A History of the Federal Reserve, Volume 2 (15 page)

The System found it difficult to reconcile its belief about how discount policy worked with the volume of borrowing in 1952.
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Sproul offered a different interpretation. Member banks remained reluctant to borrow because they “do not like to be in the position of having us able to tell them that they must reduce or eliminate their borrowing from us, which forces them to make other adjustments in their portfolios” (memo, Sproul to Trieber and Rouse, Sproul papers, FOMC Correspondence, September 26, 1952).

In 1954, the Federal Reserve modified its discount policy by changing the foreword to its regulation A, effective February 1955, governing a member bank’s use of discounting. The revision stated the general principle that borrowing was a privilege and not a right of membership in the System. It was mainly a short-term loan to assist banks facing a sudden change in the demand for credit. It should not be used to profit from rate differentials or other opportunities. All members of the Federal Advisory Council opposed the change as a restriction on their right to discount (Board Minutes, September 21, 1954, 2–8). Defending the change in language, Governor Mills explained that a System study of the discount mechanism had shown that in 1952–53, “active use of the discount window . . . had provided additional reserves . . . in a super-abundant amount which had the effect of counteracting the restrictive open market policy” (ibid., 4). This contradicted Sproul’s interpretation of borrowing and the interpretation of changes in free reserves, where an increase in borrowing indicated more restrictive policy. No one mentioned the inconsistency at the time, and no one mentioned that the Federal Reserve could raise the discount rate to restrict borrowing.

To mollify the bankers, the Board issued a statement that the “revised foreword is designed merely to restate and clarify certain guiding principles . . . [and] is not intended to further restrict or restrain access by member banks to the credit facilities of the Federal Reserve banks” (Annual Report, 1955, 83). This statement is, at best, misleading. In their discussion with the Federal Advisory Council, both bankers and Board members described the change as a response to the heavy use of the discount window in 1952–53.

44. Ralph Young, deputy research director at the time, summarized discount policy in 1952–53, a period with relatively large borrowing.

It was definitely an experiment . . . in the pattern of System discount tradition. . . . The System followed the market rather than leading it and penalizing the use of reserve bank credit by means of the discount rate. It relied on the tradition against borrowing and the reluctance to stay in debt to restrain undue credit expansion. And the System was surprised that borrowing for profit went on and that monetary expansion during the period of build-up in member bank debt was so rapid.(FOMC Minutes, August 23, 1955, 15)

The Board reconsidered the role of discounting in its 1957 Annual Report, eliminating many of its long-standing beliefs. The System had changed discount rates eight times in 1955–57, seven increases and one reduction. The Board, at last, recognized that when one bank repaid its borrowing, another might be forced to borrow, so that aggregate reserves did not decline. And it recognized that increased borrowing offset open market sales and that the “attitude of member banks toward operating with borrowed resources varies from bank to bank” (Annual Report, 1957, 12). The System discouraged reliance on extended borrowing (ibid.). Many banks avoided borrowing because pressures to repay required portfolio adjustment. Discount rate increases reinforced banks’ reluctance to borrow (ibid., 13).

The Board found no conflict between discounting and open market operations. Market and discount rates were interdependent. By raising the discount rate above the market rate, the System encouraged banks to adjust by selling securities instead of discounting. Short-term rates rose, reinforcing an open market policy of sales.

The Board did not reconcile this view of discounting with its use of free reserves as an indicator of ease and restraint. If additional discounting increased reserves, as the Board now recognized, a reduction in free reserves that increased total reserves was expansive, a point the Board did not recognize.

Other
Changes

The Federal Reserve Act of 1913 incorporated the real bills doctrines and the gold standard as guiding principles. The use of Treasury bills as the principal asset used to adjust reserve positions could not be reconciled with the real bills view that inflation was the inevitable consequence of basing credit expansion on government securities (or other speculative assets).
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In the 1950s, the System held a loose quantitative view. Inflation resulted from too much money growth and budget deficits.

Belief in the automaticity and benign properties of the gold standard faded also. As a member of the International Monetary Fund, the United States committed to maintain the price of gold at $35 an ounce. It committed also to the primarily domestic goals of the Employment Act. The latter dominated any concern about international effects of monetary policy in
the 1950s.
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The principal international concern was restoration of currency convertibility for current account transactions. With its large gold stock, unchallenged productivity, small share of exports or imports, and positive net exports, the international payments position seemed unimportant. By the end of the decade, however, concern about the capital outflow began to rise.
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45. By the late 1990s, the System had moved so far from its roots that many in the System expressed concern that budget surpluses and debt reduction would remove all outstanding Treasury bills. How could they conduct policy they asked, without government securities? The issue disappeared with the budget deficits in the early twenty-first century.

Nothing in the 1950s compares to the Board’s Tenth Annual Report or the Riefler (1930) and Burgess (1927) books. The staff’s most complete statement of the role of monetary policy and the monetary transmission process is
The
Federal
Reserve
System:
Purposes
and
Functions.
The third edition (Board of Governors of the Federal Reserve System, 1954) summarizes staff views and understanding at the time.
⁴⁸

The staff’s discussion of monetary policy was more complete than mainstream academic views of that time. In the Federal Reserve’s best statements, monetary policy affects the economy mainly by changing investment in inventories and durable capital, but also by affecting mortgage lending and housing. These responses occur through four channels: borrowing and lending, changes in the money stock and cash balances, changes in expectations, and changes in capital values and wealth (Board of Governors 1954, 123–36).

Although the various elements were not combined in an explicit framework, the emphasis given to expectations, capital values, and relative prices (or capital values) suggests an underlying sophistication that anticipated much future research. Mixed with these elements were residues of earlier ideas, including banks’ reluctance to borrow from the Federal Reserve. Growth of the money stock (usually currency and demand deposits) had a more prominent role than in the 1920s. At each FOMC meeting, the staff reported on growth of money and credit. Martin, Riefler, and others believed that to avoid inflation, money should grow at about the growth rate
of real output.
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There was general recognition that the price level could change for many reasons, but excessive money growth was necessary for sustained inflation.

46. Sproul wrote to Karl Bopp (Philadelphia): “We have been able largely to disregard our balance of payments in pursuing monetary policy” (letter, Sproul to Bopp, Sproul papers, FOMC Correspondence, May 16, 1955). Sproul then contrasted the United States with foreign central banks that daily “have to follow the foreign exchanges and the balance of payments” (ibid., 1).

47. In 1954, Chairman Martin testified against legislation to permit redemption of currency in gold, ending the embargo on private sales of gold. He acknowledged the safeguard that the proposal offered, “but there is no magic formula and no simple device.” And “there is no danger, present or prospective, that this measure would avert.” Other bills would have created a free gold market and restored bimetallism (Martin speeches, March 29, 1954).

48. Ralph Young supervised preparation. He replaced Emanuel Goldenweiser, who had supervised the two earlier editions.

In response to a questionnaire sent as part of hearings chaired by Senator Ralph Flanders (Vermont), the New York bank wrote: “Although it is the general policy of the Federal Reserve System to promote a growth in the money supply in keeping with the long-term growth of the economy, it is unnecessary and impracticable for the System to attempt to enforce a change in the money supply month-by-month and year-by-year, either precisely parallel to the changes in overall economic activity, or at a rate of growth equal to the assumed or expected long-term growth of the economy” (Q & A Flanders, draft for question 4, Sproul papers, November 1954). The response explained why short- and long-term deviations occur with changes in velocity and economic activity and wartime budget finance. Wartime finance, the response said, produced a large increase in money that the economy absorbed as desired cash balances during the postwar economic expansion.

Again, in a letter to Senator Douglas, Sproul repeated that inflation had many causes, including excessive money growth. To guide central bankers, he proposed that “growth in the money supply should parallel the
long
term
growth in production activity. That calls for a policy of resisting too rapid expansion of bank credit and the money supply in boom periods . . . and resisting credit contraction in periods of recession” (letter, Sproul to Douglas, Sproul papers, Board of Governors Correspondence 1942–1956, August 31, 1953). Earlier, he had written, “Inflation can arise from a variety of causes even though the end result is too much money chasing too few goods” (letter, Sproul to Winthrop Aldrich, Sproul papers, Correspondence A–M, November 7, 1951)

49. One of the statements came in response to a question from Senator Joseph O’Mahoney (Wyoming).

Senator O’Mahoney. What is the yardstick by which you measure the amount of money
that ought to be created?
Mr. Martin. Well, the yardstick—there is no firm yardstick, but we have looked on the
normal growth of the country in terms of 2, 3, 4 percent, no fixed formula, and we
have added to the money supply for that purpose. (Joint Economic Committee, 1956b,
127)

On another occasion, Martin described the proper rate of money growth: “Some people think the money supply ought to grow at the rate of 3 percent a year, while others may say 2 percent a year, while others may say 2 percent or 5 percent; I do not profess to know what the figure ought to be. . . . Growth in the money supply must be regulated according to the country’s real needs” (Martin speeches, Pennsylvania Bankers 62nd Annual Convention, May 11, 1956, 10–11).

Emphasis on the role of sustained money growth as a cause of inflation appeared frequently in this period. This was a marked departure from the 1920s, when the System dismissed the roles of money and claimed to rely on the gold standard to control inflation, and the 1960s and 1970s, when money growth received little attention or was again dismissed as unimportant. The greater success at controlling inflation in the 1950s may reflect the presence at the Federal Reserve of Sproul, Riefler, and Thomas, all of whom gave prominence in their analysis to the long-term growth of money relative to output. All three left the Federal Reserve before major inflation started in the mid-1960s. Other voices, such as Malcolm Bryan (Atlanta), and Delos C. Johns, Darryl Francis, and Homer Jones (St. Louis), were unable to influence policy, in part because some of the Board’s staff and others dismissed their views.
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There were two major shortcomings in the analysis of money. First was the failure to analyze the linkage between short-term changes in free reserves and longer-term changes in money and credit and between monetary aggregates and output and the price level. The Federal Reserve did not link its actions affecting interest rates and free reserves to demands for money and free reserves. Meigs (1962), Dewald (1963), and Brunner and Meltzer (1964) showed that free reserves were not closely related to the money stock (or other monetary and credit aggregates). The Federal Reserve in the 1950s carefully monitored, and reported, how much money, credit, and other variables changed. It made no effort to separate the effects of changes in supply and demand or to learn how these aggregates changed when free reserves changed. And it did not recognize or discuss the inconsistency between procyclical money growth resulting from using free reserves and short-term interest rates as indicators of policy stance and the counter-cyclical stance described in Sproul’s letter to Douglas.
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The second major weakness was the continued failure to distinguish between real and nominal interest rates. In its handbook on changes in interest rates (Board of Governors, 1954), the staff offered useful discussion of changes in relative interest rates and asset returns, but there is not a word about adjusting market rates to remove the effect of inflation. Neither the staff nor the Board connected their discussion of inflationary anticipations
to changes in interest rates. High nominal rates were evidence of restrictive monetary policy. This error is one of the major reasons for the failure of monetary policy to control inflation in the 1960s and early 1970s.

50. An early example is Sproul’s comment to Roosa in 1959 about Malcolm Bryan (Atlanta). He described Bryan’s views as “a legacy of a fundamentalist religious slant as bent and twisted by the University of Chicago, but it is also a consequence of his having had no experience in a money market” (letter, Sproul to Roosa, Sproul papers, Correspondence from Roosa, April 27, 1959).

51. Changing short-term interest rates frequently and counter-cyclically eliminated the inconsistency in
the 1990s.