A History of the Federal Reserve, Volume 2 (19 page)

The Accord did not cause an abrupt change in policy discussion. The FOMC continued, at first, to focus on debt management and long-term interest rates. It continued to offer advice to the Treasury. Relations improved; the Treasury more readily accepted the committee’s suggestions about the pricing and maturity of its issues. Independence did not prevent Board members from participating in Treasury meetings (Board Minutes, February 19, 1952, 13–14).

The Treasury’s offer in April 1951 of a 2.75 percent non-marketable bond, callable in 1975, enabled the Treasury to exchange $13.5 billion of the 2.5 percent bonds callable in 1967. The Open Market Account took $5.6 billion (41 percent).
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Thereafter, the Federal Reserve allowed the interest rate to adjust upward. By late June, the longest Treasury security sold at a discount from par value of $3.25 per $100 (FOMC Minutes, June 27, 1951).

The System and the Treasury tried to balance several different objectives. The average maturity of government debt had declined during the pegging period. Both believed that extending average maturity required long-term interest rates to rise more than either wanted to accept at the time. Also, the System wanted to let the market determine short-term rates. It had agreed to keep the discount rate unchanged during the transition, and it believed that raising short-term rates would raise long-term rates as holders of long-term debt shifted into short-term securities.
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At the May meeting, Woodlief Thomas started the first discussion of objectives in many years by remarking that “inflationary pressures arose from the creation of additional money through credit expansion and through increased turnover of money” (FOMC Minutes, May 17, 1951, 3). Marriner Eccles observed that, with the government budget balanced, the Federal Reserve could prevent inflation if it limited growth of bank reserves (ibid.,
4). Chairman Martin had little interest in discussions of this kind. He turned the discussion to current operations.

73. During the exchange offer in April 1951, the account manager, Robert Rouse, told the Executive Committee that he had purchased the 2.5 percent bonds and anticipated purchasing more to hold the price to $99 during the exchange offer (FOMC Minutes, April 5, 1951, 2). At this time, and for many subsequent years, the FOMC maintained a “stable” bond market, holding rates within a narrow range for two weeks before a Treasury offering and during the offering (ibid., 5). Later this policy was called “neutrality” and, still later, “even keel,” discussed earlier.

74. Discussion of Treasury financing often became animated. At the September 25, 1951, meeting of the Executive Committee, Allan Sproul proposed four options to present to the Treasury. Chairman Martin argued against one option and voted against the proposal. The majority voted with Sproul, and Martin duly forwarded the recommendation to the Treasury (Executive Committee Minutes, April 25, 1951, 8–9). There is nothing in the record to suggest that this experience affected his subsequent decision to abolish the Executive Committee.

Frequent Treasury refundings interfered with Federal Reserve operations in this as in many subsequent periods. In early June 1951, for example, member bank borrowing increased to $538 million and excess reserves fell. “[T]he money market for the first time in years became tight for an extended period and interest rates moved upward” (Sproul papers, Board of Directors, memo, June 7, 1951, 1). The System “then faced an obligation both in terms of orderly markets and our accord with the Treasury to do whatever we could to assure the success of the financing. The success would be measured in the light of market acceptance of the offering and the climate thus created for future refundings and . . . the so-called attrition” (ibid., 1).

Raising rates encouraged attrition by imposing losses on those who accepted the Treasury offer. To avoid losses the Treasury offered a premium over current rates, but the premium on new issues lowered the prices of outstanding debt. The System’s commitment to support the market during refundings required them to buy, at times heavily. Sproul told the New York directors that the Treasury worked with them “in terms of an integrated debt management-credit control program” (ibid., 2). In fact, monetary policy often yielded to debt management as it had before the Accord.

Traditionally, the FOMC decided how to provide the autumn seasonal increase in August or September. In 1951, the FOMC believed that economic expansion would continue, although it expected housing starts to fall. Uncertainty about the amount of defense spending clouded the outlook. Woodlief Thomas added that “the money supply might show a further expansion of as much as $7 billion,” nearly 6 percent (Executive Committee Minutes, August 8, 1951, 4–5). This was possibly the firstreference to money supply at an FOMC briefing.

The discussion that followed reached a consensus that the System should follow a “neutral” policy. The term neutral policy or neutrality occurs frequently, at the time, without definition. The context suggests that policy is neutral if changes in open market rates do not affect the rate on outstanding Treasury issues. Later, the New York bank’s staff defined neutrality as “a policy dedicated to maintaining the volume of bank reserves . . . on an approximately stable level” (Central Subject Files, May 8, 1952, Box 1433). For the rest of the decade and beyond, the conflict continued between the System’s wish to remain “neutral” during Treasury refundings and financings and its desire to pursue its goal of low inflation.

Although inflation remained low, the FOMC remained concerned that continued spending by the private sector, wartime deficits, continued Trea
sury borrowing, and frequent refundings made inflation inevitable.
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To reduce uncertainty about timing, the Treasury began to put refundings on a regular schedule. Some members of FOMC wanted the Treasury to extend maturity by offering more long-term debt at higher interest rates.

Chairman Martin held a fiscal theory of inflation at the time. He expressed concern that open market operations could not prevent inflation under the anticipated defense spending and projected budget deficit (FOMC Minutes, October 4, 1951, 8). Since he believed that the Federal Reserve had to assist the Treasury in financing the spending that Congress approved, fiscal deficits meant either higher interest rates or additional money creation, usually both. Others added that the administration was unlikely to ask for additional tax increases. Several FOMC members favored higher interest rates to prevent inflation. President Bryan (Atlanta) urged more attention to this longer-term problem and less emphasis on short-term financing. Martin ended the discussion by sidestepping the issue of higher rates and emphasizing the need to attract more money into government securities other than by rate increases (ibid., 10).

The FOMC voted to appoint a committee to study long-term debt management and to recommend policy to the Treasury. In November, it abandoned the pegs it still used, while maintaining a commitment to orderly markets.
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For the first time since 1942, a Treasury financing had no support. Soon after, President Sproul suggested that the New York directors consider increasing the discount rate (Sproul papers, Board of Directors, December 20, 1951, 1).
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Economic activity remained expansive early in 1952, and System discussion anticipated continued high-level activity.
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The New York bank operated under a directive calling for a neutral policy “under which market forces of supply and demand are permitted to have their effect with a minimum of System intervention except to the extent necessary to promote
orderly market conditions” (Executive Committee Minutes, April 4, 1952, 9). The staff interpreted the directive to mean that normally the System would stay out of the market. After some discussion, the Executive Committee agreed to a “somewhat freer interpretation” (ibid., 12). That decision gave the manager more discretion, a result that Martin and some other members would later regret.

75. At about this time, the Board’s staff estimated that government spending would rise from $58 to $84 billion in the next two fiscal years, an increase of nearly 50 percent. The actual increase was about 15 percent.

76. It voted “to carry on operations in both short-term and long-term Treasury securities for the purpose of maintaining an orderly market and that the points previously fixed below which long- and short-term issues would not be allowed to decline had been abandoned” (Executive Committee Minutes, November 14, 1951, 2).

77. Earlier, the Federal Advisory Council favored providing additional reserves by reducing reserve requirement ratios (Board Minutes, September 18, 1951, 3). The council frequently pointed to the conflict between policies to restrain credit expansion and government spending and lending programs to assist veterans, farmers, and others to buy houses and farms.

78. At the March 1, 1952, meeting Winfield Riefler, assistant to the chairman, becam
e Secretary of the FOMC.

At mid-year 1952, the staff said that the economy would maintain “the current balance of high economic activity and low inflation” (FOMC Minutes, June 19, 1952, 7). Concerns remained about Treasury deficits to finance Korean War expenditures. Restraint depended on greater reliance on monetary policy (ibid., 7). The staff suggested a discount rate increase.
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The pleasant economic prospects forecast in the spring hid some problems. Governor Rudolph Evans pointed out that the System’s objectives included: (1) extending the maturity of the debt by having the Treasury issue more long-term bonds; (2) reducing banks’ holdings of governments; and (3) reducing bank loans to slow inflation. The Treasury was reluctant to raise the interest rate.
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Evans believed that the combined effect of deficits financed with short-term debt and bank credit expansion would bring inflation.

Evans’s concerns gained support the following month, when the staff raised its projection for the rest of the year and warned about increasing price pressures (Executive Committee Minutes, July 22, 1952, 3–4). A strike in the steel industry temporarily reduced these pressures, so the FOMC changed its policy stance from neutral. It agreed to “provide some controlled relief [to the market] through open market operations while forcing member banks to increase their borrowing” (ibid., 5). The new policy was, in fact, a modest step toward restriction.

With member bank borrowing above $1 billion, the Executive Committee regarded the market as tight when it met a month later. Staff at New York and Washington suggested that economic growth, Treasury borrowing, and seasonal expansion required $1 to $2 billion of additional reserves. Sproul favored letting member bank borrowing rise above $2 billion. Martin was uncertain. He was inclined to supply more reserves through open market purchases. The decision soon shifted in Martin’s direction. The Treasury, on the advice of the Federal Reserve, had issued a
fourteen-month 2.125 percent certificate. The issue was not attractive, despite its higher rate, because market rates increased between the decision and the announcement. The Executive Committee felt obligated to support the issue but was uncomfortable with the need to do so.

79. The FOMC voted to permit each reserve bank to purchase prime bankers’ acceptances at rates set by the FOMC. The first move to coordinate market operations in the 1920s was made to centralize purchases of acceptances (letter, Rieflerto Sproul, Sproul papers, June 27, 1952). See volume 1, chapter 4.

80. Attempts to sell long-term bonds without raising rates failed. In June the Federal Reserve purchased $300 million in the market to support a Treasury issue.

The FOMC remained unhappy with the choices it had to make between debt management and monetary policy. The Accord had allowed interest rates to rise, but Treasury debt operations continued to influence Federal Reserve actions. Chairman Martin expressed concern that the FOMC strengthened this obligation by continuing to make specific recommendations to the Treasury in a letter signed by the Chairman. The post-Accord arrangement produced harmonious relations with the Treasury, but it took the FOMC back toward fixing rates to assist the Treasury.
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Despite its concerns, the FOMC did not change its “neutral” policy during the October financing. A change would have required higher interest rates, a step that the committee did not want to take. It continued to support the new certificate issue until October 8, when it voted to restrict operations to the short-term market.

New York, as usual, found an argument for leaving more discretion to the manager and the New York bank. Sproul cited technical problems in carrying out specific instructions. The staff had difficulty foreseeing economic developments, the final guide to credit policy. Also swings in factors affecting reserves showed the administrative difficulties of fixing a pattern or program by committee action (Sproul papers, President’s Conference, September 24, 1952, 3). These difficulties may explain some of the short-term variability in data for the period, but they point up the short-term focus. Sproul also complained that the instructions changed frequently. “One time the guide . . . might be interest rates and at another member bank borrowing” (Sproul papers, draft, August 13, 1952). Martin and the Board wanted more control, not less. They did not yet know how to instruct the manager in a way that would maintain control while permitting the manager to respond to daily or hourly changes in the money market.

The expansion of output, credit, and member bank borrowing continued through the fall. In a statement to the Joint Committee on the Economic Report (1954, 7) Martin later described the expansion as a “bubble on top of a boom.” The Executive Committee noted that borrowing often exceeded $1.5 billion, but it took no action. Sproul proposed a discount rate increase
at the November meeting. Reversing years of System discussion, he recognized that banks borrow for profit. He told the Executive Committee:

81. The Treasury was unhappy also. During the August refunding it had to pay cash (attrition) for 17 percent of the expiring bonds. The Federal Reserve bought an additional 7 percent ($430 million). In the October refunding, attrition was 8 percent, System purchases 17 percent.