17. The letter appears to have been sent after Adolph Miller raised the issue at the January 8 Board meeting. Miller understood that open market operations had a monetary effect. He wanted the banks to explain the reasons for their purchases and their plans for 1923 (Board Minutes, January 8, 1923).
The Board’s Response
From the very beginning of centralized purchases, the Board tried to find ways to control operations. Soon after the Treasury began to express concern about purchases, the Board asked its general counsel for an opinion about its powers. The counsel’s report concluded that the “Board has legal right to impose any restrictions and limitations it may deem proper” (Board of Governors File, box 1434, April 14, 1922, 190). The memo left decisions to purchase and sell up to the reserve banks; the Board had general supervisory powers.
During the winter of 1923, the Board was pressed to adopt a policy from one side by Secretaries Mellon and Gilbert and from the other by Adolph Miller. The Treasury wanted the Board to stop the reserve banks’ open market purchases and get the banks to liquidate their holdings (letter Mellon to the Federal Reserve Board, Board of Governors File, box 1434, March 10, 1923). Vice Governor Platt’s response expressed general agreement with Mellon’s concerns, but he noted that the Board could coordinate actions by the reserve banks but did not have authority to stop all purchases. Mellon’s reply did not accept the Board’s argument. Under its power of general supervision (section 11[j]), he wrote, the Board had ample authority to prohibit the reserve banks from investing in government securities. Mellon sharply distinguished investments from credit market transactions. Only the former should be prohibited. Credit market transactions “should not be hampered by regulations any more than is absolutely necessary” (Mellon to Platt, Board of Governors File, box 1434, March 15, 1923).
Miller wanted open market policy to be made with regard to the general credit situation. On March 8 the Board voted to ask Miller to draft a policy statement, and meanwhile it wrote to all the reserve banks urging them to allow their certificate holdings to run off without replacement. Two weeks later the Board considered Miller’s proposed resolution. Citing its powers of general supervision of investments under sections 13 and 14 “to limit and otherwise determine the securities and investments purchased,” the need to maintain a proper relation between discount and open market operations, and the embarrassment that past operations had caused the Treasury, the Board ruled that the reserve banks should conduct open market operations “with primary regard to the accommodation of commerce and business, and to the effect of such purchases or sales on the general credit situation” (Board Minutes, March 22, 1923, 177–78). The resolution abolished the Committee on Centralized Purchases and Sales and appointed the five members of that committee as the Open Market Investment Committee (OMIC). Miller’s resolution placed the committee under the Board’s control.19
18. The reserve bank governors’ concern for earnings is shown by the votes on the resolutions offered at the October 1922 meeting. The governors defeated Strong’s proposal that open market operations be used to regulate discounts and gold imports. When the resolution omitted “gold imports,” the proposal passed unanimously. The difference affected earnings. Substituting securities for discounts leaves earnings unchanged; substituting securities for gold changes the earnings flow.
To placate the Treasury, the Board’s resolution required the committee to conduct most of its operations in the acceptance market. Reflecting the real bills view incorporated in the act, the resolution instructed the committee to take account of the effect of purchases of government securities, “especially short-dated issues, upon the market for such securities, and to restrict open market purchases to primarily commercial investments, except that Treasury certificates be dealt in, as at present, under so-called repurchase agreement” (Board Minutes, March 22, 1923, 177–78; emphasis added).
The governors were meeting down the hall. A joint meeting with the Board, which Burgess (1964, 221) describes as “stormy,” discussed the Board’s resolution and its claim to general powers over portfolio decisions. W. P. G. Harding had replaced Morss as governor at Boston. Perhaps because he was the former governor of the Board and Strong was on leave, Harding led the governors’ criticism of the proposed resolution. He was not opposed to selling government securities, but he opposed doing so on the Treasury’s orders. This gave the Treasury a voice in open market policy and set a bad precedent. Further, he objected to the part of the resolution that severely restricted the banks’ right to buy government securities. The Board did not have power to prevent the reserve banks from buying securities. Its power was supervisory only, and the Treasury had no power at all (Joint Meeting of Governors and Board, Governors Conference, vol. 2, March 22, 1923, 669–70).
Miller responded that the banks’ purchases in 1922 had not been coordinated by the Committee on Centralized Purchases and Sales. The banks had purchased $400 million more than needed to meet expenses and dividends. This criticism angered McDougal, who argued that the additional purchases were made because discounts had increased more than expected as the economy recovered.20
19. Miller’s recommendation had the open market committee chaired by the Board. The Board removed this phrase to meet the objections expressed at the Governors Conference. Miller was not satisfied with the Board’s role. In the 1926 Stabilization Hearings, he urged the House Banking Committee to strengthen the Board’s role by making open market operations “subject to the approval and the orders of the Federal Reserve Board” (House Committee on Banking and Currency 1926, 866), and he proposed Board control again in 1928–30, when the committee’s size increased to twelve members. The Banking Act of 1935 transferred control to the Board.
The Federal Reserve Act gave the Board general powers of supervision. None of the governors questioned the extension of these powers to open market operations. Harding, joined by Case and Norris, objected to the Board’s claim that it would “limit and otherwise determine” the amount and type of open market purchases and sales. Norris said the Board lacked general authority over a reserve bank’s portfolio decision. General authority would mean that the law created a central bank, in Washington, with the reserve banks as operating branches.
Miller’s response recognized the importance of open market operations: “The open market operations of the system are going to be the most important part of the system, largely because it is through the open market clause of the Act that the reserve banks are in a position to take the initiative” (ibid., 700).
The Board was the proper authority, Miller argued, because it had a national, not a regional, perspective. Harding replied that there was no general power in the Federal Reserve Act. The Board’s counsel could not point to any place where the Board was empowered to limit the amount of government securities that the reserve banks could purchase.
Miller’s response recognized the law’s limitations but chose to ignore them. Without intending to prophesy, he foresaw what would happen: “The powers of the Board have been challenged in this matter. I regret to say that there has even been some question in the Board itself as to whether it had the power. A Board that doubts its power doubts its responsibility, and a Board that doubts its responsibility is very apt to be charged with responsibility later. . . . I think we have got the power; to me it is almost as clear as though it were there” (ibid., 694).
Miller found no support for his interpretation among either the governors or his Board colleagues. The governors, on their side, did not question the Board’s supervisory role or its power to replace the Committee on Centralized Purchases and Sales with the OMIC. Hamlin proposed that the offending paragraphs claiming general authority be stricken. With that change, the Board and the banks reached agreement. On April 7 the Board approved an amended version of Miller’s resolution that omitted the offending language. The Board also issued a statement of objectives for open market policy. Open market investments were to be “governed with primary regard
to the accommodation of commerce and business, and to the effect of such purchases or sales on the general credit situation.” Thus the new procedure was blended with the old and brought under the congressional mandate. The banks had thwarted the Board’s attempt to control policy operations, but the issue would return.
20. Undersecretary Gilbert was present at the meeting. He did not participate in the heated exchanges, confining his remarks to urging additional liquidation first of certificates and then of notes (House Committee on Banking and Currency 1929, 741).
The compromise did not satisfy either side. Before the first meeting of the OMIC on April 13 at Philadelphia, Miller proposed that Vice Governor Platt tell the governors they must sell all their government securities before the Board would approve an increase in discount rates. Strong was annoyed repeatedly by the Board’s failure to endorse OMIC decisions and by the frequent delays and changes in the decisions reached by the committee. Miller continued to press for more control. As chairman of the Board’s Committee on Discounts and Open Market Operations, Miller was well placed to interpose his views of proper actions. Further, he tried unsuccessfully to reduce the committee’s power. Early in 1925 he proposed that the Board outlaw repurchase agreements. In 1928 he again asked the Board’s counsel to review the Board’s authority over open market operations. The resulting memo left no doubt that the Board lacked the power Miller sought. The memo also made it clear that the open market agreement was voluntary—that any bank could withdraw if it chose to do so:
The Board, under this Section [14(b)], is given the power to regulate, and probably it could prescribe, maximum and minimum amounts which could be sold during any one period, but it could not forbid sales or purchases absolutely, for the power to regulate is not the power to destroy. . . .
The formation of the Open Market Investment Committee grew out of a voluntary agreement entered into between the Federal Reserve Board and the Federal Reserve banks. Under this agreement, the individual authority and discretion of each Federal Reserve bank to buy and sell Government securities is taken away, and the power is given to the Open Market Investment Committee and the Federal Reserve Board. I believe a Federal Reserve bank could withdraw from this agreement at any time. . . .
In my opinion, the Federal Reserve Board has no legal right under the Federal Reserve Act to create such a Committee, or to take over to itself such functions, except by voluntary agreement. (Board of Governors File, box 1435, April 25, 1928)
What Changed?
The decision to create an open market committee did not introduce a new policy instrument. Open market operations had been used for more than a century, and it was widely believed that purchases and sales could be used to change interest rates and expand credit and money.21
The principal changes were in interpretation or beliefs about the effect of open market purchases and sales, the role of the reserve banks, and their influence on national, as opposed to regional, financial conditions. Strong’s view that the principal effect of open market operations fell on member bank borrowing, not interest rates or credit, became the foundation of a revised view of how monetary operations worked. The new view changed the role of the reserve banks in two ways. Burgess (1964, 220) reports the two conclusions drawn at the time:
First, as fast as the Reserve banks bought government securities in the market, member banks paid off more of their borrowings; and, as a result, earning assets and earnings of the Reserve bank remained unchanged. Second, they [the reserve banks] discovered that the country’s pool of credit is all one pool and money flows like water throughout the country. . . . These funds coming into the hands of banks enabled them to pay off their borrowings and feel able to lend more freely.
Burgess (1964) recognized that the new policy view depended on the large gold reserve. This allowed policymakers to ignore any gold movements induced by purchases or sales. Reserve banks did not have to wait for gold movements or for member banks to borrow or repay; they could take an active role, forcing borrowing or encouraging repayment by reducing or increasing bank reserves. Further, discount rates now had at best a secondary role of supporting open market policy. The System could curtail borrowing without raising rates to levels that brought political and public criticism.
21. In September 1921 a private citizen, Albert Russell, wrote to Governor Harding urging action to stop the deflation. Russell wanted the Board to authorize purchases of bills, acceptances, and government securities to expand credit, lower interest rates, and reduce unemployment. Russell also wanted to let New York buy securities in districts with higher rates to bring rates toward equality in the various districts. Harding’s reply did not disagree but claimed that the Board lacked authority. The “Board does not have the power to compel a Federal Reserve bank to make any investment which its own directors may deem inadvisable.” Harding urged Russell to write to the reserve banks, “particularly the Federal Reserve Bank of Chicago,” but he asked that the letter not mention Harding’s reply. Russell wrote to both McDougal and Strong (and perhaps to others). The letters urged that “the Federal Reserve Banks force lower commercial rates by increasing on their own initiative the reserve funds of commercial banks.” The letter went on to argue that there would be a multiple expansion of money and credit. McDougal replied that he could not comment because “I prefer not to be quoted” (Board of Governors File, box 1433, September 26 and 28, October 1 and 6, 1921). Strong replied that purchases would not lower interest rates or expand credit “but would probably result in the immediate repayment of borrowings for a like amount by the member banks.” Strong added: “I agree that ultimately in more normal times . . . the operations of the Reserve banks will be principally through open-market purchases rather than discounting for member banks” (Chandler 1958, 207–8). Chandler criticizes this passage for its lack of understanding and comments on the change that occurred in Strong’s thinking in the next two years (by 1923). In fact, the passage shows that Strong had already formed the main new idea he held in the 1920s—that open market operations drove banks to borrow or repay discounts.
The new view, developed in New York, was based partly on observation of the effects of open market purchases in 1921–22 and partly on empirical studies. At the time, Burgess summarized the empirical findings about interest rates from 1831 to 1922 as showing that the System’s main effect on rates would be less seasonal variation. He reported that
(1) there is no long-term effect of Federal Reserve operations on interest rates; in the long-run rates depend on the productivity of capital;
(2) changes in the demand for and supply of money cause fluctuations around the long-term rate;
(3) the Federal Reserve is one factor reducing interest rate variability; other factors include reduced speculation on natural resources, other improvements in money market organization, and increased wealth and saving;
(4) a main effect of the Federal Reserve was a change in the seasonal; rates were lower in October to December, and higher in April to July, after 1914. (Board of Governors File, box 1240, December 1923)
As was customary at the time, and long after, Burgess did not distinguish between real and nominal interest rates.
The Board’s Tenth Annual Report
Studies of policy actions and development of statistical series by the Board’s staff, led by Walter Stewart, complemented the findings at New York. Stewart’s work formed the basis for the most important policy statement of the period—the Board’s tenth annual report—offering substitutes for the gold reserve ratio as a guide to Federal Reserve policy (Board of Governors of the Federal Reserve System, Annual Report, 1923, 29–39).
The report, written mainly by Stewart with Miller’s support, blends the old and the new policy views by joining the real bills doctrine underlying the Federal Reserve Act with the more activist policy of responding to current and anticipated changes in the credit market.22 Instead of waiting for member banks to borrow or repay, the reserve banks could influence the supply
of real bills. Instead of a portfolio consisting of real bills and gold, the reserve banks would now choose to hold government securities as part of their portfolios.23
22. “The discussion had moved away from the concept of the Reserve system as a mechanism responding semiautomatically to the demands made upon it to that of an organization responsible for taking the initiative” (Burgess 1964, 222).
The report offered two “tests” of policy, qualitative and quantitative. The qualitative test, as before, was whether credit was used for productive purposes. The new quantitative test replaced the gold reserve ratio with measures showing how credit changed relative to production. The report argued that the qualitative test alone could not be sufficient. Credit is fungible. A bank could offer real bills while financing speculative activities. Or a bank could borrow on government securities to finance production.
A History of the Federal Reserve, Volume 1 Page 23