A History of the Federal Reserve, Volume 2 (24 page)

The Kansas City reserve bank was the first to request a higher discount rate. It based its request on the desire “to place the [discount] rate in closer relationship with short-term market rates that had moved upward in response to strong demands for credit” (Board Minutes, April 13, 1955, 2). It seems clear that the account manager did not prevent the change in market rates on this occasion, as on many others in the 1950s and 1960s. At the time the FOMC relied on qualitative targets, or wide ranges for free reserves. Members could criticize after the fact, but they often disagreed on whether or not the manager followed the directive or acted independently.
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Sproul missed the directors’ meeting on April 14, when New York voted for the increase. He believed the increase was too early but “the timing of the change was forced by the Treasury’s needs” (Sproul papers, FOMC comments, Board of Directors, April 21, 1955, 1). He recognized that, by its choice of procedures, the Federal Reserve remained responsible for debt management. He found this “disturbing. Despite our break for freedom, monetary policy has to recognize the continuing need for coordination with Treasury financing” (ibid., 2).
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In the early 1950s the Federal Reserve renewed its traditional interest in encouraging the acceptance market, perhaps out of habit, perhaps as a remnant of the real bills doctrine. Perhaps also relevant, Sproul wanted
to increase the manager’s options by relaxing the bills-only policy.
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Governor Robertson asked whether the account manager could purchase bankers’ acceptances. Sproul replied that, under bills-only, he could not.
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Sproul urged a change in the rule (Executive Committee Minutes, February 8, 1955, 2–6). Martin agreed to reopen the subject at the next FOMC meeting.

117. The Bank of England raised its discount rate twice in the winter of 1955. Sproul noted the change in March, but argued against responding. The domestic situation did not require a change, and “it might be helpful to have as wide a spread as possible in short rates” (correspondence, Sproul to Sherman, Board records, March 8, 1955, 2). Although control of international policy had shifted to the Treasury, New York, as in the 1920s, wanted to help maintain the fixed exchange rate system and restore convertibility without causing inflation at home. Support for the UK policy was a secondary reason for opposing an increase in discount rates in March. “Finally, there is the question of international money market relationships to which we are again paying some attention. . . . [T]emporary relief to the British position . . . would be in our long run interest” (Sproul papers, FOMC Comments, March 2, 1955, 2–3).

118. The claim that the manager frequently moved in advance of FOMC decisions is made and supported in Brunner and Meltzer (1964).

119. On the same day, the Board approved a letter to the federal reserve bank of Chicago asking about personnel policies. The letter noted that the bank “has no negroes presently employed and apparently has been following a policy which operated to preclude the employment of negro applicants” (Board Minutes, April 22, 1955, 12). The letter instructed the directors that if such policy exists “it is neither defensible nor in line with sound personnel policies” (ibid.). The letter was sent a decade before the non-discrimination legislation of the 1960s.

The Board’s staff considered several options before the meeting, including purchases of acceptances for the System account by individual reserve banks at posted prices and at market prices. The manager, Rouse, favored use of market rates. The discount rate would serve as an upper limit. He wanted authorization to use bankers’ acceptances in repurchase agreements (memo, Riefler to George B. Vest, Board files, February 25, 1955).

The FOMC agreed to acquire bankers’ acceptances as part of the System account, permit individual reserve banks to make repurchase agreements with non-bank dealers using acceptances, and eliminate the posted buying rate. Governor Robertson opposed the motion. He preferred to continue posting an acceptance rate and purchasing all offers to sell at that rate. He favored this traditional method as a way of encouraging the acceptance market by maintaining a rate advantage over commercial loans (FOMC Minutes, March 2, 1955, 48–49; March 29, 1955, 15–17). Robertson and Mills wanted to restrict the manager’s options to increase committee control and the manager’s accountability. Sproul and Martin agreed to limit purchases to $25 million.
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The weekly average of System holdings did not remain above $25 million until December 1956.

120. In March 1954, the FOMC instructed the manager to buy up to $30 million of acceptances. At the January 11, 1955, Executive Committee meeting, the FOMC abolished the minimum-buying rate for acceptances and substituted the market rate. Governor Robertson opposed this on the grounds that the market “was growing and broadening without help from the committee” (Executive Committee Minutes, January 11, 1955, 4–5). Governor Mills, harking back to the 1913 act, wanted to “further the use of a form of financing that will strengthen and enlarge the United States as an international money market” (memo, Bankers’ Acceptances, Board files, October 11, 1955). He opposed direct purchases by the reserve banks, believing that this would change the relative yield and reduce the market’s scope.

121. Sproul had argued for operations in short-term securities other than bills on June 23, 1953. Martin opposed on grounds that “it was a step backward from the free market concept.” Mills and Szymczak opposed also on grounds that it would lead back to pegging (memo, Riefler to Sherman, Board files, February 9, 1955, 1). Riefler noted that the issue had not been discussed since that meeting.

122. Robertson also objected to excessive use of repurchase agreements to supply reserves temporarily. He questioned the legality of repurchase agreements, because they were loans even if not classified as such. But he did not oppose them on that ground. He proposed to limit repurchase agreements to providing loans to non-bank dealers in government securities at a rate equal to the banks’ discount rate. Sproul opposed vigorously. He argued that bank borrowing was a privilege of membership and that the analogy comparing bank and non-bank dealers was false. Although his definition of restraint contemplated the discount
rate above market rates, he now argued that a penalty rate would eliminate borrowing and repurchase agreements. Robertson and Mills, especially the former, continued to annoy Sproul by opposing any increase in New York’s authority and by insisting on a strict bills-only policy. When put to a vote, however, Robertson’s proposals to restrict use of repurchase agreements drew no other support (FOMC Minutes, July 12, 1955, 11–12). Robertson’s opposition to repurchase agreements reopened an issue from the 1920s. Adolph Miller, a member of the Board from 1914 to 1936, had wanted to eliminate all repurchase agreements. In October, Mills and Robertson objected vigorously when the manager asked to lift the ceiling to $50 million. The arguments were the same on both sides. By December 1959, weekly averages reached $70 million seasonally. Generally, the account had $20 to $40 million in 1959 and 1960.

Martin was not given to hyperbole or exaggeration. In a rare statement of satisfaction, he described the early months of 1955 as “the most prosperous period the country had ever been in” (FOMC Minutes, June 22, 1955, 43). He warned against excessive optimism about what monetary policy could do.

Concerns about excessive expansion increased by early August. The staff briefing for the August 2 FOMC meeting described the economic situation as positive, but the expected seasonal deceleration of activity had not occurred. Several industries operated at or near capacity. Auto purchases were at record rates, 40 percent above the previous year. Unemployment fell below 4 percent of the labor force, the lowest rate in almost two years. Weekly yields on new bill issues, after remaining in a narrow range during May and Jun
e, rose almost 0.5 percentage points from July to early August. Bill rates were now above the discount rate.

Since the start of the year, rates on three- to five-year Treasuries had increased from 2 to 2.75 percent; long-term governments rose above 3 percent in early August, and mortgage rates had increased, a change the System believed would slow home construction. Farm and food prices continued to decline, but prices of industrial materials continued to rise. Productivity growth slowed.

Discount
Policy

Chairman Martin usually waited to speak about monetary and credit policy until he could interpret the views he had heard. In August 1955, he spoke first, urging the whole committee to discuss discount policy and reviewing the actions of the past two weeks. The market was full of rumors of an impending discount rate increase. He had discussed the issue with Treasury Secretaries Humphrey and Burgess, with Chairman Burns (CEA), and with his Board.
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He expressed concern that “all the danger signals
[for inflation] . . . are now flashing red” (FOMC Minutes, August 2, 1955, 13).
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He favored a 0.5 increase in discount rates to 2.25 percent, but he noted that Winfield Riefler believed it would be disruptive. He also wanted to change the directive to “restraining inflationary developments in the interest of sustainable economic growth” (ibid., 14). His aggressive stance contrasts with his less forceful actions in the late 1960s.

123. Martin asked Humphrey, Burgess, and Burns whether they favored two 0.25 increases or a 0.5 percentage point increase. They chose 0.5 all at once but, within a few days, reversed their recommendation out of concern for the purchasers of the Treasury’s recent issue of 3 percent bonds. The Board also favored an increase of 0.5 to 2.25 percent (FOMC
Minutes, August 2, 1955, 11). Eight of the ten reserve bank presidents at the meeting favored the smaller increase. Three banks had submitted increases. A 0.5 percentage point increase would be the largest since 1937.

Sproul agreed with Martin about the risk of inflation, but he was less certain that the risk was imminent. He questioned whether the economy had reached its capacity. He favored a 0.25 percentage point increase in the discount rate and an open market policy that would force member banks to increase borrowing and raise interest rates. A 0.5 increase gave “expression to a judgment about a future economic situation which we do not yet have to make.” Once again, it placed too much of the burden on credit policy: “Credit policy can’t do the whole job, and shouldn’t try to do it” (ibid., 21–22). Sproul, like Riefler, warned of the possible credit market reaction to a 0.5 percentage point increase.

As usual, the outlook was uncertain, so the members did not agree about what to do. Bryan (Atlanta) reminded the members that the U.S. had experienced inflation only in wartime or postwar periods. Money supply had increased modestly. Free reserves had become negative. Twelvemonth CPI inflation was between 0 and −1 percent. In the weeks before the meeting, interest rates had increased. He favored no increase in the discount rate and a rise in short-term market rates (ibid., 31–32). This would allow discounting to act as “a safety valve” if they had misjudged the current situation.

Other members expressed a wide range of opinions. Balderston had earlier favored a 2.25 percent discount rate (0.5). He reaffirmed his position. At the opposite pole as usual, Mills favored adding reserves to offset the reserves withdrawn by repurchase agreements. Despite these differences, the committee voted unanimously to adopt Martin’s proposal to change the directive to emphasize “restraining inflationary developments.”

As agreed at the FOMC meeting, Martin, Balderston, and Sproul met with Treasury representatives and Chairman Burns to report on the discussion at the meeting. Administration officials were divided also. Secre
tary Humphrey now favored the smaller increase, but could accept the 0.5 increase, if the System agreed to prevent a disorderly market. Chairman Burns expressed concern that a 2 percent rate was not high enough. He favored 2.25 percent (Board Minutes, August 2, 1955, 2–3).
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124. Martin was both pessimistic and prophetic about the political response to inflation. “[O]nce such action [inflation] has occurred, neither monetary policy nor anything else could effectively restore the purchasing power of the dollar without creating such distress as to preclude its usefulness” (FOMC Minutes, August 2, 1955, 13).

After much discussion about the public relations and market problems of announcing different rates for different banks, the Board voted unanimously to approve action by Cleveland’s directors to raise the discount rate to 2.25 percent and to approve 2 percent rates requested by Chicago, Boston, and Atlanta.
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It was late in the day, so the increases were made effective August 4. At the next weekly Treasury bill auction, rates increased by 0.45 percentage points from the preceding week, suggesting that the market had not anticipated the change.

Within a few days, all remaining reserve banks adopted the 2 percent discount rate. Several governors expressed concern that Cleveland might lower its rate to match other banks. They preferred that all banks move to the higher rate. There was a sense of impending crisis. Governor Vardaman said that if the reserve banks delayed raising their rate to 2.25 percent, “he would be willing to exercise the Board’s prerogative and fix that rate” (Board Minutes, August 18, 1955, 7).
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Merchants had started to build large inventories for Christmas. It would be “unfair” to delay further restraint. Balderston supported him. He wanted a penalty discount rate imposed on the reserve banks if they did not approve the increase. He suggested that 2.5 percent might be more appropriate, if the Board imposed a rate. This would have meant a 0.75 increase, a very large increase imposed in a highly unusual way at a time of modest deflation or price stability.

At the August 23 FOMC meeting, Martin raised two issues: whether the discount rate should be a penalty rate, and whether it should lead or follow market rates. Riefler reviewed the history of discount policy. Traditionally, the committee used open market operations to remove reserves and increase market rates before increasing the discount rate. The failure
to adopt a “penalty rate has created a problem for us of administering the discount facility in such a way as to prevent member bank abuse of the discount privilege by over-borrowing” (FOMC Minutes, August 23, 1955, 10).
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He favored increasing the discount rate until it served as a penalty rate. Riefler reported on his analysis, showing that it takes “a very large volume of negative free reserves to put the market bill rate above the discount rate . . . The normal position is for the bill rate to be below the discount rate” (ibid., 12). The force driving that result was that banks sell bills when the discount rate is above the bill rate and discount when the rates reverse relative position. Goodfriend (1991) offered a more formal analysis of this issue.

125. Burns later described the incident. “In 1955, I was pushing Bill [Martin] hard, along with Sproul, to pursue a tougher monetary policy because the economy was heating up, and the Federal Reserve was not moving fast enough in my judgment. That was also the thinking of Sproul” (Hargrove and Morley, 1984, 104). Note that at the meeting, Sproul opposed the larger increase, whereas Martin favored it. Burns’s memory may have been faulty. As the text suggests, Martin was more concerned than Sproul about incipient inflation.

126. At the same meeting, the Board agreed to appoint Alexander Sachs, Jacob Viner, and Edward Shaw as consultants to explore an “appropriate research approach to longer-term financial problems” (Board Minutes, August 2, 1955, 7). This action recognized the overemphasis on current and near-term events and relative neglect of longer-term implications of monetary actions, a problem that continued.

127. The Board had ordered reserve banks to change their rates only twice before, in
1919 and in 1927.