A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  101. Purchases were made for a new Special System Investment Account to be used for all purchases and sales by the committee. Allocation to individual reserve banks was based on earnings needs of the reserve banks. The reserve banks paid or received payment by transferring gold on the books of the gold settlement fund.

  Strong was cautious. The System bought only $30 million in December. At its January 1924 meeting, the OMIC adopted a “waiting policy” at a time of “extreme caution” (Board of Governors File, box 1436, January 14, 1924). The committee purchased only $15 million. The reason for caution was the fear of inflation caused by adding securities purchases to a continued gold inflow.102 The background memo prepared for the meeting mentioned stock market speculation as a possible sign of inflation but noted that commodity prices showed no sign of inflation. In February, with a renewed decline in industrial production, the OMIC resumed purchases. On February 25 the Board approved purchases of an additional $100 million. By November 1924, the OMIC had bought more than $500 million in twelve months, with the bulk of the purchases between February and August, nine to fifteen months after the recession started.103

  The reserve banks easily reached agreement on purchases. Nine of them, including New York, had negative earnings. In May, the OMIC revised the allocation formula to reflect the projected earnings positions. New York took 51 percent of purchases in June (instead of its previous 29 percent), and Chicago took 10 percent. Thereafter, allocations changed monthly.

  Treasury officials did not oppose purchases by the reserve banks, but they asked for a limit on the size of the System account (OMIC Minutes, Board of Governors File, box 1436, April 22, 1924). The Board and the Treasury continued to resist purchases of long-term securities. The Federal Advisory Council supported the Board’s position, and the Board used the council’s opinion to reject Chicago’s request to purchase long-term securities for income (Letter Board to McDougal, Board of Governors File, box 1434, May 23, 1924).104 The issue did not die. In November 1924, with most of the reserve banks in deficit, the governors voted on a proposal to defy the Board by purchasing long-term governments to increase earnings. The motion was defeated on a tie vote.

  102. The bulk of the gold was in bullion. Beginning in January, governors agreed to ask the Treasury to increase gold coinage and to issue more gold certificates until coins and certificates equaled 20 percent of notes and deposits, 6 percent in coin and 14 percent in certificates (Governors Conference, May 6, 1924, 340–47; November 10–14, 1924).

  103. Wicker (1966) interprets the 1924 purchases as made mainly for international reasons. He dates the principal purchases as occurring between June and August (88). This neglects $100 million made in March 1924. As noted below, Strong later testified that purchases should have stopped in June.

  Early in May 1924, New York reduced its discount rate to 3.5 percent in two steps.105 By July only Minneapolis remained at 4.5 percent. Open market rates for commercial paper fell to 2 percent. For the first time, some member banks began to report rising excess reserves. The difference in discount rates suggests, correctly, that there were sizable regional differences. Excess reserves at banks in large cities accompanied heavy borrowing in agricultural districts, particularly in June and July. A large United States crop and small crops abroad raised farm prices and improved the farmers’ position, so discounts declined in the fall, counter to the usual seasonal pattern. Strong later described the effect on the United States market:106 “The outcome of the crops made it necessary for Europe to make unprecedented purchases of our small grains at very high prices compared to recent years. But the coincidence of low rates for money in this market and higher rates in London enabled foreign. . . borrowers to place a billion and a quarter of loans in this market” (House Committee on Banking and Currency 1926, 337).107

  The recession ended in July, but open market purchases continued. As noted earlier, gold outflow from Britain threatened Britain’s return to the gold standard. With United States interest rates below British rates, the United States gold stock reached a peak in June 1924 and declined slowly through the fall. Following a recommendation of the Federal Advisory Council, the OMIC discussed purchases of future sterling bills at its October meeting but decided that the futures market was too small. The committee was uncertain about its next move. It voted to give the chairman authority to buy or sell up to $100 million, but the Board would not consider giving the decision to Strong. By November, market rates were rising. The reserve banks’ acceptance rates were below market rates, so they supplied the usual seasonal demand for reserves and currency through the acceptance market.

  104. The Board was divided on the issue. The vote was three to two to reject Chicago’s request. Crissinger abstained. Hamlin believed the Board exceeded its authority.

  105. This was a year after the start of the recession. The only discount rate change in 1923 was a 0.5 percent increase by San Francisco two months before the cyclical peak. Chandler’s claim (1958) that the Federal Reserve, particularly Strong, had discovered countercyclical policy (along Keynesian lines) is not consistent with the long delay at the start of the 1923–24 and 1927 recessions. What Strong and other proposed, and did, depended mainly on credit markets, particularly the level of borrowing. Although Strong talked about measures of production, his actions were based on discounts and interest rates as suggested by the Riefler-Burgess doctrine.

  106. In July, the OMIC voted to allow its chairman to sell and repurchase securities in the new Special System Investment Account to smooth the market during tax payment periods. New York and Chicago had been smoothing on their own earlier.

  107. The statement is based on a memo that Strong wrote in December 1924 and read to the Banking Committee at the 1926 hearings.

  Strong prepared a lengthy congratulatory report for the November meeting on the first full year of the OMIC’s operations. Purchases had added $500 million to the System account without adding directly to the volume of credit. Credit had shifted from discounts to government securities with little change in the total. As a result, gold imports and currency had their full effect on the credit markets and contributed to ease markets during the recession, and later a gold outflow contributed to the “readjustment of world finance” (Riefler 1956, 26).108

  Further, Strong said, the System had built its portfolio so that it was now in a position to offset gold inflation. All of this had been achieved “without business disturbance or price inflation but rather with considerable benefit to business” (ibid., 26). The report argued that by changing the amount of credit available the Federal Reserve could smooth the business cycle, and that by reducing interest rates in recession it could help foreigners to finance recovery abroad. The report cited the financing of the Dawes loan to Germany that year as an example.109

  Within a few weeks, the atmosphere at the meetings changed. The early months of recovery were very strong. Consumer prices rose at a 4.5 percent annual rate in October and November, and stock prices were 25 percent above 1923. At the December 2, 1924, Board meeting, Adolph Miller introduced a resolution calling on the reserve banks to raise discount rates by 0.25 percent above open market rates, restoring a penalty rate. The motion failed four to two. Reserve bank credit and the monetary base continued to increase despite the redemption of $65 million from the open market account. The M1 money stock rose at an annual rate of 10 percent for the quarter and 12 percent for the second half of the year. When the OMIC met with the Board on December 19, Miller favored an increase in the acceptance rate to 3 percent to slow the rise in stock prices and brokers’ loans. He feared that businesses would start to borrow, requiring a rapid increase in interest rates: “We have an enormous volume of credit poured into the market, and member banks are going to be put to it to meet demands. They will go to the reserve banks to get it” (OMIC Minutes, Board of Governors File, box 1436, December 19, 1924, 11).

  108. W. W. Riefler prepared a summary of open market decisions for 1923 to 1931 based on the princip
al documents for the period. His summaries are in the Board’s files.

  109. Strong also responded to criticism of the policy by the American Bankers Association. The bankers accused the Federal Reserve of accentuating financial swings and competing for securities with member banks. They suggested that Federal Reserve banks return “to their primary functions as banks of issue and rediscount” (Riefler 1956, 30). Strong recommended that the Board reply in the Federal Reserve Bulletin. The Dawes loan was part of the Dawes Plan to reduce German reparations payments and restore convertibility of the mark.

  Strong urged caution. December was not the time for a shift in policy. He wanted the Board and the OMIC to wait for the January meeting, when the market situation would be clearer, but he did not oppose an increase in the acceptance rate to 3 percent on ninety-day paper. Within a few days, New York increased the rate. During the rest of December discounts rose, and the System allowed government securities to mature without replacement. At year end the System account stood at $540 million—about $50 million below its peak but $40 million above the amount set as a maximum in November.

  The minutes have no evidence that Strong wanted to delay sales in December to assist Britain’s return to the gold standard. Foreign borrowing and low rates in the United States helped the pound to appreciate nearly 9 percent against the dollar from the summer low, with no further increase in the Bank of England’s discount rate. In January the pound appreciated further, driven by rumors of a return to gold. On the record, Strong’s position at the December meeting is not very different from Miller’s and others’. All shared some uncertainty about the strength of the recovery and the size of the seasonal movement at the end of the year. The committee voted not to increase the OMIC account and to respond to demand for reserves by discounting.110

  Recovery and Expansion

  Despite a mild recession beginning in October 1926, real GNP grew at an average rate of 6 percent a year in 1925 and 1926. Prices remained within a band from –2 percent to +4 percent monthly, at annual rates. Common stock prices rose 24 percent in 1925, and total return to equities reached nearly 12 percent in 1926.111 These figures suggest a strong and steady expansion. Closer examination shows a much more variable pattern in 1925. Industrial production rose rapidly in January, then declined unevenly until late summer, so much of the rise for the year was completed in the first month. Balke and Gordon’s (1986) data on real GNP shows strong positive growth in the first and fourth quarters of 1925, declines during the second and third quarters, and renewed growth in 1926. Prices rose in 1925 and fell in 1926 following a decline in money (M1).

  110. The following week, Strong wrote a lengthy memo to the files summarizing the events of 1923–24. Subsequently he read from this memo at a congressional hearing, as cited above. One part of the memo refers to the gold inflow as “one of the greatest menaces to our ultimate security against inflation.” Recognizing the role of United States interest rates as helpful for the recovery of the pound, he concluded that Britain was now able to resume gold payments: “A lower interest level . . . was a further influence in turning the tide of gold away from the United States” (House Committee on Banking and Currency 1926, 337).

  111. Beginning in 1926, I rely on appendix table A-1 in Ibbotson and Sinquefeld 1989 for annual returns on common stocks.

  The OMIC met in Philadelphia on January 9, 1925, with Crissinger and Platt present. The secretary’s report showed that since the December meeting the open market committee had sold $57 million of governments and bought $125 million of acceptances, mainly in December. In the first week of January, as market rates fell, acceptances ran off. The committee anticipated that the market would firm in February and March. It voted to continue sales to prevent undue ease (OMIC Minutes, Board of Governors File, box 1436, January 9 and 10, 1925).

  The February meeting renewed the decision to sell. Between November and March, the System sold $210 million. In the same period, member bank discounts rose $170 million and acceptances rose $30 million, offsetting the sale, as Riefler-Burgess implied. The gold stock fell almost $200 million, and open market rates rose. New York responded in late February by raising the discount rate from 3 to 3.5 percent, where it remained for the rest of the year. Strong coordinated the increase with Norman both during his visit in January and by cable (Governors Conference, April 6–7, 1925, 21).112

  Strong credited the open market sales and the rise in the discount rate with reducing speculative activity on the stock exchange and lowering stock prices. He made no mention of the decline in business that occurred about the same time (Riefler 1956, 44).113

  At the April 1925 meeting of the Governors Conference the governors considered a problem that continued for the rest of the decade—the use of credit by securities brokers and dealers. Strong explained how New York analyzed the problem. A tightening of the money market reduced loans by brokers to their customers if the New York banks were in debt to the reserve bank. Higher money market rates in New York also brought loans from banks in the interior. Governor Willis J. Bailey (Kansas City) asked how the interior banks could be prevented from sending money to the call money market. Strong replied: “I do not know that it can be done” (Governors Conference, April 6–7, 1925, 16).

  112. Strong wanted to increase the rate before the British resumed gold convertibility (Governors Conference, April 6–7, 1925). The Bank of England preceded New York by raising its discount rate in February and again in April (to 5 percent). Board of Governors of the Federal Reserve System 1943, 656, shows the British increase in April but not in February. This record is not consistent with discussion at the time.

  113. Reed (1930, 93) suggested that the slow shift to tighter policy and the aggressive ease in 1924 were the forerunners of the aggressive policy of ease in 1927 and the slow reversal in 1928.

  Adolph Miller pressed Strong on the role of the discount rate as a factor affecting member bank borrowing and the volume of stock exchange lending. Strong, as usual, said he was uncertain about the effect of the discount rate. Gold flows and open market operations were the factors he cited as driving banks to borrow or repay discounts. Strong’s reasoning later made it difficult to persuade the Board to increase the discount rate in 1929, when New York wanted a 6 percent rate (Joint Meeting, Governors Conference and Board, Governors Conference April 8, 1925, 27–29).114

  The April 1925 meeting reversed direction by purchasing up to $50 million to offset continuing gold outflows. This decision brought the power struggle into the open. The Board did not consider the action for two weeks and neither approved nor rejected it.115 No purchases were made. On May 21, 1925, the Board revoked the authority to purchase without its approval.

  The OMIC met again on April 30 but devoted most of its attention to the reserve banks’ earnings. Strong defused pressure for purchases of long-term securities by agreeing to reapportion $83 million of the existing portfolio to increase the earnings at reserve banks with losses. Payments were made through the gold settlement fund.116

  114. At its April joint meeting the Board and governors also appointed a committee to consider legislation introduced by Congressman Louis T. McFadden. The legislation included renewal of the Federal Reserve’s charter. The Board appointed O. M. W. Sprague of Harvard and Walter Stewart, a former research director, to work with the Board. Sprague also undertook a study of member bank borrowing. He found that, contrary to the “reluctance” theory, a large number of member banks in agricultural areas continued to borrow, to carry loans made in 1918–20. He urged the reserve banks to notify members that continuous borrowing was not permitted.

  115. The authorization to buy or sell up to $100 million, agreed to in November 1924, was still in effect. Critics of Strong’s policies in 1924 and 1927 never mentioned this decision to sterilize the gold outflow just at the time Britain resumed convertibility.

  116. After the April 6 meeting, Adolph Miller challenged the argument that System purchases should be made to prevent individual bank pu
rchases. That undermined the case for a System account and a System policy. Miller added that purchases should not be made to increase earnings. Strong and McDougal defended the purchases as consistent with the agreement under which they participated in the OMIC. Although the OMIC made no purchases, the incident brings out the concern of many governors for their earnings and the pressure on Strong to accede to these demands in the interest of maintaining a System policy. The pressure came mainly from the reserve banks in the South and West. In March, Dallas had made purchases for its own account until March 26, when the Board ordered it to stop. Governor Lynn P. Talley of Dallas replied that the Board had approved purchases in October 1923 and never revoked the authority. Chicago, Kansas City, and Minneapolis made small purchases also. At the time, Dallas and some of the others were probably below efficient size. They owed their existence to the decision to establish twelve reserve banks rather than eight.

  In late June 1925, the OMIC described the economy as in recession but above the level reached a year earlier. In the same month, the stock market reached a new high. The committee ignored the possible recession; it discussed sales to tighten the money market seasonally, if needed during the summer.

  Stock prices continued to increase. When the OMIC met on September 21, the Standard and Poor’s index had risen 24 percent in twelve months, and volume was at a record level. Brokers’ loans to September 30 had increased more than $1 billion in a year, a 50 percent increase, and so-called street loans to finance stock purchases were $700 million above the previous year. Much of the increased lending to brokers and dealers came from outside New York.