A History of the Federal Reserve, Volume 2 (23 page)

Knipe (1965, 11), who worked for Chairman Martin at this time, characterized policy discussions and directives to the manager as shifting “from one expression of interest to another, often with no clear relationship to the policy actually in force.” He added: “While nearly all the directives and most of the other material in the records of the Federal Open Market Committee may read as though the purpose was to conceal, rather than to reveal, a change from one particular ambiguity to another did occasionally correlate with policy changes” (ibid.). Like Maisel a decade later, Knipe deplored the absence of “an account of how policy was made” (ibid.).
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Policy actions in the 1954–57 period had a classical central banking flavor. The discount rate increased from 1.5 percent to 3.5 percent in seven steps. During the same period, the rate on prime commercial paper rose from 1.3 percent to 4 percent, 0.7 percentage points more than the discount rate (Board of Governors, 1976, 681–82). The rise in the discount was less than the increase in the annual rate of consumer price inflation, so expost real discount rates declined. The Federal Reserve’s action was less restrictive than they, and others, believed at the time.

Levels of free reserves show little relation to reported inflation. Such relation as occurred was perverse; deflation came in 1955 when free reserves were positive, and inflation rose most rapidly in 1957 when free reserves remained about –$500 million. The FOMC believed that it had tightened policy during this period. Annual growth of the monetary base, however, remained between 0.5 and 1.5 percent in the two years ending August 1957, a mildly deflationary policy that showed no sign of change. (See Chart 2.5 above.)

Neither base growth nor free reserves adequately explain the shift from rapid to moderate expansion. Chart 2.8 shows that the modest changes in the federal funds rate in 1957–58 are much smaller than the increase in inflation, a pattern that returned during the Great Inflation. The inflation adjusted (real) federal funds rate reached a peak in 1955–56 and turned negative in 1957, an unplanned and unwelcome easing of monetary policy brought about in considerable part by rising inflation in 1956–57.

As in the 1930s, Federal Reserve officials did not distinguish between nominal and real interest rates. Unlike the early 1930s, however, the inflation rate was positive after 1955, so the real interest rate (and real free
reserves) was lower than the nominal rates the FOMC watched. Its efforts to tighten policy failed in part because its failure to make this distinction prevented it from tightening enough.

109. In their report for the Banking Committee, Brunner and Meltzer (1964) noted the inchoate nature of Federal Reserve directives and policy statements at the time and proposed an explicit framework.

Budget position does not explain inflation either. Under the Eisenhower administration’s policy of fiscal restraint, surpluses in 1956 and 1957 replaced a modest deficit in 1955. This may explain why contemporary observers blamed inflation on wage increases and talked about cost-push inflation brought about by union power.
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With money growth modest and GNP rising more rapidly, monetary velocity—the ratio of GNP to the money stock—rose at an annual rate of 5 percent during the 1954–57 expansion.
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The Federal Reserve hinted that the increase in velocity reflected the combined effects of rising economic activity and inflationary expectations.
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The same forces worked
on interest rates also. Both short- and long-term rates rose during the expansion as the world economy expanded, domestic investment increased rapidly and, after the middle of 1956, consumer prices began a sustained rise that brought them from the mild deflation of 1954–55 to a 3.5 percent annual rate of increase in 1957. This was a high rate of peacetime inflation by the standards of the time.

110. Growing union power would be required, but neither union power nor growing union power could explain why inflation was negative in much of 1955 and declined in 1958 and 1959.

111. Friedman and Schwartz (1963, 615) note the more rapid growth of a broader monetary aggregate (M
₂
). As in the late 1920s, slow growth of the monetary base in a period of rising demand for credit and money led banks to induce customers to increase time deposits, thereby reducing average reserve requirement ratios. Banks could peg interest on time deposits.

112. “A rising velocity of circulation of money . . . is typical of periods of increasing economic activity. . . . An increase in velocity is also likely to occur in inflationary periods when expectations of rising prices provide an additional incentive to minimize the holding of cash balances” (Annual Report, 1956, 10–11). In the light of this statement, it is puzzling that the
Board did not take the next step of recognizing that expected inflation would raise nominal interest rat
es also.

The rise in velocity slowed after inflation declined, then remained low, from 1958 to 1961. The continued, but slower, rise in velocity reflected several forces at work during the period, including technological improvements in banking and finance that reduced desired cash balances and growing optimism about prospects for growth in the United States and other market economies. Optimism about future growth increased the demand for capital and claims to capital.

Anticipated inflation or the end of deflation seems too small to account for the growth of actual (real) balances in this period. The one available measure of anticipated inflation for the period is a survey of market opinion known as the Livingston Survey. The survey data in Charts 2.9 and 2.10 show a rise from anticipated deflation to anticipated price stability in 1955 followed by continued price stability. Although the Livingston Survey has been found to be biased downward, the bias would have to be large to accommodate much anticipated inflation at this time.

Federal
Reserve
Actions
1955

The System started 1955 by raising margin requirements on stock purchases and short sales from 50 percent to 60 percent. The Board acted in executive session, so no record of the reasoning exists. The Board’s announcement said the increase “was designed to prevent the recovery from being hampered by excessive speculative activity” (Annual Report, 1955, 82).
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The reference suggests concern that credit was used for speculative purposes instead of “real” activity. Sproul subsequently commended the Board for “warning concerning the use of credit in the stock market . . .
[and for] proper use of a selective control” (Sproul papers, FOMC comments, J
anuary 11, 1955, 1).

113. Stock price increases slowed modestly following the change. On April 22, the Board again increased margin requirements by ten percentage points to 70 percent. Again the decision was made in executive session. The Annual Report (1955, 84) explains the Board’s intent to “prevent excessive use of credit” from adding to speculative pressures. The Board discussed an additional increase, to 80 percent, on September 21, but decided against it. This time the discussion is on the record. The main concern is the use of credit for speculation, but the rate of increase in credit and stock prices had fallen, so the only decision was to request data on margin balances (Board Minutes, September 21
, 1955, 10–11).

The Board reacted to the rise in equity prices. In the latter half of 1954, the Standard & Poor’s (S&P) index of stock prices maintained a 30 to 35 percent average rate of increase for more than six months. In August
1954, the S&P index passed the nominal 1929 peak. Despite the impressive rise, the price level (deflator) had increased more than 75 percent in the same period, so the real value of the index remained far below its 1929 level.

The Federal Reserve was very alert to inflation in this period. On January 5, Chairman Martin asked Riefler to poll the members of the Executive Committee to learn whether current policy “should be tighter than had been decided” a week earlier at the December 28 meeting. All members agreed that policy should be tighter (Riefler to files, Correspondence, Board files, January 5, 1955). The following week, Martin held a special FOMC meeting to discuss the strong recovery and “the possibility that inflationary seeds may be germinating” (FOMC Minutes, January 11, 1955, 7). His conversations with businessmen showed extreme optimism in the business community.
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Also, the level of free reserves remained between $400 and $700 million, a level that he thought was too high.

Sproul saw no reason for tightening. He acknowledged that the recovery had strengthened and would continue, but the “revival reflects more a cessation of deflationary influences than the emergence of new and continuing expansionary forces” (Sproul papers, FOMC comment, January 11,

1955, 6). Sproul expressed skepticism about incipient inflation. Although he opposed a shift to more restrictive policy, he was willing to accept Martin’s proposal to change the directive modestly, from “promoting growth” to “fostering growth” (FOMC Minutes, January 11, 1955, 14).
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The other members differed widely on whether and how they should change the directive. Balderston favored a reduction in the discount rate; H. G. Leedy (Kansas City) proposed restraint. After much discussion, the members voted to change the directive as Martin had suggested. The directive to the manager called for “fostering growth and stability in the economy by maintaining conditions in the money market that would encourage recovery and avoid the development of unsustainable expansion” (ibid., 24). That left the decision to the manager.

President Bryan (Atlanta) abstained on the vote. In a lengthy statement, he complained that he was prepared “to discuss appropriate policy
in terms of reserves and money rates” (ibid., 24). They had instead spent their time discussing “textual changes in the directive . . . [He was not prepared] to appraise the significance of the textual changes actually adopted, or the magnitude of the policy changes contemplated by the changes of language” (ibid., 25). He urged them to adopt quantitative measures, as Sproul had attempted to do, to “better discharge our responsibilities, within acceptable canons of delegation as between principal and agent” (ibid., 26)

114. The Federal Advisory Council told the Board that the Council was unanimous in predicting good business in the months ahead. He said that it was the first time in his nineteen years on the Council that there had been such agreement (Board of Governors, February 15, 1955, 2). The Council had doubts and concerns about the second half of the year.

115. Sproul’s statement included the definitions of “ease” and “restraint” discussed above. Martin replied that everyone should read Sproul’s definitions. “One of the biggest problems of the Committee was understanding the terms that were used in describing credit policy and in translating those terms into instructions or directives” (FOMC Minutes, January 11, 1955, 14). But he did not instruct the staff to develop more precise definitions.

Bryan’s criticism was the first of many attempts by FOMC members to get better control of operations by making committee recommendations more precise. These efforts eventually succeeded when the FOMC adopted a numerical target for the nominal federal funds rate. That came many years later, after Martin had retired.

Although the Federal Reserve made many changes to avoid supporting, or appearing to support, the Treasury market, it gradually adopted a firm policy of avoiding changes in free reserves and interest rates for the two weeks surrounding Treasury debt operations. By 1955, this procedure, known as “even keel,” had become standard practice. The practice was so well understood that the committee could vote for “even keel,” without defining it, as it did on January 25, 1955, and many other occasions.

Economic growth remained robust through the spring and summer. Between January and August, the FOMC made only one change in the operative clause of the directive to the manager.
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In the same period, free reserves declined from $400 million to $90 million, and the federal funds rate rose from 1.37 percent to 1.68 percent. No one questioned these changes or asked how the manager could interpret the directive as requiring changes in money market conditions.

A possible explanation for the change is that the System raised the discount rate by 0.25 to 1.75 percent effective April 14 and 15 at eight reserve banks. By May 2, discount rates were again uniform. Under an “easy” policy, as described by Sproul, “sensitive money market rates move up toward the discount rate” (FOMC Minutes, January 11, 1955, 11). Since the
discount rate increased, apparently money market rates could rise without a change in the directive.
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A problem with this explanation is that market rates rose before the discount rate.

116. The May 10, 1955, meeting discussed Sproul’s motion to change the directive to reflect the end of the recovery phase. He proposed to substitute “avoid the development of unsustainable expansion” for “fostering growth and recovery.” Sproul made clear that he envisaged no change in policy. “[W]e should hold steady for the next month or six weeks” (FOMC Minutes, May 10, 1955, 7). A steady policy, he said, would keep free reserves about zero and “interest rates in line with the present discount rate” (ibid.). The committee discussed whether the directive should “foster growth” or “foster stability.” After much discussion of “fostering growth,” “orderly growth,” “stable growth,” and “stability” (ibid., 9), the committee voted unanimously for Sproul’s proposed change.