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For release upon delivery
(Approximately 6 p.m. EST,
Friday, November 19, 1965)




Monetary Tools and Capabilities
Remarks of George W. Mitchell
Member, Board of Governors of the Federal Reserve System
before the
Missouri Economics Association
Columbia, Missouri
November 19, 1965

Monetary Tools and Capabilities

This seemed to me an appropriate occasion to share with you some
reflections and speculations on current attitudes toward monetary policy, its
tools and capabilities.

From my vantage point there appears to have been in

recent years an increasingly keen professional interest in re-examining the
nature of monetary processes, the linkages between monetary action and the
real world, and the possibility of using monetary tools in a more sophisticated
and selective way.
Reserve System.

This interest is evident within and without the Federal

Among the academic economists whose work is illustrative are

Lee Bach, Lester Chandler, James Duesenberry, Milton Friedman, Allan Meltzer,
Franco Modigliani, Arthur Okun, and James Tobin.

Within the System a similar

list would include Daniel Brill, Richard Davis, Fred Deming, Jr., Frank DeLeeuw,
Herbert Furth, Lyle Gramley, Robert Holland, Homer Jones, John Kareken, and
Robert Solomon.
A central theoretical problem engaging the attention of several
persons in the foregoing list, as well as many others, is the nature of the
linkages between monetary action and the ultimate goals sought by monetary
policy--relationships that are not well known or even adequately understood.
This is hardly surprising for it is extremely difficult to measure empirically
the impact of monetary action taken in a changing environment where numerous
forces are affecting the economy.

It is only when monetary action is so over­

whelming as to dominate other economic forces at work that most observers,
looking at the data, might agree that far too much or far too little money
creation has been a necessary and sufficient condition for the occurrence
of inflation or deflation.




.. ,
dosages of monetary action provide
vidence1 as to the role of monetary
1

-2-

One could argue, for example, that it makes little or no
difference at what point or in what form the central bank introduces
liquidity into the economy.

Once introduced, money and credit promptly

flow to those sectors where needed, and disturbances can occur only when
the total provided to the system proves either insufficient or excessive.
If insufficient, the need for additional money or credit becomes
immediately apparent in the form of further demands for central bank
accommodation, and can be satisfied by whatever injection is deemed
technically convenient.

If excessive, the only policy action required

is to reduce or stop further injections or, if inflationary pressure has
been permitted to build up, to withdraw money and credit from the system,
again in any technically convenient way.
But these operations become vastly more complex once the
assumption of complete flexibility in the financial system is abandoned.
It is quite possible to find an excess of liquidity in one sector, or in
one form of liquidity, and simultaneously a deficiency in another.

And

it is possible to find the banking system enlarging and shrinking its
role as a financial intermediary as its competitive efforts wax and wane.




-3-

In these cases, a general increase or contraction in liquidity,
worked through the banking system, is unable to cope with the problems of
the economy, and it becomes vitally important to remedy an imbalance in the
correct form and in the correct sector.
Thus we may find the natural preference of most central bankers
and economists to use the general and quasi-automatic mechanisms of the
economy giving way to methods that strike at the special problems more directly.
Since we live in an economy where subsidy, statutory constraint and largescale productive and distributive combinations, some with monopolistic
tendencies, are common, direct monetary methods can hardly be regarded as
,out of context.1 Selective treatment of particular problems should not
f
1
be dogmatically rejected without considering the unsought hurt that a general
policy might work in channels where constraint or expansion is neither called
for nor consistent with broader public policy.
These comments on attitudes toward monetary policy point to the
need to explore more fully the relative merits of the principles of generality
and selectivity.

This exploration means thorough analysis of the famous

problem of linkages--the way in which money and credit flows are connected
with the behavior of banks, business, and the public in general; and the way
in which central bank action influences that connection.

The monetary

research program of the Federal Reserve System, both at the Board and at the
Banks, is now being specially directed to these problems, and I hope that it
will lead not merely to better theoretical insights but also to important
practical applications.
Meanwhile, however, central banking policy will need to proceed on
the assumption that both general and selective measures have their place in




-

the system.

4-

Hence, I shall briefly consider two problems of general monetary

policy--technical improvement and anti-inflationary action--and later touch
on the more numerous problems of selective policies.
General Monetary Policy
The first question, which concerns both the technical efficiency of
general monetary policy and its use as an anti-inflationary tool, refers to
the relation between monetary policy and fiscal policy.
The old idea, according to which monetary policy affects primarily
credit and thus investment while fiscal policy affects primarily income and
thus consumption, has recently, in some quarters, been supplanted, or at
least supplemented, by the idea that monetary policy affects primarily the
international, and fiscal policy primarily the domestic sector of the economy.
The basis of this thesis is the postulate that, under the assumption of
complete mobility of international capital, any fall (rise) in interest rates-which under the further assumption of perfect domestic capital markets is
associated with any substantial increase (decrease) in the availability of
credit--would make investment abroad more (less) attractive and therefore
immediately lead to an outflow (inflow) of funds.
This seems to open the way for the solution of any domestic and
international financial problem simply by changing the "mix" between monetary
and fiscal policy.

If a country were suffering from domestic inflation and

international deficit, for instance, the first ill would be cured by a
tightening of fiscal policy and the second by a firming of monetary policy-the classical recipe for such a situation.

But if a country were suffering

from lagging domestic growth and international deficit, as the United States
has done for part of the most recent period, some would argue the remedy




-5-

would be a combination of expansionary fiscal with firming monetary policy.
To some extent, such a new "mix1 is actually to be found in U.S. policies
1
during the past two years; but the thesis has not been carried to its
ultimate conclusion, and I, for one, believe that there are good reasons
for not doing so.
First of all, international capital flows are influenced by many
economic factors other than interest rate differentials.

Market imperfections,

differences among countries in financial structure and sophistication, and
governmental regulations all play a highly important role in determining the
international flow of capital.

Moreover, a considerable part of international

capital flow takes the form of equity investments, including both direct
acquisition of real assets abroad and purchases of foreign shares.

Certainly,

the attractiveness of equity investment abroad, in either of these forms, can
vary quite differently from the movement in interest rates.
Still, while the new theory of the "mix" cannot be accepted in its
entirety, there is room and need for further study of the relationship between
the tools of monetary and fiscal policy, and of the possible variations in the
appropriate "mix."

For instance, an expansionary fiscal policy, by creating

or increasing a budget deficit, will necessitate an increased flow o f
investable funds into Treasury securities, and therefore--unless supported
by easier monetary policy--will in itself tend to raise interest rates.
Econometric studies may show whether the inhibitive impact on investment
of the rise in interest rates is likely to have smaller, equal, or greater
multiplier effects on total economic activity than the stimulative impact
on consumption of the rise in disposable income.

Another important and

related question for the econometrician is the relative contractive effect




-6-

of a rise in interest rates on the domestic flow of funds and on the capital
outflow when the former is more than 10 times as great as the latter.
The second question refers to the age-old controversy about the
impact of monetary policy on cost and availability of credit.

Obviously,

the problem would not arise if financial markets could be assumed to be so
perfect that any change in availability would produce a definite change in
cost, and vice versa.

Even in imperfect markets, it would be helpful if

we had even a proximate measure of availability and if we could accurately
measure to two or three significant places the level of interest costs in
bank lending.

One could also argue that the most orthodox economic theorist

should concede that all prices are formed within a region or penumbra; that
the intersection of demand and supply curved forms a zone on a plane rather
than a point.
If this is true, the relevant question has two parts: first, how
large is this penumbra in which measurable costs may be changed without
affecting measurable supply, and measurable supply may be changed without
affecting measurable costs; and, second, how do the various traditional
tools of general monetary policy differ among each other in their relative
impact on cost and availability?
The third question relates to the technical efficiency of the
three traditional tools of monetary policy.

The efficiency of changes in

discount rates depends importantly on the willingness of member banks to
borrow from the central bank, or on a tradition to change administered
market rates in sympathy with changes in the discount rate.

The efficiency

of open market operations depends on the efficiency of the securities market.
And the efficiency of changes in reserve requirements depends upon the




-

7-

extent to which lenders are subject to such requirements--in the United States,
for instance, on the relative importance of member and nonmember banks, and of
the commercial banking system as a whole and other types of lending institutions.
It seems quite possible that, in the United States, the efficiency of
all three instruments of general credit control might be increased, both by
changes in the Federal Reserve Act and by changes in the administration of the
existing legal provisions.

Much innovative thinking along these lines does

not see the light of day, and shouldn1t .

But, at the same time, I feel we may

be too constrained by the heavy layer of ancient traditions and conventional
wisdom that encrusts both academic and central banker views.

For this occasion

only, I am going to try to shake free that handicap for a few minutes and,
leaving aside the wise, old, experience-tested limits on central bank action,
discuss some alternative guidelines which would change our ways of dealing
with various monetary problems.

Some may sound prosaic, others may have an

unreal ring to them, but I would hope that in the aggregate they would, at
least, suggest some new and useful perspectives to you.
Suppose we begin with the discount window.

Casting off the idea

of keeping "the tradition against borrowing," the discount window could be
made a more effective instrument for putting reserves directly where needed
within the banking system by making loans to member banks in larger amounts
and for longer periods whenever community demands for funds for seasonal or
other purposes dictated.
The discount mechanism would work more smoothly and less incongruously
with respect to present-day banking practices if the statutory restrictions
as to eligible paper were repealed and advances were made on the basis of
any appropriate collateral, or even on an unsecured basis where warranted




-8by the quality of the bank's loans and investments and its capital and liquidity
position.

Another innovation worth considering would be widening the scope of

open market operations to include other debt instruments than Treasury securities.
As the money markets, in particular, have broadened, new instruments have come
into use and the Open Market Account Manager is gradually being forced to deal
in a smaller and smaller relative sector of the entire market that is relevant
to the Committee’ objectives and operations.
s
Selective Monetary Policies
Although our present system of monetary action is clearly based on
preference for generality, it has significant selective aspects, even apart
from the margin requirements for security credit.

Selectivity is in another

guise, however, and its impact on broad policy goals could almost be called
inadvertent.

Reserve requirements, for example, are differentiated by

location of bank (a crude proxy for size), by type of deposit (demand or time),
and according to the membership in the Federal Reserve System and State of
incorporation.

This differentiation is aimed at certain structural goals,

the equalization of competitive conditions--or in some instances at nothing
at all.

Nonetheless, some selective effects on broader goals have doubtless

resulted.
Though open market purchases are usually thought of as a method of
reserve creation which is general in its impact, they are not neutral among
a family of assets that could be alternatively used for the same purpose.
System purchases of coupon issues in connection with "Operation Twist"
illustrate the selective possibilities and the side effects on primary
operating goals of varying the type of asset to be held in the System
po rtfolio.




-

9-

Discounting policy is also thought of as completely general, but its
selectivity is manifested in the rules that define the terms under which the
privilege of obtaining Federal Reserve credit can be exercised.
In pointing out that generality in monetary operations does not
exist in the pure form often alleged for it, I should note that specific
measures will usually have some effect on the general goals.

Either type

of tool has some of the dominant characteristics of the other.
The Federal Reserve has for a long time been concerned about ways
to render the selectivity of reserve requirements more rational.

In the case

of differentiation among banks, reserve requirements might be graded according
to the bank1s deposit volume rather than according to its location--a change
that, incidentally, would recognize the difference in competitive potential
between large and small banks.
Differentiation by type of deposit has been deprived of some of its
meaning by the emergence of a variety of time deposit forms, ranging from
short-term marketable C D 1s

to long-term savings bonds which give their

holders differing degrees of liquidity plus interest yields. Reserve require­
ments conceivably could be varied for different types of time deposits but
they can hardly be raised much as long as similar funds held with nonbank
institutions are exempt from all such requirements.

Here again, the question

of improving the structure of monetary mechanism becomes entangled in the
political problem of the extent of central bank influence on the country1s
financial institutions.




-10-

The main application of selectivity in monetary policy is not to be
found in bank location, bank size, or of type of deposit but rather in the
credit-granting function of banks.

Monetary policy aims primarily at

influencing the cost and availability of credit through the supply of bank
reserves, but as banks vary their earning-asset holdings in response to
changing reserve availability they can impinge selectively upon a number
of different credit markets.

Such selectivity needs to be recognized, and

it may lead to selective countermeasures if the end result is not in accord
with over-all public policy goals.

When selective measures are used for

this purpose, they typically differentiate among various types of bank
assets rather than among various types of bank liabilities: for example,
stock exchange credit under Regulations T and U, instalment credit under
Regulation W, mortgage credit under Regulation X, and credit to foreigners
under our voluntary restraint program.
General monetary policy is vulnerable to the accusation that it
does not, and can not, distinguish between credits that are likely to
maximize the full employment of our productive resources, and those that
will make minimal contributions in this respect.

It would be difficult

if not impossible to make an operational a priori distinction between those
two categories; but by and large, it could be argued that long-term credits,
as they have been used, tend to promote investment more than short-term
credits, and that credits to domestic borrowers tend to raise the level of
domestic economic activity more than similar credits to foreigners.

The

latter distinction becomes particularly important under circumstances like
those obtaining for the past several years, when a payments deficit involving
a very large outflow of capital existed side by side with domestic




-

underemployment.

11-

Hence, the main problem confronting selective monetary policy--

and perhaps the most serious problem confronting monetary policy in general-relates to the possibility of devising selective measures that have different,
and perhaps opposite, effects on short-term and long-term credits, or on
credits to foreign and to domestic borrowers.
Short- and long-term credits--Discount policy, as hitherto practiced,
tends also to have a selective effect: since Federal Reserve lending is typically
short-term, banks are, to that extent, encouraged to favor short-term asset
holdings in order to be in some position to liquidate such debt as required.
This Federal Reserve lending practice has been justified as a means of
promoting and protecting the liquidity of commercial banks.

But it deprives

the Federal Reserve of a tool for indueing shifts in banker emphasis between
short-term and longer term lending, when such shifts would patently serve the
public interest.
Open market operations can be used for differential effects on shortand long-term credit conditions by means of the "twist," i.e., simultaneous
opposite operations in short- and long-term securities.

By means of "twist"

operations it is possible, for instance, to keep money-market rates higher
than they otherwise would be, say, in order to attract volatile funds from
abroad, while keeping long-term interest rates lower than they would otherwise
be, say, in order to promote domestic investment.
But "twist" operations have a serious limitation.

The term structure

of interest rates and the relation between demand and supply of credit funds
of different maturity generally can only be dominated by central bank action
for a limited period of time.




If market forces were tending to establish a

-12-

pattern of interest rates markedly different from that aimed at by the central
bank, it would have to engage in continuous and massive open market sales and
purchases--an operation that could interfere with the achievement of some
other goal--either contemporaneously or in the future.

It is true that the

operations of the central bank would in many circumstances influence market
expectations as to the near-term relationship of long to short rates, but
the fact remains that when the market judgment as to appropriate rate relation­
ships differs substantially and persistently from that of the central bank,
the power of the latter to affect the pattern is limited.
Hence, a substantial and enduring influence on the relative cost
and availability of short- and long-term credit can be exerted only if the
central bank is able to modify the relative profitability of the two types
of credit independently of market reactions.

Such influence could be exerted

through any or all of the conventional monetary mechanisms.

Reserve require­

ments, for example, might be based on types of assets rather than deposits,
i.e., if the central bank wished to encourage long-term rather than short­
term lending, it could impose additional reserve requirements on short-term
credit accommodation in excess of a given percentage of its total assets-or conversely to reduce reserve requirements for long-term credit extended
in excess of a given percentage of its total assets.

Obviously, in our

monetary system such action would require an amendment of the Federal Reserve
Act.
Credits to domestic and foreign borrowers--While it can be
reasonably argued that under current conditions selectivity between different
types of domestic credits is not essential for a smooth working of the
economic system and that the allocation of funds between domestic short- and




-

13-

long-term credits can be left to market forces, there is little doubt that the
market allocation of funds between domestic and foreign uses has worsened our
balance of payments problem.

The stability of the international payments

system as well as adequate growth of our domestic economy have for years
been jeopardized by the tendency of U.S. lenders to grant credits

and

corporations to invest abroad greatly in excess of the amounts that would
have been compatible with full employment and payments equilibrium.
This is not the place to go into the economic, political, and
institutional reasons for the disequilibrium between credit and capital yields
in the United States and other industrial nations, which lies at the root of
the excessive outflow.

We may hope that this disequilibrium will disappear

in due time and that the international allocation of credit and capital then
will proceed with the same tolerable degree of efficiency and rationality as
the allocation of funds within the United States.

But until this happy stage

is reached, I am afraid that selective measures may remain necessary in order
to avert excessive outflows of U.S. capital to the surplus countries of
Continental Europe.
At present, such selective measures include the IET and the voluntary
credit restraint program inaugurated in accordance with the Presidentfs
message of February 10, 1965.

Both of these measures have disadvantages

for the long pull--the one is confined in application and relatively
inflexible, the other is by its nature of limited duration.
Should we be looking forward to more durable and efficient technique?
So far as banks are concerned there is the possibility of using a system of
selective monetary measures, such as specific reserve requirements for credits
to foreigners.




This system could be flexible enough to differentiate between

-14-

various regions--less developed and fully-developed countries, Western Hemisphere
and rest of the world, countries dependent on or independent from U.S. credit
and capital--or even, but with some lesser hope for effectiveness, between
various purposes--financing of U.S. exports, of development programs, of
foreign subsidiaries of U.S. firms--or between various forms of credit-liquid funds, short-term credits, long-term credits, equity investments, and
so on.
A significant objection to a technique of this type is its limitation
to member banks.

Nonmembers and nonbank lenders should be placed under a

similar restraint if such a method of dealing with the capital outflow were
used.

Political and practical difficulties would be posed by such an under­

taking, and I do not want to give the impression that I know the answers to
all the questions that could and should be raised in this connection.

Certainly

we should be wary of any avoidable step that might take us to the strict
Government regulation of foreign payments.

The fact that the regulating power

would be vested in a central bank and be exercised through monetary policy
rather than through direct controls would not eliminate the inherent risk to
maximum possible freedom of international commerce.

But in the absence of

international agreement on a better world monetary system, we may well have
to choose from among an assortment of essentially repugnant methods in order
to restore balance in the international payments of the United States and
the international monetary system in general.

Selective monetary policies

may well turn out to be a lesser evil than the others.




-15Conclusions
One thing, I hope, emerges clearly from this brief review of some of
the problems of monetary policy: whatever else we may be lacking, we do not
lack new challenges.

Some of the departures from traditional central banking

mentioned, not necessarily advocated, I hasten to say, in my paper may, upon
closer examination, prove unnecessary, or undesirable, or outright hamful.
But 1 believe that at least some of them may point a way to a more rational
and more efficient use of monetary policy.

And even if not a single one of

the ideas set forth today were ever to see the light of practical experimenta­
tion: I hope that those of you who entered this room convinced that central
bankers are staunch supporters of orthodoxy

and unable to grasp or consider

novel ideas, will— if they did not decide to leave while the going was good-have found out that even the most stolid of all professions is subject to the
law of eternal change and, we hope, eternal progress.