A History of the Federal Reserve, Volume 2 (47 page)

Scattered through the hearings and questionnaires to the Federal Reserve and the Treasury were many other topics. Members of Congress did not feel bound by the subject. They inquired about anything that interested them.

Discounting.
One set of written questions, early in the year, concentrated on the role of discounting and discount rates. Senator Douglas asked why the System changed discount rates. If the Federal Reserve relied on open market operations and refrained from changing discount rates “interest rates generally would not rise, or not rise as much. . . . [W]ould you agree that this result would be desirable [in recoveries], since higher rates would tend to ‘hold back full recovery’?” (Board Minutes, March 17, 1959, 1, replies to Douglas-Patman questions).

The Board’s answer showed the gradual evolution from the RieflerBurgess doctrine that dominated analysis in the 1920s. Discount policy supplemented open market operations, as before. Now it had a larger role. Banks could choose to adjust to tighter policy by reducing liquid assets or by borrowing from a reserve bank. As before, “banks are generally reluctant to become indebted to the Federal Reserve” (ibid., 2). But a new thought entered at this point. “The deterrents to borrowing are greatly weakened if market yields on securities owned become and remain substantially higher than the discount rate. In these conditions, banks may even be induced to borrow for profit”
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(ibid., 2).

The Board added that borrowing was a privilege and not a right of mem
bership in the System. Continuous borrowing was inappropriate under ordinary conditions. The Board quoted from the 1955 revision of regulation A to reinforce these points. Then it added a carryover from the past: “[I]t is of prime importance that the general reluctance of banks to borrow at the Federal Reserve be reinforced by a discount rate with real deterrent power at times when a tempering of bank credit growth is in the public interest” (ibid., 3).

320. In 1952 Riefler had recognized that banks borrowed for profit when the tax treatment of borrowing made borrowing profitable. That was treated as a special case.

The inconsistency in the Board’s analysis of discounting came out clearly when the board explained why it increased the discount rate. Profits came to the fore. “[T]o make the discount mechanism an effective supplement to open market operations the Federal Reserve is obliged
[sic]
to maintain discount rates not markedly lower than market yields on . . . Treasury bills” (ibid., 3). If it failed to do this, “administering the discount window to prevent excessive credit expansion would become very difficult. In the absence of a rate deterrent to borrowing, Federal Reserve bank officers would be without workable guidelines in acting on a great number of borrowing requests from banks, many of whom would be in a position of profiting directly from the relatively low rate on borrowing” (ibid., 3). In the 1980s, the System ignored this conclusion without causing instability. Banks increased borrowing.

Staff and officers did not take the next two steps—fi rst, recognizing that borrowing added to aggregate bank reserves and bank credit even as it lowered free reserves, and second, distinguishing between changes in discount rates that led and followed the market. It was inconsistent to regard the reduction in free reserves as contractive and the increase in bank credit and bank reserves as expansive.
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Several of the changes in discount rates came after market rates increased.

Using the presence or absence of a change in the weekly new issue yield of Treasury bills as a measure of response, Table 2.8 suggests that most discount rate changes in the 1950s were not anticipated before they were made. An N in the last column, about one-third of the changes, indicates little or no response. Several times the change in bill yields exceeded the discount rate change.

Role
of
monetary
policy.
A questionnaire sent to the Secretary of the Treasury and the Board of Governors provided an opportunity for each institution to give the committee its views on macroeconomic issues. Both agreed
that monetary policy had been asked to bear too much of the responsibility for stabilizing the economy in the 1950s. The Treasury response blamed the lack of budget surpluses in most years, and their small size in others, for the wide swings in interest rates and problems in debt management. It was not that the “monetary authorities have been overly aggressive in the use of their powers” (ibid., 1720).

321. “Banks are always in a position to supplement their lending capacity by borrowing at the Federal Reserve. It is to keep this source of supplementary lending power under continuous and effective regulation that the Federal Reserve must rely on flexible adjustment of the discount rate” (Board Minutes, March 17, 1959, 5, replies to Douglas and Patman questions).

The Federal Reserve’s response outlined the ways monetary policy affected output. It did not restrict the transmission process to the effect of reserves, interest rates, and availability of credit on bank lending. It cited also “[l]iquidity, capitalized values, and profit expectations” (Employment Growth and Price Levels, Answers to Questions on Monetary Policy and Debt Management, Hearings, Part 6C, 1763). The Board described the inflation process as the cumulative effect of demands for goods and services that can occur “even while the economy as a whole is still rising toward capacity levels” (ibid., 1765). Restrictive monetary policy at such times reduced marginal loan demand, increased saving, and tempered expectations about future earnings (ibid., 1766). The Board’s response began to recognize an effect of inflationary expectations on interest rates. Inflation
ary expectations reduced saving by depreciating its value (ibid., 1767). It did not carry this thought over to recognize that inflation increased nominal interest rates and compensated savers for expected loss of purchasing power, if nominal interest rates adjust freely.

The committee asked about selective effects of general monetary policy. The Board responded at length but not directly or informatively. It emphasized the availability of credit and the level and structure of interest rates, but it did not respond to criticisms of selective effects of monetary policy by explaining why long-lived durable capital responded more quickly and by larger amounts than short-lived capital assets or non-durables to a change in real interest rates. It tried to dodge the question or cloud the answer by telling the committee that “it is impossible to break down the responses of individual sectors of the economy to changes in credit availability and interest rates, so that those attributable to monetary policy may be identified and appraised apart from those due to other market factors” (ibid., 1771).
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Chairman Martin’s responses to the committee’s many questions provide a reading on the System’s analysis at the end of the 1950s. Unlike the 1920s, there is no general framework like the Riefler-Burgess version of the real bills doctrine. The Bretton Woods arrangement is mentioned rarely. International effects are mentioned, but they are not part of the general framework.

The most common description highlighted the role of credit availability and interest rates. The two started as inseparable partners, but soon afterward interest rates became less important. “Availability of credit and the level-of-interest rates are twin influences, the significance of which cannot be separated for individual examination. For many purposes, the availability of funds and the terms on which they are available other than the interest rate provisions, are considerably more important to borrowers than interest rates themselves” (ibid., 1771). An outsider cannot know whether statements of this kind reflected staff analysis or Martin’s beliefs or an attempt to evade responsibility for the effects of interest rate changes.

Credit availability suggests quantities or aggregates, but neither the responses to questions nor direct testimony attempts to use a quantitytheoretic (or any other explicit) framework. In practice, several members of FOMC compared money growth to output growth as a measure of long
term inflation, but this time Martin was not one of them. In his answer, Martin referred to the flow of funds data that the Board collected and published at the time, but this is the only reference, and it responded to a specific question about flow of funds.
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Martin’s response also referred to inflationary expectations. He argued that people who feared inflation would pay less attention to interest rates, but he did not develop the point (ibid., 1777).

322. The response then considered evidence of effects on state and local expenditures, small business, business in competitive as opposed to oligopolistic industries, residential construction, and public utilities.

The questions then turned to policy instruments and procedures. Martin denied that the System wanted a secular decrease in reserve requirement ratios or that it reduced these ratios to increase bank profits. He turned back a question on the usefulness of consumer credit controls leaving Congress to decide whether such controls would have the public’s support.
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But he opposed direct controls on bank credit, except in national emergencies. Controls would not be effective because substitutes were readily available. Unregulated institutions would supply the loans if the law restricted regulated institutions from lending. Further, “the Board has grave reservations as to the longer run effect of any such direct control on the healthy growth of our free enterprise economy” (ibid., 1782).

As the hearings and staff study neared an end, Martin sent a letter to Senator Douglas, responding to the argument that inflation was mainly the result of cost-push by unions and oligopolistic industries, as the committee staff claimed. He accepted that “there are these imperfections as regards the behavior of individual prices and that they create inflationary pressures or biases” (Board Minutes, December 9,1959,1, letter, Martin to Douglas). Then he asked whether monetary policy should be less or more restrictive than if imperfections did not occur. His answer was that the Federal Reserve could not ignore these pressures on prices, called “creeping inflation” in his letter. He gave two main reasons. First, if policy ignored efforts to raise prices and wages, the perpetrators would not stop; they would again try to increase wages above productivity gain and to increase prices to cover the increase in cost.
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This, the letter said, would bring “all the
social injustices that economists universally agree accompany inflation, and it would also disrupt the saving and investment process” (ibid., 2).

323. The housing market was used as an example of how availability affects output. Interest rates and availability change monthly payments, thus the volume of spending on new houses and the relative attractiveness of renting as compared to owning
(Answers
to
Questions
on
Monetary
Policy
and
Debt
Management, Joint Economic Committee, 1775).

324. In an earlier, written response to a question from Congressman Reuss, Martin said: “[T]here’s little question but that restrictive regulation of the terms offered to installment and mortgage borrowers would effectively reduce the total demand for credit and thus relax somewhat the upward pressure on interest rates.” But he left the judgment to Congress as to whether controls should be reintroduced (Joint Economic Committee, Hearings, 1959, July 30, 1490).

325. This argument was common at the time. It did not explain why the monopolists and monopsonists did not extract the economic rent and stop. The entire discussion used the
same term “inflation” to refer to one-time changes in the price level and changes in the rate of price change. This common confusion continues.

Second, Martin’s letter tried to establish an effect, through anticipations, of cost pressures on aggregate demand. The link was borrowing, but the argument did not distinguish real and nominal rates. Anticipations of rising prices encouraged borrowing to accumulate inventories (by raising the expected real return) and build plants to profit from the increase. The same anticipations reduced the supply of loanable funds and increased demand (ibid., 3). Hence, interest rates rose. Also, the balance of payments deteriorated because prices rose in home markets, reducing foreign demand.

Market forces of this kind put pressure on the Federal Reserve to increase reserves. It had to choose between sharply higher interest rates or open inflation of the “demand pull variety” (ibid., 3).

The letter was most likely written by the staff. It argued in a way that Martin never did. The proposed solution was to prevent the inflation by limiting credit expansion “to a rate of growth consonant with the increase in the physical output of goods and services” (ibid., 3). Institutional imperfections in the price mechanism “cannot be corrected simply by a sound monetary and fiscal policy; they surely cannot be corrected by an unsound financial policy” (ibid., 5).

The letter summarized some reasons for opposing inflation, asserting a position that the congressional staff rejected and that did not become common until after the Great Inflation. “My interest in a monetary policy directed toward a dollar of stable value is not based on the feeling that price stability is a more important national objective than either maximum sustainable growth or a high level of employment, but rather on the reasoned conclusion that the objective of price stability is an essential prerequisite for their achievement” (ibid., 5). The response did not mention the obligation to maintain a fixed exchange rate.

Martin opposed the report’s main proposals—secondary reserve requirements of Treasury bills, real estate credit controls, controls on issuance of state and local government securities, and controls on insurance company lending or lending by other non-bank financial intermediaries. However, his answer did not distinguish between spending financed from saving and money growth. And he failed to distinguish the one-time effects on the price level arising from a change in the community’s saving rate and a reallocation of spending financed at an unchanged saving rate.

A series of questions on debt management began by asking whether
Treasury debt management interfered with the execution of monetary policy. Martin named three ways in which conflicts occurred. Most important was that the frequency of Treasury offerings affected the timing of Federal Reserve operations. Martin noted that, on average, the Treasury sold securities other than Treasury bills eight times a year during 1954–58 and eleven times in 1959. The Federal Reserve followed an even keel, at these times, avoiding any overt actions in the money market before, during, and after Treasury operations. “[T]he time intervals during which the Federal Reserve System could appropriately take policy action have been relatively few in number and relatively limited in duration” (ibid., 1785). The only improvement Martin suggested was fewer deficits, but new issues were only half the problem. Refundings of maturing issues were just as frequent.
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