February’s minutes show the first clear recognition that a recession had started. The council “was definitely of the opinion that the country was in a recession. . . that the business decline was spreading (ibid., 3–4). McCabe challenged this view: “In spite of the decline in business activity, there was more optimism than had been expressed by the Council” (5).165 Council members demurred and used the recession to argue against the Board’s program. In a statement reminiscent of Miller or Young in the 1920s, Eccles showed that he had forgotten why he came to Washington in 1933: “The business decline that was now occurring was an inevitable result of the unprecedented inflation during the past two or three years, that the longer the unbalance and distortion in the economy continued the more disastrous the deflationary adjustments would be. . . and that some adjustment was necessary and desirable [sic] if the economy was to return to a period of stability” (13–14).166
162. The president’s staff objected to including insured banks on the grounds that the recommendation was too “controversial” for the State of the Union message. The Board agreed to delete the sentence from the speech provided it remained in the Economic Report of the President (Board Minutes, December 22, 1948, 5).
163. Several Board members accepted payment of interest on reserves reluctantly. Governors Szymczak, Evans, Vardaman, and Clayton preferred a secondary reserve of securities but regarded that proposal as unacceptable to Congress.
164. State banks could convert to national charters, but national banks could not convert to state charters. The increase in maximum reserve requirement ratios may have stimulated interest in removing this restriction. The Board opposed the change unless Congress approved its request to place nonmember banks under its reserve requirements. The so-called membership problem continued to occupy the Board until the 1980s (Board Minutes, March 17, 1949, 2–4).
165. During the general discussion, Eccles responded that the increase in reserve requirements “did nothing more than immobilize reserves received by the banking system as a result of the System’s support policy and, therefore, was entirely justified for that reason” (Board Minutes, February 15, 1949, 8). Despite the recession, Eccles favored the rate increase.
A widening rift between the Federal Reserve and the Treasury developed at the March 2, 1949, FOMC meeting. Secretary Snyder’s letter, responding to the committee’s request for an increase in short-term rates, stimulated an active discussion during which several members gave their views. Three issues were in contention at the time. First, the secretary again rejected the proposed 0.125 percent increase in certificate rates. Second, he cautioned the System to reconsider its policy of allowing rates on Treasury bills to rise because it would force a rise in the certificate rate.167 Third, the Treasury would not commit to retire debt from the reserve banks. It preferred to retain its freedom to choose the source of open market retirements. The System saw this as a threat to its role.
FOMC members differed about whether interest rates should be raised. Some of the Board’s staff and Governor Clayton opposed the increase in rates as inappropriate in a recession. Some noted that prices had fallen (since October). Sproul described the decline as “a healthy readjustment.” He proposed to continue pressure to increase the bill rate, while avoiding an increase in the discount rate, to “improve the interest rate structure . . . and avoid the appearance of more or less permanently pegged rates at both ends of the rate pattern” (Minutes, FOMC, March 1, 1949, 12).
The FOMC adopted Chairman McCabe’s suggestion that it ask Secretary Snyder to increase the rate but to be less insistent than in the past. To show its awareness of conditions in the economy, the committee included the words “in the light of changing economic conditions” in its directive. The vote, however, was to raise rates. Some members may have voted for the increase knowing that the Treasury would reject it.
166. The council also favored an increase in short-term rates despite the clear recognition of recession and deflation, but it opposed an increase in the discount rate.
167. Snyder irritated the FOMC by writing that the 1.25 percent certificate rate should remain until “a different rate can be mutually agreed upon” (Minutes, FOMC, March 1, 1949, 6). The FOMC recognized that it would not act unilaterally, but it disliked the presumption that the Treasury had veto power. It voted to so inform Snyder (7).
In March, four months after the peak, with industrial production down almost 6 percent, the Board made its first public acknowledgment of recession. By a vote of five to one, it reduced down payment requirements on furniture and appliances to 15 percent (from 20 percent) but kept the 33.33 percent down payment on autos. The maximum maturity on all loans increased to twenty-one months (from fifteen or eighteen months). Eccles opposed the change as “premature.” Further, he thought it encouraged families to go heavily into debt on “too easy terms at high prices” (Board Minutes, March 2, 1949, 2–3).
At the end of the month, by unanimous vote, the Board reduced stock market margin requirements from 75 percent to 50 percent, effective March 30.168 The purpose was to stimulate investment without reducing open market rates. The decline in output continued at a steeper pace. The Board continued to press for a rise in short-term rates and new issues of long-term debt restricted to nonbank holders. The staff continued to view falling prices as helpful and to regard future inflation as a more serious concern than current deflation (Minutes, FOMC, March 1, 1949, 4).
Sproul explained the System’s dilemma in an April memo. Wholesale prices and industrial production were 8 percent below their previous peaks. Factory man-hours had fallen 9 percent. Bank credit had declined “rapidly and substantially.” The economic and credit situation called for lower interest rates; the problem was that the Treasury might not permit a reversal after the economy recovered. He proposed a resolution calling for greater interest rate flexibility that would allow “the short rate to move up and down from the new level with some freedom while trying to find a long rate. . . which will float by itself without too great deviations either up or down” (Sproul Papers, FOMC, April 1949, 2–3).
On April 21, the Board began discussing a reduction in reserve requirements. Interest in an expansive action conflicted with a desire to have Congress renew temporary authority for higher maximum reserve requirements. Facts overcame politics. A key fact was the size of the contraction of bank credit, described as one of the most severe on record (Board Minutes, April 28, 1949, 7). Effective May 1 and 5, the Board reduced reserve requirement ratios by two percentage points at central reserve city banks, one percentage point at other banks, and one-half percentage point on all time deposits (see table 7.9 above). The relative size of the changes reflected the relative size of the decline in bank credit in the year to date. In all, the staff estimated that the changes liberated $1.2 billion of reserves.169 The Treasury issued $100 million in long-term debt to absorb part of the reserves without lowering rates unduly. In May the System sold $1.3 billion, offsetting the effect of the reduction on the monetary base.
168. Before acting, the Board informed the Securities and Exchange Commission (SEC). The SEC did not object.
Open market rates remained unchanged except for a modest (0.005) decline in the ninety-day bill yield. The Board’s policy now aimed to “twist the yield curve” by raising short-term rates while slowly reducing long-term rates.170 The Treasury was unwilling to permit higher short-term rates, so the System was forced to sell long-term, bonds to prevent a steep decline and buy short-term to prevent a rise (Minutes, Executive Committee, FOMC, May 3, 1949, 2).
The Federal Advisory Council praised the Board for reducing consumer credit controls but questioned why controls were needed when durable goods were in excess supply. Governor Vardaman sided with the bankers: controls had been authorized to reduce inflation; inflation had ended. Some manufacturers wanted the controls retained to regulate trade practices but, Vardaman said, that was not authorized in the law (Board Minutes, May 17, 1949, 13–14).
Th
e council again opposed supplementary reserve requirements and asked the Board why it did not reduce requirement ratios below the former maximum values. McCabe questioned the members about the effect on interest rates. W. Randolph Burgess, a member of the council, said there would be little if any effect if the Board sold securities and the Treasury issued medium-term bonds to fill gaps in the maturity structure.
By early June, several in the System began to express concern that the recession was spreading. Their policy of pressing for higher short-term rates and resisting lower long-term rates prevented any effective monetary response to the decline. FOMC members who wanted a more expansive policy agreed that the Treasury would not oppose rate reduction. Later, they hoped, rates could be raised if necessary and policy would be more flexible.
169. The Board decided to ask for renewal of authority to change reserve requirements, to make the supplemental reserve requirements permanent, and to extend the requirements to all insured banks that received demand deposits (thereby exempting mutual savings banks). The members wanted the maximum requirements increased by 10 percentage points for demand and 4 percentage points for time deposits, as initially requested in the State of the Union address, but they realized this was not likely to pass. They prepared two bills, one with the higher ratios they wanted and one renewing authority beyond June 30 with maximum increases of 4 percentage points and 1.5 percentage points above former statutory ratios. The Board also asked for a two-year extension of consumer credit controls instead of the permanent authority it preferred (Letter McCabe to Maybank, Board Minutes, May 5, 1949, 2–3). The chairman of the Federal Advisory Council testified against the bill.
170. “Twisting the yield curve” was the name given in the early 1960s to a policy of raising the interest rate on short-term debt and lowering the rate on long-term debt. As this experience shows, the policy had been tried before.
Sproul took the lead in urging flexibility, but Eccles and McCabe joined him. Eccles said that future policy should maintain an orderly market without supporting a pattern of rates. He favored a symbolic reduction in the discount rate and in reserve requirements. Sproul agreed that the time had come to ease the money market to combat deflation, but he insisted that the change to an independent policy should be permanent, not tied to a current reduction in rates.
Congress did not renew supplementary reserve requirements or consumer credit controls. Both expired on June 30, so demand deposit reserve requirement ratios returned to 26, 20, and 14, with 6 percent for time deposits. The Board considered additional reductions near the end of June but postponed its decision until the Treasury agreed to a general program that included an end to the peg on short-term rates.
policy changes Seven months of recession, and a growing sense of its impotence, had moved the System toward a new policy. On June 21, McCabe and Sproul met with Snyder to propose lower rates on bills and certificates. The Federal Reserve would remove the peg at the short end but retain it at the long end. It would announce the change publicly. Privately they assured Snyder that rates would probably fall and would not be allowed to rise when the peg was removed. Snyder liked the proposal but was hesitant to announce the change.
By July the consumer price index had fallen in six of the preceding nine months and was below the previous year’s level. To stop the deflation, the Board’s staff proposed that reserve requirements be reduced by three percentage points on demand deposits and one point on time deposits, to release $2.6 billion of required reserves. The proposed reductions were an addition to the reserves released by the expiration of supplementary reserve requirement ratios. The Board also reduced the discount rate by 0.25 percent (Board Minutes, June 21, 1949, 16).171
As the System began a more activist policy, it restored the indicators of ease and restraint it had used in the 1920s. Riefler played a major role in drafting and presenting the proposal, so it is not surprising that the proposal discussed policy in terms of excess or free reserves (excess reserves minus member bank borrowing). Reducing reserve requirements, he said, increased excess reserves and put downward pressure on market rates, easing policy.
171. Eccles said that although he favored the proposal, it “implied that credit policy had a greater influence on the economic situation than the facts warranted” (Board Minutes, June 28, 1949, 2).
Although the proposal called for a Board decision, it was the main subject of the June 28 FOMC meeting. The committee held the most active policy discussion in many years. What seems remarkable in hindsight is that opinion was divided about the need for change. Of those who are recorded, Presidents C. E. Earhart (San Francisco), Ray M. Gidney (Cleveland), and Hugh Leach (Richmond) were most aggressive; they favored ending the peg for both short- and long-term rates and announcing the change as a permanent change whether rates moved up or down. Governor Evans, at the opposite pole, favored letting rates decline but wanted the Board’s public statement to reaffirm the commitment to the 2.5 percent rate as a maximum. Keeping the 2.5 percent rate “was one of the major accomplishments of the postwar period” (Minutes, FOMC, June 28, 1949, 8).
Snyder’s support for lower rates seemed to give the opportunity Sproul had waited for. He favored letting rates fall, but he was reluctant to announce that rates would be more flexible henceforth. He wanted to limit the public announcement to a statement that the FOMC would maintain orderly conditions, omitting words about stable rates but not making a permanent commitment to market-determined rates (ibid., 22).
McCabe hesitated also. He “felt it would be catastrophic if long-term government bonds were allowed to drop below par” (ibid., 11). He proposed avoiding the issue in his letter to Secretary Snyder by reaffirming that the “programs and policies to be pursued would be decided upon after full discussion and mutual understanding” (10). This formulation did not assert independence or accept a Treasury veto. It was ambiguous enough to gain unanimous consent.
The committee next had to decide what it would announce publicly and what it intended to do about the $800 million that would be released when the supplementary reserve requirements expired in two days. There was general agreement that the System would not absorb the $800 million by open market sales but, instead, would allow banks to lower market rates. Riefler wanted to supplement the $800 million by a further reduction in reserve requirement ratios. Reverting to the Riefler-Burgess framework of the 1920s, “he was not interested in lower short-term rates as such. . . . [He] was prepared to accept them as the inevitable consequence of bank reserve positions that would put banks under some pressure as lenders” (ibid., 18–19). Sproul emphasized market rates, not free reserves. He thought $800 million of additional reserves was a sufficient increase to reduce rates. The presidents agreed with Sproul. Only President W. S. McLarin Jr. (Atlanta) favored the staff position.
The public announcement, approved unanimously, emphasized the “needs of commerce, business, and agriculture,” and the “general business and credit situation.” It added that “under present conditions the maintenance of a relatively fixed pattern of rates has the undesirable effect of absorbing reserves from the market at a time when the availability of credit should be increased.” This formulation left open whether the decision to drop the peg was temporary or permanent.172 The committee’s hesitation proved costly when it wanted to increase rates. Because it failed to tell Snyder and the market what it wanted to do, it weakened its claim that the June 1949 change permitted rate increases later.
Stock prices reached their cyclical low in mid-June, 13 percent below the October 1948 peak. The announced change in policy may have contributed to a rise in stock prices; the July average is more than 5 percent above June. The actual change in policy was slight. Contrary to its discussion, the System sold securities, withdrawing $800 million of reserves in July. Bill, certificate, and bond rates declined in July, with long-term bonds reaching the lowest rate in two years, 2.27 percent in late July. Gold continued to flow in, increasing the monetary base. The decline in rates
was not steep enough to compensate for ongoing deflation, so real rates of interest continued to rise.
The following day, urged on by McCabe, the Board again discussed an additional reduction in reserve requirements. All other governors opposed, preferring to observe the full effects of the expiration of supplementary reserve requirements.173 Ten days later, and continuing through July, Board members and staff frequently suggested additional action, including reductions in the discount rates and in reserve requirement ratios. Several governors were on vacation, so discussions remained informal.
172. Leading banks welcomed the June 28 action as the end “of the fixed rates . . . and of the close relationship of System open market policies to Treasury financing policies that had existed since the war” (Minutes, FOMC, August 5, 1949, 2).
173. Eccles cited the overnight drop in Treasury bill yields from 1.16 percent to 1.10 percent following the Board’s announced policy change. Yields fell to 1.02 percent by the end of July, then rose back to 1.10 percent by late December.
Eccles drafted a long statement after the June 29 meeting. He proposed releasing the statement to the public, but only four governors agreed to the statement. McCabe, Vardaman, and Draper did not sign. Part of the statement shows the mistaken interpretation of low nominal interest rates as evidence of monetary ease. The relevant section reads: “Since we have had easy money conditions with relatively low rates all along in the money market, it should not be supposed that still easier conditions with lower rates will completely correct or cure a deflationary trend, although they may encourage greater use of the existing money supply. . . . To the extent that the Reserve System becomes a reluctant seller of its holdings of Government securities, banks may be more disposed to make productive loans to private borrowers. . . . Monetary policy by itself cannot make lenders lend or borrowers borrow. . . . It cannot by itself bring about the very necessary price and other readjustments within the economy” (Board Minutes, June 29, 1949, 17–18).
A History of the Federal Reserve, Volume 1 Page 98
