Chicago led the increase in discount rates back to 4 percent. Between January 25 and March 1, the other banks followed. The reason for the higher rates puzzled some officials. R. L. Austin, chairman at Philadelphia, requested an explanation of Chicago’s action and the Board’s approval. Young replied that the Board’s action was almost unanimous. The members had acted because open market sales in January had not raised rates very much. Young later repeated that credit extension had increased more than normal (Letters Young to Austin, Board of Governors File, box 1240, January 28 and 31, 1928). At this point, both the Board and the reserve banks agreed that the Federal Reserve could control credit expansion by open market operations and discount rate changes.
Agreement did not last. Early in February, Harrison told Young that discounts by New York banks had reached $156 million, indicating a modest increase in market tightness. New York wanted to suspend sales for a few days. The Board accepted the proposal with some members urging an indefinite suspension (Riefler 1956, 182).150
148. President Coolidge found nothing alarming about the stock market. His statement to this effect shocked Hoover, who was about to campaign for the presidency (Kettl 1986, 34).
149. Strong was not present at the time, but he favored sales. Burgess (1964, 219) reports a visit early in 1928 to Strong, who was recuperating in Atlantic City. Strong was concerned that the New York banks had reduced borrowings from the Fed. He favored greater restraint (increased borrowing) to prevent inflation. The wholesale price level, recorded at the time, was 97 (base 100 in 1926). See also Chandler 1958, 454–55.
150. At about this time, Hamlin asked the research division what open market operations accomplished. The reply was that open market operations support discount rate changes, but their effects “are not as great as is generally believed” (memo, Goldenweiser to Hamlin, Board of Governors File, box 1435, February 17, 1928).
The OMIC met again in late March and noted that recovery was under way. Net sales of $150 million since January had reduced the System account to $273 million, but the New York money market did not show evidence that the discount rate was effective. The Board accepted a proposal for additional sales but exacted a promise that sales would be used to make discount rates effective without raising rates (Open Market, Board of Governors File, box 1436, March 26, 1928). Miller voted against the resolution, citing no evidence of increased borrowing for commercial purposes and uncertainty about business conditions (ibid.).
In April, credit expansion continued to exceed growth of output. The recovery from recession was complete, and there was no sign of price inflation.151 The main concern was that after a lull during the winter, security loans had increased. The OMIC continued to sell securities. Late in the month, Boston and Chicago raised their discount rates to 4.5 percent. Richmond, St. Louis, and Minneapolis promptly followed. New York waited a month.
Case was optimistic when the Governors Conference met at the end of April (1928). With call money rates at 5 percent and discount rates at 4.5 percent at several banks, the credit situation seemed well in hand. The French elections had been won by Raymond Poincaré, so French stabilization and continued United States gold outflow seemed likely. The governors discussed the possibility that some countries (France) would want to return to selling foreign exchange holdings to restore a full gold standard. Harrison dismissed this possibility as unlikely. He was soon proved wrong.
The committee once again discussed the continuing shift from demand to time deposits that lowered the average reserve requirement ratio and expanded bank credit. Bank credit was 9 percent above the previous year, production 2.5 percent. This was far from the norm proposed in the tenth annual report, but the governors could not agree on what should be done about time deposits (Governors Conference, April 30–May 2, 1928).
Between the April Governors Conference and the May 25 OMIC meeting, France withdrew $97 million in gold. Bank borrowing in New York increased to between $200 million and $300 million. New York now raised its discount rate with the intention of reducing borrowing. By May 25 the System account had fallen to $100 million, so it was no longer of much use (Riefler 1956, 202).152 System sales and gold outflows continued to reduce the monetary base, and member bank borrowing continued to rise; New York banks had borrowed $272 million, the System $880 million, far above the $100 million and $500 million that Strong regarded as “tight.” Market interest rates reached the highest level since 1923, with call money at 6 percent.
151. The year-to-year change in stock prices (S&P) was 33 percent, in consumer prices – 1 percent.
152. The reserve banks continued to hold about $150 million on their own account for income, so total holdings of governments were about $250 million.
The preliminary memo recognized that discount rate changes in New York relative to the rest of the country changed the place where banks borrowed without much effect on the total amount borrowed. With call money 1.5 percent to 2 percent above discount rates, banks found borrowing profitable. The committee voted to continue open market sales.
June brought renewed, large gold outflows, almost $150 million to France alone, that reduced the reported gold stock to the lowest level since 1923. Chicago voted to increase its discount rate to 5 percent in early July. The Board was divided and delayed action. New York opposed an increase. With the call money rate at 10 percent, Case wrote to Young that the rise in call money rates was a more effective response than a new round of discount rate increases (Case to Young, Board of Governors File, box 1240 July 3, 1928). The following week the Board approved the Chicago increase, with James and McIntosh opposed. Despite the presidential election, Mellon favored the increase: “The sooner the rate increases come, the better” (Letter Platt to Young [on vacation], Board of Governors File, Box 1240, July 10, 1928). New York followed. By the end of July seven banks were at 5 percent, but the rate did not become uniform until the following May.
By the time the Board approved the higher rates, stock exchange trading had slowed to the level of previous years. Call money rates fell from 10 percent to 5 percent, and the Standard and Poor’s index was below the May level. These changes were seen as hopeful signs that the speculative boom was over. The OMIC met on July 18 but took no further action. Table 4.4 shows, however, that stock exchange volume soon increased.153
The mood was not entirely cheerful. The memo prepared for the July 18 OMIC meeting compared business activity with interest rates since 1900 and concluded with a prophetic warning: “High [interest] rates have almost invariably been followed by business declines after a lag of six months to a year” (Memo to OMIC, Board of Governors File, box 1436, July 17, 1928). The memo suggested that the restriction worked by slowing construction and new financing. It noted, however, that there was no current evidence of slower domestic activity or of adverse effects abroad. These circumstances did not last.
153. Market acceptance rates had fallen below the Federal Reserve’s minimum buying rate, so the acceptance portfolio declined. One reason was a change in tax laws exempting foreign central banks from tax on interest received on acceptances.
By mid-August, some exchange rates abroad had moved toward the gold export point. The OMIC did not want to absorb more gold but also did not want foreign banks to sell their short-term bill or security holdings at a time when the Federal Reserve provided additional credit to assist the seasonal crop movement. The reserve banks bought bills from foreign central banks to prevent a rise in market interest rates.
Miller proposed that the Board send a letter to all the reserve banks setting a preferential rate for seasonal crop marketing paper at 0.5 percent to 1 percent below market rates. James suggested, instead, a preferential rate on all acceptances to help move the crops (OMIC Minutes, Board of Governors File, box 1436, August 13, 1928). Only Governor Harding (Boston) favored the proposals, and they were not adopted.154 The principal objections were that without a general reduction in rates, member banks would not reduce their lending rates to farmers. The g
overnors did not believe that preferential rates would affect the distribution of credit (ibid.).
The OMIC voted to ease money and credit through open market purchases, if necessary, to prevent “an emergency situation.” Young proposed that the Board purchase only to relieve a strain “which may react unfavorably upon commerce and industry,” but he also proposed allowing the OMIC to buy securities from foreign governments to prevent higher rates. He again suggested a preferential rate on crop-moving paper (draft letter, Young to Harrison, Board of Governors File, box 1436, August 15, 1928). The Board considered but rejected Miller’s proposal for a preferential rate for agriculture and also rejected a grant of discretionary authority to New York.
154. Harding (Boston) was the principal advocate of preferential rates in 1920–21.
Typical seasonal credit expansion added $100 million to $200 million during the fall. With prices falling, Young thought many producers would hold inventories, so credit demand could be as much as “$300 million or more” (Letter Young to Cunningham, Board of Governors File, Box 1436, August 17, 1928). Member banks were heavily in debt; the concern was that they would not borrow enough to prevent a sharp increase in interest rates. Recalling the 1920–21 experience and the political influence of agriculture, some Board and OMIC members agreed to open market purchases as a last resort to prevent a substantial increase in market rates.155 By a three to two vote, the Board approved a limit of $100 million in purchases, only as a last resort. It urged the reserve banks to ease through purchases of acceptances only if ease was “unavoidable” (Open Market, Board of Governors File, box 1436, August 16, 1928).156
Although the August decision was cautious about purchases, it was not cautious enough to satisfy some of the reserve banks. C. R. McKay, deputy governor at Chicago, reported that the Chicago directors opposed any open market purchases and expressed “very little concern” about moving the harvest to market. The banks could rediscount if a problem arose. Governor Seay (Richmond) opposed open market purchases also: “Our directors are on record that this bank should not only not purchase government securities but that it should sell those which it has. . . . [T]his bank will not participate in any purchase of government securities.” Seay recommended a reallocation of credit from “those who have absorbed credit for other than business purposes.” His letter explicitly reflects a recurring issue—loans by large corporations to the securities market. R. L. Austin, chairman at Philadelphia, approved of the decision to supply seasonal credit but urged the Board to state its policy publicly (McKay to Young, Seay to Harrison, Austin to Young, Board of Governors File, box 1436, August 17, 20, 23, 1928).157
155. The OMIC also discussed reductions in discount rates to encourage borrowing. Opinion was unanimous that reductions should be avoided but that the lower (4.5 percent) rates should be maintained in dominantly agricultural districts (Letter Young to Cunningham, Board of Governors File, box 1436, August 17, 1928).
156. Hamlin and Cunningham were on vacation (Young to Cunningham, Board of Governors File, box 1436, August 17, 1928). Miller and James voted no. Miller (1935, 451–52) claimed the easy policy in the second half of 1928 was “lacking in strong conviction” (452), but he did not say what he wanted to do at the time. Seasonal factors favored an increase in credit. The gold stock and the gold reserve percentage fell. Discounts remained near $1 billion, evidence of tight, not easy policy on the Riefler-Burgess interpretation. The main evidence of ease was the rise in acceptances. Acceptance rates remained below discount rates.
157. Strong returned from Europe in early August but was too ill to resume his duties. Soon after, he offered to resign, but the directors refused. He no longer had an active role. He received a memo from Walter Stewart, at the time an adviser to the Bank of England. Stewart warned that money was tight in New York. Concerning the large volume of borrowing, Stewart wrote: “Surely it was never intended that member banks should bear the full burden of gold exports for currency stabilization in France” (quoted in Chandler 1958, 459–60). Strong was less concerned about the short term than the long. He replied that the Federal Reserve could reduce short-term pressure by open market purchases and discount rate reductions. Then he added: “If the System is unwilling to do it, then I presume the New York Bank must do it alone” (ibid., 460). With respect to the stock market, he wrote: “I fear voluntary assumption of responsibility for this matter just as much as I fear voluntary assumption of responsibility for the prices of commodities” (ibid., 460–61). At the time, he believed New York’s discount rate was too high. He preferred a 4.5 percent rate in New York, with 5 percent elsewhere, to push discounting toward New York. However, he avoided mentioning the System’s major problem—reaching several inconsistent goals simultaneously.
The Board was in no position to issue a policy statement, since it had no policy and focused only on the short term. One financial journalist described the problem as a choice between three risky options. First, the System could ease to finance seasonal agricultural inventories. The risk was that the additional credit would lead to “another boiling stock market with ultimate danger to business.” Second, the System could tighten enough to reduce stock prices. This path led to deflation, recession, and accusations that policy was influenced by “the money power.” Third, the System could continue the status quo (Temple 1928).158
The presidential election made an additional complication. Early in January, the Treasury announced its intention to refund the Second Liberty Loan in September at 3.5 percent interest (Reed 1930, 136). This put the Federal Reserve on notice nine months in advance. No less important was the expected effect of higher interest rates in the midst of congressional and presidential campaigns. Temple (1928) quotes as the opinions of “Chicago bankers” that “the fall will see the greatest political market in history” and of an eastern investment banker that “there will be the greatest bull market in history from the middle of September until November.”
In the event, when commercial paper rates rose to 5.625 percent in September, the System bought acceptances to lower rates. In effect, it pegged the acceptance rate at 4.5 percent by buying $300 million of acceptances between August and November.159 The increase in acceptances and a small renewed inflow of gold offset a decline in discounts. The monetary base fell at an 8 to 10 percent rate in July and August, then increased in the fall. Nevertheless, the annual rate of change remained between 0 and –2 percent from March 1928 to August 1929. Long-term rates remained unchanged in the fall of 1928, but rates for new stock exchange loans increased almost three percentage points (to 8.9 percent) between August and December, the highest rate since 1920. The preliminary report for the November 13–16 OMIC meeting referred to “the presence of few other buyers of bills [acceptances]” and the reduction in discounts as banks borrowed at the lower acceptance rate to repay discounts.
158. Alan Temple was managing editor of a business weekly. His memo brings out the political, and policy, conflict between support of the crop movement and concerns about Wall Street and the stock market.
159. This policy was not accidental. In a letter to the Board dated September 26, Harrison proposed the policy that they followed (Riefler 1956, 338). In December, Miller proposed an increase in the acceptance rate, but the motion failed. Hamlin and Platt joined Miller in voting to approve. This was a bold interference, since the reserve banks set acceptance rates.
The memo mentioned three guides to current policy: ending expansion of credit for speculation; limiting effects of interest rates on the volume of business; and limiting effects on world rates and world trade. The report noted that new stock and bond offerings through October were about the same in 1928 as in 1927. An increase in new stock issues almost offset an $800 million decline in bond issues. On September 28, the Federal Advisory Council agreed that the 5 percent discount rates had delayed some permanent financing but had not harmed business. All in all, the current situation seemed favorable for continued expansion and credit availability. The Board st
aff’s memo on the business situation is about expansion in production and sales without inflation (Board of Governors File, box 2461, November 8, 1928).
The situation abroad was more disturbing. The Bank of England began to lose gold in September 1928. Losses continued, with only brief interruption, throughout the fall and in 1929. The report for the OMIC meeting noted that earlier gold outflows from the United States improved countries’ ability to defend exchange rates, but continued high rates at home would force higher rates abroad. They soon did.
The OMIC congratulated itself for providing seasonal credit expansion at relatively low interest rates. The committee proposed that New York consider a 0.125 percent increase in the buying rate for acceptances. The Board accepted the recommendation, but the New York directors rejected the proposal. The acceptance rate remained at 4.5 percent until January. Adolph Miller later criticized New York for failing to tighten in the fall of 1928.
Balke and Gordon’s (1986) quarterly data show a small decline in the GNP deflator in third quarter 1928, the first such decline after three quarters in which the price level rose at an annual rate of 3.8 percent. It was not the last decline; the deflator fell persistently for the next eighteen quarters with only one exception.160 Thus ex post real interest rates remained above market rates during the 1929 expansion. And despite a sharp reversal of the gold outflow, beginning in fourth quarter 1928 (and continuing for the next three years) the monetary base declined at an average annual rate of 1.3 percent in the year ending June 1929.
160. The twelve-month percentage change in the consumer price index is negative from July 1926 to May 1929. Between June 1929 and January 1930, the annual change is between 0 and 1 percent. It then turns negative for more than three years.
A History of the Federal Reserve, Volume 1 Page 35