A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  87. The Treasury also sold $11 billion of nonmarketable special issues to its trust accounts to fund its obligations, and the public added $7 billion to its holdings of government savings bonds.

  Market yields changed very little during the period. After a short-lived decline to 2.08 percent during winter 1946, yields on long-term bonds remained between 2.15 and 2.25 percent until late in 1947. Thereafter, yields rose slowly toward 2.45 percent. These yields give no hint that the public anticipated sustained inflation. Growth of the monetary base and money suggest that inflation would remain low. Table 7.6 shows that, after an initial surge that includes the removal of price controls, the rate of inflation slowed in 1948. By the end of 1948, prices were falling. All of the 5.8 percent inflation in 1950 came after the start of the Korean War. During the years of low inflation and falling prices, the monetary base and money fell. Treasury debt retirement, not Federal Reserve policy, was the main influence on monetary growth and inflation. The Federal Reserve urged the Treasury to pursue deflationary policies, but it had little influence on decisions.

  Since the Treasury used its surplus to retire debt, it had less reason to be concerned about interest rates. In similar circumstances in the 1920s, Secretary Andrew Mellon pressed the Federal Reserve to avoid actions that lowered rates. Secretaries Vinson and Snyder were more concerned about rolling over maturing obligations, so they continued to insist that wartime interest rates be maintained.88

  Unlike the bond market, the government saw a threat of inflation. President Truman called a special session of Congress in fall 1947 to restore price and wage controls, renew consumer credit controls, and introduce controls on commodity speculation. The Federal Reserve asked for secondary reserve requirements, a new power.89 Congress did not approve any of these requests at the time, but in August 1948 it restored consumer credit controls on installment loans for one year to show its concern about inflation at election time. Although installment credit had not increased rapidly, the Board reimposed regulation W effective September 20, 1948.

  88. When bond yields fell to 2.08 percent in the winter of 1946, Chairman Brown of the Advisory Council asked Eccles whether the Treasury was concerned that rates were far below the ceiling. Eccles replied that the Treasury had no financing in prospect and so was unconcerned (Board Minutes, April 24, 1946, 11).

  89. The Federal Reserve proposal is discussed in the next section.

  Prices rose after the start of the Korean War in June 1950. The twelvemonth change in consumer prices increased from –0.5 percent in June to 5.8 percent in December. President Truman disliked budget deficits; he proposed to fight the war with a balanced budget. In September Congress increased individual and corporate income tax rates and levied some new excise taxes on durable goods purchases. In January 1951 an excess profits tax passed Congress, retroactive to July 1950. An additional round of tax rate increases for individuals and corporations passed in October 1951. The net effect, as shown in table 7.6 above, was to continue surpluses in the cash budget despite the large increase in military spending. Total outlays rose $30 billion from 1950 to 1952 (calendar years), an increase of 71 percent. Revenues rose almost as much, so the budget had a surplus in 1951 and a modest deficit in 1952.

  President Truman’s determination to finance the war by taxation may have convinced the public that the wartime price increases were a one-time change, not the start of sustained inflation. Although measured inflation rates were more than double the interest rate on long-term Treasury bonds, rates on long-term bonds remained below the 2.5 percent ceiling. Between late June and December 1950, the long-term rate rose only from 2.34 percent to 2.39 percent. Short-term rates rose slightly more—from 1.17 percent to 1.37 percent on new issues of Treasury bills. Growth of the monetary base remained low throughout. These data suggest that the Federal Reserve’s concern about inflation was misplaced. Its error, repeated by many economists at the time and subsequently, was a failure to distinguish one-time price level changes from the sustained rate of change that constitutes inflation.

  The period provides evidence on the role of money in inflation. The surge in the price level was nonmonetary; recalling wartime shortages, rationing, and allocation of scarce materials, consumers and producers bought goods and ordered larger inventories. Prices rose, but base money growth remained low or negative. Within a few months, the price level stabilized.

  The dominant view in the academic profession and the Board of Governors was that the price increases were evidence of inflation, but that monetary policy could do little to prevent inflation.90 Eccles’s strong belief was that the budget was a much more important instrument for responding to depression or inflation. Unlike many of the Keynesian economists who had joined him in urging larger deficits during the 1930s, Eccles urged budget surpluses after the war. He forecast postwar inflation, not depression, so he recommended tax increases at every opportunity and supported other policies including maintenance of price and wage controls and consumer credit controls until peacetime production was restored (Eccles 1951, 409).91 The Board’s staff and its members reflected the views of contemporary economists, as they had in the past and would in the future. They minimized or denied the effect of money growth on inflation. Such views now seem extreme, but they dominated professional writing in the 1940s and 1950s.92

  A central belief at the time was that the large wartime increase in government debt had rendered traditional monetary policy useless. Banks did not borrow from reserve banks, so discount policy could not be effective. Eccles described the discount rate as “largely irrelevant” because banks could sell government securities (ibid., 420): “A moderate rise in yields on government securities would not prevent and would only slightly restrain banks from selling securities in order to make loans. On the other hand, an increase in rates large enough to exercise effective restraint on banks may have to be too great or too abrupt to be consistent with the maintenance of stable conditions in the government securities market” (420).

  90. “The notion that inflation is a monetary phenomena and that it can be prevented by refusing to allow the quantity of money to increase is to mistake a symptom for a cause” (Robinson and Wilkinson 1985). See also Kaldor 1982.

  91. The Board formally disapproved of tax reduction in 1947 and notified the president (Board Minutes, June 9, 1947, 1–2). Eccles also proposed, and the Board agreed unanimously, to recommend to President Truman that he sign the Taft-Hartley Act. The Board recognized that labor relations was not its field but agreed that strikes and labor unrest would disrupt production and raise prices. The letter was approved and sent (Board Minutes, October 17, 1947, 1–5).

  92. Three sources will suggest how broadly these views were held in the academic community. Henry Villard (1948) was commissioned by the American Economic Association to survey monetary theory. The paper was published in the association’s Survey of Contemporary Economics. The Committee on the Working of Monetary System (1959), known as the Radcliffe Committee, denied any role for a policy of monetary control in Britain. As late as 1965, the American Economic Association’s Readings in Business Cycles has no role for money (Gordon and Klein 1965). Citations of popular textbooks such as Ackley 1961 or of econometric models of the period provide additional evidence.

  Eccles had always chafed under Morgenthau’s control of interest rates and monetary policy. In the 1930s the Treasury had exercised control by threatening to use the Exchange Stabilization Fund and other Treasury accounts to buy securities. Eccles and the Board believed they were in a weak position to pursue an independent policy or counter the Treasury. The Federal Reserve held a small securities portfolio relative to the gold inflows, so it had no way to control the monetary base had it chosen to do so. These problems vanished with the wartime growth of debt and the Federal Reserve’s portfolio. Now the argument was that the large debt made traditional monetary policy tools and techniques useless.93

  Further, market-determined interest rates would confront the Treasury with
“an impossible debt-management problem” (ibid.). The Treasury would be at the mercy of the market and subject to chaotic swings in interest rates. Therefore Eccles restricted his recommendations for monetary policy and debt management to modest increases in short-term rates on bills and certificates, more reliance on selling debt to the public, and new powers to control bank reserves. Since the Federal Reserve owned most of the outstanding Treasury bills and (pegged) long rates exceeded short rates, the main effect of a rise in the bill rate would be the increased interest cost as the bill rate rose and other rates moved in response.

  The New York Federal Reserve Bank, and many bankers, held a different view. Directors of the New York bank began pressing for higher rates on Treasury certificates late in 1944. In December they arranged to meet with Secretary Morgenthau to convey their views (Minutes, New York Directors, December 28, 1944, 112). In January 1945 they discussed the difficulty of maintaining the existing yield curve (pattern of rates) when holders were free to shift from one maturity to another (ibid., January 18, 1945, 139).

  Allan Sproul, president of the New York bank, spoke out against the prevailing view. In a December 1946 speech he argued publicly that small changes in interest rates would have beneficial effects by changing bond values and by introducing uncertainty about future market rates. Uncertainty would remove the belief that reserves could be obtained on demand without loss of principal. He believed this would have a modest effect on the banks’ decisions to expand. Sproul did not claim that monetary policy could have more than a secondary role in controlling inflation, but he wanted to adjust market yields to reflect the change from war to peace and the increased risk of inflation (Sproul 1947).

  93. This belief in the impotence of monetary policy was so widely held that it is rare to find a memo suggesting the opposite. One such memo, by Walter Salant, warned that the swing in opinion since the 1920s went too far. Monetary policy was not totally impotent, Salant wrote, and experience did not support total impotence. Drawing on Currie 1934, he argued that policy had not been easy during most of 1929–33 or in 1937–38. He concluded with a double negative: there is no reason to believe that monetary policy “cannot exert a significant expansive influence” (Salant 1948, 8). The memo, dated May 21, concerns mainly policy in recession. At the time, Salant was on the staff of the Council of Economic Advisers. He sent me a copy of the memo.

  At times Sproul pressed for a policy change. He was one of the first to urge the Treasury to relax the ceiling on long-term interest rates. In 1950, before the Korean War renewed concern about inflation, he told his System colleagues: “There cannot be a purposeful monetary policy unless the Federal Reserve System is able to pursue alternating programs of restraint, neutrality, and ease. . . . The terms of Treasury offerings for new money, and for refunding issues, must be affected” (Board of Governors File, box 1433, April 4, 1950).

  Vinson remained at the Treasury about a year. His successor, John W. Snyder, knew very little about monetary or fiscal policies. Morgenthau’s staff continued to serve Vinson and later Snyder. Its priority was minimizing the current budget cost of financing the debt.94 Further, by maintaining the pattern of rates the Treasury staff kept control of interest rates away from the Federal Reserve. Though nominally an independent agency, the Federal Reserve remained under Treasury control.

  Issues and Views

  In May 1947 the Board unanimously approved the text of a long letter that Eccles sent to Thomas B. McCabe.95 McCabe had expressed concern about inflation and Federal Reserve policy. Eccles’s reply shows the ambivalence that characterized policy at the time. Concern about inflation had to be balanced by concern that an effective policy would require a steep rise in interest rates.96 “It was not possible by any practicable means, except higher taxes, to contract either current income or accumulated buying power in the form of liquid asset holdings” (Eccles to McCabe, Board Minutes, May 28, 1947, 7).

  94. Eccles describes the clash with Snyder as arising from conflicting responsibilities, not personalities (Eccles 1951, 421). Casimir Sienkiewicz, who worked in the System from 1920 to 1947, is less charitable. He described the Treasury as under the control of its staff. “Mr. Snyder did not really know very much about the problem he should have been coping with” (interview with Casimir Sienkiewicz, CHFRS, March 18, 1954, 3).

  95. At the time, McCabe was chairman of the Philadelphia Federal reserve bank. In 1948, he succeeded Eccles as chairman of the Board of Governors.

  96. “Every member of the Open Market committee is aware of the disastrous consequences that would follow if the system were to attempt to force rates up to levels that would be effectively restrictive on private borrowing” (Board to McCabe, Board Minutes, May 28, 1947, 8). The letter spells out the “disastrous consequences” as substantial losses on bank (and other) portfolios, increased cost to the Treasury, and loss of any freedom of action by the Board, a reference to the political consequences the Board most feared.

  The issues at the time were in several respects a replay of earlier issues in a different context. Contemporary writers, within and outside the Federal Reserve, expressed concern about whether monetary policy could operate with a large debt. This concern was both economic and political. A rise in interest rates sufficient to stop inflation would lower bond prices below par (initial offering price), imposing losses on all holders. Reserve officials and some senior staff could recall the political response in 1920–21 to higher interest rates and the public’s losses on war bonds.97

  Vestiges of the real bills doctrine remained. Board members feared that speculative credit would increase: “It is too much to expect that further increases in bank credit will be confined to productive loans, the more likely outcome, in the absence of repressive measures, will be an increase in speculative credit” (Minutes, FOMC, October 14, 1947, 4). Under the real bills doctrine, speculative use of credit would be evidence of inflation. Even the New York reserve bank, which had rejected the real bills doctrine in the 1920s, expressed concerns about “speculative purchasing and carrying of securities” and opposed loans for that purpose (Minutes, FOMC, June 10, 1946, 10).

  Eccles’s reasons for opposing an increase in interest rates are a mixture of economic and political considerations that seem inconsistent. He too referred to 1920–21 and argued that rates could not be changed until the public supported the move (ibid., 10–11). At times he opposed an increase in interest rates because a small increase would have little effect.98 But he also claimed that the effect on the prices of government bonds would be too great.99

  Eccles’s economic views seem confused. In the 1930s he saw no reason for Federal Reserve action because monetary policy was ineffective when interest rates were low in a recession. In 1946, a period of anticipated expansion, part of his argument was that policy would have little effect unless the Federal Reserve undertook large-scale operations and raised interest rates substantially. He saw no way of stopping an expansion of private credit by rate action except by rates high enough to seriously affect the government securities market, and if such action were taken by the System “it would be received in much the same way as action to increase rates was received following the last war” (ibid.). But he also claimed that using the modest budget surplus to retire Treasury debt had increased bond interest rates in fall 1946. He urged additional retirements and favored rate increases on (nonmarketable) savings bonds to encourage purchases and reduce redemptions100 (Minutes, FOMC, October 3, 1946, 13, 17).

  97. “Mr. Evans stated that he was opposed to increasing the rate on certificates because the burden of such an increase would fall on the farmers, and the small businessmen, and the taxpayers. He recalled the situation after World War I, when the Federal Reserve was blamed for increasing interest rates, tightening credit, and causing a fall in prices, and he said that in some places the Federal Reserve system was still held responsible” (Minutes, FOMC, May 2, 1947). Rudolph M. Evans served as a member of the Board of Governors from March 1942 to Augus
t 1954. He held the “agricultural seat” after the resignation of Chester C. Davis in April 1941.

  98. “Chairman Eccles did not think that a higher rate of interest—unless it was a very much higher rate—would have any substantial effect in curbing the demand for credit for private purposes” (Minutes, FOMC, June 10, 1946, 10).

  99. A partial resolution of the apparent inconsistency is that there was a large debt outstanding, so a small change in interest rates would have a larger effect on private wealth than heretofore. Williams used the same argument, however, to claim that a small change “would have a greater retarding effect than in the past” (Minutes, FOMC, June 10, 1946, 13).

  Differences of opinion between New York and the Board were similar to the differences in 1928–29. New York, under the leadership of Allan Sproul, periodically pushed for higher interest rates. The Board preferred alternative methods of controlling credit. As in 1928–29, the Board was more concerned about the political response to higher interest rates and the effects on commerce and agriculture. Hence it favored control of specific uses of credit instead of more general policies. The Board’s political concern is clear in the letter to McCabe: “If the Secretary of the Treasury were confronted with any such consequences as would be produced by the System’s abandonment of support of the Government bond market, he would no doubt take the issue directly to the President who, in turn, would take it to the Congress if the Open Market Committee remained adamant. There can hardly be any doubt as to what the result would be” (Eccles to McCabe, Board Minutes, May 28, 1947, 9).101 During the rest of his term as chairman, Eccles held to this view. In his memoir, he recognized that he erred in not taking a more independent position (Eccles 1951, 425).