A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

13. The Federal Reserve minutes for the period return repeatedly to the topic of “educating” the public about the importance of holding the bonds they purchased. The problem was not ignorance but knowledge of opportunities.

  Eccles proposed a three-part alternative. First, he wanted more of the debt made ineligible for bank purchases. This limited the profits that nonbanks could make by buying bonds at a favorable price during bond drives and reselling them to banks after the drive. Second, Eccles thought more of the debt should be in nonmarketable securities to supplement the (non-marketable) series E, F, and G bonds sold to individuals. The Treasury accepted part of this proposal, issuing a nonmarketable short- term bond. They did not issue a nonmarketable long-term bond, mainly because they did not want to pay the additional cost. Third, Eccles wanted to limit bank eligible issues to the residual amount required to finance the budget. He urged Morgenthau to sell banks only short-term securities with low yields. This “would have prevented the excessive profits which many banks were able to make” (Eccles (1951, 365).

  To support Eccles’s suggestions, the executive committee of the FOMC voted to recommend a long-term program. On January 28, 1942, it sent a memo to the Treasury that proposed (1) tap issues (on demand) to absorb surplus funds of nonbank corporations; (2) a 2.5 percent rate on securities with fifteen or more years to maturity; and (3) flexible rates on shorter maturities, bounded between 0.25 percent and 0.5 percent for Treasury bills.

  As on many subsequent occasions, the Treasury did not accept most of the FOMC’s suggestions. It was not interested in a long-term plan. Morgenthau preferred to remain opportunistic, and he was not concerned with rate flexibility or higher interest rates. He accepted only the fixed 2.5 percent maximum rate. At war’s end, he was proud of his achievement—financing more than $200 billion at an average cost of 1.94 percent. In World War I, he noted, the average interest cost was 4.22 percent (Blum 1967, 30).15

  In all, there were seven war bond drives and a Victory Loan drive between November 1942 and December 1945. Judging from discussions by the New York Federal Reserve directors and the open market committee, problems with “speculators” increased in the later drives. The bank put limits on the volume of discounting and issued warnings to member banks not to participate in these activities (Minutes, New York Directors, November 16, 1944, 48; July 5, 1945, 8; October 25, 1945, 96).

  14. As shown in table 7.1, the rate of base growth slowed in 1946. Morgenthau blamed “speculative practices” for the sales by nonbank investors. In contrast, Eccles recognized Treasury practices as the cause. Suspicious of bankers, Morgenthau argued that Eccles’s program (see text) would have raised interest rates, increasing the profits of banks and Federal Reserve banks (Blum 1967, 29).

  15. Morgenthau was so pleased with his achievement that he concluded the Treasury should have a larger role in monetary and financial policy. He advocated returning the secretary to the Board of Governors (Blum 1967, 31).

  The warnings did not reduce the undesired activities. The open market committee was reluctant to change course at the end of the war until the Treasury completed the last (Victory) bond drive in the fall of 1945. But it agreed unanimously to discuss with the Treasury “policies which should be adopted for the reconversion and postwar periods” (Minutes, FOMC, October 17, 1945, 5).

  Price and Wage Controls

  Unable to persuade the Congress to pass all its proposed tax increases, the administration turned to price and wage controls to prevent wartime inflation. In July 1941 the president asked for selective controls on prices, but the bill did not pass in the Senate. After the war started, Congress approved the Emergency Price Control Act in January 1942, authorizing selective controls.

  In March the president appointed a committee to consider the inflation problem. The committee concluded that selective price controls would fail. It recommended controls on rents, profits, wage rates, and prices and a $50,000 a year limit on incomes of corporate executives and professionals.16 Workers would have an incentive to increase income by working more hours (at overtime rates). Morgenthau opposed wage controls, but he favored limiting profits to 6 percent of invested capital (Blum 1965, 314).

  In April and July 1942 the administration tried selective price controls. Prices rose at a 4.8 percent annual rate in that year’s first three quarters. The administration considered that rate too high. The president requested authority to freeze prices and wages, warning Congress that if the bill was not passed by October 1, he would issue an executive order. The Stabilization Act gave the president broad authority to control prices and wages. A former senator, Justice James Byrnes resigned from the Supreme Court to administer the Office of Economic Stabilization. Controls remained until the fall of 1946, when Congress repealed the authority it granted in 1942.17

  16. The committee also recommended compulsory saving and lower tax exemptions to absorb purchasing power. In the Treasury, Undersecretary Randolph Paul and Harry Dexter White also favored compulsory saving (Blum 1967, 43).

  17. Two modest policy benefits during the war were the end of the wasteful policy of purchasing Canadian silver and a reduction of the purchase price for Mexican silver to 35 cents an ounce, slightly below the world market price. The reason for these changes was to release silver for wartime use in photography and armaments. The Treasury continued to purchase domestically produced silver at 71.11 cents an ounce, as required by law (Blum 1967, 12).

  THE FEDERAL RESERVE IN WARTIME

  In a prescient 1942 memo, the staff of the Philadelphia reserve bank analyzed the problem the Federal Reserve faced in wartime. Although the war was less than a year old, the bank’s staff projected that by the end of 1944 the government debt would reach $200 billion. Banks would hold between $85 billion and $100 billion; bank reserves would have to increase by $14 billion to $18 billion to support the purchases (Memo, Supply of Reserve Funds, Board of Governors File, box 1452, October 8, 1942). The memo concluded that open market purchases were the best method of supplying the reserves (ibid., 7).

  With discount rates at 0.5 percent and open market rates on Treasury bills below 0.375 percent, banks preferred to sell bills rather than discount. The main wartime decision of the Federal Reserve was to keep this structure unchanged.

  Pegged Rates

  On April 30, 1942, the Federal Reserve announced its commitment to purchase all ninety-day Treasury bills offered “on a discount basis at the rate no higher than 0.375 percent per annum” (Board of Governors File, box 1441, April 30, 1942). It did not fix rates on other government securities explicitly, but it established a pattern of rates that it maintained throughout the war and beyond. It held one-year rates at 0.875 percent. At the longest end, it held the rate on bonds with twenty-five years or more to initial maturity to a maximum of 2.5 percent, as noted earlier. During the war and early postwar period, the duration of the longest-term bonds declined, but the maximum yield remained fixed.

  The announcement put maximum Treasury bill rates above the rates prevailing at the time. During 1941 and early 1942, the Treasury bill rate had increased gradually from 0.02 percent to 0.25 percent. At the long-term end, bond yields had increased from 2 percent in much of 1941 to 2.5 percent in January 1942. The announcement had no effect on the long-term yield.18

  The Federal Reserve did not vote to fix yields on all securities for the duration of the war. Memos written in early 1942 are explicit about rates on the shortest and longest maturities. Conversations with bankers and other active market participants show some concern that the 2.5 percent long-term rate might be too low; Federal Reserve officials wanted to increase the prevailing 0.25 percent rate on short-term bills. But the uniform opinion was that “the cost of war is a social cost and its risks should be borne by the public at large, not by any one group, such as those who have bought government securities” (Letter Sproul to Bell, Sproul Papers, Monetary Policy 1940–41, March 16, 1942, 2). “The Treasury, representing the public at large, should assume the risk of a change in credi
t conditions.”19 (ibid., March 10, 1942, 3).20

  18. The Treasury’s initial interest was not in an explicit peg. They asked the System to keep large excess reserves in the market, preferably by reducing reserve requirement ratios. When the Federal Reserve objected, the Treasury proposed the 0.375 percent bill rate. The FOMC approved the agreement unanimously. The agreement to support the “pattern of rates” was made in March. “The general market to be maintained on about the present curve of rates, but this does not mean special support for issues that maybe out of line” (Minutes, FOMC, May 8, 1942, 3). The agreement provided for more flexibility than the Treasury allowed and much less than the FOMC anticipated.

  Households would get nonmarketable securities that they could redeem at the Treasury at a fixed price. This decision avoided the problem of imposing losses on the general public, a concern based on experience after World War I. Banks would be large holders of marketable debt, so it would be “necessary . . . for the Federal Reserve and the Treasury to protect that market, not only during the war, but during the post-war period” (ibid., March 16, 1942, 2). Sproul recognized that protecting the market meant that government debt would “have some attributes of a demand obligation.” The problem was to manage the debt “in the way least likely to contribute to . . . inflation” (2).21

  A few days later, Sproul’s letter to Eccles summarized the agreement with the Treasury. At the short end, the Federal Reserve agreed to support the market “when the rate on Treasury bills reaches 1/4 of 1 percent, and support[ing] with increasing strength as the rate approaches 3/8 of 1 percent” (Sproul to Eccles, Sproul Papers, FOMC 1942, March 21, 1942). The general market would be kept “on about the present curve of rates but this. . . does not mean that we must hold the 2’s of 1951–55 or the 21/2’s of 1967–72, or any other issue, at par, or any other fixed price” (ibid.). The System maintained this position for a time, but it was unable to get the Treasury to agree.22

  19. This is a very different rationale than Eccles gave: “It would have been wrong for the government to pay increasing rates of interest for the use of the funds it helped to create” (Eccles 1951, 350). The same statement could be made at any time about any supply of base money. It expresses a preference for relying on inflation to tax wealth instead of relying on explicit taxation.

  20. The memos do not mention that the benefits of victory would go to both future and current generations, justifying some sharing of the social costs through taxation to retire the debt after the war.

  21. Sproul proposed interest rates starting at 0.375 percent for up to six months, rising by 0.25 percent to 1.375 percent at two and a half years, then by 0.125 percent to 2 percent at five years. The Treasury proposed a lower short-term rate and a steeper slope starting at 0.25 percent and progressing by 0.25 percent to 2.5 percent at five years. By June some in the System recognized that a fixed pattern of rates increasing with maturity gave holders an opportunity to “play the pattern of rates” by buying long, letting the price rise as maturity shortened, taking the profit, and then repeating the operation. The (unsigned) memo proposed letting rates fluctuate to reduce certainty (Sproul Papers, FOMC, June 1, 1942).

  Even granting that the Federal Reserve had no choice but to finance the war at fixed rates, it was a mistake to accept the prevailing structure of interest rates. That structure reflected market anticipations in April 1942 about future economic expansion and inflation. The positive slope of the yield curve, expressing rates by maturity of the debt, suggests that the market anticipated that output, inflation, and therefore interest rates would rise over time. The fixed pattern of rates was inconsistent with this anticipation, so it invited debt holders to sell low-yield securities and buy at higher yields. Since the peg made all government securities equally liquid, or nearly so, the Federal Reserve’s decision was the cause of its principal problems for the next nine years. First, banks could lend to their customers for short periods at rates below the rates on long-term debt. As debts matured, bond prices rose to a premium. Holders sold, took capital gains, and purchased longer-term debt. Although the Treasury disliked both practices, it was unwilling to consider any changes in the structure of rates during the war. Second, banks followed the same pattern, selling bills with yields of 0.375 percent to the Federal Reserve and buying longer maturities with higher yields. By 1945 the Federal Reserve had acquired almost all of the outstanding bills: “They ceased to be a market instrument” (Eccles 1951, 359).

  In the late 1930s, the Federal Reserve urged the Treasury to increase the supply of short-term debt. The Treasury refused. With the short-term rate fixed, the Treasury could now reduce interest cost by issuing a relatively large volume of short-term debt. At prevailing rates and policies, the market wanted more long-term debt. By fixing the structure of interest rates, the Federal Reserve sacrificed its ability to change the composition of the debt held by the public. Market demand dictated the amount and composition of its purchases and sales.

  In 1944 some members of the open market committee began to shift their position. They asked the Treasury to increase bill rates to 0.5 percent by lengthening the initial term to four months (Minutes, FOMC, March 1, 1944, 5). Eccles opposed the request on the improbable grounds that large banks would use the additional revenue to absorb exchange charges on checks. Small banks would increase these charges, weakening the banking system (Board Minutes, March 8, 1944, 2).

  22. In June the Federal Reserve repeated that the pattern of rates “does not involve fixed or pegged prices for individual issues, but means maintenance of prices within a range which may include prices below par as well as above par” (Sproul Papers, FOMC, June 27, 1942, 4). The Federal Reserve did not refer to this position in the postwar years.

  Despite the comments about flexibility he made in 1942, Eccles favored the fixed rate structure throughout the war to reduce financing costs and to prevent owners of Treasury securities from profiting from war finance. He opposed a proposal to extend the maturity of the debt by selling more three- to four-year securities and fewer bills because “there was no reason why they [banks] should receive 11/4 or 11/ 2 percent” (Board Minutes, Meeting of the Federal Advisory Council, December 4, 1944, 9). “It was highly desirable that the proportion of outstanding Government debt in the form of bills and certificates (under one year) should continue” (11). He regretted only that banks did not buy more short-term securities. It was a mistake, he thought, not to restrict them to these short-term issues in 1941 (13). The banks had too much profit.23

  With its chairman firmly holding views of this kind, the Federal Reserve did not seek changes in interest rates during the war. Even if it had sought higher rates, it would have faced two obstacles. Morgenthau opposed any increase. And populists in Congress claimed the interest cost was too high. Congressman Wright Patman (Texas), a member of the House Banking Committee, denied that he wanted “printing press money.” He wanted lower interest rates: “If money must be created on the government’s credit, the taxpayers should not be compelled to pay interest on it” (Board of Governors File, box 141, July 1942).24

  The Board and the banks understood the inflationary consequences of pegging rates, but they did not oppose the policy during the war. Those most concerned about inflation urged higher income tax rates, sales or expenditure taxes, or compulsory savings to absorb purchasing power. To improve understanding of the problem and disseminate information more widely, Eccles urged the reserve banks to expand their research staffs and coordinate their efforts through a System committee (Board Minutes, March 2, 1943, 2–7).25

  Open Market and Other Purchases

  With rates fixed, the FOMC had little to do. It approved new limits on the size of the account and authorizations to purchase and sell. It spent much of its time discussing problems associated with bond drives, banks playing the pattern of rates, and the possibility of lending to banks instead of buying securities or using repurchase agreements instead of discounts and outright purchases.

  23. H
e said that since the banks had a franchise from the government to create money in the form of checks, the banking system was vulnerable to the trend throughout the world to socialize banking (Sproul Papers, FOMC, June 27, 1942, 17).

  24. The quotation comes from a June 1942 letter to a Dallas newspaper signed by Congressman Wright Patman. The news clipping is in the Board’s files.

  25. Eccles’s proposal called for a staff member at the Board “to direct the coordination of the work of the Board and the Federal Reserve Banks.” This brought a quick response from Allan Sproul of New York opposing direction by the Board.

  Banks held more than $6.5 billion of excess reserves early in 1941. At first they purchased securities by reducing excess reserves. The decline was most rapid in New York, slowest at country banks.26 By August, New York banks had all but eliminated their excess reserves (Minutes, FOMC, August 8, 1942). To provide reserves, the Federal Reserve removed all restrictions on the amount of short-term securities (bills and certificates) in the System Open Market Account by the end of 1942. Limits on the amount of longer-term securities remained.

  Table 7.2 shows the rates of purchase from 1942 to 1945. By the end of the war, short-term government securities had become the Federal Reserve’s principal asset. The pre–World War I problem of a portfolio insufficient to offset a gold inflow or, in the 1930s, excess reserves greater than the portfolio, would not return. Financing World War II left the Federal Reserve balance sheet and the monetary base dominated by the open market portfolio. This result was very different from the founders’ plan; the System had become an indirect source of government finance.