A History of the Federal Reserve, Volume 2 (59 page)

Eisenhower’s fiscal tightening was planned. The Federal Reserve did not plan a restrictive policy in 1960. FOMC minutes show the members divided on several issues and concerned about whether their usual indicator, free reserves, gave them correct information. The main division was between those who wanted less expansive action to stop the gold outflow and those whose main concern was domestic growth. The committee did not make a serious effort to choose between these goals. The System reduced discount rates twice, but for much of the year it issued vague directions to the account manager that gave him considerable discretion but also exposed him to criticism.

FEDERAL RESERVE ACTIONS

In March 1960 the FOMC voted to increase the supply of reserves. Free reserves rose from −$359 million in February to −$198 million in April, but the federal funds rate did not change. When the FOMC met on May 3,
the members agreed to move free reserves toward zero without changing the discount rate during a period of Treasury borrowing.
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Free reserves rose as member bank borrowing fell. The Federal Reserve interpreted the change as expansive.

The staff reported that business confidence improved but leading indicators had fallen to levels found at the start of major recessions. The balance of payments position improved also, and there was no sign of inflation.

Malcolm Bryan (Atlanta) noted that total reserves were lower than a year earlier. This level of restraint was “inappropriate and dangerous” (FOMC Minutes, May 3, 1960, 15). He described the economy as expanding slowly with “unutilized and growing supplies of manpower, materials, and plant capacity” (ibid., 15). He called for an increase in bank credit and urged his colleagues to use daily average total reserves as the policy target. As usual, Bryan’s remarks drew no response and no support.

Members divided equally between those who favored a more expansive policy and those who preferred to maintain the status quo. Martin said the consensus was to increase free reserves to zero, but he opposed a reduction in the discount rate because the FOMC was not ready to signal a change in the economy.
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Bryan gained support at the May 24 FOMC meeting. Several members commented on slow growth of money. Even Chairman Martin wondered why the money stock had not responded to increased ease. He favored a reduction in the discount rate but wanted to delay because of international political uncertainty.
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Governor Charles N. Shephardson suggested reduction of the discount rate before the next meeting. Alfred Hayes opposed both further ease and a reduction in the discount rate, noting that a majority had spoken against it. Ten days later, Philadelphia and San Francisco reduced their discount rates 0.5 percentage points to 3.5 percent. All other banks followed in the next two weeks.
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The May 24 meeting also approved a change in the directive. The new
directive called for “fostering sustainable growth in economic activity and employment by providing reserves needed for moderate credit expansion.” The FOMC removed the clause “guarding against inflationary credit expansion” (FOMC Minutes, May 24, 1960, 54). The manager interpreted the new directive as calling for a further increase in free reserves.

59. Recognition was rapid. The Brunner and Meltzer (1993,69) scaling of policy actions assigned +1/4 and +1/2 to the decisions at the meetings on May 3 and 24, the month following the peak in the economy.

60. Martin reported that the Board’s staff was trying to develop a better target than free reserves.

61. The Soviet Union had shot down a U2 plane and captured the pilot, Francis Gary Powers. Following that event, Chairman Khrushchev cancelled a summit meeting with President Eisenhower.

62. The May 17 meeting of the Federal Advisory Council described the outlook as favorable but “not as buoyant as the optimistic forecasts earlier this year” (Board Minutes, May
17, 1960, 2).

The members and staff recognized slowing growth and acted promptly to ease policy. Unfortunately, their main indicator of ease and restraint, the level of free reserves, misled them. Once again, the problem was the interpretation of reduced member bank borrowing as evidence of greater ease. Growth of the monetary base or the money stock suggested increased restraint. Woodlief Thomas’s report discussed at length the problem of finding an indicator of policy thrust and offered several suggestions without accepting any. To increase free reserves he proposed holding the discount rate above the market rate to impose a penalty on borrowing and credit expansion (ibid., 12). This reflected the standard claim that reduced borrowing (increased free reserves) was expansive.

Free reserves continued to rise. In June, the federal funds rate began to decline following reductions in discount rates. The funds rate continued to fall for the rest of the year. In December, the rate reached 1.98 percent, half of its level in the previous January. Partly for seasonal reasons, free reserves reached $682 million in December, more than $1 billion above December 1959.

At the July 6 meeting, Hugh Leach (Richmond), Abbott Mills (San Francisco), M. S. Szymczak, and H. N. Mangels (San Francisco) joined Hayes’s call for an end to the bills-only policy, but Martin only said he was “flexible.” The reason for the shift in sentiment was the sharp drop in Treasury bill rates in July. The Treasury had reduced its supply of bills, and the System owned about half the outstanding amount. By purchasing from the limited supply, it changed the rate more than usual. The manager began to purchase other short-term securities after checking with the FOMC.

Industrial production fell in July 1960 for the sixth consecutive month. Business inventories rose. Unemployment reached 5.5 percent, a 0.6 percentage point increase since May (FOMC Minutes, July 26, 1960, 4). Stock prices declined sharply. There were signs of strength accompanying the weakness; net exports increased strongly, consumer spending continued to rise, and housing starts were about to increase (ibid., 5).

The staff report on monetary and credit changes recommended a greater than seasonal increase in reserves to offset an estimated $100 million a month gold export and to increase money growth (ibid., 10). The report proposed that an additional amount of vault cash be counted as reserves, and it urged an additional reduction in discount rates. Reflecting the differ
ence between international and domestic concerns, the international staff opposed a reduction in the discount rate.

Several members described the economy as either in recession or on the edge. They favored additional ease but disagreed about whether by open market purchases, by a reduction in the discount rate, or in reserve requirement ratios. Several expressed concern about easing policy a few months before the presidential election. Hayes wanted to do nothing more. Martin favored additional expansion if it were covert, but he did not explain how that could be done. He also favored a discount rate reduction on August 16, after the Treasury auction closed. He expressed the consensus as favoring free reserves at $200 million, about where they were at the time, but he agreed with Bryan that total reserves should increase.
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Cleveland did not wait for completion of the Treasury sale. Its directors voted to reduce its discount rate to 3 percent, effective August 12. The Board hesitated to accept the change because it had announced earlier in the week increases in the share of member banks’ vault cash counted as reserves and a 0.5 percentage point reduction in the reserve requirement ratio at central reserve city banks to 17.5 percent.
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This was a step toward implementing legislation in 1959 eliminating the central reserve city classification. Reserve requirement ratios for central reserve city banks remained one percentage point above requirements at reserve city banks (Board Minutes, August 11, 1960, 11–14).

The Board approved Cleveland’s decision unanimously and voted to approve the change at any bank that chose the 3 percent rate. By the end of the day, New York, Richmond, and Kansas City joined Cleveland. Others soon followed, but San Francisco and Dallas delayed until September 6 and 8 respectively.

The federal funds rate resumed its decline following these changes, but Treasury bill and bond yields rose. The manager explained that in districts that still had a 3.5 percent discount rate, banks adjusted in the federal
funds market. In the districts that reduced the discount rate, borrowing was profitable, so banks borrowed at the discount window. This again contradicted free reserves doctrine, but no one seemed to notice. The manager added that the Treasury market remained under pressure. Market supply had declined in part because dealers had increased their positions to twice their normal inventories to profit from further rate reductions.

63. The following day the Board reduced stock market margin requirements from 70 percent to 50 percent. Governor Robertson dissented because the change responded to the decline in stock prices, not to the use of credit as the law intended. These technical changes showed recognition of the decline without arousing concerns about influence on the election (Board Minutes, July 27, 1960, 27–28).

64. The vault cash ruling was the second step toward returning to the provision in effect prior to 1917. Effective August 25 country banks could include the excess vault cash over 2.5 percent of reserves as part of reserves. For all other member banks the release date was September 1. They could count vault cash above 1 percent of reserves. On November 24, the Board removed the remaining restriction. All vault cash could be included in reserves. This change later proved to be more valuable than originally conceived. With the development of automatic teller machines (ATMs), banks’ demand for vault cash increased so much that reserve requirements were no longer a binding constraint at
many banks.

Annual growth of the monetary base increased in August. The staff favored an increase in the money stock, despite a larger gold outflow.

Arthur Marget, head of the Board’s international staff, explained that during the first six months, the gold stock declined $125 million. In the six weeks since July 1, the outflow rose to $285 million. Marget objected to press reports describing the outflow as a “flight from the dollar” (FOMC Minutes, August 16, 1960, 10). Much of the outflow was the counterpart of an increased balance of payments deficit. Foreigners had not fled from the dollar; they had acquired gold as settlement of the deficit and had increased their ownership of dollar assets. Marget concluded that international concerns did not call for a more restrictive monetary and fiscal policy. Governor Balderston was the only one to respond to Marget’s statement. He expressed concern about the long-run consequences of a continued payments deficit. The only solution he proposed was to bring home the troops, a move over which the System had no control and little influence. The United States should supply equipment, but let foreign governments use their own troops. No one mentioned the Democrats political campaign strategy of blaming the Federal Reserve for tight money and slow growth.

FOMC members and the staff did not agree on whether the economy was in recession, growing slowly, or moving sideways. After considerable discussion, the members voted six to four to change the directive to read: “encouraging monetary expansion for the purpose of fostering sustainable growth in economic activity and employment” (ibid., 55). Governors King, Shephardson, and Szymczak and President Allen voted no. The instructions to the manager did not change. Three months after the peak in the economy, four FOMC members opposed the modest change in wording.

Balderston, acting as chairman with Martin and Hayes absent, expressed the consensus as unchanged from the last meeting but with more discretion to the manager to err on the side of ease. Szymczak reminded them that keeping free reserves unchanged would cancel the effect of the Board’s action to count more vault cash as reserves. His statement had no effect on the instructions to the manager.

The meeting also heard a staff report on targeting total reserves instead of free reserves. The conclusion was strongly negative. “It is literally impossible to quantify in advance either the change in total reserves or the
volume of System operations which would be necessary to maintain the existing level of the seasonally adjusted money supply or to increase it or decrease it by a specified amount” (ibid., 9). The report concluded that nothing could be gained by estimating the future path of total reserves. The best the staff could do would be to report on actual changes in money. That put aside control of money.

Economic conditions continued to deteriorate at the time of the September 13 FOMC meeting. Consumer expenditures had slowed. The unemployment rate reached a postwar high of 7 percent. Industrial production continued to fall. The FOMC remained divided, but the reason for division changed. Several members, including Martin and Balderston, said that the System had done its best and could do no more. Martin clarified his statement by suggesting that lower interest rates would harm the country, presumably a reference to the gold outflow. Others agreed, but H. N. Mangels (San Francisco) wanted to target free reserves at $500 million, twice the August average. The manager said the level of free reserves did not give useful guidance about the state of the money market. He did not mention an alternative.

The staff report on financial markets concluded that the money supply was a more appropriate indicator of reserve effectiveness when compared with any measure of reserves.
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These comments displeased Martin, who said there was no shortage of money, but they pleased Bryan (Atlanta), Johns (St. Louis), Fulton (Cleveland), and Shephardson, who wanted increased growth of reserves and money.

Gold outflows received more attention both because they reduced bank reserves and because the gold price had increased to $35.25 an ounce in London and Zurich. This shifted demand for gold to the United States.

Martin had just returned from Europe. He believed that foreigners had not lost confidence in the dollar, as Marget had said, but they watched what the United States did and would regard a Treasury bill rate below 2 percent as evidence of a cheap money policy.

Martin added that the System had been too expansive in 1958. This postponed price adjustments. He did not want to repeat that mistake. He agreed with Mills that monetary and credit policy alone could not manage the economy. Painful adjustments were inevitable.

Less than two months remained before the election. Martin wanted the System to avoid overt action until after the election. The current consensus
was to maintain an even keel during the Treasury funding with doubts resolved on the side of ease.

65. The staff suggested that the “free reserve concept can be a useful indicator to the Manager of the Account . . . if, but only if, the effect of changes in reserve availability on such more fundamental measures as bank credit expansion, the money supply, and interest rates are under constant watch” (FOMC Minutes, Septem
ber 13, 1960, 9).