A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  44. Discount rates were discussed at a meeting of the Board and the governors on November 9, 1917. New York saw no need for a change in rates, but Boston wanted higher rates to prevent borrowing for profit. Chicago wanted uniform rates at all reserve banks. On November 21, Harding telegraphed the reserve banks that the Board had concluded that rates should be raised by 0.5 percent. Rate increases were approved in late November for all banks except Boston and New York. New York did not increase its rate to 3.5 percent until December 21. At the time all other banks were at 4 percent (Board Minutes, November 9, 21, 26 and December 21, 1917).

  The Treasury’s borrowing tested the System’s ability to pool reserves. By far the largest part of the Treasury’s short-term borrowing was in New York, so the New York bank was under pressure to finance the purchases. The Board urged other reserve banks to buy acceptances from New York to relieve the strain on its reserve position, and New York renewed the request at the November Governors Conference. All banks except Kansas City, Chicago, and Atlanta agreed to buy acceptances to earn interest for their banks and thereby supply additional gold reserves to New York.

  The intent of the Treasury’s policy was that sales of certificates would be retired out of the proceeds of the Liberty Loans. From April 1917 to October 1919, the Treasury sold $6 billion of tax anticipation certificates and $19 billion in anticipation of bond and note sales. The intent was not realized. A large volume of certificates remained outstanding at the end of the war. The Treasury opposed raising short-term rates to refund the certificates as they came due. It expressed concern not only that higher short-term rates on certificates would carry over to long rates, lowering bond prices, but also that an increase in rates would abrogate commitments made to purchasers of Treasury bonds under the borrow and buy policy.

  By offering discounts at a preferential rate on Treasury certificates, the Federal Reserve abandoned the penalty rate, one of the main principles on which it was founded. Member banks could borrow at a preferential rate below the rate paid on the Treasury certificates or Liberty bonds, so borrowing became profitable.45 Penalty rates for other types of borrowing remained, but most borrowing was at the preferential rate, so higher rates had no effect. One consequence was that state banks membership increased, as noted earlier. Another consequence was that much of the collateral for borrowing was Treasury debt, contrary to the spirit of the Federal Reserve Act.

  Table 3.2 compares the interest rates at which the Treasury sold Liberty bonds to the preferential discount rates at New York. Congress set the rate on the First Liberty Loan below the market rate on savings deposits. The intention was to avoid a drain of existing savings into war bonds (Warburg 1930, 2:12). On May 22, 1917, a week after the borrowing campaign began, New York introduced the preferential discount rate. The other banks followed within a few weeks. The decision reflected concern about the ability to sell the issue at the low interest rate Congress set (Wicker 1966, 14).46

  45. The Board objected to the low rate paid by the Treasury on the initial certificates, $50 billion at 2 percent interest. Secretary McAdoo responded by threatening to invoke the Overman Act, under which the president could give the secretary (or other official) authority to carry out any of the functions of the reserve banks. The Board withdrew its objections. McAdoo was President Wilson’s son-in-law. This was the first clash with the Treasury over wartime finance. It was a preview of experience during and after the two world wars.

  The preferential rate enabled the Treasury to borrow on favorable terms between bond drives. The Treasury sold short-term certificates to the banks. The member banks paid by crediting the Treasury’s account at their banks and retained the deposits until the Treasury drew on its balances. Treasury balances were not subject to reserve requirements, but after they were spent, the money returned as private deposits subject to reserve requirements.47 The preferential discount rate allowed the banks to meet this obligation at low cost. The preferential rate soon became the modal borrowing rate. The Federal Reserve continued the practice until December 1919, after the war ended and the fifth and final war loan, the so-called Victory Loan, had been sold.48

  The System considered direct purchases to be “inflationary.” To avoid making open market purchases, it encouraged banks to offer installment loans to nonbank purchasers on favorable terms. Most commentators point out (correctly) that it is no more inflationary for the Federal Reserve to buy the bonds directly (or in the open market) than to lend money to the banks at below market rates so that banks can either purchase the bonds or finance the public’s purchases. The increase in the monetary base is the same in both cases. However, the distinction was important to the Federal Reserve and many others who shared the real bills framework. Central bank purchases of government securities expand money (or credit) based on speculative paper. This paper would have to be eliminated after the war to restore the central bank’s reputation. Although the members recognized that it would be difficult to reduce member bank indebtedness by restoring a penalty rate in the face of almost certain Treasury opposition, far more difficult would be postwar direct sales of Treasury obligations by the reserve banks with the secretary and the comptroller on the Board. Further, currency issues had to be backed by gold and real bills. Treasury securities and commercial paper were not close substitutes for this reason.

  46. The governors’ recommendation was that the first Liberty Loan should be for $1 billion, a sum they considered very large (Governors Conference 1917, 317–20). The Treasury ignored this advice also. See table 3.2.

  47. This change was made in April 1917 as part of Federal Reserve support of war finance.

  48. During and after World War II, Secretary Henry Morgenthau pointed out frequently that Liberty Loans had been sold at rising interest rates, whereas he financed World War II at constant rates. Another major difference is that in World War II the Treasury offered the public nonmarketable bonds, with fixed nominal redemption value. These were used to attract small savers and avoid the losses of nominal value that followed World War I.

  By 1918 most of the Liberty Loans sold in the secondary market at a small discount. To raise their prices, Congress, in approving the Third Liberty Loan, permitted the Treasury to purchase not more than 5 percent of each outstanding issue in the market. Purchases were made at the market price and financed by short-term certificates subject to preferential rates for borrowing from the reserve banks. The effect was to lower the average maturity of the debt and to increase the incentive for the Treasury to maintain low interest rates on Treasury certificates and the preferential discount rate after the war. The purchase operations ended on June 30, 1920, when a sinking fund replaced the purchase program. In all, the Treasury purchased $1.7 billion under the program, with most of the purchases made after the war. The program did not succeed in bringing taxable bonds to par value.

  Since the commercial banks could use the certificates at their option to borrow at preferential rates, the reserve banks were the source of the financing no more and no less than if they undertook the same volume of purchases directly. Despite a rising rate of inflation, Liberty bonds remained only slightly below par throughout the war. For example, at the time of the Third Liberty Loan, in spring 1918, the GNP deflator rose at an annual rate of about 7.5 percent. For the year 1918 as a whole, the deflator rose by 10 percent (Balke and Gordon 1986) and the consumer price index by 18 percent. Yet the Treasury was able to sell bonds at par with a 4.5 percent coupon and to keep its outstanding debt close to par by making occasional purchases. One partial explanation is that the market did not anticipate continued inflation over the life of the bonds. Although there was an embargo on sales of gold abroad, the United States remained legally on the gold standard, and the bonds contained a gold clause, permitting the holder to demand gold at redemption. Further, the common anticipation, based on experience in previous wars, was that budget deficits would end and the gold standard would be restored at the end of the war. Evidence of this disinflationary antici
pation is given by the inverted yield curve: commercial paper with a maximum of 180 days maturity yielded 6 percent.49

  Unlike its World War II policy, the Federal Reserve did not agree to purchase all government securities at fixed rates. In keeping with its mostly passive policy orientation, it achieved the same end by setting the discount rate on Treasury securities below the market rate on the securities. Bank reserves and the monetary base were thus set by the banks’ demand to borrow. Any bank with Treasury certificates could borrow profitably. The price of Treasury securities was kept relatively stable by this arrangement at the cost of supplying reserves and money at the market’s demand. As in World War II, the Federal Reserve became the “engine of inflation.”

  The wartime policy achieved the Treasury’s objective of marketing an extraordinary increase in debt at relatively low direct cost to the Treasury.50 The public bought most of the debt, but between 1916 and 1919 commercial banks bought almost $5 billion, approximately 20 percent of the total issued. The banks financed their purchases in part by borrowing $2 billion from the Federal Reserve.

  In June 1917 Congress amended section 13 of the Federal Reserve Act by reducing collateral behind the note issue. Initially, a reserve bank had to deposit with the Federal Reserve agent (at the reserve bank) 40 percent of the issue in gold and 100 percent in commercial paper and bills of exchange with less than ninety days to maturity. The new requirement reduced the total of real bills and gold to 100 percent of the note issue, 40 percent in gold. A year earlier, banker’s acceptances became eligible as collateral and, slightly altering a premise of the act, reserve banks could also use as collateral promissory notes of member banks secured by government bonds or notes.

  Gold inflows slowed after 1917 (Schwartz 1982, table SC14). For the next three years Federal Reserve credit—mainly discounts—became the driving force in the expansion of the monetary base and inflation. The Federal Reserve Board’s annual report for 1918 looked forward to the time when “the invested assets of the Federal Reserve Banks have been restored to a commercial basis” (Board of Governors of the Federal Reserve System, Annual Report, 1918, 87). This appeal to the real bills standard gives a misleading impression of what had happened. From December 1916 to December 1918, Federal Reserve notes outstanding increased by $1.7 billion and bank reserves increased by $400 million. On the asset aside, discounts for member banks rose by $1.5 billion, gold by $200 million, and government securities by $180 million. Nearly all of the discounts, however, were secured by government obligations (Board of Governors of the Federal Reserve System 1943, 340).

  49. This does not explain why short-term rates rose so little, hence it can only be a partial explanation of interest rate changes.

  50. Congress approved the Third Liberty Loan with a 4.25 percent maximum interest rate. This restriction on the interest rate remained for all government bonds issued until the 1960s. The restriction did not apply to notes.

  THE POSTWAR STRUGGLE FOR INDEPENDENCE

  The history of the early postwar years is principally the story of the Federal Reserve’s struggle for independence from the Treasury and the deflationary consequences of its policies after it obtained independence. This was the System’s first opportunity to take independent policy action. It made several mistakes, some avoidable, some unavoidable in the circumstances. By promising not to raise interest rates during the last wartime bond drive, the System relinquished a chance to moderate the postwar inflation. By raising discount rates from 4 percent to 6 percent and then to 7 percent in the space of a few months, it contributed to the postwar contraction.51 By failing to lower discount rates for more than a year after the cyclic peak, the System prolonged the recession and contributed to its severity.

  In the first four years of Federal Reserve operations, the compound average rate of inflation was 12 to 13 percent, using consumer prices and the GNP deflator. Table 3.3 shows the annual data. The peak in the quarterly rate of inflation is in third quarter 1918, at the end of the war, but the price level did not reach a peak until second quarter 1920. For the first two quarters of the latter year, the deflator rose at a 20 percent annual rate. For the last two quarters, it fell at a 15 percent annual rate. The price level continued to fall throughout 1921, although the rate of decline slowed after midyear.

  The inflation period has two phases. At first the Treasury dominated the Federal Reserve, aided by the System’s commitment to assist in war finance and, after the war, commitments under the borrow and buy policy. In the second phase, the commitments had expired. The System was free to act but uncertain about what to do.

  51. The 7 percent discount rate was posted (as the lowest available rate for commercial and agricultural discounts) at only six of the twelve reserve banks. Philadelphia, Cleveland, Richmond, St. Louis, Kansas City, and San Francisco held the minimum discount rate at 6 percent, but some of these banks adopted progressive rates to penalize heavy borrowers. Dallas did not adopt the 7 percent rate until February 1921, more than a year after the NBER date for the cyclic peak, January 1920. Less than two months later, Boston lowered the discount rate to 6 percent on April 15, followed by New York on May 5. The 7 percent rate applied to commercial paper. A 5.5 percent rate for borrowing on Treasury certificates remained in effect throughout the period. The latter was the applicable rate for most borrowing.

  The Inflation Phase, Part 1

  The Board’s annual report for 1920 blamed the inflation on “an unprecedented orgy of extravagance, a mania for speculation, overextended business in nearly all lines and in every section of the country” (Board of Governors of the Federal Reserve System, Annual Report, 1920, 1). At best this was disingenuous, as the Board had recognized in its annual report for 1919. The Board wrote there that the absence of a penalty rate “is enough to prevent a normal functioning of a Federal Reserve Bank, whose rates should be so fixed that resort thereto is unprofitable . . . and thus has a tendency to check expansion” (Board of Governors of the Federal Reserve System, Annual Report, 1919, 2).

  In fact, the Federal Reserve lacked any consensus on a policy regarding rates. A return to penalty rates might be sufficient to stop the inflation but was likely to conflict with accommodating the needs of trade and commerce. This was a principal concern for several governors. Others viewed the wartime policy as a violation of the real bills basis for credit expansion, hence inflationary. Insisting on a return to a real bills policy meant that the preferential discount rate on Treasury securities had to be raised. As long as the preferential rate remained in effect, the discount rate would be controlled by the Treasury when it set the rate on Treasury issues.52 Thus there was an issue of control or independence as well as a policy issue about rates. Members were aware, however, that the president could invoke the Overman Act and assign their responsibilities to another agency. This act did not expire until six months after the end of the war, in April 1919.

  52. The first restive sign came early. Chairman Perrin (San Francisco) wrote on October 3, 1917, to ask whether the discount rate should be raised to 4 percent for loans on 4 percent certificates and 4 percent Liberty bonds. Miller replied for the Board, saying that an increase in rates would hurt the Second Liberty Loan. Two weeks later, in a lengthy memo, Miller argued that rates should have been raised after the First Liberty Loan so they could be reduced to support the Second Liberty Loan. Miller defended the policy as part of the Federal Reserve’s responsibility to help the government finance the war “with a minimum of injury to the health and strength of the banking situation” (Board of Governors File, box 1239, October 3 and 17, 1917). Miller also stressed the need to modify the System’s real bills orientation by reducing commercial loans to nonessential industries. On December 12 Warburg responded, noting the Board had no power to discriminate against particular borrowers. Rates were raised by 0.5 percent after first payments were made on the Second Liberty Loan. This established a precedent that the Treasury was not willing to follow in 1919.

  The division of opinion r
emained throughout the war and beyond. In February 1918 Governor Harding suggested an increase to 4 percent on commercial discounts with less than fifteen days to maturity. Opinion was mixed, and the rate remained unchanged. In June Adolph Miller wrote a long memo pointing out that the government had spent less than planned in fiscal 1918 but would increase spending to $24 billion in fiscal 1919. He estimated that this would be half of current GNP, and he urged an immediate increase in rates to curtail commercial lending. He included an increase in rates on loans secured by Treasury certificates. Hamlin replied in a letter to Harding, opposing Miller’s proposal and recommending “rationing credit as we now ration food.” Raising rates would be “bad faith” with the banks that bought certificates (Board of Governors File, box 1239, February 21 and 25, June 27 and 28, 1918).53 The only action was a decision by the Cleveland and Richmond banks to raise the discount rate from 4 to 4.25 percent in April. Kansas City followed in May, raising its rate to 4.5 percent. The others remained at 4 percent.