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BOARD OF OF GOVERNORS THE FEDERAL RESERVE SYSTEM Office Correspondence To Chairman Eccles Ijj^i Mr. Goldenwelser/ Date March 19,1936 Subject: I attach a report of the meeting of the economic s t a f f with members of the Board, which was held on Monday, March 9* This report was prepared by Mr. Longstreet* CONFIDENTIAL Notes on meeting of March 9> 1936 INSTRUMENTS OF FEDERAL RESERVE CONTROL The framers of the Federal Reserve Act had two chief purposes i n mindi to provide an e l a s t i c currency and to avoid the pyramiding of "bank reserves, which, "by concentrating reserves in New York City, had been an important causal factor i n monetary panics of the sort that occurred i n 1907* In i t s lending provisions the Federal Reserve Act was similar to Bank of England practice, "but i t adopted the Reichsbank system of requiring a minimum gold r a t i o . The chief instrument of control i n the Act was considered to be the discount rate, while b i l l rate was considered important as an instrument of developing an American acceptance market. Buying rate on acceptaftces From the start the acceptance market has "been fostered by the Federal Reserve System. Mr. Warburg, a member of the f i r s t Board, had received h i s training under the German school of banking, and he f e l t that a well developed acceptance market was necessary for control. A v e i l of mystery has surrouhded the b i l l market, chiefly because of the erroneous b e l i e f that farmers and other makers of b i l l s d i r e c t l y benefit from a low b i l l rate, a broad b i l l market, and from Reserve bank purchase of b i l l s . This mystery should be dispelled and the^ b i l l rate, i although i t has not received the consideration that has been accorded the discount rate, should be reviewed and determined just as carefulljp Changes i n the b i l l rate have always been i n i t i a t e d by the Reserve banks. After review by the Board, which usually set a minimum* the Reserve banks discussed the proposed change with operators i n the market and the rate f i x e d was a result of compromise and trading. Changes i n the b i l l rate have been discussed with operators because i t has usually set the rate f o r the market as a whole. The importance of the b i l l rate can be i l l u s t r a t e d by experience i n the autumn of 1928. was adopted. At the beginning of that year a p o l i c y of restraint The System sold about $U00,000,000 worth of securities during the f i r s t f i v e months of 1S28 and the discount rate at New York and at most of the other Reserve banks was progressively raised from 3 l / 2 to 5 percent by the end of July. During the same period the New York Reserve bank ! s buying rate f o r 90~&ay acceptances was raised from 3 l/^ to b if2 percent f This l e v e l was below the discount rate and below the rate i n the market, but i t was f e l t that the b i l l rate did not affect the money market as a whole and that the benefit df the r e l a t i v e l y lotr rate accrued to farmers. As a result of t h i s policy the Reserve System's holdings of b i l l s more than doubled i n the l a s t four months of 1928, increasing from about $200,000,000 to $500,000,000. These additional funds acquired by the market were available not only to farmers, but f o r any purpose for which the market wished to apply them. There was a spurt i n a c t i v i t y i n the security market, brokerb* loans increased, stock prices rose i n the midst of what was presumably a p o l i c y of r e s t r a i n t . The fact that funds acquired by the market through the sale of acceptances to the Reserve banks were available f o r any purpose was not clear to the managers of the System at that time either i n New York or Washington* -3Another example of the importance of the "bill rate occurred i n the f a l l of 1931t After England*s departure from the gold standard i n September of that year gold began to move out of the United States i n large volume. a period of six weeks we exported over $700i000,000 of gold* In This loss subjected the banking system to additional strain during a deflationary period when bank f a i l u r e s were numerous# The System turned orthodox; the discount rate of the New York bank was increased from 1 1/2 to 3 1/2 percent and the b i l l rate from 1 to over 3 percent. Those high rates no doubt contributed to an accentuation of the deflationary movement* Tra~ d i t i o n a l central banking practice prescribed that a run on a country*s gold bo arrested by higher rates and this partly explains why rates wero raised. Another important factor f however, was that the Glass-Steagall Act had not yet been passed and Government securities were not e l i g i b l e as c o l l a t e r a l against Federal Roserve notes. The amount of Federal Reserve notes i n c i r c u l a t i o n had increased markedly during the hoarding of 1931 and as cover for these notes the commercial paper held by the Reserve banks was inadequate. Consequently a large amount of gold had to be retained, Discount rate p o l i c y The importance of discount rate was early recognized* Discount rate i s usually less than short-term rates in the open'market as well as rates banks charge their customers for loans* not a penalty rate* In this sense discount rate i s I t has usually been possible for banks to borrow from the Federal Reserve bank and to relend at a p r o f i t . This i s not the practice, however, because of the attitude toward borrowing, which shows on the statement of the indebted banks, thus creating an unfavorable impression. -ItTho Reserve "banks u s e d t o t a k e the l e a d i n d i s c o u n t r a t e changes, b u t i n 1927 t h e B o a r d assumed an a c t i v e p a r t Chicago b a n k . i n f o r c i n g a reduction at the I n May o f t h a t y e a r an e a s i n g p o l i c y was adopted l a r g e l y a i d European c o u n t r i e s i n t h e i r post-war r e t u r n t o the g o l d to standard* A number o f f o r e i g n c o u n t r i e s h a d j u s t r o t u r n e d t o g o l d and many more were p r e p a r i n g t o do so* t h e open market* The Reserve banks f i r s t p u r c h a s e d s e c u r i t i e s -Then i t was agreed t h a t i n J u l y t h e Kansas C i t y Resorvo bank s h o u l d t a k e t h e f i r s t stop i n a g e n e r a l r e d u c t i o n i n discount rates, as a g e s t u r e t h a t t h e p o l i c y was b a s e d i n l a r g o p a r t 03a a g r i c u l t u r a l siderations. on con- Governor B a i l e y o f t h a t bank, when asked l a t e r why ho r e d u c e d the d i s c o u n t r a t e , replied, Ben S t r o n g t o l d me t o " * " F o r a good and s u f f i c i e n t reason — bocause The manner i n w h i c h Reserve p o l i c y was determined i n t h o s e days i s w e l l d e s c r i b e d i n a r o c e n t book b y K a r l R . Bopp, " A g e n c i e s o f F e d e r a l Reserve entitled Policy". The F e d e r a l Reserve Bank o f Chicago was not i n f a v o r o f t h i s and r e d u c e d i t s r a t e o n l y under c o m p u l s i o n b y t h e B o a r d . Senator policy Glass o b j e c t e d t o t h i s c o m p u l s i o n on t h e grounds t h a t t h e B o a r d was e x c e e d i n g i t s authority* I n 1919» however, Senator G l a s s , a c t i n g i n h i s c a p a c i t y as S e c r e t a r y o f t h e T r e a s u r y , had r e q u e s t e d t h e A t t o r n e y G e n o r a l t o r e n d o r an o p i n i o n as t o whether o r n o t t h e l a w gave t h e B o a r d t h e power t o a change i n d i s c o u n t r a t e s , a t t h o same t i m e p r e s e n t i n g arguments as t o why ho thought t h o B o a r d d i d have t h o a u t h o r i t y * b y t h e A c t i n g A t t o r n e y G e n e r a l t o the e f f o c t poTTer t o f o r c e a change i n d i s c o u n t r a t e s . t h i s power became e x p l i c i t require An o p i n i o n was r e n d e r e d t h a t t h o B o a r d d i d have tho W i t h tho B a n k i n g A c t o f 1935 i n t h o s t a t u t e s and now t h o B o a r d must r e v i e w and determine t h e d i s c o u n t r a t e s o f each Resorvo bank every f o u r t e e n d a y s , or oftenor i f deemed necessary* -5Dlrect action The B o a r d a l s o p l a y e d an important p a r t i n discount rate p o l i c y i n e a r l y p a r t o f 1929» ^hen the Ne\7 Y o r k R e s e r v o hank f o r a number o f s e c u t i v e weeks v o t e d i n c r e a s e s con- i n i t s d i s c o u n t r a t e from 5 to 6 p e r c e n t , w h i c h wore not approvod by the B o a r d . d i r e c t action* the The B o a r d reconnended a p o l i c y The r o l a t i v e m e r i t s o f r a t e i n c r e a s e s as opposed t o a c t i o n have b e e n a n a t t e r o f c o n s i d e r a b l e controversy. b e g i n n i n g the R e s e r v e Systen has employed d i r e c t of direct Fron the very a c t i o n , and c o n t a c t with banks on numerous n a t t e r s a f f e c t i n g the b a n k i n g s y s t e n consunes a l a r g e share o f t h e t i n e o f t h e o f f i c e r s o f t h e Reservo b a n k s . After a d o p t i o n o f t h e p o l i c y o f d i r e c t a c t i o n the New Y o r k bank on o c c a s i o n s oallmL banks t o t a s k f o r b o r r o w i n g f r a n the Reserve and r e l e n d i n g i n the n a r k e t . The pov/ers o f p e r s u a s i o n o f t h e New Y o r k bank were not e f f e c t i v e and t h e New Y o r k banks r e f u s e d t o l i s t e n # c o u l d b a r neriber'banks f r o n r e d i s c o u n t i n g i f F e d e r a l Reserve f u n d s i n s p e c u l a t i o n . discount f o r very The New Y o r k bank they p e r s i s t e d i n using B u t t h e Hew Y o r k bank c o n t i n u e d t o such banks and a f t e r a t i n e r e f u s e d t o p a r t i c i p a t e f u r t h e r the d i r e c t a c t i o n p o l i c y . without e f f e c t . Brokers1 Ihile it l a s t e d t h i s p o l i c y was n o t totally l o a n s i n May 1929 were a t about the snne as i n F e b r u a r y , w i t h s t o c k p r i c e s i n the p e r i o d a l s o l e v e l l i n g o f f . o f t h e o t h e r R e s e r v e banks v i g o r o u s l y p u r s u e d t h e p o l i c y o f d i r e c t level Sone action. Perhaps t h e f a i l u r e o f Net? Y o r k t o do so was p a r t l y a t t r i b u t a b l e t o the d i s f a v o r t h a t had r e s u l t e d f r o n i t s a p p l i c a t i o n i n o t h e r d i s t r i c t s , such as i n D a l l a s , where t h e r e had b e e n i n 1925 a b a n k e r s 1 Governor T a l l o y f r o n o f f i c e . that c a n p a i g n t o renove The D a l l a s banks, however, were anong those stood the depression b e s t . in Failure of diroct action after May was due to lack of power, lack of cooperation, and lack of doternination. The Board d i d not have the power to force the Reserve banks to cooperate i n direct action nor did i t have the deternination to carry through i t s policy, for i t reversed i t s e l f . In May David Lawrence wrote i n h i s d a i l y newspaper column that the System was about to abandon diroct action, a statement that was inspired by a neriber of the Reserve Board. the l i d was off* The general tenor of the statement was that In relaxing pressure the reasons were given that diroct action had already been successful, that brokers 1 loans and borrowing for stock exchange purposes were down, and that the market was approaching a period of heavy financing. Discount ratos at the Federal Reserve banks wore almost uniformly 5 percent i n May 192$, conpared with k percent i n the oarly part of 1928. The mistake of the Board appears to have been the b e l i e f that rates at the Reserve banks could be kept low i n face of a rapid r i s e i n rates i n the New York noney market. Funds were moving to New York to bo used i n stock speculation. After the May reversal of policy brokers 1 loans began to increase sharply. Fron the end of May to the middle of Soptenber the increase amounted to about $1,300,000,000. During the sane period security prices increased by sonething l i k e 20 percent. Had the policy of direct action been carried through i t i s doubtful i f t h i s r i s e could have occurred, although the 1928 and 1929 developments nay have had their origins in the easing policy of 192U# In 192^ ovring largely to an import of gold fron abroad, reserve balances of nenber banks had increased fron about $1,900,000,000 to a l e v e l of $2,200,000,000* A l l of these added reserves, ~7~ which were f u l l y u t i l i z e d by nenber banks i n expanding their loans and investments, l a i d a foundation for subsequent dovelopnents. The whole period fron I92U to 1929, however, i s one of great controversy, and i t is better to f e e l that nono of the views rogarding this period aro conclusive® Or>en-»narket operations The powers of the Reserve banks to buy and s e l l securities i n tho open narket, granted i n the o r i g i n a l Federal Reserve Act, were not considers ed of very great importance at the t i n e . For sone years there was only a vague understanding of their purpose, which was currontlj7, explained by such phrases as, "to keep i n touch with the narket" and "to nako the discount rate e f f e c t i v e " . In 1913 there were p r a c t i c a l l y no Governnent securities available for purchase by the Reserve banks. Most of the Governnent securities outstanding were held by national banks as backing for national bank notes. At tho outset tho 5yston , s purchases were confined to warrants and were nade i n order to keep up earnings. This point of view was perhaps a l l right i n those days because tho operations of the Federal Reserve Systen wore of snail magnitude and not inportant i n their effect upon general noney narket conditions. Later with the developnont of the acceptance narket and the heavy Treasury financing that appeared during the war, open-narket operations of the Systen assuned a new importance. During the period of war financing and the post-war boon i n 1919 and 1920 discounts and consequently earnings at the Reserve banks were large. With tho collapse of 1921, however, discounts at the Reserve banks f e l l fron a l e v e l of $2,800,000,000 to about $400,000,000. Earnings at the Federal Reserve banks as a consequence declined sharply and the banks began to purchase securities on the open market i n c o n p o t i t i o n w i t h ono a n o t h e r . I n o r d e r to a v o i d t h i s competition and t o r e g u l a r i z e S y s t e n p u r c h a s e o f s e c u r i t i e s w i t h o u t "upsetting T r e a s u r y finance, Parker G i l b e r t , then U n d e r - S e c r e t a r y o f the T r e a s u r y , and Governor S t r o n g o r g a n i z e d a committee o f f i v e g o v e r n o r s o f t h e Reserve hanks t o s u p e r v i s e t h e S y s t e n f s open-narket activities* But e a r n i n g s c o n t i n u e d t o p l a y a l a r g e p a r t i n t h e p u r c h a s e s e c u r i t i e s u n t i l Mr. M i l l e r l a t o r proposed that tho p r i n c i p l e s of stated in tho l a w f o r d e t e r n i n a t i o n o f t h e d i s c o u n t r a t e "be f o l l o w e d w i t h r e s p e c t t o open-market o p e r a t i o n s * T h i s p r i n c i p l e was adopted b y t h o B o a r d and p u b l i s h e d i n i t s a n n u a l r e p o r t f o r 2$23 follows: "That tho t i n e , nannor, c h a r a c t e r , and volume o f openn a r k e t i n v e s t n o n t s p u r c h a s e d b y the F e d e r a l Reserve banks be governed w i t h p r i m a r y r e g a r d t o the a c c o r m o d a t i o n o f connerce and b u s i n e s s and t o t h e e f f e c t o f s u c h p u r c h a s e s o r s a l e s on the g e n e r a l c r e d i t s i t u a t i o n . " T h i s f o m u l a i s vague, b u t perhaps t h e r e i n l i e s its strength. exact f o r m u l a i s n o t l i k o l y t o b e -understood by t h e p u b l i c , t o o n u c h t o be a c c o m p l i s h e d b y the c e n t r a l b a n k . w i t h i n the S y s t e n t h a t tho o b j e c t i v e i s It w h i c h nay expect is generally to pronote business An understood stability. The n e n b e r s h i p o f t h e open-narket c o n n i t t e e was r a i s e d f r o n f i v e all t w e l v e g o v e r n o r s i n 1930® This connittee received statutory i n t h e B a n k i n g A c t o f 1933* as p r o v i d e d i n section 12(a). i n c o r p o r a t e d i n the law the B o a r d ' s p r i n c i p l e acceptance That A c t t h a t open-narket to also operations were t o b e governed w i t h a v i e w t o a c c o n n o d a t i n g connerce and b u s i n e s s and w i t h r e g a r d t o t h e i r b e a r i n g on t h e g e n e r a l c r e d i t situation* F e d e r a l Reserve bank c o u l d s t i l l r e f u s e t o p a r t i c i p a t e i n open-narket o p e r a t i o n s reconnended under the l a w . t i o n s were t o o r i g i n a t e The l a w i m p l i e d t h a t recommenda- i n the c o n n i t t e e , b u t i n p r a c t i c e t h e o f p o l i c y was l a r g e l y i n Washington o r New York* A formulation New i n s t r u m e n t s o f c o n t r o l s i n c e 19^3 The B a n k i n g A c t o f of control, all 1933 c o n f e r r e d upon t h e B o a r d f o u r n o v e s s e n t i a l l y b a s e d upon t h e p r i n c i p l e instrunents of d.irect action. I t was p r o v i d e d t h a t when undue u s e was b e i n g nade o f b a n k for the s p e c u l a t i v e commodities, conditions it or f o r carrying of or t r a d i n g i n s e c u r i t i e s , credit r e a l estate, any o t h e r p u r p o s e i n c o n s i s t e n t w i t h sound credit s h o u l d bo r e p o r t e d t o t h e F e d e r a l R e s e r v e B o a r d b y t h e R e s e r v e b a n k and t h e B o a r d c o u l d suspend t h e n e n b o r b a n k s f r o n t h e facilities o f the F e d e r a l Reserve Systen. credit I t was a l s o p r o v i d e d t h a t after a proper; h e a r i n g the F e d e r a l Reserve Board c o u l d order the removal o f director or o f f i c e r of a nenber b a n k who c o n t i n u e d t o v i o l a t e c o n t i n u e d u n s a f e o r unsound b a n k i n g S e c t i o n 11(n) Board to f i x district or the the law o r practices. o f t h e A c t was anendod t o enpower t h e F e d e r a l R e s e r v e the i n d i v i d u a l c a p i t a l s t o c k and s u r p l u s t h a t nay b e r e p r e s e n t e d b y l o a n s c o l l a t e r a l nade b y n e n b e r banks i n t a k e n any a c t i o n u n d e r t h i s i n each Reserve secured by s t o c k o r bond such d i s t r i c t s . The B o a r d h a s n o t yet section. S e c t i o n 13 was anendod t o enpower t h e B o a r d t o r e c a l l a l o a n nade b y t h e Resertre banks on c o l l a t e r a l security if the i n d e b t e d nenber bank, d e s p i t e a warning o f t h e Reserve bank or Board, collateral loans, or l o a n s to s e c u r i t i e s d e a l e r s f o r p u r c h a s i n g o r carrying s t o c k s o r i n v e s t n e n t tions increased i t s of the U n i t o d S t a t e s . a t t h e i n s t i g a t i o n o f S e n a t o r G l a s s who d i s l i k e s Reserve bank r e c a l l e d c o l l a t e r a l of except obliga- i n the Act largely l e n d i n g on n o t e s . l o a n s nade u n d e r t h i s nenber bank c o u l d s u b s t i t u t e o t h e r paper and n u l l i f y the purpose securities, T h i s p r o v i s i o n was p u t outstanding section, its effect. the If a ~10~ Of those added pctrors -under t h e A c t o f 1933 t h e n o s t important t h o s e empowering the B o a r d to d e p r i v e banks o f t h e System's and t o remove member bank o f f i c e r s . are facilities No machinery has been s o t up f o r making these powers e f f e c t i v e , b u t t h e p r i n c i p l e under which t h e y nay be exercised i s important, r e c o g n i z e s t h a t t h e Reserve S y s t e n i s under for i t t h e o b l i g a t i o n t o s u p e r v i s e b a n k i n g d e v e l o p n e n t s i n a g e n e r a l way* I n t h e S e c u r i t i e s and Exchange A c t o f I93U t h e B o a r d was g i v e n the power t o r e g u l a t e t h e amount o f n a r g i n r e q u i r e d b y b r o k e r s and banks and dealers i n s e c u r i t i e s against security loans. (These powers a r e t h e b a s i s f o r R e g u l a t i o n T and t h e y e t u n i s s u e d R e g u l a t i o n U . I n t h e B a n k i n g A c t o f 1935 t h e B o a r d was g i v e n the power t o r e s e r v o r o q u i r e n e n t s o f member b a n k s . quirements f i r s t it alter The power t o i n c r e a s e r e s e r v e re- appeared i n the Thomas amendment p a s s e d i n May 1933* h u t c o u l d b e e x e r c i s e d o n l y w i t h t h e a p p r o v a l o f t h e P r e s i d e n t and d u r i n g an emergency. I n 1935 t h e a p p r o v a l o f t h e P r e s i d e n t and t h e emergency c l a u s e wore o m i t t e d and the B o a r d nay now r a i s e r e s e r v e r e q u i r e m e n t s and i n t i o n reduce t h e n t o n o t below the p r e s e n t ous c r e d i t expansion or c o n t r a c t i o n . n e n t s nay b e i n c r e a s e d , nents* Furthernore, however, l e v e l i n o r d e r to p r e v e n t addiinjuri- The amount b y w h i c h r e s e r v e require- i s U n i t e d t o d o u b l e the p r e s e n t roquire- r e q u i r e n e n t s nust be changed f o r a l l c e n t r a l and r e s e r v e c i t y banks c o n b i n e d , f o r a l l c o u n t r y banks combined, neriber banks a s a w h o l e . or f o r all Reserve r e q u i r e n e n t s o f some banks a i g h t he* a l t e r e d * howeyer; w i t h o u t a l t e r i n g the r e q u i r e m e n t s f o r o t h e r banks i n t h e same c l a s s i f i c a t i o n b y c h a n g i n g t h e c l a s s i f i c a t i o n o f t h e member banks cerned. S i n c e t h e o r i g i n a l F e d e r a l Reserve A c t t h e B o a r d has had t h e power t o a l t e r c l a s s i f i c a t i o n o f member b a n k s . con-
@FedFRASER