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For Release on D e l i v e r y M o n d a y , July 23, 1973 11:30 a . m 0 , E C D . T . MONETARY POLICY, SAVINGS F L O W S , AND THE AVAILABILITY OF HOUSING FINANCE Remarks By Andrew F . Brimmer Member Board of Governors of the Federal Reserve System Before the 86th Annual Convention of the Michigan Savings and Loan League Grand H o t e l Mackinac Island, M i c h i g a n July 23, 1973 M O N E T A R Y POLICY, SAVINGS F L O W S , A N D THE AVAILABILITY OF HOUSING FINANCE By Andrew F . Brimmer* W h e n I accepted the invitation extended to me last winter to speak at this A n n u a l Meeting of the Michigan Savings and Loan L e a g u e , I indicated that I would focus on some aspect of monetary policy as it relates to housing finance. At that time, I obviously could not have anticipated that the interrelations between the two would be so central to our mutual concerns when the date for this M e e t i n g actually arrived! Of course, given the fundamental importance of credit availability for the housing m a r k e t , I am certain that there is always a meaningful dialogue to be carried on between those of us who help to formulate and execute monetary policy and the members of your industry w h o supply such a large proportion of the funds needed to f meet the n a t i o n s demand for housing. But the decision made earlier this m o n t h by the Federal Reserve Board and other Federal supervisory agencies to raise or remove the interest rate ceilings on savings and consumer-type * M e m b e r , Board of Governors of the Federal Reserve System. I am grateful to several members of the Board's staff for assistance in the preparation of these remarks. M e s s r s . James Kichline and Michael Prell helped to trace recent developments in savings flows at depository institutions. M r . Bernard Freedman provided assistance in the assessment of trends and prospects in homebuilding, and M r . Robert Fisher did the same thing w i t h respect to the mortgage m a r k e t . M r . Kichline also helped with the appraisal of the financial outlook in the months immediately a h e a d . H o w e v e r , while I am grateful to the staff for its support, the analysis presented and conclusions reached are my own and should not be attributed to the Board's staff. Nor should they be attributed to my colleagues on the B o a r d . -2time deposits has clearly sparked a v i g o r o u s discussion of some of the v i t a l issues that are close to thrift institutions and others concerned w i t h housing finance. S o , I decided that in these r e m a r k s , I would attempt to examine several of these issues from the vantage point of a M e m b e r of the Federal Reserve B o a r d . Let me a c k n o w l e d g e , h o w e v e r , that because w e have responsibility for the conduct of m o n e t a r y and credit policy w i t h the objective o f enhancing the economic welfare of the country as a w h o l e , our perspective may not be precisely the same as that held by participants in a particular industry. Before turning to the body of these r e m a r k s , it m i g h t be helpful to summarize several of the m a i n points: --The Federal Reserve has followed a policy of substantial m o n e t a r y restraint in 1973. H o w e v e r , by June the need for additional measures to check the excessive expansion of the monetary aggregates had become increasingly e v i d e n t . O t h e r w i s e — f a r from serving to help dampen the persistently strong inflationary pressures in the U . S . e c o n o m y — m o n e t a r y policy could have become an instrument of further inflation. --In pursuit of this g o a l , the Federal Reserve has employed all of its traditional tools of monetary control: it has supplied fewer reserves through open m a r k e t operations; it raised reserve r e q u i r e m e n t s , and it advanced the discount rate to the highest level posted since the early 1 1920 s. --As is generally k n o w n , the discount rate lagged behind rising market rates through late 1972 and in early 1973. T h i s differential created an incentive for a number of the largest member banks to borrow heavily through the discount window to help meet the strong credit demand of the private s e c t o r — e s p e c i a l l y the demand orginating w i t h business firms. -3— M a n y of the largest corporations in the country in turn were induced to borrow from commercial banks partly because the relatively low prime lending rate prevailing at the latter in the face of sharply rising yields in the money m a r k e t . Until April of this y e a r , policies followed by the Committee on Interest and Dividends limited the ability of the commercial banks to pass on to business borrowers the higher cost of money which the banks themselves were facing. As a r e s u l t , a substantial proportion of corporate demand for short-term funds was shifted from the commercial paper market to the b a n k s . --Homebuilding was a major source of economic strength during the early months of 1973. H o w e v e r , by m i d - y e a r , the pace of housing activity was dampened appreciably by the lessened availability of mortgage finance at thrift institutions. The latter experience itself was the result of the severe competition for savings reflected in the sharply rising level of interest rates on market instruments. --To moderate the adverse impact of these developments on savings intermediaries (and through them on the supply of mortgage funds), the ceilings on interest rates payable on consumer-type deposits were raised earlier this m o n t h . In the final section of these remarks, some of the principal elements in the financial outlook over the next several months are discussed. I r e a l i z e , of c o u r s e , that the continuing uncertainties affecting the dollar in the foreign exchange m a r k e t s — a s w e l l as the uncertainties on the domestic political f r o n t — w i l l have a bearing on financial developments in the United S t a t e s . These can only be noted here to indicate my awareness of their presence. -4Strategy and Implementation of M o n e t a r y Policy During the first half of 1 9 7 3 , monetary policy sought to restrain the large demands for funds registered in the m o n e y and capital m a r k e t s as part of the national effort to check inflation. In pursuit of this g o a l , the Federal Reserve System employed all of its traditional tools of monetary policy: through open m a r k e t operations; fewer reserves were supplied the discount rate was raised six times, and m e m b e r b a n k reserve requirements w e r e increased. Moreover, the System resorted extensively to m o r a l s u a s i o n , and interest rate ceilings on time deposits were relaxed on two o c c a s i o n s . The inter- play of strong credit demands and a restrictive monetary policy contributed to a significant firming in financial m a r k e t s . This firming was reflected in a sharp increase in short-term interest r a t e s , and--as the year p r o g r e s s e d — i n a general tightening in lending practices at commercial b a n k s . A t nonbank thrift institutions, a slowdown in deposit growth during the spring and early summer reportedly also prompted a tightening of mortgage commitment policies. Behavior of B a n k Reserves: In the first six months of this y e a r , total reserves of member banks expanded at a seasonally adjusted a n n u a l rate of 7.3 per c e n t . H o w e v e r , the volume of reserves supplied by the Federal Reserve expanded less rapidly (at an annual rate of 4.8 per cent). C o n s e q u e n t l y , the pressure on b a n k reserves arising from the strpng demands for b a n k credit led to -5a significant rise in the federal funds r a t e . In the first q u a r t e r , the rate banks pay for reserve funds borrowed overnight from other banks rose more than 175 basis points to a level of 7.09 per cent in March. Pressure on bank reserve positions increased even further in the second q u a r t e r , and the federal funds rate exceeded 9 per cent in early J u l y , more than 300 basis points above the level prevailing at the end of last D e c e m b e r . On M a y 1 6 , a marginal reserve r e q u i r e m e n t of 3 per cent was imposed on large denomination ($100,000 and over) certificates of deposit (CD's) issued by Federal Reserve member b a n k s . This move raised to 8 per cent the reserves required against increases in the amount of CD's outstanding after m i d - M a y . S u b s e q u e n t l y , the Board asked nonmember banks and agencies and branches of foreign banks in this country to subscribe voluntarily to the same r e q u i r e m e n t . Late in J u n e , reserve requirements were raised by 1/2 per cent on member b a n k s ' net demand deposits in excess of $2 m i l l i o n , effective in midJuly. Accompanying the rapid credit e x p a n s i o n , reserves available to support private non-bank deposits (RPD's) rose at a seasonally adjusted annual rate of 11.3 per cent in the first half of this y e a r . However, with private m e m b e r b a n k demand deposits growing more slowly, m o s t of this increase w e n t to support the sharp expansion in outstanding C D ' s . Total reserves grew at a much slower rate reflecting a sizable decline -6in Federal G o v e r n m e n t and interbank d e p o s i t s . N e v e r t h e l e s s , as the m o n t h of June p r o g r e s s e d , it became clear that the overall availability of b a n k reserves was expanding a t a rate in excess of that w h i c h w a s consistent w i t h a policy of m o n e t a r y r e s t r a i n t . For e x a m p l e , in June nonborrowed reserves rose at an annual rate of 24 per cent and RPD's at an a n n u a l rate of 16 per c e n t . As these trends emerged m o r e clearly, the Board concluded that reserve requirements should be r a i s e d , and the step w a s taken at the end of J u n e . Behavior of the M o n e y Supply: During the first six m o n t h s of 1 9 7 3 , the m o n e y supply turned in a mixed p e r f o r m a n c e . The rate o f growth slowed appreciably in the first q u a r t e r , b u t a sharp acceleration occurred in the last three m o n t h s — e s p e c i a l l y June. during In the January-March p e r i o d , the narrowly defined m o n e y stock (Mi, privately-owned demand deposits and currency in the hands of the public) rose at a 1.7 per cent annual r a t e . This w a s in noticeable contrast to the relatively rapid 8.6 per cent growth rate in the final quarter of 1972. Several factors m a y have accounted for the slower pace of expansion in M ^ , during the first q u a r t e r . It is possible that the demand for m o n e y w a s dampened by the cumulative impact of rising interest r a t e s . M o r e o v e r , deepening concern over inflation m a y have led some consumers to substitute goods for c a s h . A s i d e from these general i n f l u e n c e s , a number of special factors may have helped to -7hold down the rate of growth in M ^ . For i n s t a n c e , it appears that State and local governments (who received a sizable amount of revenuesharing funds last December) reduced their checking accounts and shifted the funds into time deposits. The evidence also suggests that corporations borrowed less than usual to pay income taxes in m i d - M a r c h and instead drew down their demand b a l a n c e s . F i n a l l y , the disturbances in the foreign exchange market in February and M a r c h could have resulted in the movement abroad of a minor amount of funds w i t h d r a w n from demand d e p o s i t s . The first quarter of the year also saw a considerable slackening from the strong rates of growth in the broadly defined measures of the m o n e y stock. One of these, M 2 (defined as M ^ plus time deposits at commercial banks other than large C D ' s ) , rose at an annual rate of 5.7 per cent during the January-March m o n t h s . Over the same p e r i o d , M ^ (defined as M 2 plus deposits at thrift institutions) expanded at an annual rate of 8.6 per cent. To some e x t e n t , these slower rates of expansion reflected the tapering off of growth in M ^ . Beyond this, h o w e v e r , a further decline occurred in February in the inflow of consumer-type time and savings deposits at commercial banks as w e l l as thrift institutions. This slower inflow, in turn, was a reflection of the fact that consumer-type time deposits became progressively less able to attract investors as yields on competing market assets rose appreciably. -8In the second q u a r t e r , the expansion of M ^ accelerated sharply to an annual rate of 10.4 per c e n t . w a s 12.9 per cent at an annual r a t e . In June a l o n e , the rise A p p a r e n t l y , the rapid growth in GNP and increasing inflationary expectations resulted in a substantially larger transactions demand for m o n e y b y consumers and businesses. In a d d i t i o n , special factors such as unusually large p e r s o n a l income tax refunds in A p r i l and M a y perhaps contributed to the faster second quarter pace. For the first six m o n t h s M*l increased at about a 6.1 per cent annual r a t e . together, This was appreciably b e l o w the 8.5 per cent pace in the second half of 1972. Y e t , as the second quarter drew to a c l o s e , the growth of the m o n e y supply was ballooning a g a i n . If allowed to continue u n c h e c k e d , the quickening pace of m o n e t a r y expansion would further strengthen inflationary expectations and undermine the effort to restore reasonable price stability by the use of wage and price controls. To forestall that p r o s p e c t , m o n e t a r y policy became much more restrictive toward the end of J u n e . As interest rates on competing m a r k e t assets rose further in the second q u a r t e r , inflows of savings and consumer type time deposits slowed. C o n s e q u e n t l y , b o t h M 2 and M 3 expanded at rates below that recorded for M ^ . In fact, the prospect for substantial outflows of such deposits was the m a i n factor which persuaded the Federal Reserve -9Board of the need to lift interest rate ceilings on such deposits earlier this m o n t h . This action is discussed further b e l o w . W i t h deposit inflows slowing, banks bid aggressively for funds to finance rising credit demands through sales of large negotiable C D ' s . As a result, in the first six months of 1973, CD's increased by close to $19 b i l l i o n — c o m p a r e d entire year 1 9 7 2 . to $10 billion for the A significant proportion of the increases occurred in the first quarter when the inflows of demand and time deposits were w e a k e s t . In the second quarter, banks found it increasingly costly to attract CD funds, and net sales were somewhat less than in the preceding three m o n t h s . By M a r c h , rates offered by most large banks on CD's w i t h maturities of 90 days or more were at ceiling levels—which were below rates available on competing money m a r k e t instruments. C o n s e q u e n t l y , b a n k sales became more concentrated in short-term issues. On M a y 16, the Board suspended interest rate ceilings on all large f denomination C D s , and rates on longer-term instruments rose sharply. The increase in marginal reserve requirements on CD's late in the second quarter made additional use of these funds even more expensive to b a n k s . Behavior of Bank Credit: During the first half of this y e a r , b a n k credit expanded at an annual rate of 14.3 per c e n t . increase was dominated by an expansion in business This sharp loans—basically -10a reflection of an increased cyclical need for working capital. In a d d i t i o n , especially in the first quarter, the relatively low commercial b a n k prime lending rate resulted in sizable substitutions of bank credit for more costly commercial paper borrowing by corporations. Other loan categories (including real estate and consumer loans) were unusually strong throughout the first six months of the year--in association w i t h the large rise in consumption spending and continuing high levels o f homebuilding activity. In the first quarter a l o n e , commercial b a n k s ' total loans and investments rose at roughly an 18.5 per cent annual rate. almost 1-1/4 times the growth rate recorded in 1972. This was During the January-March period, banks reduced their holdings of U . S . Government securities, but these cutbacks were more than offset by the upsurge in business borrowing. These businesses, in turn, were borrowing heavily to finance inventory investment and to meet working capital requirements. In addition, as discussed further b e l o w , the restraint on the b a n k s 1 ability to increase their prime lending rate m a d e it difficult for them to discourage borrowing by large corporations. As a result, a substantial number of these businesses relied more on commercial banks and less on the commercial paper market to obtain funds. The drawdown of U . S . credit lines by foreign commercial banks also gave a substantial boost to bank credit expansion during the first quarter. Changing foreign exchange rates and the differentials between -11U . S . interest rates and yields available in the Euro-dollar market apparently provided an incentive for these foreign banks to borrow here and to use the funds abroad. As a consequence, loans to foreign banks climbed by about $2 billion in February and M a r c h . Although some r e p a y m e n t of these loans had gotten underway by late M a r c h , the volume outstanding remained exceptionally large. On the domestic s c e n e , b a n k lending directly to consumers rose substantially in the first q u a r t e r . The banks also expanded their lending to finance companies--which in turn channeled the funds primarily to households. Other n o n b a n k financial institutions (especially mortgage bankers and real estate investment trusts) also borrowed heavily at b a n k s . D u r i n g the second q u a r t e r , the rate of growth of b a n k credit slackened s o m e w h a t — r e g i s t e r i n g an annual rate of expansion of 9.8 per cent compared with 18.4 per cent in the first three months of the year. Banks expanded moderately their holdings of both U . S . Government and other securities. Among types of loans, the slackening in the pace of growth was m o s t noticeable in the case of business loans—which expanded at a n annual rate of 20.3 per cent in second quarter v s . 39.1 per c e n t in the first three m o n t h s . The b a n k s 1 real estate loans rose at an a n n u a l rate of 16 per cent in both quarters. The growth of consumer loans slackened somewhat-—receding to an annual rate of 14.2 per cent in the M a r c h - J u n e period compared w i t h 17.6 per cent in the first quarter. -12The behavior of business loans in the last month is especially noteworthy. In J u n e , bank loans to business firms rose at a 14 per cent annual r a t e . This rate suggests that business demand for funds is still strong, but it seems to have moderated considerably compared w i t h the exceptionally high rates of growth which occurred earlier this y e a r . Undoubtedly, part of this slowing can be attributed to the increases in the b a n k s 1 prime lending rates as they responded to the rising costs and lessened availability of funds. Furthermore, borrowing by corporations to make quarterly income tax payments seems to have been somewhat below the volume borrowed in previous y e a r s . Apparently corporations relied on a sizable run-off of CD's to meet a significant part of their needs. It also seems that a number of businesses turned to the commercial paper market in June to raise a relatively greater proportion of the funds they r e q u i r e d — s p u r r e d to some extent by the rapidly rising prime lending rates at commercial banks. Discount Rate Policy and Member Bank Borrowing: As mentioned a b o v e , the Federal Reserve B a n k s ' discount rate was raised six times during the first half of this y e a r . On January 12, the rate was raised to 5 per cent from 4-1/2 per cent (where it had been since December 10, 1971). times to 6 per cent. Through m i d - M a y , the rate was moved up three more On each of these occasions, the Board emphasized that the actions were taken to bring the discount rate more into line -13w i t h m a r k e t r a t e s — a l t h o u g h the latter remained w e l l above the former. H o w e v e r , in early J u n e , the discount rate was increased to 6-1/2 per c e n t , and the Board stressed that the action w a s designed partly as an anti-inflation m o v e . F i n a l l y , at the end of last m o n t h , the discount rate w a s again raised by 1/2 per cent to 7 per c e n t . On that o c c a s i o n , the B o a r d ' s desire that the measure be seen as a further anti-inflation move w a s m a d e quite e x p l i c i t , and it was combined w i t h a 1/2 per cent increase in reserve requirements on demand d e p o s i t s . A s money market interest rates r o s e , the gap between such rates and the discount rate became progressively larger. This strengthened the incentive of m e m b e r banks to borrow from F e d e r a l Reserve B a n k s . Such b o r r o w i n g rose sharply in the first quarter to an average of $1.5 b i l l i o n — c o m p a r e d with an average of $740 m i l l i o n in the last three m o n t h s of 1972. The average level of b o r r o w i n g has risen steadily since t h e n — t o $1.8 billion in the second quarter and to $2.0 billion in the first two weeks of J u l y . Viewed in a longer p e r s p e c t i v e , the y e a r - t o - y e a r change in the level of m e m b e r bank'borrowing is even more striking. For e x a m p l e , in 1972, weekly average borrowing ranged from a low of $12 m i l l i o n to a high of $1,223 m i l l i o n ; this year the range has b e e n from a low of $688 m i l l i o n to a h i g h of $2,401 m i l l i o n . M o r e o v e r , borrowing has been heavily concentrated among the largest m e m b e r b a n k s . The 46 money m a r k e t banks (which report daily to the F e d e r a l Reserve on their federal funds transactions) typically -14accounted for o n e - q u a r t e r to one-third of total m e m b e r b a n k b o r r o w i n g during the first 6 - 1 / 2 months of this y e a r . In c o n t r a s t , during the period of severe monetary restraint in 1 9 6 9 , their share of total b o r r o w i n g averaged only one-sixth, and it rose to only o n e - f i f t h in 1970. A n even closer look at the statistics on borrowing from the F e d e r a l Reserve Banks demonstrates clearly that m e m b e r banks h a v e 1/ lost m u c h of their traditional reluctance to b o r r o w . I n s t e a d , they seem quite willing to include borrowing at the Federal R e s e r v e discount w i n d o w along w i t h C D ' s , Euro-dollars, and other sources in p l a n n i n g their portfolio s t r a t e g y . In choosing among the various a l t e r n a t i v e s , they seem to be influenced far more b y differences in the cost of m o n e y than was typically thought to be the c a s e . U n d o u b t e d l y , the vast m a j o r i t y of m e m b e r b a n k s do remain reluctant to borrow from F e d e r a l Reserve Banks; and w h e n they do b o r r o w , they normally m a k e few trips to the w i n d o w and for fairly short periods of time. But among the v e r y large b a n k s , the frequency of borrowing has i n c r e a s e d , and its timing suggests strongly that these banks are motivated b y differences b e t w e e n the discount rate and the cost of substantially funds in the money market. 1/ See A n d r e w F . B r i m m e r , "Member Bank B o r r o w i n g , Portfolio S t r a t e g y , and the M a n a g e m e n t of Federal Reserve D i s c o u n t P o l i c y , " W e s t e r n Economic J o u r n a l , V o l . X , N o . 3 , S e p t e m b e r , 1 9 7 2 , p p . 2 4 3 - 2 9 7 . -15F o r this reason, I have become convinced in recent years that the F e d e r a l Reserve discount rate should be kept much more closely aligned with market r a t e s . This was recommended in 1968 by a F e d e r a l Reserve committee which made a comprehensive study of the discount m e c h a n i s m . proposal. Initially I had reservations about that H o w e v e r , as I have watched the changing posture of member banks with respect to borrowing from Reserve B a n k s , I have become increasingly convinced that the F e d e r a l Reserve System—particularly the Board of G o v e r n o r s — n e e d s to revise its attitude toward the discount r a t e . I believe the rate should be managed in a much more flexible m a n n e r , and it should be kept in much better alignment with money market y i e l d s . Interest R a t e s : Competing Policy Objectives As I noted a b o v e , short-term interest rates have continued to climb steeply through 1973. This uptrend is the by-product of strong demands for short-term credit and a more restrictive monetary p o l i c y . O n the other h a n d , some short-term interest rates have risen less rapidly than one w o u l d have expected--and are still at levels below those which might have b e e n implied by the vigor of economic activity and the growing scarcity of resources. T o some e x t e n t , these divergencies -16- may reflect the efforts of the Administration's C o m m i t t e e on Interest 3/ and Dividends (CID)— to moderate increases in administered interest rates to increases in costs that resulted primarily from pressures in the money and capital m a r k e t s . M o n t h l y average rates on three-month Treasury bills r o s e over 200 basis points from Decemberj 1 9 7 2 , to J u n e , 1 9 7 3 . D u r i n g the same p e r i o d , commercial paper rates increased by about 250 basis points; the federal funds rate advanced over 300 basis p o i n t s , and commercial banks 1 prime lending rate moved from the 5.00-5.25 per cent range at the beginning of the y e a r to 7-3/4 at the end of J u n e . Following the increase in the discount rate to 7 per cent effective J u l y 2 , all of these rates rose s h a r p l y . For e x a m p l e , by m i d - m o n t h , rates on 3-6 m o n t h Treasury b i l l s had climbed by some 65 basis points to the neighborhood of 7.89 p e r cent. The rise in private short-term rates generally exceeded the advances in b i l l r a t e s . In m i d - J u l y , the highest rates being quoted in the 3-month m a t u r i t y range on prime b a n k e r s ' acceptances and large CD's at New Y o r k City banks (9-1/4) and on prime commercial paper (9 per cent) were 80-90 basis points above the levels 3/ A g r e a t deal of confusion has developed between the role of the CID and the responsibilities of the Federal Reserve B o a r d . It is true that D r . A r t h u r F . Burns is Chairman of b o t h . B u t , in f a c t , the two entities are quite separate and d i s t i n c t . The CID is a unit of the Administration's Cost of Living Council which a d m i n i s t e r s the w a g e and price control p r o g r a m . The Federal R e s e r v e B o a r d (no M e m b e r of w h i c h besides the Chairman serves on the CID) remains an independent a g e n c y charged by Congress w i t h the responsibility to conduct m o n e t a r y policy so that it can m a k e its m a x i m u m contribution toward the achievement of economic s t a b i l i t y . -17prevailing two weeks e a r l i e r . M o r e o v e r , reports w e r e heard that even higher rates had to be paid to do a substantial volume of business. Commercial b a n k s 8-1/2 per c e n t . 1 prime lending rates had also moved to T h u s , by m i d - J u l y , short-term interest rates had generally risen almost to--and in a few instances a b o v e — t h e levels set in late 1969 and early 1970. record B u t , given the persistence of inflationary pressures and the strong competition for funds, the uptrend of interest rates was consistent with a policy of monetary restraint designed to help check inflation. But while interest rates were generally a d v a n c i n g , some rates lagged appreciably b e h i n d . This was true, at times, not only of consumer and mortgage rates--traditionally lagging r a t e s — b u t also of rates commercial banks charged their corporate and small business customers. In response to requests by the Committee on Interest and D i v i d e n d s , during the first quarter of this y e a r , banks limited increases in the structure of rates to the rise in their own cost of funds. Apparently the CID was apprehensive that the Administration's Economic Stabilization P r o g r a m might be undermined if administered interest r a t e s — w h i c h the Committee stated to be its sole c o n c e r n moved upward rapidly on a broad front. The Committee stressed that it was at no time concerned with open market rates. -18Opinions differed sharply over the approach of the CID to the b e h a v i o r of interest r a t e s . But independently of where one's o w n views m i g h t rest in this c o n t r o v e r s y , the effects of the p o l i c y on the demand for b a n k credit can be seen c l e a r l y e As the b a n k s ' p r i m e rate lagged behind interest rates in the commercial paper market early in 1973, m a n y corporate borrowers found it advantageous to switch to b a n k credit as a m e a n s of m e e t i n g their working capital n e e d s . As a r e s u l t , dealer placed paper contracted by $3.8 billion during the J a n u a r y - A p r i l period of this y e a r . The amount of such paper outstanding rose by $1.1 billion in the same period of 1972 and by $1.7 billion in 1971. In c o n t r a s t , business loans at large commercial banks rose by $11.6 b i l l i o n during the January-April m o n t h s of this year--whereas the increase in the same months of 1972 was $677 m i l l i o n , and in 1971 a decline of $481 m i l l i o n was r e c o r d e d . lending rate at commercial banks T h u s , the relatively low prime led to the substitution of b a n k credit for a sizable amount of borrowing which corporations otherwise would have done in the money m a r k e t . In A p r i l of this y e a r , the CID issued guidelines w h i c h permitted a two-tier prime rate to e m e r g e . Under this a r r a n g e m e n t , the prime rate that banks charge large corporate borrowers could be aligned m o r e closely w i t h rates o n other m o n e y market i n s t r u m e n t s , w h i l e the rates charged small businesses w e r e expected to remain fairly stable. Banks m o v e d quickly to take advantage of this greater f l e x i b i l i t y , and lending -19rates to large borrowers were raised substantially. Partly in response to the rising cost of b a n k credit, business loans at large banks rose by only $884 m i l l i o n in M a y v s . an average of $2.9 billion in the preceding four m o n t h s . The increase in June was much larger ($2.1 b i l l i o n ) , but the M a y - J u n e average of $1.5 billion was well below that recorded in earlier m o n t h s . Also in M a y , the volume of dealer- placed commercial paper rose by $222 m i l l i o n , and June brought another gain of $180 m i l l i o n . S o , by m i d - y e a r , as commercial banks raised their prime lending rate p r o g r e s s i v e l y , an increasing number of corporate borrowers w e r e induced to look to nonbank sources of funds to meet their demands for funds to finance working capital and inventory investment. -20H o u s i n g Demand and the Supply of Funds T h e significant role which the housing sector has played in economic expansion during the last few years is widely known and need not be recounted h e r e . H o w e v e r , it might be h e l p f u l to summarize the highlights of recent (and prospective) developments relating to the demand for and supply of h o u s i n g . As mentioned a b o v e , the increasingly adverse impact of rising market interest rates on the availability of mortgage funds was one of the major factors influencing the d e c i s i o n of the F e d e r a l Reserve Board and other F e d e r a l b a n k regulatory agencies to lift interest rate ceilings on consumer-type savings earlier this month. Trends in R e s i d e n t i a l Construction: R e a l outlays for private residential construction have drifted downward since M a r c h . Underlying the decline has been a noticeable decrease in private housing starts from the near-record pace of activity during the w i n t e r m o n t h s . Neverthe- less, the average level of starts in the first quarter of this year (at a seasonally adjusted a n n u a l rate of 2.40 million units) was second only to the p e a k recorded in the same period last y e a r . M o r e o v e r , starts in the second quarter averaged 2.22 m i l l i o n u n i t s — s t i l l one of the h i g h e s t averages on r e c o r d . On the other h a n d , on the basis of preliminary figures for J u n e , it appears that the sharply higher level of starts reported for M a y (2.42 m i l l i o n ) was not s u s t a i n e d . A t 2.12 m i l l i o n u n i t s , the level of housing starts last m o n t h a p p a r e n t l y receded to that recorded in A p r i l (which w a s also 2.12 million). -21In the m e a n t i m e , an unusually large volume of housing units is still under construction. This suggests that homebuilding activity through the remainder of 1973 and into 1974 w i l l remain at a fairly high level- thereby affording an increasingly strigent test of the absorptive capacity of the real estate m a r k e t . These newly-completed u n i t s , carrying rather liberal mortgage financing terms arranged sometime earlier, will add to downward pressures on new housing starts financed under relatively less favorable terms. Supply of Mortgage Funds: Through last m o n t h , the slackening of deposit inflows at thrift institutions (caused mainly by the rise in market interest rates) apparently had a growing adverse impact on the availability of new mortgage funds. f At savings and loan associations ( S & L s ) in particular (the largest single source of housing finance), the growth of share capital appears to have slowed to a seasonally adjusted annual rate of 9-1/2 per cent in the second quarter, compared with 16 per cent in the January-March months. If this were the c a s e , the April-June quarter would be the first one since che same period of 1970 in which share capital has failed to grow at a rate significatly in excess of 10 per cent. Under these circum- stances, the total of S&L mortgage loans in process and outstanding commitments for future mortgage loans was down by 7 per cent through the month of May from record high levels. For e x a m p l e , outstanding commitments and loans in process peaked at $21.5 billion (seasonally adjusted) in February; by M a y the level had declined to $20,1 b i l l i o n — a relatively sharp decline for these items but--nevertheless--to a level still above that for any time p r i o r to this y e a r . -22But as the spring continued to unfold, the cumulative effect f of reduced net savings inflows to the S & L s and savings banks during June and through early July apparently continued to induce further cutbacks in the volume of new residential mortgage commitments, particularly in view of the large backlog of outstanding commitments. Consequently, under these f circumstances, S & L s have been borrowing heavily from the Federal Home Loan Banks (FHLB). To date this year, they have borrowed a net of $3,5 billion-- $700 million of which was raised during the 3 weeks ending in mid-July. By then, outstanding advances had reached more than $11 billion. The willingness of the FHLB system to support S&L's in their lending efforts has been an important source of partial protection for the housing market in 1973 in the face of sharply rising interest rates. Of course, reliance by S&L's on higher cost FHLB advances is no real substitute for regular deposit inflows as a means of sustaining the flow of funds into h o u s i n g . But such advances do enable S&L's to adjust their residential mortgage lending in an orderly manner as the pull of market interest rates dampens savings inflows. Just how important FHLB advances have been to S&L's can be seen by a comparison of this year's experience with that registered in 1966 and 1969-70. In 1966, the FHLB Board responded in limited fashion to the restricted flow of funds to its member institutions. At that time, its policy on advances was initially influenced by concern with the loan portfolio quality and dividend rate policies of the S&L's. Futhermore, the FHLB System's ability to raise funds for advances was subject to some -23uncertainty in the market environment it faced and because of a Government program of restricting agency borrowing. As a consequence, advances outstanding rose less than $1 billion during 1966, and net mortgage debt formation by S&L's fell three-fifths from the 1965 level. Housing starts also fell sharply in the course of the y e a r . The experience in 1969-1970 differed markedly from that in the 1966 period of credit restraint. The FHLB System responded aggressively to the credit squeeze in order to assure the availability of mortgage funds. Advances outstanding rose by $4 billion during 1969 and by another $1.3 billion in 1970--despite the upsurge of deposits in the second half of the latter y e a r . The greater availability of FHLB advances in 1969 helped S&L's to m a i n t a i n a steadier flow of mortgage loans than in 1966, and hence aided in cushioning the decline in housing starts in 1969. Thus, 1 the F H L B s actions in the 1969-1970 episode, rather than those in 1966, better reflect its current perception of its role in support of the savings and loan industry and the nation's housing objectives. Trends in Mortgage Interest Rates: Even before ceilings on savings deposits were raised earlier this m o n t h , interest rates on residential mortgages had already risen appreciably. In late J u n e , conventional first mortgages on new homes carried contract interest rates which averaged 8.05 per cent. This represented an increase of 50 basis points from the most recent low registered in M a r c h , 1972, and it was the highest monthly average since late 1970. Even so, the June level was roughly 55 basis points below the peak attained in the Summer of 1970. -24The average rate of interest on existing-home mortgages was also 8.10 per cent in J u n e . In a number of states (located primarily in the East and South) that still have fairly low usuary ceilings, yields required by lenders had already reached the legal limits by last month. The gradual uptrend in costs of residential mortgage financing that began early in 1973 has apparently accelerated in July. To some extent, this represents a reaction to the increase in ceilings on consumer-type savings effected earlier this month. Moreover, contract interest rates on FHA and VA mortgages were raised by 75 basis points in early July, although no new commitments can be made under these programs until the Congress reinstates the insurance authority that expired at the end of June. Rates on new commitments for conventional home mortgages apparently were averaging 10 to 15 basis points in excess of 8 per cent as of mid-July, thereby intensifying structural problems associated with usury ceilings that have become increasingly restrictive again. In the secondary mortgage market, the uptrend in yields also has accelerated, partly stimulated by the announced upward adjustment in FHA/VA mortgage rates. In the mid-July FNMA auction of forward commitments to purchase Government underwritten home mortgages, the average yield climbed to 8.38 per cent, the highest level in more than 2-1/2 years. -25Interest Rate Ceilings and Savings Flows The decision made earlier this month by the Federal bank regulatory agencies to raise interest rate ceilings on consumer-type time and savings deposits was received with mixed feelings on the part of many depository institutions. In fact, among some officials in these institutions, there have been explicit criticism of the increase in rate ceilings. Perhaps to some extent this has reflected a misunderstanding of the role and effect of such ceilings when viewed from the national-as opposed to the industry--level. After an unusually high rate of growth in January of 1973, deposit flows to nonbank thrift institutions began to slow in succeeding months. The seasonally adjusted annual rate of expansion in these deposits was 13.6 per cent during the first three months of the y e a r , but it is estimated to have moderated to about 8-1/2 per cent in the second quarter. The personal savings rate during the first half of this year was only marginally lower than in 1972, and savings flows may have been buttressed in April and May by income tax refunds. But deposit inflows slowed under the impact of the sustained and sharp rise in yields on alternative investment instruments. At savings and loan associations, the reduced expansion in savings accounts came at a time of an exceptionally high volume of mortgage takedowns. This generated a substantial increase in borrowing from the Federal Home Loan Banks, some reduction in liquidity positions, arid a reported tightening of mortgage commitment policy. -26? I can understand why spokesmen for S&L f: and other depository institutions urged that interest rate ceilings (particularly those on p a s s b o o k savings) not be increased. It is true that interest rate ceilings can and have protected the thrift institutions from competition of commercial banks that could prove undesirable for mortgage credit supplies. B u t , at the same time, it is necessary to realize that ceilings on depository claims cannot protect depository institutions as a group from the increased relative attractiveness of yields on market securities. f At both S & L s and mutual savings banks,the inflow of funds in M a y and June seems to have exceeded the volume which many observers a n t i c i p a t e d — g i v e n the already high and still rising level of market y i e l d s . During the first quarter, deposits at mutual savings banks expanded at an f 8.1 per cent seasonally adjusted annual rate, and at S & L s the rate of increase was 16 per cent. per cent. So their combined growth rate was about 13-1/2 In A p r i l , the annual rate of deposit growth eased off to 5 per f cent at mutual savings banks and to 7 per cent at S & L s - - f o r a combined growth rate of 6-1/2 per cent. H o w e v e r , in M a y a rebound occurred. At m u t u a l savings b a n k s , the rate of expansion climbed to 6.1 per cent, and 1 at S & L s the rise was even more marked at 10.7 per cent. Taken together, the two sets of institutions recorded an annual rate of increase 9.3 per cent in M a y . M o r e o v e r , the uptrend in deposit growth appears to have continued during the early weeks of J u n e . For the month as a w h o l e , inflows may h a v e risen at an annual rate of 8 per cent at mutual savings banks and r at a n 11 per cent rate at S & L s . If so, these figures would suggest a combined annual rate of expansion of 10 per c e n t . -27Y e t , when the trend of inflows within the month of June is examined more closely, it becomes quite evident that the substantial increases in market interest rates had placed these thrift institutions on the brink of disintermediation. with a significant inflows. Commercial banks also were faced reduction in the rate of increase in deposit The pattern and magnitude of inflows at the three typeff of institutions can be traced in the following statistics: Net Deposit Inflows at Insured Savings and Loan Associations-^ (Millions of Dollars) Month 1972 January February March April May June 3,117 2,700 2,532 1,668 2,107 1,626 1973 3,117 1,795 1,628 724 l,741p 700e 1/ Net of interest crediting, p - preliminary, e - estimated. Deposit Inflows During the Reinvestment Period at the Seventeen Largest New York City Mutual Savings Banks (Millions of Dollars) Year Last Three Grace Days of June Net Adjusted for Passbook Loans Net 1969 1970 1971 1972 1973 1/ -326.3 -242.7 -112.3 -147.2 -118.0 -170.6 -118.9 - 69.8 - 67.7 - 86.8 First Five Business Days of July—^ -108.0 - 28.5 1.4 38.0 - 88.6 Net deposit flows, adjusted for repayment of passbook loans made earlier to save earned but unpaid interest. -28Consumer-Type Time and Savings Deposits at Weekly Reporting Commercial Banks (Change in Millions of Dollars) Time Period May 31 - June 28, 1972 May 30 - June 27, 1973 Passbook Savings Consumer-Type Time Deposits 220 22 761 568 The message transmitted by these figures is inescapable: in the face of sharply rising short-term market interest rates, all of the principal depository institutions faced an increasingly real prospect of serious attrition in the inflow of funds. ! It appears that S&L s--after allowing for interest credited—experienced a substantially slower net inflow in June. At mutual savings banks in New York City, outflows during the June grace period were the largest since 1970; in early July of this year, they also had a large net outflow in contrast to net inflows in the previous two years c The increase in passbook savings at large commercial banks in the month of June this year was only one-tenth the size of that recorded in 1972; inflows of consumer-type time deposits also fell off by one-quarter. So, in the absence of a change in interest rate ceilings during the present period of monetary restraint, savings inflows most probably would have deteriorated much more sharply. As a consequence, institutions undoubtedly would have cut back on new mortgage commitments, raised mortgage f rates, tightened nonprice terms, and S&L s would have borrowed much more heavily from the Federal Home Loan Banks than is now in prospect. Moreover, those institutions able and willing to compete for funds through offering higher deposit rates could not have done so. Along with these inefficiencies, -29small s a v e r s — t h o s e of moderate income and minimal financial sophistication-would have been more severely and inequitably penalized by being paid much less than the return that their savings could earn if employed in other channels« I realize, of course, that a chief problem in the regulation of interest rate ceilings at depository institutions concerns the interest paying capacity of S&L's, where longer-term assets provide a slower cyclical change in cash flow and gross earnings than is experienced at commercial banks or mutual savings banks. Since early 1970, when interest rate ceilings were last adjusted upward, S&L earnings have improved sharply with the addition of higher-yielding mortgages to S&L portfolios. For example, in 1970, the f cost of funds to S&L s averaged 5.30 per cent; their average interest return on mortgages was 6.56 per cent--giving them an earnings spread of 126 basis pointso By 1972, the cost of money had risen to 5.38 per cent; the average return on mortgages had risen by s u b s t a n t i a l l y more to 7.05 per cent. So the margin had widened to 167 basis p o i n t s — n e a r l y as high as it was in 1965. On the basis of this evidence, I conclude that the S&L industry— if not all a s s o c i a t i o n s — i s in a position to compete for funds by offering higher rates to depositors. By so doing they can pay a return to savers closer to the economic value of their deposits. f It is still too early to tell in a definitive way how S&L s and other depository institutions have responded to the greater flexibility afforded them to set their own offering interest rates on savings 0 However, on the basis of information from informal soundings and other sources, it -30appears that a sizable number of commercial banks have moved up to the new 5 per cent ceiling on passbook accounts, and they also have raised rates on savings certificates of under 4-year maturities. A much smaller number of banks have posted rates on the new 4-year $1,000 minimum denomination consumer certificates. Where they have done so, nominal rates have generally centered at 7 or 7-1/2 per cent. Fragmentary information suggests f that many S & L s have generally adopted the new 5-1/4 per cent passbook rate. However, in some areas, it seems that they have perhaps been slower than commercial banks in raising their rates on certificates. On balance, as I mentioned above, I believe the decision of the Federal Reserve Board and other regulatory authorities to raise the ceilings on the maximum interest rates payable on consumer savings was well-founded. As thrift institutions adjust their offering rates, the pull of market yields on the flow of funds to them--and on into the housing s e c t o r — w i l l be moderated compared to the more adverse impact they would have otherwise suffered. -31Concluding Observations: Elements in the Financial Outlook Before concluding these remarks, we ought to pause briefly to see what inferences for the financial outlook we can draw from the foregoing review of recent developments in money and capital markets. But I must confess at the outset that there are severe limitations on the extent to which I am able to scan the horizon to chart the probable course of interest rates and credit flows. Of course, one of these constraints arises from my own limited ability (along with most other economists!) to forecast economic developments with any substantial degree of accuracy—particularly in times such as this. But beyond this difficulty, as a Member of the Federal Reserve Board, I am faced with another serious handicap. By long-standing tradition (which I fully support), Members of the Board refrain from speaking publicly about the probable future course of monetary and credit policies. Since I share in the formulation and implementation of such policies, any attempt on my part to forecast the future path of interest rates would necessarily involve telegraphing my own views and preferences with regard to the appropriateness of prospective decisions. Within these limitations, however, several elements which will undoubtedly influence financial developments in the months ahead can be cited. First among these, of course, is the impact of Phase IV 1 of the Administration s wage and price controls program on the rate of inflation. I have no special basis on which to evaluate the effects of the effort on price pressures or to form a judgment about its -32probable effects on the public's deeply-rooted inflationary expectations. But to the extent that the strengthened program does help to check the upward tendency of wages and prices, it might also help to dampen the public's demand for money and credit. In a similar vein, the continuing uncertainties affecting the dollar in the foreign exchange m a r k e t s — a s well as the uncertainties on the domestic political f r o n t — w i l l also influence financial developments in the United States. These can only be noted here to indicate my awareness of their presence. It seems quite probable that the exceptionally strong demands for goods and services that have been evident so far in 1973 will abate somewhat as the year progresses. Just how rapidly this abatement might be expected to emerge cannot be predicted with precision. Yet, it appears that a number of strategically placed manufacturing industries are working at or close to capacity, and this factor can be expected to restrain somewhat the rate of growth of real output. On the demand side, consumer expenditures (especially outlays for durable goods) are clearly expanding much more slowly than they were earlier in the year. As indicated above, homebuilding—which was a major source of strength during the first q u a r t e r — h a s already eased off somewhat, and the level of activity is expected to decline through the rest of the year. The demand for output generated by the business sector (particularly in the form of spending for fixed investment) will probably lessen somewhat as well in the months ahead. It also seems unlikely that -33spending by the Federal Government will give a noticeable boost to the economy. So, when the principal economic sectors are viewed in the aggregate, the unfolding evidence suggests that the overall pace of economic activity is likely to slacken through the second half of 1973. With respect to financial developments, the money and capital markets are still adjusting to the recent monetary policy moves to restrict further the availability of money and credit. Both short- and long-term interest rates are still responding to those actions, and it may require somewhat more time for the process to be completed. On the other hand, in view of the continued high level of economic activity (as measured by the rate of growth of nominal GNP), credit demands appear likely to remain quite heavy for some time. Under these circumstances, commercial banks and other financial institutions can be expected to tighten further their lending policies and to make more of the difficult portfolio adjustments—such as liquidating municipal s e c u r i t i e s — t h a t are required if monetary policy is to be effective in restraining excess demand. In the case of business firms, funds generated through internal cash flow may lessen appreciably as profits shrink. Since their need for funds to finance working capital and inventory investment will continue to expand, businesses will have to turn increasingly to external sources. -34- Undoubtedly they will rely heavily on credit provided by commercial banks. To respond to such needs, banks themselves may find it necessary to attract a sizable amount of deposits through the sale f of high-yielding CD s and by borrowing from non-deposit sources. Moreover, bank liquidity—which has already shrunk well below the high levels prevailing a year a g o — c a n be expected to decline further. Banks will undoubtedly attempt to pass on to business borrowers as large a proportion as they can of the increased cost of money w h i c h they must themselves assume. Other lending terms may be tightened still more, and customers w i l L probably find it increasingly difficult to obtain accommodations for some of their projects. In response to the reduced availability of credit at banks, many corporate borrowers can be expected to rely much more heavily on the commercial paper market to meet their credit needs. Corporations may also become more interested in floating long-term issues in the capital market as pressures in the short-term market remain strong. So far, however, industrial enterprises apparently have shown little inclination to tap the long end of the market for an appreciable amount o f funds. On the basis of the experience in previous periods of monetary restraint, State and local governments may encounter somewhat greater difficulties in marketing long-term obligations. Some of these might arise because of statutory interest rate limitations. Other borrowers may choose to postpone projects—especially if the funds are to be raised through sales of long-term revenue bonds which frequently contain restrictive call-protection features^ -35As far as the Federal Government is concerned, there may be little need for direct borrowing over the months immediately ahead. On the other hand, Federal agencies may bring to the market a sizable volume of debt issues. Among these, offerings by the FHLB Banks may be especially l a r g e — s i n c e these institutions are committed to a f policy of providing substantial support to S&L s in the face of declining savings inflows. Nevertheless r it appears that furtfter cutbacks in new commitments for home mortgages are clearly on the w a y , and additional upward pressure on conventional mortgage interest rates seems to be in store. I know that the picture which emerges from the foregoing scanning of the financial horizon is far from comforting. If it materializes, a number of borrowers may be disappointed in their quest for funds to meet all of their needs. Still others will have to bear interest rate costs that they find particularly burdensome. However, all of us should recognize that these consequences are inherent in the use of a restrictive monetary policy as a leading instrument in the fight against inflation. At the same time, of course, the greater the contribution to the overall stabilization effort that is made by fiscal policy and Phase IV of the wage and price controls program the smaller is the burden which monetary policy has to carry. But, in the final analysis, my own responsibilities—along with my colleagues at the B o a r d — c e n t e r in the area of monetary policy. The task before -36us at this juncture seems clear and unmistakable: given the tenacity of the continuing inflation in the United States, we ought to be prepared to stick with the policy of monetary restraint as long as it is required. - 0 -
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