275. The Bank of England sold dollars in large volume during August. New York Federal Reserve records report $235 million from August 10 to August 24, with the daily amounts increasing. The bank told the Federal Reserve of its decision to float the pound the night before the public announcement (Sproul Papers, Bank of England, August 1939).
276. Harrison reports Eccles as saying: “Why try to stabilize at all, why not let it go down 2 or 3 points? I [Harrison] said that was our judgment [to let it open 1/2 point down] and if he did not like it, he [Eccles] could take a vote and we would abide by that” (Harrison Papers, file 2140.5, September 5, 1939, 1).
277. With Eccles absent, the executive committee split two to two, so no change was made. The Board members voted to keep the gradual policy. Harrison was angry when the news of the split appeared in the papers. The Treasury believed the committee had opposed action to embarrass the secretary (Harrison Papers, file 2140.5, September 22, 1939, 12–13).
The System’s aggressive purchases, to slow the rise in interest rates, contrast sharply with its passivity throughout the depression. There are only two previous periods in which weekly rates of purchase were closely comparable to the $800 million purchased jointly with the Treasury in three weeks at the war’s start. One was in the fall of 1929 when, despite the Board, New York purchased $157 million in two weeks. The other was at the peak of the purchase policy in spring 1932, when the System purchased $640 million in seven weeks.
Three main reasons explain the 1939 purchases. First, the FOMC had discussed for months the policy it should follow in the event of a European war. Eccles had committed to an expansive policy in meetings with the president and the Treasury. The reserve banks had agreed in advance to purchases of up to $500 million for the System account. Second, the objective was to stabilize the money or bond market in the face of an external disturbance. This objective was widely shared and uncontroversial. Unlike New York’s effort in October 1929, there were no issues about the inevitable consequences of stock market speculation dividing New York and Washington. Third, low rates were interpreted as “easy” policy, rising rates as evidence of tightening. Neither the Federal Reserve nor the Treasury distinguished between real and nominal rates, so they did not mention, and probably did not recognize, that the war changed real expected returns and risk premiums.
The Federal Reserve agreed to lend to member and nonmember banks at the prevailing discount rate. This was a major change—the first time the System publicly accepted responsibility for systemwide liquidity.278 As Walter Bagehot had urged, it announced its policy in advance. Although there is no mention of the deposit insurance system, by lowering the risk to the Federal Reserve of lending to nonmember banks, deposit insurance may have contributed to this change.
At the September 18 FOMC meeting, Eccles presented three issues: the speed at which the bond market should decline, the size of purchases during declines, and the timing of purchases. He favored strong resistance to prevent bonds from going below par value (Minutes, FOMC, September 18, 1939, 6.
For the first time in many years, Eccles asked for individual views. The committee was divided. Harrison repeated Morgenthau’s view that the System had been too active. He preferred to let the market decline while avoiding disorder by placing bids below current prices. This would revive the private securities market and help the Treasury. Roy A. Young (Boston) and John S. Sinclair (Philadelphia) expressed views similar to Harrison’s. George Hamilton (Kansas City) wanted aggressive purchases if bonds fell below par, because the public expected it. Most of the others preferred to continue the policy of purchasing to prevent rapid decline and opposed pegging yields.
278. New York agreed to hold clearing balances for nonmember banks in 1935 (Minutes, New York Directors, August 22, 1935, 1134).
The committee voted to buy up to $500 million additional if needed to maintain an orderly market. Within a week, the System was able to sell as yields reached a peak and declined. The decline in yields continued for the rest of the year. Sales and retirements brought the account below $2.5 billion by year end, and lower than before purchases began. Bond yields ended the year at 2.30 percent, 0.16 percent above the lowest rates of the year and 0.44 percent below the peak.
The FOMC resumed the quiet life. The December 13 meeting concluded that the System should confine its activity to smoothing the market by buying or selling on a sliding scale when there were few other bids. Again, it explicitly resolved not to peg interest rates.
The policy statement at the December meeting, withdrawing from active play, reflected earlier discussions with the Federal Advisory Council. The council again unanimously approved a statement opposing the “easy money” policy and urging the Federal Reserve to allow bonds to be priced by the market, “free of official intervention” (Board Minutes, October 10, 1939, 2). It approved of actions to prevent a disorderly market but opposed the prevailing actions—sales to force rates back to earlier levels.
Discussion at this meeting was a prelude to discussion of “bills only” in the 1950s. Governor Ransom asked, What is an orderly market? Several members acknowledged that they could not define “orderly.” The best the group did was to define an orderly market either as “a natural self-supporting market” that, if perturbed, maintained the new price without panic buying or selling or as a market in which bids and offers were not too far from the last sale (ibid., 4–5). A market was not orderly if there was a single buyer or seller “whose one purpose was to maintain a market” (14).
The members stated forcefully that they opposed “easy money,” and they disliked the System’s requirement that buyers and sellers had to give their names during the market break.279 They again suggested a return to the 1920s policy of letting individual reserve banks buy and sell government securities with district banks.
279. This requirement remained in effect for only a few days. The idea was to prevent speculative selling. Several bankers argued that it also prevented buying, so the effect was ambiguous at best. The bankers’ discussion mentions some of the rumors spread by security dealers to increase transactions volume (Board Minutes, October 10, 1939).
Eccles’s main comment is similar to Goldenweiser’s statement at the June meeting. He denied that the System influenced the interest rate structure. Any influence was temporary, he said.280 The System had not bought to maintain “easy money”; the dominating factors were the gold flow and the level of excess reserves.
Three lasting procedural and administrative changes were made at the end of 1939. Although he was a member of the executive committee, Hugh Leach (Richmond) was not included in the frequent telephone conversations between New York and Washington. In response to his complaint, Harrison ordered the manager of the System Open Market Account to call Leach every day at about noon to keep him informed. This is the origin of the daily conference call that continues to the present (Harrison Papers, file 2140.6, November 29, 1939).
Early in November the New York bank nominated Robert Rouse to replace Allan Sproul as manager of the System Open Market Account.281 At about the same time, the bank adopted new rules limiting trading to “recognized dealers.”
Search for a Policy Guide
By March 1940, the pace of decline had slowed. Goldenweiser and Williams regarded the decline as a correction of heavy inventory building after the war started. They proposed no policy action, and none was taken (Minutes, FOMC, March 20, 1940).
The main decision was to undertake a study of the role of open market operations under prevailing conditions—conditions of relatively large and growing excess reserves and minuscule yields on Treasury bills. The study produced the first statement of guiding principles in many years (Memo, Despres to Goldenweiser, Board of Governors File, box 1433, April 29, 1940).282
The report began by repeating the explanation of how open market operations worked in the 1920s, made familiar by Riefler and Burgess. The new elements were the large volume of excess reserves and the relatively small supply of
short-term assets issued by government and corporations. Monetary policy could work in this environment by changing the interest rate structure—the relation of short- to long-term rates. Changes in money were irrelevant: “Any volume of expenditure in the markets for goods and services can be financed by any quantity of money” (ibid., 2). The memo illustrated how changes in short-term interest rates induced changes in borrowing, money holding, and spending. The discussion emphasized mainly borrowing costs.283
280. For several years the FOMC had been trading bonds for shorter-term securities, at times with the announced intention of changing relative yields. Eccles’s statement suggests that he concluded that these operations had only temporary effects.
281. Rouse joined the New York bank as assistant vice president on July 1, 1939. He became a vice president when he became manager.
282. Emile Despres was an international economist at the New York bank and later a professor at Stanford University.
The memo then made a significant break with standard beliefs: “Excess reserves are truly ‘excess’ only in the legal sense. In an economic sense, they meet the banking system’s demand for liquidity which was formerly met by its holding of short-term assets. The willingness of banks to hold their present portfolios of Government securities at existing yields is dependent on the present supply of reserves” (ibid., 4). Goldenweiser’s marginal comment: “That I think is doubtful.”
The memo applied similar analysis to money holdings. The argument reflected contemporary understanding of Keynes’s 1936 General Theory. There were fewer alternatives to cash than in the twenties. Money holders had shifted into long-term bonds, but their willingness to hold bonds depended on expectations about future interest rates, and thus on Federal Reserve policy: “If the market believes that the System is prepared to furnish vigorous support to the government security market, holders of high-grade securities will be less disposed to press their holdings on the market” (ibid., 5). By signaling its intentions, the System could shift holders between cash (money) and bonds, with significant effects on long-term rates.
The conclusion was that excess reserves and low short-term rates did not remove the possibility of controlling inflation. With short-term rates near zero, the System had much greater influence over long-term rates than in the past, so it could operate directly on the margin between money and long-term assets (ibid., 5). The memo concluded by urging a policy to promote “expansion now and stability later.”
Entrenched views were too strong to overcome. The System continued its inactivity, and the Federal Advisory Council continued its concern for the System’s “easy money” policy. At the Board’s suggestion, the council developed a statement of the causes of easy money and what might be done. The council wanted the statement published in the next issue of the Federal Reserve Bulletin.
The council’s statement gave seven main causes of “easy money.” Placed first was the Board’s easy money policy and “its continuous advocacy” of that policy. The Board had not “set up warning signals against the evil effects of the extreme to which it has been carried and of the dangers of its continuance” (Board Minutes, May 21, 1940, 8). The policy began at the end of 1929 and had not been reversed. Instead, bill rates had been pushed to zero, and the System had bought long-term debt (a speculative asset). The government’s spending program and deficits also contributed by making the Treasury a proponent of low interest rates, dollar devaluation, silver purchases, and the Johnson Act (prohibiting loans to foreign governments that had defaulted on war debts). Finally, the statement cited the continued gold inflow and discontinued sterilization policy.
283. Goldenweiser’s handwritten comment is, “Availability is more important than cost” (Memo, Despres to Goldenweiser, Board of Governors File, box 1433, April 29, 1940, 4).
The council proposed open market sales, purchases only to offset disorderly markets, sale of Treasury issues to nonbank investors, and jawboning by the Federal Reserve against easy money policy. The quality of the council’s understanding is suggested by its simultaneous call for a return to a full gold standard, followed in the very same sentence by a request to resume gold sterilization.284
The only proposal that appealed to Eccles came near the end—an increase in legal reserve requirements. He told the council he could think of nothing more injurious to the position of the council than publication of its views. The Board would respond to the statement, bringing the conflict before the public. He urged them to cooperate in a joint statement that might get Congress to act.
Several members of the Board denied responsibility for “easy money.” Criticisms of the Board and the administration aside, there was general agreement on the need to end easy money by reducing excess reserves. Governor Szymczak raised the usually unspoken issue. If the System reduced its bond portfolio, “it would be without sufficient earnings and would be forced to go to Congress for appropriations” (Board Minutes, May 21, 1940, 17). Eccles added that only a small amount could be sold before earnings fell below expenses. And he reminded the council that it had publicly opposed giving the Board authority to increase reserve requirements when the Banking Act of 1935 came before Congress.
The outcome was an agreement to work on a joint statement and to invite the reserve banks to join the discussion. In December the Board, the council, and the presidents of the reserve banks agreed on three main recommendations: (1) authority to double reserve requirement ratios from the current maximum to 28 percent, 40 percent, and 52 percent for the three classes of banks; (2) decisions about reserve requirements to be transferred from the Board to the FOMC, where the reserve banks, hence the member banks, had more influence; and (3) reserve requirements to apply to member and nonmember banks. Eccles explained that he had agreed to the second change to avoid opposition from commercial banks.285 The discussion and recommendations show no recognition of Emile Despres’s memo to Goldenweiser. Excess reserves were treated uniformly as an inflationary threat, “excess” in the economic as well as the legal and accounting sense.
284. The council ended its statement by reciting its opposition to many “artificial” devices. The list includes devaluation, pump priming, taxing undistributed profits, and easy money. These policies had failed, they said.
The final draft offered the recommendations as part of defense policy, necessary to prevent inflation from hindering mobilization. In addition to the powers to change reserve requirements, the memo called for repeal of the silver policy, the Thomas amendment authorizing the president to issue greenbacks, and the president’s authority to devalue the dollar. These provisions removed several of the irritants that bankers disliked. The memo also suggested that, as production expanded, a rising share of government spending should be financed by taxation.
The Board sent the statement to Morgenthau, who angered Eccles by doing nothing for ten days and failed to endorse the statement or comment on it publicly when it was sent to Congress at the end of December. When long-term bond yields rose (from 1.88 to 1.97), Morgenthau blamed Eccles and declared the increase in interest rates “not warranted” (Eccles 1951, 355). In response to a question, he suggested that Congress was unlikely to act on the statement. He would give his opinion of the policy only if Congress took the proposal seriously (Sproul Papers, Monetary Policy, 1940–41, January 9, 1941). Eccles complained to Roosevelt without effect.286
Morgenthau’s only policy proposal asked Congress to make interest on all government securities taxable. Dismissal of the joint proposal started a new period of hard feelings and intermittent feuding between the Federal Reserve and the Treasury and between Eccles and Morgenthau. Eccles described the Board’s response to Morgenthau’s statements as “a mood of impotence and frustration” (Eccles, 1951, 355).
285. Eccles’s acceptance of a large role for the reserve banks reversed his position at the time of the 1935 banking act. President Young (Boston) wanted to add to the statement that it was a change from the “easy money” policy, but other preside
nts opposed. Goldenweiser suggested that the limit be raised to three times present requirements, but it was not adopted.
286. Morgenthau’s reaction should not have surprised Eccles. Eccles, Harrison, and Edward E. Brown, chairman of the Federal Advisory Council, presented the statement to Morgenthau on December 19. Morgenthau’s response was that issuing the statement might raise interest rates. He promised only to discuss the issue with the president, and he urged Eccles to discuss the matter with Lauchlin Currie, who was then on the White House staff as economic adviser. In conversation with Morgenthau, Roosevelt dismissed both the idea and Eccles: “This is so unimportant, the Federal Reserve system is so unimportant, nobody believes anything that Marriner Eccles says or pays any attention to him” (Blum 1965, 298). Later Roosevelt assured Eccles that everything would “work out all right” (Eccles 1951, 357).
The bankers’ criticisms and reconsideration of policy actions had a modest effect on decisions. The FOMC was much less active at the time of the German invasion of the Netherlands, Belgium, and France and the fall of France in May and June.287 The FOMC authorized sales at the May meeting, to prevent disorderly conditions. It made a few sales in June, as interest rates fell. During the autumn, sales increased. Between September and December the FOMC sold $250 million, more than 10 percent of the portfolio. By December, members expressed concern about whether the portfolio would be large enough to pay the reserve banks’ expenses and dividends. Authority to prevent disorderly markets replaced the authority to sell (Minutes, FOMC, December 18, 1940, 10). The FOMC made no further purchases or sales until the United States entered the war a year later. During most of this period, long-term bond yields remained between 1.9 percent and 2 percent. The gold stock rose above $22 billion, and excess reserves reached $5 billion. On November 1, 1941, with inflation above 10 percent, the Board reversed the 1938 reduction in reserve requirement ratios, returning to the maximum values and removing approximately $1.5 billion of excess reserves.
A History of the Federal Reserve, Volume 1 Page 81
