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1 1 /1 6 /5 5 AS R elation of F ree R e se rv es and T rea su ry B ill R ates (Thom as M em o of 1 1 /3 /5 5 ) Some of the conclusions are obvious, som e appear to be tru e , and som e are questionablee That b ill yields tend to vary with free r e s e r v e s , and that this is particularly so at tim es of an actively easy credit policy se e m s to m e to be in accord with facts and lo g ic . The conclusion that when credit policy is r e str ic tiv e , the discount rate appears to fix a ceiling for the bill r a te , seem s to me to be questionable* At p resen t, when the banks hold^few b ills , and therefore f c / ^ ^ f € * v* are not relying cm bills as a principal instrum ent of re serv e adjustm ent, 4 and when certain nonbank investors have special needs and a special d e sire for b ills , the ceiling relationship of the discount rate to the b ill rate is not so clear as the chart might indicate, A ls o , as the chart show s, the b ill rate was above the discount rate for som e time in 19 5 3 , There is quite a leap from the chart readings to the suggestion that at tim es (such as the present) the discount rate is probably the significant elem ent of r e str a in te This conclusion fo llo w s, it seem s to m e , only if restrain t is defined wholly in term s of the b ill rate, and if you re je ct the idea tha€ the reluctance of banks to stay in debt tb the F ed eral R eserve Banks, or their inability to do so , are important elem ents of credit restra in t. And even then, unless open m arket policy m aintains the situation in which banks are forced to se ll securities or borrow , or is expected to maintain it, the discount rate is not so likely to be the significant elem ent of restraint* jjfc*• ' / ./ Jf // J~ *, £ / / ' t f i f ^ f t$ ti , # / / * #X In other w ord s, I dont believe^flHkt a higher discount rate accom panied by higher bill yields is the m ost ^effective way of increasing re stra in t, without referen ce to open m arket operations. In the present situation, I think we can achieve som e further restraint by increasing the discount rate, p rim a rily because it w ill dispel whatever off that we w ere about to relax^ 4? *rt eAf r h-X of the idea ) *>{ If, la te r, we want to achieve further * > re stra in t, it m ay be m ore effective to push borrowing up by open m arket operations, leaving the discount rate alone CONFIDENTIAL (FR) November 3, 1955. To: The Federal Open Market Committee From: Woodlief Thomas Subject: Relation of Free Reserves and Treasury Bill Rates. tv r . (T ' The attached chart shows fluctuations in wee1:ly averages of net free reserves and of the margin between the discount rate and Treasury bill yields. It should be noted that, in order to show a positive relationship with the curve for free reserves, the curve showing the interest rate spread moves in opposite directions from the general trend of interest rates since it rises when Treasury bill yields decline relative to the discount rate and falls when Treasury bill yields rise relative to the discount rate, Hie following relationships seem to be shown by the chart: \ 1, When free reserves are positive, the bill rate is generally below the discount rate, i 0e,, the spread curve is above zero, and when free reserves are negative the bill rate tends to be close to the discount rate. 2, Short-term variations in the two curves tend to move in the same direction, 3, When free reserves are positive, the broad movements in free reserves and bill yields tend to be fairly close, h. When free reserves are negative, although there con tinues to be some similarity in short-term variations of the two curves, Treasury bill yields tend to re main fairly close to the discount rate, i.e., the spread curve does not decline below zero as net borrowed reserves increase. From these relationships, it would appear that bill yields tend to vary with variations in free reserves, particularly when borrowings are less than excess reserves. When borrowings exceed excess reserves, however, the discount rate seems to set an upper limit on the rise in the bill rate regardless of the volume of net borrowed reserves. This indicates that when the bill rate is close to or above the discount rate, banks prefer r-* to borrow rather than sell bills. It also means that in such a situation, the level of bill rates is influenced more by the level of the discount rate than by the level of the net borrowed reserves. Thus at such a time, of I which the present situation is an example, the discount rate is probably the significant element of restraint. MEM BER BANK FREE RESERVES AND D ISCO U NT RATE LESS TR EASU R Y BILL YIELDS Per cent Billions of dollars 2.50 2.00 - 2.00 -2.50 1952 1953 1954 1955 1956