151. The administration, not the Board, initiated the decision to reimpose consumer credit controls (Board Minutes, July 20, 1948, 3). The Board sent Woodlief Thomas to participate in a meeting on July 23 at which the White House staff presented the details of the president’s message to Congress. The Board authorized Thomas to say that the Board favored consumer credit controls, to last three years, and authority to increase reserve requirement ratios “in such form as it might wish.” If required to be specific, Thomas was authorized to ask for ten percentage points for demand and four percentage points for time deposits above current maximum rates. He was told not to raise the issue of whether the change applied to all banks or only to member banks (Board Minutes, July 23, 1948, 6).
152. This statement is clearly disingenuous and misleading, since the Federal Reserve would not change the 2.5 percent rate without Treasury approval, and the Treasury was concerned about interest costs on the debt. McCabe recognized the Treasury’s concern later in his testimony (House Committee on Banking and Currency 1948, 95).
153. The Board’s proposal was part of the program for the special session of Congress in August 1948. The bill authorized state bank supervisors to enforce reserve requirements against nonmember banks. The Senate bill limited the change in reserve requirements to member banks.
Chairman Jesse P. Wolcott and other members questioned McCabe and Evans about the reason for credit controls. McCabe tried to shift responsibility to Congress, suggesting that Congress should order an end to pegged rates. Wolcott demurred.155 He challenged McCabe and Evans to explain how credit controls would reduce demand, pointing out that people could take out larger home mortgages to offset larger down payments on cars and other durables. Other members cited examples showing that credit controls did not curtail demand for durables. McCabe and Evans had no answers.
During the summer of 1948, the Board continued to press the Treasury to raise short-term interest rates on its refundings and to use its balances to retire Treasury bills. On July 16 McCabe gave Snyder the draft of a letter outlining the Board’s concerns. The Board again referred to its “statutory responsibility” to control inflation, warned of higher inflation ahead, and expressed concern that the Treasury had failed to increase the rate on certificates at the April and June refundings. The letter warned that credit demands remained strong and that insurance companies and other holders of long-term bonds were likely to sell as much as $1.5 billion of such debt to the System in the second half of 1948. To offset these prospective purchases, the System had to be able to sell an equal amount in the short-term market.
The letter again proposed higher rates on certificates and higher discount rates. The Federal Reserve pledged again to support the long-term market, and it asked the Treasury to continue retiring short-term debt from the reserve banks. While awaiting the Treasury’s response, the Board began to discuss a further increase in reserve requirements, to 26 percent, at central reserve city banks.
154. Congressman Jesse P. Wolcott was the committee chairman. “The Chairman: Then you mean . . . that it is going to be your continued policy . . . to buy Governments in the open market? Mr. McCabe: I would not say that it is our policy forever. I say for the foreseeable future. . . . The Chairman: That is to support our debt. Mr. McCabe: That is to support our debt; yes, sir. The Chairman: Then you are saying that it is necessary to continue inflation in order to carry the national debt? Mr. McCabe: I would not like to put it that way, sir” (House Committee on Banking and Currency 1948, 101).
155. “The Chairman: There have been orthodox ways of controlling it [credit] heretofore. . . . I do not know why we have to supplement those with consumer credit controls at the present time, anymore than we did before. Mr. McCabe: . . . [I]f it is the wisdom of this Congress that the Federal Reserve should not support the Government bond market, then I think Congress should so direct the Federal Reserve. . . . The Chairman: I do not think we are going to direct you not to support the government bond market. I do not think we are going to direct you to support the Government bond market at a particular figure” (House Committee on Banking and Currency 1948, 109).
In July the annualized monthly rate of increase in consumer prices reached 15 percent, and the twelve-month rate reached 9.3 percent. The Treasury agreed to an additional 0.25 percent increase in the discount rate, to 1.5 percent, a 1.25 percent rate on one-year certificates, and an increase in the bill rate. In return, Snyder asked the Board to again reaffirm its support for the 2.5 percent long-term rate and to postpone a decision about reserve requirements until September (Letter, Snyder to Board, Board Minutes, August 10, 1948, 3). The Board promptly notified the reserve banks that they could raise discount rates. All banks voted for an increase. Open market rates on short-term securities rose. Two years after the war’s end, the spread between short- and long-term rates was down to 1.25 percent.156
Table 7.10 shows the minimum and maximum rates fixed in August 1948. These rates applied only to member banks and were temporary until June 30, 1949. Congress refused again to authorize the Federal Reserve to set reserve requirements for nonmember banks.157
At the Board’s August 24 meeting, Governor Vardaman announced that he intended to propose increases in reserve requirement ratios for demand and time deposits at the first meeting after Labor Day. McCabe spoke in favor of the increase as part of a more general program developed jointly with the executive committee of the FOMC. Vardaman and Szymczak preferred immediate action. Eccles was not present but sent a letter proposing increases, effective within the next two weeks, and expressing concern that, having been granted additional authority, the Board would hesitate to use it (Board Minutes, September 7, 1948, 7–14). The discussion reached an informal agreement that the Board would increase reserve requirements by two percentage points for demand and 1.5 percentage points for time deposits and would notify Secretary Snyder of its intention. The only formal decision was to postpone the vote until after the meeting of the FOMC executive committee the following day.
156. The account manager, Rouse, explained how the market worked at the time. The Federal Reserve was the residual buyer at the end of the day. If it allowed prices on certificates or bonds to move by more than 1/32 , the market would offer all maturities to learn whether the support price had changed. This made it difficult to move to a more flexible rate policy. This description makes clear that the market was no longer confident that the peg would remain indefinitely.
157. Out of more than fourteen thousand banks in 1948, eleven withdrew from membership in 1948 and four in 1949. Admissions to membership were twenty-seven in 1948 and fifteen in 1949. More than two thousand banks had not agreed to par collection at the time, so they were not eligible for membership.
At that meeting, President Clifford S. Young of the Chicago bank gave the correct analysis: “The increase would not do much good as an anti-inflationary move because banks would only sell securities which the System would buy in order to give them the reserves to meet the increased requirements” (Minutes, Executive Committee, FOMC, September 8, 1948, 6). Sproul, on the other hand, thought the change was too big. It would “ churn the market unnecessarily” as banks sold governments to meet the higher requirements (6). McCabe favored lowering the support price for long-term bonds to the 2.5 percent rate, a reduction of only $25 on a $1,000 bond, but Sproul opposed using the same argument that had been used against him—that such a move would “create apprehension as to whether the entire support program was going to be continued.” They would then have to buy large amounts (9).158 McCabe urged a drop in other support prices with an announcement that the 2.5 percent rate would be maintained, but Sproul cautioned that they had done that successfully in December 1947 and could not repeat the promise a second time after imposing losses on bondholders in December. He wanted to be rid of pegged rates, and he disliked further commitments to support them, but he did not favor the small step McCabe proposed (10). Sproul also opposed McCabe’s suggestion that the bill rate be all
owed to fluctuate more freely. With a fixed rate on certificates at 1.25 percent and the bill rate at 1.08 percent, there was little to be gained.
The Board met the same afternoon and voted unanimously to increase reserve requirement ratios, as previously agreed, for demand and time deposits. The staff estimated that the change would absorb $1.9 billion in reserves. On average the system portfolio rose $1.54 billion, and the gold stock rose $130 million, canceling most of the restrictive effect. Banks and others responded by selling long-term and buying short-term securities. Short-term interest rates remained unchanged, and the monetary base continued to decline.159
158. A notable feature of these discussions is the unwillingness to pay a one-time cost to improve control and reduce certainty about the 2.5 percent rate. This problem remained long after the peg was removed.
New York now had a more important role than at any time since the 1920s. Sproul took the lead in shaping the September decision. McCabe deferred to Sproul’s views, whereas Eccles had not.
The 1948–49 Recession
Industrial production fell in August and September, rose in October, then fell sharply in November. The consumer price index reached a peak in August, remained unchanged in September, and fell in October. The fall was precipitate, from a 15 percent annualized rate of increase in July to unchanged in September.
The Board and the FOMC were unprepared and at first did not respond to the recession. The only mention of a decline referred to an eventual, inevitable recession if inflation continued. At a meeting of the System Research Advisory Committee in late September, Woodlief Thomas, the director of research, forecast a substantial increase in expenditure and income and continued price increases (Sproul Papers, Board of Governors, Memorandums and Drafts, September 27, 1948). He urged actions to slow the expansion. The Board’s staff forecast 10 percent growth of GNP in the last three quarters of 1948 and the first quarters of 1949 (ibid., September 30, 1948).
The recession eventually forced the System to face facts it had tried hard to avoid; it could not control inflation and was reluctant to respond to recession. Consumer credit controls, changes in stock market margin requirements, or adjustment of reserve requirement, with interest rates unchanged, accomplished little. Interest rates and money growth were set by markets, not by the System.
Realization grew slowly and spread even more slowly. More than halfway through the recession, the Board and the FOMC continued to press the Treasury to raise short-term interest rates, despite sustained declines in industrial production and consumer prices. Two closely related reasons help to explain why policy was slow to change. First, the principals regarded the recession as temporary, and for many it was a welcome interlude. The problem of greater concern was long-term inflation. Second, market interest rates were at historical lows, so they believed policy was easy. No one mentioned the effect of falling prices on real interest rates, a repeat of behavior in previous periods of deflation.
159. The volume of security sales was so heavy that the manager had to make three requests to increase the ceiling on purchases during September.
The New York bank was more perceptive than the Board about the start of the recession. At the October FOMC meeting, John H. Williams predicted that the economy was about to enter a mild recession, while inflation “was in the process of wearing itself out” (Minutes, FOMC, October 4, 1948, 5). He favored additional increases in short-term rates and no change in long-term rates.
His comments about recession had no impact, perhaps because the FOMC welcomed a mild recession. The main topic at the meeting was an increase in certificate rates to 1.5 percent as soon as possible but before the January refunding. The increase would permit the Treasury bill rate to rise toward the certificate rate and increase commercial banks’ bill purchases. Sproul proposed that the Federal Reserve should present its plan to the Treasury without seeking approval or disapproval. Following the FOMC meeting, Sproul and McCabe met with Snyder, but they waited for approval and did not act. A month later, in mid-November, over Federal Reserve objections, Secretary Snyder announced that the certificate rate would remain unchanged through January. Short-term rates remained the same until May 1949.
Stymied by the Treasury’s reluctance to increase rates, the Board discussed a further increase in reserve requirement ratios but did nothing. Banks objected to the further increase as costly to them and ineffective against inflation.
President Truman’s reelection surprised many bankers, businessmen, and others. The Federal Advisory Council ignored the deflationary policy but blamed the election for “a very profound change in business sentiment” (Board Minutes, November 16, 1948, 2). The council reported that businessmen were concerned about an excess profits tax, higher corporate tax rates, and new price controls. It warned that these policies would slow the economy. The risk of recession had increased. There would be a pause; construction and expansion would slow. The length and depth of the slowdown depended on the administration’s programs.
Long-term bond yields fell after the election, at least partly in response to recession and deflation. Insurance companies had been heavy sellers before the election. They now began to buy, so the Federal Reserve reversed course, selling long-term and buying short-term securities.160 The Treasury also changed its operations after the election. Instead of retiring bills from the Federal Reserve, it began to retire bills held by commercial banks. The effect on the stock of debt was of course the same, but the monetary base and the money stock increased.
160. Between May and November 1948, Federal Reserve holdings of governments with ten years to maturity increased by $4.3 billion. In the next six months to May 1949, during the recession, its holdings decreased by $2.3 billion.
The FOMC discussed the Treasury’s new procedure at its November 30 meeting and concluded that the Treasury was trying to reduce the outstanding stock of bills to the point where the rate could be set free. Although the FOMC preferred to keep pressure on bank reserves, it did not object that the new procedure increased reserves. It decided also to reduce the premium above par on long-term debt. There was no mention of recession.
After his reelection, President Truman asked the Board for its legislative program. The Board suggested several changes: (1) extend the temporary powers to raise reserve requirements and impose consumer credit control beyond June 30, 1949; (2) enact new legislation giving the Board power to regulate bank holding companies; (3) authorize the Federal Reserve to guarantee loans by banks to businesses; and (4) ease membership requirements by reducing capital requirements for branches of state banks (Board Minutes, November 30, 1948, 4–6). Later the Board modified its request. It asked to maintain new maximum reserve requirements only if they applied to member and nonmember banks. None of the proposals had much to do with inflation (or deflation), and none became law.
At its December 1 meeting, the Board reviewed material to be included in the president’s economic report. The draft showed no awareness of recession or deflation. The principal recommendations called for a larger budget surplus, achieved by raising tax rates and reducing spending to retire debt at reserve banks (Board Minutes, December 1, 1948, 3–5). On the critical issue of the bond price support, the Board recognized “a serious dilemma,” but it offered no new solution and did not recommend increasing long-term rates (5).161
The Board asked the reserve bank presidents to comment on consumer credit controls and reserve requirements. The presidents favored credit controls, and some wanted to make them permanent. A majority opposed further increases in reserve requirements. They reported that “banks continued to hold the view that the only effect of an increase was to transfer Government securities from the banks to the Federal Reserve banks” (ibid., 6). They noted that bankers talked about withdrawing from membership, but none had done so.
161. Although the recession had started, the administration’s budget ignored evidence of recession and deflation. The budget asked for higher taxes on profits and estates and a surtax on
incomes, and it assumed continued growth. It requested more spending for defense and education. By mid-February, when Chairman McCabe testified on the budget, he recognized that a mild readjustment was occurring, but he continued to urge his legislative program to control inflation.
The Board responded by making two changes in its proposals for the State of the Union message. It proposed paying interest on the additional required reserves.162 And it limited its request for authority to regulate reserve requirements for nonmember banks to those that offered deposit insurance, thereby exempting the smallest, nonmember banks (Board Minutes, December 17, 1948, 5).163
At the turn of the year, the FOMC continued to press gently for a 0.125 percent increase in short-term rates. One of the main objectives at the time was to reduce the spread between short- and long-term rates so that holders would have no incentive to play the pattern of rates. Sproul reported that the Treasury would resume its former practice of retiring debt from the reserve banks and, despite declining economic activity, was open to the idea of increasing short-term rates at the March and April refundings (Minutes, Executive Committee, FOMC, January 4, 1949, 5–7).
The January 1949 meeting was the first time the FOMC discussed how it could end support of the long-term market. Sproul proposed refunding outstanding long-term debt into higher-yielding issues that would not require support (ibid., 8). The Treasury did not agree until 1951.
The Federal Advisory Council opposed the Board’s legislative program. It reminded the Board that increases in reserve requirements had no effect on inflation. The council also opposed interest payments on reserves and extension of the Board’s authority to include nonmember banks (Board Minutes, February 15, 1949, 3).164
A History of the Federal Reserve, Volume 1 Page 97
