100. Consumer prices show a similar pattern. They fell until March 1922. Their annual growth rate did not turn positive until early 1923, in part as the result of a large negative value in August 1922.
101. Real base growth is the annual rate of change of the monetary base deflated by Balke and Gordon’s (1986) GNP deflator. Real long-term interest rates are rates on Treasury debt minus the annual rate of change of the deflator.
Falling prices raised real balances and attracted gold from abroad. The public used its increase in money balances to purchase goods and assets. Judging from stock market prices, after July 1921 asset prices rose absolutely and relative to prices of new production, stimulating the demand for new production. The change in relative prices and real wealth more than offset the negative effect of high real interest rates on spending.
The recovery from the 1920–21 recession provides some evidence on the way money and monetary policy influence the economy.102 Relative price changes are not limited to market interest rates. Prices of housing, autos, buildings, and many other assets change relative to the price of new production of substitutes. The relative price change stimulates or retards production (Brunner and Meltzer 1976).
POLICY FRAMEWORK
The 1920–21 recession was the first test of the policy conception implicit in the Federal Reserve Act. The act provided three principal means of regulating money—gold flows, discounting, and the discount rate.103 The Federal Reserve was expected to follow gold standard rules, allowing money and interest rates to rise and fall with gold movements. Discounts were at the discretion of the banks; they presented or paid off real bills at the given discount rate. The Federal Reserve responded by issuing or withdrawing base money. The discount rate was intended to be a penalty rate that changed in response to market rates.
102. Real money balances are M1 balances deflated by Balke and Gordon’s (1986) deflator.
103. Acceptances and open market security purchases or sales had a smaller policy role at the time. Acceptances, like discounts, were at the discretion of holders, given the rate posted by the reserve banks. The Federal Reserve wanted to expand the role of acceptance markets but did not succeed. Warburg (1930, 1:457) regarded the failure to develop markets for discounts outside New York as the System’s biggest failure. In his view, this failure left the banks dependent on the call money market and thus on the daily movements of the New York Stock Exchange. After he left the Board, Warburg returned to Wall Street. He became the representative of the New York Federal Reserve bank to the American Acceptance Council. In 1922 he proposed a preferential discount rate for trade acceptances. The Federal Reserve disliked preferential discount rates and voted to treat acceptances as open market paper, where they would have a lower rate only if endorsed by a bank.
Whether judged by money, interest rates, or economic activity, policy failed in 1920–22. The recession was long and deep; two years after the NBER peak, real GDP was 8.4 percent below its peak value. Principal monetary aggregates fell throughout the recession, and as noted, nominal interest rates were higher at the trough than at the previous peak. Table 3.7 shows the peaks and troughs in several of these series and the changes from the NBER peak to trough.
The monetary base and the money stock declined from peak to trough despite the heavy gold inflow in 1921. Measured by either the deflator or the consumer price index, prices fell after midyear 1920; the rate of deflation remained between 20 and 30 percent from fourth quarter 1920 through second quarter 1921. Thereafter, prices declined more slowly until mid-1922.
The movements of gold, discounts, and money were a response to a common cause. Federal Reserve policy held nominal interest rates high. With prices falling, real interest rose, reducing discounts and attracting a gold inflow that continued after nominal interest rates declined from their peaks. The relatively high real interest rates and declining activity also reduced the supply of acceptances offered to the Federal Reserve. The net flow of discounts, gold, and acceptances accounts for the peak to trough decline in the monetary base. Federal Reserve open market sales and re-demptions of government securities made a further small negative contribution to the base.
Charts 3.3 and 3.4 show the relation of monthly values of the gold stock and the monetary base during the recession and recovery. Despite the gold inflow from October 1920 to January 1922, the Federal Reserve kept interest rates unchanged until September, contrary to gold standard rules, and allowed the monetary base to decline. After January 1921, the relation of gold to the monetary base reversed. Gold inflows supplemented by Federal Reserve open market purchases more than offset the continued decline in discounts, producing a rise in the monetary base.
At the time, the Federal Reserve did not use the gold reserve ratio as a guide to discount policy. To reduce pressure for reductions in discount rates, it excluded gold held abroad from the gold reserve in February, as Strong had proposed (Board Minutes, January 28, 1921, 94). By May 1921, the gold reserve ratio was above 55 percent. A classical response required reductions in discount rates despite member bank borrowing in excess of $2 billion. Although a reduction in discount rates would have helped Britain and others to accumulate gold for a return to the gold standard, as noted earlier, the Federal Reserve required prodding from the new administration and Congress to reduce its rates in May and June.104
Failure to respond to the reserve ratio was not the only departure from the classical gold standard. At the May meeting, Strong reported on a recent conversation with Montagu Norman in New York. Their concern was exchange rate instability. They had considered a plan to stabilize exchange rates among eight countries—the United States, Britain, Switzerland, Holland, Denmark, Norway, Sweden, and Japan. The participating countries would establish a trading account of about $300 million to buy and sell foreign exchange. Risks would be limited by an agreement to ship gold to pay for losses. To overcome legal obstacles, Strong proposed to implement the policy by buying foreign bills instead of currencies. Strong believed the operations would be highly profitable. The proposal was never adopted (Governors Conference, May 28, 1921, 721–41).105
104. In a speech delivered late in 1922, Strong recognized that the gold reserve ratio was not likely to be useful as a policy indicator or guide: “The present banking system has created a situation where there is a surplus of banking reserves (gold and foreign exchange) in the country, and where there is not likely to be a deficiency. The real reserve barometer is the reserve percentage of reserve banks. The impulse, which led the Reserve System to change rates, must for the present largely arise from general conditions, and it cannot be expected that the impulse to advance rates will be given by gold exports for a long time to come. Therefore, the regulation of the volume of credit which is the chief function of the Reserve System must be effected by a combination of rate changes and due caution as to members’ borrowings” (Strong 1930, 197).
By October 1921, the gold reserve ratio was above 69 percent and still rising. At the Governors Conference, the Treasury proposed putting gold into circulation. The governors objected on two grounds. The proposal was contrary to the System’s policies of centralizing gold reserves at reserve banks and encouraging the use of Federal Reserve notes. And the policy would be viewed as a subterfuge to avoid reducing discount rates. The action would raise new concerns about the System’s responsibility for deflation and high interest rates (Governors Conference, October 25, 1921, 90– 91, 374–77). In March 1922 the Treasury, on its own, announced a policy of unrestricted gold circulation. New York followed later.
105. The plan is a forerunner of the swap arrangements developed after 1960.
The Treasury’s action put more gold into circulation but did not keep the reserve ratio from rising. The ratio reached a peak of almost 80 percent in August 1922 and did not fall below 75 percent until late in 1924.
The governors were not alone in rejecting the gold reserve ratio as a guide to policy. Many academic economists also held that view. For example, Oliver
M. W. Sprague (1921) argued that the Federal Reserve could not adopt traditional Bank of England practices. Most countries had left the gold standard and would not soon return. Hence moderate credit expansion would not automatically induce an outflow of gold to limit credit expansion. Sprague urged the Federal Reserve to adopt a domestic standard, based on discretionary judgment. He favored a modestly countercyclical policy of “lessening price fluctuations within particular business cycles, checking somewhat the upward movement, and thereby lessening the subsequent decline” (ibid., 26). A policy of this kind could work, provided there was support from public opinion and “general confidence in the wisdom of the policies” (29).
Sprague wanted to substitute price stability for the reserve ratio as a guide to action. The price level should change “with permanent changes in prices associated with variations in the world’s supply of gold” (ibid., 28), but fluctuations around this level should be damped by the Federal Reserve acting on its best judgment.
This view was strongly criticized externally in papers or comments by Russell Leffingwell (1921) and Adolph Miller (1921). Leffingwell agreed that the reserve ratio was not an adequate guide when most countries had left the gold standard. He favored a penalty discount rate, to get the banks out of debt to the Federal Reserve, and circulation of gold to reduce the gold reserve ratio at the reserve banks. Miller recognized that, in principle, price stability could be a guide to policy. He found no practical merit in the proposal, however. Nothing in the Federal Reserve Act authorized such a policy, while both the act and tradition favored continued reliance on the reserve ratio. The problem was not one of finding a substitute for the reserve ratio, it was finding ways to make the “reserve ratio a more sensitive and immediate indicator” (Miller 1921, 195). Like Leffingwell, Miller blamed the 1917 amendments that centralized gold holdings at Federal Reserve banks for the reserve banks’ slow response to gold.106
Price stability as the goal of policy is a recurrent issue for the rest of the decade and again in later years. The internal discussion of price stability as a goal contains much that is repeated in these later episodes. Frederic H. Curtiss, chairman of the Boston reserve bank, accepted price stability as an important aim of policy. He argued that an explicit price level objective would have several defects. First, it would open the System to irresistible political pressure to create prosperity. Second, the public would not distinguish relative and absolute price changes. The farm bloc in particular would want the index to reflect its concerns. Third, changes in the price level are not entirely the result of monetary changes: the relation between money and the price index was looser, he thought, than quantity theorists like Irving Fisher and Knut Wicksell believed.
106. Miller favored a system more like the Bank of England’s, in which gold reserves were held separately against notes and bank reserves with a higher percentage against currency than under the Federal Reserve Act. The aim was to absorb some of the excess gold and restore the gold reserve ratio as a policy indicator. At about the time this public statement was published, Miller argued internally that the reserve ratio was a faulty indicator that was inconsistent with the prevailing discount rate. His proposal was intended to remove the problem (Governors Conference, April 1921,1098–99). The Governors Conference did not accept his proposal. A principal counterargument was the uncertainty about whether or when the gold reserve would fall. The members were unwilling to make a permanent policy change based on a gold stock that might prove to be temporarily high.
As usual, Strong was more forceful. He opposed price stability as a guide to policy: “It is not the business, the duty, or the function of the Federal Reserve System, or of central banks generally, to deal with prices” (Governors Conference, May 28, 1921, 629). For Strong, price stability was a desirable outcome of a proper monetary policy, not a policy objective. He continued to hold this position throughout the 1920s. Although his opposition lessened in 1928, he preferred to reconstruct the international gold standard, in the belief that the standard would maintain price stability, and he worked to that end.
If the reserve ratio was no longer useful, what principles should govern policy? At the October Governors Conference, the Board asked the governors to state how interest rates should be set.
Governor Norris expressed the confused state: “No two of us would write exactly the same essay. . . . The only thing we could agree on would be absolutely nothing” (Governors Conference, October 27, 1921, 591). The Federal Advisory Council had been asked to discuss the issue. It provided a list of factors affecting decisions, such as gold reserves, conditions of banks, or national, district, and world business conditions. The governors recognized that these were guides, not principles.
Roy Young (Minneapolis) proposed that discount rates should be penalty rates, “equal or slightly in excess of what the customer pays the member bank” (ibid., 599). Several governors agreed with this principle, none more than James McDougal (Chicago): “If the reserves of the Federal Reserve System were to be safeguarded against misuse and to be held available for legitimate seasonal requirements, as the law contemplated they should be held, the discount rate policy should be one which should hold those rates as high or slightly higher than the prevailing rates in the commercial centers” (619–20). George W. Norris (Philadelphia) and George Seay (Richmond) strongly agreed.
Strong’s reply is a sharp break from his earlier views favoring a penalty rate. In a March 1921 letter to Norman, he called the indebtedness of the member banks “absolutely the fundamental and controlling factor” (Chandler 1958, 172). He estimated that there would have to be a $6 billion to $7 billion reduction in lending, a decline equal to 20 percent of the outstanding stock, a contraction of lending five times greater than the contraction that he estimated had occurred to that time. A different signal had to be found, at least for the present.
The following month he told the Governors Conference that he opposed putting undue pressure on banks to liquidate debt. The effect would be to force inventory liquidation and additional deflation. He believed the correct policy was to lend freely at a penalty rate, and he again cited Bagehot’s rule.107 In July he continued to favor a penalty rate in principle, but he recognized that the principle had to give way. He told Norman that money market conditions “hardly justified . . . making a further reduction.” There were other considerations, however, that made classical methods “not always the wisest,” and he added, there were “political considerations brought about by the change of administration” (Chandler 1956, 176).108
At the October Governors Conference, Strong noted that the reserve ratio at the New York bank was 82 percent. If he followed Bagehot’s formula, the discount rate would be 2 percent. Further, he now saw that United States markets differed from Britain’s. Only one type of paper, acceptances, mattered for the Bank of England. The Federal Reserve bought many types of paper, each with its own rate, so the same procedures could not be applied. The problem was to keep the banks from borrowing for profit. This problem, he now believed, was more acute when the outlook for business was good and the community was more inclined to speculate (Governors Conference, October 27, 1921, 624–29).
Strong offered an observation that was to have an important role in shaping future policy operations and the policy framework. When banks were in debt, they used surplus reserves to reduce borrowing. Once some were out of debt, they reduced rates to put surplus funds to work: “The reduction in our rate had no influence in the market. It was the competition to lend money that did it” (ibid., 634).
Weekly data for 1921 and 1922 show that reductions in the discount rate at New York preceded declines in interest rates on four- to six-month commercial paper. All the reductions occurred with market rates on commercial paper above the discount rate. The timing was contrary to the penalty rate conception and suggests that the Federal Reserve had abandoned the idea of a penalty rate as a rule for setting the discount rate without making an explicit decision to do so.109
107. He seemed unaware that Bagehot’s argument for maintaining a high discount rate was offered as a means of reversing a temporary gold drain and was inappropriate in 1921 with the gold reserve rising and the price level falling.
108. Classical conditions meant maintaining a penalty rate and following market rates down. Strong mentions five factors that guided his policy. Four were short-term interest rates—the rates on banker’s bills, short-term Treasury certificates, commercial paper, and stock exchange call loans. The fifth factor was the Treasury’s success in selling three-year notes and the rate at which they sold. He does not mention that these are nominal rates and that real rates were much higher.
109. In contrast, rates on short-term Treasury certificates led market rates down. At each of the reductions in the New York discount rate during 1921 and 1922, open market rates on certificates were from 0.5 percent to 0.75 percent below the discount rate in the month before the discount rate reduction. For these securities, the penalty rate was in effect. However, the Federal Reserve had no intention of allowing these securities to be used as collateral. That was contrary to their real bills view and the principles of the act. Long-term governments with a minimum of eight years to maturity or first call were also below the discount rate in July 1921 but 0.25 percent above at the other reductions.
Perhaps the main force producing a major policy change was the political response to the 1920–21 experience. Congress began to discuss legislation limiting the Federal Reserve’s power to raise discount rates beyond a ceiling rate without congressional approval. In January 1921 Congress revived the War Finance Corporation to finance agricultural and other exports. Eugene Meyer, later governor of the Federal Reserve Board, returned as head of the corporation. In August 1921 Congress appointed the congressional Joint Commission of Agricultural Inquiry to investigate the reasons for agricultural distress, the protracted economic decline, and the level of interest rates.
A History of the Federal Reserve, Volume 1 Page 19
