A History of the Federal Reserve, Volume 2 (34 page)

The Federal Reserve’s principal measures of ease, free reserves and the federal funds rate, recovered quickly and decisively. By December 1959, both were back at the levels reached at the August 1957 peak. Growth of the nominal monetary base, after expanding rapidly, fell back to its August 1957 rate also. The real federal funds rate suggests a much tighter policy than at the earlier peak. As the deficit declined, fiscal thrust also turned contractive. By April 1960, the deficit fell to $2 billion and, in the first quarter of 1960, the budget had a $7 billion surplus at annual rates.

The Federal Reserve and the administration managed to achieve their principal objective, preventing the stimulative policy during the recession from generating persistent inflation. In 1959 and 1960, the annual increase in the consumer price index remained between 0 and 2 percent. Arthur Burns recognized later that the reversal from highly expansive to contractive policies was too abrupt and too large a change (Burns and Samuelson, 1967). He attributed the decisions to “excessive concern over inflation” (ibid., 6) resulting from the recent experience in 1956–57, but he recognized that the reductions in government spending in aggregate “came to a much larger total than our fiscal authorities had either planned or advocated” (ibid., 7). He ignored the likely effect on anticipations. By promptly removing the stimulus, policy reversed the growing belief that inflation would continue. Inflation and anticipations of inflation remained low for several years.

The early recovery was robust, 9.8 percent growth of real GNP in the second half of 1958, and more than 6 percent in the first half of 1959. In August the unemployment rate began to fall. By January 1959, it reached 6 percent, 1.5 percentage points below its peak. Industrial production
started to rise in May 1958. By January, it had reached its previous peak. In the first year of recovery, production increased 20 percent.

Inflation remained a short-term problem. The twelve-month rate of change of consumer prices did not fall below 3 percent until June 1958, after the recession ended. The CPI inflation rate fell toward 1 percent or less in 1959, but the deflator continued to rise. The administration’s concern for fiscal responsibility gave priority to reducing the size of the deficit and growth of government spending (Council of Economic Advisers, 1959, 48–52).
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The president asked, also, to make price stability an explicit goal of economic policy (ibid., 52).

Federal Reserve policy actions remained restrictive, as Table 2.3 (above) suggests. Annual growth rates of the monetary base rose above 2 percent in only one month of the twenty-four-month expansion. In the two years of expansion, the cumulative increase in the base was 1.7 percent. Interest rates rose under the influence of robust growth, moderate inflation, and restricted monetary growth. Treasury bill rates increased 1.7 percentage points (to 2.6 percent) in the first six months of recovery, and ten-year rates rose almost a full percentage point.

Together, fiscal and monetary actions set the stage for a brief but rapid decline in the unemployment rate to a level well above previous periods of recovery and expansion (see Chart 2.2 above). Recovery then slowed and ended. Tight policies made it the shortest postwar recovery to that time.

Federal
Reserve
Actions

Once again, the Federal Reserve promptly recognized the turning point but was slow to act. At the first FOMC meeting after the trough, May 27, 1958, the staff reported that the recession was near its end. Woodlief Thomas warned of inflationary tendencies in the recovery. New York was less certain. Hayes saw no sign that the recession was over (FOMC Minutes, May 27, 1958,9). He favored another reduction in reserve requirement ratios, even during the forthcoming Treasury financing. Six FOMC members agreed, although most preferred to wait until the Treasury completed the financing. Martin favored an even keel, and the FOMC agreed unanimously to do nothing. Free reserves remained about $500 million, and the federal funds rate reached a low of 0.2 percent for the week ending May 28. Long-term Treasury yields remained above 3.1 percent, a wide spread over the funds rate, probably reflecting some anticipation that inflation would follow the aggressive fiscal stimulus.

207. The report asked for a line item veto, a request that would recur with greater emphasis in future years (Council of Economic Advisers, 1959, 51).

Hayes held to his interpretation: “there is certainly no evidence yet pointing to any substantial recovery in 1958” (FOMC Minutes, June 17, 1958, 10). He saw the inflation outlook as “more encouraging than at any time in the last few years” (ibid., 11). In an unusual move, he challenged Martin’s statement of the consensus calling for no change in policy. He thought a majority favored a reduction in reserve requirement ratios, to meet the holiday demand for currency, but Martin believed the money market was too easy. The committee voted unanimously to make no changes.
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In May, the Treasury offered to refinance $9.5 billion of maturing securities by issuing either a 2.625 percent seven-year bond or a 1.25 percent one-year certificate. With the end of recession still uncertain, holders exchanged $7.5 billion for the new seven-year bond. “This was a surprise to the market and suggested that a sizeable amount of the newly acquired securities were speculatively held”
(Federal
Reserve
Bulletin,
August 1959, 5). The market soon received information that caused bond yields to rise. Estimates of the government deficit for fiscal 1959 suggested that it would be the largest since World War II.
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Much of the Treasury’s demand for new financing would come in the fall, when the Treasury would also have large demands for refinancing. By mid-June, “observers took into account that economic recovery might already have begun,” ending the period of credit ease (ibid., 5). Holders began to sell the new seven-year bond and other long-term bonds. The Treasury intervened in the long-term market in June and July, purchasing almost $600 million for its accounts, but the System limited its purchases to bills.
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By early July, Ralph Young’s staff report concluded that the recession had
ended. Several presidents agreed, and proposed either a prompt or nearterm increase in the discount rate. Hayes remained skeptical about the recovery and concerned about Treasury issues. He favored giving less attention to free reserves and more to money supply growth, which remained slow. Mills and Szymczak shared his concern about the Treasury market.

208. At the June 25 Board meeting, the reasoning became clearer. There were problems in the bond market (see text) following a Treasury issue. Government securities dealers had large positions, evidently speculating on a continued decline in long-term rates. The System had supplied about $600 million in open market purchases in the previous two weeks (Board Minutes, June 25, 1958, 7). Martin was cautious, citing labor negotiations. Mills, Robertson, Vardaman, Shephardson, and Balderston agreed that the System should act only, if at all, in the open market. Szymczak wanted to use the opportunity to reduce reserve requirement ratios and believed that there was a “need for reserves” to allay uncertainty (ibid., 10).

209. The unified budget deficit reached $12.8 billion, a record peacetime nominal volume of borrowing to that time. The following year, the budget had a small surplus. Saulnier (1991, 124) responded to critics of the large fiscal tightening by noting that part of 1959 spending was a payment to the International Monetary Fund that had no economic impact on the U.S. economy. Nevertheless, the spending had to be financed.

210. An exceptionally large number of speculators bought the new bond issue anticipating further reduction in interest rates by the Federal Reserve. Many of the purchasers bought on margin, with as little as 5 percent equity. Bremner (2004, 108) reports that one small banker purchased and resold $500 million in this way. Total loans secured by Treasuries reached $6.1 billion compared to a $7.4 billion issue, evidence that the bonds were not held in permanent portfolios.

Thomas’s staff report warned that the Treasury bond market was weak, despite the large increase in reserves. Speculators had closed out their positions, and time deposits had increased substantially because their return was favorable. The banks had expanded credit, and additional expansion seemed likely. Then he added a statement that could have been written by a 1920s real bills advocate. “The experience of June is an example of the pitfalls that may be encountered in following a path of forcing down interest rates and stimulating credit commitments regardless of current needs . . . Is economic recovery aided by such false and temporary movements?” (FOMC Minutes, July 8, 1958, 13).

Although the recovery was only two months old, Martin favored an increase of 0.5 percentage points in the discount rate after the even keel policy ended, but he asked the presidents not to initiate a discount rate change before the next meeting. In the interim, he favored operating “within the color, feel, and tone of the market” (ibid., 46). He found it difficult to know what to do. The week after June 19 “was one of the worst that he had spent since coming into the System, with many people who were stirred up about rumors of a change in System policy calling him with various kinds of stories” (ibid., 42). “The System ought to do something that would be really clear-cut” (ibid., 43). But it should “not do anything to create more difficulty for the Treasury than necessary” (ibid., 44).
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With so much hesitation in the leadership, the only decision taken instructed the manager to keep free reserves at about $500 million. Irons (Dallas) suggested eliminating the free reserve target, substituting a measure of reserve availability. Hayes agreed in principle, but he favored retention because the public was accustomed to watching free reserves.

Once again, the System recognized that it did not have firm control of interest rates, but it was unwilling to move decisively to increase control. The next move came from the market. On July 15, the FOMC held a telephone meeting to discuss the proper response to a political crisis in the Middle East that involved sending 3,500 Marines to Lebanon. Bond prices
fell sharply on the news, but selling remained orderly. The System did not act for three days. On July 18, Rouse told a telephone meeting that the market was falling and “the Treasury could not, in its opinion, deal with it” (FOMC Minutes, telephone meeting, July 18, 1958, 2).
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Rouse regarded the situation as an international emergency but, since some buying continued as the market declined, he did not call the market disorderly. He asked for authority to purchase up to $50 million of long-term securities that day, “with the expectation of using less than $25 million” (ibid., 4). The committee voted the authority, with Robertson and Mills dissenting, because the markets were not disorderly. Martin, too, expressed reluctance to violate bills-only, but he voted to approve purchases.
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On Friday July 18, the account bought $27 million, a small fraction of the Treasury’s prior intervention (Board of Governors, 1976, Table 9.5, 490). Subsequently, it purchased $1.1 billion of the new issue and announced that the committee had authorized the manager to purchase longer-term securities. The announcement “went a long way to correcting what had really been a disorderly market” (letter, Hayes to Roelse, Hayes papers, Federal Reserve Bank of New York, correspondence, July 22, 1958).

211. The Board also heard by telegram from Congressman Patman, who asked what the Federal Reserve would do “to check the jungle-like activities being carried on by gamblers and speculators.” He urged them to abandon the bills-only policy (Board Minutes, July 16, 1958, 1). Patman sent another telegram on July 21 commending the FOMC for supporting long-term bonds.

By the end of the month, the federal funds rate had fallen from 1.32 percent in the week of the crisis to 0.36 percent. The real funds rate was negative; a near-zero nominal rate did not signify a liquidity trap. Yields on three- to five-year Treasury bonds remained at 2.5 percent, a pattern that would be repeated broadly in several subsequent recessions. This suggests that the market did not expect any cyclical reduction in the inflation rate to persist. In fact, the staff reported that markets anticipated higher inflation driven by the high current rates of “time deposit and monetary expansion, the continued ease of bank reserve positions, . . . and the Treasury’s large deficit” (FOMC Minutes, July 29, 1958, 5). The staff also reported that preliminary GNP figures for the second quarter showed a modest increase. Foreign economies had strengthened also.

212. In mid-June the Treasury sold $7.3 billion of the 2.625 bonds with seven-year maturity. A popular bond market columnist, Joseph Slevin, wrote on June 19 that the Federal Reserve had ceased efforts to reduce interest rates. Although there is nothing in the record to support Slevin’s claim, he was known to have good relations with System officials. The Treasury did not intervene until July 10. The System waited until late in the afternoon on July 18 (Knipe, 1965, 134–35).

213. At a second meeting, on the same afternoon, Rouse reported that the market was disorderly. Bids had dried up. The ten participating members of FOMC agreed to give the manager authority to make additional purchases of government securities without limitation. For the next several days, the FOMC held daily telephone meetings. On July 24, the committee rescinded purchase authority. The System offset its purchase of $27 million of five- to ten-year bonds (most likely seven-years) by a sale of $27 million of over-ten-year bonds. Its net purchase was $10 million of one- to five-year bonds.