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The Federal Reserve and
the Problem of inflation
. . . John J. Balles, President, discusses the nature o f the
Federal Reserve System and the problem o f inflation
Monetary Policy: A Letter (II)
. . . Professor M ilto n Friedman puts fo rth his views on the
subject o f m oney and Federal Reserve policy
Primer on Reserve Requirements
. . . Background inform ation on the Federal Reserve
proposal fo r uniform reserve requirem ents
PUBLICATION NOTE
The Business Review henceforth w ill be published on a quarterly basis.
It is edited by W illia m Burke, w ith the assistance of Karen Rusk
(editorial) and Janis W ilson (graphics).
Subscribers to the Business Review may also be interested in receiving this
Bank's Publications List or weekly Business and Financial Letter. For copies
of these and other Federal Reserve publications, contact the Research
Inform ation Center, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco, California 94120. Phone (415) 397-1137.
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By John J. Balles, President
Federal Reserve Bank of San Francisco
Remarks 10 the Joint Directors' Meeting Luncheon
San Francisco. California. March 7, 1974
I am delighted that we could arrange to have a cross-section of
bankers, business executives, and
other professional leaders in the
San Francisco area meet with us
today. As you were informed, this
is the occasion of the Annual Joint
Board Meeting of the Federal
Reserve Bank of San Francisco
and its fou r branches.
Chairman Wilson, as the historian
in our group, has reminded us of
the historic forces wh ich preceded the establishment of the
Federal Reserve and which
brought it into existence over 60
years ago. He has also introduced
the Boards of Directors of this
Bank and its branches, which represent important elements in the
structure of the Federal Reserve
System.
Today, I would like to describe
some of the current forces operating on the Federal Reserve, and
then examine the causes and possible cures for the dangerous inflationary spiral we are now witnessing. However, before getting
to these topics, I think that it
would be appropriate to say a few
words for our guests about the
role of a Federal Reserve Bank
and its directors in the context of
today's problems. For I am often
asked, "Just what does a Federal
Reserve Bank do? And what is the
authority and responsibility of
your directors?" It happens that
the Federal Reserve System has a
policy of rotating its directors
after a certain period of service. It
is likely, therefore, that some of
our guests today might be approached in the future and asked
to consider serving as a director.
If so, I hope you would give it
favorable consideration.
Role of the Directors
The Board of Directors of a Federal Reserve Bank has a unique
function in that it combines some
of the traditional responsibilities
of directors in a private corporation with the special responsibilities of contributing to the formulation of public policy. This dual
role has evolved from the unique
structure of the Federal Reserve
itself-i.e., part government and
part private, guided by a central
authority in Washington, but with
twelve semi-autonomous Federal
Reserve Banks.
As the nation's central bank, the
Federal Reserve System's basic
responsibilities fall into three
basic categories: (1) to regulate
the flow of money and credit in a
manner that contributes to economic growth without inflation;
(2) to supervise and examine
those commercial banks which
are members of the System, to
regulate bank holding companies, and to oversee the foreign
activities of U.S. banks; and (3) to
prOVide numerous "wholesale"
3
central banking services, such as
provision of currency and coin,
operation of a check collection
system, and service as fiscal agent
forthe U.S. Treasury.
The central policy-making body in
the Federal Reserve System is the
Board of Governors, appointed
by the President and confirmed
by the Senate. The twelve regional Federal Reserve Banks
share certain of the responsibilities relating to monetary policy
with the Board of Governors,
administer various regulations,
and provide the "wholesale"
banking services noted earlier.
Thus, the Federal Reserve System
is characterized by coordinated
control through the Board of
Governors and by decentralized
administration through the Reserve Banks.
The affairs of each Reserve Bank
are conducted under the supervision and control of its Board of
Directors, subject to general supervision by the Board of Governors. The Board of Directors of
each head office of a Reserve
Bank consists of nine members,
three of whom (including the
Chairman and Deputy Chairman)
are appointed by the Board of
Governors as representatives of
the general public. The public
members may not be officers,
directors, employees or stockholders of any bank. he re4
maining six directors at each
Head Office are lected by the
member banks, which own all the
stock in the Federal Reserve Bank.
Of these six, three are representatives of the member banks and
are usually actively engaged in
banking; and the other three
must be actively engaged in
commerce, industry, or agriculture, and may not be officers,
directors, or employees of any
bank.
Similarly, for each branch of a
Federal Reserve Bank, the Board
of Governors appoints certain
directors as representatives of the
public interest, while the majority
of the branch directors are appointed by the Head Office
Board. The affairs of each Branch
office are conducted under the
control of its Board of Directors,
subject to general supervision by
the Head Office Board.
Thus, a Federal Reserve Bank is a
privately-owned institution with a
public purpose. Except for a dividend on member-bank stock,
which is limited by statute to 6%,
the great bulk of our earnings is
paid over to the U.S. Treasury. A
Reserve Bank has a certain degree
of regional autonomy, but it is
also part of a national system.
The Federal Reserve System is a
unique blend of publ"c interest
and private representation of
"grass roots" interests. In meaningful ways, it reflects the traditional belief in this country in a
system of checks and balances.
This type of organization has
served the country well, in my
opinion.
Our directors are successful men
in many fields of endeavorbusiness, finance, agriculture and
universities, to name a few. They
provide counsel and advice to
ensure that the Bank has c1earlydefined goals and objectives, and
programs for reaching them, and
they have the responsibility for
overseeing the efficiency of operation and quality of management.
In the area of economic intelligence, our directors provide us
with information on the economy
weeks or even months before
developments are reflected in
national economic data. At other
times their first-hand information
reminds us that ours is a diverse
economy in which developments
in many industries and regions of
a country can run counter to nation-wide trends.
Our directors also provide information and insights on the proper
course for public policy, and they
can add substance to their views
by recommending changes in the
Federal Reserve discount rate.
This is the rate which the Federal
Reserve Bank charges for loans to
its member commercial banks,
and it is one of the tools of monetary policy. Although the Board of
Governors in Washington has the
ultimate authority to approve or
disapprove a proposed change in
the discount rate, it is s rongly influenced by the "grass-roots"
reaction expressed by the directors, especially if the directors of
a number of Federal Reserve
Banks make the same recommendation.
One of the major strengths of the
decentralization of the Federal
Reserve System is its ability to
draw on the best talent in various
regions of the economy to serve
as directors with the foregoing
responsibilities.
Role of the Federal Reserve
The unique structure of the Fed,
which I believe gives it unusual
strength in performing its job,
also subjects it to criticisms by
those who do not appreciate its
role and its structure.
The Federal Reserve has at least
two elements which make it institutionally unique. First, it is independent within, but certainly not
from, the Federal Goverment.
More specifically, it is an independent agency but with ultimate
responsibility to the Congress,
and it is not a part of the Executive
Branch. Second, the decisionmaking process within the Federal Reserve System is decentralized in the sense that it is shared
by the Board of Governors in
Washington with the twelve regional Federal Reserve Banks. I'd
like to say a few words about each
of these functions.
When Congress and the Administration established the Federal
Reserve in 1913, it was deliberately made an independent institution within Government, in
order to free it from day-to-day
political influence. Senator Carter
Glass, the architect of the original
Federal Reserve Act, hoped that
the System would act as a "Supreme Court of Finance." That
hope has been at least partly fulfilled over the decades. The establishment of the Federal Reserve System as the central bank
indicated that Congress believed
that monetary pol icy was too
important to leave to private
bankers. On the other hand, the
fact that Congress, over the years,
has specified 14-year terms for
members of the Board of Governors in Washington, and 5-year
appointments for Presidents of
the regional Reserve Banks, indicates that monetary policy also is
too important to be left to the
day-to-day pressures from the
political arena. The goal was to
establish a Federal Reserve
System which is responsive to the
long-term economic needs of the
nation in an objective and nonpartisan way.
Over the years there have been a
number of attempts to erode the
independence of the Fed. There
have been repeated legislative
proposals to retire the capital
stock of the Reserve Banks, to
eliminate their directors, to centralize all powers of the Fed in
Washington, and to make the
System more directly amenable to
influence by the Congress.
A current example is a bill scheduled for vote in t e House of Representatives in the near future,
which would provide for a fullscale audit and review by the
General Accounting Office of the
finances, operations and monetary policy actions of the Federal
Reserve System. Although we are
completely in favor of audits in
the traditional sense, we are opposed to the bill forseveral reasons. With respect to financial
transactions, the Federal Reserve
Board is already thoroughly audited by a nationally-known CPA
firm, and the results are reported
to Congress. In turn the Board
performs exhaustive examinations of the Federal Reserve
Banks, in addition to the work of
5
the resident auditing staff at each
Bank which reports directly to the
Board of Directors. Secondly, the
Federal Reserve System, both at
the Board of Governors and at the
Reserve Banks, has in place effective and hard-hitting programs
aimed at operational efficiency.
Thus a financial audit and an "efficiency" audit by the GAO would
merely duplicate effective programs already in place.
The really serious objection,
however, has to do with the proposed policy review by the GAO.
I n our view, this could be an entering wedge for direct Congressional control over monetary
policy-with consequent adverse
effects on the economy if such
control were to be influenced by
partisan goals and political pressures. Forty years ago, the Congress wisely decided to remove
the Federal Reserve System from
the scope of the GAO, in order to
provide for independence of
judgment on the part of the
System in carrying out the responsibilities delegated to it by
Congress. We believe that it
would be unwise to change that
arrangement.
A second unique feature of the
Federal Reserve is the decentralization of policy making. The Federal Open Market Committee
(FOMC), one of the two major
policy-making bodies of the Fed6
eral Reserve, meets once a month
in Washington to decide on the
course of open market operations, the most important instrument of monetary policy. The
majority of the FOMC consists of
the seven members of the Board
of Governors. The remaining five
members are drawn from the
twelve Reserve Bank Presidents,
on a rotating basis. But those
Presidents who are not currently
voting members have an opportunity to attend the meetings and
express their views. Thus, the
formulation of monetary policy
benefits from regional inputs and
from a variety of viewpoints.
Role of the San Francisco Bank
The advantages of a decentralized
Federal Reserve System extend
beyond strictly policy-related issues. Let me describe some of
those that I am most familiar with,
using the experiences of the San
Francisco Bank.
Until very recently, banking structure in the Twelfth Reserve District, with its state-wide branch
banking, was relatively unique in
the nation. The Federal Reserve
Bank of San Francisco has
brought these special institutional
factors to the attention of the
Board of Governors, and in most
cases obtained regulatory treatment which is suitable to this particular bank structure.
The Reserve Bank in San Francisco also has taken an active
interest in developing the West
Coast as an international financial
center. It has encouraged a legal
and regulatory environment favorable to international banking
operations, and has attempted to
get government and financial institutions to consider the longerrun developmental interest of our
financial markets. The Bank itself
is in the process of strengthening
its own research capability with
regard to the Pacific Basin area
and will assist in the growing financial integration of trading
partners in this region.
Over 90 percent of the budget of
the Federal Reserve Bank of San
Francisco is expended to prOVide
payments mechanism services,
currency and coin, fiscal agency,
and other services to government, banks, and to the economy
in general. In my view, the decentralized organization of the Federal Reserve System promotes efficiencies in these operations
because the System's semi-autonomous Reserve Banks can adjust their procedures to local
conditions; they can innovate in
improving the quality and reducing the cost of service; and
they can recruit and challenge
better staff.
Two examples may illustrate this
point. The Federal Reserve Banks
issue virtually all new currency in
circulation and are responsible
for retiring and destroying unfit
currency. More currency is issued
and destroyed in the Twelfth District than anywhere else in the
nation. To do this job more efficiently, the Bank is experimenting
with a number of methods, including some automated ones,
for verifying and destroying wornout currency. Another example is
in the area of improving the payments mechanism. The San Francisco Reserve Bank operated the
first automated clearing house in
the nation, and electronic funds
transfers were first processed by a
Reserve Bank computer in the
Twelfth District. We expect to
continue to take a leading role in
this field and to support commercial bank efforts to reduce the
flow of paper checks.
Perspectives on Inflation
I would now like to turn to the
major economic problem facing
the nation today-namely,
rampant inflation that is occurring
even in the face of a softening in
economic activity. It may be
helpful to put this problem in historical perspective, before attem pti ng to assess the possi ble
cu res.
Effect of Budget Deficits. During
the first half of the 1960's, the
United States enjoyed a period of
sustained and stable economic
growth, with very little inflation.
The origi ns of our cu rrent problems seem to lie in the major escalation of the Vietnam war
starting about mid-1965.
Government deficits increased at
an alarming rate in the Vietnam
build-up period of 1965-68, when
the economy was at, or near, full
employment. President Johnson
perceived a lack of popular support for the war and was fearful
that his "Great Society" spending
programs might get scuttled if he
asked Congress for a tax increase.
He therefore elected initially to
finance expanded military commitments in South Asia with government debt. The deficits which
resulted from this decision were
temporarily relieved by the belated income-tax surcharge in
mid-1968, and by a leveling off in
mil itary expenditures at about the
same time. However, the fiscal
situation deteriorated further in
1969-70 when outlays for civilian
programs outstripped recessionreduced revenues, and became
still worse in the 1971-72 period
when recovery from the recession
. got underway.
The persistence of substantial
govern ment deficits regard less of
the phase of the business cycle
has been a major source of the
inflation that is now built into the
U.S. economy, in myview.
Monetary Policy Undermined. It
can be argued that a tighter monetary policy ought to be able to
offset the inflationary effects of
large, sustained deficit financing.
In theory this may be true, but in
practice the opposite tends to
occur. When huge Federal credit
demands are added to those of a
fully-employed private sector,
interest rates tend to escalate.
There are some sectors of the
economy, such as housing construction and programs financed
with municipal bonds, that are
especially sensitive to such a development because they depend
heavily on long-term credit.
When these sectors are confronted with high interest rates,
demands for relief are quickly
heard. Moreover, the U.S.
Treasury itself has a natural desire
to finance its deficits at the lowest
feasible cost.
In short, large-scale deficit financing by the Government tends
to bring great pressures on the
central bank to keep interest rates
from risi ng to" un reasonable,"
"unacceptable," or "dangerous"
levels. You may recall that about a
year ago there was a serious
threat in the Congress to freeze
interest rates, or even roll them
back to the level of January 1,
1973.
7
'"I
Obviously, the only way that
mounting credit demands can be
satisfied without an increase in
interest rates is for the Federal
Reserve to accelerate the growth
of money and credit. If done for
too long, or to an excessive degree, such action can generate
inflationary pressures which may
persist for a lengthy period.
seekers. However, present evidence su ggests that structu ral
shifts in the labor force during the
last decade would now make the
"practical minimum" about4.5%
or 5%, especially in view of the
increase in the labor force represented by teen-agers and other
new entrants into the labor force
who often lack marketable skills.
It has been my observation that
large and persistent Federal deficits are a leading factor in pulling
monetary policy off course, in the
direction of excessive monetary
expansion, as the central bank
attempts to cope with the conflicting pressures that develop
from such a situation. Too often
in practice, therefore, an expansionary fiscal policy tends to generate excessive expansion in
money and credit.
In myview, there has not been
enough refined analysis of the
employment and unemployment
data, concentrating on the "hard
core" of our labor force-i.e.,
heads of households or
"breadwinners"-for whom the
social and economic costs of
unemployment are highest.
Among this group, the unemployment rate in January of this year
was only 2.8%, in contrast to the
conventional or aggregate unemployment rate of 5.2%.
Priority of Employment Coal. A
second factor which tends to inhibit the use of monetary policy in
combatting inflation is an unresolved conflict in national goals as
between full employment and
stable prices. Since the early
1960's in the U.S., achievement of
the "full employment" goal has
usually contemplated an unemployment rate of 4% or less. Such
a rate was regarded by many as a
practical minimum, in view of
normal shifting of workers between jobs and the lack of marketable skills of some job8
Studies by the Brookings Institution indicate that the conventional unemployment rate
seriously understates the tightness of labor markets. Similarly,
studies by our Bank indicate that
it takes a higher rate of inflation
now to achieve a 4 percent unemployment rate than it did ten years
ago. This is due to two factors:
first, the changing structure of the
labor force has brought higher
participation rates for workers
with marginal skills; second, increased inflation expectations
have caused labor to demand
larger wage increases even at
times when the unemployment
rate is relatively high. If we should
now attempt to follow a monetary
policy aimed at reducing unemployment to 4%, the likely consequence would be to exacerbate
present inflationary pressures,
which have already reached dangerous levels.
For whatever reason, there has
been a tendency for the goal of
"full em ployment" to take
priority over stable prices, in view
of actions in recent years by the
Administration and Congresswhose job it is to determine national priorities. Not enough attention seems to have been paid
to the trade-off-i .e., the additional inflation that must be accepted to get a lower unemployment rate. In essence, my
argument is that we have both a
faulty diagnosis as well as the
wrong medicine for the unemployment goal. First we need a
more meaningful "target rate" for
unemployment, as I've explained.
Secondly, we need new perceptions and new remedies for unemployment. Rather than imposing inflation on everyone, by
attempting to reach our employment goal through expansive
monetary and fiscal policies, our
aim should be a more vigorous use
of selective measures to deal with
the problem. These measures
'I'
1
could include low-interest educationalloans to youth and minority
groups, retraining programsdirected toward skills where job
vacancies are high, and steps to
facilitate worker mobility.
Lags in Monetary Policy Impact. A
third factor which tends to inhibit
the use of monetary policy in
combatting inflation, and to call
for its use by the Administration
or the Congress to provide shortterm stimulus to the economy, is
a technical one. This factor has to
do with the lags in the impact of a
change in monetary policy on
production, employment, profits
and prices. While the technical
reasons are complicated and
while our knowledge in this area
is imperfect, it seems reasonably
clear that the lags are longer for
an impact on prices than for the
impact on the other measures
noted.
Thus, the "good news" about
easy money appears first-i.e.,
favorable effect on production,
employment, and profits; while
the "bad news" comes lateri.e., inflation. Conversely, if a
tight money policy is adopted, the
bad news comes first-i.e., unfavorable effects on production,
employment, and profits;
whereas the good news is
delayed-i.e., a reduced rate of
inflation. Under these circumstances, it is not su rprising that
elected officials who must face
the voters at a given time would
prefer to see easy money.
Has Monetary Policy Been Too
Expansive? Thus, it may be asked,
has monetary policy been a principal cause of our inflation problem, and is there a simple cure in
the form of tight money? I n recent testimony before the Congress, the Chairman of the Board
of Governors, Arthur F. Burns,
acknowledged that, with the benefit of hindsight, monetary policy
may have been overly-expansive
in 1972. Some of our critics, such
as Professor Milton Friedman,
would go much further-alleging
that the money supply has grown
too fast si nce abou t 1970, and that
this played a major role in producing the current inflation.
Such criticism, whether or not
justified, is easy enough to make,
based both on monetary theory
and statistical studies. But it
seems to me to ignore real problems in the real world. No central
bank can be or should be wholly
independent of Government. The
elected representatives of the
people of the U.S., both the Congress and Administration, must
have the ultimate responsibility
for economic policy, and that includes monetary policy. In today's world, a central bank that
consistently defied its government on major issues would
quickly be taken over by the government.
I have been attempting to convey
an understanding of some of the
forces that impinge on the
freedom of action of the Federal
Reserve System in using tight
money to combat inflation.
Whether by accident or design,
our Federal budget has ?een
characterised by large deficits in
most recent years, giving rise to
very large financing needs and to
higher interest rates, to a point
where serious damage was threatened in some sectors of the
economy and where many members of Congress were in a mood
to freeze interest rates. Also,
whether based on a faulty analysis
or a misplaced emphasis, those
elected officials with ultimate
responsibility for economic policy
have placed a high priority on the
"full employment" goal, even at
the expense of stable prices. Central banks cannot completely ignore such imperatives-even
against their better judgment.
It seems to me that ou r best hope
lies in a better understanding of
the long-run inflationary damage
done to our economy by excessive monetary and fiscal stimulus
and by over-emphasis on employment targets, whatever the shortrun benefits. It is vital that this
matter be thoroughly appreciated
not only by the Congress and the
Administration, but also by the
business and financial community
and the general public. It is only
9
in this way thatwe can get support for the belt-tightening measures needed to overcome the
corrosive problem of rampant inflation.
Price Controls-Hidden Inflation.
In completing the analysis of the
basic causes of inflation in recent
years, I would note that the
problem was compounded by
price controls. The "new economic policy" implemented by
the Administration in Augus of
1971 had some favorable price
effects in its initial two phases
because excess capacity existed in
the economy and because the inflationary pressu res were largely
of the cost-push variety in 1971
and early 1972. However, by late
1972 and early 1973, the economy
was at Virtually full employment,
and continued wage-price controls led mainly to a misdirection
of resources and to artificial
shortages. Further, the illusion of
stable prices tended to conceal
for a while the effects of continued expansionary economic
programs. This illusion was rather
rudely shattered by the price
freeze experience last summer
when, for example, certain agricultural sectors quite literally
began to shut down. By now,
popular support for wage-price
controls has declined to a point
where they probably will be
dropped almost entirely this year.
10
Special Causes of Inflation, 197273. In addition to fiscal problems
and the nation's misadventure
with wage-price controls, three
other factors deserve special
mention in analyzing the origins
of our present inflation problem.
The first is the unprecedented
world-wide grain crop failure in
1972 that sent agricultural prices
through the roof. The second is
the fact that the business cycle in
virtually all industrial countries
was in a coincident boom phase
in 1973, which placed extreme
pressure on the supplies and
prices of internationally traded
goods. The third factor, of
course, was the unanticipated
imposition of the Arab oil embargo last fall. Inappropriate fiscal
policies and overstaying the usefulness of wage-price controls
would have created difficult price
problems in any case-but these
policy mistakes in conjunction
with the special factors I've noted
produced an inflation problem of
epic dimensions.
Inflation and the Current Outlook
How do we get out of the apparent box we have gotten ourselves into? The first thing to
remember is that at this time our
main economic problem is a
shortage of oil, not money. The
current rise in unemployment
and the cutbacks in production to
this point have resulted primarily
from supply problems which
cannot be solved with monetary
policy. Even if a deficiency in aggregate demand develops from
the supply-induced slowdown in
the economy, monetary policy
could do little to relieve the situation this year because of the lags
in its impact on the economy,
which I mentioned earlier. In
these circumstances, monetary
policy should be directed towards
1975 and beyond when the policies we adopt now will have their
major impact.
If we wish to overcome inflation,
it is going to be a long, hard uphill
battle, and our monetary-economic time horizon must be expanded to at least three years to
see the success of ou r actions.
Also, since there is a trade-off
between inflation and unemployment, we must be prepared to
accept at least a temporary rise in
the unemployment rate-even
after the energy problem is
solved-and to use special programs to ease the plight of those
affected. Such programs could
include liberalization of welfare
payments, increased unemployment benefits, and more public
employment. Whatever is done in
this regard, it is vital that we not
try to solve the unemployment
problem of the few, by imposing
inflation on everybody through
expansionary fiscal and monetary
measures.
In the final analysis, itwill not be
possible to solve our inflation
problem without fiscal and monetary restraint. For that reason, I
found it encouraging to note the
recent testimony before Congress
by the Secretary of the Treasury.
He warned against broad-based
increases in spending programs
or tax cuts as means of pumping
purchasing power into the
economy at this time. One can
only hope that his point of view
will prevail over that of an official
of the Office of Management and
Budget who was widely quoted
recently to the effect that the
Administration would "bust the
budget," if necessary, to combat
unemployment and any downturn in the economy in the
months ahead.
One can also hope that the
budget reform bill which has
passed the House will be enacted.
Under present procedures, a
large number of appropriations
bills are considered separately,
without regard to an overall expenditure target, any assigning of
priorities, or sources of financing.
The budget reform bill would, for
the first time, give members of
Congress a chance to vote on
fiscal policy. Until such a measure
is passed, the balance between
expenditures and revenues will
continue to be a "happening"
rather than a policy-and with a
high likelihood of chronic deficits.
Similarly, if we are to overcome
inflation, the Federal Reserve
System must be free to pursue a
non-inflationary growth target for
money and credit-even if higher
interest rates are necessary in the
short run, as inflationary forces
are wrung out of the economy. It
is particularly vital that we not be
pulled off course toward excessive credit ease by the two major
forces that have done so in the
past-i.e., the necessity to finance large-scale budget deficits,
and the tendency to call for easy
money to solve unemployment
problems that could be handled
better through selective measu res.
We are now on the verge of LatinAmerican style inflation, measured in two digits. We must bite
the bullet now, because it will be
much harder to fight inflation the
longer we wait. This effort will
require less expansionary monetary and fiscal policies than we
have been following in recent
years. If we are not prepared to
take these 3ctions, we will be
faced with turmoil, uncertainty
and economic instability for years
ahead. I am confident that the
people of this country, and its
leaders, have better sense.
Conclusion
The fight against inflation this
year and in the years immediately
ahead will not be easy, but it is
absolutely essential. As Chairman
Burns stated in recent testimony
before Congress, continued inflation will "reduce the dollar's
strength in foreign exchange
markets-destroy the gains we
have recently made in strengthening our competitive position in
world markets- ... undermine
confidence ... send interest rates
soaring and wreck our chances of
gaining a stable and broadly
based prosperity in the near future."
11
By Milton Friedman
The Business Review of November/ close reading reveals that it does
December 1973 carried a letter
not do so, and other evidence,
from Federal Reserve Board Chair- to which the Reply does not
man Arthur F. Burns to Senator
refer, establishes a strong case
William Proxmire of Wisconsin on
that
the Fed has contributed to
the subject of monetary policy. To
round out this discussion, the
inflation. The Reply appears to
Review is reprinting a letter from
attribute admitted errors in
Professor Milton Friedman of the
monetary policy to forces outside
University of Chicago on the same
the Fed, yet the difficulties in
subject.
controlling and measuring the
money supply are largely of the
The Honorable William Proxmire
Fed's own making.
Joint Economic Committee
United States Senate
The essence of the System's
Washington, D.C. 20510
answer to the criticisms is contained in three sentences, one
Dear Senator Proxmire:
dealing with the Fed's responsibility for the 1937 inflation; the
On September 17, 1973, you
other two, with the problem of
asked the Chairman of the Board
controlling and measuring the
of Governors of the Federal
money supply. I shall discuss
Reserve System to comment on
each in turn.
certain published criticisms of
Responsibility for Inflation
monetary policy. On November
6,1973, the Chairman replied on
"The severe rate of inflation that
behalf of the System. This Reply
we have experienced in 1973
has been widely publicized by
cannot responsibly be attributed
the Federal Reserve System. It
was reprinted in the Federal
to monetary management"
Reserve Bulletin (November,
(emphasis added).
1973) and in at least five of the
separate Federal Reserve Bank
As written, this sentence is unexReviews.
ceptionable. Delete the word
"severe," and the sentence is
The Reply makes many valid
indefensible.
points. Yet, taken as a whole, it
evades rather than answers the
The Reply correctly cites a numcriticisms. It appears to exonerate
ber of special factors that made
the inflation in 1973 more severe
the Federal Reserve System from
than could have been expected
any appreciable responsibility
for the cu rrent inflation, yet a
12
Q
I
from prior monetary growth
alone-the world-wide economic boom, ecological impediments to investment, escalating
farm prices, energy shortages.
These factors may well explain
why consumer prices rose by 8
per cent in 1973 (fourth quarter
1972 to fourth quarter 1973) instead of, say, by 6 per cent. But
they do not explain why inflation
in 1973 would have been as high
as 6 per cent in their absence.
They do not explain why consumer prices rose more than 25
per cent in the five years from
1968 to 1973.
The Reply recognizes that "the
effects of stabilization policies
occur gradually over time" and
that "it is never safe to rely on
just one concept of money." Yet,
the Reply presents statistical data
on the growth of money or income or prices for only 1972 and
1973, and for only one of the
three monetary concepts it refers
to, namely M 1 (currency plus demand deposits), the one that had
the lowest rate of growth. On the
basis of the evidence in the
Reply, there is no way to evaluate
the longer-term policies of the
Fed, or to compare current monetary policy with earlier policy, or
one concept of money with another.
From calendar year 1970 to calendar year 1973, M 1 grew at the
annual rate of 6.9 per cent; in the
preceding decade, from 1960 to
1970, at 4.2 per cent. More striking yet, the rate of growth from
1970 to 1973 was higher than for
any other three-year period since
the end of World War II.
The other monetary concepts tell
the same story. From 1970 to
1973, M 2 (M 1 plus commercial
bank time deposits other than
large CO.'s) grew at the annual
rate of 10.5 per cent; from 1960
to 1970, at 6.7 per cent.
From 1970 to 1973, M 3 (M 2 plus
deposits at non-bank thrift institutions) grew at the annual rate of
12.0 per cent; from 1960 to 1970,
at 7.2 per cent. For both M 2 and
M:i , the rates of growth from
1970 to 1973 are higher than for
any other three-year period since
World War II.
As the accompanying chart demonstrates, prices show the same
pattern as monetary growth except for the Korean War inflation.
In the early 1960's, consumer
prices rose at a rate of 1 to 2 per
cent per year; from 1970 to 1973,
at an average rate of 4.6 per cent;
currently, they are rising at a rate
of not far from 10 per cent. The
accelerated rise in the quantity
of money has clearly been reflected, after some delay, in a
similar accelerated rise in prices.
However limited may be the
Fed's ability to control monetary
aggregates from quartu to quarter or even year to year, the monetary acceleration depicted in the
chart, which extended over more
than a decade, could not have
occurred without the Fed's acquiescence-to put it mildly. And
however loose may be the yearto-year relation between monetary growth and inflation, the
acceleration in the rate of inflation over the past decade could
not have occurred without the
prior monetary acceleration.
Whatever therefore may be the
verdict on the short-run relations
to which the Reply restricts itself, the Fed's long run policies
have played a major role in producing our present inflation.
There is much evidence on the
shorter-term as well as the
longer-term relations. Studies for
the United States and many other
countries reveal highly consistent
patterns. A substantial change in
the rate of monetary growth
which is sustained for more than
a few months tends to be followed some six or nine months
later by a change in the same
direction in the rate of growth of
total dollar spending. To begin
with, most of the change in
spending is reflected in output
and employment. Typically,
though not always, it takes an13
Table I:
Dates for
M I , M 2 , M;1
Annual Per Cent Rates of Growth from First
Quarter to First Quarter of Indicated Years
Mj
1959
1961
1963
1965
1967
1969
1971
to
to
to
to
to
to
to
1961
1963
1965
1967
1969
1971
1973
Money and Prices
0.8
2.4
4.1
3.7
7.3
4.8
7.2
M2
Ms
2.5
5.9
6.9
7.2
9.4
6.3
10.4
4.6
7.6
8.3
6.7
8.8
6.4
12.6
Consumer
Prices
1.1
1.3
2.7
4.2
5.5
3.9
[9.1] *
Dates for
Consumer
Prices
1961
1963
1965
1967
1969
1971
1973
to
to
to
to
to
to
to
1963
1965
1967
1969
1971
1973
*First quarter 1973 to fourth quarter 1973.
other year to 18 months before
the change in monetary growth is
reflected in prices. On the average, therefore, it takes something
like two years for a higher or
lower rate of monetary growth
to be reflected in a higher or
lower rate of inflation.
Table I illustrates this relation
between monetary growth and
prices. It shows rates of change
for three monetary aggregates
and for consumer prices over
two-year spans measured from
the first quarter of the corresponding years. The average
delay in the effect of monetary
change on prices is allowed for by
matching each biennium for
prices with the prior biennium
for money. Clearly, on the average, prices reflect the behavior of
money two years earlier.
14
To avoid misunderstanding, let
me stress that, as the table illustrates, this is an average relationship, not a precise relationship
that can be expected to hold in
exactly the same way in every
month or year or even decade. As
the Reply properly stresses, many
factors affect the course of prices
other than changes in the quantity of money. Over short periods,
they may sometimes be more
important. But the Federal
Reserve and the Federal Reserve
alone has the responsibility for
the quantity of money; it does
not have the responsibility, and
certainly not sole responsibility,
for the other factors that affect
inflation. And the record is unmistakably clear that, over the
past three years taken as a whole,
the Federal Reserve System has
exercised that responsibility in a
way that has exacerbated inflation.
This conclusion holds not only for
the three years as a whole but
also for each year separately, as
Table II shows. The one encouraging feature is the slightly lower
rate of growth of M 2 and M;; from
1972 to 1973 than in the earl ier
two years. But the tapering off is
mild and it is not clear that it is
continuing. More important, even
these lower rates are far too high.
Steady growth of M 2 at 9 or 10
per cent would lead to an inflation of about 6 or 7 per cent per
year. To bring inflation down to
3 per cent, let alone to zero, the
rate of growth of M 2 must be reduced to something like 5 to 7
percent.
Table II: Recent Monetary
Growth Rates
Calendar
Year
1970-1971
1971-1972
1972-1973
Annual Per Cent
Ra te of Growth
7.0
6.4
7.4
11.8
10.2
9.5
12.8
12.5
10.6
Controlling and Measuring
Billion Dollars
600
"The conduct of monetary policy
could be improved if steps were
taken to increase the precision
with which the money supply
can be controlled by the Federal
Reserve. Part of the present control problem stems from statistical inadequacies" (emphasis
added).
550
Again these sentences from the
Reply are literally correct, but
they give not the slightest indication that the difficulties of controlling and measuring the money
supply are predominantly of the
Fed's own making. The only specific problems that the Reply
mentions are the "paucity of data
on deposits at nonmember
banks" and the fact that "nonmember banks are not subject to
the same reserve requirements as
are Federal Reserve Members."
Non-member deposits do raise
problems in measuring and controlling the money supply, but
they are minor compared to other
factors. The Reply's emphasis on
them is understandable on other
grounds. Almost since it was
established in 1914, the Fed has
been anxious to bring all commercial banks into the System,
and has been worried about the
defection of banks from member
to non-member status. It has
Index (1967=100)
Ratio Scales
500
450
400
350
300
250
200
150
140
130
120
llC
100
100
(PI
-
90
80
70
60
194851
'53
'55
'57
'59
'61
'63
'65
'6769
'71
'73
Prices tend to reflect the behavior
of the money supply two year earlier
15
therefore seized every occasion,
such as the Reply provides, to
stress the desirability of requiring
all banks to be members of the
System or at least subject to the
same reserve requirements as
member banks.
Control. Non-member banks
raise a minor problem with respect to control. Their reserve
ratios do differ from those of
member banks. But non-member
banks hold only one-quarter of
all deposits, this fraction tends
to change rather predictably, and
changes in it can be monitored
and offset by open market
operations.
A far more important problem
with respect to control is the
lagged reserve requirement that
was introduced by the Fed in
1968. This change has not worked
as it was expected to. Instead,
by introducing additional delay
betweel. Federal Reserve open
market ofJerations a'ld the money
supply, it has appreciably reduced
"the precision with which the
money supply can be controlled
by the Federal Reserve." Other
measures taken by the Fed have
had the same effect. In an article
on this subject published recently, George Kaufman, long
an economist with the Federal
Reserve System, concluded, "by
increasing the complexity of the
money multiplier, proliferating
16
rate ceilings on different types of
deposits, and encouraging banks,
albeit unintentionally, to search
out non-deposit sources of funds,
the Federal Reserve has increased
its own difficulty in controlling
the stock of money. . . . To the
extent the increased difficulty
supports the long voiced contention of some Federal Reserve
officials that they are unable to
control the stock of money even
if they so wished, the actions
truly represent a self-fulfilling
prophecy."
Even more basic is the procedure
used by the Open Market Desk
of the New York Federal Reserve
Bank in carrying out the directives
of the Open Market Committee.
These directives have increasingly
been stated in terms of desired
changes in monetary aggregates
rather than in money-market
conditions. However, the Desk
has not adapted its procedure
to the new objective. Instead, it
tries to use money-market conditions (that is, interest rates) as an
indirect device to control monetary aggregates. Many students
of the subject believe that this
technique is inefficient. Moneymarket cond itions are affected by
many forces other than the Fed's
operations. As a result, the Desk
cannot control money-market
conditions very accurately and
cannot predict accurately what
changes in money-market conditions are required to produce
the desired change in monetary
aggregates.
An alternative procedure would
be to operate directly on highpowered money, which the Fed
can control to a high degree of
precision. Many of us believe that
the changes in high-powered
money required to produce the
desired change in monetary
aggregates can be estimated
tolerably closely even now. They
could be estimated with still
greater precision if the Fed were
to rationalize the structure of
reserve requirements.
Measurement. Repeatedly, in
the past few years, the Fed's
statisticians have retrospectively
revised estimates of monetary
aggregates, sometimes, as in
December 1972, by very substantial amounts.
The one source of measurement
error mentioned in the Reply is
the unavailability of data on nonmember banks. This is a source
of error because non-member
banks report deposit data on only
two, or sometimes four, dates a
year. The resulting error in estimates for intervening or subsequent dates has sometimes been
sizable, but mostly it has
accounted for a minor part of
the statistical revisions. In any
event, this source of error can be
reduced drastically by sampling
and other devices which the Fed
could undertake on its own
without additional legislation.
More important sources of error
are seasonal adjustment procedures and the estimation and
treatment of cash items, nondeposit liabilities, and foreign
held deposits.
It has long seemed to me little
short of scandalous that the
money supply figures should
require such substantial and frequent revision. The Fed is itself
the primary source of data required to measure the money
supply; it can get additional data
it may need; it has a largp. and
highly qualified research staff.
Yet for years it has failed to
undertake the research effort
necessary to correct known
defects in its money supply
series. *
'On January 31,1974, after this comment had been drafted, the Board of
Governors of the Federal Reserve
System announced "the formation of a
special committee of prominent academic experts to review concepts, procedures and methodology involved in
estimating the money supply and other
monetary aggregates." I have agreed
to serve as a member of this
committee.
Conclusion
For more than a decade, monetary growth has been accelerating. It has been higher in the past
three years than in any other
three-year period since the end
of World War II. Inflation has also
accelerated over the past decade.
It too has been higher in the
past three years than in any other
three-year period since 1947.
Economic theory and empirical
evidence combine to establish a
strong presumption that the
acceleration in monetary growth
is largely responsible for the
acceleration in inflation. Nothing
in the Reply of the Chairman of
the Federal Reserve System to
your letter contradicts or even
questions that conclusion. And
nothing in that Reply denies that
the Federal Reserve System had
the power to prevent the sharp
acceleration in monetary growth.
a temporary, though perhaps
fairly protracted, period of low
economic growth and relatively
high unemployment. Avoidance
of the earlier excessive monetary
growth would have had far less
costly consequences for the
community than cutting monetary growth down to an,appropriate level will now have. But
the damage has been done. The
longer we wait, the harder it
will be. And there is no other
way to stop inflation.
I recognize, of course, that there
are now, and have been in the
past, strong political pressures on
the Fed to continue rapid monetary growth. Once inflation has
proceeded as far as it already has,
it will, as the Reply says, take
some time to eliminate it. Moreover there is literally no way to
end inflation that will not involve
If the Fed does not explain to
the public the nature of our
problem and the costs involved
in ending inflation; if it does not
take the lead in imposing the
temporarily unpopular measures
required, who will?
The only justification for the Fed's
vaunted independence is to
enable it to take measures that
are vvise for the long-run even if
not popular in the short-run.
That is why it is so discouraging
to have the Reply consist almost
entirely of a denial of responsibility for inflation and an attempt
to place the blame elsewhere.
Sincerely yours,
Milton Friedman
Professor of Economics
17
~®~®lfW®
IR.®cq]lillTIlf®m:rn®Iffi fr~
IPIT'TIm®IT' ((J)Iffi
By William Burke
The Federal Reserve Board of
Governors has proposed
extending the present system of
reserve requirements to nonmember institutions-including
both banks and thrift institutions
-to the extent that such
institutions issue deposits that
perform any type of checkingaccount function. This report
presents, in question-and-answer
form, a discussion of this subject.
It beoins with a summary of the
Federal Reserve proposals, followed by some historical background and a discussion of the
monetary-policy uses of reserve
requirements. The report continues with an analysis of the Fed's
supporting arguments, and
concludes with a discussion of
some opposing views.
The basic function of reserve
requirements is to permit the
Federal Reserve to control the
supply of money and credit in
pursuit of its basic economicpolicy goals. Reserve requirements can influence the growth
of bank loans, investments and
deposits, and thus are an important element in the monetarycontrol mechanism. To permit
proper central-bank management
of the supply of money and
credit, banking institutions
should meet their reserve requirements by holding assets in a
form which is under the most
direct control of the Federal
18
Reserve. These assets could be
either vault cash (coins, Treasury
currency, Federal Reserve notes)
or deposits at the Reserve Banks.
This test cannot be met by
present state legislation. Under
such legislation, nonmember
banks may be subject to similar
percentage ratios but are not
required to hold reserves in the
form of deposits at Federal Reserve Banks; instead they may
hold those reserves in other
forms, such as correspondent
balances with other commercial
banks. When such reserves are
held at a member bank, that bank
naturally must support these
balances with its own reserves
consisting either of vault cash or
deposits at the Federal Reserve,
but the size of its cash reserves
will be only a fraction of the
initial deposit at the nonmember
bank.
With present differential reserve
requirements, therefore, shifts of
deposits between member and
nonmember ban ks alter the
quantity of deposits at all commercial banks that can be supported by a given volume of bank
reserves. This factor tends to
loosen the links between bank
reserves and the money supply,
and weakens the Fed's control
over the monetary aggregates.
The problem is complicated by
the sharp fluctuations and rapid
growth of nonmember-bank
deposits. Over the past decade,
nonmember banks have accounted for roughly 40 percent
of the total rise in checking
deposits, but the proportion has
varied in individual years from as
low as one-tenth to as high as
three-fourths or more. Since
1960, moreover, the nonmemberbank proportion of total demand
deposits has risen from 17 to
about 25 percent, and it may well
continue to rise.
The growing importance of nonmember banks mainly reflects
the competitive disadvantage
imposed on member banks by
requiring them to hold reserves
in the form of vault cash or as
deposits at the Federal Reserve.
Non-member banks, in contrast,
can utilize required reserves as
earning assets even when they
are held as demand balances
with other commercial banks,
since these balances also serve
as a form of payment for services
rendered by city correspondents.
As a consequence, banks generally have an incentive to avoid
membership in the Federal
Reserve System. Since 1960,
about 750 banks have left the
System through withdrawal or
mergers, and almost 1,800 newly
chartered state ban ks have remained outside, compared with
less than 100 that elected System
membership. (Over the same
period, there have been about
870 newly chartered national
banks, and these automatically
have become Federal eserve
members.) The subject gains new
urgency because of the recent
efforts of nonbank deposit institutions to evolve new modes of
money transfer, since this factor
could further loosen the linkages
between reserves and the money
supply.
Provisions of Proposed
Legisl alion
What is the Federal Reserve's
basic proposal?
The Federal Reserve proposes to
extend the present system of
reserve requirements to nonmember institutions, to the
extent that such institutions issue
deposits that perform any type
of checking-account function.
What types of deposits would be
included or excluded?
Reserve requirements would be
applied only to nonmember
accounts which are directly
employed in making money payments-that is to demand deposits and to time accounts with
negotiable third-party payment
features. The proposal would not
apply to nonmember time deposits other than negotiable
orders of withdrawal-NOW
accounts, that is, interest-bearing
deposits for which the depositor
can make withdrawals by negotiable or transferable instrument.
Regular time-and-savings deposits would not be included
because they are not highly active
deposits, although they do serve
a money-like function, to some
degree.
What would the new
requirements be?
The reserve-requirement range
would be between 5 and 22
percent for demand deposits,
with the specific figure determined, just as now, by the
Federal Reserve Board of Governors. (The present range is from
10 to 22 percent at reserve city
banks and from 7 to 14 percent at
other banks.) The range would be
between 3 and 20 percent of
NOW accounts. In addition, the
range for member-bank timeand-savings deposits would be
changed from the present 3 to 10
percent, to a range of 1 to 10
percent.
What institutions would be
affected?
The proposal would apply to
commercial banks, of which
there are about 5,700 member
and 8,300 nonmember institutions. It would also apply to
savings and other depository
institutions, along with foreignowned banking institutions that
19
provide demand (checking account) deposits. The reserves
would be held in the form of
vault cash or non-interest-earning
deposits at the Federal Reserve.
The legislation would not require
System membership on the part
of present nonmember institutions, nor would it make any
change in supervisory arrangements.
What exemptions are included
in the proposal?
The draft legislation includes a
provision which effectively
exempts the first $2 million of net
demand deposits and NOW
accounts from reserve requirements. The average size of nonmember bank that would be
totally exempted would be about
$4 million, for total time and
demand accounts. Such institutions number about 3,000, but
they hold only about 21/2 percent
of the nation's total demand
deposits. Altogether, about 62
percent of the present nonmember banks-over 5,000 banks in
all, controlling roughly 6 percent
of deposits-would be exempt
from any reserve requirements
that exceed their present vaultcash holdings.
When would the new reserve
requirements be imposed?
To ease the transition, required
reserves would be phased in
gradually over a four-year period,
20
on those deposits (over $2 million) held at the time the law
goes into effect. The phase-in
would occur at the rate of 20
percent of the total requirement
per year, so that by the fifth year
each bank would be meeting its
full reserve requirement. However, any increase in deposits
over those existing at time of
enactment would be immediately
su bject to the fu II reserve requirement.
What benefits would nonmember
institutions receive under the
Fed's proposal?
The legislation would permit
Federal Reserve credit to be
made available to any institutions
that maintain deposits with Reserve banks, subject to existing
Federal Reserve regulations.
Under present law, credit to nonmembers is extended only in
highly unusual circumstances,
and under restrictive conditions
as to the type of collateral that
may be accepted by the Reserve
Bank. The proposed legislation
would give nonmember institutions greater access to the Fed's
discount window, especially at
times of strong pressures on their
liquidity positions.
What reporting arrangements
would be required?
The legislation would require
reporting of deposit liabilities by
institutions (member and nonmember) that are subject to
reserve requirements set by the
Federal Reserve. This information,
which is needed for monitoring
purposes, would permit comparative analysis of the various
financial institutions as the
proposed reserve structu re goes
into effect.
Historical Background of
Reserve Requirements
What was the original purpose
of reserve requirements?
Before the Federal Reserve
System was founded, reserve
requirements were imposed by
legislation at the national and
state levels as a means of protecting bank liquidity. That
philosophy was reflected in the
original structure of reserve
requirements adopted by the
Federal Reserve.
Are reserve requirements still
used as a means of protecting
liquidity?
Req u ired reserves are no longer
a source of operating liquidity,
except as they can be used within
the weekly reserve-accounting
period to absorb large fluctuations in check clearings. Instead,
the essential function of reserve
requirements today is to serve as
a fulcrum for monetary policy.
Paradoxically, the assets now
called "bank reserves" do not
serve as additional resources for
paying off withdrawals except in
a minor way. (They can furnish a
fraction of the funds needed,
depending on the reserve ratio;
for example, with a 1a-percent
ratio, 1a percent of the funds are
provided through excess reserves
as required reserves fall.) On the
other hand, the additional resources which banks actually
hold to meet withdrawals-their
reserves in a functional senseare not called reserves.
What resources do banks have to
meet customer demands for
withdrawals?
Banks can draw on their liquid
assets; these include reserveaccount balances at the Fed held
in excess of requirements (with
the proviso noted above), plus
their own deposits at other banks
and readily marketable shortterm assets from their loan and
security portfolios. Additionally,
banks usually have other sources
of funds: from other banks in the
form of inter-bank loans, from
the public in the form of interestbearing CD's, and from the Fed
through the discount window if
they are Federal Reserve members. (Nonmember banks may
Percent of Deposits
35
30
25
-
J~
Maximum
/
\
\
20
15
Actual/
f-
10
~
5
-
Minimum"
.D..e.=.sili
~Banks
f-
(Farmerly Reserve City)
o
,-------------------------------,20
15
f-
Moximum_
!-f-_ _~
I
'LJ
'-,L_---"
1O~--5
0
-'-_D~e~m_a~n_d__'D_e__'p_o__'si_ts_'__'__'__L__'_~_'__'__'____~~_'____~~~.LM_i.Ln
i_m~u_m",--,--~,---,
['
Other Bonks
•
(Formerly Country Banks)
..
15
Time Deposits
10
fMaximulT'h..
f-
o
/
(
Minimum
'45
~Arrows
Other Time: Actual
'50
'55
'60
Savings:
'65
'70
\
Actuar
'74
indicate minimum and maximum requirements under Federal Reserve proposals.
·Regulation 0 amendments (Nov. 1972) introduced graduated reserve requirements with
lower requirements for smaller categories of banks.
Reserve requirements generally have trended
downward over the past twenty years
21
borrow from the Fed only under
certain emergency provisions of
the Federal Reserve Act.)
What member-bank liabilities are
subject to reserve requirements?
Legal reserves are required
against the following memberbank liabilities: net demand
deposits (gross demand deposits
less cash items in process of
collection and balances held with
other banks); savings deposits;
other time deposits, defined as
deposits maturing in 30 days or
more; liabilities to foreign
branches, borrowings from foreign banks, and assets acquired
by foreign branches from
their domestic offices; and
funds obtained by member banks
via the issuance of commercial
paper or similar obligations by
their affiliates.
What has been the historical
trend of reserve requirements?
Present reserve percentages have
evolved from about 40 separate
changes since the Federal Reserve System was established.
Perhaps by coincidence, today's
percentages are not greatly different from the original levels.
(Depending on size of bank,
requirements now range from 8
to 18 percent on demand deposits, and from 3 to 5 percent
on time deposits, while marginal
requirements of 8 percent are
imposed on large time deposits
22
and related money-market instruments.) However, reserve
requirements generally have
trended downward over the past
twenty years. Since 1953, requirements on net demand deposits
have been reduced on balance by
about 6 percentage points for
both large and small banks.
Average requirements on timeand-savings deposits are lower
now than twenty years ago, with
requirements on savings deposits
being at their statutory 3-percent
minimum (see chart).
What about the geographic
differentiation of reserve
requirements?
This geographic differentiation
was a holdover from the National
Banking Act, which viewed required reserves as a source of
liquidity. Interbank deposits were
extremely volatile and were concentrated in the larger cities, so
banks located there were subject
to the highest reserves. But with
the passage of time, this system
of reserve classification became
increasingly outmoded. Some
large banks in cities of substantial
size enjoyed the lower reserve
requirement applicable to country members, while some small
banks in major financial centers
had to carry the higher reserve
requirement imposed on reserve
city members. To end this anachronism, in 1972 the Federal
Reserve introduced reforms so
that all member banks of a given
size, whatever their location,
were subject to identical reserve
requirements.
What about reserve requirements
on nondeposit sources of funds?
Such requirements date back to
the tight-money period of 1969.
In that year, and earlier in 1966,
market rates of interest rose
above the ceiling rates payable
on time deposits under the Fed's
Regulation Q, so that investors
switched their funds out of
deposits into bonds and other
market instruments. But Eurodollar borrowings and commercial paper sold by bank-holding
companies provided avenues
through which banks could bid
for funds to offset deposit outflows, since they had never been
subject to Reg Q ceilings. Consequently, in 1969 the Federal
Reserve imposed reserve requirements on additions to Eurodollars, and in 1970 it imposed
requirements on bank-related
commercial paper, in order to
close off those sources of loanable funds and thereby slow the
expansion of bank credit. For
similar anti-inflationary reasons,
the Fed last year imposed marginal reserve requirements on
increases in funds obtained
through CD's or holding-company paper.
What types of reserve requirements are imposed on nonmember banks?
State-chartered nonmember
banks must abide by the regulations of their respective states
with regard to reserves. Since
each state authority sets its own
rules, there are actually 50 sets
of reserve requirements in addition to that of the Federal Reserve
System. (Federa I deposit- insu rance legislation in 1933 in effect
imposed uniform reserve requirements through uniform System
membership, but this provision
was later repealed.) Most states
have reserve-requirement percentages nominally similar to the
Fed's; demand-deposit requirements in 33 states are equal to (or
greater than) those the Fed
imposes on a medium-to-large
bank. However, nonmember
banks oftp.n have more options
than member banks in meeting
reserve requirements, and these
options tend to lessen or even
eliminate their cost burdens.
Nonmembers hold a greater
percentage of their assets in a
form that earns interest or buys
services; some states permit
holdings of U.S. Treasury or
municipal securities to count as
reserves, and most states permit
use of demand balances at city
correspondents, whether or not
the deposited funds have been
actually collected. Thus, non-
members can obtain a competitive edge over member banks
and can be inherently more
profitable.
How do member and nonmember requirements compare
in this District?
In four District states (California,
Nevada, Utah and Washington)
state reserve-requirement ratios
on demand and time deposits are
almost identical to those of member banks. (In these and other
statp.s, of course, state nonmember banks have more options
than member banks concerning
the form in which reserves may
be held.) In three states (Arizona,
Hawaii and Oregon) state reserve
requirements on demand deposits are generally lower. Arizona and Oregon also maintain
a 4-percent rate on all savi ngsand-time deposits, versus 3-percent and 5-percent rates,
respectively, for member banks.
Alaska's state requirements are
higher for both demand and time
deposits. Idaho generally maintains higher reserve requirements
against demand deposits.
What types of reserve requirements are imposed on thrift
institutions?
The Federal Home Loan Bank
System, which covers about
three-fourths of all savings-andloan associations, imposes a
reserve requirement on its members. State-chartered S&L's in 16
states, and state-chartered
mutual-savings banks in 8 states,
also are governed by similar sorts
of requirement. However, the
requirements affecting thrift institutions are designed solely to
further institutional liquidity, and
generally take the form of cash,
deposits with banks, and government securities. Since a rigid
reserve requirement provides
virtually no usable liquidity, the
Home Loan Bank Board tends to
vary the ratio according to conditions, lowering it in periods of
tight money and increasing it
when easier credit conditions
prevail. Thrift institutions' liquidity reserves generally equal or
exceed the Fed's reserve-requirement ratios on time deposits,
although again, there are differences concerning the form in
which reserves may be held.
How does the U.S. differ from
foreign countries in its reserve
requirements?
The United States was the first
country to formalize the traditional cash reserves of commercial banks into a set of legally
req u ired reserve ratios. Today,
however, the U.S. is the only
major industrial country that
splits the responsibility for setting
reserve requirements between
the central bank and regional
23
banking authorities. It is the only
major country that does not grant
the central bank the power to
regulate reserves of nonbank
depository institutions, even
though most savings and other
time deposits are kept with such
institutions. In addition, no other
major country makes centralbank affiliation-and compliance
with its reserve regulationsvoluntary for a significant part of
the commercial-banking community.
How have reserve requirements
evolved abroad?
Legal reserve requirements did
not become part of most foreignbanking legislation until World
War II and the early postwar
years. Some leading countries,
such as Great Britain and France,
introduced reserve requirements
only a few years ago; in fact, the
Bank of England continues to rely
on voluntary compliance with the
ratios it sets. However, those two
countries have used reserve ratios
decisively in recent years to deal
with inflationary pressures. In
Germany, reserve requirements
have become a main tool of
monetary control in the past
several decades.
24
What has been the recent
foreign experience?
Major foreign countries, like the
U.S., have recently experienced
changes in financial structure and
in the channels of credit flows,
as well as in the scope of activity
of various credit-granting institutions. These changes have resulted in successive extensions in
the range of liabilities and in the
range of institutions subject to
reserve requirements. Over time,
reserve requirements have been
imposed on additional types of
institutions that begin to accept
deposits or that become important factors in the short-term
credit market. Moreover, some
countries which typically gain
nonresident deposits during
international crises have imposed
higher reserve ratios (sometimes
marginal requirements) on such
deposits.
Reserve Requirements as
a Policy Tool
What is the basic function of
reserve requirements?
The basic function is not to
ensure bank liquidity, but rather
to permit the Federal Reserve to
control the supply of money and
credit in pursuit of its basic
economic-policy goals. Reserve
requirements provide a known
and controllable base through
which the reserve-supplying and
reserve-absorbing actions of the
Federal Reserve can affect the
supply of money and credit. This
mechanism operates through the
Federal Reserve's control over
the percentage of deposits that
must be held as reserves, in the
form of either vault cash or
balances at Reserve Banks, and
through its influence (via openmarket operations) over the total
amount of member-bank
deposits.
How do changes in reserve
requirements tend to operate?
The Federal Reserve's control
over the level of total deposits is
exercised predominantly through
its open-market purchases and
sales of government securities.
Open-market operations create
or destroy reserves, and in a
fractional-reserve system, these
actions in turn cause a multiple
expansion or contraction of deposits, based on the reciprocal
of the required deposit ratio. But,
in addition} instead of changing
the amount of reserves available
to the banks, the Fed can simply
change the amount of deposits
each dollar of reserves will
permit. This is done} of course,
through changes in reserve requirements. For example, with a
16-percent reserve requirement
(roughly a 6-to-1 ratio) each
dollar of reserve balances permits
the issue of about six dollars in
deposits. With a change in the
requirementto 14 percent
(roughly a 7-to-1 ratio) each
reserve dollar permits about
seven deposit dollars, thereby
raising the total deposit limit to
about 7/6 of the former level.
Could reserve requirements play
a larger role?
Some observers have proposed
an increased use of the reserverequirement tool, through the
device of frequent small percentage changes in such requirements. However, the experiment
hasn't been tried because of the
overall effectiveness of openmarket operations for implementing policy objectives.
(Incidentally, the revival of
monetary policy over two
decades ago was closely linked
to the availability of the weapon
of open-market operations, since
the public debt was large and
widely distributed and was comprised largely of marketable
securities with a wide range of
maturities.) Still, the reserverequirement tool has the advantage of permitting monetary
policy to affect the reserve position of all banks immediately,
thereby permitting a prompt
change in bank-credit availability.
With uniform reserve requirements, this tool could be utilized
more frequently as an instrument
of policy.
When have reserve-requirement
changes been utilized?
The actual use of reserve requirements has varied with monetary
conditions and with prevailing
policy views. Some of the most
notable episodes were the sharp
(and widely criticized) increase in
requirements in 1936-37 to mop
up excess liquidity, the successive
reductions at large banks in 1942
to facilitate bank absorption of
war loans, the modest increases
in 1951 to offset the Korean War's
expansionary impact on bank
credit, followed by gradual reductions from 1953 to 1966 to
meet the general criticism of the
high level of such requirements.
Increases in 1968, -1969 and 1973
were made in an effort to curb
inflationary pressures.
Are differential requirements
valid, as between demand and
time deposits?
Demand deposits are part of the
money supply and are close y
associated with the volume of
spending, and fluctuations in
such deposits are generally presumed to have a greater impact
on economic stability than
fluctuations in time deposits.
Differential requirements thus
serve to neutralize somewhat the
impact on economic activity of
shifts between demand and time
deposits.
Should reserve requirements be
maintained at all on time
deposits?
The answer depends on one's
viewpoint regarding the crucial
monetary aggregate: M" defined
as demand deposits (other than
U.S. Government and domestic
interbank deposits) plus'the nonbank public's currency holdings;
M 2 , defined as M] plus commercial bank time deposits (other
than large CD's); or M o, defined
as M 2 plus thrift institution deposits. The M] advocates feel that
the monetary authorities need
control only demand deposits.
The M" advocates believe that the
leve! required against bank timeand-savings deposits should be
very close to that imposed on
demand deposits. The M, advocates believe that thrift institutions should be subject to the
same requirements as bankscertainly so if they should begin
to offer demand-deposit liabilities. The Fed's view is that some
reserve requirement on at least
bank time deposits is appropriate,
since these deposits are a partial
substitute for money and an important source of loanable funds.
However, if changes in time-andsavings deposits are small or
easily predictable, then the
matter is relatively unimportant
from the standpoint of monetary
policy.
25
Arguments Supporting
Federal Reserve Proposal
What i the basic principle
underlying the Fed's proposal?
The principle is that equivalent
cash reserve requirements should
apply to all deposits that effectively serve as part of the public's
money balances.
What are the two major issues
involved in this controversy?
The first is the need to provide a
more equitable system of reserve
requirements for financial instiutions offering similar deposit
services. The second is the need
to facilitate the management of
monetary policy by sharpening
one of the principal policy tools.
Why is the present system
inequitable?
The inequity lies in the differential cost burdens associated with
the types of assets that may be
cou nted as reserves by the
various types of banks. Member
banks must maintain their reserves in the form of either vault
cash or deposit balances at
Federal Reserve Banks. Nonmember banks have more options in
meeting their reserve requirements, and these options tend to
lessen or even eliminate their
cost burden. For example, 10
states permit use of interest-bearing U.S. Treasury or municipal
securities, and 45 states permit
26
use of demand balances at city
correspondents, to meet at least
part of nonmember-bank reserve
requirements. (State laws allow
uncollected balances to be
counted as legal reserves, and
these balances alone amount to
about 8 percent of demand deposits, or roughly half of average
reserve requirements.) Because
nonmembers hold a greater percentage of thei r assets ina form
that earns interest or buys
services, they have a competitive
edge over member banks and
thus can be inherently more
profitable.
Why does the present system
complicate monetary-policy
formulation?
To achieve good management
over the supply of money and
credit, reserve requirements must
be met by holding assets which
are outside the payments stream
and whose aggregate volume is
under Federal Reserve control.
Reserve requirements set by the
various states do not meet this
test. Nonmember-bank holdings
of interest-bearing securities or
of deposits with other banks fail
to contribute to the monetary-.
policy function of reserves, since
the funds so used remain available to finance additional deposit
and credit expansion. When a
nonmember bank satisfies all or
part of its state reserve req ui re-
ment by holding deposits at a
member bank, that member bank
naturally is required to hold cash
reserves against these deposits at
a Federal Reserve Bank or in its
own bank vault. But in this case,
the size of the member bank's
cash reserve is quite small relative
to the initial deposit at the nonmember. Consequently, the task
of monetary control is complicated by the minor degree to
which nonmember deposits are
indirectly backed by reserves
that satisfy Federal Reserve reserve requirements.
Could a shift toward nonmember
banks further complicate the
problem?
Shifts in deposits between member banks and nonmembers alter
the relationship between reserves
under Federal Reserve control
and the nation's deposits. During
an inflationary period, for example, the Fed generally attempts
to restrain monetary growth by
providing bank reserves at a
reduced pace. However, its
efforts may be offset if the public
is at the same time shifting
deposits into nonmember banks,
thereby leading to a faster growth
of deposits and the money supply
than wou Id be expected from the
slower growth of member-bank
reserves. Deposits at nonmember
institutions require less cash reserves than at mem ber ban ks, so
that the total of deposits that
would be supported by the available total of cash reserves would
be enlarged.
Has a shift of this type actually
occurred?
The nonmember-bank proportion of demand deposits has been
rising over the past decade and
a half, from 17 percent of the
total in 1960 to about 25 percent
of the total in 1973. This has come
about because of a 164-percent
increase in the demand-deposit
component of the money supply
held at nonmember banks, compared with a 61-percent growth
at member banks. Also, deposit
growth at nonmembers has
shown more year-to-year fluctuations than at member banks, thus
compounding the difficulties of
monetary control under the prevailing deposit structure (see
chart). In terms of numbers of
banks, about 750 banks have left
the Federal Reserve System
through withdrawal or mergers
since 1960, while less than 100 of
the roughly 1,850 newly chartered state banks have elected to
join the System over that period.
What accounts for the rapid
growth of the nonmembers?
This trend partially reflects the
rapid population growth in
regions of the country served by
nonmember banks. But a major
causal factor is the competitive
disadvantage imposed on member banks by being required to
hold reserves as vault cash or as
deposits at the Federal Reserve
Bank. Banks must forego earning
assets to build up a reserve
balance at the Federal Reserve.
That reserve balance pays no
interest, although member banks
do receive some services from
the Federal Reserve.
Why does the present system
hamper the use of the reserverequirement tool?
The Federal Reserve must use
changes in reserve requirements
sparingly as an instrument of
monetary policy, since an increase in requirements would
worsen the competitive disadvantage of member banks and
thereby threaten a further erosion
of membership. This inhibition
has been unfortunate, for there
have been times when the
prompt and pervasive impact of
a higher reserve requirement
would have been the best way to
signal a policy move toward
added restraint on credit availability.
Have reserve requirements
actually been raised during
inflation periods?
Twice during the late 1960's, this
weapon was utilized as an antiinflationary move. Again, last
year, the System raised requirements on demand and certain
time deposits, and also appealed
to nonmember banks to cooperate by voluntarily increasing
reserves in a like amount. The
three increases in demanddeposit requirements over the
past half-decade-V2 percentage
point each time-have brought
the requirement for the largest
banks to 18 percent. Given the
severity of the inflation, however,
requirements for large moneycenter banks might have been
raised more frequently, or
brought closer to the 22-percent
maximum, if there had been no
constraints on Federal Reserve
actions in this area (see chart).
Why does the present system
hamper the precision of policy
formulation?
Monetary-policy formulation is
based increasingly on such key
monetary aggregates as the M,
money supply, yet the lack of
current nonmember-bank data
makes it impossible to obtain a
precise measure of this keystatistical series. The latest revision,
which changed the 1973 growth
rate for M, from 5.0 to 5.7 per27
Percent
75
r-----------------------------,
Nonmember Bank Share
------------ ------ - -
- - -- - - -
Of Total Number of Banks
50
25
Of Total Demand Deposits
OL-_L--_L--__L -_ _L -
- ' _ - ' _ - ' _ - ' _ - ' _ - ' _ - - ' - _ - - ' -_ _
Annual Growth {Percent}
15
r-----------------------------
10
,,
5
/
r
....
....
/
/
OL------'-----'---""---'_-'_--'-_--'-_---'-_--'-_......L_......L_......L_......L_--l
1960
1965
1970
Nonmember-bank proportion of total demand deposits
rises from 17 to 25 percent since 1960
28
1973
cent, was caused mostly by the
largest nonmember benchmark
adjustment in the history of the
series. (This factor alone added
$2.8 billion to the level of M, for
both june and October benchmark dates.) There are only
infrequent single-day observations, two to four times a year, of
nonmember-bank deposit data.
But demand deposits are highly
volatile, especially on a day-byday basis, so that money-supply
measures can be distorted by
single-day relationships between
member and nonmember banks.
The situation is complicated by
the size and rapid growth of the
nonmembers' deposit share.
Should reserve requirements be
extended to certain thrift-institution deposits?
Mutual-savings banks in New
Hampshire and Massachusetts
offer depositors interest-earning
accounts subject to a "negotiable
order of withdrawal"-in effect,
an interest-bearing checking
account. Savings-and-Ioan associations in California are attempting to enter the electronic
money-transfer system operated
by the California Automated
Clearing House. These innovations probably represent the first
step toward what ultimately will
become a single, integrated nationwide payments system-and
they raise the question of how
the costs of such a system can be
equitably distributed among all
the institutions involved. If thrift
institutions develop extensive
checking powers and become
part of the newly emerging payments mechanism without assuming a proportional share of
the costs, the present membernonmember inequities would
only be increased.
Should uniform requirements be
imposed on bank and nonbank
time deposits?
From the viewpoint of equity, a
case can be made for uniform
reserve requirements on timeand-savi ngs deposits at all
financial institutions. At the same
time, it should be remembered
that the diversified services
offered by commercial banks
give them an advantage in bidding for such deposits, even after
taking into account their costs of
holding cash reserves. Given the
continuation of recent trends,
however, the increasing provision
of money-transfer services by
nonbank thrift institutions will
blur the distinction between the
two sets of institutions, just as it
blurs the distinction between
checking and savings accounts.
As nonbank institutions become
more like commercial banks, the
basis for difference in reserve requirements will be weakened.
Opposition to Federal
Reserve Proposal
What are some of the major
sources of opposition to the
proposa?
Nonmember banks and financial
institutions tend to oppose the
proposal, because they would
lose their present competitive
advantage if forced to operate
under Federal Reserve requirements. Some member banks also
are doubtful, because they a~e
afraid of losing a considerable
volume of correspondent-bank
balances. In addition, some financial institutions and regulatory
authorities are afraid that the
proposal would lead to universal
Federal Reserve membership,
although the Fed categorically
rejects this view, and specifically
includes widespread exemptions
with the reserve-requirement
proposal.
Is the proposal unnecessary from
the standpoint of monetarypolicy formulation?
Opponents frequently quote a
statement by Federal Reserve
Governor Mitchell, to the effect
that reserve req uirements are a
"desirable and convenient, but
not absolutely indispensable"
tool of monetary control. This
statement supports the idely
accepted view that the Federal
Reserve can influence monetary
aggregates and bank credit
sufficiently by relying solely on
open-market operations and the
discou t wi do . But the rest of
Governor Mitchell's statement,
which opponents generally ignore, states, "to do so would
place a heavier burden on financial markets, and would forfeit
the advantages of immediacy and
pervasivetless inhere t in a general change in reserve requirements." Moreover, the reporting
aspects attendant to the Fed's
proposal will ensure the availability of more precise monetary
statistics.
On equity grounds, should reserve requirements be eliminated
completely?
From the standpoint of equitythat is, equal treatment of all
financial instit tions-t e same
result could be achieved by imposing uniform reserve requirements or by eliminating requirements completely. Proponents of
the latter view argue that reserve
requirements act as a tax-like
penalty on bank earni gs, and
thus should be discarded. However, elimination of this "tax"
would result in an inordinate
increase in the level of bank
profits and a consequent windfall
gain to bank stockholders, which
could be difficult to defe d.
29
Annual Change (Percent)
15
10
5
o
-5
Percent
30 , - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ,
Requirements on Demond Deposits
(Reserve City')
20
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On equity grounds, should
interest be paid on required
reserves?
Since reserve requirements are,
in effect, an excise tax which
currently discriminates among
institutions, a case can be made
for paying some interest return
on required reserves as a means
of offsetting this "tax." The alternative, however, is to end the
discrimination by extending the
scope of the "tax" through uniform reserve requirements.
Adoption of this alternative
approach appears more urgent
because of the strength of the
Fed's arguments for uniform requirements. Moreover, if banks
did receive an interest return on
their required reserves, they
could then be called upon (on
grounds of symmetry) to pay
interest themselves on their
Treasury tax-and-Ioan accounts
and even on their demand
deposits.
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'45
'50
'55
'60
'65
• Central Reserve City prior to 1962
Problem of member-bank erosion tends to restrain Fed
from raising reserve requirements during recent inflation
30
~
o::laae.::.ec
'70
'73
Wo Id the proposal destroy the
dual-banking system?
Opponents of the proposal claim
'that it would erode or even
destroy the dual-banking system
of state and national supervision .
This is the system which, in the
words of the Conference of State
Banking Supervisors, "stimulates
banks to meet local needs
through its contribution to bank
flexibility and its innovative
qualities in a constantly changing
economy." It is alleged that state
nonmember banks are hampered
by state laws and regulations,
which tend to offset their cost
advantage stemming from easier
reserve requirements, and that
loss of this cost advantage would
induce them to switch from state
to national charters. Statechartered nonmember banks are
supervised by state banking
authorities and the FDIC; nationally-chartered banks must be
members of the Federal Reserve
System, and they are regulated by
the Comptroller of the Currency.
Thus, it is argued that a wholesale
shift from state to national charters could lead to the demise of
the dual-banking system. In
rebuttal, it should be noted that
the proposed legislation exempts
most small banks, which are predominantly nonmembers, from
uniform reserve requirements.
The exemption of institutions
with $2 million or less in net
demand deposits and/or NOW
accounts frees 62 percent of
present nonmember banks-over
5,000 banks-from reserve requirements in excess of existing
vault cash holdings.
Would the proposal destroy
correspondent-banking relationships?
Opponents of the proposal point
out that if nonmember banks
were required to place reserves
with the Fed, funds would be
transferred by nonmembers from
their correspondent accounts to
Federal Reserve Banks. Since
member banks' demand-deposit
balances with their correspondents amount to relatively only
half as much as nonmember-bank
balances, compliance with the
Fed's proposal could lead correspondent banks to lose perhaps
half of their present $10 billion
in nonmember accounts, according to the Conference of State
Bank Supervisors. A reduction of
correspondent balances of this
magnitude would sharply reduce
profits derived from providing
correspondent services, and
would thus curtail the availability
of such services and compel
banks generally to rely on the
Fed for an increasing proportion
of correspondent-type services.
In rebuttal, it should be noted
that correspondent banks have
consistently maintained profitable relationships with member
banks as well as nonmembers.
They could perhaps lose some
business under the Fed's proposal, but in view of the exemption provision, certainly nothing
of the magnitude suggested
above. In particular, large correspondent banks furnish services
-portfolio analysis and advice,
assistance in international transactions, loan participations, and
so on-that Reserve Banks do not
and should not provide.
31
@FedFRASER