A History of the Federal Reserve, Volume 2 (38 page)

A few days after the FOMC meeting, New York, Chicago, St. Louis, Minneapolis, and Dallas raised their discount rates to 3.5 percent. Cleveland and Richmond voted to remain at 3 percent. They were the last to change. By June 12, all banks posted the 3.5 percent rate.

Although the FOMC believed it had simply followed the market to a higher level, market rates rose after the increase in the discount rate. By mid-June, the federal funds rate reached 3.50 percent, with Treasury bills at 3.25 percent, and free reserves at –$500 million. The increase in the federal funds rate in the year to mid-June was 2.5 to 3 percentage points, an unusually rapid rise. The proximate cause was a strong recovery and a very restrictive monetary policy. Real GNP rose 8 percent, base money growth 1.5 percent. Interest rates rose, inducing a very sharp increase in monetary velocity. The large increase in real GNP included sizeable accumulations of steel inventories in anticipation of a steel strike beginning in mid-July.

The steel strike came as anticipated, but the rest of the economy continued to expand. Treasury operations prevented any policy change during July. With intermediate and long-term yields near 4.25 percent or above, Congress considered legislation to remove the 1918 ceiling, but it raised the dollar value of the debt ceiling without changing the interest rate ceiling.
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The Treasury would have to sell short-term securities. These rates had increased. The Board feared that continued increases in short-term rates would spill over to the prime rate and then to the discount rate.

The consensus was to maintain an even keel. Chairman Martin warned, however, that the System had to supply enough reserves to avoid the criticism that System policy made Treasury financing difficult (FOMC Minutes, July 7, 1959, 38). He believed the government securities market “was in a critical state” (ibid., 36).

237. Congress was reluctant to raise the 4.25 percent ceiling rate. The House Ways and Means Committee offered to suspend the ceiling for two years, but it wanted to add a section that would end bills-only. Martin sent a letter that described the two-year limit as unsound. He objected in principle to the amendment about bills-only. The legislation did not pass that year. Congress raised the interest ceiling for U.S. Savings Bonds but not for marketable government securities. Martin believed that the main reason for failure to remove the 4.25 percent ceiling was concern in Congress that a higher rate would hurt the savings and loan associations by inducing withdrawals (Board Minutes, July 9, 14, and September 15, 1959).

The FOMC then reconsidered the number of people who could attend FOMC meetings or have access to the minutes.
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FOMC members, alternates, and other presidents had voted on five options ranging from the very restricted attendance in effect from 1936 to 1939 to the current procedure. Half of the group voted to maintain current attendance, with perhaps minor changes, and three-fourths voted to maintain a broad distribution of the minutes (Memo, Riefler to FOMC, Board Records, July 7, 1959). Martin and Hayes also favored retention of current procedures, so the policy did not change.

A window of opportunity for changing monetary policy opened in August. The Treasury did not plan another offering until late in the month. The steel strike had slowed economic activity temporarily, so the FOMC chose to maintain policy unchanged until September.
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Despite this decision and a constant federal funds rate, rates on Treasury bills rose sharply in August. By September 1, the rate was almost 0.75 percentage points above the rate at mid-month. The manager described the market as much tighter than expected. The decline in industrial production during the summer was concentrated in the steel and coal industries, entirely the result of the prolonged strike. Major banks increased their prime rates to 5 percent, a new high. The market and the banks did not wait for the steel strike to end. The Federal Reserve believed that it had to wait.

All the usual signals for a discount rate increase were in place. The New York bank warned against an increase while Congress was discussing legislation to repeal the 4.25 percent maximum rate on Treasury bonds.
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Following the meeting, New York, Cleveland, Richmond, Chicago, St. Louis,
Dallas, and San Francisco voted to increase discount rates to 4 percent, effective September 10.
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The others soon followed. With Governor Mills absent, the first vote was unanimous. The following day Mills said that “the technical conditions in the money market completely justified the increase” (Board Minutes, September 11, 1959, 9). He argued, however, that the Board’s policies had increased market rates. He had strong reservations about the cumulative policy action, so he abstained that day on the vote increasing rates at Boston, Atlanta, and Minneapolis. Consumer prices gave no sign of inflation. Prices declined in August, and rose less than 1 percent for the year ending in August. With the strike slowing activity and prices stable, on September 22, the FOMC took a modest step toward ease. It agreed to resolve doubts on the side of ease.

238. The number had increased from about twelve to twenty in 1936–39 to forty to fortyfive at the time of the meeting. In 1936, alternate members could attend only if they replaced the regular member. Gradually, attendance expanded to include all presidents and one economist from each reserve bank. Distribution of minutes and materials had expanded also. Up to eighty-five Board and bank employees had access to FOMC records in addition to officers of FOMC (memo on attendance, Board Records, July 8, 1959).

239. The IMF asked U.S. permission to sell $300 million in gold to buy Treasury securities, as it was obligated to do under the agreement authorizing U.S. membership. The Federal Reserve left the decision to the Treasury. The Treasury agreed to purchase the gold with an option to resell it to the Fund. Hayes’s main concern was that the gold purchase could be interpreted as an effort to support the dollar (FOMC Minutes, July 28, 1959, 14–16).

240. “If there is still a possibility of congressional action at this session, it would seem well for the Federal Reserve to avoid overt action at this time which might possibly raise extraneous issues and jeopardize the legislation. Since it is generally expected that the Congress will recess within the next couple of weeks, this basis for uncertainty should soon be removed” (FOMC Minutes, September 1, 1
959, 12).

The Treasury was not through borrowing to finance the large deficit. It could not sell bonds, but the 1918 Liberty Loan Act did not restrict interest rates on Treasury notes or bills. In October the Treasury offered a five-year note with a 5 percent coupon, popularly called “the magic 5’s.” This was the highest yield on a government security since the early 1920s. The strong positive response surprised the markets and the Federal Reserve.
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Part of the subscription came from time and saving accounts at banks and thrift associations.

Rising interest rates reflected a robust recovery, except for the steel strikes, strong productivity growth (Chart 2.1), and the Federal Reserve’s tight policy. Although inflation continued to concern Federal Reserve officials, bankers, and others, actual inflation remained modest. Monetary base growth remained about 1.5 percent for the year to October, the range
in which it had remained during most of the recovery, and the M
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money stock rose only 2 percent in the same period (FOMC Minutes, October 13, 1959, 9).

241. In August, the FOMC considered the rules for discounting. Some banks acted as “underwriters” for Treasury issues, buying more of the issues than they wanted to hold and distributing the rest. The issue was how much “underwriter” banks should be permitted to borrow from the System while they performed this function. Some banks complained that they did not serve as underwriters because of concern that they would be questioned or reprimanded for borrowing. The Treasury found System policy not helpful. The FOMC agreed informally that each reserve bank should review its procedures and be able to explain them to the Treasury (FOMC Minutes, August 18, 1959, 34–38; Holland memo, Board Records, August 7, 1959). The FOMC’s concern was to relate their discount policy to the even keel policy. A side effect of this discussion was a new definition of “even keel” as “no greater ease or tightness at the end of the financing period than at the beginning, with the supplying of only such additional reserves during the period as will take care of the additional drain on reserves caused by the financing itself. Theoretically the amount of such reserves required would be 18 percent of the amount of cash financing taken by the banks” (FOMC Minutes, August 18, 1959, 37).

242. “The market had estimated figures starting at $300 million and then, as the enthusiasm developed, raised the estimates to $500 million and then to $750 million. The actual response exceeded these estimates” (FOMC Minutes, October 13, 1
959, 3).

Rising monetary velocity financed much of the recovery. The rise ended, temporarily, during the steel strike, as output declined both absolutely and relative to the money stock. The Board’s staff suggested that the postwar rise in velocity had ended (ibid., 10). This proved premature. Continuing strong growth in demand and modest money growth raised interest rates, reduced average cash balances, and restored velocity growth. In the fourth quarter, the government ended the steel strike using a Taft-Hartley injunction. Output and monetary velocity rose.

Public and private demand for credit remained strong. With base growth below growth in credit demand, banks sold Treasury securities to make loans. This was particularly true of the 1959 and 1960 periods. Table 2.5 shows these data.

For the two years that roughly correspond to the expansion, bank loans rose at a 10.3 percent annual rate; bank investments fell at a 5.6 percent rate. These data suggest that part of the sharp rise in interest rates at this time reflected increased demands for credit. The cyclical increase in the nine- to twelve-month rate shown in Table 2.5 reflects the pressure on banks and other lenders to satisfy borrowers wishing to finance increased consumption and investment, while the federal government increased nominal spending by almost 12 percent in fiscal 1959. Most of the increase was for non-defense spending. However, part of the increase in interest rates reflected a rise in anticipated inflation, as suggested earlier by the FAC members. The Livingston Survey, taken at the time, showed an uptick to 1.1 percent in the rate of inflation expected a year ahead. Though modest, the level of anticipated inflation is the highest in the six years that the survey had run. The subsequent decline in actual and anticipated inflation suggests that anticipations may not have been firmly held.

A lesson from the 1958–60 experience was that the Federal Reserve could maintain low inflation (or price stability) despite large government spending and deficits, despite frequent periods of even keel, and despite
its contrary belief. It had to be willing to allow market interest rates to increase in the face of criticisms, even mounting criticisms, in the Congress and elsewhere.
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This was always a difficult choice, made more difficult by the firm belief that the System had an obligation to support Treasury issues. It would take many years of inflation before the System drew the conclusion that to control inflation required independence.

With rates rising, banks preferred to borrow from the System instead of selling securities at a loss. This reduced free reserves to between –$500 and –$600 million. The FOMC rarely permitted free reserves to exceed that range. For this period, free reserves, interest rates, and base growth offered compatible interpretations of the policy stance.

The 1959 increase in interest rates to levels not seen in a generation raised a new issue that would return many times. With open market rates at 5 percent, far above the 3 percent ceiling on time and saving deposits at commercial banks, New York asked again for an increase in regulation Q rates, or a special rate for foreign deposits. Only Mangels (San Francisco) and Leedy (Kansas City) supported the increase. Several presidents reported that the banks in their districts opposed any increase. No one supported an increase limited to foreign bank deposits, and several expressed concern about criticism of a split rate for foreigners. Regulation Q remained unchanged.

The October 13 meeting kept monetary policy unchanged but introduced a new procedure. Instead of Martin ending the meeting by expressing the consensus, the FOMC voted to approve his statement. The committee accepted that the fiscal 1960 budget would be balanced and that the threat of inflation had lessened as a result. They disagreed about whether the threat would reappear once the steel industry reached a settlement. Martin’s conclusion called for “marking time.” Only Mills voted no. As usual, he wanted to ease.
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After 3.5 months, small steel producers reached agreement with the union. A few weeks later the federal government invoked the Taft-Hartley Act to end the strike at larger firms. Industrial production soared, briefly, at year-end. Once again, there was uncertainty about persistence. Hayes re
marked that there were “growing doubts as to the vigor and duration of the expansion” (FOMC Minutes, November 4, 1959, 29). Woodlief Thomas expressed similar concerns. The Federal Advisory Council did not agree (Board Minutes, November 17, 1959, 1–2). The FOMC continued to “resolve doubts on the side of ease.”
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243. Secretary Anderson told the FOMC that, during the summer several Congressmen had called the Federal Reserve doctrinaire and inflexible (FOMC Minutes, November 4,1959, 16). This was a criticism of bills-only.

244. Voting on the consensus started because Mills objected to Martin’s statement of a consensus without recording Mills’s dissent. Prior to the change, the FOMC had voted only when it changed the directive. Martin responded to the complaints in a letter (October 9) explaining the new procedure. Mills objected to the change but, on the opinion of the Board’s counsel that the statute required them to vote, they adopted the new procedure (FOMC Minutes, November 4, 1959, 59–64).