A History of the Federal Reserve, Volume 2 (11 page)

One set of proposals made the manager an employee of the FOMC instead of the New York bank and gave the FOMC a separate budget and its own staff. Sproul opposed the change, arguing, in a five-page letter to Martin, that the recommendation confused policy and operations. The FOMC was a policymaking body; it was never intended to have operating responsibilities. He defended his own role vigorously, argued for continuing the manager’s discretion, and defended the established practice of having the manager serve as a vice president of the New York bank (memo, Sproul to
Martin, Sproul papers, February 18, 1953). Martin postponed discussion of the last issue to a later date so that the subcommittee could meet with Sproul (FOMC Minutes, March 4, 1953, 27). The FOMC discussed the proposed change in its relationship to the manager several times in the next few years. The manager remained a vice president of the New York bank, but he received his appointment as manager from the FOMC after 1955.

13. The account manager operated the “desk” (trading desk) charged with execution of open market operations. At the time, the manager made the decisions about how much and when to provide or remove reserves. The subcommittee found other “anomalies in the structure and organization of the Federal Open Market Committee” (FOMC Minutes, revised, March 4, 1953, 27). It mentioned a separate budget, separate staff responsible only to the FOMC, and making the manager “directly responsible” to FOMC (ibid.). Sproul objected strongly, so these recommendations were put aside. The FOMC eventually took responsibility for appointing the manager, although he remained a New York bank vice president. The committee never implemented proposals about separate budget and staff. Sproul’s response said that the problem was “to make an effective transit from policy to execution of policy” (Sproul papers, “Organization of Federal Open Market Committee,” FOMC Correspondence, July– December 1953, February 18, 1953). He defended the manager’s role and claimed that the proposed changes would not remove the gap between policy choice and execution. (No one suggested more explicit instructions to the manager.) Separately in a letter to Oliver Powell (Minneapolis), but sent to all FOMC members, Sproul charged the subcommittee with trying to appease congressional critics who wanted greater centralization of control in Washington. The Board wanted to strengthen its position and weaken New York, an old and continuing struggle (letter, Sproul to Powell, Sproul papers, FOMC Correspondence, July–December 1953, July 16, 1953). Martin responded, agreeing with many of the points Sproul made about the need for managerial discretion in executing FOMC directives. But he added that delegation could go too far. “The management of the Account, if it chooses, may make a lot of policy on its own” (letter, Martin to Sproul, Martin papers, undated but likely July 1953).

The subcommittee proposed a new form for the directive summarizing the FOMC’s decisions. Martin’s intention was to give more explicit directions to the Executive Committee. Once a year, the committee would reconsider general operating instructions, the first part of the directive. The second part would be a specific directive issued to the Executive Committee. The committee would then issue any instructions concerning direct purchases from the Treasury.
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Instructions to the New York bank would follow. The last of these was not published as part of the Annual Report.

Martin’s concern was not just operating control. He believed that the government securities market expected the Federal Reserve to limit losses on longer-term government bonds. As long as the manager intervened at various maturities, the market would expect the manager to do so. It would not develop its own arrangements for limiting risk to portfolio holders. A small decline in price would not call forth buyers willing to clear the market and conversely. Instead, the market would wait for Federal Reserve support. If the Federal Reserve did not support the price, Martin believed the market would expect the price to fall further; a fall in bond prices would therefore bring forth an excess supply and a further price decline. In the terminology used at the time, the market lacked depth, breadth, and resiliency.
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Buyers and sellers did not support an existing price by taking advantage of small deviations from equilibrium to restore equilibrium.

One way to stop the manager from intervening, and to lessen Sproul’s influence, was to make the manager report to the FOMC, where Martin
could exercise control. With that option put aside, an alternative was to limit or eliminate operations in long-term securities.

14. Authority to purchase limited quantities directly from the Treasury began as a temporary accommodation in the 1930s. In 1952, the Treasury requested Congress to make the authority permanent. The Board discussed the issue several times in 1952 and concurred in the Treasury request (Board Minutes, February 18, 1952, 5–6; November 4, 1952, 11–12).

15. Riefler coined these terms, which were widely used at the time. He said he chose depth, breadth, and resiliency because DBR were his son Donald’s initials (Hetzel and Leach, 2001, 50). In a written response, Martin defined these terms as: “dealers willing to quote firm prices at which they will buy reasonably large quantities of securities, . . . [and] variations in quotations between successive transactions are minor.” He also used “continuity” and “responsiveness” (Sproul papers, Flanders Hearing Folder 1, Roosa to Sproul, December 2, 1954). Robert Roosa at the New York bank criticized Martin for discussing the issue “in the rarefied atmosphere of theoretical discussion conducted in another world” (ibid., 3). This criticism of Martin is v
ery wide of the mark.

Martin’s subcommittee had concluded that the government securities market had not developed as a “self-reliant” market, even though the Treasury sold an issue in November 1952 without System support for the first time since the war began. One reason was that a “disconcerting degree of uncertainty existed . . . with respect to both the occasions which the Federal Open Market Committee might consider appropriate for intervention and to the sector in which such interventions might occur—an uncertainty that was detrimental to the development of depth, breadth, and resiliency of the market” (Annual Report, 1953, 89). It also increased the risk premium. The report recommended limiting policy actions to transactions in Treasury bills, a policy that became known as bills-only.

Bills-Only

By unanimous vote, the FOMC agreed on March 4, 1953, that: (1) operations for the System account would be confined to the short end of the market; (2) purchases and sales would be made only to meet the objectives of monetary and credit policy (not to support any pattern of yields and prices); and (3) during periods of Treasury financing, the System would not purchase maturing issues, when-issued securities, or issues with comparable maturity (FOMC Minutes, March 4, 1953, 40–42). Two years after the Accord, approval of the resolution ended the transition period.
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The Federal Reserve increased its independence of Treasury.

The market soon tested the new policy. On the same mid-April day that Martin, in a speech, told the market that it would be free to set prices and yields in the long-term market, the Treasury announced that, to lengthen the maturity of outstanding debt, it would offer $1 billion of thirty-year bonds with a 3.25 percent coupon.
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This was the first issue of long-term
bonds since the war. The yield was generous; at the time long-term Treasury bonds yielded slightly less than 3 percent. After an initial, positive response, market yields began to rise.
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16. The April 8 Executive Committee meeting approved unanimously a letter from Chairman Martin to President Sproul setting out the March 4 agreement. The letter limited operations to short-term securities (except in disorderly markets), and abandoned “rigid qualifications for dealers” (Executive Committee Minutes, April 8, 1953, 10).

17. The speech, called “The Transition to Free Markets,” set out Martin’s philosophy and beliefs about the role of monetary policy. It was, he said, “a mistake to claim too much for monetary policy . . . But it was equally misleading to conclude that this steady progress [since the Accord] would have been achieved without the aid of the monetary policies and actions that were initiated two years ago. . . .

“In a free market, rates can go down as well as up and thus perform their proper function of the price mechanism. . . .

“Under our government institutions and our economic system, the maximum benefits for all of us flow from utilizing private property, free, competitive enterprise, and the profit motive” (Martin speeches, April 13, 1953, 4).

At the May 6 Executive Committee meeting, the manager reported that “there was virtually no market for government securities at the present time” (Executive Committee Minutes, May 6, 1953, 2). Sproul wanted to intervene in the long-term market, but Martin wanted to maintain the bills-only policy (letter, Sproul to Martin, Sproul papers, December 4, 1953, 3). In the next three weeks, the System purchased $134 million and increased repurchase agreements. Banks reduced discounts by $513 million, more than offsetting the System’s expansion. Long-term yields continued to rise.

Martin claimed that speculators subscribed to the bonds thinking that they would go to a premium. Instead, they went to a discount. As prices fell, speculators sold their bonds. Average yields on government bonds rose from 3 percent at the end of April to 3.19 percent in the week ending June 6. This was a large change at the time.

Later, he explained the importance of bills-only policy: “The market appeared constantly to expect action by the System which, by the standards of a free market, would be unpredictable and might seem capricious” (ibid., 7). He added: “[W]hen the Federal Reserve, with its huge portfolio and virtually unlimited resources, intervened in the market during Treasury refundings, many other investors tended to step to the sidelines and let the market form around the System’s bids. This was a natural and highly rational investor reaction” (ibid., 9). As a consequence, the market was uncertain about the proper pricing of new issues. Martin then described characteristics of a properly functioning market, distinguishing transitory and persistent changes. “[F]luctuations resulting from temporary or technical developments are self-correcting without any official intervention. Of the movements that are not selfcorrecting, most reflect basic changes in the credit outlook which should be permitted to occur. Only very rarely is there likely to be a disorderly situation that would require Federal Reserve intervention for reasons other than credit policy” (ibid., 11). Disorderly and orderly proved difficult to define, as New York recognized at the time. The purpose of the change was to avoid giving the market reason to think that the Federal Reserve had resumed pegging interest rates (Sproul papers, Q and A for the Flanders hearings, answer to question 3).

18. The rise was not entirely unforeseen. Banks’ loan demand rose following the end of selective credit controls in January 1952. To finance lending, banks sold $3.9 billion of government securities in the three months ending April 1953. Sproul told his directors in April that Treasury borrowing would increase in part because the Treasury would have to pay off maturing F and G bonds sold to big investors during World War II. However, two weeks later, he warned that economic expansion might be nearing its end (Sproul papers, FOMC meeting comments, April 2 and 16, 1953). In early May, he told the FOMC that increased Treasury borrowing might raise rates and “the market might become ‘disorderly’” (ibid., May 7, 1953, 2). The policy of neutrality “has become a tight money policy—money can be tight even at rates of interest which ‘look’ low” (2). On the day the Treasury announced the issue, nine United States senators urged the Treasury to withdraw the issue as a “triple threat to the American economy” (quoted in Knipe, 1965, 87). This is an example of the heightened political interest in economic policy.

The manager continued to follow bills-only, purchasing (net) $848 million for the System account in the middle two weeks of June, a3.5 percent increase in Federal Reserve holdings. In addition, the manager purchased long-term debt, including the 3.25 percent bonds, for the Treasury trust funds. By the end of the month, long-term yields were halfway back to the April level.

At the June 11 FOMC meeting, Sproul reopened discussion of billsonly, arguing that the market had not shown the promised resiliency. He accused proponents of bills-only policy of a “doctrinaire attitude on free markets” (Sproul papers, FOMC meetings, June 11, 1953, 3). Two Board members did not attend the meeting, and there was one vacancy on the Board following Oliver Powell’s departure to become president of the Minneapolis reserve bank. The presidents, therefore, had a five-to-four majority at the meeting. They voted together to rescind the bills-only policy and permit the Executive Committee to decide what to purchase. The temporary market disturbance passed, and the two absent members returned. The FOMC again reversed itself and restored bills-only at its September meeting. This time the vote was nine to two with Sproul and Powell dissenting. The other presidents voted with the majority.

Sproul tried again to modify the decision at the December FOMC meeting. He proposed that the bills-only policy be adopted (or changed) at each meeting, and that the rule be rescinded unless explicitly approved. The majority argued that the rules could be changed at any time. By a nine-totwo vote, the committee rejected Sproul’s motion. Only Joseph Erickson (Boston) joined Sproul.

Sproul did not give up. In March 1956, shortly before he retired, he prepared a twenty-three-page memo for the FOMC. He argued, as on previous occasions, that the bills-only policy had not increased, and would not increase, the depth, breadth, and resiliency of the long-term market. Dealer positions had fallen because risk had increased. Dealers had become brokers of long-term securities instead of market makers. In the same period, the floating supply of Treasury bills had declined, so the Treasury bill yield had become a less reliable indicator of money market conditions. For these reasons, he claimed operations in the short-term market did not affect the long-term market, as the committee had expected (memo, Sproul to Riefler, Board files, March 28, 1956).
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19. Martin hit back, rejecting Sproul’s argument and his analysis. “I do not understand how any judgment about depth, breadth, and resiliency can be based on statistical comparisons of the volume of transactions in various sectors of the market when the market was pegged with the volume of transactions in those same sectors when the market was free” (Martin to FOMC, Board files, April 17, 1956, 1). Sproul responded, accusing Martin of an
all-or-nothing approach and reiterating his belief that the FOMC should use all available tools (Sproul to FOMC, Board files, May 3, 1956). Sproul left the FOMC a few weeks later. In 1961 purchases of all maturities resumed. Market activity slowed or ceased when the System purchased longer-term securities.