Monday, January 24, 2011

1966 Monetary Policy Blunder

April 6, 1967
By Leland J. Pritchard, Professor of Finance, the University of Kansas, Lawrence, Kansas.

The need for hikes in Reg. “Q” is challenged by a leading professor and writer in the field of money and banking. Prof. Pritchard faults the Federal Reserve for needlessly collapsing the home mortgage market in 1966 when, understandably adopting a tight money policy, it successively raised Reg. “Q” and caused an inequitable distribution of available credit. He calls for further reductions in member bank deposit interest rate ceilings than those belatedly lowered in July and September, 1966. Says this would further reduce the ratio of time deposits, reduce bank costs and increase profits, stimulate funds to S&L Associations., and Mutual Savings Associations, and obviate Governmental infusions to relieve the mortgage money shortage.

The sharp drop which occurred in residential construction in 1966 was almost entirely a credit phenomenon. It was the result of both a severely curtailed flow of credit into the housing industry and the sharply rising cost of credit. Both the reduced volume of funds, and the higher cost of mortgage credit, were the direct consequence of the Federal Reserves’ tight money policy.

By the third quarter of 1966 the impact of this policy had reduced housing starts, on a seasonally adjusted annual basis, approximately 50 percent from the level prevailing at the end of 1965.

The crisis thus created in the housing industry called for and brought forth massive infusions of government credit, and other emergency measures. The Federal Home Loan Banks (FHLB’s) relaxed the conditions for making advances to member savings and loan associations, and in mid-1966 Congress appropriated $1 billion to the Federal National Mortgage Association (FNMA) for purchases of certain private housing loans.

On July 1 the Board of Governors of the Federal Reserve System took the unprecedented action of authorizing the Federal Reserve banks to make their credit facilities available, through the member banks, to the mutual savings banks and the savings and loan associations. Fortunately it was never necessary to use this emergency measure.

It seems to be the general consensus that the housing industry must inevitably bear the major impact of a tight money policy. In the words of William McChesney Martin Jr., Chairman of the Board of Governors, “Home building was elbowed to the end of the line; residential construction activity was reduced for below the levels needed to meet our long-term housing needs.”

In fairness to Mr. Martin and the other member so the Board it should be said that it was neither their wish nor intention to “elbow the housing industry to the end of the line.” This unfortunate situation was simply the inevitable consequence of a severely restrictive monetary policy. It is with this fatalistic assumption that I wish to take issue.


No responsible person contends that the Reserve authorities were not correct in pursuing a restrictive monetary policy in 1966. Considering the lack of fiscal restraint exercised by the Federal Government, particularly after the first major escalation of the Vietnam War in June 1965, there was no alternative. But it was not necessary that the burden of monetary restraints be imposed so inequitably.

Federal Reserve credit policy in 1966 can be roughly divided into three periods. The period from January through March can be characterized as one of increasing though moderate restraint; from April through October as a period of severe restraint, and the remainder of the year, a period of rapid relaxation. It is with the April through October period that we are most concerned. During this period the Federal Reserve forced an actual reduction in member bank legal reserves, down about $1 billion from a level of approximately $24 billion. Since this reduction was accomplished through the open market operations of the System, we can logically assume that a proportionate decrease in the legal reserves of the non-member banks was also affected.

Combined with an intense demand for loans, the contraction of reserves forced the banks to operate with a large volume of net-borrowed reserves. The extreme point of stringency was reached during the first week in October when net-borrowed reserves position, to a net-free-position of approximately $500 million. The extent of the sharp reversal in monetary policy since October 1966 is revealed in the shift from this extreme net-borrowed reserve position to a net-free reserve position of nearly $200 million at the present time (March 1967). As a byproduct of the Reserves’ credit policies, the stock of money declined at an annual rate of 1.7 per cent during the April-October period.

The whole of 1976, however, the story is quite different. The Reserve authorities allowed bank credit to expand during 1966 by $19.7 billion, or at an annual rate of approximately 6 per cent. This compares to an annually compounded rate of increase of approximately 7 per cent in the preceding ten years, and a rate of about 5 percent for the entire period since World War II.

Since banks made a negligible change in their aggregate security holdings, decreasing only $200 million from the end of 1965 to the end of 1966, the entire increase in bank credit was available to finance loans.

During 1966 the commercial banks made a net addition of $5.5 billion to their aggregate holdings of nonfarm mortgages. This compares to a figure of $5.5 billion for 1965; $4.2 billion for 1964; $4.6 billion for 1963; and $3.8 billion for 1962.


In other words the commercial banks cannot be faulted for the dearth of new mortgage money in 1966. At the same time the banks were increasing mortgage lending above previous year levels, they were increasing their loans to business by approximately $14.2 billion. As many a businessman can now attest who has an excessive volume of inventories on hand, it would have been far better had the effects of the tight money policy been distributed more equitably – specifically by denying to him the funds he thought he needed in 1966.

The Savings & Loan industry on the other hand was able to expand its aggregate mortgage holdings by a net amount of only$3.8 billion in 1966. This figure compares with a net increase in 1965 of $8.9 billion in 1966. This figure compares with a net increase in 1965 of $8.9 billion; of $10.4 billion of 1964; and of $12.1 billion in 1963.

Those who have argued so vigorously that the lack of mortgage money was due to disintermediation (a shift by the public from indirect investment through financial intermediaries to direct investment), and who also insist that the commercial banks are only another type of financial intermediary, should ponder the above data.


We may now consider the question; “How could the Federal Reserve have pursued a tighter money policy toward business and at the same time an easier money policy toward the housing industry?” And what is even more important to those who believe in the free enterprise system, how could such a segmented control of the credit market be accomplished through indirect, rather than direct controls?

The answer is: By reducing the volume of time deposits held by the commercial banks, and by reducing the over-all volume of bank credit.

The Board has the power to change the time deposit/demand deposit mix. Under its Regulation “Q” the Board has the power to fix the maximum interest rates member banks can pay on time deposits at any level the Board deems appropriate. By lowering the ceilings the Board can induce a shift from time deposits, to demand deposits and, since the Federal Deposit Insurance Corporation (FDIC) follows the lead of the Board of Governors, the effect of the Board’s action to virtually all commercial banks.

It is a fact that people choose to hold savings in the form of pass book savings account, or multiple-maturity non-negotiable certificates of deposit in commercial banks for about the same reasons they choose to hold share accounts or share certificates in Savings & Loan Associations or Savings Deposits in Mutual Savings Banks.

If time deposits are made less attractive fewer funds will be held in this form and more savings will flow through the Savings and Loan association and the Mutual Savings Banks, the principal institutional suppliers of nonfarm mortgage credit.


A shift from time to demand deposits and the transfer of the ownership of these demand deposits to the Savings and Loan Associations and the Mutual Savings Banks does not force a reduction in the size of the banking system. These transactions simply involve a shift in the form of bank liabilities (from time to demand deposits) and a shift in the ownership of demand deposits (from savers to Savings and Loan Associations, et al).

The utilization of these demand deposits by the Savings and Loan Associations and the Mutual Savings banks also would not reduce the volume of demand deposits held by the commercial banks, or the volume of their earning assets. In the context of their lending operations it is only possible to reduce bank assets and demand deposits by retiring bank-held loans.

And in any event, a loan paid off can be replace irrespective of what is happening to time deposits, for the size of the banking system is not determined by the willingness of the public to save, and to entrust their savings to the commercial banks. The aggregate size of the banking system, and the volume of earning assets held by the banking system-given the opportunities to make “bankable” loans – is determined by the willingness of the Federal Reserve to supply legal reserves to the banking system.

A shift from time to demand deposits would not only increase the flow of funds through the Savings and Loan Associations and the Mutual Savings Banks, and thereby increase the funds available for mortgage financing; it would sharply reduce bank expenses, and increase bank profits.


Using differential cost figures prepared by the Federal Reserve Bank of Boston and income and other data on member banks from the Federal Reserve Bulletin, I have been able to prepare estimates on the relative cost of time and demand deposits and estimates on the relative cost of time and demand deposits and rates of earnings on loans for the year 1965, the last year for which adequate data are available. The average annual cost of maintaining a $1,000 time deposit came to $43, compared to an average cost of $14.30 per $1,000 of demand deposits. Thus for every shift of $1,000 from time to demand deposits bank costs are reduced by $27.70.

The differential is probably greater for 1966 as it appears that interest rates paid on time deposits have increased faster than the various other costs, involved in administering, either time of demand deposits.

Obviously, however, the overheated situation of the economy in 1966 required that if more funds were to be permitted to flow into the housing industry a compensating curtailment was required elsewhere. This could have been accomplished by reducing the rate of growth of bank credit to less than 6 percent.

The shift from time to demand deposits, b y reducing excess reserves, would have forced some credit contraction. Open market sales by the Federal Reserve would have provided any additional pressure for contraction if this were necessary.


Bank credit contraction means, of course, reduced loan volume and reduce bank earnings, but if this is accomplished by an even greater reduction in banks expenses, bank profits will obviously increase. And it is profits, not size, that is presumably the primary objective of bank managements.

Using the same source material referred to above, I estimated that member bank net earnings per $1,000 of loans outstanding was approximately $41.10 in 1965. This figure represents gross earnings, less those specific costs chargeable to the acquisition and administration of loans, plus an allocation of overhead costs.

If the net earnings per annum on $1,000 of loans is $41.10 and the net cost of acquiring, holding and service $1,000 of time deposits is $43 this would suggest that the banks should get out of the time deposit business altogether. This may be true, but, the reader should be cautioned that the direct comparison of return on assets, with cost of savings, is only valid for intermediary types of financial institutions; it is not valid to apply such a comparison to the commercial banks.

To determine whether time deposit banking is profitable from the standpoint of the banking system it is necessary to answer the following question: Does a given growth in time deposits induce the monetary authorities to follow a policy of greater ease, or less restraint, such as will enable the banking system to acquire an additional volume of reserves on the basis of which the banks can expand their earning assets, and thereby their net earnings, by an amount sufficient to more than offset the over-all increase in costs associated with the growth of time deposits?

Since in a net sense time deposits originate exclusively from shifts out of demand deposits (either directly or indirectly via the currency or undivided profits account routes), and sine time deposits are more expensive to maintain than are demand deposits; it is actually possible to increase the over-all profits of the banking system by inducing a return shift from time to demand deposits even though the net rate of return on loans is greater, dollar-for-dollar, than the cost of maintaining time deposits.

Assume for example, that the net annual return per $1,000 of loans was at the absurdly high level of $70, far above the rate of return than now prevails. The Federal Reserve would have to force a reduction of bank credit by more than $500 for every $1,000 shifted from time to demand deposits, before any reduction would take place, in over-all bank profits. The calculations are as follows: A shift of $1,000 from time to demand deposits, decreases expenses by $27.70. A further reduction of demand deposits by $500 (an inevitable consequence of reducing loans by $500) reduces expenses by $7.65, or a total reduction in expenses of $35.35. This is approximately the same as the loss in income ($35) resulting from the reduction in loans by $500. Any further reductions in loans, unless compensated for by additional shifts from time to demand deposits would, of course, reduce profits.


On July 20, 1966 the Reserve Authorities made the first reduction of interest rate ceilings on time deposits since February 1, 1935. The maximum rates payable on multiple maturity non-negotiable certificates of deposit were reduce from 5 ½ to 5 percent on certificates maturing in 90 days or more, and from 5 ½ to 5 percent on certificates maturing in less than 90 days. These are the consumer-type credit instruments issued by commercial banks which are most competitive with the share accounts and share certificates of savings and loan associations and the savings deposits of mutual savings banks.

A second reduction was effected on September 26, 1966 when the maximum rates on single maturity negotiable and non-negotiable certificates of deposit of less than $100,000 denomination were reduced from 5 ½ to 5 percent. The FDIC of course extended all of these reductions to non-member insured banks.

Since banks are generally paying the maximums allowed these changes had a considerable effect on the relative attractiveness of time deposit, vis a’ vis accounts in Savings and Loan Associations, and savings deposits in Mutual Savings Banks. For example time deposits, which increased $8.3 billion during the first half of 1966 and stood at a figure of $156.8 billion in July grew by only $1.1 billion the remainder of the year, Share accounts in Savings and Loan Associations on the other hand had $2.9 billion of their total 1966 growth of $3.5 billion, in the last half of the year.

Furthermore, while the aggregate of time and demand deposits continued to increase after July, the proportion of time to demand deposits diminished. Whereas time deposits were 105 percent of demand deposits in July, by the end of the year, the proportion had fallen to 98 percent. These were all desirable developments.

Not only was the flow of savings through the Savings and Loan Associations and the Mutual Savings Banks stimulated, and more funds made available for housing construction, but these developments had a favorable effect on bank profits.

Favorable as these developments were, they were nevertheless inadequate to counteract adequately the degree of stagnation and paralysis that had overtaken the housing industry.

The latest available seasonally adjusted annual figure for housing starts (February 1967) indicates that the industry is operating a level of about 1 million units, a very depressed level, both historically, and in terms of our current, and future housing needs.

What was called for was a much greater reduction in the interest ceilings on the consumer-type certificates of deposit. Since the Board uses the criterion, “equalization of competition for savings” in the fixing of rate ceilings, it is understandable why they would be loathe to lower the rate ceilings for commercial banks significantly below the rates paid by the FDIC for insured mutual savings banks and by the FHLB Board for member savings and loan associations.


While the action of the Board is understandable, it is nevertheless indefensible. It bears repeating that the commercial banks, from a system standpoint, do not acquire savings from outside the system. All savings held in the commercial banks originate within the system itself. Commercial banks are not therefore in any meaningful sense competing with Savings and Loan Associations and Mutual Savings Banks for the savings of the public.

Commercial banks are credit creating institutions. The aggregate lending capacity of the commercial banks is predicated upon the willingness of the Federal Reserve authorities to supply the banking system with legal reserves; it is not dependent upon the savings practices of the public, and the willingness of the public to hold time deposits in the banks. Commercial banks do not loan out time deposits, or the “proceeds” of time deposits; neither do they loan out existing demand deposits, or any type of existing asset, or liability. Commercial banks create new demand deposits when making loans to, or buying securites from, the nonbank public.

If the Board of Governors whishes to increase the lending capacity of the commercial banks they always have it within power to do so. All that is required are open market purchases by the Reserve Banks of an amount sufficient to cause a net additional in bank legal reserves. Since open market purchases are participated in by the customers of nonmember as well as member banks, these operations add to nonmember, as well as to member bank reserves.

Raising interest ceilings on time deposits, as the Board did on five successive occasions beginning January 1, 1957 and culminating in the disastrous increase to 5 ½ per cent on December 6, 1965, simply allowed the banks to increase their expenses with no concomitant increase in income. The earning assets held by the commercial banks, from a system standpoint, are not the result of the growth of time deposits.

The sequence is not from time deposits to earning assets, rather the sequence is from earning assets, and new demand deposits, these two come into being simultaneously, and from “old” demand deposits (which the public has saved) to time deposits.


Proper public policy calls further reductions in the interest ceilings allowable under regulation “Q”. This would reduce further the proportion of time to demand deposits, reduce bank costs, increase bank profits; and stimulate an increased flow of funds through the Savings and Loan Associations and the Mutual Savings Banks.

There would then be no need of massive infusions of government credit to relive the shortage of mortgage money.

This course of action would not reduce the size of the banking system, the volume of earnings assets held by the banking system, the income received by the system, or the opportunities of the banks to make safe and profitable loans. Quite the contrary in fact. By promoting the welfare and health of such an important segment of the economy as is represented by the housing industry, the health and vitality of the whole national economy will improve. The aggregate demand for loan funds will expand, the volume of “bankable” loans will grow, and so will the banking system, - the Federal Reserve being willing.

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