A History of the Federal Reserve, Volume 2 (40 page)

Riefler had held a dominant position. Less than a month after he left, members of the FOMC began discussing the directive, the operating target, the role of free reserves, and alternatives. Malcolm Bryan (Atlanta) began the discussion by proposing “total effective reserves,” computed by adjusting total reserves for changes in reserve requirement ratios and for reserves released or absorbed by shifts in deposits between banks with different reserve requirements.
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He presented a chart showing the trend and seasonally adjusted values. The trend was 3.6 percent a year for 1947–59. Effective reserves moved procyclically, generally rising during months of expansion and declining prior to and during the early months of the three recessions after 1947. Bryan used the chart to show that reserve growth had been excessive at the end of the 1957–58 recession, but restrictive policy had eliminated the “reserve surplus” and, with it, the problem of inflation (FOMC Minutes, January 26, 1960).
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Two weeks later, the committee discussed Bryan’s proposal and a related proposal by the Board’s vice chairman, Canby Balderston. The latter related growth of reserves and money to economic growth. If money growth exceeded projections, banks would have to borrow to get additional reserves, increasing restraint in the System’s interpretation. In the opposite event, banks would repay borrowing. Balderston proposed that the System offset changes in total reserves resulting from borrowing or repayment (FOMC Minutes, February 9, 1960, 41–47). Borrowing would then change the distribution of reserves, not the total outstanding. As the staff noted, Balderston’s proposal differed from the free reserve-operating target by avoiding open market operations to maintain free reserves when reserves rose above target. The Balderston proposal treated an increase in borrowing as expansive because it added reserves. The Board’s tradition, based on the Riefler-Burgess analysis of the 1920s, considered borrowing
contractive. Balderston agreed with the traditional System view that banks would be under pressure to repay borrowing, but he recognized that if repayment induced other banks to borrow, total reserves did not decline.
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Neither Bryan nor Balderston discussed the speed with which the FOMC would return to the target.

255. The adjustment follows the procedure discussed in Brunner (1961) and later used by the St. Louis bank. Brunner’s paper circulated about this time, but Bryan’s proposal may have developed independently.

256. Woodlief Thomas responded to the charts, telling Bryan that the money supply was “in many respects a preferable guide” (letter, Thomas to Bryan, Board Records, February 4, 1960, 1). “Preferable” refers to Bryan’s reserve measure. However, for daily or weekly operations, Thomas preferred free reserves because most of the manager’s actions offset temporary changes. “From a long-term standpoint total reserves, or money supply, seasonally adjusted, provide a much better guide to System operation than figures for net borrowed reserves. On a short-term basis, however, the latter are probably more satisfactory” (ibid.,
3).

Martin did not believe that rules or formulas could contribute. Hayes expressed polite interest, but he doubted that the System could guide weekly or daily decisions. Martin agreed. He recognized, however, that “there was more concern within the System than for a long time about the question of growth of the money supply” (ibid., 49–50). He preferred to talk about “color, tone, and feel” of the money market. He believed firmly that short-term changes in money were not informative.

Bryan continued to urge adoption of a total reserves target. On March 22, he warned FOMC members that “the recovery is losing momentum, that some massive readjustments are taking place, and others are in prospect” (FOMC Minutes, March 22, 1960, 18). The principal changes were increasing foreign and domestic competition and adjustment by the public from inflationary to non-inflationary beliefs. The latter change was highly desirable, but he warned that the transition could be “gravely troublesome in its economic implications” (ibid., 18). His major concerns included a highly illiquid banking system, the consequence of no growth of reserves in 1959 and declining reserves since year-end. He cited a “highly competent body of monetary theory” as showing that
“some
rate of growth of reserves is necessary to an expanding economy” (ibid., 19; emphasis in original). Bryan added that the money supply had declined also. Then, he warned:

[O]ur policy, unless greatly ameliorated, will in a matter of time, whether weeks or months, produce effects that we do not at all want . . . [M]onetary policy produces lagged effects. If the effects of an overdone restriction begin sooner or later to be overtly evident, and are unfortunate, a
s I think they will be, we should not be able to plead ignorance. . . . Let me also
suggest, as a sort of aside, that the period we are in is one that illustrates the grave dangers of the free-reserve, net-borrowed reserve concept as a guide to policy. (ibid., 20)
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Bryan’s statement made little impact. Shephardson questio
ned the definition of money. Robertson said it was a mistake to overemphasize the
money supply. Leedy (Kansas City) said FOMC could not use a formula to guide policy. Mills and Johns (St. Louis) supported Bryan. Mills argued that rising velocity with declining money supply is not evidence of expansion. It shows that holders of cash balances are strained. Johns recalled that the committee had called for ending the decline in the money supply at its March 1 meeting. But total reserves and money had continued to decline. He urged the FOMC to “reverse the decline in total reserves with a view to reversing also the decline in the money supply” (FOMC Minutes, April 12, 1960, 36). But Martin resisted Bryan’s argument. He found short-run changes in money difficult to interpret.

257. Balderston allowed for an increase in currency held by banks and the public and provided for 2 percent annual growth of the money stock, currency and deposits. His rule is a type of total reserve or base money rule that set growth of reserves at $8 million a week (2 percent a year) plus or minus any change in currency demand.

258. Bryan’s comment may have been heavily influenced by Milton Friedman’s (1961) work on lags published a few years later.

Events soon confirmed Bryan’s prediction. The National Bureau dates the peak of the expansion in April 1960, a few weeks after the warnings by Bryan and Johns. The Standard & Poor’s index of stock prices had fallen since September 1959. Industrial production began to fall in February, and the unemployment rate started to rise in March. The large, sudden shift from a $12 billion budget deficit to a surplus played a role by reducing spending. As was often the case, the monetary base and free reserves gave different signals. Annual growth of the monetary base fell to 0.25 percent in February, March, and April. Free reserves rose from −350 in January and February to −200 in March and April, mainly resulting from a decline in borrowing. The federal funds rate remained unchanged at 4 percent.

As Bryan, Johns, and Mills warned, the free reserve targets misled the FOMC. With the discount rate about equal to the federal funds rate, financial institutions sold Treasury bills and reduced discounts to avoid the administrative and regulatory costs of borrowing. Free reserves rose, as discounts fell, suggesting incorrectly that policy had eased. The decline in base money growth implied the opposite, as Johns pointed out (FOMC Minutes, April 12, 1960, 36).

The FOMC started 1960 with the belief that, after the steel strike ended, the economy would expand rapidly. The Federal Advisory Council (FAC) held this view in February; they foresaw favorable conditions for the first six months. They tempered this optimism by noting the decline in farm income and stock prices, slower sales of automobiles, and rising unsold auto inventories (Board Minutes, February 16, 1960, 2). Despite the low reported rates of inflation in 1959, the FAC warned that the wage agreement in the steel industry and the government’s budget problems raised concerns about long-term inflation. The adverse balance of payments and the administration’s efforts to have a budget surplus reduced these pressures in 1960.

As the year progressed, the FOMC recognized that the economy had slowed and that monetary policy was restrictive. In early January, all mem
bers except Mills wanted to increase the discount rate, but only one or two preferred not to wait for the end of the Treasury refunding. The main reason for the increase was to realign the discount rate with market rates.
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Some members wanted a one percentage point increase in February, March, or April instead of 0.5 after the refunding.

Martin opposed the increase. Although he liked to follow the consensus and not dictate to the committee, this was an exception. He had spoken with Secretary Anderson, who did not want to put pressure on the System, but he expected the coming Treasury auction to be difficult and he preferred a delay. Martin then asked all of the presidents not to change their discount rates. The discount rate remained at 4 percent.

By early February, the committee recognized that the economy had slowed. Martin accepted responsibility. He said that Federal Reserve policy had restrained the economy. He preferred an easier policy.
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Staff reports noted that banks continued to sell governments, investors had become more cautious, and foreigners had purchased both gold and dollar securities.
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Martin proposed to change the directive, but the committee opposed. Some members said that the directive had little importance. They preferred to change the policy. The FOMC could not reach a consensus; Martin proposed a slight but not visible easing.

Criticism of the bills-only policy in Congress and Riefler’s departure began to weaken support for bills-only within the System. Ralph Young pointed out that many outsiders thought the rule was too restrictive. On March 15, the Board received a letter signed by twenty-one senators, led
by Senator Douglas, urging the System to adopt four reforms: (1) tighten regulation of government security dealers including margin requirements for their customers, (2) end bills-only, (3) permit the money supply to increase on average at the rate of output growth, and (4) use open market operations (not reserve requirement changes) to provide secular growth of money. The letter suggested that if the Federal Reserve made these changes, Congress would consider removing the 4.25 percent interest rate ceiling on Treasury bonds.

259. Bryan (Atlanta) said that some banks in the sixth district had used the discount window to supplement their capital. He was considering a progressive discount rate to discourage overborrowing. The only time a reserve bank used a progressive rate was 1921. It proved very unpopular with many bankers and Congressmen.

260. Martin’s suggestion to ease policy in the winter partly absolves him from the blame that Nixon placed on him for the recession that, he and many others believed, cost Nixon victory in the very close 1960 election. In March Burns warned Nixon about an impending recession and urged him to press for increased spending and monetary and credit expansion. Andersen and Saulnier were not convinced, and Eisenhower wanted to reduce spending, not increase it (Nixon, 1962, 310). Nixon brought his request to a cabinet meeting on March 25, but nothing was done (Ewald, 1981, 293–96). In 1971, Nixon reminded Burns frequently about the good advice Burns had given in 1960 as a way of urging him not to restrict monetary expansion before the 1972 election.

In Hargrove and Morley (1984, 154–55), Saulnier questions the extent of Nixon’s concern at the time. He noted that President Eisenhower told him to brief Nixon about the economy. At the weekly briefings Saulnier explained that “the economy was not growing to the extent we wanted it to grow. . . . Never once did I have a word out of him that he was dissatisfied” (ibid., 155).

261. Governor Szymczak warned that the markets had figured out that the System targets free reserves. He proposed to move the target around to keep the market guessing. Otherwise, it would thwart policy actions (FOMC Minutes, Febru
ary 9, 1960, 34).

Martin replied on April 14. He rejected tighter regulation of the government securities market, reminding the senators that Congress had considered the issue in the 1930s and exempted the dealer market from regulation.
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Also, higher costs for government security dealers would reduce participation in the market to the Treasury’s detriment. He defended bills-only, assured the senators that the System was not “rigid and inflexible” as sometimes charged. He noted that the System adapted to unusual conditions when it purchased longer-term debt in 1955 and 1958 and when it exchanged for other than short-term securities in the 1959 and 1960 Treasury refundings.
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He agreed with the third recommendation: “As I have testified to the Congress on various occasions, it is the Board’s position that we should provide for such increases in the money supply as can be absorbed by a growing economy without generating inflationary pressures” (Board Minutes, April 14, 1960, 5, letter, Martin to 21 senators). He expressed a reservation, however, about any close relationship between growth of money and output over periods lasting several years, and he explained the slow growth of money in the late 1950s as a reduction in excess money balances accumulated during World War II. He declined to make a commitment to keep reserve requirements unchanged, and he reminded the senators that they had voted recently to reduce reserve requirements in the legislation concerning vault cash.

In a modest step away from bills-only, the staff proposed in February to permit the manager to buy bonds when they became short-term.
The FOMC would approve each decision. Rouse (the manager) suggested that short-term could include up to two years. As usual, Hayes argued for giving the manager more discretion, but many of the members were reluctant.
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262. He referred them to the 1959 Treasury–Federal Reserve study of the dealer market, carried out following the speculation that induced the Federal Reserve to buy long-term securities in 1958. This study is discussed later in the chapter. The Treasury also opposed margin requirements for purchases of government securities. To reduce speculation in new issues, they proposed subsequently to remove “rights” to new issues from holders of expiring securities. The public could then subscribe to a new issue on a cash or exchange basis, with no preference given to current holders (the Federal Reserve, the Treasury trust accounts, and small holders would continue to have preference if they chose to replace existing securities) (Board Minutes, March 29, 1960, 9).

263. At the Treasury’s request, the FOMC agreed to help in the April 1960 refunding by exchanging for a one-year bill.