By August the Board was ready to reduce reserve requirement ratios by two percentage points on demand deposits in a series of steps (Board Minutes, August 4, 1949, 10). The following day the FOMC agreed to absorb the reserves released by the Board’s action so as to hold bill and certificate rates within their current ranges. Although discount rates were now above market rates on Treasury bills and certificates, McCabe proposed postponing any rate reduction. Discussion of a discount rate reduction continued throughout the fall, but discount rates remained unchanged.174
Several FOMC members asked the reasons for the August reduction in reserve requirement ratios. The Board did not give a credit or monetary reason. The reasons given were that the System wanted to make clear that it was no longer concentrating its efforts on controlling inflation; that requirements could be raised later, if needed; and that increased ownership of government securities would increase bank earnings.175
The August 5 meeting raised issues that would not be resolved for a decade. New York pressed for flexibility in the range of short-term rates and authority to purchase and sell at all maturities. It claimed that it was difficult to forecast how much of any increase in reserves would be held as excess reserves, so the account manager needed to respond to the market. As usual during discussions in this period, Robert Rouse, manager of the System Open Market Account, Woodlief Thomas, the Board’s chief economist, and Winfield Riefler, adviser to the chairman, took an active role not limited to staff or operating duties. Sproul’s was the dominant voice, Eccles’s a close second. McCabe remained relatively passive, looking for compromise and unwilling to challenge the Treasury. Most of the bank presidents were recorded infrequently or not at all.
Rouse suggested a further reduction in reserve requirements so that they could be raised later if inflation developed. The committee members rejected this proposal, recognizing at last that they could act through open market purchases (or sales) if they were willing to let market rates change. For the first time, there was general recognition that the System could not control the size of excess reserves while maintaining a fixed level of interest rates. It gave up using excess reserves as a target. Instead, it set a target for Treasury bill rates at 0.94 to 1.06, about the prevailing range.
174. The New York directors voted to reduce the discount rate to 1.25 percent, effective September 19. At first the Board postponed action pending discussion with the Federal Advisory Council (Board Minutes, September 16, 1949, 8). One reason for hesitation was signs of recovery, but the Board also cited the British devaluation that week. The Federal Advisory Council opposed the reduction, as did several presidents (Minutes, FOMC, September 21, 1949, 6–7). They preferred to keep the discount rate as a penalty rate (Board Minutes, September 20, 1949, 2–3). New York tried again in October, but the Board refused again. Governor Eccles cited the explosion of a Russian atomic bomb as a reason for opposing the reduction. The Russian action would cause United States defense spending to increase, with inflationary consequences.
175. Chairman McCabe read a letter from Leslie Rounds of the New York reserve bank citing the low prices of bank stocks in relation to book values (Minutes, FOMC, August 5, 1949, 7).
end of the recession The National Bureau of Economic Research dates the end of the recession in October. Industrial production increased at a 12 percent annual rate in August and again in September. October’s decline reflected strikes in that month. In November and December production rose at a 25 percent annual rate, and third quarter GNP rose 2.5 percent.
The FOMC executive committee recognized the turn in November. Renewed fears of inflation replaced concerns about recession and deflation. Using a phrase that recurred many times in the next fifty years, the minutes referred to “the largest peacetime deficits in the history of the United States at a time of very high levels [sic] of production and employment” (Minutes, Executive Committee, FOMC, November 18, 1949, 2). The members agreed that interest rates should rise and now asserted more forcefully that the flexible policy adopted the previous June allowed rates to change up as well as down. The committee unanimously approved an increase in bill rates by 0.07, a range for bills from 1.00 to 1.14 percent and for certificates 1.10 to 1.16 percent.
The minutes show that the Treasury would not agree to flexible rates. It wanted to sell certificates at 1.125 percent. Since the System was unwilling to challenge the Treasury in the marketplace, it could only petition and advise but was not free to act.
Much of the committee’s discussion in this period concerned advice on Treasury debt management. Sproul and McCabe continued to meet with Snyder, or to petition him by mail, seeking higher rates at Treasury re-fundings. Occasionally the advice was accepted; most often it was not.
The System did not limit its advice to rates for new issues and refundings.176 It expressed concern about the decline in the maturity of the debt, a reflection both of the passage of time and of Treasury policy. The rate structure did not permit the Treasury to sell longer maturities. As notes and bonds matured, the Treasury substituted bills and certificates. Five years after the war, Treasury notes had declined from a peak of $20 billion to less than $4 billion. The stock of bonds outstanding also continued to fall as bonds matured. There were no new bond issues until 1952, after the interest rate peg was removed.
176. The System also responded to requests from the president for legislative proposals and for statements to be included in the January 1950 Economic Report. The principal legislation sought at the time was regulation of bank holding companies. It asked also for renewal of authority to purchase a limited volume of securities directly from the Treasury, authority over nonmember banks, and modification of limits on the cost of new Federal Reserve buildings.
why did the recession end? The Federal Reserve was slow to respond to deflation and recession but quick to dampen recovery. Until June, seven months after the recession started, the System did little, none of it effective. Yet it raised rates in November, one month into the recovery. This behavior raises two questions. Why was policy action, and the recognition of a need for action, asymmetric? Did policy actions contribute to recovery?
The minutes suggest some answers. Many policymakers believed the economy would expand because of pent-up wartime domestic and foreign demand. Also, the System had struggled to raise interest rates and was reluctant to give up some of its “progress” toward higher rates and a flatter term structure. It acted only after Secretary Snyder accepted greater flexibility in principle, with some concern about whether the Treasury would permit flexibility both ways. This was a legitimate concern, given the Board’s experience, and it soon proved to be correct. Further, Eccles and other Board members remained skeptical about the effectiveness of monetary policy. This view was widely held by officials and economists within the System and outside.
At another level was the belief that had done much harm in the Great Depression—failure to distinguish between nominal and real rates. With market rates from 1 to 2.5 percent, officials thought monetary policy was easy. John H. Williams offered a classic restatement of this view: “The System had not had a tight money policy. . . any effort to ease money conditions to counter the recession would be starting from an already easy situation, and he felt that the System was likely to be frozen into a low-interest rate situation about which it might not be able to do anything” (Minutes, FOMC, May 3, 1949, 4).
Prices were falling at the time, so real interest rates rose. The rise increased the cost of investing in new capital relative to the cost of buying existing assets and increased the return to holding money. But falling prices raised the real value of money balances and the excess supply of money.
Chart 7.5 compares the change in real base money to the ex post real rate of interest on long-term bonds. Both series reflect the common influence of falling prices, hence they are roughly parallel in the months preceding the 1948–49 recession and during the recession.177
177. Inflation in chart 7.5 is based on the deflator from B
alke and Gordon 1986. The interest rate is the yield on long-term Treasury bonds with ten years or more to maturity.
The chart suggests that monetary policy in 1948–49 is qualitatively similar to that in 1920–21. Both recessions followed an inflation that drove down the real interest rate and the real value of the monetary base. The real value of the monetary base reached a trough two months before the 1948–49 recession started, and it turned positive in April, six months before the recession’s trough. Industrial production started to rise in July, three months later. As in 1920–21 and 1937–38, but to a lesser extent, gold inflows under a fixed exchange rate contributed to the increase in real balances.
Real interest rates give a very different picture of events. Ex post real rates were lowest before the recession and highest before the recovery. The fall in real rates did not prevent the recession, and the rise did not prevent recovery. As in 1920–21 and 1937–38, the effects of real rates on economic activity appear to have been dominated by the response to rising real balances.
Two of the deflationary recessions, 1937–38 and 1948–49, provide evidence on the frequently stated proposition that monetary action becomes ineffective at low nominal interest rates. The data suggest that nominal interest rates near zero did not make monetary policy ineffective or irrelevant. Between November 1948 and July 1949, the rate on new issues of Treasury bills remained between 1.13 and 1.16 percent. In July the rate fell to about 1.05 percent, where it remained for most of the summer and fall. Changes in the rate of deflation dominated the small changes in the growth of the base and the level of nominal rates.
The deflationary recessions provide evidence, also, on the process by which monetary policy affects output. The fall in market prices raised the public’s stock of real balances above the desired amount, just as if the Federal Reserve had increased base money at a constant price level. The public used its excess real balances to purchase assets, goods, and services. These purchases stimulated production directly and by changing asset prices relative to the prices of new production, thereby increasing the demand for new production. The rise in real interest rates worked in the opposite direction, but it was less powerful.
RECOVERY, EXPANSION, AND INFLATION
Industrial production passed its prerecession peak in April 1950. Consumer prices started to rise but remained near 1948 levels. The Federal Reserve took no action. Throughout the winter and spring of 1950, FOMC meetings considered, in detail, whether the Treasury should sell tap issues on demand, long-term nonmarketable debt, or bank eligible debt. The committee again offered advice on Treasury refundings and new debt issues. Typically the advice called for a slight increase in rates with the hope that the System could follow by raising its buying and selling rates for bills and certificates. The opposite was also true. Unless the Treasury was willing to increase its offering rate, the System could not raise open market rates. If it pushed the market rate above the offering rate, it expected large open market sales by private holders, who were expected to sell outstanding debt and buy new issues.178
The System remained unwilling to confront the Treasury publicly and was frustrated by its failure. As long as Secretary Snyder insisted on a 1.125 percent offering rate for new issues or refundings, the System had to either insist on independence or remain subservient. Fearing the consequences of the first course, it remained with the second.
The government budget heightened the members’ concerns. After three (fiscal) years of surplus, in the 1950 fiscal year the budget had a deficit. Instead of net debt reductions, the Treasury sold more than $3 billion of new issues. Defense spending and foreign aid rose. There seemed to be no prospect of soon again using a budget surplus to reduce the monetary base.
The Treasury permitted very modest increases in short-term rates in February and May and a larger increase in June, without any negative market reaction. The long-term rate remained between 2.38 and 2.43 for the entire period, and the stock market index rose 13 percent between December and June as recovery gained momentum.179
178. In March 1950 the FOMC authorized reserve banks to enter into repurchase agreements with nonbank government securities dealers to provide reserves temporarily. These were the first such operations since the 1920s.
179. Real GNP rose at an annualized 15 percent rate in the first half of 1950 (Balke and Gordon 1986).
Table 7.11 shows the interest rates set at each meeting between December and June. In June the staff suggested that the economy showed signs of an unsustainable boom. Real estate and commodity prices had increased. Reported rates of inflation were 5 percent or higher in May and June.
The return of expansion and inflation turned attention back to monetary policy. At the May 3 meeting of the executive committee, Sproul proposed to confront the Treasury. Referring to the June 1949 decision to permit flexibility, he “saw no reason why the System should, and every reason why it should not, make statements about support or non-support of the Government securities market at par or any other price” (Minutes, Executive Committee, FOMC, May 3, 1950, 5). In June he continued to press for a firmer policy, including an increase in certificate rates to 1.25 percent followed by an increase in discount rates, as “a signal to the whole financial community and to the public that there has been a change in our policy in the light of the changed business and credit situation” (Minutes, FOMC, June 13, 1950, 4).180 He wanted to continue selling long-term bonds from the System account and, if the problem arose, to let these bonds go below par.
Eccles gave Sproul limited support. He continued to urge new issues of long-term nonmarketable bonds. Although he favored an increase in bill and certificate rates, he opposed an increase in discount rates and was not yet ready to allow long-term bonds to go below par value. The FOMC remained unwilling to confront the Treasury over long-term rates. It agreed to let the long-term rate rise until long-term bonds were at 100.75 and to have the executive committee meet again if that happened. The committee, however, increased short-term rates in two steps, immediately to a maximum of 1.24 percent, and after the Treasury refunding to 1.36 percent, consistent with a 1.375 percent certificate rate.
180. Sproul went on to assert that there was no difference between the effect of selling marketable and nonmarketable bonds. This is the first clear rejection of the view held by Eccles and others that it was less inflationary to sell nonmarketable issues.
The Treasury did not accept the System’s advice or accede to its threat to raise rates. It continued to issue Treasury bills at 1.15 percent and certificates at 1.25 percent. Open market rates on bills remained unchanged and were only 0.05 percent higher on certificates, at the lower end of the System’s support range.
The issue remained unresolved when the Treasury came to market. Snyder refused to raise offering rates. The System was unwilling to allow the new issues to fail, so it purchased heavily, offsetting part of the purchases with sales of bills. For the month of June, System holdings in the one- to five-year range rose nearly $2 billion, and total holdings of governments rose $942 million (5.4 percent). In the market, certificate rates rose by 0.05 percent to 1.23 percent in the week ending June 3. System purchases kept rates at this level through the refunding and beyond. The first skirmish with the Treasury ended with the System supporting the rates set by the Treasury.
Reform of Reserve Requirements
In the months before the start of the Korean War, both the Board and Congress again considered eliminating geographical location as the basis for reserve requirements. Classification into reserve city and country classes caused repeated problems. Not all banks in reserve cities held correspondent deposits of country banks, and some large country banks served as correspondents. The Board exempted from reserve city status banks on the periphery of a reserve city that did not hold correspondent balances, but it recognized that this was not entirely satisfactory.
After discussions with interested groups, the Board proposed the system based on type of deposit it first developed in the 1930s.
Reserve requirement ratios would be 26 percent for interbank deposits, 15 percent for demand deposits, and 4 percent for time deposits. The requirements would apply to all commercial banks, not just members. The proposal did not attract support from bankers. Country banks would face increases, so they were strongly opposed. Banks that held a large volume of interbank deposits also opposed. Reserve city banks would have lower requirements for demand deposits, but they did not trust the Board to administer the requirements objectively: “The Federal Reserve System would go to almost any end to get banks to join the System and in so doing would take steps that would injure the business of the correspondent banks” (Board Minutes, October 3, 1950, 4). Bankers told the Board that to get banks to accept the proposed changes, it would have to reduce reserve requirement ratios. With concern about inflation rising, the Board was unwilling to consider anything that would increase the credit multiplier. The proposal remained on the System agenda but was never implemented.181
The Korean War
The Korean War began on June 26, 1950. The almost immediate economic response was a surge in domestic demand and prices. The economy was recovering rapidly, with real incomes rising. Memories of wartime shortages of durable goods remained strong. Also, war periods in the United States had always been financed by deficit spending and money growth. The public anticipated a repetition. When it did not occur and money growth did not rise, inflation concerns vanished. In the first two quarters of 1950, real GNP rose at a 14.9 percent annual rate. Third quarter GNP increased slightly faster, and consumer prices accelerated from a 4.5 percent rate of increase in the second quarter to 10 percent in the third.
A History of the Federal Reserve, Volume 1 Page 99