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FUNDAMENTAL REAPPRAISAL OF THE DISCOUNT MECHANISM

DISCOUNT POLICY AND
OPEN MARKET OPERATIONS
PAUL MEEK
Prepared for the Steering Committee for the Fundamental Reappraisal of the
Discount Mechanism Appointed by
the Board of Governors of the Federal Reserve System




The following paper is one of a series prepared by the research staffs of the Board of Governors
of the Federal Reserve System and of the Federal Reserve Banks and by academic economists
in connection with the Fundamental Reappraisal of the Discount Mechanism.
The analyses and conclusions set forth are those of the author and do not necessarily indicate
concurrence by other members of the research staffs, by the Board of Governors, or by the Federal
Reserve Banks.







RJNDAMENTAL REAPPRAISAL OF THE DISCOUNT MECHANISM

Discount Policy
and .
Open Market Operations

by
Paul Meek
Open Market Operations and Treasury Issues Function
Federal Reserve Bank of New York

February 26, 1968




TABLE OF CONTENTS

Page
Introduction

1

Summary of Findings

2

k View of the Policy Process

4

Direction of Open Market Policy

8

The Implementation of the FOMCfs
.Policy

11

Open Market Operations and Changes
in Discount Administration

18

INTRODUCTION

The "basic responsibility of any central bank is monetary
management--managing the liquidity and credit conditions of the entire
economy, primarily through its influence on the commercial banking sector.

In the United States, open market operations are the principal

instrument for exercising the Federal Reserve System's initiative in
affecting the full range of credit and monetary conditions.

As the ul-

timate source of liquidity to the economy, the System cannot control
total bank reserves precisely in the very short run because the monetary
system of a modern economy must be able to respond flexibly to wide
week-to-week changes in the demand for currency, bank deposits and
credit that .are imperfectly predictable as to timing and amount.

But

the System can and does exert a strong influence over the growth path of
total bank reserves, deposits and credit by varying over time the division between reserves provided without strings through open market
operations and those provided with strings through the discount window.
Within the framework provided by Regulation A, governing individual bank
access to reserves borrowed from the Reserve Banks, the Federal Open
Market Committee (FOMC) acts in this way to influence bank behavior in
the interest of national economic objectives.
This paper sketches the process whereby the decisions of the FOMC
are brought to bear through open market operations and the discount
window on the liquidity of commercial banks.




It describes broadly how

2
the Manager of the System Open Market Account, a Vice President of the
Federal Reserve Bank of New York, relies on patterns of "bank behavior
and the Federal funds market to aid in the day-to-day decisions that
carry out the FOMC's instructions.

The paper also ventures some ob-

servations on the implications for discount policy of the necessity of
integrating open market and discount policies, and on the constraints
that these implications impose on changes in the administration of the
discount window.
/' SUMMARY OF FINDINGS
The nationwide level of member bank borrowing from the Federal
Reserve Banks is an important element in the money market conditions
that the Federal Open Market Committee instructs the Manager of the
System Open Market Account to achieve, particularly in periods of
monetary restraint.

In specifying the money market conditions to be

achieved, the FOMC, in effect, determines that such member bank borrowing will stay within a certain range--!.e.; that member banks somewhere in the banking system will be forced to borrow at the discount
window in an aggregate that corresponds on average to the Committee's
desires regarding money market conditions.

The Committee increases

monetary restraint and affects commercial bank behavior by having the
Manager, through the Trading Desk of the Federal Reserve Bank of New
York, reduce the provision of reserves by open market operations in
relation to the demand for them so that member banks come into the
window in larger numbers and/or more frequently.

Banks appear indi-

vidually at the discount window and are exposed to its discipline, but
it is the FOMC that regulates the discipline imposed on the banking
system as a whole.




3
From the Trading Des^s standpoint the daily average level of member
bank borrowing at the discount window over the seven days of the statement week is an important and workable operational guide—one that interrelates with a number of other money market indicators. Armed with
statistical forecasts of member bank reserves and a knowledge of bank
patterns of reserve management, the Desk can make reasonably good judgments of the level of unsatisfied demand for reserves that is likely to
appear at the discount window after the operation of the Federal funds
market. The Manager can ordinarily detect when actual reserve availability is appreciably larger or smaller than expected—without knowing
at the moment the cause of the deviation—and he can adjust his actions
accordingly.
The FOMC is not concerned with member bank borrowing or any other
money market indicator for its own sake, but as an operational means of
both providing flexibly for the economy*s short-run cash needs and influencing the growth of bank credit and the behavior of interest rates
over the long run. Member bank borrowing provides only a first, and
imperfect, approximation to the money market conditions that are consistent with achieving the Committeefs longer-run financial objectives.
The relation between the Federal funds rate and the discount rate at a
given level of such borrowing is probably a somewhat better short-run
indicator than borrowing alone of the effectiveness of open market
operations in influencing the banking system in the desired direction.
The behavior of such monetary aggregates as bank credit and the money
supply—in conjunction with interest rates—provides even better evidence on this point, although the monetary aggregates are not themselves targets which the Manager can hit directly in the short run.




4
In an effort to improve the responsiveness of open market operations to
changing external circumstances, the FOMC introduced in 1966 a new form
of the directive that has provided for varying its short-run operational
targets in accordance with the unfolding behavior of bank credit. Thus
far, this approach seems a promising one for improving the implementation of the System's monetary policies.
Changes to be made in the operation of the discount mechanism
should maintain the responsiveness of the banking system to the policy
moves of the Federal Open Market Committee. Discount policy will necessarily remain a principal cutting edge of a policy of monetary restraint, imposing on a succession of individual banks, beginning with
the larger money market banks, the need to adjust assets and/or liabilities within a reasonably short time period in order to repay borrowing from the Federal Reserve. Such a requirement need not interfere
with liberalizing the access of smaller banks to the discount window
for seasonal liquidity needs. Under any set of rules of discount
administration, however, the FOMC will need to be able to direct open
market operations to increase or reduce the pressure on a major segment of member banks—certainly the larger ones. Discount policy will
need to provide incentives for banks to pay off their borrowing at the
discount window in fairly short order. For operational purposes,
changes in the discount rules shouldlprobably be timed to coincide
with a period of monetary ease, thereby enabling both the System and
the financial community to grow accustomed gradually to the new framework within which open market policy would be conducted.
*

A VIEW OF THE POLICY PROCESS

As noted, any central bank has primary responsibility for managing
liquidity and credit conditions in the economy through its influence on




5
the banking sector with a view to promoting national economic
objectives. To exert this influence, a central bank develops policy
instruments that enable it to initiate policy changes and to give
centralized direction to the implementation of its policy.
Central banking in the. United States has developed, and come
to rely increasingly on, open market operations as the most efficient means for influencing national liquidity and credit conditions.
This development flows naturally from the growth of the specialized and
interdependent

financial markets and institutions that serve a highly

developed economy. The System bases its policy judgments on its reading
of the full range.of financial flows and interest rates in relation to
economic developments and objectives, rather than narrowly on the behavior of the banking system alone. Moreover, the Federal Reserve is
the ultimate source of liquidity to the entire financial system and
thereby to the economy.

It must make its operational decisions about

liquidity needs on the basis of centralized information about the
banking sector and the evidence provided by the financial markets themselves about, those needs. From a policy standpoint, open market operations provide a logical and natural point of contact between the Federal
Reserve and the financial system.
In managing the reserves of the banking system, the monetary
authorities have two interlocking responsibilities. Routinely, they
enable the banking system to provide in the short run for the highly
variable needs of the economy for cash--both currency and bank deposits.
Over the longer run, they seek to influence the liquidity of the economy,,
financial flows, and interest rates with a view to fostering national




6
economic objectives. A central problem of monetary management is to
keep short-run flexibility from impairing long-run policy objectives.
The Federal Reserve System depends on an integration of open market
policy and discount policy to carry out these dual responsibilities. In
the very short run, open market operations provide reserves flexibly in
accordance with the overall economy1s shifting cash needs. Discount
policy, on the other hand, provides a limited adjustment mechanism for
both the individual bank and the banking system when reserves fall short
of reserve requirements—assuring short-run accommodation at the discount
rate.

Over the longer run, however, individual banks cannot rely on

continuous borrowing from the Federal Reserve, and therefore such borrowing generates a need for adjustment of assets or liabilities that is
missing as long as reserves are being provided without stint by open
market operations.
Open market operations and the discount window, as operated under
the current Regulation A, enable the banking system to meet the economy1s
short-run cash needs without undue strain. These needs fluctuate widely
from day to day and week to week in relation to the increase in money
supply that takes place over the course of a full year. Member banks as
a group will have to borrow from their Reserve Banks to cover their reserve deficiencies in a given week to the extent that open market operations ip that week fail to compensate for changes in currency
outstanding, bank deposits, other factors affecting reserves, or in reserves that accumulate unused within the banking system.

Such borrowing

will be necessary whatever the reason for the deficiency—whether.it is
deliberate System policy, an unexpectedly large bulge in deposits at
tax payment time, or a much sharper decline in float than had been




7
anticipated. The geographic pattern of such borrowing depends, of course,
importantly on the movement of deposit* and reserves, including the very
important redistribution of reserves among individual banks effected
through the Federal funds market and the-correspondent banking system.
As a consequence of providing "an elastic currency" and of acting as
lender of last resort, the Federal Reserve System must give up precise
control over total deposits and currency outstanding in the very short
run.
The System, nonetheless exerts leverage on the credit creation
process through open market policy applied against the fulcrum provided
by the discount policy embodied in Regulation A.

The essence of

Regulation A has been that an individual member bank's borrowing from
its Reserve Bank is to be temporary. The discount window is not to
provide a continuing supplement to a bank's resources. Hence, member
banks have been expected to adjust their assets or liabilities over a
period of weeks so that borrowing from their Reserve Bank will no
longer be necessary.

Given this fulcrum, the FOMC can consciously

direct open market operations to change the amount of borrowing member
banks in the aggregate must undertake and thereby influence directly
bank lending and investment decisions. In this context, it can be
seen that the discount rate has little effect on the aggregate level of
member,bank borrowing.

(The influence of the discount rate--by its

relation to other interest rates—instead comes through its effect on
the calculus.of commercial bank policies and actions, and thereby on
the rate of bank credit growth.)
The interaction of open market policy and discount policy over the
cycle is familiar. If the economy requires stimulation, the System




8
uses open market operations to flood the "banks with reserves that can be
employed in loans and investments*

The discount rate is also lowered,

although member bank borrowing will naturally fall to a friqtional
minimum as open market operations supply reserves in abundance. As the
economy expands and less stimulation is required, the System typically
supplies reserves through open market operations somewhat less freely
in relation to expanding credit demands. This policy change forces mdmber banks to come to the discount window in increasing numbers and/or
with increasing frequency. As the FOMC steps up the degree of restraint, open market operations insure that more and more banks are
gradually affected by the necessity of not abusing their privilege of
borrowing at the discount window, but of reserving it for the increasingly frequent occasions on which they have exhausted alternative
means of balancing out their reserve positions.
*"' DIRECTION OF OPEN MARKET POLICY
The System has used open market policy as its primary continuing
instrument, both for providing liquidity to the economy in the short
run and for influencing liquidity, credit conditions, and spending over
the longer run. In making policy, the Federal -Open Market Committee
must embody its policy prescription in instructions to the Manager of
the System Open Market Account that are operationally feasible.
Essentially, the Committee does this by:

(l) specifying the terms on

which the reserve needs of the banking system are to be accommodated by
the Manager on a week-to-week basis, and (2) varying the terms from time
to time to influence bank liquidity and the financial variables in the
direction desired.

In recent years, the FOMC haa specified the terms

of accommodation—i.e. money market conditions--in terms of a number of




9
indicators. These indicators include free reserves, member bank borrowing
from the Reserve Banks, the Federal funds rate in relation to the discount
rate, and Treasury bill rates.1 The POMC has sometimes given particular
weight to one of these. For example, shoring up Treasury bill,rates for
balance-of-payments reasons was an active concern in the early stages of
the economic expansion that began in 1961. In the main, however, the
Committee has come to rely less than in the 1950?s on any single measure,
such as free reserves.

It tries instead with the aid of its staff to

specify for a constellation of variables the ranges of short-term variation that are believed to be consistent with a projected rate of growth
in total bank deposits over the next month or so.
As noted earlier, the System wants to exert a degree of influence on
the lending and investment decisions of banks—and an important means of
exerting this influence is by governing aggregate recourse to the discount window.

It is the essence of a short-run accommodative posture,

when policy is not changing, for open market operations to seek to maintain daily average member "bank borrowing reasonably stable on a week-toweek "basis. Then, the pressure exerted by discount officers on borrowing
banks to adjust their assets and repay the Reserve Banks will be reasonably steady. Discrete changes in the levels of average member bank borrowing, and the pressures exerted by the System on bank management, flow
from the FOMC's decisions rather than emerge haphazardly as a by-product
of other factors affecting reserves.

1. Free reserves is defined as the excess reserves of member banks
less their borrowings from the Federal Reserve Banks. This formulation
is equivalent to the difference between the nonborrowed reserves and required reserves of member banks.




10
A problem remains. The Manager may successfully maintain member
bank borrowing from the Reserve Banks and the other elements of money
market conditions within the prescribed ranges, but bank credit and
a variety of interest rates may behave differently than the FOMC expected.

Such discrepancies are likely to be particularly large—and

significant--when the economy1s demand curve for credit is shifting
rapidly in either direction. The FOMC may then find that interest
rates and the rate of bank credit growth turn out to be higher than
it intended at times when credit demands are burgeoning, and lower
than it intended at times when credit demands are falling sharply.
The reasonably short interval of three to four weeks between FOMC
meetings provides considerable assurance that large shifts in credit
demands will be detected fairly promptly. The Committee has sought
in recent years, however, to increase the rapidity of its response
to changing conditions.
To this end the FOMC began experimenting in 1966 with a new form
of its directive governing the conduct of open market operations. It
included a proviso clause that instructed the Manager to change conditions in the money market in a prescribed direction if the rate of
bank credit growth differed significantly from what was expected.
(Other conditioning elements—the timing of Treasury financing, pressures on liquidity, etc.--continued to be employed as well.) For
example, the operational paragraph of the directive adopted1 by the
FOMC on September 13, 1966, was as follows:




"To implement this policy, System open market
operations until the next meeting of the Committee
shall be conducted with a view to maintaining firm
but orderly conditions in the money market; provided,

11
however, that operations shall be modified in the
light of unusual liquidity pressures or of any
apparently significant deviation of bank credit
from current expectations."^
In the process of implementing this and succeeding directives, the
Manager of the System Open Market Account gradually leaned toward a
little less firmness in the money market as bank credit persistently
fell somewhat short of projected levels.2 By the time the Committee
voted on November 22, 1966, to promote "somewhat easier conditions
in the money market", the proviso clause had already led to a clearly
discernible shift in money market conditions away from the degree of
restraint prevailing in August and September*
The inclusion of the bank credit proviso clause in the Committeefs
directive did not represent any downgrading of member bank borrowing
from the Reserve Banks as an important policy variable. The new directive merely provided a procedure for increasing or reducing the degree
of restraint--and the level of such borrowing—under specified conditions in the interval between meetings of the FOMC. The direction of
open market operations in periods of monetary restraint necessarily
must include some implicit specification of the range of member bank
borrowing from the Reserve Banks that the Manager is to foster in the
banking system as a whole.
* THE IMPLEMENTATION OF THE FOMC!s POLICY
The Manager of the System Open Market Account and his colleagues
at the Trading Desk operate in, and operate on, a financial environment

1. Board of Governors of the Federal Reserve System, Annual
Report, 1966 (Washington: 1967), P- 179-




2.' Ibid., pp. 248-256.

12
whose dominant short-run characteristic is variability.1

To be sure,

such factors affecting reserves as Federal Reserve float, currency in
circulation, and member bank deposits (through their effect on re*
quired reserves) behave in roughly similar patterns at corresponding
times from year to year. But the day-to-day behavior of these factors
in a particular year differs, almost routinely, from an average of
the behavior of past periods. Changes in the timing of Treasury
financings and tax collections have been especially noteworthy in the
past few years. The distribution of reserves among different groups
of banks and the marginal use made of reserves by these banks change
frequently also. Interest rates, too, can vary considerably over the
interval between FOMC meetings in response to a multiplicity of real
and expectational forces. The conduct of open market operations involves a continuing strategy of successive approximation to the FOMCfs
specification of money market conditions.
Operationally, the Manager focuses in the first instance on the
behavior of bank reserves during the statement week and money market
clues to that behavior. Affecting his strategy for each week is the
knowledge that the excess reserves held by the banking system change
from week to week as a result of changing conditions of reserve distribution and use. Country banks, for example, usually build up excess reserves in the first week of their reserve settlement period
and then run them down by $150-200 million in the second week of their
period. Unusual churning in the money or Government securities

1. . See Paul Meek and Jack W. Cox, "The Banking System—its
Behavior in the Short Run,11 Monthly Review of the Federal Reserve Bank
of New York, April 1966, pp. 84-91.



13
markets—as on a quarterly corporate tax date—will increase the volume
of reserves that are likely to pile up unused somewhere in the banking
system. The Manager can maintain the steady degree of pressure on the
banks desired by the FOMC—keep member bank borrowing from the Reserve
Banks reasonably stable--only by allowing the daily average of free
reserves to vary from statement week to statement week with the distribution and utilization of reserves.
The Manager depends importantly in his daily judgments on the
close connection between member bank borrowing from the Reserve Banks
and other indicators of money market conditions—particularly the information on reserve availability and/or use provided by the Federal
funds market. Each morning the Manager receives information on borrowing from the Reserve.Banks by all member banks on the previous day
and estimates of total and required reserves for major groups of banks
for the previous day.

(Estimates of total reserves are usually accu-

rate within $50 million, although occasionally errors exceed $100 million.) The Manager also receives reports on the previous dayfs
activity of 46 major reserve city banks in trading Federal funds and
in lending to Government securities dealers. The Manager has estimates
of daily levels of free reserves stretching three to four weeks ahead—
projections that rely on the patterns of factors affecting reserves
observed in similar periods of past years. On the basis of this information, experience with the shifting strategies that banks pursue
in managing their reserve positions, and knowledge of any large special
strains, such as occur at times of a Treasury financing, the Manager
and his associates will formulate their expectations of how the Federal
funds "market should behave that day.




14
The Trading Desk matches these expectations against the developing
situation revealed by its continuing contact with the Federal funds
brokers, the money desks of the major New York City banks, and the
closely related efforts of the nonbank dealers in Government securities
to finance their positions• "The Federal funds market reflects with
considerable accuracy the marginal availability of bank reserves and
the demand for them on each day.

If the Federal funds market

is much

tighter than the reserve data suggest should be the case, the Trading
Desk will not usually know whether it is because Federal Reserve float
is $300 million lower than expected, or country banks are holding on
to more excess reserves than usual. But the Desk will get a fairly
clear indication that member bank borrowing from the Reserve Banks is
likely to bulge unless reserves are provided through open market operations. Consequently, in such circumstances, the Desk is likely to
supply reserves in a volume intended to moderate the mounting tightness.
Its intervention may itself tend to affect the willingness of a few banks
to wait another day or two before resorting to the discount window*
Conversely, the Desk may respond to easier-than-expected conditions in
the Federal funds market by deferring action to' supply reserves or by
actually mopping up reserve excesses.
A major strength of the System's conduct of open market operations
in recetot years has been the extent to which this day-to-day decisionmaking meshes with the FOMC's policy objectives of maintaining a fairly
even degree of restraint on the banks in the short run. As described
above, the Manager is essentially making daily judgments about the marginal demand for reserves that will go unsatisfied in the Federal funds
market and will be likely to appear at the discount window. The Manager



15
is able to detect changes in the degree of pressure on bank reserve
positions and to cast the System1s weight on the other side of the
scales. He cannot control member bank borrowing at the Reserve Banks
with much precision on a daily basis, but he can adapt his weekly
strategy to resist large deviations in average borrowing from the
range embodied in the money market conditions specified by the
Committee. Such borrowing and the degree of firmness in the Federal
funds market are opposite sides of the same coin. The Committee's
objective of influencing bank behavior has a practical day-to-day
focus.
Member bank borrowing from the Reserve Banks is really only an
approximation to the degree of monetary pressure or ease that the
Manager is instructed to foster in order to further the System1s
longer-term goals. The Federal funds rate itself, in relation to
the Federal Reserve discount rate, has become increasingly a sort of
fine tuning device in daily reserve management. The FOMCfs increased
attention to this rate as a supplemental indicator of the interaction
between bank -policies and the credit demands falling on the banks
reflects expanded member bank activity in the Federal funds market.
The Federal funds rate has proved increasingly sensitive as an indicator cf the banking system's need for reserves, trading at rates
above the discount rate as well as at rates below.

1. Treasury bill rates were useful as such an indicator at
one stage. In the 1960's, however, Treasury bill rates have become
much less meaningful because alternative means of bank reserve adjustment have multiplied and bank holdings of Treasury bills have declined
in relation to the total volume of bills outstanding. The Committee's
concern with Treasury bill rates in the I9601s was more the product of
balance-of-payments, than of domestic, considerations*



16
Use of the Federal funds rate as a conditioning element in the
Committeefs instructions to the Desk has been clearly evident in periods
of monetary ease. At such times open market operations provide reserves
in such volume that member bank borrowing at the discount window falls
to a frictional minimum.

In seeking to promote rapid growth in bank

credit, the System not only lowers the discount rate but keeps the cost
of reserves in the Federal funds market below the discount rate. It
thereby seeks to insure that open market operations are supplying reserves
more rapidly than the banks are using them to expand loans and investments—
in effect, maintaining pressure on the banks to expand credit.
The appearance of Federal funds trading at a rate well above the
discount rate in 1966 brought a new dimension to bank behavior and
probably to monetary policy as well.

The increase in the size of the

premium from l/8 percentage point in early March to 1 l/2-l 3/4 percentage points in early September 1966 was associated with a marked
increase in the degree of effective restraint on bank lending and.
investment. The increase in restraint was probably considerably
greater than in earlier years would have been associated with the rise
of average member bank borrowing from the Reserve Banks from $551 million in March 1966 to $776 million in September 1966. The behavior of
bank credit, the money supply and interest rates in 1966 was consistent
with such an interpretation.

By October 1966 a number of Committee

members were specifying an upper range of the premium on Federal funds
to 1 to 1 l/2 percentage points among the money market conditions to
be achieved—presumably, with a view to* easing the pressure on the banking system.
For the Manager, member bank borrowing from the Reserve Banks and
the Federal funds rate provide objectives that he can achieve reasonably



17
well within his operational horizon of the statement weeks between
FOMC meetings.

Open market operations bear directly on both of them.

The Manager!s influence over other interest rates—for example, the
Treasury bill rate or the yield on long-term Government securities—
is much more indirect and uncertain.

Changes in the expectations of

market participants can easily outweigh any marginal influence the
Manager may exert in the course of pursuing the FOMC f s marginal reserve
objectives.

A sustained System effort coordinated with the Treasury's

issuance of Treasury bills was necessary to shore up bill rates a few
years ago for balance-of-payments reasons.
The implementation of the directivefs bank credit proxy involves
a shading of money market conditions over the interval between FOMC
meetings.

In determining its application, the Manager is guided by

the relation between the FOMC's desired range of growth for total bank
deposits for a month or so ahead and updated projections of those deposits prepared weekly by the staffs of the Board of Governors and the
Federal Reserve Bank of New York.

Should bank credit appear to be

expanding more rapidly than the FOMC indicated was acceptable, the
Manager would consider a shift in the direction of greater restraint
if other conditioning elements in the Committee!s instructions--e.g.
Treasury financing--permitted.

Such a move would involve promoting

a higher level of member bank borrowing from the Reserve Banks, and
possibly also a somewhat higher Federal funds rate, than prevailed
on average before implementation of the proviso clause.

Since the

interval between meetings is only three to four weeks, the FOMC!
itself determines whether such a shading is to be held, carried
further, or reversed.




18
'

OPEN MARKET OPERATIONS AND CHANGES IN DISCOUNT ADMINISTRATION
As noted earlier, monetary policy is an integration

policy and discount policy.

of open market

The Federal Open Market Committee basically

determines the desired aggregate level of member bank borrowing from the
Reserve Banks by its specification of the money market conditions the
Manager is to achieve.

Discount officers encourage the individual bor-

rowing banks to pay off their borrowing after a time--by asset adjustments if necessary.

Monetary policy exerts restraint on the banks

because the discount window is not continuously open to individual
banks.

Open market operations are used quite consciously to vary the

pressure on the banks to adjust their lending and investment policies.
Monetary management in a modern economy is so closely related to
the performance of the money and credit markets that there is no
desirable alternative to open market operations as a policy instrument.
There is general agreement that discounting cannot provide efficiently
a centralized management of reserves that is integrated with national
liquidity needs.

Fortunately there do not appear to be any major

obstacles ahead in the future use and development of open market operations as a policy tool.

In the unlikely event.that the supply of

United States Government and Federal agency securities in the hands of
the public should become so limited as to impair open market operations,
such operations could be conducted in the debt obligations of other
issuers.
A great virtue of the present arrangements is that policy-making
is centralized in the Federal Open Market Committee.

The Committee

exerts its leverage on the monetary process against the fulcrum of a
reasonably uniform policy of discount administration.




The linkage

19
between money market conditions and bank credit may change, but the
Committee can now be reasonably sure that such changes do not reflect
an independent monetary policy being pursued by discount officers.

At

first glance it might appear desirable to vary discount administration
over the cycle to reinforce the effects of the Committee's open market
policy—either in the direction of ease or restraint.

But changing

institutional arrangements repeatedly would shake up unpredictably the
banking system's behavior, increase the already considerably difficulty
of deciphering its response to open market policy changes, and impair
the Committeefs growing ability to give instructions to the Manager
of the System Account that relate meaningfully to the Committee's own
bank credit and interest rate objectives.

The Trading Desk would prob-

ably find its task complicated considerably if the behavior of the money
market and the banking system were being affected by changes in discount
administration.

There would not appear to be any substitute in monetary

management for the centralized policy direction and centralized execution
that open market operations make possible.
The discount window will continue to play a key role in enforcing
a policy of monetary restraint.

It is axiomatic to such a policy that

the banking system cannot be permitted to borrow from the central bank
without, restraint the reserves that are absorbed, or are not supplied,
by open market operations.

Any revision of the System's approach to

discounting must provide a mechanism for limiting the access that the
individual banks in the banking system have to reserves on their own
initiative.

Since borrowing at the window must remain a principal

cutting edge of monetary restraint, one cannot allow the total to rise




20
and fall except as a reflection of monetary policy.

To allow banks to

borrow without restraint—for example, to meet long-term growth needs
or to deal with aggregate intramonthly and seasonal reserve needs—
would involve loss of control over the reserve base.
The present system of administrative rationing on the basis of the
current Regulation A meets the test of providing an adequate fulcrum
for the FOMC's exercise of monetary restraint, but the rules .of discount
administration could be modified or changed without impairing this function. Under a different set of rules, administrative rationing could
permit all banks more frequent or longer access to the window than at
present before administrative counseling began. Under such rules it
would probably take considerably longer to achieve a given degree of
monetary restraint, but the System could undoubtedly achieve its objectives in time.
The lag between a policy move toward restraint and its effect on
bank behavior would probably be less under a hybrid system in which
"small" banks were allowed to borrow for seasonal needs in amounts
specified in advance while larger institutions remained on a short
tether as at present•

Small banks with marked seasonal patterns could

negotiate with the discount officer of their Reserve Bank in advance
a credit line for continuous borrowing for the period in question-perhaps as much as two or three months--thereby enabling them to reduce
their own provision for seasonal liquidity needs. Such a borrowing
facility would recognize the limited time that bankers in such institutions can give to daily liquidity management, and be an added attraction
of System membership.

Only borrowing above a seasonal amount would be

subject to administrative scrutiny for disciplinary purposes. The frequency of such borrowing permitted before administrative counseling was



21
called into play might also be increased somewhat. Aggregate member
bank borrowing at the discount window would presumably be higher under
such a "hybrid" system than under the present system for a given degree
of monetary restraint.

In periods of easy money some "seasonal" bor-

rowing would be added to the frictional borrowing already experienced.
As the Committee moved toward restraint, one would expect borrowing to
rise to higher levels than at present, without necessarily involving
any very sizable swings in total borrowing around the policy-determined
level.
Access to reserves borrowed from the Reserve Banks could also be
limited through a structure of quantitative limits and discount rates.
There has always been a considerable body of academic opinion that has
felt tftat the discount rate should be a penalty rate. The 1966 experience, of course, showed that policy could be quite restrictive with a
discount rate well below outstanding market rates. Such a discrepancy,
however, does raise some questions of the desirability of providing
reserves to the banking system at an unrealistic rate and of equity
between borrowing and nonborrowing banks. These questions are of limited
significance as long as borrowing at the discount window is a small part
of total reserves, but they would become more important if revisions in
discount policy increased substantially the proportion of total reserves
represented by such borrowing.
A structure of quantitative borrowing limits and discount rates
could supplement or substitute for administrative counseling as a means
of affecting bank behavior.

Such a system might involve, for example,

an automatic boost in the effective cost of borrowing from the System
once borrowing exceeded a certain proportion of required reserves or a




22
certain frequency or some combination of the two. Conceivably, it could
alleviate some of the problems of equity that emerge between borrowing
and nbriborrowing banks, although there are manifold problems in designing an equitable system because the sizes of the reserve swings experienced by banks vary so widely.

One might also expect that such a

system would reflect to some extent the degree of restraint being
achieved by the Committee--i.e., borrowing at penalty rates would increase with the degree of restraint.
While a structure of rates or quantitative borrowing limits may
be a suitable means of trying to influence the reserve base and credit
conditions in countries without well developed money and credit markets, it is hardly an acceptable substitute for open market operations
as the primary instrument of general control in this country.

One may

question whether the complexities of even a supplemental system might
not render the conduct of monetary policy and its impact on economic
activity even more mysterious and subject to misunderstanding than at
present.
Policy and operational considerations suggest a number of considerations to be observed in any process of mpdifying the present rules
of discount administration.

The importance of fostering uniform admin-

istration is self-evident. A corollary of this is that changes in discount administration should be of the once-over variety.

The policy

decisions of the Committee and the operations of the Desk could adjust
to modified rules without major difficulty provided there were no continuing change of the rules nor any effort to substitute discount policy
for open market policy.

In making discount rule changes that may seem

desirable for purposes of dealing with individual banks, it would also




23
seem advisable to time the changes to coincide with a period in which
monetary policy was expansive, and borrowing by member banks was near a
frictional minimum.

Then, discount officers, the commercial banks,

the Federal Open Market Committee, and the Trading Desk could 9 1 adapt
,1
gradually over the expansionary period to the effect of the changed
regulations on bank behavior and monetary developments.





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102