A History of the Federal Reserve, Volume 2 (25 page)

Young urged the committee to experiment with control procedures. With a penalty discount rate, “the System can then broadly govern the volume of reserves needed for growth through open market operations while at the same time restraining an undue credit expansion financed primarily on borrowed reserves” (FOMC Minutes, August 23, 1955, 15).
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Martin concurred in the staff proposal, but several members of the committee remained skeptical or opposed. The committee resisted Martin’s effort to decide whether the discount rate should lead market rates higher. It did not make a decision.

Following the meeting, effective August 26, Atlanta joined Cleveland at 2.25 percent. Other banks soon followed. By mid-September, all banks had adopted that rate. Bill rates rose to 2.1 percent in mid-September (from 1.7 in late July); the discount rate was a penalty rate. Borrowing declined briefly, then rose to the highest level since 1953, a monthly average of $800 million for September.

Sproul missed the Aug
ust 23 meeting, so he reopened the discussion
of discount policy three weeks later. He forcefully opposed Riefler and Young’s arguments for a penalty rate, partly because he disliked rules as guides to policy, but he disagreed also with their substantive claims.
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The penalty rate tradition in central banking was a British, not a U.S., tradition. The System had abandoned a penalty rate as inapplicable to the U.S. not only because there was no single dominant asset used for reserve adjustment, as in Britain, but also because there were many small banks. Discounting helped small banks to adjust to temporary changes in reserves. Further, Sproul denied that Treasury bills had become the dominant means of adjustment. “I doubt if we are much closer than we were to having a single short-term market rate against which a penalty discount rate could be uniformly set” (FOMC Minutes, September 14, 1955, 22). This ignored the growing importance of the federal funds market.

128. Here Riefler accepts that banks borrow for profit, contrary to the assumption in Riefler (1930). He recognized that this change conflicted with the interpretation of negative free reserves, large borrowing, as necessarily restrictive. Ralph Young, the research director, followed Riefler. The staff now favored a penalty rate during periods of economic and credit expansion. The main change from the 1920s affecting borrowing and the role of the discount rate, Young said, was that there was now a single, dominant instrument in the money market—Treasury bills. In the 1920s, there were many different instruments, so it was not clear where to set the penalty rate. This is very similar to some reasoning used to give up the penalty rate after the 1920–21 recession. One of the reasons at that time was that the U.S. market was unlike the London market, where bankers’ acceptances were the main instrument for banks adjusting reserve positions. See volume 1, chapter 4. As Sproul noted at the next meeting, it was not the only reason.

129. Young argued also that excessive credit expansion cannot later be contracted by counter-measures, at least not without serious deflationary dangers of “chain-reaction potential.” He favored strong action to prevent “the bubble on top of the boom” (FOMC Minutes, August 23, 1955, 15).

Sproul accepted that the discount rate had remained above the bill rate most of the time in the past two years. He opposed “a timeless or rigid formula to achieve this result” (ibid., 23). And he questioned whether the System would follow a rule that required “shoving the discount rate up, during periods of credit restraint, with real risk of creating disorderly conditions in the capital markets.”
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Appealing to the other presidents, he argued that the rule would “reduce the role of the directors of the individual banks in setting discount rates” (24). It would, in short, further reduce regional bank autonomy.

Karl Bopp of the Philadelphia bank, later its president, had the more persuasive argument. He showed that the Riefl er-Young formula required another increase in the discount rate. Only Governor Robertson favored the increase and only after the Treasury completed its October financing.

Uncertainty following President Eisenhower’s heart attack in September put a temporary hold on policy changes. A telephone conference on September 26 decided to maintain an unchanged policy, despite a sharp decline in stock prices that day, but to show concern for the market’s anxiety by showing a temporary increase in reserves for the statement week. On October 4 Robertson read a memo to the FOMC criticizing policy as “wholly inadequate” and “too slow to act” (memo, Re: Open Market Operations, Board files, October 5, 1955, 1). Sproul responded by recommend
ing a modest reduction in free reserves to –$300 million and moving the short-term rate close to the discount rate. He believed that “the effectiveness of credit restraint is greatly influenced by opinions about the future and because opinions about the future may be undergoing some revision, I [favor] . . . a policy of maintained but not intensified pressure” (FOMC Minutes, October 4, 1955, 24).

130. Sproul and others at the New York bank did not think highly of Riefler. Sproul’s statement on discount policy starts by criticizing Riefler and Young harshly for not making their papers available in advance of the meeting (FOMC Minutes, September 14, 1955, 21).

131. This statement suggests that banks would adjust by selling Treasury bills or other securities instead of discounting, thereby forcing higher rates. This is as close as Sproul came to hinting at the negative political response to discount rate increases in 1920, a principal reason for abandoning the penalty ra
te at the time.

Robertson again raised the issue of the discount rate at Board meetings on November 3, 9, and 16. The market did not anticipate an increase, so they would have the benefit of surprise (Board Minutes, November 3,1955, 10–11). He considered surprising the market an advantage, and “[h]e considered an increase in the rate almost a necessity . . . [S]uch a move at this time would have a real impact” (Board Minutes, November 9, 11). Although new issue Treasury bill yields were above the discount rate, Chairman Martin hesitated. He saw merit in Robertson’s argument, but he remained uncertain.

None of the reserve banks had requested an increase. Robertson favored acting without a request. After discussion, the Board agreed to send telegrams to each reserve bank, urging them to discuss an increase at their next meeting.
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Although several reserve banks held directors’ meetings, none increased the discount rate that week. Discussion resumed at the FOMC meeting the following week.
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Most of the presidents favored an increase, but Irons (St. Louis) was reluctant, and Sproul favored the increase but opposed a tighter policy. Martin shared his view. He favored an increase in the discount rate but “that did not mean that the supply of money also should be decreased” (FOMC Minutes, November 16, 1955, 23).
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132. The telegram was careful not to trample on the directors’ prerogative, but it was disingenuous. “This move is not in any sense a suggestion that your directors act to increase the rate” (Board Minutes, November 9, 1955, 13–14).

133. The previous day, November 15, the Federal Advisory Council forecast continued growth in the first half of 1956 at a slower pace. The economy was near capacity. “There is a uniformly optimistic outlook” except for farmers (Board Minutes, November 15, 1955, 2). The Council opposed an increase in the discount rate and favored an unchanged policy stance (ibid., 20).

134. On November 3, Woodlief Thomas circulated a memo containing a chart showing the relation of the discount rate to free reserves and Treasury bill rates. “When borrowings exceed excess reserves, . . . the discount rate seems to set an upper limit on the rise in the bill rate regardless of the volume of net borrowed reserves. This indicates that when the bill rate is close to or above the discount rate, banks prefer to borrow rather than sell bills. . . . Thus at such time . . . the discount rate is probably the significant element of restraint” (memo, Thomas to FOMC, Board files, November 3, 1955). Sproul accepted the first conclusion but doubted that the discount rate was the appropriate measure of restraint. This follows “only if restraint is defined wholly in terms of the bill rate” (Sproul papers, FOMC comments, November 16, 1955). The exchange shows that members did not agree on measures of ease
and restraint or on the effect of a higher discount rate. They never discussed how monetary policy affected the economy.

The Board did not force the banks to increase, but it took the unusual step of voting in advance to approve a discount rate increase of 0.25 to 2.5 percent for any bank that made the request. By November 22, all reserve banks were at 2.5 percent.

Treasury
Problems

Soon after the new discount rates took effect, the Treasury announced a refunding offer of $12 billion of 2.625 percent one-year certificates. The initial response showed the offer was properly priced. The “when issued” securities soon fell below par on the expectation that a large number of holders would redeem for cash. The Treasury formally requested the Federal Reserve to support the issue by buying the “when issued” certificates. Doing so would violate the bills-only policy, at least temporarily. But any temporary deviation would raise a question about future actions.

Sproul favored the purchases and suggested putting reserves into the market on the settlement date, extending the length of repurchase agreements to carry them over the New Year holiday, and purchasing “when issued” certificates as needed. Martin was reluctant, but he was willing to make an exception and let it be known that they would not return to the support policy.

Mills opposed on grounds that there was no emergency. If they did not intervene, the Treasury would have to pay cash and, probably, sell additional bills to raise cash. He was willing to extend the length of repurchase agreements to aid the market without violating bills-only policy. Robertson and Vardaman joined Mills in opposition. By a vote of nine to three, with all member presidents joining the majority, the FOMC voted to purchase $400 million of “when issued” certificates. This was the first departure from bills-only. On settlement day, December 8, the manager informed the committee that free reserves had fallen from –$300 to –$500 and interest rates had increased. The System supplied additional reserves by purchasing bills and offering repurchase agreements, but it used less than half of the $400 million to purchase “when issued” certificates.

Looking back a few weeks later, Martin said that the System would have been open to the charge of being “doctrinaire” if it had not responded to a direct request from the Treasury. He remained convinced that the principles reflected in the bills-only policy were correct. “Nevertheless, every time we give way on those principles we encourage the market to think that the System has been ‘panicked’ into taking a position to bail the Treasury
out” (FOMC Minutes, December 13, 1955, 25).
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Sproul argued that the longer the committee went without making an exception, the more concern in the market when it made an exception. “This would mislead the market” (Sproul papers, FOMC Correspondence, December 13, 1955, 1).

The discussion continued. In January, Robertson wrote a memo criticizing the decision to assist the Treasury by purchasing “when issued” securities. The purchases abandoned the March 1953 policy agreement. It was a long step back toward support of the Treasury market, and it reduced independence.

Sproul’s response did not hide his irritation. He accused Robertson of reverting “to the pronouncements of the 1952 Ad Hoc Subcommittee report,” oversimplifying recent experience, and treating the 1953 policy as if “the commandment [bills only] had been chiseled in stone and could only be sandblasted out” (memo, Sproul to Sherman, Sproul papers, January 24, 1956, 2). Sproul pointed out that the FOMC regularly assisted Treasury debt management through its even keel policy and by lending directly to the Treasury. Even keel at times had required the FOMC to accept a “temporary halt in a policy of tightening credit which we intended to pursue” (ibid., 3). The System put additional reserves into the market, if needed, to assist the Treasury with its financing, but it left to the Treasury the decision about how to support its new issue.

Robertson wanted to notify the Treasury that it should not expect support in the future and that the departure from policy was a temporary change. Sproul replied that the Treasury understood that, and Martin agreed that they did not need a statement to the Treasury.

Total System purchases of certificates for the week reached $167 million. The committee discussed an announcement to call attention to the departure from policy and to indicate that it was exceptional. It decided not to issue the statement.

The decision to assist the Treasury financing irritated Senator Douglas. Douglas favored coordination of Treasury and Federal Reserve policy but expected each agency to operate independently. Although he opposed billsonly, he also opposed setting the policy aside temporarily to support a Treasury refinancing. This violated Federal Reserve independence that he had
worked hard to achieve in the 1949 hearings and in 1951. If the Treasury mispriced an issue, they should accept their failure and not depend on the reserve system to rescue them.

135. Bremner (2004, 92) reports that Martin agonized about intervention and support all night. Governor Robertson offered a lengthy statement that pointed to mistakes by the Treasury. The Treasury had issued securities at year-end, when there was a heavy demand for cash. The solution should be to either avoid Treasury sales at such times or supplement the sales by additional sales of Treasury bills to pay for the attrition (shortfall). He preferred to have the Treasury borrow from the Federal Reserve for a few days, until they raised cash, instead of asking the Federal Reserve to support their issue (FOMC Minutes, December 13, 1955, 27–28).