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BOARD OF GOVERNORS
OF THE

FEDERAL RESERVE SYSTEM

Office Correspondence
Xo

Chairman F^l^s

Date December l 7 t 1947
Subject:

Thomas Lee Smith

I talked with Mr* Willis of the Hew York Reserve Bank
after the olose yesterday about a tentative yield curve he has prepared for Mr* Rouse as the basis for discussion of the pattern of
rates to be supported* Mr* Rouse had not seen the curve* The
objective was to set up a curve that will be reasonably tenable in
view of expected pressure on the money market in the first quarter
of next year and a desire to avoid additional upward pressure on oneyear rate* A net supply of bonds from all sources is expected in the
first quarter*
Mr# Willis1 curve does not allow for a full range of adjustment on outstanding issues* The curve is almost as flat as it can
get and still allow some increase of yields, touching par for the restricted issues callable in 1959* 1ยป71 P 0 r oent (price 101*13) for the
2 per cent eligible bonds callable December 1952, 2*I|7 VQr o e n * (100*15)
for the 2 l/2 per cent restricted bonds callable in December 19&7*a n ^
2*ij2 per cent (lO2*2i|.) for the eligible bonds callable in September 1967*
The rise is kept gradual rather than steep so that no inducement to give up 1 \/Q per cent one-year certificates will result*
Mr* Til H i s considers a yield of 1*71 per oent for a five-year maturity
the maximum permissible if we are to avoid upward pressure on the 1 l/8
per oent rate*
So as to avoid the necessity for a second lowering of support
prices, the curve I drew is at the lowest points in prices that we can
permit consistent with par for all except restricted 2 l/hf s* I do
not think the market will support itself before reaching the suggested
yields, but, if it should, so much the better*
Some upward pressure on the 1 l/8 per cent and 2 l/2 per cent
anchor rates may develop because of shifbing that probably will result
if yields are allowed to increase to the curve I have indicated* Once
the curve is established, however, there should be a smaller net supply
of Government securities in the aggregate*
The latter curve shows a substantial rise in the yields of
1-5 year bonds and some increases in the yields of shorter restricted
bonds, while holding the 1 l/8 per cent and 2 l/2 per oent anchors*
Therefore, there should be fewer sellers of 1-5 year bonds and perhaps
some increase in buyers, and fewer buyers of 1-year certificates and
perhaps some increase in sellers. At the long end, because all 2 l/2
per cent restricted bonds are shown about at par and the 2 1/lj. per oent




To5

Chairman Eccles

- 2 -

restricted at less than par in price, there would be additional
sellers of the longest-term restricted issue sellers on shifts into
the shorter restricted issues*
Some tendency to shift from the restricted 2 l/4j. per cent
bonds callable in 1959 " o the bank eligible 2 1 l . per cent bonds
t
/j
callable in 1956 may result from the necessarily smaller spread between these issues as the yield curve is allowed to rise* It is
assumed that we would maintain the bank eligible 2 l/U. per cent
issue at par* and allow the market to determine the spread*
Although the 20-year 2 l/2 per cent bank eligible issue
is shown with a premium of 1 l/2 points, the initial tendency would
be for this issue to drop very close to par since temporarily the
absence of any bank demand for this issue affords the investor no
better market than for a comparable restricted issue* However, once
institutional investors are convinced the restricted issue will be
held at par, they may switch from the restricted to the bank eligible
2 l/2 per cent issue and reestablish a spread* They would do this
because of the potentially better market for the bank eligible issue
after, say, 6 months or a year* Consideration might be given to
establishing our support rate at some point closer to par and below
the price that might be established by arbitrage in the market*
Looking beyond the first quarter of next year, there would
be no subsequent problem in adjusting the yield curve to a lower
pattern of rates unless such lower pattern were not justified by market
demand* Should there be a resurgence of demand, the pattern of rates
will automatically adjust to a lower level*
In order to maintain either of the suggested yield patterns,
it would appear necessary for the System and Treasury to support only
a few issues; namely, the 1 l/8 per cent certificates, the 2 per cent
December 1952-5U eligible bonds, the 2 I I . per cent September 1956-59
/4
eligible bonds, and the 2 l/2 per cent December 1967-72 restricted
bonds* Everything else, including the partially tax-exempt bonds,
short eligible bonds, other restricted bonds and the 20-year bank
2 l/2f s, might be allowed to seek its own level*