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November 18, 19U0 IASY Decline in ^onoy Sates Money rates are at an extraordinarily low level. As is'shown by tot attached table, rates on various classes of loans and open-r.-arket investments declined substantially between 1929 and 1936 and declined soiaewhat further since then* term open-market rates* '£he rost drastic declines have been in short- Hates on Treasury bills and Treasury notes have approached tero and in certain periods these obligations have been selling at negative rates* Yields on bonds of all kinds have also declined* Hates on ooEEierci&l loans by banks in le&din, cities, whioh were exceptionally nigh in 1929* dropped abruptly between that y*r and 1936» Further de- clines have not been reported since that time, but £tany loans to wellestablished customers are being made at rates lower thsc those rerorted* All kinds of real estate leans have also declined in yield, but are still at levels that are relatively not low* Problems Raised by Low Hates For For some time past the lower returns on first-elsjss investments have constituted an acute problem for all kinds of endowed and fiduciary institutions* Insurance companies have difficulty in finding what they oonaider satisfactory investments} beneficiaries of trust funds have had their incomes seriously curtailed, and universities and other institutions of learning, as well as charitable foundations and all kinds of other endowed organ isationa, have had difficulties in meatin^ their budgets. Some - 2 - of the adjustments that have been ?aade to the lower l#vel of return* on investments are a necessary recognition of the fact th^t th© economic position of the country has radically ©hanged* it has beeosae a ereditor country* From & debtor country Instead of having & limited supply of reserve r.oney it has a great abundance of reserve funds* F^ates whieh were normal a decade or two ago would be clearly out of line with presentday conditions* Bet ;reat increase in available capital has radically ehanged the rel*.tloa«hip betweea th« sup ly and the demand for long-term funds, and capital may well find it necessary to be satisfied with a lower return than was to be expected at a time when the country was still ex* perieneinr, a scarcity of investment funds# The fundasent&l adjustment hat now been made, however, Ami further de«lime» endanger th« fuaotionit^; of the capitalistio system, a funclatsental principle tf w ich is thtt invested capital is entitled to a reasoaablo re-turn. For Banks. There haa been a good deal of oritieism of easy money by banks which have viewed with apprehension the disturbance of the rate structure to which they hare been accustomed* nevertheless, it snould be recognised that the readjustment downward of certain ratos which have been too high was necessary, particularly in reducing the cost of money to local borrowers in smaller cities and in rural districts* It is also true th*t, as a result of availability of CHnrernmeat securities, of the decline In losses and the increase in recov«ries of items previously written off, together with reduced . 3- payments of interest on deposits, banks hare had reasonably good earnings in recent years. Further declines of the higher long-term rates, however, and continuance of excessively low rates on large loans and epen-aarket investments makes the problem a serious one for the banks. Inflationary Danger Aside from the point of viewof the lenders as to returns on their money, the very lew level of interest rates now prevailing may contribute to unhealthy inflationary developments if they should get started. The situation is a very different one from the period of deflation when abundance of funds at as reasonable rates as possible was a means of combating the downward spiral, YJith business and employment Increasing, with the prospect of a broad and rapid recovery, the possibility must be faeed that the availability of funds at excessively low rates would tend to encourage unsound expansion. Reasons for Low Rates In the light of these circumstances, a careful review of the reasons for the excessively low rates and of System policy in relation to it is appropriate, with a view to formulation of a poliey for the immediate future and for the longer range. The System*s «o-called "easy money" poliey in the last ten or eleven years way be reviewed from several angles. The term "easy money" has four different meanings whieh are not always clearly distinguished. It is sometimes used in describing efforts to combat deflation, sometimes • k* in referring to the reduction of money rates, at other tines It refers to a policy of providing abundant funds for lenders, and still another Meaning is one that has reference to the possibilities of inflation. The System1 s policy in general has been directed primarily towards the furnishing of abundant funds, without special reference to money rates. In the four years from 1929 to 1935 the System was combating deflation. During that period a rapid decline in money rates was en* oouraged by System policy. With the exoeption of a brief period in the autumn of 1951* after England went off gold, the System pursued a policy of easing credit conditions and adding to the volume of available funds. This was for the purpose of helping to arrest the violent deflation which was under way. The System reduced its discount rates and made large purchases of Government securities. Most of the funds released by the System, however, did not increase member bank reserves, but merely helped the banks to meet the foreign demand for gold, and the domestic demand for currency for hoarding, and at the same time to reduce the member banks* indebtedness to the Federal Reserve Banks. It was a period of tight not easy money in whieh the Federal Reserve System was attempting to moderate existing bad conditions. By the autumn of 193? the banks had reduced their indebtedness to the Federal Reserve Barks to a small amount, gold and currency had begun to pour back into the banking system, and funds began to accumulate in the form of excess reserves. In November 1933 member banks had $800,000,000 of reserves in exoess of requirements. Since that time the System has not added in the net to i t s portfolio, but on the contrary hi s substantially reduced i t . The con- tinuous growth of men- er bank reserves from 1933 to 1940 has been Sue chiefly to the inflow of p l l ^rom abroad and to a l©sser degree to s i l v e r purchases by the Government, ^he banks have beea out of dobt ana d l the f 'unis added to reserves have helpen to support the growing volume of deposits nd to build up an extraordinary volume of excess reserves. The excess reserves, therefore, are attributable chiefly to the gold inflow, As i s well <cno^nt much of the gold has come as th* r e s u l t of an export balance of have purchased. rade. *e have sold more goods than are As e creditor nation to which payments are constantly being made from abroad on interest «nd principal of indebtedness, we M)uld have to h a e an import balance of commodity trade i f we do not wish to be recipients of gold. Our t a r i f f policy, which was conceived at a time when t h i s wss a debtor nation, i s not adapted to our new condition aad i t s continuance has contributed in so small measure to the Inflow of gold. Much the greater part of erold, however, has come not in settlement of couaaodity trade balances, but in the om of capital seek- ing asylum from disturbed conditions sbroed. Large-scale Government expenditures financed to a eonside able extent by borrowing from sanies has also been e factor in the decline in r a t e s , because i t has created a large volume of deposits in the hands of * i • the public available for investment. Goveisiraont deficit ^inenclng ioes I t increase menbe* bank reserves, as i s sometimes stated. On the con- trary, i t creates ^epOAite and, therefore, increea 8 MM voliae of reui7"»<5 r^'srvj^ takea the 'JIB • a<i reduces excess reserve?, *t does, however, when i t b.rre«t&#i from banks, create & large relume of funds in the h^c's of tt;e public that presses on theinvestKent markat end tends to reduce yields on fixed interest obligations. All these factors have of e nip >iy of ftMldtb r ; tly contributed to tn© building up On the otaer h»nd, the leaand has not been adequate to absorb this gro*ing supply* Bsnfe loans here been in small volume o*i.ng to t i e low level of business aetivlty # ly because of scarcity of opportunity. investment h&» lagged behind, pert| «rtly because o^ eautloc duced by lack of assurance of succen ful business operations. in» The situa- tion tee been one in <vhieh persons vith alecuate credit standing were not borrowing, ^cile persons and institutions *?Mcb. wirini to borrow lacked the necessary basis of credit* A great de 1 aee been '.one by the Government to relieve distressed conditions of borrowers on "«r»s ^nd urban ho«e» and this has greatly improved not only the ntatas of the borrower, but slao the fiaancial condition i f the lenders. Meverthalees, the policy of Qov- erm^nt agencies to borrow at the low rates available to the Government fmdreland to the public at v&«t looks like very low rates to business leaders has been one of the factors dep easing money rates* While the rgency refinancing has done a gre-at deal of good from the public pcint view, «ven in the *leld of Governmsat credit agencies the ti".e has come - 7 - when the lending policy of these organiza:io«s should be carefully reconsidered in the light of changed conditions. Recent s The System hss orov*n continuously an awareness o* the of inflation sud has not been interested in low rates &. , particu- l a r l y on short xaonsyt An indication o f the System's - t t i t u ; e toward short-term openmerket rates i s £lTea by the "act that in 1939 i t allowed i t s sntire portfolio of |500t000,000 of Treasury b i l l s to mature in order to increase the supply of these b i l l s available end relieve the pressure that wes forcing these rates below a no-yield level. The Systesa has been interested in maintaining funds ^butt'-aat for all legitimate enterprises at 8 time t&en business recovery has been iscoiaplete. At the e^m© time i t has beea aware o^ the possibilities of inflation arising from an orer supply of ^un s« In 1935 the pov r to raise rest?Te requirements was obtained in order to absorb some of the res ires on whi h a urtber erpensioa could occur, ^he i&x i | ich Congress granti-ct to the Bo&rc. in tiiis matter wes limited to doubling the reserrefi, ^nd in 1936 and 1937 the System used this power to the full. In the spring of 1938 i t reduced re^uiraaeats by one-eighth •8- as a part of a general government program for dealing with deflationary developments at that time. But this reduction was of no particular con- sequence because the S./rtem retained the power to reabsorb the reserves thus released and because dirstribtrelon and further large gold imports soon increased bank reserves to a point where the System's power was not adequate to control them. The Chairman of the Board of Governors opposed the silver purchase policy, and tried to obtain authority for discouraging the inflow of foreign capital which was the ssost important tingle cause of the growth of excess reserves. The Board has constantly pointed out to Congress and to the public the need for adequate powers for controlling reserves. Particularly in i t s annual report for 1936 the Board stated emphatically that i t would not be in a position to discharge i t s responsibilities unless it were given adequate authority to deal with reserves. Prograa The important question, however, i s what can and should be done now in order to prevent further declines in money rates and to increase somewhat those rates that are excessively low. It would seen that the first necessary action would be to stake strong representations to Congress for obtaj ning additional powers over reserves. In the seoond place the System should recommend the discontinuance of the policy of silver purchasest thirdly, i t should give careful study to the question of gold policy, particularly after active warfare stops* I t would seen that for the present purchases of gold are principally from England and there would http://fraser.stlouisfed.org/ be ofnoSt. support Federal Reserve Bank Louis for depriving England of this means of obtaining necessary armament. After the war stops, however, the question of the gold pur- ehase polloy will have to be reconsidered in t he light of world condition* as they emerge from the conflict. The System's policy in regard to open-aer ket operations has for some time past been one of attempting to aaintain orderly conditions in the Government security market end indirectly in the entire capital market. Purchases of ^overnment bonds during the drop in the market after the outbreak of the or Id Me? hare been offset to a very large degree by •ales made at times when the sarket has been strong end the demand for securities has exceeded the supply. Some further reduction in securities may be desirable and feasible, but i t should be pointed out that i f the System*s earning assets f e l l to the point where i t did not earn enough t o meet i t s expenses, this would either diminish the System's finanoial independence or else stake i t necessary fbr i t to discontinue or charge for many services to business which i t now performs free of cost to them. So long as membership in the Federal Reserve System i s optional i t i s doubtful whether much ean be accomplished in fte way of service charges without encouraging some banks to leave the System, In the field of public finance It i s clear that in present conditions everything should be done to encourage such financing as i s done by borrowing to come out of savings and not through the creation of additional bank credit. This means that the System should use i t s influence with the Treasury in the direction of Issuing long-term obligations which mor* generally are purchased by investors rather than short-term obligations - 10 •which are irore likely to be absorbed by banks. It should encourage ths) issuance of savings bonds with current income coupons in order to induce small oarers who wish to have current income on their savings to purchase Government bonds* Finally, the System should consider the point wt which further governmental expenditures should be met out of taxation rather than frost boffowing. This should be done as soon as i t becomes clear thi-t further additions to theincOme stream through Government financing; no longer increases the nation*s real income and ie beginning to result in a rise in prices* It would appear that when the national incase reaches the level of 95 or 100 billion dollars i t will become safe to balanoe the budget out of existing or newly imposed taxation. Prevision far this situation should be made promptly since the formulation Q?.' tax measures i s a lengthy process, and oertain new taxes beooae fully effective only after a lapse of more than a year fron the time the laws are passed* The System should be prepared to make i t s views on this subject known to the Congress*