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RESERVE BANKING IN A DYNA1IIC ECONOMY by M . S . SZYIiCZAK Member of the Board of Governors of the Federal Reserve System before the FIFTY-FIRST ANNUAL CONVENTION of the NATIONAL ASSOCIATION OF SUPERVISORS OF STATE BANKS Lord Baltimore Hotel Baltimore, Maryland WEDNESDAY, September 2h, 19^2 (E.D.S.T.) 2:U0 P.M. E2L£elease at Time of Delivery, RESERVE BANKING IN A DYNAMIC KCQNQi.lY This was to have been one of those "off the cuff" and "off record" presentations, But a few days ago a member of the press reminded me that scheduling an "off the record" talk arouses curiosity an d increases expectations to the point that unless I intended to ^vulge some confidential information or unless I intended to be ^itical of someone or something, it would be better for me to speak 0n t h e record so as not to mislead you as to the nature of my remarks. Since i proposed to be neither confidential nor critical, I was easily per suaded two or three days ago to change the form of presentation, In this process even the title of my talk has undergone a change so that n °v' it is "Reserve Banking in a Dynamic Economy" rather than "Elements of Monetary Policy." It is my purpose to review with you basic changes in reserve inking practices. of The past two years have provided a reorientation these practices that has been a matter of considerable public interest. Since you are responsible for supervising the State chartered Ur *its in our commercial banking system, you have a special interest in rev iewing credit and monetary policy because it affects financial lns titutions in your State whether or not they are members of the p , ueral Reserve System. of Financial Abnormality For more than two decades, our economy has experienced varying e gree s of financial abnormality. aric The credit crisis of the late Twenties * the early Thirties was followed by a prolonged depression of SEP - 2 - unprecedented severity. As a result of this background, lenders and borrowers during the latter half of the Thirties were timid in rem a n d i n g credit. At the same time, international forces caused a very ar •*- ge flow of gold into this country. This combination of factors re sulted in the accumulation of substantial excess reserves by our ba nking system as a whole. Reserve banking operations had to be adjusted to this abnormal banking liquidity as well as to the desirability of reestablishing a financial climate favorable to credit expansion and economic recovery. In Practice, there was a virtual disappearance of member bank rediscounts ari( i a minimum volume of open market operations. Such changes in the °Pen market account of the Federal Reserve System as were undertaken in thj x s period were mainly associated with the maintenance of orderly c °nditions in the market for Government securities and with adjustments member bank reserve requirements under new legislative authority tn acted in the early Thirties. The first half of the Forties ushered in Y.orld War II with Problems of financing huge Government deficits. The financial headaches Cre F °ated n i e s , by the wartime deficits carried over into the last half of the During the war period, Treasury requirements for money to fin ance global war deserved and received primary consideration at the Calc ulated risk of substantial wartime credit and monetary expansion, recall that rate the pivotal reserve banking policy maintenance of a will stable interest structure for the public debt.wasThethemarket - 3 - structure of interest rates had as its principal anchor a 3/8 per cent rate nJ m ° - °nth Treasury bills and from that rate the structure graduated upward to 00 a 2-1/2 per cent rate on long-term Treasury bonds, working with the Tre a s u r y , the Federal Reserve during war years used every means at s command to facilitate the Government's financing through the credit Ctnd m o n e y market. This involved adjusting reserve requirements, setting re * ierential discount rates for member bank advances secured by short-term Gov e rnment obligations, and carrying on extensive open-market operations to Su Pport theReadjustment established to pattern market interest rates. postwarof conditions entailed carrying over some Of reserve banking practices adopted to meet the war emergency. r The ^nsition from a war to a peacetime economy required many adjustments re n l y orientation of discount and open market operations could take place gradually. In the Government securities market, because of the sheer l 2 e bg +• uof thq. war accumulated public debt, the dominant focus continued to e 0 Maintenance of orderliness and stability, and this pattern persisted the first year of the current defense emergency. The nature of the n ^ a t i o n a r y threat posed by the defense emergency ultimately brought about 0 Sei a joint decision by the Treasury and Federal Reserve to conduct v e banking and debt management operations so as to minimize further ° ne tization of the public debt, ^Hgj^oental Measures of Credit Restraint These periods of extreme financial abnormality brought many Partures from operating procedures worked out during the formative 0ci of the Federal Reserve Lystem. To prevent the development of - in±, ne h - lationary pressures from excessive credit expansion, it became cessary to adopt various supplemental measures of reserve banking policy. Throughout toorld 1/jar II, the use of credit for purchasing and d r y i n g stock exchange securities was closely watched. Margin requirements, ^ich had been subject to regulation since 193U with a view to lessening the ev impact of stock market speculation on credit and banking conditions, were entually increased substantially above prewar levels. The Board's Peculations T and U governing margin requirements have been at a 75 per cent level during most of the postwar period. Regulation of consumer credit terms — both as to amount and Maturity of new credit contracts — was another supplementary device in u se during a substantial part of the past decade. First introduced 19U1, the regulation of consumer credit under Regulation Ti applied duri -ng the war to charge accounts, instalment sales of a comprehensive lis t of consumer goods, and instalment and single-payment loans. th During e postwar period, it was limited to the most volatile portion of this credit — the instalment segment. As you know, the most recent authority of the Board of Governors to regulate this type of credit lapsed on Jy h e 30 of this year. In 19b'0, a third type of supplementary credit instrument was authorized, namely, regulation of credit terms on loans to finance new re sidential and nonresidential construction. Cr edit is in the form of home mortgage debt which has roughly tripled si h c e the end of \iorld \<ar II, rising from about 19 billion dollars to The bulk of real estate - 5 - ^Proximately 57 billion dollars at the present time. In view of Mandatory provisions of certain amendments to the Defense Production adopted during the last session of Congress, this regulation was SUs Pended two weeks ago. I should like to express the appreciation the Board for your splendid cooperation in helping us to introduce, ex Plain, and enforce both these Regulations• These particular devices affected only selected credit are a a s and, hence, were only partial supplements to instruments which ^ected the availability and supply of credit generally. These Citation's of application and effectiveness led to considerable use ^ U r ing the past decade of the authority to change member bank reserve ec l u irements. During war years, changes in reserve requirements related ftv* * n) arily to war financing needs. In the postwar period, they were used both + offset the effects on bank reserve positions of reserve banksupport of the Government securities market and to affect directly liquidity position of banks. You may recall that the postwar use of the reserve requirement ns trurnent was accompanied by extensive study and discussion of supple- er ^tal reserve requirement proposals, such as a plan for holding u Pplemental reserves in short-term Government securities, another for hold-^ reserves equal to deposits in excess of a specified amount, ^ still another for increases in reserves related to bank loan expansion. uiese proposals may now be largely of historical interest, they ssented efforts to find substitutes for traditional methods of reserve Nankin at a time when these metnods were not wholly effective because the necessity for reserve banking support of the market for Government Cities. - 6 - Restoration of Flexible Reserve Banking After more than a decade of departure from reserve banking pr ocedures developed earlier to deal with credit and monetary problems, ^adjustment to these procedures has not been easy. have complained that the pace has not been fast enough, that we have crawling when we should have been running. aav ta There are some who There are others who e doubted the wisdom and effectiveness of the steps which have been ken. Nevertheless, readjustment has gone forward step by step and uCc °mplishments to date in restoring responsive credit and monetary Orations along traditional lines have exceeded the expectations of many. one of the major difficulties in making the transition has been Cau sed by the size and composition of the Government debt. Still another ^Portant consideration has been the delicate economic balance of the p0s twar period in which there have been substantial risks that abrupt and ^ - r e a c h i n g changes in reserve banking operations might tip the scales to ° far in one direction. arici Finally, there has been the problem of credit money market reorientation to changed reserve banking procedures. Discontinuance of the wartime preferential discount rate on a ^ v ances to member banks secured by short-term Government securities in marked the beginning of postwar reserve banking transition. Then, in A b a t i n g postwar inflationary pressures, support prices on short-term Gov rai ernment securities were gradually lowered; the discount rate was -sed in successive steps; and reserve requirements were tightened close to thi statutory limits. As I observed earlier, open market operations in s period, in addition to functioning in general support of the Government Se curities market, also served to facilitate banking adjustments to higher le serve requirements. - 7 - By 19h9f economic developments pointed up the fact that inflate onary pressures resulting from the war were beginning to lessen. The ®aJor portion of pent-up demand of both business and consumers had been Sat isfied. In recognition of this easing of inflationary pressures, the ^deral Reserve moved to increase the availability and use of credit t a x i n g terms on instalment and stock market credit and later by re( lucing reserve requirements and adjusting open market operations acc ^dingly. Credit and monetary action in 19k9 helped to cushion economic rece s s i o n and to set the stage for recovery. During the first half of l95o recovery gained full momentum. £®act__of Korea The final stage in the readaptation of reserve banking N a t i o n s was precipitated by new inflationary pressures inherent in -full-scale defense program which this country embarked upon after outbreak of hostilities in Korea. The prospect of a garrison economy °r a n extended period of time required a thoroughgoing review of all ItU n c i a l measures which could be brought to bear on inflationary forces. V; as obvious that, if these pressures were to be held in check, primary fell ce v.ould have to be placed on measures curbing inflationary pressures their source. This approach increasingly involved a coordinated program fiscal, debt management, and credit and monetary policies. Of prime importance in this program was maintaining the defense ^ o r t as long as possible on a pay-as-we-go basis, thus avoiding a ftyrij o m e n t a l mistake of World Vvar II financing. The maintenance of a balance - ln 8 - ^ e Government's cash accounts throughout 1951 and the l'irst half of thi s year shut off what could have otherwise been a substantial source inflationary pressure. In March 1951> the Treasury and the Federal Reserve took a major* o+ step in coordinating debt management and credit and monetary N i c i e s in such a way as to assure successful financing by the Government £n<i at + v tne same time to minimize the monetization of the public debt, conversion offer carried out at that time for the two longest-term d i e t e d bonds substantially reduced the amount of Government bonds the market and paved the way for discontinuance of Federal Reserve ^ c h a s e s of such bonds in support of their prices, p... .iimaryjnstruments of Reserve Eanking Emergence of a flexible and self-sustaining market for Government j-^ies was a vital development in reestablishing a more normal pattern of V, e serve banking operations. It has necessitated a full-scale review 0f the methods and techniques of open market and discount functions to ^-te Alnirie hcv/ the credit market can operate smoothly with minimum of^rverition by the Federal Reserve System and without monetization e Public debt. This review has involved consideration of such ^ U e sti J-ons as: S3c I,hat are the rules of the game for reserve banking in a ibl e credit market? Giving account to the generally accepted goal Economic stability at high levels of output and employment, how are V e funds most effectively supplied to the market to meet the changing credit 'ith x e needs of commerce and industry? Vhat does this objective mean spect to the use of open market and discount operations? Ijith v - 9re spect to changes in reserve requirements? filth respect to margin requirement on stock market loans? in a flexible market? How can the Government's borrowing be best accomodated All those connected with financial markets — the Reserve System, G oimnercial banks, investment banking houses, security dealers, savings ins titutions and investors as well as borrowers — are in the process 01 mar Su adjus ting their operations to the fact of a self-sustaining credit ket. They must re-acquire a body of market experience under varying Pply and demand conditions on which to base operating decisions. The Secretary of our Federal Open Market Committee, TIV. W . Riefler, i recently pointed out that reserve banking experience during the ! I U n t i e s indicated that a combination of responsive discount and open lilar anci ket operations was an effective means of regulating the availability supply of credit. In that period, bankers were sensitive in their Ending and investment decisions to variations in the source of their Q u i r e d reserves. Whenever open market operations withdrew reserves r °m the market, banks tended to become more restrictive in their Ending policies even though they could, and did, make up any reserve ^ i c i e n c i e s at the discount window of the Reserve Banks. Further, M e r e s t rates were influenced both by the volume of member bank borrowand by changes in the discount rate. dif Finally, although it was ficult of measurement, tightness or easiness in the credit market was Elected through banker sentiment and the attitudes of many businessmen. The past 18 months have provided additional experience supple^nting that of the Twenties. As there has been more frequent resort - 10 - the Federal Reserve discount window, it appears that member banks nave n °t been unmindful of the substantial shifts in the volume of 1 ^eir borrowing. uere With tightness in the availability of reserve funds, is evidence that banks have shown increasing reluctance to enter lnto n e w commitments as the level of discounts and other borrowing I ^ct risen. Interest rates have reflected these changes. In other words, recent as well as earlier experience would n dicate that open market operations can be used to increase or decrease the dependence of member banks on borrowing; and further, that because 4 natural hesitancy of bankers to carry extensive borrowings on 0"f Vethe r than a temporary basis, the total of member bank indebtedness w U l exert a determining influence on the availability and supply of credit. Hole n f n ^ J ^ R e s e r v e Requirements Earlier in the postwar period, changes in member bank reserve rem e n t s assumed unusual importance as a reserve banking instrument. As t «,a. , . ^aid before, this was the case largely because the System's older s truraents for influencing the total volume of credit and money were v in n erely limited in use at that time. The present increased emphasis discount and open market operations indicates, in my opinion, that changes i e s e r v e requirements will resume a more secondary role in reserve ^ing operations. be C a i s e Cnanges in reserve requirements are a harsh instrument they have disproportionate effects among individual institutions. Their* a cross-the-board characteristics are devoid of the element of ^ibili-ty which is essential for frequent use in influencing the total 6 Us of bank credit and bank deposits. They are a measure to be used in n a l circumstances for contracting or expanding the liquidity position of eri tire banking system. This was the original conception of their use. - 11 - S!£g£al Observations The development of more flexible debt management, credit, and Monetary policies over the past 18 months has been accompanied by relative Economic stability at a high level of output and employment. IldS i j e e n r<iCe The economy able to absorb an expanding defense program whicn now runs at the of over 50 billion dollars a year and at the same time has actually Pr °duced more for other purposes than it did before Korea. Yihile financial measures have been indispensable and primary ln attaining this degree of stability, I do not want to give the S e s s i o n that I think they alone were responsible. Nor do I want to give the impression that at long last we have found a formula for n °uic stability and that our job is done. In a truly dynamic economy, the job of maintaining economic ability is never done.
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