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Federal Reserve Bank of St. Louis

Federal Reserve Bank of Richmond
Federal Reserve Bank of St. Louis



Economic Activity EasesDecember 1966-J une 1967 . . . . . . . . . . . . . 22

System Policy Objectives . . . . . . . . . . . . . . .


Structure of the Federal Reserve System . . . .


System Service Functions . . . . . . . . . . . . . . . .


System Influence on Economic Activity . . . . .


The Impact o Monetary Policy . . . . . . . . . . .


The Policy-

aking Process . . . . . . . . . . . . . . 12

Background: Economic Developments
in the Early 1960's. . . . . . . . . . . . . . . . . . . . 14
Inflation AppearsNovember 1964-December 1965 . . . . . . . . 18
Inflation ContainedDecember 1965-December 1966 . . . . . . . . . 19

This pamphlet was written primarily to provide
the layman with an understanding of the role
of the Federal Reserve System in our nation's
economy. The material was originally part
were the authors of the original text, which has been
subsequently updated by A. N. SNELLINGS.
Library of Congress Catalog Card Number: 77-187896
First Edition ...... 1961
Second Edition, First Printing ...... 1962
Second Edition, Second Printing ...... 1963
Second Edition, Third Printing ...... 1964
Second Edition, Fourth Printing ...... 1965
Second Edition, Fifth Printing ...... 1966
Third Edition . . . . . . 1967
Fourth Edition, First Printing ...... 1969
Fourth Edition, Second Printing ...... 1970
Fifth Edition, First Printing ...... 1971
Fifth Edition, Second Printing ...... 1973
Sixth Edition ...... 1974
Federal Reserve Bank of St. Louis

Inflation ReappearsJune 1967-December 1968 ............. 23
The Battle Against InflationDecember 1968-December 1969......... 25
Another Difficult PeriodDecember 1969-August 1971 ........... 28
A New ApproachAugust 1971-December 1972 . . . . . . . . . . . 33

Limitations of Monetary Policy . . . . . . . . . . . 38
Advantages of Monetary Policy . . . . . . . . . . . 39
The Net Result ........................ 40

Objectives, Structure, and 'Functions
Federal Reserve System Keeps Taut
Rein on Credit
Bank Reserves Boost Studied in Fed's
War on Inflation
Discount Rate is Raised; Reserve Board
Calls Boost Anti-Inflationary Move
Banks Cut Borrowing From Fed

These captions from leading New York newspapers describe important Federal
Reserve actions. Such moves naturally raise a number of questions. "What is
the Federal Reserve?" "What does it do?" "How do its actions affect the economy?" "How does it establish policy?" "What are its aims?" "How effectively
can it accomplish its objectives?" Answers to these questions lie at the heart of our
nation's financial mechanism.

System 'Policy Objectives
The Federal Reserve System is the nation's central
bank. Like other central banks throughout the
world, its chief responsibility is to regulate the
flow of money and credit in order to promote
economic stability and growth. It also performs
many service functions for commercial banks, the
Treasury, and the public.
Its policy is aimed at providing monetary conditions favorable to the realization of four objectives: a high level of employment, stability in
the overall price level, a growing economy, and a
sound international balance of payments. System
policy alone cannot, of course, achieve these objectives since many other factors also play important roles. Nevertheless, all System actions are
made in an attempt to facilitate the attainment of
these goals. As economic conditions shift, the
System at times must change the emphasis placed
on each of the four objectives, but all four are
ever in mind. Policies of restraint and ease are
but two phases of System efforts to· achieve these
The four goals are closely interdependent.
Without high employment, an economy can
neither remain prosperous nor grow. With persistent inflation, business practices become waste-
Federal Reserve Bank of St. Louis

ful; speculation replaces productive activity; excesses leading to economic collapse may develop;
and balance of payments problems are apt to
arise. Chronic deficits in the balance of payments
can so tie the hands of fiscal and monetary authorities that they cannot pursue, as actively as
they would like, policies designed to stimulate
employment or facilitate economic progress.
Achievement of high employment, a stable price
level, and a sound international balance of payments, however, promotes the kind of savings,
incentives, and enterprise needed in a growing
economy. Hence, System policies contributing to
these three objectives also produce a monetary
environment conducive to long-term growth.

Structure of the
Pederal '!?§serve System
The System has several important parts: member
banks, the Federal Reserve Banks, the Board of
Governors, the Federal Open Market Committee,
and the Federal Advisory Council.
MEMBER BANKS At the base of the Federal
Reserve pyramid are the System's approximately
5,750 member banks. All national banks must be


members, and state banks may elect to join if
they meet certain requirements. Member banks
held about 77 per cent of all commercial bank
assets and deposits, although less than half the
nation's commercial banks belong to the System.
There are two classes of member banks. Most
banks, located in 46 centers designated by the
Board of Governors as reserve cities,are classified
as reserve city banks, and all other banks are
called country banks. Until July 28, 1962, the
larger New York and Chicago banks were called
central reserve city banks, but now they are
classed simply as reserve city banks.
Membership conveys many privileges but also
involves obligations. Obligations include: holding specified reserves against deposits; subscribing to capital stock of the district Federal Reserve
Bank; complying with various requirements of
Federal banking law; paying at par customers'
checks presented through the mail; completing
necessary System reports; and in the case of State
member banks, being examined and supervised
by the Federal Reserve Banks.
Among the more important advantages a bank
receives from System membership are the prestige of being a member bank and the privileges of
borrowing under certain conditions from its
district Federal Reserve Bank, using System check
collection and wire transfer facilities, obtaining
currency and coin free of transportation costs,
receiving an annual cumulative 6 per cent dividend on its Federal Reserve Bank stock, participating in the System's functional cost analysis
program, using the facilities of the Reserve Banks
for safekeeping securities, and requesting information and receiving aid on various problems
from the Federal Reserve staff.
FEDERAL RESERVE BANKS The country is di-

vided into twelve Federal Reserve districts-each
with a Federal Reserve Bank. There are also 24
Federal Reserve Bank branches serving particular
areas within the districts. Cities with Federal
Reserve head offices are: Boston, New York,
Philadelphia, Cleveland, Richmond, Atlanta,
Chicago, St. Louis, Minneapolis, Kansas City,
Dallas, and San Francisco. These 36 Reserve
Bank offices comprise the second level of the

Federal Reserve Bank of St. Louis

The corporate structure of Federal Reserve
Banks resembles that of commercial banks. All
issue capital stock, have boards of directors who
elect their officers, have many similar official
titles and departments, and obtain their earnings
largely from interest on loans and investments.
There are three main differences, however,
stemming from the Reserve Banks' responsibilities to the public. First, Federal Reserve stockholders do not have the full privileges and powers
that stockholders of privately managed corporations usually have. Second, Reserve Banks are
not profit-motivated, although they do earn large
profits. Expenses and member bank dividends
absorb some earnings, but most are turned over
to the U. S. Treasury as "interest" on Federal
Reserve notes. In 1970 dividends totaled $41 million, and payments to the Treasury ran almost
$3.5 billion. Third, if the Reserve Banks should
ever be liquidated, the Federal Government would
receive any assets remaining after the stock was
paid off at par.
Each Reserve Bank has three Class A directors,
three Class B directors, and three Class C directors. Member banks elect both Class A and
Class B directors by ballot. Those in Class A must
be representatives of the member bank stockholders and usually are commercial bankers.
Class B directors must be actively engaged in
agriculture, industry, or commerce and may not
be either bank officers, directors, or employees.
Class C directors-one of whom is designated as
chairman and one as deputy chairman of the
board-are appointed by the Board of Governors.
A Class C director may be neither a director,
officer, employee, nor stockholder of any bank.
In addition to their regular duties in overseeing
the operations of the Reserve Banks, the boards
of directors also have certain duties in the field of
monetary policy. First, they establish, subject to
the approval of the Board of Governors, the discount rates Federal Reserve Banks charge on
short-term loans to member banks. Second, they
elect five of the presidents of the Federal Reserve Banks to serve as members of the Federal
Open Market Committee. Third, they provide the
Reserve Bank presidents and the Board of
Governors with an invaluable source of "grass
roots" information on business conditions.

BOARD OF GOVERNORS At the peak of the
pyramid is the Board of Governors in Washington. It consists of seven members appointed by
the President of the United States with the advice
and consent of the Senate. Board members are
appointed for fourteen-year terms and are ineligible for reappointment" after having served a
full term. No two Board members may come from
the same Federal Reserve district. The Chairman
and Vice Chairman of the Board are named by
the President of the United States from among
the Board members for a four-year term and can
be redesignated.
One of the Board's important duties is supervision. The Board approves the salaries of all
Reserve Bank officers, the appointment of Reserve Bank presidents and first vice presidents,
and the budgets of Reserve Banks. The Board
also examines Reserve Banks and branches each
year to ensure compliance with regulations and
proper control of expenditures. In addition, it
coordinates System economic research and data
collection and reviews all System publications. It
must also approve acquisitions by bank holding
companies, some bank mergers, and certain other
commercial bank actions.
The Board's prime function, however, is the
formulation of monetary policy. In addition to
approving proposed changes in the discount rate,
it has authority to change member bank reserve
requirements within specified limits, to set margin
requirements for the financing of securities
traded on national security exchanges, and to set
maximum interest rates payable on member
banks' time and savings deposits. Even more
important, members of the Board of Governors
are also members of the Federal Open Market
Committee and participate in the formulation and
administration of open market policy.
Federal Open Market Committee-the System's
most important policy-making body-is composed of the seven members of the Board plus
the President of the New York Federal Reserve
Bank and four other Reserve Bank presidents.
Its main responsibility is to establish System open
market policy-the extent to which the System
buys and sells Government and other securities.
Federal Reserve Bank of St. Louis

It also oversees the System's operations in
foreign exchange markets. It ordinarily meets
every three or four weeks but sometimes more
The "Trading Desk" of the New York Reserve Bank serves as the Committee's agent in
making actual purchases and sales. Government
securities bought outright are then prorated
among the twelve Reserve Banks according to a
formula based upon the reserve ratios of the
various Reserve Banks.
Similarly, the foreign department of the New
York Reserve Bank acts as the Committee's agent
in foreign exchange transactions. Foreign currencies purchased in these operations are also
prorated among the Reserve Banks.
OTHER COMMITTEES Several other committees also play significant roles in System operations. One is the twelve-man Federal Advisory
Council composed of bankers, one from each of
the Federal Reserve districts. Members are elected
by the boards of directors of the Reserve Banks
of their districts. The Council meets in Washington four times a year and advises the Board on
important current developments. The Conference of Presidents and the Conference of Chairmen of the Reserve Banks also meet periodically
to discuss System problems. In addition, several
other System committees continuously review
System operations and policy problems.

System Service 'Functions
Like most other central banks, the Federal Reserve performs many service functions for the
public, the Treasury, and commercial banks.
FISCAL AGENCY FUNCTIONS The twelve Federal Reserve Banks act as the Government's
principal fiscal agents. They hold the Treasury's
checking accounts, receive applications from the
public for the purchase of securities being sold
by the Treasury, allot securities among bidders,
deliver securities, collect from security buyers,
redeem securities, wire-transfer securities to other
cities, make denominational exchanges of securities, pay interest coupons, and assist the Treasury and other Government agencies in many
other ways. The Reserve Banks receive no compensation for handling the Treasury's checking


accounts and redeeming its coupons, but they are
reimbursed for most of the other fiscal agency •
work they perform. During 1970 the System
handled for the Treasury about 276 million
Government securities valued at more than $1.4
ITEMS Federal Reserve Banks also collect for the
public vast quantities of bank checks and substantial amounts of noncash items such as drafts,
promissory notes, and bond coupons. During
1970 the System processed almost 8 billion checks,
totaling more than $3.5 trillion, and 41.5 million
noncash items, valued at over $26.7 billion.

facilitates payments by making available to member banks a wire service that can be used to
transfer funds quickly from one part of the
country to another. For example, a Richmond
buyer wishing to pay a New York seller the same
day can have a member bank request the Richmond Reserve Bank to transfer the funds to the
seller's bank. The Richmond Federal Reserve
Bank deducts the funds from its member's reserve
account, and the New York Federal Reserve Bank
credits the reserve account of the New York member bank so that it in turn can credit the seller's
bank account. The two Reserve Banks then settle
by wire at the end of the day through the System
clearing agency-the Interdistrict Settlement
Fund in Washington. During 1970 the System
made over 7 million wire transfers totaling about
$12.3 trillion.

Federal Reserve Bank of St. Louis

Federal Reserve Banks are the channels through
which practically all cash moves into and out of
circulation. When the public withdraws cash
from commercial banks, the banks replenish their
supply by obtaining shipments from the Reserve
Banks. As the public's need for cash tapers off,
banks return their surplus money and receive
credits to their reserve accounts. During 1970 the
System received and counted over 19 billion bills
and coins valued at over $47 billion.
NOTE ISSUE Nearly 90 per cent of the nation's
"pocket money" is issued by the Federal Reserve
Banks in the form of Federal Reserve notes. All
Federal Reserve notes must be fully collateralized
by Government securities, gold certificates, or
certain other types of assets. When a Reserve
Bank needs more currency to meet the demands
of commercial banks, it can easily obtain additional Federal Reserve notes by pledging the
proper collateral. Conversely, Reserve Banks can
return the notes and recover their pledged collateral when the demand for currency declines.

Banks and the Board of Governors also provide
many other service functions such as answering
requests; distributing monthly business reviews
and other publications; providing speakers for
various occasions; and, upon request, assisting
banks in solving problems.

System Influence on
'Economic u}.ctivity
System policy operates primarily through affecting the availability of bank credit and the money

supply and thereby the volume of spending.
While the initial impact is felt by the commercial
banking system, effects of monetary policy spread
throughout the nation's entire financial mechanism because of the central role played by commercial banks in major loan and securities
WHY COMMERCIAL BANKS ARE DIFFERENT Commercial banks play a key role in monetary policy because they alone among financial
institutions can "create" new money. Other
financial institutions merely transfer existing
money to borrowers when they make loans or
investments. The commercial banking system,
however, can increase the money supply by paying out cash or setting up new demand deposits
when it expands its earning assets. Demand deposits are by far the more important of the two,
constituting nearly 80 per cent of the total and
accounting for an estimated 90 per cent of all
Of course, not every increase in commercial
bank earning assets results in an equal rise in the
privately held money supply-that portion of
demand deposits and cash held by the public.
Sometimes other types of deposits such as time,
Government, or interbank rise instead. Generally, however, an expansion in bank earning assets increas~s the privately held money supply.
Here's how the process of money creation
works. Assume that the Federal Reserve buys
Government securities from a dealer, crediting
the reserve account of the dealer's bank in payment. Since commercial banks are profit-motivated, that bank will then probably use its new
reserve funds to expand earning assets. Whether
it makes loans or investments, deposits or cash
outside banks will increase. If the bank makes
loans, it will probably create the new money by
crediting its borrowers' demand deposits. If it
purchases securities, deposits will rise when the
security dealer deposits the funds received from
the bank.
If these new deposits are checked out to other
banks, reserves of these banks will increase and
those of the dealer's bank will decrease. The
banks holding these new deposits must then set
aside part of their new reserves to meet reserve
requirements against their additional deposits
Federal Reserve Bank of St. Louis

but will be able to lend or invest approximately
the remaining amount. As they expand earning
assets, deposits and possibly public cash holdings
will rise still further. Another part of the new reserves will be used to meet reserve requirements
against these additional deposits, but some excess
reserves will still be available for further loan or
investment expansion. Eventually, the process
ends when deposits rise to the point that banks
must use all the new reserves in meeting reserve
requirements. By this time, however, deposits
will have increased by several times the original
addition to bank reserves.
THE KEY ROLE OF MONEY Money is unique
in that nothing else is generally acceptable in
payment for goods and services. Other assets
such as savings deposits, short-term Treasury securities, and savings and loan shares so closely
resemble money that they often perform some of
the functions of money. Nevertheless, such assets
cannot be spent directly. They must first be converted into cash or demand deposits if a holder
is to buy something in place of them.
Rising economic activity involves increasing
expenditures, and rising expenditures require
either additional money or a higher monetary velocity-the rate at which money is spent on goods
and services. If expenditures,financed with either
new money or rising velocity, increase faster than
the flow of goods and services, inflation results.
If expenditures do not keep pace with the flow,
demand is insufficient to prevent recession. Thus,
a sound economy requires the "right" amount of
spending. Since money plays such a key role in
the spending process, it is essential that the banking system create neither too much nor too little
new money.

a large extent, changes in the volume of bank reserves determine the amount of money banks can
create. When reserves increase, banks have an
incentive to acquire additional earning assets,
which expands deposits or cash outside banks.
Conversely, a reduction in reserves usually forces
banks to cut back loans and/or investments, thereby reducing deposits and cash outside banks.
The extent to which banks can expand the privately held money supply on the basis of new


reserves varies according to a number of factors.
Normally, the lower the reserve requirements,
the larger the expansion since less reserves are
required for each dollar of deposits. The more
"pocket money" expands the smaller the increase, since banks must draw down reserves to
obtain cash for their customers. Changes in the
volume of deposits that are not part of the private
money supply-interbank, Government, and
time deposits-can also have important effects by
either absorbing or releasing reserves. In addition,
shifts of reserves bet.ween country and reserve
city banks affect credit creation since the two
groups hold varying percentages of reserves
against deposits. Finally, variations in the volume of excess reserves that banks choose to
maintain can increase or decrease expansion
Despite all these variations an increase in the
volume of reserves generally results in the creation of additional money, and a decline in reserves usually leads to a reduction in the money
supply. Consequently, the Federal Reserve can
affect interest rates, the money supply, and the
availability of bank credit through its control
over the volume of bank reserves. Because the
banking system plays such a vital role in the
credit mechanism, such effects generally spread
throughout all credit markets.

'(Je Impact of ~onetary 'Policy
Monetary policy affects domestic expenditures
by influencing the behavior of three different
groups: lenders, borrowers, and nonborrowing
Probably the most important effect is its influence on the availability of lenders' funds. During
some periods, for instance, the System may observe inflationary pressures developing as the
public's demand for goods and services exceeds
the available supply. Since part of this demand
is always financed by credit, the System at these
times adopts a policy of restraint to try to prevent
the volume of loanable funds from increasing as
fast as the demands for credit rise.
During these periods, lenders may take two
types of action to balance credit demands with

Federal Reserve Bank of St. Louis

their available supply of loanable funds. First,
they may increase their prices-the interest rates
they charge. In many cases, however, interest
rates do not rise enough to prevent borrowers'
demands from outrunning available funds. Thus,
lenders, in addition,often "ration" credit among
borrowers by various means-raising their standards of credit worthiness, requiring larger down
payments or larger compensating balances in order to limit their available funds to the best credit
risks. Marginal borrowers consequently cannot
expand their spending since they are unable to
obtain as much credit as they want even though
they are willing to pay existing interest rates.
On the other hand, the System at times may
consider it appropriate to increase the availability
of credit to give a boost to total expenditures.
This "easy money" policy provides lenders with
funds to accommodate marginal borrowers, previously part of the "unsatisfied fringe of borrowers," and also encourages lenders to reduce
interest rates to attract still more borrowers.
Borrowers' credit demands are affected in several ways. When money tightens, some demands
-nobody knows exactly how many-are undoubtedly cut back because higher interest rates
discourage some marginal projects. The expected
difficulty of obtaining the desired credit accommodation also may deter borrowers who have
doubts about being able to obtain sufficient funds
to complete their projects even though initial
financing is available. Legal interest rate ceilings
on GI loans and some State and local bond issues
also cut borrowers' demands by i-emoving potential home buyers and governments from the market when prevailing rates exceed the amounts
they can legally pay. Poi tfolio losses, such as declines in bond prices resulting from higher rates,
may likewise discourage potential borrowers
from undertaking projects. Conversely, easy
money can stimulate borrowers' demands by lowering rates, by fostering expectations that funds
will be more readily available, and by creating
"paper" portfolio profits.
Tight and easy money can also influence the
attitudes of spenders who neither borrow nor
lend. An effective tight money policy may, for instance, dampen inflation psychology and cause
the postponement of some outlays that might

otherwise have been made in anticipation of price
increases. In addition, it may cause certain
spenders to reduce expenditures by causing portfolio losses in their security holdings. Conversely,
easy money can stimulate outlays by fostering a
"things-will-get-better" atmosphere and by creating paper profits in spenders' portfolios.

Monetary policy affects not only domestic expenditures but also, directly and indirectly, international trade and international capital movements. Tight or easy money may have direct
effects on the availability of credit to foreign borrowers from U. S. banks and other U.S . lenders
and investors. Indirect effects may be complex
and varied. Generally speaking, however, actions
that encourage noninflationary growth of the
domestic economy contribute also in the long run
to a healthy balance of international payments.

Reserve has two types of tools with which it can
affect the level of domestic economic activity and
the basic balance of international payments:
quantitative or general credit controls and qualitative or selective controls. Quantitative controls
influence the money supply, interest rates, and
the overall availability of credit. Qualitative controls, however, are directed at a particular kind
of credit. The System's principal quantitative
tools are: changes in the discount rate, changes in
reserve requirements, and open market operations . At present the System's only strictly qualitative controls are changes in margin requirements on securities listed on national securities
exchanges. The System also has two other tools
that are partly quantitative and partly qualitative.
One is the setting of maximum interest rates payable on time and savings deposits at member
banks. The other is the buying and selling of foreign currencies in the foreign exchange market.

THE DISCOUNT RA TE Perhaps the best known
of the quantitative tools is the discount rate-the
interest rate charged member banks on loans
from Federal Reserve Banks. Member banks can
borrow in two ways: by giving their own secured
notes or by rediscounting drafts, bills of exchange, or notes from their portfolios. In practice,
Federal Reserve Bank of St. Louis

borrowing banks usually use their own notes
secured by Government obligations.
Changes in the discount rate must be made
separately by each Federal Reserve Bank since
the Bank's directors initiate the change. Generally, all Reserve Banks act at about the same time,
however, since all make their decisions on the
basis of the same sort of evidence. Differences in
timing result mainly from variations in the meeting dates of the twelve boards of directors. The
initial change is the important one, however,
since buyers and sellers in the market generally
expect that other Reserve Banks will soon take
similar actions.
Certain vital effects of changes in the discount
rate are psychological. Such effects are particularly important when observers feel the discount
rate is being used by the System to signal a shift
in the direction of policy. In such cases, the financial markets react immediately-sometimes even
in advance of System actions-when the move is
anticipated. If the rate is increased, interest rates
- particularly those on short-term securitiesgenerally rise, and credit markets tighten. Conversely, a cut in the discount rate that clearly
signals an easing of policy is ordinarily followed
by easier conditions in the money and capital
markets. At times, however, the System nudges
credit markets first with its open market operations and changes discount rates only to bring
them into line with other money rates. Such
changes are often "discounted" in advance and
thus have little immediate effect on the money
Changes in the discount rate also have some
direct effects on short-term interest rates by making borrowings from the central bank either more
or less costly. When the discount rate is increased, banks are more inclined to adjust their
reserve positions by selling short-term Government securities rather than through expanding
their borrowings at the Federal Reserve. The increased sale of securities tends to lower security
prices and raise their yields. These higher market yields in turn tend to push up longer-term
interest rates .
On the other hand, if the discount rate is lowered during an easy money period, banks are
likely to maintain borrowings at the Federal Re-


serve's discount window at a higher level than
would otherwise be the case. This tends to push
rates lower by encouraging banks to hold larger
quantities of Government securities.

operations are the System's most important
credit tool. Operations are conducted primarily in
Government securities, but the System also buys
and sells bankers' acceptances. Both kinds of securities may be purchased either outright or under repurchase agreements requiring the dealers
to buy back the securities within a few days.
Security purchases and sales directly affect the
volume of member bank reserves and, consequently, the overall cost and availability of credit.
When the System buys securities, it credits the
reserve account of the seller's bank, and the bank
in turn credits the seller's bank account. As a
result of the increase in reserves, the banking system can expand credit by a multiple amount.
Conversely, System sales reduce reserves and, if
ever conducted in large volume, would force
banks to contract credit.

Open market operations are either defensive
or dynamic. Defensive operations are those taken
to offset other factors that change the volume of
member bank reserves. If, for example, gold outflows or increases in Treasury deposits at the Reserve Banks are tending to reduce member bank
reserves, the System may make offsetting Government security purchases even though it is not
trying to ease credit policy. Conversely, when it
wishes reserves to drop during a slack season, it
may buy securities if other factors are tending to
Federal Reserve Bank of St. Louis

reduce reserves too fast. Thus, it is impossible to
tell from a sale or a purchase whether the System
is tightening or easing unless one knows how
other factor~ are affecting reserves.
Dynamic operations consist of either causing
or permitting changes in banks' reserve positions
in order to stimulate economic activity or prevent
inflation. Even when the System conducts dynamic operations, it often must take defensive
measures as well so that the dynamic policy can
proceed smoothly.

most immediate and widespread impact is the
Board's power to vary member bank reserve requirements within specified limits. On time deposits, the limits are 3 per cent to 10 per cent for
all member banks. On demand deposits, they are
10 per cent to 22 per cent for reserve city banks
and 7 per cent to 14 per cent for country banks.
Changes in reserve requirements affect member bank actions in two ways. First, they either
destroy or create excess reserves by changing the
amount of reserves required against existing
deposits. Reductions in reserve requirements release reserves and generally bring about an
expansion in bank credit and the privately held
money supply. Increases in requirements have
the opposite effect. Second, changes in requirements alter the amount of deposits a given volume of reserves can support. If reserve requirements are 10 per cent, $1,000,000 in additional
reserves can support up to $10,000,000 of new
deposits. If requirements are 20 per cent, however, the additional reserves cannot support more
than $5,000,000 of new deposits.
MARGIN REQUIREMENTS The Federal Reserve Board also has the right to set margin
requirements-the percentage down payment
required when borrowing to finance purchases
or holdings of securities listed on national exchanges. There are three separate regulationsRegulations T, U, and G. Regulation T covers
brokers' or dealers' loans to customers. Regulation U regulates commercial bank loans to
brokers, dealers, or other customers. Regulation
G governs loans of other lenders.
Margin requirements are directed at only one
type of credit-that used to finance security pur-

chases and holdings. If expansion of security
loans appears to be a factor in undue increases
in security prices, requirements can be raised.
At other times, when there seems to be little
danger of speculation, the System cuts requirements since it prefers not to interfere with the
allocation of credit among different sectors of
the economy.

INTEREST CEILINGS ON TIME AND SAVINGS DEPOSITS The Board also can use its ability to set interest ceilings on member bank time
and savings deposits to influence the overall level
of economic activity. The rates are specified in
the Board's Regulation Q. Rates must be set in
consultation with the Federal Deposit Insurance
Corporation, which sets ceilings on rates paid at
nonmember insured banks, and the Federal Home
Loan Bank Board, which sets ceilings on dividend
rates payable by its member and other insured
savings and loan associations.
Since the Board has the freedom to set many
combinations of ceilings, there are numerous
ways in which the control can be used. If, for
example, the Board wishes to sloyV down the rate
of growth in bank credit, it can refuse to raise
the ceilings payable on certificates of deposit
when competitive rates are moving up and thus
restrict the ability of banks to compete for time
money. If it wishes to lower long-term rates at
the expense of short-term rates, it can raise such
ceilings and enhance the ability of banks to channel funds into the long-term market.
early 1962 the System has also been conducting
foreign exchange operations. Foreign exchange
balances can be acquired either by purchases in
the market or through "swap agreements" with
foreign central banks under which the foreign
central banks credit the System's account on their
books in terms of their own currency in return
for like dollar credits on the books of the Federal
The System can use such foreign balances to
buy from foreigners temporary holdings of surplus dollars that might otherwise result in
unnecessary gold outflows, to prevent disorderly
speculative capital movements from undermining
Federal Reserve Bank of St. Louis

confidence in the dollar, and to assist foreign
monetary authorities in fighting inflation resulting from an inflow of funds. Such measures cannot cure a basic balance of payments problem,
but they can provide a temporary respite during
which a permanent solution can be sought. System actions to promote a healthy domestic economy can, however, contribute to a permanent
solution: (1) by enabling us to compete more successfully in foreign markets and (2) by discouraging excessive outflows of capital resulting from
international differences in financial market
Since System exchange operations have important impacts upon foreign countries as well as
upon the United States, they are conducted in
close cooperation with foreign monetary authorities. There is also close coordination with Treasury officials since the Treasury also operates in
foreign exchange markets. Such cooperation is
facilitated by the New York Reserve Bank's role
as agent for the Treasury in its foreign exchange

COORDINATION AMONG CREDIT CONTROLS Except in the case of defensive open
market operations, the Federal Reserve's credit
control tools are seldom employed independently
of each other. To the contrary, all are coordinated
toward the same end-the System's current policy objectives. Thus, it is usually not meaningful
to speak of "open market policy," or "discount
rate policy," or "reserve requirement policy." Instead, it is more correct to view monetary policy
as a broad program embracing the three quantitative controls, margin requirements, and any
System foreign exchange operations. Action with
respect to any single control is always taken in
the light of prior or planned action concerning
the others.
In selecting various combinations of policy actions, the Federal Reserve considers both psychological and direct effects of its decisions. If it is
felt that a psychological effect is needed to reinforce the direct effects, policy measures may well
include changes in reserve requirements or the
discount rate since these actions are specifically
announced whereas open market operations are
not. Such changes, of course, cannot be made too
frequently without prejudicing their usefulness.


This is especially true of changes in reserve requirements because of their large direct effects on
bank reserve positions. These limitations on the
use of discount rate and reserve requirement
changes place a greater burden on open market
operations as a tool for attaining policy goals.
The right combination of policy moves necessary to achieve a given end depends on many
factors. Policymakers must consider not only domestic economic developments but also the direction and strength of the last policy actions, the
length of time since the last moves, the differential impact of alternative policy measures on the
structure of domestic interest rates, the country's
balance of payments position, and the relationships between domestic and foreign interest
rates. These factors are constantly changing,and,
consequently, the optimum policy combination
for achieving a given end varies from one period
to the next. Thus, monetary authorities must
have considerable latitude in the extent to which
they use the various tools. While the choice between alternative paths to a given policy goal is
secondary to the problem of setting goals, it is an
important aspect of monetary policy because of
the interdependence of the various policy tools .


'Policy- 'Making 'Process

THE POLICY FORUM The meetings of the
Federal Open Market Committee are the System's main policy forum. There both Board and
Bank representatives meet regularly to discuss
economic developments and reach a policy decision for the weeks immediately ahead. In addition
to members of the Board and the five presidents
currently serving on the Committee, the remaining Reserve Bank presidents, the manager of the
open market account and one of his principal assistants, the special manager of the open market
account who handles foreign exchange operations, several Board senior staff members, and
the senior economist from each of the Reserve
Banks ordinarily attend. In this manner, not only
Committee members, but also those presidents
who will soon serve on the Committee, the chief
advisers to the Board and the presidents, and
those who implement the Committee's day-today open market policies are always well informed on current policy actions. Cumbersome

Federal Reserve Bank of St. Louis

as this may seem, it nevertheless constitutes
probably the smoothest and most efficient way
of utilizing the unique contributions of diverse
parts of the System to reach the best-informed
policy judgments.

the meeting, each participant arms himself with
the best available data on domestic and international business conditions and the effects of
current Federal Reserve policy. Board members
and the presidents receive a steady flow of information and analyses from the research departments of the Banks and Board and their personal
contacts with business, academic, government,
and other sources.
Typical of the information sifted and analyzed
are statistics on new orders, business incorporations, construction contract awards, retail sales,
unemployment, employment, industrial production, personal income, business failures, foreign
exchange rates, international reserves, foreign
and domestic interest rates, the international balance of payments, the money supply, foreign and
domestic prices, Government receipts and expenditures, member bank reserves, inventories,
State and local government borrowings, bank
loans and investments, business and consumer
spending intentions, the turnover of demand deposits, and numerous other indicators. In short,
by the time the Committee meets, every participant is well prepared to contribute to intelligent
policy decisions.
meetings generally fall into two parts-a discussion of recent developments and the formulation
of policy for the period ahead. The special manager in charge of the System's foreign exchange
operations leads off, reviewing important developments in foreign exchange markets and
summarizing the System's foreign exchange operations. Next, the manager of the open market
account reviews the Trading Desk's experience
in implementing open market policy since the last
meeting. Senior members of the Board's staff
then summarize important domestic and international business and financial developments,
stressing particularly any new developments that

might not yet have come to the attention of
Committee members.
After the presentation of the Board's staff
members, each Board member and president
gives his interpretation of business conditions
and makes policy recommendations for the
period ahead. Presidents also contribute any significant "grass roots" information they have concerning regional developments.

BETWEEN MEETINGS Between meetings Board
members and presidents keep in daily touch with
the Trading Desk at the New York Bank. One
important means is a detailed phone call around
11 A.M. on business days between senior members of the Board's staff; sometimes the Governors themselves; the officers managing the
open market account;and,on a rotating basis, one
of the president-members of the Committee.
Among the factors discussed are developments
in markets for Government and other securities,
the tone of the money 1'!1arket, the reserve positions of member banks, inventories of Government security dealers, and the probable course of
action to be taken by the Trading Desk. Shortly
Federal Reserve Bank of St. Louis

after the conversation, a senior member of the
Board's staff summarizes the content of the conversation in a memorandum for Board members
and a telegram for presidents. Thus, any member
of the Open Market Committee has ample opportunity to raise with the manager of the account and other Committee members any questions he may have concerning the contemplated
In addition, the Desk prepares daily wires
summarizing conditions at the opening and closing of the securities markets and numerous written memoranda describing the Desk's operations.
Some of these written reports are daily, some
weekly, and some less frequent.
Committee members also keep close tab on
System foreign exchange operations. A senior
Board staff member prepares a daily memorandum for Board members and a daily telegram for
each president describing exchange market conditions, exchange rates, and recent System and
Stabilization Fund operations. In addition, the
special manager prepares for Board members and
presidents weekly, tri-weekly, and other periodic
memoranda describing similar developments.


Pederal ~serve Policy in ulction
How does Federal Reserve policy work in practice? The period from early 1960
through 1970 affords some particularly good examples since it covered economic
conditions ranging from a mild recession to a long period of remarkable growth
and prosperity, culminating in a mild inflation, followed by a period of adjustment,
and ending in a period of strong inflation. In this long period, the System used all
of its conventional tools, sometimes with modifications, and devised some new
ones as well.

13ackground: ~conomic
1Jevelopments in the ~arly 1960's
BACKGROUND The decade of the sixties entered on a note of strong confidence and optimism. The economy had rebounded vigorously
from the1959 steel strike, and both consumer and
business demands were strong. Prices were stable,
and forecasts were glowingly optimistic. Early in
1960, however, the pace of the advance began to
falter. The peak of activity was reached in May
1960, and the economy slid into a recession that
lasted until February 1961.
It was a very short and mild recession. The
decline in GNP was barely measurable, and personal income actually rose slightly. Industrial
production fell by about 6 per cent, and business
expenditures for new plant and equipment
dropped somewhat more. Housing starts held up
well, and new construction expenditures rose
In spite of the relative mildness of the recession, however, two developments were important
and troublesome. First, total employment fell by
about a half million, the number of unemployed
rose by a million and a quarter, and the rate of
unemployment rose from 5.1 to 6.9 per cent. Second, the deficit in our balance of payments, which
had been large for some time, rose further. In
October 1960 wild speculation drove up the London gold price. Over the whole period our gold
stock declined about $2 billion.
The period of recovery, following the trough in
February 1961, can be divided into two main
periods. The first period, running through July
1963, was one of slow but smooth and wellbalanced recovery. There was a distinct lull in the

Federal Reserve Bank of St. Louis

second half of 1962, but the upward movement
regained impetus early in 1963. The growth in
GNP was a low 3.3 per cent in 1961 but rose to
7.7 per cent in 1962 before dropping back to 5.4
per cent in 1963. Wage increases generally did
not exceed productivity gains and prices were
stable except for a slow upcreep of consumer
prices. Employment rose slowly during the first
year of recovery, and unemployment fell to a level
of about four million, or 5.6 per cent of the labor
force. Thereafter, increases in employment nearly
matched additions to the labor force,and over the
next two years there was little change in the level
or rate of unemployment.
From July 1963 to November 1964 the economy moved ahead at a strong pace. GNP, personal
income, and retail sales all showed healthy
growth. Paced by a record production of automobiles, industrial production expanded at an
increasing rate. Business investment expenditures had lagged throughout the first two years
of recovery, but in early 1963 these outlays began to rise sharply. Employment continued its
steady growth, and in the last half of 1964 unemployment moved down from its plateau, with
the rate touching 5 per cent at year-end. Prices
showed no significant movements. The deficit in
the balance of payments, which continued to be
a major source of concern, rose very sharply in
the fourth quarter of 1964.

BACKGROUND Even before the peak was
reached in 1960 the System detected signs of the
slowdown and began to ease credit. This policy
of ease continued through November 1964, al-

$ Billions

(Not Seasonally Adju sted )

$ Millions














Free (+) or Net Borrowed ( - ) Reserves
(Right Sca le)



o L---.....L_ _ _.....___ ___.L...-_ _- ' - - - - . . & . . . . - - - - - . 1 - - - - - - - - ' - - - - . . . . . __ __.....____ _......__ ____,_2,500
Source: Board of Governors, Federal Reserve System .

though toward the end of the period the System
began to move gradually toward less ease. The
policy of ease, however, was carried out in a very
difficult environment. Gold was flowing out of
the country, and interest rates in Europe were
high relative to those in the United States. To
avoid stimulating the outflow of liquid funds, and
thus enlarging the outflow of gold, easing would
have to be accomplished without pushing interest rates in the United States to excessively
low levels. Open market operations were used
Federal Reserve Bank of St. Louis

throughout this period to provide reserves to the
banking system, but these operations exerted direct downward pressure on short-term interest
rates . Thus, the System made an effort to supply
reserves by means other than open market operations and tried in other ways to minimize
downward pressures on short-term interest rates.

involved a change in the legal reserve requirements of member banks. The first change, car-


ried out between December 1959 and November
1960, allowed banks to count vault cash toward
meeting reserve requirements. The second move
was to reduce the reserve requirements of central reserve city banks against demand deposits
from 18 to 161/z per cent. The 161/z per cent requirement was the same as that applied to reserve
city banks, and in 1962 the two categories were
merged. Since country banks had gained most
from the vault cash change, their reserve requirements were raised from 11 to 12 per cent. In late
1962 the reserve requirement against time deposits was reduced from 5 to 4 per cent.
Twist," as it was called, was another technique
devised during this period to avoid downward
pressures on short-term rates resulting from open
market operations. This involved engaging in
open market operations in the intermediate- and
long-term maturity ranges. For some time open
market purchases had been limited, except in
unusual circumstances, to short-term bills. In
1960 purchases were made of securities with
maturities up to 15 months, and over the next
several years the System extended its practice of
buying securities with longer maturities, some
running beyond five years. During 1961 and 1962
purchases of securities with maturities in excess
of one year amounted to nearly $4.5 billion. It
was hoped that this would help to hold up short
rates, thus reducing the outflow of liquid funds,
and to restrain the rise in long rates, thereby contributing to the domestic economic recovery.
REGULATION Q The policy of holding up or
encouraging a rise in short rates was reflected in
System policy actions with respect to both Regulation Q and the discount rate. Early in 1961
New York banks had taken the lead in developing a new kind of financial instrument-the largedenomination, negotiable certificate of deposit.
It was, at the same time, a money market instrument and evidence of a time deposit in a bank.
Development of this instrument represented a
large step toward the evolving practice of commercial banks, especially the large money market
banks, managing their money positions from the
liability rather than the asset side of the balance
sheet. Development of the CD was to have far-

Federal Reserve Bank of St. Louis

reaching effects on the flow of funds and on the
implementation of monetary policy.
As short-term interest rates rose, the rates
banks had to pay on CD's and other time deposits approached the ceiling rates under Regulation Q. To avoid putting undesirable pressure on
bank reserve positions through a run-off in time
deposits, those ceiling rates were raised in January 1962, July 1963, and November 1964. One
consideration involved in these changes was the
ability of banks to attract foreign deposits. In
1962 time deposits of foreign governments and
financial institutions were exempted from the
THE DISCOUNT RATE The discount rate was
reduced twice in the early recession months of
1960, but later on changes in the rate were related to other policy measures designed to slow
the outflow of short-term capital. By the second
quarter of 1963, for example, it became apparent
that action was urgently needed to curb the
rapidly rising outflow of funds. Action was taken
on several fronts. Parts of the "package deal"
were the raising of Regulation Q ceilings and the
imposition of what was called an "interest equalization" tax. A third and important part of the
package was an increase from 3 to 31/z per cent in
the discount rate in July 1963. But by November
1964 short-term market rates were near to or
above the discount rate, interest rates in Europe
were high and rising, and the deficit in our balance of payments and the gold outflow were increasing rapidly. So in November 1964 the discount rate was raised from 31/z to 4 per cent.
The immediate cause of this move, however, was
the sterling crisis and the sharp increase in the
English Bank Rate.
A NEW TOOL The gold speculation of 1960, the
large outflows of gold, and continuing threats to
the orderly operation of foreign exchange markets led to the development of a new tool of
monetary policy. After long deliberations the
Federal Open Market Committee, in February
1962, authorized an arrangement whereby the
System might engage in-foreign currency operations. The purposes were several: (1) to offset or
compensate destabilizing fluctuations in the flow
of international payments, especially if caused by
temporary or speculative factors; (2) to temper


Per Cent
Per Annum












Source: Board of Governors, Federal Reserve System.

and smooth out sharp changes in foreign exchange rates; (3) to supplement international
exchange arrangements; and (4) to provide for
reciprocal holdings of foreign currencies which
might contribute to international liquidity. The
arrangement is a means whereby central banks
of several countries may, in cooperation, provide for the international area some of the
services that a central bank provides for its own
country. In time of crisis or great stress large resources can quickly be assembled to meet a threat
to monetary stability. The arrangement cannot
correct any basic maladjustment in the balance of
payments, but it may prevent gold losses or large
payment flows due to temporary or speculative
Under the administration of a Special Manager
at the Federal Reserve Bank of New York, reciprocal currency or "swap" agreements were arranged with the central banks of the leading
countries of the world. Under these agreements
either the System or the other central bank involved in a particular situation may draw on the
other up to the amount of the established line.
This means, in effect, that the bank with a balance to settle can borrow to get the funds rather
than paying gold or using existing funds, if any.
If the cause of the payments imbalance is temporary and is soon reversed, the transaction can
Federal Reserve Bank of St. Louis

easily be liquidated. If the imbalance persists, it
is expected that the drawing will be funded in
some other form and the proceeds used to repay
the drawing or, if necessary, that the amount will
be paid in gold.
The network of swap agreements proved to be
very useful during the latter part of this period,
with total drawings of $2 billion during the year
1964. Most of this was initiated by foreign central
banks, especially the Bank of England. The System made fewer drawings than in earlier years
and at one time in early 1964 it had repaid all
drawings. In addition, the network served as a
nucleus around which a "credit package" of $3
billion was quickly organized in November 1964
to provide emergency assistance to the pound
FISCAL ACTION Three tax changes were proposed to stimulate employment. One granted
more liberal depreciation allowances, a second
allowed a tax credit for new investments, and a
third reduced substantially corporate and individual income taxes. The first two became effective in 1962, but the third was not enacted until
1964. With these aids, corporate profits rose
rapidly and stimulated business investment.
Spending for new plant and equipment, early in
1963, started a long and steep rise.


To stem the outflow of private funds the President, in July 1963, proposed a substantial tax on
foreign investments, known as the interest equalization tax. The tax was not levied until the following year but was retroactive to the date it was
proposed and was effective immediately in reducing sharply the outflow of funds. This helped
to prevent a rise in the deficit but did little to
reduce it.
In addition to these steps, the Federal budget
provided stimulation in the form of a substantial
cash deficit each year.

Inflation c:Jlppears
?i9vember 1964-'December 1965
During this period the tempo of activity stepped
up considerably in almost every sector of the
economy. In employment, industrial production,
GNP, personal income, retail sales, and construction,rates of growth exceeded the high levels of
1964 and set new records.
Thus, the economy operated under forced draft
for much of 1965. As inflationary pressures
mounted, the usual earmarks of inflation began
to appear-a longer workweek in manufacturing,
a rising level of unfilled orders, faster accumulation of inventories, and, of course, rising prices.
The index of wholesale prices, which had been
almost completely stable for eight years, rose by
2 per cent in 1965, while consumer prices increased their rate of advance.
Total employment increased by 2.6 per centthe largest increase during the expansion. Unemployment dropped steadily and by year-end
was down to about three million, or 4 per cent of
the labor force. Gains in labor productivity
dropped while increases in wage rates quickened.
Rising business investment contributed substantially to the mounting pressures. Previously,
such investment had been financed mainly from
corporate profits. Although those profits continued upward, they were inadequate to finance
all such investments in 1965, and corporations
had to turn increasingly to banks and the capital
market for funds at a time when the demand for
funds from other sources was increasing.

Federal Reserve Bank of St. Louis

FISCAL ACTION Fiscal action by the Federal
Government contributed substantially to the increase in total demand. At the beginning of 1965
the second step of the 1964 tax reduction became
effective. In addition, Congress enacted a substantial reduction in excise taxes. In July our commitment in Vietnam was greatly increased, but
no increase in revenues was provided to cover it.
In September a substantial increase in social
security benefits, includi!}g a large retroactive
payment, became effective. An increase in payroll
taxes to cover the added expenditures was delayed until January 1966. Finally, military and
civil service pay scales were increased in October.
These extra demands of the Federal Government
were superimposed on an economy already operating at or, in some cases, beyond its optimum
rate of utilization.

BACKGROUND The demand for credit was intense during this period. Although the System
moved slowly toward a policy of restraint, member bank reserves, bank credit, and the money
supply increased at faster rates than before. Interest rates rose substantially, with the exception
of those on bank loans and mortgages, which
changed little. Money market banks continued to
attract large amounts of funds by the sale of
negotiable CD's. Bank borrowing from the System rose sharply to over $500 million, and free
reserves gave way to net borrowed reserves.
Money in circulation continued to grow.
period monetary policy was implemented mainly
through open market operations. Despite the
policy of restraint and the increased bank borrowing, purchases were made at a faster rate than
in any previous period of the expansion. In large
part, this was necessary to offset larger gold outflows and the constantly rising volume of currency outstanding. System holdings of U. S.
Government securities increased by $4 billion in
13 months to reach $40.8 billion.
REGULATION Q CEILINGS As credit conditions tightened and interest rates rose, the rates
paid on negotiable CD's moved up steadily and
by late 1965 were pushing hard against their
ceilings. In early December, in conjunction with

the increase in the discount rate, the network of
ceilings was again raised.
THE DISCOUNT RA TE By November 1965 inflation was clearly gaining momentum, and most
market rates were well above the discount rate.
What fiscal action the Federal Government might
propose in the budget to be presented in January
was uncertain. Further, Treasury financing in
that month would interfere with decisive action
by the System. These and other considerations
led to the increase in the discount rate from 4 to
4¼ per cent early in December.
System used and extended its network of swap
agreements with foreign central banks in 1965.
The principal reason for its use was recurrent
speculative attacks on the pound sterling. The
interest equalization tax,as proposed in 1963 and
adopted in 1964,did not apply to bank loans. Late
in 1964 and early in 1965 bank loans to foreigners increased tremendously, and it was suspected that they were being used largely as a
substitute for security issues. In February 1965
President Johnson extended the tax to bank loans
and at the same time inaugurated the Voluntary
Foreign Credit Restraint Program. Under this
Program, which was administered by the System,
banks and other financial institutions were asked
to keep outstanding credits to foreigners in 1965
to a level not more than 5 per cent above amounts
outstanding at the end of 1964. The System issued guidelines for both groups of institutions.
Influenced by the tax, the Voluntary Program,
and higher interest rates in this country, the deficit in our balance of payments fell sharply in
1965 to the lowest level since 1957. Despite this,
however, the outflow of gold rose substantially.
Holdings of gold certificates by the System were
drifting down uncomfortably close to the legal
minimum, and in March 1965 Congress repealed
the 25 per cent reserve requirement against deposits in Federal Reserve Banks.

Inflation ~ontained
'December 1965-'December 1966
The year 1966 was one of the most turbulent and
eventful in the history of the Federal Reserve
System. To deal with fast-changing conditions
Federal Reserve Bank of St. Louis

and unprecedented circumstances, some new
monetary tools were forged and put to use.

In the early part of the year activity continued
at a high and rising rate in nearly all sectors of
the economy. As the year progressed, however,
activity peaked or slowed in most sectors of the
private economy. By year-end,inflationary forces
were on the wane,and signs of a slowdown were
After several record years, automobile sales
turned down in April. This was followed .c losely
by a long and steep decline in housing starts.
Industrial production leveled off and showed
little change after August. Employment and business investment showed distinctly lower rates of
growth in the second half. Retail sales registered
a small absolute decline in the second half, in
sharp contrast to personal income which continued upward. Inventories accumulated at an accelerating rate and reached very large proportions
in the fourth quarter. Prices of industrial raw
materials dropped rather sharply after midyear,
and in the fall the earlier sharp advance in agricultural prices was reversed.
FISCAL ACTION Federal expenditures increased
rapidly but irregularly, and the cash budget fluctuated sharply from deficit to surplus and back
again. Defense expenditures ran far above esti-

mates, but revised estimates and projections were
not made public until late in the year, and then
it soon became apparent that the deficit for fiscal
1967 would be much larger than was originally
An increase in payroll taxes became effective
at the beginning of the year. Shortly afterward
Congress postponed two reductions in excise
taxes enacted the previous year, moved up payment dates for the corporate income tax, and
instituted graduated withholding for individual
income taxes. One result of this was a very large
increase in tax collections in the second quarter
when there was a surplus (unadjusted) of $10
billion in the cash budget for the quarter. This
helped to hold down the cash deficit for the year
ended June 30 to $3.3 billion. Despite much discussion and many proposals, there was no general
tax increase during the year. In September the


President, in an effort to moderate investment
demand, initiated a program to reduce nondefense spending and asked Congress to suspend
for a time the 7 per cent investment tax credit and
the provision for accelerated depreciation on

BACKGROUND Activity in the area of monetary
policy was intense throughout the year. In an
effort to ease the transition to the higher discount
rate, the System for a time supplied reserves more
liberally. As a result total reserves, bank credit,
and the money supply increased faster than before. Business loans in particular grew very
rapidly. At the same time, interest rates, bank
lending rates and rates paid on CD's rose rapidly.
The higher market and bank rates quickly diverted funds from thrift institutions, causing an
acute shortage of mortgage funds and a sharp
decline in residential construction. A little later
banks, under pressure to make business loans:
began to liquidate investments, especially municipal securities, which threatened the stability
of security markets. Much of what the System
did during the year represented attempts to: (1)
slow down the expansion of credit; (2) provide
some relief to the mortgage market; and (3) avoid
the development of additional pressures in the
capital market.
time deposits under Regulation Q were in this
period developed into a complex and rudimentary
tool of monetary policy. Banks, especially large
money market banks, responded to the pressure
to make business loans by pushing up the rates
they paid on negotiable CD's. This had the dual
effect of draining funds from smaller banks and
thrift institutions and shielding the larger banks
from the effects of monetary restraint. The funds
thus obtained went mainly into business loans,
which were used largely to finance fixed investment and increases in inventory, both of which
were expanding very rapidly and thereby contributing to the inflationary buildup. In the meantime many smaller banks were competing for
funds by issuing various kinds of small CD's,
savings certificates, and other instruments bearing rates higher than the rate on savings deposits.

Federal Reserve Bank of St. Louis

As CD rates approached the 5¼ per cent ceiling, the large banks continued to issue more and
more CD's, the amount outstanding reaching a
peak of $18.6 billion in August. The banks apparently were confident that, as in the past, the
ceiling would be raised when going rates approached it. But this time it was different. In
July the Board of Governors reduced the ceiling
on "multiple-maturity" CD's from 5¼ to 5 per
cent. In September, under newly enacted legislation, the Board differentiated among CD's by size
and reduced from 5¼ per cent to 5 per cent the
ceiling on time deposits under $100,000. By this
time it was clear that the ceiling on large CD's
would not be raised. Secondary market rates on
most Treasury bills and other short-term market
instruments including outstanding CD's had gone
far beyond 5¼ per cent and many banks were
able to roll over only parts of maturing CD's.
The amount outstanding started down and by the
end of November stood at $15.5 billion. Thus the
authority to set maximum rates on time deposits
became an auxiliary tool of monetary policy
through its ability to influence the flows of funds.
used its power to set reserve requirements in its
efforts to cool the competition for time deposits
and related liabilities and to restrain the expansion of bank credit generally. In June it raised
from 4 to 5 per cent and in August to 6 per cent
reserve requirements against time deposits, other
than savings deposits, in excess of $5 million at
each member bank. The two increases added an
estimated $870 million to member bank reserve
requirements. A number of banks had begun to
issue short - term promissory notes that had
many characteristics of time deposits. In June the
Board ruled that such notes and similar instruments were subject to the same reserve requirements and interest ceilings as time deposits.
rates were rising rapidly, and most short-term
rates were above the discount rate. Business loans
by member banks were rising at an unprecedented rate. For several reasons the System did
not wish to raise the discount rate, but instead
used moral suasion to hold down bank borrow-

Per Cent of Deposits
20.----------------------------------------All Member
Deposits over $5 Million
Reserve City Banks-Demand Deposits

·------ ------------------~


Deposits up to $5 Million

Deposits over $5 Million


Country Banks-Demand Deposits

Deposits up to $5 Million






I $0-$2 Mil.

Other Time Deposits over $5 Million


All Time and Savings Deposits


--------~------Savings and Other Time Deposits up to $5 Million

*Change in the series due to reclassification of deposit categories under Regulation D.
O --l;-;9;-;63:;-_.__--;-1;:;-:96;-;4_....__~19;-;-65;-_._---:-19;::--:6;-:-6-.,__"-"'.l:-:9-:-:67:--....1,__l9-:-6-8-L.....--:1-:-9-69:--...1..,_-l9_7_0_L__1_9_71_..1..,__19_7_2_L__1_9_73__J
Source: Board of Governors, Federal Reserve System.

ing. First, the president of each Reserve Bank
conferred with a small number of leading bankers
in his district and solicited their cooperation in
keeping discounting to a minimum.
But pressure for business loans was intense and
those loans continued to expand very rapidl;. By
August many banks began to lose funds through
their inability to roll over CD's. They ceased buying municipal bonds, and some began to sell investments. The investment market was threatened with a crisis. On September 1 each Reserve
Bank sent a letter to all its member banks asking
them to curtail the expansion of business loans
and to avoid further substantial reductions of investments. In return, it was noted that banks
which followed such a program might at times
need discount accommodations for longer periods
than usual. This admonition, plus the decline of
CD's because of the operation of the interest rate
ceiling, contributed to a sharp slowing in the
growth rate of business loans, and the expansion
of bank credit was halted. The September 1 letter
was rescinded in late December.
THE DISCOUNT RATE As interest rates rose
ever higher, there was considerable sentiment for
Federal Reserve Bank of St. Louis

a further increase in the discount rate. During
the summer of 1966 five Reserve Banks proposed
such an increase. The Board recognized that
several factors suggested such a move but decided that on balance it was not warranted and
disapproved the proposals.

several tools fashioned to implement monetary
policy, open market operations remained a major
instrument. As noted earlier, reserves were supplied liberally to facilitate the transition to higher
interest rates after the discount rate was raised in
December 1965. From June to November 1965,
nonborrowed reserves rose at an annual rate of
2.8 per cent. From November 1965 through January 1966 the rate was 10.1 per cent. After that,
however, reserves were supplied much more
sparingly, and for the January-June period the
rate fell to 1.7 per cent. In the following months
reserve availability was reduced even further,and
the annual rate registered a decline of 2.1 per cent
from June through November. Over the whole
period holdings of U. S. securities (unadjusted)
rose by $3.1 billion to a total of $43.9 billion.


~conomic u}.ctivity ~ases
'December 1966-June1967
Economic activity eased in most sectors of the
economy beginning in late 1966 and extending
through the first half of 1967. A sharp slowdown
in inventory accumulation was a major cause.
The growth rate of GNP in current dollars was
reduced by more than two thirds in the first
quarter of 1967, while in constant dollars there
was a slight absolute decline. In the second
quarter both growth rates increased significantly but remained well below the rates of 1965
and 1966. Total employment declined steadily
from January through May for a drop of almost
one million before rebounding in June. Unemployment increased little because the labor force
was also declining until May. The rate of unemployment varied between 3.6 and 3.8 per cent
before rising to 4.0 per cent in June. The workweek in manufacturing was shortened substantially, holding down unemployment;but, even so,
factory employment declined by some 325,000.
Industrial production fell by 2.3 per cent from
December to June, and the rate of utilization of
manufacturing capacity dropped from 89 .8 per
cent in the fourth quarter of 1966 to 84.7 per cent
in the second quarter of 1967. Wholesale prices
showed a small net decline between December
and April and then rose rather sharply in May
and June. Consumer prices advanced at a slower
pace until May when they moved up more rapidly.
FISCAL ACTION In view of the large current
and prospective Federal deficits it was generally
agreed that some fiscal restraint would be needed
during the year. In the budget for fiscal 1968 the
President recommended substantial increases in
defense and other expenses and, specifically, increases of $6.2 billion in social security and related benefits and $1 billion in civilian and military pay. On the revenue side he recommended
a 6 per cent surcharge on individual and corporate income tax liabilities and other minor tax
charges to make a total tax increase of $5.8 billion. Proposed also were increases in postal rates
to produce some $700 million, which would cut
the postal deficit about in half. None of these
proposals had been acted on by the end of June.

Federal Reserve Bank of St. Louis

BACKGROUND This period featured one of the
most massive creations of reserves in the history
of the System. As soon as signs of easing appeared, the System, in November, switched to a
policy of moderate ease. That became aggressive
ease in the first quarter and then tapered off
somewhat in the second. All interest rates fell
sharply in January, rose in February, and declined irregularly in most of March. From late
March, short-term rates continued downward,
while intermediate-term and long-term rates
started a long rise that, pushed by very large
new security offerings in the capital market, took
most of them to near their 1966 peaks. Bill rates
jumped sharply at the end of June,but most other
short rates remained relatively low. Bank borrowing of over $600 million in November dropped to
less than $100 million in June,while net borrowed
reserves of more than $200 million gave way to
free reserves of over $250 million.
OPEN MARKET OPERATIONS The major vehicle of monetary policy in this period was open
market operations, which were conducted on a
very large scale. Nonborrowed reserves declined
moderately from May through October 1966.
After rising a little in November and December,
they soared upward at the phenomenal annual
rate of 26.9 per cent in the first quarter of 1967.
This was nearly four times the growth . rate that
prevailed during the recession of 1960-61. In the
second quarter the growth rate dropped by almost half to 14.4 per cent. System holdings of
U. S. securities increased by $2.9 billion to a total
of $46.2 billion. From May 1960 to June 1967
these holdings rose by a little more than $20
RESERVE REQUIREMENTS In March 1967 reserve requirements against savings deposits and
the first $5 million of other time deposits in any
member bank were lowered from 4 to 3 per cent.
It was estimated that this reduced total required
reserves by about $850 million, mostly at country
banks. One reason for the move was to make
more mortgage funds available.
THE DISCOUNT RA TE Early in April all Reserve Banks reduced their discount rate from 41/z
to 4 per cent.

Inflation 'R§appears
1une 1967 -'December 1968
This was a turbulent period, both in the domestic
economy and in international financial markets.
In the second half of 1967 the economy began to
recover from the first half doldrums, and the rapid
pace of expansion continued through 1968. Inflationary pressures reappeared,and by mid-1968
some prices were rising at rates not seen since
the Korean War. There were three major international financial crises during this period.

The entire period from mid-1967 through 1968
was one of strong expansion, with GNP in current dollars increasing at an annual rate of about
9 per cent. This upsurge in activity was accompanied by substantial price rises, however, and
growth in real GNP was just under 5 per cent
per year. Inventory rebuilding contributed much
of the strength in the second half of 1967, with
final sales growing at a slower pace than in the
first half. Residential construction was also an
important source of strength as the housing industry staged a strong recovery from the de..:
pressed levels of early 1967. The expansion became more broadly based in 1968, however, although the strength of particular sectors varied
from time to time. Residential construction
leveled off after the first quarter and showed little
growth until late in the year. Federal Government spending on goods and services rose
strongly through the first half, tapered off
sharply in the third quarter, and increased very
little in the fourth quarter. Consumer spending
grew enormously through the first three quarters,
but increased at a considerably slower pace in
the fourth quarter.
The economy was operating at a high level at
the beginning of this period of expansion. The
unemployment rate for civilian workers stood at
3.9 per cent in June 1967, and over the next year
and a half it rose above 4 per cent in only two
months. It was below 4 per cent throughout 1968
and at the end of that year stood at 3.3 per cent,
a 15-year low. It is not surprising, therefore, that
inflation became a serious problem. From December 1967 to December 1968, the consumer
Federal Reserve Bank of St. Louis

price index rose 4.7 per cent, while wholesale
prices rose about 2.8 per cent.
The economy expanded strongly throughout
1968, but in the fourth quarter the broadly based
expansion of earlier months was changed into
one based primarily on business spending. Consumer spending, which had grown at an average
annual rate of about 10 per cent in the first three
quarters, increased only 4.2 per cent, and spending on durable consumer goods did not increase
at all. The increase in Federal Government expenditures was far below the gains of earlier
quarters. Business fixed investment, on the other
hand, increased at an annual rate of more than
18 per cent, while inventory accumulation rose
from $7.5 billion to $10 billion.
International developments had an important
bearing on policy during this period. In November 1967, the parity of the British pound was
reduced from $2.80 to $2.40. This was followed
by a run on gold, and over the next four months
the United States gold stock fell more than $2¼
billion. As a result, the gold policies of the major
countries were changed by creating a two-tiered
market for gold. The French franc was greatly
weakened in the summer of 1968 by social unrest in France, and by late fall the weakness of
the franc and the pound led to a belief that the
German mark would be revalued upward. A massive speculative movement of funds began, and
in the next few weeks the German central bank
gained billions of dollars in reserves. The governments of France, Germany, and the United Kingdom made a number of policy changes to meet
this situation but there were no changes in exchange parities.

FISCAL ACTION The Federal budget moved
into heavy deficit in the first half of calendar
1967 as receipts leveled off and expenditures rose
sharply. In early 1967, the President had asked
for a 6 per cent surcharge on income taxes to become effective in July, but because of the slowing in economic activity this request was not
pressed. In fact, the Administration requested,
and Congress granted,a restoration of the investment tax credit. Shortly after midyear, however,
with the economy again showing signs of overheating and the budget deficit promising to reach
massive proportions, the President urgently repeated his request for a surtax. This met strong



opposition in Congress, and eventually a major
deadlock developed over demands by Congressional leaders that any tax increase be accompanied by a reduction in spending. This deadlock
was not resolved until June 1968, at which time
the Revenue and Expenditure Control Act of
1968 was enacted. This Act imposed a 10 per
cent surcharge on income taxes and set a ceiling
on certain Federal spending for fiscal year 1969.
Several changes were made in Social Security
taxes and benefits during this period. In January
1968 the maximum income subject to the tax
was raised from $6,600 to $7,800, and in March
the scale of benefits was substantially increased.
The deficit in the Federal budget declined sharply
in the second half of calendar 1968.

BACKGROUND By mid-1967 the rapid improvement in the economy suggested the need
for moderate restraint in place of the policy of
aggressive ease that had been followed in the
first half. Exceptionally heavy demands on credit
markets and uncertainties as to the course of
fiscal action caused interest rates to rise throughout the second half. In the absence of any additional fiscal restraint, and with the devaluation of
sterling, the Federal Reserve System moved
toward monetary restraint in late 1967. In the
early months of 1968, however, it became obvious that further restraint was needed. The international financial system was experiencing a
crisis, domestic financial markets were marked by
a high degree of tension, while inflationary pressures gathered momentum. Monetary policy bore
the entire burden of economic stabilization in the
first five months of 1968 and the Federal Reserve
used all three traditional monetary controls to
restrain the booming economy. Agreement on a
fiscal package in May led to expectations of reduced credit demands and a relaxation of monetary policy. This brought an easing in credit
markets and a downward movement in interest
rates, which the Federal Reserve accommodated.
The impact of the fiscal restraint was much
slower than had been expected, however, and
economic activity continued to advance at a rapid
pace. Credit demands pressed against the available supply, and interest rates rose to new highs.
In the face of sharp upward price movements and

Federal Reserve Bank of St. Louis

evidence of a growing inflationary psychology,
the Federal Reserve System moved in late 1968
to a tighter policy stance.
through mid-November 1967, open market operations supplied reserves at a fairly rapid pace to
meet growing credit demands. Following the
November devaluation of sterling and the ensuing increase in the Federal Reserve discount
rate, however, open market operations were used
first to facilitate orderly market adjustment to
these developments and then to bring about
firmer conditions in money markets. As a result,
nonborrowed reserves, which had risen sharply
from July to mid-November, declined in December. Through the first five months of 1968, open
market operations were used in conjunction with
other policy tools to maintain pressure on bank
reserve positions, and at the end of May 1968
nonborrowed reserves were below the endNovember 1967 figure. Following passage of the
fiscal package, and in the face of heavy demands
on credit markets, open market operations supplied reserves at a rapid pace in the third quarter,
with nonborrowed reserves increasing at an annual rate of more than 13 per cent from June
to September. Open market operations became
increasingly restrictive in the fourth quarter and
although total reserves increased at about the
third quarter pace, member banks were forced
to obtain more of these reserves through the discount window. Borrowings rose from an average
of less than $500 million in September to about
$75_0 million in December, while nonborrowed
reserves rose at a 3 per cent annual rate over the
same period.
THE DISCOUNT RATE Frequent use was made
of discount rate changes during this period. In
November 1967 the rate was raised from 4 to
4½ per cent, mainly in response to international
developments, but the increased pace of domestic
economic activity and the rising level of interest
rates also made this move desirable. The speculative run on gold markets reached the crisis stage
in March,and as part of the response to this situation the discount rate was raised to 5 per cent.
In spite of changes in the international monetary
system, however, foreign exchange markets re-

mained tense and domestic inflationary pressures
gathered strength. These conditions, together
with the deadlock over fiscal policy, contributed
to a high degree of uncertainty in domestic financial markets. In mid-April the discount rate
was raised to 51/2 per cent, the highest it had
been since 1929. Following enactment of the
fiscal legislation and the subsequent easing in
interest rates, the rate was reduced to 5¼ per
cent. This was mainly a technical adjustment,
however, and in the face of continued strong
inflationary pressures the rate was moved back
up to 51/2 per cent in December.

percentage point in the reserve requirement
against demand deposits in excess of $5 million
was announced in late December 1967, to become
effective in January 1968.

REGULATION Q At the time of the discount
rate increase in April 1968, Regulation Q ceilings
were raised on all but the shortest term negotiable time certificates of deposit in denominations
of $100,000 or more. This action was taken to
preclude a large runoff of CD's at commercial
banks as yields on market instruments rose.
When the Federal Reserve System returned to a
tighter monetary policy late in the year, however,
the Regulation Q ceilings were not raised. The
resulting decline in CD's added to pressures on
reserve positions of commercial banks.

We 13attle c.7}.gainst Inflation
By the end of 1968 inflation had become the most
urgent problem facing economic policymakers.
To meet this threat, restrictive monetary and
fiscal policies were followed throughout 1969. By
the end of 1969, real economic growth had come
to a halt, but inflationary pressures remained
strong. The disequilibrium in the balance of payments continued to be a major unresolved problem for the United States.

Through the first three quarters of 1969 growth
in current dollar GNP continued at about the
Federal Reserve Bank of St. Louis

same rate that had been recorded in the second
half of 1968, but as the year progressed price increases accounted for an ever larger part of the
GNP gains. Growth in real GNP, therefore, fell
from an annual rate of 2.4 per cent in fourth
quarter 1968 to 2.0 per cent in third quarter 1969.
The effects of the restrictive economic policies
became even more evident in the fourth quarter,
however, with nominal GNP rising only at a 3.3
per cent rate and real GNP declining slightly.
Business spending on fixed investment was a
major factor in the 1969 expansion, with the increase for the year about double that for 1968.
Growth in personal consumption expenditures
remained fairly strong throughout the year, but
spending on durable consumer goods leveled off
in the second half. Residential construction was
strong in the first quarter, but housing starts,
after peaking at an annual rate of 1.7 million
units in January, moved substantially downward
to 1.4 million units in the fourth quarter. Industrial production peaked in September, then declined through the end of the year. Employment
rose throughout the year, absorbing most of a
very large increase in the labor force, and the
unemployment rate rose from about 3.4 per cent
in the first quarter to about 3.6 per cent in the
final three months of the year. Prices rose at the
fastest pace since the Korean War, with all of the
major indices recording sharp gains.
Speculative pressures on exchange rates and
record-high interest rates in the United States led
to massive flows of funds across the international
exchanges in 1969. The German mark was the
object of heavy speculative buying until the exchange rate for the mark was allowed to float at
the end of September. The rate was stabilized at
a higher par value in October, after which there
was a very heavy reverse flow of funds out of the
mark into other European currencies and the
dollar. The French franc, subjected to heavy
speculative selling in the spring and early summer, was devalued in August. Tight monetary
policy and strong demands for credit in the United
States led to heavy borrowing in the Euro-dollar
market by United States banks. Liquid liabilities
of U.S. banks to foreign commercial banks and to
other private foreigners increased $8.8 billion in
1969, about $7 billion of which was in the form
of an increase in liabilities of U.S. banks to their
foreign branches.



The fiscal policy stance in

1969 was largely determined by the Revenue
and Expenditure Control Act of 1968, which
imposed a 10 per cent surtax on corporate and

individual income taxes and provided for restraints on certain types of Federal expenditures.
Originally, the Act was to be in effect until mid1969. However, during 1969 the surcharge was
extended at the 10 per cent rate through the
end of 1969 and at a 5 per cent rate for the first
six months of 1970. Social Security tax rates were
increased on January 1, and the 7 per cent investment credit was eliminated effective April 21.
'fhese tax measures were accompanied by a determined effort to slow the growth of Federal expenditures. Consequently, the Federal budget,
as measured in the National Income Accounts,
shifted from a large deficit in early 1968 to a
large surplus in 1969.

BACKGROUND In 1969 the System continued
the course of monetary policy restraint initiated
in late 1968. A variety of policy measures were
used to subject the reserve position of the banking system to intense pressure. As a result the
growth in total member bank reserves, which had
been very rapid in 1968, came to a halt.
The narrowly defined money stock rose at an
annual rate of about 5 per cent in the first half,
but in the second half the rate of increase was
only slightly in excess of 1 per cent. Total member bank deposits declined over the course of the
year as certificates of deposit at large commercial
banks fell more than $12 billion.
Pressure on the reserve position of the banking
system combined with a very strong demand for
credit to push interest rates to extremely high
levels. The prime lending rate was raised three
times during the year, reaching a level of 8½ per
cent in June, and both short- and long-term
market rates rose sharply. Since the maximum
rates banks were permitted to pay on time and
savings deposits were not raised, funds were
withdrawn from banks (and thrift institutions)
for investment in market instruments offering
more attractive yields. Commercial banks, attempting to satisfy a very strong loan demand in
the face of a net deposit outflow, employed a
number of techniques (some new and quite in-

Federal Reserve Bank of St. Louis

novative) for ra1smg funds. Liquid assets were
sharply reduced, member banks borrowed heavily
at Federal Reserve Banks, and some banks engaged in outright sales of existing loans. Banks
also sold earning assets with an agreement for
subsequent repurchase. Borrowings by U.S. banks
in the Euro-dollar market doubled in the first half
of 1969 and by the end of June had reached $14.3
billion. Faced with sharply higher interest rates
in the Euro-dollar market and the prospect of a
reserve requirement on at least part of such borrowings, banks sought increasingly to raise funds
through the sale of commercial paper by bank
holding companies, affiliates, and subsidiaries.
The proceeds of such sales were transferred to the
banks by the purchase of loans from them. Some
of the actions of commercial banks, in attempting
to acquire liquidity, created both regulatory and
policy problems for the System.

1969 open market operations were used in com-

bination with other policy tools to exert sustained
pressure on the reserve position of the banking
system. As a result, total member bank reserves
increased at an annual rate of only 1 per cent in
the first half, as compared to an 11 per cent rate
in the second half of 1968, and then declined at a
rate of 4 per cent in the last six months of the year.
Nonborrowed reserves fell even more sharply,
and by mid-year net borrowed reserves exceeded
$1 billion. The System injected net $4.2 billion of
reserves into the banking system during the year.
This large expansion in the System's holdings of
securities, during a period of very tight money,
was necessary primarily to offset the effects of
increases in reserve requirements against member banks' demand deposits and the imposition of
marginal reserve requirements against liabilities
to their foreign branches.

RESERVE REQUIREMENTS In the face of a continued strong expansion in economic activity and
few signs of easing of inflationary pressures, the
Board of Governors announced on April 3 a package of measures designed to underline the System's determination to resist inflationary pressures. An increase of ½ per cent in the reserve
requirement against demand deposits at member
banks was one part of this package. This action
increased required reserves by about $650 mil-

$ Billions

$ Billions





















Per Cent

Per Cent

(Seasonally Adjusted Annual Rates)







- s L , __

___;__J._ _ _.....,_ _ _....1...._ _ _






_ ___._ _ _...,._ _ _








Source: Board of Governors, Federal Reserve System.

lion. In July, Regulation D was amended to
assure that certain officers' checks issued in connection with transactions with foreign branches
were included as deposits for purposes of computing reserve requirements. At the same time
Regulations D and Q were amended to narrow
Federal Reserve Bank of St. Louis

the scope of a member bank's liabilities under repurchase agreements that are exempt from those
regulations. The amendments provided that a
bank liability on a repurchase agreement entered
into with a person other than a bank became a
deposit liability subject to Regulations D and Q


if it involved: (1) assets other than direct obligations of the United States or its agencies or obligations fully guaranteed by them, or (2) a part
interest in any obligation. This action was believed to be necessary because it was thought that
some banks were using repurchase agreements to
avoid reserve requirements and the rules governing payment of interest on deposits. In August
the Board of Governors amended Regulation D
and Regulation M (Foreign Activities of National
Banks) in an effort to moderate the flow of foreign funds between U.S. banks and their foreign
branches and also between U.S. banks and foreign banks. The Board removed a special advantage to member banks who had used Euro-dollars,
which were not subject to reserve requirements,
to adjust to domestic credit restraint. The amendments to Regulation M established a 10 per cent
reserve requirement on net borrowings of member banks from their foreign branches to the
extent that these borrowings exceeded the amount
outstanding in a base period. A similar requirement applied to assets sold by domestic offices to
foreign branches and to loans by branches to
U.S. residents. The amendment to Regulation D
established a 3 per cent reserve requirement on
borrowings by member banks from foreign banks,
up to an amount equal to 4 per cent of the member
banks' deposits subject to reserve requirements.
A 10 per cent reserve requirement was imposed
on borrowings in excess of that amount.

THE DISCOUNT RATE In April the Board of
Governors announced approval of an increase of
½ per cent in the discount rate. This action,
which supplemented restrictive action in other
policy areas, brought the discount rate to 6 per
cent, the highest level in 40 years.

c:.71.nother Vifficult ~eriod
1Jecember1969-~ugust 1971
This was another turbulent period, both in the
domestic economy and in the international exchanges. Throughout 1970, the pace of economic
activity was slowed by the tight anti-inflationary
monetary and fiscal policies that had been pursued in 1969. At the same time, the economy was
buffeted by the reorganization of one of the coun-

Federal Reserve Bank of St. Louis

try' s largest corporations and by a long strike in
the automobile industry late in the year. Real output declined slightly in 1970, unemployment rose
sharply, while prices continued upward under
strong cost pressures. Industrial output fell about
4.8 per cent during the year, with declines centered in defense products, consumer durable
goods, and business equipment. The reduction in
defense production was especially sharp, more
than matching the decline in real GNP. Production rebounded sharply in the first quarter of
1971, with real GNP rising at an 8.0 per cent
annual rate. In the second quarter, however, the
growth in real GNP fell to less than half the first
quarter gain. Unemployment remained high, and
there were few signs of moderation in the inflation rate.
The economy followed a somewhat erratic
course over the entire period. In the first quarter
of 1970 the level of activity continued the decline
that had marked the fourth quarter of 1969, with
real output falling some 3.0 per cent. Real output
rose slightly in the second quarter, however, and
this was followed by a slightly larger gain in the
third quarter. These gains were realized in spite
of the reorganization of the Penn Central Railroad in the second quarter, a development that
almost precipitated a liquidity crisis and severely
damaged business confidence. Indeed, by the third
quarter there was reason to believe that the economy was beginning to recover from the mild
downturn that had marked the last quarter of
1969 and the first quarter of 1970. The two small
consecutive quarterly increases in real output,
combined with favorable movements in a number
of economic indicators, led many economists to
conclude that a recovery was in progress. These
hopes were dashed in the fourth quarter, however, by the depressing impact of the two-month
strike against General Motors Corporation. Current dollar GNP rose less than $5 billion in the
fourth quarter, compared with a $15 billion gain
in the third, and real GNP declined at a 4 per cent
annual rate. It is difficult to estimate precisely the
extent to which total output was reduced by the
strike, but the Council of Economic Advisers estimates that the strike's total impact was about $14
billion. The end of the strike in late 1970 was
followed by a strong upsurge in production in
the first quarter of 1971, with real GNP rising at
an 8.0 per cent annual rate. This strong gain was

largely the result of the rebound in auto production and sales following the end of the strike,
however, and the growth of production soon fell
to a more moderate pace. The increase in real
GNP in the second quarter was less than half the
first quarter gain, despite a strong rise in residential construction and the stockpiling of steel
inventories in anticipation of a possible strike
later in the year.
Weakness was broadly distributed throughout
the economy for much of this period. A rapid increase in disposable income in 1970 was accompanied by a sharp rise in the savings rate and a
slowing in the growth of consumer spending,
with most of the weakness centered in the durable
goods sector. Spending on consumer durables was
fairly weak through the first three quarters of
1970 and declined sharply in the fourth quarter
as a result of the GM strike. In the first quarter
of 1971 disposable personal income rose sharply
as a result of tax reductions, a Federal pay raise,
and the increase in wages and salaries resulting
from the resumption of auto production. Although
the savings rate remained high, personal consumption outlays rose by more than a $20 billion
rate, over twice the average quarterly increase in
1970. Disposable income registered another strong
gain in the second quarter, but the savings rate
rose sharply and the growth in consumer spending tapered off. The long business fixed investment boom came to an end in 1970 as spending
on new fixed capital rose only about 31/z per cent.
Measured in dollars of constant purchasing power,
fixed investment outlays actually declined in
1970. In the first half of 1971, business fixed investment outlays strengthened, but in real terms
the improvement was small. Residential construction expenditures continued to fall through the
first three quarters of 1970, but as funds became
increasingly available in mortgage markets, residential construction turned up in the fourth quarter. The expansion in housing expenditures continued in 1971 at a vigorous pace as mortgage
funds were in ample supply and interest rates
declining. Federal Government purchases _o f goods
and services declined in 1970 as a $3 billion cut in
defense spending more than offset a small rise in
other expenditures. The decline in defense spending continued through the first half of 1971
almost exactly offsetting a modest rise in other
types of spending.
Federal Reserve Bank of St. Louis

The weakening of demc:lnd for goods and services was reflected in the degree of utilization of
productive resources. Employment declined by
27 4 thousand between the end of 1969 and the
end of 1970, while the civilian labor force increased by two million. As a result, the unemployment rate, which had remained at a very low
level throughout 1969, rose sharply from 3.6 per
cent to 6.2 per cent. The rise in employment resumed in early 1971, but through the first eight
months of that year the growth in the labor force
almost exactly matched the growth in employment and the unemployment rate hovered
around 6.0 per cent throughout that period. Capacity utilization in manufacturing fell from 84.3
per cent in the fourth quarter of 1969 to 7 4.0 per
cent in the final quarter of 1970. Although the
utilization rate improved slightly in the first half
of 1971, it only reached 75.1 per cent in the second quarter and dropped back to 73.2 per cent in
the third.
The increase in idle capacity and unemployment did little to halt the rise in wages and prices,
however. Although employment declined
throughout much of 1970, upward pressures on
wages continued strong. A large number of union
contracts came up for renewal during the year
and workers generally attempted to make up for
past cost of living increases and to anticipate
future increases. As a result, the rise in compensation per manhour in the private nonfarm sector
averaged about 7.0 per cent in 1970. The rise in
labor costs continued at a rapid pace in the first
half of 1971. Average hourly compensation rose
at an annual rate of 7.2 per cent, even higher than
the 1970 pace. Large wage gains were widespread,
with workers in construction, transportation, and
public utilities chalking up especially large increases.
During the period January 1970 and August
1971 only modest progress was made toward
slowing the pace of inflation: The Consumer Price
Index rose 5.5 per cent from December 1969 to
December 1970, compared to a 6.1 per cent rise
in the comparable period in 1969. The rate of increase in consumer prices fell to a 3.8 per cent
annual rate through the first eight months of
1971, but this improvement largely reflected a
sharp decline in home mortgage rates. Wholesale
prices rose 2.3 per cent over the course of 1970
following a rise of 4.7 per cent in 1969. Between


December 1970 and August 1971, however, the
wholesale price index rose at a 5.1 per cent annual
The United States balance of payments deteriorated sharply over the period. In 1970, the
balance of payments picture was dominated by a
tremendous volume of short-term capital movements. The move toward an easier monetary policy in the United States brought about a large
decline in short-term interest rates . As these rates
fell relative to rates abroad and as funds became
readily available in domestic markets, U.S. banks
repaid part of their borrowings in the Euro-dollar
markets. A large part of these dollar repayments
flowed through the Euro-dollar market into foreign central banks, causing the U. S. deficit on the
official settlements basis to exceed $10 billion.
The situation worsened in the first half of 1971
as the outflow of capital increased and the trade
account slipped into deficit. During this period
funds flowed into Germany in huge amounts as
that country continued to pursue a relatively
tight monetary policy. By the second quarter the
market was speculating on another revaluation of
the mark, and on May 10 the mark was allowed
to float. This action was followed by a brief
period during which pressures on the dollar were
relaxed, but as evidence of the serious weakness
in the U. S. balance of payments mounted,
another and even more massive flow of funds
began. In the first seven months of 1971 U. S.
liabilities to foreigners soared some $13 billion
to reach a total of $37 billion at the end of July.

FISCAL ACTION In response to the sluggish
performance of the economy, the Federal Government maintained a substantially easier fiscal policy stance between January 1970 and August
1971. The net budget position as measured in the
National Income Accounts shifted from a surplus
of about $7 billion in 1969 to a deficit of more
than $13 billion in 1970. Purchases of goods and
services by the Federal Government declined for
the first time in ten years, but Federal expenditures other than purchases rose a record $17.6
billion. This increase was partly accounted for by
a 20 per cent increase in grants-in-aid to state and
local governments, a 15 per cent increase in Social
Security payments, higher disbursements for the
Medicare program, and a substantial increase in
unemployment compensation. On the other side

Federal Reserve Bank of St. Louis

of the ledger, the income tax surcharge was
phased out in two steps in the first half of 1970.
Largely because of this action tax receipts fell
some $5 billion in 1970, although receipts were
also affected by the unusually small growth in
taxable personal and corporate income. Federal
outlays on goods and services showed little change
in the first half of 1971 as further declines in defense expenditures were about offset by increased
purchases of nondefense items. Grants-in-aid to
state and local governments, higher Social Security payments, and increases in other transfer payments resulted in a rapid rise in other expenditures in the first half. At the same time, the increase in revenues was slowed by the sluggish
pace of economic activity.

BACKGROUND By the end of 1969 it was apparent that economic activity had turned downward. Throughout 1970 and the first half of 1971,
therefore, monetary policy was concerned with
the problem of cushioning the downturn while
continuing the fight against inflation. Although
inflation was a continuing concern, policy was
generally expansive over most of the period.
There was some slight firming around mid-1971,
however. The unusual turmoil in financial markets in the second quarter of 1970 and the repercussions of the long General Motors strike in
the fourth quarter made the achievement of policy objectives much more difficult.
Changes in interest rates during this period
were striking, with short-term market rates plunging sharply downward through 1970 and into the
first quarter of 1971. They then reversed direction and moved briskly upward through
mid-year. During the period of rapid decline,
short-term rates generally fell about five percentage points with the commercial paper rate, for
example, plunging from about 9 per cent at the
beginning of 1970 to about 4 per cent in early
1971. Long-term rates also moved downward over
the period, but the reductions were much smaller
than those for short rates. The pattern of rate
movements was not smooth over the period.
Rates declined sharply in the first quarter of
1970 on evidence of the economic slowdown and
a move toward monetary ease by the System, a
development that was encouraged by a cut in the
prime rate from 81/2 to 8 per cent. The direction

of movement was reversed in the second quarter,
however, as a result of growing uncertainties
concerning the course of the economy and of
monetary policy, repercussions from the Cambodian incursions and the accompanying domestic turmoil, and finally the disarray in financial
markets following disclosure of the financial
problems of the Penn Central Railroad. After
mid-year, however, tensions in financial markets
relaxed and the decline in interest rates continued through the year-end and into the early
months of 1971. From mid-September 1970 to
the end of December the commercial bank prime
rate was reduced four times, from 8 per cent to
6¾ per cent. Between the end of 1970 and March
19, 1971, the prime was changed six times, with
the rate falling in small steps to s¼ per cent. Toward the end of the first quarter, however, concern over inflation and the rapid growth in the
money supply caused a modest shift in the stance
of monetary policy. In view of the continuing
slack in the economy the System continued to
supply reserves at a substantial rate, but it did so
less readily than earlier in the year. This modest
firming of monetary policy contributed to a rise
in short-term rates that developed in the second
quarter and continued into August. Most shortterm market rates rose about two percentage
points and the prime rate moved back up to 6 per
cent on July 7.
A NEW EMPHASIS At its regular meetings the
Federal Open Market Committee considers and
evaluates a broad range of data bearing on the
current and prospective course of economic activity. On the basis of this evaluation the Committee
makes a decision respecting the appropriate posture of monetary policy for the weeks immediately ahead. It then becomes necessary for the
Committee to instruct the Manager of the System
Open Market Account, who acts as the Agent of
the FOMC in buying and selling securities in the
open market, concerning the day-to-day operations necessary to achieve the Committee's policy
goals. These instructions are embodied in a document known as the Directive.
The operating variable on which these instructions have focused has changed from time to time.
For many years the Manager was instructed to
maintain or to achieve certain specified money
market conditions, but even the~ the specific
Federal Reserve Bank of St. Louis

money market variable used as an indicator of
"money market conditions" varied from one time
to another. This term has been defined to include
such things as the Federal funds rate, the threemonth Treasury bill rate, and the net reserve position of member banks. At one time, in carrying
out instructions to maintain currently prevailing
conditions in the money market, the Manager
might place primary emphasis on the net reserve
position of member banks; at another time the
three-month Treasury bill rate might receive primary attention; and at still another time the focal
point might be the Federal funds rate.
In 1966 the FOMC altered the Directive by
adding a proviso clause stated in terms of the rate
of growth of a selected aggregate, usually the
bank credit proxy. That is, the Manager would be
instructed to maintain or to achieve certain money
market conditions provided the growth in bank
credit did not deviate significantly from current
projections. If the growth in bank credit did exceed or fall short of projections to a significant
degree, the Manager was expected to make appropriate changes in money market conditions.
Hence, the addition of the proviso clause to the
Directive explicitly recognized the current behavior of a monetary aggregate as an important
intermediate target variable in the implementation of monetary policy.
In 1970 the form of the Directive was again
changed to place even greater emphasis on the
aggregates as a target variable. In the new Directive the FOMC instructed the Manager to conduct
open market operations with a view to maintaining money market conditions consistent with
achieving a desired growth in money and bank
credit over the months ahead. While the Directive
itself specified the desired growth rate in very
general terms (e.g., a "moderate" or "modest"
growth in money and bank credit), the discussion
preceding its adoption always made clear to the
Manager the specific growth rates desired.
The 1970 action on the Directive represented a
change in emphasis rather than a sharp break
with the past. The FOMC had been concerned
with such aggregates as total reserves, bank
credit, and the money supply long before the
1970 change; and it continued to be concerned
with interest rates, net reserve positions, and
other indicators of money market conditions after
the change. Indeed, the Desk continued to use


money market conditions as operating guides in
attempting to achieve aggregate targets . Moreover, the Committee has at times relegated the
aggregates to a subordinate position when conditions in financial markets seemed · to warrant it.
The Directives issued during the period of turbulence in financial markets in May and June 1970,
for example, emphasized the importance of moderating pressures on financial markets. At the
same time, however, the Manager was directed
to continue to pursue the longer-run objectives of
moderate growth in money and bank credit, to
the extent that this was compatible with the goal
of moderating pressures on financial markets.
May and June of 1970 financial markets were
shaken by a series of developments that
threatened to precipitate a liquidity crisis. Underlying the instability in financial markets were the
very heavy corporate demands for long-term
funds, uncertainties as to the effectiveness of antiinflation policies, and growing doubts concerning
the financial positions of some important corporations. In early May the Cambodian incursion
and the accompanying unrest in the United States
served to aggravate the already uneasy situation
in financial markets. Interest rates rose sharply,
especially long-term rates, and the success of the
Treasury's May financing was threatened. Because of these developments, the System gave
primary emphasis to moderating the pressures on
financial markets. Conditions in the financial
markets calmed somewhat in early June, and
yields on long-term securities moved down from
the peaks they had reached in May. In late June,
however, the Penn Central Corporation indicated
it would be unable to pay off its maturing commercial paper. This brought immediate and intense pressure on the commercial paper market.
Over the next three weeks the volume of commercial paper outstanding declined by some $3 billion, setting off fears that many borrowers would
be unable to roll over maturing paper and that a
sharp credit stringency might ensue. Many corporations were trying to obtain funds in other markets to pay off maturing commercial paper, and
much of this demand was centered on commercial banks.
The System moved promptly and effectively to
prevent the development of a liquidity crisis by

Federal Reserve Bank of St. Louis

making it possible for banks to provide loans to
credit-worthy corporations. The Board of Governors suspended Regulation Q ceilings on largedenomination CD's with maturities of 30-89
days. This enabled banks to acquire funds that
investors were reluctant to invest in money market obligations and to channel them to borrowers
who needed them to pay off maturing commercial paper. At the same time, open market operations were used to assist the banking system to
meet the overall increase in credit demands, and
the Federal Reserve Banks informed member
banks that accommodation would be available at
the discount window in support of loans to creditworthy borrowers who were unable to roll over
maturing commercial paper. Following these actions, the scramble for liquidity subsided, and
financial markets calmed.
OPEN MARKET OPERATIONS The System relied heavily on open market operations in moving
toward an easier monetary policy stance in 1970
and in early 1971, but began to supply reserves
more reluctantly in the second quarter of 1971.
Between December 1969 and August 1971, total
reserves increased by more than $2.4 billion, with
almost all of the growth occurring between June
1970 and May 19'.ilil. System holdings of U. S.
Government securities rose almost $9 billion over
the entire period. Through the first 16 months of
this period, nonborrowed reserves grew more
rapidly than total reserves as member banks reduced their borrowing from the Federal Reserve
from about $1 billion at the end of 1969 to $148
million in April 1971. Because of concern over the
rapid growth of monetary aggregates in the face
of strong inflation and a dramatic deterioration in
the balance of payments, the System in the second
quarter of 1971 began to supply reserves with
somewhat greater reluctance. As a result, total
reserves grew very little between May and August
while borrowings at the Federal Reserve Banks
rose strongly to the $800 million level.
DISCOUNT RATE In mid-November 1970 the
discount rate was reduced from 6 to s¾ per cent,
the first of five one-quarter point reductions designed to keep the rate in better alignment with
rapidly falling short-term market rates . Other
reductions occurred in December, two in January
1971, and one in February. The reduction in Feb-

ruary brought the rate to 4¾ per cent. Then in
July 1971 the rate was raised to 5 per cent, a
reflection of the moderate firming of monetary
policy and the sharp run-up in market rates that
had begun earlier in the year.

Board of Governors amended Regulation D to
prescribe the conditions that must be met in order
for subordinated notes or debentures issued by
member banks to be exempt from reserve requirements. Among other things, the amendment provided that in order to be exempt a subordinated
note must have an original maturity of seven
years or more and be in an amount of at least
$500. Formerly the exemption had applied if the
maturity exceeded two years. The change was
considered necessary because of evidence that
member banks had used such obligations to acquire deposit-type funds.
Effective in the reserve computation period beginning October 1, 1970, the reserve requirement
against time deposits in excess of $5 million in
each member bank was reduced from 6 to 5 per
cent. At the same time, a 5 per cent reserve requirement was imposed on funds obtained by
member banks through the issuance of commercial paper by their affiliates. The purpose of the
latter action was to put bank-related commercial
paper on the same footing with respect to reserve
requirements as large negotiable CD's. The combined effect of these two actions was to reduce
required reserves for the banking system by
about $400 million. In November the marginal
reserve requirement applicable to Euro-dollar borrowings of member banks was raised from 10 to
20 per cent, with the increase to become effective
January 7, 1971. Also in January, Regulation M
was amended to permit a member bank to include
within its reserve-free base the amount of purchases by its foreign branches of certain ExportImport Bank obligations. In April, Regulation M
was again amended to include within such reserve-free bases the amount of purchases of certain U. S. Treasury obligations by a bank's foreign branches. The purpose of both of these
changes was to encourage U. S. banks to retain
their Euro-dollar liabilities and thus avoid the
deleterious effect on the U. S. balance of payments of a rapid repayment of these borrowings.
Federal Reserve Bank of St. Louis

REGULATION Q In January 1970 the Board of
Governors announced an increase in the maximum
interest rates payable by member banks on time
and savings deposits. Maximum rates payable on
savings deposits were raised from 4 to 4¼ per
cent, the first increase in this ceiling since 1964.
In addition, there was a general realignment of
ceilings on certificates of deposits, resulting in a
scaling upward of ceilings on both large-denomination negotiable CD's and consumer-type certificates. This action was part of a coordinated move
by the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Federal
Home Loan Bank Board that resulted in increases
in ceiling rates on deposits at both bank and nonbank thrift institutions. Its purpose was to make
rates payable by these institutions more competitive with market rates and to enlarge the flow
of savings into financial institutions. In June 1970
the Board of Governors suspended the rate ceilings on large-denomination CD's with maturities
of 30-89 days. This was one of a package of actions taken by the System to deal with the unsettled financial markets that followed the filing of
the Penn Central bankruptcy petition. Also in
June, the Board of Governors amended Regulation Q to prescribe the conditions that must be
met in order for subordinated notes or debentures
issued by member banks to be exempt from interest rate ceilings. The provisions of this amendment were the same as those of the amendment
to Regulation D, which was made at the same
time and for the same purpose.
Board of Governors lowered from 80 to 65 per
cent the margin requirement for credit extended
by brokers, dealers, banks, and other lenders to
finance the purchase or carrying of stocks and
from 60 to 50 per cent for credit extended by such
lenders to finance the purchase or carrying of
convertible bonds.

At mid-1971 the U.S. economy was beset by a
combination of seemingly intractable economic
problems. The economy was growing, but not
fast enough to eat into a substantial cushion of


unused resources. The unemployment rate remained near 6 per cent throughout the first half
of the year and only about 75 per cent of manufacturing capacity was being utilized. Nevertheless, prices continued to rise at an unacceptable
rate, accompanied by substantial increases in
wages. At the same time, the U.S. balance of payments position was deteriorating rapidly. The
trade balance fell sharply in the spring and a
decline in interest rates relative to rates abroad
encouraged a rapid outflow of short-term funds
from the United States. By the second quarter
these developments gave rise to speculative activities that greatly magnified the outflow of funds.
This combination of problems created something of a dilema for economic policymakers. The
use of traditional monetary and fiscal policies to
speed up the rate of growth and reduce the margin
of unemployed resources might well exacerbate
the problem of inflation and cause further deterioration of the balance of payments. On the other
hand, the use of these policies to slow the rate of
inflation by reducing aggregate demand might
only increase the slack in the economy and raise
the already high unemployment rate even higher.
Indeed, in view of the large amounts of unemployed resources and evidence of a substantial
element of cost-push inflation in the economy,
there was some question as to whether the inflation problem was amenable to the traditional
monetary-fiscal policy treatment.
The apparent conflict in achieving the Nation's
economic objectives led to a decisive change of
policy. On August 15, 1971, the President announced a new economic policy. The most important elements of the new program were a 90-day
freeze on prices, wages, and rents, to be followed
by a more flexible system of controls in the second
phase; suspension of convertibility of the dollar
into gold or other reserve assets; imposition of a
temporary surtax of up to 10 per cent on dutiable
imports; proposal of a package of tax reductions
designed to stimulate economic expansion.
The temporary freeze on wages and prices provided the time needed to set up the machinery to
carry out the Phase II program that was to succeed the freeze. On October 7 the President
announced the outlines of the Phase II program.
The goal of the program was to reduce the rate of
inflation to the 2 to 3 per cent range by the end
of 1972. The controls were to cover the economy

Federal Reserve Bank of St. Louis

broadly, they were to be mandatory, and were to
be removed when, in the President's judgment,
reasonable price stability had been restored. An
Executive Order established the administrative
machinery to develop guidelines and to make
the decisions on wages and prices necessary to
achieve this goal. A Cost of Living Council, consisting of high Government officials, was assigned
the responsibility of establishing broad goals,
determining the coverage of the control program,
overseeing enforcement, and coordinating the
anti-inflationary effort in line with overall goals.
A Price Commission and a Pay Board were created
to develop standards and make decisions on
changes in prices and compensation.

The new economic program brought about an
improved outlook for economic activity. The
strong measures to control inflation appeared to
raise the level of business and consumer confidence. Prospects for consumer spending were
favorably affected by such fiscal measures as the
proposal to remove the excise tax on autos and to
advance the date of certain personal tax reductions. The proposed investment tax credit provided encouragement for increased business
investment spending.
The overall effect of the new economic program and related monetary and fiscal policy
measures was quite stimulative. The effect on the
economy was not immediate, however, mainly
because economic activity in the third quarter of
1971 was dominated by the liquidation of inventories, particularly excess steel stocks that had
been accumulated earlier in the year in anticipation of a strike. Final sales rose somewhat more
rapidly than in the second quarter, however,
largely because of a sharp increase in purchases
of domestically produced autos after announcement of the new economic programs. Overall
economic activity accelerated in the fourth quarter as inventory accumulation resumed, as outlays
for residential construction continued to rise, and
as the rate of business capital spending picked up.
Real GNP grew at a 5.8 per cent annual rate in
the fourth quarter, while the implicit price deflator rose only 1.7 per cent.
The strong surge in economic activity that
began in late 1971 continued through 1972. Measured in current prices, GNP grew almost 10 per

cent for the year as a whole. The rise in the
implicit price deflator was only 3 per cent, however, and real GNP recorded a hefty 6.4 per cent
advance. This expansion was more than twice
that for 1971 and the largest since 1966. Growth
in real output was rapid in every quarter of 1972,
with quarterly advances ranging from 6.3 per
cent to 9.4 per cent annual rates. Moreover, the
expansion in 1972 was broadly distributed, with
all major sectors of demand except net exports
contributing to the rise in GNP. A very large
increase in gross private domestic investment, a
step-up in Federal purchases, and a substantial
expansion in consumer spending were the principal stimulative forces in the economy.
The surge in economic activity between August
1971 and December 1972 resulted in a significant

improvement in the utilization of productive resources. The most marked improvement did not
occur, however, until the final three quarters of
1972. More than three-quarters of a million
additional workers found employment between
August and December 1971, but the civilian labor
force increased by almost exactly the same number and the unemployment rate remained virtually unchanged at around 6.0 per cent. The labor
force continued to grow rapidly throughout 1972,
but employment grew even more rapidly. As a
result, the unemployment rate fell to 5.1 per cent
by the end of 1972. The index of capacity utilization in manufacturing rose from 7 4.7 per cent at
the time of the inauguration of the new economic
program to 81.5 per cent at the end of 1972.
The performance of prices and wages during
the period was somewhat mixed. There was a
temporary bulge in the first few months following
the termination of the wage-price freeze in
November 1971, but after that there was some
moderation in the rise of both prices and wages.
Employee compensation increased 6.9 per cent
over the course of 1972, compared with a rate of
8.1 per cent in the first half of 1971. Moreover,
output per manhour was sharply higher in 1972
and the rate of advance of unit labor costs was
reduced substantially by year-end. The average
quarterly increase in the GNP implicit price deflator was 2.3 per cent (annual rate) over the final
three quarters of 1972, compared with an average
of 4.8 per cent for the first two quarters of 1971.
Consumer prices rose 3.4 per cent over 1972 com-
Federal Reserve Bank of St. Louis

pared with an annual rate of 3.8 per cent in the
pre-control period of 1971. Wholesale prices, on
the other hand, advanced very rapidly in 1972
propelled by an explosion of farm prices in the
final three quarters.
The new economic program recognized the
need for a substantial realignment of exchange
rates between the dollar and other major currencies in order to restore the competitiveness of
U.S.-produced goods in world markets. The first
steps toward this goal were taken on August 15
with the suspension of convertibility of the dollar
into gold or other reserve assets, imposition of a
temporary surtax of up to 10 per cent on dutiable
imports, and limitation of tax relief for capital
expenditures to domestically produced capital
goods. Following these actions, all major countries allowed the prices of their currencies to rise
relative to the dollar, although there continued
to be substantial intervention by foreign central
banks. In mid-December, representatives of the
major trading countries met in Washington and
agreed to a significant adjustment of exchange
rates. The agreement also provided for a widening of the intervention band to 2¼ per cent on
either side of the new parities (it had been 1.00
per cent), and U.S. representatives agreed to ask
Congress to raise the dollar price of gold from
$35.00 to $38.00 per ounce. The 10 per cent surtax on imports was removed.
Despite the dramatic nature of these actions,
they brought little immediate improvement in the
U.S. balance of payments. The trade balance
worsened as the deficit in 1972 totaled $6.9 billion, more than $4 billion larger than the one in
1971. The strong expansion in the U.S. economy
in 1972 led to a strong expansion in the volume of
imports. At the same time, prices of U.S. imports
rose sharply, both because of the devaluation and
because of a general increase in world prices,
while export prices expressed in dollars increased
much less. Thus, while merchandise exports rose
14 per cent in 1972, imports increased even faster.
The enormous flows of speculative funds that
caused so much havoc in 1971 were 1argely absent
in 1972 and there was a modest reflow of private
capital into the United States. As a result, the
over-all balance of payments deficit on the official settlements basis dropped from almost $30
billion in 1971 to just over $10 billion in 1972.


FISCAL ACTION In the period between the
announcement of the new economic program and
the end of 1972 both fiscal policy and monetary
policy were designed to achieve a more vigorous
expansion of the economy and to bring about a
more complete utilization of the Nation's productive resources. As part of the new program the
Federal excise tax on automobiles was removed,
the investment tax credit was reinstated at 7 per
cent, and a reduction in the personal income tax
that had been· scheduled for later was advanced
to January 1, 1972. In addition, programmed
Federal expenditures were stepped up, mainly in
the form of transfer payments and grants to state
and local governments. As a result, Federal expenditures rose some $26 billion in the calendar
year 1972. Tax revenues soared, however, as a
result of the upsurge in economic activity and
because a change in tax-withholding schedules
resulted in substantial overpayments on individuals' taxes in 1972. Consequently, the Federal
deficit on a national income accounts basis declined to $18.5 billion in 1972 from $21.7 billion
in the previous year.

rowing at the discount window. Reflecting the
rapid economic expansion and the strong demand
for credit in 1972, short-term interest rates rose
throughout most of the year. Long-term rates,
however, remained fairly stable. The commercial
bank prime rate continued to move downward in
early 1972, but in early March it began to drift
upward and through a number of small increases
reached a high of 6 per cent in late December.

market operations provided reserves at a rapid
pace in the second half of 1971 and the first half
of 1972. Federal Reserve holdings of U.S. Government securities rose more than $6 billion between
July 1971 and July 1972 and nonborrowed reserves rose about $3 billion over the same period.
Between July and year-end 1972, open market
operations provided reserves much more reluctantly. In late 1972, however, open market operations were used to offset some of the impact on
bank reserves of changes in Regulations D and J
(discussed below).

BACKGROUND The Federal Reserve adopted a
generally accommodative policy stance following
the announcement of the wage-price freeze, and
bank reserves were supplied somewhat more
freely than earlier in the year. Apparently because
of a shift in inflationary expectations, however,
the demand for money balances declined. Consequently, growth of the monetary aggregates
was quite moderate in the final months of 1971
and interest rates declined. By year-end longerterm rates were about 1 percentage point below
their mid-August levels and short-term rates were
down by about 1 ½ percentage points over the
same period. The commercial bank prime rate
dropped. from 6 per cent in July to s¼ per cent at
year-end. This moderately stimulative monetary
policy was continued through most of 1972. In
the first half System open market operations
provided for a rapid growth of nonborrowed
reserves, but in the third quarter nonborrowed
reserves declined slightly. Total reserves grew at
a 10.6 per cent annual rate for the year as a whole,
but most of the expansion in the second half came
from an increase of more than $1 billion in bor-

Federal Reserve Bank of St. Louis

the System announced a change in Regulation D
that had the effect of restructuring the reserve
requirements of member banks. A related change
in Regulation J was designed to improve the
Nation's check clearing ~ystem. Both of these
changes had a significant impact on the reserve
position of the banking system. Prior to the
change in Regulation D member banks were
divided into two groups (reserve city banks and
country banks) for reserve purposes. Most banks
in major financial centers were classified as
reserve city banks and all others were classified
in the country bank category. The change in
Regulation D eliminated the geographically based
classification of banks for reserve purposes and
substituted a new system of graduated reserve
requirements for net demand deposits. The new
system, applicable to all member banks wherever
located, is based solely on the size of a bank's
deposits. Applicable reserve requirements ranged
from 8 per cent on the first $2 million of net
demand deposits to 17½ per cent on deposits in
excess of $400 million (see chart).
Before the November 1972 change in Regulation J, most banks located outside Federal Reserve
Bank or branch cities were required to remit funds

one or more business days after checks were presented for payment by the Federal Reserve. Most
banks located in such cities, on the other hand,
were required to remit on the same business day
the checks were presented. The November 1972
change in Regulation J requires all banks to remit
payment for checks presented by the Federal
Reserve on the same day the checks are presented.
Most member banks experienced some reduction in required reserves as a result of the restructuring of reserve requirements against demand
deposits. In the aggregate required reserves were
reduced about $3 .2 billion. The change in Regulation J, on the other hand, resulted in a net reduction in member bank reserves of about $2.1
billion. Implementation of these two changes
came at a time of regular seasonal reserve needs,
and open market operations were employed to
smooth the transition. Consequently, the net
reserve provision of about $1.1 billion had only a
Federal Reserve Bank of St. Louis

minimal impact on the reserve position of the
banking system.
DISCOUNT RATE Changes in the discount rate
were rather infrequent during this period. In
November 1971 the rate was reduced from 5 per
cent to 4¾ per cent, and in December it was reduced to 4½ per cent. In both instances the
changes were for the purpose of bringing the rate
into better alignment with falling market rates.
the margin requirement for purchasing or carrying stocks and the required deposit on short sales
were both reduced from 65 per cent to 55 per
cent. In late 1972 it appeared that stock market
credit might contribute to inflationary pressures
and this action was reversed. The margin requirement on stocks and the deposit on short sales
were returned to 65 per cent.


~imitations and <:.YJ.dvantages of
ifonetary Policy
Establishing sound monetary policy is a task of herculean proportions. Central
bankers cannot feed data into a computer and expect to get a monetary policy
tailor-made to fit a particular economic situation. No matter how rich the experience and judgment of the policymakers, human error is still possible. And
mistakes, once made, must be taken into account in future policy actions. An
overly easy credit policy can cause inflation when expansion resumes. Antiinflationary measures that are too strong can bring a period of expansion to a
premature halt. Thus, central bankers-like men walking tightropes in high and
shifting winds-must maintain their footing by leaning first one way and then another into the wind but never too far in either direction.

~imitations of 'Monetary Policy
What then are the limitations of monetary policy?
Partly, they are the effects of powerful forces
working in opposite directions. To some extent
they result from the limited influence that
monetary policy has over financial markets. In
part, they are due to imperfect knowledge and to
errors of human judgment.

PRICE-COST INFLATION The more competitive the economy, the more effective monetary
policy can be. This is particularly true when
business activity is running at near-capacity
levels, and the System is trying to combat inflationary pressures. At such times, monopolistic
pricing practices on the part of labor or business
can push prices up from the supply rather than
from the demand side. Sufficiently strong monetary policy can undoubtedly prevent some increases of this kind by dampening inflation psychology, but it is doubtful if it can completely
cure the problem in a prosperous economy with
strong monopolistic pressures. Conversely, continued monopolistic increases in wages and
prices during recession tend to hinder the adjustments that lead to business recovery. To combat
such pricing problems effectively, there must be
additional measures designed to encourage competition.

of fiscal policy-the manner in which the Federal

Federal Reserve Bank of St. Louis

Government spends, taxes, and manages its debt
-run counter to those of monetary policy, the
two can to some extent offset each other. This is
almost inevitable at times since the aims of
monetary policy are largely economic, whereas
those of fiscal policy are often political or social
rather than economic. In a democracy it could not
be otherwise, but nevertheless the net result may
be an expansionary budget deficit when monetary policy-rightly or wrongly-is moving in
the opposite direction. Or it may mean a lengthening of Treasury debt when the Federal Reserve
is combating recession. In such cases, monetary
and fiscal policy will partly offset each other.

SLIPP AGES IN THE FINANCIAL MECI-IANISM Even under the best conditions, monetary
policy must contend with two types of "slippages" in the financial mechanism. First, commercial banks may not immediately expand or
contract earning assets in response to changes in
the availability of reserves. Second, even though
banks act promptly, shifts in monetary velocity
may partly offset changes in the money supply.
Both kinds of "slippages" complicate the task of
monetary policy, but their importance is overrated.
Incomplete use of additional bank reserves
clearly calls for larger changes in reserves than
would otherwise be necessary. This kind of
special action is taken quite frequently. During
1960, for example, the System had to supply

more reserves than would have been needed had
country banks responded more quickly to the
release of vault cash. Only if banks did not respond at all would effective System policy be
A more common difficulty is the increase in the
velocity of money ordinarily accompanying a
restrictive monetary policy. Perhaps the most important cause is the liquidation by banks of shortterm Government securities to meet rising loan
demands. This leaves the money supply virtually
unchanged since the banks merely substitute one
form of earning assets for another, but it does
tend to increase velocity by transferring bank
balances from those who probably would not
spend them as quickly-the purchasers of the
securities-to those who spend them almost immediately-the new borrowers. Financial intermediaries, such as savings and loan associations
or mutual savings banks, also can contribute to
increases in velocity by raising interest or dividend rates to attract new funds for lending that
might otherwise not have been spent as quickly
and by lending the proceeds of Government security sales to borrowers who spend them immediately. Finally, velocity can be increased
through security sales by nonfinancial institutions and through the adoption of various ways
of economizing on business and personal cash
Such increases in velocity mean that monetary
policy must permit the money supply to expand
more slowly, and at times to contract, in order
to prevent spending from rising at an inflationary clip. It is sometimes argued that the money
supply cannot undergo such restraint without
unduly interfering with Treasury financing operations or upsetting securities markets through
sharp increases in interest rates.
In practice, however, these fears have not yet
been realized. System actions have been delayed
at times by Treasury financing operations, but
the System has not had to alter appreciably the
direction and intensity of policy. Nor have securities markets been disrupted by the System's
tightening actions. Increases in interest rates
have actually been rather moderate-to no small
degree because policy affects the availability as
well as the cost of credit.
Federal Reserve Bank of St. Louis

In fact, increases in velocity induced by a tightening policy perform several useful functions.
First, by providing a means for financing outlays
they act as a safety valve to prevent an inadvertent over-tightening of the money supply from
becoming serious. Second, security sales resulting in increased velocity help transmit changes
in the cost and availability of credit quickly
throughout the entire credit mechanism. Finally,
shifts in velocity make credit policy more equitable by enabling spenders to maintain those expenditures with the highest priorities by transmitting the effects of the policy to the more
marginal outlays.
policy-like any discretionary stabilizing policy
-necessarily involves judgments based upon incomplete evidence. Errors can occur for two reasons. First, delays in the availability of important
business indicators make it impossible to know
exactly how the economy is behaving at the
moment. Second, policy-making involves judgments regarding the course of business activity
iri the absence of central bank intervention and
the probable effects of various policy combinations. Errors of judgment can be minimized
through experience and careful analysis, but they
can never be eliminated completely.

uldvantages ,of 'Monetary ~olicy
Despite its imperfections, monetary policy has
several advantages over the alternative methods
of stabilizing the economy-fiscal policy and direct controls, such as rationing and price control.
market economy, most production decisions are
made indirectly by spenders through their demand for goods and services. Only those things
that spenders want will continue to be produced,
only the cheapest methods of production will last,
and only efficient producers can remain in business. Consequently, except for certain interferences, our limited supplies of land, labor, and
capital goods are used to produce most efficiently
those things spenders want most.
Direct controls obviously change all this. They,
in effect, dictate what consumers can and cannot


do. Therefore, production decisions are made by
the authorities, not by the market.
fiscal policy is quite impersonal compared with
direct controls, but variations in the direction and
volume of taxation and spending alter the composition as well as the overall level of production.
Those things the Government buys will be produced in larger quantities than otherwise would
have been the case, and those goods and services
taxpayers would have bought will be produced
in smaller quantities.
In contrast, general monetary controls are
never used to influence particular types of expenditures. A policy of restraint, for example, is
designed merely to prevent total spending from
increasing too fast. It leaves it to the market to
decide which particular activities will be curtailed. These are generally those things that
consumers and other spenders want least. They
continue to buy the things they want most. Similarly, when easy money encourages spending,
the additional outlays take whatever forms
spenders pref er.

policy is more flexible than most stabilizers. There
are, of course, lags between policy decisions and
the time the actions become effective, just as in
the case of any stabilizing policy. There are other
lags resulting from the lack of current information-lags affecting all types of discretionary
stabilizers. But when it comes to reaching a quick
decision, System policy-making machinery is admirable. Every three or four weeks-and sometimes more often-the Open Market Committee
reaches some definite policy decision at its meeting. It may decide to stand pat; it may decide to
act; but in any event it decides and initiates immediately the necessary implementing steps.
Discretionary fiscal policy actions involving
changes in spending and taxation depend to a
large degree upon Congressional action. Such decisions in a democracy like ours deserve and
receive wide study and debate. Proper consideration thus requires time, and flexibility inevitably
suffers. The so-called fiscal "automatic stabilizers"-primarily Federal income taxes and unemployment compensation payments-that tend
to create budget surpluses during boom and
budget deficits during recession do, however, act

Federal Reserve Bank of St. Louis

more quickly. These clearly constitute a valuable,
practical adjunct to monetary policy.

MONETARY POLICY IS FREE FROM DAYTO-DA Y POLITICAL PRESSURES In establishing the Federal Reserve System, Congress wisely•
gave it such independence as to enable it to act
freely in the best interests of the economy. It
spread the policy-making role throughout the
System to avoid undue concentration of power;
it provided for 14-year terms of office for appointed Board members, made them ineligible for
reappointment after a full term, and staggered
their terms of office; and it provided for the
election of Reserve Bank presidents by their own
boards of directors,subject to the approval of the
Federal Reserve Board. The net result is a unique
institution, able to base its day-to-day policy on
economic non politic al grounds.
The System, of course, must answer to Congress and has only such powers as Federal laws
give it. Within the limits of its broad powers,
however, the System is free to use only economic
considerations as guides to policy. Such can never
be entirely the case with fiscal policy or direct
controls, which are always significantly influenced by politics in our type of democracy.

When all its advantages are weighed against its
limitations, where does monetary policy stand?
What can it do, and what is it unable to do? Perhaps the best summary is the following testimony given by Chairman Martin of the Board of
Governors before the Joint Economic Committee
on February 2, 1960:
... It [monetary policy] cannot prevent
monopoly. It cannot assure that the financial needs of all socially desirable activities
are met without intervention by Government. It cannot be reli.ed upon to cover
Federal deficits. Alone, it certainly cannot
assure either stability or growth.
What a correct monetary policy can do
is to foster confidence in the dollar, so that
our people can and will save and invest in
the future with reasonable assurance that
their plans will not be frustrated by irresponsible changes in the value of money.

Federal Reserve Bank of St. Louis