A History of the Federal Reserve, Volume 2 (41 page)

On March 1, the committee revised the directive to eliminate the reference to inflation. The new directive called for “fostering sustainable growth in economic activity and employment while guarding against excessive credit expansion” (FOMC Minutes, March 1, 1960, 74). There was general agreement that policy was too restrictive. Martin expressed the consensus as favoring –$250 to –$300 million of free reserves, an increase of $50 to $100 million from the February average.
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Several members referred to the decline in the money supply and wanted to end it by using quantitative targets. The manager preferred to concentrate attention on the tone and feel of the market. This tension continued. There was no agreement about how to define and conduct policy. President Hayes proposed more active use of regulation Q ceiling rates to signal the direction in which interest rates should change, and Leedy (Kansas City) proposed using an interest rate target. The FOMC could not reach a consensus. After the March 1 decision to increase free reserves, it took no further action before the recession started, but in April it gave the manager authority to let free reserves fluctuate in a wider band (FOMC Minutes, April 12, 1960).
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The divisions within the FOMC covered several dimensions. Some wanted precise quantitative targets to hold the manager to account. Others, led by Hayes but often joined by Martin, favored qualitative targets and managerial discretion. Some wanted to use reserves or the money supply as a target, and many members criticized the use of free reserves. Despite the misleading interpretation of borrowing that Bryan and Balder- ston pointed out, free reserves remained the most frequent target when the FOMC chose a target. Some thought the economy would continue expanding. They cited consumer surveys and inflationary psychology. Others expressed concern about declining tax receipts, money supply, and credit.
President Bryan summarized the committee’s position: it had not reached a conclusion about what policy had been, so it was not able to call for a policy change (FOMC Minutes, April 12, 1960, 34). He again predicted trouble ahead.
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264. Governor King noted that the staff’s proposal frequently used the phrase “not the policy of the Committee.” He asked, what is the committee’s policy?

265. The FOMC voted at the March 1 meeting to distribute the report of its meeting to the Treasury.

266. Brunner and Meltzer (1989, 69) record a decisive move toward easier policy in April 1960 followed by a further move at meetings on May 3 and 24. Free reserves had increased in March but did not change noticeably after the April 12 meeting. Free reserves rose again in advance of the May 24 meeting. One reason often suggested for use of free reserves instead of an interest rate target was concern that Congressman Patman would increase pressure to lower the interest rate target. The System usually denied that it controlled an interest rate.

Differences of opinion about the wording of the directive surfaced again at the March 1 meeting. Chairman Martin had asked the staff to propose changes in the directive, partly to meet complaints that the System was doctrinaire and inflexible. The staff proposed a more flexible alternative that permitted the manager to request permission to intervene in the market for securities other than bills. Also, the proposal introduced “principally but not exclusively” into the bills-only clause (Memo, Thomas, Rouse, Young to FOMC, Board Records, February 5, 1960).

The committee did not address control of policy actions. Vague instructions gave the manager considerable freedom to make decisions or perhaps respond to direction from Martin or Hayes. Table 2.6 shows dates of committee decisions to ease or restrain policy at cyclical turning points and dates for a change in the three-week moving average of free reserves. Two points stand out. First, the committee voted to change policy near the turning points in economic activity, using National Bureau of Economic Research turning points. Although the early change in June 1953 was fortuitous, the Federal Reserve was alert to changes in the economy. The recognition lag was never more than four months (1954) and usually very short. Second, the manager often changed free reserves before the committee acted.

In Executive Session after its February 1960 meeting, the FOMC divided along several lines. No one proposed better control of the manager.
Hayes and Erickson (Boston) favored the staff proposal. Szymczak, Mills, and King preferred the old statement with “primarily” in place of “solely” bills, but Szymczak reminded the members that wartime and postwar pegging began as a policy of maintaining orderly markets for the Treasury. Johns rejected the complaints about inflexibility or rigidity as “a charge brought solely by those who opposed the principles which the statement expressed” (Executive Session, FOMC, March 7, 1960, 4, based on notes included by the Secretary in the March 1, 1960, minutes.)

267. Balderston described the economy as in a period of “rolling prosperity,” but he was uncertain about the direction in which it was rolling. Martin now defended recent policy as correct, reversing his February comment.

Seeing no consensus about to form, Martin proposed keeping the existing language temporarily. The committee would revisit the subject at a later meeting.

The decline in inflation in 1959–60 should have added weight to the views of policymakers and others that inflation could be prevented by reducing money growth. They did not draw that conclusion, perhaps because many of them believed that budget deficits or labor unions caused inflation while others doubted that monetary policy alone could slow inflation. Concerns that reducing inflation would increase unemployment played a role also. The shift from a large budget deficit to a small surplus strengthened beliefs about the power of fiscal deficits.

A recession started in 1960. Both presidential candidates and many in Congress and elsewhere blamed the Federal Reserve for sluggish growth and three recessions in seven years. This too reduced the confidence that policymakers might have gained from their success in reducing inflation. In the years after 1965 the members did not look back at this experience as evidence of what they could do.

Regulation
Q
Again

The Board discussed the competitive position of banks in the market for time deposits many times as open market rates rose above regulation Q ceiling rates. Both the System and the industry had multiple concerns. Large banks in New York wanted rates increased to attract large foreign deposits. Banks facing strong competitive pressures from savings and loan associations also favored higher rates. Banks that did not offer the 3 percent ceiling rate typically opposed higher rates. The Board and the reserve bank presidents reflected these pressures.

The result was much discussion but no action. The Board did not raise the 3 percent ceiling rate until 1962. It considered, but did not adopt, a redefinition of savings deposits and a proposal to offer premium interest rates to foreign depositors. Political considerations dominated economic decisions. Pressure for higher rates came mainly from New York banks. With slow growth of the monetary base, bank credit expansion depended
on growth of time deposits. Ceiling rates prevented that growth, reducing bank earnings. Higher interest rates did not appeal to homebuilders, many bankers, and populist members of Congress. Thus, the Federal Reserve took the first steps toward a policy that eventually would have devastating effects on the banking and thrift industries over the next quarter century.

In fall 1958, the New York bank suggested a staff study to determine the principles that should govern changes in regulation Q rates. The conclusion was that regulation Q should be treated as a banking issue and not a monetary policy issue, since the intent of the legislation was to prevent banks from competing aggressively for time deposits. The staff proposed that the Board set the ceiling rate high enough to allow individual banks to change rates up and down. The ceiling rate could be changed judgmentally to meet market rate changes or be set by a formula that provided automatic adjustment.

The decision to treat rate regulation as a banking issue, not a monetary issue, proved to be a costly error. It directed current and subsequent discussion to concerns about the relative position of financial institutions, encouraging banks and non-bank financial firms to base their case on the costs or benefits to them. New York would argue that a higher rate attracted foreign deposits. Regional banks pointed to the cost they would incur by raising the average rate paid to all depositors to attract a small increment of new deposits on the margin. The discussion gave little attention to the effects of disintermediation on the financial system; the System was unprepared for the strong response to ceiling rates in 1966–67 or the financial crisis in 1970. Ultimately, the costs of controls on the allocation of financial assets and the welfare of depositors had to be paid.

The staff described the difference between the economic and supervisory aspects. “From a purely economic standpoint an interest rate ceiling made no sense; but from the viewpoint of maintaining soundness in the asset structure of banks, such regulation had been considered . . . necessary” (Board Minutes, October 6, 1959, 4). The staff cited research suggesting that time deposits responded sensitively to interest rates, but savings deposits did not. Riefler proposed asking Congress to allow the Board to set different rates for different types of banks and deposits and to require that banks hold short-term liquid assets as collateral for time deposits (ibid., 5).
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268. Chairman Martin criticized the staff’s claim that saving deposits were insensitive to interest rates. “This was a dangerous view for a central banker to take. He noted that there was a time lag between any change in the interest rate and a corresponding change in the over-all supply of savings” (Board Minutes, October 6, 1959, 8). Martin added that it was difficult to estimate the length of the lag, but “sooner or later the rate had an effect” (ibid., 8). He did not favor an increase at the time.

The Board held a cursory discussion. It did not want to draw money from Treasury bills to time deposits or to assist New York banks by permitting a higher rate on foreign time deposits. A decision to pay foreign governments higher rates than domestic savers would arouse criticism that the Board could avoid (Board Minutes, January 16, 1959, 11–13).

New York banks and the New York Reserve bank did not accept defeat. They continued to petition for higher rates on foreign deposits. The Board’s only concession was to permit a grace period. Deposits received by the tenth of the month could receive interest from the first (Board Minutes, June 1, 1959, 2–4). The Board’s staff generally opposed higher rates. Several questioned whether it was desirable for banks to hold time and savings deposits (Board Minutes, June 30, 1959, 8–9). Most banks, at the time, paid less than the ceiling rate of 3 percent; the average rate was 2.4 percent (ibid., 10).
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Governor Balderston recognized the critical issue. If the current increase in market rates was temporary, he said, the Board did not have to increase maximum rates on savings and time deposits. If higher rates were permanent or long lasting, “it would be an anachronism for the System to have retained the present ceiling on savings deposits” (Board Minutes, October 6, 1959, 9). Chairman Martin agreed.

The Board returned to the discussion many times, but it did not make any changes. In December, it discussed its response to a letter from Congressman Patman about payments in kind for demand deposits. The Board’s response recalled that the Federal Reserve Act prohibited interest on demand deposits “directly or indirectly, by any device whatsoever.” As with any price control, enforcement raised many issues. The rest of the letter discussed the many decisions the Board had to make to specify what was permitted (Board Minutes, December 18, 1959, letter, Martin to Patman).
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In February 1960, New York again proposed different treatment for time and savings deposits. The Board decided to follow Balderston’s earlier
suggestion. It would change the ceiling rate for savings deposits only after a “fundamental change in the levels of long-term interest rates” (Board Minutes, February 9, 1960, 2). Rates on savings deposits would adjust, after a lag, to changes in long-term government or mortgage rates. Savings accounts belonged mainly to individuals. Many time deposit accounts belonged to corporations, foreign governments, and institutions. New York proposed that these rates should be flexible. The Board could set a ceiling above current market rates for time deposits and permit rates to adjust to market conditions.
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269. The international staff reported that the funds the banks lost as time deposits went to Treasury bills, so the balance of payments was not affected much (Board Minutes, June 30, 1959, 11). In September, the Federal Advisory Council surprised the Board by favoring higher rates on time deposits held for foreign banks (Board Minutes, September 15, 1959, 14). One of the main arguments by bankers against an increase in the rate paid to domestic savers was that the rise in interest rates had reduced the banks’ capital accounts. An increase in rates paid to savers would reduce their earnings and possibly their capital because deposits would not increase enough to cover the higher cost (ibid., 19–20).

270. As examples, the Board permitted omission of a charge for armored car service and free parking facilities, but it prohibited absorption of exchange charges when collecting nonpar checks (Board Minutes, December 18, 1959, letter, Martin to Patman).