A History of the Federal Reserve, Volume 2 (18 page)

Nevertheless, the Board removed controls reluctantly. Sproul later wrote that “the regulation of consumer credit was first weakened, and eventually abandoned, by Congressional action, contrary to the recommendations of the Federal Reserve System” (letter to Sumner Slichter, Sproul papers, September 29, 1952).
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General price controls remained in effect.

At about the same time, the Board considered, but did not adopt, a reduction in margin requirements for purchasing and carrying securities. The governors agreed that the volume of stock market credit, about $1.3 billion, was not excessive. Those who opposed the reduction argued that the Treasury would have to borrow and that private borrowing had increased.
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(Board Minutes, June 11, 1952, 12–14; July 31, 1952, 7) Margin requirements remained at 75 percent until February 21, 1953, when the Board reduced the percentage to 50 percent.

Monetary
Actions,
1951–53

In retrospect, the first two years after the Accord were a period of economic expansion with low inflation or stable prices. Once the boom in consumer and government military spending slowed, real GNP growth fell from 5 to 6 percent in the middle quarters of 1951 to a 2 to 3 percent annual rate for most of 1952. Consumer prices, subject to price controls until 1953, rose at an annual rate of 1 to 2 percent. The Federal Reserve avoided the postwar deflation, a feature of postwar experience after World War I and, earlier, in Britain after the Napoleonic Wars.

Deficit finance had a modest influence on monetary policy. The government budget had a $6 billion surplus in fiscal 1951 and a modest deficit
in fiscal 1952, despite the war and continued foreign assistance under the Marshall Plan. For the first time, war finance was not inflationary. The Accord created some uncertainty about future interest rates but reduced uncertainty about future inflation. The stock market responded by falling after the Accord, then resumed its rise. Total returns to common stocks (dividends plus capital gains) reached 22 percent in 1951 and 16 percent in 1952.

64. Amendments to the Defense Production Act in 1952 authorized the Board to remove the controls, with the concurrence of the Housing and Home Finance Administrator, after three months of relatively slow housing starts. The Board had opposed the language of the Defense Production Act authorizing control of real estate credit as unclear. “Our experience . . . has been such as to show that many questions arise” (Board Minutes, March 23, 1951, 11).

65. The letter was a very critical response to articles by Sumner Slichter in popular magazines criticizing the Federal Reserve for not being more aggressive about controlling credit. Slichter was a well-known Harvard professor of labor economics.

66. Governor Vardaman favored the reduction, arguing that the decision should be based only on stock market credit, but he voted with the majority.

The Accord provided for a gradual change, not a sudden wrench in policy. Observers at the time saw the agreement as a modest step that settled a conflict over long-term interest rates (Morris, 1951, 1). The text of the agreement encouraged that interpretation. It first announced a new twenty-nineyear, non-marketable bond with a 2.75 percent coupon issued to replace 2.5 percent marketable bonds that the Federal Reserve had been buying to prevent the bonds from going below par. The next paragraphs referred cautiously to the Federal Reserve’s increased role. If private holders tried to sell long-term securities, only “a limited volume of open market purchases would be made after the exchange offering was announced” (Annual Report, 1951, 100). The Federal Reserve pledged to maintain orderly markets at scaled-down prices. It pledged to “immediately reduce or discontinue purchases of short-term securities and permit the short-term market to adjust to a position at which banks would depend upon borrowing at the Federal Reserve to make needed adjustment in their reserves” (ibid., 100).

The immediate outcome differed considerably from the promise. The FOMC held more bills and long-term bonds after the Accord than before. The rate of purchase increased. Member bank borrowing remained within a narrow range until mid-1952. Table 2.1 shows average bill and long-term Treasury bond holdings at the Federal Reserve before and after the Accord.

As part of the Accord, the Federal Reserve agreed to keep the discount rate at 1.5 percent until year-end 1951. Discount rates remained unchanged until early 1953. Member bank reserve requirements remained unchanged also between January 1951 and July 1953.
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The Accord is described frequently as freeing the Federal Reserve to pursue an independent policy. This is a partial truth. The Accord eliminated the Federal Reserve’s commitment to maintain the 2.5 percent longterm rate and any particular pattern of yields. The Federal Reserve could change interest rates, and especially it could raise them. But it retained re
sponsibility for preventing Treasury offerings from failing, and it agreed to supply reserves to permit Treasury notes and bonds to be sold at the price the Treasury offered. Martin called this independence within the government. Martin’s achievement was to establish the structure and procedures that gave the Federal Reserve its independence within the constraints set by the budget, congressional pressure, administration exhortation, and the requirements of the Employment Act. By the 1960s, the prevailing political interpretation of the Employment Act constrained monetary policy to achieve a 4 percent unemployment rate.

67. In May 1951, the Board considered asking Congress for the authority to set reserve requirements against loans at all insured banks. The Board could not agree on a workable formula, so it did not make the request (Board Minutes, May 22–23, 1951).

In the two years following the Accord, the Federal Reserve eased its way gradually into monetary control. It had to relearn control techniques in an environment with a large, outstanding government debt. It had to become convinced that changes in interest rates, credit, and money influenced the pace of economic activity and inflation. It had to acquire some sense of the quantitative effects of its actions and the markets’ reactions. And it worried about the political response to higher interest rates and policy actions taken independently of the Treasury and the administration.
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It was slow and hesitant at first, but it gained confidence.

68. These concerns were real. The New York bank’s staff reported that a note to the 1952 Economic Report of the President, written by Vice Chairman John D. Clark, expressed “violent opposition to the actions taken by the System which have resulted in higher interest rates” (memo, Roelseto Sproul, Sproul papers, FOMC Correspondence, January 28, 1952, 1). The report itself supported the System’s actions as a contribution “to the relative stability of the last nine months” (ibid., 1). In Congress, the Patman committee issued its report early in 1952. Sproul’s discussion described the report as “pretty reasonable” (Sproul papers, FOMC meeting comments, July 7, 1952, 1). Sproul expressed concern, however, about proposed
consultation with the president and the administration if “set up by Executive Order and under [the] chairmanship of Chairman of the Council of Economic Advisers, a discredited body in terms of objectivity” (ibid., 2). Sproul also expressed concern about the recommendation that labor members be appointed to the Board of Governors
and the banks’ boards of directors.

Discounting and open market purchases and sales were the Federal Reserve’s principal means of affecting the money market. Almost a month passed before the Federal Reserve allowed interest rates on long-term bonds to rise from 2.40 percent, in the week of the Accord, to 2.5 percent. In the first month of the Accord, the System bought nearly $400 million of long-term bonds to avoid a sharp price break. By June 30, the average rate on long-term bonds reached 2.66 percent. Table 2.2 shows the rise in interest rates from the Accord to June 1953.

Interest rates rose at all maturities. By the standards of later years, the rise seems moderate. By the standards of the times, it was less so. Interest rates had not changed as much in any six-month or two-year period for decades, nor had they reached the 3 percent level since the early 1930s.
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The Federal Reserve used member bank borrowing (discounts and advances) and free reserves as policy indicators. During 1951, member bank
borrowing generally remained below excess reserves. The Federal Reserve interpreted positive free reserves, between $100 and $500 million, as evid
ence of relative ease.

69. Initially, rates changed slowly, as noted in the text. At the April 5 FOMC meeting, the account manager talked about pegging the long-term bond at $99 by purchasing as much as $50 million (FOMC Minutes, April 5, 1951, 4). The Executive Committee did not agree on whether rates should rise slowly or quickly. Ray Gidney, president of the Cleveland bank, recalled that in 1920 bonds had fallen rapidly to $82 once the Federal Reserve removed the peg. John H. Williams, from the New York bank, favored rapid decline. Chairman Martin acknowledged that the $99 floor acted as a new peg. That had to be avoided, but the System “must be in there aggressively helping [buying] to make the market” (ibid., 7). The decision gave the account manager instructions to “maintain an orderly market” after the Treasury completed its refunding.

The first signs of a major change in procedures came in mid-1952. As the Federal Reserve proposed in the Accord, and repeated at FOMC meetings, it returned to the classical approach of relying on member bank borrowing to adjust reserve positions and the money market.
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From mid-1952 to May 1953, member banks borrowed more heavily than at any time since the early 1920s. Weekly borrowing remained above $1 billion for most of the year, with a peak of $1.8 billion in mid-December 1952 to provide the seasonal increase. Free reserves remained negative.

At 1.5 percent, discount rates remained about 0.8 percentage points below the rate on prime commercial paper. Borrowing had become profitable for the first time since the 1920s. The Riefler-Burgess framework claimed that banks borrowed for need and not for profit, so the Federal Reserve, at first, regarded the borrowing as evidence of robust demand and tight money.
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After months of heavy borrowing, it began to restrict borrowing by raising rates and later discouraged banks from using the discount window to adjust their position. In January 1953, discount rates increased to 2 percent at all reserve banks.
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Borrowing declined but remained above $600 million until open market rates began to fall in the summer of 1953.

Annualized growth of the monetary base offers a different interpretation of policy thrust. Base growth rose from 2 to 3 percent in 1951 to 3 to 5 percent in 1952. As on many other occasions, nominal interest rates and
free reserves suggested that policy had tightened; growth of the monetary base suggested policy had eased.

70. Members of FOMC, including Chairman Martin, often criticized the organization of the market in which the Federal Reserve conducted open market operations (FOMC Minutes, May 7, 1951, 1–2). The FOMC did its transactions with “recognized” dealers. The New York bank favored this arrangement because the recognized dealers provided them with information about the market and about the individual dealer’s positions and transactions. The manager talked to two or three dealers about the market each morning before the market opening. Chairman Martin’s concern was that the manager gave information to the dealers. Allan Sproul urged the New York staff to study the dealer market and propose changes. At the May 17 FOMC meeting, Martin chose to chair the study and keep control of the study at the Board, another of his efforts to shift control and decisions away from New York.

71. “The discount mechanism, while supplying reserve funds temporarily, tends to discourage expansion of bank credit. While banks are in debt, they are under pressure to repay and hence are likely to be conservative in expanding their own loans” (Annual Report, 1952, 5). Knipe (1965, 85) mistakenly describes the increase in borrowing as evidence of tighter policy following publication of the Patman committee report. Borrowing increased from $365 million in April to more than $1 billion in July. Annual growth of the monetary base rose from 3.67 to 4.52 percent in the same period.

72. The Board also controlled the ceiling rate on V-loans to defense contractors. Once the discount rate increased, the American Bankers Association asked for an increase in the ceiling rate on V-loans. The Board declined (Board Minutes, January 28, February 6, April 27, May 12, May 19 and 20, 1953).