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Talk by Darryl R. Francis, President
Federal Reserve Bank of St. Louis, Before the
Financial Seminar, Elanco Products Company,
Indianapolis, Indiana
November 17, 1966

L t me s i n g l e out a few specific e l e m e n t s
of the next six o:c nine nonths in vhich you may be
particularly interested:
1) Interest rates
2) Prices
3} The flow of commercial bank funds

A sound vay to approach a discussion of these matters
is to try to understandwhereweareatpresentand
how we got there; Why dS,d interest rates rise as
they did in the past 18 months? tihat has huppenc-d
to the supply of commercial bank funds

during this

period? Why did prices of goods and services rise?
And hot? did increases in total demandfor goods and
services contribute to rises in interest rates an3
In order that we nay agx*ee on the facts
and have some "background for anslynis, 1 shall
review the recent behavior of & namber of economic


- 2~
Interest Rates
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Interest r&tes generally trend upward in
periods of economic expansion. 3 M s usual "behavior
of rising rates occurred from 1961 to 1965. In
19^5* however, rates began to spurt upward imxch
more rapidly than they had at any time during the
I96I-65 period (Chart 1).

3?rom April I965 to April

1966, rates on both highest-grade corporate bonds
and highest-grade state and local bonds increased
12 per cent. 2hen from April to September I966,
interest rates on corporate bonds rose 28 per cent,
while rates on state and local bonds ji&tped 36 per
cent* In recent ¥eeks there has been some tendency
for interest rates to decline, as show* by the
What brought about these marked rises in
interest rates? First, let us examine the demand
for loan funds.
Demand for Loan Funds
Rising demand for loan funds has been
brought about primarily by rising demand for goods
and services on the part of both the private and
Government sectors.


- 3 Consumer spending for goods and services,
which had been rising at rates of about 9 per cent
in I965 and the first quarter 6f 1966, rose less
rapidly in the second quarter* but resumed its high
rate of expansion in the third quarter. Retail sales,
a major part of consumer spending, were up about 8
per cent in September over a year earlier.
Business demands for plant and equipment
have risen sharply in 1966, with outlays for the year
now expected to surpass those in 1965 by about 17
per cent. Plant and equipment spending during the
first half of this year was up at an annual rate
of 18 per cent over the second half of I965. Government surveys of investment anticipations for the
second half indicate continued advance but at a
somewhat slower rate.
fhe major upward thrust to total demand
has come from Governments. Demands for goods and
services by Federal, state} and local Governments,
which accelerated in the second half of 19&5>
continued to advance in the first half of 1$G6.
Available evidence indicates that these demands are
intensifying in the second half of 1966. The


- k Viet Ham conflict is probably boosting defense
expenditures even more rapidly in the last half
than in the first half of this year. Defense
expenditures in the third quarter were up Jj&«2
billion (annual rate) from the second quarter.
In addition, the Federal Government has continued
to expand its welfare programsj the growth of
Medicare payments is an example of this expansion.
!Che Medicare Program will show less quarter-toquarter change subsequently, but increases in
defense spendins are expected to continue.

Supply of Funds
The increase in interest rates has
jprobably come from the junip in demand for loan
funds, not from a restriction on supply. At
least it did not result from any Federal Reserve
restriction of money and credit before last April.
From June l$6k to April I966,

Federal Reserve credit

grew at an annual rate of 10.3 per cent, bank reserves
5.4 per cent, bank credit 9,7 per cent, and the
money supply 5*2 per cent. These do not appear
to be restrictive rates of growth•


* S*

It was said that the Federal Reserve was
a major factor causing higher interest rates when
the discount rate and the Regulation Q ceiling were
raised in early December 1965. However, interest
rates had already been moving up strongly for
several months prior to these actions*

In the last

half of I965 ^Treasury bill yields had moved above
the discount rate. Also, practically every other
market interest rate had trended strongly upward.
!Rie discount rate and the Regulation Q ceiling were
adjusted upward only after market rates had moved*
We find then that monetary restraint was
* t t a factor in the tightness of credit markets
and that interest rates moved up because of the
great demand for loan funds.
It is true that this picture has changed
sime April. Monetary developments since then have
helped restrain inflationary pressures by limiting
the ability of banks to extend credit. The Federal
Reserve influences the banking system* s ability to
expand credit by altering total reserves through
purchases or sales of Government securities in the
open market. Federal Reserve purchases of securities
expand neaber bank reserves, while sales contract


* 6 •

Federal Beserve holdings of U. S. Government securities have expanded at a h per cent annual
rate since April, compared with an increase of 8
per cent from April 1965 to April I966 and a 10 per
cent average annual increase from 1961 through I965.
Total member bank reserves (adjusted for
reserve re^uirerjent changes )> reflecting the reduced
rate of net Federal open market purchases and other
factors$ have declined at a 2.2 per cent rate since
April, compared vith a 5 P^^ cent increase in the
year ending in April and a h per cent average rate
of increase from 1961 through 1965. Reserves available for private desaand deposits have declined at
a k per cent annual rate since April, compared with
an increase of 5 P^r ££&t i& the preceding year and
an average rate of 1 ^ per cent from 1961 to 1965,
In line vith these monetary developments
tending to limit the ability of banks to expand
credit, bank credit outstanding increased only
slightly from July to October, Growth in total
loans has moderated since July! business loans have
risen at a much slower pace than earlier in the
year (Chart 10).


Reflecting the cotxrse of bank reserves,
the money supply, as naeasured t>y checking accounts
plus currency, declined at a 1*5 P^^ cent annual
rate from April to October*
Ehe cosMnation of fiscal ease mid monetary
restraint, \ i t Governxaent spending and borrowing
continuing to rise yhile key monetary variables
contracted, led to the acceleration in the rise of
interest rates from April to September*
Tae Behavior of Prices
SJotal deisand has been expanding more
rapidly than the ability of the economy to produce*
Total demand for goods and services rose 9*^ P®?
cent for the year ending in the fourth quarter of
I965, while the rate of grosrth of real product uas
only 7.5 per cent, From the fourth quarter of I965
to the third quarter of 1966, total demand rose 7^7
per cent, ubtile the rate of growth in real product
vas only 3«8 por cent (Chart 3 ) .
As the econoaty approaches full utilisation
of its resources, its ability to expand real
output is limited to growth in labor, capital,
and technology. SJhis growth rate is currently


* Q *

estiiaated to be about the saine as the 3.8 per cent
rate of growth in production experienced this year.
Hence, the rate of growth of industrial production
and employment fell from 1565, when producers were
able to drau upon uaenxployed resources. In 1966,
Virtually all factors of production vera being

Industrial production grew 9 per cent in

the year ending in March IS66> and at a 6.4 per cent
rate from March i960 to Septejaber I966*

She rate

of grot/th of total employment has fallen from 3^*
per cent for the year ending in December 19^5 to 1.2
per cent from Deceniber I965 to October 1966.
Increases in total demand beyond the
capacity of the economy to increase real product
lead to increases in prices. From October 1965 to
September I966, consumer prices rose at an annual
rate of 3*7 p w cent, compared >?ith a rate of 1.7
per cent for the period June 196^ to October I9S5
and only 1.2 per cent for the period 1953 to June
196k (Chart 2 ) .

Ehe increase in wholesale prices

has been even more pronounced.

In the year ending

in October 1966, wholesale prices increased 3 per
cent, compared vith a rate of 2.3 per cent for the
period Jltne 19$* to October 1965 and virtual stability
from 1958 to 196^


- 9 -


Prospects for Interest Bates and Prices
On the basis of information that we have
- nos?, ¥hat my

ve expect the course of interest rates

and prices to "be over the next fetr months?
Bo long as the basic supply and dessand
situation *?ith respect to loan and investment f*mds
produces high general interest rates, it is necessary for the commercial hanks to go along trith these
trends. Banks must both pay high rates and charge
high rates if they are to perform their function in
the economy.

Interest rates serve the function of

allocating a limited supply of intestable funds
among competing uses. When demand rises faster
than supply, interest rates go up and souse projects
must be postponed.

In some ^ays the high and

increasing general level of interest rates is
disruptive and undesirable, but the alternative of
creating enough funds to hold interest rates lo*r
w u l d be even more disruptive and undesirable, as
other prices vould be forced up*
Since last fall, commercial banks and
other financial intermediaries have had difficulty
attracting time and savings deposits. Limitations
on the interest rates paid or charged by these


- 10 institutions mean that funds w i n flos# through
other avenues> notably the open market. Big
borrowers and big savers have better access to the
open market than snail borrotrers and savers, and
thus the allocation of funds has been affected by
interest rate limitations*
In summation, total demand for goods and
services expanded during the past year at a faster
rate than the ability of the economy to produce
them. 3 M s rapid increase in total demand was
im|>arted primarily by a stimulative Federal fiscal
policy. Fiscal actions were more stimulative in
the year ending in the second quarter 19&6 than in
any year in over a decade.
Prices have increased rapidly in response
to total demand expansion beyond the capacity of
the economy to produce. Wholesale prices in October
vera up 3 per cent over a year earlier. Consumer
prices rose at more than double their rate of
increase in previous years.
Interest rates rose as demand for loan
funds jumped in response to the rapid expansion in
total spending on goods and services. Prior to
April of this year, the increase in rates does not


- 11 appear to have been due to restrictive monetary policies.
Since Aprils hot/aver* monetary developments have
helped restrain inflationary pressures by limiting
the ability of banks to extend credit. These
restrictive actions on the supply of loanable funds
have placed further upvard pressure on interest rates.
If the level of interest rates is to be
kept down, total demand for loanable funds must
also be reduced. Public policy can reduce demand
for loanable funds by reducing demand for total
product in the econo:*iy. Shis can be accomplished
by a more restrictive Federal budget. Sueh a policy
vould permit greater monetary expansion and reduced
interest rates.