Federal Reserve System - History ; Monetary policy - United States ; Treasury-Federal Reserve Accord

Verle B. Johnston

English

Research Papers in Economics

FRBSF
April 25, 1986 WEEKLY LErrEA
Adjusting the Focus
Inflations seldom get outofhand during war-
time, but the danger carries over after peace
comes and a war weary people, tired ofwartime
controls and restraints, are eager to throw them
off. This is just the time when it may be fatal to
relax prematurely the control ofwar-engendered
inflationary forces.
So warned Marriner Eccles, Chairman of the
Board of Governors, in testimony before the
Senate Banking and Currency Committee in
1944 - a year before the end of World War II.
This Letter discusses the problems experienced
by the nation's economy in converting from
wartime to peacetime production, including the
difficulties faced by monetary policy.
Brave new world
Contrary to widespread expectations, the con-
version to a civilian economy proceeded with
considerable zip. A 60 percent drop in federal
government outlays between 1945 and 1947, an
initial drop in industrial production in 1946 of
about 15 percent, and rapid demobilization of
the armed forces, which more than doubled
unemployment to 2.4 million (or 4 percent of
the labor force), did not slow it down.
The public had tripled its holdings of liquid
assets during the War, and these assets, which
were available to support a strong demand
repressed by wartime controls, were partly
responsible for a post-war surge in consumer
spending and private investment. The surge
resulted in a rise in employment of 5 million and
a rise in nominal output of 10 percent between
1945 and 1947. However, because of a 30 per-
cent increase in prices over the same period,
real (inflation-adjusted) output declined by over
20 percent.
Inflation was fed in part by pent-up demand
(and supporting liquidity), and in part by wage
increases that averaged 15-20 percent over
1946-47. In 1946, 116 million man-days were
lost through wage-related strikes - four times
the previous record in 1937. Material allocation
controls and rationing had been eliminated
shortly after the war ended, taxes reduced, and
the excess profits tax also eliminated. Wage and
price controls were abolished in the spring of
1946, and prices rose sharply.
Fed Chairman Eccles had protested the elimina-
tion of controls and reduction oftaxes so soon
after the war to no avail. in subsequent testi-
mony before Congress on the inflationary poten-
tial of "our enormous money supply," he noted
that progress had been made in limiting the
money supply's further growth through a sharp
reduction in government spending and borrow-
ing.
However, the net reduction in the outstanding
debt ($22 bi IIion between 1945 and 1947),
accomplished by drawing on the Treasury's bal-
ances, actually contributed to a further, albeit
slower, increase in the private money supply.
This increase in the money supply took place in
spite of a modest net reduction ($2 billion) in the
Fed's holdings of u.s. government securities
which exerted a tightening effect on bank
reserves. Moreover, the funds which banks
received from redeeming over $20 billion in
their holdings of government securities gave
them the means to expand their lending.
Engine of inflation
The Federal Reserve system was thus confronted
by a dilemma much like that it faced at the end
of World War I. To facilitate the Treasury's oper-
ations, it could continue to support the Treas-
ury's bond price and rate "pegging" policy- as
the Treasury insisted, or itcould allow more
flexibility in the interest rate structure (i.e.,
higher yields) to gain better control over money
and credit. The former would increase inflation-
ary pressures, while the latter would increase the
Treasury's financing costs and inflict losses on
holders of government securities, who had been
urged to buy them at lower rates to help finance
the war.
Following the passage in 1946 ofthe landmark
Employment Act, the situation became
increasingly anomalous. This Act declared it to
be the "continuing policy" of the federal gov-
ernment "to promote maximum employment,
production and purchasing power." The Board
of Governors strongly endorsed the legislation as
consistent with Chairman Eccles earlier but
unheeded recommendations in 1935, but
resisted efforts to endorse more specific criteria
or objectives for monetary policy on the grounds
that the latter "calls at all times for the weighingFRBSF
of a great many different factors and the attach-
ing of the same factors at different times."
Pressures to continue supporting the Treasury's
policy proved not only to inhibit efforts to con-
trol inflation, but, as it turned out, also to
hamper the System's ability to deal with a reces-
sion in 1949. As private demands for credit
slackened that year, banks purchased govern-
ment securities and thereby put upward pressure
on securities' prices and downward pressure on
their yields. Maintaining the pattern of yields
compelled the System to sell government
securities - a process which absorbed reserves
and exerted a contractionary effect on the econ-
omy.
Encounter ... and accord
Early in 1950, System efforts to regain a substan-
tial degree of "independence" in the conduct of
monetary policy received support from the Con-
gressional Joint Economic Committee UEC).
However, the policy of supporting the Treasury
was strongly endorsed by President Truman,
who had refused to re-appoint Marriner Eccles
Chairman ofthe Federal Reserve when his term
expired in 1948 (Eccles stayed on as a Board
member until July 1951).
Late in 1950, Truman wrote a letter to Board
Chairman Thomas McCabe expressing his dis-
may over an article in a New York newspaper
which claimed the Board was undercutting
Treasury financing operations. The President
claimed that the Korean War's financing require-
ments necessitated stability in the government
securities market. Truman subsequently called
the Federal Open Market Committee - the
Fed's chief monetary policymaking body - to a
meeting at the White House, after which he is-
sued a press release stating that the Fed had
"pledged its support ... to maintain the stability
of long-term governments as long as the (Korean
War) emergency lasts."
In a letter to the President a few days later
designed to clarify its intent, the FOMC made
four points: (1) the System would do all in its
power to maintain confidence in government
securities and the dollar; (2) the control of bank
reserves was essential to this objective; (3)
that charges that the FOMC favored high interest
rates "confuse the issue" - its real objective
being more effective control over the creation of
money; and (4) the System would try to work
out an agreement with the Treasury both to safe-
guard confidence in outstanding government
securities and to protect the purchasing power of
the dollar.
Finally, on March 4, 1951, the System and
theTreasury signed an "Accord" in which the
System agreed to maintain an "orderly market"
in government securities, but without a commit-
ment to support them at par. The"Accord"
represented a milestone in that it enabled the
System, for the first time since the mid-thirties, to
regulate bank reserves and the money supply
effectively, and to exercise independence from
strong political pressure - in this case pressure
from the Executive branch - in conducting
monetary policy.
The Korean War . ..
The military buildup which accompanied the
Korean War boosted government expenditures
sharply, but taxes were increased, and, as a
result, budget deficits in FY 1951-53 (the year
the war ended) aggregated only $4 billion. On
balance, the Fed acquired $6 billion of govern-
ment securities during the period while commer-
cial banks and the public together made
comparable net reductions in their holdings.
To help restrain inflationary pressures, discount
rates and reserve requirements were increased
(as in World War II, the Reserve Banks again
arranged and administered guarantees for war
production loans under a reactivated "V" loan
program), and the System again administered
Congressionally mandated controls over con-
sumer and (for the first time) real estate credit.
After an initial jump of about 6 percent in the six
months following the outbreak ofthe war, the
Consumer Price Index rose by only an additional
6 percent over the next two-and-a-half years,
and, significantly, did not spurt following the
end of the war.
... and Viet Nam
Growth continued in an environment charac-
terized by general price stability until the begin-
ning of the Viet Nam buildup in the mid-1960s.
In fact, over the two decades of the 50's and
60's, industrial production almost tripled and
real GNP more than doubled (averaging annual
increases of 5 percent). Employment rose by 20
million (or over 30 percent) and helped boost
aggregate personal income by over 250 percent.
Moreover, due to the relatively low rate of infla-
tion - consumer prices rose at an average
annual rate of only 2.6 percent during the two
decades - most ofthe gains were "rea!." Thatis, per capita income after inflation rose by 61
percent. Stability in financial markets also was
evident in a low level of interest rates: the prime
rate did not hit 5 percent; mortgage rates, 6 per-
cent; and the Fed's discount rate, 4 percent,
until the mid-1960s. Treasury Bill rates didn't
reach 5-6 percent until the end of the 1960s,
under pressure from sharply rising government
expenditures in support of the war in Viet Nam
and the Great Society.
Adjusting thefocus
From the mid-fifties until 1960, the Fed gener-
ally followed a policy of purchasing and selling
"bills only" to influence bank reserves. That is,
open market operations essentially were limited
to the buying and selling of short-term T-bills to
minimize the effects on the prices and yields of
longer term securities. In the process, various
concepts of reserves came to be used as operat-
ing targets, including "non-borrowed" and
"free" reserves, and terms such as "active
ease," "ease," "neutrality," and "restraint"
were used to describe policy - all of which
focused, in essence, on interest rates rather than
the money supply.
The first comprehensive critique by the System
in which the term "money supply" and its
various measures and functions were used,
including its influence on national output and
economic activity, was prepared for the JEC in
1952. However, William McChesney Martin,
who had become Chairman in 1951, consis-
tently argued that "no single index or single
combination offactors can serve as a continu-
ing, infallible guide (to monetary policy)."
Subsequently (in 1964), Milton Friedman urged
that the FOMC be subject to a "legislated rule
... which specifies that the quantity of money
shall grow at a steady rate from week to week,
month to month and year to year," on the
grounds that knowledge of the economy and of
the effects of System actions on it simply were
imperfect. However, the System reaffirmed a
stance in favor of discretionary and flexible
operating procedures for much the same reason:
that imperfect knowledge made policy formula-
tion by rule or formula ineffective.
From the time ofthe Fed-Treasury "Accord" in
1951 to the end ofthe 60's, growth in the
money supply (M1) averaged less than 4 percent
a year - an achievement which clearly contrib-
uted to the relatively low average annual rate of
inflation. During the late sixties, the FOMC
moved in the direction of using the Fed funds
rate (the rate charged by banks to each other for
borrowing excess reserves) rather than member
banks' nonborrowed or free reserves as its oper-
ating target. In the face of rising demand pres-
sures, including pressures on the credit markets
exerted by the expanding borrowing needs of
the federal government (outlays reached $178
billion in 1968, accompanied by a record
peacetime deficit of $25 billion), efforts to keep
the Fed funds rate within its FY target by supply-
ing more reserves resulted in faster growth in the
money supply.
Supported by a 60 percent increase in the Sys-
tem's open-market portfolio from 1965-69 and a
30 percent increase in member bank reserves,
increases in various measures ofthe money sup-
ply during this period ranged from 27 to 41 per-
cent. In the context of slowing productivity and
rapidly rising wages, prices and interest rates
were moving up at an accelerating pace by the
end of the decade.
A look back... and ahead
A memorandum prepared by economists at the
San Francisco Fed in 1968 reviewed earlier in-
house debates and warned of the potentially dire
economic consequences of policies designed to
accommodate both "guns and butter,"
especially in the absence of a substantial
increase in taxes. The Board of Governors noted
in its 1969 Annual Report that moves to restrain
money growth during that year (when consumer
prices rose 6 percent) were necessitated by
"deeply rooted expectations of continuing infla-
tion." Efforts at monetary restraint were aided
that year by a small ($3 billion) surplus in the
federal government's budget.
Fiscal year 1969's $3 billion surplus, however,
gave way to an uninterrupted succession of defi-
cits over the next seventeen years, which were
to dwarf everything that had preceded them in
the nation's 194-year history. A future Letter will
discuss developments affecting monetary policy
and the nation's economy in the turbulent
decade ofthe 1970s.
Verle B. Johnston
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthe managementof the Federal Reserve Bank ofSan
Francisco, orofthe Board of Governors of the Federal Reserve System.
Editorialcommentsmay beaddressedtotheeditor(GregoryTong) ortotheauthor....Freecopiesof Federal Reservepublications
can beobtainedfrom the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.uo~6u!450m 40~n U060JO 0POi\0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
4/2/86
Change
from
3/26/86
Change from 4/3/85
Dollar Percent?
Loans, Leases and Investments1 2 202,349 1,632 11,833 6.2
Loans and Leases1 6 183,873 1,658 11,424 6.6
Commercial and Industrial 53,187 752 27 0.0
Real estate 66,562 90 3,919 6.2
Loans to Individuals 38,931 - 46 5,620 16.8
Leases 5,643 - 8 283 5.2
U. S. Treasury and Agency Securities2 10,600 32 - 553 - 4.9
OtherSecurities2 7,876 - 58 961 13.8
Total Deposits 205,244 5,922 7,143 3.6
Demand Deposits 51,565 4,855 4,174 8.8
Demand Deposits Adjusted3 34,514 2,466 4,682 15.6
OtherTransaction Balances4 16,249 1,045 2,121 15.0
Total Non-Transaction Balances6 137,431 23 851 0.6
MoneyMarket Deposit
Accounts-Total 46,396 493 2,369 5.3
Time Deposits in Amounts of
$100,000ormore 37,199 - 550 - 1,743 - 4.4
Other Liabilities for Borrowed MoneyS 27,341 777 8,027 41.5
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+l/Deficiency(-l
Borrowings
Netfree reserves (+l/Net borrowed(- l
Period ended
3/24/86
135
10
125
Period ended
3/10/86
22
30
8
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.s. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
s Includes borrowingvia FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percent change

Adjusting the focus

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Adjusting the focus

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