The Federal Reserve’s failure to act raised legal as well as political issues. The Board’s counsel advised “that the System would not be relieved of responsibility because the Treasury did not want the System to take action which it [the Board] believed . .. should be taken” (Minutes, FOMC, January 23, 1946, 12). Without political support, the Board believed it had to take the legal risk.
100. The reasoning is wrong. Debt retirements raise bond prices and lower interest rates, not the reverse.
101. This is a political argument, but the Board was also skeptical about the economic effects. The letter ends as follows: “Outside of the monetary cranks, no one at all informed on the subject would suggest that in the great complex of economic forces there is some simple monetary device that could preserve or restore economic equilibrium” (Board to McCabe, Board Minutes, May 28, 1947, 10). Eccles also expressed concern about large bank earnings if interest rates rose (Minutes, FOMC, January 23, 1946).
The Postwar Recession
An eight-month recession began in February and ended in October 1945. Data available at the time show a decline in nominal GNP of $20 billion (9.7 percent) between the first and fourth quarters of 1945. Prices rose, and real GNP fell almost 14 percent.
Resources shifted to peacetime use. Government spending declined more than $39 billion, nearly twice the decline in GNP, but spending on gross private capital formation rose from $3.6 billion to $15 billion in the same period. Private investment and consumption continued to increase and government spending continued to fall. By third quarter 1946, almost a year after the recession ended, private capital spending exceeded government spending for the first time since 1941.
Monetary actions were limited, so they had limited influence. Monetary base growth remained high during 1945 and fell with the budget deficit after the recession ended. Interest rates remained in a narrow range throughout the recession.
A major concern at the time was that readjustment to a peacetime economy would, via the Keynesian multiplier, bring a sharp decline in private consumption and investment. The data on nominal GNP and government spending suggest that the ratio of the two changes was about 1/2, far below estimates of the multiplier then in use.
First Steps, 1946–47
The Federal Reserve limited its initial postwar efforts to raising short-term rates on Treasury bills and certificates, ending the preferential discount rate for loans secured by governments, and asking for new powers. It wanted the Treasury to use its cash balance to reduce outstanding marketable short-term debt and issue more nonmarketable long-term debt to the public. During the war, the Treasury had sold nonmarketable series E bonds in small denominations to small savers and series F and G bonds in larger denominations. The public could buy and redeem these bonds on demand, but banks and financial institutions could not hold them. The System wanted to increase the amount outstanding and raise the limits on the amount a buyer could own (Board Minutes, February 18, 1946, 3–14).
Efforts to eliminate the preferential discount rate began before the war in Asia ended. In a letter to Vinson, who had just become treasury secretary, Sproul advised him that the System had two options under consideration. First was elimination of the preferential discount rate of 0.5 percent (for loans collateralized by government securities with one year or less to maturity). Second was an increase in the interest rate from 0.5 percent to 0.75 percent. The System’s concern, he wrote, was the “abuses” that had developed. The use of bank credit to finance government security purchases and “great speculative” activity occurred “in an atmosphere somewhat reminiscent of the late 1920s” (Sproul to Vinson, Sproul Papers, FOMC, July 31, 1945, 1). The letter assured Vinson that the System would support the government securities market “into the indefinite future” and that the “Treasury would continue to borrow . . . at no more than the rates it is now paying” (1). The Treasury would not agree to the changes, so the preferential rate remained.
Sproul tried again in December 1945, after the Treasury had sold the Victory Loan. This letter repeated the earlier arguments and added new ones. The preferential rate was inflationary. It encouraged banks to expand credit and made it profitable for them to borrow from the reserve banks. Also, with the war ended and no further new borrowing likely, the earlier rationale was gone (Sproul Papers, FOMC, December 12, 1945, 2–3).102 Secretary Vinson’s reply rejected the proposal. Throughout the winter, Vinson refused to accept the change, arguing that it would increase interest rates; the Federal Reserve repeated its arguments without success.
In late March, Sproul warned Eccles that the New York directors would vote to eliminate the preferential rate at the next meeting, April 4. Eccles asked for two additional weeks’ delay because the Treasury had agreed to use part of its cash balance to retire $4.8 billion of securities in March and April.
Further, to ease the Treasury’s concern, the Board notified Secretary Vinson that it would keep unchanged the 0.875 percent rate on certificates when it approved the elimination of the preferential rate on certificates (Board Minutes, March 15 and April 12, 1946). Vinson objected that the reserve banks’ action would raise interest rates. He continued to oppose the change.103
The Treasury’s position was more extreme than after World War I, when it insisted on no change in interest rates as long as it had to undertake large-scale financing. By spring 1946 the Treasury had current and prospective surpluses in its cash budget. It could now retire debt, but it continued to oppose even the slightest change in wartime monetary arrangements.
102. The quotations are from Sproul’s draft. Eccles sent the letter to Vinson the following day.
103. Total member banks borrowing was about $200 million to $300 million at the time but had reached $600 million earlier, the highest level since the early 1930s. The Treasury contributed to anti-inflation policy by running a surplus of $754 million in fiscal 1946 and retiring debt of $10 billion. The difference between the two is explained by costs of the IMF, World Bank, and veterans’ loans not spent that year ($3.9 billion), use of trust funds to purchase debt ($5 billion), and sale of savings bonds ($1.1 billion) to retire debt.
Treasury intransigence annoyed the Federal Reserve. In a strongly worded letter, the Board claimed that eliminating the preferential borrowing rate would stop further monetization of government debt without raising interest rates.104 The Board assured him again that it would act to keep the certificate rate from rising (Board Minutes, April 19, 1946, 9). The guarantee of the 0.875 percent certificate rate irritated Sproul because it bound the System unconditionally (Memo, Sproul to Ruml, Sproul Papers, FOMC, July 19, 1946, 1–3).
On April 23 the Board approved actions by directors at New York, Philadelphia, and San Francisco to discontinue the preferential rate effective April 25. The announcement emphasized that the rate was a wartime measure and that the Board did not favor higher rates. Weekly average short-term rates in the New York market remained unchanged, but average discounts fell by $100 million in the following week and, on monthly average, by $300 million from March to May.
It had taken eight months since the end of the war to achieve this first, very modest change in wartime monetary policy. Another year passed before the System could raise the 0.375 percent bill rate. Moreover, the System continued to discount banker’s acceptances at 0.5 percent.105
Eccles told the FOMC that the Board was committed to the Treasury’s interest rate policy until Congress and the public would accept higher interest rates. To gain support, he agreed to discuss the problem and the need for higher reserve requirement ratios and other new powers in the Board’s annual report, so that the public would be aware of the Board’s position. Sproul wanted to reopen the rate issue with Secretary John W. Snyder, who had just replaced Vinson. With respect to the new powers that Eccles wanted, Sproul noted that to be effective the System had to make credit less easily available and therefore more costly. Higher rates could not be avoided.
Sproul opposed an increase in reserve requireme
nts on central reserve city banks.106 His program at the time called for “some modest increase in short rates while maintaining the 21/2 percent rate on long-term bonds.” Other specific actions that he favored included using the budget surplus to retire long-term debt and increased sales of savings bonds and bank-restricted 2.5 percent long-term bonds.
104. Banks could still sell bills yielding 0.375 percent. The Federal Reserve was the principal and usually the only buyer.
105. The volume was small, however. Eccles questioned the manager (Robert Rouse) about the acceptance rate at the June 10 FOMC meeting. Sproul responded that the New York bank wanted to “go slow,” a strange argument given his interest in raising rates. The rate was raised to 0.75 percent in July and 1 percent in August (Board of Governors of the Federal Reserve System 1976, 636). Sproul’s argument recalls the New York reserve bank’s policy of nurturing the acceptance market in the 1920s.
106. A letter to Eccles explained that, with interest rates unchanged, banks would sell securities to restore their ability to lend (Sproul to Eccles, Sproul Papers, Memorandums and Drafts, May 6, 1946). Eccles’s reply argued that they had to use their existing powers or Congress would not grant additional ones. However, he argued also that the increase in requirements would force banks to sell short-term securities. They could then not sell these securities to increase bank loans (Eccles to Sproul, Sproul Papers, Memorandums and Drafts, May 17, 1946).
Eccles disagreed about interest rates. It was not useful to overemphasize the importance of credit policy in discussions with the Treasury. He concluded a very lively exchange by repeating that “there was nothing that the System could do to unfreeze the rate structure, and that the best thing it could do would be to present the problem to Congress and point out . . . [that] the use of those powers under present circumstances [was] entirely inappropriate” (Minutes, FOMC, June 10, 1946).
The Board’s annual report for 1945 emphasized the “inherent limitations of the System’s existing statutory powers, under present conditions, or the inevitable repercussions on the economy generally and on the Government’s financing operations in particular of the exercise of such existing powers to the degree necessary to be an effective anti-inflationary influence” (Board of Governors of the Federal Reserve System, Annual Report, 1945, 1). Further, the Board argued that letting holders shift substantially into longer-term debt “would be undesirable because it would increase the cost to the Government of carrying the public debt” (5).107
For the rest of 1946, the FOMC made recommendations to the Treasury for debt retirement and for new issues that would place more of the debt in private, nonbank hands. After the Board failed to get legislative approval of secondary (security) reserve requirements, it concentrated on legislation to increase maximum reserve requirement ratios, consumer credit controls, and margin requirements for purchasing and holding stock.108
107. The Board proposed three changes in powers: authority to set a maximum amount of long-term debt (public and private) that a bank could hold relative to its deposits; power to set a secondary reserve of short-term securities that a bank must hold as a percentage of its deposits; and authority to increase reserve requirement ratios. The Board recognized that with excess reserves low, an increase in reserve requirement ratios would raise interest rates as banks sold assets. The Federal Reserve would acquire the securities to prevent higher rates. This is the first time I have found the Board clear on this point (Board of Governors of the Federal Reserve System, Annual Report, 1945, 8). Elsewhere the report recommended that the Treasury issue more nonmarketable debt, a recommendation the Board and Eccles made many times. The 1946 annual report repeats the same argument but omits reference to the cost of financing the debt when discussing the importance of lengthening the maturity structure of the publicly held debt (Board of Governors of the Federal Reserve System, Annual Report, 1946, 6).
108. In October the executive committee authorized the manager to engage in direct purchases and sales of United States securities with the International Monetary Fund and the World Bank. It rejected a request from the bank that the Federal Reserve stabilize the market for World Bank debt (Minutes, Executive Committee, FOMC, October 3, 1946, 10–11).
By October Sproul had become more cautious, citing a slowdown in business activity, the Treasury’s debt retirement program, aggressive bank bidding for government bonds, and a rise in short-term rates of interest (Minutes, FOMC, October 3, 1946, 17). The last was “weak medicine” against inflation, but he was reluctant to be more aggressive with the economy weakening.
Meanwhile he proposed that the System prepare for its next moves—elimination of the 0.375 percent bill rate and 0.875 percent certificate rate. Increases in these rates would increase System earnings at the same time that Treasury borrowing costs increased. Since the System held most of the 0.375 percent bills, it could offset some of the Treasury’s higher costs by restoring the franchise tax on earnings it had paid until 1933.109 At the next meeting, in December, the executive committee decided to put Sproul’s proposal into a memorandum for Secretary Snyder.
The Board considered three methods of paying interest to the Treasury: restoring the franchise tax; charging interest on Federal Reserve notes not backed by gold certificates; and eliminating charges for performing fiscal operations (Board Minutes, February 28, 1947, 38). A majority of the reserve bank presidents favored the franchise tax, provided the reserve banks maintained an adequate surplus. Eccles’s concern was that a request for legislation would raise questions about the size of Federal Reserve earnings, the size (6 percent) of dividends paid to member banks, the amount of expenses, and the issue of ownership (39). Sproul responded that the questions could be answered, but he did not persuade Eccles.
The legal staff found an alternative. Under paragraph 4 of section 16 of the act, the Board could charge the reserve banks interest on their outstanding notes. After Eccles discussed the proposal with members of the House and Senate banking committees, the Board approved the tax in April.110 The tax was supposed to provide enough revenue to transfer 90 percent of the System’s earnings to the Treasury.
Eccles and Sproul discussed the interest charge on notes with Secretary Snyder. Snyder agreed to the tax on note issues but delayed the increase in the 0.375 percent rate. Although Eccles argued that the decision about rates was the Federal Reserve’s responsibility, the System did not act until the Treasury approved (Meeting, Executive Committee, FOMC, June 5, 1947, 4). Treasury Undersecretary Albert Wiggins explained the Treasury’s hesitancy. A rise in the bill rate would cause existing certificates to fall in price.111
109. Eccles proposed an alternative—exchange the System’s 0.375 percent bills for a lower yielding bill. Sproul opposed giving the Treasury control of the rates paid to the reserve banks (Minutes, FOMC, October 3, 1946, 18).
110. Questions were raised about the Board’s authority. The section of the act provided for the tax to restrict the note issue. Counsel ruled that the authority was broader, citing a 1920 discussion by Governor W. P. G. Harding.
On April 23, 1947, the Board voted to charge interest on the difference between the average daily amount of Federal Reserve notes outstanding and the average daily amount of gold certificates held by the reserve banks. Rates were not uniform at all reserve banks. New York and San Francisco paid more than twice the interest rate at St. Louis. In aggregate, the interest payments transferred 90 percent of the earnings of the reserve banks to the Treasury, about $60 million at the time.112
It took nine months to go from first proposal to action. On July 3, 1947, the System withdrew its commitment to the 0.375 percent rate. Beginning July 10, the Treasury issued ninety-day bills at rising rates. By September the bill rate was 0.79 percent, close to the 0.875 percent yield on nine- to twelve-month Treasury certificates. The rate continued to rise, forcing reconsideration of the rate on certificates as Sproul had hoped.113 Two years after the war ended, the Federal Reserve had taken the first small steps towa
rd market-determined rates on short-term securities, but with long-term rates pegged, bill rates had not increased enough to attract banks to hold them (Meeting, Executive Committee, FOMC, August 6, 1947, 6–9).
Regulations 1946–47
Through most of 1945–46 the System could not agree to take even small steps to increase interest rates. Yet it recognized its responsibility for inflation and knew that Congress and the public would hold it accountable. Unwilling to act effectively, or pessimistic about its ability to do so, it turned to regulatory actions.114
111. One member of the Board objected to the proposed increase in rates on certificates. It would have no noticeable effect on inflation. The banks would gain, and the System would be blamed for raising interest rates paid by farmers and small businessmen (Minutes, FOMC, June 5, 1947, 7–8).
112. This amount can be compared with the $149 million paid as franchise tax from inception to 1932. Wartime inflation and the large increase in debt held by the reserve banks account for the change in order of magnitude. At the end of 1946, the reserve banks had a $440 million surplus and capital of $374 million.
113. In 1943 Congress amended the Federal Reserve Act to permit direct purchases of government securities from the Treasury up to a $5 billion maximum holding. This power expired with the War Powers Act in March 1947. Congress renewed the authority as a temporary measure, later made permanent. At about the same time, at the Board’s request, Congress repealed a section of the Emergency Banking Act of 1933 that gave the Treasury authority to regulate and prohibit banking transactions (Board Minutes, March 3, 1947, 3–6).
A History of the Federal Reserve, Volume 1 Page 93