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Review Vol. 6 6 ; No. 5 M ay 1984 5 Has the Deregulation of Deposit Interest Rates Raised Mortgage Rates? 16 What Can Central Ranks Do About the Value of the Dollar? 27 Dutch Disease or Monetarist Medicine?: The British Econom y under Mrs. Thatcher The Review is published 10 times per year by the Research and Public Information Department o f the Federal Reserve Rank o f St. Louis. Single-copy subscriptions are available to the public fr e e o f charge. Mail requests f o r subscriptions, back issues, or address changes to: Research and Public Information Department, Federal Reserve Rank o f St. Louis, P.O. Rox 442, St. Louis, Missouri 63166. The views expressed are those o f the individual authors and do not necessarily reflect official positions o f the Federal Reserve Rank o f St. Louis or the Federal Reserve System. Articles herein may be reprinted provided the source is credited. Please provide the Rank’s Research and Public Inform a tion Department with a copy o f reprinted material. Fed eral R eserve Bank of St. Louis Review M ay 1 9 8 4 In This Issue . . . In th e first a rtic le in th is R e view , “H as th e D e re g u la tio n o f D e p o s it In te re s t R ates R a ised M o rtg ag e R a te s ? ” R. A lton G ilb ert a n d A. S tev en H o lla n d a s s e s s th e e ffe c ts o f th e rem o v a l o f d e p o s it ra te (R eg u lation Q) c e ilin g s o n th e in te r e s t ra te s c h a rg e d o n m o rtg a g e lo a n s . It is w id ely b elie v e d th a t th e p h a s e -o u t o f in te r e s t ra te c e ilin g s o n d e p o s its a t b a n k s a n d th rift in s titu tio n s h a s c o n tr ib u te d to th e ris e in U.S. in te re s t ra te s a n d , in p a rtic u la r, U.S. m o rtg a g e ra te s, o v er th e la st few y e a rs . In c o n tr a s t to th is p o p u la r o p in io n , G ilb ert a n d H ollan d e x p la in th a t e c o n o m ic th e o r y su g g e sts th a t d e re g u la tio n , o th e r th in g s th e sa m e , s h o u ld re s u lt in lo w e r ra te s th a n w o u ld o th e rw ise b e o b serv ed . C ritic s o f th is th e o r e tic a l a n a ly sis o f d e re g u la tio n have n o te d th a t th e average in te re s t ra te o n m o rtg a g e lo a n s, th e average c o s t o f fu n d s fo r sav in g s a n d lo a n a s s o c ia tio n s , a n d m a rk e t in te re s t ra te s in g e n e ra l have ris e n s u b s ta n tia lly s in c e th e in tro d u c tio n o f n e w ty p e s o f d e p o s its w ith flex ib le in te re s t c e ilin g s (o r n o c e ilin g s at all). M o re im p o rta n tly , m o rtg a g e ra te s hav e m o v ed h ig h e r relativ e to g o v e rn m e n t b o n d ra te s o f s im ila r d u ra tio n s in c e d e re g u la tio n b e g a n . H ow ever, G ilb ert a n d H o llan d s h o w th a t th is in c r e a s e in in te r e s t ra te s p re a d s is n o t re la te d to d e re g u la tio n at all; in s te a d it is d u e to s o m e c r u c ia l d iffe re n c e s b e tw e e n c o n v e n tio n a l re s id e n tia l m o rtg a g e s a n d g o v e rn m e n t b o n d s a s d e b t in s tru m e n ts . In p a rtic u la r, th e relativ e rise in m o rtg a g e ra te s h a s re s u lte d fro m m o re v a ria b le in te re s t ra te s (w h ich p ro d u c e d a h ig h e r p re m iu m o n m o rtg a g e s fo r th e o p tio n o f p re p a y in g a m o rtg a g e loan) a n d th e r e c e s s io n in th e e a rly 1 9 8 0 s (w h ich ra is e d th e p re m iu m o n m o rtg a g e lo a n s to c o v e r th e h ig h e r risk o f d efa u lt o n m o rtg ag es). In th e s e c o n d a rtic le o f th is R e view , “W h a t C a n C e n tra l B a n k s D o A b ou t th e V alue o f th e D o lla r?” D a lla s S. B a tte n a n d M a ck O tt e x a m in e w h e th e r p o lic y m a k e rs c a n d o a n y th in g to r e d u c e th e d o lla r’s c u rre n tly h ig h e x c h a n g e ra te . W h ile m a n y c o m m e n ta to r s o n U.S. e c o n o m ic p o licy have a rg u ed th a t th e h ig h v a lu e o f th e d o lla r is to b la m e fo r a v a riety o f d o m e s tic a n d in te rn a tio n a l ills, fe w h av e g o n e o n to o ffer c o n s tr u c tiv e p ro p o s a ls fo r U.S. p o lic y m a k e rs. B a tte n a n d O tt first e x p la in th e p r o c e d u r e s th ro u g h w h ic h c e n tra l b a n k s a tte m p t to a lte r th e ir c u r r e n c ie s ’ e x c h a n g e ra te s ; th e y th e n a s s e s s th e lik e lih o o d th a t U.S. m o n e ta ry a u th o ritie s c a n d o a n y th in g su b sta n tiv e to lo w e r th e d o lla r’s valu e. A fter review in g th e p ro c e d u re s fo r c e n tra l b a n k in te rv e n tio n , th e a u th o rs a rg u e th a t th e s iz e o f U.S. in te rn a tio n a l c u r r e n c y tr a n s a c tio n s a n d th e d e m o n s tra te d u n w illin g n e ss o f U.S. p o licy m a k e rs to s u b o rd in a te d o m e s tic p o licy to in te rn a tio n a l g o a ls w e ig h heavily a g a in st a n effectiv e e x c h a n g e ra te p o licy . T h e y c o n c lu d e th a t, c o n s tr a in e d b y o th e r d o m e s tic p o licy g o a ls — p rin cip a lly , a sta b le in fla tio n ra te — th e U n ited S ta te s c a n d o little b y m e a n s o f m o n e ta ry p o lic y a lo n e to a ffect th e d o lla r’s valu e. In th e th ird a rtic le , “T h e D u tc h D ise a se o r M o n e ta ris t M e d ic in e ? ” K. A lec C h iy s ta l d is c u s s e s th e p e rfo rm a n c e o f th e B ritish e c o n o m y o v er th e la st fe w y e a rs . F o c u s in g o n th e im p a c t o f th e B ritish g o v e r n m e n t’s p o lic ie s u n d e r M rs. T h a tc h e r, h e a rg u e s th a t th e s e p o lic ie s h ave n o t b e e n a s re stric tiv e a s is o fte n c la im e d . In s te a d , C h iy s ta l a rg u es th a t th e s u b s ta n tia l rise in B ritis h u n e m p lo y m e n t 3 In This Issue . . . 4 s in c e 1 9 7 9 c a n b e a ttrib u te d to th e s tru c tu r a l c h a n g e th a t th e B ritis h e c o n o m y h a s b e e n u n d e rg o in g , p rim a rily as a re su lt o f its tra n sfo rm a tio n fro m a n im p o r te r o f oil to a s u b s ta n tia l n e t e x p o rte r o f oil. C h iy s ta l e x p la in s th a t th is a d ju s tm e n t involved a lo s s o f c o m p e titiv e n e s s o f th e m a n u fa c tu rin g s e c t o r w h ic h le d to c o n tr a c tio n s in th e m a n u fa c tu rin g s e c t o r a n d th e a s s o c ia te d s u b s ta n tia l rise in u n e m p lo y m e n t. Has the Deregulation of Deposit Interest Rates Raised Mortgage Rates? R. Alton Gilbert and A. Steven Holland T EGISLATION e n a c te d in 1 9 8 0 ca lls fo r th e g ra d u a l p h a s e -o u t o f in te r e s t ra te c e ilin g s o n d e p o s its at b a n k s a n d th rift in s titu tio n s b y 1 9 8 6 .1 T h is le g isla tio n w a s in te n d e d to in c r e a s e th e e ffic ie n c y o f fin a n c ia l m a rk ets, w h ic h a d e re g u la te d fin a n c ia l e n v iro n m e n t p ro vid es, a n d p e rm it sm all sav ers to e a rn m o re c o m p e titiv e ra te s o n th e ir savings. M a n y o f th e s e in te r e s t ra te c e ilin g s a lrea d y hav e b e e n rem o v ed . S o m e e c o n o m is ts hav e su g g e ste d th a t th e p a y m e n t o f h ig h e r in te r e s t ra te s to d e p o s ito rs h a s c o n trib u te d to th e h ig h ra te s o f in te re s t in th is c o u n try ov er th e last few y e a rs . A cc o rd in g to A re n s o n (1983) in th e N e w Y o rk T im e s , “E c o n o m is ts e s tim a te th a t th e h ig h e r c o s t o f b a n k fu n d s p ro b a b ly h a s ra is e d th e g e n e ra l level o f in te re s t ra te s b y a b o u t IV 2 p e r c e n ta g e p o in ts .’’ B a c o n (1983), in th e W a ll S tr e e t J o u r n a l, q u o te s L a w re n c e C h im e rin e o f C h a se E c o n o m e tr ic s a s e stim a tin g th e sa m e e ffe ct o n lo n g -te rm re a l ra te s o f in te re s t. T h e b a s ic a rg u m e n t is th a t th e p h a s e -o u t o f R e g u la tio n Q h a s ra ise d th e in te r e s t e x p e n s e o f d e p o s ito ry in s titu tio n s ; in re s p o n s e , th e s e in s titu tio n s hav e ra is e d th e in te re s t ra te s th e y c h a rg e b o rro w e rs. T h is a rtic le a s s e s s e s th e e ffe c ts o f th e rem ov al o f d e p o s it ra te (R eg u latio n Q) c e ilin g s o n th e in te re s t ra te s c h a rg e d o n m o rtg a g e lo a n s . W h ile th e a n a ly sis d ev elo p e d h e r e a p p lie s to all in te r e s t ra te s, w e e m p h a siz e m o rtg ag e in te r e s t r a te s b e c a u s e larg e p ro p o rtio n s Ft. Alton Gilbert is a Research Officer and A. Steven Holland is an economist at the Federal Reserve Bank of St. Louis. Jude L. Naes, Jr., provided research assistance. 1Depository Institutions Deregulation (1980). o f th e d e p o s it lia b ilitie s o f m a jo r m o rtg a g e le n d e rs , s u c h a s sa v in g s a n d lo a n a s s o c ia tio n s (S&,Ls) a n d m u tu a l savin g s b a n k s, h av e b e e n s u b je c t to R eg u la tio n Q c e ilin g ra te s ; in d e e d , o n e r e a s o n fo r th e rem o v al o f th e s e c e ilin g s w a s to in c r e a s e th e a b ility o f th e s e th rift in s titu tio n s to a ttr a c t d e p o s its to u s e fo r m o rtg ag e le n d in g .2 F u r th e rm o r e , s o m e a n a ly sts have su g g e ste d th a t s u c h d e re g u la tio n h a s c a u s e d m o rtg a g e ra te s to in c re a s e m o re th a n o th e r lo n g -te rm in te re s t r a te s .3 S T E P S IN PHASING OUT D E PO S IT RATE CEILINGS T a b le 1 d e s c r ib e s th e s te p s th a t a lre a d y hav e b e e n ta k e n in e lim in a tin g d e p o s it in te r e s t ra te c e ilin g s. M a n y o f th e s e s te p s c r e a te d n e w ty p e s o f a c c o u n ts , w ith c e ilin g ra te s h ig h e r th a n th o s e o n p a s s b o o k sav in g s a c c o u n ts o r w ith n o c e ilin g s a t all. T h e first sig n ifi c a n t s te p s in th e re la x a tio n o f R e g u la tio n Q o c c u r r e d even b e fo re th e p a s s a g e o f th e D e p o s ito ry In s titu tio n s ^Thrifts currently hold around 40 percent of the one- to four-family residential mortgage debt in the United States. They originate a much greater percentage, however, selling a large proportion of their mortgages to investors in the form of mortgage passthrough certifi cates. See McNulty (1983) for a discussion of mortgage origination and investments of thrift institutions. 3For instance, Edward Friedman (1983), pp. A.40-A.41, of Chase Econometrics maintains that: The other major effect of the new deposit structure at thrifts and banks is the permanent rise in borrowing costs for deposit institution borrowers relative to open-market rates . . . . The implication is that if, for example, bond rates were to fall to much lower levels, home mortgage rates would not necessarily follow point for point. 5 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Table 1 Steps in the Phase-Out of Regulation Q Effective date of change Nature of change June 1978 Money market certificates established with minimum denomination ot $10,000,26-week maturity and ceiling rates based on the 6-month Treasury bill rate. November 1978 Automatic transfer service (ATS) savings account created, allowing funds to be transferred automatically from savings to checking account when needed. June 1979 Small saver certificates established with no minimum denomination, maturity of 30 months or more and ceiling rates based on the yield on 21/2-year Treasury securities, with maximums of 11.75 percent at commercial banks and 12.00 percent at thrifts. June 2, 1980 Ceiling rates on small saver certificates relative to yield on 21/2-year Treasury securities raised 50 basis points (maximums retained). June 5, 1980 Maximum ceiling rate on money market certificates raised to the 6-month Treasury bill rate plus 25 basis points when the bill rate is above 8.75 percent. Other ceilings apply below 8.75 percent. January 1, 1981 NOW accounts permitted nationwide. On the previous day, ceiling rates on NOW and ATS accounts set at 5.25 percent. August 1, 1981 Caps on small saver certificates of 11.75 percent at commercial banks and 12.00 percent at thrifts eliminated. Ceiling rates fluctuate with 2'/2-year Treasury security yields. October 1, 1981 Adopted rules for the All Savers Certificates specified in the Economic Recovery Act of 1981. December 1, 1981 New category of IRA/Keogh accounts created with minimum maturity of 11/2 years, no regulated interest rate ceiling and no minimum denomination. May 1, 1982 New time deposit created with no interest rate ceiling, a required denomination of $500 (but no specified minimum) and an initial minimum maturity of 3Vs> years. New short-term deposit instrument created with a $7,500 minimum denomination, 91-day maturity and a ceiling rate tied to the 91-day Treasury bill discount rate. Maturity range of small saver certificate adjusted to 30-42 months. September 1, 1982 New deposit account (7- to 31-day account) created with ceiling rate based on 91 -day Treasury bill discount rate, minimum daily balance of $20,000 and either a fixed term or a required notice period of 7 to 31 days. December 14, 1982 Money market deposit account (MMDA) created with minimum balance of not less than $2,500, no interest ceiling, no minimum maturity, up to six transfers per month (no more than three by draft), and unlimited withdrawals by mail, messenger or in person. January 5, 1983 Super NOW account created with same features as the MMDA, except that unlimited transfers are permitted. Interest rate ceiling eliminated and minimum denomination reduced to $2,500 on 7- to 31-day account. Minimum denomination reduced to $2,500 on 91-day accounts and money market certificates of less than $ 100, 000. April 1, 1983 Minimum maturity on small saver certificates reduced to 18 months. October 1, 1983 All interest rate ceilings eliminated except those on passbook savings and regular NOW accounts. Minimum denomination of $2,500 established for time deposits with maturities of 31 days or less (below this minimum, passbook savings rates apply). January 1, 1984 Rate differential between commercial banks and thrifts on passbook savings accounts and 7- to 31 -day time deposits of less than $2,500 eliminated. All depository institutions may now pay a maximum of 5.50 percent. January 1, 1985 Minimum denominations on MMDAs, Super NOWs and 7- to 31 -day ceiling-free time deposits will be reduced to $ 1,000 . January 1, 1986 6 Minimum denominations on MMDAs, Super NOWs and 7- to 31 -day ceiling-free time deposits will be eliminated. FEDERAL RESERVE BANK OF ST. LOUIS D e reg u la tio n a n d M o n e ta ry C o n tro l A ct o f 1 9 8 0 (MCA), w ith th e e s ta b lis h m e n t o f m o n e y m a rk e t c e rtific a te s (J u n e 1 9 7 8 ), a u t o m a t i c t r a n s f e r s e r v ic e a c c o u n t s (N o v em ber 1978) a n d sm a ll sa v e r c e r tific a te s (Ju n e 1979). T h e in tro d u c tio n o f NOW a c c o u n ts n a tio n w id e (Ja n u a ry 1981) w a s th e first m a jo r c h a n g e in d e p o s it in te re s t ra te ce ilin g s p u t in to e ffe ct u n d e r p ro v isio n s o f th e M CA .4 MAY 1984 Figure 1 Effect of Eliminating the Regulation Q Ceiling Rate on a Competitive Market for Long-Term Credit T h e D e p o sito ry In s titu tio n s D e re g u la tio n C o m m it te e h a s th e re s p o n s ib ility fo r c o m p le te rem ov al o f d e p o s it r a te c e ilin g s b y 1 9 8 6 . T h e c o m m itte e m e e ts p e rio d ic a lly d u rin g th e tra n s itio n p e rio d , a n d m o st o f th e c h a n g e s d e s c rib e d in ta b le 1 r e p r e s e n t th e o u t c o m e s o f th e s e m e e tin g s . C u rre n tly , th e o n ly ce ilin g s in effe ct a p p ly to p a s s b o o k saving s d e p o s its a n d NOW a c c o u n ts .5 TH E DETERMINATION O F MORTGAGE IN T ER ES T RATES In a n aly zin g h o w m o rtg a g e ra te s a re d e te rm in e d an d h o w th e y m ig h t b e a ffe c te d b y th e d e re g u la tio n o f d e p o s it in te re s t ra te s, w e a s s u m e th a t le n d e rs , d e p o s i to rs a n d b o rro w e rs a re all w e a lth -m a x im iz e rs . In p a r ticu la r, w e a s s u m e th a t le n d e rs a tte m p t to m a x im iz e th e ir p ro fits, d e p o s ito rs a tte m p t to g et th e h ig h e s t in te r e s t r e tu rn th e y c a n fo r a g iven d e g re e o f risk, a n d b o rro w e rs s e a r c h fo r th e lo w e s t in te r e s t ra te s, given o th e r c o n tr a c tu a l c h a r a c te r is tic s o f th e lo a n . W e a lso m ak e tw o a ltern a tiv e a s s u m p tio n s a b o u t co m p e titiv e fo rc e s in th e m a rk e t fo r re s id e n tia l m o r t gag es. U n d e r th e first a s s u m p tio n , in te re s t ra te s o n re s id e n tia l m o rtg a g e s a re d e te rm in e d in a c o m p etitiv e n a tio n a l m ark e t b y th e in te r a c tio n o f th e to ta l d e m a n d fo r a n d s u p p ly o f lo n g -te rm c re d it. U n d e r th e s e c o n d a s s u m p tio n , e a c h d e p o s ito r y in s titu tio n h a s s o m e m ark et p o w e r th a t p e rm its it to c h o o s e th e in te r e s t ra te at w h ic h it le n d s . In th e first ca s e , th e p h a s in g o u t o f R e g u la tio n Q w o u ld in c r e a s e th e s u p p ly o f lo n g -te rm c re d it, d u e to a n in c r e a s e in saving s b y th o s e w h o s e re tu rn s fro m saving p rev io u sly w e re lim ite d b y R e g u la tio n Q c e ilin g ra te s. T h e in c r e a s e in th e s u p p ly o f c re d it w o u ld c a u s e lo n g -te rm in te r e s t ra te s to fall. T h is is illu s tra te d in figure 1 as a rig h tw a rd m o v e m e n t in th e s u p p ly cu rve fro m S , to S 2 a n d a r e d u c tio n in th e ra te o f in te re s t from 4NOW accounts were available for many years in New England before their introduction nationwide. 5The prohibition of interest payments on demand deposits is not affected by the MCA. D - Demand for long-term credit 51 - Supply ol long-term credit before elim ination of Regulation Q 5 2 - Supply o f long-term credit after elim ination of Regulation Q i, to i2. O f c o u rs e , th e d e c lin e in ra te s m a y b e sm a ll; it d e p e n d s o n th e e x te n t to w h ic h d e p o s it ra te ce ilin g s lim ite d th e in c e n tiv e s fo r saving. T h e r e w o u ld b e n o c h a n g e in th e re la tio n s h ip b e tw e e n m o rtg a g e a n d o th e r lo n g -te rm in te r e s t ra te s, s in c e d iffe re n c e s in risk a n d liq u id ity th a t d e te rm in e th e s p re a d s in in te re s t ra te s b e tw e e n v a rio u s ty p e s o f lo n g -te rm s e c u ritie s w o u ld n o t b e a ffe c te d b y th e p h a s e -o u t o f R e g u la tio n Q. T h e c o n c lu s io n is n o t d ra m a tic a lly d iffe ren t if r e s i d e n tia l m o rtg a g e s a re m a d e b y s p e c ia liz e d le n d in g in s titu tio n s th a t h ave s o m e m a rk e t p o w e r. If a firm w ith m a rk e t p o w e r ra is e s its m o rtg a g e ra te , it w ill m ak e fe w e r lo a n s th a n if it o ffe re d m o rtg a g e c re d it a t lo w e r in te r e s t r a te s .6 T h is is illu s tra te d b y th e d o w n w ard slo p in g d e m a n d cu rv e (DM) in fig u re 2. W e a lso a s s u m e th a t th e firm m u s t ra is e th e in te r e s t ra te it p a y s o n s m a ll-d e n o m in a tio n d e p o s its if it w is h e s to a ttra c t m o re o f th e s e d e p o s its . T h is is illu s tra te d b y th e u p w a rd -slo p in g s u p p ly cu rv e (SSD). In c o n tra s t, th e firm c a n a ttr a c t a ll th e la r g e - d e n o m in a tio n d e p o s its it w a n ts b y se llin g c e rtific a te s o f d e p o s it at th e ra te o f 6Lenders might have such market power if most borrowers were limited to borrowing from institutions with offices in their local area and if the government restricted the number of institutions that may establish offices in each area. 7 FEDERAL RESERVE BANK OF ST. LOUIS Figure 2 Effect of a Regulation 0 Ceiling Rate on the Mortgage Interest Rate Set by a Lender with Market Power MAY 1984 iSD2 -7 T h e le n d e r w ill b e a b le to a ttr a c t o n ly Q j o f sm a lld e n o m in a tio n d e p o s its a n d w ill h av e to a ttr a c t an y a d d itio n a l fu n d s in th e m a rk e t fo r la rg e -d e n o m in a tio n d e p o s its . E a c h le n d e r in c r e a s e s its d e m a n d fo r larg ed e n o m in a tio n d e p o s its , c a u s in g th e in te r e s t ra te o n th e s e d e p o s its to ris e (to iLD2, fo r in s ta n c e ). B y c o n s tru c tin g a n e w m a rg in a l c o s t cu rv e in th e s a m e m a n n e r a s b e fo re (n o t sh o w n ), w e fin d th a t th e n e w e q u ilib riu m m o rtg a g e ra te ris e s to iM2, a n d th e a m o u n t o f m o rtg a g e le n d in g falls to Q 3 . T h u s , th e th e o r y in d ic a te s th a t a b in d in g c e ilin g o n th e in te r e s t ra te s p a id o n s m a ll-d e n o m in a tio n d e p o s its r e s u lts in a h ig h e r in te r e s t ra te o n m o rtg a g e lo a n s , le s s m o rtg a g e len d in g , a n d a h ig h e r i n t e r e s t r a te o n la r g e -d e n o m in a tio n d e p o s its .8 T h e re fo re , th e e lim in a tio n o f R e g u la tio n Q ce ilin g s s h o u ld r e s u lt in lo w e r m o rtg a g e in te r e s t ra te s. Given th is c o n c lu s io n , w h a t a re w e to m a k e o f th e a rg u m e n t th a t th e p h a s e -o u t o f R e g u la tio n Q c e ilin g ra te s h a s c a u s e d m o rtg a g e in te r e s t ra te s to rise ? It is an a s s e rtio n th a t is in c o n s is te n t w ith s ta n d a rd e c o n o m ic a n a ly sis, w h ic h is b a s e d o n th e w e a lth -m a x im iz in g b e h a v io r o f b u s in e s s firm s a n d in d iv id u a ls. MR - M arginal revenue S$D - Supply of small-denomination deposits mcsd= M arginal cost of small-denomination deposits in te r e s t d e te rm in e d in a c o m p e titiv e n a tio n a l m a rk e t. W ith n o R e g u la tio n Q c e ilin g s in effe ct, w e a s s u m e th is in te r e s t ra te is i LD1. T h e le n d e r m a x im iz e s p ro fits b y le n d in g th e a m o u n t o f m o rtg a g e s at w h ic h th e m a rg in a l c o s t (th e in c re a s e in toted c o s t d u e to th e la st d o lla r in c r e a s e in m o rtg a g e len d in g ) e q u a ls th e m a rg in a l re v e n u e (th e in c r e a s e in to tal re v e n u e fro m th e la st d o lla r in c r e a s e in m o rtg a g e len d in g ) . M arg in al c o s t a n d m a rg in a l re v e n u e a re illu s tra te d b y M C (th e h ea v y b la c k lin e) a n d M R, re s p e c tiv e ly, in fig u re 2 . T h e re le v an t m a rg in a l c o s t cu rv e h a s tw o p o rtio n s : (1) F o r d e p o s it lev els b e lo w Q 2 , it is th e m a rg in a l c o s t o f a ttra c tin g s m a ll-d e n o m in a tio n d e p o s its (M CSo), s in c e M C Sd is le s s th a n th e in te r e s t ra te o n la rg e -d e n o m in a tio n d e p o s its , iLD1. (2) F o r d e p o s it lev els ab o v e Q 2 , it is e q u a l to iLD1. If th e le n d e r w a n ts to a ttr a c t m o re d e p o sits th a n Q 2 fo r m o rtg a g e le n d in g , it w ill a ttr a c t Q , as s m a ll- d e n o m in a t io n d e p o s it s a n d a n y a d d itio n a l fu n d s as la rg e -d e n o m in a tio n d e p o s its . In figure 2, if th e r e a re n o c e ilin g s o n d e p o s it ra te s , th e p ro fitm a x im iz in g q u a n tity o f m o rtg a g e lo a n s is Q 4 w ith a m o rtg ag e ra te o f i M 1 a n d a ra te o n s m a ll-d e n o m in a tio n d e p o s its o f iSD1. S u p p o s e re g u la to rs im p o s e a m a x im u m in te r e s t ra te th a t m ay b e p a id o n s m a ll-d e n o m in a tio n d e p o s its o f 8 WHAT HAS H APPEN ED TO MORTGAGE R A T ES? W e n o w c o m p a r e th e r e c e n t b e h a v io r o f m o rtg a g e in te re s t r a te s w ith m o v e m e n ts in o th e r m a rk e t ra te s a n d th e averag e c o s t o f fu n d s fo r S&.Ls. T h e o b je c tiv e is to d e te rm in e w h e th e r th e e v id e n c e s u p p o rts th e a rg u m e n t th a t d e re g u la tio n o f d e p o s it in te r e s t ra te c e ilin g s h a s c a u s e d m o rtg a g e in te r e s t r a te s to rise relativ e to o th e r m a rk e t in te re s t ra te s o f c o m p a ra b le d u ra tio n . T h e m o rtg a g e in te re s t ra te s e r ie s u s e d is p u b lis h e d by th e D e p a rtm e n t o f H o u sin g a n d U rb a n D e v e lo p m e n t: th e averag e in te r e s t ra te a t w h ic h re s id e n tia l m o rtg a g e le n d e r s m a k e c o m m itm e n ts to le n d fo r lo n g -te rm , fix e d -ra te c o n v e n tio n a l lo a n s . T h e in s e rt o n p a g e s 10 a n d 1 1 d e s c rib e s sev era l s e r ie s o n re s id e n tia l m o rtg ag e in te re s t ra te s a n d d is c u s s e s th e b a sis fo r c h o o s in g th is m e a su re . 7ln the theoretical analysis illustrated in figure 2, Regulation Q ceiling rates are assumed to apply only to small-denomination deposits. This assumption corresponds to the actual structure of ceiling in terest rates under Regulation Q, which have exempted deposits in denominations of $100,000 or more for many years. 8The general conclusions would be the same if all deposits were subject to a Regulation Q ceiling rate. Imposing a ceiling interest rate on all deposits that is below the unregulated market interest rate would reduce the amount of deposits the lender could attract. The profit-maximizing lender with market power would raise its mortgage interest rate to ration the reduced supply of mortgage credit among its customers. FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Chart 1 Semiannual Comparison of M o rtg a g e Interest Rate w ith Cost of Funds to S&Ls and 10-Year Treasury Bond Yield P e rc e n t T h e y ie ld o n 1 0 -y e a r U.S. T re a s u ry b o n d s is u s e d a s a m e a s u re o f th e in te re s t ra te o n lo n g -te rm d eb t o b lig a tio n s o th e r th a n re s id e n tia l m o rtg ag es/ ’ T h e 1 0 -y e a r m a tu rity a p p r o x im a te s th e averag e le n g th o f tim e th a t re sid e n tia l m o rtg a g e s a re o u ts ta n d in g . T h is is m u c h s h o r t e r th a n th e s ta te d m a tu ritie s o f c o n v e n tio n a l lo a n s b e c a u s e o f th e p re p a y m e n t o f a s u b s ta n tia l n u m b e r o f m o rtg a g e lo a n s b e fo re th e ir m a tu rity . C h a rt 1 in d ic a te s th a t s e m ia n n u a l a v erag es o f th e c o s t o f fu n d s to S& L s, th e m o rtg a g e in te re s t ra te, a n d th e v ield o n 1 0 -y e a r U.S. T re a s u ry b o n d s te n d to m ove t o g e t h e r o v e r t i m e . 1(1 T h e r e l a t i o n s h i p b e t w e e n 9Mayer and Nathan (1983) use the 10-year Treasury bond rate for the same purpose. 10The average cost of funds for S&Ls, obtained from the Federal Home Loan Bank Board, incorporates not only the interest S&Ls pay P e rce n t c h a n g e s in th e m o rtg a g e a n d b o n d ra te s is s o m e w h a t c lo s e r (c o rre la tio n c o e ffic ie n t o f 0.897I th a n b e tw e e n c h a n g e s in th e m o rtg a g e ra te a n d th e average c o s t o f fu n d s (co rre la tio n c o e ffic ie n t o f 0.816). All th r e e s e rie s w e re s u b s ta n tia lly h ig h e r in th e late 1 9 7 0 s a n d 1 9 8 0 s th a n th e y h a d b e e n e a rlie r. T h u s, th e p h a s e -o u t o f R e g u la tio n Q c e ilin g s a llo w e d S& L s to b id fo r fu n d s b y o ffe rin g ra te s th a t k e p t p a c e w ith ris e s in m ark e t in te r e s t ra te s . O n e in d ic a to r o f h o w risin g m a r k et in te re s t ra te s a n d th e p h a s e -o u t o f R e g u la tio n Q a ffe c te d th e average c o s t o f fu n d s fo r th rift in s titu tio n s is th e d e c lin e in th e s h a re o f th e ir d e p o s it lia b ilitie s h e ld in th e fo rm o f p a s s b o o k saving s d e p o s its . B e tw e e n on deposits, but also the interest they pay on advances from their Federal Home Loan Banks and other borrowed funds. The average cost of funds is somewhat higher than the average interest rate paid on deposits. 9 F o u r M easures of M ortgage Loan In terest R ates T h is s e c tio n d e s c r ib e s fo u r m e a s u re s o f in te re s t ra te s o n m o rtg a g e lo a n s a n d e x p la in s w h y th e HUD c o m m itm e n t ra te is c h o s e n in th e te x t. S in c e th e p u rp o s e o f th e p a p e r is to d e te rm in e h o w th e p h a s e o u t o f R e g u la tio n Q c e ilin g ra te s h a s a ffe cte d in te re s t ra te s p a id b y h o m e b u y e rs o n n e w m o rtg a g e lo a n s, th e u s e o f in te r e s t ra te s o n m o rtg a g e s tra d e d in s e c o n d a ry m a rk e ts is ru le d o u t. An im p o rta n t c r i te rio n fo r th e c h o ic e o f a m o rtg a g e in te re s t ra te s e rie s is th a t th e te rm s o n m o rtg a g e lo a n s th a t affect th e ra te b e h e ld c o n s ta n t. T h is c rite rio n is e s p e c ia lly im p o r ta n t b e c a u s e o f th e m a n y c h a n g e s in th e te rm s o n m o rtg a g e lo a n s in r e c e n t y e a rs , s u c h a s th e risin g s h a re o f lo a n s w ith a d ju s ta b le in te re s t ra te s. HUD Mortgage Commitment Rate T h e D e p a rtm e n t o f H o u sin g a n d U rb a n D ev elo p m e n t su rv ey s m a jo r m o rtg a g e le n d e rs (p rim arily m o rtg a g e b a n k e rs ) n a tio n w id e to d e te r m in e th e ty p ica l c o n tr a c t ra te fo r lo a n c o m m itm e n ts o n lo n g te rm , fix e d -ra te co n v e n tio n a l m o rtg a g e s. T h is s u r vey is c o n d u c te d a s o f th e first b u s in e s s d ay o f e a c h m o n th . L e n d e rs a re n o t a sk e d to s p e c ify th e m a tu rity o r lo a n -to -v a lu e ra tio o f th e ir m o rtg a g e lo a n s. T h is s e r ie s d o e s n o t in c o r p o r a te fe e s o r d is c o u n t p o in ts p a id b y b o rro w e r o r le n d e r. T h e s e r ie s s ta rts in A pril 1960. FHLMC M ortgage Commitment Rate T h e F e d e ra l H o m e L o a n M o rtg ag e C o ip o ra tio n c o n d u c ts a w e e k ly su rv ey o f m o rtg a g e le n d e rs (pri m arily S& Ls) to d e te rm in e th e c o n tr a c t ra te s fo r c o m m itm e n ts o n fix e d -ra te lo a n s w ith m a tu rity o f 30 y e a rs a n d lo a n -to -v a lu e ra tio o f 8 0 p e r c e n t. T h is s e rie s a lso d o e s n o t re fle c t fe e s o r d is c o u n t p o in ts . It sta rts in A pril 19 7 1 . a d ju s ta b le ra te s. T h e s e r ie s b a s e d o n a lo a n -to -v a lu e ra tio o f 75 p e r c e n t s ta rts in Ja n u a r y 1973. FHLBB Series on Interest Rates on M ortgage Loans Closed T h e F e d e ra l H om e L o a n B a n k B o a rd a lso su rveys th e in te re s t ra te s o n re s id e n tia l m o rtg a g e s th a t are a ctu a lly c lo s e d (i.e., b o rro w e rs re ce iv e lo a n s to b u y h o m e s). T h is s e r ie s is a v ailab le o n a c o n s is te n t b a sis s in c e Ja n u a r y 1973. T h e c lo s in g ra te s e r ie s is d iffe ren t in sev era l w ays fro m th e th r e e c o m m itm e n t ra te s e r ie s . L e n d e rs g e n e ra lly m ak e c o m m itm e n ts fo r m o rtg a g e lo a n s a fe w m o n th s b e fo r e th e lo a n s a re c lo s e d , a n d in te re s t ra te s a re s e t at th e tim e o f c o m m itm e n t. T h e re fo re , m o v e m e n ts in in te re s t ra te s o n lo a n s c lo s e d te n d to lag m o v e m e n ts in c o m m itm e n t ra te s (see c h a rt 2). T h u s , th e ra te a t tim e o f c o m m itm e n t is a b e tte r in d ic a to r o f th e ra te at w h ic h b o rro w e rs c a n o b ta in m o rtg a g e c r e d it at a g iven p o in t in tim e . F u rth e rm o re , th e s e r ie s fo r th e in te r e s t ra te at tim e o f c lo s in g re fle c ts a c o n g lo m e ra tio n o f lo a n te rm s ; it in c o rp o ra te s in te re s t ra te s o n fixed ra te, a d ju s ta b le ra te a n d g ra d u a te d p a y m e n t lo a n s . It a lso in c o r p o ra te s m o rtg a g e s w ith a variety o f lo a n -to -v a lu e ra tio s a n d m a tu ritie s a n d s o m e m o rtg a g e lo a n s w ith d is c o u n te d r a te s u n d e r v a r io u s c r e a tiv e fin a n c in g s c h e m e s . 1 F o r th e s e re a s o n s , th e s e r ie s o n lo a n s c lo s e d d id n o t rise a s m u c h a s th e c o m m itm e n t ra te s e rie s d u rin g 1 9 8 0 -8 2 . T h e m o rtg a g e le n d e rs in c lu d e d in th e c o m m it m e n t ra te su rvey o f th e F e d e ra l H om e L o a n B an k T h e th r e e s e rie s o n c o m m itm e n t ra te s te n d to m ove to g e th e r c lo s e ly o v er tim e (se e c h a r t 2). T h e F e d e ra l H om e L o a n B a n k B o a r d ’s s e r ie s is slig h tly h ig h e r th a n th e o th e r s d u rin g s o m e p e rio d s, th e d iffe re n ce re fle ctin g p rim a rily th e a m o rtiz e d fe e s a n d d is c o u n t p o in ts . T h e HUD ra te is u s e d in th e te x t a s th e m e a s u re o f m o rtg a g e in te r e s t ra te s s im ply b e c a u s e it is av ailable o v er a lo n g e r p e rio d th a n th e o th e r tw o s e r ie s . N on e o f th e re s u lts p re s e n te d in th e te x t w o u ld b e s u b s ta n tia lly a lte re d if a d iffer B o a rd in c lu d e S& L s, m o rtg a g e b a n k e rs , c o m m e rc ia l e n t c o m m itm e n t ra te s e rie s h a d b e e n u se d . FHLBB M ortgage Commitment Rate b a n k s a n d m u tu a l savin g s b a n k s. T h e su rvey ask s th e s e le n d e rs a b o u t th e in te r e s t ra te s a t w h ic h th e y a re m ak in g c o m m itm e n ts to le n d o n n e w ly b u ilt h o m e s , u n d e r v a rio u s c o m b in a tio n s o f lo a n -to -v a lu e ra tio s. T h e m a tu rity o f th e lo a n s is s p e c ifie d a s 25 y e a rs o r lo n g e r. T h e p u b lis h e d d a ta in c lu d e a n aver age c o n tr a c t ra te a n d a n averag e effectiv e ra te ; th e effective ra te in c lu d e s th e fe e s a n d d is c o u n t p o in ts, a m o rtiz e d o v er 10 y e a rs . T h e s e rie s p lo tte d in c h a rt 2 is fo r effectiv e ra te s . T h e c o m m itm e n t ra te d a ta b e fo re S e p te m b e r 1 9 8 3 d o e s n o t d is tin g u is h b e tw e e n r a te s o n fix e d -ra te lo a n s a n d th o s e w ith 0 'One of the creative financing schemes involves reduced-rate loans to buyers of homes on which a lender has made previous mortgage loans at fixed rates substantially below current mort gage rates. The new buyers generally would prefer to assume the outstanding mortgage loans with the relatively low interest rates, but may be financially unable to do so. The lender would prefer that the new buyer borrow at the prevailing market interest rate, thereby eliminating the old low-yielding mortgage loan. To reduce the incentives for new buyers to borrow enough from other sources to assume the old mortgages with the relatively low interest rates, many lenders have offered to lend to the new buyers at interest rates between those on the old mortgages and the prevailing market interest rates. Interest rates on mortgages that involve such arrangements are reflected in the series on average interest rates on mortgage loans closed. FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Chart 2 Selected M ortgage Rates NOTE: FHLMC commitment rate begins in August 1978. FHLBB commitment rate was changed after August 1983. 1978 a n d 1983, sav in g s d e p o s its (s u b je c t to fix e d in te re s t ra te ce ilin g s) fell fro m o v er 35 p e r c e n t o f to ta l d e p o s its to le s s th a n 15 p e r c e n t. M e a n w h ile, th e n e w m o n e y m a rk e t c e rtific a te s a n d m o n e y m a rk e t d e p o s it a c c o u n ts e a c h g re w to r e p r e s e n t a b o u t 17 p e r c e n t o f to tal d e p o s its . re la tio n b e tw e e n th e c u r r e n t c h a n g e in th e m o rtg a g e ra te a n d th e c h a n g e in th e c o s t o f fu n d s tw o m o n th s la te r is 0 .6 1 2 .12 C h a rt 3 p lo ts th e s a m e th r e e in te re s t ra te s e rie s o n a T h e b e h a v io r o f m o rtg a g e ra te s s in c e 1 9 8 0 a p p e a rs to le n d e m p iric a l s u p p o rt to th e h y p o th e s is th a t d e re g u la tio n h a s re s u lte d in h ig h e r m o rtg a g e ra te s relativ e to o th e r lo n g -te rm ra te s . T h e av erag e s p re a d b e tw e e n th e m o rtg a g e ra te a n d th e 1 0 -y e a r T r e a s u iy b o n d ra te from m o n th ly b a s is s in c e M a y 1 9 7 9 .11 T h e re la tio n s h ip s a m o n g th e th r e e s e r ie s e n a b le u s to s e e th a t c h a n g e s in th e c o s t o f fu n d s to S& L s c le a rly lag c h a n g e s in th e m o rtg ag e ra te a n d th e T re a s u ry b o n d ra te, u su a lly by a b o u t tw o m o n t h s . A s im p le s t a t i s t i c a l a n a ly s is c o n firm s th e v isu al p a tte rn in c h a rt 3. T h e c o n te m p o ra n e o u s c o r re la tio n b e tw e e n c h a n g e s in th e c o s t o f The Rise o f M ortgage Rates Relative to Other Long-Term Interest Rates 1966 to 1979 ra n g e d g e n e ra lly fro m 1 to 1.75 p e rc e n ta g e p o in ts ; in th e 1 9 8 0 s, it h a s ra n g e d fro m 2 to 3 p e r c e n t ag e p o in ts. fu n d s a n d th e o th e r tw o s e rie s is a c tu a lly n eg ative, th o u g h n o t s ta tis tic a lly sig n ific a n t. H ow ever, th e c o r- "S e e Chamberlain, Olin and McKenzie (1983) for a discussion of the monthly cost of funds data. This series is actually the median cost of funds rather than the average. 12The contemporaneous correlation between changes in the mort gage rate and changes in the yield on 10-year Treasury bonds is 0.794, indicating that interest rates on both kinds of long-term debt instruments are affected simultaneously by the same credit-market influences. 11 MAY 1984 FEDERAL RESERVE BANK OF ST. LOUIS Chart 3 Monthly Comparison of Mortgage Interest Rate with Cost of Funds to S&Ls and 10-Year Treasury Bond Yield Percent Percent S in c e 1980, h ow ever, th e av erag e s p re a d b e tw e e n th e m o rtg ag e ra te a n d th e averag e c o s t o f fu n d s fo r S&.Ls also h a s in c re a s e d , b y ro u g h ly th e s a m e o r d e r o f m a g n itu d e as th e in c r e a s e in th e averag e s p re a d b e tw e e n m o rtg ag e ra te s a n d th e ra te o n 1 0 -y e a r T re a s u ry b o n d s . T h e g ap b e tw e e n m o rtg a g e in te re s t ra te s a n d th e aver age c o s t o f fu n d s sta y e d m o stly b e tw e e n 2 a n d 3.5 p e rc e n ta g e p o in ts b e fo re 1 9 8 0 ; s in c e th e n , it h a s varied b e tw e e n 3.25 a n d a lm o s t 6 p e r c e n ta g e p o in ts . T h e r e fo re, th e w id e n in g in th e s p re a d b e tw e e n m o rtg a g e ra te s a n d th e T re a s u ry b o n d ra te d o e s n o t a p p e a r to b e th e re su lt o f a h ig h e r averag e c o s t o f fu n d s to S& L s. W hy, th e n , d id m o rtg a g e ra te s rise relativ e to ra te s on T re a s u ry b o n d s o f c o m p a ra b le te rm to m a tu rity a fte r 1980? T h e a n s w e r a p p e a rs to involve d iffe re n c e s b e t w e e n c o n v e n t io n a l r e s id e n t ia l m o r tg a g e s a n d T re a s u ry b o n d s as d e b t in s tru m e n ts . T h e tw o m a jo r d iffe re n c e s are: (1) M o st m o rtg a g e s a llo w th e b o rro w e r Digitized for 12 FRASER to p a y o ff h is d e b t b e fo re m a tu rity w ith o u t p e n a lty ; a n d (2) T h e re is risk o f d efa u lt o n m o rtg a g e lo a n s . T re a s u ry b o n d h o ld e rs fa ce n e it h e r p re p a y m e n t risk n o r d efau lt risk. Mortgage Rates and the Prepayment Option In v e sto rs m u s t b e c o m p e n s a te d w ith h ig h e r in te re s t ra te s o n re s id e n tia l m o rtg a g e s th a n o n T re a s u ry b o n d s to c o m p e n s a te fo r th e risk o f p re p a y m e n t b y d e b to r s .1 3 M o rtg ag e b o rro w e rs m u s t p a y a h ig h e r in te r e s t ra te fo r s u c h a "c a ll o p tio n .” T h e v alu e o f th is o p tio n n e e d n o t re m a in c o n s ta n t o v er tim e . In p a rtic u la r, its v a lu e w ill b e h ig h e r d u rin g p e rio d s o f m o re v o la tile lo n g -te rm ' 3For a more thorough analysis of the role of the prepayment option in determining the spread between mortgage interest rates and Trea sury bond rates, see Hendershott, Shilling and Villani (1982). FEDERAL RESERVE BANK OF ST. LOUIS in te re s t ra te s th a n d u rin g p e rio d s o f s ta b le ra te s, b e c a u s e o f th e in c r e a s e d lik e lih o o d th a t th e p re p a y m e n t o p tio n w ill b e e x e rc is e d . L o n g -te rm in te r e s t ra te s w e re e x tre m e ly v ariab le b y h is to ric a l s ta n d a rd s fro m 1 9 8 0 to 1982. T h u s, w e w o u ld e x p e c t m o rtg a g e ra te s to rise relativ e to T re a s u ry b o n d ra te s d u rin g th is p e rio d . T h e size o f th e in te r e s t ra te p re m iu m n e c e s s a ry to c o m p e n s a te in v e sto rs fo r th e p re p a y m e n t o p tio n o n re s id e n tia l m o rtg a g e s c a n b e g a u g e d b y e x a m in in g th e sp re a d b e tw e e n th e y ie ld o n p a s s th ro u g h s e c u ritie s is s u e d b y th e G o v ern m e n t N a tio n a l M o rtg ag e A s s o c ia tio n (GNMA) a n d th e y ie ld o n 1 0 -y e a r T re a s u ry s e c u ritie s. T h e risk o f p re p a y m e n t is th e m a jo r d iffe re n c e b e tw e e n in v e stin g in GNMA p a s s th ro u g h s a n d T r e a s u r y b o n d s . In v e s to r s w h o p u r c h a s e th e s e p a s s th ro u g h s e c u r itie s re ce iv e th e in te r e s t a n d p rin c ip a l p a y m e n t s f r o m a p o o l o f FH A -VA g o v e r n m e n t g u a ra n te e d re s id e n tia l m o rtg a g e s. T h u s , th e re is n o m o re risk o f d efau lt o n th e in te r e s t a n d p rin c ip a l p a y m e n ts o n GNMA p a s s th ro u g h s th a n th e r e is fo r b o n d s is s u e d b y th e U.S. T re a s u ry . A n y p re p a y m e n t o f th e m o r tg a g e s , h o w e v e r , is “ p a s s e d t h r o u g h " to th e h o ld e rs o f th e p a s s th ro u g h s e c u r itie s . 1 4 T h is fe a tu re r e d u c e s th e p ro b a b ility o f a c a p ita l g ain o n GNMA p a s s th ro u g h s e c u r itie s c o m p a re d w ith a n in v e stm e n t in T re a s u ry b o n d s . If lo n g -te rm in te re s t ra te s d e c lin e a fte r a n in v e s to r b u y s T re a s u ry b o n d s , th e ir m ark e t valu e rise s, a n d th e in v e sto r re ce iv e s a ca p ita l g ain if h e se lls th e m . In c o n tra s t, if lo n g -te rm in te re s t ra te s d e c lin e a fte r a n in v e s to r b u y s GNMA p a s s th ro u g h s e c u ritie s , th e m o rtg a g e s in th e in v e st m e n t p o o l a re m o re lik ely to b e p re p a id . B e c a u s e s u c h p re p a y m e n ts r e d u c e th e siz e o f th e p o te n tia l c a p ita l gain , a p re m iu m in th e fo rm o f a h ig h e r y ie ld o n m o r t gage p a s s th ro u g h s is re q u ire d to m a k e in v e sto rs in d if fe re n t b e tw e e n th e m a n d T re a s u ry b o n d s . C h art 4 in d ic a te s th a t th e s p re a d b e tw e e n y ie ld s o n GNMA p a s s th ro u g h s e c u r itie s a n d 1 0 -y e a r T re a s u ry b o n d s ro se d u rin g 19 80 th r o u g h e a rly 1 9 8 3 . T h u s, o n e re a s o n fo r th e relativ e in c r e a s e in m o rtg a g e in te re s t ra te s d u rin g th o s e y e a r s w a s a ris e in th e ra te p re m iu m n e c e s s a r y to c o m p e n s a te in v e sto rs fo r th e p re p a y m e n t o p tio n o n m o rtg ag e s. 14Another factor that accounts for a small portion of the spread be tween rates on GNMA passthrough securities and Treasury bonds is the effect of state and local taxes. Interest earned on Treasury bonds is exempt from state and local taxes, but earnings on mort gage passthroughs are not. There is no reason to suspect that this factor has increased in importance during recent years. There also could be differences in yields on these two assets if investors do not view them as being of roughly equal term to maturity, as we are assuming. MAY 1984 Mortgage Rates and Default Risk A n o th e r r e a s o n fo r th e ris e in in te r e s t ra te s o n c o n v e n tio n a l m o rtg a g e s s in c e 1 9 8 0 a p p e a rs to b e a g e n e ra l rise in in te r e s t ra te s o n p riv a tely is s u e d d e b t s e c u ritie s relativ e to y ie ld s o n s e c u r itie s is s u e d o r g u a r a n te e d b y th e fe d era l g o v e rn m e n t. T a b le 2 s h o w s th a t th e average sp re a d b e tw e e n in te r e s t ra te s o n p riv ately is s u e d d eb t in s tru m e n ts a n d T r e a s u iy s e c u r itie s is h ig h e r in th e g e n e r a lly r e c e s s i o n a r y p e r io d , F e b r u a r y 1 9 8 0 to N ov em ber 1982, th a n in th e e x p a n s io n a r y p e rio d , A pril 1975 to Ja n u a r y 1 9 8 0 .15 T h is is a re fle c tio n o f th e g re a te r d efa u lt risk a s s o c ia te d w ith p riv ately is s u e d s e c u ritie s d u rin g r e c e s s io n a r y p e rio d s. In e a c h c a s e , th e d iffer e n c e s in m e a n s p re a d s b e tw e e n th e tim e p e rio d s are s ta tis tic a lly s ig n ific a n t a t th e 1 p e r c e n t lev el . 1 6 T h e p a tte rn o f s p re a d s b e tw e e n m o rtg a g e a n d T re a s u ry b o n d ra te s is very s im ila r to th e p a tte r n o f s p re a d s b e tw e e n y ie ld s o n o th e r p riv a tely is s u e d s e c u ritie s a n d T re a s u ry s e c u r itie s o f c o m p a ra b le d u ra tio n . T a b le 2 a lso in d ic a te s th a t th e s p re a d s b e tw e e n y ie ld s o n p riv ately is s u e d a n d U.S. T re a s u ry s e c u ritie s d e c lin e d to n e a r th e ir p re -1 9 8 0 lev els a few m o n th s a fte r th e e c o n o m ic re co v e ry b e g a n in D e c e m b e r 1982. T h e d e c lin e in th e sp re a d b e tw e e n th e m o rtg a g e c o m m itm e n t ra te a n d th e T re a s u ry b o n d ra te o c c u r r e d d e s p ite th e a u th o riz a tio n o f m o n e y m a rk e t d e p o s it a c c o u n ts — a m a jo r re la x a tio n o f R e g u la tio n Q c e ilin g ra te s th a t o c c u r r e d in th e first m o n th o f th e c u rre n t recov ery . T h e s e o b se rv a tio n s a re s u p p o rte d b y th e b e h a v io r o f d e lin q u e n c y ra te s fo r m o rtg a g e s. T h e p e rc e n ta g e o f c o n v e n tio n a l m o rtg a g e s w ith p a y m e n ts d e lin q u e n t fo r 60 d ay s o r m o re ro s e ste a d ily fro m 0.61 p e r c e n t in th e s e c o n d q u a rte r o f 1 9 7 9 to 1.37 p e r c e n t in th e first q u a r te r o f 1983, th e n b e g a n to d e c lin e . D e lin q u e n c y ra te s in th e 1 9 8 0 s have b e e n s u b s ta n tia lly h ig h e r th a n in th e p e rio d 1 9 6 4 -7 9 , w h ic h u n d o u b te d ly a c c o u n ts fo r a s u b s ta n tia l p o rtio n o f th e h ig h e r m o rtg a g e ra te s r e la tive to T re a s u ry b o n d r a te s o b serv e d s in c e 1 9 8 0 .17 1sThe period from July 1980 to July 1981 is officially classified as an economic recovery. The financial markets, however, did not re spond during that period as they typically do during expansionary periods. Stock price indexes were little affected, and the spread between corporate Baa and Aaa bond rates (known to be influenced by cyclical factors) changed little. The lack of response is un doubtedly due to the weakness and short duration of the recovery. 16Some corporate Baa bonds grant a call option to the issuer. Part of the increase in the spread between the Baa bond rate and long-term Treasury securities, therefore, is accounted for by an increase in the value of this prepayment option. 17The average quarterly delinquency rate (60 days or more) for con ventional mortgage loans between 1/1964 and IV/1979 was 0.58 percent; between 1/1980 and IV/1983, it was 1.01 percent. This difference is statistically significant at the 1 percent level. 13 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 C h art 4 Selected Interest Rate Spreads o ---------------------- ----------------------- 1----------------------- 1-----------------------1---------------------------------------------- ----------------------- ----------------------- ----------------------- ----------------------- ------------------ 1973 1974 1975 1976 1977 1978 1979 1980 1981 1 98 2 1 983 Table 2 Spreads Between Interest Rates on Privately Issued Debt Instruments and U.S. Treasury Securities (monthly average spreads in percentage points) Apr. 1975-Jan. 1980 Feb. 1980-Nov. 1982 Dec. 1982-July 1983 Aug. 1983-Mar. 1984 Mortgage rate minus 10-year Treasury bond rate 1.41 2.63 2.71 1.71 Corporate Baa rate minus long-term Treasury bond rate 1.67 2.90 2.83 1.88 3-month commercial paper rate minus 3-month Treasury bill rate 0.53 1.29 0.26 0.31 Interest Rate Spread Digitized for14 FRASER MAY 1984 FEDERAL RESERVE BANK OF ST. LOUIS Table 3 Decomposition of the Spread Between the Mortgage Rate and the 10-Year Treasury Bond Rate (monthly average spreads in percentage points)_____________ Type of risk Measure of risk Default risk Mortgage rate minus GNMA rate 0.79 1.26 1.29 0.94 GNMA rate minus 10-year Treasury bond rate 0.62 1.37 1.42 0.77 Prepayment risk Apr. 1975-Jan. 1980 Feb. 1980-No v. 1982 Dec. 1982-July 1983 Aug. 1983-Mar. 1984 T h e e ffe c ts o f th e m a jo r f a c t o r s th a t a p p e a r to a c c o u n t fo r th e rise in m o rtg a g e ra te s relativ e to T r e a su ry b o n d ra te s c a n b e s e e n in ta b le 3 (a n d a lso in c h a rt 4). F o r th e p e rio d 1 9 8 0 -8 2 , th e p re m iu m to c o m p e n s a te A lth o u g h m o rtg a g e ra te s h av e m o v ed h ig h e r relativ e to g o v e rn m e n t b o n d ra te s o f s im ila r d u ra tio n fo llow in g th e b e g in n in g o f d e re g u la tio n , th a t p a tte r n a p p e a rs to b e u n re la te d to th e d e re g u la tio n o f d e p o s it ra te s. In fo r th e risk o f p r e p a y m e n t (a p p r o x im a te d b y th e sp re a d b e tw e e n th e y ie ld o n GNMA p a s s th ro u g h s e c u ritie s a n d 1 0 -y e a r T r e a s u iy b o n d s) w a s a b o u t 75 b a sis p o in ts h ig h e r o n averag e th a n in 1 9 7 5 -7 9 . T h e d efa u lt ris k p r e m iu m o n p r iv a te ly is s u e d s e c u r i t i e s n o t ste a d , it w a s th e re s u lt o f m o re v a ria b le in te r e s t ra te s, w h ic h c a u s e d a h ig h e r p re m iu m fo r th e o p tio n o f p r e p a y in g a m o rtg a g e lo a n , a n d th e e c o n o m ic d o w n tu rn in th e e a rly 1 9 8 0 s, w h ic h ra is e d th e p re m iu m fo r th e risk o f d efa u lt o n m o rtg a g e s. S in c e in te r e s t ra te s have b e c o m e le s s v a ria b le a n d a n e c o n o m ic e x p a n s io n h a s b eg u n , th e s p re a d s b e tw e e n m o rtg a g e ra te s a n d gov e rn m e n t b o n d r a te s h av e fa lle n o v er th e la st y e a r to c lo s e to th e ir p r e -1 9 8 0 level. g u a ra n te e d bv th e g o v e rn m e n t (a p p ro x im a te d b y th e sp re a d b e tw e e n in te r e s t ra te s o n n e w co n v e n tio n a l re s id e n tia l m o rtg a g e s a n d th e y ie ld o n GNMA p a s s th ro u g h s e cu ritie s ) w a s a p p ro x im a te ly 5 0 b a sis p o in ts h ig h e r o n average d u rin g th is p e rio d . T h e re fo re , b o th e ffe cts a p p e a r to s h a re in th e re s p o n s ib ility fo r h ig h e r m o rtg a g e in te re s t ra te s relativ e to T re a s u ry s e c u ritie s in th e e arly 1980s. B o th have d e c lin e d d u rin g th e c u r re n t e c o n o m ic e x p a n sio n . CONCLUSION E c o n o m ic th e o ry s u g g e sts th a t th e d e re g u la tio n o f d e p o sit in te re s t ra te s d o e s n o t c a u s e m o rtg a g e ra te s to rise a n d m ay, in fact, re s u lt in lo w e r m o rtg a g e in te re s t ra te s th a n w o u ld o th e r w is e b e o b serv e d . N o n e th e le ss, m a n y b eliev e th a t th e h ig h e r averag e c o s t o f o b ta in in g lo a n a b le fu n d s th a t r e s u lts fro m d e re g u la te d d e p o sit ra te s have le d to h ig h e r m o rtg a g e ra te s. S in c e th e in tro d u c tio n o f n e w ty p e s o f d e p o s its w ith flex ib le in te re s t ce ilin g s (o r n o c e ilin g s a t all), th e aver age in te re s t ra te o n m o rtg a g e lo a n s, th e averag e c o s t o f fu n d s fo r savings a n d lo a n a s s o c ia tio n s , a n d m a rk et in te re s t ra te s in g e n e ra l h ave ris e n s u b sta n tia lly . T h e n o tio n th a t h ig h e r m o rtg a g e ra te s a re d u e to th e r e m oval o f d e p o s it in te r e s t ra te ce ilin g s , h ow ever, is n o t s u p p o rte d . R E FE R E N C E S Arenson, Karen W. "Why High Interest Rates Are Here to Stay,” New York Times, October 9, 1983. Bacon, Kenneth H. “ Flexible Interest Rates May Add to Stability,” Wall Street Journal, November 7, 1983. Chamberlain, Charlotte A., Virginia K. Olin and Joseph A. McKen zie. "Monthly Cost of Funds,” Federal Home Loan Bank Board Journal (January 1983), pp. 34-37. Depository Institutions Deregulation and Monetary Control Act of 1980, S. Rept. No. 96-640, 96 Cong. 2 Sess. (GPO, 1980), title II, sec. 202(a). Friedman, Edward A. “ Key Consumer Markets of the 1980s: Autos, Energy, Finance and Health Care,” in Long-Term Special Report: Consumer Markets in the 1980s (Chase Econometrics, July 1983), pp. A.29-A.46. Hendershott, Patric H., James D. Shilling and Kevin E. Villani. “The Determination of Home Mortgage Rates: Empirical Results for the 1975-81 Period” (paper presented at a joint session of the meet ings of the American Finance Association and the American Real Estate and Urban Economics Association, New York, December 29, 1982). Mayer, Thomas, and Harold Nathan. “ Mortgage Rates and Regula tion Q,” Journal of Money, Credit and Banking (February 1983), pp. 107-15. McNulty, James E. “ Secondary Mortgage Markets: Recent Trends and Research Results,” Federal Home Loan Bank of Atlanta Re view (December 1983), pp. 1-5. 15 What Gan Central Banks Do About the Value of the Dollar? Dallas S. Batten and Mack Ott o V ER th e p a s t fo u r y e a r s , th e s tu b b o rn s tre n g th o f th e U.S. d o lla r in fo reig n c u r r e n c y m a rk e ts h a s c re a te d w h a t m a n y o b se rv e rs b elie v e is a p re c a rio u s b a la n c e b e tw e e n tw o u n d e s ir a b le fe a tu re s o f th e flo a tin g e x c h a n g e ra te sy ste m . O n th e o n e h a n d , s o m e a rg u e th a t th e d o lla r is o v erv alu ed a n d , c o n s e q u e n tly , s o o n w ill fall d ra m a tica lly , g e n e r a tin g in c r e a s e d U.S. in fla tio n a n d je o p a rd iz in g w o rld fin a n c ia l sta b ility . O n th e o th e r h a n d , o th e r s a rg u e th a t th e “h ig h " d o lla r w a s a m a jo r c a u s e o f th e 1 9 8 1 -8 2 e c o n o m ic r e c e s s io n a n d n o w a s s e rt th a t th e c u r r e n t e x p a n s io n is n o t s u s ta in a b le w ith o u t a s u b s ta n tia l d e c lin e in th e fo reig n e x c h a n g e v alu e o f th e d o lla r . 1 S u rp risin g ly , b o t h s e ts o f d o lla r c r itic s h a v e a d v a n c e d th e s a m e p o lic y p r e s c r ip tio n : in te rv e n e in fo r eig n e x c h a n g e m a rk e ts. In o th e r w o rd s, th e m o n e ta ry a u th o ritie s o f th e U n ite d S ta te s a n d its m a jo r tra d in g p a rtn e rs s h o u ld b u y a n d sell fo reig n c u r r e n c ie s . T h e first se t o f c ritic s u rg e s th is p o lic y to m a n a g e th e f a l l o f th e d o lla r's fo reig n e x c h a n g e valu e, w h ile th e s e c o n d u rg es it to b r in g d o w n th e v a lu e o f th e d o lla r in o r d e r to stim u la te th e U.S. tra d e d g o o d s s e c t o r s .2 T h e p u rp o s e o f th is p a p e r is to e x p la in th e fu n d a m e n ta ls o f c e n tr a l b a n k in te rv e n tio n in fo reig n e x c h a n g e m a rk e ts a n d th e c o n d itio n s re q u ire d fo r it to b e effectiv e. F irst, th e m o tiv es, m e c h a n ic s a n d c o n s e q u e n c e s o f in te rv e n tio n a re d is c u s s e d . N ext, th e r e la tio n s h ip b e tw e e n in te rv e n tio n a n d d o m e s tic m o n e ta ry p o lic y is in v e stig a te d . F in a lly , s o m e q u a lita tiv e a n d q u a n tita tiv e e v id e n c e o n th e e ffic a c y o f in te rv e n tio n is review ed . WHY CENTRAL BANKS INTERVENE Dallas S. Batten and Mack Ott are senior economists at the Federal Reserve Bank of St. Louis. Paul G. Christopher provided research assistance. 1For examples, consider Kraus (1984), Arenson (1984) and Bank for International Settlements (1984). In the last (p. 1), Dr. Gleske, a member of the Directorate of the Deutsche Bundesbank, was some what bemused by the dollar’s persistent high value: There therefore seem to be enough reasons to support expectations that the dollar rate will decline. However, contrary to all historical experi ence, these expectations have not been fulfilled as yet. The markets do not seem to have any expectations of this nature, either. Apparently, investing in dollar assets — especially in the United States itself — continues to be lucrative despite the greater exchange rate risk, and the markets appear up to now to have hardly any doubts that the dollar will remain attractive despite the fact that the fundamental factors like the declining competitiveness of U.S. industry and sharply rising currentaccount deficits operate rather in favour of expecting the opposite. 16 T h e e x c h a n g e ra te is th e p ric e o f o n e c o u n tr y ’s c u r r e n c y in te rm s o f a n o th e r . As th e relativ e p ric e o f tw o a s s e ts (c u rre n c ie s), it is d e te rm in e d b y th e fo rc e s o f d e m a n d a n d su p p ly , a s tire th e p r ic e s o f o th e r a s s e ts , 2Traded goods are those goods that are potentially exportable or importable — whether or not they are actually consumed domestical ly or abroad. For instance, agricultural commodities, airplanes and steel are traded goods, while haircuts, legal services and housing are primarily nontraded goods. The importance of the distinction be tween traded and nontraded goods is that changes in foreign com petition will directly affect production and sales both in the home and foreign markets in the traded goods sector, while only indirectly affecting production and sales in the nontraded goods sector. FEDERAL RESERVE BANK OF ST. LOUIS s u c h as sto ck s, b o n d s o r re a l e s t a te .3 M o reov er, th e re la tiv e v a lu a tio n s o f a n d y ie ld s o n n o n -c u r r e n c y a s s e ts a lso have, as w e s h a ll see , larg e im p a c ts o n th e e x c h a n g e ra te . U nlike th e p r ic e s o f s e rv ic e s o r n o n d u ra b le g o o d s, a s s e t p ric e s re fle c t p rim a rily th e m a rk e t’s e x p e c ta tio n s a b o u t fu tu re e c o n o m ic c o n d itio n s . C o n s e q u e n tly , in th e s h o rt ru n , e x c h a n g e ra te s s h o u ld b e in flu e n c e d p re d o m in a n tly b y new in fo rm a tio n — th a t is, s u rp ris e s — w h ic h a lte rs e x p e c ta tio n s o f fu tu re e v e n ts; th e s e s u rp ris e s le a d to h ig h ly u n p r e d ic ta b le a n d o fte n s iz a b le m o v e m e n ts in e x c h a n g e ra te s . B e c a u s e n e w s c a n b e in c o r r e c t a n d b e c a u s e m a rk e ts c a n o v e rre a ct to n e w s even w h e n it is c o r r e c t, m o n e ta ry a u th o ritie s ty p ica lly b eliev e th a t m u c h o f th e s h o rt-ru n v o latility e x h ib ite d b y fo reig n e x c h a n g e m a rk e ts is e x c e s s iv e .4 C o n s e q u e n tly , in te rv e n tio n is fre q u e n tly ra tio n a liz e d b y c e n tra l b a n k s as a m e a n s to r e d u c e th e p re s u m e d e x ce s s iv e v ariab ility o f e x c h a n g e ra te m o v e m e n ts r e su ltin g fro m th e v aria b ility o f m a rk e t e x p e c ta tio n s .5 In th e lo n g ru n , m o v e m e n ts o f e x c h a n g e ra te s te n d to w ard a re la tio n s h ip a m o n g c u r r e n c ie s k n o w n a s p u r c h a s in g p o w e r p a rity (PPP). T h a t is, a d o lla r o r y e n o r d e u ts c h e m ark (DM) w o u ld e a c h p u r c h a s e th e sa m e a m o u n t o f g o o d s w h e th e r e x p e n d e d at h o m e o r a b ro a d . T h u s, a c o u n tiy w ith a relativ ely ra p id in fla tio n ra te w ill have its c u r r e n c y d e c lin e in v a lu e relativ e to th e c u r r e n c ie s o f c o u n tr ie s w ith s lo w e r in fla tio n ra te s. I g n o r in g lo n g -r u n c o n s id e r a t io n s , fr e q u e n t a n d o ffsettin g e x c h a n g e ra te m o v e m e n ts in th e s h o rt o r 3Policymakers sometimes argue that it is too important to be deter mined solely by market forces. Consider, for example, the view of Dr. Otmar Emminger, former President of the Deutsche Bundesbank, as expressed in a speech to a Bankers’ Forum at Georgetown Universi ty, Washington, D.C., on September 28,1981 (see Bank for Interna tional Settlements [1982], p. 4): The exchange rate is far too important a price — because of its effects on domestic stability and activity, the balance of payments, and interna tional trade and payments relations— to be treated with ‘benign neglect' as a 'residual outcome' of domestic monetary and other economic policies. This should not be misunderstood as a call for activism and interventionism in the field of exchange rates. It cannot be emphasised too much that the most important foundation for exchange rate stability is a policy of monetary and financial stability at home. We would, however, delude ourselves if we believed that all that is required for stable exchange rates is the pursuit of a steady money supply policy. Short and medium-term strains and disturbances are built-in elements in the field of payments and exchange markets, even if we had firm international agreement and successful implementation of concerted money supply policies. MAY 1984 in te rm e d ia te te rm c a n b e m o re th a n ju s t a n u is a n c e to m o n e ta iy a u th o ritie s — th e y a lso c a n hav e re a l e ffe cts. F o r e x a m p le , a n a p p r e c ia tio n o f th e e x c h a n g e ra te b e y o n d th a t n e c e s s a r y to o ffset th e in fla tio n d ifferen tial b e tw e e n tw o c o u n tr ie s (te rm e d ‘‘o v e r sh o o tin g ”) ra is e s th e p ric e o f tra d e d g o o d s in th e h o m e c o u n try relativ e to th e p ric e s o f tra d e d g o o d s in th e re s t o f th e w o rld . T h u s , h o m e c o u n tiy e x p o rts b e c o m e le s s c o m p e titiv e in w o rld m a rk e ts a n d h o m e c o u n try im p o rt s u b s titu te s le s s c o m p e titiv e in d o m e s tic m a rk e ts. C o n se q u e n tly , s a le s o f tra d e d g o o d s d e c lin e , g e n e r a tin g u n e m p lo y m e n t in th e tra d e d g o o d s s e c t o r a n d , su b s e q u e n tly , in d u c in g a sh ift o f r e s o u r c e s fro m th e tra d e d to th e n o n tra d e d g o o d s s e c to r. T h is re a llo c a tio n o f r e s o u r c e s is e ffic ie n t fo r th e e c o n o m y if th a t p o rtio n o f th e e x c h a n g e ra te a p p r e c ia tio n in e x c e s s o f th e in fla tio n d iffe ren tia l is p e rm a n e n t. I f th is e x c e s s p o r tio n o f th e e x c h a n g e ra te a p p r e c ia tio n is s h o rt-liv e d (i.e., re v e rse d in th e n e a r fu tu re), th e c o r r e s p o n d in g m o v e m e n t o f r e s o u r c e s w ill b e r e v ersed , a n d th e e c o n o m y w ill have e x p e r ie n c e d u n n e c e s s a iy u n e m p lo y m e n t d u e to th e c o s ts o f sh iftin g re s o u r c e s , re a llo c a tin g ca p ita l, lay in g o ff a n d h irin g. M o n e ta ry a u th o ritie s w h o w is h to avoid s u c h s itu a tio n s m ay in te rv e n e to o p p o s e e x c h a n g e ra te m o v e m e n ts th a t th e y b elie v e w ill n o t p e rs is t. T h is is a fe a s ib le p o lic y , h o w e v e r, o n ly if th e y c a n d is tin g u is h te m p o ra iy e x c h a n g e ra te flu c tu a tio n s fro m p e rm a n e n t o n e s .6 E x c h a n g e ra te c h a n g e s a lso a ffect th e g e n e ra l p ric e level a n d m a y g e n e r a te s o m e m e a s u re d s h o rt-ru n in fla tio n o r d is in fla tio n a s m a rk e ts a d ju s t to th e c h a n g in g relativ e p ric e o f tra d e d to n o n tra d e d g o o d s . In p a r tic u lar, a n e x c h a n g e ra te d e p re c ia tio n ra is e s th e d o m e s tic c u rre n c y p r ic e o f im p o r ts a n d , th u s , ra is e s th e d o m e s tic p ric e level. B e c a u s e th e to ta l im p a c t o f th is c h a n g e is n o t felt all a t o n c e , th e p ric e level c o n tin u e s to rise fo r s o m e tim e . T h u s , s in c e e x c h a n g e ra te d e p re c ia tio n u su a lly p r e c e d e s c h a n g e s in d o m e s tic p ric e s , it m ay a p p e a r to c a u s e in fla tio n .7 6This distinction is difficult to make in practice. As Martin Feldstein (1983), p. 48, observed: [TJhere is no way in practice to distinguish an exchange-rate movement that is merely a random fluctuation from one that is part of a fundamental shift in the equilibrium exchange rate. Exchange-market intervention aimed at smoothing a transitory disturbance may in fact be a counterpro ductive or futile attempt to prevent a basic shift in the equilibrium ex change rate. 4This concern, however, appears to be misdirected as Bergstrand (1983) has demonstrated that exchange rates are actually less vari able than other asset prices. Furthermore, this overshooting may occur because asset markets clear more rapidly than do goods markets, and, as a result, it may not be undesirable. 5For additional support for this characterization, see Kubarych (1983), pp. 16-19 and 43-45. 7For a more detailed discussion of the relationship between domestic inflation and exchange rate changes, see Batten and Ott (1983). 17 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Figure 1 U.S. Intervention to Support the Deutsche Mark Federal Reserve Banks (FRB) + DM deposits at B + Reserves of cb U.S. Commercial Banks (cb) + Reserves - DM deposits at Gcb F in ally, m a n y d o m e s tic r e s id e n ts , firm s a n d , e s p e cially, m u ltin a tio n a l c o r p o r a tio n s have fin a n c ia l a s s e ts a n d lia b ilitie s d e n o m in a te d in fo reig n c u r r e n c ie s . E x c h a n g e ra te c h a n g e s , th e n , p r o d u c e w e a lth e ffe cts s in c e th e y g e n e r a te c a p ita l lo s s e s a n d g a in s. F o r e x a m p le, if th e U.S. e x c h a n g e ra te u n e x p e c te d ly a p p r e c ia te s , th e d o lla r v a lu e s o f fo r e ig n -c u r r e n c y -d e n o m in a te d a s s e ts a n d lia b ilitie s fall. H e n ce , U.S. n e t m o n e ta iy d e b to rs in fo re ig n c u r r e n c ie s e x p e r ie n c e g a in s, a n d n e t c re d ito rs e x p e r ie n c e lo s s e s .8 In s u m , c h a n g e s in e x c h a n g e r a te s h a v e c o n s e q u e n c e s th a t m o n e ta iy a u th o ritie s m a y d e e m u n d e sira b le. T h u s, h av in g c h o s e n n o t to a llo w e x c h a n g e ra te s to b e c o m p le te ly m a rk e t-d e te rm in e d , m a n y c e n tra l b a n k s in te rv e n e p e rio d ic a lly in fo reig n e x c h a n g e m a rk e ts to m itig a te w h a t th e y b elie v e to b e tra n sie n t b u t d e le te r io u s e ffe c ts o f e x c h a n g e ra te m o v e m e n ts o n th e d o m e s tic e c o n o m y . HOW CENTRAL BANKS INTERVENE T h e m e c h a n ic s o f c e n tr a l b a n k in te rv e n tio n in fo r e ig n e x c h a n g e m a rk e ts c a n tak e a v a riety o f fo rm s. T h e g e n e ra l p u rp o s e o f e a c h varian t, h ow ev er, is b a sica lly th e s a m e : a u g m e n t th e m a rk e t d e m a n d fo r o n e c u r r e n c y b y a u g m e n tin g th e m a rk e t s u p p ly o f a n o th e r . An e x h a u stiv e e x p la n a tio n o f th e w a y s in w h ic h in te rv e n tio n c a n b e c o n d u c te d is b e y o n d th e s c o p e o f th is p a p e r .9 In s te a d , w e w ill d e s c r ib e th e m o s t fre q u e n tly Bundesbank(B) + DM deposits of FRB German Commercial Banks (Gcb) - Reserves - DM deposits of cb - Reserves of Gcb e m p lo y e d m e th o d — in te rv e n tio n b y th e m o n e ta iy a u th o rity . A Typical Example S u p p o s e th a t th e d o lla r is b e lie v e d to b e ov ervalu ed . T h e F e d e ra l R eserv e B a n k o f N ew York, w h ic h a c ts as th e a g e n t fo r U.S. fo re ig n e x c h a n g e m a rk e t in te rv e n tio n s , w ill p u r c h a s e fo reig n c u rre n c y , ty p ic a lly DM , w ith U.S. d o lla rs . 1 0 It c a n d o th is sim p ly b y c re a tin g d o lla r re se rv e s a n d u s in g th e m to p u r c h a s e D M . In p a rtic u la r, th e F e d c a n p u r c h a s e D M -d e n o m in a te d d e p o sits o f U.S. b a n k s a t G e rm a n b a n k s a n d p a y fo r th e m b y c re d itin g th e re serv e a c c o u n ts o f th e s e U.S. b a n k s. T h e F e d th e n p r e s e n ts to th e B u n d e s b a n k d ra fts d raw n a g a in st a c c o u n ts o f th e s e U.S. b a n k s a t G e rm a n b an k s, w h ic h a re s u b s e q u e n tly c le a r e d b y th e B u n d e s b a n k . T h e im p a c t o f th is tr a n s a c tio n o n th e fin a n c ia l in s titu tio n s involved is o u tlin e d in fig u re 1. In g e n e ra l, th e re se rv e s o f th e U.S. b a n k in g s y s te m in c r e a s e , w h ile th o s e o f th e G e rm a n b a n k in g s y s te m fall. T h e c h a n g e s in th e re serv e p o s itio n s o f th e U n ite d S ta te s a n d G er m a n y th a t re su lt fro m th is fo reig n e x c h a n g e o p e ra tio n w ill c a u s e th e U.S. m o n e y s to c k to ris e a n d G e rm a n y 's m o n e y s to c k to fall. C o n v ersely , if th e B u n d e s b a n k b elie v e s th e DM to b e u n d e rv a lu e d (i.e., th e d o lla r is overvalued), it c o u ld r e d u c e th e q u a n tity o f D M rela tiv e to d o lla rs. T h is tr a n s a c tio n is slig h tly m o re c o m p lic a te d th a n w h e n th e F e d in te rv e n e s in s u p p o rt o f th e D M . F irst, th e B u n d e s b a n k m u s t a c q u ire d o lla rs. It ty p ic a lly d o e s th is 8A net monetary foreign currency debtor is an individual or firm with greater monetary debts than monetary claims in a foreign currency. Thus, when that foreign currency depreciates, his foreign liabilities decline in value more than his foreign assets, and, on net, his wealth rises. Similarly, a foreign currency depreciation would lower the wealth of a net monetary foreign currency creditor. 9See Balbach (1978) for a detailed analysis of various forms of in tervention. Digitized for18 FRASER e ith e r b y se llin g s o m e o f its n o n -n e g o tia b le U.S. T re a s u iy s e c u r itie s to th e F e d o r b y b o rro w in g fro m th e 10ln the United States, the Federal Reserve Bank of New York inter venes for the Federal Reserve System and the U.S. Treasury. The decision to intervene, however, is made by the U.S. Treasury. FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Figure 2 German Intervention to Support the Deutsche Mark Federal Reserve Banks (FRB) + Treasury securities U.S. Commercial Banks (cb) + $ deposit of B -T reasury securities (1) (2) German Commercial Banks (Gcb) Bundesbank (B) + $ deposit at FRB - $ deposit of B - DM deposits at Gcb + Reserves of cb + Reserves F e d in e x c h a n g e fo r a d o lla r-d e n o m in a te d a c c o u n t th ro u g h a sw ap a rra n g e m e n t a lre a d y e s ta b lis h e d b e tw e e n th e tw o. T h e s e a c q u ire d d o lla rs a re th e n u s e d to b u y DM in th e fo reig n e x c h a n g e m a rk e t. - $ deposit at FRB - Reserves of Gcb - Reserves - DM deposits of cb itie s d o n o t w a n t th e ir fo re ig n e x c h a n g e m a rk e t in te rv e n tio n to a ffect th e ir d o m e s tic e c o n o m ie s , th e y m a y s te r iliz e its im p a c t w ith a n o ffs e ttin g s a le o r p u r c h a s e o f d o m e s tic a s s e ts . In figu re 2, s te p 1 d e p ic ts th e a c q u is itio n b y th e S te riliz ed in te rv e n tio n w o u ld b e th e p re fe rre d p r o B u n d e s b a n k o f a d o lla r-d e n o m in a te d d e p o s it a t th e F e d . S in c e th is tr a n s a c tio n is b e tw e e n c e n tr a l b a n k s, it d o e s n o t affect th e re s e rv e s o f th e b a n k in g sy s te m in e ith e r co u n try a n d , h e n c e , d o e s n o t affect e ith e r c o u n try ’s d o m e s tic m o n e y su p p ly . In s te p 2, th e B u n d e sb a n k p u r c h a s e s D M -d e n o m in a te d d e p o s its o f U.S. c o m m e rc ia l b a n k s h e ld a t G e rm a n c o m m e r c ia l b a n k s w ith d o lla rs. T h is tr a n s a c tio n is c le a r e d b y U.S. b a n k s p r e s e n tin g to th e F e d d o lla r - d e n o m in a t e d c la im s a g a in st th e B u n d e s b a n k a n d re c e iv in g re se rv e s in r e c e d u re if th e F e d d id n o t w a n t th e U.S. b a n k in g sy s te m ’s re s e rv e s to c h a n g e . T h u s , if th e u n s te r iliz e d in te rv e n tio n in te r fe r e d w ith th e g o a ls o f d o m e s tic m o n e ta r y p o lic y , th e F e d c o u ld se ll U.S. T re a s u ry s e c u ritie s in U.S. fin a n c ia l m a rk e ts e q u a l to th e a m o u n t o f re serv e s c r e a te d b y th e in te rv e n tio n . W ith th is tr a n s a c tio n , th e level o f re s e rv e s in th e U.S. b a n k in g sy ste m w o u ld re tu rn to its p re in te rv e n tio n level, a n d , as a re su lt, th e re w o u ld b e n o s u b s e q u e n t c h a n g e in th e U.S. m o n e y su p p ly . tu rn . (At th e s a m e tim e , th e F e d r e d u c e s its d e p o s it lia b ilitie s to th e B u n d e s b a n k .) L ik ew ise, th e B u n d e sb a n k c le a rs th e d raft it p u r c h a s e d fro m U.S. b a n k s b y lo w e rin g its re serv e lia b ilitie s to G e rm a n b a n k s. A nd finally, G erm an b a n k s, p r e s e n te d w ith a d raft a g a in st d e p o s its o f U.S. b an k s, r e d u c e th e ir d e p o s it lia b ilitie s to th e s e b a n k s b y th e a m o u n t o f th e r e d u c tio n in th e ir re serv e d e p o s its at th e B u n d e s b a n k . T h e fin al re s u lt is th e s a m e as in th e p re c e d in g c a s e — th e re se rv e s o f th e U.S. b a n k in g s y s te m rise, w h ile th o s e in th e G erm an b a n k in g sy ste m fall. Sterilized vs. Unsterilized Intervention T h e tw o e x a m p le s d is c u s s e d ab ove a re in s ta n c e s o f u n ste riliz e d in te rv e n tio n ; th a t is, th e d o m e s tic m o n e y su p p lie s hav e n o t b e e n in s u la te d fro m th e fo reig n e x c h a n g e m a rk e t tr a n s a c tio n . I f u n s te riliz e d in te rv e n tio n is u n d e rta k e n in larg e a m o u n ts , it w ill a ffect n o t o n ly th e m o n e y s u p p lie s o f b o th c o u n trie s , b u t d o m e s tic p rice s a n d in te r e s t ra te s a s w ell. If m o n e ta ry a u th o r Sim ilarly, th e B u n d e s b a n k c o u ld n e u tr a liz e th e im p a c t o f in te rv e n tio n o n th e G e rm a n m o n e y s u p p ly by in je c tin g n e w re se rv e s in to its b a n k in g sy ste m . If s te r il iz e d c o m p le t e ly , th e fo r e ig n e x c h a n g e o p e r a t io n w o u ld n o t a ffect e ith e r c o u n tr y ’s m o n e y su p p ly . T h u s, in th e c a s e o f a c o m p le te ly s te riliz e d in te rv e n tio n , p r iv a te p o r t f o lio s w o u ld c o n t a in fe w e r D M d e n o m in a te d s e c u r itie s a n d m o re d o lla r-d e n o m in a te d s e c u ritie s , w h ile th e F e d ’s p o rtfo lio w o u ld c o n ta in m o re D M -d e n o m in a te d s e c u r itie s a n d fe w e r d o llard e n o m in a te d o n e s . TH E EXCHANGE RATE CONSEQUENCES O F CENTRAL BANK INTERVENTION E x c h a n g e ra te m o v e m e n ts re fle c t tw o fu n d a m e n ta l c h a r a c te r is tic s th a t m u s t b e r e c o g n iz e d to u n d e rs ta n d th e im p a c t o f in te rv e n tio n . F irst, c h a n g e s in e x c h a n g e ra tes, like c h a n g e s in th e p ric e o f a n y a s s e t, a re h ig h ly 19 FEDERAL RESERVE BANK OF ST. LOUIS irre g u la r a n d u n p r e d ic ta b le in th e s h o rt ru n , re fle c tin g p rim a rily n e w e v e n ts th a t a lte r th e m a rk e t’s e x p e c ta tio n s o f fu tu r e e x c h a n g e ra te m o v e m e n ts . S e c o n d , s in c e th e e x c h a n g e ra te is th e relativ e p ric e o f tw o c u r r e n c ie s , its m o v e m e n ts re fle c t c h a n g e s in p o lic ie s th a t a ffect e ith e r th e s u p p lie s o f th e s e c u r r e n c ie s o r th e d e m a n d s to h o ld th e m . M o re sp e c ific a lly , e x c h a n g e ra te s re fle c t a n tic ip a te d relativ e in fla tio n ra te s th a t a re g e n e r a te d b y b o th p a s t a n d e x p e c te d fu tu re p o licy a c tio n s o f th e c o u n tr ie s involved . T h e re fo re , c u r r e n c ie s o f c o u n trie s w ith lo w e r e x p e c te d in fla tio n ra te s a re c h e a p e r to h o ld a n d a re in g re a te r d e m a n d th a n th o s e o f c o u n trie s w ith h ig h e r in fla tio n ra te s, all o th e r th in g s e q u a l. C o n s e q u e n tly , it fo llo w s fro m PPP th a t c u r r e n c ie s o f h ig h e r-in fla tio n c o u n tr ie s te n d to d e p re c ia te relativ e to th o s e o f lo w e r-in fla tio n c o u n trie s . T h e d iffe ren t im p a c ts o f s te riliz e d a n d u n ste riliz e d in te rv e n tio n o n th e e x c h a n g e ra te c a n b e a n a ly z e d in te rm s o f th e s e tw o c h a r a c te r is tic s . S u p p o s e , a s o u t lin e d above, th a t e ith e r th e F e d o r th e B u n d e s b a n k p u r c h a s e s DM w ith U.S. d o lla rs. T h is tr a n s a c tio n in c r e a s e s th e s h o rt-ru n flow d e m a n d fo r DM relativ e to th e s u p p ly o f D M a n d s h o u ld re s u lt in a n a p p r e c ia tio n o f th e D M , all o th e r th in g s e q u a l. T h is im p a c t w ill b e o n ly tra n s ito iy , h o w ev er, u n le s s th e c e n tr a l b a n k c o n tin u e s to p u r c h a s e DM d a y a fte r day, th e re b y m a in ta in in g th e h ig h e r flow d e m a n d fo r DM . MAY 1984 a s s e t p r ic e s u n le s s th e ir a ctiv ity is s u b s ta n tia l o r th e ir a c tio n s a ffect m a rk e t e x p e c ta tio n s . T h is in te rv e n tio n m a y a ffe ct m a rk e t e x p e c ta tio n s a b o u t relative a s s e t y ie ld s a n d p ric e s if m a rk et p a rtic i p a n ts in te rp re t th e e x p a n s io n o f th e U.S. m o n e y su p p ly a s a n in d ic a to r o f a p e r m a n e n t in c r e a s e in th e ra te o f m o n e ta ry g ro w th p la n n e d b y th e F e d . S u c h e x p e c ta tio n s o f fu rth e r e a s in g o f U.S. m o n e ta ry p o lic y w ill c a u s e m a rk e t p a rtic ip a n ts to a n tic ip a te in c r e a s e s in th e ra te o f U.S. in fla tio n relativ e to G e rm a n in flatio n . T h e s e e x p e c ta tio n s o f rela tiv ely h ig h e r fu tu re U.S. in fla tio n w ill d e c r e a s e th e d e s ire o f fo re ig n e rs to h o ld d o l la rs s in c e th e y e x p e c t th e d o lla r ’s p u r c h a s in g p o w e r to c o n tin u e to fall. C o n s e q u e n tly , th e D M v a lu e o f th e d o lla r w ill d e p r e c ia te a t a ra te e q u a l to th e d iffe re n ce b e tw e e n th e n o w h ig h e r a n tic ip a te d ra te o f in fla tio n in th e U n ite d S ta te s a n d th a t in G e rm a n y .1 1 If th e in te rv e n tio n is ste riliz e d , its im m e d ia te im p a c t is th e sa m e a s th a t fo r u n s te r iliz e d in te rv e n tio n ; th a t is, it g e n e r a te s a te m p o ra ry in c r e a s e in th e flow d e m a n d fo r D M . T h e n e t e ffe c t o f th is s te riliz e d in te rv e n tio n is sim p ly th a t p riv ate p o rtfo lio s w ill c o n ta in m o re d o lla rd e n o m in a te d a n d fe w e r D M -d e n o m in a te d s e c u ritie s ; n e ith e r c o u n tr y ’s m o n e y s u p p ly w ill b e a ffe cte d . C o n se q u e n tly , it is n o t c le a r w h a t la stin g im p a c t th is ty p e o f in te rv e n tio n w ill hav e o n th e D M /dollar e x c h a n g e rate. M o re im p o rta n tly , s in c e th is tr a n s a c tio n is u n s te ril ized , it c a u s e s th e U.S. m o n e y s u p p ly to rise a n d th e G e rm a n m o n e y s u p p ly to fall. If larg e e n o u g h , th is in te rv e n tio n h a s tw o p o te n tia l e ffe c ts : a tr a n s ie n t effe ct o n th e c u r r e n t m a rk e ts fo r th e tw o c u r r e n c ie s a n d a p e r m a n e n t e ffe ct o n e x p e c te d fu tu re rela tiv e in fla tio n r a te s . O th e r th in g s e q u a l, th e re s u ltin g e x c e s s s u p p ly o f U.S. m o n e y in th e U n ite d S ta te s a n d e x c e s s d e m a n d fo r G e rm a n m o n e y in G e rm a n y w ill c a u s e th e tw o c o u n t r ie s ’ m o n e y m a rk e ts to c le a r a t lo w e r a n d h ig h e r ra te s o f in te re s t, re sp ectiv ely . T h is im m e d ia te , b u t tra n sito ry , e ffe ct w ill c a u s e th e d o lla r to d e c lin e relativ e to th e DM B e c a u s e s te riliz e d in te rv e n tio n e n ta ils a s u b s titu tio n o f d o lla r-d e n o m in a te d s e c u r itie s fo r D M -d e n o m in a te d o n e s , h ow ev er, th e e x c h a n g e ra te w ill b e p e rm a n e n tly a ffe cte d o n ly if th e in v e sto rs view d o m e s tic a n d fo reig n s e c u ritie s a s b e in g im p e r f e c t s u b s titu te s . If th is is th e c a s e , in v e sto rs w ill b e u n w illin g to h o ld th e n e w p o r t folio at u n c h a n g e d e x c h a n g e a n d in te re s t ra te s. In fact, at th e o rig in a l e x c h a n g e a n d in te r e s t ra te s, a n e x c e s s d e m a n d fo r D M -d e n o m in a te d s e c u r itie s w ill a ris e . C o n se q u e n tly , in v e sto rs w ill a tte m p t to a c q u ire a d d i tio n a l D M -d e n o m in a te d s e c u r itie s in o r d e r to r e tu rn th e ir p o rtfo lio s to th e d e s ire d p ro p o rtio n o f d o llard e n o m in a te d s e c u ritie s , th e re b y p la c in g d o w n w ard as G e rm a n a s s e ts te m p o ra rily have h ig h e r y ie ld s th a n p re s s u re o n th e DM v alu e o f th e d o lla r. U.S. a s s e ts . If in v e sto rs c o n s id e r th e s e s e c u r itie s to b e p e r fe c t su b s titu te s , o n th e o th e r h a n d , n o c h a n g e in e ith e r th e W h e th e r th is e ffe c t o n th e e x c h a n g e ra te is la stin g o r tra n sie n t, h ow ev er, d e p e n d s c ru c ia lly o n th e e x p e c ta tio n s o f in v e sto rs h o ld in g U.S. a n d G e rm a n a s s e ts . If th e s e e x p e c ta tio n s a re u n c h a n g e d , in d iv id u a ls h o ld in g U.S. a s s e ts w o u ld se ll th e m — d rivin g u p th e ir y ie ld s — a n d b u y G e rm a n a s s e ts — d e p re s s in g th e ir y ie ld s — th e re b y te n d in g to o ffset th e centred b a n k ’s a c tio n s . T h a t is, ju s t as a sin g le p riv ate in d iv id u a l in a c o m p e ti tive m a rk e t c a n have n o e ffe c t o n a s s e t p ric e s b y h is s a le s o r p u rc h a s e s , so ev en c e n tr a l b a n k s w ill n o t a ffect Digitized for20 FRASER "T h is discussion is oversimplified in that it isolates only two curren cies and the exchange rate between them. In the real world, there are numerous currencies and exchange rates. Attempts to affect the exchange rate between any pair of currencies necessarily affect not only the exchange rate between this pair, but all other exchange rates as well. Consequently, intervention to move one exchange rate in a desirable direction or to calm fluctuations in that exchange rate may cause another exchange rate to move in an undesirable direction or to become more volatile. FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 e x c h a n g e ra te o r in in te r e s t ra te s w ill b e n e c e s s a r y to m o tiv ate in v e sto rs to h o ld th is p o rtfo lio . In su m m a ry , w h e n tw o d o m e s tic m o n e y s u p p lie s have b e e n u n a ffecte d b y a n in te rv e n tio n activity, th e in te rv e n tio n c a n have a p e r m a n e n t im p a c t o n th e e x c h a n g e ra te o n ly if fo reig n a n d d o m e s tic s e c u r itie s a re im p e rfe c t s u b s titu te s . c h a n g e ra te m a n a g e m e n t fro m m o n e y s to c k c o n tro l, h ow ev er, d e p e n d s o n w h e th e r c e rta in c o n d itio n s are m e t. F irst, in te rn a tio n a l a s s e ts (in c lu d in g c u rre n c ie s) m u s t b e im p e rfe c t s u b s titu te s . S e c o n d , th e m a g n itu d e o f s te riliz e d in te rv e n tio n u n d e rta k e n m u s t b e large e n o u g h — g iven th e d e g re e o f im p e rfe c t s u b s titu ta b il ity — th a t m a rk e t p a r tic ip a n ts c a n n o t u n d o th is e ffect b y e n g a g in g in o ffse ttin g tr a n s a c tio n s . INTERVENTION AND DOM ESTIC MONETARY PO LICY SOME EVIDENCE ON TH E EFFEC T IV EN ESS O F INTERVENTION T h e fo reg o in g d is c u s s io n h a s e m p h a s iz e d th a t th e r e la tio n s h ip b e tw e e n d o m e s tic m o n e ta ry p o lic y a n d in te rv e n tio n d e p e n d s o n w h e th e r th e in te rv e n tio n is ste riliz e d . D o m e s tic m o n e ta ry p o lic y c a n n o t b e c o n d u c te d in d e p e n d e n tly o f u n s te r iliz e d in te rv e n tio n s in c e , as d is c u s s e d above, it is ta n ta m o u n t to c o n d u c t ing m o n e ta ry p o lic y th ro u g h fo reig n e x c h a n g e m a rk et o p e ra tio n s. T h u s , th e e x c h a n g e ra te is a th ird a lte r n a tive m o n e ta ry ta rg e t v a ria b le to th o s e m o re fre q u e n tly c o n s id e re d — n a m e ly , m o n e ta ry ag g reg a tes o r in te r e s t A sse ssin g th e e ffic a c y o f in te rv e n tio n is d ifficu lt b e c a u s e d a ta o n c e n tr a l b a n k in te rv e n tio n a re n o t m a d e av aila b le; in c o n tr a s t to d o m e s tic c e n tr a l b a n k tr a n s a c tio n s, w h ic h a re r e p o r te d in g re a t d eta il, in te rn a tio n a l tra n s a c tio n s a re r e p o r te d o n ly in a n o n -s y ste m a tic , s u m m a ry fo rm . T h r e e p ie c e s o f q u a lita tiv e e v id e n ce , h ow ev er, c a n b e u s e d to g a u g e th e lik ely e ffe ctiv e n e ss o f in te rv e n tio n . T h e first is a n in d ire c t a s s e s s m e n t o b ta in e d by c o n s id e r in g a d o m e s tic p o lic y e x p e rim e n t, so m e w h a t a n a lo g o u s to s te riliz e d in te rv e n tio n , w h ic h o c c u r r e d in th e e a rly 1 9 6 0 s. T h e s e c o n d is a n a s s e s s m e n t o f th e p o te n tia l fo r th e U.S. m o n e ta ry a u th o ritie s to in flu e n c e th e fo reig n e x c h a n g e m a rk e t b y c o m p a r in g th e v o lu m e o f a s s e ts a n d th e ra te o f tra n s a c tio n s in th e s e m a rk e ts b y p riv a te in v e sto rs w ith th e m o n e ta ry a u th o rity ’s h o ld in g s a n d a ctiv itie s. T h e th ird is a d ire ct a s s e s s m e n t o f U.S. a n d o th e r c e n tr a l b a n k in te rv e n tio n a ctiv ity re v e a le d in a w o rk in g g ro u p s tu d y p r e p a r e d fo r th e 1 9 8 3 W illia m sb u rg E c o n o m ic S u m m it M eetin g . rates. B e c a u s e th e r e c a n b e o n ly o n e m o n e ta ry p o lic y s ta n c e , th e ro le o f u n s te riliz e d in te rv e n tio n d e p e n d s c ru c ia lly o n th e im p o r ta n c e th a t p o licy m a k e rs p la c e o n th e e x c h a n g e ra te a s a n o b je c tiv e fo r m o n e ta ry p o licy . In p a rticu la r, th e u s e o f u n ste riliz e d in te rv e n tio n n e c e s s a rily im p lie s th a t th e m o n e ta ry a u th o rity p la c e s relativ ely m o re im p o r ta n c e o n re d u c in g th e risk s a n d re al e c o n o m ic d is tu r b a n c e s a s s o c ia te d w ith e x c h a n g e ra te m o v e m e n ts th a n a ch ie v in g d o m e s tic targ ets fo r in fla tio n a n d u n e m p lo y m e n t. T h e m a n ip u la tio n o f m o n e ta ry p o lic y to a c h ie v e e x c h a n g e ra te o b je ctiv e s in ev itab ly w ill c o n flic t — o c c a s io n a lly o r fr e q u e n tly — w ith t h e p o lic y s t a n c e r e q u ir e d to a ch iev e th e s e d o m e s tic o b je c tiv e s . F u r th e r m o r e , e x c h a n g e r a te m o v e m e n ts m a y b e m o tiv ate d n o t o n ly b y c h a n g e s in th e d e s ire to h o ld d o m e s tic c u r r e n c y (w h ich p ro b a b ly s h o u ld b e offset by ch a n g e s in th e d o m e s tic m o n e y su p p ly), b u t a lso by a h o s t o f o th e r fa c to rs , e s p e c ia lly th e p o lic ie s fo llo w ed b y fo reig n p o lic y m a k e rs . D ire c tin g d o m e s tic m o n e ta ry p o lic y at a n e x c h a n g e ra te ta rg e t, th e n , s u b je c ts th e An Analogous Policy: Operation Twist A h is to ric a l e x a m p le o f a d o m e s tic p o licy e x p e ri m e n t b y th e F e d e ra l R eserv e th a t is s im ila r to ste riliz e d in te rv e n tio n is “O p e ra tio n T w is t.” D u rin g 1 9 6 1 -6 2 , th e F e d e ra l R eserv e s o ld s h o rt-te rm U.S. s e c u ritie s a n d u s e d th e p r o c e e d s to b u y lo n g -te rm U.S. s e c u r itie s ; as w ith s te r iliz e d in te r v e n tio n , th e t r a n s a c t io n s w e re o ffsettin g so th a t th e m o n e y s u p p ly w a s u n c h a n g e d . T h e r e s u ltin g i n c r e a s e in s h o r t - t e r m g o v e r n m e n t s e c u ritie s a n d th e c o n c o m ita n t d e c lin e in lo n g -te rm g o v e rn m e n t s e c u r itie s in p riv a te p o rtfo lio s w e re in d o m e s tic e c o n o m y to d is tu r b a n c e s fro m b o th d o m e s te n d e d to ra is e th e y ie ld o n s h o rt-te rm s e c u r itie s a n d lo w e r th e y ie ld o n lo n g -te rm s e c u ritie s , th u s, “tw ist tic a n d fo reig n s o u r c e s . C o n s e q u e n tly , th e m o n e ta ry in g ” th e te rm s tr u c tu r e .1 2 a u th o rity lo s e s its a b ility to c o n tr o l its ow n m o n e y In th is effort, th e first c o n d itio n d is c u s s e d ab ove w as m e t — n a m e ly , lo n g -te rm s e c u r itie s b e a r h ig h e r in su p p ly in d e p e n d e n tly o f fo reig n e v en ts. T h e d e s ire to in flu e n c e e x c h a n g e ra te m o v e m e n ts w ith o u t lo s in g c o n tr o l o f th e d o m e s tic m o n e y su p p ly is th e p rim a ry m o tiv a tio n fo r u s in g s te riliz e d in te rv e n te r e s t r a te s th a n s h o rt-te rm s e c u ritie s , a n d , th u s , th e tio n . W h e th e r a m o n e ta ry a u th o rity c a n s e p a ra te e x ,2See Malkiel (1966), pp. 219-43. 21 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 C h a rt 1 Relative Stocks of H o ld in g s of Foreign Assets Billions of dollars Billions of dollars ------------------------ , 8 0 0 8 0 0 1------------------------ 700 700 F o r e ig n - o w n e d assets in the U n i t e d States LL 600 -a too U . S . tot a l f o re ig n res erv es minus gold 2 500 soo 400 400 300 300 200 200 100 100 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 Sources: Board o f G overnors o f the F ederal Reserve System and U.S. D e partm ent o f Commerce |_1 Year-end outstanding. [2 A n n u a l a verage s o f q u a rte rly d a ta . NOTE: D ire ct in ve stm e n t d a ta p rio r to 1977 do not re fle c t 1977 b en chm a rk revision. tw o a s s e ts are im p e rfe c t s u b s titu te s . Yet, th e effort is g en era lly ju d g e d to hav e failed p rim a rily b e c a u s e th e p o lic y w a s n o t e x e c u te d v ig o ro u sly e n o u g h .1 3 T h e p o in t (as e m p h a s iz e d by M alkiel) is th a t a c e n tr a l b a n k p o licy o f affectin g th e te rm s tru c tu r e fo r in te re s t ra te s d e p e n d s , fo r its e ffe c tiv e n e s s , o n tw o p o in ts : th e tio n o f c u r r e n c ie s a n d s e c u r itie s d e n o m in a te d in th o se c u r r e n c ie s is a lte r e d ; tw o m a rk e t a ctiv ities, how ever, a re th e r e b y s e t in m o tio n th a t te n d to u n d o a n y im p a c t o n relativ e in te r e s t ra te s a n d th e e x c h a n g e rate. First, private e n titie s — b a n k s, p rim arily , b u t a lso in d i vid u al tra d e rs — se ll o r b u y s e c u r itie s d e n o m in a te d in b a n k ’s a b ility to a ffect sig n ifica n tly th e relativ e su p p lie s o f sh o rt- a n d lo n g -te rm fin a n c ia l a s s e ts a n d its w illin g th e c u r r e n c ie s th a t hav e b e e n a ffecte d . S e c o n d , a ctu a l cu rre n c y flow s a n d o p tio n s to b u y o r sell c u r r e n c ie s o r n e s s to do so . In th is c a s e o f in te rv e n tio n in d o m e s tic forw ard c o n tr a c ts a re c h a n g e d . T h u s, u n le s s th e c e n a s s e t m a rk ets, th e e x te n t o f th e a ctiv ity w a s in a d e q u a te tra l b a n k is p r e p a r e d to ta k e su ffic ie n t a c tio n s to a lte r to hav e a n y sig n ifica n t im p a c t. m a rk et e x p e c ta tio n s , it w ill b e u n lik ely to a ffect th e Sim ilarly, w h e n s te riliz e d in te rv e n tio n in fo reig n e x c h a n g e m a rk e ts is u n d e rta k e n , th e im m e d ia te d is tr ib u 13As Johnson (1963), cited in Malkiel, p. 234, concludes: Whatever might have been expected of this po licy. . . it was not in fact pursued in any effective sense. As a result primarily of Treasury fund ing operations, the maturity of the debt in the hands of the public has in fact been lengthened appreciably, instead of shortened as the policy would require. Digitized for22 FRASER e x c h a n g e ra te s b y s te riliz e d in te rv e n tio n . The Potential: Foreign Asset Holdings and the Size o f the U.S. Foreign Exchange Market T h e lik e lih o o d th a t in te rv e n tio n c a n a ffect e x c h a n g e ra te s m a y b e a s s e s s e d b y c o m p a r in g e ith e r private a n d FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Chart 2 Relative Investment Flows into Foreign Assets 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 S o u r c e s : B o a r d o f G o v e r n o r s of the F e d e r a l R e s e r v e S y s t e m a n d U.S. D e p a r t m e n t of C o m m e r c e Q A n n u a l rate. [2 P o s i t i v e v a l u e s a r e p u r c h a s e s o f d o l l a r s . N O TE : D ire c t in v e s tm e n t d a ta p r io r to 1 9 7 7 d o n o t re fle c t 1 97 7 b e n c h m a r k re v is io n . c e n tra l b a n k fo reig n a s s e t h o ld in g s o r c e n tra l b a n k activity a n d th e s iz e o f m a rk e ts fo r fo reig n e x c h a n g e . T h e re le v a n ce o f fo reig n a s s e t h o ld in g s is th a t c h a n g in g a n y sin g le e x c h a n g e ra te c h a n g e s th e p r ic e o f th e s e a s s e ts in tw o o r m o re c u r r e n c ie s . C o n s e q u e n tly , e x c h a n g e ra te m o v e m e n ts c a u s e d b y in te rv e n tio n m a y b e p r e s u m e d to in d u c e s h ifts in d e s ire d p o rtfo lio s o f a s s e ts — th a t is, flow s o f a s s e t sa le s a n d p u r c h a s e s th a t te n d to o ffset s u c h c h a n g e s . C h a rt 1 s h o w s th e s to c k s o f fo reig n a s s e ts h e ld by la rg e r s h a re o f a s s e ts tra d e d in in te rn a tio n a l m a rk e ts th a n d o th e F e d a n d th e U.S. T re a s u ry . C o n se q u e n tly , to c h a n g e th e p r ic e a t w h ic h th e s e a s s e ts a re v alu ed w o u ld re q u ire very a g g ressiv e in te rv e n tio n . M a n y h ave a rg u e d th a t th e p rim a ry im p a c t o f in te rv e n tio n is o n th e flo w d e m a n d s fo r th e c u r r e n c ie s involved. If so, o n e s h o u ld c o m p a r e th e flow s o f tr a n s a c tio n s in th e s e m a rk e ts r a th e r th a n a s s e t h o ld in g s . 1 4 F ro m th is p e rs p e c tiv e , c o n s id e r c h a r t 2 — tra n s a c tio n s in in te rn a tio n a l m a rk e ts. C o m p a rin g th e ra te o f a c- U.S. in d iv id u als a n d in s titu tio n s , U.S. a s s e ts h e ld by p riv ate fo re ig n e rs , a n d th e fo re ig n re s e rv e s (m in u s gold) o f th e U.S. F e d e ra l R eserv e S y ste m a n d th e T r e a su ry. It is c le a r th a t p riv a te in v e sto rs h o ld a m u c h 1"This leaves aside, for the moment, the indirect effect of intervention through changes in expectations of future central bank policy, which will be considered later. 23 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Table 1 Market Volume in Foreign Currency Transactions and Federal Reserve-Treasury Combined Intervention (millions of dollars) Foreign Currency Transactions by U.S. Commercial Banks April 1977 (44 banks) March 1980 (90 banks) April 1983 (119 banks) $106,400 5,300 $491,300 23,400 $702,500 33,500 Banks in 1977 survey $103,100 (41 banks) $325,800 (41 banks) $432,600 (40 banks) Banks in 1980 survey N/A $484,000 (87 banks) $648,200 (87 banks) All banks surveyed Monthly average Daily average Combined Intervention by the Federal Reserve and U.S. Treasury February-July 1977 February-July 1980 Total sales of currency Monthly average Daily average1 $212.4 35.4 1.8 $3,982.7 663.8 33.2 Total purchases of currency Monthly average Daily average1 $150.7 25.1 1.3 $6,266.9 1,044.5 52.2 Major episodes during period April 15-M ay 4 Sold $34.8 DM Mid-March-April 8 Purchased $1,396.2 February-July 1983 0 — — $254.12 — 42.4 July 29-August 5 N/A Not available NOTE: Equivalent dollar values converted using exchange rates prevailing at date of transaction. ’ Assumes 20 business days in the average month. 2Because the only transactions during the period were between July 29 and August 5, the period considered includes August 1-5. Consequently, the monthly average calculation is not applicable and the daily average is calculated only for these six days on which intervention took place. SOURCES: Federal Reserve Bulletin, September 1977, September 1980, September 1983; Press Release, Federal Reserve Bank of New York, July 12, 1977, and June 23, 1980, and "Summary of Results of U.S. Foreign Exchange Market Turnover Survey Conducted in April 1983,” Federal Reserve Bank of New York, September 8, 1983. q u isitio n o f fo reig n a s s e ts b y U.S. in v e sto rs w ith th e rate o f in te rv e n tio n b y U.S. m o n e ta ry a u th o ritie s (c o m b in e d U.S. T re a s u ry a n d F e d e ra l R eserv e) c le a rly d e m o n v o lu m e (in th e o b se rv e d m o n th ) p e r b a n k a n d th e s tr a te s th a t th e p riv a te U.S. in v e s tm e n t a ctiv ity o n n u m b e r o f b a n k s w ith s ig n ifica n t in v o lv e m e n t in fo r a n a n n u a l b a sis s w a m p s th a t o f th e a u th o ritie s , a n d , eig n c u r r e n c y m a rk e ts hav e ris e n d ra m a tic a lly s in c e in fact, so h a s th e ra te o f p u r c h a s e o f U.S. a s s e ts by 1 977. T h e to ta l v o lu m e h a s ris e n sev en fo ld , c o m p risin g a q u a d ru p lin g in th e p e r-b a n k v o lu m e (in d ic a te d b y fo re ig n e rs in r e c e n t y e a rs . A n o th e r, p e rh a p s ev en m o re relev a n t, c o m p a riso n w o u ld b e th e tr a n s a c tio n ra te s ov er in te rv a ls s h o rte r th a n a y e a r. T h a t is, it m ig h t b e a rg u ed th a t c h a rt 2 s h o w s n e t fig u res o v er a n irre le v a n tly lo n g tim e p e rio d : w h a t m a tte rs is th e g ro ss v o lu m e o f tr a n s a c tio n s in, say, a m o n th o r a d ay. F ro m th is p e rs p e c tiv e , c o n s id e r th e d a ta in ta b le 1 , w h ic h re p o r ts th e tu rn o v e r s ta tis tic s 24 fo r U.S. b a n k s e n g a g in g in sig n ific a n t v o lu m e s o f fo reig n c u r r e n c y tr a n s a c t io n s .1 5 As th e ta b le sh o w s, b o th th e th e c h a n g e s in th e activ ity o f th e b a n k s o rig in a lly s u r v ey ed in 1977) a n d a trip lin g (from 4 4 to 119) o f th e n u m b e r o f b a n k s a ctiv ely p a rtic ip a tin g in fo reig n cu r15The data in the first half of table 1 are from periodic surveys of U.S. banks that engage in significant foreign exchange market transac tions. These surveys are conducted by the Federal Reserve Bank of New York. For more details about these surveys, see Revey (1981). FEDERAL RESERVE BANK OF ST. LOUIS re n c y m a rk e ts. If th e v o lu m e in c o n t r a c ts d u rin g A pril 1983 is e x p r e s s e d in a d a ily av erag e fo rm , th e m a rk e t in U.S. b a n k s a lo n e is a b o u t $ 3 3.5 b illio n . A lm o st tw o th ird s o f th e s e c o n tr a c ts a re s p o t c u r r e n c y e x c h a n g e s . In c o m p a ris o n , th e ta b le a lso re p o r ts th e c o m b in e d F e d e ra l R eserve-U .S. T re a s u ry in te rv e n tio n fo r th e full s ix -m o n th p e rio d c o n ta in in g e a c h o f th e th r e e survey d a te s a lo n g w ith re p re s e n ta tiv e e p is o d e s o f s ig n ifica n t U.S. in te rv e n tio n . As ev en a c u rs o ry rev iew o f th e d ata reveals, U.S. in te rv e n tio n a ctiv ity h a s b e e n trivial r e la tive to th e v o lu m e o f b a n k tra d in g in c u r r e n c ie s ; o n ly rare ly h a s in te rv e n tio n b e e n m o re th a n a tin y fra c tio n o f th e p riv ate m a rk e t v o lu m e . C o n s e q u e n tly , th e n o tio n th a t th e c e n tr a l b a n k h a s in flu e n c e d th e m a rk e t p ric e o f c u r r e n c ie s — th e ir e x c h a n g e ra te — p u re ly b y a ffe c t ing th e flow v o lu m e o f e x c h a n g e is in c o n s is te n t w ith th e r e c e n t re co rd . Som e Direct Evidence: Report o f the Working G roup on Exchange Market Intervention C e n tra l b a n k in te rv e n tio n — w h e th e r in d o m e s tic a s s e t m a rk e ts o r in te rn a tio n a l c u r r e n c y m a rk e ts — c a n b e effectiv e o n ly if th e m a rk e t is c o n v in c e d th a t th e m o n e ta ry a u th o rity is b o th a b le a n d w illin g to a ffect th e flow s o f tr a n s a c tio n s . In view o f th e g ro w in g siz e o f p rivate c u r r e n c y m a rk e ts a n d th e c o n flic t w ith d o m e s tic in fla tio n p o lic ie s th a t effectiv e in te rv e n tio n w o u ld re q u ire, s u c h a n e ffe ct o n m a rk e t e x p e c ta tio n s a lso s e e m s to b e b e y o n d th e g ra sp o f th e U.S. a u th o ritie s . S u p p o rt fo r th is c o n c lu s io n is p ro v id e d b y th e stu d y o f e x c h a n g e m a rk e t in te rv e n tio n c o n d u c te d b y th e w o rk in g g ro u p e s ta b lis h e d a t th e V ersa ille s S u m m it in 1 9 8 2 .16 T h is r e p o r t is e s p e c ia lly s ig n ific a n t s in c e it re p re s e n ts th e m o s t c o m p re h e n s iv e a n a ly sis o f th e m o tiv es, m e th o d s a n d im p a c ts o f c e n tra l b a n k in te r v e n tio n in fo reig n e x c h a n g e m a rk e ts th a t h a s b e e n c o n d u c te d u s in g a c tu a l in te rv e n tio n d a ta — d a ta u n available to m o st re s e a r c h e r s . W h ile th e w o rk in g g ro u p fo u n d th a t ste riliz e d in te rv e n tio n is n o t to ta lly in effectiv e, its e ffe ct w a s m u c h s m a lle r th a n th a t o f u n s te r iliz e d in te rv e n tio n .1 7 F u r th e rm o re , th e g ro u p fo u n d th a t in te rv e n tio n c o u ld b e effectiv e in th e fa c e o f p e r s is te n t m a rk e t p r e s s u r e s o n ly if it w a s s u p p o r te d b y c o m p le m e n ta r y c h a n g e s in 16Report of the Working Group on Exchange Market Intervention (1983). What follows is a synopsis of the major conclusions drawn in this report. 1Additional support, at least for Germany, is provided by Obstfeld (1983), pp. 184-85, as he concludes that: MAY 1984 d o m e s tic p o licy , e s p e c ia lly m o n e ta ry p o licy . W h e n in c o n s is te n c ie s h a v e a ris e n b e tw e e n d o m e s tic p o lic y a n d e x c h a n g e ra te o b je c tiv e s , th e g ro u p fo u n d th a t in te rv e n tio n (c o u n te r to th e g o a ls o f d o m e s tic policy) w a s fre q u e n tly u s e le s s a n d ev en c o u n te rp ro d u c tiv e in th e a b s e n c e o f s u p p o rtiv e d o m e s tic p o licy . C o n s e q u e n tly , th e m in iste rs , in th e ir sta te m e n t re le a s e d w ith th e w o rk in g g r o u p ’s re p o rt, d o w n p la y e d th e im p o r ta n c e o f s te riliz e d in te rv e n tio n a s a s e p a ra te p o licy to o l: We have reached agreem ent [that], un der the present circum stances, the role of [sterilized] intervention can only be lim ited .. . . Intervention will normally be useful o n ly w h en c o m p le m e n tin g and su p p o rtin g oth er p olicies . 18 CONCLUSION M o st d is c u s s io n s o f th e e ffe ctiv e n e s s o f c e n tra l b an k in te rv e n tio n fo c u s o n e x p e c ta tio n s o f m a rk e t p a rtic i p a n ts a n d h o w in te rv e n tio n a lte rs th e m . Y et, ev en if th e c e n tr a l b a n k is c a p a b le o f a lte rin g m a rk e t e x p e c ta tio n s a b o u t its fu tu re p o lic ie s , s u c h a c h a n g e c a n b e b ro u g h t a b o u t o n ly if th e m a rk e t is c o n v in c e d th a t o th e r p o licy g o a ls — th e d o m e s tic in fla tio n ra te , lev el o f in te re s t ra te s, sta b ility o f d o m e s tic c r e d it m a rk e ts, e tc . — are s u b o rd in a te to e x c h a n g e ra te m a n ip u la tio n . F o r th e U n ite d S ta te s, a t lea st, s u c h a p o lic y s ta n c e w o u ld n o t b e c re d ib le . T h u s , th e e ffic a c y o f e x c h a n g e ra te in te rv e n tio n w o u ld s e e m to b e d im in is h e d g re a tly b y th e p u b lic ’s k n o w le d g e o f th e p rim a c y o f o th e r m o n e ta ry p o lic y o b je c tiv e s . 1 9 The model's verdict was that the Bundesbank has little if any power to influence the exchange rate over that time span [one month] without altering current or expected future money-market conditions [i.e., with out conducting unsterilized intervention], 18Statementonthe Report of the Working Group on Exchange Market Intervention (1983), p. 2. 19Consider again the view of former Bundesbank President Emminger (Bank for International Settlements [1982], pp. 5-6): To sum up: Exchange rate policies cover a wide spectrum: from simply 'having a view’ on the exchange rate to smoothing out disorderly conditions' to avoiding excesses which are palpably far out of line with fundamentals and are disturbing. The instruments range from interven tion to interest rate policy, general monetary and other economic policies, and to official borrowing or lending. There is also a wide spectrum in the use of such policies from country to country. This is partly a question of size. For the United States, there is quite certainly no other solution but free floating. The problems of a more active exchange rate policy are mainly relevant for middle-sized industrial countries. It is therefore natural and understandable that the attitude towards exchange rate policy differs between the United States and other industrial countries. There is also another important difference, which makes the United States a special case. Other industrial countries usually take the dollar as yardstick and intervene against the dollar. For the United States, it is more difficult to decide against which individual currencies they should measure the value of their currency, and against which to intervene in case of need. This is one of the several problems on which the oftrequested joint and concerted intervention policy would founder. 25 FEDERAL RESERVE BANK OF ST. LOUIS R E FE R E N C E S Arenson, Karen W. "Dollar Seen at or Near Peak," New York Times, February 14, 1984. Balbach, Anatol B. “The Mechanics of Intervention in Exchange Markets,” this Review (February 1978), pp. 2-7. Bank for International Settlements. 1982), pp. 2-6. Press Review (February 18, Bank for International Settlements. 1984), pp. 1-5. Press Review (February 7, Batten, Dallas S., and Mack Ott. “ Five Common Myths About Float ing Exchange Rates,” this Review (November 1983), pp. 5-15. Bergstrand, Jeffrey H. “ Is Exchange Rate Volatility ‘Excessive’?” New England Economic Review (September/October 1983), pp. 5-14. Feldstein, Martin. “The World Economy Today,” The Economist (June 11, 1983), pp. 43-48. 26 MAY 1984 Johnson, Harry G. "An Overview of Price Levels, Employment, and the Balance of Payments,” The Journal of Business (July 1963), pp. 279-89. Kraus, Albert L. “Turn in Dollar's Value Already May Be at Hand,” New York Journal of Commerce, February 14, 1984. Kubarych, Roger M. Foreign Exchange Markets in the United revised edition (Federal Reserve Bank of New York, 1983). Malkiel, Burton Gordon. The Term Structure of Interest Rates (Princeton University Press, 1966). Obstfeld, Maurice. "Exchange Rates, Inflation, and the Sterilization Problem: Germany, 1975-1981,” European Economic Review (March/April 1983), pp. 161-89. Report of the Working Group on Exchange Market Intervention estab lished at the Versailles Summit of the Heads of State and Govern ment, June 4, 5, and 6, 1982 (March 1983). Revey, Patricia A. “ Evolution and Growth of the United States For eign Exchange Market,” Federal Reserve Bank of New York Quarterly Review (Autumn 1981), pp. 32-44. Dutch Disease or Monetarist Medicine?: The British Economy under Mrs. Thatcher K. Alec Chrystal T J L HE p e rfo rm a n c e o f th e B ritis h e c o n o m y o v er th e p a s t five y e a rs h a s b e e n th e o b je c t o f w o rld w id e c u r io s ity. M u c h p u b lic ity h a s b e e n fo c u s e d o n th e g o v ern m e n t o f M arg aret T h a tc h e r a n d h e r a p p a re n tly ra d ica l d e p a rtu re fro m th e p o lic ie s p u rs u e d b y h e r p r e d e c e s s o r s . 1 T h is a lle g ed p o lic y d e p a rtu re is s o m e tim e s c o n s id e r e d a "m o n e ta r is t e x p e r im e n t .” 2 C h a rt 1 illu s tra te s s o m e o f th e m a jo r m a c r o e c o n o m ic c h a n g e s in B rita in s in c e M rs. T h a t c h e r ’s e le c tio n to P rim e M in is te r. In fla tio n first ro se th ro u g h 1980, th e n fell b y 1983 to its lo w e st level s in c e th e m id -1 9 6 0 s . In c o n tra s t, u n e m p lo y m e n t ro se a fte r 19 7 9 to its h ig h e s t level s in c e th e 1930s. B y th e e n d o f 1983, u n e m p lo y m e n t w a s m o re th a n d o u b le th a t fo llo w in g th e p re v io u s w o rst r e c e s sio n (1 9 7 3 -7 5 ) in th e p o s tw a r p e rio d . C ritics o f M rs. T h a tc h e r c la im th a t th e s e e v e n ts a re p rim arily th e re s u lt o f th e tig h t a g g reg a te d e m a n d (m o n etarist) p o lic ie s o f h e r g o v e rn m e n t a n d , fu rth e r, th a t th e p r ic e p a id fo r re d u c in g in fla tio n h a s b e e n to o K. Alec Chrystal, professor of economics-elect, University of Shef field, England, is a visiting scholar at the Federal Reserve Bank of St. Louis. Leslie Bailis Koppel provided research assistance. h ig h . T h e p u rp o s e o f th is p a p e r is to p o in t o u t th a t th is in te rp re ta tio n o f e v e n ts is m isle a d in g . A n im p o rta n t fe a tu re o f th e c h a n g in g e m p lo y m e n t levels in B ritain h a s b e e n th a t jo b lo sse s o c c u rre d alm ost e n tire ly in th e m a n u fa c tu rin g s e c to r . In 1979, th is s e c to r p ro v id ed a b o u t 2 8 p e r c e n t o f to ta l e m p lo y m e n t. B e tw e e n th e e n d o f 1 9 7 8 a n d th e e n d o f 1982, th e r e w as a 1.4 m illio n rise in th e n u m b e r o f u n e m p lo y e d . O ver th e s a m e p e rio d , th e n u m b e r e m p lo y e d in m a n u fa c tu rin g in d u s trie s fell b y 1.5 m illio n . T h is jo b lo s s c a n b e tr a c e d to a su b s ta n tia l a n d s u s ta in e d c o lla p s e o f m a n u fa c tu rin g p r o d u c tio n (ch a rt 2) b e tw e e n la te 1979 an d th e e n d o f 1980. T h u s, a n y e x p la n a tio n o f u n e m p lo y m e n t’s s te e p rise in B rita in m u st b e a b le to e x p la in th e c o lla p s e in th e m a n u fa c tu rin g s e c to r, a c o lla p s e th a t w a s e ss e n tia lly c o m p le te d w ith in 18 m o n th s o f M rs. T h a tc h e r takin g office. N e ith e r m o n e ta ry n o r fis c a l p o licy , a lo n e o r ta k e n to g e th e r, h a s b e e n so tig h t a s to e x p la in su f ficie n tly w h a t h a s h a p p e n e d in B rita in . R a th e r, a m o re lik ely c o n tr ib u to r to u n e m p lo y m e n t c o m e s fro m th e s tru c tu ra l c h a n g e s in th e B ritis h e c o n o m y c a u s e d b y N orth S e a oil p ro d u c tio n . T h e s c e n a r io is n o w w id ely 1Mrs. Thatcher came to power five years ago on May 3, 1979. She was reelected for a second term in June 1983 and may stay in office until June 1988 without recourse to a further general election. te rm e d th e "D u tch D is e a s e ," s o -c a lle d b e c a u s e o f th e n eg ative im p a c t th a t D u tc h oil a n d g a s p r o d u c tio n h ad 2See, for example, Gould, Mills and Steward (1981), Kaldor (1982), and Buiter and Miller (1981). o n e m p lo y m e n t a n d o u tp u t in th e n o n -o il tra d e d g o o d s s e c to r o f th e N e th e rla n d s ’ e c o n o m y . 27 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Chart 1 inflation and Unemployment Inflation Percent Inflation Percent Unemployment Percent Q uarterly in fla tio n c alcula ted as ((C P Ij/C P I^ ) -1)) * 100. A nnual averages are taken from qu arte rly fig u re s fo r in fla tio n and from m o n th ly fig u re s fo r unem ploym ent. B efo re d is c u s s in g th e im p a c t o f N orth S e a o il p r o d u c tio n o n th e B ritis h e c o n o m y , h ow ev er, it is n e c e s sary to s h o w w h y tw o o th e r w id ely c la im e d c a u s e s — B ritis h p o lic ie s a n d th e w o rld w id e r e c e s s io n — are in a d e q u a te e x p la n a tio n s . BRITAIN B E F O R E THATCHER M a c r o e c o n o m ic p o licy in th e 1 9 5 0 s a n d 1 9 6 0 s w as d o m in a te d b y th e c o m m itm e n t to m a in ta in a fixed e x c h a n g e ra te . F is c a l p o lic y w a s u s e d to s tim u la te th e e c o n o m y w h e n e v e r th e r e a p p e a re d to b e s la ck ; e x p a n sio n , o n th e o th e r h a n d , w a s c o n s tr a in e d b y th e b a l a n c e o f p a y m e n ts . P e rio d ic ru n s o n B rita in ’s fo reig n e x c h a n g e re se rv e s le d to p o lic y re v e rsa ls, c a u sin g a b u d g e ta ry c y c le o f e x p a n s io n a n d c o n tr a c tio n th a t b e lo w 1 p e r c e n t, a n d averag e re a l in c o m e s g re w a b o u t 3 p e r c e n t p e r y e a r. M o n e ta ry p o lic y in th is p e rio d w a s s u b o rd in a te d to th e tw in r e q u ire m e n ts o f m a in ta in in g th e e x c h a n g e ra te a n d fu n d in g p u b lic s e c t o r b o rro w in g . T h e m a in p o lic y in s tru m e n t w a s th e B a n k o f E n g la n d ’s d is c o u n t ra te (B ank R ate), th o u g h th is w a s a u g m e n te d p e rio d i ca lly b y q u a n tita tiv e c e ilin g s o n b a n k le n d in g . T h e s e c e ilin g s w e re p a r tic u la r ly im p o r ta n t fo llo w in g th e N o v em b er 1 9 6 7 d e v a lu a tio n o f s te rlin g u n til 1 9 71.3 Heath’s “Dash f o r Growth" In m id -1 9 7 0 , w h e n th e L a b o u r g o v e rn m e n t o f H arold W ilso n lo s t a g e n e ra l e le c tio n to th e C o n serv ativ e p arty e a rn e d th e n ic k n a m e o f “s to p -g o .” A s ta b le e x c h a n g e ra te w a s m a in ta in e d , h ow ev er, fo r n e a rly tw o d e c a d e s (1 9 4 9 -6 7 ). In d e e d , in r e tro s p e c t, th is p e rio d s e e m s like a g o ld e n ag e. In fla tio n a v era g ed 3 p e r c e n t, u n e m p lo y m e n t av erag ed le s s th a n 2 p e r c e n t a n d w a s s o m e tim e s Digitized for 28 FRASER 3ln both the 1960s and 1970s, monetary and fiscal policies were augmented from time to time by incomes policies which attempted to regulate the growth rate of wages. There is some evidence that these policies temporarily restrained wage increases, but had no long-run impact on wage and price inflation. See Henry and Ormerod (1978). MAY 1984 FEDERAL RESERVE BANK OF ST. LOUIS Chart 2 M anufacturing Production Index 1970 71 72 73 74 75 76 led b y E d w ard H eath, th e B ritish e c o n o m y w a s in g o o d s h a p e . B o th th e b a la n c e o f p a y m e n ts a n d th e g o v ern m e n t b u d g e t w e re in s u r p lu s . In fla tio n ( 6 p e rc e n t) a n d u n e m p lo y m e n t (2.2 p e rc e n t), a lth o u g h h ig h b y 1 9 6 0 s sta n d a rd s , w e re b y n o m e a n s at c ris is lev els — o r so it s e e m s in r e tro s p e c t. As u n e m p lo y m e n t d rifte d u p w a rd th r o u g h 1971, h o w e v e r, th e H e a th g o v e r n m e n t e m b a r k e d u p o n a s tim u la tiv e m a c r o e c o n o m ic p o lic y k n o w n a lte r n a tively as th e "dash fo r g ro w th " o r th e "B a r b e r b o o m . " 4 T h e s tim u la tio n to o k tw o fo rm s. F irst, m o n e ta iy p o licy b e c a m e e x p a n sio n a ry in S e p te m b e r 1971 fo llow in g th e in tro d u c tio n o f a re fo rm p a ck a g e k n o w n as C o m p e ti tio n a n d C red it C o n tro l. T h is p ro g ra m re m o v ed c e il in g s o n b a n k le n d in g w ith o u t re p la c in g th e m w ith a n effectiv e a ltern a tiv e c o n tr o l m ech an ism .® As a re su lt, 4The Chancellor of the Exchequer, chief minister in the Treasury, during the Heath government (June 1970-February 1974) was Anthony (later Lord) Barber, appointed July 26, 1970. 5See Hall (1983) for a detailed discussion of the scheme. The author ities presumably thought the monetary expansion would be tempo rary following the removal of ceilings. It proved, however, to be both substantial and sustained. 77 78 79 80 81 82 1983 m o n e y a n d c re d it e x p a n d e d rap id ly . T h ro u g h 1972 a n d 1 9 7 3 , th e a n n u a l g ro w th r a te o f s te r lin g M 3 r e a c h e d le v e ls w e ll in e x c e s s o f 2 0 p e r c e n t (se e c h a r t 3).B S e c o n d , a n e x p a n s io n a r y b u d g e t w a s in tro d u c e d in M a r c h 19 72 . T h is la rg ely involved c u ts in p e rs o n a l ta x a tio n , b u t w a s la te r a u g m e n te d b y a s u b s ta n tia l e x p a n s io n in p u b lic s e c t o r in v e s tm e n t p ro g ra m s. U n d erly in g th is d a s h fo r g ro w th w a s th e b e lie f th a t th e g ro w th o f th e B ritis h e c o n o m y h a d b e e n a rtificially c o n s tr a in e d bv th e fixed e x c h a n g e ra te (or, eq u iv a len tly , th e b a la n c e o f p a y m e n ts ). In th e p a st, re strictiv e fisca l p o lic y h a d to b e in tr o d u c e d every tim e th e re w as a sig n ific a n t r a n o n fo reig n e x c h a n g e re serv e s. F lo a tin g th e e x c h a n g e ra te b e c a m e a c c e p ta b le , h o w ever, fo llo w in g th e m e a s u r e s in tr o d u c e d b y P re s id e n t 6The monetary aggregates referred to are defined as follows: M1 = notes and coins in circulation with the public + U.K. private sector sterling sight deposits; sterling M3 = M1 + private sector sterling time deposits + public sector deposits. Sterling M3 was the aggre gate targeted after 1976, though after 1980 the authorities claimed to be monitoring both narrower and broader aggregates as well as sterling M3. 29 MAY 1984 FEDERAL RESERVE BANK OF ST. LOUIS Chart 3 A n n u a l G ro w th Rates o f M l a n d S terling M 3 1970 71 72 73 74 75 76 77 78 79 80 81 82 1983 S h a d e d a r e a s r e p r e se n t r e c e s s i o n s , d e f i n e d a s the con traction p h a s e of c o i n c i d e n t e c o n o m i c in d ic ato rs. w a s th e m o n e y s to c k in c r e a s e s o f 1 9 7 2 —7 3 (se e c h a r t 3). N ixon o n A u gust 15, 1 9 7 1 , w h ic h a m o n g o th e r th in g s le d to th e flo a tin g o f th e U.S. d o lla r in fo reig n e x c h a n g e m a rk e ts. T h e p o u n d flo a te d fro m A u g u st 2 3 ,1 9 7 1 , w a s re p e g g ed fo llo w in g th e S m ith s o n ia n A g ree m e n t o f D e c e m b e r, b u t flo a te d a g a in o n J u n e 23, 1972, a fte r a ru n o n re serv e s. T h e float, w h ic h w a s in tr o d u c e d a s a te m As a re s u lt o f th is e x tre m e ly fa st m o n e y g ro w th , in fla tio n in B rita in w e n t m u c h h ig h e r th a n in o th e r in d u s trial c o u n tr ie s . In th e U n ite d S ta te s , fo r e x a m p le , it w a s a b o u t 11 p e r c e n t in 1 9 7 4 a n d a b o u t 9 p e r c e n t in 1975. p o ra ry m e a s u re , h a s c o n tin u e d e v e r s in c e . A Tightening o f the “Corset" T h e e x p a n s io n a r y p o lic ie s w e re s u c c e s s fu l fo r a sh o rt tim e . In d u stria l p r o d u c tio n ro se 7 p e r c e n t in to o k th e fo rm o f a re tu rn to q u a n tita tiv e ce ilin g s o n 1973 a n d u n e m p lo y m e n t fell fro m 3.7 p e r c e n t in 1972 d e p o s its . T h is s c h e m e , w h ic h b e c a m e k n o w n as th e to 2.6 p e r c e n t in 1 9 7 3 a n d 1 9 7 4 (c h a rt 1). In v e stm e n t, how ev er, d id n o t rise sig n ific a n tly a n d th e b o o m w a s " c o r s e t ,” r e s tr ic te d b a n k s ’ ab ility to c o m p e te fo r in te re s t-b e a rin g tim e d e p o s its .7 A m a x im u m p e rc e n ta g e sh o rt-liv e d . T h e oil c ris is c o m b in e d w ith a s h a rp re v e r sal in m o n e ta ry p o lic y to b rin g th e e x p a n s io n to an e n d . B y 1975, in d u s tria l p r o d u c tio n w a s b a c k to its 1 9 7 0 g ro w th ra te w a s s p e c ifie d fo r b a n k s ’ in te re s t-b e a rin g elig ib le lia b ilitie s. If a b a n k e x c e e d e d th is g ro w th ra te , it level. T h e rev ersal o f m o n e ta ry p o lic y in D e c e m b e r 1973 w a s r e q u ir e d to p la c e n o n - in t e r e s t - b e a r in g “S u p p le m e n ta ry D e p o s its ” w ith th e B a n k o f E n g la n d (m u ch D u rin g th is tim e , h o w e v e r, in fla tio n a c c e le r a te d , r e a c h in g 25 p e r c e n t p e r y e a r in 1 9 7 5 . S o m e b la m e d th e in fla tio n o n th e o il p r ic e ris e ; th e m a jo r c a u s e , h ow ever, 30 7For a retrospective assessment of the corset, see Bank of England Quarterly Bulletin (March 1982), pp. 74-85. FEDERAL RESERVE BANK OF ST. LOUIS like th e F e d ’s re q u ire d re serv e s). T h e c o r s e t re m a in e d in fo rce u n til Ju n e 198 0 (ap art fro m tw o b re a k s: F e b r u ary 2 8 ,1 9 7 5 , to N o v em b er 1 8 ,1 9 7 6 , a n d A u g u st 1 1 ,1 9 7 7 , to J u n e 8 , 1978). T h e u p su rg e o f in fla tio n b e c a m e a m a jo r p o litic a l c o n c e r n . A v o lu n ta ry w ag e re s tra in t p o licy w a s in tr o d u c e d in m id -1 9 7 5 , a n d a c o m m itm e n t w a s m a d e th a t m o n e y s u p p ly g ro w th w o u ld c e a s e to b e a s o u r c e o f in fla tio n a ry p re s s u re in th e e c o n o m y . A ta rg e t ra n g e fo r th e g ro w th ra te o f s te rlin g M 3 w a s in tr o d u c e d in 1976 b y th e L a b o u r C h a n c e llo r D e n n is H e a le y .8 T h e p r a c tic e o f a n n o u n c in g ta rg e ts h a s c o n tin u e d to d a te . T h e ta rg e ts have g e n e ra lly b e e n a c h ie v e d e x c e p t in p e rio d s fo llo w in g re la x a tio n o f th e c o r s e t. W h ile th e in fla tio n a ry m o n e ta ry e x p a n s io n o f 1 9 7 1 73 w a s m o d e ra te d a fte r th e e n d o f 1973, th e fiscal d eficit g o t bigg er. F ro m a fin a n c ia l s u rp lu s in 1970, p u b lic s e c t o r fin a n c e s d e te rio r a te d to a p o s itio n w h e re in 1975 p u b lic s e c t o r b o rro w in g e x c e e d e d 10 p e r c e n t o f GNP. T h is w a s p a rtly d u e to th e p o lic ie s in tr o d u c e d by th e H e ath g o v e rn m e n t, b u t a lso to th e e ffo rts o f th e s u b s e q u e n t L a b o u r g o v e rn m e n t, e le c te d in F e b ru a ry 1974, to h o ld d o w n n a tio n a liz e d in d u s try p r ic e s a s w ell as th o s e o f s o m e fo o d s. T h is involved in c r e a s e d s u b s id ie s .9 T h e a rg u m e n t, in itia lly a c c e p te d in official c ir cle s, w as th a t a n in c r e a s e d b u d g e t d eficit re p re s e n te d a n a p p ro p ria te o ffset to th e im p a c t o f th e oil p ric e rise. By 1976, th e siz e o f th e b u d g e t d eficit h a d b e c o m e a m a jo r p u b lic issu e . A c ris is w a s trig g ered by a s u b s ta n tial fall in th e valu e o f th e p o u n d . An a p p lic a tio n w a s m a d e to th e In te rn a tio n a l M o n e ta ry F u n d (IMF) fo r a lo a n to in c r e a s e fo reig n e x c h a n g e re serv e s. W h y th is w a s n e c e s s a r y is n o t c le a r, s in c e th e p o u n d w a s flo a t ing, b u t th e g o v e rn m e n t in tr o d u c e d a m a jo r p a ck a g e o f p u b lic s p e n d in g c u ts in o r d e r to m e e t IM F c o n d itio n s fo r th e lo a n . W h ile c u r r e n t g o v e rn m e n t e x p e n d itu re s o n g o o d s a n d s e rv ice s w e re h e ld b a c k to a n o tic e a b le d eg ree, th e m a jo r im p a c t o f th e c u ts w a s in p u b lic s e c to r in v e stm e n t p ro g ra m s (see c h a rt 4). D e sp ite th e tig h te n in g o f fisca l p o lic y a fte r 1976, th e e c o n o m y e x h ib ite d m o d e r a te ly s tro n g re a l g ro w th th r o u g h 1979. G ro w th r a te s o f recil GDP (gross d o m e s tic p ro d u ct, w h ic h is g ro ss n a tio n a l p ro d u c t le s s n e t in c o m e fro m ab ro ad ) w e re in th e 2 p e r c e n t to 3 p e r c e n t ran g e . T h e e x p a n s io n w a s a id e d s o m e w h a t b y a te m 8lt was first announced that money growth would henceforth be noninflationary. A forecast for sterling M3 was then released. Only later did the forecast form the basis of a target range. 9A further problem was created by the fact that up to 1975 government expenditures were planned in real terms. When prices rose, nominal expenditure was increased to compensate. Subsequently, cash lim its were introduced for public spending. MAY 1984 p o ra ry re la x a tio n o f m o n e ta ry p o lic y in th e s e c o n d h a lf o f 1 9 7 7 a n d first h a lf o f 1 9 7 8 . P a rtly th is e x p a n s io n re s u lte d fro m th e re m o v a l o f th e c o r s e t; it a lso w as in d u c e d , h o w ev er, b y s u b s ta n tia l fo reig n e x c h a n g e in te rv e n tio n to s to p th e p o u n d f r o m a p p r e c ia tin g . U.K. fo reig n e x c h a n g e re se rv e s ro s e fro m $3.4 b illio n a t th e e n d o f 1 9 7 6 to $20.1 b illio n b y th e e n d o f 1977. T h is in te rv e n tio n w a s c le a rly re fle c te d in th e ra p id g ro w th o f M l (see c h a rt 3 ) .1 0 POLICY CHANGES O F TH E THATCHER GOVERNMENT W h e re a s th e 1 9 7 0 -7 4 C o n serv ativ e g o v e rn m e n t o f E d w ard H eath h a d e m b a rk e d o n a m o n e y g ro w th an d p u b lic s p e n d in g -le d b o o m , M rs. T h a tc h e r c a m e to p o w e r in 1979 c o m m itte d to a very d iffe ren t strateg y . T h e T h a tc h e r g o v e rn m e n t h a d tw o m a jo r g o a ls. O n e g oal w a s to r e d u c e th e level o f p u b lic s p e n d in g , in o r d e r to b o th e lim in a te th e b u d g e t d e fic it a n d fa cilita te lo w e r lev els o f ta x a tio n . T h is w o u ld rev e rse th e a lleg ed c ro w d in g o u t o f p riv ate s e c t o r a ctiv ity b y th e p u b lic s e c to r a n d w o u ld re s to re th e in c e n tiv e s n e c e s s a r y fo r i n d u s t r i a l g r o w t h . S e c o n d , i n f l a t io n w a s to b e s q u e e z e d o u t o f th e e c o n o m y by a g ra d u a l r e d u c tio n o f th e ra te o f g ro w th o f th e m o n e y s to c k .1 1 In Ju n e 1979, S ir G eoffrey H ow e, M rs. T h a tc h e r ’s C h a n c e llo r o f th e E x c h e q u e r fo r h e r first g o v ern m e n t (M ay 1 9 7 9 -J u n e 1983), in tr o d u c e d a b u d g e t th a t lo w e re d p e rs o n a l d ir e c t ta x e s a n d ra is e d in d ire c t ta x es. T h e b u d g e t a lso in c lu d e d a rise in th e ta x o n N orth Sea oil p ro d u c e rs . P la n n e d p u b lic e x p e n d itu re s w e re c u t. T h e ta rg e t ra n g e fo r th e g ro w th ra te o f s te rlin g M 3 w as s e t a t 7 -1 1 p e r c e n t, o n ly 1 p e r c e n t lo w e r th a n th a t se t b y th e p re v io u s L a b o u r g o v e rn m e n t. At th e sa m e tim e, h ow ever, th e B a n k o f E n g la n d ’s M in im u m L en d in g R ate (MLR) w a s ra is e d fro m 12 p e r c e n t to 14 p e rc e n t (and la te r ra is e d to 1 7 p e r c e n t in N o v em b e r ) . 1 2 T h e Ju n e 1979 p o licy c h a n g e s w e re in te n d e d to r e d u c e in fla tio n , w h ic h h a d b e g u n to rise a g a in in 1979. T h is m a c r o e c o n o m ic p o lic y s tra te g y w a s fo rm a liz e d in 10This experience with intervention did much to convince the author ities that holding down the value of the pound without generating a rapid rise in the money supply was impossible. 11The intention of eliminating inflation solely by monetary policy rather than incomes policies was one reason why Mrs. Thatcher earned the monetarist label. The nature of monetarism is outlined in Batten and Stone (1983). For a discussion of how views about macroeco nomic policy had changed over time both in Britain and the United States, see Alt and Chrystal (1983). 12Bank Rate was renamed Minimum Lending Rate in 1971. It was intended to be related to market rates, though from time to time it was still used as a policy instrument. See Hall. 31 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Chart 4 Government Transfers, Consumption and Investment as a Percent of GDP Percent N O T E : F ig u re s a r e f o u r - q u a r t e r m o v in g Percent a v e r a g e s o f th e r a t io o f e x p e n d it u r e s , N .S .A ., to G D P , N .S .A . th e M a rch 1980 b u d g e t in to a s o -c a lle d M e d iu m T e rm F in a n c ia l S trateg y (M TFS), w h ic h in volved p la n n e d r e d u c tio n s in p u b lic s p e n d in g o v er a fo u r- o r five-y ear h o riz o n to r e d u c e th e b u d g e t d e ficit a s a p ro p o rtio n o f GDP. R e d u c tio n s in tax ra te s a lso w e re c o n s id e re d . M o n etary g ro w th ta rg e ts w e re to b e re d u c e d g ra d u a lly ov er th e sa m e p e rio d , th o u g h th e r e w a s n o c h a n g e in in u n e m p lo y m e n t .1 4 T h e a b a n d o n m e n t o f th e c o r s e t in J u n e 1980 le d to g ro w th ra te s o f s te rlin g M 3 w ell in e x c e s s o f th e u p p e r ta rg e t le v e l . 1 5 th e ra n g e fo r 1980/81.1:1 ,4The previous Labour government had set up a Pay Comparability Commission to inquire into public sector pay. This commission recommended substantial pay raises for many groups. Mrs. Thatch er honored these recommendations before winding up the commis sion and substituting a public sector “ pay norm.” T h e M T F S w as e ffectiv ely a b a n d o n e d a lm o s t im m e d ia te ly . T h e P u b lic S e c to r B o rro w in g R e q u ire m e n t targ et fo r 1980/81, s e t in th e M a rc h b u d g et, w a s £ 8 ‘/ 2 b illio n . By N o v em b er 1980, th e fo r e c a s t w a s revised u p w a rd to £.11 Vi b illio n . T h e e x p a n s io n o f p u b lic s p e n d in g w as d u e p a rtly to h ig h w ag e s e ttle m e n ts in th e p u b lic s e c to r a n d p a rtly to a n u n e x p e c te d rise 13Budgets are normally submitted in March. They apply for the follow ing financial year which runs April to April. The convention used here is that 1980/81 refers to the financial year April 1980 to April 1981. 32 W h ile M rs. T h a tc h e r in te n d e d to c u t b o th ta x e s an d p u b lic s p e n d in g , th e o p p o s ite g e n e ra lly h a s o c c u rre d . 15Buiter and Miller (1981) argued that monetary policy in Britain was too tight and resulted in an excessive appreciation of sterling. In Buiter and Miller (1983), however, they admit that the evidence is not consistent with a monetary overshooting hypothesis. Indeed, they express concern for the credibility of a monetary policy that frequently exceeded targets. Since 1979, sterling M3 growth has consistently exceeded the inflation rate. M1 growth looks more restrictive, though this also is distorted by the ending of the corset. The freeing of banks to compete for time deposits led to a switch from checking accounts to time deposits. This substitution is volun tary and would not normally be considered to represent policy tightening. FEDERAL RESERVE BANK OF ST. LOUIS C hart MAY 1984 5 G overnm ent Tax Revenues as a Percent of GDP Percent Percent N O T E : F i g u r e s a r e f o u r - q u a r t e r m o v i n g a v e r a g e s o f t h e r a t i o o f t a x r e v e n u e s , N . S . A . , to G D P , N . S . A . T a x re v e n u e , fo r e x a m p le , g re w a s a p ro p o rtio n o f GDP u n til la te 1982 (ch a rt 5 ) . 1 6 S im ilarly , b o th re a l g o v ern m e n t c o n s u m p tio n (c u rre n t s p e n d in g o n g o o d s a n d serv ices) a n d re al tr a n s fe r p a y m e n ts have ris e n a s a p ro p o rtio n o f GDP s in c e 1 9 7 9 (c h a rt 4). T h e m a jo r e x c e p tio n o n th e e x p e n d itu re sid e is g o v e rn m e n t in v e st m e n t (ch a rt 4), w h ic h w a s c u t u n til m id -1 9 8 2 . T h e c u ts a ch ie v e d in th is ca te g o ry b y th e T h a tc h e r g o v ern m e n t, h ow ev er, w e re m u c h s m a lle r th a n th o s e in tro d u c e d by th e p rev io u s L a b o u r g o v e rn m e n t. ARE PO LICY CHANGES PRIM ARILY R E S P O N S IB L E ? It is h a rd to lo o k at w h a t h a p p e n e d in B rita in a fte r 1979 a n d b e c o m fo rta b le w ith th e sto ry th a t p o lic y 16Revenue from taxes on North Sea oil producers has contributed significantly to this. In 1978, the yield on Petroleum Revenue Tax was close to zero. In 1983, the taxes on North Sea oil yielded £6.1 billion which was 13.5 percent of total tax revenue. c h a n g e s m a d e b y th e T h a tc h e r g o v e rn m e n t a re e n tir e ly re s p o n s ib le . W e a lre a d y h av e s e e n th a t u n e m p lo y m e n t in 1983 r e a c h e d a level w e ll o v er d o u b le th a t a s s o c ia te d w ith th e 1 9 7 3 —75 r e c e s s io n . Y et m o n e ta ry p o lic y w a s p ro b a b ly n o tig h te r in th e T h a tc h e r y e a rs th a n in th e p rev io u s re c e s s io n . F isc a l p o licy , if a n y th in g , w a s tig h te r in th e 1 9 7 5 -7 8 p e rio d th a n in th e first th r e e y e a rs o f th e T h a tc h e r g o v ern m e n t. T a b le 1 p r e s e n ts th e c h a n g e in b u d g e t d e fic it a s a p ro p o rtio n o f GDP. T h e first c o lu m n is b a s e d o n u n a d ju s te d fig u re s . T h e s e c o n d c o lu m n a tte m p ts to id e n tify c h a n g e s d u e to d is c re tio n a ry p o li c y r a th e r th a n c y c lic a l fa c to rs . It a ls o w e ig h ts th e tax a n d e x p e n d itu re c h a n g e s a c c o r d in g to th e ir im p a c t o n d e m a n d . An a llo w a n c e fo r th e fa c t th a t s o m e ta x e s c a m e fro m oil, w h ic h w o u ld h a v e a d iffe re n t im p a c t o n d e m a n d fro m , say, p e r s o n a l in c o m e ta x e s , is th e re fo re in c lu d e d in th is m e a s u re ; th u s , it p ro v id e s a b e tte r in d ic a to r o f fisc a l p o lic y s ta n c e . N egative fig u res re flect a re d u c tio n o f th e d e fic it a n d , th e re fo re , a tig h te n in g o f p o licy . 33 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Table 1 Change in the British Budget Deficit as Percent of GDP__________________ Unadjusted 1974/75 2.57% 1975/76 0.26 Table 2 World Trade, Production and Unemployment Volume World Trade in Manufactured Goods Weighted Cyclically Adjusted Industrial Production Unemployment Rate 1975 = 100 OECD U.K. OECD U.K. 1.57% -1 .1 6 1975 100 100 100 5.2% 4.7% 112 109 103 1976/77 -1 .7 9 -1 .3 2 1976 5.3 6.0 1977/78 -1 .8 4 -2 .2 0 1977 117 113 108 5.3 6.3 1978/79 0.81 0.58 1978 123 117 112 5.2 6.3 1979/80 -0 .9 7 -0 .5 6 1979 130 123 116 5.1 5.6 1980/81 0.87 -0.51 1980 137 123 108 5.8 7.0 1981/82 -2 .6 0 -2 .1 0 1981 139 123 104 6.7 10.7 0.30 1982 136 118 106 8.2 12.4 -0 .3 0 1983 n.a. 122 109 8.7 12.9 1982/83 1983/84 0.80 -0 .1 0 NOTE: Figures for 1983/84 are partly forecast. SOURCE: National Institute Economic Review (February 1982), p. 95 and (February 1984), p. 8. NOTE: Industrial production figures for the United Kingdom in clude oil and gas. SOURCE: National Institute Economic Review (February 1984), pp. 93-94. W h a t e m e rg e s fro m th e s e fig u res is th a t fis c a l p o lic y w as m ild ly re s tra in in g in 1979/80 a n d 1980/81. It w as tig h te r in 1981/82, b u t h a s b e e n m o re o r le s s n e u tr a l s in c e th e n . It is n o tic e a b le , h ow ev er, th a t th e fisc a l larg ely c o m p le te b y th e e n d o f 1 9 8 0 .17 In b o th 1 979 a n d 1980, w o rld tra d e in m a n u fa c tu re d g o o d s ro s e stro n g ly . p o lic y o f th e T h a tc h e r g o v e rn m e n t h a s b e e n le ss r e s t r ic t iv e th a n th a t o f th e p re v io u s L a b o u r g o v ern m e n t in th e th r e e fin a n c ia l y e a r s 1975/76 to 1977/78, w h e n th e c u m u la tiv e fall in th e d e fic it a s a p e r c e n t o f GDP (w eig h ted a n d c y c lic a lly a d ju ste d ) a m o u n te d to 4.7 p e rc e n ta g e p o in ts . T h e fall u n d e r M rs. T h a tc h e r in th e th r e e y e a rs 1979/80 th ro u g h 1981/82 to ta le d o n ly 3.2 p e rc e n ta g e p o in ts . WAS TH E W ORLD RECESSIO N PRIM ARILY R E S P O N S IB L E ? B r ita in ’s e c o n o m y e x p o rts a b o u t 25 p e r c e n t o f its GDP. It is c o n c e iv a b le th a t a d e c lin e in w o rld d e m a n d co u ld re d u c e th e d e m a n d fo r B ritis h e x p o rts e n o u g h to c a u s e a c o n tr a c tio n o f m a n u fa c tu rin g p ro d u c tio n . No d o u b t th e w o rld w id e r e c e s s io n o f th e e a rly 1 9 8 0 s is p artly to b la m e ; h ow ev er, it d o e s n o t s e e m to b e th e m a in ev en t: th e d e c lin e in m a n u fa c tu rin g in B rita in p r e c e d e d th e w o rld r e c e s s io n b y sev era l m o n th s . T a b le 2 s h o w s th a t w o rld tra d e in m a n u fa c tu re d g o o d s g re w stro n g ly th ro u g h 1 9 8 0 , slo w e d in 1981, th e n d e c lin e d m a rg in a lly in 1 9 8 2 . T h e d e c lin e in sa le s o f B ritish m a n u fa c tu re d g o o d s, h ow ev er, d a te s fro m 1979 at th e la te st, a n d th e a d ju s tm e n t o f p ro d u c tio n w as 34 T h e fig u res fo r in d u s tria l p r o d u c tio n te ll a sim ila r story : O rg a n iz a tio n fo r E c o n o m ic C o o p e ra tio n a n d D e v e lo p m e n t (OECD) in d u s tria l p r o d u c tio n r o s e stro n g ly in 1979, lev eled o ff in 1 9 8 0 a n d 1981 a n d d e c lin e d in 1982. B ritis h in d u s tria l p ro d u c tio n fell a b o u t tw o y e a rs b e fo re th e fall in th e O EC D fig u re, a n d b y a c o n s id e r a b ly la rg e r a m o u n t . 1 8 B efo re 1976, u n e m p lo y m e n t in B rita in h a d ty p ica lly b e e n b e lo w th e O E C D averag e. F ro m 1 9 7 6 th ro u g h 1979, B r ita in ’s u n e m p lo y m e n t ra te w a s a little h ig h er, b u t fo llo w ed a s im ila r p a tte r n to th e O EC D average. S in c e 1979, B r ita in ’s u n e m p lo y m e n t h a s ris e n m u c h fu rth e r th a n th e O EC D average. T h u s, th e re is n o s tro n g c a s e fo r b elie v in g th a t th e w o rld r e c e s s io n p ro v id e s a n a d e q u a te e x p la n a tio n o f th e c o n tr a c tio n in B rita in in 1980, ev en w h e n c o m b in e d w ith th e T h a tc h e r g o v e rn m e n t's m o n e ta iy a n d fisca l p o lic ie s . In d e e d , th e w o rld r e c e s s io n w a s m o st sev ere in 1982, a y e a r in w h ic h B r ita in ’s m a n u fa ctu rin g p ro d u c tio n a c tu a lly re c o v e re d so m e w h a t. ^Manufacturers' stocks of unsold output rose sharply in 1979 indicat ing a slump in sales. See National Institute Economic Review (February 1984), p. 11, chart 5. Production was subsequently cut back and stocks run down through 1980. ,8lndustrial production is a broader aggregate than manufacturing, it includes oil production among other things. FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 C hart 6 Oil and Manufacturing Trade Balance 1970 71 72 73 74 75 76 TH E NORTH SEA OIL EXPLANATION T h e e m e rg e n c e o f B rita in a s a m a jo r oil p r o d u c e r p ro v id es a n e x p la n a tio n o f s o m e o f th e c h a n g e s th a t o c c u r r e d in th e B ritis h e c o n o m y o v er th e p a s t five y e a r s .1 9 Up to m id -1 9 7 6 , B rita in w a s e n tire ly d e p e n d e n t u p o n im p o rte d o il; in 1980, B rita in b e c a m e a n e t e x p o rte r o f oil. F o llo w in g s u c h a s tru c tu r a l c h a n g e in th e s u p p ly s id e o f th e e c o n o m y , th e tra d e b a la n c e in m a n u fa c tu re d g o o d s, a c c o r d in g to th e o iy , w o u ld m ove in th e o p p o s ite d ir e c tio n o f th e o il b a la n c e .2 0 T h e fo rce 19Some commentators such as Buiter and Miller (1981, 1983), Niehans (1981) and Darby and Lothian (1983) have dismissed the effects of North Sea oil. However, Forsyth and Kay (1980) argued that oil production would lead to a sizable contraction in manufactur ing. Bond and Knobl (1982), Laney (1982) and McGuirk (1983) all provide evidence that oil has substantially worsened the competi tiveness of U.K. manufacturing. See Bank of England Quarterly Bulletin (1982), pp. 56-73, for a description of North Sea oil re sources. 20See, for example, Corden and Neary (1982). 77 78 79 80 81 82 83 1984 th a t b rin g s th is a b o u t is a n a p p r e c ia tio n o f th e e x c h a n g e ra te, w h ic h ra is e s th e p ric e o f d o m e s tic m a n u fa c tu re d g o o d s rela tiv e to o v e rse a s c o m p e tito r s ’ p ric e s. C o n se q u e n tly , d o m e s tic c o n s u m e r s b u y a h ig h e r p r o p o rtio n o f fo re ig n -p ro d u c e d g o o d s, a n d fo re ig n e rs b u y relativ ely fe w e r d o m e s tic -m a n u fa c tu re d e x p o rts . T h u s, th e m a n u fa c tu rin g s e c t o r c o n t r a c ts .2 1 C h a rt 6 s h o w s th e o il tra d e b a la n c e a n d th e m a n u fa c tu rin g tra d e b a la n c e . C h a rt 7 s h o w s th e d o llarp o u n d e x c h a n g e ra te a n d th e relativ e w h o le s a le p ric e o f B ritis h m a n u fa c tu re d g o o d s c o m p a r e d w ith o th e r 21Strictly speaking, this contraction need only be relative to the rest of the economy. What has to be explained is the switching of spending from home-produced to foreign-produced manufactured goods. Our claim is that this was largely a relative price effect resulting from the oil-related decline of competitiveness of British manufacturing. There are relative price effects among inputs as well as outputs. A rise in real wages has caused manufacturers to economize on labor for given output levels. Output per person employed in U.K. manu facturing rose 15 percent between the end of 1980 and mid-1983. Thus, the decline in employment in manufacturing has been greater than the output loss alone would have led to. 35 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 Chart 7 Dollar/Pound Exchange Rate and Relative W holesale Prices 1980=100 S o urce : I n te r n a tio n a l F in a n c ia l S ta tis tic s , In te r n a tio n a l M o n e ta r y F und Q D a ta a re a v e ra g e s o f d a i ly fig u r e s . [2 W h o le s a le p ric e s a re fo r m a n u fa c tu rin g r e la tiv e to 13 o th e r in d u s tria l c o u n trie s . in d u s tria l c o u n tr ie s .22 U n til 1 9 7 3 , th e re w a s a sm a ll su rp lu s in m a n u fa c tu re d tra d e a n d a sm a ll d e fic it in oil trad e . As th e o il d e fic it grew , so d id th e m a n u fa c tu re d g o o d s e x p o rt s u r p lu s . F ro m III/1976 o n , th e oil d eficit sh ran k , a n d w a s e lim in a te d in 1 9 8 0 . B y 1/1984, th e re w a s a s u b s ta n tia l oil s u rp lu s. T h e m a n u fa c tu rin g s u rp lu s in itia lly c o n tin u e d to in c re a s e as th e p o u n d a p p r e c ia te d a fte r 1 9 76 .23 As 22Niehans, and Darby and Lothian argue that the appreciation of sterling was due to slow base money growth in the early years of the Thatcher government. This is implausible. Why, for example, was sterling appreciating for two years before Mrs. Thatcher came to power, and why did it depreciate in 1981 when base growth con tinued to slow? None of the monetary explanations of the exchange rate can explain a sustained rise in relative goods prices over a long period of time, such as that evident in chart 7. Such changes require structural explanation such as is offered by North Sea oil. Many commentators presumed that monetary policy was tight simply because sterling was appreciating. Laney offers evidence that monetary explanations of the U.K. exchange rate broke down after 1977. The price of oil is an important explanatory variable after that date. He also shows that other new oil producers have had compa rable experiences. Thus, the event of significance in 1979 may not be the election of Mrs. Thatcher but rather the rise in the price of oil. 23As the currency appreciates, the sterling price of imports falls. In the short run, this improves the manufacturers’ trade balance because 36 s te rlin g a p p r e c ia te d fu rth e r, h o w ev er, rela tiv e d e m a n d fo r B ritish a n d fo reig n g o o d s s h ifte d fa r e n o u g h to c o m p e n s a te fo r th e relativ e rise in p ric e o f B ritis h g o o d s. A fter m id -1 9 7 7 , th e s u rp lu s in m a n u fa c tu re d the same volume of imports costs less. However, as spending patterns adjust to the new relative prices, the volume of exports starts to fall relative to the volume of imports. Once the volumes adjust more than the prices, the balance in manufactured goods starts to decline. This is just the reverse of the “J curve” effect of a devaluation. It arises because demand elasticities are smaller in the short run than in the long run. Because of this, the exchange rate may appreciate “too far" in the process of adjusting to the oil surplus. That is to say that the rise in the relative price of manufac tured goods required in equilibrium is less than that actually experi enced during transition. This is consistent with events in Britain where relative wholesale prices (chart 7) overshot their ultimate level. This is a different kind of overshooting from that associated with an unexpected tightening of monetary policy analyzed by Dornbusch (1976). The appreciation of the exchange rate is brought about not just by the impact of the changing oil balance on the current account but also by capital inflows which reinforce the process. The 1979 oil price rise boosted a process already under way. McGuirk estimates that a 23 percent fall in competitiveness was required in equilibrium to adjust the U.K. trade balance to the effects of oil at the 1980 oil prices. At the 1978 price of oil, this was only 12 percent. A fall in competitiveness is a rise in the relative price of British goods. This is sometimes referred to as a rise in the “ real” exchange rate. FEDERAL RESERVE BANK OF ST. LOUIS MAY 1984 g o o d s fell sh arp ly , u n til b y 1/1984 th e re w a s a s u b s ta n tial d eficit in m a n u fa c tu re d g o o d s tra d e , ro u g h ly e q u a l to th e oil su rp lu s. REFEREN CES Alt, J. E., and K. Alec Chrystal. Political Economics (University of California Press and Wheatsheaf, 1983). In sh o rt, w e have a n e x p la n a tio n o f e v e n ts in B rita in th a t re q u ire s n e ith e r a m a jo r c o n tr a c tio n in d o m e s tic a g g re g a te e x p e n d itu r e n o r a m a jo r s lu m p in to ta l Bank of England Quarterly Bulletin, vol. 22, no. 1 (March 1982). w o rld d e m a n d to e x p la in th e c o lla p s e o f m a n u fa c tu r in g in d u s try in B rita in . T h e d o m in a n t fa c to r w a s a m a jo r sw itc h in s p e n d in g p a tte rn s re s u ltin g fro m th e rise in relativ e p ric e o f B ritis h m a n u fa c tu re d g o o d s. T h e p ro p o rtio n o f d o m e s tic d e m a n d fo r th e s e g o o d s s a tisfie d b y im p o r ts ro s e sh a rp ly , w h ile e x p o rts o f Bond, Marian E., and Adalbert Knobl. “ Some Implications of North Sea Oil for the U.K. Economy,” International Monetary Fund Staff Papers, vol. 29, no. 3 (September 1982), pp. 363-97. m a n u fa c tu re d g o o d s sta g n a te d . T h e v o lu m e o f m a n u fa c tu re d e x p o rts w a s a b o u t th e sa m e in 1983 a s it w as in 1976. O ver th e s a m e p e rio d , th e v o lu m e o f m a n u fa c tu re d g o o d s im p o rte d ro s e 63 p e rc e n t. CONCLUSION T h e g o v e rn m e n t o f M a rg a ret T h a t c h e r h a s b e e n b la m e d b y its c ritic s fo r c a u s in g a m a jo r c o n tr a c tio n o f a ctiv ity in B rita in b y a p p ly in g m o n e ta r is t p o lic ie s . W ith o u t q u ib b lin g o v er w h e th e r th o s e p o lic ie s w e re in d e e d m o n e ta ris t, th is a rtic le a rg u e s th a t th e c a s e fo r b la m in g th e rise in u n e m p lo y m e n t a n d th e c o n tr a c tio n o f m a n fu a ctu rin g o n d e fla tio n a ry a g g reg ate d e m a n d p o lic ie s is n o t a s tro n g o n e , ev en if o n e a llo w s fo r th e im p a c t o f th e w o rld r e c e s s io n . R a th er, th e p ro d u c tio n a n d sa le o f N orth Sea oil h ave h a d a b ig n eg ativ e im p a c t o n th e B ritish m a n u fa c tu rin g s e c to r. T h e p ro d u c tio n o f oil a n d th e s u b s e q u e n t rise in its p ric e c a u s e d an a p p r e c ia tio n o f s te rlin g a n d a rise in th e relativ e p ric e o f B ritis h m a n u fa c tu r e d g o o d s . As a re su lt, B ritish m a n u fa c tu re d g o o d s b e c a m e u n c o m p e titiv e a n d p r o d u c tio n c o n tr a c te d sh a rp ly . T h u s, it is im p o s s ib le to w rite a b a la n c e d h is to ry o f th e B ritis h e c o n o m y ov er th e la st few y e a rs w ith o u t r e fe re n c e to N orth S e a oil p ro d u c tio n . Batten, Dallas S., and Courtenay C. Stone. “Are Monetarists an Endangered Species?" this Review (May 1983), pp. 5-16. Buiter, Willem, and Marcus Miller. “ The Thatcher Experiment: The First Two Years," Brookings Papers (2:1981), pp. 315-79. ----------------“ Changing the Rules: Economic Consequences of the Thatcher Regime,” Brookings Papers (2:1983), pp. 305-65. Corden, W. Max, and J. Peter Neary. “ Booming Sector and Dein dustrialization in a Small Open Economy,” Economic Journal (De cember 1982), pp. 825-48. Darby, Michael R., and James R. Lothian. “ British Economic Policy Under Margaret Thatcher: A Midterm Examination,” CarnegieRochester Conference Series on Public Policy (North-Holland, 1983), pp. 157-207. Dornbusch, Rudiger. "Expectations and Exchange Rate Dynam ics,” Journal of Political Economy, vol. 84, no. 6 (December 1976), pp. 1161-76. Forsyth, P. J., and J. A. Kay. “ The Economic Implication of North Sea Oil Revenues,” Fiscal Studies, vol. 1 (July 1980), pp. 1-28. Gould, Bryan, John Mills, and Shaun Steward. perity (Macmillan Press Ltd., 1981). Monetarism or Pros Hall, Maxmillian. Monetary Policy Since 1971: Conduct and Perfor mance (Macmillan Press Ltd., 1983). Henry, S. G. B., and P. A. Ormerod. “ Incomes Policy and Wage Inflation: Empirical Evidence for the U.K. 1961-1977,” National Institute Economic Review, no. 85 (August 1978), pp. 31-39. Kaldor, Nicholas. Press, 1982). The Scourge of Monetarism (Oxford University Laney, Leroy O. “ How Contagious Is Dutch Disease’?” Federal Reserve Bank of Dallas Economic Review (March 1982), pp. 3-12. McGuirk, Anne K. “ Oil Price Changes and Real Exchange Rate Movements Among Industrial Countries,” International Monetary Fund Staff Papers, vol. 30, no. 4 (December 1983), pp. 843-84. National Institute Economic Review, no. 107 (February 1984). Niehans, Jiirg. “The Appreciation of Sterling — Causes, Effects and Policies,” Money Study Group Discussion Paper (Social Science Research Council, 1981). 37
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