A History of the Federal Reserve, Volume 2 (57 page)

The Federal Reserve had struggled for decades over the administration of reserve requirement ratios without finding a satisfactory solution. The Commission proposed uniform reserve requirement ratios for all demand deposits, infrequent changes in requirements, reduction of the range within which these requirements could change, and elimination of the statutory reserve requirement against saving and time deposits. The Federal Reserve adopted the last recommendation more than twenty years later, after legislation in 1980 eliminated the requirement.

The Commission differed with several conclusions reached in the
Report
on
Employment,
Growth,
and
Price
Levels.
⁴⁰
It did not agree that monetary policy was weak and discriminatory to an important degree. It rejected the alleged tradeoff between inflation and growth for inflation rates between 0 and 6 percent.
⁴¹
It could not agree on recommendations about selective controls, so it did not make any, but it recommended making ceiling rates for time and savings deposits uniform across institutions and changing the ceiling from a continuous regulation to a stand-by authority.

The Commission deplored the rising balance of payments deficit, but it opposed devaluing the dollar by raising the gold price or using general monetary and fiscal policies to reduce the deficit by deflation. Instead, it proposed Export-Import Bank subsidies to exports, reduced trade restrictions abroad, possible reductions in foreign aid, and other selective measures. Like many contemporaries, the Commission relied on stopgaps and neglected the adjustment mechanism for real exchange rates.

The Commission endorsed the Federal Reserve’s proposal to compel all insured commercial banks to be members. Its reasoning borrowed the Federal Reserve’s argument that non-members weakened the effect of monetary policy by permitting some banks to escape. This argument depended on a lending view of monetary policy; bank lending expands and contracts as reserves increase and decrease. The argument is inconsistent with the Commission’s emphasis on relative price (interest rate) changes in the transmission of monetary policy. Changes in interest rates and relative prices affect both member and non-member banks and other wealth owners.

The Commission made i
ts boldest recommendations on issues of struc
ture and organization. It proposed a central bank with authority over all policy operations, the plan the Republicans favored in 1912. But it adopted Marriner Eccles’ 1935 proposal to put responsibility and authority in the Board. Reserve banks would advise on open market policy, but a fiveperson Board would make decisions. Board members would serve ten-year terms, as in the 1913 act. It agreed to eliminate geographical and occupational qualifications.
⁴²
It replaced the Federal Advisory Council with a new advisory council, representing many groups in the economy (Commission on Money and Credit, 1961, 87–92). It proposed that the Federal Reserve acquire the examination and supervisory responsibilities of the Comptroller of the Currency (national banks) and the Federal Deposit Insurance Corporation (insured non-member banks). Similarly, all federally insured thrift institutions would have a single examining authority (ibid., 174–75).

40. See Chapter 2 for a summary of the earlier report.

41. “Countries with declining prices or with rates of price increase greater than 6 percent appear to have lower growth rates than those operating within those limits” (Commission on Money and Credit, 1961, 44).

The report contained many other recommendations for fiscal policy, debt management, government credit institutions, and private financial institutions. Separate volumes contained answers to questions directed to the Board of Governors and the Treasury Department. Trade associations representing groups of financial intermediaries wrote independent reports, but the Federal Deposit Insurance Corporation and the Comptroller of the Currency were not asked about the proposed consolidation of examination and supervision. The Federal Reserve responded to the recommendation by stating pros and cons.

The
Federal
Reserve’s
Response

The Commission asked the Federal Reserve twenty-five broad questions about its operations and their effect. The questions and the Board’s answers fill nearly two hundred pages. Several of the answers emphasized growth, employment, and price stability as policy goals or objectives.
⁴³

There are major differences between the Board’s answers and the policy
framework used by the Council of Economic Advisers. Four major differences of emphasis stand out. First, the Board used rising marginal cost, not the Phillips curve, to explain why prices rose before output reached capacity. Some industries brought less efficient facilities into operation when demand increased; others had idle capacity. The Board’s discussion of the interaction of prices and output was much more detailed but less structured than the Council’s analytic model (ibid., 26–29). Second, the Board’s monetary analysis focused on short-run changes in free reserves and longrun changes in the stocks of money and credit. The Council used interest rates to judge the stance of monetary policy. Third, the Board was more sanguine about the balance of payments than the Council or President Kennedy. Fourth, the Council relied on explicit analytic models relating policy actions to output, prices, and the balance of payments. The Board relied more on judgment and institutional knowledge. These differences often made communication between Federal Reserve Chairman Martin and Council Chairman Heller difficult.

42. President Kennedy recommended that the chairman’s four-year term begin on February 1 of the year in which the presidential term began. Interim appointments would complete the unexpired term. This change would give each president the opportunity to appoint a chairman of his own choice. To assure a vacancy, the proposal changed the expiration date for the fourteen-year terms of members from even to odd years. Earlier, Allan Sproul recommended a fi ve-person board with ten-year terms and elimination of geographical limitations (letter, Sproul to Martin, Sproul papers, December 31, 1952).

43. At about this time, the Board’s staff published a revised version of its handbook. The new edition claimed that its objectives had always included “sustained high employment, stable values, growth of the country” (Board of Governors, 1961, 1). This is either outright error or intentionally misleading. It ignores policy during the Great Depression. The Federal Reserve did not accept these goals until the 1940s or 1950s and, in the 1920s, explicitly denied that it could affect output or control the price level. See volume 1, chapter 4. When reading the Board’s answers to questions, one should remember that these are written by the staff.

Differences about monetary policy were often sharp. The Board gave pride of place to bank reserves, not interest rates, as the key variable that it controlled. “Through this control, [the Board and the Federal Open Market Committee] exert a strong influence directly on total loans and investments and total deposits of banks and indirectly some influence on spending, investment, and saving” (Commission on Money and Credit, 1963, 3). Effects on interest rates are “intertwined with other market forces, [so] they are not predictable or measurable” (ibid., 3). At each meeting the FOMC decides “the degree of restraint or encouragement that should be imposed on bank credit expansion” (ibid., 4). These decisions are “expressed in general terms” (ibid., 4).

While much of the phrasing was new, the emphasis on bank credit was not very different from that of the 1920s. There are notable changes, however. Free reserves or member bank borrowing received less attention. The Board accepted that it had an indirect influence on economic activity and the price level that it did not acknowledge, or denied, in the 1920s.
⁴⁴
One constant is the discussion of member bank borrowing. As in the RieflerBurgess doctrine, banks are reluctant to borrow. Increased borrowing is “a negative element of bank liquidity” because banks want to “get out of debt to the Reserve Banks” (ibid., 7). Discount rate changes raise or lower the degree of restraint that borrowing exerts.

44. Free reserves soon enter the description as a measure of primary bank liquidity. Their importance reflects the fact that they are available immediately or can be obtained quickly by using borrowings data from the reserve banks.

These answers differ from the Keynesian views of the Kennedy Council. The Council relied on a model in which an interest rate had the major role in the transmission of fiscal and monetary policy. The Board’s answer highlighted quantities. The Council used its model to trace out the expected effects of policy on output, prices, and the balance of payments. The Board did not have a formal model. It saw these connections as loose, variable, and uncertain, dependent on erratic changes in monetary velocity. The Council had started to use the Phillips curve to relate output or unemployment to inflation. Neither the Board nor the reserve banks agreed on a systematic way of thinking about the division of nominal output between real output and the price level. The Board relied on judgment influenced by leading and coincident indicators, time series that typically moved in advance of or together with real output, the price level, or inflation.

A typical passage from the Federal Reserve’s response to the Commission’s questions described the ways in which monetary operations influenced the economy.

Even though Federal Reserve operations exercise their influence primarily through the quantity of bank credit and the money supply, policy decisions cannot be made exclusively in terms of the level or rate of change of the money supply. Monetary policy must take into consideration variations in money turnover . . . Variation in money turnover need not be considered as a bar to the effectiveness of monetary policy if policy formulation takes them into consideration, although they may at times complicate its task. . . .

[E]conomic decisions are influenced by all elements of liquidity including holdings of other assets as well as of money balances. . . . Decisions of spenders and lenders are likely to be affected by the degree of their liquidity existing at any point in time and by variations in their liquidity over time. (Commission on Money and Credit, 1963, 10)
⁴⁵

The Board’s answer emphasized changes in the assets and liabilities on banks’ balance sheets and banks’ liquidity positions. It neglected the role of relative prices of assets and output. The Board did not neglect interest rates in its response, but it emphasized the costs of borrowing, not the incentives to purchase or sell, save, and invest in response to relative price changes. Further, the Board regarded its actions as “only one supply factor in interest rate determination. [B]ank credit usually comprises only
a small portion of the total [credit supply]” (Commission on Money and Credit, 1963, 14).

45. The rest of the answer discussed some of the many factors limiting the Federal Reserve’s ability to restrict the economy’s liquidity. Compare this loose, open-ended description to Thornton (1802), written more than 100 years earlier, described in volume 1,
chapter 2.

The relative price view of monetary transmission makes investment depend on the price of existing assets relative to the price of new production of similar assets. Increases in money initially increase real balances. Excess real balances increase spending on consumption goods and existing assets, raising their prices. Rising consumer spending and higher prices of existing assets induce spending on investment (Brunner and Meltzer, 1993). On this view, membership in the Federal Reserve System is unimportant for the transmission of policy impulses.
⁴⁶
Bank lending is one way, generally an efficient one, for some spenders to anticipate future income. Readily available substitutes for bank lending include bond markets, commercial paper, and other credit market instruments. Other substitutes include foreign loans and bonds.

Although several members of the FOMC often questioned reliance on free reserves as a measure of policy thrust, the Board’s response does not reflect any differences of opinion. In the short-term, the “figure of ‘free reserves’ or its negative counterpart ‘net borrowed reserves’ provides a convenient and significant working measure of the posture of policy at the time” (Commission on Money and Credit, 1963, 19).

“The general level of free reserves prevailing over a period of time may be viewed as an indicator of the degree of restraint or ease that exists in the money market. . . . [T]hey must be considered in the context of changes in the total reserve position of member banks. The particular level of free reserves that may be needed to achieve the objective of policy may vary from time to time depending on changing economic conditions. . . . Broader guides to policy operations are provided by the consequences of changes in reserve availability on the amount of total loans and investments of banks and on the money supply. Assumptions or estimates as to these elements underlie the figures for total reserves and free reserves. The Open Market Committee in its deliberations has in mind what conditions with respect to the availability of bank credit and growth in the money supply would be an appropriate end of policy at the time” (ibid., 19–20).
⁴⁷
Note the absence of output, employment, and inflation.

46. The Federal Reserve was not the only central bank to regard bank lending as central to monetary transmission. The Bank of Japan held this view firmly in the 1990s and was reluctant to increase bank reserves until bank lending increased. This policy stance has much in common with the real bills doctrine that contributed heavily to policy failure in the Great Depression.

47. This seems an accurate description of the procedures at the time. The staff estimated
the amount of total and free reserves required to support money and bank credit. The reply does not discuss the method of calculation, and there does not seem to have been much effort to improve the estimates.