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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) W have educated the banks to consider b i l l s as cash and very e 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 - 2 - 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#
