A History of the Federal Reserve, Volume 2 (9 page)

Staff reports mention money growth frequently. The staff and some members compared average growth rates of money and output, and they recognized that monetary velocity had increased in the postwar years. At a 1958 meeting, the staff described System operations as influencing the economy mainly by changing the money stock but added that measures of reserves and money varied unpredictably (Memo, Thomas to FOMC, Board Records, February 25, 1959, 1). The staff confined its analysis to estimating the money growth rate, then using it to compute the appropriate level of required and free reserves. This procedure was subject to large errors, since the connection between money growth and free reserves was weak. There is no record of concerted efforts to improve the estimates. Their imprecision may have contributed to their neglect. The staff did not estimate demand for money or velocity equations. An exception is Garvy (1959), but his work was not mentioned in the minutes or used to project velocity.
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The Federal Reserve in the 1950s did not recognize or correct some of the principal errors that had misled it from 1928 to the early 1930s. It did not distinguish between real and nominal interest rates for many years. Use of a free reserve target gave monetary policy a procyclical bias. Lauchlin Currie (1968) had complained about the procyclicality of the operating procedures in the 1920s.
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When output expanded and customer borrowing increased, banks borrowed from the Federal Reserve, and open market rates rose relative to the Federal Reserve’s discount rate. The Federal Reserve interpreted higher nominal interest rates, increased borrowing, and reduced free reserves as evidence of restrictive policy. Often it allowed growth of the monetary base and money to increase, adding first
to spending and later to inflation. When spending declined, the process worked in reverse.

3. Garvy (1959, 55, 83) explained the trend in deposit velocity as a result of growing efficiency in the use of money. He expected the trend to continue.

4. Currie worked at the Board in the 1930s, but there is no mention of his monetary analysis in Board or FOMC records in the 1950s. Brunner and Meltzer (1964) emphasized procyclicality also; they showed that money growth was slower in downturns and recessions than in succeeding expansions.

The changed political climate that produced the 1946 Employment Act also produced lasting changes in the meaning of independence and the relation of the Federal Reserve to the administration and Congress. Treasury interference in the 1930s and 1940s mainly reflected the traditional interest of debt managers in financing at low nominal interest rates. In the postwar years, governments in all developed countries accepted responsibility for maintaining employment, smoothing fluctuations in economic activity, and preventing a return of the Great Depression. As understanding of the role of monetary policy in economic stabilization improved, political pressure on the Federal Reserve increased. Congressional hearings on monetary policy became more frequent, and Federal Reserve chairmen came under pressure to participate in policy discussions with the president, Treasury Secretary, and other senior officials. Chairman Martin accommodated requests for consultation but, at first, tried to limit his role to exchanging information about the economy and its prospects. He listened to administration and congressional concerns, offered reassurance, and defended his actions. To avoid calling public and congressional attention to meetings with administration officials, the meetings became regularly scheduled events in the late 1950s.

Heightened political interest in monetary policy induced the System to look for external supporters in Congress and among the public. Banks and financial institutions under regulatory control became a source of support, particularly after the 1956 Bank Holding Company Act increased the Board’s power to approve or reject applications for new bank powers.

This chapter and the next two trace the increased importance of stabilization policy, growing recognition of the Federal Reserve’s role, increased pressure on the Federal Reserve and its chairman, particularly in election years, and reduced independence. President Eisenhower and Treasury Secretary Humphrey became concerned about Federal Reserve policy in 1956 and wary of Martin’s anti-inflation stance. Vice President Nixon blamed his defeat in the 1960 election on Federal Reserve policy, and both he and President Kennedy considered replacing Martin. The Kennedy and even more the Johnson administrations used policy coordination to restrict Federal Reserve independence.

The Federal Reserve did not, at first, link its operating procedures to the employment and price goals the Employment Act mandated. In the 1920s, it had denied any direct control over prices and output. It did not repeat these denials in the 1950s. But it made no effort to link its credit market framework to the broader and more remote goals it claimed to
pursue. As in the past, it treated $500 million of borrowing (or equivalent free reserves) as “neutral,” but it had limited understanding of how much output, employment, and the price level would change, or how inflation would change, if free reserves rose or fell by $100 million. And, it made no effort to find out for a decade or longer.

Under Martin, policy became more activist. The Federal Reserve responded to Treasury financing, output, unemployment, inflation, and later housing sales and other events. The founders’ design of a largely passive institution that let gold flows and member bank borrowing determine the stock of bank credit disappeared. By the middle of the 1950s, the Federal Reserve intervened in the money market to smooth seasonal and longerterm changes and to manage the business cycle. Politicians gave most attention to unemployment and interest rates. The Federal Reserve responded by moving toward a labor standard. When the unemployment rate rose, reducing unemployment became the System’s principal concern.

Within the free reserve framework, concerns about employment, Treasury financing, and other goals were not easy to reconcile with concerns about inflation. The annual inflation rate rose in steps from about 1 to 2 percent in 1953–54 to 3 to 4 percent in 1956–57, then declined toward zero at the end of the decade. Slow growth and recessions in 1953–54, 1957–58, and 1960–61 accompanied lower rates of inflation. Inflation, recession, and slower growth heightened interest in the economy’s response to policy actions. Although problems of growth, inflation, and unemployment became more severe later, inflation rates in the mid-1950s were high compared to previous non-war years. The price level rose persistently for the first time in peacetime history. Economic performance at the end of the 1950s, especially relatively slow growth and a rising international payments imbalance were, in part, the price paid for inflation and, in part, for the disinflation that followed. Concerns that the Federal Reserve was responsible for slow growth became a political issue in the 1960 election.

One consequence of a positive inflation rate was that, on average, interest rates on long-term bonds and mortgages remained above short-term rates. The yield curve, relating short- to long-term rates, typically sloped upward, probably reflecting the belief that inflation would increase. Housing and mortgage credit increased. While it lasted, this was extremely favorable for thrift institutions that paid a short-term rate to depositors and earned the higher long-term mortgage rate.

The Federal Reserve Board’s regulation Q set the maximum rate that commercial banks could pay on time and savings deposits. However, nonbank thrift institutions were not subject to regulation Q until later. They offered a rate slightly above the ceiling that banks could pay. As anticipated
inflation increased, banks lost time and savings deposits to thrifts and others. In 1956, the Board raised the maximum ceiling rate by 0.5 percentage points to 3 percent. It was the first step in what became an effort to manage the deposit positions and lending of both the banking and thrift industries by controlling the level of the time deposit rate and the premium offered by the thrifts. The policy failed, eventually, like most efforts of its kind. Congress was slow to act and the Federal Reserve reluctant to press the issue. The end result of managing ceiling interest rates was the failure or disappearance of a large part of the thrift industry after short-term rates fell below mortgage rates when inflation slowed in the 1980s.

A second consequence of rising inflation was the beginning of concern about operating procedures and policy goals. The minutes of FOMC meetings show that from the middle 1950s on, some members of the FOMC questioned both the use of free reserves as a policy target and the ways in which the FOMC and the manager used free reserves to implement policy. Intermittent discussion began about policy objectives beyond the money market and the role of reserves or monetary aggregates as policy targets. The System moved from the relatively passive role of letting member bank borrowing and private decisions determine money growth and inflation to a more active policy of trying to manage the business cycle to achieve the goals of the Employment Act and respond to public and political pressures. It reassured itself that it could not be responsible for what happened because it did not have complete control; monetary policy, the minutes repeat, was only one influence on the economy.

This chapter uses the minutes of policy meetings and other materials to show how the System made policy decisions in the absence of a coherent framework. One reason for its absence and the often vague policy directives to the manager was the lack of agreement among officials on the most general principles of monetary analysis. Martin’s beliefs were important also. He described himself as a market man; his concern was current market behavior. Economic analysis did not interest him because he did not find it useful. He not only did not have a model of the economy, he did not want one.
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Martin described his idea of independence as “independence within the government, not independence of the government.” This was not just a phrase to satisfy congressional critics. It meant that the Federal Reserve
had to assist the Treasury with debt finance. The 1951 Accord had not removed that responsibility; it had freed the Federal Reserve from its subsidiary role relative to the Treasury and made it co-equal. But Congress voted the budget and permitted deficits. The System adopted an “even keel” policy of supplying enough reserves to finance new or refunded Treasury issues at interest rates prevailing at or near the time of the Treasury’s announcement of financing terms. Additions to reserves usually remained in the banking system and supported increased money and bank credit.

5. Romer and Romer (2002b) claim that the Federal Reserve had an appropriate or current model of inflation in the 1950s. They attribute successful policy to reliance on the model as a guide to policy. I find no evidence to support their claim. A more important factor was the Eisenhower administration’s conservative fiscal policy during most of the decade. The Federal Reserve was not under pressure to finance budget deficits most of this decade.

Deficits remained relatively small and were followed by surpluses in the 1950s. Consequently, the System’s views on independence and even keel did not result in high, persistent money growth, so inflation remained low. The cumulative deficit for the 1960s was three times as large as that for the 1950s. Inflation rose, particularly after 1965, when persistent large budget deficits became the norm. Although Martin disliked inflation and opposed it verbally, his policies supported and increased it. This chapter traces the development of these beliefs about the System’s responsibilities to the Treasury in the 1950s.

At the end of World War II, the United States was the main developed economy that had not suffered from destruction of its capital stock but had instead increased productive capital. It could fight a war in Korea, increase domestic consumption, export capital to rebuild foreign economies, and invest abroad without concern for its international reserves. At first the outflow of gold during the Korean War seemed an acceptable, even desirable, way to redistribute the world’s monetary gold stock and strengthen countries’ ability to move toward currency convertibility. Many believed that disproportionate U.S. gold holdings in the 1920s caused the breakdown of the gold standard in the 1930s. They did not want a repetition.

Attitudes began to change in the 1950s. Revival in Europe and Japan initially increased their imports from the United States, but later increased their exports of textiles, steel, automobiles, and other goods. Growing competition from foreign producers of particular goods created political issues that began to influence economic policy by the end of the decade.

The United States encouraged and at times exhorted the Europeans to end exchange controls on current account transactions and accept convertibility of their currencies into dollars. At the end of the decade, the principal trading nations adopted current account convertibility, and Germany agreed to make the mark convertible on both current and capital account.

Concern about membership in the Federal Reserve System continued. All national banks had to be members, but state chartered banks could choose. Many elected to remain outside the System. Membership was costly; it required a bank to hold required reserves without receiving any
interest, to collect checks at par, thereby forgoing collection fees, and to submit to examinations that often were more demanding than examinations by state examiners. In June 1951, only 49 percent of commercial banks, with 93 percent of deposits, had joined the System. Nearly 13 percent of all banks did not collect at par. These percentages changed very little during the 1950s (Board of Governors, 1976, 27, 43, 61, 62).

To encourage membership, the Board changed required reserve ratios several times during the decade. Although the minutes generally do not explain the choice of this instrument, all of the changes were reductions. During the decade, the ratios declined at central reserve city, reserve city, and country banks from 24, 20, 14 to 18, 16.5, and 11. Membership did not change substantially, but influential members of Congress criticized these actions as a windfall for banks and a loss of interest payments returned to the Treasury. They pressed the Federal Reserve to stop reducing these ratios and rely on open market purchases to provide growth of money.

Some important changes in personnel occurred during the decade. Two prominent members of the FOMC left the System. Allan Sproul resigned in 1956 as President of the Federal Reserve Bank of New York after thirtyseven years of service in the System. A banker, Alfred Hayes, replaced him in New York. Marriner Eccles, former chairman of the Board, resigned in July 1951, after nearly seventeen years of service.
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At the end of the decade, the influential Winfield Riefler retired from the staff. New Board members included Abbott L. Mills, Jr. (San Francisco), an Oregon banker, and James L. Robertson (Kansas City) in 1952. Robertson was a lawyer who had worked for the Federal Bureau of Investigation and spent many years at the Office of the Comptroller of the Currency. He brought needed expertise on banking
regulation and had strong views on monetary policy, on the use of repurchase agreements, and on the need to restrict the manager’s autonomy.
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6. Other members of the Board in 1951 were: Edward L. Norton, Oliver S. Powell, James K. Vardaman, Jr., Rudolph M. Evans, and Menc S. Szymczak. Szymczakhad served since 1933. Norton and Powell resigned in 1952 after serving about two years. Powell remained in the System until 1957 as President of the Minneapolis Federal Reserve Bank. Vardaman was a banker and a friend of President Truman who served as his naval aide before his appointment. He incurred the hostility of his colleagues for several reasons, including being too close to the White House and allegedly leaking information to the White House staff during the months leading up to the Accord. Martin’s papers contain an unsigned memo written before Martin joined the Board with six pages of text and seventeen charts comparing Vardaman to other governors and detailing his faults. The memo said he was unreliable and undependable, and made “little effective contribution” to the Board’s work. He lied about what he was doing, was absent nearly 40 percent of working days, and arrived late and left early when he was in attendance. He missed 33 percent of FOMC meetings and 30 percent of Board meetings. He publicly criticized other members of the Board including in press interviews. And he used Board property for personal activities (Martin papers, undated, probably 1950, untitled). Evans left in 1954, Vardaman in 1958 and Szymczak in 1961. A list of members is in an appendix to the second half of this volume.