A History of the Federal Reserve, Volume 2 (29 page)

The rise in market rates was the critical factor bringing the Board to a decision. Rates had increased to 3.5 percent on long-term Treasury bonds and to 3 percent for the shortest maturities. Martin believed savers should share in the higher rates, and Szymczak, who had initially opposed any change, gave that as a reason for changing his mind (Board Minutes, December 3, 1956, 18). As part of the change in rates, the Board permitted banks to compound at less than quarterly intervals provided the compound rates did not exceed the new ceilings.

Several months later, the Board asked the Federal Advisory Council about the response to the change in ceiling rates. It learned that (1) banks that raised their rate to 3 percent “experienced a material increase in savings deposits”; (2) the increase in savings deposits was mainly a reallocation of assets, not a change in the saving rate; and (3) some banks responded by seeking higher rates on their earning assets (Board Minutes, May 14, 1957, 16–20). FAC President Robert V. Fleming added that there had not been a large shift from demand to time deposits.

End
of
the
Expansion

Members of the Federal Advisory Council looked ahead optimistically at their November 1956 meeting. Most told the Board that business would continue to be good in the first half of 1957. They warned, however, of lower profit margins, inventory accumulation, and the drought affecting much of the country (Board Minutes, November 20, 1956, 2). The FAC remained optimistic at its February 1957 meeting, but it repeated its concern about profits and added concern about investments. “[N]arrowing of the profit margin tends to make business investment less attractive” (Board Minutes, February 19, 1957, 2). FAC members reported some evidence of excess plant capacity after the long investment boom (ibid., 18).

In the first part of 1957, the economy continued the variable pattern of 1956, growing moderately in the first and third quarters, declining slightly in the second quarter. Industrial production rose in only four of the first eight months, followed by recession after August. The civilian unemployment rate remained near 4 percent.

The new element was persistent inflation. The GNP deflator and consumer prices both rose at a 3.75 percent average rate before the recession. The government budget remained in surplus, and money growth remained below the growth of real GNP. Monetary velocity continued to rise with interest rates, inflation, and new ways of economizing on cash holdings, including the spread of deposit banking. The public reduced its very large wartime accumulation of cash balances relative to income.

By January, the S&P index of stock prices was 6 percent below its peak
in July 1956. The index fell in three of the next eight months, reflecting the variability of output and economic activity, higher inflation, and interest rates. The Board discussed a reduction in stock market margin requirements in January, but decided against a change.
¹⁶⁵
In April, the New York Stock Exchange asked the Board to reduce margin requirements because volume had fallen. The Board’s staff reported that “margin changes appeared to have had an immediate and perceptible impact on the level of stock market credit but no consistent or sustained effects on stock prices or trading volume” (Board Minutes, April 23, 1957, 8). The Board decided that inflationary psychology and ample buying power in margin accounts suggested that requirements should remain unchanged. Margin requirements remained at 70 percent until January 1958.

Judged by member bank borrowing and free reserves, monetary policy became more restrictive. Judged by the federal funds rate or growth of the monetary base, policy remained unchanged. Judged by growth of the real monetary base, monetary policy remained restrictive until after the recession began. Judged by the Board after the fact, circumstances called for more restrictive policy. It tightened policy by raising the discount rate and reducing holdings of government securities, so that banks were forced to borrow more at a higher discount rate while adjusting to the new conditions (Annual Report, 1957, 7, 32).

At the start of 1957, the staff described credit market developments as “ominous in their implications” (FOMC Minutes, January 8, 1957, 5). Borrowing at the turn of the year had increased rapidly. At a time when System policy called for tightness, borrowed reserves began to decline. The reason was that the manager acted in anticipation of large credit demands by purchasing $1.3 billion in December in the belief that “because of reduced liquidity positions, banks might be reluctant to supply these rather large credit needs” (ibid., 6). The manager relied on the “feel of the market.” The decline in borrowing and the credit expansion showed that he had misjudged the credit situation.
¹⁶⁶

The manager, who was the target of the criticism, dismissed it citing the
difficulties of operating at the end of the year. The figures for borrowing and free reserves did not give the right impression. Interest rates had increased. The manager thought “it would be possible to recapture the spirit although not the amount of net borrowed reserves that existed early in December” (ibid., 37). The “feel of the market” was the best guide, he said.

165. The reasoning was convoluted. The staff memo reported that conditions had changed since the last increase in April 1955. The present level of margin requirements could not be justified on grounds used to support the last increase. However, the economic outlook remained positive, so a reduction could be misinterpreted as an easier policy stance (Board Minutes, January 18, 1957, 24–25).

166. “These developments illustrate the difficulty of relying upon the feel of the market and the level of interest rates as criteria for System operations . . . To attempt to relieve . . . tightness means facilitating the expansion” (FOMC Minutes, January 8, 1957, 7–8). The staff report did not propose an alternative measure to replace free reserves or borrowing, but the quoted comment shows the changed interpretation of borrowing and free reserves.

Governors Shephardson and Robertson wanted to increase the discount rate and reduce free reserves to counteract inflationary tendencies, but Hayes did not want a higher discount rate. Agreement was hard to reach, since there was no agreement on what constituted ease or tightness and how these terms related to what was happening in the economy. The consensus was to reduce free reserves and change the directive to remove the reference to seasonal factors.

Events continued to surprise the committee and the manager. Demand for credit declined, and market interest rates fell during the winter. Shephardson and Robertson continued to press for a more restrictive policy to reduce inflation. Robertson, looking back, criticized policy in 1956 for responding too quickly to temporary periods of slowing demand. In a prophetic statement he warned that the committee had to distinguish between permanent and temporary changes. The System “cannot effectively curb inflationary developments if we adopt a policy of easing every time there is a temporary lull in an expansion” (FOMC Minutes, February 18, 1957, 23). Most others worried more about the need to prevent attrition in Treasury refundings and short-term changes in the economy. Data showed a decline in industrial production and slower increases in commodity prices. Chairman Martin read the consensus as favoring the status quo.
¹⁶⁷

The budget added to the FOMC’s concerns. After two years of budget surpluses, the administration’s 1958 budget asked for a 10 percent increase in spending. Secretary Humphrey, in an unusual move, criticized the budget, especially increased spending, and asked Congress to reduce his administration’s requested spending to avoid “a depression that will curl your
hair” (Saulnier, 1991, 103).
¹⁶⁸
Apparently he thought an enlarged budget causes depression. Eisenhower agreed despite the obvious criticism of his administration’s budget. The System’s concern was that the budget provided additional stimulus to an economy faced with excess demand and inflation.
¹⁶⁹
To the Federal Reserve, an expanding budget caused inflation. Its policy of financing deficits by issuing money reinforced this conclusion.

167. The lack of clarity in the instructions to the manager continued to create difficulties in deciding whether he had followed the FOMC’s instructions. Free reserves fell in January, but the staff described policy as easier. The staff (Thomas) argued that “the ease referred to in January . . . was not because the System was not carrying out a restrictive policy but resulted entirely because credit was being liquidated very rapidly” (FOMC Minutes, February 18, 1957, 38–39). Martin added: “There was no point in trying to pursue a more restrictive policy if the objectives were being carried out” (ibid., 39). These statements shift the measure of ease and tightness from free reserves to credit growth. Free reserves “eased” because borrowing declined with the decline in bank lending. The statements recognize the problem with use of free reserves, but the FOMC resisted choosing another measure of ease and restraint. The main reasons were lack of agreement on an alternative and a reluctance to
target an interest rate.

At Hayes’s suggestion the FOMC changed the directive at the March 5 meeting to reflect its concern about the outlook. It added the words “recognizing uncertainties in the business outlook, the financial markets, and the international situation” to its concern about inflation (FOMC Minutes, March 5, 1957, 20, 42). The FOMC reappointed Robert Rouse as manager of the open market account without complaint from Martin.

Governor Mills asked whether the very slow growth of the money stock was consistent with economic growth. The System’s purported policy of keeping long-term growth of money equal to the growth of output did not contemplate a “static money supply.” Woodlief Thomas dismissed this concern, saying, “[I]t was necessary to look beyond the measure of the volume of credit to the flow of funds” (ibid., 17). He did not offer a specific measure. Chairman Martin added that “the only way in which we could have growth without inflation . . . was by reducing spending and increasing saving” (ibid., 18).

A forthcoming Treasury offering was a main concern. As usual, Mills favored supplying enough reserves to support the offer (ibid., 28). Robertson warned against “the kind of situation which had occurred time and time again of easing up the market just before a Treasury financing and then of tightening immediately afterward” (ibid., 29). Balderston, Irons (Dallas), Allen (Chicago), Fulton (Cleveland), and Bryan (Atlanta) sided with Robertson. Most of these members favored letting banks borrow to
obtain reserves instead of using open market purchases. This reflected the persistent belief that policy tightened if banks borrowed. Chairman Martin concluded that the majority opposed “too much encouragement to the Treasury financing” (40).

168. To restrict expansion, the administration increased the interest rate on FHA (housing) loans by 0.5 to 5 percent and ended accelerated depreciation schedules to reduce demand for investment. This was a perverse procyclical move. The proposed 1958 budget predicted a surplus of $1.8 billion.

169. At about this time, the Treasury asked the Federal Reserve to exchange some maturing securities for longer-term securities to help extend the maturity of the debt. The Treasury claimed that market participants would be encouraged to take longer-term bonds at refundings if the Federal Reserve was willing to take them also. This violated bills-only policy. The Federal Reserve staff (Riefler) proposed instead to exchange a large part of the System portfolio for a non-marketable perpetuity that paid interest at a 1 percent rate. The new bond would be convertible into Treasury bills if in the future the Federal Reserve needed bills to reduce the monetary base. The main purposes of the proposed exchange were to reduce the Treasury’s interest cost by $400 million and the System’s large revenues. Since the Federal Reserve paid most of its excess revenue to the Treasury, any effect would be small. The System did not adopt either proposal.

Robertson thought he had finally gained support for his opposition to the policy of assisting the Treasury. He soon found that he was mistaken. The account manager purchased securities and allowed borrowing to decline. At the next FOMC meeting, Robertson was angry. He made a lengthy statement “as dispassionately as possible,” accusing the manager of allowing bill rates to decline just before the Treasury offering, contrary to the consensus and to the even keel policy (FOMC Minutes, March 27, 1957, 4–5). Rouse replied, defending his actions and asserting that “there were pressures in the market that were not apparent from the figures presented. . . . Some members of the Committee might not realize the serious situation that the Treasury faced” (ibid., 5–6). Hayes defended the manager. Rouse added that he had kept the market too tight.
¹⁷⁰

Robertson then drew the correct conclusion. The problem lay in the statement, not the interpretation. The error was the “inadequacy of the steps the Committee had taken to specify what it wanted” (ibid., 8). He regarded the manager’s actions as inconsistent with the committee’s decision, but he recognized that other interpretations could be made. Allen (Chicago) agreed with Robertson, but Martin defended the manager. As long as Martin and several others on the FOMC opposed giving more explicit instructions, the manager had considerable autonomy. Neither the minutes nor the background papers make clear the extent to which Martin or Sproul influenced his decisions outside of the meetings.

Ralph Young used his regular briefing to explain why expectations of inflation had become established.
¹⁷¹
He described the appeal to businesses of negative real interest rates, perhaps the first time that idea appeared in a Federal Reserve statement and certainly the first time anyone at the Federal Reserve developed the idea at an FOMC meeting. Households and firms that borrowed to finance purchases of durables or invest in plants and equipment had paid little to borrow. “Little wonder, with prices con
tinuing to advance and expectations of a longer-run uptrend increasingly widespread, that business demands for short- and long-term credit multiplied” (ibid., 14).

170. The weekly average federal funds rate remained 3 percent throughout, but the Treasury bill rate declined. Hayes explained the decline as resulting from an unanticipated increase in the demand for bills (FOMC Minutes, March 27, 1957, 8).

171. “Creeping inflation was no longer a theory, it was a fact being realized. Moreover, the process was predicted to continue, with more and more confidence, for the longer-run” (FOMC Minutes, March 27, 1957, 14). Young then cited three reasons. Monetary policy had validated the postwar increase in prices and the Korean price increases. It had moved aggressively to stop the recession of 1953–54. Young gave a numerical example showing how an (unanticipated) inflation reduced the real value of a corporat
ion’s debt.