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DRAFT - l/30/6l
FEDERAL RESERVE OPERATIONS:
PEGGING, "BILLS USUALLY," AM) PRESENT PROCEDURES
During World War II, when prices were controlled, materials allocated,
consumer goods rationed, and manpower conscripted, the Federal Reserve
developed a financial counterpart for the emergency conditions of over-all
control*
It made certain that there would be ample reserves in the banking
system to provide whatever money the Government might need, ^fte^~4iie~^feasible
ma^munrihad-feeen^pbtained through taxation and through borrowing investor
savings $n part by Savings Bonds).
These reserves were provided by the Federal
Reserved purchasing securities at pre-determined, and relatively low rates;
thus a fixed pattern of rates was established for the Government securities
market.
In time, these reserves furnished to the banking system enabled the
banks to go ahead and purchase the additional issues of Government securities
required to meet the Treasury1s wartime needs for funds.
Such bank purchases of
Government securitl es, made possible by the reserves supplied by the Federal
Reserve, represented corresponding additions to the money supply, but the immediate inflationary consequences were held in check by the wartime system of
controls.
The results of the rate pegging process were, therefore, really
twofold:
(1) The money creation process was subverted to the exigencies of war
finance, in effect setting a time bomb for an ultimate inflationary explosion.
(2) Artificialities and rigidities developed in the market and in the
practices of the Federal Reserve and banking system as a whole — artificialities
clearly inconsistent with the operation of a competitive market economy*
- 2 Once the war had ended, some controls were dismantled rapidly, others
gradually, in the transition back to a vigorous {tfreev* economy.
Because
there were many problems involved in the transition back to relatively free
markets for Government securities, and because the implications of pegged
markets influenced all capaital values, the post-war transition for monetary
controls was much more gradual than any other sector of the economy.
There
was a gradual movement away from the wartime rate pattern in the short end
of the market but the process of Federal Reserve support was continued.N By
1950* ^ e need to divorce the Treasury and the Government securities market from
continuing dependence upon money creation by the Federal Reserve had become
clear on all sides; the inevitable inflationary consequences of continuing the
process were recognized generally.
A Special Subcommittee of the Joint
Congressional Committee on the Economic Report, under the chairmanship of
Senator Douglas, conducted an exhaustive investigation leading to the recommendation that means must be found for discontinuing the pegged support of Government
securities markets — if financial stability and effective control over the
creation of new money were to beedafiQ"poBcible in the decade of the r50's.
After considerable negotiation, prompted in part by the thorough analysis
of the !rDouglas Subcommittee,11 £he
Treasury and the Federal Reserve System
reached an "Accord,'1 which was announced on March h, 1951-
This Accord reaffirmed
the necessity for the Federal Reserve's policy to be directed toward the
maintenance of appropriate monetary conditions for the economy as a whole and
the necessity for the Treasury's borrowing requirements to meet the test of the
market.
It provided for the coordination of debt management and monetary policy
in such a way as to restore the Federal Reserve's control over the money supply
while assuring * successful Treasury financing in the context of a competitive
market.
Several procedures were instituted to provide for the gradual withdrawal
of the fixed arrangements that had been in effect.
- 3Late in 1951 and during 1952, it became clear that the Federal Reserve
System faced a difficult task in convincing the whole range of investors in
the Government securities market, and the whole range of borrowers in other
markets competitive with that for Government securities, that truly competitive
conditions had again been restored.
Investors continued to believe that the
Federal Reserve would attempt to maintain certain predetermined interest rates,
regardless of the over-all state of demand and the volume of other savings
entering the market. v The Federal Reserve, therefore, deeided that it would
limit all of its necessary operations in the Government securities market to
securities of the very shortest term — usually Treasury bills —
in order to
convince the market that it was not engaged in specifically pegging any rates
of interest and, most particularly, those of intermediate and long-term.
To
minimize market uncertainty as to possible Federal Reserve operations affecting
market rates this conclusion -«• that the System henceforth would operate only
in the area where its sizable operations would have least market impact ••
was relayed to the market.
In carrying out this decision, the Federal Reserve continued to place
primary emphasis in its operations upon supplying an adequate volume of reserves
to support an adequate growth in the money supply.
It no longer assumed
responsibility for specific rates of interest, although the observation of
interest rate movements continued to be one of the many bases taken into
consideration when judgments were made concerning the need for larger or for
smaller increases in the reserve base of the banking system.
In fact, it was
thought by some that the signal of interest rate movements, reflecting basic
demand and supply forces, was clearer as a result of the Federal Reserved
- k procedure of limiting operations to shortest term securities. The Federal
Reserve was not at any time, however, unmindful of the risk that unusual
developments might create "disorderly conditions" in the Government securities
market and thus in credit markets as a whole.
Consequently, the Federal
Reserve continued to be prepared to undertake operations in securities other
than Treasury bills in the event disorder actually developed. While there
were few occasions for such exceptional action, some did occur: notably,
late in October 1955, when changing market conditions threatened the failure
of a very large Treasury financing operation, the Federal Reserve became an
active buyer of the specific issues involved in the Treasury borrowing operation*
Again, in the summer of 1953, when disorderly conditions developed subsequent to
a Treasury financing, the Federal Reserve temporarily changed its practice and
made purchases of longer term securities to steady the market. Apart from
these infrequent, unusual situations, however, the Federal Reserve did maintain
its position of reliance on operations in Treasury bills without interruption
until I960.
It did not purchase maturing securities involved in Treasury
financing operations, the so-called "rights." Nor did it engage in "swaps"
in which Treasury bills might have been exchanged for other kinds of Government
securities through the market.
It did, however, engage frequently in short-
term lending operations, to provide reserves for a few days under conditions
of temporary technical shortages of funds, through "repurchase agreements"
extended to Government securities dealers. The Federal Reserve was willing
to take any Government security maturing in up to 15 months on this kind of
short-term arrangement, in which these Government securities serve virtually
as collateral for a temporary loan.
- 5By 1960, it had become clear, however, that there were likely to be more
frequent occasions when conditions in the market bordering on disorder might
develop, particularly in circumstances such as those experienced toward the
close of 1959, when borrowing demands were intense and interest rates were
rising rapidly in the free markets.
The Federal Reserve, therefore, began
to experiment by making some purchases of Government securities outside the
Treasury bill area.
The Federal Reserve entry into this field had been
assisted, too, by the Treasuryfs action in 1959 in introducing Treasury bills
of 1-year maturity, so that the System could continue to trade in "discount
obligations" while reaching into a maturity range of as much as one year.
The new developments giving particular force to the System1s desire to
lengthen the range of its operations were related to the balance of payments
position.
By the third quarter of 1960, the outflow of short-term funds from
the United States to money market centers abroad had become substantial. At
the same time, the need for easing of bank reserves and credit availability
had become clearer, as the economy moved closer to recession.
this was the conflict:
In essence
if the Federal Reserve continued to buy only the
shortest term securities, it might drive those rates to unduly low levels,
thereby encouraging a further outflow of funds which would aggravate the
already serious balance of payments deficit.
Thus, in order to minimize
the balance of payments repercussions of increases in bank reserves, the
Federal Reserve began to provide some of the reserve increases through purchases
of securities that were not as closely interchangeable with Treasury bills.
(It also reduced reserve requirements to provide last half-year seasonal
reserve needs with less rate impact than by security purchases.)
- 6Under the pressure of balance of payments considerations, this experimentation still continues*
The Federal Reserve is prepared to reach out
even further in order to provide reserves, as needed, in a manner that will
minimize reductions in the
short-term interest rates and provide the maximum
initial impact toward that reduction in long-term rates which would most
assist in helping to check and reverse recessionary developments.
In effect,
the balance of payments situation has become so extreme as to represent
virtually a "disorderly situation."
In consequence, the Federal Reserve is
now moving to broaden its operations in a manner that is consistent with its
previous principles but involves new procedures made necessary by the application of those same principles to a new and changing situation in the
financial markets.
@FedFRASER