of 1966. Most of the decline in individuals' deposit-type saving flows in 1966 occurred at thrift institutions, while, at commercial banks, growth in highyielding savings certificates substantially offset declines in passbook savings accounts. Savings growth at thrift institutions recovered in the closing months of 1966, however, and spurted in the first quarter of 1967.

3. The flow of funds into mortgage markets declined substantially in 1966 -the first significant reduction since 1960. Funds began to flow back into mortgage markets in 1967, however, as savings trends at mortgage-oriented thrift institutions strengthened.

4. Interest rates rose dramatically through the late summer of 1966, under the impact of pressing credit demands, restrictive monetary policy and deteriorating investor expectations. Yields retreated, however, in the wake of emergency measures announced by the government in September and declined rapidly in late 1966 and early 1967. Mortgage yields responded to over-all financial changes with unusual rapidity, both on the upside and on the downside, in the 1966-67 period.

5. Widespread increases in savings account interest rates at deposit-type institutions followed the Federal Reserve Board's December 1965 increase in the Regulation Q ceiling on commercial bank time deposit rates and continued in 1966, leading to imposition of across-the-board federal interest rate ceilings on savings accounts in September.

Uses of credit and equity funds. Among the most significant capital market developments in 1966 was the widespread reduction in private mortgage flows, only partially cushioned by record FNMA mortgage purchases. At $25 billion, the total volume of mortgage credit in 1966 was down substantially from the $30 billion levels attained in the 1963-65 period, but was still considerably greater than in the 1950's (See Chart 3). Relative to the total volume of funds raised in credit and equity

markets, however, mortgage flows in 1966 reached their lowest level of the post-war period. The volume of funds channeled into mortgages remained relatively large in the first half of the year, reflecting the take-down of recordhigh commitments by institutional lenders as well as substantially increased FNMA mortgage purchases. Mortgage flows fell steeply during the second half, however, as FNMA was forced to limit its purchases in the face of dwindling resources and the impact of reduced savings growth was more fully reflected in the lending activity of thrift institutions. As a result, by the fourth quarter of 1966, mortgage flows (at seasonally adjusted annual rates) were running more than one-third below the 1965 level.

Drastic cutbacks in new commitment activity by private mortgage lenders and the spiraling cost of mortgage funds brought a steep and widespread decline in housing activity. By October, the seasonally adjusted annual rate of new private housing starts had plummeted to 848,000 units, little more than half the rate prevailing at the beginning of the year. Moreover, unlike 1964 and 1965, when relatively moderate declines in housing starts largely reflected adjustments to prior overbuilding in California and other Western states, the 1966 decline was evident in all major sections of the country.

Short-term lending to private borrowers, while also declining in 1966, remained substantially greater than in any other postwar year. Reduced consumer appetites for automobiles and other big ticket items, and the effects of an increasingly stringent monetary policy, brought a progressive reduction in consumer borrowing throughout the year. Business borrowing from banks to finance huge capital investment and inventory outlays and accelerated tax payments rose sharply during the second quarter of 1966 but fell substantially in the second half, as the Federal Reserve intensified pressures on commercial banks to reduce their volume of business loans.

With external financing requirements rising strongly, and bank credit less readily available, increased borrowing from finance companies and through the sale of open market paper helped maintain total short-term credit flows to business at a relatively high level. Moreover, the net volume of corporate security issues-mostly bonds-rose to a record high in 1966, more than double the 1965 volume.

The federal government sector raised an increased net volume of funds in 1966, almost entirely through steppedup sales of federal agency issues and participation certificates prior to their temporary suspension in the second half of the year.

In contrast to the federal sector, net state and local government borrowing declined in 1966 from the record level reached in 1965, as some new issues were deferred in the face of rising financing costs and federal grants-in-aid rose substantially. Foreign borrowing also declined further in 1966, as the Administration's voluntary balance of payments program was expanded early in the year and commercial banks concentrated on meeting heavy domestic credit demands. Concern over possible increases in foreign borrowing in 1967 prompted President Johnson to propose in January an increase in the interestequalization tax on the sale of foreign securities in the United States, and extension of the tax for an additional two years.

Sources of credit and equity funds. Shifts in the composition of capital market flows during 1966 reflected equally striking shifts in savings patterns and in the relative importance of the major sources of credit and equity funds. While total financial saving by individuals declined moderately from the record 1965 volume, net acquisitions of bonds, stocks and other direct investments totaled an unprecedented $11.5 billion in 1966, more than four times the year-earlier volume and more than one-half greater than the previous record of $7.5 billion in 1959-the year of the "Magic Fives"

(See Chart 2). Net gains in savings accounts of individuals at deposit-type institutions, on the other hand, fell 27 per cent from the record $26.4 billion in 1965 to only $19.2 billion, the smallest volume since 1961. As can be seen in Chart 4, the switch from savings accounts to direct investment was centered entirely in the first three quarters of the year.

This massive shift contrasted with the pattern prevailing during the 196165 period, when flows into savings accounts rose to record levels during a period of prolonged expansion in business activity, while direct investments of individuals remained at a relatively subdued level. The impact of monetary stringency and rising interest rates in 1966 was also evident in the virtual cessation of individuals' additions to their holdings of cash and demand deposits, following steady increases during the preceding five years. Saving through life insurance and pension reserves, however, continued to rise at a relatively steady pace.

Among the three main deposit-type institutions, commercial banks maintained total savings growth at a relatively high level throughout 1966, as they aggressively promoted high-yielding savings certificates following the December 1965 increase in the Regulation Q ceiling on time deposits to 51⁄2 per cent (Chart 5). Despite the roll-back of maximum rates for savings certificates to 5 per cent in late September, consumer saving flows at commercial banks totaled $11.9 billion in 1966, only 11 per cent below the record 1965 volume. Net savings growth of $2.6 billion at mutual savings banks, by contrast, was 29 per cent lower than the 1965 gain, and was down by 40 per cent from the record 1964 increase. The 1966 decline was steepest at savings and loan associations, where net savings growth of $3.6 billion was 57 per cent below 1965, 67 per cent less than the 1963 record, and the lowest volume since 1952.

Not only was the 1966 savings decline at savings banks less severe than

at savings and loan associations but, as shown in Chart 5, it was also briefer in duration. Saving flows at savings banks fell to the lowest level in more than six years during the second quarter after seasonal adjustment but recovered substantially in the third quarter. At savings and loan associations, on the other hand, saving flows continued to decline through the third quarter of 1966, before recovering in late 1966 and early 1967.

In the 1966 period of "financial disintermediation," the relative importance of deposit-type institutions as the primary immediate source of funds to credit and equity markets declined significantly. Owing to sharply reduced savings growth at thrift institutions, net reductions in business time deposits at commercial banks and the sudden end of demand deposit expansion, all deposit-type institutions combined supplied only three-tenths of the total volume of funds raised in 1966, compared with more than one-half during each of the preceding six years. Consumers directly supplied one-sixth of all funds raised in capital markets in 1966, the highest share since 1957. The volume of funds channeled directly into capital markets by businesses and federal, state and local governments also rose in 1966, bringing the share of funds supplied directly by all nonfinancial sectors to the highest level since 1959.

Interest rate developments. Nowhere was the rapidly changing character of 1966-67 financial markets more evident than in the wide fluctuations in interest rates. The broad-based rise in interest rates which began in the second half of 1965 continued into 1966 and, after pausing in the Spring, reached a climax in August and September. Almost equally dramatic, however, was the decline in yields in late 1966 and early 1967.

During the 1966-67 period, mortgage yields were unusually sensitive to general financial market change. The swift response of mortgage yields on the upside reflected, in part, market congestion

due to record-high mortgage commitments and the large volume of loans in warehouse and mortgage banker inventories. Discounts on FHA-insured mortgages continued to deepen despite successive increases in maximum contract rates, bringing yields to almost 7 per cent in November. Responding rapidly on the downside as well, FHA secondary market yields began to decline in December 1966, and by March 1967 had fallen to the 64-61⁄2 per cent range. Conventional mortgage yields, traditionally slower to respond, also declined in early 1967.

Owing to the rapid rise in mortgage yields during 1966, the spread between FHA-insured mortgage and government bond yields increased to the widest margin in six years by January, 1967 (Chart 6). This differed from the pattern evident during the 1961-65 period, when the yield advantage of mortgages was reduced substantially under the impact of increased investor demands. The mortgage-bond yield spread narrowed significantly in February and March, however, as mortgage rates declined sharply.

Savings Bank Deposit and Account Growth

In the 1966 period of extreme financial stringency, savings bank deposit growth declined to $2.6 billion, compared with $3.6 billion in the preceding year. As shown in Chart 7, the net inflow of new money (excluding interest credited) dropped to the lowest volume since 1960. This decline was only slightly offset by a further rise in the amount of interest credited to depositors' accounts. The overall reduction in annual industry savings growth, however, obscured wide geographic variations in deposit activity within the year, as well as the strong recovery which began in late 1966 and continued into 1967. Reflecting both the rapidly changing overall financial climate and the competitive actions of individual savings banks, industry deposit activity in the 1966-67 period passed through three distinct stages:

First-half 1966 decline-Deposit gains plummeted during the early months of 1966 (Chart 8), in response to soaring yields on direct capital market investments and aggressive promotion of consumer-type time deposits by commercial banks. Pressures were especially acute at interest crediting periods when withdrawals rose sharply. Indeed, following the March 31 interest date observed by many savings banks, the industry sustained a $327 million deposit decline in April, the largest monthly net deposit reduction on record.

Midyear turnaround-While financial markets continued to tighten, a sharp turnaround occurred in savings bank deposit activity in July. This marked improvement was almost entirely confined to New York City, where savings banks raised deposit rates to 5 per cent at midyear. Deposit flows at these institutions continued at an accelerated pace in the second half of the year, while generally remaining below year-earlier levels in most other savings bank areas.

Broadened recovery in late 1966 and early 1967-The improvement in industry deposit flows strengthened and broadened in the closing months of 1966, as outflows were halted and inflows resumed in an increasing number of savings bank areas. In December, net deposit gains set a new monthly record for the first time since early 1965. And in the first quarter of 1967, net deposit growth totaled a record $1.5 billion, compared with the $844 million gain in the corresponding 1966 period and the previous peak of $1.2 billion registered in 1964. The broadened recovery of industry deposit flows has reflected: ▸ rate increases by a growing number of savings banks in areas outside New York City in the second half of 1966 and early 1967, and widened use of special high-yielding accounts;

▸ further improvement in the relative attractiveness of rates offered by savings banks, as security yields retreated from 1966 highs and the maximum rate on commercial bank savings certificates was reduced to 5 per cent;

the enhanced attractiveness of sav

ings bank accounts to large depositors resulting from the increase in FDIC insurance coverage from $10,000 to $15,000; and

the unusually high rate of total saving out of after-tax incomes by consumers in late 1966 and early 1967.

While these factors were instrumental in stimulating the rebound in deposit flows, the continuing attractiveness of savings bank services and deposit interest rates to large numbers of small savers was also of basic importance. Despite an unfavorable financial environment, savings banks were able to attract new savings in large volume throughout 1966. Indeed, gross amounts deposited in regular accounts rose by 10 per cent to a record $16 billion in 1966. This compared with only a 3 per cent rise in 1965, and with either reductions or little change in previous tight money periods.

In the face of this record influx of new savings, the reduced net deposit gain in 1966 was due to the even more rapid rise in withdrawals, particularly by interest-sensitive holders of large deposits. Overall, withdrawals increased by 21 per cent for the year as a whole, although dipping below yearago levels in December, 1966, and in the first quarter of 1967. With only 7 per cent of the total number of accounts holding 43 per cent of total industry deposits at mid-1966, large withdrawals by relatively few depositors exercised a disproportionate effect on savings bank deposit activity in 1966. By the same token, the record amount of new deposits reflected improvements in the industry's long-run competitive position and basic appeal to a large and growing number of savers.

Also indicative of the industry's improved ability to attract new savers was the 384,000 net increase in the number of regular savings accounts in 1966 (new accounts opened less accounts closed). As shown in Chart 9, this was the largest gain since 1958, when, in contrast to 1966, account growth accompanied rising dollar gains in savings and was directly stimulated by wide