Fed Flight

Anti-inflation line besieged

Washington's chief line of defense against inflation remains the nation's central bank, the Federal Reserve. It controls the money supply by manipulating key interest rates and telling private institutions belonging to the Federal Reserve System how much of the cash they have on deposit must not be lent out. Alas, this line is slowly crumbling. While 5,450 banks remain in the system, in the past 4 1/2 years some 300 have left it. Most have been small banks, but there have been some big defectors too, among them Pennsylvania's National Central Bank, which has deposits of $1.5 billion. Federal Reserve Chairman Paul Volcker calls the trend "serious and insidious."

There are 14,700 commercial banks in the U.S. Those that choose to join the Federal Reserve System are required to keep on hand non-interest-bearing reserves ranging from 7% of their checking deposits (for small banks) to 16.25% (for the biggest). Since today's high inflation began driving up the interest those reserves could be earning if the money were in Treasury bills or in the short-term money market, smaller Fed banks have been reconsidering the benefits of membership in the system. They are also feeling new competition from thrift institutions, which have got into the check-writing business but are not subject to the Fed's reserve requirements.

The Federal Reserve provides its members with various services, such as check clearing, wire transfer of funds and even emergency delivery of $5 bills. Members can also borrow money at the Fed's "discount window," but the price is high in terms of idle reserves. The fact that some big commercial banks offer many of the other services at a modest fee is encouraging smaller banks to forgo access to the discount window and leave the system. When Chicago's Oak Park Trust & Savings Bank withdrew its $9 million reserves from the system last May, its earnings rose by $300,000.

The Federal Reserve now controls about 70% of all bank deposits, but its leverage could weaken greatly if many more banks withdraw from the system. Senate Banking Committee Chairman William Proxmire and his House counterpart, Henry Reuss, have proposed dealing with the situation by enacting mandatory reserve requirements for all financial intermediaries (including thrift institutions) that accept checking accounts, thus nullifying the edge that non-Fed members now enjoy. That could permit reserve requirements to be reduced for everyone. But Congress must act soon. At present, nearly 600 banks are thought to be considering fleeing the Fed. If they do, scores of others will doubtless quickly follow.

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