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FEDERAL RESERVE B A N K
O F ST. L O U IS
SEPTEMBER 1969
Adjustment of Demand Deposit S eries........... 3
ST LOUIS
EIGHTH D
LITTLE ROCK
Vol. 51, No. 9
Stabilization Actions in 1969 —
How Much Restraint? ................................... 4
Controlling Inflation .......................................... 8
A Historical Analysis of the Credit Crunch
of 1966 .................................. .......................... 13
R ep rin t S e rie s
O V E R T H E YEARS certain articles appearing in the R e v i e w have proved to be helpful to
banks, educational institutions, business organizations, and others. To satisfy the demand for these
articles, this reprint series has been made available, and as future articles appear in the R e v i e w ,
they will be added. Please indicate the title and number of article in your request to: Research
Department, Federal Reserve Rank of St. Louis, P. O. Rox 442, St. Louis, Missouri 63166.
1. Price M ovem ents in Perspective
July 1961
2. Changes in Selected Liquid Assets, 1 9 5 V -1961
O cto be r 1961
3. M em ber Bank Reserves and the M oney S upply
M arch
4. Changes in the V e lo city o f M oney, 1 9 51 -196 2
June 1962
5. M ovements in Time & Savings Deposits, 1 9 5 1 -196 2
M arch 1963
A p ril 1963
O cto b e r 1963
July 1964
Septem ber 1964
O cto b e r 1964
M arch 1965
A p ril 1965
June 1965
August 1965
O cto b e r 1 965
A p ril 1966
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
26.
27.
Excess Reserves
Bank Loans and Investments, 19 51 -196 3
Recent Trends in Time Deposits
M oney S upply and Time Deposits, 1 9 1 4 -196 4
Bank Loans, 1 9 6 1 -1 9 6 4
Currency and Demand Deposits
Federal Reserve O pen M a rke t Transactions and the M on ey Supply
Im plem entation o f Federal Reserve O pen M a rke t Policy in 1964
Trends in Commercial Banking 1 9 4 5 -196 5
Interest Rates, 19 14 -196 5
Budget Policy in a H igh-E m ploym ent Economy
Federal Reserve O pen M a rke t O pe ra tion s in 1965:
O bjectives, A ctions, & Accom plishm ents
The Effect o f T otal Demand on Real O utpu t
Banking M arkets fo r Business Firms in the St. Louis Area
The Federal Budget and Economic S ta b iliza tio n
Economic Theory and Forecasting
1966 — A Year o f C h allen ge fo r M o n e ta ry M anagem ent
Estimates o f the H igh-E m ploym ent Budget: 19 4 7 -1 9 6 7
Three A pproaches to M on ey Stock D eterm ination
M o n e ta ry Policy, Balance o f Payments, and Business
Cycles — The Foreign Experience
M oney, Interest Rates, Prices and O u tp u t
The Federal Budget and S ta b iliza tio n Policy in 1968
28.
1967 —
18.
19.
20.
21.
22.
23.
24.
25.
a Y e a r o f C o n s t r a in t s on M o n e ta r y M a n a g e m e n t
29.
3 0.
3 1.
32.
33.
3 4.
1962
June 1966
July 1966
Septem ber 1966
February 1967
M arch 1967
A p ril 1967
June 1967
O cto b e r 1967
Novem ber 1967
N ovem ber 1967
M arch 1968
M ay
1968
Does Slow er M o n e ta ry Expansion Discrim inate A g a in st Housing?
The Role o f M on ey and M o n e ta ry Policy
The M o n e ta ry Base — E xplan ation and A n a ly tic a l Use
Interest Rate C ontrols — Perspective, Purpose, and Problems
An A pproach to M onetary and Fiscal M anagem ent
M onetary and Fiscal Actions: A Test o f Their Relative
Im portance in Economic S tabilization
35. A Program o f Budget Restraint
36. The R elation Between Prices and Em ploym ent: Two Views
Novem ber 1968
M arch 1969
M arch 1969
37. M o n e ta ry and Fiscal A ctions: A Test o f Their Relative Im portance
in Economic S ta b iliza tio n — Comment and Reply
A p ril 1969
38. Tow ards A R ational Exchange Policy: Some Reflections
on the British Experience
A p ril 1969
3 9. Federal O pen M arke t Com m ittee Decisions in 1968 —
A Year o f W a tc h fu l W a itin g
M ay 1969
4 0.
M a y 1969
C o n tro llin g M oney
June 1968
July 1968
August 1968
Septem ber 1968
Novem ber 1968
4 1. The Case fo r Flexible Exchange Rates, 1969
June 1969
42. An E xplan ation o f Federal Reserve A ctions (1 9 3 3 -6 8 )
July 1969
43. In te rn a tio n a l M o n e ta ry Reform and “ the C ra w lin g Peg”
February 1969
Comment and Reply
4 4. The Influence o f Economic A c tiv ity on the M oney Stock — Comment;
Reply; and A d d itio n a l Empirical Evidence on the
Reverse-Causation A rgum ent
July 1969
45. A H istorical A nalysis o f the C redit Crunch o f 1966
A ugust 1969
September 1969
F E D E R A L R E S E R V E B A N K O F ST. LOUI S
SEPTEMBER 1 9 6 9
Adjustment of Demand Deposit Series
T h e dem an d deposit com ponent of the m oney stock has b e en adjusted to correct for an
understatem ent of these deposits, w hich arose from an increasing volum e of cash items
gen erated by an increasing volum e of Eurodollar transactions. T h e adjusted series indi
cates that the growth of dem and deposits since m id-1967 has b een greater than previously
reported.
T h e dem an d deposit com ponent of m oney is calculated by subtracting several items,
including cash items in process of collection, from gross dem an d deposits.
T h ese d ed u c
tions are m ade to avoid double counting. T h e rapidly grow ing volum e of drafts u sed in
transferring or repaying Eurodollar borrowings, usually referred to as “bills payable ch ecks”
and “L ondon ch ecks”, w ere not inclu ded in gross deposits by th e issuing bank. H ow ever,
these checks w ere inclu ded in the cash item s of the receiving bank, and as such w ere
d ed u cted from gross dem and deposits. T h e cash items gen era ted in this m anner and d e
d u cted from gross dem an d deposits caused an unw arranted reduction in net dem and
deposits. As a result there had b e en a grow ing understatem ent of the dem an d deposit
com ponent of m oney.
Regulation D of the F ed era l R eserve System was revised, effective July 31, 1969, so
that bills payable checks and L ondon checks u sed in the borrow ing and repaym ent of
Eurodollars must now b e inclu ded in gross deposits of the issuing banks, as well as in
cash items in process of collection. As a result, since early A ugust the understatem ent of
dem and deposits caused by excluding bills payable checks and L ondon checks from gross
dem and deposits has b e en eliminated. Revision of the dem an d deposit data from Ju ne
1967 through July 1969 was based on a survey of those banks thought to be most involved
in Eurodollar transactions.
Before the adjustment, the data indicated that dem and deposits had risen at a 1.1
p e r cent annual rate from last D e ce m b er to July.
T h e adjusted series indicates that d e
m and deposits rose at a 3.3 p er cent rate in this period.
T h e revised rate is still substan
tially less than the 6.2 p e r cent rise in 1968 in the form er series and the 6.9 p er cent in
crease in the new series. Also, both series show a m uch slower growth in m oney during
the sum m er than earlier this year.
In the near future dem an d deposit data will b e revised again in accordance with the
results of an annual review of seasonal adjustm ent factors and the incorporation of new
benchm ark adjustments for n on m em b er bank deposits.
Page 3
STABILIZATION ACTIONS IN 1969
HOW MUCH RESTRAINT?
I O TA L SPEN D IN G has continued to rise rapidly
in 1969 and price increases have accelerated. M one
tary and fiscal restraints have been maintained, how
ever, and subject to the lags between policy actions
and the response of econom ic activity, total spend
ing can be expected to show definite indications of
slowing later this year. Following a deficit of $25 bil
lion in fiscal 1968, the Federal budget was slightly in
surplus in the fiscal year ended in June, and a larger
surplus is expected for the current year. The mone
tary base, bank reserves, and money grew m uch more
slowly in the first half of this year and have shown
little or no growth in recent months, after expanding
rapidly in 1967 and 1968.
dential construction. Housing starts fell from an av
erage annual rate of 1.6 million starts early in the
year to a 1.3 million rate in August. During the period
of monetary restraint in 1966, housing starts averaged
a low rate of 1.2 million.
Consumer spending has continued strong, showing
little response to the tax surcharge imposed in mid1968. Consumption expenditures rose 8 per cent in
the year ending in the second quarter, about the
same as in the previous year.
W hile total spending continues to rise rapidly,
growth of output has slowed. Real product growth
Dem and and Production
In addition to the lag between stabilization a c
tions and their im pact on total demand, there is a
further lag before prices respond. Inflationary expec
tations, apparently entrenched in econom ic decision
making processes, m ay have dampened the initial im
p act of m onetary and fiscal restraints on economic
activity.
Ratio Sca le
Billie
Ratio Scale
Q u a rte rly To ta ls a t A n n u a l R ate*
950
900
850
800
750
700
D emand, Production and Prices
650
Total spending has increased at a 7.7 per cent an
nual rate since m id-1968, only slightly slower than the
8.6 per cent rate of increase from early 1967 to mid1968. Growth of spending in 1969 has included a
rapid expansion of business investment in plant and
equipment, which rose at a 13.5 per cent annual rate
in the first half of this year, com pared with a 5.1 per
cent increase in the previous year. The increase in
business investment more than offset declines in resi
600
Page 4
550
500
_______________________________________
1961
1962
1963
1964
1965
1966
1967
1968
1969
Q G N P in current d o llars.
Sou rce: U .S . D epartment o l Commerce
[2 G N P in 1958 d o llars.
Percentages a re a nnu al rates o l c hange b etween periods indicated. They are p resented to a id in
com paring most recent developm ents w ith p ast "tre n d s."
Latest d ata p lo tted: 2nd q uarter
F E D E R A L R E S E R V E B A N K O F ST. LO U I S
SEPTEMBER 1 9 6 9
has moderated since m id-1968, slowing to a 2.3 per
cent rate in the first half of 1969, com pared with a
3.6 per cent rate in the second half of 1968 and a
4.7 per cent rate from early 1967 to m id-1968. The
rapid growth in real product until m id-1968 was un
sustainable, since it exceeded the rate of increase in
productive capacity. Expansion of output in the past
year, when the economy was relatively fully em
ployed, has been accom panied by declining produc
tivity. This decline is evident from the slowdown in
the growth of real product relative to employment.
Most of the decline in productivity has apparently
been centered in the output of services, as m anufac
turing output per man hour has changed only slightly.
Growth of total real product has
dustrial production has increased at
6 per cent annual rate from August
1969. Industrial production increased
rate from m id-1967 to August 1968.
slowed, but in
a rather steady
1968 to August
at a 4.9 per cent
Price increases continue rapid in response to ex
cessive total demand. The general level of prices in
creased at a 1.4 per cent annual rate in the 1960-65
period, at a 3 per cent rate from 1965 to 1967, and
then at a 4 per cent rate through 1968. During the
first two quarters of this year, overall prices increased
at a 5.1 per cent rate, and preliminary data indicate
that the trend continued in July and August. Con
sumer prices have risen at a 7 per cent annual rate
in the last six months, com pared with a 5 per cent
increase in the previous year.
Prices
Ratio S e a l*
Ratio Sca le
1957-59=100
1957-59=100
Aug. 66
1961
1962
1963
1964
1965
t
1966
Aug.6 7
♦
1967
1968
1969
S o u rce : U .S . D epartm ent of Labor
Percen tages a re annu al rates of change between periods in dicated. They a re presented to a id in
com paring most recent developm ents w ith past "trend s."
la te s t d a ta plotted: Ju ly
F e d e ra l G o v e rn m e n t E x p e n d itu re s
R atio S c a le
B illio n s o f D o lla rs
N a tio n a l Incom e A cco u n ts B u d g e t
_
^
, .*
.» .
“° 's .7 ,o ° 0°lljld i".w d
R a tio S c a le
B illio n s o f D o lla rs
300 — — ■
— i— ■
— i— t— ■
—■
— i— ------L—^ — — — |— — r— |— |— |— |— 300
iy4» iy^o ly s *
iy:>4 iy:>o ly^u iyou iy o * iyo4 iyoo iyo»
iy/u
S o u rc e : U .S . D e p a rtm e n t o f C o m m e rce
Percentages are a n n u al ra tes o f ch a n g e betw een periods in dicated.They a re p re sen te d to a id in
com paring m o strecentdevelo pm ents w ith p a s f'tr e n d s ."
L a te s t d a ta p lo tte d : 2nd q u a rte r p re lim in a ry
Measures of Fiscal Actions
The Federal budget deficit, on a national income
accounts basis, was at a $9.5 billion annual rate prior
to enactm ent of the income tax surcharge and curbs
on Federal spending in June 1968, then declined
sharply in late 1968. The budget attained balance
by the fourth quarter and a surplus rate of $12.5
billion in the second quarter of this year. The magni
tude and speed of the shift in budget position sug
gests a substantial dose of fiscal restraint in the past
year.
The information provided by the national income
accounts measure of the Federal budget is incomplete
and misleading, however, because it fails to take
proper account of the effects of cash deficits and sur
pluses on private borrowing. If the Government at
tempts to finance a budget deficit by borrowing from
the private sector, and the stock of money is un
changed, funds are bid away from private use. Thus,
while Government spending in excess of taxes tends
to increase total demand, borrowing from the private
sector to finance a budget deficit tends to depress
private demand. Deficits accom panied by monetary
expansion, however, are stimulative since there is lit
tle, if any, offsetting effect on private spending. It is
in this sense that conventional budget measures may
provide a misleading indication of the im pact of fiscal
actions on total spending; the m ethod of financing a
deficit determines the degree of expansiveness of a
given fiscal program .1
1Such criticism also applies to the high-employment budget,
which during times of significant unemployment is even
further removed from the financing needs of the Government.
Page 5
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
SEPTEMBER 1 9 6 9
If private demands for both goods and credit are
weak and resources are not being fully utilized, a
deficit is usually appropriate because of its tendency
to promote monetary expansion.2 But budget deficits
are not necessary for monetary expansion. Monetary
authorities possess the means to conduct monetary
actions independently of the Federal budget position.
Measures of Monetary Actions
The influence of monetary actions on economic a c
tivity may be best indicated by movements in the
stock of money. If the increase in the stock of money
exceeds the growth of demand for money to hold
by econom ic units, those units which have more
money than they want to hold will try to reduce
their cash balances by spending either for goods and
services or for financial assets. The process of spend
ing provides other units with excess balances and the
process is repeated. The net result is an increase in
aggregate income, and adjustments in interest rates
and the value of other assets sufficient to equate the
actual stock of money in the economy and the de
sired stock. In this manner, increases in money at a
rate greater than the growth of the demand for money
to hold tend to stimulate total spending for goods
and services and for financial assets. Conversely, in
sufficient growth of the stock of money relative to
demand leads to an attem pt to accum ulate cash bal
ances from current income and acts as a brake on
total spending.
M onetary actions continued to be stimulative in
the last half of 1968, as fiscal policy becam e restric
tive. The money stock, which had grown at a 7.2 per
SELECTED M O N ETAR Y AGGREGATES
(A n n u a l Rates o f C h a n g e )
Dec. 67 to
Dec. 68
Total Reserves*
Federal Reserve Credit
Monetary Base
Money Stock*
7.8
Dec. 68 to
May 69
2.4
May to Aug.
1969 p
— 11.6
10.2
5.6
0.9
6.5
5.3
— 1.0
7.0
3.6
2.0
Demand Deposits*
6.9
2.9
0.5
Currency
7.4
6.8
6.4
N ote: The money and demand deposit series are tentative, subject
to further revision in the near future.
cent rate in the first half of 1968, rose at a 6.9 per cent
rate in the second half.
Since D ecem ber monetary actions have been di
rected tow ard restraining total spending and inflation,
and these actions have been facilitated by movement
of the Federal budget into surplus. The money stock
increased at a 3.6 per cent annual rate from D ecem
ber to M ay and at a 2 per cent rate from M ay to
August. In comparison, money grew at a 7 per cent
rate in the previous two years.3
M o n e) Stock
Ratio Scale
Billions of Dollars
Ratio Scale
Billions o{ Dollars
s*7on“l”y. oA df D,u >o »i ldy F i . u , . .
205
205
200
> P ^ ,9 B 3
195
200
195
190
■
— 'V •*0M
+7
190
185
185
180
180
s' J
175
170
165
160
f
A.
y'
6 .8 %
175
(/^
170
165
Ten tativ i N ew S e r i e s -----O ld S e rie s ------
•o
S
155
■?
150 i l Itl l 1l 11 i 1Itl 11 1l 1l l 1l l
1966
1967
160
3
&
...
1968
t
$ $
42
1 !.
1969
155
150
’ ercentages a re a n n u al rates o f chan g e betw een perio ds in d ica ted . Th ey a re presente
to a id in com paring m ost recent developm ents with p a st "tre n d s.”
.atest d a ta p lotte d : A u g u ste stim ate d
The reduced growth of money reflects the mod
erated growth of Federal Reserve credit, m onetary
base and bank reserves since D ecem ber, as shown in
the accom panying table. The base has declined at a
1 per cent annual rate since May, after rising at a
5.3 per cent rate in the first five months and follow
ing a 6.5 per cent rate of expansion during the 19671968 period.
Most interest rates declined during July, and lev
eled or rose during August and early September.
This little ch a n g e , on b a la n c e , p ro b a b ly r e
flects some weakening in the demand for funds.
Business loans at large com m ercial banks have
changed little since M ay, after increasing at a 16 per
cent rate earlier in the year. The fact that interest
rates have risen more slowly recently m ay be a re-
p — Prelim inary
♦Revised series.
2See Michael Keran and Christopher Babb, “An Explanation
of Federal Reserve Actions (1 9 3 3 -1 9 6 8 )”, this Review, July
1969.
Page 6
3These figures are based on a revised money stock series,
adjusted for the effect of Eurodollar transactions on the
demand deposit component of money. Omission of this ad
justment led to an understatement of actual money growth.
The exact adjustment and its effect on the money stock series
is explained on page 3 of this Review.
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
SEPTEMBER 1 9 6 9
Currently businesses plan to spend 10.5 per cent
more for plant and equipment in 1969 than they
spent in 1968, which suggests a 5.5 per cent increase
in spending during the second half of 1969.
F e a r of continuing inflation has apparently caused
some individuals and firms to buy goods to avoid
expected further price rises. In the last half of 1968
fiscal policy succeeded in slowing the growth of takehome pay by increasing taxes, but econom ic units
compensated by spending a larger portion of their
income. The net result was little slowdown in
spending.
flection of some moderation of econom ic activity and
of credit demand, and is not an indication of easing
of m onetary restraint.
Response to Stabilization Actions
Growth of real product has slowed since passage
of the tax bill, reflecting primarily constraints on the
ability of the economy to expand production of goods
and services at a high level of resource utilization.
The earlier rapid rise in total output forced employ
ment of less efficient resources, and growth of pro
ductivity, especially in service industries, could not
be maintained.
The im pact of monetary restraint in 1969 m ay have
been cushioned somewhat by inflationary expecta
tions. The alternative cost of holding cash has in
creased as interest rates have risen, giving incentive
to economize on cash balances. Expectation of infla
tion puts upward pressure on interest rates. Users of
funds are willing to pay higher rates as they expect
to repay their indebtedness with depreciated dollars.
Lim itation of growth of demand for cash balances
resulting from anticipation of inflation offsets some of
the restrictive im pact of reduced growth of the
money stock.
As economic activity slows, the demand for funds
usually weakens and, given the supply of funds, in
terest rates tend downward. The cost of cash bal
ances thus decreases and the quantity of money
demanded increases. If m onetary expansion continues
to be relatively m oderate, the restrictive influence of
such monetary action would then be intensified.
Forecasts based on relationships presented in the
November 1968 issue of this Review indicate that
growth in the money supply at the 3 per cent rate
prevailing since D ecem ber would lead to a slow
ing in total spending to a 6 per cent annual rate by
the fourth quarter. Past experience suggests, however,
that such a slowdown will not be manifested in a
moderation of price advance until well into 1970.
The prospects for continued long-term economic
expansion are reflected in business plant and equip
ment spending plans. Business investment projects
are ventures undertaken to yield a flow of income
over the future, and, consequently, businesses must
forecast demand for long periods into the future in
order to estimate the revenue which can be expected
from investment projects. Plans for rapid plant and
equipment expansion therefore serve as an indica
tion that businesses expect continued sales growth.
Conclusion
L ate in 1968, businessmen expressed plans to in
crease plant and equipment spending by 14 per cent
in 1969, despite the restrictive nature of fiscal policy.
This represented a substantial increase from the 5
per cent rise in such spending in 1968. Investment
in plant and equipment increased at about a 13.5 per
cent rate during the first two quarters of this year,
but recent surveys of business investment plans indi
cate some slowing in the second half of the year.
Total demand is strong and prices continue to in
crease rapidly. The prospects are for slowing of eco
nomic activity later this year, but little weakness is
yet evident in the growth of total spending, employ
ment and production. M onetary restraint has been
operative since D ecem ber, and fiscal restraint since
mid-1968, and their effects will probably be progres
sively manifested in the trend of total spending as
time passes.
Page 7
Controlling Inflation
A speech given by DARRYL R. FRANCIS, President, Federal Reserve Rank
of St. Louis, at the 75th Annual Convention of the Kentucky Rankers
Association, Louisville, Kentucky, September 15, 1969
t P UR NATION has experienced excessive inflation
during most of the period since early 1965. W ith the
exception of a few months following a restrictive
monetary policy in part of 1966, the rise in the gen
eral price level accelerated throughout the period.
Since last D ecem ber consumer prices have increased
at a 6 per cent annual rate. Restrictive monetary and
fiscal policies have been adopted to curb this exces
sive demand, but such actions are effective in reduc
ing total demand only after a time lag.
In response to a more restrictive monetary policy,
the rate of growth in the stock of money has declined
in recent months. Since last D ecem ber money has
risen at a 4 per cent annual rate, com pared with a 7
per cent increase during 1968. Passage of the tax bill
in m id-1968 resulted in moving the Federal budget
to a surplus of about a $7 billion annual rate in the
first half of 1969, com pared with a deficit of more than
a $12 billion annual rate from early 1967 to mid-1968.
W hile to date these restrictive actions have had no
apparent im pact on prices, we are seeing some re
sults from these actions. The financial markets have
stopped becoming progressively tighter and the
growth rate in total spending has decelerated.
In recent months we have heard repeated sugges
tion and repeated denial that direct government con
trols of wages, prices, and credit will be necessary to
break the inflationary boom. Secretary of the Treasury
David Kennedy, in testimony before the Senate
Finance Comm ittee in early July, said he opposed
controls, but th at procrastination in renewing the tax
surcharge would bring on these regulations.1 Even
earlier, Secretary of C om m erce M aurice Stans con1Business Week, July 12, 1969, p. 102.
Page 8
eluded from letters and conversations that a growing
minority of businessmen are so concerned about the
pace of inflation that they would favor controls.2
M uch to my surprise, my contacts with business
men in recent months confirm the Com m erce Secre
tary’s observation that many are talking favorably of
w age and price controls as a solution to the problems
of inflation. This line of thinking is direct and avoids
theoretical complications. It assumes that, since infla
tion is a rise in the general price level, direct controls
over wages and prices can stabilize prices and there
by prevent the evils of inflation.
The advocates of bureaucratic control of prices as
sume that such controls are workable alternatives to
less expansive monetary policies as a means of halting
inflation.
I question the widely assumed “obviousness” of the
workability of direct controls of wages, prices, and
credit, even under ideal conditions. They are expen
sive to administer and extremely difficult to enforce.
They impair the efficiency of the price system as an
allocator of resources and fail to provide an adequate
substitute. The arbitrary rationing involved in direct
controls is a major infringement on individual liberty
and is extremely susceptible to bureaucratic abuses.
D irect controls at best are not a solution to inflation
but only a partial postponement or masking of price
increases in the face of excessive demand.
Experience with Direct Controls
Some of you will require only a reminder of the
problems of administering the Office of Price Admin
istration (O P A ) during W orld W a r II. During that
2Business W eek, June 7, 1969, p. 49.
F E D E R A L R E S E R V E B A N K O F ST. LO U I S
all-out w ar effort, conditions much more favorable
than at present existed for the implementation of
direct controls. In the face of the common enemy,
virtually all citizens were united and willing to make
sacrifices for successful conclusion of the war. In such
an emotionally charged atmosphere, broad industry
agreements and press releases may have contributed
to limitation of price increases in early 1942. During
the year, demand for goods and services continued
to rise, and production for civilian use declined as a
larger per cent of the nation’s resources was demanded
by the military. Thus upward pressure on prices b e
cam e more intense.
By late 1942 specific price schedules were neces
sary. At this time Price Em ergency Regulation No. 2
noted that rents were climbing fast, and rent controls
w ere put into effect.3 Price Em ergency Regulation
No. 3 of O ctober 1942 noted that, despite the regula
tions, wages and farm prices had moved up, forcing
continuous amendments a n d
additions to the
regulations.
In June 1943, after a hectic 16 months of operating
under intense pressure, the OPA was overhauled. The
authority for setting prices was passed from the W ash
ington office to the field offices. Numerous advisory
committees were appointed, and ration books were
issued.
By late 1943 emergence of a black market (sell
ing above OPA price limits) and a shortage of en
forcem ent investigators were noted. The substitution
of low-quality goods in the higher-quality price
brackets was also apparent. Subsidies to producers
becam e an increasing part of the price control pro
gram in the late war years, as set prices were insuffi
cient to provide the necessary incentive for produc
tion. Commodities subsidized included coal, lead,
copper, tin, petroleum, coffee, and farm products.
The number of workers required to operate and
enforce this program was staggering. By 1944, 325,000
price control volunteers,4 in addition to 65,000 paid
employees,8 were being utilized. This was a period
when the country was faced with a labor shortage,
and most of these people could have worked at pro
ductive jobs, thereby contributing to an increase in
total output and a lower rate of inflation. In addition
3U.S. Office of Price Administration, Renewal of the Price Con
trol Act, Congress, House Banking and Currency Committee,
April 12, 1944.
4Ibid., p. 58.
6U.S. Department of Commerce, Statistical Abstract of the
United. States, 1946, p. 207.
SEPTEMBER 1 9 6 9
to the number of employees required directly by
OPA, the program was a burden to all business es
tablishments. F or example, the banking system was
handling 5 billion ration coupons per month in 1944.
By 1946 people were no longer willing to make
wartime sacrifices, and much of the wartime price
control machinery was bypassed. Breaking the law
becam e extremely profitable. Little respect was
shown for a law which banned econom ic transactions
that were permitted and morally acceptable in pre
w ar years.
Both for those who had blind faith in the law and
for the profit maximizers, the choice of action was
easy — the former to obey the law and the latter to
ignore it. F o r other Americans, the decision of whether
or not to obey the law was difficult. Before the regu
lations were finally revoked, most individuals and
businesses participated to various degrees in law
breaking, including black marketing, gray markets,
tie-in-sales, kickbacks, and upgrading.
Few people were disturbed at the illegal aspect of
two or more people making a mutually satisfactory
deal at prices above the OPA legal limit. F o r example,
those who wanted a freezer of beef often went di
rectly to a farm er friend and made the purchase at an
agreed price. The packing house and retailer, where
OPA prices were enforced, w ere bypassed. Store
shelves were often empty and our efficient channels
of processing tended to collapse. Nevertheless, those
who had good contacts with producers managed to
satisfy most of their demands, although at a higher
cost through this inefficient means of production and
marketing. One OPA official reported that while tra
veling through Texas he stopped in a rural area where
a farm er was slaughtering a steer for illegal sale. The
official asked the farm er if he didn’t know that the
practice was illegal. The farm er replied, “I reckon
we ain’t heard about that law out here.”
Finally, in 1946, after a year of post-war domestic
crises which included numerous strikes, food short
ages, and a high rate of inflation, most of the provi
sions for direct controls w ere ended. Rent controls
were the last to go, with some lingering on into the
1950’s and some even to the present day. Owners
found it unprofitable to keep rental property in good
condition. By the time most rent controls w ere finally
removed, rental property had already becom e dilapi
dated. Those W orld W a r II rental apartments which
continued under controls into the 1950’s now com
prise many of our central city slum areas.
Page 9
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
Function of Price System Impaired
As an alternative to arbitrary government control,
the price system is an autom atic and impersonal con
trol mechanism. It allocates resources to various types
of production according to demand for individual
products, and output is determined according to con
sumers’ willingness to pay for goods and services. In
come is allocated to individuals and firms according
to their contribution to total output. These allocations
are m ade without personal prejudice and with neu
trality with respect to political, religious, or social
affiliation. In other words, they are m ade in a highly
objective and dem ocratic manner.
I do not contend that the price system is perfect.
In the existing market, some business and some labor
groups can exercise greater power than others. This
and other imperfections, however, are relatively
minor com pared to problems created by direct
controls.
F o r example, under direct controls, rationing is
generally necessary in order to allocate scarce items,
and almost all items are scarce under price controls.
Allocations of labor and other resources among indus
tries and firms are determined by arbitrary govern
ment rules rather than through freedom of choice.
Controls which maintain prices and wages below
market levels in any industry offer no inducement
for the increase in production necessary to alleviate
shortages. Arbitrary w age setting is not likely to pro
vide for payments according to individual produc
tivity; consequently, there is little or no inducement
to improve one’s skill.
D irect government controls, therefore, offer little
inducement for the efficient development and use of
resources, and contain no autom atic mechanism for
resource adjustments and the alleviation of shortages
or excesses in production. Rather than being an aid
to growth and vitality, they lead to econom ic retarda
tion and reduced national welfare.
Infringem ent on Freedom
Equally as important as the econom ic shortcomings
of direct controls is their useless infringement on free
dom. Freedom did not com e easily to mankind, but
we tend to take it for granted. Y et in most of the
periods since man’s early history he has been forced
to bow in both thought and action to harsh taskmas
ters. M ore often than not, his social position, his in
come, his occupation, and his religion w ere forced
upon him.
Page 10
SEPTEMBER 1 9 6 9
Some rays of freedom began to be noticed in much
of W estern Europe about the time that Am erica was
discovered. By the late 1600’s freedom of thought and
action in the Netherlands was well ahead of that in
other European Countries. Similarily, econom ic prog
ress was most noteworthy there.
The streams of W estern Europe’s citizens which
migrated to the American colonies sought both eco
nomic and other freedoms. They cam e from areas
where the state controlled their econom ic life and
the church controlled their thoughts.
Roger Williams led the w ay tow ard freedom in the
American colonies with a constitution in Rhode Island
that provided for relatively little governmental inter
ference with the daily lives of the citizens. This phi
losophy, which subscribes to a maximum degree of
individual freedom, was inherent in the thinking of
Jefferson, Adams, Madison, and other founders of this
nation.
John Locke, about 300 years ago, postulated a state
in which men w ere free and equal before the law
and before each other. His ideal government was
one which represented majority rule rather than an
exclusive structure for a king or dictator at the top.
W hile Locke recognized that most econom ic problems
were self-adjusting, w e must come forward to Adam
Smith’s day, about 200 years ago, before a harmonious
theory was developed showing how an economy
works most efficiently under relatively free conditions.
To the confusion of most people in his day and of
our time, Smith argued that most government efforts
designed to improve econom ic activity and welfare
actually were retarding influences. Along with other
great philosophers in later years, he pointed to a free
and efficient enterprise economy. Added to the free
dom to select government officials, this system pro
vides by far the greatest freedom from coercion and
want of any system that has so far been devised.
D irect w age and price controls are not compatible
with freedom. Instead of workers moving voluntarily
from job to job for relatively higher pay, under a
direct controls system they must be moved by arbi
trary action of government. Under direct controls
personal income, living costs, and the very necessi
ties of life are determined arbitrarily by government
with an army of enforcers. Such a system contains
the ingredients for complete dictatorship at the top
and com plete subservience at the bottom. It is cer
tainly not com patible with freedom as experienced
in America during most of our years since
independence.
F E D E R A L R E S E R V E B A N K O F ST. LOUI S
W age and Price Controls
No Solution to Inflation
—
In addition to the facts that direct w age and price
controls are almost impossible to administer, impair
important functions of the price system, and are con
trary to our ideals of freedom, they do not provide a
solution to inflation. During the period from M arch
1942 to October 1946, in which direct controls were
used, the consumer price index rose 6 per cent a
year, and there is fairly general agreement that the
index understated the actual rate of inflation because
of declining quality of products and black market
operations. W ages rose at a slightly faster rate than
consumer prices.
The stock of money rose at an 18 per cent rate
during this period, as the Federal Reserve System
sharply increased bank reserves while conducting
supporting operations for U.S. government securities.
This very expansive monetary policy, coupled with a
reduction in output of consumer goods and services,
put great upward pressure on prices, and how much
wages and prices would have risen in the absence of
controls is unknown.
Even if controls hold back reported price and wage
increases for the time being, they do not solve the
problem of inflation. If excess demand for goods and
services has been created, it continues to exist. D irect
controls, like a new paint job over a termite infested
house, hide the evidence but do nothing to eliminate
the cause of the problem. Unless the basic causes of
inflation are eliminated, direct controls can only post
pone the inevitable price increases until some future
date.
Attack the Cause of Inflation
The best solution to the problem of inflation is to
eliminate the cause. Inflation occurs because the stock
of money (dem and deposits and currency in circula
tion) increases relative to the amount of money that
people want to hold, given their level of wealth and
income. Starting from a position of stable prices, if
additional money is created faster than it is demanded,
people will spend more, thereby reducing the propor
tion of their wealth held in the form of money. W hen
the rate of spending rises faster than production of
goods and services, prices rise. Prices continue up
until money incomes and wealth are pushed up to
the point at which the public wants to hold the in
creased stock of money. The growth of money is thus
the key to inflation, and appropriate monetary control
provides the solution to the problem.
SEPTEMBER 1 9 6 9
The current inflation can be traced to the course of
the stock of money. Money grew at an annual rate
of 3 per cent from 1961 to early 1965. This rate of
growth in the stock of money was accom panied by
generally stable prices, moderate economic expan
sion, and a decline in the rate of unemployment.
From the spring of 1965 to the spring of 1966, the
stock of money rose 6 per cent, and both spending
and inflation accelerated. From the spring of 1966 to
the end of the year, the stock of money remained
stable, followed shortly by a decline in the rate
of inflation.
Rapid m onetary expansion was resumed in early
1967, soon followed by acceleration of spending and
inflation. From January 1967 to D ecem ber 1968 the
stock of money expanded at a 7 per cent annual rate,
and since the second quarter of 1967, the general
price index has risen at more than a 4 per cent an
nual rate. Since last D ecem ber the stock of money
has risen at a more m oderate rate, and I look for
ward, as a result, to a reduction in the growth of total
spending and in the rate of inflation during the
months ahead.
Throughout most of econom ic history, inordinate
inflations have been limited because the stock of
money was tied to a relatively stable quantity of
precious metals. That period in history has largely
passed, as precious metals are no longer a restraining
influence on money creation. Today, the prevention
of inordinate inflations depends upon appropriate
limitation of the growth in the stock of money by
central banks and treasuries.
In the United States, the Federal Reserve System
has the responsibility of formulating m onetary policy.
It is believed by most monetary analysts that the
System can control the stock of money through its
power to control Federal Reserve credit and bank
reserves. W hen the Federal Reserve System buys
government securities, bank reserves are created.
W ith a larger volume of bank reserves, bank expan
sion can proceed. As new loans and investments are
made, the volume of demand deposits, the major
component of our stock of money, rises. Sales of gov
ernment securities by the Federal Reserve can reverse
the process, reducing the stock of money.
Fiscal deficits are often associated with inflations,
primarily because of the method used to finance them.
If deficits are accom panied by an inordinate expan
sion of Federal Reserve credit (as is often the ca se ),
excessive money is created. But if the deficit is fi
nanced without the creation of new money, it will
Page 11
SEPTEMBER 1 9 6 9
F E D E R A L R E S E R V E B A N K O F ST. LOUI S
probably have little im pact on prices. Proceeds from
the sale of government securities will be removed
from the private spending stream and the rise in gov
ernment outlays will be offset by reduced spending
in the private sector. In nearly every country experi
encing a major inflation, the cause is the creation of
new money to finance government activities. W e have
no evidence, however, that government deficits which
are not monetized will lead to inflations.
Some contend that inflations are caused by “w age
push” or “administered price actions.” The argument
is based on the belief that some wages and prices can
be arbitrarily increased because of excessive market
power. “W age push” or “cost push” adherents point
out that new wage contracts in the steel industry are
followed by steel price increases, which are in turn
followed by automobile price increases. This series of
events, however, does not lead to inflation unless ex
cess demand has been created through monetary ex
pansion. If, through excessive bargaining power,
wages are pushed too high in these industries, output
will decline in the absence of monetary expansion.
Resources will then be released to other industries
where prices will fall. Average prices for all goods
and services will remain about unchanged once re
sources are again fully employed. Monetary expan
sion must accom pany “w age push” or “cost push” a c
tions in order for inflation to occur.
Summary
Our experience during W orld W ar II with direct
controls on wages and prices was a futile exercise in
the economics of admonition and legal restraint. Most
price rigidities set up by the OPA caused a break
down both in our efficient production and marketing
channels and in quality standards. Producers who
had products which were in great demand, and pur
chasers who were not satisfied with the rationing
process, generally found a way to bypass OPA regu
lations. Disrespect for the law becam e the normal
pattern of life rather than an aberration. Despite the
legal and moral restraints and an army of controllers,
prices and wages continued to rise rapidly throughout
the w ar and early postwar years.
If governments w ere sufficiently strong to set rigid
controls on wages and prices, freedom would be
greatly reduced. L abor and other resources would be
moved from job to job arbitrarily by the government
rather than through w age incentives. Much of the
m anagerial function of businesses would shift to the
government, and the need for the best managerial
talent in the private sector would disappear. Such
Page 12
controls impair the functions of the market system.
They eliminate incentive for output increases in
areas of rising demand. They are thus conducive to
economic retardation rather than progress.
Appropriate monetary policies are the only means
that have proved workable throughout history in con
trolling inflations. W hen kings and emperors debased
their nation’s currencies by reducing the precious
metal content of money, inflations ensued. Today we
debase our currency by excessive creation of paper
money and demand deposits.- Our means of currency
debasement is more sophisticated and less direct than
in medieval and ancient ages. Yet, the result is the
same — excessive money created relative to produc
tion of goods and services lowers its value. The solu
tion requires a proper limitation on the stock of
money.
Control over the stock of money in the United
States lies chiefly with the Federal Reserve System.
Control can be exercised with greater ease when the
Federal budget is in balance or surplus, since the
Government will not be forced to borrow additional
funds in a financial market where credit is restricted
by tight monetary policies. Even with stimulative
budgetary policies resulting from military or social
expenditures, however, the Federal Reserve System
can maintain a moderate rate of growth in the stock
of money and control over total demand for goods
and services through an appropriate rate of money
creation.
In contrast to the relatively certain method of con
trolling inflation through appropriate monetary a c
tions, direct controls on wages and prices do not get
at the cause of the problem. To the extent that they
retard w age and price increases, they, like an anesthe
tic, only put the patient to sleep. His malady remains
unabated when he is awakened. But in the face of
excessive demand for goods and services, the slip
pages and bypasses, such as black markets, quality
distortions, etc., experienced with such controls,
create a wide gap betw een the intent of controls
and the actual terms of transactions. This intent to
catch all prices and wages in one controls bag, when
contrasted to the actual results which have been ex
perienced, reminds m e of a short ditty regarding the
latest style in bathing suits.
“M ary had a bathing suit,
the latest style no doubt,
but when she got inside it,
she was more than halfway out.”
A Historical Analysis of the Credit Crunch of 1966
by A L B E R T E . B U R G E R
I N E A R L Y 1966 the U.S. economy was entering the
sixth year of continuous economic expansion. The
unemployment rate was at 4 per cent, a level be
lieved almost unattainable two or three years earlier,
capacity utilization was close to 90 per cent, and
firms were faced with an exceptionally large backlog
of orders. The economy had not only reached a state
of full employment, but there was every indication
that the “boom” would continue. To many, it ap
peared that the “New Econom ics” had finally re
moved the danger of recession or econom ic slowdown.
The year 1966 was not, however, to be rem em
bered as a year of smooth econom ic expansion. The
real sector of the economy, operating at the fullemployment level of real output, was forced to at
tem pt to adjust the mix and amount of real output to
m eet the increased demands of both the private and
government sectors. The two main topics in discus
sions of econom ic stabilization policy in 1966 were as
follows: ( 1 ) the sharply rising level of Government
spending for the Vietnam war, and ( 2 ) the em er
gence of inflation. A t the start of 1966, firms operating
at near capacity with record levels of backlogs of
orders, when making plans for future capital ex
penditures, expected rising aggregate demand, a ris
ing price level, and a “tighter labor market” with
rising w age demands. These types of expectations
are all precursors to a boom in capital spending.
As corporations and the government sector bid agressively for funds, financial intermediaries and the
securities markets were placed under increasing de
mand pressure. The aggregate demand for real out
put, and the ability of various sectors of the economy
to acquire funds to make their desired command
over real output effective, was such that, at existing
prices, the demand for real output exceeded the
productive capacity of the economy.
Reflecting demand pressures on the productive
capacity of the economy, prices rose rapidly. Over
the first nine months of 1966, the consumer price
index rose at a 3.7 per cent annual rate, and the
wholesale price index rose at a 3.5 per cent rate,
com pared to rises of 1.7 per cent for consumer prices
and 2.0 per cent for wholesale prices in 1965, and
com pared to an average annual rate of increase of
1.2 per cent for consumer prices and essentially no
change for wholesale prices during the 1960-64 period.
In the summer of 1966 a policy of monetary re
straint led to conditions popularly called the “Credit
Crunch of 1966.” The most publicized features of
this period were (1 ) the development in August of
an alleged near liquidity crisis in the bond markets
and (2 ) a record decrease in savings inflows into
nonbank financial intermediaries and the resulting re
duced rate of residential construction. This article
focuses on the first of these developments. The role
of monetary policy and its impact on the com m er
cial banks and the financial markets is discussed and
analyzed.
The 1966 experience has exercised an important
influence on m onetary policy decisions made since
that time and on the procedures for raising funds
used by the commercial banks. The possibility of
causing another “Credit Crunch,” with all of its feared
ramifications on the financial markets and the savings
and loan and housing industries, acted as an im
portant constraint on a decision to move toward a
tighter monetary policy in the last half of 1967. These
same fears, combined with overly optimistic expecta
tions on the potency of the fiscal actions taken in
mid-1968, constrained m onetary policy decision
makers again in 1968.
In 1966, for the first time, comm ercial banks ex
perienced a period when the Federal Reserve actively
used Regulation Q ceiling rates on time deposits as
a means to restrict the banks’ ability to extend credit.
Since that time commercial banks have actively
sought new methods, such as Eurodollar borrowings,
to obviate the constraint of Q ceilings.
Page 13
F E D E R A L R E S E R V E B A N K O F ST. LOUI S
SEPTEMBER 1 9 6 9
This article is divided into four major sections. The
first section discusses conditions in the credit markets
in the first eight months of 1966; the second section
discusses and analyzes both the intent and im pact of
Federal Reserve policy during this period; the third
section discusses the actions and reactions of the
commercial banks during the first eight months of
1966; and then the last section presents a summary
of developments in the remainder of 1966.
Much of the large demands in the financial m ar
kets resulted from the fiscal devices employed by the
Federal Government to reduce the reported budget
deficit for the fiscal year ending June 30, 1966. The
Administration tried to reduce the im pact on the fis
cal 1966 budget of increased spending for the Viet
nam W ar and the rapid rise in other Government
spending, by: ( 1 ) accelerating tax payments, and ( 2 )
selling Government-owned financial assets.
The Credit Crunch has been discussed in summary
form in numerous other short articles. This article
attempts to present a more complete exposition and
analysis of the period. The article focuses on the
specific causes of demand pressures in the markets
for funds in 1966, and the role of key institutional
developments such as the increased use by banks of
certificates of deposits and the increased importance
of municipal securities in banks’ asset portfolios.
The 1964 tax law, designed to put large corpora
tions on the basis of paying taxes on current year’s
income by 1971, was revised in 1966 to require them
to reach this point by 1968. As a result, corporation
taxes paid on June 15, 1966, were estimated to b e
about one-third larger than a year earlier. Additional
tax revenues were shifted forward into fiscal 1966 by
requiring large corporations to make payments of
withheld income and social security taxes on a semi
monthly rather than a monthly basis. Corporations
paid an estimated $1.5 billion in taxes in June that
would not have been due until July.
The im pact of monetary policy is analyzed within
the framework of a specific hypothesis about the
money supply and bank credit processes: the Brunner-M eltzer N on-Linear Money Supply Hypothesis.
To the author’s knowledge this is one of the first
attempts, aside from previous work by Professors
Brunner and Meltzer, to apply this method of analy
sis to a specific time period. The basic framework of
analysis might be called a portfolio approach to the
analysis of monetary policy. This market-oriented ap
proach emphasizes alternative costs and yields of real
and financial assets in determining the portfolio a c
tions of econom ic units.
Developments in the Money and Capital
Markets: First Eight Months of 1966
Some of the most notable features of 1966 were
the portfolio adjustment problems, culminating in Au
gust, that developed in the money and capital m ar
kets. These problems were particularly noticeable
among the financial intermediaries as they attempted
to adjust their asset holdings to m eet the strong de
mands for funds, and to m eet sharp changes in their
liabilities.
Demand Pressures in the Financial Markets
During the first eight months of 1966, the business
and government sectors placed heavy demands for
funds in the money and capital markets. Corpora
tions raised an estimated $13 billion in new cash from
the sale of securities, up 25 per cent from the $10.4
billion raised by corporations in the first eight months
of 1965.
Page 14
To m eet the additional cash demands caused by
the accelerated tax paym ent schedule, while at the
same time maintaining their high levels of capital
spending, corporations drew down their liquid assets
and relied heavily on the com m ercial banking system
as a source of funds. Corporations increased their
bank loans by $3.9 billion during the second quarter
of 1966, com pared to an increase of $2.7 billion in
the same period of 1965.
The greatest source of pressure in the financial
markets coming directly from the Federal Govern
ment sector originated in the sale of securities by
F ederal agencies, not in direct debt financing. The
amount sold by Federal agencies was three times as
great as the $1.6 billion raised in the first eight
months of 1965. In the months of M ay and June, at
the same time that the financial markets encountered
heavy demand pressures from corporations to meet
their accelerated tax payments, Federal agencies
raised $1.7 billion in new cash, about a billion dol
lars more than in the same two months of 1965. Such
security sales were entered as reductions in expendi
tures in the Federal budget, and thus acted to reduce
the reported spending totals and the cash deficit.
In August, the month of the so-called Credit
Crunch in the financial markets, corporations and
Federal Government agencies placed especially heavy
demands for credit. Typically, a lull occurs in new
issue activity in the securities markets in August.
F E D E R A L R E S E R V E B A N K O F ST. LOUI S
SEPTEMBER 1 9 6 9
Table I
ESTIMATED GRO SS PROCEEDS FROM
N E W SECURITIES OFFERED FOR CASH
IN THE UNITED STATES
(m illions o f d o lla rs )
All Offerings
U.S. Government
State and Local
Governments
Corporations
Federal Agencies
August
1965
2,354
371
August
1966
3,676
386
Per Cent
Increase
56.2%
4.0
764
1,712
799
6.4
84.1
234.3
718
930
239
Source: Securities and Exchange Commission, Statistical Bulletin.
However, in August 1966 the government and private
sectors of the economy raised an estim ated $3.7 bil
lion in new cash, a substantial increase from the
$2.4 billion borrowed in August 1965. As shown in
Table I, estimated gross proceeds from new securities
offered for cash by the U.S. Government and by state
and local governments remained at about the same
level as in August 1965. However, com pared to the
same period of 1965, corporations and Federal agen
cies issued a much larger volume of new securities.
In August, the estimated new cash raised in the se
curities markets by corporations and Federal agencies
was more than twice as great as in August 1965.
Rising Interest Rates
Reflecting primarily the heavy demand for credit
in the first eight months of 1966, m arket interest
rates rose to new peaks for the post W orld W a r II
period. The weekly average of yields on Aaa-rated
corporate bonds rose 64 basis points by the end of
August. As shown by Table II, yields on long-term
Government bonds and state and local securities, and
yields on short- and intermediate-term securities, also
rose markedly over the first eight months of 1966.
The increased demand for credit by the business
sector led to a sharp rise in interest rates on business
loans. Com m ercial bank rates on short-term busi
ness loans, as reported in a survey of banks in 19
large cities, rose from an average of about 5 per cent
in the first three quarters of 1965 to an average of
5.82 per cent in June of 1966 and then rose to 6.30
in September of that year. M arket rates on four- to
six-month com mercial paper, which averaged 4.35
per cent over the first three quarters of 1965, rose
sharply to 5.51 per cent in June 1966, and then in
creased to 5.85 per cent in August 1966.
High Interest Rates Did Not Curb Corporate
Expenditures
Once corporations had begun large capital spend
ing programs, they w ere unwilling to allow rising
market rates of interest to bring these programs to a
sharp halt. Although by past comparisons interest
rates rose to very high levels, many corporations
found that even at higher rates of interest the rate
of return they could earn on borrowed funds exceeded
the cost of borrowing. Fortu ne M agazine (Ju ne 15,
1 9 6 7 ), in its review of operations of the 500 largest
non-financial corporations in the United States, found
that in 1966 the median industry return on invested
capital was 12.7 per cent, up from 11.8 per cent in
1965. Almost all industry groups in the Fortune study
showed an increase in their return on invested capital.
The main concern of corporations seemed to be
more with the availability of funds than with the
cost of these funds. Prime rate customers placed
large orders for cash with the comm ercial banking
system. As Jerom e Behland, Treasurer of OwensIllinois, Inc., remarked in an interview with Business
W eek in late August:
O ur general corp orate attitud e is th at you can ’t
stop a $ 5 0 0 million program just b ecau se the cost of
borrow ing goes up. T h a t’s p art of the cost of the
p rogram , and if it is one th at is going to produce
a m ore profitable operations for the corporation, then
it m ust p ro ceed .1
Table II
Intent and Impact of Federal Reserve Policy:
First Eight Months of 1966
WEEKLY AVERAGES O F A N N U A L YIELDS
O N SELECTED SECURITIES, 1 9 6 6
Peak in Month
Early
Jan.
Corporate Aaa bonds
473%
Long-Term Governments
4.44
State and Local Governments 3.40
3-5 Year Governments
4.92
3-Month Treasury Bills
4.50
4-6 Month Prime Commercial
Paper
4.75
June
5.07%
4.63
3.60
5.02
4.59
July
5.22%
4.78
3n
5.25
4.89
August
5.37%
4.87
3.94
5.79
5.06
5.51
5.63
5.85
In this section w e first examine the intent of mone
tary policy in 1966, and then discuss movements in
money and bank credit, two commonly used indica
tors of the im pact of monetary policy on the real
sector of the economy. An analytical framework is
presented which permits one to determine the impact
Federal Reserve policy actions have on money and
S o u rer: Federal Reserve B u lletin, March 1967.
1Business W eek, August 27, 1966, p. 23.
Page 15
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
SEPTEMBER 1 9 6 9
bank credit, and to analyze the causes of observed
movements in money and bank credit.
The Intent of Monetary Policy
The published records of the Federal Open Market
Committee (F O M C ) meetings show that the intent
of the monetary authorities, beginning in the middle
of D ecem ber 1965, was to move to a progressively
“tighter” policy. At the D ecem ber 14, 1965 FO M C
meeting the broad policy goal expressed was:
. . . to com plem ent oth er recen t m easures [an in
crease in the discount ra te ] taken to resist the em er
gen ce of inflationary pressures . . . while accom m o
dating m o d erate grow th in th e reserve base, bank
cred it, and the m oney supply.
At the January 11, 1966 FO M C meeting the Com
mittee voted to:
. . . resist the em ergen ce of inflationary pressures
. . . by m oderating the grow th in the reserve base,
bank cred it, and the m oney supply.
At the M arch 1 meeting the Comm ittee voted to
“resist inflationary pressures” rather than the “em e r
g en ce of inflationary pressures.” In mid-April the
FO M C directive called for “restricting” rather than
“moderating” the growth in the reserve base, bank
credit, and the money supply. The directive sub
sequently remained little changed until late 1966.2
Movements of Two Monetary Aggregates
Two widely used indicators of the effect of mone
tary policy on the real sector are ( 1 ) money, defined
as currency plus demand deposits held by the non
banking public, and ( 2 ) bank credit, defined as the
loans and investments of com m ercial banks.
M oney Stock — During the last four months of 1965
and through the first four months of 1966 the money
stock expanded at a rapid rate. Over the last four
months of 1965 the money stock increased by $3.6
billion, or at an annual rate of 6.8 per cent. During
the first four months of 1966 the money stock con
tinued to increase markedly, rising at an annual
rate of 6.4 per cent. One of the most noticeable
features of this rise was that it was a fairly steady
month-by-month increase. After April, the money
stock showed almost no noticeable change. Through
January of 1967 it remained at approximately the
level reached in April of 1966.
2See Leonall C. Andersen and Elaine Goldstein, “1966 — A
Year of Challenge for Monetary Management,” Federal Re
serve Bank of St. Louis Review, April 1967, pp. 8-23.
Page 16
Bank C red it — Credit e x t e n d e d by commercial
banks increased steadily at a rapid rate from early
1965 through June of 1966. Over the last four months
of 1965, bank credit expanded at an annual rate of
10.4 per cent. Bank credit continued to rise at a rapid
rate over the first four months of 1966, rising at an 8
per cent annual rate. W hereas the growth of the
money stock stopped in April 1966, the stock of bank
credit continued to grow at an 8 per cent annual rate
through July. The growth of bank credit throughout
the whole period January 1965 to July 1966 was
manifested in a very sharp increase in bank loans.
The growth of bank credit cam e to a temporary
halt in August during the so-called Credit Crunch.
By components, this halt reflected a deceleration of
the rate of increase in bank loans and a decrease of
$0.6 billion in banks’ holdings of securities. In Sep
tem ber bank credit increased sharply, but following
September the growth of bank credit m oderated
noticeably until near the end of the year.
The Impact of Policy Actions on Money and
Bank Credit
The three major policy instruments under the direct
control of the monetary authorities are as follows:
( 1 ) the discount rate; ( 2 ) reserve requirements on
member bank deposits; and ( 3 ) changes in the F e d
eral Reserve’s holdings of Government securities. In
addition, a regulatory power of the Federal Reserve,
Regulation Q ceilings on interest rates offered by
F E D E R A L R E S E R V E B A N K O F ST. LOUI S
commercial banks on time deposits, has been used
at times since m id-1966 as if it were also a policy
instrument.
SEPTEMBER 1 9 6 9
Table III
ADJUSTED M O NETARY SOURCE BASE (Ba),
APRIL 1966
The Federal Reserve, by its policy actions alone,
does not determine the equilibrium level of market
interest rates. Likewise its policy actions are not the
only factors which enter into the determination of
the equilibrium stocks of money and bank credit. The
amount of money and bank credit supplied to the
economy also depends upon behavioral actions of the
com m ercial banks and the public. To understand
how the Federal Reserve, with its policy instruments,
can control the money supply and bank credit proc
esses, and to analyze and predict the effects of policy
actions on these aggregates, one must use a fram e
work which incorporates the behavioral responses of
the commercial banks and the public.
T h e Analytical F ram ew ork — The Brunner-Meltzer Nonlinear Money Supply Hypothesis is such a
framework.3 Money ( M) , defined as demand de
posits and currency held by the nonbanking public,
and bank credit ( B C ) are defined therein as:
M = m Ba
BC = a Ba
where B a is the adjusted monetary source base, and
m and a are multipliers. In this article the monetary
source base is adjusted by removing member bank
borrowings, and is defined as shown in Table III.4
The adjusted monetary source base ( B a) is an
asset supplied to the private sectors of the economy
by the monetary authorities. The uses of the mone
tary source base by the banks and the public are
member bank deposits at the Federal Reserve banks,
banks’ holdings of vault cash, and currency held by
the nonbank public. The source base is considered
an important quantity because:
(1 )
T h e m agnitude of B a, given the portfolio de
cisions of the banks and the public, determ ines
the size of the stocks of m oney and bank cred it;
3For a complete discussion of the Brunner-Meltzer hypoth
esis, see Albert Burger, An Analysis and Development of the
Brunner-Meltzer Nonlinear Money Supply Hypothesis, Work
ing Paper No. 7, available from Federal Reserve Bank of
St. Louis.
4In alternative formulations of this multiplier-base frame
work, member bank borrowing may be included as a com
ponent of the base and the base adjusted for reserve
requirement changes. For a more complete discussion of the
sources and use of the monetary base, see Leonall C. Ander
sen and Jerry L. Jordan, “The Monetary Base: Explanation
and Analytical Use,” this Review, August 1968, available
as Reprint No. 31.
(not seaso n ally adjusted)
(Millions
o f Dollars)
Federal Reserve holdings o f U.S. Government securities
Float
Gold Slock
Treasury currency outstanding
Less:
Treasury cash holdings
Treasury deposits at Federal Reserve banks
Foreign deposits at Federal Reserve banks
Other (net)
Equals: adjusted monetary source base
Federal Reserve holdings o f Government
securities as per cent o f B®
$40,758*
1,934
13,632
5768
941
311
148
903
59,789
68%
•-Includes $129 million of acceptances not shown separately.
( 2 ) E m p irical evidence shows th at changes in the
am ount of base m oney supplied to the public
and banks h ave been, on average, th e m ajor
cause of changes in the stocks of m oney and
bank cred it; and
( 3 ) F ro m the sources side, the am ount of base
m oney supplied is under th e com plete control
of the F e d e ra l R eserve.5
The monetary base and the multipliers jointly de
termine the supply of money and bank credit. Given
the stock of base money, the value of the money
multiplier ( m ) determines the outstanding money
stock. Likewise, the value of the bank credit multi
plier ( a ) determines the amount of bank credit that
will be supported by a given stock of base money. F or
example, if the value of m is 2.5, then each dollar
of base money supports $2.50 of currency and de
mand deposits held by the public. Given a one dollar
change in the stock of base money, and assuming
the change in base money does not alter the equi
librium value of m, the result will be a change
of $2.50 in the stock of money held by the public.
The numerical values of the money and bank
credit multipliers are determined by:
(1 )
Policy actions of th e F e d e ra l R eserve System.
T h e policy p aram eters th at en ter into the de-
5This does not mean that the Federal Reserve determines
Treasury cash policy or that the Federal Reserve determines
the surplus or deficit in the balance of payments. It means
that, through open market operations, die Federal Reserve
can offset any movements in Treasury cash policy and inflows
or outflows of gold. Also, this does not mean the Federal
Reserve will choose to offset changes in either of these fac
tors affecting the supply of base money. However, by open
market purchase and sale of government securities the Fed
eral Reserve has the power, if it wishes to exercise that
power, to determine the magnitude of base money supplied
to the economy.
Page 17
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
term ination of the values of the m ultipliers are:
( a ) legal reserve requirem ents on m em ber bank
dem and and tim e deposits; ( b ) the discount
rate and adm inistration of the discount window ;
and ( c ) R egulation Q interest rate ceilings.
( 2 ) Portfolio decisions by the public. A m ong these
decisions are: ( a ) the decision of the public as
to its desired allocation of bank deposits be
tw een dem and and tim e deposits; (b ) the d e
cision of the public as to its desired allocation
of m oney balances betw een bank m oney and
curren cy, and ( c ) the public’s desired alloca
tion of bank deposits betw een m em ber and
nonm em ber banks.
(3 )
Portfolio decisions by the banks. F o r exam ple,
( a ) the banks’ desired holdings of excess re
serves relative to deposit liabilities, and ( b )
the am ount of m em ber bank borrow ing from
th e F ed eral Reserve given the discount rate.
( 4 ) T reasu ry policy as to holding of deposits at the
com m ercial banks versus at the F ed eral Reserve.
E x a ct forms of the multipliers are given in footnote
6 below.
In this multiplier-base framework, Federal Reserve
policy actions have two major effects. First, through
its open market operations the Federal Reserve can
determine the amount of base money. Secondly, by
changing the other policy param eters under its con
trol the Federal Reserve can influence the amount
of money or bank credit a given stock of base money
will support.
eThe money multiplier in its explicit form is:
m-
1+k
(r -b ) (1 + t+ d ) +k
The total bank credit multiplier in explicit form is:
( 1 + t + d ) [ 1 + n — ( r —b )]
a~
(r -b ) (1 + t+ d ) +k
_
_
w ere.
currency held by the public
t|eman(] deposits held by the public
_
time deposits
— demand deposits held by the public
k _member bank borrowing
total bank deposits
_ total bank reserves
— total bank deposits
j _ Treasury deposits at commercial banks
— demand deposits of the public
capital accounts
— total bank deposits
The k, t, b, r, and n ratios reflect behavioral responses of
the banks and the public to ( 1 ) economic factors; and ( 2 )
the policy parameters, legal reserve requirement ratios, dis
count rate, and Regulation Q, which are determined by the
Federal Reserve System. The d-ratio reflects mainly actions
by the Treasury.
Page 18
SEPTEMBER 1 9 6 9
Table IV
M O N T H LY CH AN G ES IN THE ADJUSTED M O NETARY
SOURCE BASE A N D FEDERAL RESERVE
H O LD IN G S O F G O VER N M EN T SECURITIES*
(millions o f dollars)
Adjusted
Monetary Source Base
Federal Reserve
Holdings of
Government
Securities
1965
January
February
March
April
May
June
July
August
September
October
November
December
— 20
260
190
210
200
210
270
250
160
510
260
540
— 442
368
263
322
474
729
409
69
— 210
493
527
757
1966
January
February
March
April
May
June
July
August
September
October
November
December
100
250
80
480
220
50
600
60
430
140
210
380
— 259
9
— 237
231
500
543
549
59
455
102
510
413
*Not seasonally adjusted
T h e Im pact of O pen M arket Operations — Federal
Reserve holdings of Government securities is the
component of the adjusted monetary source base that
is under the direct, day-to-day control of the Federal
Reserve System. The Federal Reserve does not dic
tate the administration of the Treasury General Fund.
Gold movements reflect principally past movements
in the balance of payments, and nonseasonal changes
in the level of float reflect mainly such things as
w eather conditions and transportation disruptions.
To measure the im pact of Federal Reserve open
market operations on the monetary aggregates, it is
not sufficient simply to discuss changes in the Sys
tem ’s holdings of Government securities, as shown
in Table IV .7 To the extent that the System’s open
market operations only offset other factors, such as
gold flows, float, and Treasury actions, and no change
occurs in the amount of base money, no net expan
sionary or contractionary effect is transmitted to the
monetary aggregates and bank credit.8
"See “An Explanation of Federal Reserve Actions (1 9 3 3 -6 8 )”
by Michael Keran and Christopher Babb, this Review, July
1969.
8To the extent that open market operations affect market
interest rates, and these open-market-induced changes in
interest rates affect the multiplier, then open market opera
tions affect the monetary aggregates.
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
F or example, in June 1966 Federal Reserve hold
ings of Government securities rose by $543 million,
but adjusted monetary base increased by only $50
million. Although on balance the System made quite
large purchases, expansion of the adjusted source
base was only slightly greater than the normal sea
sonal increase. H ence the net expansionary influence
of open market operations in June was quite small.
In contrast, in July 1966 the Federal Reserve pur
chased the same amount of Government securities
as in June. However, the increase in the source base
in July was 12 times as great as the increase in
June. Looking at the $600 million increase in the
source base in July, we would assert that the Sys
tem’s open market operations had a very expansion
ary net effect on the monetary aggregates.
Analysis of M ovem ents in M oney — A complete
analysis of the movements observed in the money
supply and bank credit involves not only the analysis
of movements in the base, but also changes in money
and bank credit resulting from changes in the
multipliers.
To analyze the behavior of money and bank credit,
w e divide the change in each one of these aggregates
into two major components: the percentage change
resulting from the change in base money, and the
percentage change due to the change in the multi
plier.9
Looking at Table V we see that the expansion of
M over the last part of 1965 was wholly a base
phenomenon. The multiplier acting alone decreased
9To partition the effects on money and bank credit of
changes in the base and changes in the multipliers, the fol
lowing expressions were used:
Mt—M t-i
Mt—i
'
_
Bat—i ( mt—m t - i ) <
Mt—i
r m - i(B at—Bat - i )
Mt—i
.
jlqo
_j_
_j_(B at—Bat - i ) ( m t - m t - i ) _
Mt—i
For example, the percentage change in money in February,
Mt—l
Mt—i =
Bat—1 =
Mt =
Bat =
1 0 0 ), is found by letting
money stock in January
adjusted monetary source base in January
money stock in February
adjusted monetary source base in February
mt—i ( B at—Bat- i )
’
the percentage change in money in
period t resulting from the change
— in B a in period t assuming no
change in the multiplier.
B at - i ( m t —m t- i) 1flfl _
—
• 100
the percentage change in money in
period t resulting from the change
;n the multiplier in period t assum
ing no change in Ba.
SEPTEMBER 1 9 6 9
Table V
M A JO R C O M P O N E N T S O F M O N T H LY
PERCENTAGE CH AN G ES IN M O N E Y *
1965
January
February
March
April
May
June
July
August
September
October
November
December
1966
January
February
March
April
May
June
July
August
September
October
November
December
Change in
Money (M)
Change in Money
Resulting From
Change in
Monetary Base (Ba)
Change in Money
Resulting From
Change in the
Multiplier (m)
.19%
.25
.12
.31
.12
.50
.43
.49
.49
.73
.30
.66
— .04%
.46
.34
.37
.35
.37
.47
.43
.28
.88
.44
.92
.22%
— .21
— .21
— .06
— .23
.13
— .04
.06
.21
— .15
— .14
— .25
.66
.42
.35
.65
0
.12
— .35
.06
.29
— .17
-0 .12
.17
.42
.13
.80
.37
.08
.99
.10
.70
.23
.34
.61
.49
-0 .22
— .15
— .36
.04
— 1.33
— .04
— .41
— .40
— .34
— .49
*Columns two and three may not add exactly to column one because
of the cross product term.
the stock of M in the last three months of 1965. H ow
ever, an expansionary open market policy resulting
in an increase in the stock of base money more than
offset the multiplier, and the money stock showed a
marked increase.
During the first quarter of 1966 the effect of open
market operations was much less expansionary. The
base increased at only a 3 per cent annual rate,
much reduced from the 7 per cent rate over the last
half of 1965. Consequently, the impulse transmitted
to money and bank credit by open market actions
was considerably reduced.
In the first four months of 1966, the money stock
continued to increase. However, in the first three
months of this period the increase in M was largely
a multiplier phenomenon. Although the stock of base
money was increasing at a slower rate, it supported
a larger stock of publicly held money balances than
previously, due to the rise in the multiplier. Almost
one-half of the percentage change in M was a c
counted for by an increase in the multiplier. The
major cause of this increase was a reduction in the
desired reserve ratio. As the banks adjusted to the
large increase in base money occurring in the last
half of 1965, and in response to the higher yields
Page 19
SEPTEMBER 1 9 6 9
FEDERAL. R E S E R V E B A N K O F ST. LOUI S
on business loans, banks reduced their desired
reserve-to-deposit ratio, and this was reflected in a
rise in the stock of bank money. April shows a sharp
percentage increase in M, but this is entirely ex
plained by a very large increase in the supply of
base money. After April the rapid expansion of the
money stock cam e to an abrupt halt.10
During the first three months of 1966 the banks
and the public apparently were still reacting to the
rapid increase in base money that occurred in the
last part of 1965. As the increased stock of base
money was absorbed into the asset portfolios of the
banks and the public, the growth rate of M slowed.
By April the increase in the money multiplier had
stopped.
Analysis of M ovem ents in Bank C red it — Referring
to Table VI, w e see that the increase in bank credit
over the last part of 1965 was also primarily at
tributable to the growth of the monetary base. During
the first quarter of 1966 the growth rate of base
money slowed, but bank credit continued to expand
at a rapid rate. As was the case with M, the increase
in bank credit during the first three months of 1966
was not solely a base-dominated phenomenon. The
rise in the bank credit multiplier ( a ) accounted for
almost half of the increase in bank credit.
In contrast to the money multiplier, the bank
credit multiplier continued to increase after M arch,
contributing significantly to the percentage increase
in bank credit from M arch through June. In the May
through June period the percentage increase in bank
credit was dominated by the increase in the bank
credit multiplier.
The increase in ( a ) over the first part of 1966,
and its continued increase after the money multiplier
stopped rising, can be largely explained by the suc
cess of commercial banks in acquiring time deposits,
which raised the t-ratio. The t-ratio (th e ratio of
time deposits to demand deposits of the public) is
of crucial im portance when analyzing the movements
10The marked percentage change in money (-1 .3 3 per cent)
resulting from the multiplier acting alone in July reflected
changes in several components: a sharp rise in the ratio of
time to demand deposits ( t ) ; an increase in the reserve
ratio ( r ) resulting from the July increase in reserve require
ments on time deposits; a marked increase in the currency
ratio ( k) ; and a rise in the ratio of Government deposits
to demand deposits of the public ( d) . The percentage
changes in the multiplier from June to July resulting from
the change in each of these components are as follows:
t
r
k
d
Page 20
— .411
— .376
— .504
— .234
of monetary aggregates and bank credit. It is im
portant because, other factors constant, changes in
the t-ratio are accom panied by changes in opposite
directions of money and bank credit. An increase in
the t-ratio lowers the value of the multiplier associ
ated with the money stock and raises the value of
the multiplier associated with bank credit. In other
words, a decision by the public to hold a larger por
tion of their bank deposits in the form of time de
posits increases the amount of bank credit a given
stock of base money can support and decreases the
size of the money stock a given amount of base
money can support.
Over the last three months of 1965 the t-ratio
average 1.1184, com pared to an average of 1.0396
over the first three months of 1965. In the first three
months of 1966, the t-ratio continued to increase,
rising to an average of 1.1264. The t-ratio then rose
very sharply over the next three months, reaching
an average of 1.1508 over this period.
Given that the Board of Governors raised Q ceiling
rates in D ecem ber, and given the increasing profita
bility of business loans for banks, the longer lag in
adjustment of bank credit is not surprising. As long
as banks could acquire funds via time deposits, and
as long as the marginal cost of these funds remained
Table VI
M A JO R C O M P O N E N T S O F M O N T H LY
PERCENTAGE C H AN G ES IN BANK CREDIT
1965
January
February
March
April
May
June
July
August
September
October
November
December
1966
January
February
March
April
May
June
July
August
September
October
November
December
Change in
Bank Credit
Change in Bank
Credit Resulting
From Change in
Monetary Base (Ba)
Change in Bank
Credit Resulting
From Change
in the
Multiplier (a)
.67%
.86
.92
.99
.43
.46
.61
.78
.56
1.29
.55
.89
— .04%
.46
.34
.37
.35
.37
.47
.43
.28
.88
.44
.92
71%
.39
.58
.61
.08
.10
.13
.34
.28
.41
.11
— .03
.51
.61
.34
1.11
.63
.36
.99
— .13
.55
— .32
-0 .55
.17
.42
.13
.80
.37
.08
.99
.10
70
.23
.34
.61
.34
.19
.20
.30
.23
.27
-O — .23
— .15
— .55
— .34
— .07
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
less than the marginal revenue from business loans,
banks could be expected to continue to bid aggres
sively for time deposits.
Over the four months from April through July,
the banks were using w hat might be called “the
financial slack in the economy” to expand their flow
of credit to the business sector. This was accom
plished primarily through time deposits.11 By raising
their rates on time deposits, banks induced the pub
lic to markedly increase its desired ratio of time-todemand deposits (t-ra tio ). The purchase of banks’
debt obligations (tim e deposits) by the public with
bank money “freed” reserves from required reserves
and perm itted banks to expand their flow of credit
to business. A crude calculation of the effect of the
increasing t-ratio on the supply of bank credit in
dicates that $3 to $4 billion of the $9.3 billion increase
in bank credit from M arch through July was due to
the increase in the time deposits relative to demand
deposits.12
The bank credit multiplier remained constant in
July, and the large increase in bank credit reflected
solely the very large increase in base money resulting
from the Federal Reserve’s open market aotions. Al
though the t-ratio rose sharply in July, by itself in
creasing the bank credit multiplier, this was offset
primarily by a marked rise in the reserve ratio. The
rise in the reserve ratio reflected the increase in
reserve requirements on time deposits which went
into effect in the last part of July. By raising reserve
requirements, the Federal Reserve reduced the
amount of bank credit a given stock of base money
would support. However, at the same time, the F e d
eral Reserve, through open market purchases, per
m itted the stock of base money to rise by $600
million, thus offsetting the contractionary effect on
bank credit of the higher reserve requirements.
In August we observed a marked reversal of the
im pact of open market operations on the monetary
aggregates. The System purchased net only $60 mil
lion of securities com pared to $550 million in July.
Most importantly, this reversal in open market a c
tions resulted in virtually no change in the stock of
base money in August. Therefore, open market policy
n To an extent this was also accomplished by banks reduc
ing their ratio of excess reserves to deposits and liquidating
Government securities (see the following section).
12This estimate is made by recalculating the total bank
credit multiplier for July, substituting the t-ratio value for
March. This new value for the multiplier is then multiplied
by Ba for July and the new value for bank credit is com
pared to the actual value for bank credit.
SEPTEMBER 1 9 6 9
becam e m uch more restrictive in August than it had
been over the previous four months.
Actions and Reactions by Commercial Ranks:
First Eight Months of 1966
This section first presents a historical development
of the banks’ portfolios as they existed in early 1966.
Next, portfolio adjustments by the banks in the
months leading up to the Credit Crunch are dis
cussed. The im pact of Regulation Q on the banks and
consequently on the money supply and bank credit
processes is discussed. Finally a discussion of the
banks’ portfolio reactions in August, the month of the
Crunch, is presented.
A Historical Development of the Banks’
Portfolio Positions in 1966
To understand the development of the Credit
Crunch in August 1966, it is useful to review briefly
the historical development of two closely related
phenomena. The first of these is the increased use by
commercial banks of negotiable time certificates of
deposit as a means of acquiring deposits. The second
is the growth of state and local government obliga
tions (m unicipals) as a component of the commercial
banks’ asset portfolios.
N egotiable C D ’s — Until the late Fifties com m er
cial banks did not bid actively for time deposits. In
the early Sixties large commercial banks, faced with
rising loan-deposit ratios and the possible loss of de
posits of business firms to other higher-yielding
market assets, began actively to seek deposits by
issuing large C D ’s. This action by the banks marked
a significant change in banking practice. The banks
began to com pete for funds in the most interest-ratesensitive sector of the money market. C D ’s were in
competition with such interest-rate-sensitive assets as
Treasury bills and com m ercial paper. Also, the atti
tude developed among some banks that C D ’s could
be used as an avenue to borrow funds whenever
attractive investment opportunities appeared.
From 1960 through m id-1966 large commercial
banks increasingly relied on C D ’s, especially large de
nomination negotiable C D ’s, as a means of attracting
deposits. Tim e deposits, acquired by issuance of large
denomination C D ’s, accounted for 40 per cent of the
increase in time and savings accounts at weekly re
porting member banks from 1961 to the end of 1965.
Total outstanding C D ’s in denominations of $100,000
or more at member banks rose from $2.9 billion on
D ecem ber 30, 1961 to $17.7 billion on M ay 18, 1966,
Page 21
SEPTEMBER 1 9 6 9
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
and the number of member banks issuing large C D ’s
rose from 232 to 632.13
As com m ercial banks sought to issue an increased
volume of C D ’s in an environment of generally rising
m arket interest rates, the cost to the banks of acquir
ing these funds rose. After remaining at around 2.5
per cent through the middle of 1963, the new issue
rate on C D ’s rose steadily, reaching an average of 4.07
per cent in the last quarter of 1964 and then in
creased to an average of 4.58 per cent in the fourth
quarter of 1965. After the increase in Regulation Q
ceilings in D ecem ber 1965, yields offered by banks
rose sharply, reaching the Regulation Q ceiling of
5V2 per cent in the third quarter of 1966.
The rising cost of acquiring deposits by bidding
in competition with other short-term money market
instruments meant that the banks had to begin to
acquire assets with yields high enough to cover this
increased cost. Over the 1961 through m id-1965 p e
riod the rate on bank short-term business loans re
mained very stable at around 5 per cent. The prime
rate, which represents a minimum rate on somewhat
longer-term business loans, was set at 4.5 per cent by
com m ercial banks in August 1960 and remained at
this level until D ecem ber 6, 1965. Given supply and
demand conditions for bank credit by the business
sector until m id-1965, commercial banks w ere unable
to employ the funds acquired from C D ’s at higher
yields in short-term loans to business.
Banks’ M unicipal Portfolios E xp a n d — Comm ercial
banks, looking for higher yielding assets in the Six
ties, increased sharply their acquisition of tax-exem pt
municipal securities. Prior to the Sixties commercial
banks had not held a large portion of newly issued
municipals. In 1960 com m ercial banks had about 7%
cents of every deposit dollar invested in municipals.
By m id-1965 banks’ municipal portfolios accounted
for almost 12 cents of every deposit dollar. From 1961
through m id-1965 commercial banks put 23 cents of
each new deposit dollar into municipal securities, an
amount large enough to purchase over 50 per cent of
the net volume of municipals issued annually.14
The average maturity of municipals held by com
m ercial banks lengthened noticeably from 1961
through 1965. F o r all national banks in 1965, 51.5 per
13Parker B. Willis, T he Secondary Market for Negotiable
Certificates of Deposit, Board of Governors of the Federal
Reserve System, 1967.
'ija c k C. Rothwell, “The Move to Municipals,” Business Re
view, Federal Reserve Bank of Philadelphia, September 1966,
p. 3.
Page 22
cent of their total portfolio of municipals had a m atur
ity of 5 years or longer; and 25.5 per cent of their
portfolio of municipals was over 10 years to maturity.
F o r large commercial banks the figures were even
higher, at 54.7 per cent and 33 per cent,
respectively.13
As we shall see later in this section, the increased
reliance by com m ercial banks on the interest-sensitive certificate of deposit as a means of attracting
funds, together with the increased portion of com
m ercial bank portfolios in long-term municipal securi
ties, had important implications for the developments
occurring in the money and capital markets in August
1966.
Bank Portfolio Adjustments in 1966
H igher-Y ielding Business Loans In crease — During
the first eight months of 1966 the com m ercial banking
system faced heavy borrowing demands from the
business sector. Over this period the rates on bank
business loans rose sharply. The interest rate charged
by large commercial banks on short-term business
loans rose from 5.27 per cent to 6.30 per cent. The
prime rate — the interest rate at which commercial
banks extend business loans to their highest-grade
business customers — was raised by the banks in D e
cem ber 1965 from 4% per cent to 5 per cent. This
was the first increase in the prime rate since August
D
r
>
C o m m ercial B a n k R ates
on Short-Term B usin ess Lo an s
„
,
1
9 C EN TER S
f 5 CEN TER!
1
p"U
/
Average Rates
"
\
1
1
Prime Co mmercial .oan Rate
1
■■-1 - 1 - 1 -
I960
1961
i
i i
1962
i i i
_
1963
»
» »
1964
i
i
1 --
1965
i
i
i
1966
1 i
i
i
1967
Note: A v e r a g e rates on short-term b u sin ess lo an s plotted in two segm ents to e m p h a siz e
the in cre a s e in sa m p le size to 3 5 fin a n c ia l cen ters in F e b ru a ry 1967 (see F e d e ra l
R eserve B u lle tin , M a y 1967, p a g e 721-27).
1960. During the first eight months of 1966 the prime
rate was raised three more times: on M arch 10 to
5% percent; on June 29 to 5% per cent; and on
August 16 to 6 per cent — at that time the highest
prime rate in over 30 years.
15Rothwell, p. 7.
SEPTEMBER 1 9 6 9
F E D E R A L R E S E R V E B A N K O F ST. LOUI S
E ven with sharply rising interest rates, the demand
for bank credit by the business sector remained
strong. Comm ercial banks rapidly expanded their
business loans as yields on these loans rose. Over the
first seven months of 1966 commercial and industrial
loans by large commercial banks increased $6.3 bil
lion, or by 12 per cent.
Low er-Yielding Assets D eclin e — To take advantage
of the rising yields on business loans, commercial
banks restructured their asset portfolios. During the
first half of 1966, banks switched from lower-yielding
securities to higher-yielding business loans. As can be
seen from Table VII, this resulted in a sharp reduc
tion in banks’ holdings of Government securities, pri
marily Treasury bills. From the end of D ecem ber
1965 through June 1966 commercial banks reduced
their holdings of Government securities by $6 billion.
Table VII
SELECTED ASSETS — ALL INSURED BANKS
(millions o f dollars)
December 31,
1965
June 30,
1966
Annual Rates
o f Change
70,887
76,725
17.1
59,120
(13,134)
38,419
53,111
(9,174)
40,368
Commercial and
Industrial Loans
Total U.S. Government
Securities
(Bills and Certificates)
Municipals
— 19.3
(— 51.2)
10.4
This restructuring of the banks’ asset portfolios re
duced their liquidity. Government securities as a per
cent of banks’ deposit liabilities decreased noticeably
and steadily from early 1965 through the first seven
months of 1966. This trend prevailed not only for the
so-called money market banks, but for all banks. Also,
over the period 1965 through July of 1966, banks
reduced their ratio of excess reserves to deposit lia
bilities. This ratio was on average about 20 per cent
less in the period January through July of 1966 than
in 1964.
C D ’s as a Source of F u n d s — Large commercial
banks, which specialized in business loans, relied
heavily on the issuance of certificates of deposit as
a source of funds in the first seven months of 1966.
Individual commercial banks com peted aggressively
for funds by raising the rates paid on certificates
of deposit to the Regulation Q maximum of 5% per
cent. From the first week in January to the end of
June 1966 large commercial banks increased their
large denomination CD ’s outstanding by $2 billion.
L arg e commercial banks, restricted under Regula
tion Q to a maximum rate of 4 per cent on passbook
savings, began in early 1966 to compete aggressively
for household savings by issuing small denomination
non-negotiable certificates of deposit. By issuing these
small denomination C D ’s, banks were able to com
pete directly with assets offered savers by other
financial institutions.18 In a survey of member banks
covering the period D ecem ber 1965 to M ay 1966, the
Federal Reserve found that com m ercial banks with
total deposits of $500 million and over increased
their consumer-type time deposits by $3 billion.17 As
the spread between interest rates paid on passbook
savings and non-negotiable C D ’s widened, the in
crease in consumer-type C D ’s was partially offset by
a decline of $1.8 billion in passbook-type savings
deposits at these banks.18
16Some large commercial banks began issuing consumer-type
CD ’s in the form of 5-year discount bonds. Some of these
CD’s could be purchased in $25 multiples at prices below
$20 and could be cashed-in 90 days after purchase, on any
90-day anniversary thereafter, or between 90-day periods
with written notice.
17“Changes in Time and Savings Deposits: December 1965May 1966,” Federal Reserve Bulletin, August 1966.
18Large commercial banks appear to have taken the lead in
competing for consumer-type deposits. In May 1966, of the
member banks surveyed, 61 per cent of the banks with
deposits of $100 million or over were paying above 4.50
per cent on consumer-type time deposits, while only 14 per
cent of the banks with deposits below $100 million were
paying above 4.50 per cent.
Page 23
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
All of these factors operated to reduce the liquidity
of the banks. The banks were not passively accom
modating the demand for credit, but were responding
in a manner that econom ic theory would predict of
any profit-maximizing econom ic unit. As the rate of
return on business loans rose relative to the rate of
return on other assets, banks restructured their asset
portfolios to contain more of the higher-yielding busi
ness loans.
T h e E ffects of Regulation Q — Com m ercial banks
are free to raise the yield they offer on C D ’s only
up to ceiling rates set by the Federal Reserve Sys
tem with Regulation Q. In contrast, yields on com
petitive assets such as Treasury bills and commercial
paper are not restricted by any artificial ceiling rate,
but are determined by free m arket forces of supply
and demand. Therefore, when short-term market in
terest rates rise above the Regulation Q ceiling rates
on time deposits, commercial banks find their ability
to attract and hold such deposits determined not
by their willingness to pay the market price for
funds in a free market, but dependent upon the
willingness of the Federal Reserve Board to raise
the Regulation Q ceiling rates.
In three previous periods in the Sixties, July 1963,
November 1964, and D ecem ber 1965, when the sec
ondary market interest rate on outstanding certifi
cates of deposit issued by com m ercial banks moved
above the Regulation Q limit on newly issued C D ’s,
Secu rity Y ie ld s
1965
1966
1967
L I R a te on d ep o sits in am o u n ts o f $ 1 0 0 ,0 0 0 o r m ore m atu rin g in 90-179 d a y s .
[2 S e c o n d a ry m a rk e t y ie ld s on n e g o tia b le c e rtific a te s o f d e p o sits; a v e ra g e s o f w e e k ly
ra te s d u rin g the m onth.
[^ M o n th ly a v e ra g e s o f d a ily fig u re s.
S o u rce s: B o a rd o f G o v e rn o rs o f the F e d e ra l R eserv e System
an d Salom on B ro thers a n d H u tz le r
Page 24
SEPTEMBER 1 9 6 9
the Federal Reserve System raised the Regulation Q
ceiling. This policy action allowed comm ercial banks,
by offering yields on time deposits competitive with
other available m arket assets, to com pete effectively
with other borrowers.
However, when the market rate on outstanding
C D ’s moved above the Regulation Q ceiling in the
summer of 1966, the Federal Reserve System refused
to raise Regulation Q ceilings. One factor influencing
this decision was the pressure from the House Bank
ing and Currency Comm ittee to restrain commercial
banks’ competition with savings and loans and mu
tual savings banks for savings. In July 1966, in order
to further restrict com mercial banks in their attem pt
to attract consumer time deposits, the Federal Re
serve lowered the maximum interest rate payable on
multiple maturity time deposits from 5 ’A to 5 per cent
on 90-day or more multiple maturities and from 5% to
4 per cent on multiple maturities of less than 90 days.
In the first week of July, the secondary market
rate on outstanding negotiable C D ’s rose above the
maximum rate of 5% per cent on new issues. After
early July, with C D ’s selling at a discount in the
market, large com m ercial banks found it increasingly
difficult to attract and hold these funds. N ew York
banks w ere able to increase their outstanding C D ’s
by only $46 million in July.
W ith the market yield on C D ’s rising above the
ceiling rate on new issue C D ’s, and the Board of
Governors refusing to raise Regulation Q ceilings and
increasing reserve requirements on certain classes of
time deposits, banks now realized they could no
longer rely on time deposits to acquire funds to ex
pand their flow of credit to the business sector.
Further, the banks now expected a reversal of the
flow of time deposits.
In August over $3.7 billion of outstanding negotia
ble certificates of deposit m atured at large com m er
cial banks, and $6.7 billion in negotiable C D ’s w ere
scheduled to m ature in the Septem ber-O ctober pe
riod. By middle and late August there were expecta
tions of a large loan demand converging on the
com m ercial banking system just as the expected heavy
runoff of certificates of deposit occurred. L arg e offer
ings of Treasury tax-antidpation bills w ere expected
in late August, and the expected sale of Federal
National M ortgage Association participation certifi
cates and other Fed eral agency financings were
slated to add to an already heavy schedule of new
corporate and municipal offerings. There were grow
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
ing fears in the capital and money markets that the
major suppliers of funds would be unwilling to con
tinue to supply funds at currently existing interest
rates.
Hopes for a tax increase to halt inflationary pres
sures had faded in August. The feeling spread in the
financial markets that the Federal Government did
not or would not recognize the pressures its opera
tions were placing on these markets. The conviction
spread that the major burden of econom ic restraint
would fall on monetary policy.19
Banks Reactions in August
Banks had never before experienced a large out
flow of time deposits. The expectations of a runoff of
C D ’s and the uncertainty about the m agnitude of the
outflow and its effects on their operations led in
dividual banks to desire to increase their liquidity,
by acquiring a larger portion of the existing stock of
reserves to meet the expected increase in required
reserves as time deposits decreased and demand de
posits increased. To continue to expand business loans
while simultaneously building up their reserves, the
individual banks attem pted to restructure their
portfolios.
Over a period of time, if an individual bank wants
to increase the liquidity of its portfolio, the three
main ways it may accomplish this are:
(1 )
M em ber banks m ay attem p t to borrow from
the F ed eral R eserve banks via the discount
window ;
( 2 ) C om m ercial banks m ay borrow short-term funds
in the F ed eral funds m arket; or
( 3 ) A com m ercial bank m ay sell p a rt of its invest
m ent assets a n d /o r red u ce its volum e of loans.
Methods ( 1 ) and ( 2 ) are essentially short-term
in nature. They are designed to perm it commercial
banks time to restructure their portfolios via method
(3 ).
M em b er Bank Borrow ing — Fed eral funds and bor
rowings at Federal Reserve banks, to a large extent,
m ay be viewed by individual member banks as alter
native sources of short-term funds. The amount of
m ember bank borrowing at the Federal Reserve dis
count window rose steadily from an average of $402
million in January to $722 million in M ay 1966. In
19On August 25, 1966, the Wall Street Journal reported that
J. Dewey Daane, a member of the Board of Governors,
had stated that if monetary policy was going to have to
carry all the burden of fighting inflation, a further rise in
interest rates was inevitable. He asserted that he believed
such further increases in interest rates were coining.
SEPTEMBER 1 9 6 9
June the rate on Federal funds passed 5 per cent; in
July most trading was at rates above 5.25 per cent;
and in August the rate moved above 5.5 per cent
with some trading occurring at the 6 p er cent level.
However, after May, despite the sharply rising rates
on Federal funds, and despite increasing demands
by the banks for short-term funds (to perm it them
to adjust their portfolios to take advantage of the
rising yields on business loans), member banks did
not noticeably increase their borrowings at the F e d
eral Reserve banks.
The question then arises why, in the summer of
1966, with the spread betw een the 4 .5 per cent dis
count rate and the market rate on Federal funds
widening, there was no marked increase in the
amount of member bank borrowings at the Federal
Reserve banks .
This question can be answered largely by taking
into consideration the Federal Reserve system’s pol
icy of discouraging continuous borrowing by any one
member bank at the discount window, which tends
to become progressively m ore restrictive as the aggre
gate level of member bank borrowing rises and re
mains at a higher level for an extended period.
Although the Federal Reserve banks did not explic
itly refuse credit to any member banks in 1966, there
are strong indications that, as the level of member
bank borrowing approached the $750-800 million
range, rather than raising the cost of such borrowing
to ration potential borrowers out of the market, the
result of some Federal Reserve banks’ tighter ad
ministration of the discount window was, in effect,
to “close the window” to further increases in the
le v e l of m e m b e r bank borrowing.20
Beginning in about June, the Federal Reserve
banks may have used tighter administration of the
discount window to force member banks to reduce
their borrowings, or m em ber banks m ay have felt
that the Reserve banks would show great reluctance
to extend additional accommodation. Also, some mem
ber banks may have decided to husband their “good
will” at the discount window to m eet expected future
emergency cash demands.
Banks L iquidate M unicipals — Since the banks had
reduced their holdings of Government securities to
20Borrowing at the Federal Reserve Banks is a privilege
which may be extended by a Reserve Bank to member
banks in its district. It is not a right of member banks to
demand accommodation. To a significant degree, each dis
trict Reserve Bank sets its own policies on lending to
member banks.
Page 25
F E D E R A L R E S E R V E B A N K O F ST. LO U I S
near a minimum level, and believing that access to
the discount window was limited, the banks in Au
gust attem pted to adjust their reserve positions to
increase their cash holdings by selling municipal
securities. To do so, they had to induce other eco
nomic units to restructure their asset portfolios.
In the terminology of the financial community, the
market for municipal bonds could be described as
much “thinner” than the market for Government
securities. W ithin the bond markets a small number
of specialists in the buying and replacem ent of se
curities, called dealers, perform an important func
tion. These dealers broaden and add depth to the
bond market by standing ready to buy and sell debt
obligations of the Federal government, state and local
governments, and corporations, and facilitate shifting
these assets to other individuals or institutions. Hence,
their operations tend to increase the liquidity of these
assets. Dealers rely heavily on borrowed funds to
finance their positions (holdings) in these securities;
they are heavily dependent on commercial banks for
their financing requirements, especially their residual
financing.
Dealers are especially sensitive to changes in mone
tary conditions because of the special characteristics
of their business. During periods when interest rates
are falling, dealers are able to anticipate that if they
buy securities, they can distribute these securities at
a higher price as interest rates fall. Inspired by the
profit motive, dealers actively add to their holdings
and increase their participation in the securities m ar
ket when rates are falling.
In periods of rising interest rates, dealers may
find that they are unable to distribute their security
holdings at prices above what they paid. Also, they
find that the cost of borrowing funds to carry their
positions rises. W hen dealers expect market interest
rates to rise, they attem pt to reduce their positions
and engage less actively or withdraw from participa
tion in the securities market. F o r those dealers who
remain in the market, the residual financing function
of the commercial banks becomes extremely important.
Com m ercial bank loans to dealers are viewed by
the individual banks as a source of liquidity. Such
loans are callable at the discretion of the lending
bank. Also, for the banks the cost of reducing dealer
loans is less than reduced lending to business cus
tomers. During the summer of 1966 as the yields on
business loans increased, commercial banks, especially
New York banks, sharply increased their lending rate
to dealers. The lending rate of New York banks to
Page 26
SEPTEMBER 1 9 6 9
dealers in Government securities rose from a range
of 5M to 5% per cent for renewals and new loans
in the first week of June to ranges of 6 to 6M per cent
at the end of July. The lending rate to dealers then
rose to 6Vs to 6% per cent in mid-August.
Dealers responded to the sharply rising level of
credit market interest rates and the increased cost of
borrowing funds to carry their positions by ( 1 ) re
ducing their borrowing from banks, and ( 2 ) sharply
reducing their participation in the bond market. From
a high of $4.5 billion on July 6, loans by large banks
to dealers and brokers for purchasing or carrying
securities fell to $3.8 billion by the first of August,
then fell by an additional $0.4 billion during the
next three weeks. Dealers’ positions in Government
securities decreased from an average daily level of
$3.6 billion over the first eight months of 1965 to an
average daily position of $2.1 billion over the first
eight months of 1966. In the July to August period
of 1966, dealers’ holdings of Governments was only
half as large as in the same period of 1965. Dealers
also attem pted to shorten the maturity of their hold
ings. Government securities due within one year as a
per cent of total dealer positions in Governments
rose to 92.7 per cent in the July-August period of
1966, com pared to 82.5 per cent in the same period
of 1965.
After the middle of August, with banks attempting
to reduce their holdings of municipal securities, with
other principal purchasers of municipals themselves
faced with large expected cash demands, and with
dealers in the securities attempting to reduce their
own positions, price quotations for these securities
becam e almost nominal. Only a few dealers were
willing to buy municipal bonds in the secondary
market. Comm ercial banks found they could shift
their holdings of municipals to other econom ic units
only at sharply lower prices. Thus, banks found they
could buy the liquidity they desired only at a rapidly
rising cost.
Business Loans — Com m ercial banks maintained a
high level of business loans in the early summer of
1966. After totalling $56.4 billion at the start of June,
business loans by large com m ercial banks rose $2.3
billion by the first week in July.
Over the last part of July and in early August,
credit market interest rates rose sharply, reinforcing
the expectations by banks of significant run-offs in
time deposits. There was no reduction in the business
sector’s demand for credit. Expecting high interest
rates in the future and worried about the future
FEDERAL. R E S E R V E B A N K O F ST. LOUI S
SEPTEMBER 1 9 6 9
“availability of credit,” corporations, relative to past
periods, placed record demands for credit. The banks
reacted to the continued demand for business loans,
the im pact of Regulation Q, and the tighter monetary
policy by attempting to reduce their holdings of
municipals.21 A classic liquidity crisis in the munici
pal bond market resulted.
Com pared to July no large increase in base money
occurred in August. The drastic reversal of the im
p act of open market operations on the growth of base
money and the full im pact of higher reserve require
ments on time deposits had a decided contractionary
effect on the bank credit process. The statements of
Federal Reserve officials indicated to the banks that
the intent of policy was to maintain monetary
restraint.
W ith all other avenues of adjustment exhausted,
the banks reduced their lending to the business sec
tor. Between the reporting dates of August 3 and
August 17, large commercial banks reduced their
business loans by $65 million. In the last half of
August, banks decreased their flow of credit to the
business sector at a much more rapid pace. In this
period large commercial banks’ holdings of business
loans fell by $668 million. As the commercial banks
reduced their lending to the business sector, cries
from the business sector, not only about the cost of
funds but the actual availability of funds, were
added to the cries of disorder and fears of a possible
panic emanating from the financial markets.
Increasingly, even [business] custom ers having for
m al loan agreem ents or confirm ed lines of cred it
with their com m ercial banks becam e uncertain as to
w h ether these com m itm ents would, or could, be
hon ored .22
After August
During the last quarter of 1966 Gross National
Product and prices continued to expand at rapid
rates. GNP expanded at an 8 per cent rate and the
consumer price index rose at a 3.2 per cent rate. In
21This does not in any way imply an argument for using
Regulation Q as a restrictive policy instrument. If yields
banks can offer to attract time deposits are artificially held
below other credit market interest rates, and consequently
disintermediation occurs, this does not necessarily mean that
the total flow of credit is reduced. For example, during
the second quarter of 1969, Regulation Q ceilings held
yields on time deposits below other market rates. During
this period time deposits at all commercial banks decreased
by $2.4 billion, but during the same period the volume of
commercial paper rose by $2.8 billion.
22Roy R. Reierson, “Is a Credit Crunch in Prospect,” Senior
Vice President and Chief Economist, Bankers Trust Com
pany of New York, January 20, 1969.
the same period the money supply showed no net
change. In September bank credit temporarily rose
sharply, but in O ctober it decreased sharply and re
mained at this lower level through November. Over
the last part of 1966 there was a sharp decline in
the demands placed in the credit market by the busi
ness sector, with the total quantity of funds de
manded returning to a level com parable to the same
period of 1965. Reflecting the m uch-reduced increase
in the supply of new securities, rates on long-term
Government bonds, corporate bonds, and municipals
stabilized near the high levels reached in August. Yet,
money market interest rates continued to rise through
the late fall of 1966. The continued increase in short
term yields, especially on Treasury bills, reflected in
vestor expectations of increased Treasury financing.23
In the first two quarters of 1967 the effects of nine
months of an unchanged money stock showed up in
a marked slowing in the rate of increase of aggregate
23Investors expected that the cut in agency financing called
for in the President’s September 8 program would mean
that the Treasury would have to sell more Treasury bills to
meet expected cash demands. On September 2 0 the Treas
ury forecast that its overall cash demands for the rest of
1966 would total about $8 billion, and that most of this
amount would be raised through the sale of Treasury bills.
Page 27
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
demand and prices. G NP rose at only a 2 per cent
rate in the first quarter of 1967 and a 4.9 per cent
rate in the second quarter. The consumer price index
rose at a 0.7 per cent rate in the first quarter of 1967,
and at a 2.8 per cent rate in the second quarter of
1967.
The sharp decline in the growth rate of aggregate
demand reflected primarily an adjustment by the
business sector. Spending by the business sector on
structures and durable goods decreased at a 2.8 per
cent rate during the first two quarters of 1967. The
accumulation of inventories decreased very sharply,
dropping from an annual rate of $19.9 billion ( I V /
1966) to $9.0 billion (1 /1 9 6 7 ) and to $3.4 billion
(1 1 /1 9 6 7 ).
Additional Restraint and Then a
Policy Move Toward Ease
On September 1, 1966, each Federal Reserve Bank
president issued a letter to member banks in his
district. The stated purpose of the letter was:
T h e System believes th at the national econom ic in
terest would be b etter served by a slower rate of
expansion of bank loans to business within th e con
te x t of m oderate overall m oney and cred it growth.
F u rth e r substantial adjustm ents through bank liq
uidation of m unicipal securities or oth er investm ents
would add to pressures on financial m arkets. H en ce,
the System believes th at a greater share of m em ber
bank adjustm ents should take the form of m odera
tion in the ra te of expansion of loans, and particularly
business loans.
A ccordingly, this objective will be kept in mind by
the F ed eral R eserve Banks in their extensions of
cred it to m em ber banks through the discount window.
The main purpose of the letter apparently was to
bring pressures on the commercial banks to cut back
on business loans while affording them access to the
discount window to cushion the portfolio adjustments.
Regardless of what the desired intent of the Septem
ber 1 letter was, it seems to have been interpreted
in many quarters as a threat by the central bank,
rather than an indication that the Federal Reserve
planned to make the discount rate available to the
banks to ease their process of portfolio adjustments.24
However, the increase in business loans by large
commercial banks had already stopped in early Au
gust and then had showed a sharp decline in the last
p art of August. Also, the greatest danger of a liquid
ity crisis in the municipal bond m arket had already
occurred in the two weeks prior to the September 1
letter.
24In the September 2, 1966 Wall Street Journal, the article
reporting the September 1 letter was headed, “Reserve
Board Tells Banks to Curb Loans, Threatens Less Lending
to Ones That Don’t.”
Page 28
SEPTEMBER 1 9 6 9
In mid-September of 1966 the Federal Reserve
again increased reserve requirements against time
deposits. These requirements against member bank
“other” time deposits in excess of $5 million w ere
raised from 5 to 6 per cent. The effect of this restric
tive policy action was to reduce further the amount
of money a given stock of base money would sup
port. The money multiplier (th e item reflecting how
large a stock of money a given stock of base money
could support) declined throughout the remainder of
1966.
In the late fall of 1966 the intent of the Federal
Reserve System was to move toward an “easier”
policy:
F e d e ra l R eserve open m arket operations during
the final six weeks of 1966 w ere d irected a t attain
ing som ew hat easier conditions in th e m oney m arket
and providing the base for a resum ption of bank
cred it grow th. T h e easing th at h ad alread y been
p erm itted in the im m ediately p recedin g weeks un
d er the proviso clause had contributed to a m ore
relaxed atm osphere throughout financial m arkets
b u t bank cred it had rem ained w eak and interest
rates h ad risen for a tim e in the first half of
N ovem ber.
A gainst this background, the F e d e ra l O pen M arket
C om m ittee voted at its N ovem ber 2 2 m eetin g to
take a m odest b u t overt step tow ard ease . . . A
m ove tow ard som ew hat g reater ease w as voted at the
C om m ittee’s D ecem b er 13 m eetin g.25
During the last four months of 1966 open market
operations, on balance, again began to exert a strong
expansionary effect on the supply of base money.
From August through D ecem ber, Federal Reserve
holdings of Government securities increased at an
11 per cent annual rate. These open m arket opera
tions were not offsets to other factors affecting the
base, but resulted in a 5.8 per cent rate of increase
in the adjusted source base. The expanding supply
of base money offset most of the effect of the de
creasing multiplier, and the money stock remained
litde changed to the end of the year.
The expansionary effect of open market actions
continued through the first half of 1967. Over this
period System holdings of securities rose at a 10 per
cent annual rate and the adjusted base grew at a
5.6 per cent rate. In D ecem ber 1966 bank credit be
gan to expand at a rapid rate and continued at an 11.4
per cent rate through 1967. Beginning in February
1967 the supply of money, responding to the rapid
rise in base money, began to expand at a rapid rate,
26See Annual Report, 1966, Board of Governors, p. 259.
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
showing a 6.4 per cent increase in the following
twelve months. Reflecting the slowing in the real
sector and the renewed expansionary influence of
Federal Reserve policy actions on the monetary base,
credit m arket interest rates declined noticeably dur
ing most of the first half of 1967.
N ear the end of the second quarter of 1967, re
flecting the renewed acceleration of the money sup
ply and bank credit, aggregate demand and prices
began to increase again at accelerated rates. In the
third quarter of 1967, GNP rose at a 9 per cent rate,
and the price deflator rose at a 4.2 per cent rate. In
the fourth quarter, GNP rose at an 8 per cent rate,
and the rate of increase of the price deflator rose
to 4.5 per cent. Reflecting the feedback effects from
the real sector to the credit markets of the renewed
rapid rise in demand and prices, interest rates, which
had declined over the first part of 1967, began to
increase sharply by July of 1967. The marked rise in
interest rates was evident in short-term rates such
as Treasury bills and also in long-term rates on Aaa
corporate and municipal bonds.
Summary and Conclusions
The impact of Federal Reserve actions, through
open m arket operations and reserve requirement pol
icy, becam e much more restrictive in July through
August 1966, the period of the so-called “Credit
Crunch.” These actions took place within an eco
nomic environment much different from recent prior
periods. This article has discussed and analyzed the
effect of this changed economic environment on the
money supply and bank credit processes. It was
pointed out that in 1 9 6 6 , relative to p re v io u s p e rio d s
in the current expansion:
( 1 ) T h e cred it m arkets w ere faced with exception
ally large cred it dem ands from the business
sector and the F ed eral agencies;
( 2 ) T h e business sector increased its use of com
m ercial banks as a m ajor source of cred it;
( 3 ) T o take ad van tage of the profitable opportuni
ties offered by rising rates on business loans,
banks red u ced their liquidity positions by d e
creasing their holdings of G overnm ent securities
and excess reserves; and
(4 )
F o r the first tim e, com m ercial banks faced a
situation w here R egulation Q ceiling rates se
verely restricted their ability to bid for time
deposits.
Money and bank credit during early 1966 con
tinued to expand at the very rapid rates prevailing
SEPTEMBER 1 9 6 9
in the last half of 1965. This expansion reflected in
creases in their respective multipliers which more than
offset a reduction in the rate at which the monetary
base was supplied by the Federal Reserve. After
April, money remained about unchanged to the end
of the year, as a result of a decrease in the money
multiplier, which more than offset a resumption in
April of growth in the monetary base at its late 1965
rate. Bank credit, however, expanded through July
at an 8 per cent rate, then slowed markedly to late
1966.
The Federal Reserve should not have been sur
prised that money and bank credit continued to ex
pand through the first quarter of 1966, even though
there was a desire to exert a restraining influence on
total demand. The rapid expansion of base money in
the last half of 1965, and the sharply rising yields on
business loans reflecting strong demands by the busi
ness sector for bank credit, caused money and bank
credit to rise rapidly in early 1966. An increase in
the stock of base money must be absorbed into the
asset portfolios of the banks and the public, and such
an adjustment is not an instantaneous process. In
early 1966, as this adjustment process proceeded
(reflected in a rise in the money and bank credit
multipliers), market interest rates and prices in
creased, and the stocks of money and bank credit
expanded.
In the first seven months of 1966 the individual
commercial banks behaved in a manner that economic
theory would predict for any rationally behaving
profit-maximizing econom ic unit. As the yields on
business loans increased, the banks used every ave
nue available to expand their holdings of these highyielding assets. W ith the opportunity cost of liquid
assets rising, banks responded by reducing their hold
ings of lower yielding liquid assets — Government se
curities, excess reserves, and dealer loans.
The continued increase in bank credit after the
money stock ceased to expand can be largely ex
plained by the success of banks in acquiring time
deposits. An increase in the ratio of time deposits to
demand deposits increases the bank credit multiplier
but decreases the money multiplier. W ith rising yields
available on business loans, banks bid aggressively
for time deposit funds to m eet business demands
for credit. Operating on past experience, banks did
not expect that the Federal Reserve would permit
Regulation Q ceiling rates to prevent them from bid
ding competitively for time deposits.
Page 29
F E D E R A L R E S E R V E B A N K O F ST. LOUI S
In July policy actions by the Federal Reserve be
gan to exercise a much more restrictive effect on the
commercial banks. The refusal of the Federal Reserve
to raise Q ceilings as credit m arket interest rates
rose restricted the ability of banks to compete for
time deposits. In late July the increase in reserve
requirements on time deposits exercised a further re
strictive effect on the bank credit process. The F e d
eral Reserve, by its open market actions, offset most
of the contractionary effect of these two policy a c
tions. In July the stock of base money rose by $600
million.
Given the large increase in base money in July,
the Federal Reserve should also not have been sur
prised at the large rise in bank credit in that month.
Rather, given the upward trend in the bank credit
multiplier over the previous months, the central bank
should have been warned by the fact that the in
crease in bank credit was not much greater and by
the fact that the money stock showed no change.
In August the marked reversal of the im pact of
open market operations on the growth of base money
added a further restraining influence. The banks were
forced to make a portfolio adjustment. This portfolio
adjustment took the form of an attem pt by banks to
reduce their holdings of municipals. The result of
this attem pted portfolio adjustment was manifested
in the credit crunch in August.
In a period of time in which the com m ercial banks
are forced by monetary policy to restructure their
asset portfolios, one would expect there to be “above
average pressure” in the financial markets. That
SEPTEMBER 1 9 6 9
banks are forced to reduce their rate of production
of bank money and reduce the credit they extend to
the rest of the economy are the key elements of a
tighter or more restrictive monetary policy. This is a
necessary preliminary to the desired policy goals of
reduced aggregate demand and hence a reduced rate
of increase of prices.
In 1966 the intent of m onetary policy was to slow
the growth rate of aggregate demand and hence re
duce the inflationary pressures building up in the U.S.
economy. This goal was achieved in the first p art of
1967, as increases in aggregate demand and prices
slowed very markedly. This beneficial result was pre
ceded by a severe but short-lived liquidity crisis in
the money and capital markets in August 1966.
A historical analysis of the 1966 period suggests
that by following a less drastic contractionary policy
in August (perm itting less of a decline in the stock
of base m oney), and by following a more contrac
tionary policy with respect to the growth rate of base
money over the remaining months of 1966, the F e d
eral Reserve could have achieved the desirable ulti
m ate results of policy mentioned above. Also, more
gradually restrictive policies would quite likely have
prevented the severe wrenching of the money and
capital markets that occurred in August. Such a pol
icy, of course, would not have rem oved the necessity
for banks to make adjustments in their portfolios. It
would have perm itted this adjustment to be spread
over a longer period of time, thereby reducing the
threat of near-panic selling, and allowing a smoother
adjustment to a policy of monetary restraint.
This article is available as R eprint No. 45.
F EDERAL. R E S E R V E B A N K O F ST. LO U I S
SEPTEMBER 1 9 6 9
WORKING PAPERS
b IN G L E C O PIES of the following working papers are available to persons
with a special interest in these research areas, and any discussion or comment
would be welcomed by each author. F o r copies w rite: Research Department,
Federal Reserve Bank of St. Louis, P. O. Box 442, St. Louis, Missouri 63166.
Number
1
2
3
4
5
6
7
8
9
10
11
Title of Working Paper
Release Date
The Three Approaches to Money Stock Analysis
(Now available in our Reprint Series as No. 24)
July 1967
Chapter on Agribusiness Prepared for American
Institute of Banking Textbook A gricultural C redit
(5 0 pages)
Aug. 1967
Monetary Policy and the Business Cycle in Post
w ar Japan (1 0 8 pages) Revised
April 1968
The Influence of Fiscal and M onetary Actions on
Aggregate D em and: A Quantitative Appraisal
(5 3 p ages) Revised
M arch 1969
The Development of Explanatory Econom ic Hyphotheses for M onetary M anagement (4 8 pages)
Nov. 1968
A Model of the Markets for Consumer Instalment
Credit and New Automobiles (6 0 pages)
Jan. 1969
A Summary of the Brunner-M eltzer N on-Linear
Money Supply Hypothesis (6 5 p ag es) Revised
M ay 1969
The Market F o r D eposit-Type Financial Assets
(2 0 5 p ages)
M arch 1969
Im pact of Changing Conditions on Life Insurance
Companies (2 3 pages)
M arch 1969
Adjustments of Selected Markets in Tight Money
Periods (206 pages)
June 1969
A Study of Money Stock Control (41 pages)
July 1969
Page 31
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