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For release on
Sept. 10, 1969
at 9:30 p.m. EDT

A New Look at Monetary Policy Instruments
Remarks of George W. Mitchell
Member, Board of Governors of the Federal Reserve System
at the
Conference of University Professors
Milwaukee, Wisconsin
September 10, 1969




A New Look at Monetary Policy Instruments
There has always been, I suspect, a gulf of sorts
separating monetary practitioners from productive contact with
monetary theorists.

The reason is not, as is often implied, that

central bankers are always obtuse or that all monetary theorists
are obscurantists.

Their differing interests and responsibilities

shape quite different appraisals and understanding of the monetary
environment and quite different time horizons in their thinking.
Some say the difficulty lies in the lengthy gestation interval
between central bankers' college training and the assumption of
responsibility for their country's monetary practices.

However,

there is some question as to how much of the blame or credit for
monetary practices in the fifties and sixties should be attributed
to the theories taught in the twenties and thirties.
Particularly in view of the rapid developments both in
the field of monetary theory and in the arena of financial
experience, obviously what is needed is some method of keeping
monetary theory and practice in much closer touch.

Conferences

such as this one and meetings which the Board of Governors and
the Federal Reserve Banks periodically hold with academic
economists, as well as those in business and commercial banking,
are useful in exposing shortcomings in both theory and practice.




-2Today, I propose to discuss two questions of long-run
interest but with current overtones in which monetary practitioners
and monetary theorists are involved:
1.

Is it necessary, or at least desirable, in order to
enforce monetary restraint to restrict the access of
commercial banks and other financial intermediaries
to domestic money and credit markets?

2.

Should the Federal Reserve place greater reliance on
monetary and credit aggregates in guiding and gauging
its activities?
The first question centers on the role of regulatory or

statutory ceilings limiting the rates of interest that can be paid
on time deposits.

Since most major units in the banking system have

become heavily dependent on time deposit intermediation to achieve
their growth objectives, rate ceilings are said to be the real
barricade to bank credit expansion and thus vital to the potency
of monetary restraint.

Moreover, restraint is said to be jeopardized

if rate ceilings are rendered partially ineffective by banks turning
to new money and capital market instruments or to unconventional
asset and liability management techniques to capture loanable funds
through nondeposit channels.
If banks and other depository institutions can significantly
dilute monetary restraint by one technique or another, is it necessary
to develop additional tools for achieving adequate credit restraint?
This might be done, for example, by imposing reserve requirements on
assets instead of deposits.

Such requirements could be differentiated

-3-

by type of asset or by changes in holdings.

Another possibility

is an enlargement in the definition of deposits to cover additional,
if not all, kinds of banking liabilities.— ^As in the case of assets,
various type of liabilities or changes in holdings could be subjected
to differential requirements.
There is also the possibility of extending the reserve
requirement to bank competitors or affiliates functioning as inter­
mediaries directly or through money and credit markets.
1/ Banking liabilities other than deposits are subject to leverage
limits in laws covering National Banks and in many State Banking Codes.
But statutory limitations on bank borrowings have not been a very
confining influence on the flexible use of this source of funds up
to now because of numerous exceptions to such limitations and because
of the relative ease with which banks have been able, under normal
conditions, to purchase time funds. However, if monetary constraints
were long continued it is more than likely that debt ceilings would
become operative and important limitations for some banking institutions.
National banks may not have liabilities outstanding to exceed 100 per
cent of their paid-in unimpaired capital stock and 50 per cent of their
unimpaired surplus excepting, of course, deposits or drafts drawn
against them. There are several other items excepted by law or regula­
tion but the main categories pertinent to this discussion are Federal
Fund transactions, repurchase agreements and acceptances of bills
payable abroad. The aggregate limitation on National Banks amounted
to about $12 billion (December 31, 1968), compared to total deposits
of $259 billion.
Several of the largest banking States do not have limitations on
indebtedness, including New York, Illinois, and, with minor exceptions,
Massachusetts. Thirteen States, including California, Ohio and Texas,
have restrictions approximating the sum of capital and surplus. State
member and non-member insured banks' total of capital and surplus as
of December 31, 1968 was $9 billion compared to total deposits of
$176 billion.







-4-

The avenues for extending credit, on the one hand, and of
expanding or reinforcing the scope of monetary restraint on the other,
are virtually unlimited in our highly organized economy— the question
to be faced is, however, are new monetary control techniques required,
and could they work more efficiently and surely in attaining policy
goals.
The commercial bank can be regarded as a primary trans­
mission link of monetary actions— particularly those actions involving
changes in the rate at which reserves are supplied.

But it does not

necessarily follow that banks or their customers absorb or enjoy the
full impact of Federal Reserve open market or reserve requirement
actions.

For example, banks under reserve restraint and losing

deposits, or gaining them at a reduced rate, can, by selling
securities, restore their liquidity by finding someone in the market
willing to reduce his.

Re-achieving a given liquidity position in

order to accommodate loan demands is not ordinarily costless for the
bank--its asset sales under restraint conditions are likely to
result in transactions losses or, alternatively, some yield loss
if more liquid assets are held to avoid such losses.

In this sense

some monetary restraint bites into bank management at the outset
and is not shiftable.

-5-

Increases in reserve requirements likewise have shiftable
and non-shiftable components.

The meeting of higher requirements

shifts assets from an earning to a non-earning category and thus
adversely affects bank net income but the ability to meet customer
requirements may be retained in whole or in part by security sales,
borrowing, or more aggressive promotion of demand and time deposits.
If bank links to money and capital markets are convenient and well
established, banks can be expected to shift a larger share of
monetary restraint toward those markets by outright or conditional
asset sales, borrowings and the attraction of deposits.
In general over the past decade, commercial bank shares
of the flow of funds have shrunk markedly in periods of tight money,
but have expanded even more in the intervening periods of easier
credit conditions.

1967 and 1968 were the lush years of the decade

for bank intermediation; market shares were 44 and 39 per cent,
respectively, compared to 26 per cent in 1960.

Monetary restraint

in 1966 reduced banking’ share to 25 per cent--a decade low.
s

But

the record low may go to 1969 since banking’ share for the first
s
half is now estimated at only 15 per cent.
Other depository institutions (savings and loan associa­
tions, mutual savings banks and credit unions) as a group, in contrast




-6-

to commercial banks, have been experiencing a general decline in their
market shares in the 1960's.

They started the decade with a 30 per cent

of the market and dropped to a low, excluding the monetary restraint
years of 1966 and 1969, of 20 per cent in 1967 when commercial banks
were hitting their peak of 44 per cent.
Essentially all depository institutions are under rate ceiling
limitations similar to those for banks and are also vulnerable when
monetary restraint widens the gap between deposit and market interest
rates.

Their market share in 1966 was 10 per cent— so far this year it

is running at a seasonally adjusted rate of 14 per cent, not too different
from their 1968 position.
In the sixties, the larger banks have moved aggressively to
broaden and diversify their contact with the money and credit markets.
They have been particularly aggressive in bolstering their deposit bases
by the solicitation of time deposits.

But opportunities are not confined

to deposits as is evident from a comparison of outstandings of major
categories of money market instruments now and seven years ago.
Among market instruments, Euro-dollar borrowings, commercial
paper of holding company affiliates, and repurchase agreements have
provided the most important sources of funds to banks to offset the dis­
intermediation in their time deposits over the past eight months.

Euro­

dollar borrowing from mid-January (the year-end level is not used because
it was influenced by a very large and very temporary reversal) has




-7increased about $6 billion, commercial paper has provided nearly $2 billion
and repurchase agreements about $1.0 billion (at one time as much as
$1.3 billion).

In all, these and other miscellaneous arrangements have

provided at least $10 billion of resources to the banking system from
domestic and international markets.-^/

1J Non-deposit Fund-Raising Devices Used by U.S. Banks
A.

Euro-dollar and related transactions
1. Bank head office borrowing from foreign branch
2. U.S. bank borrowing from foreign bank, directly or through broker
3. U.S. bank sale of assets to foreign branch
a. Under repurchase agreement
b. Outright
4. Customer shift to borrowing from foreign branch
a. U.S. resident customer
b. Foreign customer

B.

Selected Domestic non-deposit liabilities
1. Repurchase agreements on U.S. Government and agency securities

C.

Liabilities issued by bank holding company or its non-bank affiliate
(with proceeds transferred to bank directly or indirectly)
1. Commercial paper
a. Sold by bank holding company
b. Sold by non-bank affiliate
2. Other liabilities
a. Issued by bank holding company
b. Issued by non-bank affiliate

D.

Contingent liabilities incurred by bank
1. Documented discount notes
2. Ineligible bankers acceptances (usually domestic transactions)




-8This magnitude should be related to deposit trends thus far in
1969.

Through August time and savings deposits showed a seasonally adjusted

decline of about $10 billion (an annual rate of $15 billion or -8.0 per
cent).

The demand deposit component of the money supply, seasonally

adjusted, rose about $2.0 billion (an annual rate of $3.0 billion or +2.0
per cent).

Government demand deposits declined $1.5 billion.

In the

aggregate, seasonally adjusted, net demand, time and savings deposits
have declined about $10 billion in the first eight months of the year.
There is no way of knowing what bankers1 expectations of 1969
deposit trends were when they were making loan commitments and investment
decisions early in 1969.

No doubt many were underestimating the intensity

of monetary restraint they have had to face and many more were looking for
an early turn-around in policy.

But had they been significantly influenced

by the experience of the past four years, their frame of reference for
deposit growth would have been in the range of annual total deposit
increases of $25-$35 billion, with the exception of a $14 billion increase
in the "crunch1 year of 1966.
1

If they had given particular attention to

time and savings aggregates, annual flows, excluding 1966, were $20 billion
or more; 1966 was up $13 billion.

There is little in the past record which

would have caused them to prepare for the sizable shrinkage which has taken
place so far in 1969.

It is small wonder, therefore, that they have turned

to such an aggressive exploitation of deposit substitutes.— ^
1 / Some bankers have had greater reason for developing additional sources

than others. While time and savings deposits of all member banks showed
a -11.8 per cent annual rate of change through August, those of Reserve
City Banks were dropping off at.-a:?24.9 per cent pace. Even taking into
account a somewhat better showing on ^et demand balances than country
banks, the Reserve City Banks*;: total S^t deposits fell at a 11.7 per cent
rate compared to 5.6 per ^e^ife. ' o * ajl .^embers.
-fr




-

9-

As banks extended in scope and magnitude their access to money
and credit markets in 1969, apprehension that such techniques were under­
mining the force of monetary restraint grew despite the magnitude of the
change in deposit flows.
On July 24, 1969 (effective August 25, 1969) the Board of
Governors adopted amendments to Regulations D (governing member bank
reserves) and Q (governing the payment of interest on deposits) restricting
the use of repurchase agreements by commercial banks.

This was done by

making the bank liabilities on such agreements deposit liabilities provided
the agreements had been entered into with nonbanks and on assets other than
Treasury securities and agency issues.
The purpose of the regulation was to prevent banks from borrowing
on their portfolios of loans, mortgages, and muncipal securities and thus
to obtain funds for other lending and investment or to meet liquidity
needs.

The constraint of Regulation Q ceilings applied to such trans­

actions as it would to time deposits generally.

However, if an RP could

be arranged at a ceiling rate because of some customer relationship and
in spite of a non-competitive rate handicap, the amount obtained would
be subject to reserve requirements.
This action not only had the effect of limiting the banking
system's access to money and credit markets but also to downgrading
mortgages and municipal securities as liquidity assets relative to
Treasury and agency issues.




-10Commercial loans have also been used in repurchase agreements
but ouch less frequently.

The aggregate of repurchase agreements

affected by the revised Regulations appears to have been about $1.3 billion.
Two other market sources of funds for banks were adversely
affected by amendments to Regulations D (governing member bank reserves)
and M (governing the foreign activities of member banks) adopted on
July 24, 1969 and August 13, 1969.

These related to Euro-dollar trans­

actions .
The July 24 action required member banks to include in deposits
used to compute reserve requirements all so-called "London checks" and
"bills payable checks" used in settling transactions involving foreign
branches.

Some banks had issued such checks to repay borrowings from

abroad without including them in gross demand deposits, as is required
for cashiers' checks.

At the same time, these banks were allowed to deduct

the checks previously received to convey the proceeds of such borrowing
from demand deposits used to compute reserve requirements.

This amendment

was strictly a technical change to thwart an accounting avoidance operation
on reserve requirements.

It also had the effect of reducing the attractive­

ness of overnight Euro-dollars.

The amount involved was on the order of

$500 million.
The imposition of a marginal reserve requirement on Euro-dollar
borrowings contained in the August 13 amendment and its application to
the sale of outstanding loans to foreign branches had more than one
objective but, among others, was intended to make this source of funds
somewhat «»re costly and thus discourage greater use of this market
than prevailed in the base period.




-11Without doubt regulatory policies aimed at insulating the
banking system from money and credit markets via rate ceilings or regula­
tions curbing banks' ability to substitute other liabilities for deposits,
or to make contingent asset sales, have limited the banking system's
ability to serve its customers.

This is abundantly clear from the

magnitude of the decline in market shares of funds going to banks in 1966
and 1969.

The same rate ceilings have hampered the savings and loans and

the mutual savings banks from serving their customers, too, although their
plight in 1969 has been ameliorated by the operations of FNMA, and the
lending policies of the FHLB Board.
The policy of reinforcing monetary restraint by constraining
banking's access to money and credit markets may be more controversial
than its practical significance in the present situation warrants.

But

for the long run it clearly raises important issues relating to financial
structure and the role of credit policy.
As seen by their proponents today, regulatory constraints have
forced a sharp contraction in the rate of bank and other intermediary
lending and investment.

In particular, Q ceilings by limiting bank access

to funds, have led to greater restraint on business loans than would other­
wise have occurred and this distributional effect on credit avail­
ability was desirable in view of the role of business investment in
generating excess demand and inflation.

Furthermore, since intermediaries

are more efficient in their credit allocative function than direct lenders
and markets the reduction of intermediation is the quickest and surest way




-12to slow and restrict the availability of credit and thus lead to the
modification of spending and investment decisions.

All of those borrowers

who are exclusively dependent on intermediaries encounter credit restraint
even though they may be preferred customers.

Those borrowers who also

have direct access to money and capital markets and non-intermediary funds
may shift to these sources of funds but they will rapidly bid up the price
and terms for a supply which, in the short run, will become increasingly
inelastic.
The main argument against sealing off the intermediaries
from the markets starts with the proposition that the effectiveness of
restraint is not significantly diluted as a result of its being shifted
by an intermediary to the market or another intermediary, however different
the incidence.

As banks disperse monetary restraint, and they cannot

disperse all of it, they force borrowers other than their customers to
pay higher prices for credit and to face uncertain availability.

Their

action in selling assets, raising interest rates paid for funds, entering
into repurchase agreements of assets and the like, does not result in the
diminution of over-all restraint.

Even if intermediaries were given

unlimited access to money and credit markets they would themselves be
increasingly restrained by the market environment they were creating.
The argument continues that the channeling and confinement of restraint
to intermediaries and their customers results in the unnecessary dislocation
of credit patterns, in inequities in the distribution of credit and
inefficiencies in the operation of the financial system.




-13The differential effect of forcing intermediaries to contract
their lending operations has the most certain and serious effect on
smaller customers who do not have significant access to capital and credit
markets.

Shutting off or restricting the flow of bank credit to large

corporate borrowers only means they become more dependent on markets.
Taken in conjunction with the expansion of non-depository credit instru­
ments which occurred as CD's ran off this year, some have argued that
corporate borrowers were more favorably situated so far as credit
availability was concerned as a result of bank disintermediation.
While I am more persuaded to the view that intermediaries should
have had more ready access to markets, the contrary position is not without
merit from a pragmatic short-run standpoint.

However, I believe the real

problem is not one of making monetary and credit restraint effective in
some given interval but the longer run effect of such tactics on the
process of intermediation and the institutions providing this service.
A significant change in the financial environment has occurred
in the sixties in the form of a greatly expanded role for intermediation.
Liquidity services have been shifted on a large scale to intermediaries
or specialized intermediary devices.

There has been a resulting

relative decline in demand deposits and non-intermediary holdings of
non-intermediary debts.

If long-run policies are adopted to cut off

intermediary access to markets fulfilling their liquidity function will
be greatly handicapped.

In this view, they are more in need, from a

public policy standpoint, of assistance in dispersing restraint rather
than constraints on their doing so.




-14As soon as a speaker approaches the subject of the role of
monetary and credit aggregates in policy formulation and action, he
can expect that most of his listeners will become alert long enough to
categorize his views as Friedmanesque, Friedmanite or anti-Friedmanite,
and then go back to thinking about something else.

For once the speaker

is typed there is very limited interest on the part of the listeners,
other than that which is vanity oriented, in what he has to say on this
well worn subject.

Nonetheless, and without attempting to conceal my

views, I hope to avoid both categorization and boredom.
If one rejects monetary mysticism, as I would, whether in the
form of the "Black Box" or the "tone and feel of the market" he has as
alternatives a sterile agnosticism or a belief that monetary linkages
are not beyond our expanding analytic capabilities.

The most profitable

line of approach seems to me to be found in a quantitative scrutiny of
changes in the economic and financial environment and the way in which
financial variables interact with real variables.

These interactions

may measure causal influences, responses to such influences, or be mere
reflections of the changes in spending and investment decisions or in
their timing.

In any event, before specifying a role for a particular

monetary or credit aggregate, whether that role be the target for policy­
makers or the measure of policy by outside observers, it is helpful to
have as much understanding of the nature and limitations of the underlying
data as is necessary to avoid misuse and misinterpretation.
narrowly defined money supply as an example.




Take the

-15The popular assumption is that money has the same form and
meaning for monetary guidance or interpretation— whether it be coin,
currency or demand deposits.

Coin is not a very important component in

the money supply but it is the only one showing relative growth in this
decade (about 25 per cent relative to GNP or consumer expenditure).

The

reasons are more or less obvious--the very large growth of meter hoards,
silver smelting, foreign usage, and Kennedy halves in bureau drawers.
It is hard to see much of monetary significance in any of these uses.
Currency stock and demand deposits have declined about 40 per
cent relative to GNP or consumer expenditure in the past 15 years.

The

relative decline in currency is due to the expansion in consumer checking
accounts,— ^ charge accounts, and credit cards.

Non-cash sales make up

over two-thirds of the transactions of many of our largest retailers.
Convenience credit is widely available via vendors' credit facilities
and, more recently, through bank and the expanded role of oil company and
travel and entertainment cards.

It has been estimated that in 1970 there

will be at least 50 million bank credit cards in use.

The evidence that

currency is playing a diminishing role is observable today--it will become
more and more apparent as payment patterns change in the coming years.
Net demand deposits--and I should emphasize the "net"— reflect
predominantly the declining transaction demand for money.— ^
1/ There are between 70 and 75 million today, and the number is growing
twice as fast as the population.
2/ Parenthetically, the netting of demand deposits which is essential to
avoid double counting of items in the process of collection was exposed
this year as being vulnerable to the process of reserve requirement avoidance.
While the idea of avoiding taxes is commonplace, avoiding reserve requirement
by increasing items in the process of collection was so unexpected in some
quarters as to be non-credible. The difference between gross and net demand
is large--the latter is roughly 75 per cent of the former today— and has
been growing as turnover rates have been rising.




-16Nonfinancial business holdings of demand deposits and currency
are no higher today than they were in the early fifties— and many corporate
treasurers would regard this average showing as a poor performance.
Actually corporate balances today probably reflect more than anything else
compensating balance requirements for check processing, loan and other
banking services.

Theoretically, a skilled money-managing treasurer,

unhampered by compensating balance requirements, could manage his firm's
checking account so that toward each day's end he would know if he had a
balance large enough to cover the transaction costs for an overnight
investment.

And if he had, his resultant late-day investment action

might, under certain circumstances, indirectly turn out in effect to be
lending that residual in his account to his own bank.

Electronic

facilities for check processing will make possible much closer management
of cash positions, particularly if scheduled credit transfers become
commonplace.
The best information we have on the ownership of the demand
deposit component of the money supply is none too good, but it indicates
that households own about $70-75 billion, nonfinancial businesses $45 billion,
financial business $15 billion, and State and local governments $13 billion.
About $4 billion is in foreign accounts.

It is safe to say that all

professionally-managed accounts are at or near minima established by
banking rules or practices.
Households are managing their money position more closely, too-many use a fee-no-minimum balance-type account.




Individuals have become

-17increasingly sensitive to interest costs and interest yields.

Their

response to the promotional efforts on the advantages of time and savings
accounts has been to progressively reduce demand balances to the minimum
levels consistent with the timing of income receipts.
The June 1968 Summary of Accounts and Deposits reported 79,069,000
I.P.C. demand accounts.

Sixty-four million of these had balances of less

than $1,000 and an average account size of $240.

From data presently

available, business and corporate accounts cannot be distinguished from
personal accounts in this group but it is hardly likely there were a
significant number of business accounts with balances of less than $1,000.
In any event, 80 per cent of the demand deposit accounts of individuals,
partnerships and corporations with an average balance of $240 could hardly
provide any significant liquidity for their owners.
High demand deposit turnover rates are additional evidence to
me that demand deposits are held overwhelmingly for transaction purposes
and that liquidity needs are largely satisfied by near monies of one type
or another.

In New York, for example, where superactive financial and

business accounts dominate transactions, turnover has been on the order
of 2-1/2 to 3 times per week for the past year.

It is now running 1.3

times a week in six other major cities where similar influences are
important.

In the nation outside of these cities turnover is about .75

times per week and has been rising steadily for some time.

Even though

many of the 233 cities covered by these data are relatively unaffected
by hyper-active accounts, virtually none has an average turnover rate of
less than .3 per week.




- 1 8 -

It would be tempting to conclude, perhaps, that the central
b a n k ’ control over economic activity is heightened by these develop­
s
ments, and that the money supply is becoming an increasingly useful
guide to the effect of central bank actions on money income.

For it

might appear that the kind of trends I have been describing are converting
the public's demand for money into the kind of functional relationship
to money income that Irving Fisher popularized.

It seems to me, however,

that such a conclusion is unwarranted, at least as it pertains to conven­
tional central banking in the United States.

In the first place, while

the public's money holdings are increasingly for transaction purposes, I
do not believe that there is a stable functional relationship between the
public's demand for money and its income or transactions.

Thus, even if

we could successfully control the money supply narrowly defined, this
would not by itself give us a handle with which to control the volume of
transactions.

In addition, the Federal Reserve does not directly

determine the money supply; the instruments it manipulates are reserve
requirements, discount rates, open market operations, and ceiling rates
on time deposits.

These actions serve initially to augment or diminish

liquidity positions of the banks and the public.

The public's reaction

is most clearly observable in the change in its holdings of such no n ­
monetary assets as time deposits, savings and loan shares and of market
instruments as these are channels of fundamental importance in communicating
monetary processes to the real sectors of the economy.

The impact of

monetary policies on the money supply are not felt until later, when the




-19-

results of policy actions in markets for goods and services begin to
affect spending and money incomes and thus raise or lower the demand
for money for transaction purposes.
As is apparent, my preference for monetary aggregates either
as a guide or gauge is generally for those that measure liquidity changes
in the economy.

Moreover, I would differentiate liquidity positions of

households from those of business and financial intermediaries.

There

are important time lags in the basic data for such series but they are
not too difficult to fill in or to bridge since the problem is basically
one of disaggregation in the ownership of deposits and market instruments.
It does, of course, involve some technique for getting changes in access
to credit.
The important consideration for those who urge the use of
either monetary or credit aggregates is to provide more evidence of
their linkage to spending and investment decisions— I doubt this evidence
will be found in the behavior of a single aggregate or in those most
closely related to transaction media.