A History of the Federal Reserve, Volume 2 (48 page)

Martin did not recommend auctioning long-term securities as a means of selling debt. An auction would let the market price the new issue, thereby removing the risk of a failure to sell the issue and, with it, the need for the Federal Reserve to intervene to prevent failure. The problem of not changing market conditions on the auction day would remain, but the long even keel before and after would be reduced or eliminated.
³²⁷
The Treasury opposed auctioning long-term securities, and it argued incorrectly that “adoption of the auction technique would, in itself, do nothing to change this [even keel] situation” (Joint Economic Committee, Answers to Questions, 1959, 1739).

Bills
only.
The committee ended by asking Martin whether the bills-only policy had strengthened the market for Treasury securities in any way. Martin replied that bills-only reduced market uncertainty. The reason he gave was that the bill market was much broader than the market at other maturities, so Federal Reserve operations had less effect on market yields. Martin acknowledged, however, that bills-only had not fully restored “depth, breadth, and resiliency,” at maturities over ninety days.
³²⁸

Martin suggested several reasons for the market’s weakness. He (or the staff member who prepared it) made one of the first explicit statements of the effect of inflation on interest rates in a Federal Reserve document.
“This influence [inflation] has tended to diminish the incentive to save and invest in longer maturity fixed income securities in general, including Treasury issues, except at interest rates high enough to cover the forward inflation risk.” He then considered three alternatives: the Federal Reserve could purchase and sell long-term securities (1) to smooth the business cycle, (2) to smooth bond prices, and (3) to maintain an interest rate level, or range, believed to be appropriate at the particular time. He described this as a “movable peg.”

326. Between February 1953 and May 1959, the Treasury came to market with ninetythree issues other than bills. It issued forty-six for cash and forty-seven in exchange (Joint Economic Committee, Hearings Part 6A, 1959, July 24, 1105–07). Some were issued on the same day.

327. In the 1970s, the Treasury adopted the auction technique and even keel eventually ended.

328. A market with many orders to buy and sell around the last market price has “depth.” If the market draws bids and offers from many sources, it has “breadth,” and if the volume of orders increases substantially with a small change in price, the market has “resiliency” (Joint Economic Committee, Answers to Questions . . . , 1959, 1813, note 5).

Martin rejected each of the proposed alternatives to bills-only. His answer recognizes the interaction between policy and market anticipations. The first would encourage speculation and increase volatility of long-term rates. Market participants would observe Federal Reserve actions and speculate on additional changes in the same direction.
³²⁹
The second would prevent long-term rates from rising in expansions and falling in recessions by supplying and absorbing reserves procyclically. To counter the procyclical movement in reserves, the System would have to increase the size of counter-cyclical purchases and sales of short-term securities. The third alternative would increase speculation when the interest rate approached its ceiling or floor. Martin’s discussion of this alternative anticipated the discussion of exchange rate bands many years later. The answer concluded by invoking the effect on market expectations. If the Federal Reserve adopted one of the three alternatives, the bond market would price bonds according to expected Federal Reserve action and its consequences for inflation. Participants would “turn from observation of basic supply and demand forces for longer-term securities to close attention to Federal Reserve activity in this area of the market” (ibid., 1817). Also, the Federal Reserve’s focus would shift from providing the level of cash balances consistent with stable growth to regulation of long-term interest rates.
³³⁰

Martin’s testimony emphasized the importance of changes in reserve balances. He listed three channels by which open market operations af
fected interest rates—by changing the volume of reserves, the outstanding stock of securities, and the expectations of professional traders and investors. “Of these effects, the first is by far the most important” (Joint Economic Committee, Hearings, 1959, July 27, 1233).

329. “The mere appearance of official buying or selling . . . would probably produce more extreme price effects than would be justified by the amount of reserves released or absorbed at the time” (Joint Economic Committee, Answers to Questions . . . , 1959, 1816). These effects would be temporary. Like most arguments about destabilizing speculation, this argument is incomplete, as the response soon recognized.

330. Many of the responses to questions about bills-only replied to the committee staff’s arguments for and against bills-only. The principal arguments made against the policy were (1) that there were occasional speculative excesses, as in December 1955 and July 1958; (2) that the long-term market does not respond predictably to changes in short-term rates because linkage is weak; (3) that intervention in the long-term market would stabilize security prices and encourage investment; and (4) bills-only denies the Treasury underwriting support (Joint Economic Committee, Hearings 1959, July 27, 1249). Only the third argument supported the staff claim that bills-only had raised long-term rates.

Typical of Federal Reserve discussions in this period, neither this statement nor others explained how these changes influenced the economy’s price, output, and employment objectives. There was usually a suggestion that the long-run inflation path depended on money growth. The committee and its staff concentrated on narrower issues such as operating methods, while suggesting repeatedly that the economy’s performance would improve if the Federal Reserve abandoned the bills-only policy.
³³¹

Congressman Henry Reuss (Wisconsin) questioned Martin about a resolution he had introduced at the Ways and Means Committee stating as the sense of Congress that the 4.25 percent ceiling on Treasury bonds should be removed for two years and the Federal Reserve “should bring about future needed monetary expansion by purchasing United States securities of varying maturities” (ibid., 1241).

Martin had responded in writing to a request from the Republican members. He opposed Reuss’s resolution. If Congress wanted to instruct the Federal Reserve about its operations, it should amend the Federal Reserve Act. The resolution did not do that. It simply appended the instruction to debt management legislation. Martin added: “I am convinced that this amendment, when stripped of all technicalities, and regardless of whether the language was permissive or mandatory, will cause many thoughtful people . . . to question the will of our Government to manage its financial affairs without recourse to the printing press. To me this is a grave matter” (ibid., 1287).

Reuss pressed hard against the policy of lowering reserve requirement ratios and in favor of purchasing all debt maturities. Martin could not explain why the instruction to buy and sell all maturities was inflationary or why it destroyed confidence in the government’s intention to maintain low inflation.
³³²
Congressman Reuss pressed him for an explicit response, but he did not get it.

331. One Congressman asked for the definition of a disorderly market. Martin replied that “large sell orders are pouring into the market from sellers who do not need to sell and there are no successive bids” (ibid., 1276). Later, he sent a letter describing how selling “feeds on itself” and the market develops “a trading vacuum accompanied by a buildup in the number and size of offerings and by a disappearance of bids, and a disorganized market psychology” (ibid., 1279).

332. A table in the hearings (ibid., 1261), prepared by the committee staff, showed that average interest costs on the public debt had increased from 2.27 percent to 2.824 percent between 1951 and April 1959. Compared to the changes that came later, the increase is small
indeed. The emphasis given to the change conveys (1) failure to separate real and nominal rates and (2) the intense attention to small changes in nominal rates. At the long end of the market, the increase was from 2.327 percent to 2.619 percent in the same period. On the margin, the increase is larger, about 2.5 percent from the pegged yields of 1951 to the 5 percent notes issued in 1959, but part of the rise is cyclical and part reflects a rise in anticipated inflation.

The Treasury supported the Federal Reserve’s reliance on bills-only. It acknowledged that, at times, departure from bills-only might have helped the Treasury, but the opposite was true also. System purchases or sales could cause transitory price movements that would complicate debt management. The most serious problems would arise when bond prices declined. “When investors expect higher interest rates, an attempt at small-scale support purchases by the System runs the considerable risk of encouraging large-scale liquidation” (Joint Economic Committee, Answers to Questions . . . 1959, 1743). This contrasts with Secretary Mellon’s Treasury, which insisted in the early 1920s that the Federal Reserve should not intervene at all.

The Treasury used the same reasoning to explain why it should avoid using its trust funds to support the market. It failed to point out that if Congress removed the interest ceiling, it could offset any effect of billsonly on the composition of the publicly held debt by changing the mix it offered. And neither the Treasury nor the Federal Reserve explained that purchases at the short-end of the market supplied reserves to support Treasury offerings.

The hearings enabled Congress to question the role of bills-only in the 1958 disorderly market. Martin called on Robert Roosa, from the New York bank’s staff, who replied that he was more inclined than Riefler to purchase and sell long-term securities, but he minimized the differences with the Board. His main message about 1958 was that “the problems are so complex that it will be impossible not to make a mistaken judgment once in a while” (ibid., 1296).

Auctioning
securities.
Treasury Secretary Anderson also testified at the hearing and was asked about auctioning long-term debt. He changed the Treasury’s previous position by favoring debt auctions in general, but he expressed several concerns. First, auctions would exclude small buyers. Second, there was a risk that a small change in yield would cause large capital gains or losses. Third, the number of bidders would be limited to a few syndicates. Individual buyers would not participate in the auction. With fixed prices, small holders could turn in their expiring security for the new security. In an auction, they would be paid cash, but they would not know the price to bid for the new issue (ibid., 1148–49). He did not
mention that the Treasury permitted purchasers to buy at the average auction price in bill auctions at the time.

The Treasury also submitted written answers to questions about monetary policy and debt management. One question was whether auctioning long-term securities would remove a constraint on monetary policy operations. The Treasury replied that auctioning would not eliminate the need for “even keel” monetary policy (ibid., 1739–40). Eventually the Treasury adopted the auction method; its concerns proved manageable, and the Federal Reserve eliminated even keel policy.

Other
Witnesses

The committee took testimony from economists, government securities dealers, principals in the financial services industry, and officers of the New York reserve bank. Economists’ recommendations covered a wide range, representing the differences in academic approaches and personal views.

Sumner Slichter of Harvard was the first witness. He told the committee that slow, creeping inflation is “an encouragement to enterprise. . . . It is a tax that falls on everyone. It is not a bad kind of tax in many respects” (Joint Economic Committee, Hearing, 1959, Part 1, 12).

Richard Musgrave of Johns Hopkins favored discretionary changes in tax rates as a counter-cyclical policy. He also favored adjustment of the tax rate applicable to the first bracket of the income tax. He recognized that his proposal transferred a congressional responsibility to the executive branch. He suggested several additional ways in which fiscal policies could be made more flexible, and he proposed a fact-finding board to recommend price and wage changes (ibid., October 26, 2757–69).

William Baumol of Princeton University proposed basing the tax paid by a corporation on its contribution to economic growth. Firms would get tax exemptions if their sales increased. One possibility that he mentioned made the exemption progressive. This proposal had the odd feature that tax rates would rise in recession, when growth slowed, and fall in expansions. Mergers would not increase the measured growth rate, but firms that had difficulty would face an increased tax rate (ibid., 2792–95).

Robert Triffin of Yale restricted his comments to the U.S. international payments position and the operation of the Bretton Woods system. Triffin offered several suggestions to reduce the current account deficit. His main emphasis was on changes in the international payments system. He proposed an increase in world monetary reserves to supplement the key currencies. The prevailing system required the United States and the United Kingdom to let their short-term liabilities to foreigners rise without limit and much faster than their gold holdings. An international reserve asset,
he said, would free the system from dependence on the two countries’ balance of payments deficits. To establish the new system, countries would deposit 20 percent of their international reserves at the IMF. To prevent inflation, the charter would restrict the increase in IMF lending to from 3 to 5 percent per annum (ibid., 2927–35). The IMF would function as a world central bank to lend to country central banks.