The subcommittee’s report was a victory for the Federal Reserve. The subcommittee opposed subordination of monetary policy to debt management. It supported Sproul’s and Burgess’s view that monetary policy could be used flexibly, with fiscal and other policies, to achieve the goals of the Employment Act. New powers were not necessary if existing powers were used flexibly. (Subcommittee on Monetary, Credit, and Fiscal Policies, 1950a).196
194. “Since the war the buying power of those bonds has been reduced very substantially (Subcommittee on Monetary, Credit and Fiscal Policies 1950a 181). “Let’s not get our attention focused solely on the dollar price of things. Let’s think in terms of the buying power” (184).
195. Burgess had served as account manager, so he could describe how the System could permit small changes in interest rates. He favored “orderly markets” operated according to the judgment of the manager and the FOMC.
196. The subcommittee recommended a new coordinating body in the federal government consisting of heads of four agencies, the Treasury, Federal Reserve, Budget, and Council of Economic Advisers. The group would discuss issues of common interest. The Kennedy administration tried a council of this kind, called the Quadriad, but it did not last.
Policy Actions before the Accord
Conflict over refunding rates on certificates at the end of June was a main topic at the FOMC executive committee meeting on July 10. The Federal Reserve had voted to raise rates, without Treasury concurrence. Snyder called the System’s bluff. By refusing to raise rates on the new issue, he had forced it either to let the issue fail or to hold the rate by purchasing enough to clear the market. Snyder blamed the large purchases by the Federal Reserve on leaks to the press about differences between the Federal Reserve and the Treasury. The Federal Reserve regarded the differences as real and known to market watchers. The issue for the members was whether to stay with the June policy decision to discontinue purchases of short-term securities until rates reached 1.375 percent.
The July meeting was the first meeting after the start of war in Korea. The members viewed the war and increased military spending as an additional inflationary threat. Yet they decided to take no action to increase interest rates and resolved only to draft another letter to Secretary Snyder explaining the problems they faced and asking again for a tap issue of long-term bonds, ineligible for bank purchase.197 They believed a tap issue would absorb saving, thereby satisfying part of the market demand for long-term issues. The letter explained that, as in World War II, banks were “playing the pattern of rates,” selling short-term and buying long-term securities. To keep long-term rates from falling further, the System sold long-term debt. It also purchased short-term debt to prevent yields from rising. Since the Treasury would not raise its offering rates, the System felt unable to let market rates rise.198 A long-term Treasury bond would absorb market demand, reducing the Federal Reserve’s need to sell long term bonds and buy short term. This would firm short-term rates, a System objective that the Treasury did not share.
Snyder’s reply again emphasized the need for stable market rates as the first priority. Although he did not mention the proposed tap issue, he opposed “experimentation” and emphasized the importance of leaving short-term rates unchanged.199 After canvassing the opinions of all the presidents, the executive committee renewed its request for a tap issue (Minutes, Executive Committee, FOMC, July 21, 1950). It also postponed a decision on the New York bank’s request to increase the discount rate to 1.75 percent pending discussion with the Treasury.200
197. A tap issue permits buyers to purchase from the Treasury on demand. The main reason Sproul gave for not raising short-term rates was that it might generate uncertainty, leading to further consumer buying and inventory building.
198. The only other action at the meeting was to propose reimposition of consumer credit controls.
199. Snyder explained later that in view of the uncertainties about war finance and the unprecedented size of the debt at the outbreak of the war, he wanted the Federal Reserve to maintain rates unchanged. He pointed out that far from monetizing debt and acting as an inflationary force, the Federal Reserve had reduced its portfolio by $4.5 billion in 1949 and continued the reduction in the first half of 1950 (Subcommittee on General Credit Control and Debt Management 1951, 66).
On August 18 the Board approved discount rate increases at New York and Boston, the first changes in two years. Within the week, all other reserve banks raised their discount rates to 1.75 percent. In announcing the increase, a joint statement of the FOMC and the Board declared that they were willing “to use all the means at their command to restrain further expansion of bank credit consistent with the policy of maintaining orderly conditions in the Government securities market” (Board Minutes, August 18, 1950, 3–4). The FOMC met on the same day. It supported the decision by voting to let short-term market rates rise to 1.375 percent immediately.
Before announcing the rate increases, McCabe and Sproul met with Snyder and his staff. Instead of asking the Treasury to agree, McCabe and Sproul told Snyder of their concerns about the growth of credit and inflation and their decision to raise short-term rates. They promised to maintain orderly markets. Snyder made no comment. “Chairman McCabe asked him if he was in accord with what we had done. The Secretary said we had told him what we had done and there was nothing he could say.” McCabe promised to read the announcement to Snyder when he returned to the Board (Sproul Papers, Meetings with Secretary Snyder, August 18, 1950).
The meeting was brief. “A few minutes after our return, a call came through from Secretary Snyder. He told Chairman McCabe that he was announcing his September–October financing immediately, and that he was offering the market a 13-month 13/4 percent note. . . . Chairman McCabe said that the announcement . . . would be in direct conflict with our announcement, that it would create confusion, and that it ran counter to any ideas of restraining inflation by credit measures” (ibid., 3). McCabe then called the president to read the announcement of the rate increase and to inform him of the conflict with the Treasury announcement.
200. The New York directors had discussed an increase in the discount rate on July 6, but they postponed action, at Sproul’s urging, until they had more information about the cost of the Korean War. On July 20, with Sproul absent, they voted for a 0.25 percent increase in the rate (Minutes, New York Directors, July 6 and 20, 1950). The letter from the New York directors also urged the Board to increase short-term market rates, get the Treasury to issue a long-term bond, and control consumer and real estate credit. The New York directors renewed their request on July 27. Again the Board deferred action pending discussion with the Treasury (Board Minutes, July 28, 1950, 2–3). The following week the Board approved a statement to all banks, issued jointly with federal and state banking regulators. The statement asked banks “to decline to make loans . . . used for speculative purposes” (Board Minutes, August 3, 1950, 7). The real bills tradition continued.
Neither side retreated. The System again faced a choice of supporting the Treasury issue or letting it fail. Sproul later explained that “failure” meant that the Federal Reserve had to buy most of the maturing short-term issue, $8 billion of the $13 billion refunded. To offset the purchase, the System sold $7 billion of other securities, absorbing the difference in interest rates as a portfolio loss.201 Sproul affirmed that the Treasury had been informed about the increase in the discount rate before making its announcement (Subcommittee on General Credit Control and Debt Management 1951, 518–19). Table 7.12 shows the large swings in bill and certificate holdings one year and under, and in one- to five-year maturities, between August and November.
Total system holdings increased $3.9 billion, approximately 22 percent in seven months. Gold losses offset about half of the increase; an increase in reserve requirements in December offset the other half. The net effect was a 3.2 percent ($620 million) annual rate of increase in the monetary base for the seven-month period ending in February 1951.20
2
Minutes of the August 18 FOMC meeting show the heightened antagonism that marked the Federal Reserve–Treasury relationship during this period. The Federal Reserve continued to urge the Treasury to issue a long-term, nonbank 2.5 percent tap issue. The Treasury continued to refuse, claiming there was not enough demand. The System challenged the Treasury’s data with its own estimates of demand, but it could not get Treasury staff to discuss the differences. Phrases like “the bitter experience of recent years,” “unwillingness of the Treasury to sop up nonbank funds,” or “spirited discussion” leading to “an impasse” appear in letters to the Treasury and in the discussion at FOMC meetings (Minutes, FOMC, August 18, 1950, 4–6). Secretary Snyder continued to talk about stable rates; System representatives referred to stable markets.203
201. Private holders exchanged less than 6 percent of the maturing issue; $2.25 billion was redeemed in cash, the largest change of that kind experienced to that time.
202. The $620 million increase includes all transactions affecting the base. Data on the base are from the Anderson-Rasche series (St. Louis Federal Reserve bank), so they are adjusted for the change in reserve requirement ratios in January 1951.
The FOMC held four more meetings between August and December, and the executive committee met separately twice during this period. Nothing changed. The System recommended a long-term tap issue, pressed for higher rates at refundings, and discussed its inability to persuade Secretary Snyder or his aides.
The Federal Reserve had support from members of Congress and from the Federal Advisory Council. When voting on the Defense Production Act in August, Senators Paul Douglas (Illinois), J. William Fulbright (Arkansas), and Ralph E. Flanders (Vermont) urged the Treasury and the Federal Reserve to reduce credit expansion. The Federal Advisory Council urged the Board to press its case with the Treasury, to seek Treasury cooperation but, if that failed, to take its case to the president. As a last resort, the members should resign if they felt the issues were of sufficient importance (Board Minutes, September 13, 1950, 4–7). In November, Edward E. Brown, chairman of the Federal Advisory Council, suggested letting the 2.5 percent bond go below par value (Board Minutes, November 21, 1950, 15). Eccles objected.
McCabe continued to seek a compromise with the Treasury. He urged caution, and he continued to consult Snyder before taking any action. Sproul seems to have decided that the Treasury would not agree to any rate increases. He told his colleagues in September, “We ought to proceed immediately with open market operations that would permit the short-term rate to rise” (Minutes, Executive Committee, FOMC, September 27, 1950, 3). He proposed a one-year rate of 1.75 percent, an increase of almost 0.5 percent. When McCabe and Sproul again made their case to Snyder, Snyder urged delay. The only suggestion he offered was voluntary credit restraint.204
203. On August 10, McCabe told Snyder that the System had purchased $400 million in the past three months. “He then asked the secretary just how far he thought the System could go in providing hot money. The secretary replied that ‘it wasn’t a question he should try to answer . . . and that in the natural course of things reserves needed to be supplied to the market’” (Minutes, FOMC, August 18, 1950, 7).
204. The FOMC minutes report his views (referring to the August decision) as follows: “There was a big question in his mind whether the recent increase of 1/8 percent had any value whatever. . . . Both the Secretary and Mr. Bartelt [assistant secretary] brought up the cost to the government of an increase in the short-term rate, asking in different ways what proof we had of the effectiveness of the increase. He seemed pretty emphatic that any further increase in the short-term rate would be a step of very doubtful character” (Minutes, FOMC, September 28, 1950, 8). Compare this statement with his testimony at the Douglas hearings the year before denying that he insisted on low interest rates.
The FOMC voted unanimously to let the one-year rate increase to 1.75 percent but to postpone the increase until after a further meeting between McCabe, Sproul, and Snyder. The long-term rate would remain at 2.5 percent or slightly below. On completion of the rate increase, the FOMC suggested that the Board increase reserve requirement ratios by two percentage points on demand deposits.
Not much happened. Secretary Snyder and his aides thought inflation might be ending. On October 5, he promised an answer by October 9. Although this meeting was more cordial, it was no more decisive. The FOMC executive committee could not agree on a response. McCabe and Evans wanted to wait for Snyder’s response. Sproul and Eccles wanted to increase rates but would defer putting the change into effect until October 10, after Snyder’s reply. On a two to two vote, the committee took no action.
The FOMC met again the following week. Snyder had taken a strong position against a rate increase, citing the harmful effect on sales of series E savings bonds. The committee voted to put the rate increase into the market, to let the one-year rate rise to 1.75 percent, provided the long-term 2.5 percent bond remained above par value. And it repeated its recommendation that the Board increase reserve requirement ratios by two percentage points. The Board discussed a change in reserve requirement ratios throughout the fall but did not act until December.205
In a letter to Snyder explaining the decision to increase rates, McCabe pointed for the first time to the effects of inflation on real values and purchasing power. He did not mention the effect on interest rates, but he reminded Snyder that “any resultant increase in the costs of carrying the public debt will be directly saved, many times over, if it helps to curb the rising costs of Government procurement” (Minutes, Executive Committee, FOMC, October 11, 1950, 7). He assured Snyder again that the 2.5 percent rate would remain as a ceiling for long-term bonds.
Table 7.13 shows the levels of short-term interest rates from August to February. The System’s actions did not get the one-year rate to 1.75 percent, but they permitted short-term commercial paper rates to rise by 0.30 percent between August and October and an additional 0.24 percent between October and February. Rates on government securities changed by lesser amounts, and long-term rates remained nearly constant at about 2.38 percent. To forestall Federal Reserve activism, the Treasury preannounced its December and January refunding on November 22. Acceding to the Federal Reserve’s request, and after the usual consultations with advisory committees, the Treasury offered to refund $7.9 billion in maturing bonds and certificates into a five-year, 1.75 percent Treasury note.206
205. On October 2 the Board voted to dispense with the requirement that the chairman sign the minutes of Board meetings. This requirement had been in place since 1914.
The initial market response was favorable, but market sentiment quickly changed after the Chinese entered the Korean War. The Federal Reserve supported the issue by buying $2.7 billion of the maturing issues, partly offset by sales of $1.3 billion.207 The result was a large increase in the System’s portfolio in December, as shown in table 7.12 above. “Throughout the whole period. . . a premium was maintained on the new issue despite the fact that prices on many outstanding issues continued to move lower” (Subcommittee on General Credit Control and Debt Management (1951,520).
On December 21, McCabe reported to the Board that he had again discussed an increase in reserve requirement ratios with Secretary Snyder. Snyder had questioned the effectiveness of the action, since the Federal Reserve would have to purchase securities that banks sold to meet the increase. He did not object, however.208 The Board voted an increase of two percentage points for demand deposits and one percentage point for time deposits, effective in the second half of January. The Board’s statement highlighted growth of credit and “an excessive rise in the money supply” (Board Minutes, December 21, 1950, 6).
206. Rates on three- to five-year issues had remained between 1.60 percent and 1.68 percent in October and November. The rate on November 18 was 1.60 percent.
207. Holders converted only 51 percent of the maturing issue into the new offering. They exchanged 14.5 percent of the old issues fo
r cash. At the time, the average cash redemption was about 5 percent (Subcommittee on General Credit Control and Debt Management 1951, 72).
208. McCabe also discussed the action with Charles Wilson, director of the Office of Defense Mobilization, Senators A. Willis Robertson (Virginia) and Burnet R. Maybank (South Carolina), and Leon Keyserling. None objected, perhaps because they recognized that it would have no effect on market rates.
The action moved an estimated $2 billion into required reserves. The move had been discussed so long and with so many groups that banks had accumulated more than $1 billion of excess reserves in advance. The following week the executive committee, on Sproul’s recommendation, voted to keep interest rates unchanged, so the change in reserve requirement ratios again had no effect on the monetary base. In January bank reserves and the monetary base increased.
Looking back on these events more than a year later, the Board wrote:
It was not possible during the period of August 1950 through February 1951 to carry out adequately the August 18 decision to undertake a limited program of general credit restraint. Immediately after the System in mid-August 1950 began to strengthen its efforts to curb inflation through monetary and credit action, it became necessary to buy Government securities in volume in support of an exceptionally large Treasury refinancing program. After the refunding was out of the way, short-term yields tended to adjust upward further in response to pressures in the credit market. The increase permitted, however, was very small. Under the circumstances, the policy of credit restraint could not be followed far enough to make the discount rate effective. Beginning in mid-November, both short-term and long-term yields on Government securities were again firmly pegged until the Treasury–Federal Reserve accord in early March. (Subcommittee on General Credit Control and Debt Management 1951, 365)
A History of the Federal Reserve, Volume 1 Page 101