A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  bond market jitters Neither the Federal Reserve nor the Treasury anticipated the break in the bond market on March 12. Government bond yields had remained between 2.46 and 2.48 since the start of the year, influenced partly by Treasury operations. Rates rose on March 12 and 13, ending at 2.52 percent on March 13.

  Once again Morgenthau was furious. He described the decline as a “panic” and cut short his conversation with Harrison when Harrison pointed out that rates were at the lowest level in history and refused to agree that there was a panic. Morgenthau blamed the increase in reserve requirement ratios for the market break and insisted that the Federal Reserve make net purchases of bonds to support the market (Harrison Papers, file 2012.5, dictated March 31, 1937).191 The Treasury had purchased $75 million in three days. It was time, Morgenthau said, for the System to help. Eccles agreed, but Morgenthau was doubtful that Eccles could get Harrison and Burgess to consent (Blum 1959, 369).

  The FOMC’s executive committee called an emergency meeting for March 13. Eccles reported on his meeting with Morgenthau, explaining that Morgenthau blamed the Federal Reserve and wanted outright purchases to bring the 2.5 percent bond to par (a difference of 0.02 percent). The executive committee refused to make a commitment to a particular interest rate but pledged its cooperation with the Treasury (Minutes, FOMC Executive Committee, March 13, 1937).

  The entire executive committee then went to Morgenthau’s office. Eccles reported the decision and, to strengthen his case, urged Morgenthau to balance the 1938 budget by raising tax rates and begin to retire debt. Morgenthau tried to get a commitment from the Federal Reserve about how much it would let interest rates rise, but Eccles would not go beyond a general commitment to continue an easy money policy. Morgenthau threatened to end gold sterilization, in effect nullifying the Federal Reserve’s action. The FOMC members urged him not to do that, since it would transfer responsibility for monetary policy to the Treasury (ibid., 1–2). The two sides agreed to continue operating as they had, placing bids under the market, sharing purchases without any change in the System Open Market Account. The Federal Reserve agreed to hold a full FOMC meeting on March 15 to extend its power to purchase.

  190. The Senate approved a resolution on February 5 asking for the reasons leading to the increase in reserve requirement ratios. The Board’s reply consisted of a copy of the press release announcing the change, and the reasons for it, and a longer article prepared for the Federal Reserve Bulletin showing the ability of the banking system to obtain the required reserves from correspondents if needed.

  191. The Federal Reserve began sharing purchases with the Treasury on March 12, but it continued its usual practice of offsetting purchases by sales of Treasury bills. Morgenthau wanted an increase in reserves, which Harrison opposed. Total Treasury purchases for the day were $32 million.

  At the March 15 meeting the FOMC voted unanimously to continue the policy of offsetting long-term purchases with sales of short-term bills. This increased earnings of the reserve banks, so it was popular with the presidents, and it avoided adding to the portfolio and offsetting part of the long-sought reduction in excess reserves.

  Eccles argued at length that the market break was not caused by Federal Reserve policy. He cited instability in France, British rearmament, demand for war materials, increased union activity, inventory building, and concerns about another unbalanced budget. He told the FOMC he had prepared a press release saying that monetary policy remained easy and that “the time for adoption of a restrictive monetary policy does not arise until there is full production and employment” (Minutes, FOMC, March 15, 1937, 7). No one responded that a long-term commitment to “easy money” could contribute to the increase in long-term rates.

  Harrison agreed with Eccles but took a less defensive stance, accepting that Board action was one cause of the market break, but not the principal cause. The policy change had been necessary to absorb excess reserves. He opposed open market purchases (unless offset by sales of other maturities) and attributed the bond market problem to concerns about inflation.

  Goldenweiser discussed the economic situation. Expansion was under way everywhere. As to policy, the committee should be willing to undertake purchases to avoid disorderly markets. They could be offset later. His concern was political: if the System did not act, the Treasury would. The System would run the risk that action might be taken in another form that would complicate the machinery of credit control and divide responsibility for such control (ibid., 11). Williams disagreed. Like Eccles, he regarded the disturbances to the bond market as nonmonetary in character, then added, “Sooner or later the System will be forced to take restrictive monetary action to prevent dislocation” (12). Purchases would be seen as a reversal of policy.

  Morgenthau called from Georgia to learn what the FOMC had decided. The minutes report that he was satisfied with the decision to continue bond market support, offset by short-term sales, and with authority to purchase up to $250 million in an emergency (ibid., 19).192 The minutes show that the committee wanted to tell Morgenthau it saw no reason to increase its portfolio at that time (16).193

  Eccles left for vacation. The committee had failed to specify what constituted a dire emergency, requiring purchases. When the bond market fell again on March 16 and 17, Morgenthau wanted to desterilize gold, but Roosevelt did not approve. The Treasury continued to purchase bonds for the trust funds, mainly the postal savings account, but purchases could not exceed the amount of uninvested cash in the fund.

  Harrison bought $37 million on March 16 and 17 but offset the purchases by selling bills. On March 18 the market rose, and by the end of the week the bond yield was at 2.62 percent, an increase of 0.15 in two weeks. Harrison regarded the change as an orderly adjustment; Eccles and Morgenthau saw it as an emergency. Eccles, perhaps influenced by Morgenthau, wanted purchases of $250 million—a 10 percent increase in the portfolio, the maximum amount approved by the FOMC. If the banks wanted excess reserves instead of earning assets, he would let them have them. Harrison regarded this as partly vindictive (Harrison Papers, file 2140.2, April 2, 1937, 2). Vice Chairman Ransom agreed with Harrison that there was no emergency.

  The executive committee met on Saturday, with Harrison presiding in Eccles’s absence. Ransom said the meeting had been called because the Treasury had only $14 million left in the trust accounts. It wanted the System to take responsibility for purchases. Morgenthau had told him, he reported, that “if the Treasury were called upon to make additional purchases in order to prevent a disorderly market such purchases would have to be accomplished with funds derived from the transfer of gold certificates to the Federal Reserve banks or in some other manner” (Minutes, Executive Committee, FOMC, March 22, 1937, 2).

  The threat did not perturb the members. Harrison thought the principal lesson from the recent experience was not to follow the market too closely or offset daily adjustments. He had purchased $121 million for the Treasury and $68 million for the System. Ransom presented Eccles’s case for immediate purchases. The committee disagreed. It did not see an emergency that required purchases; it was unwise to increase excess reserves; the best course was to continue Harrison’s policy of placing bids beneath the market price and offsetting purchases with sales of bills.

  192. In the 1960s, the Federal Reserve returned to the policy of offsetting long-term purchases with short-term sales in an effort to change the slope of the yield curve. Most studies of the later episode suggest it had no effect on relative yields.

  193. Harrison reports that Eccles opposed a motion to renew authority of the executive committee to increase or decrease the portfolio by telephone conference. The reason was that “it would not satisfy the Secretary” (Harrison Papers, file 2012.5, March 31, 1937, 8). The motion was redrafted to mention emergency action. “It was clearly understood . . . that the emergency in mind must be a dire one” (8). The FOMC minutes report that Morgenthau was unhappy with Eccles’s press release and with the decision to leave authority to pu
rchase with the executive committee, where Harrison would have more influence (Blum 1959, 370).

  The next day the FOMC considered a broader agenda: purchases; revocation of the May 1 increase; and ending gold sterilization. There was general agreement that none of these steps should be taken (Harrison Papers, file 2140.2, April 2, 1937).

  Morgenthau wanted more action by the Federal Reserve but was dissuaded by a conversation with Roosevelt. The president, Morgenthau told his staff, was not worried about the bond market (Blum 1959, 371). But Morgenthau was, and his concern increased as the bond market continued to fall. Yields reached 2.72 in the week ending March 27. Eccles, still on vacation, wanted to act. He blamed Harrison for the failure.194 But only Eccles and Morgenthau appear to have been disturbed.195

  Eccles and Morgenthau met on April 6. Eccles was “apologetic.” He proposed three alternatives. The Board could repeal the May I increase for country banks; the FOMC could begin outright purchases; or the System could ask the Treasury to desterilize some gold. The Treasury staff wanted some combination of the three actions to assist the Treasury at its next bond sale. Morgenthau told Eccles he wanted a “big, broad stroke,” including release of $500 million of gold and beginning net open market purchases. Eccles was “very much in favor” (Blum 1959, 372).

  If so, Eccles reconsidered. His proposed announcement of the joint program referred only to open market purchases “if necessary.” Morgenthau threatened to ease by desterilizing gold if the System would not cooperate. Eccles, at last, agreed to endorse the original joint program, even if the FOMC did not want to purchase (ibid.).196 He now had to sell the plan to the FOMC.

  194. Eccles’s biography says he hurried back to Washington (Eccles 1951, 292). In fact, he stayed on his fishing vacation in Florida for two weeks and was kept informed by telephone.

  195. Ransom reported that the Treasury staff was not disturbed. Harrison and Ransom met with Eccles on Monday, March 29. Both favored doing nothing other than continuing the swap operation, but Eccles wanted more. Eccles favored net purchases but indicated that he would accept gold desterilization (Harrison Papers, file 2140.2, April 9, 1937).

  196. Currie sent Eccles a memo that dismissed the reserve requirement change as a factor affecting interest rates. He blamed fears of inflation arising from price and wage increases. (Balke and Gordon’s deflator shows a 10.76 percent increase for the quarter; Currie to Eccles, Board of Governors File, box 1433, April 2, 1937). However, the spread between Baa and Aaa bonds, a measure of risk, fell to the lowest level in seven years. Rates on four- to six-month prime commercial paper increased from 0.75 percent to 1 percent in April. They remained at 1 percent for a year.

  The committee met on April 3. The bond yield was 2.78, 0.32 above its all-time low. Eccles began the meeting by reading the statement, prepared with the Treasury, announcing a program to release $400 million in gold from sterilization and open market purchases to increase Federal Reserve holdings197 (Minutes, FOMC, April 3, 2).198 He was willing to accept Treasury policy with the understanding that Morgenthau would again sterilize gold after the May 1 increase in reserve requirements.

  The FOMC members, other than Eccles, argued that there was no emergency and no reason for System purchases. Harrison urged the FOMC to hold a free and open discussion. It was Saturday; markets had closed. There was no reason for hasty action. Eccles replied that the committee was wrong not to have declared the markets disorderly and begun purchases. Ransom responded that he had talked to the Treasury all through the week and had heard no complaints, even from Morgenthau.199

  Perhaps without realizing it, Eccles shifted his argument. He had claimed throughout that excess reserves were redundant and could be removed without cost.200 Now he recognized that

  [the] banks have been accustomed for a long time to an extremely large amount of excess reserves, that by the actions of the Board this excess has been drastically reduced, and that it would take the banks some time to accustom themselves to operating with a smaller amount of excess, as evidenced by the fact that they had sold earning assets rather than reduce their balances with correspondents. He suggested that . . . the System would be justified in increasing the System portfolio in recognition of the fact that, because of the reluctance of banks to reduce their excess reserves, there had been a larger amount of selling of government securities than was anticipated when reserve requirements were increased, and these offerings were coming into the market at a time when the market was already disturbed by other factors and there were practically no buyers. (Minutes, FOMC, April 3, 1937, 7)

  197. Williams’s memo to Harrison reporting on the meeting described the memorandum as “an ultimatum by the Treasury” (Williams to Harrison, Harrison Papers, Open Market, April 14, 1937).

  198. The Federal Reserve proposed a sentence for the joint statement that attributed the fall in market rates to “developments wholly unjustified by underlying financial and economic conditions” (Blum 1959, 372). Morgenthau objected to the statement because he believed the increase in reserve requirements had caused the rise in interest rates. The System removed the words “developments wholly unjustified.” Eccles also wanted to insert that open market purchases would be made “if necessary,” but Morgenthau wanted no qualifications and threatened to act alone if the FOMC would not act (ibid.). Eccles had promised Morgenthau that the FOMC would decide by noon because the two of them would meet the president at 1:00, and Morgenthau had scheduled a press conference at 4:00.

  199. Williams’s memo to Harrison gives a somewhat different account of these events. He describes Eccles’s statement as “an ultimatum by the Treasury” and reports Eccles as saying that a failure to agree to the program would be evidence that the System would not “play ball” (Williams to Harrison, Harrison Papers, file 2140.2, April 14, 1937, 1).

  200. Eccles did not recognize the import of this statement, for he continued to deny responsibility for the rise in interest rates and voted that way at the next day’s meeting. His biography also denies any responsibility.

  It is difficult to know what to make of this statement. If Eccles believed what he said, he should have stopped the third increase in required reserve ratios. Although the members discussed cancellation at times, there is no suggestion that this was a real possibility. Cancellation would have recognized the System’s responsibility for the rise in long-term rates. The main arguments against it were concern about the embarrassment of reversing a policy that had been announced and the belief that inflation remained a threat. The committee was reluctant to appear to have made an error.

  The FOMC split between those who favored purchases because of the rise in interest rates, those who wanted to prevent the Treasury from taking monetary action alone, and those who favored letting the Treasury deposit gold certificates at the Federal Reserve. The main opponents of purchases, Ransom, Harrison, and John H. Williams, expressed fear of inflation, citing labor strife and the unbalanced budget.201

  Harrison asked whether the FOMC considered purchases only to meet the Treasury’s demand. In the classic New York–Washington split, he expressed a willingness to purchase if the economic situation required it, but not just to satisfy the secretary. Eccles’s reply repeated his earlier argument; rates had increased more than the FOMC had anticipated. Williams supported Harrison. He saw no reason for purchases. The problem was that the Treasury had sterilized gold without waiting for the change in reserve requirements to take effect. They could now stop sterilizing. Eccles opposed this suggestion: “It was the responsibility of the System to take the leadership in meeting this problem” (ibid., 15).

  Eccles then talked to Morgenthau, who agreed to wait until the following day for the FOMC’s decision. Morgenthau believed the time had passed for action by the FOMC alone, but he was willing to wait a day for joint action on the program he had worked out with Eccles.202 The FOMC decided to let the executive committee meet with Morgenthau at his home that evening.

  201. The Congress of Industrial
Organizations had broken off from the American Federation of Labor. At the time, there were seven strikes in the auto industry. Freeman (1998, 282) shows that in 1937 there were 2,200 strikes for union recognition, involving nearly a million workers. For comparison, 1935 had 560 strikes for union recognition involving 200,000 workers.

  202. The FOMC’s discussion of a reversal of the third increase in reserve requirements went beyond its authority and into the actions of the Board. It is clear that Eccles was not overly concerned about the separate roles of the Board and the FOMC.

  Eccles and Morgenthau met with Roosevelt in the afternoon. Roosevelt asked whether it would be inflationary to desterilize gold. Morgenthau agreed that it would. The president proposed a compromise that pleased both men. Morgenthau would tell the Federal Reserve that if it did not fulfill the responsibilities Congress had given it, he would act alone. Eccles would have the opportunity to act alone; the Treasury would not desterilize gold if the Federal Reserve purchased enough to reduce the long-term rate (Blum 1959, 373–74).

  At his home that evening, Morgenthau criticized the FOMC for allowing interest rates to rise. Harrison continued to balk. The meeting dragged on until Morgenthau exploded: “You people just don’t want to admit that . . . you monkeyed with the carburetor and you got the mixture too thin . . . You give us the policy now” (ibid., 374). Harrison would not yield. Finally, Morgenthau ended the meeting with the warning that the president had suggested. Either the FOMC would act or the government would.203

  The threat ended the controversy. After meeting for the whole next day, on Eccles’s motion the FOMC voted to begin purchases at once, to purchase $25 million in the current week, and to purchase up to $250 million by May 1. If the FOMC refused to adopt the policy, or if it failed to lower interest rates, Eccles was willing to cancel the third increase in reserve requirements ratios. He believed it was most important for the System to remain in control of policy.