A History of the Federal Reserve, Volume 2 (62 page)

Martin did not say that the change was made for political reasons. He ruled that the committee would not issue a statement. This was a strange ruling. Once the System bought longer-term securities, or asked for quotations from the dealers, the market would know that a change occurred. Martin may have been embarrassed by his decision to yield to political pressure and therefore reluctant to call attention to the decision. After further discussions with Hayes, Rouse, and Roosa, who favored issuing a statement, Martin reversed the decision so that “all market participants [would] be informed at the same time” (ibid., 62). The announcement referred to conditions in the domestic economy and the balance of payments to explain the change (letter, Rouse to Martin, Board Records, February 20, 1961).
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It did not say whether the change was temporary or permanent. Probably Martin had not decided.

That brought a formal end to eight years of bills-only. During the next two years, the FOMC purchased nearly $4 billion of coupon securities, mainly securities with one to five years maturity. Table 3.3 shows the detail. Years later, the staff reviewed the experience and the several studies of the effect of intervention. They summarized: the general conclusion drawn from the academic studies was that “even sizeable changes in the term structure of debt exert only a relatively small and short-lived impact on the shape of the yield curve” (memo, “Expanded Desk Buying of Coupon
Issues,” Board Records, May 7, 1975, 16). This was not the view taken by the Council of Economic Advisers at the time.
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82. The desk filed a report describing the first days operation. They began the operation at 2:30 p.m. to leave only a short time to react before the bond market closed at 3 p.m. The staff chose three issues and asked for offers from the fifteen dealers who traded long-term governments. Only twelve dealers made offers. The desk bought $13.5 million out of $20 million offered. The memo described the dealers’ reaction as “routine.” There were no comments or “significant questions.” The memo compared prices just before the announcement to the prices paid by the desk to show that prices did not increase. After the first purchases, dealers raised market quotations 6/32 in the issues purchased and 18/32 in longer-term issues (memo, Spencer Marsh, Jr., to Ralph Young, Board Records, February 21, 1961). These were large changes at the time. The next day Marsh reported that press reaction was mild. Dealer reaction ranged “from commendation to violent antagonism” (Marsh to Young, Board Records, February 24, 1961). Bond prices continued to rise, reducing yields one to ten basis points for intermediate bonds and three to eight basis points for long-term issues. Short-term rates rose anticipating the administration’s program.

Martin explained his willingness to change procedures in a letter to a Boston banker. The banker expressed concern that the Federal Reserve might again peg interest rates and asked several questions including whether “pressure was involved [and] how far has the Reserve System lost the independence which it regained in 1951?” (letter, Lloyd Brace to Martin, Board Records, February 23, 1961). Martin’s response showed an open mind. He denied that the Federal Reserve was about to peg yields. The reason for the new procedures was to find out “if they can be of some help in dealing with new problems, when the desirability of the result seems certain, even though the possibility of its attainment as yet remains uncertain” (letter, Martin to Lloyd Brace, Board Records, February 28, 1961). The procedural change could possibly answer some of the many questions. “Experience alone can demonstrate what otherwise can only be argued” (ibid.).

Experience did not give strong support to those who wanted intervention. By June 1961, the desk offered its explanation of why the “experiment” had not worked as expected. The System had purchased $1.466 billion of coupon issues plus $1.367 in bills, and it sold $1.903 billion of bills and other short-term securities between February 20 and June 2. The Treasury had purchased $673 million in coupon issues and sold $600 million in short-term securities. At the end, bill rates were 0.024 percent
age points lower; yields on three- to five-year issues remained unchanged. The System’s intent was to twist the yield curve. It had “no intention of dominating the market or of seeking to push long rates in a direction contrary to that indicated by market forces” (Memo, Operations Outside the Short-term Area, Board Records, June 5, 1961, 1).This effort was “seriously hampered by the numerous statements of Administration officials, and also by a great deal of press discussion, suggesting that our intentions are, ought to be, or will be, considerably more aggressive than we know them or want them to be” (ibid, 2). Nevertheless, the staff urged the FOMC to continue the program to supply reserves and avoid downward pressure on short-term rates.
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83. “The idea was to bring down rates for the long-terms because they were the ones that were important for housing, for investment and so forth. That was working fine. But the trouble is that we would have a meeting with Kennedy—and before the meeting Bill [Martin] would be out there buying those long-term securities, but afterwards his buying would flag. It would go up before the meeting and go down afterwards. . . . So I would call a meeting and sure enough the purchases would rise again, and Martin would be able to tell Kennedy, ‘We’re doing everything we can’” (Heller in Hargrove and Morley, 1984, 191).

A week before the June 6 FOMC meeting, Heller and Tobin met with Martin for more than two hours. Heller reported to President Kennedy that, though the meeting was friendly, the policy of lowering long-term rates “is in jeopardy” (memo for the president, Heller papers, Box19, May 31, 1961). Martin, he said, had lost conviction that the policy could lower long-term rates. “He will continue to buy intermediate and long-term bonds, and . . . there will be no reversal of this basic policy. . . . But, he is very pessimistic” (ibid.). He urged Kennedy to have another Quadriad meeting.
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Martin told Tobin and Heller that at least seven members of FOMC voted with him against their own conviction. The Federal Advisory Council “was against the new policy from the beginning and at its last meeting suggested that it be abandoned. . . . Many people favor returning to dealing in bills to provide the bank reserves that the Open Market Committee deems appropriate” (memo, Tobin to the files, Heller papers, Box 19, May 30, 1961, 5). Reminded that the president had committed publicly to continued monetary ease, Martin said “he had an equal desire to keep the
President from embarrassment” (ibid., 6). He agreed to keep free reserves at about $500 million.

84. The same memo noted that market participants used the System’s purchases of intermediate- and long-term bonds to adjust their portfolios cyclically. The Treasury started buying dollars forward and gained assistance from the Bundesbank to support the dollar. In 1961, the administration took steps to reduce military spending and get aid recipients to purchase in the United States.

85. Tobin’s memo about the same meeting also reports that the meeting was friendly. Martin complained about public statements by Council members that put pressure on the Federal Reserve. He cited Tobin’s statement about a reduction in the discount rate and concern about rumors of “severe disagreement” (memo, Tobin to the files, Heller papers, Box 19, May 30, 1961, 2). Martin said the Council had the right to state its position, but the System made monetary policy. On long-term rates, Martin said the Federal Reserve was the “sole buyer in the market. . . . [T]here was a real problem of maintaining government bond prices without engaging in ‘pegging’” (ibid., 2–3). Martin thought that market psychology anticipated recovery and possibly inflation. There was no shortage of liquidity with free reserves at $500 million. Tobin wanted a commitment that Martin would prevent an increase in bill rates during the recovery. Martin maintained independence and rejected that proposal (4). It restored pegging.

A month later, the desk explained that the FOMC had reduced the volume of purchases and restricted their scope to supplying reserves and offsetting sales of short-term securities. It asked for the right to purchase “when congestion appears to be developing . . . or when market expectations as to the future course of rates seem to be having clearly exaggerated effects”
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(Memo, Open Market Operations in Intermediate and Longer Term Securities, Board Records, July 7, 1961). The FOMC rejected the request.

By July, several FOMC members decided the new procedure had failed and wanted to end it. Hayes claimed that the international aspect was successful. The gold outflow slowed. Also, he claimed that long-term rates would have increased more than they did. Robertson said that the procedure had made the long-term market “thinner and made Treasury auctions more difficult,” the same position that Martin expressed to Tobin and Heller in May. Most of the members took an intermediate position; they were not ready to conclude that the new procedure had failed but were unwilling to expand it. Martin also was not ready to declare the procedure a failure or to end it, but he opposed expanding the manager’s discretionary authority (FOMC Minutes, July 11, 6–9; August 1, 1961, 54). He did not mention the commitment he had made to Heller and Tobin, but he agreed to reduce purchases of long-term debt.

Three features of this continuing discussion are representative of the way in which the System made decisions. First, no one suggested a systematic
evaluation of the experience.
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Both proponents and opponents relied on anecdotes or judgments of market participants and foreigners. These
were as mixed as the members’ opinions. Second, the capital outflow and loss of gold were a continuing problem. Keeping the bill rate at 2 percent or 2.5 percent, without changing reserve or money growth, was at best a short-term palliative. Third, most of the FOMC voted to support their chairman. No doubt they recognized the political pressure that he faced, but if a member raised such concerns at the meeting, it did not appear in the minutes. Yet Martin’s commitment, of which the members were unaware, to keep free reserves near $500 million tied the FOMC’s hands. Nevertheless, the Federal Reserve kept the commitment. Monthly average free reserves remained between $435 and $549 million from June 1961 to February 1962. Martin accepted a Federal funds rate as low as 1.16 percent in July 1961 to implement the policy. Treasury bill rates did not fall below 2.2 percent, however.

86. From February to June, the desk purchased securities other than bills in every week but one. The System stopped adding to reserves in June, and the Treasury curtailed purchases also. Council of Economic Advisers members were not convinced. Heller sent memos to the president in April, May, and June 1961 complaining about the Federal Reserve. (In their internal discussions, they included the Treasury because they believed that Secretary Dillon and Undersecretary Roosa agreed with the Fed.) After one meeting of the four top economic officials, now called the Quadriad, Heller exulted that before the meeting with President Kennedy the Federal Reserve increased its purchases (Monetary Policy, Heller papers Box 19, April 13, 1961). By mid-May, average yields on long-term Treasury bonds had fallen twenty basis points (0.2 percentage points) from their peak in January. By August, they were back above the January peak. For the rest of 1961, these rates remained about 4 percent. Yields on state and local bonds show no effect of the policy change. Corporate bond yields declined more modestly than governments and only from January to March 1961.

87. The desk investigated the use made of the proceeds received by sellers of long-term governments. It concluded, “It is virtually impossible to trace the proceeds of the earlier dealer purchases” (memo, Rouse to FOMC, Board Records August 18, 1961, 1). The effort recalls attempts in the 1920s to control the quality of credit. The staff collected data on net
acquisition of various types of assets by groups of lenders, but could not identify the marginal use of long-term funds.

Pressure from the administration to increase purchases of long-term debt remained strong. Martin cooperated, within the limits set by his concern about inflation and his beliefs about how monetary policy worked. But he regarded some of Tobin’s arguments as “hopelessly naïve” (memo, Tobin to files, Heller papers, Box 19, May 30, 1961, 4).
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Table 3.4 shows the changes in the Federal Reserve portfolio under bills-only and operation twist.
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The large percentage and absolute decline in maturities of ninety-one days to one year in both periods reflects the phasing out of Treasury certificates. As expected, the Federal Reserve acquired bills during the bills-only period. It also acquired one- to five-year securities in an amount equal to 96 percent of its overall net acquisition. During operation twist, the System acquired mainly bills, 72 percent of its net addition, and added substantially to the percentage of short-term bills in its portfolio. It continued to add to its one- to five-year holdings, but the portfolio percentage for this range changed very little. The System added a bit to its holdings of five- to ten-year bonds. These data suggest that the
pressures on Martin to raise short-term and lower longer-term rates did not have great effect on System policy actions.

88. The Council discovered also that Martin was morally committed to fight inflation and believed that only the Federal Reserve would do that. Also, he did not share their belief that inflation would not occur until unemployment reached 4 percent. He thought much of the unemployment was structural and technological and could not be lowered by monetary policy (Tobin files, Heller papers, Box 19, May 30, 1961, 5).

89. There is no terminal date for operation twist. I have used the month in which Congress passed the tax cut. President Johnson showed much less interest in meetings of the Quadriad to twist the yield curve or in the balance of payments deficit. When the payments problem worsened, he relied mainly on direct controls. The data in the table are based on Federal Reserve holdings, so they are net of sales and include redemptions and changes in maturity. Table 3.4 shows gross purchases of long-term secu
rities after 1961.