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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.




Robert C* Holland
Board of Governors

George Garvy
Federal Reserve Bank of New York

July 1968



The money market environment

. . . •


Modified market performance as a result of
amendments to Regulation D


Market influence of short-term adjustment
credit under generally stable money market


Interaction of short-term adjustment credit
with changing money market conditions •


Interaction of short-term adjustment credit
with changes in discount rates


Additional effects of seasonal credit on
the money market


Effects of extension of emergency credit
on the monay market

, . • . •



The purpose of this paper is to explore, insofar as a
priori knowledge permits, the kind of interaction that might be expected between the national money market and a redesigned discount
mechanism as proposed in the Final Report of the Steering Committee
and to outline the kind of adaptations that the Federal Reserve would
probably be required to make in the conduct of its open market operations •
This paper thus differs in concept and orientation from
other studies that have been prepared in connection with the reappraisal
of the Federal Reserve discount mechanism.

Generally speaking, the

other papers endeavored to analyze past, present, or prospective
conditions and to draw from such analyses inferences as to the
circumstances in which the current discount mechanism proved to be
inadequate and in what respects it might be improved.

This paper

takes the proposed new discount mechanism as given, and tries to
evaluate how such a mechanism might interact, in practice, with
likely money market conditions and open market policy.
The purpose of the proposed redesign of the discount window
is to make better use of monetary tools to achieve System objectives
and to improve the functioning of the banking system in general.

-2More liberal access to Federal Reserve credit at the discount window
does not imply easier monetary policy.

Rather such access would re-

distribute responsibilities for facilitating adjustments to the
posture of credit policy. The proposed design of the window should
enhance the ability of member banks to meet the needs of their customers, without reducing the effectiveness and precision of open
market operations.
Our growing economy has required a continuous broadening
over the years of the banking system's reserve base. And over the
long run, the Federal Reserve System will still have to provide substantial amounts of bank reserves, even if its efforts to achieve
greater price stability are successful and its additions to reserves
are held to a rate commensurate with noninflationary growth of the

Thus, the impact of the shift to the proposed new system on

the money market and on open market operations must be viewed against
the background of a long-run process of net reserve injection, the
precise time profile of which is subject to seasonal factors as well
as changes in System policy objectives related to cyclical developments.
Under the present Regulation A, the discount mechanism
contributes little to an appropriate growth in aggregate reserves of
banks or to accommodating recurrent seasonal swings in the reserve

Because of the reluctance-to-borrow convention, a large part

of the needs of member banks for adjusting reserves from one reserve

-3period to another are accommodated through System open market operations. Thus, over the year, open market transactions show a large
volume of purchases followed by sales (and vice versa) to accommodate
the fluctuating reserve needs of the banking system. As a result, in
any given year open market transactions (disregarding exchanges) are
several times as large as the n6t addition to the reserve base.
Restoration of the discount mechanism to the role of a buffer
willingly used by member banks to make initial adjustments to fluctuations in their loans and deposits and to meet part of regular seasonal
bulges in demand for loans will result in a change in the composition
of reserve injection.

Such injection will be more immediately guided

by the needs of individual banks. A somewhat larger proportion of
the provision of reserves will occur at the window rather than at
the initiative of the Trading Desk.

But since the Desk will continue

to be in charge of implementing the over-all objectives of credit
policy, as defined periodically by the Federal Open Market Committee,
it will need to adjust the actual conduct of its operations to the new
role that the Report of the Steering Committee assigns to discounting.
If the amount of reserves created at the initiative of member banks
is at times excessive in the light of current targets of Federal Reserve
policy, the Trading Desk will need to offset such excesses by appropriate operations. Normally, part of the reserves that banks lose and
seek to replenish by borrowing at the window will find their way to

-4banks that are anxious to reduce their borrowings from the Federal
Reserve, and the net injection through the window will tend to be
smaller--and at times considerably smaller--than the gross flow.


should be kept in mind in interpreting the rough estimates of gross
potential borrowing cited in the Report.
The greater initiative that member banks will be able to
exercise in the initial distribution of reserves tb support longterm growth and to accommodate seasonal and cyclical swings in bank
credit, as well as in the levels and composition of deposits^ will
have significant effects on the money market.

The Trading Desk will

need to make certain adjustments corresponding in its operating procedures and projection techniques. The redistribution of the responsibility for flexibility in the provision of reserves to member banks
will, on balance, reduce the volume of open market transactions without
diminishing the Desk's central role in implementing Federal Reserve
The primary purpose of this paper is to explore the probable
impact of the proposed changes on money market processes. There is no
intention to minimize either the challenge to the Trading Desk or the
magnitude of its task. Yet, the proposed changes in discount philosophy
and procedures affect the Trading Desk in a quantitative rather than
in a qualitative way.

The required adjustments involve, in the main,

a restructuring of the patterns of reserve flows with which the Desk

-5is confronted in its day-to-day operations; it is believed that these
problems can be solved by gradual adjustment, as the impact of the
new policies progressively affects credit conditions.
In the first section below, attention will be directed to
the likely operation of short-term adjustment credit at the discount
window in conjunction with ordinary money market conditions, as they
may be moderated by the recent adoption of changes in reserve regulations.

Succeeding sections will describe how such short-term adjust-

ment credit might interact with money market developments as credit
demands change cyclically, and as the general Federal Reserve
instruments--open market operations, reserve requirements, and changes
in the discount rate--are employed to implement changes in monetary
policy. Another section will discuss how these relationships might
be affected by the operation of seasonal credit assistance and emergency
credit assistance. The concluding section will explore briefly some
of the implications of the redesigned discount window for open market
The Money Market Environment
The national money market is the arena in which excesses and
deficiencies in supplies of, or demands for, liquid funds by a variety
of participants are balanced out, insofar as those participants have
the means, directly or indirectly, for reaching this market.

Some of

these excesses and deficiencies are highly transitory--that is, of a
few days1 duration; others are expected to continue for longer periods--

-6that is, several weeks, a season, a cycle, or indefinitely.

In some

instances those that supply funds and those seeking funds, as well
as market intermediaries, are likely to be uncertain as to the duration or prospective dimension of the excesses or deficiencies accruing
to them.
The response to such liquidity surpluses or deficits is
conditioned largely by expectations as to their size and duration.
In addition, responses of those with surpluses and those with deficits
are affected by their basic portfolio positions, by their view of the
current and prospective conditions in the money market, and anticipated
future trends in basic economic and financial conditions•

Guided by

these considerations, including estimates of the alternative costs
involved, participants in the money market choose among the alternatives open to them for adjusting excess or deficient liquidity.


member banks--the only category to be discussed in this paper—the
Federal Reserve discount window is one of the alternatives, albeit
one with unique terms and conditions attached.1/ Among member banks,
needs for liquidity vary widely as do swings in their cash positions
and in demands made on them and their ability to make short-run
adjustments in their assets and liabilities.

!/ For a fuller discussion of present money market performance,
bank adjustments through the money market, and the market interaction
of existing monetary instruments, see Paul Meek, "Discount Policy and
Open Market Operations,11 a research paper prepared for this study.

-7Modified Market Performance as a Result of Amendments to Regulation D
A special influence on the responses of member banks to
variations in liquidity is their need to satisfy specified reserve requirements, on average, within each designated reserve period, in
accordance with the existing provisions of Regulation D. The Board
of Governors adopted certain changes in Regulation D; the revisions,
which become effective in September 1968, are expected to alter bank
use of the discount window somewhat and therefore should be taken into
account here.
Briefly, the new reserve regulations (1) shorten the reserve
periods for country banks to the same 1-week duration already applicable
to reserve city banks; (2) base requirements on deposits 2 weeks
earlier; (3) allow holdings of vault cash 2 weeks earlier to be used
(along with the current week1s reserve balance at the Reserve Bank)
to satisfy reserve requirements; and (4) provide for the carry-over
of either deficiencies or excesses in average reserves of up to 2 per
cent of requirements from one reserve period to the next (but no
Banks will thus be able to operate with certain knowledge of
their reserve requirements and of their vault cash credit with respect
thereto at the beginning of each reserve period. On the other hand,
banks will remain as uncertain as ever about the flow of their deposits
during the current week and effect of this flow upon their reserve and



due fronr1 balances.

The cost of this uncertainty in terms of actual

reserves is fractionally larger because the fractional offsetting
effect of any deposit movement on current required reserves under the
previous regulation has been eliminated.
The provision for an automatic 2 per cent carry-forward
should moderate bank efforts to dispose of any end-of-period reserve
excesses or to meet moderate deficiencies, because it provides a
limited alternative to forcing such adjustment through the market near
the end of reserve periods when supply and demand schedules have been
most inelastic.
Shortening of the reserve period for country banks to 1 week
will increase reserve adjustment activities for those country banks
that tend to experience offsetting deposit or loan movements in successive weeks, but that choose not to carry enough excess reserves to
meet peak needs.

On the other hand, numerous country banks for pre-

cautionary reasons up to this time have tended to accumulate excess
reserves throughout most of their 2-week reserve periods and then
near the end of those periods have dumped such accumulated credit into
the Federal funds market or into their balances with correspondent banks;
with only 1 week in which to cumulate reserves, such dumping by country
banks should less often bulk large enough to swamp the absorptive capacity
of the rest of the money market.

It is b^lieVed that these changes in reserve regulations
will tend, on balance, to moderate the reserve adjustment activities
of most of the banks, and hence to reduce somewhat their demand for
end-of-period accommodation at the discount window.

However, for a

minority of country banks that are subject to swings in deposits or
loans that are largely reversed from one week to the next, requests
for intermittent assistance at the discount window may expand considerably.

But on balance, the new method of reserve computation is

likely to reduce both the recourse of country banks to the discount
window for adjustment purposes and the periodic bulge in excess reserves supplied by these banks to the Federal funds market*
Market Influence of Short-Term Adjustment Credit under Generally
Stable Money Market Conditions
For purposes of this section, generally stable market conditions are taken to include (and in part depend upon) a stable pattern
of use of the discount window for obtaining

short-term adjustment

This implies that, as a rule, member banks are making only

moderate use of System discount facilities but that they are willing
to increase their use of the window should their flows of funds turn
adverse.— A minority of banks are assumed to be using only a small

L' In most instances, it is expected that bank use of the
discount window in response to changing circumstances would be substantially symmetrical; that is, what a bank would be inclined to
do if an influence changed in one direction would be about the inverse of what that bank would do if the same influence changed in
the opposite direction. For purposes of simplicity and clarity,
influences and responses are described in a consistent direction in
the text, however.


fraction of their b isic sorrowing privilege, another minority are
assumed to be using, nor - of their basic borrowing privilege, and only
a few banks are assumed to be borrowing in excess of their basic
borrowing privilege in either amount or duration and thus to be subject
to administrative review.
Under the circumstances indicated, it is believed that interest
rates on most of the alternative types of instruments readily available
for adjusting liquidity--the markets for which are dominated by banks-would be separated from the discount rate by margins no more than equal
to the costs of the attendant transactions, credit risk, market or
liquidity risk, customer-relation effects, and the like.
In this environment, banks experiencing what they think will
be quickly reversible drains of funds should be inclined to offset
such drains by borrowing at the discount window.

Their ability to do

so will depend to a large extent upon whether they had previously
used little or most of their borrowing leeway under the basic borrowing privilege.

The longer-lived such drains of funds are expected to

be, the more inclined banks would be, at the outset, to initiate
correspondingly long-term adjustments in their portfolios, except
insofar as they would need some transitional time to become reasonably
certain of trends or to arrange orderly adjustments.
If a drain of funds should hit a sizable proportion of banks
simultaneously, there could be a considerable rise in the nationwide
total of borrowing.

If this occurred, and if the cause of the drain


was of a reserve-absorbing nature (e.g., an outflow of currency or gold),
the aggregate reserve base of the banking system would remain little

If, on the other hand, the drain consisted of a deposit shift

from one group of banks to another, the step-up in borrowing by the
deposit-losing group would enlarge the national total of reserves.


deposit-receiving banks could be expected to dispose of some of their
resultant reserve excesses through the money market, and to that degree
the supply of Federal funds (and similar money market instruments such
as dealer loans) would be expanded.

In most circumstances, the interest

rates on Federal funds and money market instruments would tend to
decline, and banks in debt to the Federal Reserve could be expected to
try to refinance such debt by borrowing in the now-cheaper funds market,
absorbing redundant reserves in the process.

However, if the outstand-

ing amount of adjustment borrowing at the discount window were too
small or the time remaining in the reserve period too short to permit
full absorption of the redundant reserves, day-to-day rates in the
money market would drop still lower, unless some buying to build up
carry-overs developed, or banks receiving part of the newly created
funds used them to repay their debts at the window.

If the decline

in such rates seemed too great to be compatible with the currently
desired money market atmosphere, the Trading Desk would need to sell
securities (outright or through reverse repurchase agreements) to absorb
the redundant reserves.


Substantially the reverse of the process outlined above
should take place if the initiating factor were an inflow rather than
a drain of funds at the banks in question.
As a result of greater reserve-adjustment activity stemming
from more general use of the discount window, the national total of
adjustment borrowing (within and outside the basic borrowing privilege)
would probably fluctuate over a wider range from day to day and from
week to week than occurs under the present system, but it would still
oscillate around a generally level longer-run trend.

Open market

operations, on the other hand, would probably tend to undergo smaller,
and perhaps also less frequent, day-to-day and week-to-week fluctuations; it is difficult to document this probability, however, because
such operations are undertaken in relation to the total of all influences affecting member bank reserves and not borrowing alone.


market operations to supplement rather than offset swings in borrowing
would be called for whenever data on the composition of borrowing
suggested a cumulative build-up of adjustment pressure at the discount

Such situations would notably arise when a greater share of

adjustment borrowing was tending to take place outside the basic borrowing privilege and was therefore under administrative review, and/or
when the preponderance of banks was moving toward the upper threshold
of use of the basic borrowing privilege.
Interest rates on those instruments of liquidity adjustment
for which banks are by far the main suppliers and purchasers would tend


to fluctuate less widely than under the present system so long as
underlying conditions remained stable.

On the other hand, interest

rates on instruments ordinarily utilized by the System in its open
market operations would tend to be influenced less by System operations
undertaken to even out reserve positions in the short run and more by
the ebb and flow of private investor interest.

This would mean that at

times such rates might be subject to wider swings than under the present
system and at other times to smaller swings, depending upon the extent
to which changes in investor interest and in the volume of Trading
Desk operations undertaken to meet banks1 adjustment needs would have
been mutually offsetting or reinforcing.
Interaction of Short-Term Adjustment Credit with Changing Money Market
_ _ _
When underlying money market conditions begin to undergo a
basic change--either because of shifts in credit demands or because
of a change in Federal Reserve policy--the proposed short-term adjustment credit facilities should work to spread the influence of such a
change somewhat more gradually, but also more broadly, throughout the
banking system.

Recourse to the discount window may be expected to

make reserves available sooner at the point of need than they would be
if they were redistributed through bank portfolio adjustments, after
having been injected through open market operations.
A cyclical expansion in demands for bank credit could be
expected in the first instance to elicit an accommodative response

-14from the bank subject to such demands.

As the consequent rise in

deposits, and perhaps also an expansion in currency, effectively absorbed reserves, member banks would be inclined to undertake sufficient
borrowing to offset such absorption at least temporarily.
As the credit expansion and resultant reserve absorption
spread and cumulated, progressively more and larger borrowing by banks
would be induced.

The borrowing banks, in turn, would gradually reach

thresholds at which they were moved to rely more heavily on alternative
methods of adjustment.

For some banks, this might happen as they drew

close to their own desired maximum use of the basic borrowing privilege;
for others, it might occur only after they had exhausted their basic
borrowing privilege, had moved on into other adjustment borrowing, and
had finally encountered Reserve Bank pressure to repay.

The speed

with which the banks reached these stages would depend, of course, on
the combined effects of the reserve absorption and of bank willingness
to use the discount window up to the limits outlined above.

It would

also depend on the degree to which reserves originally lost by the
borrowing banks would be used by the receiving banks to reduce their
indebtedness rather than to expand credit.

There would undoubtedly

be differences in behavior as between specific periods of expansion
and as among different economic areas and groups of banks.
As borrowing banks shifted to adjustment outside the
discount window, interest rates on the alternative adjustment instruments utilized would rise, both absolutely and relative to the discount



Most directly affected would probably be the Federal funds rate,

since it is dominated by bank reserve adjustment actions.

The results--

higher money market rates, a tighter borrowing posture at the discount
window, and the contracted supply of total reserves--if unalleviated,
would presumably tighten the availability of credit on a broader scale,
thus deterring some borrowers.

This shift, by itself, would operate

in the direction of general monetary restraint.

Monetary policy-makers

would then have to decide whether the tauter trends emerging in reserves,
credit, and interest rates were desirable in the changing economic environment, or whether they wished to moderate such trends by buying
enough securities in the open market to offset at least in part the
curtailed availability of reserves at the window.
Conceivably, of course, the requirements of policy might
lead the Federal Open Market Committee to accelerate rather than
moderate the financial system's adjustment to the changing supply of

In those instances, even though borrowing at the discount

window was becoming larger and more widespread, parallel sales for the
Open Market Account might be desirable.

As an alternative, an increase

in reserve requirements might be used to speed the adjustment and to
elicit greater attention thereto.
Interaction of Short-Term Adjustment Credit with Changes in Discount
_ _
The influence of a change in the discount rate on the money
market and on borrowings of short-term adjustment credit sought at the


discount window will differ considerably, depending upon whether the
change in the discount rate is leading market rates or is simply
following a change in general money market rates and conditions.
Let us consider first a situation in which a combination
of expanding demands for credit and of less expansive System open
market operations has increased the reserve pressures on banks.


pointed out in the preceding section, this process, if carried on long
enough, will impel more and more banks to undertake their reserve
adjustments outside the discount window, and the pressure of such
added demand for available reserves will tend to raise interest rates
on Federal funds and various money market instruments correspondingly.
By the same token, reserves borrowed at the discount window at the
existing discount rate will appear relatively cheaper.
This relative cheapness of discounting might entice some
additional borrowing by banks that still had not used all of their
basic borrowing privileges to make their first adjustments in reserves
in this way.

On the other hand, a sizable and growing proportion of

banks would have used all of their basic borrowing privileges and
have come under administrative review; the banks in this second
group would seek to effect their reserve adjustmants outside the
discount window—not for reasons of comparative cost but in order
to comply with the standards for repayment of adjustment credit,
and to be able to proceed to orderly portfolio adjustments when
and as needed.

-17In these circumstances an increase in the discount rate
following recent increases in other money market rates would not
appreciably alter the pattern of adjustment of the second group of
banks and would therefore not engender through them any significant
additional upward pressure on

market rates and would not reduce the

incentive for them to delay the required adjustments.

However, such

an increase in the discount rate would narrow the rate incentive for
the first group of banks to borrow at the discount window.

To the

extent that the first group rechanneled its reserve adjustment
activities away from the discount window and into the market, upward
pressures on market rates would increase.

Generally speaking, the

more the discount rate lagged behind market rate increases the larger
the second group of banks should be relative to the first, and the
less likely it would be for the eventual "following" increase in the
discount rate to trigger much additional upward pressure on market
A somewhat different pattern would tend to emerge, however,
if the discount rate were to be leapfrogged ahead of the rates on the
most closely related instrument of reserve adjustment.

First, such

a "leading" increase in the discount rate would increase the relative
cost of borrowing as compared with alternative reserve adjustment

All member banks that had been borrowing, but not in

a large enough amount or for a long enough duration to bring them


under pressure to repay, would then find it advantageous to seek less
expensive means of financing their reserve deficits.

Their added

financing efforts in the money market should quickly bring upward
rate pressures to bear on other money market instruments•

To the

extent that these banks were successful in this endeavor, and thus
were enabled to retire debt at the Federal Reserve, the aggregate
supply of reserves would be curtailed.

In consequence of all these

actions, a correspondingly tauter atmosphere should soon come to prevail
in the central money market.
The effects of decreases in discount rates, under the redesigned discount mechanism, are likely to be generally the reverse of
those outlined in the preceding paragraphs but not preciselysymmetrical.
So long as the borrowing pressure on the banking system is sufficient
to keep a large number of banks borrowing over and above their basic
borrowing privilege, reductions in the discount rate should have
only modest, easing effects on other money market rates.

The fact

that the bulk of the banks were still under pressure to repay their
indebtedness to the Reserve Banks should tend to keep the rates on
Federal funds and similar private instruments of reserve adjustment
relatively high.
However, once credit contraction or expansive open market
operations have made enough nonborrowed reserves available for such
"over-privilege" borrowing to be substantially repaid, most banks


should again be in jortantly influenced in their choice of reserve
adjustment media by the relative costs thereof.

Thereafter, reductions

in the discount rate should be followed promptly by enough rechanneling
of reserve adjustment pressures to the discount window and away from
other avenues tc cause sympathetic rate declines on such other media.
If monetary policy should ease sufficiently, however, to
encourage the retirement of virtually all adjustment borrowing from
the Federal Reserve, then money market rates would tend to become
unhinged from the discount rate and to drop to levels that would
equilibrate the demand for and supply of nonborrowed reserves.
Consideration of typical interactions and sequences suggests
a very close association between the discount rate and rates on
alternative instruments of reserve adjustment so long as member bank
adjustment borrowing is large enough to affect market rates but not
so large as to bring a significant proportion of the banking system
under pressure to repay.

As credit demands and monetary policy shift

over the cycle, discount rates would presumably be raised or lowered
more or less commensurately so as to achieve the System's objectives.
However, there would be a tendency for rates on alternative instruments
of reserve adjustment to rise even higher relative to the increased
discount rate near peaks of strong cyclical borrowing pressure and
to drop even lower relative to the lowered discount rate during
cyclical troughs,

when borrowing was very slack.


All the above discussion has abstracted from the special
question of the Mannouncement effect11 of any changes in the discount
rate on interest rates and availability of funds in the money market.
Such effects are conditioned so much by the attitudes prevailing at
the time of a given rate change that any generalization is very risky.
Nonetheless, it appears that such effects would be most marked when no
action on the discount rate was expected.

This would probably occur

when the discount rate was used to lead rather than follow movements
in market rates.
Additional Effect of Seasonal Credit on the Money Market
The seasonal borrowing privilege provided in the proposed
redesign of the discount mechanism should work to moderate the effect
on the money market of the reserves supplied or absorbed in response to
changing seasonal demands.

But since banks would be required to meet

the first portion of their seasonal drains of funds (up to an amount
equal to 5 to 10 per cent of their average deposits) out of their own
resources, it is likely--judging from inadequate empirical evidence-that the great bulk of seasonal oscillations in fund flows within the
banking system would continue to be met by resorting to the usual
reserve adjustment techniques.

To the extent that seasonal adjustments

are met at the window, however, the need for seasonal open market
operations of the conventional sort would be reduced.


banks1 resort to borrowing under their basic borrowing privileges to


deal with short-term seasonal oscillations should also reduce the
over-all amount of open market operations required to cover seasonal
The typical user of the seasonal borrowing privilege is
expected to be a relatively small bank experiencing a large seasonal
swing in relation to its available funds.

Given the diversity of

seasonal needs and their patterns, it is likely that the total amount
of reserves advanced to such banks should rise and fall more or less

Since the banks will be expected to negotiate their seasonal

borrowing needs with their Reserve Banks over their full seasonal
period insofar as feasible, the general timing and amount of reserve
injections from this source should be fairly well defined in advance.
In addition, the discouragement of temporary repayment of such credits
with funds obtained from the money market when it turns easy for a day
or two will tend to minimize abrupt changes in the level of borrowing
under the seasonal arrangement.
Inasmuch as the volume of seasonal borrowing should change
gradually and more or less predictably, it should be possible to
insulate most of this borrowing from day-to-day changes in money
market atmosphere.

Seasonal borrowing, therefore, would have little

more policy significance than float.

This means that it should be

possible to project the aggregate flow of reserves from use of the
seasonal borrowing privilege with about the same degree of accuracy


as for other market factors affecting reserves--including the component
of seasonal credit that will remain hidden in borrowing under the shortterm adjustment provisions.

If it appeared that the total of seasonal

borrowing and other factors would supply too many reserves in any
period, open market sales would be employed in the usual way to maintain the desired conditions in the money market.
Undoubtedly there will be a tendency for use of the seasonal
borrowing privilege to rise as banks and their customers become
familiar with this special facility.

And it is probable that requests

for seasonal credit assistance will tend to grow in periods of tight
money or relatively low discount rates, and contrariwise to shrink
when credit conditions are easy or when the discount rate is unusually
high compared with rates on alternative instruments.

But so long as

the business of the nation's largest banks is such that these banks
are unlikely to meet the terms of the Regulation and therefore are
prevented from suddenly becoming seasonal borrowers, the total dimensions and variability of seasonal credit assistance at the discount
window should be well within a scope that can be handled by present
methods of open market operations.
Effects of Extension of Emergency Credit on the Money Market
The very nature of emergencies makes it hard to predict the
consequences of any efforts to deal with them.
For the most part, it can be assumed that the occasional
needs of individual member banks for emergency credit assistance at


the discount window will be small and infrequent enough to have no
significant effect (in quantitative terms) on the over-all flows of
reserves through the money market.
When the emergency assumes the aspect of a large-scale
regional, sectoral, or even national liquidity scueeze, however, the
probable effects of discount window assistance on the money market
cannot be disregarded.

In any crisis of such proportions, System

open market operations would have been undertaken to bring about
approximately the desired degree of over-all credit availability.
Undesirably tight conditions in any specific group of institutions,
therefore, would be related to the inability of such institutions to
command a suitable redistribution of the national total of liquidity,
unless the emergency were of national scope.

Extension of emergency

credit to such groups of institutions by the Reserve Banks would thus
be not so much a substitute for money market activities that they
might otherwise undertake as it would be an independent and complementary source of alleviation of undue pressures.
If the funds drained from the institutions experiencing the
emergency accrued to others in the financial system, and if this
development led to an undue easing of reserve availability in the
money market, the System would need to undertake open market sales
of short-term securities to absorb such reserve excesses.

In such an

environment, investor demands would be shifted toward liquid assets in
general, and Treasury bills in particular—creating a ready market for
such sales by the Trading Desk.


Ptovision is mide in the Final Report for another kind #f
emergency credit assistance.

This assistance would apply not to

institutions in trouble, but rather to markets for the most important
types of securities, should such markets become so disorderly that
open market operations in the kinds of assets purchasable by the
Trading Desk would not calm them.

In such circumstances it is

possible that the Reserve Banks could extend emergency credit to
institutions as at least a partial substitute for further substantial
efforts on their part to dump such securities into disrupted markets.
The reserve effects of such lending could be sizable, and
it is possible that such loans could bulk so large as to tax the
ability of the Trading Desk to offset quickly any undue creation of

Here again, market demand for Treasury bills would probably

become strong, thus facilitating $he offsetting open market operations.
But in certain circumstances, emergency assistance through the window
might be the only feasible means for averting dangerous or even
disastrous developments and such assistance would be justified even
if the simultaneous or subsequent absorption of excess liquidity should
prove to pose difficult problems for the Trading Desk.
Indeed it is quite conceivable that as much or more importance
would attach to the psychological effects of emergency credit actions
at the window than to their reserve effects.

Markets plagued by fears

of a liquidity crisis seek reassurance more than anything else.


knowledge that the Reserve Banks were lending to alleviate a widespread


emergency--or even that they were prepared to do so--might well do
more to promote an orderly functioning of the market than the actual
reserve funds so injected.
Each of the major types of credit assistance envisioned under
the redesigned discount mechanism is likely to have a different effect
on the money market and on the kind of complementary open market operations needed.

However, these influences are not expected to exceed the

ability of the market and the Trading Desk to deal with them.

Many of

them should serve to reduce on balance over the year demands on the
money market and the Desk by providing an alternative for adjustments
that in the past have required alternating purchases and sales of
securities, at times in markets quite unreceptive to such operations.
The estimates of the potential maximum extension of credit
for reserve period adjustment (under the basic borrowing privilege)
and for seasonal needs that are given in the Steering Committee's
Final Report are large in comparison with the net amounts added to
bank reserves in recent years (including those reouired to offset
gold losses and currency outflows).

However, it is unrealistic to

assume that such totals will ever be reached, even for short periods,
because the conditions laid down for borrowing under the basic borrowing
privilege would require all banks to be out of debt simultaneously during a fairly protracted period prior to any rapid build-up of indebtedness to the System.

Furthermore, the estimated upper limit would be

-26reached only if all member banks borrowed maximum amounts, irrespective
of their actual needs (and in spite of the rule against reselling of
borrowed funds).

It is much more likely that in a period of growing

restraint some banks will enlarge their borrowings fairly early and
thus will be subject to strong administrative pressure to adjust their
assets by the time aggregate borrowings rise toward a statistical
maximum as monetary conditions tighten further.

One cannot guess how

far below the potential maximum total bank borrowing will tend to
remain in a time of extreme restraint.

Only experience will show what

typical profile short-term adjustment borrowing will assume in response
to extreme tightening, but it is unlikely that the estimates in the
Report will even be approached.

And in any case tha shift to the new

policy could be made gradually.
On the other hand, provision of a sizable part of the seasonal
needs of the banking system through the proposed seasonal credit accommodation is expected to result fairly soon in the emergence of a different
pattern of residual seasonal demands for reserves to be met through open
market operations.

Given the fact that fex; money market banks, if any,

are likely to become eligible for the proposed accommodation, it is
unlikely that the shift envisaged will require more than routine adjustments in projections and operations.

Indeed, because the naw types of

assistance available at the Faderal Raserve discount window will interact with existing processes and institutions in new ways, adjustments


to the new types will

take some time, and they may not progress smoothly.

Some transitional uncertainties are inevitable.
Interpretation of money market conditions by analysts—and
more importantly, by the Trading Dask--leans heavily on magnitudes that
have come to be regarded as having special relevance in reflecting current and prospective conditions.

It is obvious that any change in pro-

cedures, including those flowing from the quite far-reaching recommendations of the Steering Committee, will result in changes in the lavel and
pattern of several such variables, particularly member bank borrowing.
It may be some time before representative or stable patterns emerge
and before analysts acquire sufficient confidence in interpreting and
projecting changes in the magnitudes of these variables that are essential
for interpreting money market conditions and the posture of System policy.
But all these magnitudes are affected from time to time by innovations,
modifications in procedures, shifts in preferred adjustment processes,
and changing bankers1 attitudes and ty other reasons, as well as by
changes that reflect the more fundamental structural shifts that are
continuously taking place in our economy and in the financial system,
A specific level of borrowing (and of net torrox^ed reserves)
acquires its meaning from the cumulative experience of market participants who come to associate it with a certain averags bank attitude
and a certain market atmosphere.

The relationship between given

conditions is not fixed and mechanical, but is subject to change as a
function of variations in market pressures, in bankers' attitudes and

policies, and in other factors (as the experience of recent years amply

A range of net borrowed reserves of $200 million to

$300 million has a specific meaning when related to levels in recent
periods, but may have been associated with significantly different
credit conditions 10 years ago.
Given the fact that specific levels (or ranges) of net
borroxjed (or free) reserves acquire their analytical and policy significance as a result of collective rationalization of the way in
which they are associated with specific kinds of market and credit
conditions, it is reasonable to assume that similar associations will
become just as firmly established once Federal Reserve standards and
their administration, as well as bank attitudes, have been modified
by the adoption of the window design proposed by the Steering Committee.
A degree of tightness that recently has come to be associated with, say,
borrowings of $600 million and net borrowed reserves of $300 million
may then be identified with, say, borrowings of $1 billion and net
borrowed reserves of $900 million.

Both the new and the old levels

will synthesize essentially the same combination of conditions and
attitudes and will convey substantially the same message to market
It should become clear to the market fairly soon that temporary
bulges in around holidays are meraly a technical alternative
to providing and then absorbing equivalent amounts of reserves through
open market operations, and that such temporary borrowing under the


basic borrowing privilege affects over-all credit conditions no more
than corresponding "defensive11 operations by the Desk.
It is expected that market participants and analysts, as
well as all those within the System who are connected with formation
and execution of policy, v?ill learn~as they have in the past—to live
with the new levels and relationships and to interpret these levels
and relationships with no less insight and imagination than they have
in the past.
Uncertainties and frictions might be reduced by a campaign to
acquaint all participants with the objectives and expected modus
operandi of the new system, or by introducing the new system in tranches
over time.

The amount and frequency targets recommended in the Report

could be announced as ultimate goals, but initial levels could be set
lower and raised gradually in the light of cumulative experience.
Finally, both during the transition and thereafter, a considerably more sophisticated monitoring system may well be required to
keep the policy

makers and the operational staffs concerned with dis-

counting and open market operations fully aware of the changing interaction between member bank borrowing and the money market and the import
of this interaction for monetary policy.

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