A History of the Federal Reserve, Volume 2 (60 page)

The Federal Advisory Council also had difficulty deciding whether the economy was in recession. They noted the depressed conditions in the steel industry and the slowdown in home construction, but consumers continued to spend, at a slower pace, and employment remained near record levels. The members anticipated a modest seasonal increase through the fourth quarter, but they were concerned about 1961. Their forecast proved wrong. Real GNP declined in the fourth quarter and rose in first quarter 1961 (Board Minutes, September 15, 1960, 1–2).

Several FOMC members wanted policy to err on the side of ease but to keep market rates above 2 or 2.5 percent to slow the gold loss. They did not say what the manager should do when the two targets gave opposing signals. In mid-October, buy orders flooded the gold markets in London and Zurich. Gold prices rose to $40.00, a 16 percent premium, reflecting concern that, if elected, a liberal Democratic administration would follow more expansive policies to reach the 5 percent growth rate that the Democrats’ platform promised. Criticism of the Federal Reserve and increased gold outflows during the fall campaign reinforced these concerns.
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During the summer and fall, the manager, staff, and several members commented that free reserves were not a useful target because they did not reflect the position of the money market. Chart 3.8 shows that the response of the Treasury bill rate to free reserves during this period declined. This experience heightened concerns about the reliability of free reserve targets and whether monetary policy had done as much as it could to increase money growth and avoid recession. It suggests also that members used free reserves to proxy for interest rates.

The minutes give several reasons for the absence of a relation between free reserves and the Treasury bill rate in this period. The most plausible reason was the behavior of the manager, who increased or decreased the supply of reserves to maintain the bill rate at 2 percent or above, as Chart 3.8 suggests. The 2 percent rate was said to be the minimum rate that foreigners would accept to hold Treasury bills instead of shipping gold abroad. On this interpretation, the variability of free reserves traces out the volatile demand for free reserves in that period.

At the October 4, 1960, meeting, several members commented on the necessity of a balance of payments policy. Some suggested that higher in
terest rates abroad restricted the System’s ability to reduce short-term rates. Buying longer-term securities, and abandoning bills-only, now seemed more acceptable.
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66. In the week before the election, John F. Kennedy tried to reduce these concerns by pledging to maintain the $35 gold price. For the first time, the Eisenhower administration authorized the Bank of England to sell gold as its agent, and the Bank agreed to lower its discount rate by 0.5 to narrow the spread over the U.S. rate.

By the October 25–26 meeting several of the members noted that the economy had declined further. Their immediate concern was the balance of payments deficit and the gold price increase. Woodlief Thomas pointed out that several members proposed inconsistent actions. They proposed “purchasing longer-term securities . . . bringing about a desirable downward adjustment in long-term interest rates and stimulating borrowing in that area, and at the same time avoid reducing short-term rates and encouraging the flow of funds abroad. Any such operation would more than likely defeat the purposes for which it was intended. . . . The eventual recipients of the funds determine how they are used. What is desired is for investors to place their funds in longer-term issues, not simply for the Federal Reserve to buy them”
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(FOMC Minutes, October 25, 1960, 11).
Thomas warned them that they could not expect to stimulate economic activity by keeping short-term rates from declining “or by artificial action designed to bring about a decrease in long-term rates” (ibid., 12).

67. The new administration proposed a similar policy after taking office but expected resistance from the Federal Reserve. In October 1960, three-month Treasury bill rates in London and Frankfurt were 5.36 and 4.88 percent respectively.

68. Thomas may have remembered previous attempts to change the slope of the yield curve by selling long-term and buying short-term issues or the reverse. These efforts before World War II and during the early postwar had not been successful. Thomas’s statement explained why policy actions had failed to increase money and credit. System actions and a $500 million increase in float supplied about $900 million of additional reserves since early
August. The reserves financed a $500 million gold outflow, a $200 million reduction in borrowing, and a $200 million increase in required reserves. The last of these supported the 2 percent growth of money. But the money stock was $3 billion less than at its previous peak in June 1959 (FOMC Minutes, October 25, 1
960, 10).

Martin summarized the consensus. The manager should supply the seasonal increase in reserves even if interest rates fell below 2 percent. Robert Rouse, the account manager, responded that he understood that he was to keep free reserves between $300 and $500 million. He then asked for permission to deal in longer-term securities, up to fifteen months. The FOMC granted the request, effectively ending bills-only. After years of struggle, New York had a victory.

The committee voted unanimously to change the directive to increase maximum holdings from $1 billion to $1.5 billion and to add to part (b) of the directive the phrase “while taking into consideration current international developments” (ibid., 58). This satisfied the members but left unresolved how, if at all, the new constraint would affect their actions. In practice, the manager ignored Martin’s proviso and kept the Treasury bill rate above 2 percent.

The FOMC remained divided about how much to ease monetary policy and how much attention to pay to the loss of gold. Several members urged the manager to keep Treasury bill rates above 2 percent, but the committee did not include that instruction in the directive. The FOMC also divided over whether the manager had followed its instructions.
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Governor Robertson rebuked the manager both for keeping policy too tight and for excessive use of repurchase agreements at rates below the discount rate. Johns (St. Louis) joined in the criticism, but others, including Martin, praised the manager.
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The consensus on November 24, 1960, was to keep policy unchanged, a surprising conclusion since the members did not agree on precisely what
that meant or whether the manager had followed instructions. Martin commented that the world awaited a clear view of what the new administration would do. He complained that there was a widespread belief outside the System that the budget, the cost-price relationship, debt management policy, etc. could all be solved if the System would just increase short-term rates and cut long-term rates. The System could only target the spread briefly without getting int
o trouble (FOMC Minutes, November 24, 1960, 41–42). He did not elaborate, but his statement anticipated the pressures that would soon be upon him to “twist the yield curve.”

69. Some of the suggestions were contradictory, for example calling for targeting free reserves and the bill rate. Several members proposed ignoring free reserves at that time. Earlier the Treasury responded to a question from New York banks about financing gold purchases abroad by United States citizens. The Treasury statement said that “buying or selling gold outside the United States, although permitted by Treasury regulations, was not in the national interest and should not be encouraged or facilitated” (Board Minutes, November 7, 1960, 3). The staff reported that the Treasury had considered amending the regulation to require a license to buy or sell gold outside the country. The Board’s staff opposed because the regulation could not be enforced and might have an adverse psychological effect.

70. In early November, repurchase agreements averaged more than $500 million a week, the largest amount to that time.

Robertson urged the System to raise the ceiling rate on time and saving deposits high enough to signal their belief that interest rates would never reach that level. Banks could then set their own rates according to local conditions. Bopp (Philadelphia) and Trieber (New York) supported him. “Martin said this was an appropriate subject for discussion . . . [and that] a good case could be made for permitting banks to pay interest on demand deposits” (FOMC Minutes, November 24, 1960, 45). Nothing changed.

Between meetings, the Board completed the release of vault cash to reserves. The reserve requirement ratio for country banks increased from 11 to 12 percent, and effective December 1 the Board lowered the reserve requirement ratios for central reserve city banks by one percentage point to 16.5 percent. The ratios were now the same at central reserve and reserve city banks in anticipation of the elimination of the central reserve city classification in July 1962.
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The purpose of these changes was to release reserves seasonally without announcing a change in interest rates or in
open market operations. In fact the bill rate remained unchanged at the time of the release.

71. The Board announced the decision on October 26. The staff estimated that the action released $1.3 million reserves; central reserve city banks gained $400 million, reserve city banks $380 million, and country banks $900 million by including all remaining vault cash in required reserves. The increase in the country bank reserve requirement ratio from 11 to 12 percent absorbed $380 million. Country banks held $538 million in excess reserves in October, $200 million above the level of the previous year. The Board’s press release reported that the 1959 legislation and the Board’s actions reduced average reserve requirement ratios adjusted for the release of vault cash from 14.5 to 12 percent at country banks, 18.2 to 16.5 percent at reserve city banks, and 18.7 to 16.5 percent at central reserve city banks.

The Board also discussed a staff recommendation to reduce float by increasing from two to three days the maximum length of time before granting deferred availability credit in the check collection process. The proposal made this change effective on January 16, 1961. The plan was to use the adjustment of float to remove the seasonal increase in reserves provided by the release of vault cash. Several governors objected to changing the time schedule for deferred availability credit so far in advance or without discussion by the Federal Advisory Council. The Board approved the changes in vault cash and requirement ratios without the change in deferred availability credit. Governor Robertson voted no because he believed the action was taken too much in advance of its effective date, and because reversing a seasonal increase by changing the availability schedule should be announced at the same time. (The deferred availability schedule gave the length of time between a bank’s request for check collection and the payment of reserves.)

Treasury bill yields rose in November and December, but growth of the monetary base also rose. The unemployment rate reached 6.6 percent in December, as the rate of decline in industrial production increased. At the November 15 meeting of the Federal Advisory Council, the bankers reported that loans at money center banks were close to an all-time high level. Some of these loans were to finance inventories that would be reduced. The FAC did not think rate reduction or faster money growth was called for
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(Board Minutes, November 15, 1960, 10–11).

President Hayes (New York) shifted his position at the December FOMC meeting. He favored free reserves at $750 million, $100 million above the level of the previous week. He wanted to use “creative methods” to add reserves so that bill rates would be less affected. Robertson joined him in seeking a more expansive policy, but he also wanted a 0.25 percentage point reduction in the discount rate. Recognizing the income effect of expansion, he favored an overtly expansive policy to show that the Federal Reserve would do as much as possible to strengthen the economy. This would improve the balance of payments, he said (FOMC Minutes, December 13, 1960, 19). With inflation no longer a problem, Robertson became an avid proponent of easier policy.

The conflict between domestic and international concerns or between obligations under the Employment Act and the Bretton Woods Agreement became apparent. Both Mills and Martin wanted to tighten, although Martin recognized that the domestic economy called for ease. Bryan (Atlanta) wanted more attention to domestic problems.
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In a statement reminiscent of the 1920s, Mills warned against “forced feeding of new reserves into the commercial banking system which policy . . . has been proven ineffective” (ibid., 19). He warned against repeating the mistake of the 1920s, when policy tried to achieve conflicting aims. Martin’s consensus statement called for the same degree of ease while keeping Treasury bill rates as high as possible. As on previous occasions, that statement gave no
guidance to the manager except to use his judgment as he sorted out the conflicting opinions of FOMC members.
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72. “Chairman Martin expressed the view that the biggest shadow on the domestic business picture was cast by the balance-of-payments problem. . . . There were some suggestions that a reduction in the discount rate to a substantially lower level and a much greater availability of money would do a lot for the economy, but he questioned that reasoning” (Board Minutes, November 15, 1960, 9).

73. Bryan said that total reserves were on a 3 percent growth path, and this was adequate. See Chart 3.7, above, showing that the real value of the monetary base had turned positive. Bryan also reminded the members that when Britain devalued in 1931, the Federal Reserve had protected the gold stock instead of the domestic economy, a catastrophic error. Martin responded that there was now no question about the credit of the United States.