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norme
eview

F E D E R A L R E S E R V E B A N K OF ATLANTA

RECESSION
UNEMPLOYMENT

A
JULY/AUGUST 1980

How Bad Will It Be?

Southeast H i t by Rising Energy Costs

BANKING
MONEY

Offshore Activity Expands

Interest Rates and Monetary Policy

WORKING PAPER

REVIEW
w

•

H o m e Office Pricing

Questions and Answers

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JULY/AUGUST 1980, E C O N O M I C REVIEW

page 4

page 12

page 16

page 22

The Recession:
How Bad Will It Be?
Based on past recessions and recent developments,
how severe will the downturn be this time around?
Harry Brandt and Charles J. Haulk compare our current
experience with 1973-75, focusing on several key
variables and structural changes in the economy.

Questions and Answers
on Unemployment
12
In our September/October 1979 issue, Charlie Carter
analyzed the unemployment outlook based on his
research on discouraged workers and part-time
workers. In this question and answer format, he
updates that outlook and discusses the impact of
discouraged and part-time workers on unemployment
figures.

Rising Energy Costs Hit
Southeast Crop Production
16
How have increased energy costs affected agriculture
in the Southeast? Gene D. Sullivan examines energy's
role in the cost of crop production, how energy costs
will influence planting decisions, and how such costs
will affect the Southeast's competitive position relative
to other parts of the country.

U.S. Banks Expand Offshore
Banking in Caribbean Basin
22
The rapid expansion of U.S. banking activity in the
Caribbean has meant an economic surge for the offshore banking centers and more flexibility for U S
banks. Stuart Hoffman describes the impact of this
activity, the advantages for U.S. nonbank customers,
and the effect on money supply measurements

Monetary Policy and Interest Rates
26
Much recent discussion in the press and among economists has focussed on the relationship between
monetary policy and interest rates. In this issue's Commentary, Financial Economist Robert E Keleher argues
that interest rates can be misleading if they are taken as
an indicator of monetary policy.

Working Paper Review
Home Office Pricing:
30
The Evidence from Florida
When Florida enacted limited branch banking legislation in 1976, researchers were presented with an unusual opportunity to examine how changes in the
structure of a multibank holding company affect its
pricing behavior A review of David D Whitehead's
Working Paper.

Director of Research: Harry Brandt
Associate Director: W i l l i a m N. C o x III
Business Editor: Gary W. T^pp
Production and Graphics:
Susan F. Taylor and Eddie W. Lee, Jr.

page 26

V O L U M E LXV, N O . 4

page 30

The Recession: How
Bad Will It Be?
by Harry

Brandt

and Charles

Haulk
A Look at the Last Recession

Some characteristics of the current recession
resemble the 1973-75 period, the longest and
most severe recession since World War II. But
several key differences suggest the downturn
will be less deep than last time: much of the
current inflation is demand-pull instead of
supply-induced, the Federal budget is more
stimulative this time, inventories have been
better managed, employment has shifted
toward less volatile industries and government
transfer payments have increased sharply.

T h e r e h a v e b e e n six r e c e s s i o n s s i n c e W o r l d
W a r II (see Table). T h e ' 7 3 - 7 5 b u s i n e s s
r e c e s s i o n w a s t h e longest. It lasted s i x t e e n
m o n t h s a n d also w a s t h e m o s t s e v e r e o f t h e
six c o n t r a c t i o n s .
RECESSIONS
S I N C E W O R L D W A R II

Nov.
July
Aug.
Apr.
Dec.
Nov.

'48 - O c t . '49
'53 - M a y '54
'57 - A p r . '58
'60 - F e b . '61
'69 - N o v . '70
'73 - M a y '75

Length

Severity

No. of Mos.

Real G N P Industrial Production

10
8
10
11
16

-1.4%
-3.3
-3.2
-1.2
-1.1
-6.6

- 7.5%
- 8.1

-11.3
- 7.5
- 5.6
-13.9

Last recession was long and severe because:

Auto Sales...

Inflation Rate, led by oil
prices...

Housing Starts.

fell sharply in 1973 as.

climbed,

plummeted and.

JULY/AUGUST 1980, E C O N O M I C REVIEW

Why was the '73-75 recession so steep
and long? The oil embargo which started in
November '73 (the first recession month)
was the straw that broke the economy's
back. Auto sales, which had started to
weaken even before the oil embargo, then
fell sharply (Chart 1).
Another depressing influence was the
rapid inflation, pinching consumer
purchasing power (Chart 2). The inflation
was fueled by: (1) demands that exceeded
available supplies, (2) rising food prices
(due partly to the '72 drought), (3) the
quadrupling of oil prices, (4) off-again, onagain wage and price controls, and (5) the
dollar devaluation in February '73 and
further decline in the dollar's exchange rate
that raised the prices of foreign goods sold
in the United States.
Two developments intensified the last
recession. O n e was the slump in residential
construction, particularly apartments and
condominiums. Housing starts fell from a
2.4-million peak to 1.0 million (Chart 3).
The other was speculative buying and
hoarding by businesses, which resulted in
an enormous inventory buildup (Chart 4).
The subsequent inventory liquidation

required sharp production cutbacks and
huge layoffs. The unemployment rate,
consequently, soared to 9 percent (Chart
5).
What was the monetary and fiscal policy
response to this environment? The Federal
Reserve initially moved to a less restrictive
policy, and this relaxation along with the
lower credit demands caused interest rates
to fall (Chart 6). But because of rapid
inflation, the Federal Reserve in early '74
retightened, despite the evidence of
recession, and it was not until autumn '74
that it acted to stimulate the sagging
economy. By early '75, Congress joined to
pass a $22-billion tax cut; and even though
the recession ended in May '75, the Federal
Reserve — concerned over high
unemployment — continued on an
expansive monetary policy well into '76.

The Current Recession:
Will History Repeat?

The economic variables which are most
likely to shed light on the course of future
developments are: inflation, the Federal
deficit, interest rates, inventories, the
savings rate, and the structure of the

In response, the Fed eased,
retightened on account of
inflation...

Unemployment Rate.

Business Inventories

Rt.
Federal
— Funds
Rate

% at Ann. Rt.
=
10
Change in M l - A

1972

1973

1974

1975

were too high, causing production cutbacks. Subsequently, the...

1972

1973

1974

1975

soared.

Gray area between dashed lines indicates recession.

FEDERAL RESERVE B A N K O F ATLANTA 5

1972

1973

1974

1975

but then eased further.

1976

economy. Since many people fear we
could repeat our last recession, let us
delineate differences and similarities with
the 1973-75 experience.

Inflation Is Mostly Demand-Pull
This Time

O n the surface, the 1979-80 inflation
appears to be as bad as, if not worse than,
the inflation of 1974-75; so we might expect
the downturns to be similar. While it is true
that consumer price inflation — that most
publicly visible rate of inflation — has
exceeded rates of 1974, the broader rate as
measured by the G N P deflator has not
achieved the 1974 rates (at least as of May
1980).
Inflation continued to climb in the
recession of 1974 and did not peak until
the recession was three quarters old.
Consumer price inflation bounced around
12 percent until fourth quarter 1974,
thereafter showing marked improvement
(Chart 7).
Inflation was worsening rather than
improving, largely because of the
tremendous worldwide commodity
inflation in 1972-73, which was still feeding
into final products throughout most of 1974

despite the contraction of real activity
through 1974. However, the contraction in
final sales through the first three quarters
was not sufficient to force postponement
or cancellation of cost passthrough into
prices. Not until the full effect of the credit
crunch of July and August took hold did
sales collapse. After that, prices moderated
slightly.
Our recent inflation experience is
different from 1974. The '74 inflation was in
large part a supply phenomenon, with
shortages, oil price hikes, and world
commodity inflation imposed on the U.S.
The inflation of 1979-80 — although also
significantly influenced by oil price hikes —
is, on the other hand, more of a demandpull phenomenon combined with changes
in the structure of the economy which
make it increasingly biased toward inflation.
Internal demand-pull inflation should be
more responsive to demand restraints than
inflation induced by external supply factors.
Only in two recessions since World War II
(1957-58 and 1973-75) has inflation not
yielded quickly to weakening demand
either before or at the onset of recession.
Both were bad recessions.

While '79-'80 inflation was
initially higher than , 74...

Some people fear we
could repeat our last
recession

G N P Deflator
1973

1974

1979

1980

it yielded faster to weakening demand.

JULY/AUGUST 1980, E C O N O M I C REVIEW

O n e final point: The Consumer Price
Index was propelled to the 18-percent rate
of the first quarter, partly by the rapid rise
in mortgage interest rates. More recent
softening in these rates could begin to
show up as early as July. (Changes in
conventional mortgage rates are not
reflected for a month or more in the
index.) Some price relief, in fact, has
already occurred. The index in April and
May rose at an 11-percent rate.

Federal Budget More Stimulative
in 1980

In 1973, Federal expenditures contracted in
inflation-adjusted terms and remained flat
in 1974. Combined Federal, state, and local
budgets moved into surplus, thereby acting
as a drag on the economy, even though
real activity was contracting. The Federal
budget dropped from a $20-billion-a-year
deficit in late 1972 to a $5- to $7-billion
deficit through most of 1973 and 1974. The
fall in receipts in fourth quarter 1974 and
first quarter 1975 produced a deficit of $50
billion (Chart 8). The combined budgets
finally moved to a stimulative position in
fourth quarter 1974, after being mildly

restrictive for the first three quarters of the
recession.
After moving toward restraint in the first
half of 1979, the Federal budget became
increasingly stimulative for the last three
quarters, with expenditures increasingly
outpacing receipts. State and local budgets
have maintained a $20- to $25-billion
surplus but will probably move toward
balance over the next quarters, as receipts
fall.
In sum, the fiscal policy of 1974-75 was
one of too much restraint during the early
part of the recession and then perhaps too
much stimulus after recovery was under
way. In contrast, in 1979-80, the move
toward more stimulus came prior to the
onset of recession. Automatic fiscal
stabilizers are now under way to relieve
some recession-induced hardships.

Drop in Interest Rates May Mean
Quick Recovery

The typical pattern of interest rates would
be for Treasury bill rates to peak almost
coincidentally with a business cycle peak.
During 1974, the bill rate did the unusual.
After peaking in late 1973, which was

Federal Deficit held steady
far into last recession, but...

...but key variables
suggest a repeat is not
likely.

this time a spending increase created earlier stimulus.
Dashed line indicates beginning of recession.
FEDERAL RESERVE B A N K O F A T L A N T A

rates fall by 8 to 9 percentage points in a
matter of weeks; even mortgage rates have
dropped 3 to 4 percent. This sharp drop,
while indicative of falling activity, is setting
the stage for a quick recovery, especially in
housing (Chart 10). Less — rather than
more — monetary growth has
accompanied the decline in interest rates;
however, since April, growth in the
aggregates has picked up (Chart 11).

almost coincidental with the onset of
recession, the bill rate fell for a few months
before rising to another peak in August
1974, nine months after the start of
recession. With the current recession dated
as starting in February, we have a near
coincidence of the peak in Treasury bill
rates and the peak in real activity. Longterm government bond rates typically also
peak coincidentally with a real activity
peak. Again, we have a typical pattern in
long-term rate behavior — if not in degree,
at least in timing (Chart 9).
In 1974, we were subjected to double
peaks in short rates and a long lag after
recession-onset to the second peak in rates.
The rising rates during the recession
undoubtedly contributed to the extreme
severity of the late 1974-early 1975 drop in
activity. After short rates peaked in July,
they fell less than a point per month
through the end of 1974. The Federal funds
rate dropped from 12.92 percent in Ju ly to
8.53 percent in December. Rates on
conventional mortgages continued to rise
slowly for several months after July, before
falling slowly in early 1975.
In 1980, we have seen rates climb to
unprecedented levels and we have seen

Rise in 3-Month Treasury
Bill Rate during last recession was unusual, but...
kJ

Inventories Safer This Time

Business inventories grew very rapidly in
late 1973 and early 1974. As a result of
slowing sales, the ratio of inventories to
sales rose throughout 1973 and then sharply
in late 1974, as sales collapsed. Despite
massive cutbacks in output in late 1974 and
early 1975, inventories continued to climb
through first quarter 1975. Both durables
and nondurables inventories surged relative
to sales during 1974.
In 1979, on the other hand, durables
inventories rose relative to sales but were at
reasonably safe levels in first quarter 1980.
Further declines in sales in the second
quarter could push that ratio higher, but it
would appear that the rapid output
declines in April and May may be sufficient

increased monetary growth
since April.

Housing starts.
%

Mil. Units at Ann. Rt. 1 1

IP)

1
M1-A
-

1973

— 370

1974
1973
^

1979

—380

1980

sharp '80 drop may mean
quick business recovery.

1979

1974
^

1980
-

1980

J \

Federal
Funds
R a t e
N/v*
1980

%
_

- i o

will benefit from lower interest rates and...

JULY/AUGUST 1980, E C O N O M I C REVIEW

to prevent inventories from rising rapidly
(Chart 12).
The key will be in the pace of sales. At
this point, it would appear that durable
goods production is in for a period of
some retrenchment as manufacturers try to
avoid further inventory buildup.
Nondurables inventories went into the
downturn basically in check. Overall,
inventories have declined in real terms
since the third quarter of 1979 and do not
seem to be as seriously out of balance as in
late 1974. Lower interest rates could
encourage inventory building.

Savings Rate Differs

The behavior of savings is obviously very
crucial at this time. This may be the single
most important item in the real economy
to watch. It holds the key to the depth and
length of the recession, since inventories
were generally in check at the onset of
recession, but that was also true in 1970,
when an increase in the savings rate led to
a sharp rise in the inventory-to-sales ratio.
In 1973, as well, the consumer was
becoming more cautious. The savings rate
began climbing in the third quarter of 1972
from just under 6 percent and continued to

Business Inventories, high

in '73...

Low Personal Savings Rate
at current recession's onset...

Bil. $ at Ann. Rt.

% of Disp. Income

1973

were at safer levels this
time.

rise throughout 1973 (Chart 13), hitting 8.5
percent in the fourth quarter (the quarter
the recession started).
For the next three quarters, the savings
rate fell back rather sharply as disposable
income contracted, thus preventing real
final sales from dropping appreciably
despite weakness in durable goods and
construction. Real G N P was declining
slowly during the period as the rate of
inventory accumulation dropped. The
savings rate jumped upward in the fourth
quarter of 1974 and dropped back before
climbing to nearly 10 percent in the second
quarter of 1975 as a result of the tax rebate
program.
This time we have a somewhat different
pattern. By summer 1979, most observers
had concluded that a recession was under
way, based on April and May data that
showed clear signs of contracting activity.
But as we are aware now, the consumer
was having none of it and quickened the
pace of consumption outlays by reducing
dramatically the portion of income saved.
The savings rate, instead of climbing several
quarters prior to the recession, rose only
briefly in the first half of 1979 before
dropping to record low levels for the next

1974

holds key to this recession's
depth and length.

Dashed line indicates beginning of recession.
FEDERAL RESERVE B A N K O F ATLANTA

three quarters. The drop in the savings rate
kept final sales growing in real terms
despite no growth in real disposable
income. Durable goods sales remained
steady at just above the second-quarter
1979 level for three quarters. Meantime,
inventory accumulation declined to zero by
the first quarter.
We have seen some movement toward a
higher savings rate in March and April of
this year. A n increase in the savings rate
from 3.5 percent of disposable income (its
first-quarter level) to 5.5 percent would
entail a $35-billion cut in consumer
expenditures. That large a decrease in
spending would be a blow to an already
contracting economy. A rise to a more
traditional savings level of 6.0 or 6.5 percent
would be an even bigger shock to the
economy. Most likely, however, any
consumer retrenchment will be fairly shortlived and not of the magnitude that would
send the economy into a long nose dive.
Over the long run, as inflation subsides,
higher rates of saving should be expected
and desired.

The Structure of the Economy

Any attempt to draw inferences about the
current business cycle by examining

previous cycles must also consider the
important structural changes that occur
over time. These changes can create some
uncertainty in our comparisons and
inferences.
Three important structural changes in our
economy over the past two decades have
been: (1) the declining share of
manufacturing employment and the growth
of service and government employment, (2)
the increasingly large role government
plays in the economy, and (3) the growth
of what is called the underground
economy.
The shift in composition of employment
has been moving toward a smaller share of
manufacturing employment (both durables
and nondurables) for many years (Chart
14). The share of manufacturing
employment has dropped from 35 to 24
percent since 1952. This decrease has been
about evenly split between durables and
nondurables. The share of construction
employment has also drifted slightly lower
since 1960. These decreases in share have
been matched by increased service and
government shares.
Manufacturing, particularly durable
goods, and construction are by far the most

Declining share of Manufacturing Employment reflects ...

shift to recession-resistant
service and government sectors.
Gray area between dashed lines indicates recession.

J U L Y / A U G U S T 1980, E C O N O M I C

REVIEW

cyclically volatile due to their sensitivity to
interest rates. As their share of total
employment declines, the economy
becomes more resistant to downturns than
in the 1950s, when durable goods manufacturing plus construction represented 26
percent of total employment, compared to
19.5 percent in 1980. This tendency is
further enhanced by the fact that the
employment share lost by manufacturing
and construction is now in the service and
government sectors, which tend to be
much less sensitive to interest rate changes.
Another important structural change is
government's role in the economy. This
can be seen most readily by the share of
government transfer payments in total
income. In 1965, they amounted to 7.6
percent. By 1979, they were 13.3 percent,
nearly doubling in 14 years. The share of
transfer payments increases during a
recession. The point here is that
government's role in the economy has
tended to create built-in resistance to
downturns and to create stimulus during a
downturn.

upshot is that the economy is harder to
push into recession and has a built-in
tendency toward a quick recovery.
The role of the underground economy in
producing an inflationary bias has been
discussed elsewhere and need not be
reviewed here.1 Since the underground
economy is heavily service-oriented and
aims principally to avoid taxes, the
underground economy is arguably a
stabilizing factor (i.e., it has a countercyclical effect on downside forces in a
recession).
It appears, then, that we may have seen
the worst part of the slide already, and the
inflation during the second half of 1980
may be lower than in the first. If so, the
recession will most likely be less deep than
in '73-'75. The unemployment rate,
however, could conceivably go to 9
percent even under those circumstances.
Although that would be as high as in 1975,
the unemployment rate at the start of this
recession was 6.0 percent, compared to 4.8
percent in 1973; so 9 percent would not
represent as much increase as in 1973-75. 0R]

These two structural changes have been
under way for about two decades and have
continued since the 1973-75 recession. The

'See Charles J . Haulk, "Thoughts on the Underground Economy," this
Review, March/April 1980, pp. 23-27.

"It appears ...that we have seen the
worst of the slide already, and the
inflation during the second half of
1980 should be lower than the first."

FEDERAL RESERVE B A N K O F ATLANTA

Questions
and
Answers
on Unemployment

Accompanying the rising unemployment rate
during the current recession are public uncertainties about the measurement and meaning of
the unemployment rate. Based on his research
on discouraged workers and part-time workers,
Business Economist Charlie Carter responds to
questions about the measurement of unemployment and its outlook for the rest of the year.

with

In our September/October 1979
Review, you predicted that, based
on the data for discouraged
workers and part-time workers, unemployment would rise from then until the end of
1980. H o w does the situation look now?

Q
~
A

Those predictions are turning out
to be quite accurate. The national
unemployment rate reached a
ow point of 5.6 percent in June of last
year, gradually rose through March 1980,
and has increased noticeably thereafter. I
see no reason to alter my prediction from
last fall that the national unemployment
rate could easily get above 9 percent
before the recession is over.
12

Charlie

Carter

DO you see any special characteristics in the unemployment pat-

tern of the current recession?
Some analysts, for instance, are saying that
the U.S. auto industry will be depressed for
much longer than the rest of the economy.

Unemployment in the automobile
industry is largely attributable to
its inability to adjust to the sharp
increase in the relative price of energy and
the shift in consumer preferences to
smaller fuel-efficient automobiles. This is
likely to plague the automobile industry
with under-utilization of capital and
workers for a period well after repercussions of the current recession are over.
JULY/AUGUST 1980, E C O N O M I C REVIEW

You say t h e n u m b e r of discouraged workers (people w h o are
not currently seeking w o r k
)ecause they think they cannot find a job)
increases during e c o n o m i c contractions.
H o w long after t h e low point of a recession
does it usually take for discouragement to
decline?
• J

Discouragement ypically drops within one
quarter after the ecession ends.

The lags are short. My research
indicates that discouraged workers
begin to reenter the job market
within one quarter after the recession is
over (see chart for the pattern of discouragement during the last recession).

'70

'72

'74

'76

'78

'80

People who want a job but are not looking for work are categorized by the Bureau of Labor Statistics according to their reasons for not
looking: (1) school attendance, (2) home responsibilities, (3) ill health, (4) think they cannot find a job (discouraged), and (5) other
reasons. S i n c e the number of discouraged workers fluctuates with changes in the working-age population, a more reliable measure is the
ratio of reason (4) to reasons (1-5). This percentage provides a measure of discouragement of those people who want a job but are not
currently seeking work.

Some economists say that discouraged workers should not be
included in the labor force because they are not really "available"
for w o r k . Yet, their inclusion w o u l d have raised the 1978 u n e m p l o y m e n t rate f r o m 6.0 to 6.8 percent. W h a t other effects result f r o m
excluding discouraged workers f r o m the labor force?

Discouraged workers are presently
considered neither employed nor
unemployed but simply not in the
abor force. O n e effect of this exclusion is
that many discouraged workers move from
not in the labor force directly to employment
without ever entering the "unemployed"
category. Therefore, economic upswings
may not produce immediate improvement
\

FEDERAL RESERVE B A N K O F ATLANTA

in measured unemployment. For example,
the entry of women into the labor force
during the past few years occurred with
only gradual reduction in the overall
unemployment rate, since many of them
came from outside the measured labor
force. This experience is likely to be
repeated in 1982-85 as we recover from the
1980-81 recession.

Are there other factors (availability of welfare payments,
unemployment insurance, etc.)
)esides t l e severity of the recession that
put a worker into the discouraged" category?

T h e empirical findings generally
support the view that liberalization of welfare benefits and
expanded coverages under the unemployment insurance program have had an
upward effect on the official unemployment rate. The availability of welfare payA

ln your September/October article, you said part-time workers

might be an important clue to
w h e n unemployment will start to rise. H o w
does the "part-time employment ratio"
behave as the economy comes out of a
recession?

The part-time employment ratio
measures the number of part-

time workers who would not
work full time even if full-time jobs were
available (voluntary part-time workers) in
relation to part-time workers who would
like full-time work but cannot find it (involuntary part-time workers). Hours of fulltime workers are usually reduced in
response to falling demand (actual or anticipated). Therefore, at the early stages of
business downturns, full-time workers
become involuntary part-time workers
faster than voluntary part-time workers
increase, thereby reducing the part-time
employment ratio. Such involuntary parttime workers are treated by the Bureau of
14

ments, for instance, means that people will
not enter the labor force until market
wages reach at least that level. Because this
"reservation wage" has risen with increased
public assistance programs, more people
will stay out of the labor force when they
lose their jobs. However, work registration
requirements probably have had a small
upward effect on the
full-employment
unemployment
rate (the lowest rate of
unemployment which will not result in
increased inflation) and is one important
reason for the downward rigidity (resistance
to decline) of the unemployment rate.

Labor Statistics in some of its definitions of
unemployment as "partly unemployed."
Typically, hours of full-time workers are
reduced before layoffs. As a result, the
part-time employment ratio (the ratio of
voluntary to involuntary part timers) usually
declines sharply preceding and during
recessions, as involuntary part-time workers
(the denominator of the ratio) increase
more rapidly than do voluntary part-time
workers (the numerator of the ratio). The
1980-81 recession is no exception. While
voluntary part timers outnumbered involuntary part timers by a four-to-one margin in
December 1979, there were less than three
voluntary part-time workers for each involuntary part-time worker in May 1980. Based
on the behavior of this ratio in past recessions, the magnitude of this decline suggests that the unemployment rate will
continue to rise for the remainder of 1980
and into the first half of 1981. The behavior
of real output in 1980 and 1981, of course,
will be a very important determinant of
what happens to unemployment.
JULY/AUGUST 1980, E C O N O M I C REVIEW

D o these part-time workers
show up in the u n e m p l o y m e n t
rate w e usually see quoted?

Involuntary part-time workers
are considered unemployed in
some BLS statistics, but the rate
usually quoted in the press does not
include them. By not including these
workers (who want full-time work but
cannot find it), the generally quoted
unemployment rate understates the full
extent of unemployment.
Ik

Could the recent influx of refugees have a significant impact o n
the unemployment rate in the
Southeast?

The influence of Cuban and Haitian refugees coming into the
c o u n t r y on the national unemployment rate is negligible — probably no
more than one-tenth of one percent. The
effect on some cities and demographic
groups, especially in South Florida, is likely
to be considerably greater.
0H

D o you think the apparent expansion of the "underground econ o m y " could be distorting the
official unemployment rate?

That unmeasured economic activity is providing direct and indirect

income and employment for a
large fraction of the population is unquestionably true. But the degree to which this
is occurring is still uncertain.

FEDERAL RESERVE B A N K O F ATLANTA

Rising Energy Costs Hit
Southeast Crop Production
by Gene

Sullivan

That energy costs have risen rapidly is not
news to most people. However, the
potential impact of rising petroleum prices
on southeastern agriculture is probably not
immediately apparent to the majority of the
public. If increased energy costs should
stimulate shifts in agricultural enterprises,
the economy of rural areas could be
sharply changed. O n e needs only to recall
the changes in community infrastructure
that accompanied the shift from cotton to
pine tree production in the hilly areas of
the Southeast three or four decades ago to
realize the importance that major changes
in agricultural enterprises can have on the
economy of the region.
Evidence that energy costs of farmers
have indeed risen abruptly is provided by a
comparison of average prices paid by
farmers for diesel fuel during March of the
past three years (see Chart 1). The price has
doubled since 1978, and most of that
change has occurred within the past year.
Many other items used by farmers in
crop production are dependent upon
petroleum, and the price increase in
petroleum fuels should eventually spread
to those other products as well. The index
of prices paid by farmers for the broad
category of fuels and energy, which
includes diesel, gasoline, electricity, and
other energy sources, has risen about
three-fourths since 1978.
Prices of fertilizers and agricultural
chemicals, though heavily dependent on
petroleum products in the manufacturing
process, have not yet risen as much as the
16

Chart 1
Diesel fuel prices doubled since 1978.

(Cents Per Gallon)

— 100

1978

1979

1980

fuels and energy group. Excess
manufacturing capacity and the relatively
large supplies marketed in 1978 and 1979
may explain the lag in price increases in
these products. However, as production
capacity becomes more fully utilized, it is
likely that prices of fertilizers and chemicals
will also rise to reflect rising energy costs as
well as changes in availabilities and
demands in international markets; data
through the first half of 1980 suggest that
more rapid price increases have indeed
already set in (see Chart 2).
Note: This article's data reflect "normal" expectations. This summer's
drought, however, has materially affected yields and returns for the 1980
crop year.

The cost of energy, especially diesel, gasoline, and electricity, is a factor of rapidly increasing
significance in planting decisions and crop production in the Southeast. Because agricultural
costs in the region include a higher proportion of energy-sensitive items than the rest of the
country, energy costs could eventually diminish the Southeast's competitive position.

Chart 2

Chart 3

Fertilizer a n d c h e m i c a l s c o s t s l a g g e d b e h i n d
fuels, but m a y see more rapid i n c r e a s e s .

E n e r g y c o s t s i n c r e a s e d most for rice, but c o r n
u s e d h i g h e s t proportion of e n e r g y .
($ Per Acre)

(1967 = 100)
Total Variable [ p H T l
(Out-of-Pocket) j
Cost of EnergyCosts
Sensitive Items

'78

'79 '80

Fuel and
Energy

'78 '79 '80
Fertilizer

'78

'79

'80

Agricultural
Chemicals

Index of Prices Paid for Energy-Sensitive Farm Inputs,
March of Each Year.

Energy Costs Could
Affect Crop Choices
The impact on southeastern crop
production from these rising costs for
energy-sensitive items depends largely on
(1) how much of the cost of producing
each crop is accounted for by energysensitive items and (2) how that proportion
varies from one crop to another. If energy
costs should push up variable costs the
same amount for all crops, there would not
FEDERAL RESERVE B A N K O F ATLANTA

'78 '80
Rice

'78 '80
Cotton

'78 '80
Corn

'78 '80
Soybeans

Variable Cost of Production: Selected Crops in
Southeast.

necessarily be an impact on crop
production decisions. But if some crops are
more heavily dependent on energy-related
inputs than others, then with other factors
remaining unchanged, farmers would have
an incentive to switch to crops using less
energy.
Crops are indeed not equal with regard
to the energy required for their production
(see Chart 3). Rice production uses less
energy-sensitive products as a proportion
of total variable costs than do other types
of southeastern crops, but because that
17

usage is dominated by fuels to operate
irrigation pumps, the proportion of energy
costs changed most for rice production
between 1978 and 1980.
Corn production uses the highest total
proportion of energy-sensitive items of all
southeastern crops because of its heavy
dependence on supplemental applications
of nitrogen fertilizer. Yet, because price
increases for fertilizers were less than those
for fuels, the increase in energy-related
costs of producing corn between 1978 and
1980 is not as great as that for producing
rice.
Cotton and soybean production are
intermediate in the proportion of their
costs made up of energy-sensitive items.
The relative increase in energy costs for
cotton was the smallest of the major crops
because of cotton's heavy dependence on
the chemical group (insecticides and
herbicides) which, by the spring of 1980,
had increased less in price than other
energy-related products.
It should be noted that soybean
production might be one of the more
attractive crops available to producers in
1980 from a cost perspective, even though
it uses a substantially higher proportion of
energy-related inputs per acre than does
rice. Its attraction comes from the fact that
during the recent period of record-high
interest rates, the total variable cost per
acre for producing soybeans is estimated to
be less than one-third as much as that for
rice production. The effort to economize
on interest charges for borrowed
production expenditures could offset the
effects of rising energy costs on soybean
production during 1980.
Which of several alternative crops an
individual farmer chooses to produce in a
given year depends heavily on the crop
that offers the greatest margin of return per
acre above variable or out-of-pocket costs.
Because of highly specialized equipment or
other special restrictions regarding crops
that can be grown, the alternative choices
for a particular grower may be strictly
18

TABLE 1
P R O J E C T E D C O S T S AND R E T U R N S
S E L E C T E D S O U T H E A S T E R N C R O P S , 1980
($ Per Acre)

Total
Variable
Cost
Cotton
Corn
Grain Sorghum
Wheat
Soybeans
Peanuts
Rice
Tobacco

241
141
85
76
95
394
310
1,334

Total
Return
392
153
82
124
147
606
423
2,887

Return Over
Variable Cost
151
12
-3
48
52
212
113
1,553

Note: Cost projections were made from data published by the U.S. Department of Agriculture and agricultural colleges within the District. Projected returns reflect average yields obtained from 1977-79 and average
prices for crops during January, February, and March of 1980.

limited. In the typical situation, however,
growers may switch freely between
soybeans, corn, and cotton. Rice may be
included in the choices for some farmers,
but land that is adaptable to rice
production is more restricted than for
other crops.
Projections for 1980, based on estimates
of variable costs per acre and total returns
that reflect (1) average yields across the six
states within the District and (2) prices for
crops prevailing during the first three
months of the year, show that the per acre
returns above variable costs are greater for
tobacco and peanuts (see Table 1). But
these crops carry strict acreage allotments
and cannot be produced by all growers.
The next best alternatives are cotton, which
promises $151 per acre, and rice, which
offers $113 per acre above variable cost.
Wheat and soybeans also offer attractive
rewards for expansion, particularly when
considered in combination. Many
producers who grow winter wheat can
immediately follow that crop with soybeans
if weather cooperates and thereby obtain
returns from two crops within the same
year.
JULY/AUGUST 1980, E C O N O M I C REVIEW

TABLE 2
PROSPECTIVE PLANTINGS, S E L E C T E D CROPS,
S I X T H D I S T R I C T S T A T E S , 1980
AND PRIOR Y E A R C O M P A R I S O N S
(1,000 Acres)

1978
Cotton
2,399
Corn
3,870
Grain
Sorghum
290
Wheat
740
Soybeans 13,491
Peanuts
816
Rice
810
Tobacco
142

1979

Indicated Percent Change
1980/1979
1980

2,253
3,663

2,512
3,727

11.5
1.7

288
938
15,060
815
770
128

365
1,410
15,342
814
805
134

26.7
50.3
1.9
0.0
4.5
4.7

Source: Prospective Plantings, U.S. Department of Agriculture, April 1980.

Corn offers relatively little incentive for
expansion, since, on average, only $12 per
acre would be available to apply toward
fixed costs. For the average producer, grain
sorghum provides a negative return over
variable cost. O n e should recognize,
however, that the actual expectations of
farmers may differ from the averages
indicated here, especially for those
producers who rank well above average in
production techniques utilized and in
yields obtained.

1980 Planting Intentions
Surveys are made of farmers' planting
intentions in January and April of each
year. The results of the April survey showed
that southeastern farmers were planning to
expand acreage of cotton, wheat, soybeans,
and rice, as the analysis indicated they
would (see Table 2). The moderate growth
in tobacco acreage probably reflects the
slight expansion that can be accommodated
by the 1980 marketing quota. Growth in
soybean acreage is small in percentage
terms but relatively large in actual acreage
because of the large base of land that has
FEDERAL RESERVE B A N K O F ATLANTA

been planted to soybeans in preceding
years.
A moderate expansion was planned for
corn acreage in spite of its limited offer of
returns. However, most growers probably
anticipate higher yields than were actually
obtained during the past three years, when
production in some areas was restricted by
severe droughty conditions.
The planned expansion in grain sorghum
acreage runs sharply counter to the
indications of the analysis. Compared with
most other crops, however, the actual
expansion in acreage is rather small and is
almost totally accounted for by farmers in
Georgia, where acreages of crops produced
under irrigation have expanded rapidly in
the last year or so. The yields from irrigated
production would be sharply higher than
the average yields for the whole District.
The ability to cover variable costs with
some return to apply toward fixed costs will
keep production going for a while, but
eventually, fixed costs must also be covered
or producers will find themselves without
the means to replace machinery and
equipment when it wears out. Also, their
production techniques may not keep up
with technological changes because they
are unable to make the expenditures
required for modernization. So it is the
ability to cover total costs that determines
what farmers will produce over the long
run.
The rapid rise in costs of energy-sensitive
items has been a major cause of the recent
increases in the average total cost of
producing major southeastern crops. At the
same time, prices of most commodities
have fallen, so that for all crops examined
except tobacco, the projected total cost per
unit exceeded the price available to
producers at planting time. But costs and
returns per unit of output again confirm
that, in the short run, farmers should not
cease production because they can more
than cover the average variable costs and
the amount by which price exceeds
variable costs is available to repay some of
19

Chart 4

TABLE 3
P R O J E C T E D C O S T S AND R E T U R N S
S E L E C T E D S O U T H E A S T E R N C R O P S , 1980

E n e r g y c o s t s h i g h e r in S o u t h e a s t than U . S .
Percent

($ Per Unit)

Expected
Return
Cotton (lb.)
Corn (bu.)
Grain Sorghum (bu.)
Wheat (bu.)
Soybeans (bu.)
Peanuts (lb.)
Rice (cwt.)
Tobacco (lb.)

.73
2.91
2.23
3.71
6.22
.20
10.86
1.42

Total
Cost
$

.78
4.98
5.01
5.06
8.53
.23
12.62
1.36

Variable
Cost
$ .45
2.68
2.28
2.26
4.00
.13
7.95
.66

Rice

SOUTHEAST
UNITED STATES

Soybeans

Cotton
Note: See Table 1 for sources of costs and returns projections.

Corn

the fixed costs that would remain totally
uncovered if no production occurred (see
Table 3).

Southeast Especially Vulnerable
to Rising Energy Costs
The competitive position of southeastern
farmers with farmers in the country as a
whole can be affected by rising energy
costs. Because of a heavy dependence on
chemicals for pest control and commercial
fertilizers, energy-related items make up a
higher proportion of the variable costs of
producing most crops in the Southeast than
in the rest of the United States (see Chart
4). As energy costs rise relative to other
farm inputs, southeastern crop production
becomes more costly relative to national
production.
In the final analysis, it is not the special
whims and preferences of farmers but the
relationship between the total costs of
producing crops in the Southeast as
opposed to the U.S. that determines longrun cropping patterns. Farmers tend to
concentrate on those crops in which they
have an absolute advantage (the lowest cost
per unit) or in which their comparative
disadvantage is least (the excess of cost per
20

Energy Sensitive Items as a Proportion of Variable
Production Costs

unit in the Southeast over the nation is
smallest).
The ratio of southeastern to U.S. costs
shows that in 1978 and 1980, the Southeast's
only advantage (among six crops
compared) is in production of cotton (see
Chart 5). For that crop, the cost per unit is
slightly lower in the Southeast than in the
U.S. (ratio less than 1.0). The cost of
producing peanuts is equal to the national
average (ratio is 1.0). The Southeast's
disadvantage is greatest in production of
corn. The cost of producing a bushel of
corn in the Southeast in 1978 was 1.66 times
the U.S. average. That disadvantage is
projected to rise slightly with the increase
in costs from 1978 to 1980. If the costs of
energy-sensitive items should double
between 1980 and 1982, the Southeast's
cost disadvantage in corn production
would increase to 1.79.
In 1980, the Southeast's least disadvantage
apparently lies in the production of rice,
JULY/AUGUST 1980, E C O N O M I C REVIEW

producers must turn to crops in which their
comparative disadvantage is least.
Chart 5
With a doubling of costs of energyrelated items from 1980's level (and with
In 1980, Southeast's crop production costs.
other costs holding steady), it is estimated
Ratios that the Southeast's comparative
disadvantage would grow worse and spread
to cotton, where an absolute advantage
now occurs. Only with peanuts would
— 1.80
there be little change, since costs in the
Southeast are about the same as costs in
the rest of the peanut-producing areas of
— 1.60
the country.
In summary, the sharp rise in energy
costs
since 1978 has impacted costs of crop
— 1.40
production in the Southeast and, along
with changes in commodity prices, has
encouraged expansion of acreage in crops
— 1.20
that use relatively low proportions of
energy-sensitive farm inputs (cotton and
rice). The proportion of variable costs made
1.00
up of energy-sensitive items has increased
most, thus far, for those crops that make
heaviest use of fuels in the production
.80
process.
Cotton
Corn
Grain
Wheat
Soybeans Peanuts
Rice
Sorghum
Rising energy costs have pushed total
production costs above the expected price
were lower than U.S. only for cotton. (Above black line,
per unit for most farm products in 1980.
S.E. costs exceed U.S. costs.)
Most farmers are attempting to minimize
their losses by expanding acreages of those
crops which offer the greatest margin of
return over the variable "out-of-pocket"
followed in relatively close order by wheat
cost of production (cotton, rice, wheat, and
and soybeans. That is to say that, although
soybeans).
these crops can be produced at lower costs
The higher proportion of costs made up
per unit elsewhere in the country, the total
of energy-sensitive items in the Southeast
volume of agricultural products is greater if
as compared with the U.S. average will
other areas concentrated in producing
cause an erosion of the competitive
crops in which their advantage is greatest
position of southeastern producers as
(e.g., corn in the Midwest), and the
energy costs continue to rise. The
Southeast concentrates in production of
Southeast's advantage in the production of
crops in which it comes closest to being
cotton would be lost if costs of energycompetitive with other areas (rice,
sensitive items should double from their
soybeans, and wheat). Of course, if the
1980 levels while other crop production
Southeast could expand its production of
costs remained unchanged. The
cotton and peanuts without limits, that
continuation of the rapid rise in energy
would be the preferable alternative. But for
costs relative to other expenses could
these crops, the acreage on which
significantly alter cropping patterns in the
expansion can occur is relatively limited,
Southeast.
M\
particularly if the comparative advantage is
to be retained. Thus, to utilize the majority
of the cultivatable land in the Southeast,
FEDERAL RESERVE B A N K O F ATLANTA

U.S. Banks Expand
Offshore Banking in
Caribbean Basin
by Stuart

Hoffman

During the past decade, more and more
U.S. banks have found it useful to establish
banking offices in the Caribbean Basin.
What this growth means depends on one's
perspective:
• To the banks, these Caribbean Basin
branches provide an environment almost
entirely free of local taxes, central bank
reserve requirements, currency conversion
limitations, and with relatively simple
requirements for licensing and regulation.
• To host countries in the Caribbean
Basin, these "offshore" banking facilities
offer jobs, limited income from fees, the
prestige of being an international banking
center, and the hope of related investments
in their countries.
• To U.S. nonbank customers (pension
funds, large corporations, etc.), offshore
banking affords greater cash management
flexibility and higher interest rates than
domestic arrangements.
• To the Federal Reserve, quite aside
from regulatory concerns, Caribbean Basin
branches are of increasing interest because
deposits held with them by U.S. residents
belong, conceptually at least, in the U.S.
money supply and it is desirable to try to
measure them as such.

Rapid Asset Growth
First, a few statistics on the rapid growth
of the Caribbean Basin activity of U.S.
banks — from 1973 to 1979, total assets of
U.S. bank branches increased ninefold in
the Cayman Islands, eightfold in Panama,
22

and fourfold in the Bahamas. Still, twothirds of the dollar volume resides in
Bahamian branches.
Between 1973 and 1976, U.S. bank assets
in the Bahamas, the Cayman Islands, and
Panama increased from 21 percent to 32
percent of such assets worldwide. Since
1976, the figure has remained at about onethird. Another third, roughly, resides in
U.S. branches in Great Britain; the
remaining third is dispersed worldwide
(Table 1).
The growth in the number of offshore
branches of U.S. parent banks in each of
the three major Basin centers has been
uneven (Table 2). In Panama, the number
of U.S. branches remained unchanged
during the 1973-79 period. The number of
U.S. branches in the Bahamas actually
declined during that period as some parent
banks moved their offices to the Cayman
Islands. Bahamian offices tend to be the
largest: Assets per office in 1979 averaged
$1,082 million in the Bahamas, $363 million
in Panama, and $391 million in the Cayman
Islands. How does this growth look from the
different perspectives of the major
participants?

Advantages to U.S. Banks
Caribbean Basin branches of U.S. banks
deal almost entirely with deposit and loan
customers outside the host country. To
some extent, the transactions on the books
of these branches could be accomplished
at any number of locations.
JULY/AUGUST 1980, E C O N O M I C REVIEW

Offshore banking by U.S. banks in the Caribbean Basin grew almost five-fold from 1973 to
1979. This expansion has proved advantageous to U.S. banks, their nonbank customers, and
the host countries. Since this activity affects the U.S. money supply, it is also of increasing
interest to the Federal Reserve.

TABLE 1
MAJOR C E N T E R S ' S H A R E O F U.S. F O R E I G N B R A N C H A S S E T S
(U.S. S Millions)

1973
1974
1975
1976
1977
1978
1979

Bahamas

Cayman
Islands

Panama

Total
(B, CI, P)

20,684
27,313
38,302
54,784
62,789
73,414
82,292

3,088
4,420
6,900
11,990
16,623
18,321
26,619

1,525
2,691
3,713
3,829
4,901
7,667
11,979

25,297
34,424
48,915
70,603
83,953
99,402
120,890

Total U.S.
Foreign
Branch
Assets

Percent
of Assets
In Major
Caribbean
Centers

U.K.

Percent
of Assets
in U.K.

121,866
151,905
176,493
219,420
258,897
306,795
364,165

.21
.23
.28
.32
.32
.32
.33

61,732
69,804
74,883
81,466
90,933
106,593
130,873

.50
.46
.42
.37
.35
.35
.35

Source: Board of Governors, Federal Reserve System.

Since 1973, U.S. bank assets have Increased In the Caribbean and declined In the United

TABLE 2
NUMBER O F B R A N C H E S O F U.S. BANKS 1 IN MAJOR
BASIN O F F S H O R E B A N K I N G C E N T E R S
(December)

1973
1975
1977
1979*

Bahamas

Cayman Islands

Panama

32
49
58
68

33
33
33
33

74
76

"June.
'Member banks of the Federal Reserve System.

The three primary offshore centers in the
Basin (the Bahamas, the Cayman Islands,
and Panama) all have courted foreign
FEDERAL RESERVE BANK O F ATLANTA

Kingdom.

banking activity to some degree, employing
the following six ingredients relative to
other countries: (1) the absence of hostcountry income or asset taxation and
reserve requirements on deposits; (2)
liberal rules for conversion and transfer of
foreign currencies; (3) flexible and simple
banking regulations; (4) modern
communications facilities linked to other
financial centers around the world; (5)
similar time zones, and, hence, business
hours, as major U.S. banks; and (6) the
prospect of stable political environments. In
the Bahamas and the Cayman Islands, many
of the branches are pure "booking
centers," having no substantial physical
presence where loans and deposit
23

transactions are accomplished. These
branches are passive shell offices, whose
books reflect, almost entirely, decisions
made at parent banks in the U.S. or at
branches elsewhere around the world.

familiar to international investors and
financiers.
There are direct costs to the host
country, including expenditures for
enhanced telecommunications and airport
facilities, education and training of
Advantages to the Host Countries
residents, and limited licensing and
Host governments are very much aware
regulatory activity. Of course, these are
of the limited and passive nature of most of
difficult to attribute solely to banking, and
the banking activity going through their
exact calculation of costs versus benefits is
offices, but they nevertheless encourage
difficult. Nevertheless, the three Basin
offshore banking activity because they
offshore banking centers have obviously
expect its benefits to outweigh its costs.
concluded that, for them, the benefits
Direct benefits include additional
exceed the costs. Barbados recently arrived
governmental revenue from limited taxes
at a similar conclusion and has initiated an
and license fees, and additional residents'
offshore banking center this year.
income from rental of branch facilities and
In particular, Panama is trying to develop
employment of personnel. Indirect benefits —
a
regional
financial center with full banking
which are very difficult to quantify —
facilities,
where
employees conduct
include prestige and the prospect of
business
"face
to
face" with customers. Still,
additional investments in the host country's
Panama
is
also
a
booking
center.
economy as its advantages become more

Advantages to Domestic Customers
The Three Major Caribbean Basin
Offshore Centers

THE CARIBBEAN BASIN is here defined to include the
following economies: Mexico, Colombia, and Venezuela;
Central America, including Belize and Panama; the
Caribbean Islands; Guyana, Surinam, and French
Guiana.

A recent development of particular
interest is the growing popularity of
"overnight Eurodollar" liabilities with
domestic customers of Caribbean branches
of U.S. banks. Through a series of
accounting entries, the U.S. customer winds
up with an interest-bearing, one-day claim,
which is often more attractive than a
domestic repurchase agreement (RP)
because the overnight Eurodollar interest
rate is generally slightly above the domestic
RP, and because the "overnight Eurodollar"
claim transaction can be arranged later in
the business day than an RP. This enables
U.S. banks to give the customers an extra
dimension of cash management flexibility.

Implications for Fed

Many experts believe that "overnight
Eurodollar" claims function as money and
should be measured and included in U.S.
money supply calculations. According to
JULY/AUGUST 1980, E C O N O M I C REVIEW

data collected by the Federal Reserve, an
estimated $3 billion of "overnight
Eurodollars" were owed by Caribbean Basin
branches to U.S. nonbank customers in
early June 1980. At the end of last year,
such overnight Eurodollar claims
represented one-quarter of the total
liabilities owed to U.S. nonbank residents
by U.S. branches in the Bahamas, the
Cayman Islands, and Panama at that time.
Accordingly, within the Federal Reserve
System's new scheme of monetary
aggregate measures, "overnight

Eurodollars" are included in the broader
M-2 definition of money (as are the
domestic overnight repurchase agreements
they replace). They are not included in the
Fed's narrower money definitions (M-1A
and M-1B); however, to permit their
inclusion in M-2, the Federal Reserve
System has recently initiated a new bank
report for daily data on the overnight
Eurodollar deposits of U.S. nonbank
customers at the Caribbean Basin branches
of 27 member banks active in such
transactions.
HSl

Sixth
District
Banks
with
Foreign
Branches

7 First National Bank of
Birmingham
(10/23/73)
8 Trust Company Bank*
(1/2/74)
9

10 The First National Bank of
Atlanta*
(2/1/74)
11 Commerce Union Bank*
(5/15/74)

(with date business commenced)

CAYMAN I S L A N D S
BRANCHES

NASSAU BRANCHES
1 The Citizens and
National Bank
(5/1/69)

Southern

2 Southeast First National Bank
of Miami
(4/1/71)
3 Whitney National Bank of New
Orleans
(12/15/72)
"transferred operations from Nassau
Branch

FEDERAL RESERVE B A N K O F ATLANTA

First National Bank of
Commerce*
(12/28/73)

First American National Bank
(2/1/73)
5 Third National Bank
(2/23/73)
6

The Hibernia National Bank in
New Orleans
(10/18/73)

12 Fulton National Bank of
Atlanta
(7/23/79)
13 Deposit Guaranty National
Bank
(3/3/80)
14 Birmingham Trust National
Bank
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Commentary

Monetary Policy and
Interest Rates
by Robert

Keleher

Recently a good deal of discussion has
occurred in the press and among
economists about the relationship between
monetary policy — both domestically and
internationally — and the movement of
interest rates. D o falling interest rates, for
example, imply an easing of monetary
policy? In this commentary, the relationship
between movements in interest rates and
domestic and international monetary policy
will be discussed. 1

Domestic Monetary Policy and
Interest Rates

To many people, monetary policy has
traditionally meant a policy relating to
interest rates. Consequently, changes in
interest rates have often been closely
associated with and sometimes even
equated with changes in monetary policy.
Some analysts have regarded interest rates
as indicators and even targets of monetary
policy. To some extent, this orientation was
a holdover from periods of stable prices. 2
During periods of stable prices, an interest
rate orientation is misleading, but not
nearly as misleading as during unstable
price periods, i.e., during periods of
inflation or deflation. During periods of
unstable prices, an interest rate orientation
'In accordance with recent changes in the focus of Federal Reserve policy,
"changes in monetary policy" is here defined to signify changes in the
supply of reserves to the banking system.
2

Actually, this orientation stems from a long-lasting confusion between
money and credit. Classical monetary theorists held that money and credit
were two distinct entities. Accordingly, they held that each had a
distinguishable price. Whereas the price of credit was viewed as the rate
of interest, the inverse of the general price level was held to be the price
of money.

can lead to procyclical swings in the money
supply (increasing the money supply in
booms and decreasing or slowing it down
during recessions) and, hence, to unstable
monetary growth.
In the inflationary environment in which
we find ourselves today, the factors
affecting or determining interest rates are
somewhat different than they are in stable
price periods. This contributes to making
interest rates misleading and confusing as
guides or indicators of policy. Specifically,
in an inflationary environment, inflationary
expectations play a large role in the
determination of interest rates. Indeed, in
such an environment, inflationary
expectations become much more
important relative to other determinants of
interest rates. This contributes to making
interest rates much more volatile and
unpredictable during inflationary periods
(see Chart 1).
Thus, in an inflationary environment,
changes in interest rates are determined by
changes in many factors, the most
important of which are: (1) changes in
inflationary expectations, (2) changes in the
supplies and demands for credit (which
often reflect changes in business activity),
and (3) Fed-controlled changes in bank
reserves. The point to emphasize here is
that reserve changes are only one of
several factors determining interest rates.
Hence, interest rate changes often reflect
changes in determinants other than
monetary policy. Therefore, interest rates
can be very misleading as either indicators
JULY/AUGUST 1980, E C O N O M I C REVIEW

ER's Commentary section presents personal opinion on economic topics of current interest: in
this issue, what is the relationship between monetary policy and interest rates? Interest rates,
the author maintains, can be misleading when used as an indicator of domestic and
international monetary policy.

Chart 1
Interest rates b e c o m e m o r e volatile in a n
inflationary environment.
Percenl

.-20

Bank Rates on Short-Term
Business Loans

Average Prime Rate Charged by Banks

I I I I I I I I I I I I I L_J I 1 1 1 1 1—I 1 1 0

'60

'64

'68

'72

'76

'80

or as targets of monetary policy. All of this
suggests that the money supply is a more
reliable policy guide.
Indeed a great deal of empirical evidence
accumulated over the years has established
that the common view equating high
interest rates with "tight money" and low
interest rates with "easy money" is
misleading and incorrect. The facts indicate,
rather, that rapid monetary expansion is
associated with high interest rates and slow
monetary growth with low interest rates.
This point was recently voiced by Paul
Volcker, Chairman of the Board of
Governors of the Federal Reserve System:
The linkage in the popular mind
between monetary discipline and high
interest rates, as an historical
generalization, is simply wrong. Look
around the world: it is the countries
that have been most successful in
curbing monetary growth and inflation
that have the lowest interest rates. In
Switzerland, to take the extreme,
mortgage money in this inflationary
age is still available at 4.15 percent and
the money supply has been growing
hardly at all.3
As a further illustration of this, consider
the recent sharp decline in short-term
interest rates during April and May. This fall
in interest rates did not mean that
monetary policy has eased, particularly in

Sources: Handbook of Cyclical Indicators, May 1977; Annual Statistical
Digest, 1974-78, Business Conditions Digest, September 1978.
September 1979, April 1980

—

FEDERAL RESERVE B A N K O F ATLANTA

'Remarks of Paul Volcker before the 60th Annual Conference of the
National Association of Mutual Savings Banks, Lake Buena Vista, Florida,
May 14, 1980.

view of the concurrent sharp deceleration
in the growth of the money supply
(however measured). If the Federal Reserve
had focused on interest rates and
consequently decided to push rates back
up, this action would have had the effect
(all other things being equal) of further
exacerbating the deceleration in the
growth of money. The point to be made
here, then, is that interest rates can be
misleading when they are used either as an
indicator or as a guide to domestic
monetary policy.

International Monetary Policy and
Interest Rates

Interest rates can also be misleading policy
guides or indicators in international
monetary policy. For example, some
economists and journalists have contended
that falling interest rates are causing the
dollar to depreciate. In their view, then,
falling interest rates are associated with a
depreciating dollar; hence, low interest
rates are associated with a weak dollar and
high interest rates with a strong dollar.
Consequently, it is suggested that the
Federal Reserve should resist this fall in
interest rates in order to protect the dollar.
While this relationship between interest
and exchange rates sometimes holds over
short periods, it does not necessarily apply
in a longer run time frame and therefore
can be misleading. 4
This view, too, has its historical roots in
the operation of (international) monetary
policy under conditions of price stability.5
"The arguments presented in this section are those of the monetary (or
asset market) approach to exchange rates. See, for example, J a c o b
Frenkel, "Flexible Exchange Rates in the 1970s," and discussion by David
Laidler in Stabilization Policies: Lessons from the 7 0 s and Implications for
the '80s, Center for the Study of American Business, April 1980; and
Douglas Mudd, "Do Rising U.S. Interest Rates Imply A Stronger Dollar?,"
Review, Federal Reserve Bank of St. Louis, J u n e 1979.
S p e c i f i c a l l y , in the role performed by the central bank discount rate under
a gold standard regime (i.e., a fixed exchange rate system). Under these
conditions, monetary growth rates, as well as movements in general
prices, were importantly determined by the growth rate of the world gold
stock. Although this growth rate was not always steady and smooth
(because of new gold discoveries), over periods of time it was steady,
on average. General prices, then, were typically more stable than they are
today. T h i s argument follows that given by David Laidler, "Flexible
Exchange Rates and Monetary Policy: A Discussion of the Frenkel and
Heller Papers," in Stabilization Policies, op. cit., p. 286.

As a consequence of this stability, changes
in the anticipated or expected inflation rate
were not an important factor affecting
interest rates. Under these conditions, a
decrease in the central bank's discount rate
represented a decrease in the real cost of
borrowing and therefore led to an
expansion of domestic credit. This, in turn
(because of increased spending on
imports), led to a balance of payments
deficit and, hence, was associated with a
"weak" currency (e.g., a "declining"
dollar). In short, in these circumstances,
interest rate decreases were correctly
associated with "weak" currencies.
The circumstances of the last ten years,
however, have been quite different.
Exchange rates have been allowed to float
(and the dollar is no longer convertible
into gold). Moreover, the period has
witnessed high growth rates of money as
well as high rates of inflation. Under this
new set of circumstances, a different
theoretical framework is appropriate. This
alternative view contends that fundamental
determinants of a country's exchange rate
include the growth rate of its own money
supply (relative to money demand) and,
hence, its own inflation rate relative to the
analogous growth rates of money and
inflation elsewhere.
For example, a rapid expansion in the
money supply in one country relative to
others will tend to raise the inflation rate in
that country and lower the value of its
currency. Moreover, inflationary
expectations will quickly affect and soon
begin to dominate interest rate movements
in such a country (i.e., driving interest rates
up with inflation). During such episodes,
then, both high interest rates and
depreciated currencies are caused by the
same forces; namely, rapid monetary
growth and inflation. Under such
circumstances, high interest rates are
associated with "weak" or depreciated
currencies and low interest rates with
JULY/AUGUST 1980, E C O N O M I C REVIEW

Chart 2
1976-78 period s h o w e d that falling interest rates
do not a l w a y s a c c o m p a n y a d e p r e c i a t i n g dollar.
Index, March 1973=100

Percent

U.S.-F<>reign In lerest Rc te Differentials

y\
1974

1975

1978

1979

Short-" "ermys

1976

1977

1980

Sources: Federal Reserve Statistical Release H 13; Federal Reserve
Bulletin; International Monetary Fund, International Financial
Statistics
'Secondary market rates for 90-day large certificates of deposit in the
United States less the weighted average of foreign three-month money
market rates.

"strong" or appreciated currencies (i.e., the
opposite of the view outlined earlier).
As with the domestic case discussed at
the outset, recent evidence does not always
support the commonly held views of the
relationship between interest rates and
exchange rates.
In particular, the experience of recent
years suggests that high interest rates have
been associated with weak currencies and
low interest rates with strong currencies. 6
Over the entire 1976-78 period, for
example, rising interest rates in the U.S.

See, for example, Michael Mussa, "Empirical Regularities in the Behavior
of E x c h a n g e Rates and Theories of the Foreign E x c h a n g e Market,"
Policies for Employment, Prices, and Exchange Rates, Carnegie-Rochester
Conference Series on Public Policy, Vol. II, 1979, p. 25.

FEDERAL RESERVE B A N K O F ATLANTA

(relative to foreign interest rates) were
associated with a depreciating U.S. dollar
(see Chart 2)7 During this period, the
interest rate-exchange rate relationship was
the opposite of the view outlined above
and currently being voiced in newspapers
and by some economists.
What does all this mean for monetary
policy? First, it suggests that in an
inflationary environment, interest rates can
be misleading as guides or indicators of
policy in the international dimension as
well as domestically. In particular,
movements in interest rates in one country
relative to other countries may be
associated with a depreciating currency in
some circumstances and with an
appreciating currency in other
circumstances (see Chart 2). In short, the
relationship is confusing and unreliable. As
a consequence, interest rates may be a
misleading guide or indicator of
(international) monetary policy. Second, it
implies that attention, certainly over longer
periods, must be basically focused on the
monetary aggregates for both domestic and
international policy. That is, a gradual
deceleration of U.S. monetary growth
(relative to foreign monetary growth)
ultimately will bring about less inflation, a
stronger dollar, and lower interest rates.
To repeat, the message to be conveyed
here is that in an inflationary environment,
it is difficult and often misleading to draw
inferences from particular levels of interest
rates about whether monetary policy is
"easy" or "tight." In this environment,
interest rates are often misleading and can
lead to mistakes in assessing domestic and
international monetary policy.
0D

' S e e Douglas Mudd, op. cit.

Working Paper
Review
The following article is a staff review of a more complete study in the
Federal Reserve Bank of Atlanta Working Paper series.

David D.

Whitehead

Home Office Pricing:
The Evidence
from Florida
A survey of Florida multibank holding
companies before and after branch banking
legislation sheds light on the relationship
between the structure of a banking market and
the degree of competition in that market by
examining how and where pricing decisions are
made. It also assesses from a regulatory
standpoint how home office pricing may affect
the geographic delineation of banking markets.

For a good number of years, researchers
have been seeking to establish what the
relationship is between market structure
(the number and relative size of banks in
a market) and competitive performance (the
degree of competition in a market) in the
banking industry. Studies have generally
concluded that the relationship is statistically significant (i.e., we should be
able to predict changes in the degree of
competition from changes in the market's
concentration) but operationally weak (partly
because it takes such a large change in
market concentration to make an impact on
market price). O n e possible reason why
competitive performance is not as strongly
related to market structure as we would
expect is that the relationship also
involves a bank's market behavior or
conduct.
Performance could be predicted if all the
banks in a market always tried to maximize
their profits. For a variety of reasons,
30

however, pricing decisions may not always
be based on short-run profit maximization.
Since market behavior is difficult to
measure, it has received little attention
in the literature. In his Working Paper,
David Whitehead addresses this gap in the
literature by investigating one aspect of
market behavior — how pricing decisions
are formulated by individual banks.
Under a holding company umbrella,
pricing decisions may be made at any one
or a combination of four levels: the
holding company or its lead bank, a committee representing a number of subsidiary
banks, the home office of the bank in
question, or at the branches. The term
"home office pricing" applies when a
multi-office firm establishes a single
price for all of its offices based on
supply and demand conditions existing
either at the location of the home office
or on an average of these conditions at
all locations of the firm.
In his study, Whitehead investigates
the extent to which multibank holding
companies in Florida utilized home office
pricing prior to and following the 1976
enactment of limited branch banking legislation. Prior to this legislation, each
office of each holding company was a
separately chartered bank — presumably
making its own pricing decisions. Following enactment, each holding company was
able to consolidate all of its separately
chartered subsidiaries within a single
county into one charter with an equal
number of branch offices. The change
created a unique opportunity to examine
how changes in a firm's organizational
structure affect its pricing behavior.
Whitehead conducted a survey with a twofold purpose: (1) to observe the pricing
behavior of M H C s in order to develop
JULY/AUGUST 1980, E C O N O M I C REVIEW

testable hypotheses concerning the relationship between market structure and
competitive performance and (2) to assess
from a regulatory standpoint how home
office pricing may have affected the geographic delineation of banking markets in
Florida.

Findings

The survey, which included a wide
range of geographic coverage and organization size, found that pricing decisions
emanate from several levels: the holding
company, its lead bank, regional lead
banks, regional committees of subsidiary
banks, and individual subsidiaries prior
to and after merger. Whitehead concludes
that multibank holding companies are not
as homogenous as they have been treated in
the literature. Some specific observations from the survey include:
1. After branching, all M H C s used some
type of home office pricing to gain
consistency among their branches.
2. Florida M H C s tend to exercise more
control over the pricing decisions of
their subsidiaries than one would
expect. The largest M H C s decentralized their pricing mechanism somewhat,
letting regional groups establish
prices. The smaller holding companies
maintained more central control.
3. In general, the larger the geographic
area in which a holding company was
represented, the less central control
exercised by the holding company.
4. In establishing targets for the subsidiaries, the M H C s generally recognized the necessity to gain market
shares before maximizing profits.
Thus, smaller subsidiaries were
assigned lower target prices or rates
of return than larger subsidiaries
with larger market shares.
5. The larger the geographic area covered
by the M H C , the more likely it is to
distinguish between markets.
The question of home office pricing
also has important implications for regulatory purposes. If home office pricing for
offices located in different geographic
markets causes prices to equalize among
those markets, it effectively integrates
Home Office Pricing: The Evidence
from Florida by David D. Whitehead,

August 1980, 30 pp.

these areas into a single market. Price
equalization among markets due to home
office pricing suggests that banks in these
areas are reacting to the same set of supply
and demand conditions and hence are in
the same market. Therefore, counties
which were defined to encompass two or
more banking markets may effectively be
joined into a single county-wide market
through home office pricing. As the
geographic market expands, the relative
size of any given bank within that market
is reduced. The impact of this change on
regulatory agencies is significant, since
the major criterion for judging the probable competitive consequences of a merger
or acquisition is the relative size of the
resulting organization in its market.

Survey Suggests Further Research
The survey revealed several factors
which should be considered in future
research. First, holding company subsidiaries in a given market may face two c o m petitive stimuli, one from market forces
and the second from other subsidiaries
within its holding company competing for
targeted profits, etc. Second, researchers should investigate the propensity for
holding companies to use regional committees to price and set targets, especially
with regard to its potential impact on
local market competition. Third, if
Whitehead's sample is typical and M H C s
tend to assign profit targets differently
to large and small subsidiaries, then not
all competitors should be viewed as shortrun profit maximizers. As a result,
instead of large banks leading price
reductions, small banks — attempting to
build up market share prior to maximizing
short-run profits — may initiate price
competition. Thus, a large number of
small competitors in a market may be more
important in predicting market performance
than a few large competitors. Fourth, not
only will the organization's market c o n duct affect the market's competitive
performance, but it may also affect the
geographic extent of the market and (for
regulatory purposes) the measure of the
market's structure.
BE]
A copy of this study is available upon
request to the Research Department,

Federal Reserve Bank of Atlanta, P.O.
Box 1731, Atlanta, Georgia 30301.

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