A History of the Federal Reserve, Volume 2 (20 page)

Borrowing from the Federal Reserve as a deterrent to bank credit expansion is losing its force because of (a) the profit spread, (b) the excess profits tax,
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(c) the idea that banks are finding it difficult to sell Government securities. (Executive Committee Minutes, November 25, 1952, 8)

Chairman Martin agreed.

Bank credit and member bank borrowing continued to rise. The staff estimate of credit expansion was 50 percent above the anticipated seasonal demand (FOMC Minutes, December 8, 1952, 4). In January, the Philadelphia and Cleveland banks voted to raise their discount rates to 2 percent. Concerned that a boom had started, Chairman Martin took up the requests at the January 9, 1953, Board meeting.

Winfield Riefler spoke first, supporting an increase. He believed a boom had started after the election of a Republican administration and a Congress committed to reducing tax rates. Capital expansion took too many resources relative to consumer durables. Rapid growth of credit sustained the expansion (Board Minutes, January 9, 1953, 4 and 9). Woodlief Thomas favored a small increase also. “[M]ember banks might get in the habit of borrowing and the act of borrowing might not be adequately restrictive” (ibid., 5).

The governors were divided between an increase of 0.25 and 0.5 percentage points. Martin said “it would have been better if the rate had been raised some time ago” (ibid., 11). He favored a 0.25 increase. “[A]n increase to 2.25 percent might be likely to create a turmoil in the market” (13).

The lengthy discussion at this meeting shows prevailing opinion on the role of monetary policy. Elements of the Riefler-Burgess framework carried over from the 1920s.
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The Board and the staff had not yet developed Keynesian views, with the possible exception of Governor Menc Szymczak, who emphasized the dominant role of fiscal and debt management policies. Monetary policy could support fiscal policy by “supplying the money and credit required by a high level economy” (13).

The Board delayed the
decision for a week so that New York could be
among the first to announce. Effective January 16, the Board approved an increase of 0.25 (to 2 percent) at eight of the twelve reserve banks. The others followed within a week. Sproul’s presentation to his New York board could have been written in the 1920s. “We forced the banks to borrow every bit of the increased reserves they needed to support credit expansion. . . . It is time to bring the discount rate into line with open market policy” (Sproul papers, Board of Directors, January 15, 1953, 2–3). The only new element is explicit recognition of the market’s anticipation. The market has “already adjusted to an increase” (ibid., 3).

82. The tax reduced the after-tax cost to profitable banks and the customers who borrowed from them. The discount rate was almost 0.5 percentage points below the rate on three-month bills at the time.

83. There is even a brief discussion of whether the market anticipated the increase to 2 percent, so that it was fully discounted. The following week, the Federal Advisory Council discussed a discount rate increase. It told the Board that it opposed an increase (Board Minutes, February 17, 1953, 13–16).

The rise in the discount rate changed the profitability of borrowing relative to holding government securities. In the three months January to March, commercial banks reduced borrowing by $1.2 billion and sold $3.9 billion of government securities.

Political
Fallout

Raising interest rates is rarely popular. This time was not an exception. Sproul warned his directors not to overplay the idea of more flexibility in the use of the discount rate or a return to orthodox central banking. “[T]here are still limitations on our freedom with respect to the discount rate” (Sproul papers, FOMC meeting comments, January 8, 1953, 4).

Senator Paul Douglas had taken the lead in Congress to free the Federal Reserve from subservience to the Treasury.
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Falling money growth (M 1 ) in the first half of 1953 followed by rising Treasury yields and problems in the bond market in June gained his attention. At the time, the annual rate of increase in consumer prices was between zero and 1 percent; this measure of inflation had declined from the 2 to 3 percent range of 1952. Douglas wrote to Eccles, who supported his view, criticizing Federal Reserve policy for shifting to deflation after the Eisenhower administration took office. Eccles and Douglas argued that the Federal Reserve had ignored the falling money supply.

Sproul responded to Douglas. He denied that policy was deflationary. Short-term changes in the money supply were not very informative. He doubted that a policy of keeping growth of the money supply “directly proportional to changes in production and employment . . . on a year-to-year basis is likely to be most conducive to the maintenance of stability in the economy at high levels. . . . [A] better theory for the guidance of central bankers . . . is that growth in the money supply should parallel the long
term growth in productive activity” (letter, Sproul to Douglas, Sproul papers, Board of Governors Correspondence 1953–54, August 31, 1953, 4–5). Unlike Martin, Sproul believed that the maintained growth of money was a leading indicator of inflation.

84. Douglas, a former distinguished economics professor at the University of Chicago, enjoyed the status of an expert who was looked to by many of his colleagues in Congress. For Douglas’s role in ending Treasury dominance, see v
olume 1, chapter 7.

Douglas was not the only critic. The rise in yields and the discount on government bonds aroused fears of recession or depression and considerable criticism of the Federal Reserve and its new policy. On May 11, twenty senators and representatives introduced a resolution requiring the Federal Reserve to support government securities at par.

The Eisenhower administration had no interest in restoring an interest rate ceiling. At the Treasury, Undersecretary W. Randolph Burgess, a former Federal reserve bank officer, had criticized the pegging policy when it was in effect. Arthur Burns at the Council of Economic Advisers, despite his reputation as an advocate of free markets, favored the use of credit controls “when economic activity is high and rising and prices seem to be moving upward” (Senate Committee on Banking and Currency, 1953, 2).
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This support for supplementary policies was a preview of his advocacy of price and wage guidelines and support of price controls in the 1970s.

The Federal Reserve may have been misled by the decline in member bank borrowing and steady increase in free reserves from $−692 million in May to $−495 million on June 17. To dampen criticism from Congress, the Treasury, and elsewhere and respond to declines in agricultural prices and concerns about recession, the Board discussed a reduction in reserve requirement ratios at its June 16 meeting.
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The following week, it esti
mated that the Treasury would borrow about $6 billion of new funds. It decided to supply part of the increase by reducing reserve requirement ratios for net demand deposits by two percentage points for central reserve city banks and one percentage point for all other members.
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The new ratios became effective at different dates between June 24 and August 1. The vote was four to 1, with Governor Robertson voting no because he thought the reductions should be smaller.
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85. The Truman Council of Economic Advisers had squabbled in its meetings with the president and lost support in Congress and the administration. Congress appropriated funds only to the end of March 1953 and left to President Eisenhower to decide what to do. Technically, Burns served from March to July as Economic Adviser on a special three-month appropriation. He proposed to reorganize the council, make only the chairman responsible for briefing the president, eliminate the vice chairman, and appoint an advisory board on economic growth to bring the Council into formal relation with other economic agencies (Hargrove and Morley, 1984, 96–97). Burns warned Eisenhower about a recession in September 1953, a correct forecast that strengthened his relation to the president.

86. The discussion began in April when “Governor Evans said he would look with some favor on a reduction in reserve requirements in the event of a downturn, particularly in view of recurrent complaints from country member banks regarding the inequitable position in which they were placed with respect to their non-member competitors” (Board Minutes, April 22, 1953, 3). Treasury Undersecretary Burgess urged Martin to reduce reserve requirement ratios. Martin urged the Treasury to offer an interest rate “substantially over the market” (FOMC Minutes, June 6, 1953, 6). Industrial production rose 10 percent in March and 5 percent in April (at annual rates). The concern about recession was probably related to the anticipated Korean armistice and the belief that recessions follow after wartime spending ends. The armistice came on June 27, and a recession followed. The New York Clearing House Association and others also expressed concern about a recession.

Robertson’s dissenting statement recognized that most of the reserves released by the change would be withdrawn through open market operations at unchanged interest rates. Staff estimates of Treasury borrowing and free reserve demand concluded that $1.5 billion of additional reserves would be needed to keep free reserves between $500 and $600 million for the rest of the year, but Robertson expected that only about $200 million of the reserves released would remain in the market. He preferred a smaller reduction followed by another reduction later in the year.

Robertson was right. With short-term interest rates unchanged, the demand for reserves declined approximately by the amount released. The measures that the FOMC used to judge its operations suggest little change in reserve availability or market ease. New issue yields on Treasury bills declined by 0.06 percentage points, but free reserves declined slightly. In the next three months, total bank reserves fell by $700 million, offsetting part of the change in required reserves. Thus, a principal result of lower reserve requirements was to reduce the cost of System membership.

The monetary base, adjusted for the change in reserve requirements, fell precipitately in the second half of the year. Chart 2.6 shows annual growth of the real value of the monetary base and the real interest rate in 1953–54. Data on anticipated inflation are not available for this period, so the real interest rate is an expost rate obtained by subtracting the most recent annual rate of price change from the long-term Treasury rate. Real interest rates fell one percentage point early in the recession, then rose to about 2.5 percent as the recession ended. The sharp deceleration of money, the change in the real interest rate and the rapid reduction in defense
spending following the armistice helped to bring on or sustain the 1953–54 recession.
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As on several other occasions, real base growth is a better indicator of recession and recovery than the real interest rate. Real base growth started to fall in March, and fell more decisively in June 1953. The National Bureau marks July as the peak in the economy. Real base growth began to rise in March 1954; the trough in the economy came two months later.
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87. Alternative proposals were: (1) to increase open market purchases substantially and increase the discount rate to show that policy was not inflationary; and (2) to make a modest increase in open market purchases. Those favoring the reduction in reserve requirement ratios wanted a strong gesture to show that the System did not want deflation.

88. There were two vacancies on the Board. In August, President Eisenhower appointed C. Canby Balderston and Paul E. Miller. Miller died within two months of his appointment. In March 1955, Balderston became vice chairman. Balderston was a Board member from August 1954 to February 1966. Before coming to the Board, he had served as dean of the Wharton School at the University of Pennsylvania and also as deputy chairman of the Philadelphia reserve bank.

THE 1953–54 RECESSION

The June 1953 reduction in reserve requirement ratios came just as the economy slowed. The National Bureau of Economic Research (NBER) described the downturn as a “sharp recession.”
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It lasted ten months, ending
in May 1954. Real GNP fell 3.2 percent and industrial production 9.4 percent. Unemployment increased to a peak rate of 6.1 percent (Zarnowitz and Moore, 1986, Table 7).

89. In the year ending second quarter 1954, government purchases declined 20 percent. At their peak, government purchases were 16 percent of GNP, but their decline in the year was 119 percent of the decline in GNP. The total fiscal impulse for calendar 1954 was smaller because excise tax reduction took effect in January 1954. A major income tax reduction became effective after the recession ended. Saulnier (1991,65) says that military contract awards done in the United States at the peak in first quarter reached nearly $11 billion. By fourth quarter 1953, such awards had fallen to $1.6 billion. GNP was about $350 billion.

90. The expost real long-term interest rate rose about 0.5 percentage points between March and July 1953. During the early months of the recession, the rate declined slowly to 0.96 percent in February 1954. By June 1954, it was back to 2 percent. Romer and Romer (1994, 18) computed the real value of the federal funds rate in recessions and recoveries. Their measure increased procyclically for the first three quarters following the peak; the recession lasted ten months.

91. The NBER defines a sharp recession as a recession of intermediate severity, less se
vere than a major depression, more severe than a mild recession. The scale is relative, based on the expost characterization o
f recessions (Zarnowitz and Moore, 1986).