A puzzling feature about this period is that interest rates rose very little, a repeat of the experience during and after World War I. As inflation rose from 4 percent to more than 10 percent during the second half of the year, rates on prime commercial paper rose from 1 to 1.25 percent and rates on three- to five-year Treasury securities rose from 1.25 to 1.5 percent. Although long-term interest rates rose modestly in autumn 1947, long-term Treasury bonds were at 2.36 percent at the time of Eccles’s testimony.127
One partial explanation of the puzzle is that the public did not expect inflation to persist.128 The “peg” on rates contributed to the lack of response, but despite the interest rate ceiling, money growth remained modest. For the year as a whole, the base increased less than 1 percent. The money stock rose slightly faster, 4.9 percent for the year.
The Federal Reserve recognized that using the Treasury’s surplus to retire debt from the reserve banks reduced the stock of money. Hence, despite a $2 billion increase in the gold stock, Treasury operations left the monetary base little changed for the year. As long as money growth remained low, the public was right to interpret the higher rates of inflation reported for July to September 1947 as temporary and unsustainable.
The Bretton Woods Agreement fixed the dollar to gold at $35 an ounce. At the time, many considered this arrangement a type of gold standard, involving a commitment by the United States to a fixed gold exchange rate. Although United States citizens could not buy gold from the Treasury, foreign banks could.129
126. The reply argues that an “attempt to use those [the System’s established] powers would increase sales of Government securities in the market by banks and others. If the System refused to purchase any more securities, bond prices would decline sharply. The threat of such a policy would induce a wave of selling. . . . The Reserve System would have to purchase securities in order to meet the drains on the Treasury, and new reserves would therefore be created” (Board Minutes, November 26, 1947, 22–23).
127. The Treasury sold securities from the trust accounts in May to raise long-term rates toward the ceiling. This annoyed the FOMC members because they had not been notified in advance.
128. Friedman and Schwartz (1963), suggest that the public expected postwar deflation. A related explanation is that on the margin, bondholders believed that inflation would be followed “inevitably” by deflation. Such explanations compound the problem. Why did expectations of a future deflation, at an uncertain date, overwhelm evidence of current inflation?
Further, by the fall of 1947 the United States government was committed to aiding European recovery by lending and transferring funds abroad. This limited the gold inflow at the time. With neither a budget deficit nor a large capital inflow to expand domestic money, the risk of persistent inflation may have seemed slight.
This explanation is partial. It can explain why rates on long-term securities did not reflect reported rates of inflation. It does not explain why short-term rates, adjusted for measured inflation, remained negative during and immediately after the war.
margin requirements Stock prices rose rapidly at the end of the war. Urged on by the chairman of the Securities and Exchange Commission, the Board increased stock market margin requirements to 100 percent on future purchases effective January 21, 1946. Eccles explained to President Truman that “elements were present . . . which might result in a speculative movement exceeding even 1929” (Board Minutes, January 17, 1946, 2). He believed that raising margin requirements was a poor substitute for an increase in the capital gains tax or control of bank credit. In their absence, margin requirements would have a modest effect against speculative use of credit. The peak in stock prices and trading volume came in May. In February 1947, with the Standard and Poor’s index 16 percent below its peak, the Board reduced margin requirements to 75 percent. Trading volume remained between 25 million and 30 million shares a month, and the Standard and Poor’s index continued to decline until May.
The Board’s announcement, lowering margin requirements effective February 1, 1947, recognized that the adjustment to a peacetime economy was far along. Despite many strikes, industrial production rose rapidly in the second half of 1946. Ten million demobilized veterans found jobs. Shortages of most goods had ended.
Eccles favored a further reduction of margin requirements for banks, but not for brokers and dealers. He also favored a change in the law to eliminate all broker margin accounts and to leave regulation of banks’ margin loans to the bank supervisory agencies. The Board did not propose legislation, however. The new requirements remained in effect until March 30, 1949, when the Board reduced the margin requirement to 50 percent.
129. Surprisingly, Board and FOMC minutes make no mention of the commitment under Bretton Woods or its possible effect on inflation. The slow response of interest rates to inflation occurred again in the 1950s and 1960s. This is consistent with the view that, at the time, creditors believed inflation was temporary, although there is no direct evidence.
Beginning of Restraint
The October 1947 meeting was a turning point. Although Eccles had not presented the System’s program in his testimony to Congress, the FOMC resumed discussion of higher rates. There was general agreement that the special session of Congress had created anxiety in the market. Bond yields had increased as banks reversed the way they played “the pattern of rates.” They now sold long-term securities and, at the increased rates on bills and certificates, bought short-term securities.
The directive issued at the October meeting reflected the change at the Federal Reserve. Instead of referring to particular prices or interest rates to be maintained, the directive now called for “maintenance of stable and orderly conditions in the government securities market” and for “relating the supply of funds more closely to the needs of commerce and business.” The new directive looked more to the economy and less to the Treasury market. It left open the meaning of “stable and orderly,” but by referring to the “needs of commerce,” it pointed the System back toward the 1920s and away from the years under Treasury control. And by referring to an orderly market, the FOMC tried to end its commitment to the pattern of rates. Only the commitment to the long-term rate remained.
The change was easier to state than to put into practice, but some changes were made. The Treasury agreed in November to use its surplus to retire Treasury bills held by the reserve banks instead of paying out cash to retire debt held by the commercial banks or the public.130 The Board joined with other regulators to warn lenders and borrowers that “our country is experiencing a boom of dangerous proportions” (Board Minutes, November 21, 1947, 3). Its letter urged bankers to “ exercise extreme caution in their lending policies” and to curtail loans for speculation in real estate, commodities, or securities.131 As in the 1920s, the letter did not advise banks how to identify such loans.132
The December meeting took a more effective step. It agreed that long-term yields should be allowed to rise to the 2.5 percent ceiling once the Treasury completed its January refunding. Governor Szymczak suggested letting bonds go below par, but the FOMC decided to hold bonds at or above par value until the Treasury agreed to a higher rate.
130. Between November 1 and June 30 the Treasury retired $6.8 billion, of which $4.9 billion came from reserve banks.
131. The warning was aimed especially at insurance companies to try to stop their sales of long-term bonds. Banks complained about competition from insurance companies in the loan market, claiming that they exercised restraint but insurers did not.
132. A further change brought an end to the practice of exempting Treasury war loan accounts at commercial banks from reserve requirements. The exemption was a wartime measure, taken in 1943 to increase banks’ returns from bond sales. War loan accounts served as a depository for receipts from sales of Treasury new issues. Removing the exemption in 1947 forced a small increase in required bank reserves. A secondary effect was a reduction in the contractive effect of a shift in Treasury depos
its from commercial to reserve banks.
Also in December, Eccles opened a discussion of discount rates by reporting that the Board was now ready to consider an increase in rates.133 Eccles favored 1.25 percent, above the rate on one-year certificates. Sproul favored 1.125 percent. On January 12, discount rates were set at 1.25 percent, the first change in almost six years. The 1.25 percent rate equaled the rate on securities held by banks that would mature in the next five years. Eccles wanted short-term rates at that level to encourage banks to hold short-term and sell longer-term securities.
The new program worked more quickly than expected. Banks, insurance companies, and other holders of long-term debt perceived these changes as a first step toward increased rates on long-term bonds. Bonds no longer seemed as riskless as before, so banks, insurance companies, and others sold bonds and bought bills and certificates. The Federal Reserve now faced the question, Should it allow bonds to go below par?
Its actions give the answer. Table 7.7 shows the large volume of System purchases of long-term debt, and sales of short-term debt, between October 1947 and March 1948. To support the market, the System purchased as rates fell. In addition, the Treasury bought about $1 billion for the trust accounts.
The Treasury continued to run a surplus. Instead of holding the surplus (in war loan accounts) at commercial banks, the Treasury withdrew its balances to the Federal Reserve banks, then used them to retire short-term debt as it matured. The shift in Treasury balances from commercial banks to the reserve banks reduced bank reserves, as expected at the time. The monetary base declined in the first two quarters of 1948.134
133. The issue was first discussed in July, after the increase in bill rates. The Board postponed consideration until rates on certificates rose. In October, after the Treasury accepted the 1.125 percent rate on one-year certificates, the Board considered raising discount rates to 1.25 percent. It decided to observe the response to the higher certificate rates before acting. The Board renewed discussion on December 5 and 19, but it again delayed action because of seasonal demands and to give the market time to adjust to recent changes in rates.
The principal disagreement at the FOMC meeting was about how quickly tightening should proceed. Eccles was more aggressive than Sproul. He argued that the Treasury’s cash position presented “an opportunity to exert enough pressure on the reserve position of member banks to curb to a substantial extent the volume of capital expansion that otherwise would take place, that such expansion was undesirable at the present time because of the shortage of labor and materials” (Minutes, Executive Committee, FOMC, January 20, 1948, 15). Sproul did not disagree on the desirability of reducing bank reserve growth, but he believed the committee should spread its effort over months rather than weeks. He suggested that Eccles wanted a bold program so that he could tell Congress that the System had used its existing powers and needed new authority (17).135
The difference was not resolved at the January meeting, so the FOMC’s letter to Secretary Snyder included both views, along with a recommendation to raise the certificate rate from 1.125 percent to 1.25 percent at the March refunding. The Treasury used a decline in commodity prices in February to postpone the rate change.
The decline in commodity prices concerned the FOMC also. At the February 27 meeting, Sproul interpreted the decline as a temporary correction, not the start of recession and deflation. Nevertheless he proposed a less restrictive policy than he had urged in the fall: no further reductions in the Treasury’s war loan accounts at commercial banks; receipts from taxes held in the war loan accounts; continued run-off of System bill holdings at the rate of $100 million a week; and reducing to eleven months the maturity of the 1.125 percent certificate issued in April, to signal that certificate rates would rise in June. The FOMC approved Sproul’s program. Governor Evans voted no on the recommendation to raise certificate rates. Once again he objected that the rate increase would be ineffective against inflation and would increase bank earnings. He preferred the secondary reserve plan. Eccles explained that the purpose was to flatten the yield curve so that banks and others would stop playing the pattern of rates (Minutes, FOMC, February 27, 1948, 12–13).136
134. Rouse’s memo to the FOMC estimated that the shift in Treasury balances in the first quarter would reduce bank reserves by $7.3 billion before offsets from gold inflows and other (estimated) changes (Minutes, Executive Committee, FOMC, January 20, 1948, 11). Rouse was the account manager. His report also shows the relative changes in bond prices at the end of 1947. Some long-term bonds fell as much as $4.50. These were large changes. The Treasury accepted them, unlike Secretary Morgenthau, who had treated almost any price decline as a crisis. Rouse reported that almost all the bond price decline occurred on December 24, “when the new support level was adopted” (5). Later the Treasury blamed the Federal Reserve for the disturbance in the bond market.
135. Sproul made his argument for a gradual approach in a lengthy January 13 letter to Senator Taft. The letter responded to speeches Taft made criticizing monetary policy as too expansive. He emphasized the need to avoid depression while achieving deflation. In a prelude to the position Sproul and others took during the recession that started later that year, Sproul wrote: “We are all a little enchanted, of course, with the idea of a modest downturn which would relieve some existing pressures and forestall worse disturbances later. But no one has yet found a sure way of bringing just a little depression, and I think our present program of modest restraints involving a combination of debt management and credit policy is the best course to follow in trying to achieve that objective” (Sproul to Taft, Sproul Papers, January 13, 1948, 3). Sproul’s letter may have convinced Senator Taft to choose a different target. Soon after, Taft chaired the committee that responded to the 1948 economic report. The response does not repeat the criticism. It blames inflation on the government’s “huge programs” of foreign aid, public works, and domestic assistance and criticizes Eccles’s proposals for credit controls, secondary reserve requirements, and price and wage controls (Joint Committee on the Economic Report 1948, 3–6).
For the first time, the committee agreed unanimously that it would not prevent interest rate increases even if some bonds went below par. “At the appropriate time” Eccles would advise Secretary Snyder that “the only commitment the System had made was, under existing and prospective conditions, to maintain the 2.5 percent long-term rate and not that it would support all issues of Government securities at par” (16).137
By March, holders apparently had become convinced that the System would maintain the price of long-term bonds above par. Selling slowed, and System purchases ended. During 1948, long-term Treasury yields remained between 2.41 and 2.45 percent. Although still operating under the Treasury’s strictures, for the first time since the 1930s the Federal Reserve had managed a sudden shift in market sentiment following a policy change. The Treasury had a smaller role, supporting the System’s operation by purchasing for the trust accounts.
New Leadership
Leadership at the Federal Reserve changed after the war. Emanuel A. Goldenweiser retired as research director in January 1946. Governor John K. McKee retired the following month, but he remained at the Board until his successor, James K. Vardaman Jr., arrived in April. Eccles’s former assistant, Lawrence Clayton, joined the Board in February 1947. Vice Chairman Ronald Ransom died at the end of 1947. A month later, President Truman notified Marriner Eccles that he would not reappoint him as chairman when his third term expired on February 1, 1948. The new chairman was Thomas B. McCabe. Truman offered Eccles the vice chairmanship of the Board, and Eccles accepted.138
136. Although not yet confirmed by the Senate, chairman-designate McCabe was present at the meeting.
137. Since 1944, the System had licensed a limited number of dealers in governments to trade with the System. Small dealers, who were excluded, complained that their business was hurt because the Federal Reserve had become the principal buyer in the market. They claimed th
e conditions to become a licensed dealer were too burdensome. The executive committee decided to keep the requirements unchanged (Minutes, Executive Committee, FOMC, March 1 and April 21, 1948). No major change was made for many years.
President Truman gave no reason for removing Eccles as chairman. In his memoirs, Eccles made a strong circumstantial case that Truman wanted election year support of the Giannini family that controlled Bank of America and Transamerica Corporation.139 There was ample reason for the Giannini family to want Eccles removed. The Federal Reserve had tried to obtain legislation to limit further expansion by their holding company, Transamerica Corporation.140 After years of investigation, the Board began a proceeding under the Clayton Act to prevent Transamerica from expanding further. Eccles believed he had been removed in the expectation that the investigation would end.
Transamerica may have contributed to Eccles’s dismissal, but there were other possible reasons. Eccles’s relations with the banking industry had never been friendly. Bankers and Secretary Snyder strongly opposed his call for secondary reserve requirements. Despite Snyder’s objections, Eccles testified in favor of his proposal. Moreover, he had become friendly with Republican Senators Robert A. Taft and Charles W. Tobey and critical of the administration’s budgets. He openly favored increased taxation to prevent inflation. His working relationship with Secretary Snyder was never comfortable. It probably did not help that the Board raised discount rates and allowed bond rates to rise in December and January. These changes came at the same time that President Truman’s budget message to Congress supported maintaining the pattern of rates on government bonds.141
A History of the Federal Reserve, Volume 1 Page 95