91. Balke and Gordon’s deflator returns to the level of mid-1918, the consumer price index to the level of early 1919. These data were not available, of course.
92. Friedman and Schwartz (1963, 770) suggest how much the size of the disequilibrium increased from 1920 to 1921. The ratios of United States prices to British, Swedish, and Swiss prices (each base 100 in 1929 and each adjusted for exchange rate changes) are:
The deflationary policy turned the terms of trade in favor of the United States and required revaluation or deflation in the rest of the world.
At the start of 1921, rates for borrowing collateralized by Treasury certificates and Liberty bonds were generally 5.5 percent to 6 percent, and for agricultural and commercial paper 6 to 7 percent. On January 12 the Board sent a telegram to each of the reserve banks suggesting a uniform rate of 6 percent on all types of borrowing. The responses were mixed. The southern and western banks mainly favored the proposal; the larger eastern reserve banks opposed it. New York and Cleveland cited as reasons for their opposition that market rates were about to stabilize or fall below prevailing discount rates. Governor Richard L. Van Zandt of Dallas reported on the unsatisfactory and illiquid position of the Dallas bank. He suggested that discount rates be raised to correspond to market rates. The Board replied that the bank’s “condition . . . constitutes a serious reflection upon the management” and ordered the bank to set discount rates at 6 percent for government securities used as collateral and 7 percent for commercial paper (Board Minutes, January 24, 1921, 72).94
The outgoing Wilson Treasury at last agreed to end preferential rates on certificates of indebtedness. In late January, Undersecretary Parker Gilbert wrote to Governor Harding urging the reserve banks to raise their minimum rates to 6 percent. Between January 19 and February 9 several banks, including New York, adopted the 6 percent minimum rate on Treasury obligations.
President Harding’s administration had a different attitude than its predecessor. Pressure for lower discount rates came from farmers, Congress, the Treasury, and particularly Andrew Mellon, who had become secretary of the treasury in the new administration and was therefore ex officio chairman of the Federal Reserve Board. Mellon favored a reduction in the discount rate from the time he took office, March 1921.95
93. Chandler (1958, 174) quotes Strong’s letter to Parker Gilbert of July 1920 to this effect. Strong wrote in a very similar vein to Montagu Norman almost nine months later—April 1921—after he had been pressured to reduce the New York bank’s discount rate by Secretary Mellon and the Federal Reserve Board.
94. Within a year the Dallas bank replaced Governor Van Zandt. The problems at the Dallas bank arose from the agricultural depression. Later recollections by officers of the Dallas bank describe their memories of the period. They recall that cotton prices fell from 60 cents to 5 cents a bale. All eleven banks in El Paso, Texas, failed in 1920; eight hundred banks failed in Texas the same year (CHFRS, interviews with William D. Gentry and Joseph Dreibilbis, March 4 and 31, 1955).
95. In 1921 Secretary Mellon also proposed, and Congress agreed to, a reduction of $835 billion in tax revenues out of a budget of approximately $5 billion (17 percent).
Mellon took office with the volume of discounts below its peak but above $2.3 billion and with prices falling at a 25 percent annual rate.96 Banks still held $2.5 billion of government securities, and their outstanding loans had declined very little from the peak. To the Federal Reserve, at the time, the banking data indicated inflationary pressure, both because the banks were borrowing heavily and because they continued to hold government securities. Hence banks could be regarded as financing speculative holdings by borrowing at the reserve banks. Moreover, the gold reserve ratio had increased only to 50 percent, and three of the reserve banks—Dallas, Richmond, and Minneapolis—continued to rediscount with other banks to maintain the legal reserve ratio behind their note issue.97
At his first meeting with the Board, in April, Secretary Mellon urged reducing rates at all reserve banks to a 6 percent maximum. Miller was opposed, arguing that wages had not been reduced enough. Other Board members did not want to dictate rate changes to the reserve banks again. Boston then proposed a reduction from 7 to 6 percent, but the request was denied pending a meeting of the Governors Conference the following week.
At the Conference, April 12–15, only Boston and Atlanta favored lower rates. Strong was opposed on grounds that a penalty rate had not yet been established. He claimed that a reduction in rates would encourage speculation on the stock exchange that “might very well extend to commodities. . . . I think the sound policy is to leave the rate unchanged” (Governors Conference, April 1921, 28–29).
Strong’s reasons for opposing rate reduction are set out more clearly in a March letter to Montagu Norman: “What I have written to you. . . is absolutely the fundamental and controlling factor, that is, the debt of member banks to the Reserve Bank” (quoted in Chandler 1958, 172). Bank loans had fallen only 4 percent, not the 20 percent reduction Strong believed necessary to reestablish sound conditions. During a period of liquidation, rate reduction would not encourage business. Businesses were liquidating inventories. Banks would not increase their borrowing at the reserve banks unless the Federal Reserve encouraged “a period of inflation with all the accompanying evils of speculation and extravagance.” The proper policy, he believed, was to follow “Bagehot’s golden rule” (Chandler 1958, 173–74).
96. The March 1920 volume of discounts was not reached again until 1980, when the price level, the economy, and the size of the banking system had increased manyfold.
97. The system hailed the interdistrict lending as evidence of the importance of the new system. After 1921, however, the system relied much more on open market operations and could use the allocation of the open market portfolio among banks to smooth earnings and gold reserves.
On one of the four meeting days, the Board and the governors met with representatives of the American Farm Bureau Federation. This group told them that “the farmers feel that they have no financial system designed to meet their needs” (Governors Conference, April 13, 1921, 468). “Money is borrowed from Federal Reserve banks to be reloaned on Wall Street” (477). The farm representatives asked, “Who decided that deflation was necessary?” (472).
Strong replied that the deflation was an inevitable consequence of the previous inflation: “No one could have stopped it, and no one could have started it. In our opinion, it was bound to come” (ibid., 496). Governor George W. Norris (Philadelphia) supported him. Ignoring the effect of the gold standard, he said deflation was not confined to the United States. All countries had inflated during the war, and all must deflate.
Pressure for rate reduction was rising, however. Unlike some banks, the Board no longer argued for penalty rates or elimination of Treasury certificates from the banks’ portfolios. The 1920 annual report comments that “the Board’s purpose [in raising rates in 1920] was to maintain the strength of the Federal Reserve banks,” a reference to the gold reserve (Board of Governors of the Federal Reserve System, Annual Report, 1920, 12). Harding expanded the argument in a May letter to the Atlanta reserve bank. The 7 percent rates were emergency rates. He denied that the Federal Reserve responded to political pressure. Rates had been reduced because the emergency was over (Board of Governors File, box 1240, 1921).
At the end of the meeting, on April 15, Boston lowered its rate by one percentage point to 6 percent. The reduction and political pressure from Congress led New York to lower rates by 0.5 percent in early May. The following day, Strong wrote to Norman:
So far as I can discover, the demand [for lower rates] comes from no other class than those engaged in agriculture. They made an impressive showing, and their complaints reached all classes of Congressmen and executive officers of the government right up to the President.
. . . The general feeling prevailed that the New York Bank was causing the deadlock. My own belief is that the principle followed so long by
your institution, and . . . first enunciated by Bagehot, that in such times as these, money should be loaned freely, but at high rates, is the principle which should now govern our operation. (Ibid., 175)
This was not the unanimous view of System officials. The Board was more responsive to political pressure. On June 10 the Board sent a telegram to all reserve banks recommending that “rates on paper secured by new Treasury notes should be 6 percent flat at all banks” (Board of Governors File, box 1240, 1921). Within a week, several banks (including New York) lowered rates to 6 percent. By June all the major banks had reduced their rates, and in July New York, Boston, Philadelphia, and San Francisco again lowered rates to 5.5 percent. Criticism of the Federal Reserve did not stop. On July 25 Harding wrote John Perrin (Federal Reserve agent in San Francisco): “I do not know whether you appreciate how violent the attacks are which are now being made upon the Board and the system” (Board of Governors File, box 1240, 1921).
Complaints were not limited to speeches and editorials.98 State legislatures, and Congress, considered legal limits on interest rates. In August 1922 the Senate approved a resolution criticizing the use of progressive rates only in agricultural districts and asking the Federal Reserve to refund any excess over the amounts that would have been paid at a 10 percent annual interest rate. It authorized Federal Land Bank to lend to farmers in distress but restricted loans to farmers who owned their land.
Those who had opposed a central bank on grounds that it would penalize agriculture by keeping rates high to benefit bankers and lenders believed that the Federal Reserve System had acted like the central bank they thought they had prevented. Typical of the criticism was a letter from the governor of Nebraska: “The War Finance Corporation promised relief to the . . . corn belt, but this relief should have come from the Federal Reserve. . . . [T]he tremendous reserves of the Federal Reserve Banks at a time when there was much need for credit in essentials [remained unused]” (Governors Conference, October 27, 1920, 580).
The Federal Reserve was torn between concern for the political power of the farmers and belief that the farmers’ problems were not of their making. They pointed to the worldwide decline in agricultural prices but made no mention of the deflationary effect of renewed United States accumulation of gold on other countries attempting to return to the gold standard. Their defense was that credit to agriculture had fallen very little. The much greater reduction was in nonfarm regions. Reserve banks had not called agricultural loans. Farmers had borrowed to buy land and increase output during the war and postwar inflation. Worldwide deflation had now reduced the value of farm assets while leaving loan liabilities unchanged. This forced liquidation, low prices, and bankruptcy. The governors were relieved when this interpretation was accepted by Congress’s Joint Commission of Agricultural Inquiry (Governors Conference, October 27, 1921, 567).
98. The Board’s records for the period contain many editorials, especially from agricultural areas, denouncing and criticizing the Federal Reserve. To meet the criticisms, the Board requested the reserve banks’ opinions on a proposal to establish a preferential rate for commodity paper. The banks opposed it, and the proposal died (Board of Governors File, box 1240, August, 1922).
Livestock farmers faced particularly severe distress as prices fell and loans came due. Congress responded by extending the life of the War Loan Corporation to help livestock producers. In October the governors and Board members met with a group of senators who described at length the problems faced by farmers and ranchers. The governors responded that the Federal Reserve could not make long-term loans and was not authorized to direct credit to particular uses. Part of Strong’s response is a firm denial of the efficacy of direct pressure, or qualitative credit control, that played such a large role in the Board’s approach and was to return at the end of the decade. The Federal Reserve, Strong said, “has no power to tell any of its members what kind of loan it shall make, nor to restrain it from making any loan it wants to make” (Governors Conference, October 27, 1921, 390–91). He was concerned, however, that state member banks would withdraw from the system if Congress permitted the Federal Land Bank to make long-term loans. He urged the senators to confine such loans to member banks (392–93).
Deflation brought a large gold inflow. Strong’s first reaction was to favor keeping the gold abroad, earmarked at the Bank of England and thus not counted as part of the gold reserve (Governors Conference, April 15, 1921, 1083). This would avoid the need for monetary expansion. Others pointed out that this was politically risky. The system would be criticized for refusing to expand.99
By late October New York’s gold reserve ratio reached 82 percent. Strong told the October Governors Conference that if the gold reserve was the only factor, as at the prewar Bank of England, the discount rate would be 2 percent (Governors Conference, October 28, 1921, 622–24). He favored lower rates, and he urged the other governors to keep downward pressure on rates. Although a penalty rate had not been restored, he favored faster reductions in discount rates “as long as speculative fever is not on.” The New York bank intended to keep downward pressure on rates by remaining in the acceptance market and by making small purchases of new issues of Treasury certificates to keep them at a premium price (Governors Conference, October 28, 1921, 634–36).
99. Miller asked Strong whether he could maintain a 7 percent interest rate if the gold reserve reached 60 or 65 percent. Strong replied, “Yes, I think we ought to fight that out right now” (Board of Governors File, box 1102, April 15, 1921).
Shortly after the meeting, most reserve banks reduced discount rates by 0.5 percent. The more important change was in the open market portfolio. That portfolio had remained in a narrow range since the summer of 1919. In November it began to increase. In the next seven months the portfolio increased threefold, an addition of more than $400 million.
During the winter and spring of 1922, open market rates continued to fall. As the discount portfolio fell, the reserve banks bought acceptances and Treasury certificates principally to improve their earnings. But Strong’s revised view had gained acceptance. At the Governors Conference in May, Morss (Boston) noted that a reserve bank could increase “momentum” by purchasing in the open market and then reducing the discount rate. And Strong pointed out that buying in the open market is equivalent to member bank borrowing (Governors Conference, May 2, 1922, 155–56). Some at the Federal Reserve had found virtue in activist policy, but the view was far from unanimous.
END OF THE RECESSION
The NBER dates the trough of the business cycle at July 1921, four months before the activist policy began. Industrial production turned in August and rose strongly. By March 1922 production was more than 20 percent above the previous year. Perhaps influenced by continuing agricultural problems, Balke and Gordon’s (1986) real GNP series shows a mixed pattern. A strong recovery in fourth quarter 1921 is followed by renewed contraction after the start of 1922. Averaging the two quarters suggests continued contraction. On this basis, real GNP does not return to expansion until second quarter 1922. Stock prices, however, reached a bottom in August 1922, and by December they were 13 percent above their trough.
The monetary base was subject to two principal countervailing forces. Federal Reserve discounts and advances continued to decline until September 1922, at times offsetting the continued strong inflows of gold. Quarterly average growth of the base did not become positive until second quarter 1922, nine months after the NBER trough. Quarterly average growth of M1 was weakly positive after fourth quarter 1921 but did not increase strongly until two quarters later. The New York discount rate remained at 4.50 percent until late in June 1922. This is the only business cycle in Federal Reserve history where market interest rates on many instruments—including commercial paper, long-term Treasury and corporate bonds—were higher at the NBER trough than at the preceding peak. Since prices fell throughout 1921, ex post real interest rates were far above nominal rates. Using Balke and Gordon’s (1986) deflator, real
rates on commercial paper were between 13 percent and 26 percent around the recession trough.100
The economy recovered despite these high rates and the restrictive Federal Reserve policy. Two forces were at work. The monetary gold stock rose 28 percent in 1921 and 18 percent in 1922, moderating and finally reversing the effects of falling discounts on the monetary base and the money stock. Falling prices raised the value of the public’s real balances as well as real interest rates. Of the two, the rise in real money balances was the more potent.
Chart 3.1 compares the growth of the real value of the monetary base with the real long-term interest rate.101 The two series reach a peak just before the NBER trough in the economy. The recovery occurs despite an (ex post) real interest rate of more than 20 percent. Although the real interest rate fell after June 1921, the decline was gradual.
Real money balances show a very different pattern, surging during the early months of 1921 and, after a brief decline, rising in 1922. Chart 3.2 shows that this pattern is similar to the growth of real GNP two quarters later.
Growth of real money balances predicts the start and end of the recession; the growth rate declines precipitately before the recession, remains negative during 1920, and starts to rise five months before the trough (chart 3.2). Real interest rates show almost the opposite pattern, falling before the recession and rising during the recession. The reason is that both series have a common element—the annual rate of price change.
A History of the Federal Reserve, Volume 1 Page 18