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The Plateau in Business Activity Although key indicators o f business activity show ed m oderate improvement in March and early April, the output o f the economy since mid-1% 2 has risen no m ore rapidly than the growth in its resources . Earnings and Expenses of Eighth District Member Banks Excess Reserves Volume 45 • Number 4 FEDERAL RESERVE BANK OF ST. LOUIS P. O. Box 4 4 2 • St. Louis 66, Mo. M ovements in excess reserves do not appear to reduce significantly the Reserve System’s control o f bank credit and the money supply. It is also questionable if the level o f excess reserves can be re garded as a reliable indicator o f w hether the monetary system is likely to expand or contract. C h a rt 1 Gross National Product - Selected Components Billi. ns of D o lla rs 170 1954 D o lla rs - S e a s o n a lly A d ju s t e d Billio ns of Dolllars 170 160 160 150 150 140 140 130 130 120 120 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 -10 -10 340 340 310 310 280 280 250 250 220 220 190 170 190 170 160 160 150 150 140 140 130 130 120 120 110 110 100 100 90 90 80 80 70 70 60 60 50 50 40 40 30 30 o r 1 0 d a t a plotted: 1st q u a rte r 1963 The Plateau in Business Activity I HE ECONOMY has been characterized as having been on a plateau since mid-1962. Whether the word "plateau” is the most appropriate description of the economy depends on the nature and scope of the analysis employed in studying the data. Real output of the economy, i.e., gross national product measured in constant dollars, increased at an annual rate of about 3 per cent from the second quarter of 1962 to the first quarter of this year. On the surface this increase does not seem descriptive of a “plateau.” In order to give meaning to the term it is instructive to look somewhat deeper into the performance of the economy. One approach is to analyze those dynamic segments of our economy which are the chief source of cyclical variation in activity. Consumer expenditures on dur ables and business spending on inventories and fixed investment typically vary substantially in the course of a business cycle (upper tier, Chart 1, page 2). Ex penditures by the Federal Government on goods and services are also of a dynamic character. These expendi tures tend to vary in a countercyclical manner. The tQtal of these components has risen at an annual rate of 2 per cent since the second quarter of last year, considerably less than the 8.5 per cent average rate of increase for periods of business expansion during the 1951-62 period. In contrast, a large number of GNP components— such as consumer spending on ser vices and nondurables, and spending of state and local governments—tend to move upward at a rather steady rate quarter after quarter. The sum of these compo nents, which accounts for about two-thirds of total GNP, also rose at an annual rate of 3 per cent from the second quarter of 1962 to the first quarter of 1963. This rate of increase may be compared with an av erage rate of 3.9 per cent for periods of business ex pansion in the 1951-62 period. The impression of a plateau emerges more vividly in comparing the actual performance of the economy with measures of its potential performance.1 Since 1 For a study of the problem of measuring potential growth see: James W . Knowles and Charles B . Warden, Jr., The Potential Economic Growth in the United States, Joint Economic Committee, Congress of the United States, I960. mid-1962, actual GNP (in constant dollars) has re mained about 7 per cent below what might have been achieved if resources had been more fully utilized (Chart 2). C h a rt 2 Actual G N P as a Per Cent of Potential GNP Per C e nt Per Cent Thus, it appears that the term “plateau” describes a situation in which the dynamic factors in the econ omy are no longer demonstrating buoyancy, a situa tion in which the economy is not moving toward the level of activity of which it is capable. It is within this context that the term "plateau” may describe the performance of the economy since mid-1962. Productive Activity The general stability in the economy is reflected prominently in the index of industrial production, a measure of the output of the nation's mines, factories, and utilities. Since August of 1962, output has in creased only fractionally, at a 1 per cent annual rate. Since the beginning of this year, however, the rate of increase has quickened. Although total industrial output has been relative ly stable since mid-1962, there have been substantial shifts in its composition. Production for consumers, especially of household goods, appliances, and other durables, has risen markedly since November of last year (see Chart 3). During this same period output of business equipment has declined. Output of ma terials drifted downward from the fall of 1962 to January and then rose sharply through March. Construction, particularly in the private sector, has declined sharply in recent months. From June 1962 to January of this year outlays on new construction hovered about the $62.6 billion level. From January C h a rt 3 195 7-59=100 Industrial Production 1957-59=100 cent. The length of the average workweek in manu facturing has edged downward from the levels pre vailing in the spring of 1962. D uring the second quar ter of last year the average workweek was 40.6 hours; during the first quarter of this year it averaged 40.3 hours. Consumer Incom e and Spending to March, the annual rate of expenditures declined $1.8 billion, to a level 3 per cent below the earlier plateau. Residential construction, which has shown considerable weakness since the middle of last year, declined 2.4 per cent from January to March. Housing starts during the early months of this year have av eraged about 1,250 thousand units (at seasonally ad justed annual rates); this represents a sharp decline from the March-November 1962 pace when housing starts averaged just less than 1,500 thousand units. Em ploym ent— Unem ploym ent shows, instalment credit has increased rapidly in other periods during the past 12 years, usually during pe riods of business expansion. The most recent rise is about the same as the 1959-60, 1955-57 increases, but C ha rt 4 Status of the N ation al Labor Force M illio n s o f P e rs o n s 76 1 1 1 V M illio n s of P e r s o n s 76 c „ ... . . Sea son a lly Adjusted i i i 72 72 1 i 1 The relatively high level of unemployment has been accompanied by increases in other measures of joblessness. Man-hours lost to the economy because of unemployment and economic part-time employ ment (expressed as a proportion of total potentially available man-hours) held stable at 6.6 per cent in the spring of 1962, began edging upward in the sum mer and fall, and reached 7.1 per cent in February of this year.2 In mid-March the rate declined to 6.6 per To a considerable degree consumer spending has been maintained by an increase in consumer credit. Since spring of last year outstanding instalment credit has risen at a 12.2 per cent annual rate. As Chart 5 . There were 68.6 million persons employed in midMarch of this year, 550 thousand above the seasonally adjusted February level. Employment had fluctuated within a narrow range from February 1962 to Febru ary of this year, increasing less than 1 per cent on balance. W ith the inclusion of March, however, the rate of increase is 1.5 per cent. The proportion of the civilian labor force unemployed, which fluctuated near the 5.5 per cent level during the spring of 1962, and averaged nearly 6 percent in January and Febru ary of this year, returned to a 5.6 per cent rate in midMarch (Chart 4). Reflecting the stability in productive activity and employment, payments to wage and salary workers were about unchanged during the summer of 1962 and have increased only moderately since last fall. Total personal income increased at a moderate pace last fall and has been virtually unchanged on balance since December.3 Retail sales were approximately un changed on balance from July to October, increased sharply in November, and then rose moderately from November to March 1963. Civilian Liibor force : 68 68 _ _ _ Total Employment 64 64 - ----- n Per C e n t /. it Per C e n t 1----------- ! ■ i ir............. Liabor Forcei Time Loiit A l t 1" - Unemiployment Rate =L ---------2Potentially available man-hours is the sum of actual hours worked, hours lost by those with a job but not working (as suming a 37.5 hours workweek), hours lost by the unem ployed (assuming a 37.5 hours workweek), and hours lost by those working part-tim e for economic reasons (lost time being the difference between 37.5 hours and actual number of hours worked). Page 4 1956 1957 1958 1959 1960 1961 1962 1963 S o u r c e ; U n i t e d States B u r e a u of L a b o r S tati sti cs Lat est d a t a p lo tt ed : M a r c h p r e l i m i n a r y 3 Total income includes wage and salary payments; dividend and interest payments; business, professional, and rental income; farm proprietors’ income; and transfer payments. C ha rt 5 Consumer Credit B illi o n s o f D o l l a r s considerably smaller than the 1952-53 experience, as shown by the table below. P erio d s o f R a p id In cre a se in C o n su m er C red it March 1962—February 1963 February 1959—December 1960 February 1955—December 1957 March 1952—December 1953 Average Annual Rate of Increase 12.2 14.9 15.2 30.3 B illio n s o f D o l l a r s Because of the relative stability in sales and orders since the spring of 1962, manufacturers appear to have shown little disposition to add to their inventories (see Chart 6). Should activity turn up in the near Chart 6 Sales, Inventories and Orders R a tio S c a l e M a n u fa c tu re rs' R a t io S c a |e One way to view developments in consumer credit is to relate the repayments burden to some measure of income. It appears as if people are now using about the same portion of their after-tax income to make instalment payments as they did last year (Chart 6). Indeed, there has been little change in this percent age for the past eight years. Business Income and Spending Preliminary estimates of corporate profits ( after taxes) for the year 1962, at $26 billion, show an in crease of 21 per cent from 1961. However, the esti mates also indicate that corporate profits during the final quarter of 1962 were little changed from the level which has prevailed since the final quarter of 1961. future the inventory situation might provide a factor in business expansion; current inventory levels could prove inadequate to meet an expanding volume of production and sales. On the other hand, if activity should turn down, the inventory situation may not be exceptionally vulnerable. Plant and equipment expenditures in 1962 were 8.6 per cent above the 1961 level. Since mid-1962, Page 5 however, business spending on new plant and equip ment has been cautious. D uring the fourth quar ter of 1962 these expenditures, just under $38 billion, were down fractionally from the previous quarter and are estimated to have continued at about this same level during the first quarter of 1963. serves available to support private demand deposits (i.e., total reserves less reserves behind Treasury de posits and time deposits) declined at a 2.5 per cent annual rate from January to March. These reserves have expanded at a 0.6 per cent rate since March last year. The cost of long-term borrowing has edged down ward during much of the 1961-63 period of business expansion. D uring other periods of expansion over the past twelve years, long-term interest rates rose markedly. Despite the fact that rates have declined for more than a year and a half, the current level of rates remains higher than the levels which prevailed during most of the past decade. H igh interest rates are generally considered to be a depressant to invest ment, but other factors are also important. There is a view that business investment may be stimulated, at least in the short-run, by expectations of a rising price level. To the extent that expectations of a rising price level have been dampened during recent years, any given cost of borrowed capital may have become a more inhibiting factor in investment decisions. Excess reserves, which normally increase during the early months of the year, have drifted downward since February (Chart 8).4 Excess reserves averaged Chart 8 Excess Reserves & Borrowings of Member Banks Monetary Developments Member bank reserves available to support all pri vate deposits (i.e., total reserves less reserves behind Treasury deposits) increased at an annual rate of 1.1 per cent from January to March. Over the past year these reserves increased 3.1 per cent (Chart 7). Re I9 6 0 1961 Latest d a ta plotted: M a rc h 196 2 1963 p re lim in a ry Chart 7 Reserves of Mem ber Banks B illio n s o f D o l la r s B illio n s o f D o l la r s M o n th ly A v e r a g e s of D a i l y F ig u re s $443 million in March and remained near this level in early April. This was about $26 million below the av erage level of late January and February and about $140 million below the last two months of 1962. Bor rowings averaged $155 million in March, slightly high er than earlier this year, and about $50 million above the average level during 1962. In early April borrow ing averaged about $90 million. Total bank credit increased at an annual rate of 12.8 per cent in the first quarter. Both loans and in vestments rose during the period. The money supply (demand deposits plus currency), seasonally adjusted, increased $200 million from January to March, or at an annual rate of 0.8 per cent. From March 1962 to March 1963, the money supply has increased 2.2 per cen** L atest d a t a plotted: M a r c h p r e lim in a r y Page 6 4See p. 11 this Review. Continued on page 10 Earnings and Expenses of Eighth District Member Banks N, I ET EARNINGS of member banks in the Eighth Federal Reserve District were virtually the same in 1962 as in 1961. A large increase in total expenses was matched by a nearly equal rise in total earnings, leaving net earnings about unchanged. Chart 1 Earnings and Expenses E ig h th D istrict M e m b e r B a n k s M il lio n s o f D o lla r s q, « u M illio n s of D o l la r s 4 0 0 ------------------------------- R atio S c a le ----------------------- ------ 40Q 200 200 100 100 Rapid Increase in Both Expenses and Earnings Expenses— Total expenses of member banks in the district were 12 per cent higher in 1962 than in 1961, continuing the postwar rise (Chart 1 and Table I). An increase in interest paid on time and savings deposits constituted the largest rise in any major expense item m 1962 as in each of the past six years. Salaries 40 1946 48 20 60 196 2 TABLE I Earnings and Expenses of Eighth District Member Banks (In millions of dollars) Percentoge C hange + 3.0% + 7.1 + 16.8 + 6.1 + 4.4 + 7.6 + + + -+ 6.0 3.7 4.8 7.7 2.8 73.8 38.2 68.2 $ 1 8 0 .2 $ 1 0 9 .0 + 4.0 + 31.9 + 7.0 + 11.9 - O .l + + + + — 2.3 21.5 +3.4 -8 .5 — 1.8 -6 .9 $ 9 9 .9 +7.4 — 6.9 -1 .7 -1 .3 $ 1 0 7 .8 + 55.9 + 18.8 -2 7 .8 — 11.6 + 0.6 — 54.1 + 23.2 + 5.9 + 430.8 — 7.3 42.1 57.8 $ 23.9 $ 33.9 46.0 61.8 $ 24.0 $ 37.8 — 2.1 + 2.8 + 4.6 + 1.5 — — — $ 187.0 $ 181.6 + 60.4 16.7 13.1 20.3 $ 2 9 7 .4 57.0 16.1 12.5 22.0 $ 2 8 9 .2 75.5 46.4 68.7 $ 1 9 0 .6 $ 1 0 6 .8 + 5.3 -10.1 - 1.3 - 6.1 41.2 Taxes on net profits................. 59.4 N e t profits after ta x e s Cash dividends on common stock . .. . $ 25.0 Net retained earn ings................... $ 34.4 Interest and discounts on loans .. . . . . $ 200.6 Interest on securities 64.7 a. U.S. Government............ 19.5 b. O th e r........................... 13.9 Service charges on deposits....... 21.2 Other earnings ....................... Total e a r n i n g s .................. 78.5 61.2 73.5 Salaries and w a g e s................... Interest on time deposits............ Other expenses........................ N e t e a r n i n g s .................... Net recoveries and profits (+), losses (— ): a. On securities................. b. On loans .................... c. O th e rs......................... . .. Total net recoveries and profits . . . .. N o te: 7.3% 0 .7 5.8 2.0 8.5 6.5 0.4 10.3 Detail may not add to totals due to rounding. Page 7 Chart 2 and wages and other current expenses also increased from 1961 to 1962. The amount of interest paid on time and savings deposits rose 32 per cent from 1961 to 1962 compared with a 22 per cent rise in the previous year and an average annual increase of 23 per cent from 1956 to 1960. The substantial rise in interest payments re flected a continuation of the secular increase in the average rate paid on time and savings deposits and a rapid growth in volume (see Chart 2). Effective January 1, 1962, the Board of Governors of the Federal Reserve System amended Regulation Q by increasing the maximum allowable rate from 3 per cent on all savings deposits to 4 per cent on savings that remain on deposit 12 months or more and to 3Ja per cent on all other savings deposits (see Table II). The maximum permissible rates of interest paid on time deposits with maturities of 12 months or more was raised to 4 per cent and on those with maturities of more than 6 months but less than 12 months to SH per cent. Tim D sits e epo E ig h th D is tric t M e m b e r B a n k s M illio n s o f D o lla rs M illio n s of D o lla rs Per C en t Table II J ____ 1 ____ I ____ I ____ I ____ I ____ I ___ 1 _ ____ 1 ____ I ____ I ___ L _ 1946 Maximum Interest Rates Payable on Time and Savings Deposits1 (Per cent per annum) Effective Date Time Deposit Savin gs deposits held for: 1 year or m ore................. i Less than 1 y e a r ................) Jan. 1 1936 Jan. 1 1957 Jan. 1 1962 ( z /2 Other time deposits payable in: 1 year or m ore................. i 91/ 6 months -1 y e a r.............. J 90 days - 6 m onths............ ........2 Less than 90 d a y s .............. ........1 J \ - i I 2% 1 4 3% 4 3 Vi 2y2 1 1 Beginning October 15, 1962, time deposits of foreign governments and certain foreign institutions have been exempt from regulation as to the maximum rates of interest which banks may pay on tffese deposits. Most district member banks increased their rates on time or savings deposits.1 Some banks moved to the new maximum on all or a portion of the categories of deposits while others made increases short of the permitted maxima. The average rate paid on time 1See "Interest Rates on Time Deposits, Mid-January 1962,” Fed eral Reserve Bulletin, February 1962, and "Changes in Rates on Time Deposits at District Banks,” in the March 1963 Review of this bank. Page 8 Per C ent Average Rate Paid 48 50 52 54 56 58 J ____ L 60 2 1 0 1962 and savings deposits increased .14 of one percentage point, from 2.41 per cent in 1961 to 2.55 per cent in 1962. This rise in the average rate paid on time and savings deposits was about the same as the previous years increase of .15 of one percentage point, from 2.26 per cent in 1960 to 2.41 per cent in 1961 (see Chart 2). The public responded to the higher rates paid on time and savings deposits in much the same manner as to the lower interest rates in the previous year. These deposits increased 16 per cent from 1961 to 1962 compared with a 13 per cent increase from 1960 to 1961. Time and savings deposits as a per cent of total deposits have risen markedly in the postwar period. They constituted 19.6 per cent of total de posits in 1946, 22.7 per cent in 1951, 24.3 per cent in 1956, 30.9 per cent in 1961, and 32.9 per cent in 1962.2 Salaries and wages of district member banks rose 4 per cent from 1961 to 1962. Other expenses, which 2 For a discussion of changes in the rate of growth of time deposits see: "Movements in Time and Savings Deposits 1951-1962,” in the March 1963 issue of this Review . include such items as advertising, depreciation, and local taxes, increased 7 per cent. Total expenses in 1962 were equal to 2.86 per cent of assets compared with 2.77 per cent in 1961, 2.05 per cent in 1956, 1.64 aged 6.37 per cent compared with 6.31 per cent (see Chart 3). Chart 3 Y ie ld s o n E a r n in g A s s e t s per cent in 1951, and 1.20 per cent in 1946. Earnings— Total earnings of district member banks increased about 8 per cent. This rise reflected largely the increase in earning assets, but it also reflected a somewhat higher return on them. The growth in time and savings deposits went into higher yielding assets in which these deposits are traditionally invested. The ratio of total earnings to total assets increased from 4.01 per cent in 1961 to 4.09 per cent last year. Most of the gain resulted from a rise in the amount of inter est and discounts received on loans. D uring 1962, outstanding loans averaged 10 per cent more than the previous year, and the return on these loans aver TABLE III Selected Operating Ratios of Eighth District Member Banks (In per cent)1 Banks G rouped according to Average Deposits (In millions of dollars) Up to $3 $3 - $25 1962 N et e a rn in gs to c a p i t a l ............ N e t profits (after taxes) to capital 11.8 ,. C a sh divid en d s to c a p i t a l ........ Total e arn in gs to total assets . . . 1961 12.3 7.7 2.6 7.8 2.6 $25 and O ver 1962 1961 1962 14.3 9.1 3.1 14.0 8.8 3.2 15.2 8.5 1961 16.6 3.7 9.0 3.9 13.7 8.5 3.0 4.01 1.37 2.7 7 1.24 0.71 0.74 0.78 0.77 3.22 3.21 2.99 3 .3 4 3.21 3.05 6.39 3 .0 7 6.30 3.11 5.88 3 .2 7 5.90 3.13 6 .3 7 3.21 4 .1 0 2.84 4 .06 2.69 1.20 1.26 0.83 0.82 0 .7 7 0.74 3.3 6 3.27 3.35 3.31 6.51 3.4 7 6.43 13.7 8.7 3.0 1961 2.86 1.23 4.14 2.93 1.21 4.05 2.85 1.25 Interest on U. S. G overn m ent securities (Chart 3 ) .............. Interest a n d dividen ds on other securities .................... Earn ings on loans (C h art 3) . . . . 1962 4.09 3.95 2.66 1>29 3 .9 7 2 .72 Total expenses to total assets . . . N et e a rn in gs to total assets . . . . N et profits (after taxes) to totql a s s e t s ...................... All Mem ber Banks 9.2 32.9 6.31 9.3 30.9 2.41 C a p ita l to total a s s e t s .............. Time to total d e p o s i t s ................ Interest p a id to time deposits . . , 10.8 29.5 2.34 27 .5 2.31 8.6 34.7 2.56 8.7 32.9 2.43 30.8 3.12 U. S. G overn m e nt securities to total a s s e t s ...................... O th e r securities to total assets . . Loans to total a s s e t s ................ C a sh assets to total a s s e t s ........ 36.2 36.0 31.2 31.6 25.2 26.4 3 2 .0 32.5 7.2 35.5 20.2 7.2 35.9 1 1 .0 10.9 38.1 18.3 3 7 .7 18.4 8.6 44.3 20.2 7.4 4 4 .4 9 .7 3 8 .0 19.0 9.5 3 7 .7 19.0 43 42 N u m ber o f b a n k s ................ ,. 127 10.9 20.0 149 302 286 8.2 8.3 29.4 2.6 0 20.1 2.55 472 477 1 A more detailed breakdown of m em ber bank operating ratios is available in the report: “M em ber Bank Operating Ratios/* This report will be furnished upon request to the Research Department, Federal Reserve Bank of St. Louis. Page 9 The higher average returns on loans reflect the in crease in the volume of consumer loans and real estate and other longer term loans relative to total loans. Such loans generally earn a higher return than loans with shorter maturities. W ith the rise in time and savings deposits, bank liabilities are thought to be more stable, reducing somewhat the need for liquidity. C h a rt 4 R a tio s o f P ro fits a n d D iv i d e n d s to C a p i t a l Interest on securities increased 9 per cent from 1961 to 1962, with incomes from both Government and other securities rising. The increased return was due to an increase in bank holdings of securities, a rise in some rates, and a lengthening of the average maturity of bank investment portfolios. Increased holdings of long-term Government and state and local bonds, which are less liquid than shorter term securities, re flect, in part, the growth of time and savings deposits. Profits Up Slightly Reflecting the almost equal increases in total ex penses and total earnings, net earnings of district member banks were practically the same in 1962 as in the previous year (see Table I). Larger net losses on loans were more than offset by bigger capital gains on security transactions, and net profits were a little larger than in 1961. Nevertheless, income taxes were about 2 per cent less in 1962 than in 1961, reflecting, in part, the increased holdings of tax exempt munic ipal securities. Net profits after taxes increased 3 per cent from 1961 to 1962, and relative to total capital accounts net profits increased from 8.5 per cent to 8.7 per cent (see Chart 4). The ratio of cash dividends to capital remained unchanged at 3.0 per cent; both the amount of dividends paid to stockholders and capital invested increased over the 1961 level. Earn ings retained to strengthen capital structures were 1.5 per cent greater during 1962 than in 1961 and amounted to 5.7 per cent of capital accounts in 1962. The Plateau in Business Activity -Continued from page 6 Stock M arket D erelop m en ts Although stock prices changed little during the first quarter of 1963, the rise from mid-1962 was rela tively steep. Standard and Poors composite index of 500 stocks averaged 55.63 in June 1962, climbed to an average of 65.06 in January 1963, and remained near that level through March. The March level of 65.67 Page 10 compares with a level of 70.29 in March 1962. Since the end of March, stock prices have moved upward, averaging 67.91 in the first two weeks of April. Since rising stock prices either may provide realized profits or may add to a holders feeling of wealth, these in creases tend to stimulate spending and have been con sidered by some as a stimulus both to consumption and investment. Excess Reserves Why Banks Hold Excess Reserves C o m m e r c ia l BANKS are required by law and custom to hold as reserves an amount of uninvested funds equal to a portion of their deposits. For member banks in the Federal Reserve System, these reserves must be either cash in vault or deposits in their Re serve Bank.1 Historically, reserve requirements were imposed to assure that banks maintain a cash fund to meet temporary drains caused by depositor withdraw als. Other methods, such as Reserve Bank credit, have been developed to provide banks with temporary liquidity, but bank reserve requirements have been retained as a method of influencing the volume of bank credit and money.2 Banks generally do not find it practical to hold exactly the prescribed amount of reserves. Reserves held beyond those legally needed for existing deposits are called excess reserves. Both reserve balances and deposits of banks are subject to daily inflows and out flows, and banks attempt to avoid reserve deficiencies. Hence, banks generally find at the end of a reserve computation period (one week in the case of the re serve city banks and two weeks in the case of other member banks) that their daily average of actual re serves has exceeded their daily average of required reserves, i.e., they have had excess reserves. Bank Management of Reserves Since excess reserves are noneaming assets, each individual bank has an incentive to keep them at a practical minimum in view of all pertinent circum stances. A bank must continuously manage its reserve balance to avoid shortages on the one hand and to avoid loss of earnings by leaving funds uninvested on the other. As a result, monthly average total and re quired reserves of member banks have, in general, moved together as can be seen in Chart 1, covering the period since 1951. 1 Reserve requirements at present for member banks are I 6 V2 Per cent of net demand deposits in reserve city banks, 1 2 per cent of net demand deposits in other banks, and 4 per cent of all time deposits. The Federal Reserve System: Fur poses and Functions, Board of Governors of the Federal Reserve System, Washington, D. C., Chapter II. 2 See: A bank has several means of changing its assets and liabilities to minimize excess reserves. If a bank has redundant funds, it can expand loans, buy securities, or reduce indebtedness. Conversely, by selling secur ities, reducing loans, or borrowing funds, a bank can replenish its reserves. Banks are constantly adjusting their assets and indebtedness to keep their nonearn ing excess reserves at a practical working minimum. Since the deposits of a bank fluctuate widely and unpredictably from day to day and week to week, both reserve balances and required reserves fluctuate greatly. Only by meticulous daily study of its re serve balances and requirements and skillful adjust ment of its assets and liabilities can a bank achieve close correspondence between reserve period averages of required and actual reserves. Movements of funds from one bank to another cause huge gains and losses for individual banks, but cancel out for the banking system as a whole. Many transactions, however, pro duce movements in excess reserves for both individual banks and the entire banking system. Factors which affect the volume of total reserves, such as flows of gold, currency movements into and out of banks, changes in Treasury cash balances at Reserve Banks, and System open market purchases and sales, cause changes in the level of excess reserves. Also, fluctua tions in the volume of required reserves (caused by changes in bank credit and deposits) result in move ments in the level of excess reserves both for an indi vidual bank and the banking system as a whole. Despite the many forces causing daily fluctuations in excess reserves of all banks combined, offsetting movements plus continuous bank management of re serve balances reduce greatly the monthly average fluctuations of excess reserves (see Charts 1 and 2). In the past two years, the average movement from month to month in excess reserves has been $85 mil lion, compared with an average daily fluctuation of $250 million. Some banks are more efficient at keeping excess re serves at a minimum than others. Large banks, be cause of the volume of funds involved, usually find it more expedient to watch closely their reserve balances Page II C ha rt 1 Reserves of Mem ber Banks B illi o n s o f D o l la r s M o n t h l y A v e r a g e s of D a i ly F igu re s B illio ns o f D o l l Q T S 20 18 •X ^Adjusted Shaded Jo f o r s e a s o n a l f l u c t u a t i o n s a n d f o r c h a n g e s in r e s e r v e r e q u i r e m e n t s . p e r i o d s of tim e r e p r e s e n t e c o n o m i c r e c e s s i o n s . L at e s t d a t a p l o t t e d : M a r c h p r e l i m i n a r y than do small banks. The largest money market banks are able to maintain nominal excess reserve balances. During 1962 excess reserves of the reserve city banks (larger banks) averaged about % of 1 per cent of re quired reserves while excess reserves of other member banks averaged 7 per cent of required reserves. Even among banks of similar size, there are differ ences in the amounts of excess reserves typically held. These variations may reflect differences in deposit sta bility, in loan demands, in accounting systems, in bank attitudes toward borrowing, in size of corre spondent bank deposits, in amount of effort devoted to minimizing excess reserves, and in aggressiveness of management Trend and Cyclical Movements in Excess Reserves Excess reserves have trended downward during the past twelve years. D uring 1951 excess reserves of all member banks averaged $760 million, of which re Page 12 serve city banks accounted for $210 million and other banks accounted for $550 million. In the first quarter of 1963 excess reserves averaged $460 million for all member banks, $40 million for reserve city banks, and $420 million for other banks. In 1951, ex cess reserves averaged 4.1 per cent of required re serves. In early 1963, excess reserves averaged 2.5 per cent of required reserves. This secular decrease of excess reserves over the past dozen years has been the result of many factors. One major factor may have been the rise in interest rates (Chart 3). By holding excess reserves a bank sacrifices returns available on interest-bearing assets. Thus, the cost of holding excess reserves varies direct ly with changes in interest rates. From 1952 to 1962 over half of the variations in excess reserves were associated with variations in short-term rates.3 3 Fluctuations in monthly averages of daily excess reserves and three-month Treasury bill rates had a correlation coefficient of — .73. C h a rt 2 Excess R e se r v e s C h a rt 3 T h re e -M o n th Treasury Bill R ate Per C ent P e r C e nt 5 M o n th ly A v e ra g e s of D a ily Figures 5 --------- 4 3 2 1 Lates t d a t a p lo tt e d : M a r c h 1951 1952 1953 1954 195 5 1956 The development of the Federal funds market prob ably has contributed to the secular reduction in ex cess reserves. This market permits larger banks which otherwise would have excess reserves to lend funds on a day-to-day basis to other large banks that other wise would be temporarily deficient in reserves. This means of utilizing redundant funds enables banks to dispose of what might otherwise be excess reserves. Also, with this additional access to reserve funds, banks may hold smaller amounts of precautionary re serves* The growth in the size of banks from 1951 to 1962, as the economy has expanded and as banks have merged and established branches, may have tended to reduce the volume of excess reserves. In 1951 the average deposit holdings of member banks amounted to $16 million; 184 member banks held deposits of $100 million or more. B y 1962, the average deposit holdings more than doubled to reach $35 million, and 1957 1958 1959 I9 6 0 1962 196 3 0 288 member banks held deposits of $100 million or more. As mentioned earlier, bigger banks generally hold a smaller proportion of excess to total reserves than do the smaller banks. Cyclical movements of excess reserves have been in a magnitude of $200 or $300 million, falling in the expansionary phases of business activity and rising in the contractions. Such movements are related in considerable measure to changes in interest rates. Demands for credit and interest rates generally fall during recessions (Chart 3), making the retention of excess reserves less expensive. Then, too, with un certain conditions and a pessimistic outlook, banks probably feel more comfortable holding larger excess reserve balances, just as individuals frequently desire to hold more cash during recessionary periods. Most of the changes in reserve requirement regulations during the past decade have been reductions during recessions, and there is probably a time lag in util Page 13 izing all of the “freed” reserves. During periods of business expansion the outlook is more optimistic and both interest rates and the demand for loans rise, pro viding motivations for banks to hold less excess re serves. C hart 4 Cum ulative C h an ge s in M e m b er Bank Reserves D u rin g P e r io d s o f R a p id In c re a se in Total R e se r v e s a n d S ix M o n th s T h e re a fte r Effect of Increase in Total Reserves One question in monetary theory and central bank management is whether an increase in total reserves, especially in time of economic recession, results in an expansion of bank credit and money or whether it is merely accompanied in large measure by an increase in excess reserves. There have been three periods since 1951 in which total reserves have been increased markedly for sustained periods.4 Each of these pe riods began in a time of economic recession. These periods were December 1953-November 1954, November 1957-June 1958, and April 1960-February 1961. Chart 4 shows cumulative dollar changes in total, required, and excess reserves of member banks during these periods of rapid expansion in total re serves and for six months thereafter. From December 1953 to November 1954 total re serves (adjusted for seasonal influences and to take account of reserve requirement reductions) were ex panded $1,040 million, required reserves rose $920 million, and excess reserves increased $120 million. Similarly, from November 1957 to June 1958, total reserves were expanded $1,060 million, required re serves rose $945 million, and excess reserves increased $115 million. In the April 1960 to February 1961 period, total reserves were increased $905 million, re quired reserves rising $660 million, and excess reserves rising $245 million. The expansion in excess reserves near the end of 1960 probably reflects a lag in util izing some of the additional reserves which resulted from the change in the regulation permitting banks to count all of their vault cash as legal reserves. During these periods of rapid expansion in total reserves, changes in excess reserves have normally been small compared with changes in total reserves. During the initial stages of each period, total reserves rose rapidly and required reserves rose also, but usu ally at a slightly lesser rate (meaning that excess re serves rose). After a few months, total and required reserves increased in a parallel fashion, and there was little change in excess reserves. When the rate of ex pansion in total reserves declined, required reserves usually continued to rise somewhat and excess re serves declined. 4 See Chart 1, bottom panel, and also "Member Bank Reserves and the Money Supply” in the March 1962 issue of this Review. Page 14 Excess reserves have risen during each of the three most recent business contractions (Chart 2 ). In creases in the early parts of recessions were associated with modest rises in total reserves and declines in re quired reserves. Sharp increases in total reserves usually occurred late in recessions and early in recov eries, after excess reserves had already risen some what (Chart 1). Hence, when total member bank reserves have been increased rapidly in time of eco nomic recession, bank assets, bank deposits, and the money supply have also increased markedly. The in creases in total reserves have not been manifested in any considerable measure in increases in excess re serves. Conclusions Use of the term "excess reserves” to indicate a sup ply of readily available funds or unused lending power is probably misleading. Evidence suggests that each bank attempts to keep excess reserves at a practical minimum in view of all pertinent circumstances. For practical purposes, these reserves are excess in a legal sense only, since the bulk of them seem to be needed for smaller banks to operate efficiently. Fluctuations in excess reserves do not appear to re duce significantly the Reserve System’s control of bank credit and the money supply. Trend and cycli cal movements in excess reserves have been moderate and have been related to items such as movements in interest rates, changes in banker demands for liquid ity, bank growth, and technological changes. Appro priate Federal Reserve System actions can offset these movements, according to the evidence available. When tofal reserves have been increased sharply in periods of recession and early recovery, only a small fraction of the increase has generally taken the form of excess reserves. Increases of total reserves in times of recession or early recovery have for the most part been accompanied by increases of bank credit, bank deposits, and the money supply. The concept of the magnitude of excess reserves as an indication of whether the monetary system is likely to expand or contract is questionable.5 A relatively high average level of excess reserves that persists for several months does not necessarily indicate that there is an expansive force on bank credit and money; instead, it may reflect a weak credit demand, low. interest rates, or an increased desire for liquidity by bankers. Similarly, a relatively small average volume of excess reserves is not a signal that total bank re serves are being provided stingily and that bank credit and money are rising slowly (or declining). 5 Another indicator of ease or tightness often used (but inversely) is the volume of member bank borrowing from Reserve Banks. Some analysts employ as an indicator of monetary conditions the net of the two concepts, called "net free” or "net borrowed” reserves. 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