A History of the Federal Reserve, Volume 2 (10 page)

The 1950s was a decade of moderate growth with low but variable average inflation. Outcomes were among the best, on average, until the 1990s. Real GNP rose at a compound annual rate of 2.6 percent despite a relatively mild recession in 1953–54 and a deeper recession in 1957–58. Productivity and output per hour in the private sector rose at a 2.7 percent average annual rate. Chart 2.1 shows productivity growth and fluctuations. Productivity growth rose and fell cyclically but not uniformly. For example, productivity growth fell more in the relatively mild 1953–54 recession than in the more severe 1957–58 recession.

The percentage of the labor force unemployed (Chart 2.2) started the period at about 3 percent, averaged 4.5 percent for the decade, but rose above 7 percent in the 1958 recession (Council of Economic Advisers, 1971). Each cyclical rise in the unemployment rate started from a higher level than the previous rise. Many in Congress blamed the Federal Reserve for the rising average rate.

Inflation remained positive, at the time an unusual experience for the peacetime United States. As Chart 2.3 shows, inflation rose after 1953–55 and remained above its earlier range until the end of the decade. For
the period as a whole, inflation measured by the GNP deflator averaged 2.5 percent, with a peak rate above 5 percent in 1957. This experience was far superior to that of the next three decades.

7. Martin recommended Mills and Robertson in a letter to President Truman (Martin papers, January 21, 1952).

Inflation contributed to a rise in real and nominal interest rates over the decade. The nominal rate on Treasury notes and bonds with three to five years of remaining life rose from about 1.5 percent in 1950 to approximately 4 percent at the end of the decade. At peak interest rates in 1959,
the Treasury sold a 5 percent note, called the “magic 5s” because their coupon rate was above any yield the Treasury had offered since before the Federal Reserve started.

These and other data on interest rates, wages, and prices suggest that a change occurred during the decade. Inflation during World Wars I and II, and briefly during the Korean War, had not raised interest rates very much. Nor had the postwar years of pegged rates, despite the Federal Reserve’s belief that it had become an “engine of inflation.” A partial explanation is that the public did not expect inflation to persist, but it was also true that until the Accord they could sell their bonds at fixed rates to the Federal Reserve whenever they chose. In contrast, by 1959, long-term interest rates suggest that markets expected inflation to persist over time. Also, bondholders could no longer sell their bonds to the Federal Reserve without loss. Bond yields reflected the changed risk and expectation of inflation.

Contemporary observers pointed to budget deficits and (non-productive) expenditures for defense and foreign aid as a source of inflation. Despite President Eisenhower’s many calls for fiscal prudence, and a budget surplus in three of the ten years, the government’s fiscal position and policy were much different in the 1950s than in the 1920s. Secretary Andrew Mellon and Presidents Warren Harding and Calvin Coolidge ran large surpluses that they used to pay down debt and reduce tax rates; President Eisenhower had one tax cut that reduced high wartime rates by about 10 percent in 1954, but the public debt rose during his administration. Chart 2.4 shows that the Eisenhower administration achieved budget surpluses in 1956 and 1957 followed by a very large deficit by the standards of the time in 1959—2.5 percent of GDP. It made a major effort to restore budget
balance in 1960. At one point, it called on the Federal Reserve to help by making an extra cash payment to the Treasury.

Judged by base money growth, monetary policy was highly variable around a relatively stable trend after 1952. In the first years after the Accord, System actions reduced average base growth to the 1 to 2 percent range, in which it remained for the rest of the decade. Chart 2.5 shows these data.

The System did not attempt to control or monitor the monetary base. The main source of the base is open market operations and changes in reserve requirement ratios. The Federal Reserve could sustain its choice of a shortterm interest rate only by standing ready to buy or sell reserves (base money) as the market required. At different times, the same market interest rate might require large Federal Reserve sales or equally large purchases, hence falling or rising stocks of base money. Fixing a nominal interest rate can expand or contract money growth depending on the expected rate of inflation and expected real growth. The growth rates of the nominal and real monetary base relative to GDP show whether the Federal Reserve’s choice of interest rates eased or restricted the growth of base money.
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8. Two common criticisms of the monetary base are: (1) the base consists mostly of currency, so it is demand determined because the System supplies currency on demand; and (2) as much as 60 percent of the monetary base is held abroad. First, on the sources side, the base consists mainly of the open market portfolio, and growth of the base reflects Federal Re
serve purchases. If the base rises rapidly because the demand for currency increases rapidly, that is a signal either that the economy is expanding rapidly at current interest rates, or that there is a run from bank deposits to currency. Second, foreign holdings are part of the stock of base money. Monetary policy should concentrate on base growth, not level. The former is not much affected by changes in growth of foreign holdings. See appendix.

Many contemporary observers blamed labor unions and businesses for inflation. The Economic Reports of the President in the later part of the decade exhort labor unions and corporations to moderate their demands in the public interest (Council of Economic Advisers, 1956, 1959). The Eisenhower administration did not offer numerical guidelines for wages and prices. That waited for its successors.

REDESIGNING THE FEDERAL RESERVE

For the first time since 1928, the Republicans, led by retired General Dwight Eisenhower, won control of the presidency and both houses of Congress in the 1952 election. Eisenhower had pledged to go to Korea to end the war if elected. A truce was declared on June 27, 1953. With the truce, growth of defense spending fell sharply from a 100 percent rate of increase in fiscal 1952 to a 13 percent rate for 1953. In fiscal 1954, defense spending fell more than 6 percent. Eisenhower’s policy called for a balanced budget and reduced government spending. He firmly believed that government set the rules and promoted “conditions favorable to the exercise of individual initiative and effort” (Saulnier, 1991, 15). He immediately showed that deficit reduction and budget balance had priority over tax cuts by postponing the expiration of wartime excise taxes against opposition from many in his own party (Eisenhower, 1963, 202). He removed Korean War price controls soon after taking office and followed by closing the Reconstruction Finance Corporation, a relic of the Great Depression, retaining only small business lending in a new Small Business Administration.

The new administration appointed W. Randolph Burgess as Undersecretary of the Treasury. Burgess had spent many years as an officer of the New York Federal Reserve Bank. After leaving the New York bank to become vice chairman of National City Bank, he represented the second district on the Federal Advisory Council. He had spoken and testified against the policy of pegging interest rates.
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Martin believed that the new administration gave him an opportunity to separate monetary management from debt management. The Federal Re
serve did not peg bond prices after March 1951, but until November 1952 it supported refunding of Treasury certificates, usually by purchasing rights to the new issue. Almost a year of cooperation with the Treasury after the Accord had convinced him that the Federal Reserve would not free itself from support of Treasury issues if it continued to advise the Treasury on debt management. Martin appointed a three-person subcommittee of the FOMC, in April 1952, to recommend changes in operating procedures. He served as chairman. The other members were Abbott Mills, newly appointed to the Board, and Malcolm Bryan, president of the Atlanta Federal Reserve Bank.
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The subcommittee completed its report in December 1952.
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9. As president of the American Bankers Association, Burgess actively opposed the Bretton Woods Agreement. He was willing to change his position if the Treasury agreed to changes. Harry Dexter White refused, but Congress included some of the changes (affidavit of E. M. Bernstein, in Sproul papers, Correspondence A–M 1936–1955, January 15, 1954). Burgess did nothing to change the IMF during his service at the Treasury.

The report was a main topic at the March 1953 FOMC meeting. After much discussion, the FOMC voted to change the wording of its directive to reflect its less active role in the long-term market. In place of “maintaining orderly conditions in the Government security market,” the directive now read “correcting a disorderly situation” (FOMC Minutes, March 4, 1953, 22). The committee reaffirmed its commitment to rely on discounting to supply reserves, using Riefler-Burgess reasoning to explain how discount policy worked. Discounting “limits credit expansion, puts pressure on banks, and makes them more responsive to changes in the discount rate” (Annual Report, 1953, 87).
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The subcommittee recommended that the Federal Reserve stop making specific proposals about the terms of
Treasury issues. It concluded also that the account manager and the New York bank had too much discretion and that a few members dominated decisions.
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The report obliquely accused Sproul of conflict of interest because he made operating decisions and participated in the policy discussion and the assessment of operations. It proposed to increase participation by the regional bank presidents and reduce New York’s influence. In a letter to Sproul, Martin made two major criticisms of existing arrangements. First, members did not understand how the desk implemented FOMC decisions. The System would be embarrassed if Congress learned about this in a hearing. Second was the principal-agent problem that arose because the FOMC could not fire the manager (letter, Martin to Sproul, Martin papers, undated but likely July 1953). The entire discussion shows that Martin saw the problem as a lack of administrative control. H
e did not recognize that the FOMC could control the manager by giving precise instructions and assuring that the manager followed them.

10. Abbott L. Mills, Jr., served on the Board of Governors from February 1952 to February 1965. Mills filled the vacancy left by Marriner Eccles’s resignation. Mills was an active member with an independent view that he expressed forcefully at a time when most FOMC members did not. He favored expansive policies and dissented several times when the FOMC voted to tighten (Katz, 1992). Bryan was an economist who had taught at the University of Georgia before joining the System. He spent five years as vice chairman of a Georgia bank.

11. Robert H. Craft of Guaranty Trust served as technical consultant on leave from his bank. The complete report is printed in Joint Committee on the Economic Report (1954, 257–307), followed by comments by the New York Federal Reserve Bank. Martin wanted to commission the report in May 1951 but delayed a year to await the report of the Joint Economic Committee chaired by Congressman Wright Patman in 1952. Volume 1, page 715 discusses this report.

12. Riefler-Burgess reasoning refers to the work in the 1920s at the Board and the New York bank that provided the policy framework used in the 1920s and early 1930s. See volume 1, chapter 4. In the 1950s, Riefler continued to hold that banks did not borrow for profit and interest rate spreads did not affect the volume of borrowing. Karl Bopp at the Philadelphia bank took the opposite view. Rate spreads affected borrowing, according to Bopp. At New York, Sproul and one of the vice presidents, Harold V. Roelse, sided with Riefler (memo, Roelse to Sproul, Sproul papers, September 29, 1954). Robert Roosa took an intermediate position, arguing that the reason for changing discount (and other) rates was that “there’s still room for profitability as an independent influence” (quoted in ibid., 1). Roelse’s memo shows that the New York and Board staffs had resumed their quarrels from the 1920s. Roelse remarked that he rarely found much to agree with in Riefler’s work.