A History of the Federal Reserve, Volume 2 (33 page)

The FOMC meeting on March 4 changed the directive without changing policy action. Hayes proposed that the directive read “combating economic recession,” but Martin preferred the milder “contributing further by monetary ease to a resumption of stable growth.” Most of the discussion at the meeting suggested that the recession continued and deepened. The general sentiment was to maintain free reserves but lower the discount rate. Johns (St. Louis) proposed a 0.75 percent reduction, but Karl Bopp (new president at Philadelphia) reminded the members that 1929 was the only time the committee had reduced that much. Martin left the decision about discount rates to the reserve banks.
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Two days later, the Board approved reductions of 0.5 percentage points (to 2.25 percent) at New York, Philadelphia, and Chicago. All remaining banks soon followed. Treasury bill rates declined 0.23 percentage points at the next auction. By the end of March, the federal funds rate was about 1 percent, the lowest rate in four years. Again, there is no evidence that monetary actions had become futile. Rates on long-term Treasury bonds changed very little.
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Borrowing fell to about $100 million and free reserves rose to $500 million. The System believed its policy was extremely easy. It had moved in response to the recession despite continued inflation of 3 percen
t or more.

201. The March meeting changed the composition of the FOMC and renewed all the directives and operating policies. Martin again objected to the arrangement under which New York chose the manager and New York objected to the bills-only policy. Hayes proposed to introduce “as a general rule” to weaken the commitment to bills-only, but Martin did not agree. Hayes’s was the only dissent. The FOMC also agreed, over Mills’s objection, to extend the manager’s authority to include purchases of acceptances from foreign banks. Also, Congress had increased the ceiling on public debt from $275 to $280 billion, so the committee withdrew temporary authority to sell debt to the Treasury in exchange for gold certificates. The staff raised a question about what should be included in the Record of Policy Actions published as part of the Board’s Annual Report. A problem arose because the FOMC regularly discussed discount rate changes, a decision left by law to the reserve banks. One suggestion would have omitted all references to discount rate changes. The Committee rejected that suggestion and decided to make clear that “this was discussed in an objective fashion as something within the responsibility of the directors of the Federal Reserve banks” (FOMC Minutes, March 25, 1958, 5). A second problem was that “the record for the first six months of 1957 . . . did not seem to justify the policy of restraint actually adopted” (ibid., 5). This is as close as the FOMC came to recognizing that it had made a mistake. It did not compound the mistake by adjusting the record.

202. Hayes commented on the widening spread. He blamed it on “the congestion in the capital markets” (Notes for March 4, 1958, FOMC meeting, Board Records, March 17, 1958, 3). He did not mention that long-term rates probably reflected unchanged anticipations of inflation over the longer-term as President Allen suggested earlier.

The following day the Board reduced reserve requirement ratios by 0.5 percentage points from 20, 18, and 12 percent for demand deposits at the three classes of banks, effective February 27 in central reserve and reserve city banks and on March 1 for country banks. Governor Mills opposed the action, but he voted for it to keep unanimity.

The Board’s action came after renewed consideration of the structure of reserve requirements. Martin had encouraged the American Bankers Association (ABA) to study the issue and suggest revisions, including uniform reserve requirement ratios and a target date for phasing in the new arrangements. The Board was not willing to go to uniform requirements; although it seemed unaware of the hostile political response to any reduction in reserve requirement ratios, it believed that political considerations made it necessary to have different requirements for small and large banks (Board Minutes, February 21, 1958, 5–6).
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After discussion with members of the ABA committee, the Board added a provision making maximum reserve requirement ratios for central reserve city banks 20 percent, the same as for reserve city banks. The Board then approved the proposed regulation by a vote of five to two. Robertson and Vardaman objected to the provision lowering requirements for central reserve city banks; the ABA subsequently endorsed the proposal (Board Minutes, March 18, 13–15, April 2, 1958, 6–7).

The Board next considered a further reduction in reserve requirement ratios. The Treasury would soon offer from $3 to $5 billion of securities. Since the Board did not announce its open market operations, Martin preferred to add reserves by reducing requirement ratios so that the market would know about the change before the Treasury offer. By unanimous vote the Board reduced reserve requirement ratios by 0.5 percentage
points, effective March 20 for central reserve and reserve city banks and April 1 for country banks. Requirements were now 19, 17, and 11. The ratio for time deposits remained 5 percent. The Board did not mention pressure from the ABA as a reason for choosing to lower reserve requirement ratios. It continued to act as if lower ratios with unchanged interest rates permanently increased available reserves.

203. The Board’s staff began by reviewing the proposal for reserve requirements based on deposit turnover developed in the early 1930s. The Board again rejected that plan as difficult to administer and complex. Robertson proposed counting vault cash as reserves and graduating requirements according to bank size without accepting the uniformity or the time schedule proposed by the ABA (Board Minutes, February 3, 1958, 5–6). Balderston favored different requirements for time and saving deposits, but others noted that separation would be difficult to enforce. Robertson’s proposal drew considerable support, but the Board broadened it to include several different categories of banks by size and location. The Board wanted discretion to vary requirements for particular types of banks; small banks in reserve cities or large banks classed as country banks are examples. Martin noted that the Board’s proposed legislation would permit uniform reserve requirements, as proposed by the ABA. Others objected that the proposal would stimulate many requests for exemption and reclassification. All parties agreed that the prevailing classification was inequitable, penalizing especially small banks in reserve or central reserve cities. The ABA would not join in supporting the Board’s proposed legislation. They insisted on uniform requirements of up to 14 percent for all banks (Board Minutes, March 6, 1958,
Appendix item 1).

Through April and early May, several FOMC members favored additional ease. In May, even Robertson urged free reserves of $800 million, $300 million above the April average (FOMC Minutes, May 6, 1958). The federal funds rate fell below 1 percent in May, reaching 0.2 percent at the end of the month. Martin remained cautious and concerned about public relations. His summaries of the consensus were less expansive than statements by a majority of the members.
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He preferred to reduce reserve requirement ratios.

On April 16, the Board’s Executive Committee discussed a further reduction in reserve requirement ratios. Hayes called to say that he would propose a 0.5 percentage point reduction in the discount rate to 1.75 percent at the directors meeting that day and would like to announce the change at 4 p.m., after the close of trading.
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Mills questioned why the System now relied on changes in reserve requirement ratios and the discount rate instead of open market purchases. He did not point out that a reduction in the discount rate to 1.75 percent would leave the discount rate one percentage point above the federal funds rate, so banks would continue to use the funds market and avoid discounting.

Martin responded that if Congress approved the Board’s proposal and allowed vault cash to be counted as reserves, the proposed reserve requirement ratios would narrow differences in reserve requirement ratios for the three classes of banks. He believed that the proposed actions on reserve requirements and the discount rate would “remove the need for further System actions for some time to come.” He made clear, however, that the proposed adjustment toward lower required reserve ratios was not taken to ease the market. It could be made, he said, “without interfering with over-all monetary policy” (Board Minutes, April 17, 1958, 8).

The gold outflow was one of his concerns. Like his predecessors in
1936, he noted that if the gold outflow reversed, the Board could raise reserve requirement ratios. “The Board should look for opportunities to make reductions when consistent with credit policy” (ibid., 9). After further discussion, the Board approved unanimously an immediate 0.5 percentage point reduction for central reserve city banks and a further 0.5 reduction for central reserve and reserve city banks a week later. The Board left the country bank ratio unchanged. When the change beca
me effective the requirement ratios were 18, 161/2, and 11.

204. At the May meeting, he opposed changing the directive to say “continuing to combat the recession” because it “might imply that the Committee had been unaware of the recession earlier in the year” (FOMC Minutes, May 6, 1958).

205. The staff briefing noted early signs of an end to recession. Required reserves had increased and currency had not shown the expected post-Easter decline (Board Minutes, April 17, 1958, 3). Thomas estimated that the proposed reduction would release $450 million of rese
rves (see text).

Although the Board did not have a formal request for a lower discount rate, it approved reductions to 2 percent or 1.75 percent, effective the next day for any reserve bank that acted that day. New York, Philadelphia, Chicago, St. Louis, and Minneapolis lowered their rates to 1.75 percent. All other banks followed. San Francisco and Dallas waited until May 1 and 9. Treasury bill rates continued to fall, as banks purchased bills following the reduction in reserve requirement ratios, but long-term rates began to rise in the first week of May.

Annual growth of the monetary base remained at 2 percent throughout the spring. Though lower than potential growth of the economy, base growth was at the highest rate in almost four years. Real base growth remained negative until August. Expost long-term real interest rates remained near zero through April, the last month of the recession according to National Bureau dating. Thereafter expost real interest rates rose. As often before, the rise in real rates contributed to the Federal Reserve’s misinterpretation of its actions. It interpreted the decline in nominal rates as an indication that policy had eased. This ignored both the effect on rates of the change in anticipated inflation and the change in economic activity. Chart 2.13 shows the acceleration of the real base in February 1958, a few months before the start of the recovery. Again, faster base growth offset the restrictive effect of rising real interest rates.

The Federal Reserve had faced inflation and rising unemployment. At first, it moved slowly to stimulate spending out of concern for inflation. As unemployment and the output gap rose, it shifted to more expansive policy actions. This set a pattern to which it returned in the late 1960s. As Governor Robertson warned, once the public learned that rising unemployment (or the output gap) had highest priority, it expected inflation to persist. Thus, stagflation (persistent inflation and unemployment) became a problem in later years.

The System was slow to recognize the start of recession and slow to recognize its end. It was not alone. Congress approved supplementary unemployment compensation on June 4, after the recession had ended, and repealed transportation taxes on August 1. The Federal Advisory Council
told the Board in late May that “although the rate of decline in business activity may have lessened, the economy continues a moderately downward trend” (Board Minutes, May 20, 1958, 1). The Council favored maintaining the degree of ease and did not want further reductions in the discount rate. Industrial production rose at a 12 percent annual rate that month.

THE SHORT EXPANSION, 1958–60

The Federal Reserve had decisively increased free reserves and lowered interest rates during the recession, and the administration permitted a large peacetime budget deficit.
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Concern about inflation rose with the recovery and the budget deficit at both the Federal Reserve and the administration. The Federal Reserve responded without hesitation to inflation concerns. The administration did not do much about the 1959 deficit, but it was determined to bring the deficit down in 1960. It succeeded; 1960 had a small surplus brought about by an $11 billion increase in receipts and a $2 billion reduction in spending.

The Federal Reserve tightened policy soon after recovery seemed assured. Table 2.3 uses annual dollar change in the gross public debt to suggest the magnitude of the budget deficit and the sharp turn from fiscal re
straint to ease and back to restraint. Several real and nominal magnitudes measure the size of monetary expansion or contraction.

206. In a letter to a banker, Hayes remarked: “Undoubtedly, the size of the prospective deficit . . . was a shock to the market and accentuated fears of further inflation that had already been aroused by discouragement over the lack of progress in bringing the wage-price spiral under control” (letter, Hayes to Hillestad, Sproul papers, Correspondence, December 4, 1958.).