Economic conditions - United States ; Depository Institutions Deregulation and Monetary Control Act of 1980 ; Federal Reserve System - History

Verle B. Johnston

English

Research Papers in Economics

FRBSF WEEKLY LETTER
April 17, 1987
Transition
It is my strong conviction that inflation remains
the Nation's number one economic problem. To
fight inflation . .. we must concentrate on
reducing the budget by holding down Federal
spending and foregoing tax reductions, (and)
monetary policy wil1 have to continue firmly in
support ofthe same anti-inflationary goals.
So commented President Carter in his State of
the Union message in January 1980, when he
announced that he would cut the budget deficit
for fiscal year 1981 in half to $16 billion. The
issue of inflation pervaded economic and politi-
cal arguments of the time. In the financial ser-
vices industry, inflation had been the mother of
financial innovations, but these innovations,
unshackled by government regulation, in turn,
presented grave threats to the traditional reg-
ulated financial industry.
This Letter reviews major developments in the
nation's economy during the transition from the
Carter Administration to the Reagan Administra-
tion and the passage of what Senator Proxmire
hailed as the most significant piece of financial
legislation since the Federal Reserve Act of 1913
- the Monetary Control Act of 1980.
Inflation
In his State ofthe Union and budget messages to
the Congress early in 1980, President Carter
called for increased efforts to reduce supply-
related cost pressures, including an expansion of
job training programs for disadvantaged youth
and programs to increase domestic energy sup-
plies to reduce the nation's heavy dependence
on foreign sources. He also called for increased
efforts to simplify and reduce costly government
regulation.
His FY 1981 budget was projected to rise by 9
percent in current dollars. With the rate of infla-
tion projected at 8 percent (as measured by the
GNP deflator), the increase in the budget in real
(inflation-adjusted) terms, was only 1 percent,
even with an accelerated (3 percent) increase in
real defense spending. He emphasized that "to
reduce inflation in subsequent years, the budget
will have to remain tight," and he also forecast a
"mild recession" early in 1980.
Rites of Spring I
The Spring of 1980 witnessed a number of dra-
matic developments. On the heels of a 13 per-
cent increase in 1979, the consumer price index
hit a 17 percent annual rate of increase in
March. Following President Carter's order invok-
ing the 1969 Credit Control Act and the some-
what reluctant implementation by the Federal
Reserve of a stiff program of credit controls
aimed at reducing inflation, the economy took a
sharp dip.
The controls were lifted in early Summer and
the economy again picked up - along with the
rate of inflation. Consequently, and to the great
dismay of President Carter, the Fed raised the
discount rate by a full point late in September, to
11 percent. When the electorate went to the
polls late in November, inflation was still rising
at a 12 percent annual rate; interest rates, after a
brief drop, were at record levels, bolstered by
progressively deepening expectations of con-
tinuing inflation (the prime rate hit 17.75 per-
cent); and the unemployment rate reached 7.5
percent.
The rising levels of unemployment and interest
rates were attributed by many to the shift in
operating procedures and "tighter" stance
adopted by the Fed in the interim since October
1979. Over the year (December to December),
the nation witnessed a drop in the growth rate of
M 1 from 7.7 to 6.5 percent. (In contrast, the
growth of M2 increased from 8.0 to 8.9 percent
and M3, from 9.7 to 10.2 percent.) After the
votes were counted in November of 1980, Presi-
dent Carter was convinced that high interest
rates had been a major factor contributing to his
defeat in his bid for re-election.
Rites of Spring II
The Spring of 1980 also witnessed the passage
of the Depository Institutions Deregulation and
Monetary Control Act (MCA) late in March. The
Act had the strong backing of the Carter Admin-
istration and that of the leadership of both the
House and Senate Banking Committees. It
marked a major step in the direction of promot-
ing greater competition and equity in financial
markets, while at the same time strengtheningFRBSF
the Fed's direct influence over the fulcrum of
monetary control- the reserves of all deposi-
tory institutions.
The Act also marked the end of a long debate
extending from the 1930s, when the Federal
Reserve repeatedly, but unsuccessfully, urged
that its reserve requirements be extended from
just member banks to all commercial banks.
(Formal membership in the Federal Reserve was,
and still is, compulsory for national banks but
voluntary for state-chartered banks.) The Fed's
recommendation was strongly resisted by state
banking authorities and the Congress, but, in
1961, was endorsed by theCommission on
Money and Credit (CMC).
In the same time period (mid-1950s and 1960s),
the Board of Governors rejected the argument
that the rapid growth of "near money" assets,
such as the "shares" or savings accounts of non-
bank depository institutions not subject to Sys-
tem reserve requirements, inevitably would
result in "leakages" in monetary control. They
would exert this effect partly through their influ-
ence onthe velocity of the money supply - the
rate at which money is spent. This atgument was
advanced by Stanford Professors Gurley and
Shawand was embraced by, among others,
economists ofthe San Francisco Fed.
The Board of Governors, at the time sensitive to
potential charges that it was engaged in a
"power grab", rejected the argument in a reply
to a question on the subjectby the CMC. It
asserted that "the long-run rise in the volume of
near money assets ... has not reduced the
effectiveness of monetary policy", and, more-
over, that velocity had reached its "practical
limit" of 3.0 (it was 6.0 in 1986Q4).
Nevertheless, in 1972, the Report of the Presi-
dent's Commission on Financial Structure and
Regulation" (the Hunt Commission), and, in
1975-76, the House Banking Committee's study
of "Financial Institutions and the Nation's Econ-
omy" both recommended that thrift institutions
be granted full third-party payment powers, and
that all institutions offering such accounts be
subject to System reserve requirements (and be
given accessto the Reserve Bank's discount
"window"). They also recommended phasing
out interest rate ceilings on time and savings
deposits which had become an increasingly
leaky "umbrella" and had failed to protect
depository institutions from "disintermediation"
(an outflow of funds) during periods of rising
market interest rates.
Harmonizing objectives
In 1975, in response to mounting Board and
Reserve Bank concern, System Task Forces were
established to address the interrelated issues of
Fed membership, competitive equity, and mone-
tary control, including one Task Force on Access
to System Services, three of whose six members
(including the Chairman) were from the San
Francisco Fed. Their report, which envisioned
difficult times ahead for the nation's economy in
both short and longer term, focused on specific
means by which potential conflicts in the Sys-
tem's multiple objectives and responsibilities
could be eliminated or minimized. (These objec-
tives included the promotion, through monetary
policy, of high and rising levels of income, out-
put and employment, and stable prices; the pro-
motion, through the implementation of its
supervisory and regulatory functions, of "com-
petition" and a "safe and sound" banking and
financial system; and the promotion, through its
check clearing and other services, of an efficient
payments system.)
In pursuit of these objectives, the Task Forces
recommended that all depository institutions
offering payments services be given access to
System clearing and other services (including the
discount window) irrespective of membership in
the System, that the services be explicitly priced
to all users, and that reserve requirements be
both reduced and applied to all depository
institutions.
The withdrawal of hundreds of banks from the
System in the mid- and late 1970s in response to
the rising "opportunity cost" of membership-
the income lost on nonearning reserves held at
the System as market rates of interest rose-
finally impelled action. According to one Board
estimate, the loss of income in the aggregate far
more than offset (by at least $650 million) the
value of the "free" check clearing and other ser-
vices provided to member banks by the Reserve
Banks.
As passed by the Congress, the MCA embraced
the aforementioned recommendations (but
exempted institutions with under $2 million in
deposits from reserve requirements) together
with a six-year phase out of interest rate ceilings
on time and savings deposits. It also authorized
expanded lending powers for thrift institutions,
authority for all depository institutions to offer
NOW accounts to individual and nonprofit
organizations, and provided for the federal pre-
emption of various state usury ceilings and
increased deposit insurance. In addition, it
established procedures by which conflicts,
duplications, and inconsistencies in financial
agency regulations could be eliminated orreduced, and compliance costs thereby
minimized.
In most particulars, the MCA thus represented a
major step away from the competition and
"risk"-restraining attitudes and regulations
spawned by the Great Depression, including the
deep skepticism regarding the ability of market
forces to achieve a desirable allocation of
resources.
No other piece of legislation, with the exception
ofthe Federal Reserve Act itself, has exerted
such a profound effect upon the System's opera-
tional activities. For example, from 147 member
banks prior to passage of the MCA in 1980, the
San Francisco Fed now processes weekly reserve
reports for about 500 member and nonmember
banks, in addition to over 35 Edge Act corpora-
tions, 124 foreign banks, and about 465 thrift
institutions (mutual savings banks, S&Ls, and
credit unions). An additional 70 (small) institu-
tions maintain clearing balances and 295 others
report quarterly. Over 1,000 of the District's
4,000 depository institutions currently use the
Bank's various payments services, and
altogether, the volume of the Bank's operations
since passage of the MCA has increased by over
40 percent.
Old song, new singers
To some who have been around awhile, the
strains of "Happy Days Are Here Again" - a
traditional ballad of the Democratic Party -
reverberating through the Republication conven-
tion in the Summer of 1980 seemed strangely
out of place. But the switch was not without
precedent.
While campaigning in 1932, FDR had chastised
the Hoover Administration for budget deficits
that "have added $5 billion to the national
debt", and it presumably was with this "early"
FDR in mind that candidate Reagan excoriated
the deficits of the Carter Administration. Fiscal
year 1980 closed $74 billion in the red, almost
double the expected shortfall, and FY 1981 was
to end with a record $79 billion deficit - far
above the $16 biIIion projected by President
Carter early in 1980.
The incoming (1981) Reagan Administration
"Program for Economic Recovery" included
four key elements designed to enhance incen-
tives, encourage savings and investment, and
thereby spur economic growth, while at the
same time winding down inflation. They
included substantial cuts in business and per-
sonal taxes, a reduced rate of growth of federal
spending (centering on "entitlement" programs
and other nondefense areas in order to accom-
modate a significant increase in defense outlays
in "real" terms), a reduced rate of growth in the
mon~y and credit aggregates (some administra-
tion spokesman suggested a reduction of per-
haps one-half over a six-year period), and a
substantial reduction in the burden of regulation.
According to David Stockman, former Congress-
man and new Director of the Office of Manage-
ment and the Budget, and Congressman Jack
Kemp (R-NY), a "supply side" enthusiast and
co-author of the sweeping tax reductions, failure
to act forthrightly on these initiatives would
result in an "Economic Dunkirk for the GOP".
Moreover, in their view, "recalibration of (the
Fed's) monetary objectives and restoration of its
tattered credibility is the critical linchpin in the
whole program." To this end, they urged Presi-
dent Reagan to "issue (the Federal Reserve
Board) a new informal 'charter' - namely, to
eschew all consideration of extraneous eco-
nomic variables like short-term interest rates,
housing market conditions, business cycle fluc-
tuations, etc., and to concentrate instead on one
exclusive task: bringing the growth of... bank
reserves (and the money supply) to a prudent
rate ..."
They added that, given this course of action by
the Fed, the Administration and the Congress
"would stoutly defend the Fed from all political
attacks." In view of the rancor that was to fol-
low, it was an imaginative assessment.
Future Letters will discuss the evolution of the
Reagan Administration's economic program, the
course of monetary policy, and other develop-
ments affecting the nation's economy in the
Brave New World of the 1980s.
Verle B. Johnston
Opinionsexpressed in this newsletterdo not necessarily reflect theviews of the managementofthe Federal Reserve Bank ofSan
Francisco,orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor....FreecopiesofFederal Reserve publications
can beobtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone(415) 974-2246.uo~6U!450m 40~n U060JO 0POI\0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
3/25/87
Change
from
3/18/87
Change from 3/26/86
Dollar Percent!
Loans, Leases and Investments' 2 203,658 - 816 1,312 0.6
Loans and Leases1 6 182,580 - 1,297 - 1,034 - 0.5
Commercial and Industrial 53,812 - 220 659 1.2
Real estate 67,830 - 49 1,530 2.3
Loans to Individuals 37,133 - 95 - 3,675 - 9.0
Leases 5,450 9 - 207 - 3.6
U.S. Treasury and Agency Securities2 13,959 473 3,197 29.7
Other Securities2 7,119 7 - 853 - 10.6
Total Deposits 205,423 - 1,598 4,674 2.3
Demand Deposits 50,743 - 831 3,804 8.1
Demand Deposits Adjusted3 35,942 1,128 3,666 11.3
OtherTransaction Balances4 19,359 - 80 4,154 27.3
Total Non-Transaction Balances6 135,321 - 686 - 3,284 - 2.3
MoneyMarket Deposit
Accounts-Total 46,299 - 477 396 0.8
Time Deposits in Amounts of
$100,000or more 32,247 - 248 - 6,213 - 16.1
Other Liabilities for Borrowed Monevs 22,747 - 1,741 - 5,250 - 18.7
Two Week Averages
of Dailv Fi2ures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
3/23/87
87
11
77
Period ended
3/9/87
91
18
72
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and othersources
6 Includes items notshown separately
7 Annualized percentchange

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