Tape 22 - Current Monetary Developments: Prospects for Interest Rates, Nixon Budget, Peace Rumors and the Market Federal Funds Rate
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- | Hello, this is William Clarke | 0:02 |
of The Tribune, Chicago Tribune. | 0:04 | |
Welcoming you, once again, to a visit | 0:05 | |
with distinguished economist, | 0:08 | |
Professor Milton Friedman of the University of Chicago. | 0:10 | |
Doctor Friedman, I wonder if we might take a minute | 0:13 | |
at the outset here to catch up on | 0:15 | |
what the monetary figures are telling us? | 0:18 | |
- | Well, of course, week to week changes | 0:21 |
in the monetary figures are not to be relied on very much | 0:23 | |
because the monetary figures are extremely erratic. | 0:28 | |
They have been particularly in recent months | 0:31 | |
when the changes in the quantity of money | 0:34 | |
have shown a series of sharp ups and downs. | 0:37 | |
I think the best overall judgment | 0:40 | |
is that monetary tightness in the sense of the behavior | 0:43 | |
of the quantity of money is still continuing, | 0:46 | |
that from December to now, the party of money, M1, | 0:48 | |
the narrow definition is rising at a rate | 0:53 | |
of between two and three percent and year, | 0:55 | |
which is very low. | 0:56 | |
It's a rate, which if continued indefinitely | 0:59 | |
would mean declining prices, | 1:01 | |
not our present five to six percent rise, | 1:03 | |
five percent or so rate of rise in prices. | 1:05 | |
And to the broaden total, also has been rising recently | 1:08 | |
and if we abstract from the large run off of CDs | 1:14 | |
that we've talked about so many times, again, | 1:16 | |
it is rising at about the same rate, as a narrower total. | 1:19 | |
If you look just at the last week, | 1:23 | |
all of these totals showed a substantial rise, | 1:25 | |
they went on the upturn. | 1:29 | |
But, my conjecture is that this is one of those | 1:30 | |
week to week aberrations, movements around a trend, | 1:35 | |
and that there is, as yet, | 1:38 | |
no evidence that there has been any significant change | 1:40 | |
in the very tight stance of monetary policy | 1:43 | |
over the past three months. | 1:45 | |
- | Doctor Friedman, I wonder if you might take a minute, too, | 1:47 |
to comment on the outlook for interest rates | 1:49 | |
at this particular juncture is, as you see them? | 1:53 | |
- | Well, there are several forces at work on interest rates | 1:56 |
and the most interesting aspect of it, | 2:00 | |
I think at the moment, has to do with | 2:03 | |
the fairly long term interest rates, | 2:06 | |
and these, of course, had been rising. | 2:09 | |
Government bond prices, | 2:12 | |
prices of long term government security's are at all, | 2:13 | |
a nearly all time low. | 2:17 | |
In the past few days, or the past week or so, | 2:20 | |
there has been a minor turn around, | 2:22 | |
substantial turn around, not so minor as then, | 2:25 | |
but minor from a long perspective, | 2:27 | |
and the question is, is this a random aberration | 2:29 | |
or is there any reason to expect, give the signal a change. | 2:32 | |
But, I think that's a very interesting question | 2:35 | |
because, in my opinion, | 2:37 | |
the long term trend of interest rates is still up. | 2:38 | |
You still do not have interest rates fully adjusted | 2:41 | |
to the current rates of inflation | 2:43 | |
and as long as people's expectations of inflation | 2:45 | |
are continuing to rise, the long term interest rate is up. | 2:47 | |
On the other hand, I think there's a substantial chance | 2:50 | |
that you may have a window | 2:53 | |
in that long term movement of interest rates, | 2:55 | |
that is to say that you many have a temporary period, | 2:57 | |
and by temporary, | 3:00 | |
I mean something like six to eight to 10 months, | 3:01 | |
during which, interest rates will on the whole decline | 3:03 | |
and long term bond prices will rise. | 3:07 | |
The reasons for that are several. | 3:09 | |
In the first place, past experience shows | 3:10 | |
that when you institute tight money | 3:13 | |
that is a very slow rate of growth of the quantity of money, | 3:15 | |
while the initial effect is to raise interest rates, | 3:19 | |
after a lag of about six months or so, | 3:22 | |
the effect is to lower interest rates. | 3:24 | |
The reason for that is, | 3:27 | |
that the tight money tends to produce a slowing down | 3:28 | |
in the rate of expenditures, the rate of growth of income, | 3:32 | |
this reduces the demand for loans, | 3:36 | |
this tends to lower, therefore, | 3:37 | |
the pressure on interest rates. | 3:40 | |
And if you took the usual lag, the usual six months period, | 3:44 | |
it's a little early for that to happen | 3:47 | |
because a turn in monetary policy came, say in December, | 3:49 | |
this would ordinarily be expected to produce | 3:52 | |
a turn in interest rates in something, like, about May. | 3:54 | |
But, as I've emphasized repeatedly, | 3:57 | |
there is no absolutely mechanical fixed relationship. | 3:59 | |
What's one time six months, | 4:03 | |
may another time be eight months, nine months, | 4:04 | |
another time three or four months, | 4:06 | |
and I think there are some reasons to suppose | 4:07 | |
that the lag might be abnormally short this time. | 4:10 | |
In the first place, there was a widespread recognition | 4:12 | |
all of a sudden, so to speak | 4:18 | |
and the inflation area possibilities | 4:19 | |
and their effects on interest rates | 4:21 | |
which may have lead the market to over-discount | 4:22 | |
the inflationary possibilities | 4:25 | |
from a short run point of view, | 4:26 | |
not from a long run point of view. | 4:28 | |
In the second place, the enormous shift | 4:29 | |
in the government budget | 4:31 | |
from large deficit to a surplus | 4:32 | |
in the first half of this year, | 4:36 | |
and the prospects of further surpluses, | 4:38 | |
introduce another factor tending to make | 4:41 | |
interest rates come down. | 4:43 | |
So, it might well be that these factors would mean | 4:44 | |
that the present turn in interest rates | 4:47 | |
are the turn, is the turn to be expected | 4:49 | |
but coming a little earlier than usual, | 4:52 | |
perhaps a month or two. | 4:54 | |
If this is the case, then the question, | 4:56 | |
the next question is, | 4:58 | |
how long will a decline in interest rates continue? | 4:59 | |
This depends partly on how long tight money in continued. | 5:02 | |
Suppose for a moment that you start getting | 5:06 | |
a slow down in business in the second half of this year, | 5:09 | |
as you would expect from the tight monetary policy, | 5:12 | |
and suppose as of that time, | 5:15 | |
The Federal Reserve were to ease up somewhat. | 5:17 | |
Well, then you reverse the story. | 5:20 | |
The short run effect of easing up would be | 5:22 | |
to lower interest rates, although it's longer, | 5:24 | |
effects will be to raise it. | 5:27 | |
But for a time, then, you would have the delayed effects | 5:28 | |
of the tight money, working in the same direction | 5:32 | |
as the immediate effects of easing | 5:35 | |
to mean a lower interest rate. | 5:38 | |
So, I would be inclined to argue that, | 5:40 | |
whether the Fed continues tight money | 5:42 | |
or whether it eases up, | 5:44 | |
there will be monetary forces tending to make | 5:46 | |
for falling interest rates for something like | 5:49 | |
the next six, eight, nine months, | 5:52 | |
for whatever the period of tight money is, | 5:54 | |
plus the first period, | 5:55 | |
first four or five months of easier money. | 5:57 | |
That's what leads me to believe that there's a possibility | 6:00 | |
of a window opening up in this long term trend, | 6:03 | |
however I should emphasize that while monetary factors | 6:07 | |
are important for interest rates, | 6:10 | |
they are not the only factor affecting interest rates. | 6:11 | |
All sorts of other things that are in, | 6:15 | |
such as the demand for capital funds | 6:16 | |
on the part of enterprises, | 6:19 | |
changes in the government, | 6:21 | |
government's demand on the markets, | 6:24 | |
changes in people's expectations about the future, | 6:27 | |
what might happen to Vietnam war and so on. | 6:29 | |
So, I am not trying to say that there is anything | 6:31 | |
like a certainty in this, but only that it looks like | 6:34 | |
a pretty good probability. | 6:36 | |
- | Now, Doctor, would it be relevant at this point | 6:39 |
to mention President Nixon's budget statement | 6:41 | |
of the other day? | 6:44 | |
His proposal to produce a surplus of $5.8 billion, | 6:45 | |
does that have a bearing on the outlook? | 6:50 | |
- | Yes, it certainly does have a bearing, | 6:52 |
and as my listeners know now, | 6:54 | |
I do not believe that such a move | 6:57 | |
has any very important implications | 7:00 | |
for the inflationary pressures | 7:03 | |
because government surplus will be, in general, | 7:05 | |
deflationary only if it produces a tighter monetary policy | 7:10 | |
that what otherwise exists. | 7:14 | |
However, I do believe that it has | 7:17 | |
some implications for interest rates. | 7:19 | |
If the government generates a larger surplus, | 7:21 | |
that it otherwise would have, | 7:23 | |
that will mean that the government | 7:26 | |
will be providing funds to the market. | 7:27 | |
We'll essentially be retiring debt, | 7:29 | |
this will tend to mean an addition to the supply | 7:32 | |
of loanable funds, which will tend to other things | 7:34 | |
the same to reduce interest rates. | 7:36 | |
And with a change of the size that's under discussion, | 7:37 | |
a change from a one or two billion surplus | 7:42 | |
to a five or six billion dollar surplus, | 7:44 | |
that's in quantitative magnitude a very small change, | 7:46 | |
and I do not blame that a change of that size | 7:50 | |
would have enough of an effect on interest rates | 7:54 | |
to be a very important factor, here after all. | 7:56 | |
We had a switch in the government budget | 7:58 | |
from something like an annual deficit | 8:00 | |
in the order of $20 billion to essentially a zero deficit. | 8:02 | |
And that has had some effect, | 8:06 | |
but a small effect interest rates. | 8:08 | |
That did not prevent the other forces | 8:10 | |
from raising interest rates. | 8:13 | |
Judged in that context, | 8:15 | |
I think a $2 or $3 billion | 8:17 | |
change in the government surplus is not gonna be, | 8:18 | |
going to be a major factor affecting interest rates. | 8:21 | |
From my point of view, the main, | 8:23 | |
my main reaction to the President's budget message | 8:27 | |
is connected less with interest rates | 8:31 | |
and less with inflation that it is with the problem | 8:34 | |
that seems, to me, far more basic. | 8:37 | |
Namely, what fraction of the nation's income | 8:39 | |
is being spent by the government? | 8:41 | |
And I welcome very much the initiative | 8:43 | |
taken by President Nixon, since it is a first real sign | 8:46 | |
of a concerted effort to slow down | 8:50 | |
the rate of growth of government spending, | 8:53 | |
which in turn would enable us to reduce taxes, | 8:55 | |
would enable us to spend a larger fraction | 8:58 | |
of our money ourselves instead | 9:00 | |
of sending it off to Washington. | 9:02 | |
Right now, we are continuing this send, | 9:03 | |
not far from one dollar in every four | 9:06 | |
of income that we generate, | 9:09 | |
not far from one dollar in every four | 9:11 | |
is going to Washington and I continue to believe | 9:13 | |
that we're not getting our money's worth | 9:15 | |
for what we are sending, | 9:17 | |
and that, therefore, we would, all of us, | 9:18 | |
be better off if we could cut down | 9:20 | |
on the level of government spending | 9:23 | |
and it's from that point of view | 9:24 | |
that President Nixon's actions seems, | 9:25 | |
to me, highly desirable. | 9:28 | |
I should, in all candor aside, | 9:30 | |
that what I regard as a mistake in belief, | 9:33 | |
namely the belief that this is | 9:36 | |
a strong anti-inflationary device, | 9:37 | |
undoubtedly contributes to the political possibility | 9:39 | |
of achieving this result. | 9:43 | |
I don't like that. | 9:47 | |
It's, I hate to say, a virtue come out of error as it is. | 9:48 | |
(laughs) | 9:52 | |
But, in this case, that particular error | 9:53 | |
is certainly having some favorable effects. | 9:55 | |
- | It's interesting. | 9:57 |
You mentioned a moment ago, | 9:59 | |
among the factors affecting the economic future | 10:00 | |
as being the developments in Vietnam, | 10:05 | |
and of course, there are currently all sorts of rumors | 10:08 | |
about secret talks perhaps bringing peace closer. | 10:12 | |
Particularly these rumors flourish in Wall Street | 10:16 | |
and they have their day to day effects | 10:19 | |
on the fluctuations in the stock market, | 10:22 | |
but I wonder if you would comment, Doctor Friedman, | 10:24 | |
on the likely effect of peace | 10:26 | |
in Vietnam on the stock market? | 10:30 | |
- | Well, it certainly is true, that rumors flourish, | 10:32 |
whatever else, Wall Street, and they generate, | 10:36 | |
it certainly generates rumors. | 10:38 | |
- | It sure does. | |
- | And I know that there's the widespread discussion | 10:41 |
of the possibility of bringing 50,000 troupes | 10:44 | |
back from Vietnam, regardless of what else happens | 10:48 | |
is perhaps the rumor that is most widespread | 10:52 | |
in Wall Street at the moment. | 10:55 | |
Yeah, but it's interesting to speculate | 10:57 | |
on what affect that could or should have. | 11:00 | |
Instead of talking about it in terms | 11:03 | |
of the 50,000 troupe return, | 11:05 | |
it's easier to take the more extreme case | 11:07 | |
and say, let's supposed that tomorrow or next week, | 11:09 | |
it was announced that a deal had been signed | 11:15 | |
between the US and the North Vietnam | 11:17 | |
and that there was really gonna be | 11:20 | |
a real honest to goodness peace, | 11:22 | |
which was going to enable us within the next two years | 11:23 | |
to withdraw three or four hundred thousand men, | 11:25 | |
or almost all of our men. | 11:27 | |
That ought to have an effect in the same direction, | 11:29 | |
but of much greater magnitude | 11:32 | |
than withdrawing 50,000 troupes. | 11:35 | |
And so, it's easier in a way, to see the direction of effect | 11:37 | |
of the smaller change if you look at the bigger change, | 11:41 | |
which is easier to make as you measure. | 11:43 | |
Now, here there are a number of different cross currents. | 11:46 | |
One thing that's fascinating to me, always, | 11:50 | |
is that the market likes certainty. | 11:53 | |
It's a strange thing, the people who are operating | 11:57 | |
in Wall Street are mostly people | 11:59 | |
who make their living out of uncertainty. | 12:00 | |
They're the, as it were, the gamblers and the plungers. | 12:03 | |
- | Yeah. | 12:05 |
- | And yet if you look at the behavior of the market, | 12:06 |
whenever there is introduced any uncertainty | 12:09 | |
into the world, the market tends to fall, | 12:12 | |
when things clear up, the market tends to rise. | 12:14 | |
So, the market obviously likes uncertainty. | 12:17 | |
- | Like certainty. | 12:22 |
- | Like certainty. | |
Thank you, I got myself backwards, like certainty. | 12:23 | |
The example of that that has always impressed me the most | 12:26 | |
is what the market did on the outbreak of war in Europe | 12:28 | |
in the summer of 1914, and again in the fall of 1939. | 12:31 | |
On both of these occasions, the outbreak of war in Europe | 12:37 | |
caused a decline in the market. | 12:40 | |
Now, looking back in retrospect, it seems insane. | 12:42 | |
You say to yourself, "Well, surely, the war | 12:45 | |
"was a factor that produced substantially inflation. | 12:47 | |
"Inflation you would expect to raise phenomenal | 12:51 | |
"prices of stocks. | 12:53 | |
- | Yeah. | |
- | "And yet, the stock market fell." | 12:55 |
well, you can say, maybe you can understand it | 12:57 | |
in July 1914, because at that time, | 12:59 | |
people weren't sophisticated, | 13:02 | |
there hadn't been a major war. | 13:03 | |
At least since the US Civil War in this country | 13:06 | |
and in Europe since the Napoleonic Wars, | 13:08 | |
essentially earlier. | 13:10 | |
And so you might say people were unsophisticated. | 13:11 | |
But, after the experience of World War I, | 13:14 | |
when you had widespread inflation as a result | 13:16 | |
of the war, when you had prices of stocks rise | 13:18 | |
drastically and substantially, | 13:21 | |
you might expect that the outbreak of war the second time, | 13:23 | |
in 1939, would have been inflationary, | 13:25 | |
but it wasn't and I think the fundamental reason | 13:29 | |
is because it introduces a great deal of uncertainty | 13:31 | |
about the future and although some of that uncertainty | 13:35 | |
is in a direction which promises much higher prices, | 13:38 | |
other aspects of that uncertainty | 13:41 | |
are in the other direction. | 13:43 | |
Well, from this point of view, | 13:44 | |
the announcement that peace had been achieved | 13:46 | |
would undoubtedly be greeted by the market | 13:51 | |
as adding to certainty, making the future more certain. | 13:54 | |
I'm not sure that's right. | 13:57 | |
That's not necessarily a valid judgment. | 14:00 | |
The terms on which, if there is a deal, | 14:02 | |
the terms of the deal may well involve | 14:04 | |
making the future more uncertain rather than less uncertain. | 14:07 | |
It isn't clear that any kind of a deal | 14:10 | |
is a good thing from the point of view | 14:12 | |
of the future peace of the world. | 14:13 | |
But, it seems to me, almost certain, | 14:17 | |
that the market would interpret the signing of a deal | 14:20 | |
as a fact of producing certainty | 14:25 | |
and that thing by itself, | 14:27 | |
which certainly tend to raise stock prices, | 14:29 | |
it will tend, that is, if I may put it in this way, | 14:31 | |
to raise the prices earning ratio | 14:34 | |
that people at the market would accept as normal. | 14:37 | |
Now, beyond this, the effects are much more | 14:41 | |
difficult to say. | 14:44 | |
So far as one factor that people emphasize | 14:47 | |
is that either peace on the one hand | 14:50 | |
or the withdrawal of troupes | 14:52 | |
would enable government expenditures to be reduced, | 14:54 | |
would thus reduce from this point of view | 14:56 | |
the pressure on, of inflation. | 14:59 | |
Well, any effects of this kind | 15:01 | |
are going to be very small from this source. | 15:03 | |
A reduction of 50,000 troupes would hardly make a dent, | 15:05 | |
the armed forces claim that they are postponing | 15:10 | |
all sorts of other expenditures, | 15:13 | |
that they are running down inventories, | 15:14 | |
it would be very easy indeed for them to absorb | 15:16 | |
any saving and funds from that source | 15:19 | |
and other aspects of the budget. | 15:21 | |
The great cry all over, not one which I share | 15:24 | |
but one which has to be regarded | 15:26 | |
as having great political force | 15:28 | |
is that is military expenditures go down, | 15:31 | |
there are the alleged pressing needs of the cities | 15:33 | |
and of other sources, so that it's almost certain, | 15:36 | |
it seems to me, that the effect of peace in Vietnam | 15:39 | |
would not be very much of a reduction | 15:42 | |
in government spending. | 15:45 | |
Beyond then, even if it did have an effect | 15:48 | |
on government spending, | 15:53 | |
even if I did have an effect on the level of taxes, | 15:54 | |
it's not clear why that would be. | 15:56 | |
That would be expansionary to the market | 15:58 | |
if it reduced corporate taxes | 16:00 | |
which left profits after taxes higher. | 16:01 | |
But, any effects in that direction, | 16:04 | |
it seems to me are very problematical, indeed. | 16:05 | |
And there's another effect of a very different kind | 16:08 | |
that I think has not been given much attention, | 16:10 | |
this is a kind of an indirect political effect. | 16:13 | |
One of the problems on the part of administration | 16:16 | |
of maintaining a tight posture | 16:19 | |
of a strong, anti-inflationary posture, | 16:21 | |
is it in so far as this has the unintended affect | 16:25 | |
of raising unemployment. | 16:28 | |
It makes it politically very difficult | 16:30 | |
to maintain, political. | 16:31 | |
There'll be strong political pressures to ease up. | 16:33 | |
One effect of a peace over in Vietnam | 16:36 | |
would undoubtedly be enormously to enhance | 16:38 | |
the popularity of the present administration. | 16:41 | |
- | Yes, yes. | 16:43 |
- | It's hard to believe that it could have any other effect. | 16:45 |
But that would mean that it would be politically feasible | 16:47 | |
for the administration to maintain a tight economic posture | 16:52 | |
longer than it otherwise was. | 16:56 | |
And thus, I think the most important implication | 16:58 | |
for inflation from a peace settlement | 17:01 | |
is not the direct effect on the budget at all | 17:04 | |
but this indirect political effect | 17:07 | |
which would make it politically feasible | 17:08 | |
and desirable to take greater risks in the direction | 17:11 | |
of unemployment in order, ready to stop the inflation. | 17:14 | |
Now, from that point of view, | 17:17 | |
that move is bullish for stocks | 17:19 | |
in terms of their real value in the long run | 17:22 | |
if we look forward five or 10 years, or more. | 17:26 | |
Because I believe that the health of this economy | 17:28 | |
will be far greater if we can maintain | 17:31 | |
a noninflationary expansion | 17:33 | |
if we have to resort to inflation. | 17:35 | |
But, in terms, not of the real value, | 17:38 | |
not of the value of stocks in terms of what they'll buy, | 17:40 | |
but in terms of the dollar value of stuff, | 17:42 | |
that prospect is bearish in the short run | 17:45 | |
because the short run effect of a tighter posture | 17:49 | |
will be tighter money | 17:51 | |
or a longer period of relatively tight money, | 17:53 | |
which will be a longer period | 17:57 | |
of relatively slow demands for capital good | 17:59 | |
and for loanable funds and so on. | 18:01 | |
So I think the affects of that | 18:04 | |
would, in the short run, be bearish. | 18:06 | |
So if you put these things together, | 18:08 | |
it doesn't seem to me that you have | 18:10 | |
any clear prediction about effect of a break out of peace. | 18:11 | |
On the one hand, to summarize, it would through, | 18:15 | |
increasing certainty would raise a desire | 18:18 | |
to price earnings ratio. | 18:21 | |
On the other hand, through it's short term effects | 18:22 | |
on enabling the anti-inflationary policy | 18:26 | |
to be carried further, it would reduce the earnings | 18:29 | |
to which the price earnings ratio | 18:33 | |
was applied the anticipated earning. | 18:34 | |
It's long run effect, in promising a long run, | 18:36 | |
healthy economy would be bullish. | 18:40 | |
Now, I think it will take the crystal gazers on Wall Street | 18:43 | |
to combine those factors into an unambiguous answer | 18:47 | |
about the affect in the long run on stock market prices. | 18:49 | |
- | That's an interesting commentary, Doctor. | 18:53 |
I noticed in the Wall Street Journal this morning, | 18:56 | |
or very recently, a statement about the federal funds rate | 18:59 | |
going up to, I believe, around 8%. | 19:04 | |
I think this is an area in which, I certainly, | 19:08 | |
and I think many of us could stand a little more education. | 19:10 | |
What is the significance of that? | 19:14 | |
- | Well, a federal funds rate is a very interesting rate | 19:17 |
and it has risen very, very rapidly. | 19:21 | |
The federal funds rate, technically speaking, | 19:25 | |
is the interest rate that one bank pays to another bank | 19:28 | |
in order to acquire from the second bank reserves. | 19:33 | |
Now, what do we mean by that? | 19:37 | |
Each bank in our commercial banking system has deposits | 19:38 | |
at the Federal Reserve System. | 19:42 | |
These deposits are used to satisfy | 19:44 | |
their reserve requirements. | 19:46 | |
If one bank has a larger volume of deposits | 19:49 | |
than it needs to satisfy it's reserve requirements, | 19:52 | |
it can lend that excess to another bank | 19:54 | |
and the other bank can then use it | 19:58 | |
to satisfy it's reserve requirements. | 19:59 | |
That's why it's called federal funds, | 20:02 | |
because it deposits at the Federal Reserve banks. | 20:04 | |
- | I see. | 20:07 |
- | Now, this market is therefore a market between banks, | 20:08 |
it's a market which always comes | 20:12 | |
to a culmination on Wednesday | 20:13 | |
because the settlement period for banks, | 20:15 | |
the day that which they calculate | 20:17 | |
whether they have met reserve requirements in Wednesday. | 20:19 | |
It's, I think a very undesirable thing, | 20:21 | |
but it happens to be the fact. | 20:24 | |
That's why you have this great disturbance | 20:25 | |
on Wednesday in the market. | 20:28 | |
And now, the interesting thing about it is, that it, | 20:30 | |
consider a bank which has a deficit in it's reserves. | 20:35 | |
At the moment, it's required reserves are higher | 20:38 | |
than the reserves it has available. | 20:41 | |
It has the most immediate alternatives, | 20:43 | |
either to borrow federal funds from another bank | 20:47 | |
or to discount at the Federal Reserve Bank, | 20:50 | |
it can take commercial paper to the Federal Reserve Bank | 20:52 | |
and borrow from the Federal Reserve Bank. | 20:54 | |
The Federal Reserve discount rate, | 20:56 | |
as you know, was raised from 5.5% recently to 6%. | 20:58 | |
- | Yes. | 21:02 |
- | So, now here is the case. | 21:03 |
A bank can meet it's reserve deficit by borrowing | 21:04 | |
from the Federal Reserve Bank at 6% | 21:07 | |
or by borrowing on the federal funds market. | 21:09 | |
How can the rate on federal funds ever be higher than 6%, | 21:12 | |
you will ask. | 21:15 | |
As yet, here it is, 8%. | 21:16 | |
Well, the answer is, that the Federal Reserve System | 21:18 | |
has long imposed the idea and the tradition | 21:22 | |
that banks should not borrow from the Federal Reserve | 21:26 | |
on a continuing basis. | 21:31 | |
Borrowing is a privilege and not a right, | 21:32 | |
and banks are reluctant to resort to the discount window | 21:35 | |
for fear of pressure from the Federal Reserve Bank. | 21:38 | |
I may say, that in itself is an interesting story, | 21:43 | |
I've talked to many Federal Reserve Bank presidents | 21:45 | |
and many commercial bank presidents | 21:47 | |
and I have never really quite been able to understand | 21:49 | |
how this pressure is ever exercised, | 21:51 | |
but it's a very real thing | 21:53 | |
and the fact that it's a real thing is shown | 21:55 | |
by the willingness of banks to pay 2% | 21:57 | |
above the discount rate in order to borrow | 22:00 | |
from other banks instead of in order to borrow at the window | 22:03 | |
at a Federal Reserve Bank. | 22:08 | |
And so, in a fact, the difference between the divergence, | 22:09 | |
between the federal funds rate and the discount rate | 22:14 | |
really measures the extent of reluctance of banks | 22:18 | |
to borrow from the Fed. | 22:21 | |
Now that difference, therefore, | 22:22 | |
depends on how much they have to borrow. | 22:24 | |
The difference is now, about two percentage points, | 22:26 | |
this is extremely high. | 22:29 | |
If you look back at the past record, | 22:30 | |
if you go back, for example, to, well, | 22:33 | |
as recently as let's say the fall of last year, | 22:36 | |
September or October. | 22:38 | |
The difference between the federal funds rate | 22:40 | |
and the discount rate was of the order | 22:42 | |
of about a half of one percent | 22:44 | |
or three quarters of one percent. | 22:45 | |
A difference of 2% is very large. | 22:46 | |
Why is the difference so large? | 22:49 | |
Well, the answer comes out very clearly | 22:50 | |
if you look at another number. | 22:52 | |
What has happened to the amount of money | 22:53 | |
which commercial banks are borrowing from the Feds? | 22:56 | |
Well, on average, on balance, commercial banks are now | 22:59 | |
borrowing close $1 billion a year from the Fed. | 23:02 | |
Whereas, if you go back to last September or so, | 23:06 | |
they were borrowing from the Fed in the order | 23:10 | |
of $100 million a year. | 23:11 | |
Well, the more they have to borrow from the Fed, | 23:14 | |
the more they have to search for a bank | 23:17 | |
that has reserves to lend | 23:18 | |
and what you have, in a fact, if I may put it that way, | 23:20 | |
is you have a kind of a game of musical chairs. | 23:23 | |
In which, the banks that are in deficit | 23:26 | |
shove the deficit over on other banks | 23:30 | |
until you find the banks that have the least reluctance | 23:32 | |
to borrow from the Fed. | 23:35 | |
Then those banks borrow the $1 billion | 23:36 | |
and the other banks satisfy their reserve requirements | 23:39 | |
by this shuffling between banks | 23:41 | |
and the 2% is a price that the second group of banks | 23:43 | |
pay the first for undertaking the nasty task | 23:46 | |
of borrowing off the Fed. | 23:48 | |
And how much you have to pay for undertaking | 23:50 | |
this nasty task depends on how high the borrowings are. | 23:52 | |
Now, they're very large, therefore you have to pay a lot. | 23:55 | |
A federal funds market has no great significance | 23:58 | |
outside of that. | 24:02 | |
However, this raises a slightly different question | 24:03 | |
which is closely related to it. | 24:08 | |
You may ask, why is the borrowing so high? | 24:09 | |
- | Yes, indeed. | 24:12 |
- | And the answer is, the borrowing is so high | 24:13 |
for two reasons. | 24:16 | |
It's so high because the Federal Reserve System | 24:17 | |
has decided it shall be high. | 24:18 | |
It is able to be so high because it is, | 24:21 | |
with the present market rates, it is profitable | 24:25 | |
for banks to borrow from the Fed at 6% | 24:29 | |
in order to lend at 7.5%, or 8%, or 8.5%. | 24:31 | |
One of the little known things, that I don't know, | 24:35 | |
that very few people know about | 24:39 | |
is the change that took place | 24:39 | |
in the method of calculating reserve requirements. | 24:42 | |
Last fall, Federal Reserve System instituted the change. | 24:45 | |
Which is kind of fascinating to a student | 24:50 | |
of money and banking, like myself, | 24:53 | |
although it may not be so interesting to the general public, | 24:54 | |
because it changes drastically the precise way | 24:57 | |
in which a monetary policy operates, | 25:00 | |
although it doesn't change the long run | 25:02 | |
possibilities in monetary policy. | 25:04 | |
This change had to do with the way in which commercial banks | 25:06 | |
calculate their required reserves. | 25:09 | |
As you know, a commercial bank, which is a member | 25:12 | |
of the Federal Reserve System, as most of them are, | 25:17 | |
has to satisfy certain reserve requirements. | 25:20 | |
These reserve requirements are expressed | 25:22 | |
as a percentage of deposits. | 25:24 | |
For every $100 of deposits, a bank has to have an amount | 25:26 | |
of reserves equal to a certain percentage, say $20. | 25:30 | |
That reserve ratio depends on the particular bank and so on. | 25:34 | |
And it's different for time deposits and demand deposits, | 25:38 | |
but for the moment, for our purposes, that's not important. | 25:40 | |
20% is a little high, but it's a simple number. | 25:43 | |
Now, that required reserve of 20% can be held | 25:46 | |
in either of two ways under present law. | 25:50 | |
The bank can hold it as cash in it's vault, | 25:52 | |
as every bank needs to have a certain amount of currency | 25:57 | |
in coin in order to meet the demands of depositors | 26:00 | |
who would like to have some hard coin of the realm. | 26:02 | |
And the rest of it can be held, for the rest, | 26:05 | |
it is held as deposits at the Federal Reserve System | 26:07 | |
and the sum of it's deposits at the Federal Reserve System | 26:10 | |
in it's cash in vault is the amount it has | 26:12 | |
to satisfy required reserves. | 26:15 | |
Now, the question is one of how to calculate. | 26:17 | |
On the one hand, the requirements. | 26:20 | |
And on the other hand, the reserves | 26:23 | |
that satisfy that requirement. | 26:25 | |
Prior to last September, banks had a settlement period, | 26:26 | |
it was a one week period for banks in big cities, | 26:31 | |
in the reserve cities, | 26:34 | |
it was a two week period for country banks. | 26:35 | |
In this period, for this period, | 26:38 | |
let's take the one week period for Chicago Bank. | 26:41 | |
The bank would calculate the average deposits | 26:46 | |
during that week. | 26:48 | |
The average amount, that would determine | 26:50 | |
it's required reserves. | 26:53 | |
It would calculate it's average federal reserves deposits | 26:54 | |
for that week and it's average flow of cash, | 26:57 | |
that would determine how much it had to satisfy it. | 27:00 | |
The important point is that both actual reserves | 27:02 | |
and required reserves were calculated for the same week. | 27:04 | |
- | I see. | 27:08 |
- | Now, in September, the Federal Reserve instituted | 27:09 |
a new system of requiring, which separates the dates | 27:12 | |
for which these two things are calculated. | 27:16 | |
If you are Chicago Bank now, you calculate | 27:18 | |
your required reserves for this week, | 27:22 | |
are based on average deposits two weeks ago. | 27:25 | |
Take what you had in deposits two weeks ago, your average. | 27:28 | |
Your actual reserves are a mixture | 27:32 | |
of what you have in cash two weeks ago | 27:34 | |
and what you have in deposits this week. | 27:37 | |
So, you count today, in calculating both required reserves, | 27:40 | |
in calculating required reserves, | 27:44 | |
your average deposit two weeks ago, | 27:45 | |
and calculating actual reserves, | 27:47 | |
you count average cash in vault two weeks ago. | 27:48 | |
And then, you can see that that determines | 27:52 | |
how much you need to have in deposits | 27:56 | |
at the bank this week. | 27:57 | |
And then you determine your actual reserves this week. | 27:59 | |
Now, the reason the Fed made that change | 28:02 | |
was, in order to reduce the uncertainty | 28:05 | |
which banks have about how much reserves they require. | 28:09 | |
It was an honor to make it easier for them | 28:13 | |
to calculate reserves. | 28:17 | |
And it has made it easier for them to calculate reserves. | 28:18 | |
Banks now have no uncertainty about | 28:20 | |
what their required reserves will be. | 28:22 | |
They're only uncertainty is about | 28:24 | |
what their actual reserves are. | 28:25 | |
And this is showing up very clearly in the figures, | 28:27 | |
whereas before September, banks on the average | 28:30 | |
used to carry between $300 and $400 million | 28:32 | |
of excess reserves on the average of reserves, | 28:34 | |
over and above the amount they needed. | 28:36 | |
That has been cut down to something like | 28:38 | |
about $200 million now | 28:40 | |
because now they have less uncertainty about it. | 28:41 | |
But the other affect of it has been that it has | 28:44 | |
loosened links in a certain sense | 28:47 | |
between Federal Reserve action and what the banks can do. | 28:49 | |
The banks, this week, by what they do this week | 28:54 | |
cannot change their required reserves. | 28:56 | |
It used to be under the old system, | 28:58 | |
that if banks saw that they were letting into trouble | 29:00 | |
and they didn't have enough reserves, | 29:03 | |
they could try to call loans | 29:05 | |
and acquire reserves in this way. | 29:07 | |
This would transfer funds from one bank to another, | 29:09 | |
but for the system as a whole, | 29:12 | |
they would also reduce the amount of deposits outstanding | 29:13 | |
and thus reduce required reserves. | 29:16 | |
But now that's out. | 29:18 | |
Nothing that a bank does this week | 29:19 | |
can, for the system as a whole, affect required reserves. | 29:22 | |
It doesn't look that way to each bank. | 29:24 | |
Any one bank itself will say, | 29:26 | |
"Well, if I sell a bill or call a note, | 29:28 | |
"I will be able to add to my reserves." | 29:33 | |
But he only does it at the expense of the system. | 29:35 | |
I see our time is running out and won't be able, really, | 29:37 | |
to spell out the rest of this, | 29:40 | |
what to me, is a fascinating topic. | 29:41 | |
Let me only briefly say, and maybe we can resume this, | 29:44 | |
and just cut it out later. | 29:47 | |
Let me only briefly say that the fact of this has been, | 29:48 | |
first to introduce an element of short term erraticism, | 29:53 | |
ups and downs and you see these figures fluctuate | 29:57 | |
much more from week to week that they did before. | 29:59 | |
And second of all, to enable to the Federal Reserve System | 30:01 | |
to determine almost precisely | 30:04 | |
the volume of borrowing outstanding. | 30:07 | |
The text books all used to say that borrowing | 30:09 | |
was at the discretion of the bank, | 30:11 | |
it's not longer true, as you now have a set | 30:13 | |
of Federal Reserve operates essentially through borrowing. | 30:16 | |
If it wants to induce banks to contrive | 30:19 | |
and it forces them to borrow more, | 30:23 | |
in the hope that this will lead on the change | 30:24 | |
in their policy two weeks from now, | 30:26 | |
see right now, the thing that gives the system stability | 30:29 | |
is that banks look ahead a little bit beyond | 30:35 | |
their present day, they look ahead two weeks from now. | 30:38 | |
And as I say, we're gonna have to stop that, | 30:40 | |
but maybe we can develop it further next time. | 30:42 | |
- | I hope we can. | 30:45 |
Thank you, Doctor Friedman. | 30:45 | |
If your listeners or subscribers would like to | 30:47 | |
suggest questions or subjects | 30:49 | |
to be discussed on future tapes, | 30:51 | |
I hope they will write to | 30:53 | |
Instructional Dynamics Incorporated, | 30:55 | |
166 East Superior Street, Chicago, Illinois, 60611. | 30:58 | |
Send in your suggestions. | 31:04 | |
Doctor Friedman and I will be talking | 31:05 | |
with you again next week. | 31:07 |
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