A History of the Federal Reserve, Volume 2 (22 page)

Until December 1954, seven months after the recession ended, the System continued the policy of “actively maintaining a condition of ease in the money market” (active ease) agreed upon at the December 15, 1953, meeting. The FOMC carefully followed conditions in the economy; it was aware at its June 23, 1954, meeting that the decline in production and consumption had moderated and, in September, that the economy had “moved sideways” during the summer. The Federal Advisory Council reported as early as May, the month of the NBER trough, that “the decline is leveling out. . . . [T]here is much more optimism” (Board Minutes, May 18, 1954, 5). At its September meeting with the Board, the Council noted that the recession had ended, but it did not expect “any significant upsurge or decline . . . in the next three months or in the first quarter of next year” (Board Minutes, September 21, 1954, 8).
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This judgment proved wrong.

In October, the recovery strengthened. By November, Chairman Martin expressed concern about a speculative boom. “[T]here were indications of an exuberance of spirit among intelligent businessmen with respect to 1955 business prospects that seemed to him to be dangerous” (Executive Committee Minutes, November 9, 1954, 10–11). Most other members did not share his concern. They were wrong. In the next six months, industrial production rose at a 21 percent annual rate, and the unemployment rate fell from 6 to 4.7 percent. With real GNP rising at a 5 percent annual rate, Chairman Martin proposed to “re-examine the active part of the phrase ‘active ease’” (FOMC Minutes, December 7, 1954, 5). Sproul agreed, but Vice Chairman Balderston opposed any announcement of a change on grounds that the announcement would mislead the public. Martin dissented strongly; he did not want the words “active ease” to remain in the directive. His concern was inflation. “[H]e did not believe that inflation provided jobs for people on a sustained basis although it might temporarily promote jobs” (ibid., 22). The committee agreed to remove the word
“active.” Some members wanted to remove the word “ease” also, but the majority opposed.

101. The Council estimated the Treasury would soon borrow $10 to $11 billion on new issues.

102. The Council praised the System’s response to the recession but criticized the low interest rate policy that brought short-term rates on commercial paper and acceptances back to the levels of the 1948 recession. In February, the Council urged that “it would be proper policy to sell bills to an amount approximately offsetting the decline in loans” (Board Minutes, February 16, 1954, 8). This statement amplified the Council’s concern about “undesirably cheap money” (ibid.) that lowered bank earnings. The Council divided on whether the February reduction in the discount rate was desirable. Earlier the FOMC had increased the rate on repurchase agreements to 2 percent.

A few weeks later, the Executive Committee heard that “a vigorous economic recovery was now visible and tangible.” The members voted to keep free reserves in the $300 to $500 million range.

Chart 2.7 shows levels of free reserves and a short-term interest rate during the recession and surrounding months. The two variables are negatively related. Although there is considerable variation, low levels of the Treasury bill rate generally accompany large positive values of free reserves. Both measures offered the same general interpretation of the policy stance. For example, during “active ease” in the fall of 1954, the Treasury bill rate and free reserves remained about 1 percent or less and $650 to $700 million respectively. A shift from “active ease” to “ease” in December 1954 raised the bill rate by 0.25 percentage points and reduced free reserves by about $250 million. In contrast, during the same period, growth of the monetary base remained between 0.5 percent and −0.5 percent.

In a significant departure from its earlier experience, the Federal Reserve responded to measures of economic activity when choosing policy, and it took a more active role. Guided by the real bills framework in the 1920s and early 1930s, the System had generally let banks take the initiative for expansion by increasing the volume of discounts. The System had a more limited role. Its open market purchases encouraged banks to repay
borrowing during a contraction, but monetary expansion usually had to wait for economic recovery to increase member bank borrowing.
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In contrast, the minutes for the 1953–54 recession do not show any FOMC member urging the System to wait for borrowing to increase. No one opposed open market purchases or described them as a source of speculative credit. These older ideas did not disappear completely, but they no longer dominated policy decisions or justified inaction. Everyone in authority accepted that the System’s responsibilities included intervention to moderate fluctuations in economic activity even if they believed that recessions had a beneficial effect.

Policy operations remained procyclical, however. Money growth was higher in the expansion than in the recession. As before, the principal reason was that the Federal Reserve interpreted the decline in member bank borrowing and rise in free reserves as evidence of ease. Although it had not yet adopted an explicit, numerical free reserve target in its directive, by 1954 it often instructed the account manager to keep the level of free reserves within a specified range.

Federal
Funds
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Growth of the public debt, particularly short-term debt, provided a market in which the Federal Reserve could conduct open market operations on a regular basis. It used this market to smooth fluctuations caused by changes in Treasury balances, float, seasonal demands for currency, and random events and also to change free reserves. Growth of the federal funds market, in which banks and corporations bought and sold claims to balances at the reserve banks became the lowest-cost way for banks to adjust reserve positions to meet requirements.
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Reserve balances linked the two markets. The federal funds market started in the 1920s, disappeared with low nominal interest rates from the 1930s to the middle 1950s, then returned and became the principal market for reserve adjustment.

103. Governor Strong (New York) received considerable criticism for open market purchases in 1924 and 1927. Many blamed his 1927 actions for the stock market boom and subsequent economic collapse. The point of the criticism was that the purchases financed speculative credit, not real bills. See volume 1, chapters 4 and 5.

104. The Board’s staff explored many different ways to analyze the economy. One of these was “flow of funds,” a vast accounting system that sought to mimic national income accounts by recording changes in balance sheet positions. See Board of Governors (1955). This substantial effort produced a comprehensive system of accounts, but it failed to provide a useful framework for monetary analysis.

105. A buyer of federal funds received an immediately available deposit at a reserve bank. It paid by issuing a check payable at the clearinghouse on the following day. The buyer obtained funds immediately and paid the interest rate for one day (or longer). Free reserves are the difference between excess reserves and member bank borrowing.

One consequence of the increased use of federal funds was that the call loan market did not resume its former role. The call money post at the stock exchange closed for lack of business. Loans to brokers and dealers continued, but they no longer had a major role in banks’ adjustment of reserve positions. The federal funds rate, not the call money rate, took over the role of adjusting the excess demand and supply for reserve balances.

The increased importance of the Treasury bill market gradually changed beliefs about the effects of a large government debt. In the 1940s, many economists and Federal Reserve officials expressed concern that a large outstanding debt hampered the use of monetary policy. The concern was that increases in interest rates caused bond prices to fall, imposing wealth losses. Small changes in interest rates would have little effect and large changes would be disruptive.

By the mid-1950s, these concerns no longer seemed relevant. Most people on both sides of the discussion of bills-only policy believed that interest rate changes were desirable and necessary. The Federal Reserve accepted the changed interpretation in a 1952 pamphlet. It now said that a large debt “induced much greater sensitivity to small changes in interest rates, and especially to changes in the direction of rates” (Roelse, 1952, 7). The essay concluded that it was unlikely that policy operations would require interest rate fluctuations similar to the relatively large fluctuations in call money rates in the 1920s (ibid.).
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The Board also changed the rules for issuing currency. Instead of returning all notes to the issuing reserve bank, banks could reissue currency of other banks.

RECOVERY AND EXPANSION, 1955–57

Recovery from recession and the subsequent expansion lasted thirteen quarters. Real GNP rose at an average 3.4 percent annual rate and industrial production at a 6 percent average rate. These averages hide the character of the recovery and expansion. Year-over-year growth of indus
trial production remained between 10 and 14 percent through most of 1955, declined sharply in 1956, owing partly to strikes, before returning to annual growth of 2 to 4 percent until the start of the 1957–58 recession. Output per hour, Chart 2.1 above, shows a similar pattern.

106. The new interpretation reflected the thinking of Robert Roosa at the New York bank. Roosa (1951) challenged the orthodox view at the time, claiming that since banks held a large volume of government securities, the central bank was “capable of reaching any segment of the rate structure” (ibid., 271). This accorded with New York’s position that operations should be conducted at all maturities. Roosa highlighted “availability.” By reducing availability and raising interest rates, he claimed the Federal Reserve made lenders less willing to lend. Availability, or its absence, dominated the rate change; and Roosa’s emphasis is on the desire of lenders to lend, not on the willingness of borrowers to borrow or the cost of capital relative to the return on investment. Rising interest rates affected investors by creating uncertainty, thereby inducing investors to shift into short-term securities. Roosa’s conjectures remained incomplete and, as noted by Robertson (1956, 70), required borrowers and lenders to draw opposite inferences from a change in interest rates.

Year-to-year changes in the consumer price index remained modestly negative from September 1954 through August 1955. As noted years later, CPI changes overstate the rate of inflation, so the deflation in this period may be somewhat greater than reported figures show. The economy continued its recovery and, as in several earlier periods of modest deflation, output rose. There is no evidence of the monetary impotence that many economists suggest comes with deflation. Monetary actions remained effective despite the alleged zero bound on nominal interest rates often cited as a source of problems in economic models with a single interest rate.

Deflation did not last. While it lasted, it had no effect on Federal Reserve policy, and the Federal Reserve paid no attention. By late 1956, annual CPI inflation reached 2.5 percent on its way to 3.5 percent in the spring and summer of 1957.
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The FOMC continued to rely mainly on free reserves both to guide policy and implement it. Explicit targets for free reserves supplemented general guidelines such as “slightly more ease” or “active restraint” used earlier in the 1950s. Not all of the members used free reserves as their target, but that did not prevent them from criticizing the manager’s frequent failures to hit the target.

Some FOMC members characterized “ease” and “restraint” more explicitly. Sproul offered the most complete statement using multiple measures including the relation of the discount rate to “sensitive” market rates, the extent to which banks obtained reserves by borrowing or open market operations, and the absolute level of market rates.
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His characterization moved away from the 1920s Riefler-Burgess framework. The discount rate had a more important role and functioned, at times, as a penalty rate. No
table also was Sproul’s emphasis on interest rates in addition to borrowing and the reduced role of free reserves as an indicator of ease or restraint.

107. The implicit price deflator shows a very different pattern (Chart 2.3 above). There is no deflation. The lowest reported rate is 0.2 percent in third quarter 1954. The average rate of increase in 1955–57 is 3.4 percent, and there is no trend in the quarterly rates of increase (U.S. Department of Commerce, 1989).

108. Sproul had four categories: active ease, ease, neutrality, and restraint. He defined “active ease” as: ample excess reserves to meet borrowing needs; market rates low and falling absolutely and relative to the discount rate; banks borrow little from reserve banks and obtain reserves from open market operations (FOMC, January 11, 1955, 10–12). Sproul’s commendable attempt to define terms failed to distinguish real and nominal changes. He rejected use of free reserves, citing distribution of reserves as one reason, then added: “We may find that . . . we can and should get rid of the idea of free reserves, and of free reserves themselves, but I still want to move gradually” (Sproul papers, FOMC Comments, January 11, 1955, 8). The distribution of reserves refers to the proportion of excess reserves at country banks.