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For release on delivery (Approximately 8:30 p.m. ESI Thursday, November 3, 1966) FEDERAL RESERVE POLICY AND THE CREDIT MARKETS Remarks by Chas. N. Shepardson Member of the Board of Governors of the Federal Reserve System at a Business-Economic Forum Austin Peay State College Clarksville, Tennessee November 3, 1966 FEDERAL RESERVE POLICY AND THE CREDIT MARKETS I am doubly pleased to be with you this evening. It is always refreshing to me, as a former college professor and, lest it be thought I travel under false colors, a former college dean as well, to return to an academic atmosphere. In addition, I appre ciate the timeliness of this invitation, for it provides an oppor tunity to talk with you about some aspects of current national economic and financial developments, when public concern with these developments has once again been heightened. Goals of the Federal Reserve System Congress in creating the Federal Reserve made the System its responsible agent for conducting monetary policy, its purpose among other things being “ to create an elastic currency" geared to the needs of the economy. As you know, monetary policy affects the economy principally through its influence on the cost and availability of credit and on the supply of money. Because credit and money play such vital roles in our day-to-day activities, the System necessarily keeps a sensitive finger on the nation's economic pulse, so that hopefully the policies it establishes will reflect the economy's needs. In appraising these needs, we are guided by the goal of encouraging the nation to achieve a continuously rising standard of living, with growing job opportunities for all and a reasonable over-all price stability so that the purchasing power of the dollar can be relied on. We also seek to encourage equilibrium in our - 2 balance of payments with foreign countries so as to maintain confidence in the dollar internationally, and to facilitate the expansion of our trade with other countries. Finally, we are mindful of the need to contribute to the continued satisfactory functioning of financial markets and to the achievement of the declared goals of public policy. Monetary policy in the early 60's Up until the last 12 months or so, the nation's main economic problem in the 1960's was to create a level of demand sufficient to absorb its available supply of resources. The United States entered this decade with an unemployment rate of nearly 7 per cent, which meant we had a large pool of unutilized resources— of capital as well as labor. In this environment, over-all economic policy of the Govern ment needed to be expansionary. In conjunction with fiscal policy, the task of monetary policy was to help create a financial and economic atmosphere which would permit an expansion in demand sufficient to bring idle manpower into productive work and to encourage the annual additions to our productive capacity that would ensure sustainable economic growth. During these years bank credit was permitted to expand rapidly, encouraged by a liberal provision of bank reserves through Federal Reserve purchases of U.S. Government securities and also by Federal Reserve regulations which enabled banks to pay competitive interest rates on time and savings deposits. Prior to 1961, banks were generally at a competitive disadvantage relative to other savings institutions. At the same time in the early 1960's, fiscal - 3 - policy became more expansionary through a series of moves, including liberalized depreciation rules, an investment tax credit, and a sizable personal and corporate income tax cut. The nation enjoyed a five-year period of unparalleled sus tained economic growth, with total output of goods and services increasing by $175 billion, between the end of 1960 and the start of 1966. Just to indicate the magnitude of this increase, it was more than the value of our total output in 1942. In addition, this expan sion was achieved in a noninflationary manner— that is, prices were comparatively stable during this long period of continuous prosperity. Intensification of inflationary pressures By the fall of 1965, however, it was becoming apparent that the underlying picture was changing. The economic pendulum seemed to be swinging over to the side of excessive demand, and inflationary pressures were mounting. The underlying sources of these pressures in the economy were the apparently rising defense expenditures asso ciated with the Vietnam conflict and, partly in consequence, an intensified boom in private capital spending by business. Both types of expenditures added markedly to the pressure on our available pro ductive capacity, and came at a time when the earlier policy measures had already succeeded in bringing our economy fairly close to the goals of high and rising levels of employment and production. As a result, with consumer demands continuing to grow, not all demands could be satisfied through rising output, and prices began to show more of a tendency to rise. In addition, the nation began to import more and more goods and services from abroad as domestic - 4 - productive capacity limitations were approached. As a result, both the stability of the dollar and our progress toward containing our balance of payments deficit were threatened. In the absence of any impending fiscal restraint, the System last December initiated actions leading to monetary restraint. At that time the discount rate, which is the rate Federal Reserve Banks charge member banks who borrow from them, was increased to 4-1/2 per cent. At the same time the ceiling on the rates banks were permitted to pay on their time deposits was raised to 5-1/2 per cent. Because short-term interest rates were rising, the previous ceiling on these deposits of 4-1/2 per cent, established in November 1964, had placed banks at a competitive disadvantage with rates on other forms of financial assets and, if left unchanged, could have resulted in distortions in the flow of funds at a time of seasonally strong credit demands. So, given the uncertainties in the economic and financial outlook at the time, we attempted to maintain the availability of bank credit by providing banks with leeway to compete for funds as interest rates moved up in response to a more restraining Federal Reserve policy. Recent economic developments As 1966 progressed there was some intensification of the Federal Reserve's posture of monetary restraint because of mounting demand pressures in the economy. Federal expenditures were increasing by more than was expected when the budget was presented last January, mainly because of rising defense needs associated with Vietnam. Furthermore, private demand, particularly for investment purposes, - 5 - remained strong. Consequently, the economy’ s earlier exemplary record of price stability in the early 1960's has been broken this year, with prices for certain groups of products, such as industrial materials and consumer services, rising twice as fast as they did last year. Not all the price increases were the result of demand, however; agricultural prices, for instance, rose in part because of shortages induced by ad verse weather conditions. The restraining effects of Federal Reserve policy in this buoyant economic environment can be seen in a number of financial indicators. For example, in the first nine months of this year, as compared with the corresponding period last year, bank credit, the money stock, and the amount of reserves provided the banking system by the Federal Reserve, all increased at a slower rate. The rise in interest rates this year— a rise which has taken most rates to 40-year record levels— is an additional indicator of restraint, although the extent of the interest rate rise was in large part influenced by the continuing expansion of credit demands, mainly by businesses. With the supply of lendable funds below the large demands, the increases in interest rates rationed available credit among potential borrowers. In addition, banks and other institutional lenders began to institute more stringent nonprice lending conditions. These limitations on the availability and increases in the cost of credit appear to have brought about some reduction in the demand for credit. The mortgage market appears to have been the area which first felt the incidence of the policy of monetary restraint. And borrowing by business and State and local governments since late summer has been somewhat more moderate than many had expected. - 6 - Housing industry especially hard hit While monetary policy primarily attempts to affect the total supply of bank credit and money in the economy, rather than its alloca tion, it remains true that specific areas of the economy feel its pinch more than others during periods of restraint. But experience in this respect has not been uniform, with businesses, consumers, or State and local governments sometimes pinched the most, while at other times mortgage borrowers have been hit the hardest. Monetary restraint has had an impact on the housing and construction industry during the current period, as well as at times in the past, because it has been associated with a more limited flow of savings to institutional lenders. During monetary restraint, as interest rates rise, the flow of new funds from the nonfinancial sector of the economy to depositary institutions— commercial banks, savings and loan associations, and mutual savings banks— tends to decline in volume, and a larger proportion of these funds are placed directly into credit and equity instruments— such as corporate bonds, finance company paper, and U.S. Government securities. This altera tion of flow occurs because, in the face of rising yields on competing market instruments, the yields offered by financial institutions tend to show less upward flexibility, and consequently deposits and saving shares in these institutions become a less attractive form of financial investment. The slower pace at which institutions acquire additional time and savings funds to lend naturally diminishes the capacity of these institutions to make additional new loans. Since savings and loan associations and mutual savings banks invest the bulk of their - 7 - assets in mortgages, changes they experience in the inflow of savings always greatly affect the housing industry. Moreover, since 1961 the commercial banking system has com peted much more aggressively for time deposits, first through the widespread introduction of large denomination certificates of deposit-intended to attract the large corporate depositor— and, since last spring, by the active promotion of consumer-type savings certificates and savings bonds. As a result, and in contrast to the 1950's when bank time deposit flows were severely reduced during periods of monetary restraint, commercial banks have, at least until recently, enjoyed a great deal of success in the competition for these deposits, with savings and loan associations and mutual savings banks faring less well. The combined impact of these two factors illustrates quite clearly why the housing industry is feeling its present pinch. First, there has been a slackening in the growth of deposits at financial institutions and, second, commercial banks have obtained a larger share of this reduced total. Since commercial banks are primarily lenders to business, and not principally mortgage lenders, it follows that the available supply of funds for the buyers and builders of houses has been sharply curtailed. The decline in housing starts and building permits since the beginning of the year reflects this reduction. Strong business loan growth At the same time, and in part because of their greater competitiveness for time deposits, commercial banks have been able to satisfy much of the intense demand for credit on the part of business borrowers this year. Their large time deposit inflows, plus the continued liquidation of some of their holdings of U.S. Government securities, and the reduced pace at which they have ac quired the securities of municipal and other governmental units, provided banks with the funds needed to fulfill these requests. However, since last December banks have raised the rates at which they will make loans and have upgraded their lending standards as well. This implies that some potential applicants for bank loans have probably been deterred by higher rates, whereas others who actually applied, and who might have been accommodated in previous years, were turned down. Partly in order to guard against further excessive growth in business loans and partly in order to assure a more even distribu tion of available bank credit and of savings flows, the Federal Reserve recently instituted a number of other changes. Recent policy changes Since early summer member bank reserve requirements on time deposits in excess of $5 million were raised twice. This change meant that it was more costly for large banks to seek time deposit money because they could relend somewhat less of the funds, with the remainder having to be kept as cash reserves. In addition, the banks had to obtain more cash to hold as reserves on existing deposits, and to do this meant that they had to sell off assets that in effect migh otherwise have been converted into loans. - 9 - In addition, on September 1, the Board of Governors announced a modification in its policy regarding member bank borrowing. As most of you undoubtedly know, borrowing by member banks from their respec tive Reserve B?nks is permitted only under a limited set of circum stances and normally for very brief periods. However, the Federal Reserve was concerned over the excessive rate of expansion of business loans, which had been moving up at an annual rate exceeding 20 per cent. Also, it was expected that banks might lose substantial amounts of their time deposits— the rates on which had lost much of their com petitive edge as interest rates rose further during the summer. Under the modified policy, a member bank that was actually experiencing this deposit loss, and was also making a determined effort to curtail its business loans, could now be accommodated at the discount window for a longer period than was traditional. This longer accommodation would enable banks to take steps to reduce business lending, and also at the same time reduce banks' needs to sell securities in the market, especially State and local government issues, thereby moderating further upward pressure on long-term interest rates. In late September, Congress enacted a bill empowering the three financial regulatory agencies to distinguish among types of depositors when they established ceiling rates on time and savings deposits and savings shares. Subsequent to its passage, the Federal Reserve and the Federal Deposit Insurance Corporation announced a rollback of the ceiling to 5 per cent on future time deposits of less than $100,000. While this reduction would probably only affect consumer-type time deposits, it was presumably commercial bank competition - 10 for these deposits which was hitting hardest at savings and loan associations and mutual savings banks. This step was taken so as to even out the terms of competi tion between banks and other savings institutions and also to provide some relief to the mortgage market. Only time will tell how successful this will be. With market interest rates at their present high levels, the public has been tending to place a large proportion of its funds directly in corporate, municipal, or Treasury securities rather than in savings institutions. Under the circumstances, both banks and other savings institutions have had to adjust their operating policies to a smaller inflow of funds. Conclusion In conclusion, let me say that I fully recognize that I have missed my suggested assignment a country mile. Professor Gentry originally asked that I speak to the topic, "The Current Honey Market— Present and Future Forecasts." I am sure you all realize why it would be impossible for me to attempt to forecast future money market condi tions. As I have already indicated, it is our job to influence money supply and hence money market conditions in light of the changing needs of the economy. Because of the many unknown variables in the future, Vietnam developments for example, it is impossible for me to make such a forecas at this time. Furthermore, I would not even if I knew since it is within our power and responsibility to influence those conditions, and any forecast of what we might do might only turn out to be self-defeating. - 11 For these reasons, I have confined myself to a review of our approach to the problem in recent months in the hope that it might give a better understanding of our objectives and our reasoning in the actions we have taken. I am well aware of the divergence of views as to the correctness of these actions. However, I am sure you recognize the inevitable possibility of error either as to timing or degree of pressure when one is faced with the problem of taking actions to be effective in the future based on developments of the past. I can assure you, how ever, that we shall continue to strive for the best and most current information on economic trends and shape our actions accordingly, always maintaining the flexibility to enable us to change either direction or degree of pressure if the situation seems to warrant it.
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