than the prime customers, particularly where usuary statutes are low. Some bank adjustment to tight money is not a mere matter of changing interest rates on loans to customers. Banks became conscious of the need to screen their loans, particularly following the experience of 1966, and many established loan allocation committees to examine lending practices. Some of the considerations in such allocation practices are discussed in an ABA publication entitled "The Banker's Role in Reinforcing Monetary Policy." In general, however, funds flow freely throughout the system and pressures are felt in all markets.

Specific mention should be made of the supply of mortgage money. It seems less vulnerable to tight money in 1969 than it was in 1966. This is largely because thrift institutions do not have to contend with runoffs of hot money as they did in 1966. The volume of mortgage lending at commercial banks continues strong and construction money has not been curtailed according to our information. The rate of homebuilding may be affected by the anti-inflation policy, but it does not appear that we have another 1966 on our hands.

Concern sometimes is expressed that commercial banks divert funds that allegedly should go to particular areas, such as to consumers for homebuilding, to feed the demands of business for capital spending. The picture of banks accepting funds from small depositors and channeling the proceeds to large corporations to the exclusion of the small man, be he businessman or consumer or farmer, is incorrect.

Banks, like most other financial institutions, provide funds for the same broad classes of users as those from whom they obtain funds. Thu, with substantial business deposits, many banks may be expected to make a sizable portion of their loans for business purposes.

Others will be highly consumer oriented in both loans and deposits. Moreover, most business users of credit either directly or indirectly provide consumer goods and services such as homes, clothing, food, durable goods, and transportation. Therefore, in addition to the approximately $40 billion in residential mortgage loans presently owned by commercial banks, a major part of other bank business loans presently outstanding are directly for the benefit of consumers and home

owners.

Lastly, of course, it is business which provides the jobs and income to create the market for homes and other consumer goods.

How effective is an antiinflationary policy which finds its major impact on the volume of bank credit and upon interest rates? Bankers are beginning to see some unsatisfied demands, some customers turned away, and acceleration of repayments of high-interest rate loans. These are what make antiinflationary policy effective.

The growth rate of the money supply has abated, suggesting in due course there will be a slower rate of advance in the economy. Monetary policy and a considerable reduction in the stimulative role of the Federal Government, through at least a reduction in the Federal deficit and hopefully a surplus, may be expected to reduce inflationary pressures gradually. It is encouraging that the Federal fiscal policy will be working with, rather than against, monetary policy in 1969.

I do not want to be falsely encouraging about an early end to highinterest rates. Certainly, the intensity of credit demands and the rigorous pursuit of a restrictive monetary policy would indicate otherwise. Nor do I think interest rates will decline to levels of the thirties, forties, fifties, or the early sixties even after the current inflation is licked.

High-employment levels, a goal we apparently have learned to achieve, means large opportunities for investment and increased consumer spending on durables. Both generate heavy credit demands.

As the ABA indicated in its recent comments on the economy to the Joint Economic Committee of the Congress, the strains on the financial structure at high-employment levels even without inflation are substantial enough to require thorough study.

That statement also pointed out that much of the present inflation was created because monetary policy tried to hold down interest rates by permitting undue monetary expansion. We thus are reaping in current high-interest rates the whirlwind of previous policy. Ironically, it is the effect of these high rates that will restore conditions whereby excess demand is curtailed and rates can once more reflect merely high demand, not inflationary expectations and abnormally restrictive policies.

Senator PROXMIRE. Thank you very much, Mr. Morthland.

Mr. Leach?

Mr. LEACH. Mr. Chairman, I wish to thank this committee for its invitation to come here and attempt to make some contribution to its discussion of the present level of interest rates.

At Morgan Guaranty Trust Co.-and I think it is fair to say this applies generally throughout the banking community-we are disturbed about the economic situation which has brought interest rates to their current level.

We share the feeling that the chairman of this committee has expressed concerning the desirability of getting interest rates back to a "normal and reasonable" level.

Since interest rates merely express the price relationship which mediates between the demand for and the supply of credit, this will require either a dampening of the overwhelming desire to use borrowed money, or an increase in the willingness to save money, or a combination of the two.

The Chairman of the Board, Mr. John Meyer, stated the problem this way at the annual meeting of our stockholders last week:

The inflationary binge that we've been on since 1985 has really been a whopper, and part of the problem is convincing the celebrants that the party is coming to an end. So long as inflation is expected to continue, and so long as actions are based on that expectation, the danger of inflation is present and the lid of restraint must be kept on.

Many people overlook the fact that there are two sides to the phenomenon of rising interest rates. The obvious assumption is that, since higher rates mean more income for lenders, therefore bankers and other lenders always try to push rates to the highest possible level. The other side of this, often forgotten, is that banks are borrowers as well as lenders and higher rates mean higher costs for them. In addition, banks have large portfolios of fixed-income securities, and higher interest rates mean depreciation in the market value of these holdings.

In fact, banks in New York City in 1968 experienced after taxlosses on sales of securities from their portfolios which more than offset the increase in their net operating earnings. This doesn't count the increase in unrealized depreciation which most New York banks experienced during the year.

From many years of living day-to-day in the markets where money is bought and sold, borrowed and lent, it is my feeling that the level of interest rates, by and large, reflects the appraisal of borrowers and lenders of the prospects for future price stability. This is particularly true of long-term rates, since an investor who is turning over his savings to someone else under a long-term fixed-income contract naturally will expect not only a reasonable return for the use of his money but an additional rate of return to compensate him for any anticipated loss of purchasing power.

Another way of saying this is that only those countries which can demonstrate longrun price stability can expect an economic and savings pattern which will provide low long-term interest rates.

We at Morgan Guaranty have used this premise as the basis for extensive analysis designed to aid the bank and its customers in anticipating interest rate movements for business purposes. In doing this we have utilized techniques of the new science of operations research. Our objective has been to improve our own investment performance and the counsel we give our clients with respect to their financing plans. Some of the results of this analysis have a bearing, I think, on the topic I am discussing this morning.

We started our analysis by trying to determine a proper assumption as to a reasonable rate of return in a noninflationary setting. Our observations, historical and otherwise, led us to conclude that an expectation of absolute price stability over the life of a long-term security involving virtually no credit risk would produce an interest rate of about 3 percent.

We tested this assumption over periods of U.S. financial history and that of other countries. Unfortunately, there aren't too many periods of price stability to study. The financial upheavals associated with the great depression of the 1930's knocked relationships out of kilter for quite awhile in most countries.

It is interesting, however, that in the one extended period of price stability recent enough so that we have fairly good records of both rates and prices, the idea of a basic 3-percent rate seems to be supported. The economic history of the last half of the 19th century in England reveals that by and large it was a period free from inflationary pressures, that the consumer's shilling bought approximately as much at the end of the century as it did in the 1850's. Long-term British issues fluctuated around a 3-percent yield during the entire half century, and in fact, the rate tended to decline as the period of currency stability lengthened.

In order to relate this to the current situation I would like to refer to some charts which you will find attached to your copies of this statement. Chart A shows what has happened to a moving average of interest rates on new issues of high grade corporate bonds in recent years. I think it illustrates dramatically the problem that concerns us here this morning.

Applying the concept which I outlined earlier, this average rate which we have charted can be visualized as consisting of two components; a basic, or "real," return of 3 percent plus some additional percentage based on investors' expectations of future inflation.

In an attempt to quantify this expectational factor, we took various measures of inflation and checked out their correlation with interest rate movements. The measure which showed the highest degree of correlation was the annual rate of increase in prices over the 24 months preceding each point on the interest rate chart. In simple terms, this measure can be called an inflation-experience factor. It records the degree of inflation that actually occurred during the 2 years prior to each reading on the interest rate scale.

This inflation-experience factor is shown on chart B. It is based on changes in the so-called GNP deflator, the figure which the Commerce Department uses to eliminate from the gross national product the effect of price changes. In order to compute the rates of change plotted on this chart, we have converted the official quarterly deflator series to a monthly series by interpolation.

Now, if you will turn to chart C, you will see that we have repeated the line from chart A, showing us a solid line the actual course of longterm interest rates. The dotted line, labeled "calculated," is the sum of the 3-percent basic, or "real," return and the rates of experienced inflation that were plotted on chart B.

I think you will agree that the calculated rate follows a course that is remarkably close to the actual rate set in the marketplace. In my judgment this is persuasive documentation of the link between inflation and interest rates. If I am correct in this, then I would respectfully suggest that your inquiry might well concentrate on the means of controlling inflation and, more immediately, on ways of reducing the widespread current expectation that a high and perhaps increasing rate of inflation will continue in the period just ahead.

With a lowering of the rate of inflation, or even a lessened expectation that the current rate will be maintained, a lowering of interest rates will almost certainly follow. In fact, a realization on the part of investors that the Congress, the administration, and the Federal Reserve System are determined to control inflation would in itself have a powerful effect on the interest rate level.

Some people argue that interest rates could be kept from rising by the adoption of a perpetually easy money policy. Simply inject reserves into the banking system, they say, and low levels of yields will automatically follow.

For awhile indeed, such a policy can keep rates low in the shortterm end of the market. However, each increment of reserves supplied by the Federal Reserve System only serves to convince another segment of investors that price stability has been sacrificed, at least for the time being, to expediency.

At each such stage, we find these investors turning to equity-oriented employment of their funds and avoiding investment in long-term fixed-income securities. As a result, a monetary policy which is judged by the market to be unduly easy, or easy for too long, will almost certainly result in raising rather than lowering long-term interest

rates.

The experience in 1967 illustrates this point, as is brought out in chart D. Beginning late in 1966, long-term yields had started downward while the short-term money market was still fairly tight, re

flecting market conviction that the Federal Reserve clearly intended to curb inflationary pressures.

For awhile after monetary policy turned easy, both long-term and short-term rates moved lower. Fairly early in 1967, however, the market began to sense that the massive stimulative thrust of both fiscal and monetary policy risked an early resumption of inflationary pressures. From February until June, despite a steady supply of reserves to the market which pushed short-term yields steadily downward, long-term rates moved back up because inflationary expectation was increasing.

Experience over the past few years has convinced borrowers and lenders alike that in any future period of uncertainty as to the economic outlook-that is, a situation in which the Federal Reserve System is confronted with a risk of a business slowdown or potentially greater inflationary pressures-doubts will be resolved on the side of economic stimulation.

This market conviction not only has produced higher rates, it has also undermined the breadth and resilience of the fixed-income securities market. Proclaiming that the bond market is dead may be only a slight exaggeration. Yet the survival of this market is essential to the whole financial fabric of the country.

It is true that some underdeveloped countries manage to survive without long-term capital markets-that is, of course, one reason why they are underdeveloped.

And the United States doubtless could, over a period of time, restructure its markets and institutions to the expectation of perpetual inflation and still survive-but only at horrendous cost to our standard of living.

We have come dangerously close to the total disruption of financial markets by yielding to the tempting thought that a little inflation never hurt anyone. That notion certainly is open to challenge, but in any case this has not been a "little" inflation, and the harm that has been done in the last 3 years may take many years to undo.

I would not wish to leave you with the impression that there is nothing that can be done now to bring interest rates down-and bring them down substantially. If you will turn back to chart C you will note that the "actual" line is well above the "calculated" line.

Last week an issue comparable to those on which the chart is based offered a 7.80-percent yield to investors, roughly a full percentage point higher than the current calculated rate. In other words, rates are considerably higher today than our actual inflationary experience over the past 2 years would explain.

It seems to me that this is clearly the result of a sort of "credibility gap." It evidences an assumption by borrowers and lenders that disinflation will not be pursued effectively and that, in fact, we will see even higher rates of inflation.

If this assumption were to be shattered by evidence of decisive support in Congress for anti-inflationary action I would predict with some confidence that rates would fall promptly by something close to a full percentage point and fluctuate around the 634-percent "calculated" level shown on the chart.

They would then decline further, but more gradually, as the promised disinflation actually materialized.