A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  125. Strong admitted, however, that he was startled by the amount, more than $1 billion, above the highest estimates before the data were reported (Governors Conference, March 1926, 124).

  Rising Conflict

  A turbulent 1927 followed the relative calm of 1926. Weaknesses of the Federal Reserve Act and the inconsistent objectives and divergent beliefs of officials hindered the System in choosing and maintaining policies. The recession that started in October 1926 called for open market purchases and lower discount rates to expand money and credit. Bond yields declined and stock prices rose throughout the year. Credit to carry securities rose, renewing and strengthening concerns about speculative credit expansion. The pound depreciated against the dollar, particularly in the winter and spring. Renewed gold flows to the United States increased the gold reserve ratio. Beginning in April, the Federal Reserve tried to hide the gold inflow by keeping the gold on deposit under earmark abroad.127

  126. Comparison of bank participation in the System account in 1928 with the initial distribution of securities when the System account started in 1924 shows that Boston, New York, Richmond, and Atlanta reduced their shares while Cleveland, St. Louis, Minneapolis, Kansas City, and Dallas increased by relatively large percentages. As suggested above, New York, possibly assisted by Boston, appears to have worked systematically to redistribute income within the System toward the small, mainly agricultural regional reserve banks. For comparison with table 4.3, the distribution in January 1924 is as follows (percentage):

  The Board, the New York bank, and the open market committee could not agree on which of these changes was most important. Strong’s views finally dominated; the System reduced interest rates during the summer and early fall, long after the recession had started, in part to support the pound. Miller blamed Strong for making a serious error, and he later told Herbert Hoover that Strong bore “a large measure of responsibility” for the 1927 increase in reserves (quoted in Kettl 1986, 34). Many contemporary observers shared this view. Reed (1930) called the credit expansion in 1927 excessive and argued that it contributed to a sustained rise in share prices.

  In fact, growth of the monetary base was only slightly above 1 percent for the year; modest positive base growth in the first half turned negative in the second half. Growth of the money stock, currency, and demand deposits was slightly faster, about 1.5 percent for the year. More rapid growth of bank lending was achieved by growth of time deposits, in part encouraged by bankers’ efforts to reduce required reserves while increasing deposits.

  The 1926–27 recession did not reach its trough until November 1927, thirteen months after it began. The National Bureau of Economic Research ranks the recession as one of the mildest in the years since 1920. Industrial production fell only 7 percent from peak to trough, one of the smallest reductions on record.

  The Federal Reserve began open market purchases in May 1927, about halfway through the recession. Purchases added a total of $240 million to reserves, but much of the increase was offset by a decline in borrowing and in the reported gold stock.

  On February 25, Congress passed the McFadden Act.128 Section 18 renewed the Federal Reserve’s charter and extended its term “until dissolved by Act of Congress” (Krooss 1969, 4:2656). The act also expanded the powers of national banks by permitting them to make loans on real estate for more than one year.129 And it permitted national banks to establish branches under the rules that applied to state-chartered banks in the state of domicile. This effectively prevented the spread of interstate and, in many states, intrastate banking for more than fifty years.

  127. Earmarked holdings were excluded from reported gold holdings, so they did not appear in the Federal Reserve published reports or in the monetary base. In 1927 earmarked gold rose $160 million, but the Federal Reserve was able to report a decline in gold holdings of $113 million for the year (Board of Governors of the Federal Reserve System 1943, 536).

  128. The McFadden Act began as an effort by the comptroller to revitalize the national banking system. To escape restrictions in the national banking laws, national banks converted to state banks in the mid-1920s. Before the McFadden Act, national banks could not establish branches or purchase investment securities.

  Despite the recession, the February meeting of the Federal Advisory Council found no reason to reduce discount rates or change open market policy. The OMIC did not meet until March 1927. With Strong once again on leave for health reasons,130 the committee voted to replace $25 million of expiring securities and to purchase an additional $50 million if the situation required. The preliminary memo prepared for the meeting offered three reasons for not selling securities or permitting them to expire without replacement: to hold the portfolio to protect against future inflation; to avoid attracting more foreign balances and gold “from countries who need them, to us who do not want them”; and to prevent higher interest rates worldwide in a period of falling commodity prices (OMIC Final Minutes, Board of Governors File, box 1436, March 21, 1927).131

  Hamlin moved that the Board accept the OMIC’s recommendations. Miller offered a substitute motion permitting replacement of the $25 million but rejecting standby authority to purchase up to $50 million. The Board approved the substitute, keeping decision power at the Board; only Hamlin voted no (Board Minutes, March 21, 1927, 235–37).

  Strong returned at the end of April. Early in May, he informed the Board that the Bank of France was in the process of shipping $90 million in gold to a New York bank: $30 million had already been shipped. The gold had served as collateral for a loan from the Bank of England. The Bank of France prepaid the loan, releasing the gold for sale. After discussion with the other members of the OMIC, Strong bought the remaining $60 million from France and held it on earmark at the Bank of England. New York offset the effect of the purchase on the New York market by selling the Bank of France securities from the open market account.132

  129. Before the change, loans were for one year, renewable at the one-year rate. Telser (1996, 19) claims this change contributed to the severity of the depression by increasing bankers’ risk. In fact, real estate loans by national banks were a modest share of national bank portfolios and did not increase rapidly after February 1927.

  130. His deputy at the OMIC, Pierre Jay, resigned as chairman of the New York bank in December 1926. His replacement was Gates McGarrah, who served from May 1927 to February 1930, when he resigned to become president of the Bank for International Settlements. McGarrah would not accept appointment as chairman until the Federal Reserve Board agreed that he could remain a member of the general council of the Reichsbank set up as part of the Dawes agreement.

  131. This was a change of mind. In February, New York had concurred with the Federal Advisory Council’s recommendation that the March maturities should not be replaced. The change reflected the increase in securities market activity and rise in stock prices (Riefler 1956, 95). The Board staff’s memo for the meeting gave an additional reason for inaction: belief that the recession had ended. The memo shows industrial production back to the level of the previous year. The National Bureau of Economic Research dates the end of the recession eight months later. The memo reports the price level as 6 percent below the previous year (Board of Governors File, box 2461, March 18, 1927).

  The preliminary memo, prepared for the May 9 OMIC meeting, mentioned a number of special factors—floods, problems in the oil industry, collapse of some real estate speculation—but made no reference to the general recession, then six months old. The report noted that a considerable fall in commodity prices had affected agricultural and nonagricultural prices and expressed concern about the growth of total credit (estimated to have increased $1.5 billion in the past twelve months), renewed gold flows to the United States, and the reduced size of the open market account after sales to France. The Federal Reserve had the same problem as in 1916; the remaining balance in the OMIC account, about $100 million, was too small to prevent future inflation or sterilize additional gold inf
lows.

  Chart 4.3 (p. 173) shows a main source of the problem. The difference between New York and London rates had decreased, along with the covered spread, so New York was a relatively more attractive market for foreign and domestic accounts. Moreover, the Treasury paid up to 98 percent of the value of imported gold when it acquired the gold. This gave sellers a few additional days to earn interest, raising the effective price above prices abroad.133

  Strong presented twelve ways of responding to the problem but did not recommend any action pending a meeting with the Board (OMIC Minutes, Board of Governors File, box 1434, May 11, 1927). The following day the OMIC voted unanimously to stop selling securities to offset gold inflows and to begin seasonal purchases no later than August 1 to bring the account up to $250 million, if it could be done “without undue effect on the money market” (OMIC Final Minutes, Board of Governors File, box 1436, May 11, 1927). The committee defined “undue effect” to mean that interest rates and borrowing would remain approximately unchanged during the summer. The decision permitted purchases of $150 million.

  132. These actions avoided showing an increase in the gold stock on the weekly release. The bank reported the earmarked gold on the published statement as “gold held abroad,” a new item. Since the gold had originally been offered to the Irving Trust, there was no secret about the Bank of England’s changed position.

  133. One of twelve possible actions discussed at the meeting was to stop this practice, thereby lowering the gold price by the amount of interest lost on delayed payment.

  Once again, Hamlin moved for approval by the Board and Miller offered a substitute that delayed the decision. Miller’s substitute passed on a close vote. The next day, with Mellon present, the Board reconsidered. Hamlin again moved for approval; Miller again proposed delay, and Vice Governor Platt proposed to permit purchases up to $250 million but at a slower rate. Platt’s motion passed seven to one.134

  The Board staff’s presentation to the May Governors Conference noted that the Bureau of Labor Statistics price index had fallen 10 percent in two years and was approaching its postwar low. The staff report mentioned the return of many countries to the gold standard, but it rejected this reason for the price decline. Although the staff produced no evidence to support its argument, it concluded that the price decline resulted from increased productivity (Governors Conference, May 9–12, 1927, 506). The Board made no mention of falling prices as a reason for open market purchases. Miller was generally opposed to using open market operations for such purposes. He preferred to let prices result from the ebb and flow of real bills relative to output.

  Surprisingly, none of the governors disagreed with the staff argument that a return to gold convertibility by many countries had not lowered prices by increasing the world demand for gold. The price declines of the 1880s, when several countries adopted the gold standard, were well known. Even Miller, who had made this point in the 1926 hearings, did not insist on the deflationary effect of restoration.

  Between May 16 and June 8, the System’s portfolio increased $180 million to $316 million, well above the limit established by the Board. On June 9, Strong wrote to Crissinger explaining that only $16 million of the $180 million was for the System account.135 The rest had been purchased to offset gold movements, changes in earmarked gold, and Treasury overdrafts. Later in the week, New York sold the Bank of France the $60 million in gold that it had acquired from the Bank of England. Britain’s gold sales renewed pressure on the pound.

  Strong had considerable difficulty explaining the purchases to the Board. In letters written in mid-June, he described the technical changes in the money market resulting from Treasury operations, seasonal factors, gold flows, and actions of the Bank of France. France had withdrawn $100 million of deposits, converted them to gold, and shipped the gold. This alone would have reduced reserves and base money by $100 million if Strong had not purchased securities. Strong did not want to count the purchases made to offset these disturbances against the purchases authorized in May. His aim was to lower, not raise, market rates in New York (Strong to Crissinger, Board of Governors File, box 1434, June 9, 16, 20, 1927).

  134. Miller’s principal concern was the rising stock market. The vote on his proposal to delay was five to three against. He argued that the Federal Advisory Council was to meet and report on its proposal to change the OMIC’s methods and objectives and that delay would give an opportunity to purchase after trade (and discounts) expanded. The last, real bills view was repeated frequently during 1929–33 as a reason for delaying purchases.

  135. The monetary base increased less than 1 percent in the twelve months ending in May.

  Strong argued that if open market rates increased, acceptances would come to the bank. To avoid the increase, the bank’s discount on acceptances would have to increase, followed by an increase in the discount rate to restore the rate spread. He gave three reasons for opposing higher rates. Higher rates would hurt business, reduce the sterling exchange rate and other foreign rates, thereby renewing the gold inflow, and interfere with a large Treasury refunding operation then in process (ibid., June 20, 1927).

  Miller prepared the Board’s response. He acknowledged Strong’s argument about Treasury operations, made no mention of the other reasons Strong gave, and insisted on holding the System account within the limits agreed on in May. Additional purchases would have to be approved by the Board (Crissinger to Strong, Board of Governors File, box 1434, June 22, 1927).

  By going to Washington to discuss the issue, Strong was able to get a majority of the Board to exclude the $100 million of purchases made to offset the gold outflow. Miller, joined by Edward Cunningham, did not agree; both voted against the resolution. Miller explained that he believed all authorizations to purchase and sell should be approved explicitly by the Board. He was not in favor of higher rates; his concern was the Board’s control of open market policy.

  Shortly after the New York meeting between Norman, Schacht, Rist, and Strong, the OMIC met with the Board in Washington. Miller was on vacation. The meeting was free of conflict. The Board unanimously approved an additional $50 million of purchases. The members also discussed discount rate reductions:

  There was no exception to the view that the time had arrived, or was approaching, when the discount rate in New York should be reduced, and with one or two exceptions, there was no dissent from the view that a System policy of lower discount rates should in general prevail. It was pointed out, however, that local conditions in some of the interior reserve districts did not indicate any demand for rate reductions in those districts. . . .

  The most important consideration at the meeting was undoubtedly the fact that the differential between the rates in New York and the rates in London was not today sufficient to enable London, and therefore the rest of Europe, to avoid general advances in rates this autumn unless rates here were lowered, and that the consequences of such high rates as would result in Europe would be unfavorable to the marketing of our export produce abroad and would have an adverse effect generally on world trade. (OMIC Final Minutes, Board of Governors File, box 1436, July 27, 1927, 2)

  The reasoning taken from the minutes shows that, at the time, the Board accepted Strong’s policy of helping Britain. Although the statement mentions domestic factors, they are not the main reason for acting. Later, many of those who voted for the rate reduction disavowed the decision and blamed Strong for the stock market boom that followed.

  The background memo showed that the spread between market rates and the (penalty) discount rate had narrowed in London and Berlin and that the discount rate had increased in Berlin, drawing gold from London. At home, commodity prices continued to fall and, the committee noted, “there was some slackening in business” (ibid, 2).136 The System had continued to purchase in July; the System account increased to $265 million, but gold and foreign exchange changes, and reduced borrowing, canceled much of the effect on bank reserves and the monetary base.137

  Discoun
t rate reductions (to 3.5 percent) began in Kansas City, acting on Strong’s request. Four other banks followed within the next two weeks. By mid-August only four banks—Philadelphia, Chicago, Minneapolis, and San Francisco—kept their rates at 4 percent.

  the chicago rate controversy The Wall Street Journal reported on August 4 that the Federal Reserve Board had asked Chicago to reduce its discount rate, following reductions by Boston and Cleveland. Chicago replied that “there was no basis or necessity.” Governor Crissinger and two other Board members responded by notifying Chicago that the Board, acting under the authority of the attorney general’s opinion in 1919, would lower the rate without waiting for the Chicago directors to act (Letter Platt to Hamlin, Board of Governors File, box 1434, August 4, 1927).138

  136. The Board staff’s background memo notes that industrial production in July was the lowest for the year and back to the 1925 level. Preliminary figures for August were weak also (Board of Governors File, box 2461, August 19, 1927).

  137. The London market strengthened in August. Strong sold sterling bills in London and, to offset the effect on the base, purchased governments in New York. By mid-August the System account was at $347 million, more than $20 million above the ceiling approved at the July 27 meeting. Strong kept Crissinger and the Board informed, and there was no criticism of his decisions at the time. Nor is there any record that the Board approved the additional purchases.