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THE MARKET FOR FEDERAL FUNDS*
Seth P. Maerowitz

The market for the most liquid of money market
instruments-Federal
funds-evolved
as borrowers
and lenders sought to exploit opportunities
through
trading in reserve deposit funds. Trading in Federal
funds began in the 1920s and involved only a few
Federal Reserve member banks located in New York
City. Today, the market includes over 14,000 commercial banks and a wide range of nonbank financial
institutions.1
The characteristics
of Federal funds as
well as the mechanics
of their purchase
and sale
reflect the needs of today’s market participants.
What
Are Federal
Funds?”
Federal
funds are
short-term
loans of immediately
available funds, i.e.,
funds that can be transferred
or withdrawn
during
one business day. Such immediately
available funds
include deposits at Federal Reserve Banks and collected liabilities
of commercial
banks and other depository institutions.
Federal funds are exempt from
reserve requirements
and the vast majority
are unsecured.
Most Federal funds are “overnight
money”
-funds
lent out on one day and repaid the following
Loans of longer maturity, known as term
morning.
Federal funds are not uncommon,
however.
The law requires, for purposes of monetary control, that all depository institutions
maintain reserves
as prescribed by the Federal Reserve System.
Federal Reserve Regulation
D delineates specific classes
of liabilities
which are subject to Federal Reserve
requirements.
Commercial banks, thrift institutions;
U. S. branches and agencies of foreign banks, and
Edge Act corporations
must hold set percentages
of
these liabilities
in a combination
of vault cash and
noninterest-earning
reserve balances at a Federal
Reserve Bank.
The opportunity
cost of holding reserve balances, which yield no return, provides the
incentive to depository institutions
to minimize their

* This article was written
for Instruments
of the Money
Market, 5th ed., Federal Reserve Bank of Richmond.
1 Thomas
D. Simpson,
The Market for Federal Funds
Board of
and Repurchase Agreements (Washington:
Governors
of the Federal Reserve System, 1979), p. 20.
2 The term “Federal
funds” is occasionally
used in a
broader sense than that described in this article.
Sometimes, members of the financial community
will consider
all funds which are immediately available and not subject
to reserve requirements
to be Federal funds.
Repurchase
included
under this broad definition,
agreements,
are
excluded from this discussion.

The Federal
funds
holdings
of excess reserves.
market provides the primary avenue for doing so.
Ordinary
banking activities give rise to variations
in a bank’s asset and liability holdings. These changes
in the balance sheet result in corresponding
fluctuations in a bank’s reserve position.
Consequently,
on any given day some institutions
hold reserves
above their desired reserve position while others are
below their desired position.
An institution
holding
excess reserves can earn interest
on its funds by
loaning them to others in need of reserves.
Such a
transaction
is considered
a Federal funds purchase
by the borrowing
institution,
and a Federal funds
sale by the lending institution.
The Mechanics
of Federal
Funds
Transactions
Federal funds transactions
can be initiated by either a
funds lender or a funds borrower.
An institution
wishing to sell (buy) Federal funds locates a buyer
(seller) either directly through an existing banking
relationship
or indirectly
through a Federal
funds
broker located in New York City.
Federal funds
brokers maintain frequent telephone contact with active buyers and sellers of Federal funds.
Brokers
match Federal funds purchase and sale orders in return for a commission on each completed transaction.
At the center of the Federal funds market are
financial institutions
that maintain
reserve accounts
at Federal Reserve Banks.
These institutions
use
the FederaI Reserve communications
system, or Fedwire, to carry out rapid transfer of funds nationwide.
The Federal Reserve communications
system links
all Federal Reserve Banks and branches.
Private
financial
institutions
and government
agencies are
able to gain access to the wire network either through
direct (on-line)
links to Federal Reserve computers
or through telephone or telegraph
(off-line)
contact
with their Federal Reserve Bank.
When transfers
are conducted
within a Federal
Reserve district, the institution
transferring
funds
authorizes the district Federal Reserve Bank to debit
its reserve account, and to credit the reserve account
of the receiving institution.
Interdistrict
transactions
are only slightly more complicated but are best clariSuppose a thrift institution
in
fied by an example.
Richmond
(the Fifth
Federal
Reserve
District)
wishes to transfer funds to a bank in New York (the
Second Federal Reserve District).
The thrift initi-

FEDERALRESERVEBANK OF RICHMOND

3

ates the transaction.
The Federal Reserve Bank of
Richmond debits the account of the thrift and credits
the account of the Federal Reserve Bank of New
York.
Finally, the Federal Reserve Bank of New
York debits its own account and credits the reserve
This
account of the receiving
commercial
bank.
series of accounting
entries is carried out instantaneously.
Overnight
Federal
Funds
In a typical
Federal
funds transaction
the lending institution
with reserve
funds in excess of its reserve requirements
authorizes
a transfer from its reserve account to the reserve
account of the borrowing
institution.
The following
day, the transaction
is reversed.
The borrower pays
back the loan through a transfer of funds from its
reserve account to the lender’s reserve account for an
amount equal to the value of the original loan plus
an interest payment.
The size of the interest payment is determined
by market conditions at the time
the loan is initiated.
Numerous
institutions
that buy and sell Federal
funds do not maintain accounts at the Federal Reserve. Instead, these institutions
buy and sell funds
through a correspondent
bank. Correspondent
banks
will often agree to purchase on a continuing
basis all
Federal funds that a respondent has available to sell.
Typically, the respondent
institution
holds a demand
deposit account with the correspondent.
To initiate a
Federal funds sale, the respondent bank simply notifies the correspondent
by telephone of its intentions.
The correspondent
purchases funds from the respondent by reclassifying
the respondent’s liability from a
demand deposit to Federal funds purchased.
Upon
maturity
of the contract, the respondent’s
demand
deposit account is credited for the total value of the
loan plus an interest payment for use of the funds.
The rate paid to respondents
on Federal funds is
usually based on the nationwide
effective Federal
funds rate for the day.
Alternatives
to Overnight
Federal
Funds
The
different needs of participants
in the Fed funds market and the wide range of financial environments
in
which they operate have resulted in the development
of alternatives
to overnight
Federal funds.
These
alternatives
include term and continuing
contract
Federal funds.
According
to the results of a 1977
7.5 percent of all Federal
survey, approximately
funds transactions
have maturities longer than overnight.3 Banks contract for term Federal funds when
3 Board of Governors, Repurchase Agreements
and Other
Nonreservable
Borrowings
in Immediately
Available
Funds.
Report giving results of a 1977 survey, 1978, p. 4.

4

they foresee their borrowing needs lasting for several
days and/or believe that the cost of overnight Federal
funds may rise in the immediate future.
Like overnight Fed funds, term Fed funds are not subject to
For this reason, term Fed
reserve requirements.
funds are often preferred to other purchased liabilities
of comparable maturity.
The majority of term Federa1 funds sold have maturities
of 90 days or less
but term Federal funds of much longer maturity are
purchased occasionally.
Federal funds sold through a correspondent
banking relationship
are sometimes
transacted
under a
continuing
contract.
Continuing
contract
Federal
funds are overnight
Federal
funds that are automatically renewed unless terminated
by either funds
lender or borrower.
In a typical continuing
contract.
arrangement,
a correspondent
will purchase
overnight Federal funds from a respondent
institution.
Unless notified by the respondent,
the correspondent
will continually
roll over overnight
Federal funds,
creating a longer term instrument
of open maturity.
The interest payments
on continuing
contract Federal funds are computed from a formula based on
The specific
each day’s Federal funds quotations.
formula used varies from contract to contract.
Most
Secured
and Unsecured
Federal
Funds
Federal funds transactions
are unsecured,
i.e., the
lender does not receive collateral
to insure
him
against the risk of default by the borrower.
In some
cases, however, Federal funds transactions
are secured. In a secured transaction,
the purchaser places
government
securities in a custody account for the
seller as collateral to support the loan. The purchaser
retains title to the securities, however.4
Upon completion of the Federal funds contract, custody of the
securities is returned to the owner.
Secured Federal
funds transactions
are sometimes
requested by the
lending institution,
or encouraged
by state regulations requiring
collateralization
of Federal
funds
sales.
The History
and Evolution
of Market
Structure
The Federal funds market of the 1920s developed
out of the common interests of a few Federal Reserve
member banks operating in New York City that often
found themselves
with temporary
shortages or surpluses of reserves.
Before the emergence of the Federal funds market,
banks having a deficiency
of
reserves had to borrow from the discount window,
4 The crucial difference between a secured Federal funds
transaction
and a repurchase
agreement
is that in a
Federal
funds transaction
title to the security
is not
transferred.
RPs are available to a wider range of market participants
than Federal funds.

ECONOMIC REVIEW, JULY/AUGUST 1981

while banks with a surplus of reserves had no profitable use for their excess reserve deposits.
A market
in reserve deposits was formed that benefited both
deficient
reserve and surplus
reserve institutions.
Banks that borrowed in the new market found Federal funds to be an inexpensive
substitute
for the
discount window, while banks that lent funds were
pleased to receive a liquid earning asset to replace
their nonearning
excess reserve balances.
By 1929, the daily trading volume in Federal funds
had expanded
to over $250 million, but with the
stock market crash of October 1929 and the economic
contraction
that followed, the Federal funds market
disintegrated.5
The contraction
and the large number of bank and industrial failures that accompanied
it led to great uncertainty
about the safety of most
earning assets except U. S. Government
securities.
It resulted in a market preference for cash, reflected
in the large increase in excess reserve balances maintained by commercial banks in the period.
The disinterest in Federal funds trading by potential lenders
was matched by the diminished
needs of potential
borrowers.
Weak loan demand and large gold inflows throughout
most of the early and midthirties
left few institutions
in need of borrowings
to meet
their reserve requirements.
The market revived briefly in 1941 in response to
financial pressures
resulting
from World War II.6
The revival was short-lived,
however;
Federal Reserve pegging of Treasury
bill prices from 1942 to
1951 rendered the funds market superfluous.
With
the price of Treasury bills fixed, banks made adjustments in their reserve balances through trading TreaThe funds market
sury bills free of market risk.
remained
dormant
until securities prices were unpegged by the Treasury-Federal
Reserve Accord of
1951. Since trading in Treasury bills was now subject to the risk of securities price fluctuations,
Federal
funds trading became the preferred mode of reserve
adjustment.
Furthermore,
the higher market rates
of interest
prevailing
after the Treasury-Federal
Reserve Accord increased
the opportunity
cost of
holding sterile balances, making more frequent
reserve adjustments
desirable.
Consequently,
the volume of aggregate
trading
in Federal
funds grew
sharply.
Improvements
in banking
technology
and the
5 Marcos
T. Jones, Charles M. Lucas,
and Thorn B.
Thurston, “Federal Funds and Repurchase
Agreements,”
Federal Reserve Bank of New York, Quarterly Review 2
(Summer
1977): 39.
6 Parker
B. Willis,
The Federal
Funds
Market,
Its
Origin
and Development
(Boston:
Federal
Reserve
Bank of Boston, 1970), p. 15.

growth of correspondent
banking during the sixties
brought about important
changes in the nature of
Federal funds trading.
Large correspondent
banks
intentionally
began to run down their reserve positions, substituting
Federal funds as a new source of
loanable funds.
Smaller regional banks specializing
in retail banking, with a large inflow of deposits but
few lending opportunities,
sold Federal funds to the
larger institutions.
Banking relationships
developed
such that large correspondents
stood ready to purchase all the funds that their smaller respondent
banks had available to sell.
In this environment,
the Federal funds market took
on a broader role, beyond that of reserve adjustment
borrowing.
Large banks began to depend on Federal
funds as a semi-permanent
source of nondeposit funds
while smaller respondents
recognized
Fed funds to
be a profitable,
liquid investment.
In 1963, the
Comptroller
of the Currency
eliminated capital adequacy restrictions
on Federal funds purchases
and
sales, and in 1964, the Federal Reserve Board ruled
that member banks could purchase
Federal funds
from nonmember
respondents.
These two rulings
increased the supply of Federal funds to the purchasing banks,. further augmenting
market growth.
The Federal
Funds
Rate and the Discount
Rate
The Federal Reserve limits most borrowing
at the
discount window to banks facing temporary shortages
of reserves.
Prior to the mid-1960s,
the Federal
funds rate rarely rose above the discount rate. Federal funds were viewed primarily as a substitute for
discount window borrowing.
Since banks only used
the discount window occasionally,
they were generally not constrained
by Federal Reserve discount
window policies.
Temporary
borrowing
needs were
easily met at the discount window leaving little incentive to purchase funds at a rate exceeding the
discount rate.
By late 1964 the practice of liabilities management
had become widespread.
In this environment
incentives existed for banks practicing liabilities management to borrow from the discount window on a continuing basis. Discount window administration
policies, however, remained oriented towards providing
funds to banks facing temporary reserve deficiencies,
thus preventing
banks from using the window as a
continual
source of funds.
Since access to the discount window was limited, banks in need of additional funds were willing to pay a premium above the
discount rate for Federal funds.
In late 1964, the
Federal funds rate rose above the discount rate reflecting a demand for overnight funds exceeding the
supply available at the discount window.

FEDERAL RESERVEBANK OF RICHMOND

5

During the “credit crunch” of 1966 regional banking institutions
without well developed networks of
funds suppliers often found Federal funds difficult to
obtain.7 Problems of funds availability soon subsided,
however, and the funds market continued
to grow
rapidly throughout
the late 1960s. Banks willing to
purchase
Federal funds at the market rate found
them to be expensive,
but readily available.
The
Federal funds rate rose rapidly towards the end of
the 1960s and reached a peak of 9.2 percent in August of 1969.
Many banks were squeezed in the
short run by the rapid increase in the cost of funds.
Over the long run, however, they adjusted
by developing flexible asset management
and loan pricing
policies in order to deal more effectively with variation in the cost of nondeposit
funds.
In 1970, approximately
60 percent of all member
banks were active buyers or sellers of Federal funds.8
Despite questions of funds price and availability,
the
Federal
funds
market
had grown
dramatically
throughout
the sixties.
In 1960 daily average gross
interbank
Federal
funds purchases
of 46 money
By 1970 daily
market banks were $1.1 billion.9
average purchases of this group had soared to $8.3
billion.10 The rapid growth in Federal funds trading
throughout
this period reflected the expanded
role
of the Federal funds market as a source of purchased
liabilities, as well as its value as a tool of member
bank reserve adjustment.
The Market in Recent Years11 The Federal funds
market of the 1970s was characterized
by further
7 S. M. Duckworth,
Problems
in Liability
Management:
Case Studies of Attitudes at Seven Banks (Boston:
Federal Reserve
Bank of Boston,
1974), pp. 20-22.
This
discussion
is drawn from interviews
of bankers in the
First Federal Reserve District.
8 Willis,

The Federal

Funds

Market,

p. 52.

9 Federal
Reserve Bulletin (August
1964), table, “Basic
Reserve Position,’ and Federal Funds and Related Transactions of 46 Major Reserve City Banks”, p. 954; same
table in various issues of 1970, 1971.
10 Ibid
11 The analysis of the Federal funds market of the 1970s
and ’80s is complicated
by the development
of the repurchase
agreement.
Repurchase
agreements
gained
rapid acceptance
by bankers as a near perfect substitute
for Federal funds.
Data on Federal funds sales and
purchases were, and continue to be, reported in aggregate
with data on repurchase
agreements.
According
to
studies by the Federal Reserve Board of Federal funds
and RPs supplied to 45 large member
banks, Federal
funds accounted
for 89.4 percent of gross nonreservable
borrowinns
of immediately
available funds from depository institutions
and U. S: Government
agencies on December 7, 1977. Since Federal funds hive remained the
predominant
money
market instrument
for borrowing
immediately
available funds among banking institutions,
an analysis of the Federal funds market in the ’70s can
still be made on the basis of the available data.

6

growth spurred on by regulatory
change.
Prior to
1970 borrowings
from nonbank financial institutions
were subject to reserve requirements,
and consequently, nonbanks
were not active in the Federal
funds market.
In 1970 an amendment
to Regulation
D exempted borrowings
from savings and loan associations, mutual savings banks, and U. S. Government agencies from reserve requirements.
Following
the 1970 ruling, the nonbank institutions
assumed a
role in the Federal funds market very similar to that
of small commercial banks.
Savings and loan associations and mutual savings banks found sales of
Federal funds to be a profitable and liquid alternative
to purchases of Treasury securities.
In recent years,
nonbank depository
institutions
supplied 35 percent
of the Federal funds purchased by the 45 large weekly
reporting banks.12
The funds market of the 1970s continued to reflect
the patterns of growth which had developed in earlier
years.
During periods of high short-term
interest
rates, the Federal funds market expanded as small
financial
institutions
sought to economize on their
cash and reserve balances while large banks practicing liabilities management
demanded Federal funds
to meet the needs of their loan customers.
In times
of low short-term
interest rates and slack loan demand, growth in the Federal funds market was less
rapid. The Federal funds market, however, was not
subject to large declines in trading volume, as were
other markets for purchased liabilities such as large
certificates of deposit.13
The Federal
Funds Market and Monetary
Policy
The Federal Reserve exerts control over the money
supply primarily influencing the level of nonborrowed
reserves available to the banking system.
The Federal funds rate reflects the cost of interbank borrowing, in essence the price of nonborrowed
reserve
deposit funds. If the supply of nonborrowed
reserves
is reduced, the immediate effect will be an increase in
the Federal funds rate ; conversely, an increase in the
supply of nonborrowed
reserves will bring about a
fall in the funds rate. Following a rise in the funds
rate, banks will slow the growth of their loan portfolios and/or increase the rates charged on new loans
to reflect the higher cost of nondeposit funds. Hence,
12 Board
of Governors,
Repurchase
Agreements
and
Other Nonreservable
Borrowings,
p. 4.
A data series
consisting
of 46 large banks was begun by the Federal
In March 1980, the sample
Reserve
System in 1964.
group was expanded to include 121 large member banks.
The figure is based upon a special survey of the original
46 bank group, conducted
on December
7, 1977.
13 CDs were subject to a rapid runoff
(See Summers [15]).

ECONOMIC REVIEW, JULY/AUGUST 1981

in 1975 and 1977.

the Federal funds market acts as an integral part
the transmission
process for monetary policy.

of

Throughout
the 1970s, the Federal Reserve used
the Federal funds rate as its principle operating target of monetary
policy.
When money growth was
above the desired growth path, the Federal funds rate
target was raised.
The Open Market Desk was
directed to sell government
securities and drain reserves from the banking
system until the desired
funds rate target was met. If more rapid monetary
growth was desired, the funds rate target was lowered, and reserves were added to the banking system.
Funds traders formed their expectations
of the funds
rate based on what they believed the Federal Reserve’s target rate to be; under usual procedures,
whenever the funds rate rose 1/8 to 3/16 percentage
points above its target level, the Federal
Reserve
provided reserves through the purchase of government securities (via overnight
RPs), and whenever
the rate dropped 1/8 to 3/16 points below target, the
Federal Reserve absorbed reserves through the sale
of securities.
Market participants
soon came to depend on such signals of Federal Reserve intentions,
which provided important information
for forecasting
Federal funds rate movements.
The inflation of recent years and the tendency of
the Federal Reserve to overshoot its money supply
targets raised serious questions about the efficacy of
the Federal funds rate as an operating
target for
monetary policy. On October 6, 1979, a major policy
shift was announced.
The Federal Reserve would
now focus more attention
on nonborrowed
reserves
and less attention
on day-to-day
fluctuations
in the
Federal funds rate.
The impact of the new policy on the market was
immediate and dramatic.
Variation in the funds rate
increased from a daily trading band of approximately
2 percentage points during the month preceding October 6th to a daily trading band of approximately
5
percentage
points during the month following
October 6th.14 Despite greater variation
in the funds
rate, trading volume continues to be strong, reflecting
the importance
of Federal
funds as a short-term
money market instrument.
Conclusion
The Federal
funds market
of today
is the evolutionary
result of changes in general economic conditions,
Federal and state regulations,
and
financial innovation.
From its beginnings
as a market limited to the purchase and sale of excess reserve
14 Federal
Reserve
Bank of New
York,
Closing
Quotations
for U. S. Government
September 4, 1979 - November
9, 1979.

“Composite
Securities,”

deposits among member banks, the Federal
funds
market has undergone tremendous expansion.
Active
liabilities management
practices of the past two decades created new demand for Federal funds, and less
restrictive regulations
brought the funds market to a
new group of financial institutions.
Today, Federal
funds are an important
purchased liability for large
banks, a profitable liquid investment for a wide range
of market participants,
and a valuable reserve adjustment tool.
References
1.

Board of Governors
of the Federal Reserve System.
Repurchase
Agreements
and Other Nonreservable
Borrowings
in Immediately
Available
Funds.
1978.

2.

Board of Governors of the Federal Reserve
Selected
Interest
Rates and Bond Prices.
ington, D. C.: 1969.

3.

Brandt,
Harry.
“The Discount
Rate Under the
Federal Reserve’s
New Operating
Strategy.”
Economic Review,
Federal Reserve Bank of Atlanta
6
(March/April
1980) : 6-15.

4.

Depamphilis,
Donald
Michael.
A Microeconomic
Econometric
Analysis
of the Short-Term
Commercial Bank Adjustment
Process.
Boston:
Federal
Reserve Bank of Boston, 1974.

5.

Duckworth.
S. M. Problems
in Liability
Management:
Cask Studies of Attitudes
at Seven Banks.
Boston:
Federal Reserve Bank of Boston, 1974.

6.

Federal
Reserve
Bank’ of New York.
“Monetary
Policy
and Open Market
Operations
in 1979.”
Quarterly
Review,
Federal
Reserve Bank of New
York 5 (Summer 1980) : 50-64.

7.

Fieldhouse,
Richard
C. “The Federal Funds Market.”
Money Market
Memo.
New York:
Garvin,
Bantel & Co., October, November
1964.

8.

Gambs, Carl M., and Kimball,
Ralph C.
“Small
Banks and the Federal Funds Market.”
Economic
Review,
Federal
Reserve Bank of Kansas
City 64
(November
1979) : 3-12.

9.

Jones, Marcos
T.; Lucas, Charles M.; and Thur“Federal
Funds and Repurchase
ston, Thorn B.
Agreements.”
Quarterly
Review,
Federal
Reserve
Bank of New York 2 (Summer
1977) : 33-48.

System.
Wash-

10.

Kaufman,
Herbert
M., and Lombra,
Raymond
E.
“Commercial
Banks and the Federal
Funds MarRecent
Developments
and
Implications.”
ket :
Economic
Inquiry 16 (October
1978).

11.

Kimball,
Ralph C.
“Wire
Transfer
and the Demand for Money.” New England Economic
Reviev,
Federal
Reserve
Bank of Boston
(March/April
1980), pp. 5-22.

12.

Monhollon,
Jimmie R. “Federal
Funds.”
Instruments of the Money Market.
4th ed.
Edited by
Timothy
Q. Cook.
Richmond : Federal
Reserve
Bank of Richmond,
1977.

13.

Simpson,
Thomas
D.
The Market
for Federal
Funds and Repurchase
Agreements.
Washington,
D. C.: Board of Governors
of the Federal Reserve
System, 1979.

14.

Stigum, Marcia.
The Money Market Myth, Reality,
and Practice.
Homewood:
Dow Jones-Irwin,
1978.

15.

Summers,
Bruce J.
“Negotiable
Certificates
of
Deposit.”
Economic
Review, Federal Reserve Bank
of Richmond
66 (July/August
1980) : 8-19.

16.

Willis, Parker B. The Federal
Funds Market,
Its
Origin and Development.
Boston:
Federal Reserve
Bank of Boston, 1970.

FEDERALRESERVEBANK OF RICHMOND

7

MONETARY
POLICY ECONOMIC
AND
PERFORMANCE,
SUMMER
1976-NOVEMBER ANOVERVIEW*
1980:
Robert E. Weintraub

In May 1975, pursuant
to House
Concurrent
Resolution
133, passed in March 1975, the Federal
Reserve began to set and disclose in Congressional
hearings
that were held four times a year money
supply growth targets for the four quarters immediately ahead.
Now, under the Hawkins-Humphrey
Act, the hearings are held only twice a year-February and July.
In July, preliminary
targets are disclosed for the next calendar year. Also in July, and
in February as well, the targets are set (or, if desired,
revised) for the current calendar year.
Initially,
May 1975, plans were announced
to
increase what was then the basic measure of the
nation’s supply of exchange media or money, Ml,
between 5 and 7½ percent per year. The lower end
of the range was reduced to 4½ percent effective
beginning
in the fourth quarter of 1975. The upper
end of the range was reduced to 7 percent effective
the following
quarter,
and further reduced to 6½
percent effective in the summer or third quarter of
1976.
Early 1975 to Late 1976: Recovery with Declining Inflation
In association with lowering its
sights, the Federal Reserve kept Ml growth at the
bottom or below the planned ranges until the third
quarter of 1976. During the year and a half from
March 1975 through the third quarter of 1976, measured between the same quarters from one year to
the next, Ml growth ranged between 4.5 and 5.2
percent.
(Later, beginning
with our discussion
of
events from late 1976 on, M1B is used to measure
the nation’s supply of exchange
media or money.
Here, it suffices to note that its growth ranged be* Extracted

from

the author’s

report

The Impact of the Federal Reserve System’s Monetary
Policies
on the Nation’s
Economy,
(Second
Report),
Staff Report of the Subcommittee
on Domestic
Monetary Policy of the Committee on Banking, Finance and
Urban Affairs,
House of Representatives,
96th Congress, Second Session, December
1980,
presented at a research seminar at
Bank of Richmond,
April 17, 1981.
herein are those of the author and
of the Federal Reserve
Bank of
Board of Governors
of the Federal

8

the Federal Reserve
The views expressed
not necessarily
those
Richmond
or of the
Reserve System.

tween 5.0 and 5.8 percent during the earlier period
now under discussion.)
In retrospect, the economy performed exceptionally
well during the early 1975 to late 1976 period.
l

The recession that began late in 1973 ended in
the second quarter of 1975. The nation’s output, measured
by constant
dollar GNP, increased 6.5 percent between the second quarter
of 1975 and the second quarter of 1976 and 4.7
percent between the third quarter of 1975 and
the third quarter of 1976. Unemployment
fell
from the recession peak of 8.9 percent in May
1975 to 7.7 percent in September
1976.

l

Inflation,
measured
by the rise in the GNP
deflator dropped from 11.6 percent in the four
quarters ending with the first quarter of 1975
to 4.8 percent in the four quarters ending with
the third quarter of 1976.

Few believed, in early 1975, that our economy
could achieve vigorous recovery of production
from
the 1973-1975 slide, and realize a substantial
decline
in unemployment,
if money growth was held below
6 percent per year. And not many persons believed
that this could happen while at the same time the rate
of inflation fell sharply.
Rather, it was widely believed that money growth substantially
higher than
6 percent per year was essential to a strong recovery,
and that a strong recovery was sure to prevent inflation from falling sharply.
However,
the events of
1975-1976 contradicted
both beliefs.
First, vigorous
recovery of production took place even though money
growth measured over 12-month periods was maintained near the economy’s long run growth potential,
which is estimated to be 3½ to 4 percent yearly.
Second, inflation dropped nearly 60 percent together
with the recovery of growth of constant dollar GNP.
Recovery
The recovery
of 1975-1976 was made
possible by (and indeed required)
the erosion and
elimination
of the forces that caused the 1973-1975
recession. The recession resulted from a combination
of factors. The acceleration of domestic inflation beginning
in 1973, the quadrupling
of imported
oil

ECONOMIC REVIEW, JULY/AUGUST 1981

prices between the end of 1972 and the spring of
1974, and the cutback of fiscal stimulus in 1973 and
the first half of 1974 all played important
parts in
depressing production
in 1973-1975.
The sharp deceleration of money growth that began in mid-1973
and was speeded up in the second half of 1974 was
another contributing
factor.
All of these forces had
eroded or were eliminated
by the spring of 1975.
Their erosion and elimination acted to halt the decline
in the nation’s output.
The recovery was then able
to start.
Beginning
in the spring of 1975, constant dollar
GNP grew strongly.
It was propelled upward by the
natural resiliency of the economy’s private sector, a
modest boost in the 12-month rate of money growth
from the low reached in the recession, and the input
in 1975 of strong incremental
fiscal stimulus.
Increased money growth was only one of several contributing factors. It was hardly crucial. However, it
was crucial that the sharp decline of Ml growth that
began in mid-1973 and speeded up in the second half
of 1974 be stopped, and that the 12-month rate of
Ml growth be maintained at or near a rate commensurate with the economy’s long run potential to increase constant
dollar GNP.
And this much was
done.
The Decline of Inflation There remains the question of the decline of the rate of inflation that occurred together with the rise of constant dollar GNP
and the corollary fall of unemployment
in 1975 and
1976. Many attribute it to the lagged effects of the
loosening of labor and other input markets and easing
of cost pressures
that accompanied
the 1973-1975
recession, including
the leveling-off
of imported oil
prices after the spring of 1974. However, the recession and leveling-off of imported oil prices were not
unrelated to the course of money growth.
The view
that we hold is that the sharp deceleration of the rate
of growth of the money supply that began in mid1973 and continued until early- 1975 was a common
cause of (1) the 1973-1975
recession,
(2) the
leveling-off of imported oil prices after the middle of
1974, and (3) the decline of the rate of inflation in
1975-1976. It played a crucial role in the slowing of
inflation.
This is not to say that inflation
is always and
everywhere
a purely monetary
phenomenon.
Certainly, in periods as short as a year it is not. Measured quarter to quarter, over four-quarter
periods,
or year on year, and even over longer periods, inflation can be triggered or worsened by any of a large
number of events.
An occasion of severe inflation
was initiated in the United States by the buying spree

that followed the invasion of South Korea in June
1950. A temporary inflationary
impact was given by
the OPEC oil price increases of late 1973 and early
1974 and again in 1979. Because of the influences of
such shocks, any particular
rate of growth of the
money supply is not related with mathematical
precision to the accompanying
or following rate of inflation. But it is a basic and demonstrable
reality that
in the post-Korean
War era in the United States the
rate of inflation measured over four-quarter
periods,
or year on year, and over longer periods, has been
profoundly
affected by the rate of growth of the
money supply.
However, it is past money growth, not the accompanying growth of the money supply, that matters
most. Changes in money growth can change the rate
of growth in expenditures
on assets and even GNP
goods and services relatively
rapidly.
Rates of rise
of some prices (financial and other asset prices, commodity

prices,

quickly,

but a number

adjustment

and

prices

of shelf

of factors

goods)

combine

adjust

to slow the

of the rate of rise of prices in general.

To begin with, there is no assurance that regulated
prices, including rents and utilities, will be allowed to
rise quickly and commensurately
in the wake of an
acceleration
of money growth and corollary rise in
the growth of spending on GNP goods and services.
Also, it is a sticky problem to raise prices that have
been advertised or “established”
such as tuition, hotel
room rates, brand-name
product prices, doctors’ fees,
and theater ticket prices. In the event of declines in
the growth rates of the money supply and spending
on GNP goods and services, it is equally sticky to
cancel or scale down planned price increases of advertised goods.
And it is highly unlikely that requests for increases of regulated prices will be withdrawn quickly in such case.
Further, price adjustments
to changes in economic
conditions
often are delayed by agreements
reached
in the past under different conditions.
Wage rates
are set ahead by collective bargaining
in important
economic sectors.
Forward
contract prices are the
norm in the provision
of such financial
services as
term loans and insurance,
and in the supply of diverse raw materials
and energy.
Price and wage
increases contracted for in the past ordinarily are put
into effect whether new conditions
warrant
scaling
them down, or up. Finally, the post-1932 tradition
of using monetary and fiscal stimulus to end recessions acts to deter adjusting
wage and price demands
downward
in renegotiating
contracts to conform to
current recession conditions.
This is because, in the
post-1932 tradition, ongoing declines in spending or

FEDERALRESERVEBANK OF RICHMOND

9

its growth are expected to be reversed reasonably
soon by new monetary and fiscal stimulus.
As a result of these diverse factors it takes time
for changes in money growth to change the rate of
rise of the general level of prices, i.e., the rate of
inflation.
However, by 1975 and 1976, enough time
had elapsed for the rate of inflation to substantially
adjust to the slowdown of money growth that began
in mid-1973 and continued to early 1975.
Late 1976 to October
1979: Money Growth
Accelerates
As was noted in discussing
events from
early 1975 to late 1976, during the year and a half
from March 1975 through the third quarter of 1976,
measured between the same quarters from one year
to the next, Ml growth ranged between 4.5 and 5.2
percent. Because Ml growth was kept at the bottom
of the Federal
Reserve’s planned
ranges for Ml
growth, and because the target ranges had been reduced, we had high hopes in 1976 that inflation would
be permanently
checked and that another recession
could be avoided.
Unfortunately,
Ml growth was
accelerated sharply beginning
in the fourth quarter
of 1976.
Quarter-to-quarter
Ml growth, which had been
kept between 2.9 and 5.8 percent per year and averaged 4.4 percent per year in the four quarters ending
with the third quarter of 1976, was suddenly
increased to 7 percent per year in the fourth quarter
of 1976. In 1977, it ranged between 6 and 8.8 percent
per year and averaged 7.5 percent per year.
The story is virtually the same for M1B. Quarterto-quarter
M1B growth ranged between 3.2 and 6.3
percent per year and averaged 4.8 percent per year
in the four quarters ending with the third quarter of
1976. It was increased to 7.6 percent per year in the
fourth quarter of 1976. In 1977, it was allowed to
range between 6.5 and 9.3 percent per year and averaged 7.9 percent per year.
MlB is one of the Federal Reserve’s two new measures of the supply of exchange media, replacing M 1.
The other is MlA.
The two series were first published in February
1980. They were constructed
to
start in 1959. They can be extended back in time by
assuming they are identical to the old Ml series in
years before 1959. MlA excludes the demand deposits of foreign banks and official institutions
in
U. S. banks, but otherwise is identical to old Ml.
MlB equals MlA plus commercial
bank ATS accounts and checking accounts in depository
institutions other than commercial banks.
(See Glossary.)
Reasonably
accurate
data have been available
on
ATS accounts and checkable accounts in depository
institutions
other than commercial
banks as they
10

grew.

Thus

it is legitimate

to use the MlB

series

for years before 1980, when the series was first published.
able

It also is logically
accounts

change

media.

correct

in all depository
Accordingly,

the U. S. money

supply

MlB

to count all checkinstitutions

as ex-

is used to measure

in this article from here on.

MlB growth remained high in 1978 and through
the summer or third quarter of 1979, just before the
October
6, 1979 change in the Federal
Reserve’s
focus which is discussed later.
Quarter-to-quarter
MlB growth ranged between 4.8 and 10.7 percent
per year and averaged 8.2 percent per year during
this period.
Charting
the Year-on-Year
Relation
of Inflation
to Money Growth
In the wake of the acceleration
of money growth, inflation, which had been checked
and reduced, increased again.
The GNP price deflator increased 6.2 percent in the four quarters ending with the fourth quarter of 1977, 8.2 percent in
the four quarters ending with the fourth quarter of
1978, 8.9 percent in the four quarters ending with
the fourth quarter of 1979, and 9.6 percent in the four
quarters
ending with the third quarter of 1980.
The 1977-1980 record confirms the evidence accumulated since the Korean War ended. Specifically,
by and large and on average, the four-quarter
rate of
inflation follows closely the rate of money growth two
years earlier. The relation of the four-quarter
rate of
inflation to the four-quarter
rate of MlB growth two
years earlier during the post-Korean
War period is
mapped in Chart 1.
The chart maps percentage
increases,
measured
between the same calendar quarters from one year to
the next, in the GNP deflator and MlB.
The solid
line maps the percentage
rise of the deflator;
the
dashed line maps MlB percentage growth.
To capture the lag between changes in money growth and
changes in the rate of inflation, the growth of MlB,
which is represented by the height of any point on the
dashed line, refers to the percentage
growth that
occurred in the four quarters ending two years earlier
than the date shown directly below that point on the
horizontal
axis.
For example, the height of the
dashed line directly above the first quarter of 1956
on the horizontal axis shows the percentage
growth
of MlB from the first quarter of 1953 to the first
quarter of 1954. Unlike this lagged mode of timing,
the rate of inflation,
which is represented
by the
height of any point on the solid line, refers to the
percentage
change in the GNP deflator in the four
quarters ending in the quarter indicated by the date
directly below this point on the horizontal
axis.

ECONOMIC REVIEW, JULY/AUGUST 1981

Chart 1
YEAR-TO-YEAR
MEASURED

BETWEEN

THE

SAME

PERCENT
QUARTERS

Inspection of the solid and dashed lines mapped in
Chart 1 shows that, measured
over four-quarter
periods, percentage
increases in the GNP price deflator from 1956 to the third quarter of 1980, closely
track percentage increases in MlB two years earlier.
However, this visual approximation
of the relationship of inflation to money’ growth in the U. S. since
1956 captures only part of the power of changes in
MlB growth to change the GNP rate of inflation.
Only the part that is centered on price behavior two
years after the change in MlB growth is captured.
The Long-Run
Adjustment
Changes in the dollar
value of the economy’s GNP always can be attributed
to changes in MlB or its velocity or turnover
in
relation to the dollar value of GNP. This proposition
has nothing to do with economics.
It is a matter of
arithmetic.
As a useful approximation,
the percentage change in the dollar value of GNP in any given
time period can be expressed as the sum of the same
period’s percentage changes in MlB and its velocity.

CHANGES
FROM

ONE YEAR

TO THE

NEXT

Mathematically,
1) the percent
+2)
the percent
=3)
the percent
GNP.l

change in MlB
change in MlB’s velocity
change in the dollar value of

Because percentage
changes. in velocity can vary
from period to period, percentage
changes in MlB
will not result in proportional
changes in the dollar
value of GNP in the same period, except by accident.
Thus, a crucial question
is: How do percentage
changes in MlB’s velocity vary?
Measured from one quarter to the next, percentage
changes in MlB’s velocity vary substantially.
However, as the unit of time used to group the data is
1 The exact relationship is:
(l+(the
percent change in M1B/100))
x(l+(the
percent in MlB’s
velocity/100))
-1
=the percent change in the dollar value of
GNP/100.

FEDERALRESERVEBANK OF RICHMOND

11

lengthened,
the variance falls. For example, in the
twelve years from 1956 to 1967, on average, velocity
increased 3.45 percent measured year on year.
In
the next 12 years, from 1968 to 1979, the year-onyear or yearly increase of velocity averaged
2.97
percent, a difference of less than ½ percentage point.
Table
I sets
changes of-

forth

yearly

average

Table I

3-YEAR

YEARLY

AVERAGE

IN VELOCITY,

PERCENTAGE

NOMINAL

NONOVERLAPPING

CHANGES

GNP AND MlB,
PERIODS

1956-1979
Yearly average percentage change in

percentage
Period

l

MlB’s velocity
of GNP,

in relation

the dollar value of GNP,

value

and

M1B

1956 to 1958

3.00

4.00

0.97

1959 to 1961

to the dollar

Nominal GNP

3.90

5.27

1.32

1962 to 1964

l

Velocity

3.48

6.71

3.13
4.25

M1B

for eight consecutive
nonoverlapping
3-year periods
in the post-Korean
War era, beginning
with 19561958 and ending with 1977-1979.
The data show
that in the post-Korean
War period, measured
as
yearly
averages
for 3-year
periods,
percentage
changes in velocity have been fairly stable. Over the
full twenty-four
years from 1956 to 1979, velocity
increased, on average, 3.2 percent per year.
In the
eight 3-year periods into which 1956-1979 divides,
the average yearly percentage
increase in velocity
never exceeded 4 percent or fell below 1.62 percent, a
range of only 2.4 percentage points.
Except for the
1968-1970 period, the average yearly 3-year increase
was well within 1 percentage point of the full 24-year
period average rise. In 1968-1970, it was 1.58 percentage points below the full-period
average rise.
In sharp contrast to the rate of rise in velocity, 3year percentage
changes in both MlB and dollar
spending on GNP varied considerably
in the 19561979 period. Measured as yearly averages for 3-year
periods, percentage changes in MlB ranged from a
low of 0.97 percent to a high of 7.81 percent, or
nearly 7 percentage points, and changes in the dollar
value of GNP ranged between 4 and 11.58 percent,
a range of more than 7½ percentage points.

3.41

7.81

1.62

7.27

5.55

1971 to 1973

l

1965 to 1967
1968 to 1970

2.74

9.98

7.04

1974 to 1976

4.00

9.23

5.02

1977 to 1979

3.56

11.58

7.81

the two are very closely related.
For the 3-year
periods into which 1956-1979 divides, changes in
MlB are matched by nearly proportional
concurrent
changes in- the dollar value of GNP.
As a convenience, the least squares regression
equation
of the
3-year average yearly percentage change in the dollar
value of GNP regressed on the 3-year average yearly
percentage change in MlB is drawn in the chart, and
its relevant statistics provided below.
Accelerations
in the growth of dollar spending on

Chart 2
ANNUAL PERCENTAGE CHANGE OF MlB
AND CURRENT DOLLAR GNP FOR
3-YEAR NONOVERLAPPING
PERIODS,
1956-79

Moreover,
grouped
in the 3-year periods
into
which 1956-1979 divides, there is no relationship
between the yearly rate of rise in velocity and either
the yearly rate of rise in MlB or the year-on-year
growth of the dollar value of GNP. However, 3-year
average yearly percentage changes in the dollar value
of GNP closely match 3-year averages of yearly percentage changes in MlB.
The relationship
between
the two is depicted in Chart 2.
For each 3-year period, the chart relates the average yearly percentage growth of MlB, which is measured on the horizontal axis, and the average yearly
percentage rise in the dollar value of GNP, which is
measured on the vertical axis. The chart shows that
12

ECONOMIC REVIEW, JULY/AUGUST 1981

GNP goods and services which accompany
accelerated money growth can result in faster inflation,
accelerated output growth, or some combination
of
A short-lived
increase in the growth of
the two.
output is likely in the short run. However, over the
long haul, accelerated money growth tends to be fully
dissipated in faster inflation.
This is the fundamental
lesson of the data.
There is nothing mysterious
about this conclusion.
Money facilitates production
only when it is introduced into a market.
Unlike in the cases of labor
and material input, increases in the input of money
(in full-fledged
money economies such as ours) do
not increase the potential to produce.
In the long
run, measured
real GNP growth is neutral
with
respect to money growth.2 This does not mean living
standards are unaffected ; via inflation, rapid money
growth generates deadweight losses in real GNP.
Because the limits on production cannot be changed
by changing money growth, the acceleration of spending that results from accelerating
money growth ultimately is registered in faster inflation.
It is only a
question of how long it takes.
The longer
term relationships
between
money
growth
rates and rates of constant
dollar GNP
growth and inflation are pictured in Chart 3. The
top panel of Chart 3 relates MlB growth to the
growth of constant
dollar GNP;
the lower panel
relates MlB growth to the rate of rise in the GNP
deflator.
The data are again grouped in the eight
consecutive, nonoverlapping
3-year periods that comprise the 1956-1979 period.
For each 3-year period, the top panel relates the
average yearly percentage growth of MlB, which is
measured
on the horizontal
axis, to the average
yearly percentage
increase in constant dollar GNP,
which is measured on the vertical axis.
The lower
panel relates average yearly MlB percentage growth,
again measured on the horizontal
axis, to the average yearly percentage
increase
in the GNP price
deflator, which is measured on the vertical axis. The
chart shows that the long-run
growth of constant
dollar GNP or output is essentially
independent
of
the rate of rise in MlB, while the rate of inflation is
closely related to MlB growth.
Again for convenience, regression
equations fitting rates of rise of
constant dollar GNP and the GNP deflator, respectively, to MlB growth are drawn in the appropriate
2 This statement is valid assuming full employment
only
at the start of the run. It need not be assumed at points
in the run.
What happens is that shortfalls
in output
growth during recessions
are matched by output growth
above
full employment
potential
growth
in recovery
periods.

Chart 3
ANNUAL
AND

PERCENTAGE
CONSTANT

3-YEAR

CHANGE

DOLLAR

NONOVERLAPPING

OF Ml B

GNP FOR
PERIODS,

1956-79

ANNUAL
AND
3-YEAR

PERCENTAGE
THE

CHANGE

GNP DEFLATOR

NONOVERLAPPING

OF MlB
FOR

PERIODS.

1956-79

panels of Chart 3, and their relevant statistics provided alongside.
Finally, because, as was earlier discussed, the rate
of inflation changes in response to changes in money
growth only with a lag, which in the post-Korean
War period has averaged two years, we also have
mapped, in Chart 4, the 1956-1979 3-year relation-

FEDERAL RESERVEBANK OF RICHMOND

13

ships of average yearly constant dollar GNP growth
and the average yearly rate of rise in the GNP deflator, respectively,
against earlier average year-onThis evidence confirms that in
year MlB growth.
the longer run, constant dollar GNP growth is unaffected by MlB growth.
It also confirms that the
rate of inflation
is powerfully
influenced
by Ml B
growth, and that, on average, changes in the rate of
GNP inflation have lagged changes in MlB growth
by about two years in the post-Korean
War period.
In view of the evidence described and discussed
above, it was a dreadful mistake to accelerate money
growth beginning
in October 1976.
The question
that is examined
next is why the Federal Reserve
did this.
Late 1976 to Late 1979:
What Went Wrong
The acceleration
of MlB
growth
that began in
October 1976 and led inexorably
to the acceleration
of inflation,
and’ in turn to the recession that now
afflicts the economy, does not appear to have resulted
from a deliberate
decision
to accelerate
money
growth.
The Federal Reserve’s targets for money
growth were not raised when the acceleration began.
They were not raised later. What happened was not
planned or even projected.
However, given the Federal Reserve’s policy, it was a predictable event. The
acceleration
of MlB growth that began in October
1976 was the predictable
corollary
of the Federal
Reserve’s deemphasizing
money supply control and
placing more emphasis on resisting changes in interest rates beginning
around April 1976.
Federal Reserve monetary policy is reviewed and
determined
roughly once a month by the System’s
Open Market Committee.
The Committee
is comprised of the seven members of the Board of Governors of the Federal Reserve System and five of the
twelve Reserve Bank presidents who, apart from the
president of the New York Reserve Bank, who serves
as a permanent
Open Market Committee
member,
serve in rotation.
At its monthly or near-monthly
meetings,
the Committee
sets inter-meeting
or immediate targets for both money growth and the Federal funds rate (see Glossary).
These targets are
used to guide and constrain
the manager
of the
System’s open market accounts in the New York
Reserve Bank until the next Open Market Committee meeting.
From March 1975 through March
1976, the manager usually (12 out of 13 times) was
directed to keep per year money growth within a
band 2½ to 4 percentage points wide and the Federal
funds rate within a band 1 to 1¼ percentage points
wide.
However,
beginning
in April
1976, the Open
14

Chart 4
ANNUAL PERCENTAGE CHANGE OF Ml B LAGGED
2 YEARS AND CONSTANT DOLLAR GNP
FOR 3-YEAR NONOVERLAPPING
PERIODS,
1956-79

ANNUAL PERCENTAGE CHANGE OF MlB
LAGGED 2 YEARS AND THE GNP DEFLATOR
FOR 3-YEAR NONOVERLAPPING
PERIODS,

Market Committee narrowed
the band in which the
manager was instructed
to keep the Federal funds
rate and widened the inter-meeting
target range for
money growth.
Thereby, the Committee
deemphasized control of the money supply as an operating
goal and increased the importance
of resisting interMoney growth subsequently
est rate movements.

ECONOMIC REVIEW, JULY/AUGUST 1981

emerged primarily as the incidental
Committee’s Federal funds interest
pertinent policy record is presented

upper limit to 11½ percent.

corollary of the
rate goals.
The
in Table II.

Market

still another

The results of this mode of operating proved to be
Strong
credit demands
put upward
unwelcome.
pressure on the Federal funds rate almost continuously from April 1976 until early 1980. These pressures should have been allowed to dissipate by keeping money growth and hence spending on GNP goods
and services from rising.
Instead, they were fueled.
Given its policy of resisting short-term
changes in
interest rates, the Federal Reserve was obliged to
supply banks with increasing input of reserves.
This
input provided the base for accelerated money growth
and ultimately resulted in faster inflation and weakness of the dollar on foreign exchange markets. With
faster inflation, credit demands and interest rates rose
higher and higher.
The Federal funds rate climbed
from a daily average of 4.82 percent in April 1976
to a daily average of 10.29 percent in June 1979.
In the summer
became

of 1979, the rise of interest

intolerably

difficult

to contain

Committee

conditions

boost in the targeted

11¾ percent.
even inside

At the September

meeting,

range

By the end of September
the Federal

Reserve,

IN PERCENTAGE
RANGES

rates

even between

POINTS
FOR Ml
APRIL

OF INTER-OPEN
GROWTH

MARKET

AND THE

1976 TO SEPTEMBER

COMMITTEE

FEDERAL

FUNDS

MEETING
RATE

1979
Ml growth target range

Funds rate range

1977

1978

1979

1976

1977

1978

1979

1976

. ...
...

0.75
.75

0.50
.50

(1)

...
0.75
.75

1.00
.75
.50

.50
.75
.50

0.75
.75
.75

4
4
4
4
4

5.0
5.0

March
April
May

.. ..
.. . .
...
4.0
3.5

4.0
4.5
5.0

(1)
4
4
5
5

June
July
August
September

.50
1.00
.50
.75

.50
.50
.50
.50

.50
.25
.50
.50

(1)
.75
.50
.50

4.0
4.0
4.0
4.0

4
4
5
5

5.0
4.0
4.0
4.0

(1)
4
4
5

October
November
December

.75
.75
.75

.50
.50
.50

.50
.25
.75

. ...
____
. . ..

4.0
4.0
4.0

5
6
6

6.5
5.0
4.0

...
...
...

January
February

rates

open mar-

From October
6, 1979 Until November
1980 On
October 6, 1979, the Open Market Committee announced an historic change in the object and method
First, control of the
of open market operations.
growth of the monetary
aggregates
was made the
primary object.
Second, to achieve better control of
the growth of the monetary
aggregates,
the Committee shifted the method of open market operations
“to an approach placing emphasis on supplying the
volume of bank reserves estimated to be consistent
with the desired rates of growth in monetary aggregates, while permitting
much greater fluctuations
in
the Federal funds rate than heretofore.”
Immediately, the Committee
instructed
the Manager of the
System’s open market account “to restrain expansion
of bank reserves to a pace consistent
with growth
from September
to December at an annual rate on
the order of 4½ percent in Ml . . . . provided that in
the period before the next regular meeting the Federal funds rate remained generally within a range of
11½ to 15½ percent.”

Table II

TARGET

to

ket operations on keeping them from rising, and subordinating
control of money growth to that end. A
new approach was needed.

Open Market Committee meetings.
At its July 1979
meeting, the Open Market Committee set the intermeeting Federal funds rate target at 9¾ to 10½
percent.
However, it proved necessary to raise the
upper limit to 10¾ percent before the August meeting. At its August meeting, market conditions compelled the Committee to set the inter-meeting
Federal
funds rate at 10¾ to
11¼ percent, but before the
September meeting it became necessary to raise the

SPREAD

to 11¼

it was clear,

that interest

had not been kept from rising by focusing

Open

compelled

(2)

1 No meeting.
2 No range was specified. The Committee directed that the Federal funds rate be maintained
“at about the current level (10 percent).”

FEDERALRESERVEBANK OF RICHMOND

The Summary
Records of the Committee’s meetings since October 6, 1979 display policy statements
indicating
a continuing
commitment
to achieving
close control of the growth of the monetary
aggregates and considerable willingness to allow wide fluctuations in the Federal funds rate.
The immediate
or inter-meeting
target range for the Federal funds
rate has been at least 4 percentage points wide and as
much as 8½ percentage
points wide in the period
since October 1979. In the case of money growth,
the immediate target, which was expressed in terms
of per annum growth of Ml until January
1980 and
MlB from then on, was specifiedl

in October 1979 as “on the order of 4½ percent” for the September-December
1979 period,

l

in November 1979 as “about 5 percent”
November-December
1979 period,

l

in January 1980 (there was no December
meeting)
as “between 4 and 5 percent”
the first quarter of 1980,

l

in February
1980 as “(about 5 percent”
first quarter,

l

in March
somewhat

l

in May 1980 as “7½
next meeting,

l

in July 1980 (there was no June meeting)
as
“8 percent” until the next meeting, except that
“in view of the shortfall in monetary
growth
over the first half of the year, moderately faster
growth would be accepted if it developed
in
response to a strengthening
in the public’s demand for money balances (i.e., falling velocity
rates). . . .”, and

l

in August
meeting.

for the

1979
over

over the

and April 1980 as “5 percent . . . or
less” over the first half of 1980,
to 8 percent”

1980 as “9 percent”

until

until

the

the next

Unfortunately,
despite the Federal Reserve’s new
willingness
to let the Federal funds rate fluctuate
over a wide range, money growth has not been stabilized as intended since October 6, 1979. The pertinent record is set forth in Table III.
It shows wide
fluctuations
both in the Federal funds rate and MlB
growth from October 1979 until November
1980.
From October
1979 to October
1980, per year
M1B growth(1) was allowed to fall below the Federal Reserve’s target growth range in November
1979,
(2) was propelled
in February
1980,
16

close to the top of the range

(3) was allowed to fall sharply
April-May
1980 period, and then

below it in the

(4) was propelled near the top again in August
1980 and over it in October 1980.
The miss in the April-May
1980 period was especially large and undoubtedly
exacerbated
the recession that began in January 1980. The extraordinary
reacceleration
of money growth since May 1980, portends higher inflation and another recession ahead.
In light of the record, it is difficult to know
whether to be pessimistic or optimistic about the Federal Reserve’s actually achieving
control of MlB
growth in the months and years ahead. Our inclination at this time is to wait and see.
A Reason for Optimism Monetary policy should
aim in the years ahead at reducing MlB growth from
the nearly 8 percent rate of this (1980) and recent
years to 2½ to 3½ percent per year, which we estimate would be consistent with inflation of 1 to 3 percent per year.
This can be done (1) if, upon observing MlB to be growing faster or slower than
targeted for the current year, corrective
action is
taken and this year’s target is hit, and (2) if the
target is steadily reduced from year to year until the
desired 2½ to 3½ percent range is reached.
The
corrective action required to get MlB growth back
on course when it is off is not difficult to implement
and carry out. All that is required is to scale open
market purchases up when MlB has been growing

Table III

MONTHLY

AVERAGES

RATE AND PERCENT
OCTOBER
Date
October 1979
November 1979
December 1979
January 1980
February 1980
March 1980
April 1980
May 1980
June 1980
July 1980
August 1980
September 1980
October 1980
November 1980

OF THE

PER YEAR

FEDERAL
GROWTH

1979 TO NOVEMBER
FFR
13.77
13.18
13.78
13.82
14.13
17.19
17.61
10.98
9.47
9.03
9.61
10.87
12.81
15.59

FUNDS
OF MlB

1980
MlB Growth
2.20
4.07
6.87
5.28
9.89
-.31
- 14.11
-1.24
14.60
11.05
21.60
15.84
11.21
... .

Note: FFR is the interest rate on Federal funds, monthly
average. MlB growth is the percent per year rate of
rise in MlB.

ECONOMIC REVIEW, JULY/AUGUST 1981

too slowly, and down when it has been growing too
fast, and to persist until it is brought back on track;
if one scalar doesn’t work another will.
The saw-tooth pattern of MlB growth from October 1979 to October 1980 described above provides
some reason for believing that the Federal Reserve
now takes its announced target for MIB growth seriously; that deviations
engender responses designed
to hit it. In December 1979, the Federal Reserve
acted promptly to accelerate MlB growth because it
had been growing
too slowly in the OctoberNovember 1979 period. In March 1980, actions were
taken to slow money growth because it had grown
too rapidly in the December
1979-February
1980
period.
As a result of these actions, MlB growth
was stopped completely in March 1980; it actually
fell $100 million.
The following month, April 1980,
it fell $4.6 billion.
Measured from September 1979,
MlB growth moved below the target range, in April
1980. It dropped even further below in May 1980.
Once again, the Federal Reserve moved to change
course.
By June 1980, MlB was again growing
rapidly and it continued to grow at very rapid rates
in the July-November
1980 period.
Now there are
signs that the Federal Reserve is again moving to
reduce MlB growth.
In summary, since October 1979, MlB growth has
not been allowed to careen up and down for very
long, as was the case in past years, and most recently
from October 1976. to September
1979. This provides a reason for optimism.
Reasons for Pessimism
We would be more optimistic about the future if the Federal Reserve completely stopped trying to minimize short-run
fluctuations in the Federal funds rate, and revised its regulations with respect to the assessment
of reserve
requirements.
Currently
the assessment
is delayed
two weeks so that required
reserves are matched
against deposit liabilities of two weeks ago.
The events of 1980 show the damage that can be
done, at least in the short run, by the combination
of
lagged reserve accounting
and the setting of shortrun ceilings and floors, no matter how far apart, for
the Federal funds rate.
Beginning
in late March the public suddenly and
substantially
increased its demand for coin and currency vis-a-vis demand (checking)
accounts.
This
was not an accident.
Switching from checking accounts to currency was impelled by the higher costs
of using credit cards that were imposed by new regulations that were issued by the Federal Reserve pursuant to the President’s
invoking of the Credit Control Act of 1969 on March 14, 1980. Currency and

credit cards are easily and commonly
used in disCheckcharging on-the-spot
payments
obligations.
ing deposits are not so easily or commonly used for
this purpose. As a result, deposits were drawn down,
and banks were subjected to a loss of reserves which
forced a sharp contraction
of the money stock-i.e.,
negative money growth for a time. MlB fell $6.6
billion from the four weeks ending March 12, 1980
to the four weeks ending May 14, 1980, or at an
annual rate of nearly 10 percent.3
No harm would have resulted, indeed the money
supply would have continued to grow, if the Federal
Reserve had made open market purchases in sufficient volume to replace the reserves that banks lost
at this time because of the currency drain that resulted from the higher costs of using credit cards.
But until late May the Federal Reserve failed to replace the reserves that were drained as a result of the
It did not supply
imposition
of credit controls.
replacement reserves because it was afraid that doing
so would cause the Federal funds rate to fall precip-

a To capture the impact of the imposition
of credit controls on the public’s demand for coin and currency, the
4-week moving average series of the public’s holdings of
coin and currency measured as a percent of its checking
deposits (including NOW accounts et al.) was regressed
on an internally generated time scale for the period from
the twenty-seventh
week of 1979 to the eleventh week of
1980, just before the imposition
of credit controls,
and
the values of the regression
equation’s
predictions
were
compared to actual 4-week moving average values of coin
and currency expressed as a percent of checking deposits.
The regression equation isCoin and currency as a percent
=37.347+.0280
time scale
(.037)(.0017)

of checking

deposits

The standard error of the regression
equation is .110
percent. data are seasonally adjusted.
Between
the twenty-seventh
week of 1979 and the
eleventh week of 1980, just before credit controls were
imposed, the value of the regression equation’s prediction
of coin and currency measured as a percent of checking
deposits averaged .02 percent less than the actual value.
The two were never more than .23 percent apart. In the
eleventh week of 1980, the predicted value was .08 percent
below the actual value. In the fifteenth week, four weeks
after credit controls
were imposed,
the predicted
value
was .19 percent higher than the actual value.
In subsequent weeks the gap widened to .30 percent, .46 percent,
.86 percent, 1.06 percent, 1.18 percent, and 1.22 percent.
This latter is more than eleven times larger than the
regression’s
standard error.
The gap then drifted down
to .85 percent, still nearly eight times larger than the
standard error, in the twenty-seventh
week of 1980-i.e.,
about the same time that credit controls were relaxed and
eliminated.
By the thirty-seventh
week of 1980, the predicted value was only .02 percent higher than the actual
value and since then it has fallen below the actual value.
In the forty-fifth
week it was .37 percent less than the
actual value.
The results strongly
support the contention
that the
imposition
of credit controls
caused the public to suddenly and substantially
increase its demand for coin and
currency relative to its demand for check money, thereby
paving the way for the sharp contraction
in the money
supply which occurred last spring (1980).

FEDERALRESERVEBANK OF RICHMOND

17

itously. As put by Federal Reserve Board Governor,
Emmet J. Rice, in a New York City speech on
May 7, 1980With
the aggregates
registering
growth
substantially
below their target ranges, we could, of
course, increase
reserves
by an amount sufficient
to bring them within the announced target ranges.
However,
the increment
in reserves
necessary to
achieve this could imply a federal funds rate that
is far lower than seems prudent
under present
conditions.
Such a provision
of reserves would run the risk
of creating
too much liquidity too soon.
Moreover,
it might
be interpreted
by market
analysts
as
indicating
an abrupt shift by the Federal Reserve
towards
monetary
ease, possibly
thereby
encour-

aging inflationary

expectations.

Given its lagged reserve accounting
system, the
Federal Reserve’s fear was not unfounded.
In a twoweek lagged reserve accounting
regime, if deposits
fell two weeks ago, required reserves necessarily must
fall this week. In turn, this means that if total reserves are increased
this week or even kept unchanged from the total of two weeks ago, excess
reserves will rise and cause a sharp drop in the Federal funds rate.
The banking system cannot easily
eliminate
excess reserves, but most banks with excess
reserves will try to do so. Banks with excess reserves
sell them in the Federal funds market, and the Federal funds rate tends to fall with these sales.
Because
under

the

the Federal
Federal

funds

Reserve
rate,

chose to put a floor
reserves

were

allowed

to fall and M1B growth became negative (-10
percent per year) in the mid-March to May 1980 period.
This greatly aggravated the recession then underway.
It need not have happened.
It wouldn’t have happened if the Federal
Reserve had not put a floor
under the Federal funds rate at the time and focused
on controlling
MlB growth.
The Federal Reserve also continues to set ceilings
on the Federal funds rate and keeps the discount rate
below market interest rates when market rates are
rising.
In combination
with lagged reserve accounting, the ceilings
often produce
explosive
money
growth.
This is because, in periods when the economy and deposits are growing, the Federal Reserve,
to avoid reserve deficiencies and increases in interest
rates, provides new reserves regardless of the implications for money growth. The June-November
1980
period shows that explosive money growth can result
if this is done, despite the best intentions.
As stated
by Federal Reserve Board Governor, Lyle E. Gramley, in a Denver, Colorado speech on July 17, 1980. . . during the earlier phase of economic recoveries,
growth in supplies
of money and credit has often
begun to accelerate
because the Federal
Reserve
18

did not let credit markets tighten sufficiently
while
unemployment
and excess capacity
were still relatively high.
That is the mistake we must be particularly
careful to avoid when the current
recession bottoms out and recovery
begins again.

The record shows that the same mistake was made
again this year.
In the six months ending in November 1980, MlB grew at an annual rate of 15 percent, the highest in any six-month period since World
War II. And the events of the past 25 years warn,
in turn, that explosive money growth results in time
in the acceleration
of inflation, elevation of the Federal funds rate ceiling, and recession.
Conclusion
Clearly, it would help in the management of M 1B growth if the Federal Reserve did not
subordinate
achievement
of planned MlB growth to
minimizing
fluctuations
in the Federal funds rate (or
in the value of the dollar on foreign exchange markets) even for a week or a day.
Widening
of the
Federal funds rate control band, as was done beginning in October 1979, is not enough.
When the Federal funds rate is bumping
the top of the control
band, it doesn’t matter whether the interval from the
top of the band to the bottom is one percentage point
or eight. What matters is that the Federal funds rate
is not allowed to rise any further,
or alternatively,
pressure
on the Federal funds rate is relieved by
keeping the discount rate constant and the discount
window open wide. As a result, the input of reserves,
whether through open market purchases or discounting, must be accelerated.
In turn, this accelerates
money growth.
The end results are faster inflation
and, ironically, even higher interest rates than would
occur if there were no Federal funds rate control
band whatever.
In the same way, when the Federal funds rate is
pressing
the floor of the control band, it doesn’t
matter how high the top of the control band is. Preventing the floor from being broken requires slowing
MlB growth, and the end result is recession and
lower interest rates than would occur in the absence
of any Federal funds rate constraint.
It also would help in the management
of MlB
growth if required
reserves were matched against
current deposit liabilities.
In this case the Federal
Reserve could supply or withdraw reserves consistent
with achieving its money growth plans without having to worry about creating
excess reserves or a
reserve deficiency,
and thereby providing
pressure
for sharp changes in the Federal funds rate.
The
Report from which this article is extracted
emphasizes the importance
of achieving
close continuing
control of MlB growth.

ECONOMIC REVIEW, JULY/AUGUST 1981

GLOSSARY

Money - Money
Measures of

is defined
the supply of

conventionally,
exchange

as the dollar quantity

of exchange

media.

media:

MI - Ml
was used to measure the supply of exchange media until 1980. It was comprised of (1)
checkable (demand)
deposit liabilities of commercial banks other than domestic interbank
and
U. S. Government
less cash items in the process of collection and Federal Reserve float; (2)
foreign demand deposits in Federal Reserve Banks ; and (3) coin and currency outside the
Treasury,
Federal Reserve Banks, and vaults of commercial banks.
In essence, Ml measured
holdings by the public (other than commercial banks), and by state and local governments,
and
foreign banks and official institutions
of demand deposits in commercial
banks, coin and currency, and foreign demand deposits in Federal Reserve Banks.
MIA - MlA
is one of the two measures which the Federal Reserve adopted in 1980 to replace Ml
in measuring the supply of exchange media. MlA equals Ml less the demand deposits of foreign banks and official institutions.
Through
1979, year-to-year
percentage changes of Ml A
tracked those of Ml except in 1959 when, following the restoration
of convertibility
of pounds
and francs into dollars, there was a large input of demand deposits by foreign banks.
MlB equals MlA plus autoM1B - MlB
is the other measure adopted in 1980 to replace Ml.
mated transfer service and negotiable order of withdrawal
accounts and other checkable deposits in depository institutions,
including commercial banks, credit unions, savings and loans,
and mutual savings banks.
Federal funds rate-The
Federal funds rate is the interest rate charged on inter-bank loans. Banks
Usually the loans are
short of reserves can and do borrow from banks with excess reserves.
repaid the next business day. Because the funds involved are deposits in Federal
Reserve
Banks, they are called Federal funds, and the interest rate on transactions
of Federal funds is
called the Federal funds rate.
Monetary or current dollar GNP - The

nomic cost of producing the nation’s
cifically, it equals the year’s sum of
l

wages,

l

corporate

salaries
profits

current dollar value of Gross National
output in a given year plus certain

Product is the ecoadjustments.
Spe-

and supplements,
(before

l

rental

l

net interest,

l

proprietary

l

plus business transfers,
government
enterprises,

taxes),

income,
and
income;

Constant dollar or real GNP-Real

indirect business
and depreciation
GNP

taxes, subsidies
allowances.

is the inflation-adjusted

less

or deflated

surpluses

accruing

value of current

to

dollar

GNP.
GNP

deflator-This
is the price measure used in this article.
The GNP deflator is the index of
It is used
the prices of all the goods and services that make up the Gross National
Product.
instead of the Consumers’ Price Index because it measures the inflation rate for domestically
produced goods and services.
The prices of imports, including oil, affect it only indirectly and
Using the GNP deflator allows us to focus on inflation born and bred here at
marginally.
home.
In addition, consistency with using constant dollar GNP to measure the nation’s production or output requires its use.

Velocity - Velocity
is simply the dollar value of GNP divided by stock of money however defined.
Every monetary aggregate has its own velocity. MlB’s velocity equals the average dollar value
of GNP in a given period divided by the average amount of MlB outstanding
in the same
period.

FEDERALRESERVEBANK OF RICHMOND

19