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Fr'*. R. 1 1







Office Correspondence


D t A m 2,1957,
ae p

The bond situation

Lauchlin Currie

As I have not had an opportunity to discuss the bond situation
with you and I have some views on the matter I have written them up
in the attached memorandum, Mr* Goldenweiser has read the memorandum.



April 2, 1937,
L. B. Currie

In view of (a) the substantial fall in bond prices that
has occurred since the first of the year and (b) the possibility
that certain banks will have to make further adjustments to
meet the pending increase in reserve requirements, the question
arises whether the System should engage in any open market
purchases and, if so, of what character and in what degree.
Action mast necessarily be based on diagnosis, objectives,
and a weighing of the probable consequences, in all of which
differences of opinion exist. My own view is as follows:
While the increase in reserve requirements may have had
something to do with the fall in bond prices there are various
considerations that suggest that other factors have been more
important. For one thing, the movement started back in December.
For another, it would seem that the extent of the movement,
combined with the fact that it is known that banks will be left
with some $600 million excess reserves and that other funds
available for investment are abnormally large, indicate that
other considerations are paramount.

These considerations appear

to be a renewed fear of inflation arising from rapid price and
wage advances, rearmament, the fall of interest rates in England,
and the warnings of various writers. Recently this has been
aggravated by a change in the federal budget picture, and a
rejection of the proposal to levy additional taxes.


If this is the correct diagnosis of the present situation
there m^ould be danger that open market purchase of government
obligations would be interpreted as inflationary in its implications and contribute to increased rather than reduced sales of

This view was expressed, in financial editorial comments

in both the New York Times and the Wall Street Journal in recent
days, following the rumor that henceforth the Federal Reserve
would have to support the bond market, In short, it appears
hardly proper to adopt "inflationary" measures to cope with a
situation which arises from inflationary fears, An affirmation
by the President that there will be no boom would be more effective
than a reaffirmation of an easy money policy on our part, if the
above diagnosis is correct.
There appear to be two objectives that would be served by
open-market purchases. One would be to support government bond
prices by direct purchases.

The other would be to prevent forced

sales to meet increased reserve requirements, by giving banks
more reserves. While related, these too objectives are capable
of separate treatment.
The first objective of supporting bond prices implies
(a) that we feel responsibility for the level of




(b) that we feel that the present levels or any
further recessions will be detrimental to the course of
(c) that our action would be effective and
(d) that x e would have no difficulty in disposing
of our purchases and mopping up the additional excess reserves
at a later date.

I will consider these points in order.

(a) How that almost all the financing requirements of
the government are out of the way, it does not appear that
we should feel much responsibility for the level of government
bond prices, except to the extent that a decline may be
attributable to action on our part.

In this case it should be

one of the considerations that must be weighed against other
considerations. Financial critics of the Administration have
repeated again and again that the ship of monetary control would
founder on the rock of fiscal policy —

that the Treasury would

never permit its interest cost to be raised.

Deliberate action

to support bond prices might be interpreted as confirmation
of this view.
(b) It appears unlikely that the recent movement in bond
prices is detrimental to the course of business. A substantial
portion of new capital has been raised by new stock issues and



the bulk of bond financing has been for refunding purposes.
The effedt of refunding at this stage of the cycle is to
increase profits which are already mounting rapidly. The
recession cannot be long continued and new capital issues
will appear in abundance when prices are stabilized. A temporary
slackening of new issues might even be held to be salutary at
the present time, tho this is more debatable.

Even should bond

prices remain at a lower level than before the movement began,
a difference of one-half percent or even one percent in bond
yields in this phase of the cycle would be a negligible influence
in checking expansion. Present conditions, in other words,
differ widely from those in 1931, when buying was declining
rapidly, or 1934, when the recovery was still uncertain.


of course, a wide open break occurred, accompanied by damping
of all bonds regardless of price, the situation would be different.
With reference to the position of member banks, we are
naturally concerned to prevent bank failures.

So far, however,

recession has mainly cancelled paper profits and has not resulted
in large actual losses. The movement would have to be much
more drastic to threaten the solvency of banks#



(c) As remarked before, there is no guarantee that
purchases will be effective in achieving their objective,
as this depends on the uncertain psychological repercussions.
It is worth noting that the Treasury has expended some $200
million without arresting the decline. A fixed amount of
purchases might be worse than ineffective. A bold policy
of unlimited support might entail purchases of veiy large
magnitude, undoing much of the increase in reserve requirements.
(d) Finally, there is no guarantee that the additional
excess reserves created through Government bond purchases
can be absorbed later without affecting bond prices when the
securities are sold. This depends on the amount, the future
course of the market, confidence, etc. This may not be a
serious danger, but it deserves mention. Additional bond
purchases, by increasing excess reserves relative to our
Treasury bill holdings, would leave us in a less secure
position to mop up excess reserves and arrest deposit expansion
in the future.

The second objective is to prevent forced sales arising
from the adjustments incident to meeting the new requirements.
This appears to be a more justifiable objective and does not


lend itself to the same inflationary implications as would a
policy of supporting government bonds.

It would be consistent

wlth our general policy of moving toward the absorption of excess
reserves as a precautionary measure, while not departing for the
time being from an easy money policy. We could adopt the position
that while we do not feel that the fall in bond prices attributable
to inflation fears justifies a counteractive policy on our part,
do feel that banks should not have to dispose of governments at
this time in order to meet the increase in requirements.
There is a real problem in making this distinction clear.
The explanation would not be accepted, in my view, if we bought
government bonds on balance.

It could be pointed out that if we

wanted to supply additional reserves we could do so without directly
buying long-term government bonds. There is a similar danger in
buying Treasury bills. The financial coimminity has got into the
habit of lumping together all government obligations held by all
the reserve banks. Any increase in the grand total of #2,4 billion
of government obligations, even tho attributable solely to increased
Treasury bill purchases, might be regarded as indicative of a change
in open-market policy and, hence, inflationary*
These objectimis and difficulties would not apply to increased
purchases of acceptances. Variations in acceptance holdings have


been the traditional means of making temporary and seasonal
adjustments and are not generally regarded as indicative of any
change in "open-market policy*. There would be assurance that
the reserves created by additional purchases would go to the large
city banks that need additional reserves. Bond purchases, on the
other hand, might create reserves for country banks that have
plenty of reserves already and are merely selling because they
mistrust the future trend of bond prices.
Re coxmaendat ion
I would favor an issaediate reduction in the bill buying rate
from one-half percent to three-eighths percent.

I do not think

this action would be regarded as inflationary and it would have
the effect of giving additional reserves to New York banks and
forestall the necessity on their part of disposing of bonds at
present prices.

I believe, moreover, that the present relatively

generous yields combined with the knowledge that excess reserves
will amount to some #700 or #800 million (depending on our acceptance
purchases) and that further forced selling or borrowing will be
obviated, would contribute to a cessation of pressure on the market
and possibly to a rally. If, however, this does not happen, nothing
will have been lost and we will still be in a position to consider
whether any further action on our part is required.

It is to be

expected that the Treasury will continue to work for an orderly

In the present uncertain conditions prudence suggests that

resort to possible dangerous expedients be delayed until after we
have given a fair trial to relatively safe expedients.


Listing the various expedients in order &f preference I
would suggests
(1) A vigorous anti-inflationary statement by the President.
(2) Purchase of acceptances by reserve banks,
(3) Purchase of bonds by the Treasury in ways that do not
involve the creation of additional excess reserves.
(4) Purchase of bonds by the Treasury thru use of the free gold.
(5) Suspension of gold sterilizing operations by the Treasury
for time being.

(6) Use of inactive gold.
(7) Purchase of bonds by the reserve banks.