View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

FEDERAL RESERVE BANK

-

OF NEW YORK
December 10, 1942,

The Honorable Marriner S. Eccles,
Chairman, Federal Open Market Committee,
c/o Board of Governors of the Federal
Reserve System,
Washington, D.C.
Dear Chairman Eccles:
Enclosed is a memorandum of views on Credit Policy and Treasury
Financing which I have prepared in anticipation of the meeting of the Federal
Open Market Committee, to be held on Monday, December L^th. I am sending
a copy of this memorandum to you, and to the other members of the Committee,
so that you may have an opportunity to read it before the meeting and in the
hope that it may facilitate discussion of our problems at the meeting.
Yours faithfully,

^

CTORY
BUY
UNITED
STATES
WAR
SAVINGS

NDS
AND
STAMPS




AllanySproul,
Vice Chairman, Federal Open
Market Committee.

CKEDIT POLICY AMD TREASURY FINANCING.

It is essential that during the period between the present Victory Loan
campaign and the next major Treasury financing—now scheduled for February 194-3—
there be a further determination of policy with respect to member bank reserves
and Treasury borrowing methods. After a year of active participation in the war,
and a year of trial of fiscal and credit policy under war conditions, the Treasury
and the Federal Reserve System should be able to plot a general course for 194-3.
Member Bank Reserves.
Two main problems present themselves with respect to the immediate question of member bank reserves:
1. Is there some minimum volume of excess reserves which must be
maintained to help secure the success of Treasury financing during the coming year, and have we reached that minimum at $2 1/2
billion of excess reserves for the country?
2. How are the banks to be supplied with the additional reserve
funds they will need during 194-3 so that they may do their part
in financing the deficit?
Thus far we have been steering a course somewhere between the Treasury1s
desire for a commitment as to the maintenance of excess reserves at a fairly high
figure, and our desire to avoid such a commitment and to do the job with the smallest possible volume of excess reserves. Since the middle of this year, however,
we have in fact maintained excess reserves of all member banks between $2 billion
and $2 1/2 billion, so that we have given the Treasury about what it wanted, and
what appeared to be required in view of the financing methods used. (Large offerings for immediate subscription without prior preparation or an organized campaign
to sell to others than banks.)
This has placed the System in a somewhat contradictory position with respect to its own banking and credit policies. Our program has been one of urging
all banks to invest their funds in Government securities to the fullest possible
extent, and we have made it profitable and practically riskless for them to do B O .
Such a program is compatible with the idea that the required ratio of excess reserves to bank buying of Government securities is a gradually diminishing one. It
will not fit very long nor very well with a program of maintaining a constant high
level of excess reserves. (Our effort to maintain excess reserves at a large
fixed amount has already placed us in competition with the banks for short-term
securities, thus running counter to our policy of urging the banks to keep fully
invested.) If we are to adopt the Treasury views on excess reserves, we should
try to make our policy more nearly conform to these views.
It is only recently that we have had an explanation of these Treasury
views. It seems to be that the provision of reserve funds (open market operations)
should not wait for pressure to be expressed in the market, but should be based
upon consideration of prospective reserve needs of banks. It is not enough to rely
upon open market operations (and borrowing ? ) automatically supplying the banks
with such reserves as they need, when financing of the present magnitude is contemplated, because the expression of these needs in the market may not come until
the financing is under way, and market pressure during a financing period, even

though taken care of as quickly as possible by the Federal Reserve System, would
http://fraser.stlouisfed.org/
have
an unfavorable effect upon subscriptions. There should, therefore, be an
Federal Reserve Bank of St. Louis

2.

advance determination of the probable amount of reserves that the banks will need
to make the financing a success, and the banks should be supplied with these reserves prior to the offering of the issue.
This reasoning may be questioned on its fundamental assumption that a bank
must have excess reserves before it will be able and willing to subscribe to new
issues of Government securities at existing rates of interest, and that some specific amount of excess reserves can be determined for all banks which will make each
financing a success. This conception denies one of the chief reasons for the existence of a central banking system, which is to give assurance to its member banks
that in time of expanding credit needs for approved purposes, their reserve positions can and will be maintained without the pressure of higher interest rates.
It is a reversion to the idea that each individual bank can and should act as its
own central bank by carrying its own excess reserves. It draws heavily upon the abnormal experience of the past decade and it requires that some of the abnormalities
of that period continue. It is instructive, perhaps, that no other country finds
it necessary to maintain the equivalent of our large volume of excess reserves in
order to secure the success of its war financing and without submitting to rising
rates of interest.
So long as the method of financing which had developed during the lush
period of excess reserves was being used (one or two day offerings for quick subscription and allotment), we did face the danger of declining excess reserves
colliding with increasingly large Government security offerings with unfortunate results. Now that transition to the periodic drive method is taking place, however,
the case for doing the job with the minimum amount of excess reserves is greatly
strengthened. If the shrinkage in excess reserves is not so abrupt as to cause disturbances in the market, and if cushioned by open market operations, it could
probably proceed considerably further without materially affecting interest rates
or the response to new issues of Government securities.
Such a program would contribute not only to our primary objective of selling the maximum amount of Government securities outside the banking system; it also
would support the only slightly less important objectiveof spreading the load within
the banking system. So long as a large volume of excess reserves is maintained,
with no possibility of control of the location of these reserves, this load will be
spread most unevenly. The New York City banks, for example, will tend to use all
of the reserve funds which are supplied to them, while excess reserves pile up beyonc
any need and without use in thousands of banks in other parts of the country.
Now that we are developing a selling program for our Government security
offerings adequate to the size of the offerings, a better method than the indiscriminate maintenance of some fixed volume of excess reserves is becoming available
to assure adequate banking support—by all banks—of the Treasury's financing. It
is a compound of two elementss
1. Continued assurance from the central banking system that adequate
reserves will be provided at all times;
2. Further education of all commercial banks, or pressure upon them,
to do their share in the program with a diminishing volume of excess reserves. (I think it can be demonstrated that over a period
of months the volume of Treasury securities absorbed by the banks
has been a steadily increasing proportion of the amount of excess
reserves held by the banks.)




3.
The first step is to get the banks, generally, to abandon the continuous
holding of substantial amounts of excess reserves and to become more fully invested,
even though they may fear that a considerable part of the current increase in their
deposits is only temporary. As the banks learn that they are incurring no great
risk in adopting a policy of keeping fully invested, the next step is to convince
them that by active use of War Loan deposit accounts they can safely subscribe for
new securities in amounts considerably greater than their excess reserves at a
given time. The final step is to break the barrier against bank borrowing from
the Reserve Banics so that a bank which has subscribed for Government securities in
excess of its surplus funds, through use of the War Loan deposit procedure, will
not be under pressure even though the Treasury deposit is withdrawn before the
bank's deposit position is restored in other ways.
These things are harder to do than maintaining a large volume of excess
reserves. They will pay dividends, however, in keeping up the pressure for sales
to non-bank investors, in bringing home to all of the banks of the country their
individual responsibility for the success of the Treasury's financing program, and
of permitting the Federal Reserve System to follow a credit policy which will be
both effective during the war and appropriate to the conditions which may be expected in the post-war years. These things can be done by a concerted effort on
the part of the Federal Reserve System, the Victory Fund Committees, the American
Bankers Association, and the various State bankers associations. We should now
determine what is the approximate share of each Treasury issue to be taken by the
banks in each Federal Reserve District$ we should indicate to the banks alternative
methods of calculating what their individual subscriptions ordinarily should be;
and we should make sure that they understand that they can do their part without
undue risk.
If this program, which envisages a further gradual decline in the volume
of excess reserves, is accepted, we shall still have to supply a very large amount
of reserve funds to the banks of the country. The Board's recent estimates indicate that, if the banks continue to take approximately 60 per cent of the increase
in the National debt as in recent months, bank holdings of Government securities
will probably increase from about $40 billion on December 31, 1942, to something
over $70 billion a year later, and that, largely as a consequence of this increase
in their investments, their deposits will rise from $72 billion to $107 billion.
The increase in the amount of currency outstanding during the year is estimated at
$4- billion. An increase of $8.3 billion in reserve funds is estimated to be necessary during 194-3 to support these changes, even if all existing reserves were
absorbed during the year. These estimates are probably conservative, for, although
it is to be hoped that the banks will not have to take as much as 60 per cent of the
increase in the National debt, the actual increase in the debt may be greater than
the $65 billion estimated, if war expenditures reach the rate of $100 billion now
discussed, and furthermore the increase in currency outstanding may be more than
$4 billion.
How are the banks to be supplied with these additional reserve funds? In
an earlier memorandum (Excess reserves, Reserve Requirements, Credit Policy and
Treasury Financing - June 1942) it was suggested that the answer is a combination
of lowered reserve requirements, open market operations, and bank borrowing. Reserve
requirements have already been lowered at central reserve cities, large open market
operations have been undertaken, and the way has been prepared for member bank borrow
ing through the establishment of differential discount rates on advances secured by
short-term U. S. Government obligations. All of these methods can still be used.



i,

,

.

.

.

-

,

.

.

•

•

•

.

i

'

.

•

It ie not practicable at present, however, further to reduce reserre re*
quiremente* The requirement in central reserve citie3, where the pressure is still
greatest, is probably low enough* ?&* basis for reduction in other classifications
does not exist so long as these banks still have over $2 billion of excess reserves 1
which they Are not using even under present favorable conditions* When that situation has been corrected, tone farther adjustment of reserve requirements, which
would be appropriate to the war period and have due regard for the difficulties we
shall face in the post-war period, could be made, the following figures are again
suggested as limits for reductions to be made in reserve requirements during the war;
Percentages of Reserves to be Maintained against •

Central ReserveCity Banks
20
5

Demand Deposits
Time Deposits

Reserve City . Country
Banks
Banka
16

The approximate amount of reserves which would be released by reductions
to these levels would be as follows (based on deposits in September, 1942, the last
published figures)t
;

•

'

.

'

.

.

'

•

. .

.

.

'

'

Central Reserve City Banks
Reserve City Banks
Country Banks , ;

"

i •

• • ; '

• -

•

(Millions of Dollars)
& 10
710
250

• •

Open market operations should continue, meanwhile, to be the principal
method used in making additional reserve funds available to the banks, In view of
the present distribution of excess reserves, this is a more selective prooess of
providing reserve funds than a reduction in reserve requirements, and the dosage can
be mors easily regulated* ,
• The open market method of providing reserve funds has its problems, however, particularly when combined 11with a policy of maintaining substantial excess
reserves and a "pattern of rates* Ac the amounts involved have Increased, the dlffi
culties of our purchase program have increasedj it is no longer easy at all times
to buy the amounts of short-term Government securities required, and at the same time
to maintain a substantial fixed volume of excess reserves. The banks are being urgsc
to keep fully Invested, and are provided with additional funds in excess of their
needs to enable them to subscribe to and to hold new issues* This naturally conflicts with their use as a source of supply for System account purchases. And the
selling of non-bank holders tends, increasingly, to take the form of sales of premium bonds, thus forcing us to validate a profit accrued over a long period of
declining interest rates.
This situation has led to suggestions that our purchases, for the purpose
of putting reserve funds into the market, should be made direct from the Treasury<
This would enable us to buy short-term securities, at par, in whatever amounts are
required, and might also enable us to accelerate purchases before each Treasury
financing (to build up a reservoir of reserve funds) and to feed into the market
the amounts the market would absorb after the financing is completed.
Judgment on this question, it seems to me, must be based largely on the
importance which we ascribe to maintaining the thin H u e between present financing
methods and direct financing of the Treasury by the central bank. We should not be
(ggjjj.) involved in some of the present hokoa

bythe much larger profits which the banks will enjoy if we continue our


present program. It is primarily a question of public reaction, which I think would
be bad and might be disastrous. Even in England, where there was betterprecedent
for the practice, central bank purchases of Government securities direct from the
Treasury have been limited and confined to special circumstances. To preserve the
form of ordinary borrowing, the fairly transparent Treasury deposit mechanism has
been created. Another question, directly related to this primary question, is the
possible end of the road of direct purchases, except such as those which have already been made to meet temporary situations. If the Federal Reserve System were
to accumulate a large portfolio of Government securities purchased direct from the
Treasury, ammunition would be provided for those who have long advocated that we
finance the Government without interest. Once we cross the present thin line, I
should be afraid that we might have to go down that road.
Another means of helping to relieve the situation, which is more nearly
in accord with our established practice, does exi§t, however,- and would be useful,
particularly if the policy of gradually declining excess reserves is adopted.
First, there would be a substantial increase in offerings of bills (and of certificates) paralleling the need for additional reserve funds, so that we could supply
these funds more largely through purchases of very short paper. Second, the Treasur
could continue the temporary use of the special certificate of indebtedness, to
anticipate the receipt of funds from security offerings, as it did prior to the
December financing. This would have the effect of putting funds into the market
before a financing and taking them out after the financing by an almost automatic
process. Such an operation would not disturb the market as would Federal Reserve
purchases from the Treasury and subsequent attempts to sell to the market, and it
would conform to the pledges given when the authority to purchase Government securities direct from the Treasury was granted by the Congress.
Finally, borrowing by the banks should not be dismissed as a supplement
to other means of providing reserve funds. It is not suggested that banks would
subscribe for the necessary volume of Treasury securities at present rates if they
had to obtain all or a substantial part of the necessary reserve funds through
borrowing. It is suggested that borrowing is a semi-automatic method of providing
reserve funds for individual banks exactly when and where the funds are needed,
and that a substantial amount of reserve funds could steadily be made available to
the banks through this window, even though individual bank borrowing was temporary
in character. (It is recognized, of course, that banks which hold Treasury bills
will probably "borrow* at the bill window through use of the repurchase agreement.)
If it were arranged to have some of the leading banks of the country set the fashion
so that no discredit would adhere to borrowing, it is believed that the banks of
the country would readily resume the habit.
Treasury Borrowing Methods.
The apparent success of the Victory Loan campaign, which is now in progress
should establish this method of borrowing larger amounts less frequently than in the
past, as standard practice. Our experience thus far in the present campaign raises
certain questions which should be discussed with the Treasury before another campaigr
is undertaken.
1. The question of organization is still important. Organization in the
various districts has been, to a considerable extent, a matter of improvisation as
we went along. This will be tightened up before the next drive. Effective organization at the Treasury is also/to be accomplished, assuming that the Secretary of the
3

still


6.
Treasury and the Under Secretary cannot give their continuing attention to this one
phase of their work. This seems to be a sore spot, but more effective National
direction of the promotion and sale of Government securities should still be recommended.
2. An allied problem is the expense of the sales and promotional campaign
necessary to the success of the drive method. The Treasury appears to have been
reluctant to request appropriations from Congress to pay some of the costs of selling its securities, and reluctant also to engage in those negotiations concerning
advertising and other promotional methods which a complete sales program will require. While it is believed that the services of salesmen can be retained on a
voluntary basis, except for out-of-pocket expenses, it is not believed that the
Treasury can or should continue to depend entirely on contributions from banks and
corporations for its sales promotion work. Neither should it depend on the Federal
Reserve Banks. This is a legitimate part of the cost of selling a very large amount
of Government securities. The funds should be provided by the Treasury, and the use
of the funds should be directed by the Treasury working through the Federal Reserve
Banks and the Victory Fund Committees.
3. The length of time between Victory Loan campaigns will determine to some
extent the continued effectiveness of the volunteer sales organization and the continued response of investors. It is suggested that bi-monthly drives are too
frequent for the best results and that, specifically, every attempt should be made
to raise enough money in the present drive so that the next Victory Loan campaign
can be postponed until April 194-3. If necessary, this suggestion would include extending the present drive into the first week of January in order to take advantage
of the existing momentum of the selling group and of the January reinvestment demand.
If this is to be done, it shoald be decided promptly so th: t plans may be made for
the extended drive. A study to show where and how the Treasury might finance its
requirements until April 194.3f in the absence of another Victory Loan campaign prior
to th-.t monthf should be made immediately.
J+. Separation of bank offerings from non-bank offerings should also be considered. The bank offerings in the December drive have tended to get lost in the
crowd, and the Victory Fund Committees in any case have little to do with sales to
banks. Offerings to banks can be used to fill in the periods between Victory Loan
campaigns and the drives could then be directed solely at non-bank investors. There
is an advantage also in making rather frequent offerings of securities to the banks
in not too large amounts. It fits in well with the idea of a gradually diminishing
volume of excess reserves and of educating the banks generally to undertake to keep
fully invested. And it would afford a better opportunity to adjust bank borrowing
downward to the extent that drives for non-banking funds are successful.*
5. In addition to a National quota, the fixing of quotas by Federal Reserve
Districts and within districts has been discussed. It is suggested th t the fixing
of such quotas for a drive aimed at non-bank investors is very difficult on any
reasonable and continuing basis and that it is more likely to impede than to accelerate the sales effort. On the other hand, the fixing of quotas by districts and
*To encourage a further use of War Loan deposit accounts, and possible bank borrowing
to subscribe to Government securities, consideration should again be given to the
question of the requirement of a reserve against Government deposits and the Federal
Deposit Insurance Corporation assessment against such deposits. It would seem that
the latter, at least, should be eliminated since these secured deposits create no

risk for the Federal Deposit Insurance Corporation and since this would facilitate


7.
oven within districts for bank subscriptions is a much less difficult job and is
more nearly comparable to fixing an underwriters participation than to fixing a
sales quota. It would have the advantage of helping to spread the load within
the banking system and of impressing upon individual banks their responsibility
for the success of each financing.
Undoubtedly other questions will have arisen in other districts, or
will arise during the remainder of the December campaign, and should be added to
this list of questions to be discussed with the Treasury.
Whenever the present drive ends, immediate steps should be taken to begin organizing for the next drive. Even three months is not too long for the
thorough preparation which will be needed if we are to increase substantialiy
the amount of funds obtained from non-bank investors.

December 10, 1942,