A History of the Federal Reserve, Volume 2 (28 page)

This time the administration did not object to the rate increase, despite the election (Saulnier, 1991, 92). The rise in inflation convinced Martin’s critics that he had been right. Long-term interest rates did not peak until shortly after the peak in inflation in the fall of 1957, additional evidence of the market’s new-found concern that inflation would not only rise and fall but would persist.

The FOMC responded to inflation by suggesting a 3 percent discount rate at the ten banks still at 2.75 percent, a move that followed the market.
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Several members suggested an increase of 0.5. Only Governor Mills expressed concern that policy was too restrictive. He warned about a “destructively restrictive credit policy” that could cause “waves of unemployment with consequences both to the Federal Reserve System and the economy” (FOMC Minutes, August 21, 1956, 21). Borrowing declined slightly after the increase in the discount rate, raising free reserves, but the federal funds rate rose to nearly 3 percent, a percentage point above the year’s earlier level.

Chairman Martin complimented the members on avoiding targets for free reserves. Although he expressed concern about inflation, the consensus, he said, was to avoid any change in open market policy. The FOMC was reluctant to tighten further until after the election. Martin urged the committee on September 11 to neither ignore nor be influenced by the election, but Robertson said he would argue for a tighter policy if it were not for the coming election (FOMC Minutes, October 16, 18).

The larger problem was lack of agreement about what should be done.
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The staff report for the September 25 meeting tried to reduce concerns about persistent inflation. Ralph Young noted that growth of the money stock (M
₁
) was below the growth of real GNP for the year. For the previous five years, the two growth rates were about equal.
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The System had followed a counter-cyclical policy by keeping money growth below the growth of real output, raising interest rates, in the face of increased demand for goods and credit. There is no sign in the members’ comments that they recognized the implications of his statement or accepted it as a policy guide. In later testimony, Martin disagreed, describing policy in retrospect as slightly too easy in 1955–56 (Joint Economic Committee, 1957, 606).

155. The Board made the change on Friday despite a Treasury bill auction the following Monday. Martin noted that the market anticipated the change, so it would not surprise the market. Bill rates rose fifty-eight basis points from the previous weekly auction.

156. The members did not agree about what should be done or why. One group, concerned about the seasonal demand for reserves, proposed to reduce reserve requirements on time deposits by one percentage point to supply $400 million of reserves. Bryan (Atlanta) pushed his proposal to improve the competitive position of country banks relative to thrift associations and to help finance crop inventories. Only three others joined Bryan. Hayes wanted to tighten (after the next Treasury financing) by selling bills and forcing banks to borrow reserves. To assist their borrowing, he proposed easing regulation A governing use of the discount window. During the Treasury financing, the System should provide “whatever reserves should be needed to permit the banks to do their part in a successful program” (FOMC Minutes, September 25, 1956, 10). Leedy (Kansas City) proposed reducing reserve requirement ratios in New York and Chicago to assist the Treasury. Mills favored a somewhat easier policy. Robertson wanted to tighten. Governor Shephardson expressed concern about the stability of the dollar. He favored a penalty rate to discourage continuous borrowing by a few banks.

The Federal Advisory Council told the Board on September 18 that business continued at a high level in all districts. Housing starts were below the previous year, so the administration eased mortgage credit in September to encourage housing purchases before the election.
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The System made no other changes in policy before the election. The federal funds rate remained near the discount rate at about 3 percent, but long-term rates continued to rise. In October, the Treasury experimented with auctioning longer-term Treasury bills instead of taking bids at a fixed price. The auction was successful for the Treasury, and it reduced pressure on the Federal Reserve to support a fixed price, but it did not become standard practice.

Three issues that would reoccur many times arose as the year ended. First, the Treasury bill rate rose above the discount rate. Second, the fixed exchange rate for the British pound came under pressure.
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Third, rates on
federal funds, Treasury bills, and all longer-term instruments rose above the fixed ceilings on time and saving deposit rates administered by the Federal Reserve under the Board’s regulation Q.

157. “The slower growth of the money supply this year is to be attributed in part to Federal Reserve policy. That policy since 1951 has been geared to counter-cyclical objectives in the short-run and orderly growth at sustained high levels of activity without inflation over the longer-run” (FOMC Minutes, September 25, 1956, 4).

158. Martin asked the bankers on the FAC three questions that indicated his concerns at the time: (1) does tax deductibility of interest payments reduce the deterrent effect on borrowing? (2) have demands for long-term financing of investment increased relative to demands for short-term financing and, if so, are bank portfolios less liquid? (3) are large and preferred creditors satisfied while legitimate demands of smaller business are not? FAC members replied that real estate credit and loans to carry securities were most sensitive to the interest rate, but that much borrowing was not. Council members dismissed the second question and said there was no evidence of relatively greater restriction on loans to small business (Board Minutes, Sept. 18, 1956, 11–16).

159. Britain’s currency problems in late 1956 followed the invasion of Egypt (with France and Israel) after President Gamal Nasser of Egypt nationalized the Suez Canal. The canal had been owned by British and French investors. Despite continued exchange controls in Britain, reported gold holdings fell to a low of $1.77 billion in December 1956, a loss of about $250 million from the previous year. Britain also sold about 30 percent of its holdings of U.S. Treasury securities (Board of Governors, 1976, 916, 968–69). The U.S. Treasury sold a special issue of $1 billion of Treasury bills to assist the British by absorbing the capital inflow.
The Federal Reserve purchased between $60 and $70 million to support the offer. The pound weakened against the dollar, but Britain did not devalue.

At the FOMC meeting on October 16, New York asked for guidance about the rise in Treasury bill rates above the 3 percent discount rate. The market anticipated an increase in the discount rate.
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By December, new issue bill rates were nearly 0.25 percentage points above the discount rate. The FOMC’s only monetary policy decision was to add the words “while recognizing additional pressures in the money, credit, and capital markets arising from seasonal factors and international conditions” to their continuing directive calling for “restraining inflationary developments in the interest of sustainable economic growth” (FOMC Minutes, December 10, 1956, 29). Only Governor Mills favored reducing interest rates below the discount rate by open market purchases. None favored an increase in the discount rate, although Mangels (San Francisco) thought his directors might soon vote an increase.
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Regulation
Q.
The Banking Act of 1933 empowered the Board to set maximum interest rates on time and savings deposits. A common belief at the time was that competition for time and savings deposits had contributed to stock exchange speculation by financing speculators. Banks, it was said, would not reduce deposit rates, so they took more risk instead. The Board initially set the rates at 3 percent. On January 1, 1936, it lowered ceiling rates to 2.5 percent, where they remained. By late 1955, open market rates on new issues of Treasury bills temporarily reached the regulation Q ceiling. A year later, open market rates were well above posted ceiling rates.
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The Board held discussions of ceiling rate violations throughout 1955. As usual when prices (rates) are controlled, there were ways around the
ceiling. Banks offered an array of services—free safety deposit boxes, advisory services, use of foreign exchange facilities, etc.—and reduced rates on loans to circumvent the ceiling (Board Minutes, April 19, 1955, 12). Cases of this kind had occurred in the past, but their frequency increased as interest rates rose. The Board had considered, but not adopted, a general statement about what constituted payment of interest in violation of the ceiling, knowing that an explicit statement opened opportunities to circumvent it. The Board’s only general policy was not to have one by leaving most cases to the examiners to decide on a case-by-case basis.

160. The concern at the time was that the volume of float would rise. If the manager offset float by selling Treasury bills, bill rates might rise further above the discount rate. Martin used the occasion to define “feel of the market.” If float reduced borrowing and increased free reserves while the System account maintained the same degree of tightness that the committee had been trying to have, he would not be bothered by the increase in bill yields (FOMC Minutes, October 16, 1956, 34). The statement left discretion to the manager, as Martin recognized, and avoided stating how to judge the degree of tightness. It relied on a judgment about persistence of higher bill yields.

161. When the manager first asked permission to buy and sell acceptances, Robertson suggested the manager would soon ask to enlarge operations. In December, the FOMC increased the account to $50 million over objections by Robertson and Carl Allen (Chicago). The principal objection was that purchases supported a price.

162. The ceiling rates were maximum rates. Non-member banks could not pay more than the maximum rate set by state agencies for their state (Board o
f Governors, 1976, 638).

The Federal Advisory Council also could not state a general policy specifying what constituted indirect payment of interest. They favored selfpolicing by individual banks, and they agreed with the Board that the main violation of the law was the absorption of exchange charges by large banks to obtain correspondent balances of non-member banks that charged customers for collecting checks.
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The reserve banks disagreed with the FAC; they did not want to announce “self-policing.” The Board continued its policy of relying on examiners.

The next challenge to the existing ceiling came in December 1955, when a New York bank asked permission to compound interest payments monthly instead of quarterly. Several governors supported Governor Robertson’s proposal to increase the ceiling rate to 3 percent as an alternative. The reserve banks, representing many of their members, opposed any increase. The Board agreed to permit monthly compounding but left the maximum rate unchanged. The new rule applied to time deposits but not passbook savings.

Ceiling rates became a frequent topic for discussion at Board meetings in 1956. The record suggests the number of unforeseen problems that arise when price controls become effective.
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Most of the governors favored higher rates to recognize changes in
the market and to maintain competition. Several of the staff opposed any change. Riefler made the most forceful statement, arguing that banks would use time deposits to expand their non-commercial banking activities. He opposed “mixed banking . . . a mixture of long- and short-term banking in one institution” (Board Minutes, August 24, 1956, 13). Furthermore, higher rates allowed banks to issue “a due bill on the government” (deposit insurance) to expand their long-term, high-yield investments (ibid., 14). Governor Szymczak agreed with Riefler, while Governors Vardaman and Shephardson argued that Riefler’s argument would permit less regulated competitors to take over banking functions. Governor Robertson said that if the statutes could be rewritten, he favored elimination of interest rate regulation.

163. The Board’s practice was more restrictive than the FDIC’s. The Board asked the FDIC to adopt a common standard, but the FDIC declined (Board Minutes, March 25, 1955, 9–10). Some member banks complained about the advantage to state non-member banks that were members of FDIC.

164. The State of North Carolina did not permit its treasurer to deposit state funds in banks that paid less than the yield on Treasury bills. The legislature was not scheduled to meet, and the banks were under pressure to hold the deposits and reserves so that they could lend to farmers for spring planting (Board Minutes, April 30, May 9). If regulation Q ceilings changed, Treasury saving bonds would be at a disadvantage. Congress would have to increase the rate to avoid runoff. Changes would alter the competitive position of non-member banks and thrift associations unless other regulations changed at the same time. Raising rates on short-term time deposits would attract spillover from demand deposits and thus expand credit by lowering average reserve requirement ratios (Board Minutes, June 27, 1956, 5). Ceiling rates also caused New York banks to lose deposits to foreign banks.

Chairman Martin postponed further discussion until after a meeting of the FAC. At first, he had been persuaded by Riefler’s argument, but he was now uncertain. The Comptroller and the FDIC opposed any increase. The Treasury had not taken a position, but it considered asking Congress to increase interest rates on savings bonds.

The Federal Advisory Council unanimously favored higher ceiling rates on deposits with no more than six months maturity. These rates would rise from 1 to 1.5 percent under ninety days and from 2 to 2.5 percent from ninety days to six months. New York banks had lost time deposits to foreign banks because of the low ceiling rates. The higher rates also attracted deposits of state and municipal governments (Board Minutes, September 18, 1956, 26–33). A week later, the reserve bank presidents agreed with the proposed change also.

Chairman Martin discussed the proposed change in ceiling rates with Secretary Humphrey, and the Board notified the FDIC of the proposed change. Finally, on December 3, effective January 1, the Board rejected the FAC proposal and voted to increase to 3 percent the ceiling rates on all savings deposits and on time deposits with six months or more to maturity. It voted to increase to 2.5 percent the rates on time deposits with more than ninety days and less than six months maturity. Rates for shorter-term time deposits remained at 1 percent. The FDIC changed its rates also.

Governor Robertson voted against the change, although he had been one of the first to endorse higher rates when discussion began early in the year. He believed that higher interest rates would raise bank costs, making it more difficult to raise capital, and encourage banks to take risky positions. Higher rates would not increase the amount saved; it would redistribute the stock of savings deposits among institutions (Board Minutes, November 30, 1956, 10–11). These were the arguments made earlier by Governor Mills, who now voted for the change.