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To:
From: Woodlief Thomas

October 10, 19$Q.

Attached for your confidential information is a summary or brief of principal points
with reference to recent Federal Reserve policies
and the Government securities market.

Confidential

October 10, 1950
FEDERAL RESERVE POLICIES AMD GOVERNMENT SECURITIES

Nature of Problem
1* Grave inflationary dangers are presented by the defense program,
because of
(a) Increase in national income resulting from additional
Government expenditures without increase in goods
available to consumers.
(b) Possible shortages and rising prices give stimulus to
increased buying financed from accumulated savings or
borrowing as well as from increased income.
2. Limited program does not require comprehensive harness of rationing
and price controls, but general limitations of buying power through
vigorous fiscal and credit restraints, as stated in Presidents
Liidyear Economic Report
"First of all, for the immediate situation, we
should rely in major degree upon fiscal and
credit measures• These general measures can
be helpful not only in restraining inflationary
pressures, but also in reducing the civilian
demand for some specific products, such as
automobiles and housing, thus making available
for necessary military use a larger proportion
of an already short supply of some critical
materials. The more prompt and vigorous we
are with these general measures, the less need
there will be for all of the comprehensive
direct controls which involve the consideration
of thousands of individual situations and thus
involve infinitely greater administrative difficulties and much greater interference with
individual choice and initiative•»
Also stated ty Senators Douglas, Fulbright, and Flanders in the
Report of the Senate Banking and Currency Committee on the Defense
Production Act of l?50




"The primary method of dealing with inflation
should be the coordinated use of proper monetary,
credit and fiscal policies, which can actually
prevent inflation. Higher taxes, on personal
and corporate incomes, and excess profits taxes
should be given an opportunity to work their
effect, preferably before the country is placed
in the economic strait-jacket of another OPA,
or at least simultaneously with such controls•

- 2 Credit should be restrained by controls on
installment buying, real estate credit, and
general bank creditj and these controls should
be coordinated with each other• The Treasury! s
debt-management policies should be reexanined,
especially in view of the new situation, and
they should be coordinated with the duties of
the Federal Reserve Board to restrain credit."
Credit restrictions are important because great expansion can
occur, and is occurring, before fiscal and other measures begin
to operate.




Bank loans increased k billion dollars in third
quarter - unprecedented for period*
Money supply—deposits and currency—increased
2.3 billion, about same as in inflation year,
19k7.
Turnover of existing money supply has also
increased.
Reflected in sharp and continued rise of prices.

- 3 Lleans of credit restraint




(a) Selective controls - restraints already applied and
Board is under pressure to make very restrictive.
(In billions of dollars)
Amount
Yearly
Outstanding Increase

h»$

21.0
(13.0)

(3.I4.)

Ui.o

6.0

1.2

Consumer credit (Reg. W )
Installment credit
Real Estate credit (Reg. X)
Nonfarm mortgages
Security loans (Reg. T)
Debit balances at brokers

6

(b) General controls over supply and cost of bank reserves.
Much more important, broader in scope, and more basic.
Affect commercial banks, which are ultimate source of
all credit and money supply.
(Estimates)
Sept. 30
Yearly
Outstanding
Increase
Loans & investments , total
Loans
U. S. Government obligations
Other securities
Reserves •with F. R. Banks
Required

123J3
63 ll
11.8
16.7

+5.2
+7.2
-3.6
+1.6
+ .7
+ .7

Applied through (1) Rediscount rate on advances to banks, now
1-3A per cent
(2) Reserve requirements - now near legal maximum average about 16 per cent of deposits
(3) Open market operations - buying and selling
Government securities

$. Principal source of increased credit arises from sales by banks
and others of short-term securities to the Federal Reserve•




(a) Traditionally source was member bank borrov&ng at
rediscount rate £rom Federal Reserve, supplemented
by occasional open market operations.
(b) Because of great importance of public debt in the
economy* however, Federal Reserve has responsibility
to maintain orderly market, and must buy or sell
regularly*
(c) But to buy at fixed rate of interest below prevailing
rates in market encourages banks to sell Government
securities in order to make other loans•
(d) Purchases by Federal Reserve increase bank reserves,
which provide basis for six-fold expansion in bank
credit•
(e) Process illustrated by events since May 3 Treasury attempted to r efund issues maturing June 1
and July 1 and again September 1$ and October 1 with
13-month notes at 1-l/lj. per cent, which was below
prevailing market rate.
Refunding made possible only by Federal Reserve purchases* In August and September System bought 8
billion of maturing issues, added to 2«U billion
previously held, out of 13•6 billion of total issue•
Cash redemptions were 2.h billion* Purchases partly
offset by sales of other issues and by gold and currency outflow.
Changes in reserve position were as follows:
May 3 Aug. 16
Federal Reserve holdings of
U* S« securities
Treasury bills
Certificates and notes
Bonds
Total
Other principal factors
affecting reserves
Gold stock
Currency in circulation
Member bank reserves
Total
Required
Excess

- .1
+2.0
~l.lt
+0,6
•
-0.3
+0.1
+0.3

+oTH

-0.1

Aug. 16 -

Oct. k
-2.9

+U.8
-0.9
+1.0

-0.5

-0.2
+0.3
+0.2
+0.2

6. Federal Reserve can not restrain credit while it continues to expand
reserves in this manner•
(a) Limitation on purchases would result in rise in shortterm interest rates^
If banks continue to try to sell to obtain funds
io lend.
(b) Higher rates (lower prices of securities) would have
following results (1) Discourage bank sales of securities.
(2) Rise in rates would bring in buyers
other than Federal Reserve - no increase
in reserves*
(3) Rise in interest might also discourage
borrowers•
7* Increase in reserve requirements




Force banks to sell some of Government securities to
Federal Reserve to obtain additional reserves required.
VJould reduce bank's supply of liquid secondary reserves.
Discourage selling raore securities to make loans.
More restrictive if short-term interest rates were
permitted to rise first•
Remaining power permits increase of 2 to 2-1/2 billion
in required reserves.
Member banks hold over kO billion of short-term
Government securities, from which to meet
increase.

- 68. Relation of short-term and long-term rates.




Would rise in short-term rates depress long-term
bond prices below par?
Probably not.
(a) Short-term rates very low relative to long-term rates,
Usually in periods of active credit demands,
short-term rates have been higher.
(b) Lon^-term rates have been tending to decline.
Persistent investment demand.
(c) Temporary fluctuations of speculative nature would
be moderated by Federal Reserve support to bond
market*
(d) System vrould limit rise in short-term rates if it
tended to depress bond prices.
(e) Higher short-term rates should not diminish demand
for savings bonds.
Rates are not in question.
Buyers should prefer them to marketable
issues because of protection against price
fluctuations.
Willingness to buy savings bonds affected
more by confidence in value of dollar
(avoidance of inflation) than by market
prices of marketable securities.

- 79. Effectiveness of recent Federal Reserve policies




(a) Since adoption of more restrictive policy bank credit
has continued to expand at unprecedented rate.
(1) Partly seasonal
(2) Partly based on earlier commitments
(3) Various powerful stimulants—due to
defense program—could not be stopped
but may have been retarded.
(b) No genuine test of policy
(1) System continued to buy maturing issues
at low rates to assure success of
Treasury refunding,
(2) Had to sell other issues to absorb
increased reserves - more difficult and
less effective than refraining from
buying.
(3) Rate rise very small so far - only 1/8
of one per cent.
Bill rate from 1.18 to 1.33
One-year rate from 1.23 to 1.35
Bonds declined slightly in price
(c) Policy should be continued if credit is to be restrained.
(1) No longer necessary to support refunding.
(2) Banks again are selling one-year securities
at current rates to obtain reserves.
(3) Rate structure in market is distorted rate for 3-iaonth bills (1.33) too close to
supported rate on one-year notes (1«35>)
and below unsupported rate on one-year
bonds (1.1*6) - should be permitted to
adjust to normal relationships*

- 8 Division of Responsibilities
Treasury function is to finance Government in most economical manner
possible, with due regard to short-run and long-run effect on
general economic growth and stability.
Should establish terms and rates on securities in accordance with
market demands.
Does not have power to determine what rate of interest investors
are willing to receive - rates in market are determined by supply
of funds available and existing demands for them - also ty
anticipations•
Unlimited Treasury borrowing at artifically low rates only possible
if Federal Reserve creates additional money and bank reserves—
inflationary policies.
Government should avoid accusation of "rigging the market" for its
own securities - will affect confidence in bonds.
Federal Reserve is resioonsible for regulating supply of credit and
money in accordance with needs of commerce, industry, and agriculture with view to economic growth and stability.




Federal Reserve can create money and can to a considerable degree
determine the level of interest rates.
Cannot, however, maintain a rigid level or structure of rates
regardless of market forces of demand and supply, v/ithout causing
either inflation or deflation.
Should not be called upon to buy any amount of Government securities at rates below those determined by market forces*
Inevitable result, in a period of stroijg credit demand,
would be inflation.
Federal Reserve, nevertheless, has responsibility under existing
conditions for maintaining orderly market for Government securities.
Should moderate market fluctuations, especially if caused
by temporary or speculative forces, but should not eliminate
them.
Should also for present prevent decline in long-term bond
prices.

Problems of credit policy and debt management are partly technical,
concerning
Relationships between different parts of market
General market psychology
Appraisal of various short-run and long-run factors.
Federal Reserve can advise Treasury of its judgment as to market conditions> which Treasury should take into consideration in determining
debt-management policies. But if Federal Reserve is required continuously to support prices that are contrary to market forces,
inflation will result.