A History of the Federal Reserve, Volume 2 (35 page)

Chairman Martin followed the staff reports with a request for recommendations to change the directive. He suggested “absorbing reserves whenever consistent with an orderly market” in place of “contributing further to monetary ease” (ibid., 12). Concern about inflation had to wait, however. The Treasury believed that its latest offering, a 1.625 percent oneyear certificate to be issued on August 1, was about to fail. In the week before the meeting, the Federal Reserve departed again from bills-only by purchasing “when issued” securities to support the issue.
²¹⁴

Mills argued his usual position: The FOMC had to supply enough reserves to keep the market orderly. President Hayes opposed tightening policy or any major change. The recovery was uncertain; so was the Middle East situation. Unemployment remained high. Hayes wanted to maintain $500 million of free reserves, and favored only a modest change in the directive—removing “further” from “contributing further to monetary ease.” Even if the money stock rose 6 percent for the year, average growth for 1955–58 would be a modest 2 percent. Robertson wanted to tighten “to the fullest extent possible” (ibid., 25). Bryan (Atlanta), joined by several others, expressed concern that the budget deficit in an expanding economy would cause loss of confidence “in the future integrity of the dollar” (ibid., 17).
²¹⁵
The shift from correcting disorder to “the most massive support operations ever undertaken” (ibid., 18) exacerbated the problem. Several spoke of the dangers of inflation, usually mentioning the Treasury’s prospective deficit.

Martin gave a lengthy summary. Referring to relations of the Federal Reserve and the Treasury after the summer’s problems, he said, “The Committee was dealing with the most difficult problem in political science in the whole world” (ibid., 49). Both institutions had the same goal, and the problems were not all caused by the Treasury. “[I]f the System had not been as intent on following an easy money policy [during the recession] there could not have been the speculative fever that developed and finally culminated in the speculation in the 2.625 percent bonds” (ibid., 50).

Along with some of his colleagues, Martin believed that the Federal Reserve could not treat the deficit as the Treasury’s problem. Independence was not absolute. The Federal Reserve was a creature of Congress. Congress created (or permitted) the deficit that the Treasury had to finance.
The Federal Reserve shared that responsibility, and it had to balance it against its responsibility for preventing inflation. It could not allow the bond market to be disorderly.

214. Market yields, though rising, show no reason for concern. For the weeks ending July 26 and August 2, yields were 1.36 percent and 1.49 percent (Board of Governors, 1976, 702). The prediction was accurate, however. Weekly average yields rose above 1.625 in the week of August 9 and continued to rise to a peak of 3.04 percent in early October.

215. This is probably a reference to the $1 billion gold outflow (4.5 percent) in th
e year ending in July.

The committee did not agree on the wording of the directive. Martin proposed putting off the decision, accepting “recapturing redundant reserves” as a short-term statement of policy, and agreeing on other language at the next meeting. Agreement was again unanimous.
²¹⁶

At the manager’s request, the FOMC met again in the afternoon. The 3.5 percent bonds of 1990 had fallen to 98. He called the market “disorderly,” using the word required for the System to purchase other than bills, and he proposed submitting a few bids, using brokers to hide the intervention. “They did not want to go in, start to buy and create ‘an avalanche’ of offers” (FOMC Minutes, July 29, 1958, 3). Only Mills favored aggressive intervention. The FOMC decided to wait, but it continued to monitor the market closely and held daily telephone conferences. On July 30, it sold Treasury bills to withdraw some reserves. The market remained stable, so it repeated sales on the next two days. The bill yield remained below 1 percent.

Between meetings, the Board responded to Congressman Patman’s complaints by making two moves intended to show its concern about speculation and the growth of credit and money. On August 4, it raised margin requirements for stock purchases from 50 percent to 70 percent, returning to the level prevailing in January. Although stock prices had increased rapidly in July and August, there was neither a sign of increased volume before the change, nor an effect of the change on prices or volume of trading.

The San Francisco bank proposed to raise its discount rate to 2 percent (from 1.75). The directors acted against the advice of President H. N. Mangels, who preferred to wait. Their main reason was concern about inflation and a desire to show that they were alert to the danger (FOMC Minutes, August 19,1958,29). Chairman Martin also favored the change, citing the strong recovery and the increase in Treasury bill rates to 1.5 percent. Other members questioned the necessity of the increase or preferred to wait until after the FOMC meeting early the following week. The meeting adjourned without acting. Later that day, after consulting the Treasury, Martin re
opened the discussion. He reported that the Treasury did not object. The Board then approved the increase, effective August 15.

216. The manager proposed increasing the maximum size of the System’s portfolio of bankers’ acceptances to $75 million. (It had started at $25 million in 1955 and increased to $50 million in 1957.) The aim was to allow the acceptance portfolio to parallel the open market account. Robertson again objected forcefully and at length, arguing that intervention prevented the market from developing resiliency. This was the same argument used to support bills-only. Martin did not join Robertson; the FOMC followed Martin and took no decision.

The following Monday, August 18, the Board approved a 2 percent discount rate at any Bank that chose to increase its rate. Dallas, Atlanta, and Kansas City responded in the next ten days. All others, including New York, retained the lower rate.

Ralph Young’s staff report for the August 18 and 19 meeting warned of the dangers of inflation. He compared the 1957–58 recession to eight previous contractions, concluding (incorrectly) that “it seems certain . . . that the 1957–58 recession will go down . . . as one of the milder recession experiences” (FOMC Minutes, August 19, 1958, 8). Money supply growth had been rapid, up to 8 percent. There was “only one course” to follow (ibid., 9). The System should reduce money growth; the first step should be “to reduce to zero as rapidly as possible the net free reserve position” (ibid., 9). For the future, Young proposed reducing money growth to 2 to 3 percent.

New York remained cautious. In Hayes’s absence, Vice President Trieber presented the Bank’s statement. He urged that any reduction in reserves be done cautiously. New York opposed a higher discount rate and favored a change in the directive to emphasize fostering growth and recovery. Although Trieber acknowledged Martin’s concerns about the deficit and inflation, clearly New York did not share his concerns or want to act on them.

FOMC members divided. Board members expressed most concern about inflation. At least five presidents agreed with New York that fostering recovery should take precedence over controlling prospective inflation. Martin’s summary recognized the division. The Federal Reserve could not jeopardize its responsibilities by failing to act when faced with a $12 billion prospective deficit. He favored reducing free reserves, but he would not set a target. The committee changed the directive to call for “fostering conditions in the money market conducive to balanced economic recovery” (ibid., 63).

As often occurred, the manager permitted the three-week moving average of free reserves to decline about a week before the FOMC met. The average fell from about $550 million to about $100 million in midSeptember. Brunner and Meltzer (1964, 68–69) date the policy turn toward restraint in mid-August, four months after the cyclical trough. Martin and several of his colleagues seemed determined to act promptly to prevent a return of inflation.

The September 9 meeting was one of the most contentious meetings the FOMC had ever held. President Hayes, back from vacation, commented that “the present is emphatically not the time for backing away from our
policy of outright monetary ease” (FOMC Minutes, September 9, 1958, 10). He was troubled by the dramatic increase in interest rates during August, opposed an increase in the discount rate, and favored higher free reserves, perhaps $500 million instead of the $100 to $200 million at the time of the meeting.
²¹⁷
Hayes recognized the threat of long-term inflation but could not “see any justification for combating this long-term threat by means of a rapid shift in monetary policy” (FOMC Minutes, September 9, 1958, 12). He preferred a government wage policy (ibid., 12–13), a reference to growing interest in wage-price guidelines.

Hayes’s challenge to Martin and the majority of the Board drew little support. Bopp (Philadelphia) favored “moderation,” and Mills, as usual, expressed concern about Treasury financing and warned that the “System would be ill-advised to be so overwhelmingly concerned with the problem of inflation” (ibid., 24). But even Mills did not support Hayes’s easier policy. The rest of the committee remained divided between those who wanted to pause and those who favored greater restraint. Vardaman, Shephardson, and Robertson argued for a more vigorous response to inflation. Balderston criticized New York and several others for failing to increase their discount rate. A split rate made the System look weak and indecisive (ibid., 49).
²¹⁸

Lacking a consensus among the very divided members, Martin overlooked New York’s criticism and made two characteristic moves. He waited for a consensus to form, and he gave a strong warning about inflation and its consequences. The problem the System faced was “inflation in a bigger way than anything that had been faced in his own lifetime” (ibid., 49). He warned that “he saw certain similarities to 1929,” a comment he made again in 1967 (ibid., 50). It was time for the System to “stand up and be counted . . . not dilly-dally about risks” (ibid., 53). An additional increase in the discount rate (to 2.25 percent) was infeasible, so System policy should head toward zero free reserves.
²¹⁹

217. Long-term rates at the time were back to the peak levels of the previous year, 3.75 percent for long-term Treasuries. Short-term rates had increased about one percentage point in August, but were below the peaks of 1957. The staff statement pointed to strong increases in credit demand, speculation, and the large expected deficit. The staff described higher rates as “clearly justified” (Recent Financial Developments, Board Correspondence, September 9, 1958, 2).

218. New York, Cleveland, Richmond, and St. Louis changed to 2 percent on September 12. Boston waited until September 23, one day before Philadelphia, Richmond, St. Louis, Minneapolis, and Dallas changed to 2.5 percent. The split discount rate continued until November 7, when all banks had a 2.5 percent rate.

219. Martin’s reference to the political infeasibility of an additional increase in the discount rate probably referred to public criticism of the earlier 0.25 increase so early in the recovery. Much public commentary expressed concern that the Federal Reserve would prevent
or hinder the recovery. Martin made only an oblique reference to New York’s opposition, warning that if some directors of reserve banks opposed his policy, that was disappointing, but if they interfered in open market policy, changes would be made (FOMC Minutes, September 9, 1958, 51). The implication was that the changes would be in the role of directors. Contrary to earlier belief about political influence, it was the Board, not the bankers, who emphasized inflation.

The following week, Martin found support for his view, but not his policy, at the Federal Advisory Council meeting. The members agreed that business prospects would improve for the next six months and that the recovery was widespread and would continue (Board Minutes, September 16, 1958, 1–2). They agreed, also, that “the feeling that further inflation is inevitable is spreading” (ibid., 19). The FAC cited rising stock prices as evidence that the public expected higher inflation and also mentioned wage increases in excess of productivity growth. The FAC did not, however, mention the Treasury deficit until Martin expressed his concern that the $12 billion expected deficit put pressure on the Federal Reserve to increase the money stock.
²²⁰
FAC members praised the System for its steps toward greater restraint, but the majority believed that the System should “provide any reserves that may be required for the forthcoming Treasury financing and for normal seasonal needs” (Board Minutes, September 16, 1958, 27). Martin complained about criticism of the 2 percent discount rate, stating a lesson that would be repeated many times. “Many people . . . are inclined to say that it is fine to go down and that monetary policy must be flexible, but when the reserve bank discount rate was raised by one-quarter of one-percent the view was heard that this would destroy the process of recovery” (ibid., 25). In the 1970s Keynesian economists would repeat the criticisms of early action against inflation. They wanted to wait until inflation appeared.

Disagreement within the FOMC continued. New York recognized that recovery had occurred, but it continued to favor unchanged policy. The Board and its staff warned about inflation. To make the Board’s case, the staff presented its analysis of recovery and the inflation problem. The presentation was almost entirely descriptive, a comparison of the movements of principal statistical series in the prewar and postwar years. The report gave “new support to the proponents of the theory of the inevitability of creeping inflation. Once again, as in most of the postwar period, the central problems of the years ahead may well be those of unsustainable de
mands and widespread price advances”
(FOMC Minutes, September 30, 1958, 10).

220. Martin recognized the lags in the response of inflation. “Perhaps the country might have six months or so of happiness, with the recovery not yet having reached boom level, but it would certainly not be a solution simply to take up the check book and print money to the tune of $12 billion” (Board Minutes, September 16, 1958, 23). Purchase of $12 billion was based on the extreme assumption that the Federal Reserve purchased the full amount of the deficit. It would have increased the monetary base by 30 percent.