A History of the Federal Reserve, Volume 2 (58 page)

The Board insisted that it did not control interest rates and did not peg them. “Federal Reserve policies generally are directed toward providing an appropriate volume of reserves and not toward establishing or maintaining any particular level or pattern of interest rates. Such rates are determined by the forces of the market, one of which is the supply of bank credit” (ibid., 21).
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Instability of velocity and changes that offset the effect of monetary policy on spending were often used to explain why monetary policy was impotent. The Board’s response recognized both arguments. It denied that changes in velocity were sufficiently erratic to make policy operations useless, and it concluded that “the quantity of money can be adjusted to compensate for velocity changes” (ibid., 95).
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The Board rejected Warren Smith’s argument used by the congressional committee in 1959.

The Commission’s questions explored other reasons why monetary policy would not work. The Board’s answers rejected all of them. The existence of a large government debt “neither ‘assists’ nor ‘hampers’ to any significant extent the effectiveness of monetary policy” (ibid., 78). The Board said that the debt helped to transmit monetary impulses across the term structure, and it permitted the System to rely mainly on open market purchases and sales in its operations. The main problem caused by a large debt, the Board said, came from the frequency of Treasury operations. At times, these made the “execution of policy more difficult” (ibid., 79). The Board did not mention that the System could avoid these difficulties if the Treasury auctioned its debt instead of selling at a fixed price and yield.

The Board did not mention the
Report
on
Employment,
Growth,
and
Price
Levels,
but it responded to the call for direct controls on credit. “Selective controls are awkward, costly, and onerous to enforce effectively. When continued over extended periods, moreover, such controls tend to be subverted by changes in credit market relationships” (ibid., 50). Further, direct controls distort demand.

In 1951 the System ga
ve a prominent place to discounting as a monetary
tool. By the 1960s, the Board described the role of discounting much as it had in the 1920s. “Discount policy and open market policy are inevitably integral parts of a single policy. . . . [S]hifts between policies of ease and restraint often do not involve absolute changes in the total amount of reserves available to the banking system, but rather changes in the sources of reserves” (ibid., 118). “Reserves obtained through borrowing are typically accompanied by a spreading atmosphere of credit restraint, as contrasted with the effect of a corresponding amount of reserves injected by open market operations . . . Administrative restraint exercised by discount officials together with the reluctance of banks to borrow make it likely that a bank forced to borrow will in turn search for Federal funds, seek correspondent accommodation, offer securities for sale, . . . and/or curtail its direct loan activity” (ibid., 118).
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48. In a final gasp of support for the bills-only policy, the Board added that it conducted its operations to “minimize their influence on the structure or pattern of rates” (Commission on Money and Credit, 1963, 21). The Board’s insistence on control of reserves and not interest rates shows continuing concern to avoid pressure from Congressman Patman and others to return to a pegging policy. If they admitted that they controlled an interest rate, he could urge them to lower it and peg it.

49. The answer attributed the postwar increase in velocity to the working off of the large wartime increase in the money stock, firms’ resumption of cash management practices used in the 1920s, and the development of credit cards for consumers.

The Board’s response gave the discount rate a larger role than in the past, especially if the discount rate was above the market rate. Elements of the older “reluctance to borrow” view remained, but banks now responded to differences between the discount rate and the market rate. The summary on the discount rate lists three determinants of member bank borrowing— the discount rate or cost, reluctance to borrow or to remain in debt, and administration of the discount window by the reserve banks. The Board continued to reject proposals for a penalty rate that moved the discount rate in step with a prominent market rate, for example the Treasury bill rate.
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And the statement neglects the effect on banks as borrowed reserves spread through the system. A receiving bank had no way to know whether the reserves it received originated in borrowing or in open market operations.

The Board’s reply recognized that ceiling rates for time deposits affected banks’ competitive position without any effect on the aggregate amount saved. The clearest case was foreign owned dollar assets. These deposits shifted into non-bank assets, such as Treasury bills, when ceiling rates became binding. Money center banks lost deposits at such times. Other banks were often reluctant to raise time deposit rates to the ceiling. One reason was the prohibition of interest payments on demand deposits. By raising time deposit rates, banks induced customers to shift from demand deposits to time deposits, reducing the average reserve requirement ratio
but raising interest cost. Although the Board commented on the distortions caused by interest rate regulation, it did not suggest removing the regulation or putting it on stand-by.

50. A few pages later, the Board recognized that borrowing increased reserves. “Even though each bank borrows only temporarily, additional reserves are drawn into the banking system providing the basis for credit and monetary expansion” (Commission on Money and Credit, 1963, 122).

51. The Commission asked only one question about reserve requirements. The Board rejected basing reserve requirements on deposit turnover or bank assets. It had considered such arrangements since the 1930s, but seemed to prefer the prevailing system.

The Commission asked only one question about the balance of payments and the influence of international concerns. The Board’s response denied any role to international objectives.
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It recognized the long-run adjustment problem but relied on a strong gold reserve position to maintain confidence during recessions, when there was a balance of payments deficit. And it recognized international considerations as they affected prices and demand in the domestic market. Much of the long-run problem was either non-economic, for example military assistance or foreign aid, or was caused by “shifts in the international competitive situation” (ibid., 176). The Board had an obligation to maintain price stability, but it recognized that stable prices alone would not assure long-run balance of payments adjustment.

The Commission proposed structural changes that removed reserve bank presidents from the FOMC. These angered the presidents. Allan Sproul blamed former Chairman Marriner Eccles, a member of the Commission, who had advocated similar changes in 1935 (letter, Sproul to Hayes, Sproul papers, Correspondence, July 4, 1961).
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Subsequently the proposal reappeared several times but never gained a following in Congress.

The
Administration’s
Response

The Kennedy administration responded to the Commission’s report by appointing two internal committees, one to restudy the role of financial institutions, the other to study federal credit programs. The two reports found no reason either for major changes or for urgent attention to restructuring existing arrangements (Federal Credit, 1963; Financial Institutions, 1963).
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52. “Considerations related to the international transactions of the United States do not change the underlying objectives of monetary policy, which are to contribute to the maintenance of U.S. financial stability and to sustainable growth in the U.S. economy, they do at times have a bearing on the choice of actions to be taken” (Commission on Money and Credit, 1963, 172). The Board pointed out that in the 1960 recession, it had to consider the effect of lowering interest rates on capital outflows, gold, and confidence in the dollar (ibid., 175).

53. See volume 1, chapter 6. The proposal also raised old internal concerns. William Trieber, New York’s vice president, reported that Chairman Martin opposed the proposed change, but “I’m not sure how strongly he’d fight for it [the present structure]” (letter, Trieber to Sproul, Sproul papers, August 11, 1961). Sproul declined to testify in Congress, but he wrote a strongly worded letter to Congressman Patman opposing any change in the membership of the FOMC (letter, Sproul to Patman, Sproul papers August 16, 1961).

54. Meltzer (1964) reviewed the two reports. The summary in the text comes from that review article.

Financial Institutions (1963) proposed (1) basing reserve requirements for demand deposits on volume of deposits instead of location (reserve city and country banks), (2) subjecting member and non-member banks to the same reserve requirements; (3) extending Federal Reserve discount window privileges to all commercial banks; and (4) continuing voluntary membership in the Federal Reserve System for state banks. The Commission on Money and Credit favored elimination of reserve requirements on time deposits and mandatory membership in the System for state banks. Financial Institutions (1963) preferred to equalize competitive position by imposing reserve requirements on shares at savings and loan associations and deposits of mutual savings banks.

None of the recommendations was adopted at the time. In the 1980s, all commercial banks became subject to reserve requirements on transaction deposits (demand deposits, negotiable order of withdrawal accounts) and non-personal time and saving deposits. Personal time and savings deposits became exempt. Congress did not require all banks to become member banks.

On the more critical issue of interest rate regulation, Financial Institutions (1963) made a bold proposal—to replace interest rate ceilings with stand-by controls that could be used in an emergency. Congress did not implement the change.
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THE 1960–61 RECESSION

In April 1960 the economy reached a peak only two years after the trough of the previous recession. The recession proved mild. It lasted ten months, but the decline in real GNP, 1.2 percent, was the smallest of the postwar recessions to that time. The unemployment rate rose to 7.1 percent in May 1961, somewhat higher than in 1953–54 because it started from a higher level (Zarnowitz and Moore, 1986, Table 7).

The timing of the recession, and the history of three recessions in eight years, helped the Democrats elect their presidential candidate, John F. Kennedy, on a platform of getting the economy moving. Kennedy blamed the bills-only policy and the Eisenhower administration’s policy of allowing the budget to swing from a $12 billion deficit to a $500 million surplus in one year (Office of Management and Budget, 1990, Table 1.1).

Most of the change was in tax receipts that rose with the economy. The Eisenhower administration, and the president himself, could toler
ate a budget deficit during the recession, but they believed that deficits caused inflation and weakened the dollar. Raymond Saulnier, chairman of the Council of Economic Advisers, explained later that a steel strike in the second half of 1959 left a large inventory accumulation. “It was very difficult in the first half of 1960 to see whether you were dealing with a backlash of the steel strike or whether you had a cyclical problem on your hands” (Hargrove and Morley, 1984, 137). But Saulnier also rejected the claim that the budget was too restrictive.
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55. Federal Credit (1963) accepted many of the recommendations of the Commission on Money and Credit and discussed implementation. President Kennedy recommended several of the proposed changes.

Although the administration denied a request from Arthur Burns and Vice President Richard Nixon to ask for easier Federal Reserve policy to avoid a recession, Saulnier explained that the administration wanted a more expansive monetary policy than the Federal Reserve in 1960, but the difference was not great.
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And he agreed with the Federal Reserve’s concern about the importance of keeping inflation low to support the dollar. President Eisenhower also believed firmly in the importance of sustaining confidence in the dollar (Stein, 1990, 368).
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A major reason for low inflation followed by recession is plainly visible in the slow growth, followed by decline, in the real value of the monetary base, shown in Chart 3.7. The modest decline in ex post real interest rates through most of 1959 and early 1960 was accompanied by a steeper decline first in growth of the real monetary base and later in its level. Annual growth of the nominal base fell from 2.25 percent in December 1958 to 0 in spring and summer 1960. Consumer prices rose modestly, but more than the base.

The 1959–60 policy was the only sustained deflationary action during
the Bretton Woods years. It was an unintended consequence of paying attention to free reserves and ignoring money growth. It sacrificed domestic expansion to strengthen the dollar. The short-term effect was negative; the recession lowered returns on domestic assets relative to assets abroad, increasing the capital outflow. There was not enough political support to sustain the program long enough to get the full benefits. Instead, the Kennedy administration introduced a number of actions to stimulate expansion.

56. Saulnier described the Keynesian claim based on the full-employment budget as “an unduly narrow view of the economy” (Hargrove and Morley, 1984, 138). The proper way to judge the credit system, he believed, was to look at the whole credit system—borrowing by households, business, and government. He accused the Keynesians of being “narrow and myopic” (ibid., 138) for concentrating only on the government budget. A few pages later, he attributed the 1959 decline entirely to the effect of the steel strike. “1959 was not a cyclical problem. The steel strike was in 1959, and you can’t really discuss anything but the steel strike in 1959” (ibid., 152).

57. “Our position on the question . . . was more inclined to an easing of the situation than his [Martin’s]” (Hargrove and Morley, 1984, 137). Later Saulnier defended Federal Reserve policy, noting that free reserves rose from −$500 to +$500 million. Short-term interest rates declined from 4 percent in December 1959 to 2.4 percent in November 1960. There is no evidence that the election influenced the policy change (ibid., 154). Like Federal Reserve officials, Saulnier ignored money growth when discussing policy thrust. This experience heavily influenced Nixon’s negative view of Martin and positive view of Burns.

58. “In October [1960], usually a month of rising employment, the jobless rolls increased by 452,000. All the speeches, television broadcasts, and precinct work in the world could not counteract that one hard fact” (Nixon, 1962, 311).