Regional President Speech

D I S C O U N T P O L I C Y A N D T H E D I S C O U N T R A T E Reprinted from the Annual Report Issue of the BUSINESS REVIEW, January, 1959 FXIDXIBJLli R B S E X I V X ] B i O T K OX* P H I I . A D E L P H I A Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ?, .n pi r- ;•« i/“» r;;'\ ir.jfia ’ iu ‘-¿a la u '•¿X&" A ii L.a a -; r k'-jn rv, r-r| Li Li 'ft ii-3 In 1958, member-bank borrowing from the Re­ of supporting the prices of Government securi­ serve Banks declined as conditions in the money ties, particularly the % per cent rate on Treasury market became easier. Daily average borrowings bills, gave member banks ready access to Reserve reached a low of about $100 million in July, and Bank credit. Thus, for almost two decades, little then rose as business activity improved and the use was made of the discount window. money market tightened. There were five changes The importance of discount policy and the dis­ in the discount rate— three reductions in the first count rate re-emerged following termination in half and two increases in the latter part of the year. 1951 of the policy of supporting the prices of Discount policy refers to the conditions govern­ Government securities. Member banks turned to ing discounting and borrowing from the Reserve the discount window in increasing numbers to Banks. It establishes the framework within which obtain funds to cover reserve deficiences. The dis­ member banks may ha^e access to Reserve Bank count rate regained a position of importance as credit. The discount rate is a means of influenc­ an instrument of monetary policy, although not ing the willingness of member banks to use the the preeminence of earlier years. access to Reserve Bank credit afforded them by The revival of interest in discount policy and discount policy. the discount rate has stimulated questions as to Both discount policy and the discount rate their significance and as to their use. This article played prominent roles in the early history of the deals with three related questions: (1) Why do Federal Reserve System. Their importance waned member banks sometimes borrow from the Re­ in the thirties, however, as an inflow of gold and serve Bank? (2) When is borrowing from the a weak demand for credit resulted in banks accu­ Reserve Bank appropriate and when is it inap­ mulating large excess reserves. During World propriate? (3) What are the effects of a change War 11 and the early postwar period, the policy in the discount rate? 16 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis WHY MEMBER BANKS NEED TO BORROW crease in the reserve balance of the receiving bank. Business firms and other depositors with­ We all have the problem of keeping enough cash draw cash to meet payrolls and other needs. on hand or having ready access to cash sufficient United States Treasury receipts and expenditures, to meet current payments. Sometimes cash re­ which nowadays are in large volume, constantly ceipts exceed, at other times fall short of expenses. shift funds among banks. These are only a few To be in a position to meet expenses, therefore, of the many transactions that result in daily we have to accumulate funds when receipts are changes in a bank’s reserve balance and the vol­ larger than payments or borrow when our pay­ ume of its deposits against which the reserve ments are larger than receipts. is held. As a result, a bank’s reserve position— Most individuals and business firms turn to whether in excess or below the legal requirement commercial banks or to other financial institu­ — is constantly changing. tions to balance out these short-run fluctuations Even though many factors affect a bank’s re­ in receipts and payments. The process of balanc­ serve position, certain patterns of behavior are ing short-run changes in receipts and expendi­ frequently discernible. First, most banks experi­ tures thus tends to converge on commercial banks. ence sudden irregular shifts of only one or a few days duration. A bank may have a reserve defi­ Factors affecting a bank's reserve position ciency one day, an excess the next. It is extremely Commercial banks are required by law to main­ difficult to anticipate these day-to-day changes tain a reserve equivalent to a prescribed minimum with reasonable accuracy. Second, seasonal trends percentage of their deposits. Member banks of the frequently result in an inflow of funds in one Federal Reserve System are required to hold this season and a persistent drain on reserves in minimum reserve in the form of deposits in a another. Banks in agricultural areas, for example, Reserve Bank. usually have a substantial inflow of funds during A great variety of transactions affects a mem­ the crop-marketing season. They lose funds as ber bank’s reserve balance and the deposits farmers draw on their deposit balances for living against which the reserve is held. Many checks expenses and the costs of producing next year’s are deposited in banks other than the banks on crop. In resort areas, banks gain funds during the which the checks are drawn. Banks send these vacation season and lose funds in the off-season. checks drawn on other banks through regular Third, a bank’s reserve position may reflect clearing channels for payment. If a bank has an longer-term trends arising from its own policies. adverse clearing balance, it loses funds to other If a bank is expanding its loans and investments banks; if the balance is favorable, it gains funds more rapidly than other banks in its market area, from other banks. A corporate depositor may it is likely to suffer a persistent loss of funds authorize its bank to transfer a large sum to a through clearings. Banks expanding less rapidly, bank in another city where additional funds are on the other hanil, tend to gain reserves. Finally, needed to meet expenses. The transfer, made over regional differences in the rate of economic ex­ the Federal Reserve’s wire transfer facilities, pansion and growth cause some banks to gain results in an immediate reduction in the sending deposits and reserves, others to lose them. Crop bank’s reserve balance and a corresponding in­ failure, floods, or some other form of disaster 17 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis may drastically curtail economic activity and put statement the following day. By comparing the local banks under severe reserve pressure. amount of reserve which Would be required on the basis of net demand deposits and time deposits Estimating the reserve position at the opening of business w ith the actual reserve Bankers have a profit incentive for keeping close balance at the close of business on the same day, tab on their reserve positions. A reserve balance a bank can determine with reasonable accuracy in excess of the legal requirement earns no whether it is running a deficient or an excess income; a deficiency incurs a penalty. reserve position. Certain features of the legal reserve require­ Some member banks keep in closer touch with ment are especially important in managing a their reserve position than others. Large banks bank’s reserve position. A member bank is not in financial centers watch their positions very required to maintain a reserve balance equal to closely to avoid having excess reserves that earn the specified percentages of its demand and time no income. They prepare estimates, as early in deposits every day. The requirement is in terms the morning as possible, of their reserve positions of averages over the computation period— of a for the day. Most of them, on the basis of these bank’s reserve balance each day and of daily estimates, make daily adjustments in their reserve totals of its demand and time deposits. (The positions, putting an excess into some income- reserve computation period is one week for mem­ producing asset or acquiring funds to cover a ber banks in central reserve and reserve cities, deficiency. and semi-monthly for country member banks.) These large banks usually try to avoid having The reserve balance may drop below the required excess reserves. Their percentage of excess to minimum for one or a few days, provided excess required reserves is quite small. Smaller banks reserves on other days are sufficient to offset the hold much larger percentages of excess to deficits. required reserves but the dollar amounts of their Another point is that certain deductions excesses are typically small. Small sums cannot be are allowed in computing the legal requirement NUMBER OF CENTS EXCESS PER DOLLAR against demand deposits. The two principal OF REQUIRED RESERVES, BY SIZE GROUPS deductions are cash items in the process of col­ OF MEMBER BANKS, THIRD DISTRICT First Half November 1958 lection and demand balances with other banks in CENTS the United States. The minimum percentage \ V*; ' requirement is against net demand deposits, after 2-1 - deductions, not gross demand deposits. 20 - To facilitate estimating its reserve position, each member bank is supplied with a form with columns for entering total net demand deposits and total time deposits each day during the re­ serve computation period. The Reserve Bank sends each member bank a daily statement show­ ing its actual reserve balance at the close of busi­ ALL * 5 OR *510 * 10 25 * 25 50 ♦ 50 100 *100 AND LESS ÛVFR ness that day. Most member banks receive this ’Deposits in Millions of Dollars 18 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis employed in the money market so easily and no risk of price change as in the case of short­ profitably as large amounts. It is not so conven­ term securities. Although the mechanics vary ient for many of the small banks located some widely, the essence of a federal funds transaction distance from a money market to make daily is that a bank short of reserves borrows the excess adjustments in their reserve positions. For these reserves of another bank, agreeing to pay a spe­ and other reasons, officials of many small banks cified rate of interest. maintain a cushion of excess reserves to avoid a Because of its advantages for very short-term deficiency. adjustments, the federal funds market has become widely used by the larger banks in financial cen­ Alternative media for adjusting reserves ters to make daily adjustments in their reserve Banks can use several methods to adjust their positions. The daily volume of transactions ranges reserves. They can invest excess reserves in Treas­ from about one-half billion to over a billion dol­ ury bills, commercial paper, or other securities; lars. The typical unit of trading is $1 million; they can lend them temporarily to another bank however, transactions for smaller amounts are or a securities dealer, or deposit them with a cor­ frequently made, especially in periods of tight respondent bank. To meet a reserve deficiency, money. Banks with only small excesses or defi­ a bank may liquidate securities, borrow the excess ciencies are thus handicapped in using the federal reserves of other banks, draw on its correspond­ funds market. ent balance, or borrow from a Reserve Bank. Member banks can borrow from a Reserve Bank preference is influenced by a number of Bank to meet temporary reserve deficiencies, factors. Treasury bills, other short-term securities, using subsequent excesses to repay the indebted­ and commercial paper are commonly used as ness; however, the Reserve Bank is not a profit­ secondary reserves. Excess reserves so invested able outlet for excess funds because excess reserve earn income and yet can readily be converted balances earn no income. into cash with a minimum risk of capital loss Relative cost is a significant influence in choos­ when additional funds are needed. Short-term ing among these reserve adjustment media. Banks paper and securities are especially suitable for naturally prefer to obtain funds as cheaply as meeting seasonal and other longer-term reserve possible. Normally, they will not borrow federal adjustments. Outright purchases and sales are not funds if they can borrow from the Reserve Bank suitable, however, for daily or very short-term at a cheaper rate. This explains why the federal adjustments. For such adjustments, a bank may funds rate rarely rises above the discount rate. need to buy one day and sell the next. The spread Other influences are the attitude of bank manage­ between buying and selling prices absorbs most ment toward borrowing and toward such factors or all of the interest earned unless the securities as the convenience of the different methods. are held at least two or three days. The federal funds market— the borrowing and DISCOUNT POLICY lending of excess reserve balances— has advan­ One of the functions of a central bank is to pro­ tages for daily reserve adjustments. The bulk of vide elasticity in a country’s currency and credit these transactions is for one day, and there is to avoid seasonal and other temporary strains and no spread between buying and selling prices and stresses. This means supplying currency and re- 19 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis serves to meet the growing demands and absorb­ is that of regulating the supply, availability, and ing currency and reserves during periods of cost of reserves and credit in such a way as to seasonal slack. help keep the price level stable and to help main­ Open-market operations are used to adjust the tain economic stability at high levels of produc­ supply of reserves to the changing seasonal needs tion and employment. To achieve these objectives, of the economy as a whole. For example, the a central bank must have effective control over Federal Reserve usually purchases Government the volume of reserves it creates. This means that securities in the latter part of the year to supply access to the discount window may have to be reserves absorbed by the outflow of currency into limited; otherwise, the amount of reserves created circulation and other seasonal factors; it reduces would be at the initiative of member banks, not its holdings of Governments in the early part of the central bank. In practice, access to central- the year to absorb some of the reserves created bank credit has usually been limited in two prin­ by the return flow of currency. cipal ways: (a) by establishing certain condi­ The discount window is more effective than tions under which banks can borrow, and (b) by open-market operations for meeting the seasonal changing the discount rate, making it more or reserve needs of particular banks or particular less expensive for them to borrow. regions. Seasonal trends are not uniform for all banks. The peak needs of some banks may occur Historical development during a period of seasonal slack for the economy There has been a number of amendments to the as a whole. Through the discount window, the provisions of the Federal Reserve Act relating to Reserve Banks can supply reserves directly to the discounting and member-bank borrowing from member banks which need them. Another advan­ the Reserve Bank; however, the principal devel­ tage is that the reserves are supplied “with a opments in the philosophy of discount policy can string attached.” Once the temporary need is over, be summarized briefly. the reserves are absorbed as member banks repay The dual nature of the discount function was their indebtedness to the Reserve Banks. recognized in the provisions of the Federal Re­ Another important function of a central bank serve Act relating to the extension of credit to member banks.. To provide the elasticity required BORROWING FROM FEDERAL RESERVE BANK in meeting seasonal and other temporary needs, BY COUNTRY MEMBER BANKS IN AGRICULTURAL AREAS, THIRD DISTRICT the Federal Reserve Banks were given authority Semi-Monthly Average of Daily Figures to discount commercial paper for member banks. MILLIONS $ Access to the discount window was limited, how­ ever, by making only certain types. of paper eligible for discount. Originally, the Federal Reserve Act defined eli­ gible paper as notes, drafts, or bills of exchange maturing within 90 days (except agricultural paper which could have longer maturity) and drawn to provide funds for commercial, indus­ trial, or agricultural purposes. Paper was ineli- 20 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis BORROWING FROM FEDERAL RESERVE BANK The supply of eligible paper had been declining BY COUNTRY MEMBER BANKS IN RESORT and was especially low during the crisis of the AREAS, THIRD DISTRICT early thirties when deposit withdrawals were put­ Semi-Monthly Average of Daily Figures ting a heavy strain on the banks. The scarcity of MILLIONS $ eligible paper severely restricted the capacity of the Reserve Banks to issue Federal Reserve notes and to make discounts and advances to member banks. Finally, it became clear that eligibility requirements did not result automatically in a volume of reserves appropriate for maintaining stable prices and business stability at high levels of production and employment. Current provisions gible for discount if the proceeds were to be used Experience led to significant revisions in the Act for speculative purposes, for fixed investment of which broadened member-bank access to Reserve any kind, or for the purpose of trading in securi­ Bank credit. Member banks may now obtain ties except United States Government securities. credit directly from a Reserve Bank for short In short, the philosophy of discount policy em­ periods by: (a) discounting eligible commercial bodied in the Federal Reserve Act was that the paper maturing in 90 days (except for agricul­ Reserve Banks should extend credit to member tural paper which may have a maturity up to nine banks only for short terms and for commercial, months) ; (b) borrowing on their own notes se­ industrial, and agricultural purposes. It was also cured by eligible paper or Government securities; believed that by confining discounts to eligible or (c) borrowing on their own notes secured by paper, as defined, the quantity of Reserve Bank any other assets satisfactory to the Reserve Bank credit would adjust automatically to the varying but at a rate V2 per cent above the discount rate. needs of commercial and business activities. As a matter of convenience, member banks obtain Experience, especially in the thirties, revealed credit from the Reserve Banks almost entirely by shortcomings in this early philosophy. Eligibility borrowing on their own notes collateraled by requirements proved ineffective in confining Government securities. Reserve Bank credit to certain uses. Member The importance of administering the discount banks discounted or borrowed against eligible window in order to help maintain sound credit paper to meet reserve deficiencies. The type of conditions was also recognized. Borrowing from paper offered was no indication of the use made a Reserve Bank was clearly established as a privi­ or to be made of the proceeds. Actually, discounts lege, not a right. Section 4 as amended states that and advances supplied member banks with addi­ a Reserve Bank may extend to each member bank tional reserves. These reserves might be used for such discounts and advances “as may be safely appropriate or inappropriate purposes. and reasonably made with due regard for claims A second difficulty was that eligibility require­ and demands of other member banks, the ments proved to be unduly restrictive at times. maintenance of sound credit conditions, and the 21 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis accommodation of commerce, industry, and agri­ general principles, however, that serve as guides culture.” in administering Reserve Bank loans and dis­ Furthermore, each Reserve Bank is directed to counts which can be summarized briefly. keep informed as to the general character and Even the most prudently managed bank may amount of loans and investments of its member experience reserve drains for a few days which banks to determine whether undue use is being occasionally reduce its daily average reserve bal­ made of bank credit for speculative purposes or ance below the legal minimum. Borrowing from for any other purpose inconsistent with the main­ the Reserve Bank is one way of meeting these tenance of sound credit conditions. In determin­ short-term reserve deficiencies. Should the defi­ ing whether to grant or refuse credit to a member ciency prove to be for a more extended period, bank, the Reserve Bank shall give consideration borrowing gives the bank time to make such to such information. adjustments in its assets as may be necessary. Finally, a Reserve Bank is to administer the Unusual seasonal requirements are another discount window, as well as its other affairs, case of appropriate borrowing from a Reserve “fairly and impartially and without discrimina­ Bank. Seasonal needs can be pretty well antici­ tion in favor of or against any member bank.” pated and prepared for so long as they conform Authority was given to the Board of Governors to past experience. But deposit losses may be to issue regulations further defining the condi­ exceptionally heavy, loan demands unusually tions under which Reserve Bank credit is to be strong, or both. Secondary reserves may not be extended to member banks. The latest revision sufficient to meet such unexpected seasonal of Regulation A governing member-bank borrow­ requirements. Member banks may rightly turn to ing was made in 1955. The principal change was the discount window for additional funds. to put in a foreword to the regulation a statement There may be occasions when it is appropriate of general principles governing Reserve Bank for a member bank to borrow for a more extended loans and discounts to member banks. period. Sometimes local or national emergencies put severe pressure on banks’ liquid resources. Appropriate borrowing Considerable time may be required to make the Many member banks have been able to manage necessary adjustments and work out a solution. their asset and reserve positions without having It is recognized that in such infrequent and unus­ to borrow from a Reserve Bank. Over one-half of ual situations, borrowing for an extended period the member banks in this district have not bor­ may be appropriate in order that a bank may rowed since 1950. better meet community needs. It is not possible to pinpoint every case in which it is appropriate or inappropriate for a inappropriate borrowing member bank to borrow from the Reserve Bank. Many member banks borrow from a Reserve Bank One of the lessons of experience is that the dis­ only as a last resort. Few attempt to borrow for count window cannot be properly administered inappropriate purposes. Those instances usually by mechanical rules. The conditions and needs arise from misunderstanding of the true function which give rise to borrowing vary. Each must be of the discount window. Final decision as to considered on its own merits. There are certain whether borrowing is inappropriate must take 22 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis into consideration the particular circumstances short maturities assumes the risk of incurring a of the individual borrower. There are certain larger capital loss should the securities have to general types, however, which usually fall in the be liquidated to meet expanding credit demands inappropriate category. or other purposes. The inducement of a higher Borrowing to finance speculative activities— return on longer maturities should be weighed whether in securities, real estate, or commodities against the risk incurred. Extending credit to — is an inappropriate use of Reserve Bank credit. member banks to enable them to meet loan Paper drawn for such purposes has been ineli­ demands without liquidating investments is incon­ gible for discount from the beginning of the sistent with the Federal Reserve’s responsibility System. Such use of Reserve Bank credit is unde­ for “maintaining sound credit conditions.” This sirable from the standpoint of both the individual kind of discount policy would seriously weakeii bank and monetary policy. Commercial bank offi­ efforts to curb inflation during periods of strong cials have long frowned on loans to finance spec­ credit demand. ulative activities. Experience has demonstrated Continuous borrowing, except in an emergency that such loans are risky and all too frequently or some unusual situation, is also inconsistent lead to financial difficulties. Even if safe for the with the principles embodied in the Federal individual lender, Joans for purposes of specula­ Reserve Act. The purpose of the discount window tion have a disruptive influence on the economy. is to make Reserve Bank credit directly available Certainly, supplying member banks with reserves to member banks for temporary needs. Borrow­ to support speculative loans is inconsistent with ing for a short period also gives a bank time to administering the discount window in such a way make such adjustments in its assets and lending as to ‘"maintain sound credit conditions” as pro­ policies as may be required in meeting longer- vided in the Federal Reserve Act. term requirements. Borrowing to finance a member bank’s own Borrowing from the Reserve Bank was never investments is contrary to the spirit of the Federal intended to be a source of capital to supplement Reserve Act. investment is not a short-term, tem­ a bank’s own resources. Even before the Federal porary need which bank management cannot Reserve System w'as formed, continuous borrow­ reasonably anticipate. Borrowing to purchase ing from correspondent banks was frowned upon securities for its own account is, in essence, an because experience had clearly demonstrated that open-market operation conducted at the initia­ a bank with a large debt was in a poor position tive of the member bank instead of the Federal to cope with hard times. Continuous borrowing, Reserve System. Such borrowing, if widely prac­ it should be noted, refers not only to consecutive ticed, would seriously impair Federal Reserve days but also to consecutive reserve periods. A control over the supply of reserves and therefore member bank borrowing $7 million for one day its ability to regulate credit and the money supply increases its daily average reserve balance by the in the interest of price and economic stability. same amount as by borrowing SI million for Similar in principle is borrowing from a seven days. Reserve Bank to avoid liquidating investments at Borrowing to earn a rate differential or to gain a capital loss. Bank management in deciding to a tax advantage are other purposes which are invest surplus funds in longer-term rather than considered inappropriate. 23 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE DISCOUNT RATE The policy of a penalty rate, long adhered to by the Bank of England, is based on the cost effect of Discount policy is designed to promote sound the discount rate. The objective is to keep the dis­ banking practices and to maintain sound credit count rate above the rates received by the bor­ conditions. It establishes the framework within rower on its own loans and investments so that the which member banks have direct access to central bank will be used only as the lender of last Reserve Bank credit. The principles followed in resort. In England this means keeping the Bank administering the discount window do not change rate (the discount rate) above market yields on from recession to boom. Treasury bills and short-term paper, which ac­ The discount rate, however, is one of the prin­ count for the bulk of the assets of the discount cipal tools used in combating inflationary and houses. Commercial banks in need of funds call recessionary tendencies. There are three principal some of their loans to the discount houses, forcing channels through which changes in the discount them to borrow from the Bank of England. The rate may influence the volume of reserves, the discount rates of the Reserve Banks have rarely, cost of credit, and the flow of total spending. if ever, been used as a penalty rate in this sense. The direct effect is to raise or lower the price To serve as a real penalty rate, the discount rate of admission to the discount window. An increase would have to be higher than the rates received by in the discount rate makes it more expensive and member banks on the bulk of their loans and tends to discourage member-bank borrowing; a investments. reduction tends to have the opposite effects. A second and more important channel is the The cost effect of a change in the discount rate influence of the discount rate on the whole struc­ cannot be isolated from other factors influencing ture of market rates. There is a close interrelation­ the volume of member-bank borrowing. Obvi­ ship between the discount rate and short-term ously, an important influence is whether condi­ market rates because the Reserve Banks and the tions are such that banks feel the need for money market are alternative media for adjust­ additional funds. Given such needs, cost is a ing cash and reserve positions. If the discount factor influencing their willingness to borrow rate is above market rates on Treasury bills and from the Reserve Banks. As the discount rate is other short-term securities, there is an incentive increased, the rising cost of borrowed reserves for banks to liquidate short-term investments in­ is an incentive for bankers to screen their loan stead of borrowing from the Reserve Bank. applications more carefully to reduce the need Increased liquidation of short-term securities for borrowing. The discount rate, if raised high tends to push short-term rates up to the discount enough, can be a strong deterrent to obtaining rate. If the discount rate is below market rates, it additional reserves by borrowing from the Re­ is cheaper for member banks to borrow from the serve Banks. On the other hand, a reduction in Reserve Banks than to obtain funds by liquidating the discount rate tends to increase the willingness securities in the market, The availability of of banks to borrow so long as they need addi­ reserves at the discount window at a lower rate, tional reserves. The discount rate is an essential by diminishing the sale of securities, tends to but not in itself an adequate tool for regulating lower short-term rates. The discount rate has the supply of member-bank reserves. little influence on market rates when reserves are 24 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis so plentiful that member banks do not need to Developing recessionary tendencies had created borrow. uncertainty as to the future of business and inter­ Changes in the discount rate, mainly through est rates. The reduction in the discount rate the more direct effect on short-term rates and seemed to remove all doubt that the future course expectations (which will be discussed later) also of interest rates was downward. As a result, influence intermediate and long-term rates. A rise investors and speculators moved promptly to in­ in short-term rates, for example, makes short crease their holdings of Government securities maturities more attractive relative to intermediate and other fixed income obligations. The shift in and longer maturities. As investment funds are expectations was an important reason for the diverted into shorter maturities, intermediate and sharp decline in market rates. long-term rates tend to rise. Thus a change in the The effect on spending and the volume of busi­ discount rate tends to be reflected in the entire ness activity is not so clearly discernible. A reduc­ structure of market rates, although the effect on tion in the discount rate, by inducing expectations the rates of shorter maturities is more direct and of easier money and lower interest rates, may also usually more pronounced. A change in the dis­ result in more favorable anticipations with respect count rate sometimes induces banks to make a to the volume of business and tend to bolster similar change in their rates on customer loans. spending. It may be interpreted, however, as an The effect on market rates is one of the more indication that Federal Reserve officials anticipate important channels through which discount-rate slackening business activity and the initial effect action affects spending. The impact is likely to be on spending may be adverse. Public reaction to a greater on borrowing for capital expenditures change in the discount rate is often capricious. than borrowing for working capital purposes. The effect on expectations, therefore, cannot be When long-term rates are relatively high and the accurately anticipated. bond market is weak, borrowers are more reluc­ The role of the discount rate is such that a tant to float new bond issues to finance capital change does not always represent a change in expenditures. There is a tendency to defer new Federal Reserve credit policy. It may be only a offerings pending a more favorable market. Ris­ technical adjustment to bring the discount rate ing long-term market rates, by making bonds closer into line with market rates as a means of more attractive relative to mortgages, also tend to maintaining the existing degree of restraint or reduce the flow of funds into mortgages. Declin­ ease. If as a result of open-market policy, reserve ing long-term rates, on the other hand, tend to availability relative to credit demands has lifted stimulate the flow of funds into capital expedi- market rates above the discount rate, an increase tures and mortgages. in the latter may be required to maintain the exist­ The effect on expectations is a third channel ing degree of restraint. Otherwise, member banks through which changes in the discount rate may would seek relief from the higher rates by bor­ influence spending and the volume of business rowing at the discount window, thus relieving activity. The public tends to interpret a change in some of the pressure on the market and market the discount rate as a signal of Federal Reserve rates. credit policy. The reduction in the discount rate The close interrelationship between open- in November 1957 was an excellent illustration. market operations and the discount rate is the 25 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis reason use of these two instruments is coordi­ financial transactions which are constantly shift­ nated. In a period of expansion, when the objec­ ing funds among banks. As a means of meeting tive is one of restraint, open-market operations temporary reserve needs, such loans have the may be directed toward supplying less reserves advantages of channeling reserves directly to the than are needed to meet expanding credit banks which need them, and with a string demands, thus forcing member banks to obtain attached. Once the need is over, member banks additional reserves by borrowing. The reluctance repay their indebtedness and the reserves are of many banks to be in debt to the Reserve Bank extinguished. causes them to screen their loan applications more Unlimited access to the discount window would carefully. For maximum effectiveness, however, be inconsistent with maintaining sound credit the discount rate should be kept close to or above conditions and an effective monetary policy. Dis­ market rates. When the objective is easier credit, count policy is designed to afford member banks the effect of reducing the discount rate can be ready access to reserves for temporary and emer­ substantially augmented by supplying enough gency needs but without impairing the ability of reserves through open-market operations to re­ the Federal Reserve to regulate reserves and the duce substantially member-bank indebtedness to money supply in order to help maintain sustain­ the Reserve Banks. able economic growth without inflation or defla­ tion. If it were not for discount policy, the discount rate would probably have to be raised IN CONCLUSION higher — perhaps much higher — in periods of The principles underlying current discount policy strong credit demand to restrict sufficiently the and use of the discount rate developed from many availability of reserves to prevent excessive credit years of experience both here and abroad. The expansion. The result might well be a severe discount window was the primary source of penalty on member banks needing to borrow to reserves, and the discount rate the primary instru­ cover short-term deficiencies which could not ment of monetary policy in the early years of the reasonably be anticipated. Federal Reserve System. Although open-market The discount rate, although not the preeminent operations have since become the principal instru­ tool of the early years of the Federal Reserve ment for regulating the total supply of reserves, System, is an important instrument of monetary the discount window and the discount rate con­ policy. Directly, it operates as a cost, influencing tinue to play significant roles in Federal Reserve somewhat the willingness of member banks to policy. borrow from the Reserve Banks. Indirectly, it Reserve Bank loans to member banks make a affects the structure of market rates. Use of the significant contribution toward smoothing out the discount rate and open-market operations are day-to-day and month-to-month stresses and coordinated because each helps to make the other strains generated by a multitude of business and more effective. 26 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Karl R. Bopp (1958, December 31). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19590101_karl_r_bopp

@misc{wtfs_regional_speeche_19590101_karl_r_bopp,
  author = {Karl R. Bopp},
  title = {Regional President Speech},
  year = {1958},
  month = {Dec},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19590101_karl_r_bopp},
  note = {Retrieved via When the Fed Speaks corpus}
}