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November 6, 1947.
SQ\ Allan Sproul, President,
Federal Reserve Bank of Mew Tork,
New York (45) W. T.
Dear Allan:
I have your l e t t e r of October 24 regarding the proposed
increase in the discount rate. I agree that the action need not be
taken at this time. The present program of Treasury retiresifent of
Federal Reserve holdings by use of i t s cash balance and accumulating
surplus promises to exert considerable pressure on the market for the
next month or so. W can probably wait at least until an issuing
rate of 1-1/8 per cent on certificates has been announced.
The increase in the discount rate should be made when further
restraint seems necessary. If banks persistently borrow in order to
increase their reserves, or even to maintain the??, rather than s e l l
securities for the purpose, then there would be a strong case for increasing the discount rate.
As to the spiount of the next raise in the discount r a t e , I
think the rate should not be kept as close to the current certificate
rate as you suggest. I t seeras to me that the discount rate should be
designed to discourage banks from borrowing and, therefore, should be
somewhat above the prevailing rate for Treasury certificates, which
now seem to afford the raost popular current market instrument for the
investment of liquid funds.
You state that "the discount rate of the Federal Reserve
Banks is now in approximate balance with other rates in the money
market, including the rates on Treasury bills and certificates." For
many months, however, the discount rate was l/B per cent above the
prevailing rate on Treasury certificates. I believe that a difference
of 1/3 or 1/4 is proper. If the discount rate is the aaim as the
current market yield on certificates, then banks needing additional
reserves will find i t more profitable to borrow than to sell the certificates. Sales and subsequent repurchases involve some cost because
of the spread between buying and selling prices, conaaissions, etc. To
equalise the two alternatives — borrowing ar selling certificates —
a soaewfaat similar cost should be imposed on borrowing by a higher
discount rate.


Mr. Allan Sprcml, - #2

November 6, 1947

If banks do not want to hold certificates when the discount
rate is above the current certificate rate, they have three choices:
(1) They can sell their certificates to the Reserve System and hold
excess reserves; (2) they can sell certificates and buy b i l l s ; (3)
they can sell certificates and endeavor to purchase longer-term, higheryielding seearities. Ton mention only the last of these choices.
In the case of the first choice, if banks prefer to hold excess
reserve* in order to be prepared to meet current demands without the
necessity of borrowing, the restrictive effect is the saiae as if they hold
certificates. In either case the funds are not beinf: used for current
lending. I t is simply a question of whether the coranercial banks or the
Reserve Banks hold the certificates j no more or no less private credit is
in use. I t is true that excess reserves are more readily usable, but if
they are reduced the bank will impair i t s liquidity position and probably
will want to restore i t to the desirable point.
Fxrr banks to sell certificates to the Reserve System and purchase bills would, I believe, be a desirable development. This might
happen if the b i l l rate rises until i t reaches a lwvel in relation to
the issuing rate on certificates at which banks would prefer bills to
certificates. If the System held more certificates and less bills and
current bids by banks determined the b i l l rate, the market for b i l l s
would be much isore flexible, ks a means through which to effect tei^porary reserve ad,1t»tn»nts, an active and free market for weekly b i l l
issues is better than the use of certificates that have fixed coupon
rates and mature quarterly. At the saas time investment of a larger
portion of the System's holdings in certificates would reduce the volume
of unnecessary rollovers.
I see l i t t l e reason to be alamed about the possibility of
banks shifting from certificates to higher-yielding securities if the
discount rate is only slightly above the certificate rate. In view of
the fact that the amount of such securities available for purchase by
banks is linited, any attempt on the part of the banks to purchase them
would raise the price and reduce the current market yield. I t seeiss
doubtful that banks would want to follow this course in view of the general expectation of rising short-term rates and the consequent danger of
the loss of premiums on longer-term securities. If they do follow i t ,
the ease would be stronger for bringing about a further rise in the certificate rate in order to discourage such shifting.

Ifr. Allan Sproul, - #3

Hovsaiber 6, 194-7

Tour fear about banks purchasing longer—term securities instead of certificates is not entirely consistent with your aversion to
bringing about a "sledge hamraer adjustoent." l a cannot by the sarae
action cause banks to shift from certificates to bonds and also put excessive pressure on the btnfl rcarket.
these reasons, when an advance in the discount rate i s
made, I would favor an increase to a rate above the then current issuing
rate on certificates rather than to the saine level. The timing of the
action 3hould depend on the need for imposing further restrictions on
bani: credit expansion.
I t seesas to m that during the next few weeks our aim should
be to keep the banks under enou. h pressure to discourage further expansion in bank credit. Our powers to prevent, such expansion are limited
by the need for aaintainin^ a reasonable degree of stability and orderliness in the Government securities market, which is todteyof such great
inportance in our financial structure. Nevertheless, under the existing
economic situation we should not be held back by fear of bringing the
boom to an end by curtailing capital expenditures.
At the present stage soiae curtailment in expenditures i s vitally
iaportant. Overall expenditures — for consumption, capital purposes, and
to meet foreign requirements — are in excess of the productive capacity
of our existing industrial structure and labor force and seem to be increasing niore rapidly than production can possibly be increased. Further
expansion in the volume of bank credit and in the velocity of th* existing
aoney supply can only add to the pressure of expanding expenditures on the
limited supply of goods and services and result in further price rises.
Heavy capital cosmitioBnts at this tiise not only contribute to inflationary
pressures but also threaten serious problems of adjustment for the future
when raore normal relationships between demand, supply, and prices are
restored. 1 e should not worry too much at this stage about bringing a
downward pressure on prices. In fact some decline would be beneficial.
There are three general lines of action that might be brought
into use for checking inflation. *Rie f i r s t of these, applied with a high
degree of effectiveness during the war, is the use of direct controls.
While there may be a few strategic points at which such controls may now
be applicable, I a sure you will agree that, in general, imposition of
an effective harness of direct controls at this tlos is not feasible.
Fiscal measures afford the second means of approach to the
problem. Again, while a l l possible pressu es should be exerted toward
maintaining a high level of taxes and reducing expenditures for avoidable or deferable purposes, we must recognise that there is l i t t l e hope
for measures in this field that will be sufficiently restrictive.

Xr. Allan Sprcral, - #4-



In the monetary field sorae additional restrictions, admittedly of limited effectiveness, can be imposed. W need not be
fearful about bringing the boom to an end. Further expansion oi bank
credit trill help to extend the boora unduly and to create serious
problems for the future. The purpose ol action should be to end "the
troom, -which is now of dangerous proportions. BM quicker i t can be
ended, the nore chance there is for avoiding an aftermath of prolonged
and disastrous depression.
This discussion is out of focus with the importance of the
subject of this letter, namely, whether the discount rate increase
should be l/8 or 1/4 per cent, but i t has a bearing on our attitude
toward all policies that may be followed in the roonetary field in
coioinc weeks. For this reason I an setting forth my views at some
Sincerely yours,

M. S. Fccles,