sharply over the last decade. 11 This greater variability has increased uncertainty and risk in financial
markets-particularly in markets for long-term securities. This increased interest rate risk has created
strong incentives for financial institutions to devise
new financial instruments and develop new markets
that make it possible for institutional and other investors to reduce their exposure to risk.

III.
INNOVATION IN FINANCIAL MARKETS

The combination of forces and incentives described
in Section II of this paper has produced a series of
financial innovations in the United States that have
become increasingly visible to the general public
since the late 1950s. Rather than attempting an
exhaustive inventory, 12this section will focus on the
major innovations. Special attention will be given
to innovations in banking and depository markets,
since these particular innovations have important
implications for the conduct of monetary policy as
well as the provision of financial services.13 In addition to discussing the innovations themselves, the
important movement toward the deregulation of
10
Ceiling rates on other time deposits subject to ceilings
were scaled upward from the passbook ceiling.
11

This heightened variability may have been due in part
to changes in late 1979 in the operating procedures used
by the Federal Reserve to implement monetary policy.
These changes shifted the short-run operational emphasis
from the Federal funds rate to various reserve aggregates.
See Axilrod (1982).
12

A comprehensive listing as of the end of 1982 can be
found in Silber (1983), p. 91.
13

The monetary policy
Section IV below.

FEDERAL RESERVE BANK OF RICHMOND

implications

are

discussed

in

7

interest rates that is currently in progress will be
summarized to date, 14 and the impact of these developments on the quantitative structure of depository
markets will be detailed.
A. Innovation in Banking Markets
Innovation in banking and other depository markets has been proceeding at a rapid pace for at least a
quarter of a century. 15 The initial developments
primarily affected commercial banks and their corporate customers. By the end of the 1970s, however,
it involved all depository institutions and a number
of nondepository and even nonfinancial firms, and
household as well as business customers.
1. The 1960s and Early 1970s: The “Cat and
Mouse” Game between Banks and Regulators and
Initial Steps toward Deregulation By the late 1950s
it had become apparent to most money center banks
in the United States that many major corporate customers had sharpened their cash management practices and found ways to lower their average holdings
of non-interest-bearing deposits. Since these deposits
were a major source of funds for these banks, it was
essential that the banks react to this development,
which they did with the introduction of large negotiable CDs in 1961. These CDs bore interest, although
they were initially subject to the Regulation Q ceiling. The important thing about the negotiable CD
was precisely that it was negotiable. Hence, when it
neared maturity, it was essentially a marketable,
interest-bearing liquid asset, in contrast to ordinary
time deposits, which could not be transferred and
could not bear interest at maturities under 30 days.
The negotiable CD was a huge success in the early
1960s, and it allowed the money center banks to
regain at least temporarily much of the ground they
had lost. Beyond that, the negotiable CD introduced
the concept of “liability management,” which dramatically altered the character of wholesale banking
in the United States. Prior to that time, banks had
depended primarily on demand deposits as their
major funding source. Since banks were prohibited
from paying explicit interest on these deposits, they
compensated their business customers-and to a

lesser degree their household customers-implicitly
by providing them a variety of free services, especially payments services. The negotiable CD substituted explicit interest for implicit interest. By varying the rate of interest, banks could actively influence
the volume of deposit inflows rather than merely
accepting deposits passively. Further, since negotiable CDs involved no payments services, their introduction moved banks in the direction of pure intermediation. 16 While these changes benefited banks
in a number of ways, they also exposed them to the
risk of unanticipated short-run swings in the cost of
funds due to market forces beyond their control.
The volume of negotiable CDs grew steadily up to
16

See Heurtes, “The Regulation of Financial Institutions,” in Benston (1983B), p. 24.

Table III

MAJOR ACTIONS TO DEREGULATE
INTEREST RATES ON DEPOSITS
1972-1983
Action

Year

1972

Negotiable Order of Withdrawal (NOW) accounts introduced in Massachusetts.

1973

Initial use of ceiling-free,
‘Wild card” experiment.
small denomination time deposits. Deposits had minimum maturity of 4 years. Experiment lasted 4 months.

1978

Introduction of 6-month money market certificates with
yields tied to 6-month Treasury bill rate.

1979

Introduction of small saver certificates, with yields tied
to U. S. Treasury securities with comparable maturities.
Minimum maturity initially 4 years, but subsequently
reduced.

1980

Passage of Depository Institutions Deregulation and
Monetary Control Act.
1. Set 6-year phase out of interest rate ceilings on
time deposits.
2. Authorized NOW accounts nationwide, effective at
the end of 1980.

1981

Introduction of nationwide NOW accounts.
Introduction of ceiling-free Individual Retirement Accounts (IRAs).

1982

Introduction of several new accounts paying market
rates.
1. 91-day money market certificate.
2. 3½year ceiling-free time deposit.
3. 7-31 day time deposit.
Passage of Garn-St. Germain Act, which authorized
money market deposit accounts.

14

Table III lists the principal actions taken to deregulate
interest rates between 1972 and 1983.
15

Several economists have attempted to formulate theo-

retical models to capture the nature of the process described in this section. See in particular Ben-Horim and
Silber (1977) and Kane, “Microeconomic and Macroeconomic Origins of Financial Innovation,” in Federal
Reserve Bank of St. Louis (1984), pp. 3-20.

8

1983

Nearly complete deregulation of interest rates on time
deposits.
1. Elimination of ceilings on all time deposits with
original maturities exceeding 32 days.
2. Elimination of all ceilings on time deposits with
original maturities from 7 to 31 days with minimum
balance of $2,500.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

1966, but the credit crunch of that year drove market
rates well above the Regulation Q ceiling, and this
condition persisted through most of the remainder of
the decade. As a result, banks again experienced
large outflows of funds and were driven to seek
alternative sources not subject to the ceiling. There
ensued what has been described as a “cat and mouse”
game in which banks would first develop either (1) a
new source, such as borrowing Eurodollars from
offshore affiliates, or (2) new short-term instruments, such as commercial paper issued by holding
company affiliates and various forms of RP contracts. After a brief delay, the Federal Reserve
would then step in, define the instrument as a deposit
and subject it to the Regulation Q ceiling and to
reserve requirements. In short, the 1960s illustrated
the cycle of banking innovation, regulatory reaction
and further innovation in an especially dynamic form.
While this process was fascinating to witness and
highly profitable to the lawyers, accountants and
other specialists employed by it, it was also costly,
both to individual institutions and to society as a
whole in terms of its relatively inefficient use of real
resources to avoid regulatory constraints. By the
early 1970s it had become apparent to financial economists and many public officials that the bank regulatory system that had been built in the 1930s was
not an appropriate structure for the financial environment of the 1970s. Several events occurred in this
period that were the initial steps in the deregulation
process that reached its full stride in the early 1980s.
First, in the face of continued disintermediation, the
Regulation Q ceiling was lifted in 1970 for CDs over
$100,000. Second, a Presidential Commission on Financial Structure and Regulation (the Hunt Commission) issued an important report at the end of
1971 that recommended among other things that all
ceilings on time deposits be phased out over a fiveyear period and that both thrift institutions and banks
be granted somewhat broader powers. Banks, in
particular, would be allowed to underwrite some
municipal revenue bonds and sell mutual funds. 17
Finally, so-called NOW (for negotiable order of
withdrawal) accounts were introduced in several
New England states beginning in 1972. These essentially transactions accounts were functionally equivalent to demand deposits but they bore explicit interest. NOW accounts were originally devised by thrift
17

For an interesting retrospective on the influence of the
Hunt Commission’s report written by the Commission’s
co-directors, see Almarin Phillips and Donald P. Jacobs,
“Reflections on the Hunt Commission,” in Benston
(1983B), chapter 9.

institutions as a means of competing more effectively
with commercial banks for retail customers, but their
broader significance was that they were the first financial innovation to have a direct (and beneficial)
effect on ordinary retail customers as opposed to
corporations and wealthy individuals.
2. 1975-1983: Accelerated Innovation, Increased
Competition and Deregulation As indicated in Chart
2, the sustained rise in market interest rates well
above Regulation Q ceilings after 1976 greatly increased the incentive for banks to devise means to
circumvent the restriction. The rise in rates also
increased the opportunity cost of the non-interestbearing reserves that banks that were members of
the Federal Reserve System were required to hold,
which caused many banks to drop their membership
and created strong incentives to devise instruments
not subject to reserve requirements.
Finally, as
suggested above, technological advances coupled with
the relatively high profitability of banking activities
created powerful incentives for nonbank institutions
to enter banking markets and provide bank and
quasi-bank services. These conditions ignited an
explosion of financial innovation and subsequent deregulation in depository markets over the eight-year
period between 1975 and 1983.
A key innovation in this period was the money
market mutual fund (MMMF). 18 These funds are
pools of liquid assets managed by investment companies that sell small denomination shares in the
funds to the public. Although the funds are not
covered by deposit insurance, they are backed fully
by high quality liquid assets, are not subject to rate
ceilings or reserve requirements, and in some cases
allow limited third-party transactions. Aggregate
MMMF assets grew rapidly after 1976, from $3.3
billion in 1977 to $76.3 billion in 1980 to $186.9
billion in 1981. (See Chart 3.)
The growth of MMMFs put enormous competitive pressure on U. S. banks. The banks, in turn,
put substantial pressure on the regulatory agencies
and Congress for relief. The first response to this
pressure was the authorization of so-called money
market certificates (MMC) by the regulatory agencies. These certificates had no third-party payment
capability, but they were covered by deposit insurance, and they had a rate ceiling that floated with
the 6-month Treasury bill rate.
The MMCs were generally well received, but they
18
See Cook and Duffield (1979) for an extensive description and analysis of MMMFs.

FEDERAL RESERVE BANK OF RICHMOND

9

did not significantly reduce the growth of MMMFs.
Intense political pressure for further deregulation
developed and culminated in the passage of the Depository Institutions Deregulation and Monetary
Control Act in March 1980. This watershed legislation was the most comprehensive banking law enacted by Congress since the Banking Acts of 1933
and 1935. It had a large number of diverse provisions, but the critical ones were the following:
1. All interest rate ceilings on time deposits were
to be phased out over a six-year period.
2. NOW accounts were authorized for all banks
and thrift institutions nationwide, effective December 31, 1980. (The accounts can be offered
to individuals but not to corporations.)
3. State usury laws that put ceilings on mortgage
rates were to be eliminated unless a state government specifically passed a law reinstating
the ceiling.
4. The restrictions on the ability of thrift institutions such as savings and loan associations to
invest in assets other than residential mortgages were eased somewhat.
5. All depository institutions were given access to
the Federal Reserve discount window and to
other Fed services, but they were also subjected to Federal Reserve reserve requirements.

10

The importance of this legislation in the context of
the historical perspective developed earlier in this
article should be apparent. In particular, the lifting
of interest rate restrictions in items 1, 2, and 3 above
reversed a fundamental element-and, implicitly, a
fundamental premise-of the 1930s legislation: that
price (i.e., interest rate) competition in banking
markets is unhealthy.
The final steps in the process of deregulation to
date were taken in 1982 and 1983 following passage
of the Garn-St. Germain Act in late 1982. Like the
1980 law, this Act contained numerous detailed provisions, but the most important authorized banks and
other depository institutions to offer accounts with
characteristics similar to those of MMMFs. In accordance with this legislation, banks and thrifts introduced money market deposit accounts (MMDAs) in
December 1982. Subsequently, so-called Super
NOW accounts were introduced in January 1983.
Neither of these instruments is subject to a rate
ceiling. The principal difference between the two
accounts is that there are no limits on the number of
third-party payments transactions that can be made
with a Super NOW account, while there are limits
in the case of MMDA accounts. Since Super NOWs
have more of the characteristics of pure transactions
accounts than MMDAs, they are subject to the same
reserve requirements as ordinary demand deposits
and other transactions accounts. MMDAs are considered savings deposits, which are not subject to
reserve requirements. Further, Super NOWs, because of their greater transactions powers, typically
have lower yields than MMDAs.19 Unlike MMMFs,
both MMDAs and Super NOWs are covered by
federal deposit insurance. At present, however, both
instruments require a $1,000 minimum balance.
The authorization of MMDAs and Super NOWs
has done much to restore the competitive position of
commercial banks and thrifts in depository markets.
Since most MMMFs, like MMDAs, limit the number
of third-party payments the holder of an account can
make, these two instruments are generally similar,
and it is appropriate to compare their growth since
the introduction of MMDAs. As Chart 4 shows,
MMDAs grew explosively immediately following
their introduction to a dollar level of approximately
$350 billion, well above the peak level attained by
19
MMDAs permit up to six transfers per month other
than by appearing in person, but no more than three of
these can be by check. In recent months, MMDA yields
have exceeded Super NOW yields by approximately 2
percentage points.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

MMMFs. 20 The level of MMMFs declined markedly in this period, and some market professionals
predicted their eventual demise. The funds have
made a strong effort to restore their competitive
position by improving their products, however, and
as the chart shows, the funds appear to be maintaining their position in 1984.
3. The Quantitative Impact of Innovation and
Deregulation on the Structure of Depository Markets
The innovations and resulting deregulation in depository markets have had a profound impact on the
structure and cost of bank and thrift liabilities.
Table IV shows the principal instruments as percentages of the total from 1959 through 1983. In 1959,
non-interest-bearing demand deposits accounted for
41.1 percent of the liabilities shown in the table.
20
The considerably stronger response to MMDAs is
believed to be due primarily to the insurance feature and
the general public’s greater familiarity with the banks and
thrifts issuing MMDAs than the investment companies
issuing MMMFs.

Table IV
PRINCIPAL LIABILITIES OF DEPOSITORY INSTITUTIONS, YEAR-END 1959-1983
(Percentage of Total1)
(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

Year

Demand
Deposits

Other
Checkable
Deposits 2

MMDAs

Savings
Deposits

Small
Time
Deposits

Large
Time
Deposits

Term
RPS

Term
Eurodollars

Total

1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983

41.1
39.2
37.3
34.6
32.5
31.0
29.6
28.8
27.8
27.5
27.9
26.5
24.5
23.4
22.0
20.9
19.7
18.4
17.5
16.7
16.0
15.1
12.5
11.7
10.5

0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.1
0.2
0.3
0.6
1.0
1.6
4.1
5.0
5.5

0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
2.1
16.1

4.2
4.4
4.7
5.9
6.8
7.1
7.7
11.8
15.0
17.8
21.2
24.2
26.4
28.0
29.0
28.9
31.0
32.1
32.7
34.4
38.9
41.3
43.7
41.7
34.0

0.4
0.7
1.2
2.0
2.9
3.7
4.7
4.9
6.0
6.6
3.6
7.2
8.0
8.9
12.1
14.5
11.9
9.7
10.6
12.9
13.6
14.6
15.9
16.0
14.0

0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.5
0.3
0.4
0.4
0.7
0.8
0.8
1.2
1.4
1.8
1.8
2.0
2.0
2.0
2.4

0.3
0.3
0.4
0.5
0.5
0.6
0.4
0.4
0.4
0.5
0.5
0.3
0.4
0.4
0.6
0.8
0.9
1.2
1.5
2.1
2.7
2.8
3.6
4.0
4.0

100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0

1

54.0
55.5
56.2
57.0
57.3
57.5
57.5
54.1
50.9
47.6
46.4
41.5
40.4
38.8
35.6
34.0
35.7
37.2
36.0
31.7
25.9
22.7
18.3
17.6
13.4

(10)

Details may not add to totals due to rounding.

2

Other Checkable Deposits includes negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository
institutions, credit union share draft accounts and demand deposits at thrift institutions.

Source: Board of Governors of the Federal Reserve System.

FEDERAL RESERVE BANK OF RICHMOND

11

Passbook savings deposits subject to a ceiling rate
accounted for most of the remainder. By 1975, just
prior to the accelerated deregulation of the late 1970s,
the demand deposit share had declined to 19.7 percent. By 1983, the share had dropped further to 10.5
percent, and the Regulation Q ceilings had been
lifted on all time deposits with the exception of passbook savings accounts. Of particular importance in
the current situation, the category of “other checkable deposits” (column 3 in the table), which includes ordinary NOW accounts, Super NOWs and
other interest-bearing transactions accounts, has
been rising rapidly since 1980, while the demand
deposit category has been declining. This trend
will almost certainly continue in the years ahead.
The changes manifested in Table IV have obvious
implications for U. S. depository institutions. First,
although in the past banks and other depositories
paid implicit interest in a variety of forms on demand
deposits and other liabilities that did not yield explicit interest, there can be little doubt that deregulation has raised the average cost of funds for many
of these institutions, especially in recent years. This
increase has forced the adoption of more systematic
and explicit pricing policies for loans and other services and has probably reduced cross-subsidization
across various categories of customers. Second, the
trend toward explicit interest has increased short-run
variations in the cost of funds. This has made it
necessary for depository institutions, like other financial and nonfinancial firms, to “manage” interest
rate risk to a much greater extent than formerly, by
either shortening loan maturities, making loan rates
variable, or hedging the risk in futures markets.

4. The Present Situation: Further Increases in
Competition from Nondepository Institutions, Consolidation in the Supply of Financial Services, and
the Demise of Geographic Restrictions While
changes in the level and variability of the cost of
funds have had important effects on depository institutions in recent years, the increased competition
from nondepository institutions has been equally
significant. In addition to the competition from
MMMFs, there have been several mergers involving
large investment banks and insurance companies, and
some of the largest nonfinancial companies in the
nation have recently added an array of additional
financial service activities to their existing installment credit operations. The purpose of these consolidations is the creation of financial service conglomerates capable of providing comprehensive financial services including banking services to business
12

firms and households. As an example, Sears, Roebuck and Company, the country’s largest retail chain,
has recently acquired a large investment bank and a
large real estate finance company and linked these
operations to its existing insurance, credit card and
other financial services. By offering these services
through its vast chain of retail stores, Sears can reach
virtually every geographic market in the United
States. Merrill Lynch, American Express, and other
large companies are rapidly building similar financial
service conglomerates.
Although it is difficult to quantify the degree of
this competition in the aggregate, some idea of the
order of magnitude is conveyed by diverse statistics.
At the end of 1981, the financial service subsidiaries
of three large manufacturing companies (General
Electric, Ford, and General Motors) held $45.8 billion of consumer installment credit compared to the
$27.7 billion held worldwide by Citicorp, the Bank
of America and Chase Manhattan. At the end of the
same year, total business lending (commercial and
industrial loans, commercial mortgage loans, and
lease financing) by 32 nonbank companies was
slightly over $100 billion, one-third of the total outstanding at the 15 largest bank holding companies.21
In their effort to compete still more directly with
banks and other depositories, a number of nonbank
financial service providers have acquired commercial
banks in recent years. In order to avoid being classified legally as bank holding companies and therefore
subjected to banking regulation, the acquiring companies have then taken advantage of a provision in
the current bank holding company law that defines a
bank as an institution that both (1) offers demand
deposits and (2) makes commercial loans. After the
elimination of one of these two activities from the
acquired bank’s operations, the bank is no longer a
bank in the eyes of the law, and the acquiring company is not a bank holding company. These affiliates,
thus transformed, have earned the awkward designation “nonbank banks.” Since nonbank banks are not
banks, they are not subject to the remaining restrictions on banks, notably geographic branching restrictions. Therefore, there is no legal barrier to prevent a
nonbank financial service provider from establishing a
national network of nonbank banks, which enormously increases the deposit base on which the company can draw. In the view of many observers, nonbank banks constitute a rather blatant circumvention
of the Glass-Steagall Act, and they were the subject
21

See Rosenblum and Siegel (1983), Chart lB, p. 16 and
Table 10, p. 26.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

of much regulatory and legislative attention in the
United States in 1984. Both houses of Congress
passed bills that would have redefined a bank in
such a way as to include most existing nonbank
banks. For various reasons, no final bill was enacted,
but the issue is almost certain to surface again in
1985.
The trend toward consolidation in the supply of
financial services has not been restricted to nonbank
and nondepository companies. Both banks and bank
holding companies have sought to enter a variety of
nonbanking industries throughout the postwar period, and their efforts have intensified in recent years.22
Although Congress does not appear to be prepared
to repeal the main provisions of the Glass-Steagall
Act, an omnibus bill passed by the Senate in the
summer of 1984 would have permitted bank holding
companies to underwrite municipal revenue bonds
and engage in several other previously proscribed
activities. In addition, the Federal Reserve has approved the acquisition of discount brokerage companies (which trade but do not underwrite securities)
by bank holding companies, and this action has been
upheld in the federal courts.23
Apart from their efforts to expand into nonbanking activities, the larger bank holding companies are
presently strengthening their effort to dismantle, de
facto if not de jure, the remaining restrictions on
geographic expansion. As noted earlier, banks and
bank holding companies have not generally been
permitted to carry on full banking operations across
state lines. Many bank holding companies, however,
operate numerous nonbank affiliates such as consumer finance companies in several states,24 and in a
somewhat ironic twist, several bank holding companies have recently announced their intention to
establish interstate chains of retail-oriented nonbank
banks known as “consumer banks.” Finally, in ac22

A major reason for the emergence of the bank holding
company as the dominant corporate form in U. S. banking markets has been the effort to circumvent restrictions
on bank entry into nonbanking activities. Both the Bank
Holding Company Act of 1956 and the Amendments to
that Act in 1970 sought to close this loophole.
23
Space does not permit a discussion of the international
activities of large U. S.-based banks. These banks are
engaged in a number of nonbank activities via overseas
affiliates that they are not permitted to enter in the
United States. They would therefore be able to establish
domestic operations in many of these activities rather
quickly if the restrictions were lifted.
24

As of 1981, for example, Citicorp, which is based in
New York, operated 422 nonbanking offices in 40 states
and the District of Columbia.

cordance with a provision of the bank holding company law that allows bank holding companies based
in one state to operate banks in another state if the
government of the second state specifically permits
it, a number of states in particular regions are presently establishing or attempting to establish reciprocal
regional interstate banking agreements. These agreements would permit bank holding companies based in
the region to operate banks in any state in the
region but would preclude entry by banks based
outside the region.25 In the absence of specific legislation halting these various developments, an acceleration of the growth of interstate banking activities
appears likely in the years immediately ahead.
5. S u m m a r y The powerful innovative forces
unleashed by rising inflation and advancing technology have substantially eroded the restrictive bank
regulatory structure that emerged from the Great
Depression. This erosion has had three principal
effects. First, the structure of bank funds, the average cost of these funds, and the stability of the cost
of funds have all changed dramatically since 1960.
These changes have greatly altered the character of
banking operations in the United States. Second,
although the legal separation of banking and other
lines of commerce remains in force, the actual boundary has become increasingly blurred due to the ability
of nonbank institutions to offer deposit-like products
and services and the expansion of bank holding companies into nonbanking activities. Finally, geographic
restrictions on banking operations have lost much of
their force in recent years.
It is still too early to determine whether these
developments have strengthened American banking
markets or weakened them, and what the longer run
effect on the welfare of the general public will be.
Although the overall profitability of U. S. banks is
still relatively high, the current strains in the American banking and thrift industries are well known.
The number of insured banks closed due to financial
difficulties in 1983 (48) was the highest in any year
since the 1930s. The extent to which these strains
are the result of innovation and deregulation is not
clear, nor is it clear how these difficulties will affect
innovation and deregulation in the future. The final
section of this article will speculate briefly on the
prospects.
25

A principal objective of these regional compacts appears to be to restrict entry into regional and local
markets by the large money center banks.

FEDERAL RESERVE BANK OF RICHMOND

13

B. Other Innovations
The innovations in banking markets just described
have been particularly visible to the average American citizen, and they have far-reaching implications.
The same forces driving innovation in banking, however, have also produced important innovations in
other financial markets. Developments in the securities markets and in mortgage markets have been
especially dramatic, in the form of both new instruments and markets and changes in the character of
existing instruments and markets. The common
theme in nearly all of these innovations has been the
effort to reduce the risk occasioned by the heightened
volatility of interest rates. It would be difficult to
list all of these developments, but some of the more
important are the following.
1. Bond markets A sizable proportion of corporate bonds issued in domestic U. S. markets currently are floating-rate bonds, and the remaining
fixed-rate issues frequently have early call or put
provisions. Further, the volume of zero-coupon
bonds, which pay their return in the form of price
appreciation rather than coupon interest payments
and therefore present no reinvestment risk, has
grown significantly since 1980.
2. Mortgage markets A majority of the residential mortgages issued in the United States at
present are adjustable rate mortgages (ARM S ) ,
which permit the lender to vary the interest rate
during the term of the loan, usually on specified dates
and subject to specified restrictions. Also, a large
and active market for securities backed by pools of
mortgages has developed, which has increased the
volume of mortgage lending by insurance companies
and pension funds and thus insulated the market to
some extent from the difficulties currently plaguing
the thrift industry as a result of the secular rise in
interest rates. On balance, these innovations appear
to have benefited both the residential construction
industry and home buyers, since the recovery of the
homebuilding sector of the economy following the
1981-1982 recession was strong. There is presently
considerable concern, however, that the existence of a
large stock of variable rate mortgage debt will increase the incidence of default if and when interest
rates come under renewed upward pressure.
3. Futures markets Trading in interest rate futures in the United States has grown rapidly since the
first market opened in 1975. There are currently
markets for six instruments: mortgage-backed securities guaranteed by the Government National Mort14

gage Association (GNMA), U. S. Treasury bonds,
U. S. Treasury bills, domestic bank CDs, Eurodollars, and U. S. Treasury notes. The existence of
these markets and their increasing depth make it
possible for both institutions and individuals to hedge
their exposure to interest rate movements considerably more cheaply than is possible in cash markets.26
Because it is possible, however, for market participants motivated by a desire to speculate rather than a
desire to hedge to engage in futures transactions with
relatively small cash outlays, it is not yet clear
whether the existence of futures markets has reduced
or increased the overall level of risk in financial
markets.
This section has focused on the impact of recent
financial innovation on the structure and behavior of
markets. The next section examines the implications
for monetary policy.
IV.
THE EFFECT OF INNOVATION ON U. S.
MONETARY POLICY

In addition to their impact on markets, innovation
and deregulation have led to an intensive and extensive reexamination of the conduct of monetary policy
in the United States, and this reexamination in turn
has clearly affected the substance of policy actions in
some recent years. This section will briefly describe
the present strategy of U. S. monetary policy and
then indicate some of the principal questions and
operational problems that innovation and deregulation have raised regarding this strategy.
A. The Current Strategy of U. S.
Monetary Policy
The evolution of U. S. monetary policy in the
postwar period has been a long and rather diffuse
process. Although there has always been some attention to monetary conditions-as opposed to credit
conditions-and the behavior of monetary aggregates,
it is probably accurate to say that most of the emphasis in the actual conduct of policy in the 1950s and
1960s was on the effect of the Federal Reserve’s
policy actions on the availability and cost of credit in
short-term credit markets.
Since about 1970, however, increased attention
has been given to monetary conditions and specifically
26

The recent development of options markets for several
financial futures contracts has significantly broadened the
range of hedging strategies available to investors.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

to the growth rates of various measures of the money
supply. This increased focus on money, which has
also developed in several other industrial countries
in the same period, has resulted partly from the rise
of “monetarism” to prominence in the academic literature on monetary policy in the late 1960s and early
1970s and partly from dissatisfaction with the perceived failure of credit- and interest-rate oriented
policies to deal effectively with the secular rise in
inflation.
As a result of these developments, the present
stated strategy of Federal Reserve policy centers
around control of the monetary aggregates.27 At the
beginning of each year, the Fed establishes a target
range for the growth rate of each monetary aggregate
from the fourth quarter of the preceding year to the
fourth quarter of the current year. It then monitors
the actual growth of the aggregates in relation to the
targets and acts to correct deviations from the
targets unless it feels that unanticipated economic
or financial developments warrant the deviation. The
ultimate objective of this strategy is to contribute to
the stabilization of both economic conditions in general and the behavior of prices in particular. For
this reason, the strategy is often referred to as one of
using monetary aggregates as “intermediate” targets
of policy.
It is obvious that the successful implementation of
this strategy requires a stable and predictable relationship between the monetary aggregates targeted
and the ultimate objectives of monetary policy such
as the rate of growth of nominal GNP and the behavior of the price level. It is widely asserted that
recent financial innovation and deregulation have
weakened this relationship in the United States and
made it less predictable. Further, some monetary
economists believe that innovation and deregulation
have reduced the ability of the Fed to control the
growth of the aggregates effectively. The remainder
of this section summarizes the evidence supporting
these contentions.
B.

Evidence of Instability in the Relationship
Between the Monetary Aggregates and
Nominal GNP in the United States

1. Possible downward shifts in money demand,
1975 and 1980-1981 The problems encountered in

the conduct of U. S. monetary policy have stimulated
considerable new research over the last decade on
the relationship between money and GNP. Much
of this research has taken the form of empirical estimation and re-estimation of conventional Goldfeldtype money demand equations or variations of these
equations using the Ml aggregate, coupled with tests
of the ability of the equations to predict the longer
run growth of the monetary aggregates in the out-ofsample period. 28 Table V reproduces a table from a
recent article by Porter and Offenbacher29 that presents empirical evidence typical of that produced by
much of this research. The table shows both the
annual and cumulative errors in the predicted growth
of M1 30 from a standard money demand equation
over the 1967-1974 and 1974-1981 periods, respectively. The annual growth rate errors suggest that
there may have been downward shifts in the demand
for money in relation to income in 1975 and again in
1980 and 1981. Economists who believe that such
shifts in fact occurred generally attribute them to
financial innovation and deregulation. Improved cash
management techniques in the corporate sector are
thought to be mainly responsible for the shift in 1975.
More careful management in the household sectormade possible by the introduction o f M M M F s - i s
thought to have contributed significantly to the shift
in 1980 and 1981.31
28

Following Goldfeld (1973), these money demand functions have the following general form:

where M D = money demand
P = price level
r l = a nominal short-term market interest rate
r 2 = a nominal short-term regulated interest
rate
y = real income.
For a review of much of this research, see Judd and
Scadding (1982B).
29

See Richard D. Porter and Edward K. Offenbacher,
“Financial Innovations and Measurement of Monetary
Aggregates,” in Federal Reserve Bank of St. Louis
(1984), Table 3-1, pp. 53-54.
30

The M1 series used in constructing the table was
adjusted to eliminate the effects of institutional changes
on this aggregate. See footnote 2 of the PorterOffenbacher article.
31

27

The Humphrey-Hawkins Act of 1978 requires the
Federal Reserve to report its objectives for the growth
of the monetary and credit aggregates each year. The
current formal definitions of the monetary aggregates
are published each month in the notes to statistical table
1.21 in the Federal Reserve Bulletin.

For specific evidence on the impact of MMMFs see
Dotsey, Englander and Partlan (1981-82). It should be
noted-that although the view that a downward shift in
money demand occurred in the mid-1970s is widely held,
there is much less agreement regarding the possible shift
in 1980-1981. For an argument that no shift occurred in
the latter period, see Pierce (1982).

FEDERAL RESERVE RANK OF RICHMOND

15

typically declines or grows more slowly in recessions

Table V

OUT-OF-SAMPLE ERRORS FROM A GOLDFELD M1 EQUATION
FOR 1967:l TO 1974:2 AND 1974:3 TO 1981:4
1

Date

Cumulative
Percentage
Error

1967:1
:2
:3
:4
1968:1
:2
:3
:4
1969:1
:2
:3
:4
1970:1
:2
:3
:4
1971:1
:2
:3
:4
1972:1
:2
:3
:4
1973:1
:2
:3
:4
1974:1
:2

Annual
Growth
Rate
Errors

-.2
-.3
-1.0
-1.0
-.8
-.9
-1.5
-1.9
-2.3
-1.6
-.5
-.3
-.1
.1
-.2
-.1
.9
.8
.4
1.2
1.7
1.7
1.2
.5
.2
.7
.7
.7
1.4
2.6

-1.1

-.9

1.7

.2

1.4

-.8

1.0

Date

1974:3
:4
1975:1
:2
:3
:4
1976:1
:2
:3
:4
1977:1
:2
:3
:4
1978:1
:2
:3
:4
1979:1
:2
:3
:4
1980:1
:2
:3
:4
1981:1
:2
:3
:4

1967:1 to 1974:2
Annualized
Quarterly
Growth Rates

Mean Error
Root Mean
Square Error
1

Annual
Growth
Rate
Errors

Annual
Growth Rates

1.2
3.0
5.1
5.4
5.9
7.6
7.8
7.5
8.2
8.6
8.3
8.9
9.2
8.9
8.5
9.4
9.9
10.6
11.9
11.7
11.5
11.9
12.6
16.3
15.3
14.8
18.0
18.1
20.8
22.1

4.8

.9

.3

1.7

1.2

2.8

6.4

1974:3 t o 1981:4
Annualized
Quarterly
Growth Rates

Annual
Growth Rates

.4

.2

2.6

2.6

2.1

1.1

4.7

3.3

Error is predicted value minus actual value.

Source: Porter, Richard D. and Edward K. Offenbacher, “Financial Innovation and
Measurement of Monetary Aggregates,” in Federal Reserve Bank of St. Louis
(1984), Table 3-1, pp. 53-4.

2. The unusual behavior of M1 velocity, 19821983 A further instance of apparent instability in
the relationship between M1 and nominal GNP occurred during the recession in 1982 and the recovery
from that recession in 1983. In contrast to the
possible downward shifts in money demand in 1975
and 1980-1981, M1 grew unusually rapidly in relation to nominal GNP in the 1982-1983 period. This
can be depicted by charting the growth of M1 velocity, i.e., the ratio of nominal GNP to M1, as in

Chart 5. As the chart makes clear, while velocity
16

than in other stages of the business cycle, the decline
was much sharper in the 1981-1982 recession than in
any other cycle since the 1950s. Research done by
the staff of the Board of Governors of the Federal
Reserve suggests that the introduction of interestbearing NOW accounts (which are included in Ml
as it is presently defined) has increased the interest
elasticity of Ml demand in a manner that could not
have been easily predicted in advance.32 An implication of this view is that further deregulation may
also change the parameters of the M1 money demand
function in ways that cannot be anticipated. Research
done at the Federal Reserve Bank of San Francisco,
however, indicates that the unusual behavior of velocity in 1982 and 1983 can be explained by (1) the
decline in inflation in 1982 and (2) the precipitous
drop in interest rates in the third quarter of 1982 in
the context of a stable money demand function.33
C. Effect of the Evidence of Instability on
the Recent Conduct of Monetary Policy
and Policy Research
As one might expect, the evidence of possible instability in the money-GNP relationship has raised
doubts regarding the feasibility of continuing to use
intermediate money supply targets as a central element in the strategy of U. S. policy. In this regard,
it should be noted that much of this evidence pertains
to M1. M1, which is the narrowest of the aggregates,
is intended to be a measure of transactions balances,
and it has generally received more attention than the
broader monetary aggregates from the general public.
One of the results of the events in 1982 and 1983 just
described was a temporary change in the operational
emphasis of policy away from Ml in the direction of
the broader measures. In particular, the Fed announced in late 1982 that it was deemphasizing Ml
and giving greater weight to M2 and M3 in its operations. Further, in 1983 the Fed established a range
for the growth of a broad measure of total credit for
the first time, partly in response to arguments that
M1 had lost its meaning.34 The emergence of a more
normal pattern in the behavior of M1 velocity in the
32

See Brayton, Farr and Porter (1983).

33

See Judd (1983). See also Broaddus and Goodfriend
(1984), pp, 11-14.

34

The case for focusing on credit rather than monetary
aggregates has been advanced especially strongly by
Frank E. Morris, the president of the Federal Reserve
Bank of Boston. See Morris (1982).

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

latter part of 1983 and the first half of 1984, however,
led to the restoration of Ml to target status in July
1984.
As noted in the discussion of prospects for monetary policy in the next section of this article, the Fed
has come under pressure from several quarters recently to drop its money supply targets in favor of
one of several alternative strategies. To date, the
Fed itself has given no indication that it is planning
to take such a step. Indeed, much of the research
done by the staff of the Board of Governors of the
Fed in recent years has been aimed at improving the
technical foundation for the continued use of a monetary aggregates strategy.
This research has taken two separate directions.
First, an effort has been made to improve the specification of money demand equations in order to im-

prove their performance. An example of this research
is the Simpson-Porter model of money demand,
which includes a so-called “ratchet” variable designed
to capture the impact of cash management innovations
induced by the successively higher interest rate peaks
in the 1970s and early 1980s.35 Although inclusion of
this variable does not eliminate the overprediction of
money demand shown in Table V, it reduces it
significantly.
The second area of research has focused on the
construction of alternative monetary aggregates
known as Divisia aggregates using the theory of index
numbers. 36 Conventional monetary aggregates such
35

See Simpson and Porter (1980). For a more recent
example of further research on the money demand function see Brayton, Farr and Porter (1983).
36

See Barnett and Spindt (1982).

FEDERAL RESERVE BANK OF RICHMOND

17

as M1 are simple summations of their various components with no attention given in the aggregation
process to differences in the monetary services provided by the components. For example, M1 as it is
currently defined includes (1) currency and demand
deposits, which pay no explicit interest but provide a
wide range of transactions services, and (2) several
interest-bearing accounts such as conventional NOW
accounts and Super NOW accounts, which are also
partly transactions instruments, but which provide
some savings services-i.e., store of value servicesas well. Divisia aggregation takes account of these
differences by assigning different weights to the components of an aggregate in constructing the aggregate. To be specific, the weight attached to each
component is determined by the spread between the
market yield paid on a nonmonetary asset such as
commercial paper and the explicit own yield paid on
the component in question. This spread is the opportunity cost of holding the component (in terms of
explicit interest foregone) and is assumed to be a
reasonable proxy for the rental cost of the monetary
services provided by the component and therefore for
the flow of services themselves. In this way, the
highest weights are assigned to assets like currency
that have the highest spreads and therefore presumably yield the greatest flow of monetary services.
Although Divisia aggregation would appear to be
superior in principle to conventional simple-sum
aggregation, empirical results using these aggregates
have been mixed. In recent dynamic simulations
using two money demand specifications,37 the Divisia
aggregates generally outperformed their conventional
counterparts in the case of the broader aggregates,
but they yielded inferior results in the case of the
narrower aggregates such as Ml. For this reason,
and in view of the obvious difficulties the Fed would
encounter in communicating its objectives to the
public if it were to substitute the Divisia aggregates
for the standard aggregates in setting its monetary
targets, it is unlikely that the Divisia measures will
play a major operational role in the actual implementation of policy in the foreseeable future. Continued research with these measures, however, and
informal monitoring of their behavior may help the
Fed avoid being misled by temporarily aberrant behavior of the conventional aggregates due to innovation and deregulation.
37

See Porter and Offenbacher (1984), pp. 72-6.

18

V.
PROSPECTS AND CONCLUSIONS38

To this point this article has dealt with the past
and the present. This section will look to the future
and speculate on how the lingering effects of the
innovation that has already occurred and the effects
of further innovation may influence the structure and
functioning of financial markets and the conduct of
monetary policy in the years ahead. Long and sometimes unhappy experience has taught the author that
forecasting is the most dangerous of all the professional activities economists engage in. Accordingly,
the speculative comments that follow will focus primarily on the relatively near-term future through the
remainder of the 1980s.
A.

Prospects for the Financial Markets and
the Provision of Financial Services

As noted above, American financial institutionsespecially commercial banks and thrift institutionshave come under severe pressure in recent years due
to rising competition from external sources, the impact of deregulation on the cost of funding, the apparent deterioration in the quality of some bank loan
portfolios, and the increased incidence of bank failures. As a result of these developments and the
concern they have stimulated both in the political
arena and among regulatory agencies, the pace of
deregulation slowed in 1984, and it may well remain
lower in the near-term future.
The forces driving the longer run process of innovation and deregulation, however, are still very much
alive, and the process is therefore likely to continue
in the absence of a major financial catastrophe.
Several developments seem probable in the years
immediately ahead. First, one of the measures available to deal with the current weakness of some thrift
institutions and the associated risk is a more lenient
stance by the regulators toward acquisitions of thrifts
by bank holding companies. Such consolidations
would further blur the distinctions between various
categories of depository institutions. Second, the
breakdown of the barriers to interstate banking is
almost certain to continue. At the moment, it appears
that the next stage of this process will take the form
of regional agreements that exclude the money center
banks, but the latter can be expected to press hard
38
It should be emphasized that the somewhat speculative
views presented in this section are the author’s and do
not necessarily reflect the views of the Federal Reserve
Bank of Richmond or the Federal Reserve System.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

for equitable access to these markets, and it is possible they will receive judicial relief under the antitrust laws. Finally, the line of separation between
(1) banking and (2) other financial and nonfinancial
activities is likely to be eroded further as banks and
nonbank institutions both seek to expand further
into the other group’s territory. In particular, there
is a fairly high probability that legislation will be
passed in the relatively near future allowing banks to
underwrite municipal revenue bonds and perhaps
securities backed by mortgage pools, since the potential for abuse seems minimal in these areas.
The examples just given relate to near-term prospects and are relatively narrow in scope. The larger
and more important issue is: What will the structure
of U. S. banking and financial markets look like in
1990? Will there be significant further erosion of
product-line barriers so that banks and other companies meld into “department stores” of finance?
Will small banks and other small financial institutions
be swallowed up by larger institutions ? It is impossible to do more than guess at the answers to these
questions. Some further consolidation across product
lines may occur. But many of the conflicts of interest
and other risks that the Glass-Steagall Act attempted
to prevent are still perceived to be real dangers, so
it is unlikely that the basic legal barrier between
banking and commerce will be dismantled in the
foreseeable future. Perhaps more fundamentally, the
microeconomics of such consolidations is not well
understood at present. Specifically, the extent of
joint economies in the production and consumption of
diverse financial services is not known. In these
circumstances, it seems likely that a substantial degree of specialization in the provision of financial
services will persist even if a further dismantling of
the regulatory barriers occurs. In a similar way,
since there is no clear evidence of significant economies of scale in banking, the specter of large bank
holding companies absorbing most small, communityoriented banks seems far-fetched, although there will
probably be some reduction in the number of independent banking organizations operating in the
country.
Two final comments should be made regarding the
prospects for change in (1) the structure of the financial regulatory agencies and (2) the system of
federal deposit insurance. Suggestions have been
made for many years for changes that would simplify
the currently cumbersome structure of U. S. financial regulatory agencies, which involves a mixture of
federal and state agencies and the existence of several
agencies with somewhat overlapping responsibilities

at the federal level. The most recent formal recommendations were announced in early 1984 by the
Task Group on Regulation of Financial Institutions
chaired by Vice President Bush. 39 Among other
things, these recommendations called for simplifying
the structure at the federal level by assigning the
responsibility for regulating and supervising all but
the largest banking organizations to a new agency
built around the present Office of the Comptroller
of the Currency. Responsibility for the largest organizations would be vested in the Federal Reserve.
If past experience is any guide, resistance by the
affected agencies and their constituencies will prevent the early adoption of these recommendations.
Regarding the deposit insurance system, the failure
of the Continental Illinois Bank and the events leading up to that failure have brought earlier recommendations for reform of the system to the attention
of both the Congress and the public.40 Many of these
recommendations are for changes that would reduce
the danger that the existence of deposit insurance
might tempt banks to take risks they would otherwise
avoid. Examples of the suggested changes are reductions in the coverage of time deposits, permitting
private insurance companies to compete with government agencies in providing insurance, and permitting
graduated premiums that reflect the relative risk of
failure of individual institutions. Despite their logical
appeal, these recommendations raise a number of
questions. What criteria, for example, would be
used to determine relative risk in administering graduated premiums? These kinds of questions plus the
broad public support for the present insurance system
make it unlikely that wholesale changes will be forthcoming at an early date unless further disruptions in
banking markets force them.
B. Prospects Regarding Monetary Policy
As pointed out in Section IV of this paper, the
evidence of a reduction in the stability of the empirical
relationship between the U. S. money supply and
nominal GNP has caused some observers to question
whether the Federal Reserve should continue to
follow a strategy of using monetary aggregates as
intermediate policy targets. The conventional theory
of short-run economic stabilization41 implies that if
the monetary sector of the economy is less stable and
39

See Office of the Press Secretary to the Vice President
of the United States (1984).
40

See, for example, Benston (1983A).

41

See Poole (1970).

FEDERAL RESERVE BANK OF RICHMOND

19

predictable than other sectors-in terms of a conventional Hicksian model, the position of the LM
curve is less stable and predictable than the position
of the IS curve-targeting interest rates will yield a
better policy performance than targeting the money
supply. Against this background, some economists
have concluded that innovation has in fact reduced
the predictability of the money-GNP relationship to
such an extent that targeting money supply growth is
no longer appropriate, at least as long as significant
innovation and deregulation are occurring. Several
alternative targets have been suggested including
nominal GNP and real interest rates.
Others, however, favor retention of the present
strategy at least for the present. They point out that
the instability that has been observed in recent years
has resulted from (1) concerted efforts in the 1970s
to circumvent regulations in the face of high inflation
and high interest rates and (2) the disruptions caused
by subsequent deregulation. With the deregulation
process now well advanced, future innovation may be
more gradual and more predictable. Further, while
innovation and deregulation may have temporarily
affected the relationship between the conventional
measures of money such as Ml and the economy,
they have not necessarily destabilized the monetary
sector in any fundamental way. Therefore, targeting
the monetary base or some other measure of highpowered money might still be feasible even if empirical problems with other monetary aggregates persisted.
A related issue that has received attention recently
concerns the feasibility of monetary control if remaining interest rate ceilings are removed. A control
procedure the Fed has used frequently in the past
involves the direct or indirect manipulation of shortterm interest rates in order to affect the opportunity
cost of holding money balances and therefore the
demand for money. It is sometimes argued that with
interest rate ceilings removed, yields on the components of the money supply will vary with market
interest rates, thereby reducing the elasticity of
money demand with respect to interest rates and
increasing the change in interest rates required to
produce any desired change in the growth of money.
Even in a completely deregulated environment, however, explicit yields on assets providing significant
monetary services are likely to vary less than market
yields. Therefore, the interest elasticity of money
demand--especially the demand for Ml, which includes currency and other transactions instrumentsmay remain sufficiently high for the purposes of
monetary control.

20

This rather technical discussion regarding intermediate targets and monetary control is important,
but it is only a relatively narrow aspect of the broader
public debate about monetary policy that is currently
going on in the United States. The experience in
recent years of historically high peace-time inflation,
high and extremely volatile interest rates, two severe
and protracted recessions, and wide swings in the
value of the dollar in foreign exchange markets has
produced demands from some quarters for farreaching changes in the strategy of monetary policy
and in the responsibilities and authority of the Federal Reserve. In particular, a small but vocal group
is pressing for a return to the gold standard or some
alternative commodity standard.
Although another sharp rise in interest rates or
inflation or another recession might motivate the
Congress to require fundamental changes in the conduct of monetary policy, the more likely outcome over
the remainder of the 1980s is continuation of the
present monetary aggregates strategy coupled with
an effort to change the institutional regime in which
the strategy is pursued in ways that will make it
more likely to succeed. Some of these changes are
already in place. The Monetary Control Act of 1980
extended Federal Reserve reserve requirements to all
depository institutions,42 which reduces variations in
the aggregate required reserve ratio due to shifts
of deposits across classes of institutions. Further, a
change in the reserve accounting mechanism in
early 1984 from a lagged system to a (nearly)
contemporaneous system has made it feasible for the
Fed to change its procedure for controlling the monetary aggregates from one that operates through
changes in short-term interest rates to one that operates through the supply of total reserves.43 It should
be emphasized, however, that although the current
strategy of U. S. policy is formally one of controlling
monetary aggregates, there is considerable room
within this strategy for discretionary changes in the
emphasis actually given to monetary controlespecially short-run monetary control-as against
other objectives such as stabilizing interest rates in
particular time periods. Because it regards such
flexibility as desirable, the Fed is likely to resist
committing itself to a monetary control regime that
42

The requirements had previously been applied only to
the minority of commercial banks that were members of
the Federal Reserve System.
43

Many monetary economists believe that control via a
reserve instrument is more efficient than control through
interest rates, even though there is relatively little historical experience on which to base a test of the proposition.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

significantly restricts the range of its discretionary
actions in the short run.
C. Concluding Comment
This paper has presented an overview of recent
financial innovation in the United States, the deregulation it has helped to force, and some of the major
effects of this process on financial institutions and
markets and on monetary policy. As the discussion
has indicated, these developments are extremely diverse when they are considered individually. Nonetheless, there are certain unifying themes. In broadest terms, the last ten years have witnessed the

collapse of an important part of the regulatory regime erected in the 1930s and the erosion of at least
part of the philosophy of banking and financial regulation that sustained it. The forces that produced
this change had been building since at least the 1950s,
but they attained a certain critical mass in the 1970s
that accelerated the process of change. It is of course
possible that the process will continue at this same
accelerated pace in the years immediately ahead. But
it is also possible-and perhaps more likely-that
the remainder of this decade will be a welcome period
of consolidation characterized by a slower rate of
innovation and change.

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Banking.” American Economic Review 73 (December 1983), 1080-91.
Rosenblum, Harvey, and Christine Pavel. Financial
Services in Transition: The Effects of Nonbank
Competitors. Federal Reserve Bank of Chicago,
Staff Memorandum 84-1, 1984.
and Diane Siegel. Competition in Financial
Services: The Impact of Nonbank Entry. Federal
Reserve Bank of Chicago, Staff Study 83-1, 1983.
Roth, Howard L. “Recent Experience With M1 as a
Policy Guide.” Economic Review, Federal Reserve
Bank of Kansas City 69 (March 1984), 17-29.
Silber, William L., ed. Financial Innovation. Lexington, Mass. : D. C. Heath and Company, 1975.
“The Process of Financial Innovation.”
American Economic Review 73 (May 1983), 89-95.
Simpson, Thomas D. “Changes in the Financial System: Implications for Monetary. Policy.” Brookings papers on Economic Activity. (1:1984), pp.
249-65
and Patrick M. Parkinson. “Some Implications of Financial Innovations in the United
States.” Washington, D. C.: Board of Governors
of the Federal Reserve System. Staff Studies
Series No. 139, 1984.
, and Richard D. Porter. “Some Issues Involving the Definition and Interpretation of the
Monetary Aggregates.” In Controlling Monetary
Aggregates III. Proceedings of a conference sponsored by the Federal Reserve Bank of Boston, 1980,
pp. 161-234.
Vrabac, Daniel J. “Recent Developments at Banks and
Nonbank Depository Institutions.” Economic Review, Federal Reserve Bank of Kansas City 68
(July/August 1983), 33-45.
Wall, Larry, and Robert A. Eisenbeis. “Risk Considerations in Deregulating Bank Activities.” Economic
Review, Federal Reserve Bank of Atlanta 69 (May
1984), 6-19.
Wenninger, John. “Financial Innovation-A Complex
Problem Even in a Simple Framework.” Quarterly
Review, Federal Reserve Bank of New York
(Summer 1984), pp. l-8.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

FORECASTS 1985
Roy H. Webb

The projections in this article are those of the
various forecasters and should not be attributed to
this Bank or the Federal Reserve System.
The Current Forecast
Moderate economic growth and moderate inflation
are predicted for 1985 by economic forecasters, according to a survey of forecasts collected for this
Bank’s Business Forecasts 1985. Summaries of the
forecasts are presented in Tables I and II ; however, a
much more detailed summary can be found in Business Forecasts 1985 itself.
An important feature of this year’s survey is that
only one of forty-eight forecasters predicts that a
recession will begin in 1985. The median forecast
calls for 3.4 percent growth of real gross national
product (GNP) in 1985, as indicated in Table I.
That rate of growth would be below recent growth
rates, 6.3 percent in 1983 and 5.6 percent in 1984. Of
course, such high rates of growth of real activity
would be unusual for the third year of a cyclical expansion. Projected growth would indicate generally
rising levels of income, production, and employment;
however, little reduction in the rate of unemployment
is predicted.
The predicted growth in nominal expenditure
shown in Table I is somewhat uneven. Consumer
spending is expected to rise by 7.6 percent, slightly
below GNP growth. Business fixed investment is
expected to rise by 8.2 percent, slightly faster than
GNP, while residential investment is expected to be
relatively strong, rising by 10.6 percent. As has
frequently occurred in recent years, Federal spending
is expected to rise more rapidly than GNP, increasing by 9.5 percent. Finally, net exports are expected
to continue to decline, falling by almost $20 billion
from the end-of-1984 value.
Only moderate increases in inflation are expected
in 1985. Consumer prices are expected to rise by
4.5 percent and producer prices by 3.5 percent. Those
rates, although slightly higher than in 1984, would
nevertheless remain well below the high rates experienced in the late seventies. The projected in-

crease in inflation would also be relatively moderate
for the third year in a cyclical expansion.
Underlying this scenario, however, are two major
imbalances in the economy. First, many observers
argue that the nation’s fiscal policy is unsustainable.
One symptom is that interest on the national debt is
rising much faster than the nation’s ability to pay
that interest. For example, over the last seven years,
interest payments on the federal debt have risen at a
22 percent annual rate, while the gross national product has risen at only a 9.5 percent rate.
Another imbalance is the large foreign trade deficit, which grew by $34.5 billion in 1984. Corresponding to that excess of imports over exports was a
capital inflow into the United States, as foreigners
accumulated U. S. financial assets. The rapid accumulation of those assets has led some analysts to
believe that current trade and asset flows are unsustainable. For example, from the first quarter of 1983
to the third quarter of 1984, foreign holdings of U. S.
financial assets rose by 29 percent, whereas total
U. S. financial assets grew by only 18 percent. Again,
some analysts maintain that such a trend cannot be
sustained indefinitely.
Forecasters generally expect these imbalances to
continue in 1985, but not to severely disrupt the
economy. Some of the more pessimistic forecasters
do see strains developing. For example, one predicted that rising interest rates due to the large
federal deficit will choke off economic expansion.
Others believe that a sharp reduction of net exports
will stifle domestic demand. However, other forecasters looking at those same difficulties see reasons
for optimism. Examples include the expectation that
meaningful fiscal reform will occur, or that foreign
economic growth will spur exports. Thus the median
forecast conceals a wide range of possible outcomes,
in large part due to the obvious fiscal and trade
problems.
A notable omission from the forecasters’ list of
major uncertainties is monetary policy. Perhaps due
to the Federal Reserve’s success in hitting its announced targets for growth in the money supply

FEDERAL RESERVE BANK OF RICHMOND

23

Table I

MEDIAN QUARTERLY CHANGES FORECAST FOR 1985
Percentage Changes at Annual Rates Unless Otherwise Noted
Actual Changea
4Q 834Q 84

Forecasts 1985*
I

II

III

IV

4Q 844Q 85

Gross national product____________________

9.3

7.6

7.8

8.1

8.0

Personal consumption expenditures____
Durables _____________________________

7.6

7.5

7.4

7.7

7.8

7.6

8.3

8.6

8.7

6.4

6.3

7.5

Nondurables ________________________

6.0

5.2

5.7

6.4

6.1

5.9

Services_____________________________

8.5

8.6

9.0

8.6

9.0

8.8

Gross private domestic investment ______
Fixed investment:

17.7

2.1

6.4

10.3

10.4

7.3

Nonresidential ___________________
Residential ________________________

16.9

10.6

7.9

7.2

7.1

8.2

8.4

7.4

12.0

11.7

11.1

10.6

34.7

33.0

34.9

38.8
-84.0

Change in business inventoriesb ______

3 1 . 1c

7.9

Net exports _________________________

-64.3

-80.9

-81.2

-87.1

Government purchases _________________
Federal ____________________________

13.2

9.9

8.3

8.4

8.4

8.8

18.7

12.6

8.3

8.5

8.4

9.5

State and local _______________________

9.8

8.1

8.0

7.6

7.3

7.8

Gross national product (1972 dollars) ____

5.6

3.4

3.4

3.4

3.3

3.4

4.6

10.0

11.2

6.2

8.0

10.0

8.3

0

1.2

4.9

12.2

2.4

4.8

3.9

5.8

b

c

Corporate profits after taxes ______________
Private housing starts _____________________

-8.2

Domestic automobile sales _______________

0.1

Rate of unemployment __________________

7.2

7.3

7.2

7.2

7.2

Industrial production index ________________

6.3

4.0

4.4

3.1

3.5

3.8

Consumer price index ____________________

4.1

4.1

4.3

4.6

4.8

4.5

Producer price index _____________________

1.7

2.9

3.3

3.6

4.3

3.5

GNP implicit price deflator ________________

3.5

4.2

4.3

4.5

4.5

4.4

d

c

* Median quarterly percentage change forecast for each quarter for each category, incorporating 30 forecasts.
a

National income and Product Account data for the fourth quarter of 1984 are preliminary and subject to revision.

b

Quarterly levels, billions of dollars at annual rates.

c

Level, 4Q 1984.

d

Quarterly levels, percent.

(M1) in 1984 and the last half of 1983, most forecasters predict that monetary growth in 1985 will
be within the Fed’s tentative range announced in
July. The median projection for Ml growth is 6.1
percent, while the announced range for Ml growth
is 4 to 7 percent.
Past Forecasts
As indicated in Table III, the median forecast was
unusually accurate in 1984. Although real growth

24

was underestimated and inflation overpredicted, the
misses were smaller than in recent years. Most
striking, however, was that the interest rate paid on
Treasury bills was forecast exactly for the fourth
quarter of 1984.
While forecasts for the year as a whole were unusually accurate, the pattern of economic activity
within the year was not predicted well. During 1984,
real GNP was predicted to grow between 4.0 and 4.5
percent during each quarter. Yet during the first

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

Table II

MEDIAN ANNUAL AVERAGES FORECAST FOR 1985
Percentage Change
Unit or
Base

Preliminary
1984*

Forecast
1985**

Preliminary
1984/1983

Forecast
1985/1984

Gross national product ________________________

$ billions

3661.3

3936

10.8

7.5

Personal consumption expenditures ________

$ billions

2342.3

2523

8.6

7.7

Durables_________________________________

$ billions

318.4

344

13.8

7.9

Nondurables ____________________________

$ billions

858.3

905

7.1

5.4

Services

__________________________________

$ billions

1165.7

1275

8.5

9.4

Gross private domestic investment _______

$ billions

637.3

674

35.1

5.8

Fixed investment:
Nonresidential _________________________

$ billions

426.0

472

20.7

10.8

$ billions
$ billions

154.4
56.8

164

16.8

6.0

Residential ____________________________
Change in business inventories ___________

38

Net exports ________________________________

$ billions

-66.3

-84

Government purchases ____________________

$ billions

748.0

823

9.1

10.0

Federal _________________________________

$ billions

331

9.6

11.9

State and local __________________________

$ billions

295.5
452.4

492

8.8

8.7

Gross national product (1972 dollars) ______

$ billions

1639.0

1693

6.8

3.3

Private housing starts _________________________

thousands

1745

1696

2.4

-2.8

Domestic automobile sales ____________________

millions

8.0

7.7

17.6

-3.8

Rate of unemployment _______________________

percent

7.5

7.2

Industrial production index ___________________

1967= 100

163.5

168.9

10.8

3.3

Consumer price index _______________________

1967= 100

311.1

324.5

4.3

4.3

Producer price index _________________________

1967= 100

291.2

298.5

2.1

2.5

GNP implicit price deflator ____________________

1972= 100

223.39

232.55

3.7

4.1

* Data available as of January 1985.
** These data are constructed using preliminary 1984 data and the median annual percentage change forecast for each category,
incorporating 45 forecasts.

two quarters the economy boomed, with real GNP
growing at 10.1 and 7.1 percent annual rates. Then
real activity decelerated, with real GNP rising by
only 1.6 percent in the third quarter. Neither the
boom nor the deceleration was generally forecast. In
addition, the intrayearly patterns of inflation and
interest rates differed from the median forecasts.
In many ways, therefore, 1954 furnishes a good

illustration of both the benefits and the hazards of
economic forecasts. Relatively accurate forecasts for
the year as a whole were undoubtedly valuable for
many users. But even in such a relatively good year,
forecasters were generally unable to predict short-run
changes. Users looking for guidance on the exact
timing of particular events, such as the onset of a
recession, should keep that record in mind.

FEDERAL RESERVE BANK OF RICHMOND

25

Table Ill

THE RECORD OF MEDIAN FORECASTS
Real GNP (Growth Rate)
Actual Predicted

1971

Error

Treasury Bill Rate

Inflation Rate (GNP Deflator)
Actual Predicted

Error

Actual Predicted

Error

_________________

4.7

3.8

0.9

4.7

3.6

1.1

1972 _________________

7.0

5.6

1.4

4.3

3.2

1.1

1973 _________________

4.3

6.0

-1.7

7.0

3.3

3.7

1974 _________________

-2.7

1.2

-3.9

10.1

5.5

4.6

7.3

6.0

1.3

1975 _________________

2.2

-0.6

2.8

7.7

7.1

0.6

5.7

7.1

-1.4

1976 __________________

4.4

6.0

-1.6

4.7

5.4

-0.7

4.7

7.1

-2.4

1977 __________________

5.8

5.0

0.8

6.1

5.7

0.4

6.1

5.8

0.3

1978 __________________

5.3

4.2

1.1

8.5

5.9

2.6

8.7

6.5

2.2

1979 __________________

1.7

1.5

0.2

8.1

7.1

1.0

11.8

8.1

3.7

1980 __________________

-0.3

-0.8

0.5

9.8

8.2

1.6

13.7

8.6

5.1

1981 __________________

0.9

2.4

-1.5

8.9

9.1

-0.2

11.8

10.8

1.0

1982 __________________

-1.7

2.8

-4.5

4.4

7.1

-2.7

8.0

11.2

-3.2

1983 __________________

6.1

3.9

2.2

4.1

5.4

-1.3

8.8

8.1

0.7

1984 (preliminary) ______

5.6

4.3

1.3

3.5

4.9

-1.4

9.0

9.0

0

Mean Absolute Error __

1.7

1.6

1.9

Note: Predictions are from Business Forecasts, published annually by the Federal Reserve Bank of Richmond. The error is the actual value
minus the predicted value. Real GNP and the GNP deflator are expressed as percentage changes from the fourth quarter of the
previous year to the fourth quarter of the stated year. The Treasury bill rate is the average yield on three-month bills in the fourth
quarter.

BUSINESS FORECASTS 1985
Edited by Sandra D. Baker
The Federal Reserve Bank of Richmond is pleased to announce the publication
of Business Forecasts 1985, a compilation of representative business forecasts for
the current year. A concensus forecast for 1985 also is included. Copies may be
obtained free of charge by writing to Public Services Department, Federal Reserve
Bank of Richmond, P. O. Box 27622, Richmond, Virginia 23261.

26

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

THE AGRICULTURAL OUTLOOK FOR 1985
. . . LITTLE PROMISE SEEN
Raymond E. Owens

Economists from the U. S. Department of Agriculture as well as agricultural industry and trade
analysts attended the 1985 Outlook Conference held
in Washington, D. C. in early December. Their
appraisal of the agricultural economy for 1985 is
summarized here.
Overview
Entering 1985, the farm sector continues to be
plagued by a variety of economic and financial problems. Farm income levels have exhibited weakness
for the last five years. Farmland, a significant component of total farm assets, has fallen in value in
response to weak income levels and has thereby reduced the equity positions of many farmers. Highly
leveraged farmers (i.e., those with high debt to asset
ratios) have been most adversely affected by the
economic weakness. Agribusiness industries have
also suffered substantial financial hardship as lower
farm incomes have led to reduced purchases of farm
production inputs.
On balance, 1985 offers little promise either to our
nation’s farmers or those engaged in the agribusiness
industries. That is the conclusion reached by analysts
who participated in the U. S. Department of Agriculture’s annual Outlook Conference in December.
According to these analysts, 1985 can be characterized as a year of continuing adjustment, with agricultural commodity supplies growing more rapidly than
demand. Conference participants indicated that agricultural prices will remain under downward pressure
throughout this year, although food prices are expected to increase modestly, probably less than the
rise of prices generally as measured by the CPI.
Agricultural output rebounded in 1984 after being
held down in 1983 by the payment-in-kind (PIK)

program 1 and a severe drought. Output should continue to increase through the current year, participants concluded.
They also noted that while domestic agricultural
demand has been buoyed by the vigorous U. S. economic recovery, foreign demand has been dampened
by a sluggish worldwide recovery and a strong dollar.
The emergence of new foreign producers of exportable grains has further hindered U. S. agricultural
exports. In light of these obstacles, the volume of
exports for the United States is expected to continue
its downward slide in 1985.
Cash receipts from farm marketings should rise
this year as increased production outweighs lower
prices. But reductions in government payments
should offset these increases, resulting in an unchanged gross income figure. Production expenses
will rise only modestly, leaving the net cash income
of farmers in the $31 to $36 billion range, 5 to 9
percent below the 1984 level.
Food price increases are expected to moderate for
the current year, finishing probably somewhat below
the 4 percent increase of 1984. Since the farm value
component of food prices should show no increase,
hikes in marketing costs will likely be responsible for
most of the expected rise in the food price level.
As always, the outlook for agriculture involves a
high degree of uncertainty. Domestic farm output
levels are dependent on weather conditions as well as

1
Payment-in-kind was a “one time” U. S. Department
of Agriculture (USDA) program enacted in 1983 designed to reduce the large grain stocks accumulated
during 1981 and 1982. Under the terms of this program,
producers received the title to government held grain
stocks in exchange for limiting their plantings. Farmer
participation was strong, leading to a removal of 78
million acres of cropland from production that year.

FEDERAL RESERVE BANK OF RICHMOND

27

foreign production levels. On the export side, trade
agreement announcements can significantly affect demand and price levels. Apart from these uncertain
influences, other factors, including the U. S. economic
recovery, the strength of the dollar, and the development of the 1985 farm bill are all expected to affect
the performance of the agricultural economy in 1985
and beyond. The discussion below provides a more
detailed account of participants’ forecasts for agriculture in 1985.
Farm Income to Fall
As noted above, downward pressures on agricultural prices, increases in output, and lower government payments are all likely to dominate the outlook
for farm income in 1985. After reaching a record
high of $40.1 billion in 1983, agricultural net cash
income levels have been declining. The expected 1985
level shown in Table I should total between $31 and
$36 billion in nominal terms, the lowest net cash
income level since 1980.
On the crop side, analysts indicated that anticipated rises in production levels should outweigh an
overall price decline of up to 4 percent leading to
slightly higher crop cash receipt levels. Crop output
should rise 1 to 3 percent in 1985 with crop cash
receipts projected to reach $70 to $74 billion, compared to the estimated 1984 total of $68 to $72 billion.
Both food grains and feed grains should post higher
cash receipt figures in 1985 as increased output dominates lower prices. Soybean prices may fall sharply
this year while peanut production and prices are also
anticipated to be lower. Cash receipts for both will
likely fall.
Livestock output and price levels will probably be
unchanged to slightly higher in 1985 producing a
modest improvement in livestock cash receipts. Overall livestock cash receipts will likely total $71 to $75
billion this year, an increase of $1 billion over estimates for 1984.
Lower cattle supplies should result in higher beef
prices and slightly higher cash receipts from cattle
marketings. Hog output is expected to remain flat
in 1985, but higher prices should improve hog cash
receipt figures. Broiler production will likely expand
this year with lower prices and unchanged cash receipts anticipated. Milk prices should trend downward, leaving the cash receipts from milk somewhat
below 1984 levels.

28

While total cash receipts from the marketings of
crops and livestock shown in line one of Table I are
expected to rise $3 to $4 billion in 1985, an anticipated decline of $3 billion in direct government payments should result in a largely unchanged gross cash
income figure for farmers. In contrast to the $6 to
$10 billion increase in farm inventories in 1984,
adjustments for agricultural commodities are expected to show little change this year, pointing to a
total gross income figure about $7 to $8 billion below
last year.
Production expenses should rise moderately as
indicated by lines nine and ten of Table I. The increase is likely to be attributable equally to a rise in
inputs used (a result of higher planted acreage and a
buildup of livestock inventories) and small increases
in the price levels of replacement livestock and fertilizer. Overall, a rise of up to 4 percent is expected
in total production expenses, with the total forecast
in the $142 to $147 billion range.
From line 18 of Table I, it is indicated that the net
cash flow position of farmers will continue to deteriorate in the coming 12 months.2 More precisely, the
table shows that combination of the lower estimated
1985 net cash income and very modest loan growth
will likely result in a net cash flow of $26 to $31
billion, down from the $29 to $33 billion in 1984.
The lower net cash income and tighter net cash
flow will probably result in increasing financial problems for many farmers in 1985. Although conference
participants predict modest increases in the total cash
receipts of farmers this year, the increase will probably be insufficient to counter a combination of higher
production costs and reduced government payments.
1985 Farm Bill to Challenge Tradition
As stressed by the conference’s analysts, potentially
the most important aspect of the 1985 agricultural
economic outlook concerns the fate of agricultural
legislation that will come before Congress this session.
The Agriculture and Food Act of 1981, usually referred to as the Farm Bill, is due to expire on September 30, 1985. The Farm Bill embodies the legislation that provides for the wide spectrum of federal

2

The net cash flow position is an indicator of the farmers’
abilities to pay current expenses and service debt. The
net cash flow has been trending downward for several
years.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

Table I

FARM INCOME AND CASH FLOW STATEMENT
(Billion dollars)
Item

1981

1982

1983

Cash receipts _________________

142.6

144.8

138.7

139-143

142-147

Crops 1 ______________________

73.3

74.6

69.5

68-72

70-74

Livestock

69.2

70.1

69.2

70-74

71-75

1.9

3.5

9.3

7-10

4-7

Cash Government payments

1.9

3.5

4.1

3-5

4-7

Value of PIK commodities __

0.0

0.0

5.2

4-6

0

1984F

1985F

Farm income sources
1.

___________________

2. Direct Government payments

Other cash income ___________

1.9

2.0

1.5

4. Gross cash income (1+2+3)3

3.

146.4

150.2

149.6

2

5. Nonmoney income4 ____________

13.6

14.2

13.6

6. Realized gross income (4+5)

160.0

164.4

163.2

1-3

1-3

150-154

150-155

12-14

12-14

163-167

163-168

7. Value of inventory change ____

7.9

-2.6

-11.7

8. Total gross income (6+7) _______

167.9

161.8

151.4

171-175

163-168

6-10

-2-2

Production expenses
9.

Cash expense 5,6 ______________

111.4

113.4

109.5

115-117

118-122

10.

Total expenses ________________

136.9

139.5

135.3

141-143

142-147

35.0

36.8

40.1

34-38

31-36

17.9

17.8

18.6

15-17

13-15

16.1

29-33

19-24

Income Statement
11. Net cash income: 1 , 6
Nominal (4-9) ______________
Deflated (1972$) 7
12. Net farm income

1

Nominal total net (8-10)______

31.0

22.3

Total net (1972$)7 ____________

15.9

10.8

7.5

13-15

Total net (1967$)8 ___________

11.4

7.7

5.4

9-11

6-8

Off-farm income ______________

39.8

39.4

41.0

41-45

43-47

14. Change in loans outstanding 6

15.5

6.8

2.9

0-4

0-4

Real estate _________________

9.3

3.7

2.1

-2-2

-2-2

Nonreal estate9 _____________

6.2

3.1

0.8

0-4

0-4

15. Rental income ___________________

5.7

5.6

4.3

4-6

4-6

16. Gross cash flow (11+14+15)

56.1

49.3

47.3

41-45

38-43

13.

8-10

Other sources and uses of funds

17. Capital expenditures ____________

16.8

13.6

13.1

12-14

11-15

18.

39.3

35.6

34.2

29-33

26-31

6

Net cash flow 1,6 (16-17) ______

F = Forecast.
1

Includes net CCC loans.

2

Income from custom work, machine hire, and farm recreational activities.

3

Numbers in parentheses indicate the combination of items required to calculate a given total.

4

Value of home consumption of farm products and imputed rental value of farm dwellings.

5

Excludes depreciation and prerequisites to hired labor.

6

Excludes farm dwellings.

7

Deflated by the GNP implicit price deflator.

8

Deflated by the CPI-U.

9

Excludes CCC loans.

Source: U. S. Department of Agriculture, Economic Research Service.

FEDERAL RESERVE BANK OF RICHMOND

29

programs pertaining to agriculture. Components of
this legislative package include price supports and
quotas for tobacco and sugar, dairy supports, peanut
quotas, and grain target prices. It is estimated that
the farm bill legislation covers almost half of the total
U. S. agricultural production. But the current interest in the 1985 Farm Bill focuses not in the breadth
of its coverage but rather in its proposed changes in
the basic emphasis of U. S. farm policy.
Since its inception in 1930, farm commodity legislation has sought to emphasize improvement in the
income of U. S. farmers. Over the years, the legislation has employed a variety of programs designed
to accomplish this goal by either reducing commodity
supplies or by influencing commodity prices through
price supports, target pricing, and loan rates. Although farm programs can claim some success in
supporting domestic farm income levels over short
periods of time, the income support has often proved
to be costly to taxpayers and consumers in the long
run.
Opponents of the current policy direction advocate a less regulated market structure in the agricultural sector. They argue that commodity price
supports have created artificially high U. S. price
levels which have seriously eroded this country’s
position in global agricultural trade by pricing do-

mestic producers out of world markets. Participation
in these markets is vital to the economic survival of
substantial portions of the agricultural sector as indicated by the fact that fully one third of the crops
grown in the United States are destined for foreign
markets. In addition, opponents contend that the restriction of domestic agricultural production through
land banks or programs such as PIK induce more
foreign suppliers to enter the world market, creating a situation with unfavorable long-run consequences for American farmers.
Furthermore, the PIK program of 1983 was enacted coincidentally with a severe drought and contributed to a massive reduction in grain stocks which
boosted grain prices and squeezed the profit margins
of livestock producers. Agricultural suppliers were
also adversely affected by the program, as grain
producers required less seed, fertilizer, and chemicals.
Moreover, the cost of farm programs had reached
an alarming $21.7 billion in 1983 at a time when
federal budget deficits were already under increasing
scrutiny.

30

Many conference participants indicated that the
1981 farm commodity legislation appears likely to
undergo a major change in direction in 1985. Not
only is USDA on record as favoring a modification
of some farm programs over a multiple-year time
period, but support for a return to freer markets in
agriculture has also come from agribusiness interests,
farm producer groups, and Congress. Support for a
return to free agricultural markets, however, is far
from unanimous. With the farm economy in a weakened state, proponents of an unchanged agricultural
policy maintain that the elimination of federal programs at this time would severely disrupt the agricultural sector, causing unwarranted harm to thousands of farmers. All considered, conference participants felt it likely that the policies that have governed
U. S. agricultural production for the last 55 years
are destined to shift toward a closer orientation to the
constraints imposed by world agricultural markets.
Agricultural Financial Conditions Weaken
Attendees of the Outlook Conference expect continued difficulties to dominate the current outlook
for the financial conditions of farmers in 1985. The
trends that have plagued the agricultural sector since
1980-namely, declining farmland prices, low income,
and inadequate cash flow-are expected to continue
this year and may in fact worsen. Furthermore, the
increasing debt-to-asset ratio and declining equity
position experienced by the farm sector for the past
four years will likely continue.
Farmland has traditionally been the financial pillar
of the agricultural sector. Almost all long-term or
secured credit in agriculture is backed by farmland, a
fact which worked heavily in the favor of farmers
during the 1970s when farmland prices regularly
increased faster than the overall rate of inflation.
However, by 1980 high interest rates and low farm
incomes combined to halt and reverse the upward
price trend of farmland. The resulting downward
trend in farmland prices over the last few years will
probably continue throughout 1985. As a result, it
will be increasingly difficult for farmers to secure
additional long-term debt. In fact, real estate backed
debt may show no growth in 1985.
Conference participants expect farm income and
cash flow to fall this year. Net cash income could fall
8 to 10 percent while the net cash flow may be reduced by more than 10 percent. This will limit the

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

ability of farmers to service existing debt, and will
tend to reduce the growth rate of new short- and
long-term debt. Already at the limits of their debt
servicing ability, financially leveraged farmers will
find 1985 to be particularly difficult.3 Many farmers
will postpone the purchases of farm equipment and
other capital items, further hampering the profitability of farm related industries. Slow growth of
short-term and intermediate-term debt is anticipated
in 1985.
Downward pressures on farm asset values combined with flat or slow debt growth should lead to a
further weakening of the equity position of farmers
in 1985. The debt-to-asset ratio, which has been increasing in recent years, is likely to rise further,
although agriculture still enjoys a low average ratio
compared to many other industries.
Overall, farm financial stress is likely to increase
in the current year. Both farm foreclosure rates and
involuntary bankruptcy rates are projected to rise.
Financial institutions, already holding large amounts
of farmland, are finding the market saturated and are
reluctant to release more on the depressed market.
As a result, efforts to restructure existing loans are
widespread.
In an effort to assist the commercial banking sector
in the restructuring process, the Farmers Home Administration (FmHA) proposed a loan guarantee
plan last October. Under the original proposal, farm
lenders were asked to write off permanently 10 percent of the total outstanding principal and interest on
their farm loans in exchange for a FmHA administration guarantee against default on the remaining
balance. Subsequent modifications of the original
proposal have been aimed at encouraging farm lenders to step up their participation in the program.
Under later proposals, such lenders could choose to
write off either principal, interest, or a combination
of the two in order to fulfill the 10 percent requirement. In addition, beginning in fiscal 1986 the
administration intends to phase out direct FmHA

loans by shifting farm loans to the commercial banking sector and by reducing the FmHA role to one of
guaranteeing loans only.
Agricultural Export Outlook Mixed
Decreased export volume combined with expected
increased import levels will lower the agricultural
trade balance again in 1985. Agricultural export
volume should reach 142.5 million tons in 1985, down
slightly from the 143.6-million-ton level of 1984. The
expected decrease in export volume combined with
declining farm prices will cause downward pressure
on cash receipts from export sales. As a result, the
total value of agricultural exports is expected to
decline to $34.5 billion. The value of agricultural
imports is likely to rise for the third consecutive year
to a total of $19.5 billion. The agricultural trade
balance for the United States is projected to decline
to $15 billion, 44 percent below the 1981 level.
The current increase in export volume will stem
primarily from the substantially higher usage of
United States corn in such drought stricken areas as
the USSR and Middle East. Northern Africa is also

U.S. AGRICULTURAL
TRADE ACTIVITY
$ Billions
46
42
38

26
22
18
14
1980

1981

1982

1983

1984

1985*

‘Projected
3

While the majority of U. S. agricultural producers are
experiencing no financial difficulties., the highly leveraged
operators continue to have financial problems. These
operators (who have debt to asset ratios of 40 percent or
greater) owe an estimated 60 percent of the total outstanding.
To service their sizable debt loads, highly
leveraged operators require higher and more stable income flows than their non-highly leveraged counterparts
and are therefore more vulnerable to loan default in years
of low farm income.

The U.S. agricultural trade surplus has declined
substantially in recent years as exports have trended
downward and imports have risen somewhat. In light of
the heavy dependence on export sales, U.S. farmers
face downward pressure on incomes as unit sales
are lost to foreign producers, and prices in U.S.
markets fall in response to larger domestic supplies.

FEDERAL RESERVE RANK OF RICHMOND

31

expected to increase the importation of U. S. feed
grains to support the build up of livestock numbers
in that region. Additionally, oilseed exports should
recover somewhat from last year’s 19 million tons.
Also, horticultural items should exhibit a small increase, and U. S. livestock product exports are expected to be stronger this year.
The export volume of wheat and wheat flour
should fall in 1985 due to stiff competition from the
European Economic Community and a strong dollar.
Cotton exports are expected to drop sharply as the
world supply has shown a significant expansion.
For several years U. S. agricultural export volume
has been trending downward as an appreciating dollar
has made U. S. farm goods relatively more expensive
to foreign countries. Other factors contributing to
limit potential foreign demand have been the sluggish
world economic recovery and severe international
debt problems.4 Downward pressure on exports
should continue through 1985 unless world economic
growth accelerates.
Food Price Outlook
Retail food prices are expected to exhibit only a
modest gain in 1985. After experiencing a rise in
food prices of 4 percent in 1984, consumers may see a
2 to 5 percent increase at the supermarket this year.
Adverse weather conditions could, of course, dramatically alter the food price outlook, causing price
increases to exceed the projected levels. In the
absence of such shocks, however, rises in the farm
value of domestically produced foods are expected
to contribute little to food price gains this year. The
forecasters expect that abundant supplies of farm
produced foods will continue throughout 1985, limiting upward pressure on farm price levels overall.
Food marketing costs are likely to rise only 4 percent
over the same period. Increases in the processing,
distribution, and marketing cost of food have moderated in recent years with the deceleration of inflation.
4
As a result of the strong dollar, foreign producers have
found themselves at an advantage relative to U. S. farmers. In some instances foreign producers have increased
production and entered the world agricultural markets.
This has created an expanded world supply of grains.
World demand has, at the same time, grown less rapidly
as many potential net grain importing countries have
experienced economic hardships that have sharply reduced their incomes and hence power to purchase imports. The United States remains the dominant figure
in worldwide grain trade, but has nevertheless seen its
share of export markets diminish since the late 1970s.

32

The prices of red meats and fish are expected to
increase in 1985. Beef and pork producers began to
cut inventories in 1984, but abundant supplies of red
meats should continue to be marketed through the
first quarter of this year. Inventory reductions will
likely result in lower marketings in the latter half of
1985, however, causing upward pressure on prices.
Nevertheless, the red meat price levels should post a
gain of only 1 to 4 percent over the year. Fish and
seafood prices are expected to rise somewhat as a
result of increasing consumer demand.
Poultry and egg prices are expected to exhibit
sharp drops this year. Poultry ouput is predicted to
be higher than in 1984. However, lower feed input
costs will ensure that poultry producers maintain
profit margins in spite of lower prices. Egg production should be well above the 1984 total, with the
price of eggs averaging 14 to 17 percent below 1984
levels.
The price of fruit should average higher in 1985
as a result of low inventory levels. Adverse weather
conditions in 1984 caused a drawdown of fruit inventories which will probably not be offset this year.
Fruit prices will continue to be very sensitive to
weather conditions throughout the remainder of 1985.
Vegetable prices are expected to remain stable
throughout 1985. A large potato crop in 1984 is
expected to be a key factor in limiting any substantial
upward pressure on vegetable prices.
1985 OUTLOOK FOR MAJOR COMMODITIES

Commodity analysts attending the Outlook Conference outlined their predictions for individual farm
commodities for 1985. A summary of their comments
for some of the major commodities produced in the
Fifth District is presented below.
Tobacco
Uncertainty surrounding the direction of government programs will dominate the tobacco picture in
1985, although other longer term problems are likely
to persist. The domestic market for tobacco products
remains weak, while the export of U. S. leaf also
continues to trend downward. Domestic leaf output
has outrun demand growth in recent years, resulting
in lower quotas for growers and higher government
held inventories. Since cigarette sales dominate the
demand for tobacco, declining consumption in the

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985

United States-per capita and total-is an ominous
sign for the industry. In addition, larger health
warning labels on tobacco products in 1985 will probably limit demand further. At the processing level,
higher quality foreign tobaccos and a strong dollar
have caused tobacco manufacturers to rely increasingly on foreign leaf to meet their needs. In 1983,
foreign tobacco made up 33 percent of the total used
for cigarette manufacturing in the United States;
since then the foreign share has probably grown.
In contrast to a weakening demand for domestic
leaf, tobacco supplies have been growing steadily over
the past two years. The 1984 production of tobacco
was 22 percent above the previous year with much of
the crop going under government loan. Despite the
plentiful supplies, 1984 prices averaged 3-cents-apound higher for flue-cured, primarily because of the
high quality of the crop.
The poundage quota and acreage allotment for fluecured will be lower in 1985. Although the flue-cured
poundage quota will be set at a level 3.7 percent
below the 1984 base, the effective quota will be even
lower because tobacco growers sold more poundage
in 1984 than their allotment allowed. These surplus
marketings, or overmarketings, are deducted from
the poundage quota the following year, resulting in a
9 percent drop in the effective quota this year. The
1985 national acreage allotment has been reduced 4
percent to 389,643 acres. The price support for fluecured tobacco will likely be unchanged from the 1984
level.
The quota for burley tobacco will be set at 525
million pounds for 1985. This level is a 10 percent
reduction from the 1984 quota and represents the
maximum quota reduction allowed by law. The
effective quota will total 520 million pounds however,
as 5 million pounds were overmarketed in 1984.
Burley price supports will likely rise about 2 percent
in 1985.
Cotton
Weaker demand in both the domestic and foreign
markets is likely to be the key factor affecting cotton
this year. The strong recent increase in textile
imports has significantly reduced domestic mill usage
of U. S. produced cotton. The export of cotton is
also trending downward as the world cotton supply
expands. China has been a major contributor to the
increased world supply.

Cotton production and prices will likely be under
downward pressure throughout 1985. Planted acreage is predicted to total 9.5 to 11.0 million acres while
production is expected to fall to between 10.0 and
12.5 million bales. This compares to 11.1 million
acres and 13.3 million bales in 1984. Domestic usage
may run 4.5 to 5.5 million bales while exports will
likely total 4 to 6.5 million bales.
Lower price expectations for cotton could substantially increase participation in USDA’s Upland
Cotton Program in 1985. Participants will be required to hold 30 percent of their cotton base acreage
idle but will receive a price of 81 cents per pound for
their production on the remaining acreage. The price
support remains unchanged from the 1984 level.
Poultry and Egg Outlook
Increased production and lower prices characterize
the outlook for both poultry and eggs this year.
Lower red meat production, which encourages poultry consumption, and an abundance of grain, which
lowers feed costs, should result in expanded broiler
and turkey production in 1985. Growth in the economy and expanded poultry marketings by fast food
outlets are also expected to spur poultry demand.
Broiler output is projected to increase 4 to 6 percent over 1984, but prices should average lower with
wholesale broiler prices likely to range between 48
to 54 cents per pound, down from the 54 to 56 cent
range of last year. Broiler producers are expected
to at least break even or do slightly better owing to
the decreased feed costs.
A sharp increase in the production of turkeys is
also likely this year. Output may increase 10 to 12
percent in the first six months of this year compared
to the first half of 1984, but average only 2 to 4
percent above 1984 levels in the second half of 1985
as red meat production picks up. Turkey prices
should remain relatively strong, despite the large
supplies, averaging 65 to 69 cents per pound in the
first half of this year and 63 to 67 cents in the latter
half.
Egg producers received record returns in 1984
when fear of avian flu spurred the demand for eggs,
but this year promises higher output and sharply
lower prices for eggs. Low returns to egg producers
in 1983 limited new pullet placements in early 1984.
As a result, the avian flu outbreak occurred at a time
when no surplus eggs were available to limit egg

FEDERAL RESERVE BANK OF RICHMOND

33

price hikes in 1984. The higher returns to producers
in the latter half of last year caused an expansion in
pullet placements and will boost egg production by
2 to 4 percent in the first six months of 1985, and by
2 percent in the second half. Egg prices are expected
to average between 64 and 69 cents per dozen this
year, down from 93 cents in 1984.
Dairy Outlook
The dairy industry will continue to face an excess
supply problem this year. Production of milk should
rise about 1 percent in 1985, but marketings may be
up 2 percent as the farm usage of milk declines.
Overall, removals of milk by USDA will likely total
8.5 billion pounds, about equal to the 1984 removals,
but one-half the 1983 level.
The increase in milk production this year should
occur despite a reduction in dairy herd numbers.
After peaking in November 1983, the dairy cow
number had fallen by 329,000 head a year later. A
further decline is anticipated for 1985, although this
year’s reduction will probably be small. Higher output per cow in 1985 should offset the smaller herd
size.
The large quantity of milk subject to removal by
USDA will likely keep downward pressure on farm
level milk prices in the coming year. As a result,

wholesale prices may average near the Commodity

34

Credit Corporation (CCC) purchase prices which are
generally below the market price. A decline of 35 to
70 cents is anticipated in the overall price level of all
milk in 1985, but a government deduction of 50 cents
per hundredweight which pays for part of the milk
diversion program is scheduled to end in March,
leaving the effective price level unchanged to 35 cents
lower than the 1984 average of $13.37 per hundredweight.
Meat Animals
Lower cattle numbers are expected to exert upward pressure on beef prices this year. As of January 1 of this year, cattle inventory figures showed a
decline of 2 to 3 percent over year earlier totals.
Lower inventory figures combined with declining
breeding herd numbers point to a lower level of cattle
slaughter this year, with the decline in beef production totaling 3 to 4 percent. Beef prices should
strengthen for the year, probably averaging $65 to
$69 per hundredweight.
The production of hogs should not change from
1984 levels, although commercial production is expected to be below last year’s levels for the first 6
months, followed by expansion in the second half of
1985. Hog prices are expected to peak in the summer, but average in the low $50s per hundredweight
in the fall as larger supplies are marketed.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1985


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102