Read A History of the Federal Reserve, Volume 2 Online
Authors: Allan H. Meltzer
This was the first recession under a Republican president since 1929. It worried an administration sensitive to criticism about its economic management and its emphasis on fiscal prudence, budget cutting, and size of government. Its critics claimed that it lacked concern about rising unemployment.
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When CEA Chairman Burns told the cabinet in September
1953 that a recession had started, Eisenhower “recalled the Republican party’s commitment to use the full resources of the federal government to prevent another 1929” (Eisenhower, 1963, 304).
The advent of recession was not a complete surprise. In May, the Federal Advisory Council told the Board that a nine-to-three majority believed “that the probability is for a moderate downturn in business in the next months” (Board Minutes, May 19, 1953, 2). The Council expressed particular concern about excessive automobile inventories and production. Chairman Martin responded that “in his judgment the probable trend of business would be downward” (ibid., 6). He still held to the old notion that recessions had a desirable, purgative effect.
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Nevertheless, both the Republicans and the Federal Reserve now accepted federal responsibility for counter-cyclical policy. The new view responded to the public consensus that business cycles were a legitimate problem for government policy, not the unavoidable working of fate. This view had influenced Congress as reflected in the Employment Act of 1946, the 1952 Patman heari
ngs, the 1954 Flanders hearings, and at the end of the decade the extensive
Report
on
Employment,
Growth
and
Price
Levels
prepared for the Joint Economic Committee (1960b). These congressional and public pressures encouraged the Federal Reserve to respond more actively to rising unemployment than in the 1920s and 1930s. Inevitably, issues about employment and business conditions became intertwined with the dispute over the billsonly procedures.
92. In his presidential campaign and as president Eisenhower emphasized that he believed government had to take an active role against unemployment and recession. He would not raise taxes to balance the budget, as Hoover had done in 1932. The administration developed a stand-by public works program, in the event of a deeper recession, but it never implemented the program (Eisenhower, 1963, 307). The government reduced tax rates in 1954, fulfilling the campaign promise to lower wartime tax rates (Stein, 1990, 301, 305). A $7.4 billion tax act passed on August 16, 1954, after the recession ended, and $5 billion of Korean War excise taxes expired in January 1954 (Eisenhower, 1963, 297, 303). The top bracket rate remained at 85.7 percent at $1 million under the new law, and the lowest bracket had a 4 percent rate at $3000.
93. In Martin’s opinion, “an adjustment was desirable for the economy which had been at too high a level for too long” (Board Minutes, May 19, 1953, 6). He hoped the adjustment would occur serially, not all at once. The purgative effect would lower prices. Most of the Federal Advisory Council agreed (ibid., 7). They agreed also that monetary policy was too tight, citing rising interest rates, the banks’ demand for discounts, and the decline in bond prices below par that, they claimed, made banks reluctant to sell bonds. Martin later described his policy in this recession as “leaning against the wind.”
The 1953–54 recession was the Federal Reserve’s first major trial after it regained independence. Its performance was mixed. It recognized the slowdown promptly and voted to provide additional ease. In June, a month before the start of the recession, the FOMC decided on a policy of “aggressive supplying of reserves to the market” rather than “exercising restraint upon inflationary developments” as agreed at the March meeting (FOMC minutes, June 11, 1953, 93).
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The committee listed doubts about strength in the economy, concerns about a policy “more restrictive than was desirable” (ibid., 93), and the Korean armistice.
The bond market gave an additional reason for deciding to ease policy. Prices of the Treasury’s new 3.25 percent thirty-year bonds dropped below par.
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Martin had warned the market in April that the Federal Reserve had adopted a bills-only policy and would not support the long-term bond market except in disorderly periods. This left the market uncertain about how far bond prices would be allowed to fall. Selling increased. The Treasury had not made such a pledge, so it supported the new issue bond market, and the FOMC bought bills. In July, long-term Treasury yields began to fall in response to the Treasury’s support operation, Federal Reserve easing, and the start of the recession. By year-end long-term Treasury rates had fallen to the level at the start of the year.
Martin criticized the desk for “(1) failing to purchase Treasury bills more aggressively prior to June 1 and June 2 and (2) failing to notify the Executive Committee that a disorderly market existed on June 1” (memo, Robert Link to Tilford Gaines, Sproul papers, FOMC Correspondence,
November 7, 1955, 2). The New York bank attributed the market break to rising interest rates, including an increase in the prime loan rate at the end of April, heavy demands for capital, and government borrowing. It used free reserves to establish that the desk had eased the money market, allowing member bank borrowing to decline by $600 million in May and early June without offset. But new issue Treasury bill rates increased nearly forty basis points, so the free reserve data probably misled the manager on this as on other occasions. The manager’s instructions at the time were that “reserves should be supplied in sufficient volume to prevent further tightening but not in such volume as to ease the degree of credit constraint” (memo, Gaines to Roosa, Sproul papers, FOMC Correspondence, November 9, 1955, 3). Martin explicitly rejected any specific measure of ease or restraint.
94. In Brunner and Meltzer (1964), we used the Board’s Annual Report for 1953 to 1964 to register FOMC decisions on a scale from +1 (active ease) to −1 (active restraint) based on statements in the directive. We scaled this meeting +1 and the next meeting, in September 1953, + 1/2. As in the text here, we compared the scale value to the change in free reserves, the indicator used by most of the Board and FOMC members. Boschen and Mills (1995) use a scale from −2 (strongly reducing inflation) to +2 (strongly promoting growth). They record an end to mild anti-inflation actions in June, a mild shift to expansion in October followed by a strong expansionary policy starting in December. Romer and Romer (1994) date the start of monetary expansion in July and record the shift to “active ease” in September 1953. Their scaling neglects the FOMC’s strong statement in June.
95. Eisenhower’s first State of the Union Message proposed lengthening the average maturity of the debt. This policy had wide support in the financial markets (Sa
ulnier, 1991, 50).
The manager had discretion. He purchased more than $300 million of bills, a relatively large volume, in the four weeks ending June 3, and the Treasury supported its new issue by purchasing $3.5 million for its trust accounts in early June. Nevertheless, bond prices fell by as much as 1.25 points at the end of May and an additional half point in early June. The report of the ad hoc subcommittee appointed by the FOMC in 1955 said that a disorderly market occurred “when selling feeds on itself so rapidly and so menacingly that it discourages both short coverings and the placement of offsetting new orders by investors who would ordinarily seek to profit from purchases made in weak markets” (ibid., 7). The manager and Chairman Martin disagreed about whether this condition had been met on June 1. The manager’s main defense was that his bill purchases, the Treasury’s bond purchases, and the (false) rumor that the Federal Reserve had purchased bonds stopped the price decline.
From a cyclical standpoint, the injection of reserves to assist the market was fortuitous, since it provided additional reserves just as the economy reached a peak. The reduction in reserve requirement ratios became effective early in July. The interest rate on Treasury bills declined. By year-end, monthly average free reserves had more than doubled since June, and bill rates were at 1.63 percent, near the lowest level in two years. By these standards, monetary policy had eased, but these signals were misleading, influenced more by the decline in borrowing and spending than by Federal Reserve actions. In contrast, annual growth of the nominal monetary base declined from a peak of 5.3 percent in June 1953 to 1 percent at year-end. With a positive, but relatively low, rate of increase in consumer prices, growth of the real value of the base was below nominal base growth (Chart 2.6 above). The base data suggest that prevailing interest rates remained above the level at which the public chose to increase transaction balances.
In September, the FOMC adopted a policy of “active ease” to avoid deflationary tendencies. Inflation fell. Growth of industrial production remained strong through the summer, rising at annual rates of 17 percent and 10 percent in July and August, as the FOMC noted at its September meeting. The FOMC minutes reported slowing economic activity in retail sales, construction, personal income, government spending, and inventory accumulation. These declines more than offset growth of industrial production. Farm incomes fell, and real GNP declined in the third quarter.
In December, the FOMC described the decline in the economy as moderate but unmistakable. The directive to the manager called for “promoting growth and stability in the economy by
actively
maintaining a condition of ease in the money market” (FOMC Minutes, December 15, 1953, 5). In response, free reserves rose. The increase came from two main sources, a relatively small seasonal increase in the System’s open market portfolio and a $500 million decline in Treasury cash in the first half of November.
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The latter reflected an unusual event, Congress’s failure to increase the ceiling on Federal government debt. To pay its obligations, the Treasury used the profit remaining from the 1934 devaluation that had been left in the general fund in gold, part of Treasury cash. This action increased Treasury deposits at the Federal Reserve, but the money was spent, increasing bank reserves and the monetary base.
Real GNP in 1954 was slightly below the average for 1953, but the economy recovered slowly after the second quarter.
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In August, the administration and Congress agreed on a 10 percent reduction in income tax rates, retroactive to January. With the war over, Federal purchases of goods and services, adjusted for price changes, worked in the opposite direction, declining 18 percent from peak to trough of the recession. The Federal Reserve continued the policy of “active ease.”
Interest rates on new issues of Treasury bills remained 1 percent or below until mid-December 1954.
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Free reserves remained in the range $500
to $600 million that the Federal Reserve regarded as evidence of an “easy” money market. With the discount rate above the Treasury bill rate, banks reduced discounts, increasing free reserves. In the System’s analysis, the reduction in discounts was evidence of an easier policy. The monetary base rose modestly (see Chart 2.6 above).
96. Treasury cash includes the Treasury’s holdings of gold, silver dollars, Federal Reserve notes, and other minor items. A decline in Treasury cash increases bank reserves and the monetary base.
97. The National Bureau dates the end of the recession in May 1954. Real GNP increased beginning in the second quarter, but industrial production did not begin a sustained rise until October. FOMC described the recovery in summer as sluggish, with “unusual stability” (Executive Committee Minutes, July 20, 1954, 3).
98. In a reprise of the 1930s, the bankers on the Federal Advisory Council complained in May that rates were too low (Board Minutes, May 18, 1954, 9). They were not alone. The Life Insurance Association complained also (letter, Carroll Shanks to Martin, Sproul papers, FOMC meetings, March 1, 1954.) Later, New York explained that short-term rates were lower than intended. It blamed bills-only policy (Sproul papers, Q and A for Flanders hearings, question 3, 1954, 11.). At the time, however, the main argument was uncertainty about estimates of
reserve positions and the need for “a substantial cushion on the downside against forecasting errors” (memo, Sproul to Roelse, Sproul papers, FOMC comments, May 13, 1954.). Earlier, the Federal Advisory Council opposed an increase in regulation Q rates paid on time deposits, a mistake they would later regret. The issue arose because the New York State Banking Board removed ceiling rates for mutual savings banks. The Council said that higher rates would encourage “unsound” practices (Board Minutes, N
ovember 17, 1953, 9–10).
The Board reduced discount rates to 1.75 percent in February and 1.5 percent in April 1954.
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At the same time, the FOMC reduced buying rates for acceptances. Unlike the 1920s, when the System had tried to foster an acceptance market by holding the acceptance rate below the discount rate, it now held its buying rate at the discount rate.
Periodically the Board considered changes in the system of reserve requirement ratios. The main problem was that the high reserve requirement ratios raised the cost of membership.
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Martin appointed a committee to revisit the issue but, as on many earlier occasions, it could not reach agreement on the type of change to recommend (Board Minutes, November 27, 1953, 3). There was general agreement that reserve requirements should be uniform but no agreement on the level or how to phase in the change. The issue did not go away. A letter from the New York Clearinghouse requesting the Board to change New York’s classification from central reserve to reserve city led to discussion of the pros and cons of a general reduction in these ratios (Board Minutes, April 23, 1954, 5–6). The Board asked the Federal Advisory Council for its view. It favored a reduction, timed to pro
vide additional reserves to permit banks to buy the Treasury’
s new issues (Board Minutes, May 18, 1954, 9–10).
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99. An unusual incident speaks to tensions within the Board. After each Board meeting, members initialed the minutes. Governor Vardaman refused to initial the minutes for March 19, 1954, because he was angry about what had happened and did not think the minutes reflected the specific event accurately. The minutes report that Vardaman came to the 10 a.m. meeting for one hour, announced that he would have to leave to attend another meeting, and asked that the agenda be changed to permit him to suggest amendments to a letter the Board intended to send to a member of Congress. The Board refused, and Vardaman left without making his comments. Instead of signing the minutes, Vardaman wrote on the cover sheet: “As long as I have been on the Board, there has never been an occasion when a member has been denied the opportunity to voice his views on a proposal” (Board Minutes, March 19, 1954, initials page). He accused the Board of not stating the facts accurately, probably a reference to the absence of a statement saying that he had been prevented from offering amendments. Chairman Martin wrote alongside: “The minutes state the facts properly.”
100. The number of state member banks declined from 1901 in 1951 to 1871 in 1954. Only 21 percent of state banks (with 65 percent of deposits) were members in 1954. Including national banks, Federal Reserve members represented 48 percent of all banks and 85 percent of deposits (Annual Report, 1954, 44).