Full text of Economic Quarterly (Federal Reserve Bank of Richmond) : March-April 1986, Vol. 72

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AN ANALYSIS OF
FEDERAL RESERVE PRICING
Anatoli Kupriunov*
I. INTRODUCTION
In 1981 the Federal Reserve System adopted a
new pricing policy for certain correspondent banking
and other services, such as check clearing and settlement, supplied by Reserve Banks. The new policy
was mandated by the Monetary Control Act of 1980,
which gave all depository institutions equal access to
Federal Reserve clearing services and required that
prices charged for those services be set so as to
reflect all costs of production, including an allowance
for taxes, a return to capital, and all other expenses a
private sector firm would bear.
Federal Reserve Banks have supplied correspondent banking services to the banking industry
throughout most of their history. Before 1980 only
member banks had direct access to all Federal Reserve clearing services. They received these services
free of charge as partial compensation for the cost of
the non-interest-bearing reserves they were required
to hold. Private correspondent banks and clearinghouses supplied clearing services to nonmember banks
and other depository institutions such as thrifts and
credit unions.
When Congress granted equal access to Federal
Reserve services it recognized that this action would
put the Fed in more direct competition with private
correspondent banks. The pricing requirements included in the act were intended to enable private
firms to compete with the Fed. Pricing was also
seen as a way of encouraging more rational resource
utilization, since there was little incentive to conserve
on the use of Fed services when no explicit prices
were charged.1
* This article grew out of a research project originally
undertaken with Ward McCarthy, formerly an economist
with the Federal Reserve Bank of Richmond, but currently associated with Merril Lynch Economics. In
addition to Mr. McCarthy, the author wishes to acknowledge helpful comments by Marvin Goodfriend, David
Humphrey, Tom Humphrey, David Mengle, Bruce Summers, and John Walter. Any remaining errors or omissions are the sole responsibility of the author.
1

Another reason Congress required the Fed to price
certain of its services was to offset the cost to the U. S,
Treasury of the lower reserve requirements brought

This article describes and evaluates the pricing
methods adopted by the Federal Reserve. Issues
related to Fed pricing can be divided into two categories. The first pertains to the determination of
imputed private sector costs; the second to the allocation of those costs to individual service prices.
Sections II and III describe and analyze the methods
used in cost determination, while Sections IV and V
do the same for cost allocation. Conclusions are
stated in Section VI.
II. IMPUTING THE COST OF CAPITAL
TO THE FEDERAL RESERVE
The cost of capital is by far the most important of
the costs the Federal Reserve must impute to its
priced services, Accordingly, most of the analysis of
cost determination focuses on capital financing costs.
A detailed description of the methods used to determine imputed costs follows a review of some relevant
aspects of the theory of capital finance.
Factors Determining the Cost of Capital
Capital goods, by definition, yield a stream of
productive services over an extended length of time.
The cost of capital refers to the price of capital services. As the name suggests, the cost of capital
measures opportunity cost. It is the expected rate
of return on alternative investment opportunities
that bear the same amount of risk.
Investors in financial markets determine the cost
of capital. Firms finance capital investment through
the sale of financial assets such as equity shares, or
stocks, and bonds. Market prices of those financial

about by the Monetary Control Act. Revenue considerations were not responsible for the legislative provisions
requiring the Fed to recover imputed private sector costs,
however. Instead, those provisions were intended to
foster competition and promote efficient resource allocation, as noted in the text. A detailed account of the
legislative debate over Federal Reserve pricing can be
found in Anatoli Kuprianov, “The Monetary Control Act
and the Role of the Federal Reserve in the Interbank
Clearing Market,” Federal Reserve Bank of Richmond,
Economic Review 71 (July/August 1985): 23-35.

FEDERAL RESERVE BANK OF RICHMOND

3

assets reflect the return on capital the firm is expected to earn. All other things equal, the lower the
expected return the lower will be the market value
of a firm’s outstanding financial assets. Because
investors typically demand a premium in exchange
for greater risk, the cost of capital is higher for firms
that undertake riskier investments.
A firm’s cost of capital can be expressed as the
total expected return to investors divided by the
market value of outstanding financial assets. That
ratio, in turn, can be expressed as a weighted average
of the expected rate of return to equity and the
interest rates paid on outstanding debt.
In a market economy prices allocate resources.
The cost of capital, as determined in financial markets, determines how capital is allocated. A firm
will invest in capital if the expected rate of return on
investment is at least equal to the cost of capital at
the margin ; otherwise, the market value of its outstanding equity will fall until the expected rate of
return to shareholders once again equals the expected
return on other investments bearing equivalent risks.
Assuming firms attempt to maximize their market
value, capital will be allocated to investments with
the highest expected return for a given amount of
risk. A firm that is unable to earn a rate of return
at least equal to its cost of capital over the long run
will experience difficulty in attracting capital from
investors.
The Cost of Capital to the Federal Reserve
Federal Reserve Banks, because of their unique
status as quasi-governmental agencies, are not subject
to the same market forces confronting private firms.
Although they are legally privately owned institutions, their stock is issued only to member banks and
cannot be bought or sold in financial markets. Moreover, dividends paid on that stock are fixed by law
at a six percent annual rate, with all remaining revenues net of expenses turned over to the U. S. Treasury. Thus, unlike a purely private firm, the cost of
capital to the Fed is not determined in financial
markets. Nevertheless, capital acquired by the Fed
does have an opportunity cost. For capital used in
the production of priced clearing services, that opportunity cost is reflected in the cost of capital faced by
its competitors in the private sector.
Capital Structure Assumptions
Total imputed financing costs for Federal Reserve
priced service operations are determined by the asset
base (the value of capital assets devoted to priced
4

services), the assumed capital structure (the proportions of equity and debt used to finance the asset
base), and the imputed rate of return to equity and
interest rates on debt. Table I summarizes the
capital structure assumptions applied to the priced
services asset base.
Overall capital structure is
determined by matching different types of assets with
separate funding sources. This matched-book capital
structure, as it is termed, treats long-term assets as
being financed by a mix of equity and long-term debt,
while short-term assets are assumed to be financed
by short-term debt.
Assets classified as long-term are physical assets,
such as buildings and equipment. Short-term assets
consist of working capital; that is, funds needed to
conduct a firm’s day-to-day transactions. Prepaid
expenses, materials and supplies, and receivable accounts reflect such funding needs.
Imputed financing costs for the assets listed in
Table I are recovered using two different methods.
The Fed distinguishes between assets directly related
to the production of priced clearing services and
other assets used to facilitate the clearing and settlement of payments transactions. Financing costs for
long-term assets and working capital are determined
using a financial model of large bank holding companies and recovered through a mark-up added to
service prices. Self-financing assets earn separate
and identifiable income streams apart from the fee income earned from the sale of priced clearing services.
Two types of self-financing assets are listed in
Table I. The first is Federal Reserve float. The
cost of float is largely recovered through separate
charges against institutions that receive credit for
checks and other items before the Fed receives the
funds for those items. Clearing balances are deposits
held with Reserve Banks (in addition to required
reserves) to facilitate the transfer of funds associated
with the transactions they process.2 Funds obtained
from clearing balance deposits are assumed to be
invested in short-term government securities. This

2

Although the Monetary Control Act imposes uniform
reserve requirements on all depository institutions, some
institutions may not hold sufficient reserves directly with
Reserve Banks to facilitate clearing and settlement. Situations such as this can arise because reserve requirements
can be satisfied by vault cash holdings or by reserve
accounts, known as pass-through reserve accounts, administered by private correspondent banks for their
respondents. Institutions are required to hold separate
clearing balance deposits as a condition for receiving Fed
services in these cases to prevent the occurrence of overnight overdrafts. Banks that otherwise hold sufficient
reserves for clearing purposes can also hold clearing
balances in addition to required reserves.

ECONOMIC REVIEW, MARCH/APRIL 1986

Table I

THE MATCHED CAPITAL STRUCTURE ASSUMPTION
FINANCED

ASSETS:

BY:

Long-Term
Equity and long-term debt1

Premises
Furniture and equipment
Leases and leasehold improvements
Short-term
Working Capital:

Short-term debt1

Receivables
Materials and supplies
Prepaid expenses
Self-Financing Assets:
Net items in the process of collection (float)

Balances arising from early credit of uncollected items 2

Imputed reserve requirements

Clearing balances 3

Investment in marketable securities
1 Imputed financing costs determined using the bank holding company model.
2 Imputed cost is the federal funds rate.
3 Cost of funds determined by the earnings credit rate paid on clearing balances deposited with Federal Reserve Banks.
Source:
B o a r d o f G o v e r n o r s o f t h e F e d e r a l R e s e r v e S y s t e m , “Financial Results of Federal Reserve Priced Services Operations,”
(November 20, 1985).

assumption is reflected in the two asset accounts
corresponding to clearing balance liabilities in Table
I. The Federal Reserve pays implicit interest on
designated clearing balances in the form of earnings
credits that can be used to pay for its priced services.
Imputed earnings on the funds placed in the corresponding asset accounts offset the cost of these earnings credits to the Federal Reserve. The treatment
of self-financing assets is described in greater detail
at the end of this section.
The Bank Holding Company Model
A financial model of large bank holding companies
is used to impute a cost of capital to the Federal Reserve. The bank holding company model adopted by
the Fed uses financial data on the twenty-five largest
bank holding companies in the United States to estimate the average pre-tax rate of return on capital
for the sample.3 That estimated rate of return is
3

Because of unique circumstances, one of the twentyfive largest bank holding companies was removed from
the sample used to calculate the targeted rate of return
for 1986, and another holding company was substituted
in it place. 50 Federal Register 47,624 (November 19,1985).

then used to determine a targeted rate of return on
long-term assets and working capital. As noted
above, imputed financing costs for these two categories of assets are recovered through a mark-up
added to service prices.
The resulting targeted rate of return is a pre-tax
rate. It reflects both the imputed after-tax rate of
return and corporate income taxes that would be
levied against the pre-tax return. The pre-tax rate
of return to capital can be expressed as a weighted
average of the pre-tax rate of return to equity and
the interest rates paid on outstanding debt. Formally
stated, that expression is

where the variable r represents the aggregate pre-tax
rate of return to capital, r1 the after-tax rate of return
to equity, t the average corporate tax rate, r 2 t h e
average interest rate paid on long-term debt, r3 the
average short-term interest rate, and a1, a2, and a3 the
proportions of equity, long-term debt, and short-term
debt used to finance capital investment.
Accounting data taken from the financial statements of the bank holding company sample are used

FEDERAL RESERVE BANK OF RICHMOND

5

to construct an estimate of the average pre-tax rate
of return. An estimated rate of return calculated on
the basis of accounting data is termed a book rate of
return. Book rates of return can be contrasted with
market rates, which are calculated using market data
on actual returns earned by investors. A formal
derivation of the rate of return formula used in the
bank holding company model is presented in the
shaded box on the opposite page. A description of
how the variables appearing in that formula are calculated follows.
The procedure used to determine the average rate
of return earned by the bank holding company sample
can be divided into three steps. First, the pre-tax
rate of return to equity, r1/(1-t), is estimated. This
term measures both the cost of equity finance and
corporate income taxes. Second, interest rates on
long-term debt, r2, and short-term debt, r3, are estimated. Third, the assumed financial structure (reflected by the weights a1, a2, and a3) is determined.4
The Pre-Tax Rate of Return to Equity Determining the pre-tax rate of return to equity requires three
steps. In the first step the after-tax rate of return is
calculated by dividing after-tax profits by the book
value of outstanding equity. This yields an estimate
of the variable rl.
Average corporate income tax rates are estimated
by dividing actual taxes paid, with an adjustment
that adds back the tax benefits that banks get from
holding municipal bonds, by gross income. Deferred
taxes are excluded from the estimated tax rate. The
imputed tax rate is then determined as a weighted
average of the estimated tax rates for each of the
holding companies in the sample. The weights used
to compute the sample average are individual holding
company profits divided by total profits for the entire
sample.
Finally, the pre-tax rate of return to equity is
determined by dividing the after-tax rate, rl, by
(l-t), where t denotes the average tax rate. The
values of rl and t used in this final step are threeyear moving averages of the sample averages.

4 Information on the bank holding company model was
gathered from a series of Federal Register notices pub-

lished by the Federal Reserve Board: 46 Federal Register
1,338 (January 6, 1981); 49 Federal Register 11,251
(March 26, 1984); 49 Federal Register 44,556 (November 7, 1984); and 50 Federal Register 47,624 (November 19, 1985).

6

Interest Rates An imputed interest rate on longterm debt is determined by averaging the interest
rates paid on all outstanding long-term debt for the
holding companies sampled. The short-term interest
rate is estimated in the same way, except that demand
deposits and other deposits subject to interest rate
ceilings are excluded from the calculation. Because
banks often pay implicit interest in the form of free
gifts or services for deposits subject to interest rate
ceilings, explicit interest rates provide downwardly
biased estimates of the true cost of these funds.
Since implicit interest payments are difficult to estimate, all such deposits are excluded from the calculation of the cost of short-term debt finance.
Capital Structure The weights a1, a2, and a3 appearing in the bank holding company rate of return
formula are determined on the basis of the matchedbook capital structure assumption described earlier.
Long-term assets are assumed to be financed by a
mix of equity and long-term debt. Proportions of
equity and long-term debt, represented by the variables al and a2, are based on the corresponding proportions observed for the bank holding company
sample. The sum al + a2 is determined so as to
equal the proportion of long-term assets in the bank
holding company model asset base, which is composed
of long-term assets and working capital. The variable
a 3 is the share of working capital in the asset base.
The cost of finance for working capital is r 3 , the
short-term interest rate.
Other Imputed Private Sector Costs
The estimate of the pre-tax cost of capital obtained
using the bank holding company model includes an
imputed allowance for the cost of corporate income
taxes. However, Federal Reserve Banks, because of
their nonprofit status, are also exempt from certain
sales taxes that private firms are required to pay. A
separate allowance for such taxes is therefore added
to the total cost recovery target.
Other imputed expenses include an allowance for
federal deposit insurance assessments, based on total
clearing balances, and Federal Reserve Board staff
expenses attributable to priced services development.
As part of this last allocation, a portion of Board
assets are added to the priced services asset base.5
5

49 Federal Register 11,251 (March 26, 1984).

ECONOMIC REVIEW, MARCH/APRIL 1986

The Rate of Return to Capital as a Weighted Average of
Interest Rates and the Return to Equity
The financial model of large bank holding
companies used by the Federal Reserve to
determine its imputed cost of capital is based
on a formula that breaks down the aggregate
rate of return to capital into a weighted average
of the pre-tax rate of return to equity and the
interest rates paid on long- and short-term debt.
In the derivation that-follows, all variables
represent accounting data that appear in bank
holding company financial statements.
Consider a firm that finances its investments
by issuing a mix of equity shares, long-term
debt, and short-term debt. Let the variable s
represent the book value of the firm’s outstanding equity, b1, the book value of long-term debt,
and b2 the value of short-term debt., The aggregate book value, v, of all claims against the

and
the
the
the

short-term debt, To see this, first note that
pre-tax rate of return to equity, denoted by
variable re, is the ratio of pre-tax profits to
value of outstanding equity. Formally,

The average yields on long-term debt, r 2, and
short-term debt, r3, are defined as

and

FEDERAL RESERVE RANK OF RICHMOND

7

III. EVALUATION OF THE
BANK HOLDING COMPANY MODEL
Two ultimate goals underlie the pricing policy for
Federal Reserve services mandated by the Monetary
Control Act. The first is to give private sector firms
8

an opportunity to offer competing services. The
second is to bring about an efficient use of economic
resources.
To be able to compete with the Federal Reserve,
private firms must perceive an opportunity to earn a
rate of return at least equal to their cost of capital.

ECONOMIC REVIEW, MARCH/APRIL 1986

Other types of float are charged directly to
the parties receiving the resulting extension of
credit. Institutions that close during midweek
must pay the cost of float generated by such
closings. 4 Banks receiving early credit for
checks drawn against banks in other districts
must pay for the resulting float.6
Because ACH transactions are not affected by
the same factors that can delay check collection,
ACH float is a smaller problem than check float.
When data processing problems or network
transmission delays result in the creation of
ACH float, the associated costs are allocated to
ACH overhead expenses and recovered through
service fees. Float resulting from midweek
closings is priced in much the same way as
check float in corresponding cases.6
Financial institutions can choose among one
of two payments options for float. They can
either authorize the Fed to directly debit their
reserve or clearing accounts for the cost of float
arising from interterritorial check deposits or
from midweek closings, or they can have their
reserve or clearing account balances adjusted
after the fact by the amount of float received
over that period. These “as of” adjustments,
as they are termed, reduce the amount of earnings credits paid on clearing balances or, alternatively, require holding higher required
reserve balances in subsequent days to meet
average reserve requirements.
4

Nonstandard holidays are treated differently from
midweek closings, however. Nonstandard holidays
are state holidays during which Federal Reserve
Banks and most banks nationwide are open for
business. In cases where banks are legally required
to close for a state holiday, credit to the sender of
an item is deferred to the next business day, 12
C.F.R. Part 210 (Regulation J, Collection of Checks
and Other Items and Wire Transfer of Funds).
5

48 Federal Register 10,753 (March 14, 1983).

6

49 Federal Register 6,564 (February 22, 1984).

That opportunity can exist only if the targeted rate
of return to capital incorporated into Federal Reserve
service prices reflects the cost of capital faced by its
potential competitors.
A pricing policy that encourages competition is also
efficient from the standpoint of economic theory.

The cost of capital is, by definition, the opportunity
cost of capital. An opportunity cost is the cost of
foregone alternatives. In a market economy decisions
regarding resource allocation are based on perceptions of relevant opportunity costs. When prices
reflect true opportunity costs, they give purchasers
incentives to use different goods and services only so
long as the value they place on those items is at least
as great as the cost to society of producing them.
The resulting outcome is efficient in the sense that it
allocates resources to the production of goods and
services most valued by market participants.
These considerations suggest that the bank holding
company model can be evaluated on the basis of how
well it estimates the cost of capital faced by private
firms that compete with the Federal Reserve. That
evaluation criterion is adopted in the following
analysis.
Evaluation Criteria
Determining the appropriate targeted rate of return
to capital poses a number of difficult methodological
problems. These problems, however, are not unique
to the Federal Reserve. Regulatory agencies such as
public utility commissions have long been faced
with a similar task. These agencies attempt to determine service prices that permit regulated firms to
earn rates of return high enough to attract capital
without yielding monopoly profits.
The pricing methodology adopted by the Federal
Reserve closely resembles the rate-setting methods
commonly used by regulatory agencies. Rate-setting
methods for regulated industries have received a
great deal of attention from economists. It seems
reasonable, therefore, to apply the same evaluation
standards developed to analyze public utility pricing
to the methodology adopted by the Federal Reserve.
Kolbe, Read, and Hall have proposed two theoretical evaluation criteria for analyzing rate-setting
methods used in public utility regulation.6 The first
is a test for consistency with economic theory. This
test looks at the assumptions and procedures used to
estimate the cost of capital to determine whether they
are consistent with accepted economic theory. T h e
second criterion is a test of the logical consistency of
the rate-setting procedure. Its purpose is to determine whether a rate-setting procedure can be logically expected to achieve certain goals.
6

A. Lawrence Kolbe and James A. Read, Jr, with
George R. Hall, The Cost of Capital, Estimating the
Rate of Return for Public Utilities (Cambridge: The
MIT Press, 1984), chap. 3.

FEDERAL RESERVE BANK OF RICHMOND

9

Consistency with Economic Theory
Consistency with economic theory is a useful evaluation criterion because theory identifies the opportunity costs relevant to decisions affecting resource
allocation. A great deal of published data, especially
accounting data, measure historical costs rather than
opportunity costs. Because market conditions change
over time, historical cost data generally provide poor
estimates of current opportunity costs. Unfortunately, exact measures of opportunity costs, such as
the cost of capital, are not always available. In such
cases, economic theory can be used to develop estimation methods that are free from systematic bias.
Viewed from this perspective, the purpose of the
test for consistency with theory is to determine
whether a rate-setting procedure utilizes the best
available methods to estimate true opportunity costs.
The Difference between Realized Returns and the
Cost of Capital As noted earlier, the pre-tax cost of
capital can be expressed as a weighted average of the
expected pre-tax rate of return to equity and the
interest rates paid on debt issued to finance new investment. The cost of capital differs from the realized
return to capital in that it is an expected rate of
return. Using the notation developed earlier, the
pre-tax weighted average cost of capital can be expressed as

where now E(r) denotes the expected aggregate
pre-tax rate of return to capital, or cost of capital;
E ( rl) the expected return to equity, which measures
the cost of equity; t the marginal tax rate on new
investment; r2 and r3 the interest rates paid on longand short-term debt issued to finance new investment; and al, a2, and a3 the targeted proportions of
debt and equity used to finance new investment.
The bank holding company model uses historical
returns to estimate the cost of capital. Two implicit
assumptions underlie that approach. The first is that
the average historical book rate of return yields good
estimates of the past cost of capital to the banking
industry. The second is that the historical cost of
capital can be used to infer the cost of capital currently faced by its private sector competitors.
Whether these assumptions are justified can be determined by examining available evidence on the behavior of capital markets.
There are a number of reasons why the cost of
capital can differ from historical rates of return.
First, past returns to equity can differ from the
10

expected rate of return. Second, fluctuations in
market interest rates change the cost of issuing new
debt. Third, tax laws do not, as a general rule, treat
different types of capital investment equally ; moreover, those laws are periodically revised so that effective marginal tax rates on new investment can differ
from tax rates on past investment. Finally, financing
decisions, reflected by the weights a1, a2, and a3, may
differ at the margin for new investments. Each of
these issues must be considered in evaluating different
methods of estimating the cost of capital.
Estimating the Cost of Equity As residual claimants to the income earned by a firm, shareholders
bear two types of risk. Business risk refers to the
risk inherent to the activities a firm engages in ; i.e.,
risk stemming from capital investment. Financial
risk is created when investment is financed by borrowing. The more highly leveraged a firm is the
more variable are rates of return earned by shareholders and the greater is the risk of default. Both
of these sources of variability in earnings determine
the risk premium demanded by shareholders. Firms
that bear similar business and financial risks should,
according to theory, face the same cost of equity.
The bank holding company model estimates the
historical cost of equity to large holding companies
by averaging past realized rates of return earned by a
sample of firms. Two implicit assumptions underlie
that approach. The first is that the cost of equity
faced by the nation’s twenty-five largest holding companies is the same. The second is that expected rates
of return to equity equal subsequent realized rates on
average. The last assumption is commonly made in
economic research and, at least in the case of market
equity returns, appears to be empirically justified.7
Because changes in market conditions can cause
rates of return to fluctuate over time, the bank
holding company model uses a three-year average of
past rates of return to determine the imputed cost of
equity. Basing the imputed cost of equity on a simple
average of historical rates assumes that the cost of
equity is constant over the sample period. The last
7

Studies have found that capital markets are efficient in
the sense that market prices of financial assets fully
incorporate all publicly available information about the
firms issuing those securities. Under certain assumptions, market efficiency implies that discrepancies between realized and expected rates of return should be
zero on average. See, for example, Eugene F. Fama,
“Efficient Capital Markets: A Review of Theory and
Empirical Work,” The Journal of Finance 25 (May
1970): 383-417. A more recent survey can be found in
Thomas E. Copeland and J. Fred Weston! F i n a n c i a l

Theory and Corporate Policy, 2d ed. (Reading, Mass.:

Addison-Wesley Publishing Company, 1983), chap. 10.

ECONOMIC REVIEW, MARCH/APRIL 1986

assumption is a strong one, but has some empirical
justification. Studies have found that market rates
of return for virtually all firms whose stocks trade in
organized markets are uncorrelated over time. Eugene Fama has noted that such behavior is consistent
with the joint hypothesis that markets are efficient,
in the sense that expected rates equal realized rates
on average, and that the expected rate of return to
equity is constant over time.8
An alternative approach more commonly used to
estimate the cost of equity to firms is based on the
Capital Asset Pricing Model (CAPM). The Capital
Asset Pricing Model specifies rates of return to
risky assets as a function of their covariance with a
diversified market portfolio. A principal result of
that model is that only undiversifiable risk, that is,
the portion of the variation in equity returns correlated with the returns to a fully diversified market
portfolio, determines the risk premium demanded by
shareholders. In recent years the Capital Asset
Pricing Model has gained increasing acceptance in
public utility rate-setting hearings.
More recently, Arbitrage Pricing Theory has
begun to replace the CAPM as the dominant analytical framework used in research into capital market
behavior. Arbitrage Pricing Theory is more general
than the Capital Asset Pricing Model in that it relates
equity returns to a number of other factors in addition to the return earned on a diversified portfolio.
As with the CAPM, Arbitrage Pricing Theory can
be used to estimate the cost of equity to firms. The
CAPM can be viewed as a special case of Arbitrage
Pricing Theory.
The above discussion has assumed that market
rates of return are used to estimate the cost of equity.
As noted earlier, however, the bank holding company
model uses book rates of return based on accounting
data. Differences between book rates of return and
market rates are examined below.
return earned by shareholders are the sum of the
dividend yield, the ratio of dividends to the market
value of equity, and any capital gains or losses to
shareholders resulting from changes in the market
value of equity. Market rates of return are the
theoretically correct measure of shareholder earnings.
Book rates of return typically differ from market
rates. Kolbe, Read, and Hall note two principal
reasons for these discrepancies.
8

See Eugene F. Fama, Foundations of Finance ( N e w
York: Basic Books, Inc., 1976), chap. 5.

First, the market value of a firm’s equity will
typically differ from its book value. Although there
is reason to believe that investors’ expectations are
correct on average, realized returns in specific cases
can differ markedly from initial expectations. When a
firm’s earnings fall short of expectations, for example,
the market value of its outstanding equity falls until
the expected rate of return to equity is once again
equated with the cost of equity. Thus, when market
value is less than book value the book rate of return
will tend to understate the true rate. Conversely,
when market value exceeds book value the book rate
overstates the true rate.
Second, book rates of return use accounting profits
to measure the return to equity. Accounting profits
may differ systematically from true economic returns,
however. Standard accounting procedures typically
do not recognize changes in asset values, except when
assets are disposed of. Moreover, depreciation schedules used in standard accounting practices are arbitrary from an economic point of view. To the extent
that accelerated depreciation schedules used for tax
purposes overstate the true rate of depreciation, for
example, accounting profits may understate profits.
Finally, generally accepted accounting principles
allow considerable discretion in the way income can
be reported. It is thus theoretically possible for two
firms that earn the same true incomes to report quite
different accounting profits. Moreover, there is no
evidence that these discrepancies will cancel out on
average. 9
It would be a straightforward task to incorporate
market rates of return into the bank holding company
model. Available evidence suggests that market rates
would yield better estimates of the cost of capital
than book rates.
The Cost of Borrowing Unlike the expected return to equity, data on market interest rates are
readily available. Interest rates paid on debt contracted in the past do not reflect the cost of borrowing
to finance new investment: current market interest
rates do. Therefore, estimates of the cost of capital
should be based on currently prevailing market interest rates.
Measuring Effective Tax Rates Tax laws stipulate
both a legal or statutory tax rate and rules that
specify how taxable income for a firm must be computed. Accounting conventions required by tax laws
9

Kolbe, Read, and Hall, The Cost of Capital, p p .

FEDERAL RESERVE BANK OF RICHMOND

11

do not measure true economic costs, however. Depreciation schedules used for tax purposes, for example, rarely correspond to true economic depreciation. Consequently, effective tax rates can differ
systematically from statutory rates. Effective tax
rates can be either higher or lower than statutory
rates, depending on whether depreciation schedules
used to compute taxable income understate or overstate true depreciation.
Special tax concessions, such as the investment tax
credit on purchases of new machinery and equipment,
also influence effective tax rates. Investment tax
credits act to lower effective marginal tax rates on
income earned from such investments.
Thus, although the maximum statutory tax rate on
corporate income is 46 percent, recently liberalized
depreciation allowances and investment tax credits
produce effective marginal tax rates on income from
new investment that are much lower. A recent study
by the U. S. Treasury reports estimates of effective
marginal tax rates in the range of -8 to 20 percent
on equipment and 40 percent on structures.10
The bank holding company model uses average tax
rates, calculated as the ratio of taxes actually paid
(with an adjustment that adds back the tax benefits
banks receive from holding municipal bonds) to
pre-tax profits, to estimate the effective tax rate for
the holding company sample. As with the imputed
cost of equity, the imputed tax rate is based on a
three-year average of estimated historical tax rates
for the bank holding company sample. For 1986 the
imputed tax rate is 37.6 percent.1 1
While average tax rates do reflect the aggregate
effects of depreciation allowances and investment tax
credits on total taxes paid by firms, they do not
necessarily measure effective marginal tax rates on
income from new investment. Research on corporate
income taxation reveals that average tax rates have
systematically overstated effective marginal tax rates
in recent years. An article by Alan Auerbach has
analyzed the reasons for this finding.12 Three factors

discussed by Auerbach are relevant to the evaluation
of the Federal Reserve’s method of imputing taxes.
First, some firms may earn a rate of return to
capital that is in excess of a competitive return. Such
excess returns may reflect the entrepeneurial ability
of management or the exercise of market power
rather than a return to capital. To the extent that
these excess returns do not come from depreciable
capital, they face a marginal tax rate of 46 percent.
Auerbach argues that the taxation of excess returns
is not directly relevant to the incentives to invest in
fixed capital, but is incorporated in measured average
tax rates.
Second, average tax rates reflect effective tax rates
on different vintages of capital. The Economic Recovery Tax Act of 1981 and the Tax Equity and
Fiscal Responsibility Act of 1982 have reduced effective tax rates on income from depreciable capital
below rates prevailing in the pre-1981 period. Capital
acquired before these tax law changes is effectively
taxed at higher rates than those applied to new capital
investment. Moreover, the depreciation allowances
permitted for tax purposes tend to overstate true
economic depreciation. Compared to true income,
taxable income is lower during the early years of an
asset’s life and higher in later years. As a result,
effective tax rates on income from older vintages of
capital tend to be higher than those on new investment. Estimates of effective tax rates based on
accounting data measure the average tax rate on
different vintages of capital and thus do not accurately reflect the lower effective tax rate on income
from new investment. The practice of averaging
estimated tax rates over time further exacerbates
this problem.
The third and final point deals with asymmetries
in the treatment of gains and losses. While corporate
earnings are taxed at a positive rate, the tax on
operating losses, which are negative earnings, is zero.
Firms that operate at a loss are unable to exploit tax
preference such as the investment tax credit. Thus,
average tax rates overstate the effective marginal tax

10

rate on new investment. While firms that incur losses

These estimates apply to equity-financed investments
and assume a four percent real rate of return to equity
and a five percent inflation rate. Effective tax rates for
different types of equipment vary with depreciable lifetimes; effective tax rates are generally higher for assets
with longer depreciable lifetimes. In addition to longer
depreciable lifetimes, structures face a higher effective
tax rate because they are not eligible for the investment
tax credit. U. S. Treasury Department, Tax Reform for
Fairness, Simplicity, and Economic Growth, vol. 2 (November 1984), p. 156.
11
50 Federal Register 47,627 (November 19, 1985)
12
Alan J. Auerbach, “Corporate Taxation in the United
States,” Brookings Papers on Economic Activity 2
(1983) : 451-505.

12

do have limited options to carry those losses over,
such options do not correct for the bias introduced
by the asymmetric treatment of gains and losses.
To conclude, estimates of tax rates that are based
on accounting data do not measure the effective marginal tax rate on income from new investment. The
relatively higher tax rates on income from past capital
investment reflected in such data represent sunk
costs, which are not relevant for current investment
Imputed tax rates applied to Federal
decisions.

ECONOMIC REVIEW, MARCH/APRIL 1986

Reserve priced service operations should be set so
as to reflect effective tax rates on new investment.
Such a policy would be consistent with the goal of
pricing in a manner that permits entry by private
sector competitors.
Using Effective Marginal Tax Rates to Impute
Taxes Imputed tax rates for Federal Reserve priced
services could be calculated using a methodology similar to that employed in economic studies of effective
corporate tax rates on U. S. industry. 13 To start, implicit user costs would have to be calculated for each
type of asset. These user costs would be computed
so as to reflect the present value of tax benefits, such
as depreciation allowances and ‘the investment tax
credit where applicable. Total imputed financing and
tax costs could then be determined by aggregating
imputed earnings for each asset.
It should be noted that the procedure suggested
above does not correspond to rate-setting practices
employed by public utility commissions. Regulated
utilities are permitted to recover actual tax liabilities
incurred as a result of past tax laws. In competitive
markets, however, prices are determined by prevailing opportunity costs. The cost of new investment
does not depend on effective tax rates on capital purchased in the past, but on current tax laws. Ratesetting procedures that base prices on actual tax
liabilities effectively protect shareholders of regulated
firms from capital gains and losses resulting from
changes in tax laws. Nonregulated firms, however,
are not protected from such risks. The procedure
outlined above would therefore be more consistent
with economic theory.
Logical Consistency
The test for logical consistency attempts to determine whether a rate-setting procedure can be logically
expected to attain its goals. The ultimate goals of
Federal Reserve pricing are to permit private sector
entry into the markets it serves and also to promote
efficient resource allocation. Both of these goals are
attained when the targeted rate of return to capital
reflects the true cost of capital faced by private sector
competitors. Therefore, the logical consistency of
the Federal Reserve’s rate-setting procedure can be
judged by whether it can be expected to produce
targeted rates of return that equal the true cost of
capital on average.
13

A review of these methods is contained in Alan J.
Auerbach, “Taxation, Corporate Financial Policy and the
Cost of Capital,” Journal of Economic Literature 21
(September 1983) : 905-40.

The Problem of Circularity At present the Federal Reserve bases its targeted rate of return on the
average historical book rate of return earned by a
sample of firms it views as its principal competitors.
Rates of return earned by these competitors are determined in part by the prices the Fed charges for its
services, however. A recent congressional report on
Federal Reserve pricing practices noted that this
could lead to a potential circularity problem. 14 I f
targeted rates of return are set too low, as can happen
when book rates of return are below market rates,
correspondent bank earnings can be adversely affected
by Federal Reserve pricing policy. To the extent
that correspondent bank earnings are measurably
affected by Fed pricing policy, subsequent targeted
rates of return would be based on artificially depressed earnings that are themselves a product of the
rate-setting procedure. In this case, as long as targeted rates continue to be based on book rates of
return, the rate-setting procedure cannot logically be
expected to target the true cost of capital.
It could be argued that the circularity problem is
unimportant as a practical matter because correspondent banking services account for only a small share
of revenues earned by bank holding companies. According to this argument, revenues earned from activities such as commercial lending, for example, are
likely to be relatively more important than revenues
from the sale of services such as check clearing
(which is the principal area of competition between
the Federal Reserve and commercial banks) in determining overall rates of return for the holding company sample.
This argument was acknowledged in the congressional report. That report, however, also noted that
the argument calls into question the assumptions
underlying the adoption of the bank holding company
model. Use of the bank holding company model is
predicated on the assumption that, because the largest
bank holding companies are the Federal Reserve’s
principal competitors, the cost of capital to those
firms should determine the targeted rate of return for
priced services. But when a firm engages in a
number of different activities its cost of capital for
different investment projects will, as a general rule,
differ because different projects do not carry the same
risks. Thus, an estimate of the cost of capital based
on overall rates of return earned by bank holding
14
The Role and Activities of the Federal Reserve System in the Nation’s Check Clearing and Payments System, Report of The Subcommittee on Domestic Monetary

Policy of the Committee on Banking, Finance and Urban
Affairs, 98 Cong. 2d sess., pp. 41-43.

FEDERAL RESERVE BANK OF RICHMOND

13

companies might not reflect the cost of capital for
payments services even if the bank holding company
sample does include the Federal Reserve’s major
competitors. Implicitly, then, the bank holding company model assumes that the cost of capital for investment projects related to payments services is the
same as the average cost of capital faced by large bank
holding companies. This is a strong assumption, and
one that is difficult to either prove or disprove. It is
worth noting, however, that bank holding companies
are not the Fed’s only competitors. In the market for
automated clearinghouse services, for example, a nonbanking firm has recently begun to compete with the
Fed.
A Suggested Alternative Procedure Problems
with circularity are not unique to Federal Reserve
pricing. They are also encountered with rate-setting
procedures commonly employed by public utility
commissions.
Indeed, the pricing methodology
adopted by the Federal Reserve is based on such
commonly used procedures. The problem of circularity is therefore a familiar one to regulatory economists.
As an alternative to the bank holding company
model, the congressional report cited earlier suggested using the Capital Asset Pricing Model in conjunction with data on market rates of return for a
broad-based sample of U. S. industry. The proposed
methodology outlined in the report is one that has
gained increasing acceptance among public utility
commissions in recent years.1 5
Adoption of a broad-based ‘sample of U. S. industry was suggested as a means of dealing with the
potential problem of circularity. Firms included in
this larger sample should ideally bear risks that are
comparable to those facing suppliers of correspondent
banking services. To some extent, the CAPM could
be used to adjust for differences in financial risk
across the sample.
Using market rates of return could help mitigate
any potential problems with circularity because market forces cause equity prices to adjust until the
expected return to equity and the cost of equity are
equated. Thus, to the extent that Federal Reserve
pricing policy does affect correspondent bank earnings, subsequent realized rates would not deviate
systematically from expected rates as book rates of
return would.
15

It is also the methodology that appears to be favored
by regulatory economists. See, for example, Kolbe, Read,
and Hall, The Cost of Capital, chap. 3.
14

These suggestions appear to offer a means of
improving the current procedure. However, the proposed methodology is not without its own shortcomings. First, the CAPM has itself been subject to
criticism on theoretical grounds because it assumes
that the covariance of returns with the market portfolio is the only factor determining the risk premium
expected by shareholders. As noted earlier, Arbitrage Pricing Theory is not subject to the same
criticisms.
Second, adoption of the method described above
would also require the Fed to resolve a number of
difficult problems not normally encountered in other
types of rate-setting procedures. The weightedaverage cost of capital depends not only on the cost
of equity finance, but also on the cost of issuing debt
and the overall financial structure. In determining
allowable rates of return for privately owned public
utilities, the firm’s financial structure need not be
assumed or imputed. The amount of outstanding
debt, the interest rates paid on that debt, and the
debt-equity ratio are all given.
In contrast, estimating the appropriate cost of
equity finance for the Federal Reserve is only the
first step in determining the overall imputed cost of
capital. If bank holding companies are not used as a
model of financial structure, then some other model
must be adopted. A more appropriate model is not
immediately evident, however. Finally, because the
financial structure of banks tends to differ from that
of other types of firms, it could prove difficult to
select a sample of firms from other industries that
bear comparable business and financial risks. For the
present, these latter issues remain unresolved.
IV. COST ALLOCATION
As the nation’s central bank, the Federal Reserve
System bears responsibility for discharging a variety
of tasks. Fed services are grouped into four general
categories : ( 1) Monetary Policy, (2) Supervision
and Regulation, (3) Treasury, and (4) Financial
Institutions and the Public. Monetary policy can be
characterized as a nonexcludable public good, and
would therefore be difficult to price explicitly since
everyone benefits whether they pay or not. Bank
supervision has some attributes of a public good,
although the Federal Reserve is the only federal bank
regulatory agency that does not charge for examinations. Treasury, or fiscal agency functions, are not
priced because the Federal Reserve routinely turns
over all surplus revenues to the Treasury. Correspondent banking and payments services fall into the

ECONOMIC REVIEW, MARCH/APRIL 1986

fourth category. The Monetary Control Act requires
these services to be priced.16 Pricing is feasible for
these services because they have the characteristics of
private goods.
Because not all services are priced, costs attributable to priced services must be identified and separated from other costs. Sales of priced services vary
among Reserve Banks, so individual cost recovery
targets must be set for each Bank. Finally, separate
cost recovery targets must be set for each individual
priced service line.
The Private Sector Adjustment Factor
Operating expenses are allocated to different services using a cost accounting system known as PACS
(Planning and Control System). PACS also determines the value of capital assets devoted to priced
services. (See insert for more details.) Capital
financing costs and other imputed private sector costs
are distributed to the different priced service lines
using a uniform mark-up over operating expenses
known as the Private Sector Adjustment Factor
(PSAF).
As a first step in calculating the PSAF, total
capital financing costs are determined using (1) the
estimated financial cost of capital from the bank
holding company model, and (2) the value of the
priced services asset base obtained from the PACS
accounting system. If the variable r represents the
imputed pre-tax cost of capital and K the value of
the asset base, then total imputed capital and corporate income tax costs, denoted by the variable CC,
are given by :
CC = rK.
Other PSAF adjustments include allowances for
sales taxes, federal deposit insurance assessments,
and a portion of expenses incurred by the staff of the
Board of Governors. Strictly speaking, these imputed
costs should be classified as operating expenses.
However, the PSAF cost allocation procedure groups
them together with imputed capital and income tax
costs. For purposes of this discussion, therefore, the
variable CC should be regarded as representing
capital costs plus the other imputed private sector
costs mentioned above.
16

The fourth category also includes a number of services that are not priced. The basic service lines subject
to the pricing requirements of the Monetary Control Act
are: (1) currency and coin services, (2) check clearing
and collection services, (3) wire transfer services, (4)
automated clearinghouse services, (5) settlement services,
(6) securities and safekeeping services, (7) float, and any
new services the Federal Reserve offers.

Cost Accounting Methods
The Federal Reserve’s Planning and Control
System (PACS) was designed initially as a
budget expense and control system, but was
modified to serve as a cost accounting system
capable of meeting the requirements of pricing.
PACS performs three basic tasks. First, it
identifies all direct expenses incurred as a result
of separate activities. Second, it allocates overhead expenses to different service lines. Third,
it allocates capital assets to different services so
that imputed capital financing costs can be
determined.
Identifying the direct expenses” incurred in
producing different services is, at least in principle, a straightforward task, and one that
PACS was originally designed to perform.
Like other cost accounting systems, PACS
allocates direct expenses, such as wages and
salaries, to different services.
Allocating indirect, or overhead, expenses
poses a more difficult problem. Examples of
overhead activities include Bank administration,
personnel administration (including recruiting
and placement and wage and salary administration), and protection (security services).
PACS uses estimates of the proportion of overhead expenses attributable to each activity to
allocate overhead expenses. For example, costs
associated with personnel administration are
allocated according to the ratio of personnel
employed by each service, while cost allocations for Bank administration are determined
by the ratio of direct expenses incurred by
different priced services. Expenses arising
from security services, on the other hand, are
allocated according to a survey of the percentage of manhours devoted to protection of valuables.
The priced services asset base is determined
using a direct determination method that allocates all single purpose assets directly to the
activity employing them. Some capital assets,
termed joint-purpose assets, are used for a
variety of different purposes. A good example
of a joint purpose asset would be a Federal
Reserve Bank building, which typically houses
all activities performed by the Bank. Jointpurpose assets are allocated to different services
in much the same way as overhead expenses ;
that is, based on estimates of usage. Assets
used in overhead activities are allocated to individual services based on overhead expense
allocation ratios.

FEDERAL RESERVE BANK OF RICHMOND

15

The PSAF procedure groups direct operating expenses together with overhead expenses measured
and calculated by PACS. Let the variable OE
represent total operating expenses, including noncapital overhead expenses, allocated to priced services. The PSAF mark-up is the ratio of imputed
private-sector costs to all other operating expenses:
CC
PSAF = OE
Notice that, multiplying this ratio by total operating
expenses, OE, would just recover total imputed costs.
In calculating the PSAF, aggregate cost data for
all the Federal Reserve Banks and all priced services
are used. The resulting mark-up is applied uniformly
to all services offered by Reserve Banks to arrive at
separate cost recovery targets. To see how the procedure works, let OEij denote total expenses allocated
to activity i (where activity i represents a particular
priced service) at bank j. Then, total private sector
expenses imputed to that activity are determined by
the product PSAF x OEij.
For services such as check clearing, for which
prices may vary by region, separate cost recovery
targets are determined for each Reserve Bank. Other
services such as electronic funds transfer have prices
set uniformly on a nationwide basis. Cost recovery
targets for those services are determined on the basis
of aggregate systemwide costs incurred in producing
the service, calculated by summing service costs
across all Reserve Banks.
Notice that the PSAF cost allocation procedure is
not intended to recover “overhead” expenses in the
sense that that term is usually understood. The Fed’s
accounting conventions group overhead expenses
other than capital costs together with other routine
operating expenses in the variable OE. In contrast,
the overhead mark-ups used by private-sector firms
typically include all indirect overhead expenses (such
as the cost of personnel management services) together with capital financing costs in the numerator
of the mark-up ratio. The PSAF ratio is often mistakenly interpreted as representing such a mark-up.
It should be clear from the preceding discussion that
this is not the case.
Allocation of Imputed Costs
Now consider the effects of this allocation procedure on individual cost recovery targets. Notice that
the imputed cost allocation to service i at bank j can
be equivalently stated as :
16

where :

total direct expenses incurred by Reserve Bank j in
providing some projected amount of service i. From
the above expression it is evident that using the same
systemwide PSAF to impute capital and tax costs to
separate activities amounts to weighting total imputed
costs by the ratio of expenses incurred in providing
service i at bank j to expenses for the system as a
whole. Consequently, those services that are relatively costly to provide in terms of noncapital expenditures are also allocated a relatively larger share
of capital and other imputed private sector costs.
Similarly, regional Reserve Banks having relatively
high noncapital costs in relation to other Reserve
Banks are required to bear a relatively larger share
of imputed private sector costs. The resulting cost
allocation may or may not accurately reflect true
underlying costs.
V. EVALUATION OF THE PSAF
COST ALLOCATION METHOD
Like the bank holding company model, the PSAF
cost allocation method resembles rate-setting methods
commonly used in public utility regulation. These
methods are reviewed and evaluated below and the
analysis is applied to the PSAF methodology.
Fully Distributed Cost Pricing Methods
Fully distributed cost pricing refers to a variety
of average cost pricing methods. Under this type of
pricing, total projected revenue requirements are
fully distributed on a per-unit cost basis and prices
are set so as to satisfy those requirements. Such
pricing methods are commonly used in public utility
rate-setting proceedings to allocate targeted capital
cost recoveries and other joint production costs to
different types of services.17 The PSAF mark-up
used by the Federal Reserve is an example of fully
distributed cost pricing.
17

For a more complete description of different fully
distributed cost pricing methods used in public utility
regulation, see Alfred E. Kahn, The Economics of Regulation: Principles and Institutions, vol. 1 (New York:
John Wiley and Sons, Inc., 1970), pp. 150-58.

ECONOMIC REVIEW, MARCH/APRIL 1986

One reason for the widespread use of fully distributed cost pricing methods lies with their relative
simplicity. A second reason for the popularity of
these methods stems from the widespread perception
that they allocate costs fairly. By definition, fully
distributed cost pricing imposes equal mark-ups on all
services. It thus avoids the appearance of discriminatory treatment of different classes of customers.
Evaluation of Fully Distributed
Cost Pricing Methods
Prices perform the task of allocating resources in a
market economy. Economists therefore evaluate
different pricing methods according to whether resource allocations resulting from those methods are
efficient. In addition to economic efficiency, policymakers are also concerned with the issue of equity.
Discriminatory pricing policies are prohibited under
existing antitrust laws. The analysis that follows
evaluates fully distributed cost pricing methods according to the criteria of efficiency and equity.
Economic Efficiency As a general rule economic
theory finds that efficient resource allocation is
attained when prices are set so as to reflect underlying marginal costs. Marginal costs measure the
opportunity cost of the resources used to produce
different goods and services. Efficient resource allocation requires that the ratio of prices charged for
different goods and services equal the corresponding
ratio of marginal costs, or that prices be proportional
to marginal costs. When these conditions are satisfied, prices charged for different goods and services
reflect the true cost to society of producing those
items. From an operational standpoint, then, different pricing methods can be evaluated using departures from marginal costs as a guide to losses in economic efficiency.1 8
A special case arises when production is subject to
economies of scale. This is typically the case for
public utilities. Certain services produced by the
Fed also appear to be subject to economies of scale. 19
When scale economies exist, marginal costs are below
average costs so that strict marginal cost pricing will
not recover total costs. In this case, efficient resource
allocation is attained by setting prices in inverse pro18

This is the approach taken by Kahn, The Economics
of Regulation, in his analysis of fully distributed cost

portion to demand elasticities.20 A second-best solution involves either two-part pricing (e.g., an access
charge plus a per-unit service fee reflecting marginal
costs), or setting prices proportional to marginal
costs so that total costs can be recovered while leaving
price ratios equal to ratios of marginal costs.
For firms that produce a single output the last
method amounts to average cost pricing. When a
firm produces more than one output, however, production may involve joint costs. Joint costs exist
when the same productive inputs are used to produce
more than one type of output; for example, Reserve
Bank buildings in the case of the Fed. When production is subject to joint costs, marginal costs are
determined according to causal responsibility. The
marginal cost of a good or service is the cost that
could be avoided if the last unit of output were not
produced, holding production of all other outputs
fixed.
Unfortunately, marginal costs may be difficult to
determine when production relies on joint inputs.
For this reason, fully distributed cost allocation
methods are often used to allocate joint production
costs. In general, fully distributed cost allocations
differ from marginal costs. But because marginal
costs can be difficult to measure, precise measures of
efficiency losses resulting from the use of fully distributed cost allocation methods are difficult to determine. Indeed, the cost of implementing true marginal
cost pricing can exceed the economic value of efficiency gains resulting from such a policy. Thus, total
economic costs may be lower under fully distributed
cost pricing than under marginal cost pricing. This
could occur if, for example, departures of fully distributed costs from marginal costs are small while
the added cost of implementing marginal cost pricing
is large.
Arguments such as the one above are frequently
made to justify the use of fully distributed cost
pricing methods. Unless some attempt to measure
marginal costs is made, however, there may be no
way to judge whether these methods really are relatively efficient.
Equity Price discrimination occurs when price
differentials do not reflect differences in the underlying cost of selling to different purchasers. By

pricing methods.

19

See David B. Humphrey, “Costs, Scale Economies,
Competition, and the Product Mix in the U. S. Payments
Mechanism,” Staff Studies 115 (Board of Governors of
the Federal Reserve System, 1982).

20

For a more complete discussion of efficient pricing see
William J. Baumol and David E. Bradford, “Optimal
Departures from Marginal Cost Pricing,” American Eco-

nomic Review 60 (June 1970): 265-83.

FEDERAL RESERVE BANK OF RICHMOND

17

definition, then, marginal cost pricing is not discriminatory. 21 As noted by Alfred Kahn, “It is fair,
as a general rule, to impose costs on people when and
to the extent that they impose costs on society.”2 2
Antitrust laws generally permit firms to charge
price differentials when those differentials are based
on differences in cost. Marginal cost pricing is therefore permissible under those laws. In view of the
above considerations, marginal costs can be used as a
standard to evaluate the fairness of different pricing
methods in cases where marginal cost pricing is
feasible.
Although fully distributed cost pricing methods are
generally viewed as being fair, economic theory would
classify them as discriminatory to the extent that the
resulting prices depart from marginal costs. Imposing equal mark-ups may appear to be fair, but it does
not always insure that purchasers pay the true cost
of the goods and services received. The perception
that fully distributed cost pricing methods are equitable continues to enjoy widespread, if misguided,
acceptance, however, and such pricing practices have
not been found to violate antitrust laws.
An Evaluation of Federal Reserve
Pricing Practices
The preceding discussion suggests that fully distributed cost pricing methods can produce outcomes
that are less than ideal from the standpoint of economic theory. In the case of Fed pricing policy,
however, the existence of competition provides an
independent check of cost allocation practices and
mitigates the distortionary effects of inappropriate
pricing decisions when they occur.
Economic theory predicts that firms operating in
purely competitive markets will price according to
marginal costs. Under these conditions the issues of
efficiency and equity are resolved by the market. In
contrast, competition is restricted in regulated markets such as those served by public utilities so that
regulatory agencies take the place of the market in
determining prices. Rate-setting methods used by
those agencies are shaped by the goals of efficiency
and equity, but the definition of equitable pricing
behind the adoption of those methods do not always
agree with the economist’s notion of that term.
21

For a more detailed discussion of price discrimination,
see. F. M. Scherer, Industrial Market Structure and Economic Performance 2d ed. (Boston: Houghton Mifflin
Company, 1980), chap. 21.
22
Alfred E. Kahn, “The Road to More Intelligent Telephone Pricing,” Yale Journal of Regulation 1 (1984): 146.

18

Debate over appropriate standards of equity and
efficiency that should guide Fed pricing policy is a
less contentious issue because the Fed must compete
with private sector suppliers. As long as aggregate
imputed costs are estimated correctly, an inappropriate allocation of costs between different service lines
would result in some services becoming relatively
overpriced while others are underpriced. If that
happened, the Fed would find it difficult to retain
market share for those services that are relatively
overpriced, thus making it difficult to continue indirectly subsidizing relatively underpriced services.
Thus, the presence of competition makes it difficult
for the Fed to adhere to a pricing policy that might
otherwise result in inefficient resource allocation or
unequitable treatment of certain customers.
Market-Sensitive Pricing In response to market
forces and to minimize the distortionary effects of
fully distributed cost pricing the Fed has instituted
market-sensitive pricing for individual services within a service line. While overall cost recovery targets
for broadly defined service lines, such as commercial
check clearing and ACH, are partly determined by
the PSAF mark-up, prices for individual services
comprising those service lines are set in response to
market forces. Market-sensitive pricing is efficient
to the extent that the PSAF mark-up allocates total
imputed capital costs to each service line appropriately.
A feasible alternative to the current practice of
allocating costs using a uniform mark-up would be to
set targeted cost recoveries based directly on capital
assets allocated to each service line by the PACS
accounting system, in effect creating a separate markup, or PSAF, for different service lines. The resulting cost allocation should more closely approximate
true marginal costs.
Imputed Deposit Insurance Costs There is at least
one other area, namely imputed deposit insurance
expenses, where marginal cost pricing principles
could be applied to Fed pricing. At present, these
expenses are allocated together with imputed capital
costs using the PSAF mark-up. Since they are determined by the level of clearing balances held with
Reserve Banks, it would seem more appropriate to
charge imputed deposit insurance costs against the
profits earned on clearing balances. This would
probably require a downward adjustment to the
interest rate paid on clearing balances.

ECONOMIC REVIEW, MARCH/APRIL 1986

VI. SUMMARY AND CONCLUSIONS
Because the Federal Reserve is a nonprofit institution, its cost of capital is not determined in capital
markets as is the case with purely private, profitmaking firms. Nevertheless, the Monetary Control
Act requires the Fed to earn a return to capital comparable to that earned by private firms. Consequently, the Fed is faced with the task of determining
an appropriate rate of return to capital for its priced
services.
A similar problem arises in connection with public
utility regulation. While most utilities are privately
owned, their return to capital is determined by regulatory fiat rather than by market forces. Given the
similarity between public utility and Federal Reserve

pricing, it should not be surprising that the Fed’s
pricing methodology is patterned after rate-setting
methods developed for public utility regulation.
Rate-setting methods for regulated industries have
received a great deal of attention from economists.
Research on this topic has dealt with the problems of
identifying appropriate operational goals and developing methods of evaluating different rate-setting procedures. Although problems encountered in public
utility regulation are not identical in all respects to
those connected with Federal Reserve pricing, some
of the methods developed to analyze such rate-setting
procedures can be used to evaluate Federal Reserve
pricing methods. The analytical framework developed in this article represents a first step toward
that goal.

BUSINESS FORECASTS 1986
Edited by Sandra D. Baker
The Federal Reserve Bank of Richmond is pleased to announce the publication
of Business Forecasts 1986, a compilation of representative business forecasts for
the current year. A consensus forecast for 1986 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.

FEDERAL RESERVE BANK OF RICHMOND

19

MONETARY POLICY IN THE EARLY 1980s
Robert L. Hetzel*

1. Introduction
On October 6, 1979, the Federal Reserve System
changed its operating procedures in order to enhance
its control of the money supply. The new procedures,
which employed targets for nonborrowed reserves,
remained in force until the fall of 1982. Though the
Fed itself never characterized its policy as monetarist, it has been widely argued outside the Federal
Reserve that the new procedures constituted a
“monetarist” experiment. It has also been contended
that the attempt by the Fed to control the money
supply through reserve targeting was unsuccessful.
For example, these views are expressed in the following excerpt from a newspaper article that recommended abandonment of the October 1979 operating
procedures [Nordhaus (1982)]:
The first, step [of a new economic policy] would be
to bring down the curtain on the disastrous monetarist experiment of the last two years. The
Federal Reserve should be directed to cease and
desist its mechanical monetary targeting and to set
monetary policy with an eye to inflation and unemployment. . . . At the same time, the Fed should
overhaul its operating procedures. The techniques
of emphasizing supply of bank reserves rather than
interest rates since October 1 9 7 9 h a s p r o d u c e d
greater volatility of both interest rates and the
money supply.

In this article, a chronological review is provided
of the formulation of monetary policy and of the
implementation of the new operating procedures
during this period. Many economists have characterized monetary policy in this period in the way described above because of the coincidence of Fed
policy actions generally dominated by a desire to
reduce the rate of inflation and of Fed adoption of
reserve, as opposed to funds rate, targeting. The
review provided here, however, stresses the considerable continuity in the formulation of monetary
policy before and after October 1979, rather than the
occurrence of an isolated “monetarist” experiment.
This continuity was provided by the practice of
relaxing implementation of the new procedures when
the behavior of money did not accord with the Fed’s
perception of the behavior of the economy.
The post-October 1979 operating procedures provided an interesting experiment in monetary control.
20

They employed a combination of lagged reserve accounting and nonborrowed reserves targets. This
combination requires that monetary control be
effected through indirect control of the funds rate,
rather than through a reserves-money multiplier
relationship. In the review provided below, it is
argued that this characteristic of indirect control of
the funds rate at times contributed in practice to
volatility in the money supply and in interest rates.
2. The Post-October 1979 Operating
Procedures
Prior to October 1979, the Fed had specified
“tolerance ranges” for intra-yearly growth of the
money supply. These tolerance ranges, however, as
emphasized at the time by the Fed, were more aptly
described as benchmarks, rather than as targets.
Deviations of projected money growth from these
tolerance ranges triggered changes in the federal
funds rate, but there was never any presumption that
the resulting changes in the funds rate would be such
as to bring actual money growth into line with the
values specified in the tolerance range [Hetzel
(1981)].1 After October 1979, in contrast, there
were intervals during which the funds rate was varied
in a way intended to bring actual growth of the
money supply into line with its intra-yearly targeted
value.
This section presents an abbreviated overview of
the operating procedures adopted on October 1979.
It is assumed, however, that the reader is familiar
with one of the more thorough descriptions available,
for example, Hetzel (1982) or Goodfriend (1982).
* The views in this article are solely those of the author
and, it should be emphasized, do not necessarily reflect
the views of the Federal Reserve Bank of Richmond or
the Federal Reserve System.
1
The FOMC emphasized that the tolerance ranges were
not considered as targets for the money supply. “It was
noted that, perhaps because of the manner in which the
directive was worded, the 2-month ranges of tolerance
for Ml and M2 were subject to misinterpretation as embodying the Committee’s short-run targets for these
aggregates, intended to be achieved by appropriate
changes in the funds rate . . .” [Board of Governors
(1978), FOMC meeting of June 20, 1978, p. 189]. The
purpose of the 2-month ranges was to provide the
Manager with an indicator for determining when changes
in the funds rate were appropriate.

ECONOMIC REVIEW, MARCH/APRIL 1986

Because of lagged reserve accounting, the banking
system’s demand for reserves was essentially predetermined in a given reserve accounting period. Of
this predetermined reserve demand, whatever the
Desk did not supply through open market operations
had to be borrowed by the banking system from the
Fed. Given the pressure on commercial banks to find
alternative sources of reserves exerted through the
administration of the discount window, higher levels
of borrowed reserves increased the excess of the
funds rate over the discount rate. The funds rate,
consequently, was determined as the sum of the discount rate plus an amount that varied positively with
the level of borrowed reserves. (The relationship
between the discount rate and the funds rate is shown
in Figure 1. The relationship between borrowed
reserves and the differential between the funds rate
and the discount rate is shown in Figure 2). Ultimately, then, the new procedures worked through a
leverage over the federal funds rate. The funds rate,
which determined the cost of funds to banks, influenced bank portfolio adjustments and, as a byproduct, bank liabilities and the money supply.
At Federal Open Market Committee meetings, the
Fed specified an initial value for borrowed reserves
(termed the initial borrowed reserves assumption).
Given the intra-yearly target for M1 and, consequently, an implied path for total reserves, this initial

value for borrowed reserves determined the target
for nonborrowed reserves. Given the nonborrowed
reserves target, the movement of total reserves associated with a miss of the M1 target produced a
change in the level of borrowed reserves and in the
funds rate. The change in the funds rate acted to
offset misses of M1 from target. In addition to this
kind of “automatic” change in the funds rate, the
Desk could also effect “discretionary” changes by
varying the nonborrowed reserves target.
The remainder of this article presents a chronological review, from 1979 through 1982, of the implementation of this procedure. The purpose of this
review is to attempt to elucidate the way in which the
new procedures worked in practice.
3. The October 6, 1979 Actions
Starting in the spring of 1979, monetary policy
became concerned with the threat of recession. “The
Federal Open Market Committee received forecasts
from its staff of a recession beginning July 1979 . . .”
[Wallich (1980), p. 3]. Between February and
July 1979, M1 grew at an annualized rate of 9.7
percent, but the funds rate was raised over this
interval by only half a percentage point. By September, M1 and M2 were at the top of the intra-yearly
ranges implied by their four-quarter target ranges.

Figure 2
Figure 1

FUNDS RATE
AND DISCOUNT RATE PLUS SURCHARGE

ADJUSTMENT BORROWING
AND THE DIFFERENTIAL BETWEEN THE
FUNDS RATE AND
THE DISCOUNT RATE PLUS SURCHARGE

Note: From March 1980 through November 1981, in addition
to the basic discount rate, a variable surcharge was applied to
frequent borrowing by large banks from the discount window.

FEDERAL RESERVE BANK OF RICHMOND

21

The anticipated recession did not materialize. By
September, inflation and depreciation of the dollar
emerged as the primary concerns.
From the perspective of the Fed in October 1979,
the overriding imperative for monetary policy was to
assuage the inflationary psychology of the public that
manifested itself in speculative activity in commodity
and foreign exchange markets and threatened to
spread to wage setting behavior.
Inflation feeds in part on itself, so part of the job
of returning to a more stable and more productive
economy must, be to break the grip of inflationary
expectations. We have recently seen clear evidence
of the pervasive influence of inflation and inflationary expectations on the orderly functioning of

financial and commodity markets and on the value
of the dollar internationally. . . . [Volcker (1979b),
pp. 888-9]
. . . in the absence of firm action to deal with inflation and inflationary expectations, there was a
clear risk that the runup in energy prices would
work its way into wages and prices generally,
thereby raising the nation’s underlying inflation

rate. [Volcker (1979c), p. 959]
The actions taken by the Fed on October 6, 1979,
reflected its concern over inflationary psychology.
The Fed felt it had to establish a credible antiinflationary stance for monetary policy. New operating procedures that would allow the Fed to avoid
overshooting its four-quarter target ranges for the
monetary aggregates were considered a prerequisite
for such a policy. “. . . it was clear by early fall that
the growth in money and credit was threatening to
exceed our own targets for the year and was nourishing inflationary expectations” [Volcker (1979c), p.
959].
In this situation, the Fed took actions to limit the
extension of credit that, in its view, was financing
speculative activity. Credit extension by banks was
constrained by the imposition of marginal reserve
requirements on their managed liabilities. “And we
placed a special marginal reserve requirement of 8
percent on increases in managed liabilities of larger
banks . . . because that source of funds . . . has financed much of the recent excessive buildup in bank
credit” [Volcker (1979c), p. 960]. For the same
reason, the increased variability of the funds rate
under the new operating procedures was considered
important. “. . . in the then existing market circumstances, perceptions (right or wrong) that changes
in money market rates would be limited seemed to be
encouraging banks and other lending institutions to
aggressively market credit” [ Volcker (1980b), p.
25]. Finally, the Fed urged banks not to extend
credit for speculative purposes. “The Board of Gov22

ernors has particularly stressed its own concern that,
in a time of limited resources, banks should take care
to avoid financing essentially speculative activity in
commodity, gold and foreign exchange markets”
[Volcker (1979a), p. 4].
On the basis of interviews with four governors
and with Board staff, Woolley (1984, chap. 5) observes that, in fall 1979, effective money supply
targeting appeared to offer solutions to the Fed’s
immediate problems. First, it was recognized that a
credible anti-inflationary stance would require a
significant rise in interest rates, but there was uncertainty over the magnitude of the rise required. A
way of resolving this problem was to allow the funds
rate to rise by whatever amount was necessary to
prevent an overshoot of the four-quarter target range
for M1. Second, the new procedures allowed full use
of the language of monetary control in communicating to the public the need to raise rates. This
latter point is made in the following quotations from
Fed economists:
By clearly communicating to the public the Federal
Reserve’s objectives for monetary policy, a monetary aggregates targeting procedure enables private decision-makers to better plan their activities
and to make price decisions that are more harmonious with noninflationary growth in money and

credit. [Axilrod (1981) p. 16]
. . . the use of money stock targets in the context
of winding down excessive monetary growth over
time provides a means of communicating the objectives of policy with the rest of the government and
with the public. . . . It should be noted that the
possibility of defining an anti-inflationary strategy
in terms of a long-term path for intermediate
money growth rate targets, with its attendant
advantages for internal and external communication, apparently has no analog in interest rate
targets. There is seemingly no satisfactory way to
state a long-term anti-inflation strategy in terms
of nominal or real interest rates as can be done in
the case of money growth targets. [Davis (1981),
pp. 19-20]
In these circumstances, for the first time, the Fed
began to give the Desk meaningful targets for the
money supply. (Prior to October 1979, the FOMC
specified “tolerance ranges,” rather than targets, for
growth of the monetary aggregates. As discussed in
Section 2, these tolerance ranges were not intended
to be targets.) Beginning in October 1979, it replaced
its tolerance ranges for money growth with actual
intra-yearly targets derived from the four-quarter
targets. It is also important to note that the
Humphrey-Hawkins legislation, which took effect in
1979, required that the four-quarter target ranges for
growth of money be applied solely to a fourth-quarter

ECONOMIC REVIEW, MARCH/APRIL 1986

base, rather than to a moving quarterly base as had
been the prior practice. In this way, the phenomenon
of base drift was eliminated over the calendar year.
[Base drift seriously weakens the effectiveness of
monetary targeting through the incorporation of
misses of money from prior targets into new targets.
See Broaddus and Goodfriend (1984).]
Initially, the new procedures appeared to work.
The first significant deviation of M1 from its intrayearly target occurred toward the middle of February
1980 when it became clear that M1 was growing in
excess of its target. (See Figure 3.) The Desk
responded by lowering the target for nonborrowed
reserves modestly in late February and significantly
in early March. The Board raised the discount rate
from 12 to 13 percent effective February 15. By the
March 18 FOMC meeting, M1 was back on target.
This experience was one of the two times in the postOctober 1979 period when the Desk responded to a
miss of the M1 target by altering its nonborrowed
reserves target promptly upon appearance of the M1
target miss. (There were a number of occasions

Figure 3

M1 AND FOUR-QUARTER TARGET RANGES

1980

1981

1982

1983

Note: In order to display the data available contemporaneously,
M1 is taken from the first Board of Governors statistical release
H.6 showing complete monthly figures for a given year. In 1980,
M1-B is used. In 1981, shift-adjusted M1-B is used. This series
adjusts other checkable deposits for shifts from nondemand
deposit sources. The discontinuity after 1981 arises from the
discontinuance of the shift adjustment. After October 1982, the
target range for M1 was replaced by a “monitoring” range. The
dual ranges for M1 in 1983 reflect the rebasing of the M1 monitoring range in July 1983.

when the target for nonborrowed reserves was
changed, but only after it had become obvious that
the change in borrowed reserves associated with the
initial miss of the M1 target had failed to offset the
miss.) 2
4. Credit Controls
The Special Credit Restraint Program (SCRP)
was announced March 14, 1980. According to the
Board press release, the SCRP represented “further
actions to reinforce the effectiveness of the measures
announced in October of 1979” [Board 1980b], The
Fed valued the aspects of the SCRP that allowed it
to restrict bank lending with the intention of reducing
speculative credit extension. “Some parts (of the
SCRP) were quite acceptable to us in terms of what
we call voluntary restraints on banks” [Volcker
(1983d), p. 48]. Specifically, banks were “informally” required to hold loan growth to within 6 to 9
percent. Also, for large banks, the reserve requirement imposed on managed liabilities exceeding a base
level was increased to 10 percent. A surcharge on
the discount rate of three percentage points was
applied to borrowing by large banks. Extension of
consumer credit was discouraged by a special deposit
requirement of 15 percent on increases in covered
types of credit, and increases in assets of money
market mutual funds were subject to a reserve requirement of 15 percent.
As stated in the initial Board press release, the
SCRP was intended to prevent “use of available
credit resources to support essentially speculative uses
of funds.” The sharp effect of this program on curtailing credit extension by banks, however, frustrated
the monetary control aspects of the Fed’s October
1979 actions [Hetzel (1982)]. Just prior to the
introduction of the SCRP, M1 was on target. The
SCRP severely crimped the extension of bank credit
and, in the process, pushed M1 well below its target
range (Figure 3). The strongly depressing effects
of the SCRP on credit extension were unforeseen,
and it was undoubtedly not anticipated that the new
operating procedures and the SCRP would work at
cross purposes. The new operating procedures
caused the drop in M1 to produce a large reduction
in the funds rate. This reduction mitigated the depressing effect of the SCRP on the economy.
2

Discussion of changes in the target for nonborrowed
reserves is contained in the annual “Monetary Policy and
Open Market Operations” reports from the New York
Desk that are published in the Federal Reserve Bank of
New York Quarterly Review.

FEDERAL RESERVE BANK OF RICHMOND

23

5. Money Supply Targeting in 1980
As suggested in the introduction, the new procedures were allowed to exert their full effect on the
funds rate only when the Fed believed that the behavior of the money supply was reflecting the behavior of the economy. As shown in Figure 3, 1980
contained an incipient monetary acceleration that
peaked in February and a more sustained acceleration that dominated the second half of the year. In
the latter case, M1 exceeded its intra-yearly targets
from the August 12 through the December 19 FOMC
meetings. In the first instance, but not the second,
the new procedures were applied rigorously from the
very beginning of the monetary acceleration. Only
in the first instance, did the Fed consider, at the start
of the monetary acceleration, that the money supply
was reflecting the behavior of the economy.
In the first quarter of 1980, incoming data indicated considerable strength in the real sector. This
strength was reflected in the strength in M1; therefore, the Fed was willing to allow the strength in M1
to raise the funds rate. Incoming data in the second
and third quarters indicated weakness in the economy, and it was generally accepted by midsummer
that a major recession was under way. The strength
of Ml in the summer did not accord with the current,
widespread perception of weakness in the economy;
therefore, the new procedures were not implemented
in a way that would produce a significant rise in the
funds rate. From the July through the October
FOMC meeting, the intra-yearly target for M1 was
raised from the bottom to the top of the four-quarter
target range. The discount rate was raised a percentage point on September 26, but other increases in the
discount rate and significant reductions in the target
for nonborrowed reserves were postponed until November [Hetzel (1982), pp. 247-8]. As the fall
progressed, it became clear that the recession of late
spring and summer had only been a temporary reaction to the SCRP and that the economy was growing
strongly. As it became clear that the strength in M1
reflected strength in the economy, the Fed became
willing to allow the new procedures to increase the
funds rate sharply.
6. The Working of the New Procedures
Before discussing the behavior of interest rates and
money in the last half of 1980, it is necessary to explain several aspects of the October 1979 operating
procedures and the environment in which they were
employed. As noted in Section 2, the new procedures
continued to effect monetary control through the
24

funds rate, rather than through a reserves-money
multiplier relationship. The level of the funds rate
emerged as the sum of the discount rate and a differential that varied positively with the level of borrowed reserves. Given the predetermined demand
for reserves under lagged reserve accounting, borrowed reserves were determined as a consequence of
the target for nonborrowed reserves.
Monetary control under the new procedures was
rendered difficult through the lack of a reliable model
for deriving the funds rate from the money supply
target. 3 There also was no reliable model for deriving
the level of borrowed reserves that would produce
the desired differential between the funds rate and the
discount rate.4 Because the level of borrowed reserves determined the funds rate (given the discount
rate), it was the key variable in the new monetary
control procedure.
3

The difficulty of associating a value of the funds rate
with the money supply target was clearly recognized at
the time in relation to the former operating procedures.
. . . the operational guide for day-to-day open
market operations before October [1979] had
typically been the federal funds rate. However,
the translation of money stock objectives into
day-to-day management of this rate presupposes
a stable and predictable relationship between the
public’s demand for cash balances and short-term
market rates of interest. This relationship becomes particularly difficult to appraise in an
environment of rapid price increases, changing
inflationary expectations, and financial innovations. [Volcker (1980a), p. 139]
4

“. . . the federal funds rate, [which] the market focuses
on as a policy indicator, can vary widely for a given level
of borrowing. Changes in the federal funds rate appear
to be strongly influenced not only by the borrowing level
itself but also by past borrowing experience and by
market expectations of future rate developments” [Levin
and Meek, p. 28]. Goodfriend (1983) formalizes this
statement. Prediction of the relationship between borrowed reserves and the differential between the discount
rate and the funds rate was also rendered difficult by the
periodic use of surcharges over the discount rate that
were applied to borrowing by large banks.
The FOMC specified the value of borrowed reserves
that would begin the interval between FOMC meetings
The
(termed the initial assumption for borrowing).
Record of Policy Actions omits discussion of how this
variable was set. According to the initial description by
the Fed of the new procedures, however, a simple rule of
thumb was employed. “The amount of nonborrowed
reserves-that is total reserves less member bank borrowing-is obtained by initially assuming a level of
borrowing near that prevailing in the most recent period”
[Board (1980a)]. “Typically, the Committee has chosen
levels [of initial borrowed reserves] close to the recently
prevailing average . . .” [“Monetary Policy . . .” (1980),
p. 60]. The annual “Monetary Policy and Open Market
Operations” reviews published by the Desk in the New
York Quarterly Review provide lists of the initial values
of borrowed reserves set by the FOMC. Comparison of
these values with values of borrowed reserves observed
for the statement week in which FOMC meetings were
held indicates that this rule of thumb continued to be
employed. (The initial borrowed reserves assumption
was adjusted for erratic movements in the relationship
associating borrowed reserves with the differential be-

ECONOMIC REVIEW, MARCH/APRIL 1986

Experience has demonstrated that it is difficult to
determine in advance the appropriate level of borrowing to be employed in constructing the nonborrowed reserve path consistent with the short-run
This level of borrowing
money supply target.
would depend on a projection of market interest
rates consistent with the money supply target path
and knowledge of depository institutions’ willingness to borrow, given the spread between market
rates and the discount rate, and could differ significantly from borrowing levels based on or ranging around recent experience. . . . projections of
borrowing demand from interest rate forecasts and
past bank behavior are subject to a considerable
degree of error. [Axilrod (1981), p. 24]
. . . along with the demand for money, the borrowings function remains one of the more troublesome specifications in the monthly model. [Tinsley
et al (1982), p. 849]

In the absence of a model that could be employed to
determine reliably the value of borrowed reserves
(and the funds rate) that would produce the targeted
value of the money supply, the level of borrowed
reserves (and the funds rate) was set through the
feedback induced by misses of the M1 target.
The character of the feedback mechanism running
from a miss of the M1 target to changes in the funds
rate was shaped to a significant degree by the behavior over time of the relation running from borrowed reserves to the differential between the funds
rate and the discount rate. At the start of a monetary
acceleration, bank use of the discount window is
negligible. Banks are allowed to use the discount
window without the administrative pressure that
causes them to look to the funds market for reserves
and thus force up the funds rate and other market
rates. As a monetary acceleration persists, banks are
forced to use the discount window over an extended
period and become subject to administrative pressure.
Consequently, the passage of time causes a given level
of borrowed reserves to produce a higher differential
between the funds rate and the discount rate.5
tween the funds rate and the discount rate. In particular,
when this differential would change, for a given level of
borrowed reserves, in a way unrelated to the current miss
of the total reserves path, the initial assumption for borrowed reserves was adjusted in order to eliminate the
corresponding erratic movement in the funds rate.)
5

In discussing the monetary acceleration of the last half
of 1980, Levin and Meek argue that the temporal pattern
relating borrowed reserves to the funds rate just described was reinforced by the way in which the financial
markets formed their expectations. In particular, a
moderate initial rise in the funds rate in response to a
money supply overshoot led to larger rises later on.
The third, and in some respects, most interesting
episode began in August 1980, when a surge in
money supply led to an immediate rise in discount window borrowing as the demand for total
reserves exceeded the NBR path. H&ever,
since member banks had been essentially out of

It must also be noted that the new procedures altered the significance of discount rate changes for
monetary control. Before October 1979, when the
Desk targeted the funds rate directly, changes in the
discount rate could not affect the level of the funds
rate. After October 1979, the Desk targeted nonborrowed reserves, while the demand for total reserves was essentially predetermined because of
lagged reserve accounting. Consequently, the amount
of reserves the banking system had to borrow in a
reserve accounting period was given. Changes in the
discount rate altered the marginal cost of obtaining
this given amount of reserves; therefore, changes in
the discount rate were passed on directly to the funds
rate (provided the funds rate was above the discount
rate so that the procedures were operable).
After October 1979, the Fed continued to employ
changes in the discount rate to communicate policy
intentions to financial markets. During the 1970s,
the discount rate served as a signal of Fed intentions
with respect to the funds rate. A rise, say, in the
funds rate preceded by a rise in the discount rate
signaled to the market that the increase in the funds
rate would be long lived. In the fall of 1980, as the
differential between the funds rate and discount rate
widened, the market interpreted the Fed’s willingness
to raise the discount rate as a test of Fed willingness
to allow interest rates to rise to whatever level was
necessary in order to achieve monetary control.6
the window for some months. upward pressure
on the federal funds rate was modest. . . . Market
participants took the moderate rise in the federal
funds rate as an inadequate response to the continued rapid expansion of the money supply after
August's 19.3 percent annual rate of growth in
federal ‘funds rate did not rise more vigorously.
Talk that the Federal Reserve was not following
through on its monetary objectives probably
contributed to the widespread resurgence of inflationary objectives. . . . The fact that rapid
money growth threatened achievement of the
FOMC’s 1980 objectives fed expectations that
rates would move higher. The markets quickly
translated these expectations into higher rates
in a self-reinforcing process. [Levin and Meek
(1981), pp. 31-3]
6

Levin and Meek commented:
Participants [in financial markets] repeatedly
talked up the likelihood of discount rate increases
as the federal funds rate rose further above the
discount rate-apparently on the theory that
catch-up increases were needed under the flexibility principle specified in the announcement of
the new strategy in October 1979. This interpretation became a part of the market’s assessment of Federal Reserve dedication to monetary
restraint. The rise in the spread was taken as
indicating a further need for discount rate
change rather than a measure of the pressure of
banks’ efforts to avoid recourse to the window.
[Levin and Meek (1981), pp. 33-4]

FEDERAL RESERVE BANK OF RICHMOND

25

A final point, the significance of which is brought
out in the following section, concerns the volatility of
inflationary expectations in the financial markets
during this period. This volatility, it is argued below,
may have interacted with the implementation of the
new procedures in a way that caused monetary
accelerations and decelerations to possess some selfreinforcing dynamics [Hetzel (1982)]. The monetary acceleration in the last half of 1980 appeared to
have produced uncertainty in the bond market over
the course of long-term rates. Sellers and buyers of
bonds left the long-term markets for short-term
markets. The sellers increased their demand for bank
credit. The buyers only partly turned to the market
for the nonmonetary liabilities of banks. The increased demand for bank credit was, therefore, only
partly matched by an increased demand for the nonmonetary liabilities of banks. The result was to
increase demand deposits and M1 and to reinforce the
monetary acceleration in progress. In addition, reintermediation on the asset side of bank balance
sheets became important. Market rates rose as the
monetary acceleration progressed in the last half of
1980. Inertia in the prime rate caused it to lag
market rates. As the customary positive differential
between the prime rate and the paper rate practically
disappeared, businesses shifted out of the paper
market into the market for bank credit. The increase in the demand for bank credit added to deposit
creation and reinforced the existing monetary acceleration.
To summarize, to the usual difficulties of trying to
effect monetary control through the funds rate, the
new procedures added several additional uncertainties surrounding the relationship between the level of
borrowing and the funds rate. Moreover, the discount rate assumed a new and more significant role
under the new procedures. With the background in
this section, it is now possible to discuss the monetary
acceleration that occurred in the last half of 1980.
7. Monetary Acceleration in the
Last Half of 1980
As shown in Figure 3, the monetary acceleration
of the last half of 1980 carried M1 from well below
the four-quarter target cone to somewhat above it by
year-end. This monetary acceleration can be understood by putting together the separate pieces discussed above. In the late spring, the new operating
procedures pushed the funds rate sharply lower in
response to the monetary deceleration produced by
the SCRP. The end of this program allowed the
26

economy to revive and caused a resurgence of credit
demands. The funds rate was at too low a level to
prevent a monetary acceleration. Borrowed reserves
rose in response to the overshoot of the M1 target in
August. Because banks had been out of the window,
however, this increase in borrowed reserves initially
produced only a small increase in the funds rate. In
an environment of concern over the recession, however, the Fed did not make discretionary changes in
its operating variables that would have raised the
funds rate [“Monetary Policy . . .” ( 1981), p. 73 and
Levin and Meek (1981), p. 35].
Given the persistence of the overshoot of the M1
target, the characteristics of the operating procedures
described above acted to increase the funds rate.
First, the target for borrowed reserves was raised by
the M1 overshoot. Second, the administration of the
discount window caused given levels of borrowed
reserves to produce over time a higher differential
between the funds rate and the discount rate. Third,
as the monetary acceleration persisted, the Fed became concerned that the bond market would perceive
monetary policy as having become inflationary. For
this reason, as the differential between the funds rate
and the discount rate widened, it raised the discount
rate, even though the immediate effect of such an
action was to raise the funds rate and to leave this
differential unaffected. Finally, as the monetary acceleration persisted, the target for nonborrowed reserves was lowered.
All these factors combined to force a sharp increase
in the funds rate toward year-end. The funds rate
rose about three percentage points in each of the
months November and December, reaching a peak of
20 percent early in January 1981. The new procedures raised the funds rate in light of the monetary
overshoot. The subsequent monetary deceleration,
however, indicates that this process was carried too
far. An overshooting of the funds rate occurred and a
monetary deceleration ensued. This conclusion could
only be derived after the fact, however, in the absence
of a reliable means of associating targets for the
money supply with associated values of the funds
rate.
8. Monetary Deceleration in 1981
As background, it should be noted that the transactions measure of the money supply targeted in 1981
was called shift-adjusted M1-B. M1 comprises all

ECONOMIC REVIEW, MARCH/APRIL 1986

checkable deposits. The introduction nationwide in
1981 of the new interest-bearing checkable deposits,
NOW and ATS accounts, imparted a one-time fall to
the income velocity of M1 to the extent that these
new checkable deposits were drawn from nonmonetary sources. Institutional arrangements encouraged
in particular the relabeling of savings accounts as
NOWs due to the existence of the same Regulation Q
ceiling on savings and NOW accounts, even though
the latter offered transactions services not offered by
the former. Shift-adjusted M1 represented an
attempt to construct a money series comparable to
the old M1 series by removing increments to NOW
and ATS accounts originating from nonmonetary
sources such as savings deposits. Considerable effort
on the part of the Board staff went into the construction of the shift-adjusted M1 series [See
Bennett (1982) and Simpson (1981)]. The shiftadjusted M1 series exhibited a sharp deceleration in
1981. Using fourth-quarter to fourth-quarter figures,
Ml grew at about 8.3 percent in 1977 and 1978. In
1979 and 1980, M1 grew at 7.5 percent and 7.3 percent, respectively. In 1981, the growth rate of shiftadjusted M1 fell to only 2.3 percent.
The economic recovery begun in the second half of
1980 extended into 1981. Real GNP grew by 8.6
percent in 1981Q1. (Subsequently, the business
cycle peak was dated as July 1981.) The irregular
slowing of the rate of growth of various price indices
provided mixed evidence on whether inflation was
slowing. The implicit GNP deflator rose by 8.9
percent from 1980Q4 to 1981Q4, a slowing of only a
percentage point from the previous year. The producer price index rose at a 12 percent rate through
April, but rose more slowly thereafter. The rise
in the CPI moderated in the first and second quarters, but rose more strongly in the third quarter. In
this economic environment, the Fed continued to be
concerned about displaying a firm anti-inflationary
posture. It was hoped that such a posture would
exercise a restraining effect on wage settlements in
1982.
The stubbornness of our inflation in large part
reflects the adaptation of our economic and social
institutions to persistently rising prices.
The
process is embedded in a whole pattern of economic,
social, and political behavior that tends to sustain
and intensify its own momentum. W e s e e t h e
process at work in contracts that extend over a
period of time: in the pattern of three-year wage
bargaining, building in past or anticipated rates
of inflation into future cost. . . . The most critical
area-inevitably, because it accounts for some twothirds of all costs-is the trend of wages and
salaries. [Volcker (1981b), pp, 10-11]

. . . a crucially important round of union wage
bargaining begins next January, potentially setting
a pattern for several years ahead. That is one
reason why we need to be clear and convincing in
specifying our monetary and fiscal policy intentions
and their implications for the economic and inflation environment. [Volcker (1981a), p. 617]

The monetary deceleration that began toward the
end of 1980 caused shift-adjusted M1 to remain
below its four-quarter target cone in the first quarter
of 1981 (Figure 3). As a consequence, the new
operating procedures pushed the funds rate down
to 14.7 percent in March. M1 grew strongly in
April, but still remained only at the lower boundary of the four-quarter target cone (Figure 3).
Nevertheless, in early May the Board raised the
discount rate and the surcharge on the basic discount
rate, placing the surcharge rate at 18 percent (Figure
1). The Desk also reduced “substantially” the target
for nonborrowed reserves [“Monetary Policy . . .”
(1982), p. 47]. By May, the funds rate had been
pushed back up to 18.5 percent.
At the May 18 meeting, the FOMC emphasized
its concern that monetary policy appear firmly antiinflationary.
The indications of some slowing of the rise in the
consumer price index did not appear to reflect as
yet any clear relaxation of underlying inflationary
pressures, and emphasis was placed on the importance of conveying a clear sense of restraint at a
critical time with respect to inflation and inflationary expectations. [Board of Governors (1981),
FOMC meeting held on May 18, 1981, p. 111]
In order to prevent weakness in M1 from lowering
the funds rate, the FOMC adopted an open-ended
directive with respect to the extent that growth in
shift-adjusted Ml would decline. “. . . the Committee
decided to seek behavior of reserve aggregates associated with growth of M1-B from April to June of 3
percent or lower. . . .” [Board of Governors (1981),
FOMC meeting held on May 18, 1981, p. 112].
When M1 fell after the May FOMC meeting, the
path for total reserves derived from the M1 target
was reduced in line with reductions in actual total
reserves in order to keep borrowed reserves and the
funds rate from falling. In effect, the M1 target was
lowered in line with the fall in actual M1.
Because of the wording of the directive specifying
that M1 growth lower than 3 percent was acceptable,
the decline of M1 in May and June was not allowed
to affect the funds rate. The emphasis was placed on
the behavior of M2, which was growing strongly.
It was argued that the public’s demand function for
Ml had shifted leftward due to the growth of money

FEDERAL RESERVE BANK OF RICHMOND

27

market funds that were serving as transactions balances and that are included in M2, but not M1.7
“You may recall that last year [1981] M1 grew
slowly. . . . We believe that this was a reflection of
financial innovations including prominently the rapid
growth of money market funds, which to some limited
extent serve the function of transactions balances”
[Volcker (1982c), p. 10].
The Desk stopped the effective lowering of the M1
target in line with the actual value of M1 in the last
part of June; therefore, the weakness in M1 caused
borrowed reserves to fall in July. The normal effect
of this fall in producing a lower funds rate was offset,
however, probably due to the characteristic of discount window administration whereby extended periods of borrowing increase the pressure on banks to
turn to the funds market. In June and July the funds
rate was at 19 percent, and in August it was almost
18 percent. Only in September did the fall in borrowed reserves depress the funds rate significantly.
By early October, the shortfall of total reserves from
path had reached the unprecedented level of $370
million [“Monetary Policy . . .” (1982), p. 51].
The first significant discretionary action taken in
response to this shortfall was the one percentage
point reduction in the discount rate effective November 2. Shift-adjusted M1 remained well below its
four-quarter target cone throughout most of 1981.
Throughout 1981, the implementation of the new
procedures was influenced by the desire of the Fed
to convey to the public its firm anti-inflationary
resolve. “. . . a decline in short-term rates could
exacerbate inflationary expectations and abort a
desirable downtrend in bond yields and mortgage
interest rates” [Board of Governors (1981), FOMC
meeting held on November 17, 1981, p. 138].
9. Abandonment of the New Procedures
Early 1982 marks a transitional period during
which the Fed became increasingly concerned with
recession. Real GNP had remained essentially unchanged in the second and third quarters and fell in
7

The Record of Policy Actions states:
It was also suggested that the weakness in
growth of adjusted M-1B in the early months of

the year might be a misleading indicator of the
behavior of transaction balances, mainly because
of the rapid growth of money market mutual
funds; some part of the large flows into those
funds might also be regarded as transaction balances. . . . In evaluating the behavior of the
aggregates, it was agreed that greater weight
than before would be given to the behavior of
M-2. [Board of Governors (1981), FOMC Meeting of March 31, 1981, pp. 102-3]

28

the fourth quarter of 1981, while by year-end inflation had clearly moderated. Consequently, the perception of the economy’s most pressing problem
began to change.
Now we can see clear signs of progress on the
inflation front. . . . we are also seeing signs of
potentially more lasting changes in attitudes of
business and labor toward pricing, wage bargaining, and productivity. . . . I believe the pattern is
likely to spread, “building in” lower rates of
increase in nominal wages and prices over time.
And as the inflationary and cost pressures ease,
the economy can resume a healthy pattern of
growth. . . . [Volcker (1982b), pp. 167-8]
The Fed also continued to be concerned in early 1982
about the bond market. In the last several months of
1981, the federal deficit projected for fiscal year 1982
had risen from about $40 to $110 billion. For fiscal
year 1984, projections of a balanced budget had given
way to projections of a deficit of $150 billion. In
this environment, the Fed remained concerned that
any easing of monetary policy would exacerbate the
inflationary anticipations of participants in the bond
market.
The rate of growth of M1 rose in November and
December of 1981 and surged in January 1982 to an
annual rate of 21.5 percent. The January surge
carried M1 above the level of the year-end lower
boundary of the four-quarter target cone (Figure 3).
The Fed reacted to this bulge in M1 in a way that
reflected a compromise of conflicting concerns over
recession and the inflationary expectations of financial markets. It retained the October 1979 operating
procedures, but effectively raised the M1 target c o n e
used for purposes of setting intra-yearly M1 targets.
It retained the four-quarter M1 target cone for 1982
that employed as its base the realized 198lQ4 value
of M1. It added, however, for purposes of policy
discussions, a four-quarter M1 target cone for 1982
that employed as its base the 1981Q4 midpoint of the
1 9 8 1 four-quarter target cone for M1 [Volcker
(1982a), p. 17]. The result was a moderated increase in the funds rate. In 1981Q2, M1 had risen
$12 billion while the funds rate increased 550 basis
points, and the surcharge-adjusted discount rate was
raised 300 basis points. In 1982Q1, M1 rose $10
billion while the funds rate increased 235 basis points,
and the discount rate was not changed.
The primary concern of policy since October 1979
had been to convey a firm anti-inflationary stance in
order to assuage the inflationary psychology of the
public.

ECONOMIC REVIEW, MARCH/APRIL 1986

Progress toward disinflation at first was slowalmost invisible. . . . for a long while there was
little room for modifying policy in response to

domestic or international concerns. The danger
was that the wrong “signals” would only increase
the risk that the whole process of restoring stability--domestically or internationally--would be
longer delayed or even aborted. [Volcker (1983c),
p. 3]

In response to the moderation of inflation and the
continuation of recession, economic recovery became a
primary concern of monetary policy in 1982. A key
assumption behind the design of the post-October
1979 operating procedures was the desirability of
achieving intra-yearly M1 targets. In an environment in which a concern for inflation and the inflationary expectations of the public were no longer
dominant and in which the predictability of the relationship between M1 and nominal GNP appeared to
be diminishing, the desirability of attaining intrayearly M1 targets was increasingly questioned.
. . . we need . . . to be conscious of the fact that
the world as it is requires elements of judgment,
interpretation, and flexibility in judging developments in money and credit and in setting appropriate targets. . . . we cannot always assume a
rigid relationship between money and the economy
that, may not exist over a cycle or over longer
periods of time, especially when technology, interest
rates, and expectations are changing. . . . we must
. . . take into account a wide range of financial and
nonfinancial information when assessing whether
the growth of the aggregates is consistent with the
policy intentions of the Federal Reserve. The hard
truth is that there inevitably is a critical need for
judgment in the conduct of monetary policy.
[Volcker (1982d), pp. 406-7]
Early in July, the Fed was concerned about the
liquidity of the CD market in the aftermath of the
Penn Square Bank failure. With the benefit of
hindsight, however, it now appears that, within the
context of the general concern over the economy
described above, the primary immediate catalyst to
the phasing out of the post-October 1979 operating
procedures may have been a concern over the international debt situation. The sharp appreciation of the
dollar in 1982 as well as the continued high level of
market rates precipitated the situation in which numerous countries neared default on their external
debt. The Record of Policy Actions of the F O M C
indicates that the Fed began negotiating with the
Bank of Mexico in June to furnish reserves under the
existing swap arrangement [Board (1982a), p. 120].
Apparently, such negotiations were accompanied by
the fear that defaults by large debtor nations would
threaten the world financial system.

. . . we have to evaluate the significance of developments abroad as well as at home, as reflected in
trade accounts and the exchange rate, and of
strains in the financial structure itself. [Volcker
(1982f), p. 747]
. . . the potential for an international financial
disturbance impairing the functioning of our domestic financial markets at a critical point in our
recovery is real. [Volcker (1983b), p. 170]

Coping with the international debt situation appeared to require a substantial reduction in the level
of interest rates in the United States for a variety of
reasons. First, because much of the debt of thirdworld countries in particular was of short maturity, a
lower interest rate would reduce the burden of interest payments as debt was rolled over. Second,
because this debt was denominated in dollars, a lower
rate of interest in the United States would facilitate
repayment by limiting the contemporaneous appreciation of the dollar. Third, a lower rate of interest in
the United States would spur the U. S. economy and
in the process increase the exports of debtor nations
and their supply of foreign exchange. Finally, a
lower rate of interest in the United States would
allow central banks of other industrialized countries
to lower their bank rates. The resulting stimulus to
their economies would increase their imports from
debtor countries. “. . . an environment of sustained
recovery and expansion in the industrialized world is
critically important” [Volcker (1983a), p. 82].
The usefulness of the new procedures was seriously
questioned beginning in July.
Moreover--and I would emphasize this--growth
somewhat above the targeted ranges would be
tolerated for a time in circumstances in which it
appeared that precautionary or liquidity motivations, during a period of economic uncertainty and
turbulence, were leading to stronger-than-anticipated demands for money. We will look to a
variety of factors in reaching that judgment, including such technical factors as the behavior of
different components in the money supply, the
growth of credit, the behavior of banking and
financial markets, and more broadly, the behavior
of velocity and interest rates. I believe it is timely
for me to add that, in these circumstances, the
Federal Reserve should not be expected to respond,
and does not plan to respond, strongly to various
bulges--or for that matter “valleys”--in monetary
growth that seem likely to be temporary. [Volcker
(1982e), p. 491]

Beginning in the middle of July, the funds rate was
lowered significantly through reductions in the discount rate and increases in the target for nonborrowed reserves. From the end of June to the end of
August, the funds rate fell from about 15 percent to
about 9 percent. (At the time, M1 was just within

FEDERAL RESERVE RANK OF RICHMOND

29

the four-quarter target cone. M2 and M3 were both
above their target ranges.) The October 1979 procedures were revived for the last time in September
when the resurgence of M1 growth was allowed to
increase the target for borrowed reserves and the
funds rate rose a percentage point. The increase in
the funds rate was brought to an end by a large increase in the target for nonborrowed reserves.8 A t
its meeting on October 5, the FOMC formally
dropped M1 as a target of policy. It was argued
that M1 for the time being was no longer a useful
target because the maturing of All Savers Certificates in October and the introduction of money
market deposit accounts in December would render
its behavior difficult to interpret. Formally, M2 and
M3 were retained as targets, but the Record of Policy
Actions for the October 5 FOMC meeting indicates
that continued growth above their target ranges
would not affect the funds rate.
Higher rates of growth of Ml in the last half of
1982 could have been achieved through raising the
Ml target and retaining the new operating procedures. Instead, the new procedures were phased out.
The funds rate was lowered, primarily as a consequence of a series of reductions in the discount rate,
and whatever increase occurred in the rate of growth
of M1 was accepted. Initially, this reduction in the
funds rate caused the bond market to rally. The
market apparently viewed the reduction in the funds
rate as a judgment by the Fed that the level of
market rates necessary in order to control inflation
had fallen. This judgment was apparently accepted
by the market on the basis of the sustained reduction
in inflation that had occurred and on the basis of the
anti-inflationary credibility that the Fed had established in 1981. In retrospect, the process of lowering
market rates ended in December when a reduction in
8

The following discussion is contained in the annual
report of open market operations for 1982 by the New
York Desk:
. . . it was clear that mechanical adherence to
reserve path procedures would result in a borrowing gap in the final two weeks of around $900
million (even before any allowance for special
situation borrowing), implying considerable upward interest rate pressure. The Committee
reviewed recent developments at a conference

call on September 24.

It was the Committee

consensus that some accommodation of the more
rapid growth of money was consistent with the
directive adopted at the August meeting in view
of the strength in N O W accounts, the overall
weakness in-the economy, and the fragility o f
worldwide financial conditions. Hence, the nonborrowed reserve path was adjusted to limit
implied borrowing to the $500 million to $550
million area. [italics added] [“Monetary Policy
. . .” (1983), p. 53]

30

the discount rate of half a percentage point left
intermediate-term and long-term rates unchanged.
By December, investors had again become concerned
over a resurgence of M1 growth.
10. Evaluating the October 1979
Operating Procedures
It is difficult to evaluate the post-October 1979
procedures. First, for a variety of reasons, they were
not implemented consistently over the interval from
October 1979 until their demise in 1982. In spring
1980, they were superseded by the SCRP, the objective of which was to control credit, not money. In
early summer 1981, they were overridden. Second,
the new procedures were extremely complicated from
a technical standpoint. Monetary control was effected
through the funds rate. The funds rate was determined indirectly by the level of borrowed reserves,
which was in turn determined by the nonborrowed
reserves target, given the predetermined demand for
required reserves and the demand for excess reserves.
Despite the difficulty in evaluating the new procedures, there is reason to believe that they were not
well designed for purposes of monetary control. [A
similar conclusion is reached in McCallum (1985).
Lindsey (1984) reaches a different conclusion.]
Most important, they possessed the same basic defect
as the pre-October 1979 operating procedures. The
new procedures, like the old, effected monetary control through the funds rate. Neither before nor after
October 1979 was there a reliable model that could
determine the value of the funds rate that would
produce the targeted value of the money supply. By
default the new procedures, like the old, relied on a
simple feedback mechanism whereby, as long as an
overshoot of the money supply target existed, the
funds rate would rise, and conversely. The presumption was that the old procedures of monetary
control had failed not through inherent problems with
using the funds rate to effect monetary control, but
rather because of strict limitations in the allowable
magnitude of changes in the funds rate. Similarly,
it was assumed that the new procedures would work
because of the virtual elimination of a constraint on
the magnitude of changes in the funds rate.
The simple feedback mechanism of the new monetary control procedures for determining borrowed
reserves and the funds rate, taken in combination
with the lags inherent in monetary control, appear in
retrospect to have produced an overshooting and
undershooting of the funds rate necessary in order to

ECONOMIC REVIEW, MARCH/APRIL 1986

achieve the M1 target.9 Judged by the experience in
the last half of 1980 in particular, a money supply and
funds rate cycle would begin with a funds rate too
low to prevent a monetary acceleration. Initially, the
monetary acceleration would proceed while the funds
rate would be little changed, but later the funds rate
This behavior of the funds rate
would rise sharply. 10
may have been produced by the administration of the
discount window. When banks had been out of the
discount window, a rise in borrowed reserves would
initially have little impact on the funds rate. After
banks had been in the window for some time, however, the new, higher level of borrowed reserves
would produce a sharp rise in the funds rate. The
sharp rise in the funds rate in time would produce a
monetary deceleration and an eventual sharp drop in
the funds rate.1 1
11. Summary
In the preceding paragraphs, a chronological account was offered of the formulation and implementation of monetary policy in the early 1980s. The
character of monetary policy during this period was

shaped by a concern over the high rate of inflation.
It is, nevertheless, misleading to speak of a monetarist experiment. Policy actions were not guided
by a rule.
The post-October 1979 operating procedures incorporated significant concessions to monetary control. Short-term targets for M1 were derived from
annual targets and significant movement in the funds
rate was permitted. The new procedures adopted
nonborrowed reserves targeting. Given lagged reserve accounting, however, nonborrowed reserves
targeting resulted in a monetary control procedure
that worked through the funds rate. The new procedures, then, possessed the same problem as the old
procedures, namely, the absence of an analytical
model that could be relied upon in practice to determine the value of the Desk’s operating variable from
the money supply target. Consequently, changes in
the funds rate had to be determined by a rule of
thumb. It was argued that the new procedures contributed to unnecessary movements in the money
supply and interest rates.

References
9

Goodfriend et al (1986) address the issue of whether
the new procedures induced cyclical movements in the
funds rate and, by implication, the money supply. According to their analysis, the resolution of this issue
depends upon whether the level of borrowed reserves was
set using the rule of thumb outlined in the initial descriptions of the new procedures or whether it was set
on the basis of an analytical model capturing the relationship, running through the funds rate, between borrowed
reserves and M1. Which assumption is a more appropriate description of the post-October 1979 operating
procedures is an empirical issue not dealt with in their
paper.
10

Examination of the annual reviews of open market
operations published in the Federal Reserve Bank of
New York Quarterly Review reveals that only twice was
the target for nonborrowed reserves chanced promptly
upon the first appearance of a miss of the M1 target
(March 1980 and May 1981). (The nonborrowed reserves
target was changed on other occasions in response to a
persistent miss of the M1 target.) Prompt alterations of
the nonborrowed reserves target after an M1 target miss
would have evened out this temporal pattern of the
funds rate.
11

Furthermore, the inflationary environment of the early
1980s and the rise in the magnitude of the government
deficit seemed to produce a belief among participants in
the bond market that the level of interest rates would
have to rise in order to contain inflation. There was,
however, great uncertainty over what rise in interest
rates would be required.
In this uncertain financial
environment, participants in the bond market watched the
funds rate closely for information as to the Fed’s judgment of what rate of interest would provide for monetary
control. Consequently, changes in the funds rate were
passed on to the entire maturity spectrum of interest
rates.

Axilrod, Stephen H. “Federal Reserve Staff Study of
the New Monetary Control Procedure: Overview
of Findings and Evaluation,” in New M o n e t a r y
Control Procedures, vol. I, Washington DC: Board
of Governors of the Federal Reserve System, February 1981.
Bennett, Barbara A.
“‘Shift Adjustments’ to the
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San Francisco, Economic Review (Spring 1982),
pp. 6-18.
Board of Governors of the Federal Reserve System.
65th Annual Report, 1978.
. “The New Federal Reserve Technical ProAppendix to
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1980a. (Mimeographed.)
. 68th Annual Report, 1981.
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“Minutes of Discount Rate Actions.”
November 19, 1982b.
Broaddus, Alfred, and Marvin Goodfriend. “Base Drift
and the Longer Run Growth of M1: Experience
from a Decade of Monetary Targeting.” Federal
Reserve Bank of Richmond, Economic Review 7 0
(November/December 1984), 3-14.
Davis, Richard G. “Monetary Aggregates and the Use
of ‘Intermediate Targets’ in Monetary Policy,” in
New Monetary Control Procedures, vol. I, Washington DC: Board of Governors of the Federal
Reserve System, February 1981.

FEDERAL RESERVE BANK OF RICHMOND

31

Goodfriend, Marvin. “A Model of Money Stock Determination with Loan Demand and a Banking System
Balance Sheet Constraint.” Federal Reserve Bank
of Richmond, Economic Review 68 (January/February 1982), 3-16.
“Discount Window Borrowing, Monetary
Policv.’ and the Post-October 6, 1979 Federal Reserve Operating Procedure.” Journal of Monetary
Economics 12 (September 1983), 343-56.
Gary Anderson, Anil Kashyap, George
Moore, and Richard D. Porter. “A Weekly Rational
Expectations Model of the Nonborrowed Reserve
Operating Procedure.” Federal Reserve Bank of
Richmond, Economic Review 72 (January/February 1986), 11-28.
Hetzel, Robert L. “The Federal Reserve System and
Control of the Money Supply in the 1970s.” Journal
of Money, Credit and Banking 13 (February 1981),
31-43.
“The October 1979 Regime of Monetary
Control and the Behavior of the Money Supply in
1980.” Journal of Money, Credit and Banking 1 4
(May 1982), 234-51.
Levin, Fred J., and Paul Meek. Implementing the
New Operating Procedures: The View from the
Trading Desk,” in New Monetary Control Procedures, vol. I, Washington DC: Board of Governors of the Federal Reserve System, February
1981.
Lindsey, David E., Helen T. Farr, Gary P. Gillum,
Kenneth J. Kopecky, a n d R i c h a r d D . P o r t e r .
“Short-run Monetary Control, Evidence Under a
Nonborrowed Reserve Operating Procedure.” Journal of Monetary Economics 13 (January 1984),
McCallum, Bennett T. “On Consequences and Criticisms of Monetary Targeting.” Journal of Money,
Credit and Banking 17 (November 1985, Part 2),
“Monetary Policy and Open Market Operations in
Federal Reserve Bank of New York,
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1980.” Federal Reserve Bank of New York,
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“Monetary Policy and Open Market Operations in
1981.” F e d e r a l R e s e r v e B a n k o f N e w Y o r k ,
Quarterly Review 7 (Spring 1982), 34-53.
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Nordhaus, William. “A Map for the Road from Dunkirk.” New York Times, March 21, 1982.
Simpson, Thomas D., and John R. Williams. “Recent
Revisions in the Money Stock.” Federal Reserve
Bulletin 67 (July 1981), 539-42.
Tinsley, Peter A., Helen T. Farr, Gerhard Fries, Bonnie
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32

Volcker, Paul A. “A Time of Testing.” Speech before
the American Bankers Association, October 9,
1979a. (Mimeographed.)
“Statement” before the Joint Economic
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“Statement” before the Subcommittee on
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on Banking, Finance and Urban Affairs. F e d e r a l
Reserve Bulletin 65 (December 1979c), 968-62.
. “Statement” before the Joint Economic
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1980a), 137-143.
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“Caperton Lecture.” Speech at Vanderbilt
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“Statement” before the House Committee
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(March 1982b), 167-70.
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Committee.
1982d), pp. 406-9.
. “Statement” before the Committee on
Banking, Housing and Urban Affairs. F e d e r a l
Reserve Bulletin 68 (August 1982e), pp. 487-94.
“Statement” before the Joint Economic
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“Statement” before the Joint Economic
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1983a), 80-9.
“Statement” before the Senate Committee
on Banking, Finance and Urban Affairs. F e d e r a l
Reserve Bulletin 69, (March 1983b), 167-74.
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North ‘America, April 28, 1983c. (Mimeographed.)
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Housing and Urban Affairs, 98th Cong., 1st sess.,
July 14, 1983d.
Wallich, Henry C. “Monetary Policy in an Inflationary
Environment.” Speech before the American Bankers Association, March 7, 1980. (Mimeographed.)
Woolley, John T. Monetary Politics: The Federal
Reserve and the Politics of Monetary Policy. New
York: Cambridge University Press, 1984.

ECONOMIC REVIEW, MARCH/APRIL 1986

REAL BUDGET DEFICIT IMPLICATIONS
OF GRAMM-RUDMAN-HOLLINGS
William G. Dewald*

My article in the November/December 1985 issue
of this Review explained how implementing the August 1985 Congressional Budget Resolution would
have virtually eliminated the deficit in real (or
inflation-adjusted) terms in the next few years.l I n
December, the Gramm-Rudman-Hollings (GRH)
balanced-budget law was enacted. It mandates reducing the nominal budget deficit by about $35 billion
per year, achieving balance in 1991. The present
note translates GRH nominal deficit targets into real
terms on the basis of Congressional Budget Office
(CBO) inflation projections made in February 1986.
This conversion is important to the extent that realnot nominal-deficits influence saving, investment,
and international capital flows. There are two equivalent ways to measure the real budget deficit correctly :

• One is to calculate the annual change in the
outstanding federal debt in real terms. As the
table shows, at the beginning of fiscal 1986, the
nominal federal debt was $1,509.9 billion. At
the end of fiscal 1986, if the CBO deficit projection is achieved, the debt will be $1,714.6
billion, an increase of $204.7 billion. Given the
3.4 percent projected inflation rate for 1986,
that debt would be worth only $1,658.2 billion
($1,714.6 billion/1.034) in terms of 1985
* Economist, U. S. Department of State, and former
Professor of Economics at Ohio State University and
Editor of the Journal of Money, Credit and Banking.
Views expressed in this note are solely those of the
author and not necessarily those of the Department of
State, the Federal Reserve Bank of Richmond, or the
Federal Reserve System.
1

William G. Dewald, “CBO and OMB Projections,
Adjusted for Inflation, Show Federal Budget Deficit
under Control.,” Federal Reserve Bank of Richmond,
Economic Review (November/December 1985), pp. 1.5-22.

prices. Hence the real deficit in terms of 1985
prices would be $148.3 billion ($1,658.2 billion
- $1,509.9 billion).
•

The other way to calculate the real budget
deficit is to subtract from the nominal deficit
the depreciation in the value of outstanding
federal debt due to inflation. For example, the
projected 1986 nominal deficit of $204.7 billion
is adjusted for inflation by subtracting the 3.4
percent projected depreciation in the value of
outstanding federal debt due to inflation. Then
this difference is deflated by the price level in
terms of 1985 prices to obtain, as before, a
$148.3 billion real deficit,
$204.7 billion - (.034 x $1,509.9 billion).
1.034

If annual inflation should stabilize at 4.1 percent
by 1991 as CBO projected and GRH nominal deficit
targets are met, these calculations show that the outstanding federal debt-to-GNP ratio would peak at
41.3 percent in 1987 and then begin to decline. The
debt to GNP ratio is recorded in the table and plotted
in Chart 1. Correspondingly, the real deficit would
decline each year beginning this year until it was
eliminated in 1989, two years before the nominal
deficit is eliminated. The real deficit is also presented
in the table and plotted in Chart 2. By 1991, when
GRH targets a balanced budget, these calculations
based on CBO inflation and GNP projections show
that there would be a real federal budget surplus

equal to 1.4 percent of GNP. Thus, even moderate
inflation, once taken into account, has a substantial
effect on the measurement of federal budget deficits,
which was the main point of my earlier article.

FEDERAL RESERVE BANK OF RICHMOND

33

GRAMM-RUDMAN-HOLUNGS REAL DEFICIT PROJECTIONS
(Fiscal Years, Billions of Dollars, and Percent)

(1)

(2)

Nominal
Deficit

Fiscal
Year

1984

a

185.3

1985

a

212.3

(4)

(3)

Publicly
H e l d D e b td

l n f l a t i o ne

1,141.8
1,312.6

Price Level
1985=100

(5)
Real
Deficit

(6)

G N Pe

(7)

Real GNP

(8)
Nominal
Deficit/
GNP
(1)/(6)

(9)

(10)

Real
Deficit/
Real GNP

Publicly
Held Debt/
GNP*

(5)/(7)

(2)/(6)

3.8

96.5

147.1

3,695

3,829

5.0

3.8

35.5

3.6

100.0

165.0

3,937

3,937

5.4

4.2

38.4

3.4

103.4

148.3

4,192

4,054

4.9

3.7

40.9

4.0

107.5

70.2

4,504

4,190

3.2

1.7

41.3

4.1

111.9

28.4

4,838

4,324

2.2

0.7

40.6

5,214

4,476

1.4

-0.2

39.1

204.7

b

1,509.9

1987

144.0

c

1,714.6

1988

108.0 c

1,858.6

1989

72.0 c

1,966.6

4.1

116.5

-7.4

1990

36.0 c

2,038.6

4.1

121.3

-39.2

5,619

4,632

0.6

-0.8

36.9

1991

c

2,074.6

4.1

126.3

-67.3

6,047

4,788

0.0

-1.4

34.3

1986

O.O

Source: Congressional Budget Office,
a

a

The Economic and Budget Outlook, February 1985 and 1986 except as noted.

Actual.

b

CBO,

An Analysis of the President’s Budgetary Proposals for Fiscal Year 1987, February 1986, Summary Table 1, p, viii.

C

Legislated targets.

d

Beginning of fiscal year. Projected financing other than borrowing from the public 1987-1991 assumed zero.

e

f

CBO projections, 1986-1991.
Publicly held debt, end of fiscal year.

Chart 2
Chart 1

GRAMM-RUDMAN-HOLLINGS
PUBLICLY HELD DEBT RATIO

Fiscal Years

34

ECONOMIC REVIEW, MARCH/APRIL 1986

Deficit Projections