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November 10, 1943

Background for Treasury Financing
In order to approach present financing and Government security
market problems in a xutional way i t i s necessary to have clearly in mind
certain developments which have changed the situation radically from the
way i t was when the easy money policy and l a t e r the pattern of rates were
adopted* Briefly stated the situation a t the present time looks as follows?
(1) Monetary ease i s no longer reflected by the outstanding volume
of excess reserves« The reason for this i s that money maricet banks have
been persuaded by us that b i l l s are as good as cash. For this reason they
will hold no excess reserves, but will put a l l their idle funds into Govern^ment securities with the assurance that the b i l l s that they already hold
provide them with such liquidity as they may require*
(2) We have educated the banks to consider b i l l s as cash and very
rapidly they are beginning to think of higher yielding securities as cash
also. I t has spread so far only to certificates but the hesitanqy about
longer-teim securities will probably also begin to weaken* Once the banks
have been persuaded by the System and by the Treasury that Government securities are cash, that will become a commitment from which the Government could
not recede in good faith, I t will raise serious problems after the war be>cause i t will make i t completely impossible to tighten the money maricet
in any way a t any time while a huge public debt i s held by banks, insurance
companies, trusts, etc*
(3) Ihe existing spread from three-month b i l l s to long-time bonds
i s too wide. I t represents the freezing of an entirely unusual situation—
one characterized by the fact that money was extremely easy, reserves were
plentiful, and demands small, and assurance that long rates will remain
low was not established* The spread i s completely inconsistent now and
attempts to sustain i t result in giving banks more and more reserves with
which to buy higher yielding securities with the consequence that longerteim rates are declining* Ihe chart shows that bond rates have been working
down while yields on notes started upward in 1942 and went up throughout
that year* Bills tended the same way* but were frozen a t 3/8 • Since that
time the floor has been levelled, but the ceiling has been sagging# The
pattern cannot be sustained ty anything we can do* The question i s shall
we l e t the spread diminish through a decline in the long rate or through
an advance in the short rate? The argument that stiffening the short rate
would result in stiffening the long rate i s out of touch with the facts*
What would happen if the short rate stiffens i s not that the long rate
would advance but that i t would no longer sag.
I t i s consequently not r e a l i s t i c to say that the vol\ane of excess reserves must be maintained in the maifcet* As ^Ireacfcr started, that
cannot be done. Nor i s i t good sense to give the market more b i l l s when




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the maiicet i s refusing to buy what i s being offered and to do so on the
ground that this would provide enough b i l l s not only to meet existing
maturities* but to pass on to the Federal Reserve a constantly increasing
volume of them* At the present rate the banks would be foolish to and
would not buy the bills* Ihey would use the reserves so created to buy
higher yielding securities with tho consequence that the ceiling would
continue to sag. Since l a s t summer the banks have reduced their b i l l
holdings by 11,400,000,000 and have increased their holdings of c e r t i f i cates by #2,300,000,000 and of bonds by $2,000,000,000
(5) There i s only one rational approach to this problem, unless we
want to have the long-term rate go s t i l l further down, and that i s to l e t
the short rate advance by adopting one or the other of the proposals made
by the System* Direct increase of the rate on short b i l l s with some i n crease in length of maturity, as proposed by the New Yoric Bank, or elimination of 3-month b i l l s and of certificates and the substitution of 9~
month b i l l s , as propose^ by the Board, would both have the effect of
establishing a higher minimum rate in the market. The arguments on the
various points involved in the two plans were discussed in another
memorandum*
(6) I t i s , of course, recognized that the'Federal Reserve will have
to supply a l l the re serve 9 that the banks may need. Sane of the reserves
supplied during this year were for the purpose of meeting the demand for
currency* Increase in' reserve requirements due to growth in deposits has
not occurred because of the exemption of war loan accounts from reserve
requirements* Ihe best way for the Federal Beserve to supply the market
with the reserves i t needs i s to keep i t s buying rate and i t s option agreement on b i l l s , provided the b i l l rate i s adjusted upward. This would
encourage the banks and some others to buy b i l l s , rather than search for
higher yielding securities with a consequent depressing effect on these
yields*
(7) In order to eliminate from the discussion the question of the
expansion of Federal Iteserve revenue that would be an incidental result of
an increase in short-term rates, arrangements should be made by which the
b i l l s that will be allotted to the Federal Reserve on direct bids would
carry a rate no higher than the present 3/8 per cent. Federal Iteserve
Banks should arrange to bid every week for a t }.e£$t the amount of b i l l s in
their portfolios that mature each week#