§12. Interest Rates and Bank Reserves

That there is a relationship between bank reserves and the rate of bank discount is perhaps self-evident. Every banker and business man is familiar with it. J. P. Nor Edition: current; Page: [445] ton69 found such a correlation and the relationship finds expression in practically every treatment of commercial banking.

This relationship furthermore carries over into the rates fixed on commercial paper. Mr. W. Randolph Burgess70 has made a study of this relationship which he expresses briefly as follows:

"Banks are the custodians of money in this country. When the bankers have much money to lend, money rates tend to be easy; when they have little to lend, money rates tend to be firm. The amount a banker can lend depends upon his reserve position. Therefore, the reserve position of the banks of the country determines short term money rates, and the causes of changes in money rates are to be found in the causes of changes in the reserve position of banks."

Mr. Burgess presents an impressive inductive verification of this theory for the period 1904 to 1909 by comparing the changes in the short term money rate with the changes in the average surplus or deficit in the reserves of New York City Clearing House Association Banks.

The same relationship, Mr. Burgess finds, obtains under the Federal Reserve System between the excess or deficit in reserves of twenty-three New York City Banks and the closing call money rate for intra-week periods between the balancing of the reserves by the Federal Reserve Banks. Over longer periods of time, the relationship is shown by the similarity in the movement of the open Edition: current; Page: [446] market interest rate for prime 4-6 months commercial paper and the average daily bills discounted for member banks by all Federal Reserve Banks.

The Federal Reserve Act requires the pooling of member banks' reserves with the Federal Reserve Banks. These reserves must average the minimum legal requirements and balancing periods are maintained once a week in large cities and twice a month elsewhere. Surplus and deficit reserves are, therefore, impossible for periods of more than two weeks at the very maximum under this system. But the influence of the banks on the money market rates are now effected through borrowings at the Federal Reserve Banks. Thus a period of member banks borrowing corresponds in its relation to the money market to a period of deficit reserves under the National Banking Act, and a period when member banks are paying off their loans at the Reserve Bank corresponds to a period of excess reserves.

A similar correspondence between commercial paper rates and gold reserves is shown by a recent study by Colonel Leonard Ayres, of the Cleveland Trust Company.71

Curiously enough, this well known and sound relationship between bank reserves and interest rates is often confused with the entirely different, generally incorrect, but commonly believed proposition that the rate of interest is high when money in general is scarce, and low when money in general is abundant. The thought seems to be if the rate of interest is called the price of money it is natural to conclude that abundance of money, like abundance of wheat or anything else, makes its price low, while scarcity of money makes its price high.

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But the price of money in the sense of the rate of interest is a very peculiar kind of price. It is, as we know, the deviation from par of the price of present money in terms of future money. It is not very analogous to the price of wheat. The real analogy with the price of wheat is not the rate of interest but the purchasing power of money. In that sense it is perfectly true that the price of money is high or low with its scarcity or abundance. But in the other sense it is not true. Moreover, as we have seen, when the price of money, in the sense of the purchasing power of money, is low, that is, when the price level is high, and when, therefore, presumably the quantity of money is large, we do not then find the rate of interest low, as the theory outlined above requires. On the contrary, we find a high price level associated with a high interest rate.

That short term interest rates vary inversely with bank reserves, however, fits in with our theory of interest as related to real income. A low bank reserve is, among other things, a symptom of a prospective general increase in the income of the community. When business is optimistic, which means when future income looms large, there is an impatient desire to discount that big future and to make it even bigger by investing present income, provided the investment can be financed. Evidently the immediate effect is to increase bank loans and consequently to increase deposits. These results tend to lessen the ratio of bank reserves to liabilities. Thus the banker is led to raise his rate. It seems that the rise merely reflects his reserve situation. But back of this situation is the demand for loans, and back of that something more fundamental—the rising income stream, a period of increasing prosperity, of invention and progress, or of great financing. Edition: current; Page: [448] From these changes, rather than from a merely technical banking situation, come high rates of interest.

Thus the banker registers the effect of the increasing income stream. The reverse situation of descending income stream, lessened opportunity to invest, lessened loans and deposits, tend toward idle reserves and low interest.

Normally the banking function should do little more in relation to the rate of interest than to transmit the effects of the income stream. This would be substantially the case if we had a scientific adjustment of the ultimate source of bankers' reserves, the world's supply of monetary gold. If this were so adjusted as to maintain a constant purchasing power of that gold and so of money units, the banker could be trusted to adjust properly, even if unconsciously, the rates of interest to the income situation of the country.

Unfortunately, we do not yet have such a scientific currency system, but are still exposed to every wind that blows in the gold bullion market. The consequence is that superimposed on the normal credit operations are abnormal ones by which the rate of interest is perverted through the very banking machinery which should make it normal.

Banking thus becomes, in practice, not simply a register of fundamental economic influences, not merely their facilitator, but a most powerful independent influence. Practically, then, the banking machinery often interferes with, rather than transmits, the normal influence of society's income situation. If the gold mines become depleted, gold reserves become inadequate to support the growing inverted pyramid of credit based upon it and required by the expanding income of society. The banker Edition: current; Page: [449] then has no choice, under the law, but to raise his rates in self-defense. The result is a shrinkage of credit when an expansion is needed, a fall of prices and high bank rates at the very time that low money rates of interest are needed. The real rates are then doubly high—high because the money rates are high and still higher because of the appreciation of money.

These maladjustments are largely responsible for the so-called business cycle. When they are serious, not only are the consequences disastrous but there is little then left in the market figures of interest to register the influence of fundamental income conditions.72 The interest rate then registers, rather, a choking or stalling of the banking machinery. In an acute panic, scarcity of money itself has made interest high. Money of any kind brought into the market at such times will relieve the stringency and lower the rate of interest. To relieve the money stringency, the United States has, in times past, poured money into the channels of trade by prepaying interest on bonds, and clearing houses have accomplished it by issuing clearing house certificates.

The establishment of the Federal Reserve System has stabilized prices and interest rates in the United States, although the cataclysm of war in 1914-1921 upset the price level and the normal correspondence between real and money rates of interest as they had never been upset before.

At present, the Federal Reserve System exerts a normalizing influence and seems to be groping to apply the Edition: current; Page: [450] stabilizing principles which for many years have been suggested by Wicksell, Cassel, and other economists.

Even these efforts, while in the end they save us from price convulsions and real-interest convulsions, nevertheless themselves involve a slight interference with the natural effects of the income situation. The rediscount rate, when raised, restricts credit and stops price inflation; and when lowered, liberates credit and stops price deflation. As the effect, in either case, tends to be cumulative as long as the slight artificial raising or lowering is in force, the interference with the normal course of events need only be slight, almost negligible. It would not be surprising if a difference of one half of 1 per cent from an ideally normal rate should prove usually sufficient. Maintained sufficiently long, this deviation from a normal interest rate may prevent a very abnormal deviation in our monetary standard.

Some slight interferences are inherent in any such banking system, not only as an incident to the supremely important function of preventing inflation and deflation, but also as a necessary price to pay for the very existence of a banking system. In order to maintain a liquid condition and to avoid risk of bankruptcy, each bank must occasionally put its loan policy out of line with the ideal requirements of the income situation.

But, as we gradually perfect our banking technique and policies, we shall get closer and closer to a condition in which the rate of interest as a whole will reflect the income influences discussed in this book. The money rate and the real rate will become substantially the same, and any action of the banker which can be called an interference with, rather than a registering of, fundamental economic conditions will become almost negligible.

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