A History of the Federal Reserve, Volume 2 (75 page)

The Board missed the opportunity to take a strong stand against the ceiling. It did not choose to publicly support or oppose the Treasury’s proposal. “The Treasury had made the decision to submit the proposal, and he [Martin] did not think the Federal Reserve should be in the position of undermining it” (Board Minutes, February 28, 1961, 16). The Board decided to have its general council notify the administration informally. Robertson objected. He opposed raising ceiling rates for foreigners but not for domestic savers. When the legislation went to Congress in April, the Board repeated that it would not object, and in July Martin testified in favor of the bill.
²⁰²
Congress removed the ceiling for deposits of foreign governments and institutions for 3 years beginning October 1962. In 1965, it extended the separate treatment.

After Governor Mitchell joined the Board at the end of August, he pointed out that “an agency that had been a vigorous proponent of free markets and free competition must appear rather strange to outsiders if it administered a regulation in the manner that Regulation Q had been administered” (Board Minutes, October 31, 1961, 5). Mitchell favored delay, however, because he thought higher ceiling rates would encourage saving at a time when the economy was recovering from recession.
²⁰³
He favored removing the ceiling as a constraint in a series of steps starting soon after.

Chairman Martin expressed concern about the flow of deposits to London. He now thought that “timing . . . was the real problem” (ibid., 7). Either British rates would have to go down or United States rates would have to go up. Robertson responded that the ceiling rate had not been binding for many years after it was established. The Board’s mistake was failure “to take action earlier . . . What the Board was doing . . . was to run
counter to its general thesis favoring freedom of competition” (ibid., 9). The Commission on Money and Credit had favored stand-by authority. That was what his proposal did. Martin agreed, but King did not think that free competition in banking existed because entry was restricted. He favored keeping the regulation and opposed acting to keep “hot money” from leaving the country. Balderston argued that delay might require acting after the money flow abroad increased substantially.
²⁰⁴
With so little clarity, there was no chance of agreement about removing ceiling rates. Once again, the Board stared at the problem and passed on. It showed more concern for banks than for the public.

202. Earlier, he had written to the Senate Banking Committee that “the Board does not object” (letter, Martin to A. Willis Robertson, Correspondence Box 240, Federal Reserve Bank of New York, April 7, 1961). In August, Robertson offered a new proposal that permitted banks to increase ceiling rates based on the length time deposits remained at the bank. Martin again said that he was not sure whether regulation Q promoted sound banking. “Repeal . . . might be advisable” (Board Minutes, August 23, 1961, 10). Balderston and King objected to the timing (early in a recovery); Mills, as usual, more concerned about the cost to bankers than the cost to the public, objected that most banks opposed higher ceiling rates; and Shephardson did not like to tie rates to the duration of the deposit. As before, Robertson argued for competitive freedom—let the banks decide.

203. Mitchell also asked for a quantitative analysis of bankers’ need for protection from themselves. Were the portfolios of banks that paid the ceiling rate riskier than other banks? (Board Minutes, October 31, 1961, 5). I have not found a study of this question at the Board.

On December 1, the Board approved an increase in ceiling rates, effective January 1, 1962. Most of the governors repeated the arguments they made before. Robertson wanted higher ceiling rates than the others, and Mills wanted to raise rates only to 3.5 percent. The compromise was to raise the rate to 4 percent for deposits held one year or longer and to 3.5 percent for deposits held between six and twelve months. Ceiling rates remained 2.5 percent for deposits held from ninety days to six months. Governor King dissented.

Before releasing a statement announcing the change, the Board notified the Federal Deposit Insurance Corporation (FDIC). FDIC agreed to adopt the same rate schedule for insured, non-member banks. The Board’s statement emphasized that the change was made to improve banks’ competitive position in the markets for savings and foreign deposits, but it was for each bank “to determine the rates of interest it would pay” (Annual Report, 1962, 102).

On December 12, the Board acted to limit the effort by banks to blur the distinction in practice between demand and time deposits. The concern was that banks would attract deposits and reduce their average reserve requirement ratio by offering the new interest rate schedule.

The Board’s discussions of ceiling rates are striking for what they omitted. References to free markets aside, most of the discussion is about competitive equity and legality. The staff did not present an analysis of either the aggregate or allocative effects of ceiling rates and, with the exception of Mitchell’s statement, the Board neither asked for nor received such analysis.

204. The Federal Advisory Council opposed a general increase in ceiling rates but agreed to an increase in rates on foreign deposits. The view was not unanimous. George Murphy (New York) reported that state authorities had raised ceiling rates for mutual savings banks in New York. He urged the Board to look at the problem from a national perspective (Board Minutes, November 21,1961,19). His argument struck home. Martin agreed that there was “a little too much of a popularity basis” in the Board’s approach (ibid., 23).

Board members recognized that raising ceiling rates could reduce the capital outflow to the euro-dollar market. The press release mentioned this effect and, with an eye on congressional reaction, suggested a long-run effect on “the savings that will be required in financing the future economic growth that will be essential for expanding job opportunities” (Board of Governors, Press Release, December 1, 1961).

Analysis of the aggregative effects would have found few or none. In later years, the Board defended interest rate regulation as an anti-inflation policy, assistance to the housing industry, and help for the savings and loan associations and thrift institutions. One popular argument was that thrift institutions suffered losses when interest rates rose and the market value of existing mortgages fell. Higher interest rates had to be paid to all depositors, old and new, adding to thrifts’ costs without increasing their revenues equivalently. The problem became acute at cyclical peaks when short-term rates rose above long-term.

Regulation could restrict the increase, but it could not keep depositors from withdrawing in search of higher rates. Euro-dollars were one of the first big innovations, but others followed, including money market mutual funds, which grew rapidly in the 1970s.
²⁰⁵
By the 1980s, inflation and the effect of interest rate controls on savings and time deposits penalized, and to a considerable extent destroyed, the savings and loan industry that regulators claimed the controls would protect.

During the months following the increase in ceiling rates, the Board heard that some of the New York banks were pleased by the increase but wanted the ceiling rate raised on short-term time deposits. As expected, many interior banks “raised rates reluctantly and under competitive pressures” (Board Minutes, February 20, 1962, 11).
²⁰⁶
Growth of negotiable
certificates of deposit concerned some Board members. The Board’s counsel said they were legal (Board Minutes, January 15, 1962, 7). Governor Robertson said the certificates were securities, not savings deposits. He proposed prohibiting their use.

205. Milton Friedman (1969) and James Tobin (1969) analyzed the economic effects of regulation Q ceiling rates. They agreed that any effect on aggregate output or inflation was small. One reason was that substitutes for interest payments in the form of services, in-kind payments, or gifts occurred often. The Board spent considerable time deciding which payments could be permitted. Quantitatively more important was development of unregulated substitutes such as euro-dollars and, later, money market funds. Small and poorly informed depositors bore much of the cost. Later, ceilings were justified as assistance to housing. Tobin (1970, 10) claimed that the main reason for the policy was to permit undistributed profits to increase at savings and loans. Pressure from banks that did not want to pay higher rates was a major factor. Meltzer (1974) found evidence of positive effects of regulation Q on mortgages but not on housing. Housing, a real asset, remained independent of the nominal stock of mortgages.

206. In following months, the Board discussed several issues resulting from the regulation Q ceiling. As always, price controls raised issues that no one foresaw. For example, New York State allowed non-member banks to pay higher interest rates. It had to decide whether banks that absorbed exchange charges were paying interest. This was particularly of interest in districts with many non-par banks. A bank in Chicago permitted depositors to write checks
to borrow against their savings account. The bank paid the loan with a transfer from the account. The Board ordered the bank to stop. Banks began
offering long-term certificates of deposit (CDs) at a fixed rate. If the Board lowered the ceiling rate before the CDs expired, did the bank have to reduce the rate? Some banks gave free printed checks to customers. This was accepted if the checks lowered the banks costs but not if it benefited only the customer!

Anticipating that market interest rates would continue to rise, the New York bank sent a letter to the Board supporting legislation to change regulation Q ceiling rates to a stand-by regulation above market rates. Until Congress approved that change, it urged the Board to increase ceiling rates for time deposits before deposit rates reached the ceilings. This would avoid the inflexibilities and disruptions that would otherwise occur (letter, New York Bank to Board, Correspondence Box 240, Federal Reserve Bank of New York, June 27, 1963).

The Board did not act at the time. Six months later, the staff at New York discussed the issue again. Peter Sternlight argued for regulation to protect “the large number of commercial banks from mutually destructive competition.” One of his main concerns was that banks would invest in “excessively illiquid assets.” Others argued that banks performed a useful function as intermediaries. They doubted that many banks invested in illiquid assets. Still others favored stand-by ceilings but expressed concern about appropriate timing (memo, Sternlight to Hayes, ibid., December 26, 1963).

Persistence of disagreement within the System encouraged delay and avoidance of the issue. Many members of Congress, including Congressman Patman, would have opposed stand-by controls in place of regulation. The Board took no action.

The Comptroller of the Currency was less constrained. On January 21, 1964, he objected to the Board’s ruling that barred corporations from holding savings deposits and told national banks that the Board’s rule could not be enforced.

The Board delayed responding until prodded by Chairman Robertson of Senate Banking. Martin’s response denied that the Board lacked power to regulate rates on savings deposits along with time deposits. Then he added that the present time was not an appropriate time to remove or reduce regulation. His main reason was to prevent “competitive escalation” of rates leading to “undesirable consequences in terms of financial soundness and liquidity needs.” He favored legislation permitting the Board to
move to stand-by authority but leave the Board free to choose the time (letter, Martin to A. Willis Robertson, Correspondence Box 240, Federal Reserve Bank of New York, May 13, 1964).
²⁰⁷

INTERNATIONAL POLICY

Administration and Federal Reserve efforts and increased foreign inflation provided a slight improvement in the payments balance in 1962. The overall balance remained negative but, at about $2 billion, was half the size of the reported 1960 deficit (Council of Economic Advisers, 1963, 96). Much of the improvement reflected accelerated payments by Germany for current and future defense materials, tying foreign aid to domestic purchases, advance debt repayments by other European governments, and sales of non-marketable debt (Roosa bonds) denominated in foreign currency. Without these special factors, the 1962 deficit was $3.6 billion.

The System’s experiment with foreign exchange market intervention and currency “swaps” with foreign central banks expanded rapidly. By late May, Coombs hadnegotiated agreements with West Germany, France, Switzerland, the United Kingdom, Netherlands, Belgium, and Canada (after it returned to a fixed exchange rate on May 2, 1962).
²⁰⁸
The size of the credit lines expanded as well; for example, the swap line with Britain increased in July from $50 to $250 million. The FOMC also approved several special provisions to meet legal requirements on both sides of the swap agreement.
²⁰⁹
By August 1962, total swap agreements reached $700 million, against $19 billion U.S. liabilities to foreign official institutions (OECD, 1990). The plan was to increase swap lines to $2.5 billion from the initial ceiling of $500 million agreed to in February (Kennedy, 2001a, 39, 2).

Members asked questions about some of Coombs’s proposals but ap
proved all of them. The most basic question was what Coombs’s very active operations could accomplish. Coombs recognized that swaps and credit lines could not succeed if the balance of payments deficit continued. All that the swap line could do was postpone foreign governments’ demands for gold by offering a temporary exchange guarantee on dollars held by foreign central banks. Success in slowing the gold drain, therefore, depended on the willingness of the central bank or government that held excess dollars to accept the temporary swap in place of a more permanent acquisition of gold.
²¹⁰
Despite its swap agreement, France increased its gold stock by one billion dollars in 1961 and 1962. This was more than half the United States’ gold loss for the two years.
²¹¹

207. The Board kept rates extremely low on time deposits with less than ninety days to maturity. The ceiling rate on these deposits was 1 percent in 1964, when the federal funds rate was about 3.5 percent. To circumvent the rate restrictions and avoid reserve requirements, banks began to offer capital notes that were not deposits and thus not subject to regulation. In December 1965, the Board ruled that capital notes were a type of deposit, and therefore subject to its regulations. This is one of many examples showing that markets learn to circumvent regulation.

208. Canada floated its currency in September 1950. Faced with a large capital inflow and a strengthening currency in 1962, the Canadian finance minister described the currency as overvalued. Depreciation was sudden and sharp. Canada stabilized at 92.5 cents per U.S. dollar with assistance from the IMF and the U.S. and U.K. governments.

209. For example, the Federal Reserve could not invest in foreign government bills, and German banks could not offer an interest-bearing deposit. The Bundesbank offered to waive interest payments from the Federal Reserve, if the Federal Reserve made an interest free deposit at the Bundesbank. In May, Coombs reported that Germany changed its law. Also, Switzerland was not an IMF member at the time, so a special procedure had to be established to secure the account. Term to maturity also increased.