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Authorized for public release by the FOMC Secretariat on 8/21/2020 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM WASHINGTON, D.C. 20551 August 13, Confidential 1973 (FR) To: Federal Open Market FROM: Arthur L. Committee Broida Attached is a copy of a memorandum from Mr. Axilrod to the Board, dated August 10, 1973, of the Staff Committee on Lagged transmitting the report Reserve Accounting. This is the report which the staff was asked at the July meeting of the Committee to have available by the time of the August meeting. Arthur L. Broida Secretary Federal Open Market Committee Enclosure Authorized for public release by the FOMC Secretariat on 8/21/2020 August 10, 1973 TO: Board of Governors FROM: Stephen H. Axilrod Attached is the initial report of the Staff Committee on Lagged Reserve Accounting. This report focuses on the issue of whether lagged reserve accounting does or does not impede the Federal Reserve's ability to control the monetary aggregates through a reserve handle. The conclusions and recommendations are summarized in the first three pages of the report. The report provides a basis for Board discussion and decision as to whether in principle it is prepared to revert to a contemporaneous reserve system. Should the Board decide in the affirmative on this fundamental issue, the details of a contemporaneous system -- including the role of carry-over provisions, the lag in vault cash, whether reserves should continue to be based on end-of-day deposits, etc. -- could be prepared for decision in a relatively short time span. Because of time pressure, and since the bulk of its research had been devoted to the question of lagged reserves initially assigned to it, the Staff Committee was not able to include a systematic analysis of the carry-over provision in this report. The Committee did recognize (p. 16 of the report) that continuation of the carry-over provisions would help ease bank relations problems in instituting a contemporaneous system. I would suggest that the main issue with regard to carry-overs is whether they should be enlarged and that the Board may wish to have this specific issue considered irrespective of its decision on lagged reserves. Authorized for public release by the FOMC Secretariat on 8/21/2020 First Report of the Staff Committee Lagged Reserve Accounting of This report the Staff on on Lagged Reserve Committee Accounting will focus on the central issue of whether lagged policy's gates. also When up over into carry of country bank reserve and vault cash lagged by two weeks. lag of required reserves on aggre- reserves were introduced member banks were lagged to 2 percent one week, and monetary bank reserves next week reserve sur- the required reserves a similar carry-over privilege old contribute to monetary not or does control ability to permitted to pluses does accounting reserve for reserve period was used in The (they already had deficiencies), reduced the from two weeks calculation Committee believes in relation the that to deposits to of reserves was the two week can be discussed its merits as it control of the monetary aggregates independently of these other measures, although the Committee that many recognizes reserves affects to be in of the country banks the nature of considered lagged a quid pro quo for shortening the reserve period. Our finding procedure makes no aggregates. the is that positive the lagged reserve contribution accounting to controlling monetary If reserve aggregates are used as a handle of policy, contribution of lagged negative. The Committee as of effect, but members reserve accounting is, a whole is differ on if anything, agreed on the direction the probable magnitude. Authorized for public release by the FOMC Secretariat on 8/21/2020 As explained in the ensuing text the Committee has found that lagged reserve accounting: (a) significantly reduces the ability to hit a total reserve or RPD target in the interim between Committee meetings, though to a lesser extent a nonborrowed reserve target; (b) is a less significant¹ limitation on the System's ability to control reserves and monetary aggregates over the longer run; (c) adds to the tendency for day-to-day money market variability; and (d) increases somewhat the range over which the Federal funds rate needs to fluctuate if monetary aggregates are to be controlled by use of a reserve handle. With regard to member bank attitudes toward lagged reserve accounting, the Committee conducted a survey of Reserve Bank personnel who are in close contact with member banks. In an effort to avoid raising unnecessary bank relations problems at this time, the Committee did not sample member bank opinion directly. The response of Reserve Bank personnel suggested that the majority of member banks seem favorably disposed to lagged accounting because they believe it facilitates reserve management. Messrs. Axilrod and Sternlight feel that lagged reserve accounting is probably of little significance as an impediment over a three month control period under current operating procedures. Authorized for public release by the FOMC Secretariat on 8/21/2020 In terms of the economic considerations, abandonment of recommends system. to return to a contemporaneous System were if the a bank relations problem might arise suggests that This lagged reserve the Committee institution accounting and of a contemporaneous reserve accounting system. The members of Committee the they divided, however, on are to abandonment of attach considering monetary control the degree of importance lagged reserve accounting when term horizon. over a longer Thus, if bank relations costs are great some members of the Committee would favor retention of the current system, assuming the per- missible range of variation in the funds rate is not unduly cumscribed. relations objected seems that to The Committee recognizes the potential for a bank problem, but also recognizes to a lagged to be divided the Committee is that bank opinion (and a number appear to be of reserve market conditions, and individual bank to the principal presented below. of lagged originally currently indifferent), and the potential disadvantage lagged system. Analysis ship reserve system, that many banks a number of banks may not understand them of cir- ¹ It should to issues These issues considered by the include accounting to reserve Desk operations, to the be pointed out that members are mainly matters of emphasis and degree. relation- targets, to money demand for money, reserve management and bank not in complete agreement on analytic points, the of relations.¹ the Committee are though differences Authorized for public release by the FOMC Secretariat on 8/21/2020 Lagged reserve accounting and reserve targets The two week lag in reserves means, technically, that the Desk's capacity to affect period between total reserves, or RPD, in the FOMC meetings is more limited than it would be under a contemporaneous system. Required reserves ly fixed in the two statement weeks after a in the statement week that includes are essential- FOMC meeting and the Tuesday meeting. With required reserves fixed, all System open market operations can do in the two weeks just after an FOMC meeting is change nonborrowed reserves or, what affect free reserves. only to the extent Excess levels by banks. is in effect the same thing, RPD in those two weeks can be affected that excess reserves are in the process changed. reserves are generally kept at near minimum In any given statement week, though, operations can force excess reserves on the banking system. It is much more difficult, however, to reduce RPD's because doing so would force reserve deficiencies on the banking system. Banks would offset such deficiencies by borrowing since by law they must attempt to meet their legal reserve requirements. In any event, the Federal funds rate constraint will forestall an effort by the System to expand or contract excess reserves sharply relative to normal As a result, (though volatile) bank demands. the fixed required reserves will pretty much determine RPD in the first two week period following the Committee meeting. The inflexibility of required reserves in the lagged system will under certain circumstances seriously limit the FOMC's Authorized for public release by the FOMC Secretariat on 8/21/2020 ability to hit a shortrun RPD target through current open market operations. For example, if deposits in the two weeks preceding and surrounding the FOMC meeting turn out to have been much higher than originally estimated at the time of the FOMC meeting, and hence required reserves in the higher, this may raise RPD above target. target period much The Desk would have a very difficult time getting down to target in the period between Committee meetings because actions taken in the first two week period just after the FOMC meeting would influence required reserves and RPD only in the last two weeks of the usual four week operating period. This may not represent sufficient time to move the desired average for the month down to target. Of course, Desk operations would be affecting deposits in the whole four week inter-meeting operating period. though required reserves the Even cannot be affected by Fed operations in first two weeks, deposits can as, for example, banks sell assets to the public or restrict loans. The extent of deposit liquidation that might occur early in a period will depend on the speed of bank and public response in light of changes money market conditions and interest rates. in Given moderate changes in money market conditions, a relatively limited deposit response is likely in the first few weeks after an FOMC meeting but with the response becoming larger as more time passes. While the exact nature and time path of the lagged relationship between deposits and interest rates is not fully known and is probably highly variable in any event, the deposit Authorized for public release by the FOMC Secretariat on 8/21/2020 response set nonborrowed in motion the System's through ability to permit attainment of the in reserves and/or money market conditions run should technically control at target an RPD short- least over a two or three month period, assuming that the Federal funds rate constraint were no substantial impediment. Given that not appear accounting would lagged reserve impediment. to be a significant While reserve 2-week that period assumption,over that analysis indicates the preceding accounting itself makes an RPD to hit difficult it more lagged target in the very short run, as compared with contemporaneous reserve accounting, lagged a similar not be reserve accounting would technical impediment to a short-run nonborrowed reserve borrowed RPD target. Conceivably, such or non- a target might not be attained any more frequently than RPD because of the workings of the Federal funds rate constraint, but the on odds attainment would be greater. reserves and money market Lagged Apparently one of conditions the original purposes behind intro- duction of lagged reserve accounting was for reserve adjustments within the to develop near the close of to occur because member banks their level reserve of banking system that This a reserve period. would no longer be required reserves and positions better. to moderate pressures therefore tended was expected uncertain about could manage their Authorized for public release by the FOMC Secretariat on 8/21/2020 Our research indicates that money market conditions have, however, been more volatile toward the end of a statement week since the introduction of lagged reserves. greater day-to-day changes afterward There were toward the end of the state- ment week in member bank borrowings, the Federal funds rate, and the System's holdings of securities. Monday-to-Tuesday change in the For example, the average funds rate was 35 basis points in the two year period after the introduction of lagged reserve accounting in the latter part of 1968 and 18 basis points in the two year period before. is The Tuesday-to-Wednesday change comparison even more dramatic--29 basis points before and 83 basis points in the two years after. Analysis of two additional years of data does indicate a drop in the day-to-day change in the funds rate to around pre-lag dimensions, but this was accompanied by substantially larger changes securities as offsetting in System holdings of U.S. Government open market operations were required to moderate money market variability. The tendency toward greater money market variability under lagged reserve accounting can be explained as follows. Suppose for example, a deposit and reserve drain from a bank reflects a move into currency or decline in float rather than a shift of deposits and reserves to another bank. there will be a very clear net increase in demand In this case, for Federal funds under a lagged as compared with a contemporaneous reserve system because the banking system has lost reserves but has not Authorized for public release by the FOMC Secretariat on 8/21/2020 also experienced a partly compensating fractional decline in required reserves. more than otherwise. As a result, the funds rate will tend to rise A part of the tendency to greater fluctua- tion will be moderated, of course, by increased Federal Reserve market intervention to keep the rate within a permissible band. As well as leading to a greater tendency for money market conditions to fluctuate within a statement week, lagged reserve accounting also requires somewhat greater week-to-week movement of the funds rate to achieve a given money supply objective if that objective is sought through use of a reserve handle. For example, if M 1 turns out to be much stronger than desired in the initial week of an operating period, under a contemporaneous reserve system required reserves would rise and the money market would tend to tighten, assuming the Fed were following a nonborrowed reserve target or an RPD target. This tightening would set in motion forces leading to deposit destruction--to a small degree in the current week and more so in subsequent weeks. Under a lagged system, the rise in required reserves would occur two weeks later, and money market tightening would not occur until that time. Bank adjustments leading to deposit destruction would also not occur until that time. But because two weeks have been lost, the Federal funds rate would have to Authorized for public release by the FOMC Secretariat on 8/21/2020 under a contemporaneous it would have than rise somewhat more system.¹ It is most difficult estimate of the to obtain an rate amount of additional week-to-week variation in the funds that is needed to a lagged amount system. control money supply through reserves under The of two week lag reduces because the relatively the response is the loss the lagged reserve structure. On and in the other the amount of additional week-to-week variation would be larger to a very short period the extent We have it was desired to get back on path within following appear to be attempted to required weekly money market model. gestive. cation and in money growth. an overshoot obtain an greater week-to-week variation in would from a small delay the Any relatively short. the relation between money demand reduces also response caused by of delay in long lag in interest rates hand, smallness the Federal from simulations on The results are funds them are in an rate that an experimental at best merely sug- Weekly models are difficult to work with. estimation of the degree estimate of early Specifi- stage of development. 1 On the other hand, it is possible that if the Desk were sufficiently alert to the stronger than desired M 1 as it occurred, it could immediately impose the more stringent conditions that This would have developed automatically under the no-lag system. assumes, of course, not only adequate deposit statistics but also more confidence than decisions in using decisions as about reserves as to the a means of funds rate rather controlling M 1 . This is discussed in more detail in the section on the demand for money. Authorized for public release by the FOMC Secretariat on 8/21/2020 Moreover, so many complicated, flows affect large, money markets weekly that and often random the effect of financial lagged reserves is difficult to measure,or discern, within the large margins of error in the model. Our best conservative judgment is that a 2 week lagged reserve system might require the Federal funds rate range associated with a reserve target to be 10--25 basis points wider than it otherwise would be under a contemporaneous system.¹ Lagged reserves and Desk operations One of the by-products of lagged reserve accounting has been that the Trading Desk has had the use of a required reserve figure that is not subject to substantial later revision. Under the previous contemporaneous system, revisions in required reserves were one of the significant sources of error in day-to-day projections of factors affecting reserve availability. Accordingly, the Committee undertook to review evidence of the extent to which a return to a no-lag system might again subject the Desk to this type of projection error, and to consider the ability of the Desk to cope with additional uncertainty from this source. 1 One Committee member--Mr. Sternlight--remains skeptical whether even this modest estimated increase in Federal funds rate variation is needed to achieve comparable control of M under a lagged reserve system as compared with a no-lag system. He agrees that under a no-lag system, a bulge in M 1 produces an immediate rise in required reserves and upward pressure on the Federal funds But he points out rate, unless the Desk offsets that pressure. that under a lagged reserve system, the Desk may be able to observe the M 1 bulge and act quickly to restrict the supply of reserves, and bring about the desired money market pressure. Authorized for public release by the FOMC Secretariat on 8/21/2020 subject indeed impact of the extent (i.e. it is appropriate reach FOMC reserve and increased the later ning), to be applied in the of the reserve week starting two on deposits out during 1972 to average of later information as reduce this error, but estimate since current urgency for such no-lag system. final day on its effect. in the week just begin- and the actual requirements that finally emerged for that Receipt to of the possible extent of projection errors, (which are based week turned doubt reserves in order to objectives) some growth a absolute difference between Thursday projections required reserves weeks absorbed uncertainty would be beneficial in As to average deposit in absorbing unexpectedly reserves be that to some since would be projection misses "constructive direction" when Moreover, unmanageable. the the additional projection error, the Desk to increase would not be the lag would that while removal of is Our conclusion average up-dated A rough Some $165 million. the week progressed would no the extent of such reduction is hard reporting needs have not generated the information that would exist a estimate of a given week, within about about is that by the morning of required reserves projections $75 million of the miss under of in required the might be the mark. reserves projections would serve to offset misses from other factors, so that over-all reserve projections accuracy would not suffer to the full extent indicated above. In 1972, the average miss change in weekly reserve factors on Thursday projections of would have been boosted from net Authorized for public release by the FOMC Secretariat on 8/21/2020 about $240 million to about $300 million because of the inclusion of required reserves on a no-lag basis, while a rough guess of the increased miss in Wednesday projections of the current weekly changes in reserve factors because of unlagging required reserves would be a rise from about $90 million to perhaps $120 million (making some allowance for improved interim estimates of required reserves toward the end of the reserve week). An increase in projection misses of this magnitude, while not particularly welcome, is not unmanageable. Moreover, a major potential advantage of the no-lag system is that easing or tightening of the money market caused by a miss in projecting required reserves would be in the proper direction from a policy standpoint. For example, if deposit growth was unexpectedly strong, the absorption of reserves through increased requirements would cause a tightening of money market conditions that might well be appropriate if the deposit surge was related to a genuine strengthening of the economy. On the other hand, the firming might be inappropriate from the longer run point of view if the deposit strength stemmed from transitory factors that might soon be reversed and had no bearing on the over-all state of the economy. In the latter case, of course, the money market tightening would be followed by an offsetting easing in later weeks. Authorized for public release by the FOMC Secretariat on 8/21/2020 Lagged reserve accounting and money demand. If one were to take the view that we are reasonably certain about the characteristics of the money demand function--particularly the timing and intensity with which interest rates enter into that function-- and that we could forecast the extent of transactions demand, then one could argue that money supply objectives could be attained by controlling, say, the Federal funds rate. Or one might simply take the position that in practice ad hoc adjustment of the Federal funds rate to incoming money supply figures (assuming they were accurate) would be as effective as working on reserves. Control through the funds rate without reference to reserve targets would be in contrast to controlling money by assuming that we have bet ter knowlege of how money relates to the supply of reserves. It is difficult to argue that lagged reserve accounting has much relation to the public's demand for money. Thus, it should be pointed out that lagged reserve accounting is no impediment to an effort to control money through adjustments in the Federal funds rate, without reference to reserve targets. Lagged reserve accounting would still lead to a tendency for more day-to-day fluctuation in the funds rate than otherwise. But additional week-to-week variation would not be necessary to the extent that the Desk had accurate enough deposit figures to respond early to incoming data. It is not the province of this Committee to take a position on the key question of whether the handle for monetary policy in terms Authorized for public release by the FOMC Secretariat on 8/21/2020 or conrrolling ne money supply should be the Federal funds rate or some reserve aggregate. The FOMC appears to be giving weight to both. The Committee does take the view, however, that existence of lagged reserves should not be used as an argument in favor of a Federal funds rate target. Lagged reserve accounting introduces a little more Federal funds rate variability than does contemporaneous reserves accounting if the FOMC chooses a reserve target, and lagged accounting is clearly an unnecessary impediment to achievement of very short-run reserve targets, though not so clearly an impediment to achievement of longer-run targets. On the other hand, although lagged accounting does not impede attainment of a Federal funds rate target, that target itself may or may not bear as close a relationship to a money supply objective as does a reserve target. Whether use of a Federal funds rate or some reserve aggregate provides the best basis in practice for achieving a given money supply objective needs to be determined on its own merits. Bank relations. An extensive bank relations effort was put in by the Federal Reserve at the introduction of lagged reserve accounting in 1968. Reserve Banks, for example, began providing member banks with forms in advance of a given statement week showing what required reserves would be in that week and the amount of reserve balances that needed to be maintained that week at the Fed (assuming normal vault cash holdings of the bank). Authorized for public release by the FOMC Secretariat on 8/21/2020 The knowledge of what reserve balances will be required in a forthcoming statement week seems to simplify reserve management for a large number of banks. The advantage of fixed required reserves appears to them to offset the disadvantage to banks from the fact that their deposit flows would be as uncertain as ever, so that the reserve balances available to meet the required reserves would also be uncertain. Banks with large swings in deposits, such as those in state capitals, appear to be least enamored of lagged reserve accounting. The large number of relatively small banks, and banks with large branch systems appear most favorable toward the lag. Because of the delicacy of the matter, and for fear of wor- sening bank relations if no constructive purpose was being served, the Committee has not contacted member banks, or asked Reserve Banks to make a special effort to contact member banks to ask about their experi- ence and present position. Rather, the Committee has surveyed Reserve Bank personnel who are normally in continuous contact with member banks, such as accounting, discount, examination, and statistical reports officials. The reports from Reserve Bank personnel indicate that member banks on the whole preferred lagged reserve to concurrent accounting. Ease and accuracy of reserve position management appears to be one overriding consideration affecting bank attitudes. the There were apparently some banks who felt that they could live with contemporaneous reserves if the Federal Reserve felt it necessary to revert, but this would of course Authorized for public release by the FOMC Secretariat on 8/21/2020 involve costs of retraining at member banks. It would also involve costs of training and of new forms at Reserve Banks. If the Federal Reserve Board were to determine that it was leaning toward abandonment of lagged reserve accounting on monetary policy grounds, a more direct survey of member banks to obtain a clearer picture of their attitudes could be undertaken. would like to point out, however, The Committee that any bank unhappiness with institu- tion of a contemporaneous reserve system would likely be moderated by continuation of the carry-over provision (which is specifically designed to permit easier adjustment to unexpected deposit and reserve flows), by any educational campaign that explains the monetary policy needed for the contemporaneous system and the relationship of lagged reserves to a volatile Federal fund market, and by knowledge that the costs to banks of instituting a contemporaneous system are mainly the one-time costs of change since continuing costs would not appear to be significant for the banking system as a whole (after weighing the pluses and minuses for different types of banks). Stephen H. Axilrod, Chairman Albert Burger Dorothy Nichols William Poole P. D. Ring Kent Sims Peter Sternlight August 10, 1973
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