A History of the Federal Reserve, Volume 2 (27 page)

The tone three weeks later was very different. The staff report to the FOMC highlighted renewed growth of consumption and investment spending, business’ demands for credit, and concerns about rising prices. The staff again suggested an increase in the discount rate to slow borrowing. Sproul agreed that growth had resumed, but he was cautious about responding too vigorously to the prospect of inflation. He opposed a discount rate increase. The members divided; six favored an increase, ten favored delay or opposed change. The committee voted to change the directive, by removing the clause about deflation inserted in January. The instruction once again called for “restraining inflationary developments in the interest of sustainable economic growth” (FOMC Minutes, March 27, 1956, 36). And once again, there was no connection between the changes in words and actions. New issue rates on Treasury bills fell following the meeting.

One reason for delaying action was an unwillingness to raise rates until there was evidence of inflation. The members did not have a theory of inflation against which they might appraise developments, and they did not distinguish transitory and persistent change. Most of the comments about inflation referred to reported changes in particular prices, not a persistent rise in the general price level. The more potent reason was a political concern, the extent to which interest rates would have to rise, a concern that remained an obstacle to inflation control in the 1960s and 1970s. Sproul warned independence was not well supported, that “the Committee would be fooling itself if it thought it could prevent this wage-cost spiral short of adopting a very severe monetary policy. Whether the System would have the assent of the Government and of the public to such a course seemed to Mr. Sproul to be a real question” (ibid., 33). Vardaman shared this view. Stopping the wage-cost spiral “could easily result in the destruction of the System” (idem.).
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Bryan (Atlanta) pointed out that delay would require still higher interest rates, but his remark drew no support from Martin or Sproul.

A week later, Bryan notified the Board that Atlanta’s directors had voted to increase its discount rate by 0.25 percentage points to 2.75 percent.
Philadelphia joined Atlanta. Martin was under considerable pressure from administration officials to avoid higher interest rates. The staff, however, pointed to a 5 percent increase in demand for credit in February and increases in interest rates on long-term bonds. They attributed the higher bond yields to a “turn around in the thinking of market participants who previous
ly had anticipated some relaxation of Federal Reserve policy” (Board Minutes, April 6, 1956, 14). With higher yields, banks preferred to borrow at the discount window instead of selling bills from their portfolios.

147. The same concern arose in the 1920s and in the early postwar years. After the System raised the discount rate to 7 percent in 1921, it was reluctant in later years to consider raising rates to 6 percent or more. In the early postwar, concern about the effects on debt values delayed action. See volume 1, chapt
ers 4 and 7.

Governors Mills, Robertson, Charles N. Shephardson, and Szymczak favored the rate increase. Martin, Balderston, and Vardaman were not at the meeting, but Martin phoned to ask for a delay until the following week, when all Board members would be present and other banks could reach a decision. The Board had notified all other banks about the request for an increase following Atlanta’s decision.

Effective April 13, the Board approved increases to 3 percent at Minneapolis and San Francisco and 2.75 percent at nine reserve banks. Chicago followed a week later. The Board authorized a 3 percent rate at any bank that chose to adopt it. The System had shown its independence by winning its first confrontation with an administration in an election year.

The consequences were much less than the administration feared. Between February and April, the federal funds rate rose 0.12 percentage points, and member bank borrowing increased $200 million. Weekly data showed increases of 0.35 to 0.5 points on Treasury bills and notes by the end of April with the largest increases at the shorter term. Though relatively small, the increases in Treasury bill rates brought these rates to their highest level since 1933. Annual growth of the monetary base remained in the neighborhood of 1 percent. Stock prices continued to rise until May.
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The administration later recognized that the increase was appropriate. They did not protest the next increase in August (Saulnier, 1991, 92).

On April 27, Sproul resigned as president of the New York bank, effective June 30.
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He attended his last open market meeting on May 9 and used the occasion to propose six studies of operational and procedural
changes. Controversy arose over only one, “swaps,” to permit the manager to exchange one type of bill for another when the maturity distribution of the bill portfolio was unbalanced. Other suggestions called for studies of operating procedures, the relation of monetary policy to debt management (jointly with the Treasury), the financing of government securities dealers, and operation of the federal funds market.
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He did not include a study of the effect of monetary policy on economic activity.

148. At the April 17 meeting, Ralph Leach (Richmond) remarked that commercial banks in his district held few Treasury bills. He then illustrated how rare borrowing on commercial paper had become. Bankers had inquired about discounting eligible commercial paper, and one bank planned to borrow in that way in the next week (FOMC Minutes, April 17, 1956, 15).

149. Martin praised Sproul for his contributions to the System and invited him to return for the next meeting and to participate as long as he remained in the System (FOMC Minutes, May 9, 1
956, 23, 38).

Two weeks later, the economy again appeared less buoyant. The Federal Advisory Council (FAC) gave a mixed review. Only two members thought the economy would expand. Four expected a decline, and six expected the level to remain the same (Board Minutes, May 22, 1956, 4). Members from manufacturing regions were the most pessimistic. Industrial production fell in May and June. The FAC members favored keeping policy unchanged, unless business deteriorated. The staff report at the FOMC meeting the following day gave a similar mixed report on the economy. Consumer spending had slowed, but plans for investment remained robust.

Chairman Martin did not follow his usual custom of speaking last and forming a consensus. He spoke first, indicating that he wanted to change the directive by restoring the phrase “while taking into account any deflationary tendencies” that the committee had removed in March. The members agreed. Balderston proposed purchases of $400 to $500 million to increase free reserves to –$250 million. Martin went further. He preferred to raise free reserves toward zero over the next few months, but he described the change as a “shift in emphasis and not a change in policy” (FOMC Minutes, May 23, 1956, 29). Some members questioned both his recommendation and his characterization that this was not a change in policy. Following the meeting, borrowing declined and free reserves increased from monthly averages of $971 and –$504 in May to $769 and –$195 in June. The monthly average federal funds rate, however, remained about the same.

Once again, the intense focus on current reports, mistaking temporary for permanent change, misled the FOMC. Optimism soon returned. By late June, projections for output had become more positive, and pro
jected inflation remained low.
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In July, the staff described the economy as “showing broad strength,” despite the start of a steel strike. Actual inflation exceeded the Board’s projections; consumer prices in May had the largest one-month increase in two years; average hourly earnings rose 6 percent from the year before.

150. The Board published the federal funds market study in Board of Governors (1959). Riefler had reported earlier on experience with short-term debt since the Accord. His study traced many of the differences between the markets for bills and certificates to differences in the way the Treasury marketed the two types of security. The Treasury had experienced attrition when marketing certificates and short-term notes but not when marketing bills. The study correctly attributed the difference to the use of auctions for Treasury bills versus fixed price offerings for certificates. Errors in pricing led to attrition or excess demand. The study also mentioned the greater frequency of bill offerings and other technical details (memo, Riefler to FOMC, Board files, April 10, 1956).

William Trieber (New York), temporarily replacing Sproul, wanted to lower free reserves to –$400 million. Others expressed uncertainty about whether to ease or restrain the growth of credit. H. N. Mangels (San Francisco) and Powell (Minneapolis) discussed lowering their discount rates from 3 to 2.75 percent to align with the other banks, but Martin opposed any change while the Treasury was selling bonds.
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Alfred Hayes became president of the New York bank on August 1 and vice chairman of the FOMC on August 7 for the remainder of Allan Sproul’s term. He remained until August 1975. His first FOMC meeting coincided with the British-French-Israeli invasion of Egypt to protect the Suez Canal from nationalization by the Egyptian government. Commodity prices began to rise with the outbreak of hostilities.

The slowdown in the economy had ended by the time of the August 1956 meeting. The staff reported that the economy showed renewed strength. The steel strike settlement raised wages, followed by higher steel prices. Hayes feared that “this was likely to start a chain reaction in other industries,” a reference to prevalent concerns about inflation caused by rising costs, especially labor costs, pushing up prices, called cost-push inflation (FOMC Minutes, August 7, 1956, 10).

Hayes called for more restraint and lower free reserves, but he opposed an increase in the discount rate at that time. Most members agreed to defer a change in the discount rate until the Treasury completed its financing. As in the early postwar years, several expressed concern that monetary policy alone could not prevent inflation.
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Only Robertson forcefully urged
a restrictive policy. The FOMC “should not credit monetary policy for keeping an even keel when things go well and deny responsibility when inflationary pressures seem to get the upper hand” (FOMC Minutes, August 7, 1956, 15). His statement received no support. At the opposite pole, Mills argued that money was tight. Further tightening would reduce investor confidence, “unsettled by the international tensions resulting from the Suez Canal crisis” (ibid., 16).

151. The manager indicated at this meeting that he now watched the federal funds rate, not the Treasury bill rate. The bill rate could move for reasons unrelated to policy, for example, the sale of bills at quarterly corporate tax dates.

152. Abbott Mills commented on the excessive concern for free reserves and borrowing and the neglect of changes in the economy. “[T]he Committee’s decisions are built so largely around market considerations that it is in danger of losing sight of its responsibilities for making credit adequately available” (FOMC Minutes, July 17, 1956, 33). On July 27, the executive committee of the Minneapolis bank voted to lower the discount rate to 2.75 percent. Country banks resented the 3 percent rate at a time when crops had to be marketed. The Board deferred action, citing Martin’s concern about the national implications of a rate change during a period of Treasury financing.

153. The staff reported the annual increase in consumer prices reached 1.5 percent in June and that the rate of increase had continued in July. (In the year to May, annual rates of inflation had increased from −0.5 to 1 percent. May, June, and July show large monthly
increases.) The proximate arithmetic cause was not higher wages. Agricultural prices had lagged earlier in the decade. The report showed that they had increased 10 percent since the previous December.

Martin summarized the discussion in a lengthy statement, highlighting the wage-cost spiral. “We are bordering on a state of over-employment . . . [T]he steel strike had been a disaster” (ibid., 32). His recommendation was to stay on an even keel until buyers completed payment for Treasury securities while resolving “doubts on the side of tightness” (34). The only decision was unanimous, to remove the clause reinserted in May that took account of deflationary forces.
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The FOMC met again two weeks later. Member bank borrowing had nearly doubled, and interest rates had increased at all maturities in response to market demand and the expected increase in the discount rate. Rates on three- to five-year governments reached 3.5 percent, the highest level since 1930. Banks raised their prime lending rates before the meeting. The reported increase in consumer prices, 0.7 percent for the month, raised the annual rate of inflation to 2 percent, the highest rate since 1952. A 7 percent increase in steel prices, following the strikes, convinced the members that inflation would continue. Most members ignored the distinction between relative and general price changes.

The rapid rise in interest rates on short- and long-term maturities in August 1956 contrasts with the much smaller response of interest rates to much higher reported rates of inflation after World War II. One difference was that the Federal Reserve pegged rates in the earlier period, but this explains only part of the difference. Holders did not sell most of their bonds despite the reported inflation. In 1956–57, holders promptly sold bonds, raising yields in response to inflation. One plausible explanation of
the difference is that the public expected inflation to persist after 1956, but not after 1947. The Livingston Survey (Chart 2.10 above), however, shows a rise to only
1 percent in the inflation rate predicted for 1957.

154. The FOMC again discussed several memos on whether the manager should engage in “swaps” to balance the maturity distribution of the bill portfolio. Sproul’s memo before his retirement restated the reasons for engaging in swaps. Robertson responded, restating his argument that the benefits were small and could be achieved in other ways. Trieber presented New York’s case at the meeting. Martin opposed, generally, but would permit limited authorization. The only decision was to solicit dealer opinion and revisit the issue. A month later, the committee discussed the issue at length again, repeating most of the earlier arguments. Finally, on September 25, the FOMC decided against portfolio swaps.