138. McCabe was the chairman of Scott Paper Company. He had served as a board member and as chairman of the Philadelphia reserve bank. The Senate approved his appointment on April 12, and he took office as chairman on April 15, 1948. He served until March 31, 1951. President Truman did not announce Eccles’s appointment as vice chairman. In April, Eccles withdrew his name in a sharply worded letter to the president (Eccles 1951, 442).
139. This summary is based on Eccles 1951, 434–56. Eccles’s personal and family interest in banking in an adjacent region are part of the circumstances of the case. Eccles’s book denies any connection, although he acknowledges that the charge was made at the time (1951, 454). On the other side, Secretary Snyder was a friend of the Gianninis, and the bank’s general counsel had been counsel to a Senate committee that Truman chaired. Eccles’s account of the events shows that he ignored several strong hints from Secretary Snyder to stop investigating Transamerica.
140. The proposed legislation was the Bank Holding Company Act of 1947. The legislation did not pass until 1956.
141. Eccles’s testimony to Senator Douglas’s subcommittee by letter in December 1949 suggests that relations between the Federal Reserve and the Treasury had deteriorated. Almost every meeting of the FOMC advised the Treasury on debt management policy, but the suggestions were not often taken. Eccles recognized that the Federal Reserve had lost its independence: “It can hardly be said that the Federal Reserve System retains any effective influence in its own right over the supply of money in the country” (Eccles 1951, 460). Eccles offered three alternatives. The first continued prevailing arrangements. Credit and monetary restraint would depend on the Treasury’s willingness to accept higher interest rates. The second expanded the Board’s power over reserve requirements for all banks; he included secondary reserve requirements as one option. The third proposal restored independence. The Treasury would be required to consult with the Federal Reserve about debt management policy and interest rates. Eccles warned the subcommittee that interest rates would rise (Eccles 1951, 461–62).
Although his term as chairman ended on February 1, Eccles continued as chairman pro tem until McCabe took office on April 15. He continued to take an active role in System policy and later played an important role in removing the ceiling rate on long-term bonds. He left the Board in July 1951.
A Deflationary Interlude
The inflation rate slowed at the start of 1948. By year end prices were falling. Quarterly average values of the consumer price index show several quarters of deflation beginning in fourth quarter 1948. Inflation did not return until the start of the Korean War in June 1950.
At first prices fell rapidly. Early in 1950 the decline slowed. At the end of the deflation interlude, the consumer price index had returned to the level reached in first quarter 1948. Table 7.8 shows these data.
Both Treasury and Federal Reserve actions contributed to the deflation. The Treasury continued to use its surplus to retire debt from the reserve banks and to purchase debt for the trust accounts. This policy reduced the public’s holding of government debt without increasing the monetary base.
Falling output soon followed falling prices. The National Bureau of Economic Research puts the economy’s cyclical peak in November 1948 and the trough eleven months later, in October 1949. Industrial production (1992 = 100) fell about 9 percent from peak to trough. The unemployment rate reached a peak of 7.9 percent.
With the interest rate peg in effect, the Federal Reserve could not prevent inflation, but it was entirely capable of stopping deflation. The monetary base shows no sign of expansionary actions. Interest rates rose modestly as the monetary base declined. The rate on four- to six-month commercial paper, representative of short-term rates, increased by 0.5 percent in the year before the recession. It remained unchanged (at 1.56 percent) through July 1949, eight months after the cyclical peak.
As in 1921 and 1938, deflation had two positive effects. First the gold inflow increased. Between fourth quarter 1947 and the peak in Federal Reserve gold holdings—third quarter 1949—the gold stock rose 9.5 percent, slowing the decline in the nominal stock of base money.142 Second, falling prices raised the real value of the monetary base, creating an excess supply of real balances and a demand for goods and services.
changes in reserve requirements Early in 1948 the Board again considered an increase in a reserve requirement ratio to slow loan growth. At the time, reserve requirement ratios for reserve city and country banks were at their maximum values, 20 percent and 14 percent, respectively, but central reserve city banks, at 20 percent, were below their 26 percent maximum. The Board voted unanimously to raise reserve requirements at central reserve city banks to 22 percent, effective February 27.
The Board’s staff estimated that the change would absorb $530 million of reserves at New York and Chicago banks. This is an overstatement based on faulty analysis. The true estimate of the effect is approximately zero.143 Banks sold government securities to acquire additional reserves and slightly increased borrowing. The main effect was a transfer of income (on government securities) from commercial banks to the reserve banks.
142. Earlier, the Board sent a letter to all reserve bank presidents requesting them to notify banks that they should discourage individuals and businesses from buying gold at premium prices. The letter was a response to rumors that the dollar would be revalued against gold (Board Minutes, July 22, 1947, 10).
143. The qualification allows for a secondary effect on the profitability of loan demand. Central reserve city banks had to hold higher reserves against the deposits created when making new loans. With interest rates unchanged, loans were less profitable. Market interest rates remained unchanged.
Since the Board had voted before the Federal Advisory Council met, the council did not oppose the February 27 increase. The members expressed concern, however, about the recent decline in commodity prices and the possibility of a recession. They wanted a halt to restrictive policy, maintenance of the 2.5 percent rate, no further increases in discount rates or reserve requirement ratios at central reserve city banks, and no additional powers for the Federal Reserve. The council thought “it would be a good thing if the situation could develop into a mild recession, but . . . the members of the Council felt that it might develop into a very severe recession if not into a depression” (Board Minutes, February 17, 1948, 9). Chairman Eccles agreed that “a recession at this time would be in the best interests of the country and that the longer such a development was delayed the greater would be the downward adjustment that eventually would have to come” (10).144
The Board was eager to get the council to agree on a joint program to send to Congress, as in 1940. The bankers were reluctant, so their emphasis on the possibility of a deep recession may have been an expression of dissent.145 Eccles argued that whether inflation continued or ended in recession, the Board and the commercial banks would be blamed for what happened. They had a common interest. He agreed that discount rates could not be raised, but his reason was not concern about recession. First the Treasury had to increase the coupon on the one-year certificate to 1.25 percent. That would not be done in current circumstances. Council chairman Edward E. Brown responded that banks were so “jittery” that a change to 1.25 percent might cause additional selling of government securities.
The next three years are a unique period in the use of reserve requirements as a policy instrument. The System made nineteen changes, up and down, in these ratios. Many were small. Table 7.9 shows the level of reserve requirements on February 1, 1948, and the adjustments in the next three years. The last column shows the weighted average, or effective, ratio. This ratio changed very little from year to year. The largest change, in 1950, resulted from a shift in deposits from demand to time accounts.
After the changes in reserve requirement ratios, banks increased their use of the discount window to adjust reserves. Discounting had started to revive during the war but remained below $100 million, on a sustained
basis, until August 1944. After 1946, discounts remained between $100 million and $300 million. Discounts typically increased after an increase in reserve requirement ratios, reviving the adjustment pattern that Strong, Riefler, and Burgess had observed in the 1920s.
144. The language shows how little had changed since the early 1930s. Recessions were still seen as the “inevitable consequence” of prior inflation. Although the Employment Act was now law, the Federal Reserve had not changed its analysis.
145. Although interest rate remained low, the bankers no longer complained about easy money as they did in 1940.
After February 1948, the Board and the FOMC discussed additional increases in reserve requirement ratios at New York and Chicago. Governor Evans was often the leading proponent. Eccles remained cautious, despite strong output growth and continued inflation early in 1948. The Board and the FOMC repeatedly urged the Treasury to increase the certificate rate to 1.25 percent, so they could raise the discount rate, but the Treasury ignored or rejected the advice and the rate stayed at 1.125 percent throughout the spring and summer.146
146. An example of the Treasury’s argument against raising the certificate rate from 1.125 percent to 1.25 percent is that “the Secretary [Snyder] felt that if the rate were raised at this time it would not be as effective as at some future time when, if inflationary pressures were increased, the rate could well be raised” (Minutes, Executive Committee, FOMC, May 20, 1948, 2). Snyder explained that the actual decision to reject the System’s advice was made after discussions with “bankers from various parts of the country.” A majority had told him to make no change (11).
The System remained divided over whether future inflation or deflation posed the greater risk. After the Treasury rejected its suggestion of a 1.25 percent certificate rate for the July refunding, Sproul and Szymczak looked to the September refunding. Eccles urged the committee not to act without Treasury agreement, but it ignored him and voted to permit an increase in short-term rates before the September refunding if inflation increased during the summer. It wanted to force the Treasury to raise the rate to 1.25 percent. This was a significant change, since the committee had earlier declined to increase rates until the Treasury agreed.
Spending for foreign aid began to rise, beginning with the Greek-Turkish aid bill in 1947 and the Marshall Plan in 1948. Looking forward, the members worried that the budget surplus would decline and with it debt retirement (see table 7.8 above). Effective action against inflation would end.147 At the meeting of the Federal Advisory Council in April, the Board recalled the 1940 proposal to Congress, sponsored jointly by the council and the System, calling for a statutory increase in maximum reserve requirement ratios for all banks. The council was reluctant to increase banks’ costs. It noted that there were both inflationary and deflationary tendencies at work, so it preferred to wait until the future became clearer. It urged the System to use existing powers by raising the discount rate or reserve requirements at central reserve city banks.148
Several bankers spoke against the proposal to increase maximum reserve requirements. Their principal arguments were that a request to Congress for higher reserve requirement ratios would at once induce banks to shift assets from long- to short-term securities. If the proposal was adopted, banks would have more difficulty raising capital and would take more risk to compensate for lower earnings. Membership in the System would be discouraged, particularly if the higher reserve requirements applied to all banks, as the Board wished. They were particularly opposed to Eccles’s recent testimony calling for higher cash reserve requirement ratios and a secondary securities reserve.149
147. For fiscal years ending June 1947, 1948, 1949, and 1950, spending for national security and international affairs was (in billions): $20.9, $16.3, $19, $17.7.
148. The council showed signs of changing beliefs about the effectiveness of monetary policy: “Relatively slight changes in open market policy . . . can greatly influence bank operations, the security markets and business” (Board Minutes, April 27, 1948, 7).
149. Eccles had testified at a congressional hearing on April 13; he reported on the progress made against inflation but warned that the money supply was “excessive” and that proposed tax reduction would add $5 billion to purchasing power and reduce future budget surpluses and debt reduction. Increased military spending added a new large source of inflation both directly and through its effects on private sector attitudes. A shift from budgetary surplus to “deficit . . . would eliminate the only remaining important anti-inflationary influence” (Board Minutes, April 2, 1948, 18, with transcript of Eccles’s April 13 testimony). He asked again for new powers to increase reserve requirements at all commercial banks and secondary reserve requirements. He described the latter as “essential” in the event of larger deficits (20). None of his forecasts were correct.
Chairman McCabe asked the bankers what they would do if inflation rose. They responded that, unlike the Board, they did not expect that to happen. However, they favored maintaining the 2.5 percent ceiling rate, partly out of concern that a fall in government security prices would lower bank capital (Board Minutes, April 27, 1948, 19).
The Board continued to prepare for an increase in the reserve requirement ratio at central reserve city banks. The main issue had become not whether the change should be made but when. A principal consideration was to find a time when the change would have greatest effect on inflationary psychology, but there was concern also to use existing powers. Congress had again rejected the request for additional powers, and one of the reasons given was that Board had not used its existing powers fully.
On June 1, 1948, the Board voted to increase to 24 percent the reserve requirement ratio at central reserve city banks, effective June 11. McCabe was absent, and Szymczak opposed the timing of the increase. He argued that New York and Chicago banks had no excess reserves, so the increase would simply shift $500 million of government securities from banks to the reserve banks. McCabe wrote a letter that was read at the meeting urging the Board to delay the change for a month. He believed the change would be more effective if accompanied by a rise in the certificate rate (Board Minutes, June 1, 1948, 5–6).150
To prepare for the 1948 election and give the appearance of decisive action, President Truman called a special session of Congress in August. He asked for price controls, rationing, rent control, an excess profits tax, repeal of the Taft-Hartley Act, and regulation of commodity markets. He also asked Congress to increase spending on Social Security and education, more government aid for housing, and increases in the minimum wage and farm price supports. The aim was to return to the wartime control program while redistributing income toward traditional Democratic constituencies. The Federal Reserve asked for renewed controls on consumer credit and higher statutory maximum reserve requirement ratios as part of the program.
150. Like Szymczak, McCabe argued that the banks would sell securities to the Federal Reserve, so there would be no effect on lending or inflation. This was a correct forecast, of course; in the two weeks following the effective date, New York and Chicago banks sold securities. Interest rates remained unchanged, and the monetary base (adjusted for the change in reserve requirements) continued to fall at about a 1 to 2 percent annual rate. The action was criticized in the press as an attempt by Eccles to push through an increase against the Treasury’s wishes while McCabe was absent.
Congress rejected most of the program, but by joint resolution it approved renewal of consumer credit controls until June 30, 1949, and an increase in maximum reserve requirement ratios for member banks. In September the Board set minimum down payments of 33.33 percent for automobiles and 20 percent for other durables.
The president’s proposals suggest the haphazard way the administration thought about the substance of economic policy. Proposals for higher wages accompanied a proposal for price control, and encouragement of home building accompanied controls to discourage purchases of household durables and furniture. The increased mortg
age credit, if approved, would have substituted for consumer credit.151
On August 2 Chairman McCabe and Governor Evans testified on parts of the president’s proposal. McCabe repeated the familiar arguments supporting legislation authorizing higher reserve requirement ratios. He referred several times to the problem of controlling inflation while maintaining the 2.5 percent rate, but he insisted that it should be maintained “to insure orderly conditions in that market, not primarily because of an implied commitment to wartime investors that their savings would be protected, nor to aid the Treasury in refunding maturing debt, but because of the widespread repercussions that would ensue. . . if the vast holdings of public debt were felt to be of unstable value” (House Committee on Banking and Currency 1948, 89).152 McCabe urged that the Board’s powers be extended to include nonmember banks, but he offered no evidence of relative expansion by nonmember banks and gave more attention to increased lending at insurance companies than at banks.153
Several times, members of Congress asked McCabe whether long-term rates had to rise for effective control of inflation. The Board had discussed the possibility that this question would arise at its July 30 meeting, but it did not reach a conclusion. McCabe did not want to confront the Treasury and tried to avoid the issue by saying that “it was vitally necessary to support the 21/2 percent bonds” (ibid., 101).154
A History of the Federal Reserve, Volume 1 Page 96