A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  This summary, like similar statements about credit expansion made at the time, either is based on an error of interpretation or is deliberately misleading. It is true that bank loans increased rapidly during this period. Total bank credit and money increased modestly, at noninflationary rates. Table 7.14 shows the values of money, loans, and bank credit for the period. These data appear to support the Treasury view that monetization of debt had not occurred. In fact, monetization did occur, but its effect was largely offset by loss of gold.

  Only the data for loans show rapid expansion. Banks sold government securities to finance most of their loan growth. The Federal Reserve and the Treasury trust accounts made heavy net purchases, but the gold outflow offset most of the effect on the monetary base. The base, M1 and M2, rose modestly. Once again the Federal Reserve appears to have been misled by its focus on nominal interest rates and bank lending and its neglect of monetary aggregates.

  What about inflation? The data tell an unusual story for wartime. Inflation soared at the turn of the year. The consumer price index rose at a 19 percent annual rate for three months, December 1950 through February 1951. The rate of price change then fell back to about 1 percent (annual rate) from March through June 1951. The GNP deflator shows a similar pattern, 14 percent in first quarter 1951, –2.9 percent in the second quarter. Low rates of inflation continued for the next year or longer.

  The surge in the measured rate of inflation appears to be a one-time change in the price level. For the Federal Reserve, the timing was ideal. The inflation it had warned about appeared with a vengeance just as its conflict with the Treasury became both more open and more intense.

  Other Actions

  The Board did not confine its action to the modest changes in interest rates and reserve requirement ratios. President Truman, Secretary Snyder, and the Board agreed to bring back consumer credit controls and supplement them with controls on real estate credit, authorized under the Defense Production Act of 1950. The Board delegated regulation of credit for real estate construction to the Housing and Home Finance Administrator. On September 18 the Board restored consumer credit controls, setting minimum down payments and maximum length of contract. The following month, it introduced real estate credit controls with the cooperation of the Federal Housing Administrator and tightened controls on consumer credit.

  Although Secretary Snyder and the Board referred to credit controls as important parts of the anti-inflation program during the Korean War, at times the Board recognized that controls were “of secondary importance” though “effective in their respective spheres of operation” (Letter to President Truman, Board Minutes, December 1, 1950, 8).

  The Board’s staff had a different, and more correct, appraisal.

  Industry lawyers proved to be highly adept at developing arrangements that effectively circumvented the letter of Reg W [consumer credit]. Fed regulators found themselves lagging far behind industry lawyers, first in ferreting out the loopholes, and then in devising measures to close them. Similar enforcement problems developed in the administration of Regulation X [real estate credit].

  This generally negative experience with mandatory credit allocation programs strongly influenced Fed attitudes. Each time Congress has subsequently proposed new programs for direct credit regulation, Fed officials have taken a negative view of their feasibility. (Stockwell 1989, 19)

  The Board also raised stock market margin requirements by twenty-five percentage points, to 75 percent, in January 1951. It had discussed, and dismissed, the change several times during the fall, usually on the grounds that stock market credit had not increased rapidly. A rise of more than 7 percent in stock prices between December and January, with increased trading volume, led the Board to respond.

  THE END OF PEGGED RATES

  Between August and December 1950, conflict between the Federal Reserve and the Treasury intensified and became open. Although the FOMC continued to advise on debt management and McCabe continued to discuss Federal Reserve concerns, there was less talk about cooperation and coordination and growing determination at the Federal Reserve to free monetary policy from Treasury control.

  The Treasury’s decision to accept the FOMC’s advice by offering a four-year note in November to extend the maturity of the debt deepened the conflict. The issue’s failure to attract buyers required the Federal Reserve to support the market by buying a large part. The Treasury blamed the System’s advice for the failure and charged that rate increases had accomplished nothing useful. Federal Reserve talk and actions had unsettled securities markets, raised rates, and increased the cost of debt finance to the Treasury and the taxpayers.

  The Federal Reserve accused the Treasury of announcing refundings far in advance to prevent the System from carrying out its responsibilities to control credit and money. It had become resentful of Treasury dominance, particularly after the Treasury ignored the modest 0.125 percent increase in interest rates in August. And of greater substance, System officials were skeptical about the administration policy to control wartime inflation. Sproul in particular doubted that the resources for war could be obtained without restricting private demand more than the Treasury contemplated. In his view, the administration’s program relied too much on credit, wage, and price controls and too little on higher interest rates to restrict demand and control inflation. Sproul made these views known at a meeting with Snyder and McCabe early in January 1951.209 He again urged higher short-term interest rates, to flatten the yield curve and stop debt owners from playing the pattern of rates, and higher rates on long-term debt, to permit the Treasury to sell debt without System support. Still, Sproul stopped short of asking for a long-term rate above 2.5 percent. He limited his demands to letting the bond price fall to par.210

  Discussions between McCabe, Sproul, and Snyder could not resolve the differences over power, responsibility, and policy. On January 17 Snyder and McCabe met with President Truman in an effort to resolve differences and restore cooperation after failed attempts in August and November to market government securities. McCabe’s account of the meeting does not mention short-term rates, the immediate issue in dispute. The president said he would like the 2.5 percent long-term rate to remain “if possible.”211 McCabe replied that “we have some doubt as to whether a long-term bond can maintain itself at the 21/2 percent rate. Secretary Snyder said that he thought it could and that he would meet the situation when he came to it. . . . The Secretary said that we ought to let the public know that we are going to maintain it” (Sproul Papers, January 18, 1951, 2). McCabe replied that the FOMC had sent the secretary a letter several weeks earlier giving its views, and he could not commit the FOMC beyond that letter.212

  Snyder has a different, though not wholly contradictory, account. At the meeting with President Truman, Snyder later reported to Congress, “The President, the Chairman and I agreed that market stability was desirable, and the Chairman again assured the President that he need not be concerned with the 21/2 percent long-term rate” (Subcommittee on General Credit Control and Debt Management 1952, 73).213 Snyder responded to McCabe’s complaints about the size of recent purchases by blaming the Federal Reserve for creating uncertainty about future interest rates.

  209. Sproul and McCabe reported on the meeting. Their statements and reports of Snyder’s response are in Minutes, Executive Committee, FOMC, January 31, 1951, 4–9.

  210. Sproul also warned about savings bond redemptions. Ten-year series E bonds sold to small savers in 1941 were due to mature. Sproul urged the Treasury to increase rates and revitalize the selling organization to reduce redemptions. McCabe told the FOMC that the Federal Reserve staff had worked out a program for refunding E bonds but that Treasury staff had listened to their suggestions but ignored them (ibid., 9).

  211. The quotations are not direct. They are quoted from Chairman McCabe’s telephone discussions with Allan Sproul as reported by Sproul and available in Sproul’s papers in the Archives of the Federal Reserve Bank of New York. Othe
r quotations in this section are from the same source but are based on Sproul’s notes of meetings he attended. The notes refer to the president as “the Chief.”

  212. The latter was sent after the October FOMC meeting. Although Snyder is not quoted as asking for a renewal of the 1942 policy statement fixing interest rates for the duration of the war, it seems clear that this was his aim.

  According to McCabe, Snyder did not mention a speech to the financial community in New York that he planned to give the following day. The speech first discussed the importance of avoiding inflation and the desirability of financing the Korean engagement out of current taxes. He then forecast a $16.5 billion deficit for fiscal 1952.214 Snyder dismissed small increases in interest rates as ineffective. To control inflation, the government would rely on a return to wartime policies, allocation of materials for defense, selective credit control, and wage and price control. Then he said: “The Treasury has concluded, after a joint conference with President Truman and Chairman McCabe, . . .that the refunding and new money issues will be financed within the pattern of that [2.5 percent] rate” (Sproul Papers, FOMC, January 31, 1951; Eccles 1951, 484).215

  The speech was a turning point. Federal Reserve officials were incensed that Snyder’s speech had publicly committed them to a policy many of them no longer supported. Some, who had continued to support the 2.5 percent rate, changed their position. The speech seemed to convince them that the Treasury took their support for granted and would not change its position.216

  213. McCabe reported his statement as: “The Chief [president] said he is concerned about maintenance of the 21/2 percent rate. The Chairman replied the market has been acting well recently, that what support has been necessary has been given, and that he could not see anything to be concerned about” (Sproul Papers, January 18, 1951, 1; emphasis added). McCabe went on to refer to the letter he had sent to Snyder giving the FOMC’s position. This was not the first time President Truman intervened directly with the Federal Reserve. In early December he called Chairman McCabe at home. Referring to a newspaper article reporting that the Federal Reserve was “undercutting” the Treasury, he “hoped we would stick rigidly to the pegged rates on the longest bonds” (Minutes, Executive Committee, FOMC, January 31, 1951, 9). McCabe explained how many bonds they had bought (at the time of the failed note offering) and said they had bought the bonds at a premium, rewarding the sellers. President Truman ended with: “I hope the Board will realize its responsibilities and not allow the bottom to drop from under our securities. If that happens that is exactly what Mr. Stalin wants” (10). McCabe responded by assuring the president that they would “do all in our power to insure the successful financing of the Government’s needs” (10). After reporting to the president on the amount purchased to support the recent financing ($2.5 billion gross, $1 billion net), McCabe did not commit to announcing a firm peg. Instead, he asked to talk to the president about the risks and costs of such an announcement. The president subsequently sent some news clippings with a letter urging the Federal Reserve to stabilize the long-term rate.

  214. The actual deficit was $1.5 billion followed by a $6.5 billion deficit in fiscal 1953. Tax rates were increased to reduce the deficit.

  215. Sproul’s notes on the speech, taken at the time, do not record the reference to Truman and McCabe that caused subsequent excitement (Sproul Papers, Snyder Talk, January 18, 1951, 2).

  Four factors worked to the benefit of the System. First, it found support within the administration. Second, the financial press took its side. Third, some congressional leaders, especially in the Senate, wanted a more independent policy. Fourth, as noted earlier, economic activity and inflation were rising rapidly. Nominal GNP growth in 1950 was above 15 percent. Fourth quarter growth in GNP continued at that pace. Industrial production increased more than 20 percent in 1950. In December, consumer prices rose 14 percent. These data bolstered the Federal Reserve’s arguments with each of the groups that now supported its position.

  Support within the administration became clear when McCabe met with President Truman on January 19 to correct the impression left by Snyder’s speech. The president told him he had not known about the speech in advance. McCabe warned the president about inflation. He then read a memo he had sent to mobilization director Charles Wilson warning about the effects of inflation on defense costs. The president said he would talk to Wilson. Wilson supported the System’s view that inflation was a problem and that he wanted to avoid rising defense costs (Sproul Papers, January 19, 1951, 4; Minutes, Executive Committee, FOMC, January 31, 1951, 14).217

  Strong support in the financial press bolstered the System’s position in Washington. One of the leading financial journalists, writing in the New York Times, gave his opinion of Snyder’s speech:

  In the opinion of this writer, last Thursday constituted the first occasion in history on which the head of the Exchequer of a great nation had either the effrontery or the ineptitude, or both, to deliver a public address in which he has so far usurped the function of the central bank as to tell the country what kind of monetary policy it was going to be subjected to. For the moment at least, the fact that the policy enunciated by Mr. Snyder was, as usual, thoroughly unsound and inflationary, was overshadowed by the historic dimensions of this impertinence. (Quoted in Eccles 1951, 485)

  216. The usually conciliatory McCabe described his position as “untenable.” He had not committed, and could not commit, the FOMC. Governors Evans, Norton, and Szymczak were cautious, believing the System would lose a public confrontation. McCabe hesitated, pointing out that the statement had not committed the FOMC, only referred to consultations. Sproul protested. The press and the financial community regarded the statement as a commitment. He urged McCabe to tell President Truman that the System was not committed to the 2.5 percent rate. He did not want a press release or immediate public statement. They should inform the public in their speeches and public statements later. Governor Szymczak called Sproul later in the day to say he agreed, adding that McCabe had received a letter from Secretary Snyder reaffirming the importance of keeping the 2.5 percent rate. Eccles also called, agreed with Sproul, and advised that he would testify at the Joint Committee on the Economic Report the following Thursday (Sproul Papers, January 19, 1951, 2–5).

  217. McCabe also pointed out that before taking any decisions, he advised and consulted with all relevant parts of the government, especially the Treasury. Snyder did not reciprocate when setting interest rates on debt issues. The president agreed to talk to Snyder and urge him to be more cooperative.

  Press coverage of this kind, especially if widespread, undermines the position of officials in political Washington. Politicians who cannot have a well-founded, independent position on every issue are often influenced by public opinion as reflected in the press. This is particularly true when the criticism finds support among members of Congress who are viewed as knowledgeable about the subject.

  In this controversy, many members of Congress regarded Senator Douglas as an expert. He firmly supported the Federal Reserve and the need to control inflation by controlling money growth.218 Douglas was not alone. Senators A. Willis Robertson (Virginia) and Burnet R. Maybank (South Carolina), both influential members of the Banking Committee, worked to avoid public hearings, at which populist senators would side with the Treasury. They too supported the System’s position and opposed the Treasury. On the Republican side, Senator Taft, a minority member, invited Eccles to present the Federal Reserve’s position to the Joint Committee on the Economic Report. Eccles changed his earlier position and criticized the bond support policy as inflationary.

  The FOMC was scheduled to meet on January 31. At Secretary Snyder’s suggestion, President Truman invited the entire committee to meet with him. The White House announced the meeting to the press, so it drew considerable attention. It was the first and only meeting of this kind ever held. It shows how much independence had been lost since President Wilson’s decision not to interject pol
itical consideration into Federal Reserve proceedings.

  Before meeting the president, the FOMC discussed its options. McCabe suggested three alternatives: agree to maintain the 2.5 percent ceiling rate; agree to support the rate conditionally and to discuss a change with the president and the secretary if economic conditions changed; or resign if unwilling to make any commitment.

  Sproul disagreed. He found the first two alternatives unacceptable, the third an admission of failure. He proposed asking Congress for new instructions, thereby shifting the onus of continued inflation onto Congress

  218. In a Senate speech a month later, Douglas warned of the destructive power of inflation and compared it to wartime destruction. Then he added: “In the eyes of those who want to destroy democracy and capitalistic institutions it is a cheap way of achieving their collapse” (quoted in Eccles 1951, 481).

  if it failed to support the Federal Reserve (Minutes, FOMC, January 31, 1951, 15–19). No one suggested letting the market adjust. That would continue conflict with the Treasury, an unacceptable outcome for both sides.

  The committee did not make a choice. The members could not agree on the language for a written statement of their position. They agreed only that Chairman McCabe would speak for the group. Agreement was not unanimous. Governor Vardaman said he would offer his own view, that the committee should be “guided by whatever request was made by the President as Commander-in Chief” (Minutes, FOMC, January 31, 1951, 21).219