These indicators suggest that monetary policy was deflationary. The Federal Reserve considered policy expansive, based on the 43 percent increase in stock prices in 1928, the use of credit to support leveraged positions, faster growth of credit than of output, and the large volume of member bank borrowing. Misled by its indicators, it believed the challenge as 1929 started was to restrain “speculation.” Disagreement, though sharp, was limited to how this could be best accomplished—how monetary policy should be tightened. All parties ignored the deflation.
Discount Rates and Direct Action
The new year’s first conflict between the Board and the New York bank came on January 3. With seasonal credit demands completed, New York raised its acceptance buying rate to 4.75 percent, effective at 10:00 a.m. the next day. This was the first change since July.
Following the procedure used since 1918, Harrison publicly announced the change and notified the Board. Young responded that the Board was not a “rubber stamp.” Early on January 4, Young reminded Harrison that the Board had changed procedural rules in 1926 to require Board approval of all acceptance rate changes. He allowed the higher rate to remain, since it had been announced, but he told Harrison that new regulations would be drafted (Conversations 1926–31, Harrison Papers, January 3 and 4, 1929).161
Three days later, the OMIC met in Washington. The preliminary memo commented on the growth of credit relative to output and the rise in open market rates. Harrison reported on the international effect of United States interest rates. Foreign central banks had reduced dollar balances to support exchange rates, and some—notably England—had sold gold heavily (Board of Governors File, box 1436, January 12, 1929).
With Young present, the committee discussed the Board’s responsibilities. The Board had not approved the November decision to purchase up to $25 million in an emergency because in its view the request was open ended and gave the OMIC too much discretion. Henceforth the Board would approve specific decisions to purchase or sell a specified amount. It would no longer approve requests to be executed when, or if, the chairman or the committee chose.
161. Procedure did not change. Harrison pointed out that the 1926 rules had never taken effect. New York had changed the rate on ninety-day acceptances fourteen times in the interim. On January 21, New York raised the rate to 5 percent. Miller (1935) ignored this incident when he blamed New York for the “easy policy” and insisted that New York failed to act in 1929 until after the Board announced its “direct action” policy. Miller described New York’s policy in late 1928 as “complete abandonment of restraining action” (453). He concluded that the Board should have taken control sooner.
This exchange, coming shortly after Strong’s death the previous October, showed that the Board had renewed its effort to increase control over open market operations. The committee resisted. Harrison defended the procedures that had been in effect since 1923 and argued that the Board’s proposal would eliminate the usefulness of the OMIC. The Board’s reply is not reported in the minutes, but it is likely to have followed the lines of a letter that Young drafted after the meeting but did not send. The letter said that the Board would approve definite decisions. However, the future is indefinite, so the Board would henceforth make its decision whenever the OMIC proposed to purchase or sell (Young to Harrison, Board of Governors File, box 1436, January 12, 1929).162 The OMIC also considered selling up to $50 million in January or February if discounts and market rates declined. Since there was no definite recommendation, the OMIC did not test the Board’s new procedures.
By the end of January, System holdings of governments were down to $200 million, including both the open market account and approximately $150 million held by individual reserve banks for revenue.163 Discounts were nearly $900 million, below their peak but almost twice the level of the previous year. There was little prospect that open market sales could reduce borrowing substantially. For the first time in many years, the discount rate became the principal policy instrument available.
The Board was reluctant to use a general instrument to deal with what it regarded as special circumstances. Credit had increased 8 percent in 1928, and output only 3 percent.164 The Board believed much of the credit had financed stock purchases on margin. It aimed to reduce this use of credit without raising interest rates to the level reached in 1920–21 and to shift credit from financing speculative ventures to financing productive assets.165
162. The Board also had under consideration a proposal to replace the OMIC with a committee of twelve reserve bank governors chaired by the governor of the Board. See below.
163. The open market account changed during this period when the System purchased from foreign central banks and attempted to dispose of the purchases in the market without affecting rates. Also, securities matured.
164. There is considerable difference in measures of output growth for the period. The 3 percent estimate in the minutes and correspondence lies between the 2.2 percent later estimated as the annual average by the Department of Commerce and the 4.1 percent from the (base 1982) index of industrial production based on yearly averages. Growth rates for the four quarters or twelve months ending in December suggest substantial acceleration during the year, more in keeping with credit growth. Balke and Gordon’s (1986) average GNP growth for the four quarters of 1928 is 9 percent; Kendrick reports a 10 percent increase in manufacturing output; Miron and Romer (1989) report a 26 percent increase in industrial production for December 1927to December 1928; and the Federal Reserve’s (1982) index shows a 15 percent rate of increase. Balke and Gordon’s data show no growth in the first quarter and 16 percent (a.r.) in the fourth quarter. Miron and Romer are at the extreme with 14.4 percent (a.r.) for the first half and 36.5 percent for the second half. The high growth rates of output are more consistent with Harold Barger’s (1942) reported 23 percent increase in corporate net profits and the 37 percent return to equities.
Pressed by Adolph Miller to stop the speculative use of credit, on December 31, 1928, the Board adopted a resolution that blamed the spread between discount rates and rates for stock exchange loans for the temptation to borrow from the Federal Reserve and lend to help buy or carry securities. The Board decided to learn what the reserve banks were doing to prevent “improper use of Federal Reserve credit facilities by their member banks” (Riefler 1956, 263).
On February 2 the Board revised and approved a letter originally drafted by Miller. The letter noted that interest rates had increased, counter to the typical seasonal pattern. Since the available data underestimated the strength of the expansion, the Board blamed the rise in market rates on the absorption of funds in speculative loans. Continued growth of these loans would further increase interest rates, “to the prejudice of the country’s commercial interests.” The aim of the Board’s policy was to prevent credit expansion for uses not contemplated by the Federal Reserve Act. “The Board has no disposition to assume authority to interfere with the loan practices of member banks so long as they do not involve the Federal Reserve banks. It has, however, a grave responsibility whenever there is evidence that member banks are maintaining speculative security loans with the aid of Federal Reserve credit” (Board Minutes, February 2, 1929). On February 7 the Board issued a press release to the general public, quoting its letter.
The policy conflict between the Board and the banks intensified. After abandoning the penalty discount rate early in the decade, the System had kept the discount rate above the acceptance rate. The two were now equal, so banks and market participants believed an increase in the discount rate was imminent.166 Responding to the Board’s action, Boston notified the Board on February 4 that it voted to increase its discount rate. The Board asked that the Board’s program be implemented instead. The following day Harrison told the Board that its program “does not have any substantial effect upon the total volume of credit outstanding but that is a matter which . . . can be controlled properly only through the rate” (Conversations 1926–31, Harrison Pape
rs, February 5, 1929, 8). Nevertheless, Harrison agreed to try the Board’s program.167
165. Harrison also used the 3 percent and 8 percent numbers in his preliminary memo for the January 7 OMIC meeting. He estimated the change in deposits times their velocity (MV) as 25 percent in 1928 versus 15 percent in 1927. The probable underestimate of output growth and overestimate of money growth (or growth of aggregate demand) contributed to the belief that policy was inflationary.
166. In its 1928 annual report and elsewhere, the Board criticized the reserve banks for their policy. The banks’ “liberal purchase of bills [acceptances] in excess of credit needs was a factor in the revival of speculation and in the growth of broker loans” (Discount Rate Controversy, 11, Board of Governors File, box 1246, undated). The Board charged that the acceptance purchases nullified the discount rate increases (12).
Within a week, the New York directors voted unanimously to increase the discount rate by a full percentage point to 6 percent. The Board voted seven to one to reject the request on the grounds that New York made the request by telephone and had not given any reason for the increase. Young explained that the increase would force other banks to follow. A general increase might seriously affect agriculture and commerce.
Market rates continued to increase in March. Commercial paper reached 6 percent; banks offered 8 percent for time deposits. New York again raised the buying rate for acceptances, in two steps, to 5.5 percent. The rise had the expected effect. The System’s acceptance portfolio declined while its discounts rose, contrary to the “reluctance” theory of borrowing.
Propelled by higher interest rates, rising stock prices, and deflation, capital flowed to the United States. New York sterilized gold inflows by selling securities from the System account, reducing the account to $40 million in early March. To stem the gold flow to the United States and France, the Bank of England raised its discount rate a full percentage point to 5.5 percent. Holland, Italy, and others soon followed.168
New York’s directors voted to increase the discount rate on March 4 and March 21. The Board did not approve, citing in the latter case the decline in Federal Reserve credit. Unable to convince the Board, Harrison appealed to Secretary Mellon on March 21. Mellon agreed, but the Board insisted that direct action was the correct policy and rejected the request. Boston, Philadelphia, and Chicago discussed or voted for 6 percent rates; the requests were rejected, tabled, or withdrawn to avoid rejection (Riefler 1956, 282–84).
Standard and Poor’s index of common stocks rose more than 10 percent in the first three months of 1929. The Board’s policy succeeded in reducing bank lending to brokers, but total loans to brokers secured by stocks and bonds rose.169 Most of the lending came from corporations and other nonbanks, attracted by call rates of 9 or 10 percent. Nothing in the program prevented individuals or corporations from borrowing from banks while lending to brokers and dealers. This pattern continued through the first three quarters of the year.
167. On February 7, the Board tabled a request by the Dallas bank to raise its discount rate to 5 percent. Dallas was one of four banks with a 4.5 percent rate. The Board permitted the increase early in March.
168. The Bank of France kept its discount rate at 3.5 percent and sterilized its gold inflow by selling foreign exchange.
The April meeting of the Governors Conference had a thorough discussion of market rates. Boston, New York, Chicago, Philadelphia, and Richmond said they had exhausted the possibility of credit control through the Board’s program of direct action against speculative uses of credit. Some of the regional banks said that local businesses had difficulty borrowing because credit was going into brokers’ loans. Several of the governors warned of an impending crisis if the current policy continued (Governors Conference, Board of Governors File, box 1436, April 4, 1929).
Policy was beginning to affect economic activity without reducing stock prices. Harrison’s preliminary memorandum reports call loan rates of 8 to 20 percent at the end of March and commercial paper at 6 percent. The memo reported building activity in decline, state and local government projects postponed, and foreign borrowing curtailed. Gold continued to flow to the United States. Conditions abroad would soon reduce exports. Business conditions were sustained by automobile production “considerably in excess of retail purchases.” “Present money conditions, if long continued, will have a seriously detrimental effect upon business conditions, and the longer they are continued, the more serious will be the effect” (OMIC, Board of Governors File, box 1436, preliminary memo for April 1, 1929; emphasis added).
A rate increase now was seen as a step toward lower rates later. Boston and New York argued for a 6 percent rate immediately and perhaps 7 percent later. Philadelphia talked about a possible 8 percent rate. By raising discount rates, the reserve banks expected to reduce discounts, paving the way for a lower discount rate. The Board rejected this reasoning when it turned down New York’s sixth request in mid-April. The Board noted that New York had used the same evidence—declining exports, difficulty in placing foreign loans—when it asked to lower the discount rate in 1917.
The warnings about declining activity and a possible crisis ahead (if countries were forced off the gold standard) had no effect on Young or Miller. Young recognized that policy “has had a detrimental effect on business,” but he told the governors there was no occasion to raise rates: “There is one factor you have been unable to control, which is speculative credit. As the Board sees it, the discount rate will have no effect” (Governors Conference, Board of Governors file, box 1436, April 4, 1929). Miller said he would favor lower rates if the “abuse of Federal Reserve credit” ended (ibid.).170
169. In the first quarter brokers’ loans by New York banks fell 33 percent and those by other banks 18 percent. Nonbanks increased lending by 27 percent. Total brokers’ loans rose 6 percent (Board of Governors of the Federal Reserve System 1943, 494). Miller (1935, 456) recognized the substitution of loans by nonbanks but claimed success for direct action because, he said, total brokers’ loans decreased and loan rates increased sharply. A chart in his paper showed a small decline in total brokers’ loans in the spring followed by a much larger increase after the Board “relaxed” direct action in June (448).
The governors did not speak with one voice. Governor Fancher cited the large gold reserve as a reason for not raising rates. Cleveland would raise its rate, defensively, only if New York and Chicago increased theirs. Seay (Richmond), Eugene R. Black (Atlanta), and other governors of small banks either opposed raising discount rates or were ambivalent.
The governors agreed, informally, on a policy statement. To lower interest rates, they first had to raise discount rates. The minimum discount rate at any reserve bank should be 5 percent, with a 6 percent rate in the principal financial centers. Since the Board had to approve these rates and was certain not to do so, the governors who disagreed could accept the policy statement.
Gold continued to flow to the United States, much of it from Germany.171 Between March 6 and April 30, the Reichsbank lost $215 million in gold reserves, one-third of the stock held at the end of 1928. The Federal Reserve sold most of the gold to the Bank of France, which paid partly by selling foreign exchange, mostly dollars, and by sterilizing most of the remainder by reducing its holdings of governments. The Federal Reserve reinforced the gold outflows by reducing government securities. By the end of April the Federal Reserve’s government security holdings had fallen to $150 million, of which only $17.5 million was held in the System account. Thus, as France acquired gold, both the buying and selling countries took deflationary action. Moreover, acceptances continued to run off, further reducing the monetary base.
New York again voted to increase its discount rate, and again the Board refused. At times Boston, Philadelphia, and Chicago joined New York. On April 25, Harrison appealed to Secretary Mellon to intervene. Mellon pleaded for an increase that day, but only Platt supported him. Instead, the following week the Board sent letters to the
reserve banks listing member banks that borrowed continuously while lending to security brokers and dealers. The Board threatened to stop all discounting by these banks.
170. Harrison asked, “Are we getting what we want?” The minutes report that Miller answered: “What it is that the System wants. Considerable discussion ensued, but no definite statement was made” (Governors Conference, box 1436, April 4, 1929).
171. Part of the German gold outflow resulted from the failure to reach agreement about reparations payments.
May saw a slight change in the stalemate.172 The Board approved increases in discount rates to 5 percent at Kansas City, Minneapolis, and San Francisco. The 5 percent rate was now uniform throughout the System. The Board continued to disapprove or table requests for a 6 percent rate, but on May 15 Governor Young changed sides to vote for approval of New York’s request. With the fall approaching, he now shared Harrison’s view that to reduce rates, they must first be raised. The vote was four to four, rejecting the request (Office Correspondence and Memos, Harrison Papers, May 14 and 15, 1929).173
End of the Stalemate
The next move came from New York. Instead of again voting to increase the discount rate, the New York directors sent a letter to the Board on May 31. The letter called attention to the uncertainty created by the continuing policy conflict and rumors that all discounting would be denied. It urged agreement on a mutually satisfactory program. The letter made clear that the directors had not changed their opinion about the rate increase but decided to “refrain from rate action in the hope that a general policy. . . may be quickly determined” (Riefler 1956, 315).
A History of the Federal Reserve, Volume 1 Page 36