A History of the Federal Reserve, Volume 2 (16 page)

Tradition or history is one reason for relying mainly on free reserves or borrowing as a policy target instead of an interest rate. No less important was concern that an interest rate target invited pressure from congressional populists, especially Congressman Wright Patman, to keep interest rates low. That explains the practice, common at the time, of denying that the Federal Reserve controlled any interest rate. “Traditionally, reserve banking operations are not directed toward establishing any particular level or pattern of interest rates” (ibid., 143).
⁵²
A claim that the Federal Reserve controlled a short-term rate seemed certain to invite Patman and others to demand lower rates. Later, Volcker’s decision to target reserves in 1979–82 avoided some criticism by attributing the rise in interest rates to market forces, not the Federal Reserve.

Another major difference between the 1920s or 1930s and the 1950s is in the choice of framework. In the earlier period, policymakers appealed to the real bills doctrine and the principles in the Tenth Annual Report to support their actions and to oppose intervention. In the 1950s, there was neither a common framework nor a common set of beliefs about monetary policy. The main common elements were the free reserve target and the loose commitment to full employment and price stability. The connection between the two was left to individual judgment, and there was considerable skepticism within FOMC about the accuracy of free reserves as a measure of ease and restraint.

The absence of agreement on a framework reinforced the very strong pressure to concentrate attention on recent events and near-term prospects, heightening the short-term focus and neglecting longer-term consequences. Although the Riefler rule prohibited forecasts, the staff occasionally looked ahead a few months. Martin had little confidence in economic (or other) theories of longer-term consequences. Martin’s focus was on the money market. Although some FOMC members were aware that policy actions had effects that lasted longer than three weeks, these concerns did not affect the policy process or FOMC actions.
⁵³

52. The FOMC minutes contain many criticisms of free reserves. Even New York, which often favored relying on free reserves in the instructions to the manager, acknowledged the difficulty of specifying the level precisely. New York wanted to solve the problem by making the manager’s discretionary authority explicit.

53. Martin often used a metaphor to describe how policy operated. “I think of it, that flow of money and credit, as I do a river or stream or a brook. . . . Our purpose in trying to see that this brook, this stream has a little bit of gurgle . . . that it doesn’t overflow the banks and flood the fields” (Martin testimony, v. 1, Board Records, January 12, 1956, 7–8). He used the
same metaphor when I interviewed him in 1963 as a temporary staff member of the House Banking Committee. Throughout his term, the minutes show no evidence of his interest in a more precise framework.

The System did not dismiss longer-term concerns entirely. For example, in 1959 Delos Johns (St. Louis) urged that the System use the money stock as the principal guide to policy operations. Woodlief Thomas responded: “The money supply is the principal
quantitative
end of Federal Reserve policy, because System operations exercise their influence primarily through the money supply, although there are broader and more complex ultimate objectives” (Thomas to FOMC members, Board Records February 25, 1959, 1; emphasis in the original).
⁵⁴

Others faulted the System for its lack of quantitative targets but did not want to use money or money growth as part of the manager’s instruction. Balderston shared Bryan’s concern about control of the manager’s actions, but he usually favored free reserves as a target (memo, Balderston to FOMC, FOMC Minutes, April 3, 1957).
⁵⁵
Still others favored total reserves as a more accurate quantitative target. But some opposed precise quantitative targets, preferring to give the manager discretion and permit him to exercise judgment. The New York bank was in the latter group. Though it claimed to favor more precise instructions, it would point out the pitfalls of being overly precise. Hayes’s response to Balderston developed this reasoning (memo, Hayes to FOMC, FOMC Minutes, April 15, 1957).

Independence
and
Political
Influence

The Federal Reserve had always been aware that Congress could change its status, but political influences inserted themselves in the 1950s to a much greater degree than in the 1920s. Congressional approval of the Employment Act made a major difference. The Federal Reserve had for
merly denied that it could control output and the price level. Now it shared responsibility with other agencies for economic welfare. Martin often described this mix as independence within the government.
⁵⁶

54. The memo then discusses the importance of the money supply for System operations and the difficulty of interpreting short-term changes. He observed correctly that “[i]t is not possible, or even desirable, to relate day-to-day or even week-to-week operations precisely to the money supply” (Thomas to FOMC members, Board Records, February 25, 1959, 2). However, money supply affected short-term projections of reserve needs by the Board’s staff. Deviations of money from its projected path gave the FOMC reason to change the path. But Thomas did not provide a means of making the change effective by linking it to the current target.

55. Balderston’s memo recognizes several weaknesses. First, correlation between free reserves and Treasury bill rates was low for short periods and even for a month or a quarter. Second, large borrowing may supply reserves and change the interpretation of a decline in free reserves. Third, he cited other changes in borrowing that affect interpretation of a given level of free reserves. Fourth, he recognized that the interpretation of a given supply of free reserves would vary with the strength of demand for free reserves (Balderston to FOMC, FOMC Minutes, April 3, 1957). Comments about the relation of free reserves to interest rates suggest that the System paid attention to interest rates but would not say so publicly.

New responsibilities changed the meaning of Federal Reserve independence in practice. In its early days, President Wilson started a tradition of not interfering in Federal Reserve decisions. Although Treasury Secretaries were members of the Board,
ex
officio,
until 1936 they usually did not attend Board meetings. The Roosevelt administration ended this tradition of independence. Before the war, and even more during the war, Secretary Morgenthau wanted low nominal interest rates. In the 1930s, he either used, or threatened to use, the Treasury’s trust accounts and the Exchange Stabilization Fund (ESF) to buy securities and lower interest rates if the Federal Reserve did not support his policy or accept his judgment. This threat may have been empty. The resources of the ESF were limited. The Federal Reserve, however, avoided conflict, sacrificing independence. During the war, the Federal Reserve agreed to maintain a pattern of interest rates after April 1942. In effect, the Treasury could veto interest rate changes.

The large outstanding debt after World War II, its short maturity, and the need to refund or borrow frequently made Treasury Secretaries and Budget Directors very conscious of interest rate changes. Although the Federal Reserve had been freed of Treasury control in 1951, its supporters in Congress favored some type of coordination with the administration. Independence did not mean to them that the Federal Reserve would ignore debt management (Subcommittee on Monetary, Credit, and Fiscal Policies, 1950, 4).

Chairman Martin worked hard to avoid involvement in decisions about the choice of debt instruments, and he succeeded in reestablishing and strengthening greater separation of monetary and debt management policies. The meaning he assigned to independence, however, did not go so far as to make the Treasury pay whatever interest rate the market might demand. From the very beginning of his tenure, Martin saw the Federal Reserve and the Treasury “as partners in promoting the welfare of the government securities market” (Senate Committee on Banking and Currency, 1951, 5).

Martin explained what he meant by “independent within the government.” The Federal Reserve had to recognize that

56. The view was general within the System. “The Federal Reserve does not have, never has had, and never has claimed to have an independence in monetary affairs which divorces it from the general economic policies of the Government” (Sproul, 1964, 236). However, Sproul said “an independent Federal Reserve System is one that is protected from narrow partisan influence” (Joint Economic Committee, 1952, 508).

Congress appropriates the money; they levy the taxes; they determine whether or not there should be deficit financing. The Treasury then is charged with the responsibility of raising whatever funds the Government needs to meet its requirements. . . . I do not believe it is consistent to have an agent so independent that it can undertake, if it chooses, to defeat the financing of a large deficit, which is a policy of the Congress. (Subcommittee on Monetary, Credit, and Fiscal Policies, 1950, 231)

Martin also said repeatedly that the Federal Reserve could not refuse to finance a deficit that Congress approved. He told a news magazine, “[W]e have no obligation to finance the Treasury at just any rate, arbitrarily chosen. But we do have an obligation to see that the expenditures which are authorized by the Congress are met” (quoted in Kettl 1986, 84). He never went beyond ambiguous statements of this kind. He made it clear that to him independence did not permit the Federal Reserve to prevent inflation if the administration and Congress ran large budget deficits. His was a very narrow definition of independence. He could not prevent inflation if the deficit remained large, so he could not meet the primary responsibility of an independent central bank—to maintain money’s purchasing power.

Even keel policy was one way of contributing to Treasury finance. Governor Balderston defined an even keel as “no greater ease or tightness at the end of the financing period than at the beginning, with the supplying of only such additional reserves during the period as will take care of the additional drain on reserves caused by the financing itself. Theoretically the amount of such reserves required would be 18 per cent of the amount of each financing taken by the banks” (FOMC Minutes, August 18, 1959, 37). Under this policy, reserves increased during a Treasury offering to keep interest rates from rising in that period, and the reserves remained in the market after the financing ended, unless the System explicitly changed policy.
⁵⁷

The role that Martin accepted as part of the Federal Reserve’s responsibility went beyond even keel. Congress decided expenditures and tax rates. If the Treasury had to borrow to finance a deficit, he believed the Federal Reserve had to assist, mindful of the inflationary consequences
of too much assistance. His initial thought was: “The Federal Reserve must do everything in its power to see that the Treasury is successfully financed, but neither the Treasury nor the Federal Reserve should succumb to the temptation to ignore the judgments of the market through our price mechanism in arriving at financial decisions” (Martin speeches, Speech to the 18th Annual Convention of the Independent Bankers Association, May 19, 1952, 3).

57. Bremner (2004, 79) quotes Martin as saying in 1953, “The System no longer needs to inject periodically into credit markets large amounts of reserve funds which are difficult to withdraw before they have resulted in undesirable credit development.” This misinterprets even keel. Knipe (1965, 27) noted that “even keel” did not have a single definition. He listed four: “(1) an unchanged level of free reserves, (2) a changed level of free reserves but changed in such a way that the Board thinks the market effect is unchanged, (3) an unchanged level of some interest rate, or bond yield, or group of interest rates and bond yields, or (4) steady progress in a policy direction already determined.” As Knipe noted, ambiguity applied as well to terms such as neutrality. In practice the manager made the final decision, and the FOMC and Treasury would not complain unless the Treasury issue failed.

What if the Congress continued to run persistent deficits? Martin believed that there were limits beyond which the Federal Reserve could not insist upon its independence. Independence within government meant to him that the Federal Reserve would help the Treasury sell its securities. He explained this responsibility in a 1956 speech:

The Federal Reserve’s task of managing the money supply must be conducted with recognition of the Treasury’s requirements, for two reasons: One, the Federal Reserve has a duty to prevent financial panics, and a panic surely would follow if the Government, which represents the people as a whole, could not pay its bills; second, it would be the height of absurdity if the Federal Reserve were to say in effect that it didn’t think Congress was acting properly in authorizing expenditures, and therefore it wouldn’t help enable the Treasury to finance them. (Martin speeches, Speech to Pennsylvania Bankers, May 11, 1956, 10)

Martin recognized that the Treasury had a responsibility also. It should conduct its operations in ways that did not jeopardize economic and currency stability. What if it did not? “Nobody has given the Federal Reserve the authority to tell the Congress what appropriations it should make, and the Treasury financing must always be a major consideration of our policy. But that does not mean that either the Treasury or the Federal Reserve can ignore the market and dictate what the rate should be” (Martin speeches, January 12, 1956, 19).

“Independence within the government” was not just a nice phrase. Repeatedly, Martin emphasized that the Federal Reserve’s obligation to help the Treasury differed from its responsibility toward the private sector. By implication the Federal Reserve was the residual buyer of government debt, whether new offerings or refinancings. The Federal Reserve was not obligated to avoid interest rate increases that it regarded as appropriate or to prevent the failure of private offers. It could raise interest rates even when the market held new private issues awaiting placement.
⁵⁸

58. The Federal Reserve was less independent than the German Bundesbank. Even a strong chancellor like Konrad Adenauer learned that he lost public support when he criticized
the bank for raising interest rates in 1956. See Neumann (1999, 290–91). The occasion, however, was an increase in private demand. But the Bundesbank used the incident to establish its independence and could defend itself against political pressure thereafter.