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A HALF-CENTURY OF
FEDERAL RESERVE
POLICYMAKING,

1914-1964

Clay J. Anderson
Economic Adviser

FEDERAL RESERVE BANK OF PHILADELPHIA

FOREWORD
November 16, 1964 marked the fiftieth anniversary of the Federal
Reserve System. This half-century witnessed a transition in
central bank policy from a simple, formalistic principle of using
Bank Rate to influence the balance of payments and protect
the gold reserve, to using central bank powers to achieve broad
domestic economic goals as well as protect the external value of
the currency.
Official records of policymaking discussions of Federal Reserve
authorities have not been available to outside scholars and
students of central banking. Recently a major step was taken in
this direction: the minutes of the Federal Open Market Committee from 1936 to 1960 were made available to scholars at the
libraries of the Board of Governors and the Reserve Banks, and
the Library of Congress.
The primary purpose of this book is to bridge this gap; to make
available a summary of the thinking of Federal Reserve officials
about policy as it developed. The study is based almost entirely
on the minutes of the meetings of the various policymaking
bodies. The author's aim is an objective presentation of the principal views of the policymakers as they evolved in the course of a
somewhat turbulent first fifty years.

May, 1965

President

iii

PREFACE
This book is a history of the central banking thought of Federal
Reserve officials during the first half-century of the Federal Reserve System. The primary objective is to trace their thinking as
they developed policies to meet the major problems arising from
an ever-changing environment. What goals did policymakers try
to achieve; what were their views as to the nature and causes of
business fluctuations; what guides were considered useful in deciding when and what action should be taken to achieve these
goals; how could the tools of Federal Reserve policy best be used
and coordinated; how were policymakers influenced by a changing economic environment? These are some of the threads of
thought the study tries to trace during fifty years of policymaking
by Federal Reserve officials.
The author's aim is to present as objectively as possible the
principal views on policy as expressed by policymakers themselves. There is no attempt to give the views of each official who
participated, to discuss or appraise the role of individuals, or to
evaluate policies formulated except for some of the author's views
on the first fifty years given in the last chapter. The study is a
history of ideas about policy rather than of policies actually pursued. Ideas did not come in a steady flow; they came in waves as
Federal Reserve officials grappled with problems created by a
somewhat turbulent environment.
The scope of the study is limited; it is based primarily on the
views of officials as recorded in the minutes and proceedings of
meetings of policymaking groups such as the Federal Open
Market Committee and its predecessor committees; the Conference of Presidents (prior to August, 1935, the Governors of the
Federal Reserve Banks); the Conference of Chairmen and Federal
Reserve Agents of the Federal Reserve Banks prior to August,
1935; joint conferences of these groups with the Board of Governors (prior to August, 1935, the Federal Reserve Board), and
v

FEDERAL RESERVE POLICYMAKING

the Board of Governors for selected periods. The detail with
which discussion and views were recorded over the years varied
widely. Although other sources were consulted at times, such as
the Annual Reports of the Board of Governors and statements
of Federal Reserve officials in Congressional hearings on the
Federal Reserve System, the book is confined almost entirely to
the minutes. They are the primary source of information on
what officials were trying to do and why, and thus far most of
this material is not available to the public.1
The author incurred many obligations in this study. Officials
of the Federal Reserve Bank of Philadelphia, the Federal Reserve
Bank of New York, and the Board of Governors made available
minutes of policymaking conferences. The library staff of the
Federal Reserve Bank of Philadelphia rendered valuable research assistance, including preparation of the list of policymakers
given in the Appendix. The Secretary's office of the Board of
Governors and librarians of some of the Reserve Banks cooperated willingly in checking and providing some of the information in the Appendix.
The author is also indebted to those who read part or all of the
manuscript and who gave many helpful suggestions. He is especially indebted to W. Randolph Burgess, who took the time to
read the chapters dealing with the period prior to the midthirties; to Merritt Sherman, Secretary, and Lewis N. Dembitz,
Division of Research and Statistics, Board of Governors; and to
Karl R. Bopp, David P. Eastburn, Evan B. Alderfer, and Lawrence Murdoch of the Federal Reserve Bank of Philadelphia.
Even though others have given many valuable suggestions, the
author accepts full responsibility for the views expressed. It
should be added that these views do not necessarily represent
those of this Bank or the Federal Reserve System.
The author owes a special debt of gratitude to Kathryn
Kalmbach for assistance with the research and preparation of
1
Minutes of the Federal Open Market Committee from 1936-1960 were recently
made available, as mentioned in the Foreword. Minutes of the Open Market Investment Committee for several years in the twenties were made available with the
Harrison papers.

vii

PREFACE

the index, and to Charles J. Mustoe for assistance throughout the
project, including preparation of the index, editing and preparation of the manuscript for publication. Credit is also due Donald
Hulmes for the art work and format.
Last but not least is a special obligation to my wife for assistance with parts of the manuscript, for encouragement throughout
my career, and for the tranquility conducive to concentration in
the many evenings devoted to this project.
May, 1965

C.J.A.

CONTENTS
PAGE

FOREWORD

iii

PREFACE

PROLOGUE

1. LAUNCHED ON THE EVE OF WAR

Role of a Central Bank
Prewar Views on Policy
Underwriting War Financing

4
5
10

2. POST-WORLD WAR I: BOOM AND DEPRESSION

Boom, not Depression
How to Deal with Excessive Member Bank Borrowing?. .
A New Problem: Depression
3. PIONEERING IN POLICY: OBJECTIVES AND GUIDES

Policy Objectives
Guides to Policy
Research and Statistics
Foreign Operations

15
21
25
31

32
35
39
40

4. PIONEERING IN POLICY: USE OF THE TOOLS

Discount Rate
Discount Policy
Open Market Operations
Reserve Requirements
Coordination and Timing
"Between the Devil and the Deep Sea"

43
46
47
54
54
56

5. T H E GREAT DEPRESSION

Passive Ease
More Active Ease
Cooperating with the Recovery Program
6. A N E W PROBLEM: EXCESS RESERVES

Appraisal of the Situation
Excess Reserves: A Dilemma
A New Objective Emerges
ix

61
69
72
75

75
77
82

CONTENTS
PAGE

7. WORLD WAR II: PEGGED RATES

War Financing
More Research
8. SQUIRMING IN A STRAITJACKET

Implications of New Environment
Two Basic Approaches Emerge
Attempts to Regain Control
Events Leading to the "Accord"
The Accord
9. RETURN TO FLEXIBILITY—ALMOST

Transition to a "Free
Market"
Open Market Operations
Administration of the Discount Window
Objectives and Guides
10. DEFENDING EXTERNAL VALUE OF THE DOLLAR

Dilemma: Domestic vs. External Goals
Another Return to Flexibility
Foreign Exchange Operations
Other International Activities
11. FEDERAL RESERVE-TREASURY CONTROVERSIES

Financing World War I
Post-World War I
Financing World War II
Post-World War II
Core of the Controversies
12. IN RETROSPECT

Ebb and Flow of Policy
The Great Depression
War Financing
Role of Research
Decisionmaking Process
Relation to the Government
EPILOGUE

Environmental Factors
Federal Reserve Performance
APPENDIX (List of Policymakers, 1914-1964)
INDEX

87
93
94

94
98
100
103
108
110

110
112
121
122
129

129
131
134
138
140

141
142
145
148
152
155

155
163
166
168
171
173
175

175
179
183
193

PROLOGUE
The more extensive a man's knowledge of what has been done,
the greater will be his power of knowing what to do.
—Disraeli

Money has long been a periodically troublesome problem, not
only for individuals but for nations as well. For centuries, governments had direct control over coinage and the issue of paper
money. History records numerous instances of debasement of
coin, overissue of paper currency, and depreciation in the value
of money. It was so much easier to create more money than to
collect more taxes to meet emergency expenditures that government officials not infrequently succumbed to the temptation.
With the development of private commercial banks, demand
deposits or checking accounts became an important means of
payment. The total volume of bank deposits expanded and contracted as banks responded to increases and decreases in customer demands for credit. Private enterprise, guided by the profit
motive, proved to be an ineffective regulator of the money supply
in the public interest. Creation of too much money sometimes resulted in inflation and depreciation of the currency; too little contributed to financial panics, deflation, and depression. Demonstrated deficiencies of both government and private control of the
money supply was an important reason for a wave of central
banks established in the early part of the present century.
Central banks have a long history. The Bank of Sweden was
established in 1668, the Bank of England in 1694, the Bank of
France in 1800, the Bank of the Netherlands in 1814, and the
Reichsbank in 1875. The First Bank of the United States was
established in 1791, and continued in operation until 1811. The
Second Bank of the United States was chartered in 1816 for a
20-year period. But functions and responsibilities of early institutions differed from those of a modern central bank.

xii

FEDERAL RESERVE POLICYMAKING

Some central banks were established to help finance the government. Most early central banks had two major functions:
banker for the government, and right of note issue. These functions gave the central bank considerable prestige. As it gained
prestige and public confidence, commercial banks began holding
some of their cash balances in the form of a deposit in the central
bank. Thus central banks gradually became custodians of much
of the cash reserve of the banking system and the country's gold
reserve.
The essence of modern central banking is discretionary control
of credit and the money supply. As custodian of the ultimate reserve, central banks began to formulate policy and take actions
needed to protect the reserve. The principles enunciated by
Walter Bagehot, a noted English economist of the latter half of
the 19th century, regarding central bank policy in a period of
financial crisis were widely quoted. He said that in a time of crisis
the Bank of England should use its reserve and lend freely to avert
panic and runs on commercial banks, but lending should be at a
high rate to discourage unnecessary borrowing.
Recurring crises revealed a close relation between excessive
credit expansion and demands likely to be made on a central
bank's reserve. Use of Bank Rate to prevent undue credit expansion and an excessive drain on its reserve became established
Bank of England policy in the latter part of the 19th century.
The major industrial and commercial countries adopted the
gold standard in the latter half of the 19th century, and protecting
the gold reserve became a primary objective of central bank
policy. Credit expansion and rising prices usually affected a
country's balance of payments adversely and, if long continued,
resulted in an outflow of gold. Credit contraction, high interest
rates, and falling prices tended to produce an inflow of gold.
Gold flows became an important determinant of central bank
policy and Bank Rate its chief instrument. An outflow of gold was
a signal for an increase in the rate to check credit expansion and
a drain on the reserve. Reserve accumulation was a signal that
the rate could be reduced.
The role of a central bank prior to World War I was a limited
one. Its actions were directed primarily toward avoiding an ex-

PROLOGUE

xiii

ternal drain on the gold reserve, and at times an internal drain
arising from excessive credit expansion and speculation.
Development of central banking accelerated following World
War I both in terms of the number of central banks and the scope
of their responsibilities. A large number of central banks were
established following World War I, and today most independent
countries have a central bank.
Post-World War I also brought major changes in responsibilities of the central bank. War financing and its aftermath of boom
and depression focused attention on internal economic conditions
and the need for greater business and price stability. With abandonment of the international gold standard, policymakers had to
look for objectives and guides that were suitable in the new environment. Reappraisal of the role of a central bank led to development of more comprehensive objectives, new and more
involved techniques designed to achieve them, and much greater
emphasis on domestic economic conditions.
There is now considerable uniformity among countries as to
the general objectives and functions of a central bank. Its primary
responsibility is to regulate credit and the money supply in the
public interest. Generally accepted goals are to help maintain
reasonably full employment and use of resources, a stable level of
prices, sustained economic growth, and to help protect the value
of the currency in foreign exchange markets. In addition, the
central bank usually serves as banker and fiscal agent of the
national government, custodian of cash reserves of the banking
system, and a clearing center for collection of checks.

LAUNCHED ON THE
EVE OF WAR

It should never be lost to sight that the Reserve Banks are
invested with much of the quality of a public trust. They were
created because of the existence of certain common needs and
interests, and they should be administered for the common
welfare—for the good of all.
—First Annual Report of the Federal Reserve Board, 1914

The seven members of the first Federal Reserve Board took the
oath of office on August 10, 1914, and the 12 Federal Reserve
Banks opened for business November 16, 1914. At the end of
1914, the Federal Reserve System had less than 400 employees;
today it has nearly 20,000.
Those officials who had the responsibility of organizing this
new central banking system in the latter part of 1914 faced a perplexing task. None had any experience in central banking but
they recognized that the Federal Reserve System was a unique
type of institution which should be operated "for the good of all."
The Federal Reserve Act provided a comprehensive legal framework within which the new System was to operate, but offered
little guidance as to goals it was expected to achieve.
The outbreak of war in Europe in 1914 disrupted financial relations among the major industrial and commercial countries.
Europeans dumped their holdings of American securities, the
securities market in New York was demoralized, securities prices
dropped sharply, and initially there was a serious drain on the
country's gold stock. The first Annual Report of the Federal
Reserve Board, describing conditions when the System began
operations, stated: "Seldom, if ever, has the banking and business
community of the country found itself in a situation of such uncertainty and perplexity."
1

FEDERAL RESERVE POLICYMAKING

Federal Reserve authorities were confronted with the task of
launching a new central bank in an economic environment deranged by a major war. The President of the Federal Reserve
Bank of New York, later described the task in these words:
In the middle of October, 1914, these 24 men who are responsible for the
management of each of the reserve banks, . . . were literally handed the
Federal reserve act and told to have these banks open for business on the 16th
of November. . . . There wasn't any man living in this country who had had
any experience in that kind of banking. . . . Not only that, but it was at a
time when the world was in the midst of the greatest war ever fought, and after
two and one-halfyears these infants, so to speak, were called upon to conduct
the business in the field of the Treasury of the United States, which in turn had
to finance our own war efforts and a very large part of that of the allied
countries.1

The new officials faced three major problems: implementing
the operating functions provided for in the Act; trying to resolve
jurisdictional questions and disputes; and determining the role
and policy functions of the new central bank.
Long and frequent were the early meetings of the official
groups—the Federal Reserve Board, the Governors of the Federal
Reserve Banks, and the Chairmen and Federal Reserve agents of
the Federal Reserve Banks.2 A large part of the discussions was
devoted to organizational and operational problems. For instance, items on the agenda for discussion at the second Conference of Presidents of the Reserve Banks in January, 1915, included the cipher code, distribution of organization expenses,
commercial paper, revenue warrants, credit information for
member banks, settlements between Federal Reserve Banks, use
of Reserve Banks as redemption agencies for national bank notes,
bonding of employees, recent ruling of the Comptroller of the
Currency with respect to national bank notes, definition of time
1
U.S. Congress, Agricultural Inquiry, Hearing before the Joint Commission of
Agricultural Inquiry, 67th Cong., 1st Sess. (Washington: U.S. Government Printing
Office, 1922), Vol. II, pp. 812-813. He was referring to the 12 Governors and 12
Chairmen and Federal Reserve Agents of the Reserve Banks.
2
Prior to reorganization under the Banking Act of 1935, the Board of Governors
was known as the Federal Reserve Board and the titles of Governor and Vice Governor of the Board corresponded to the current titles of Chairman and Vice Chairman. The president of a Reserve Bank then had the title of Governor. To avoid
confusion, the current titles are used throughout the remainder of the study, except in footnote
references to official sources.

LAUNCHED ON THE EVE OF WAR

deposits, waiver of demand notice and protest, loans to member
banks secured by commercial paper, collection of notes by one
Reserve Bank for another, acceptances, reports of member banks,
clearing-house relations, meaning of lawful money, issue of
Federal Reserve notes, borrowed securities, newspaper articles,
initiation of changes in rates of discount, and regulations governing commercial paper. There were 76 items on the agenda for the
fourth Conference of Presidents in mid-1915 and, according to
the Conference Chairman, there were a number of other topics
that should be discussed.
Division of authority between the Reserve Banks and the Board
of Governors, and between the Federal Reserve agent and president of each Reserve Bank was not clearly defined in the Federal
Reserve Act. The result was time-consuming discussion, interpretation, and frequent controversy. For instance, at the second
Conference of Presidents of the Reserve Banks in January, 1915,
the Chairman thought the authority of the Reserve Banks and
the Board of Governors, respectively, in changing the discount
rate was so important each president was asked to give his views
and those of his board of directors. The consensus was that the
board of directors of the Reserve Bank had authority under the
law to establish the discount rate. Vesting this authority in the
Reserve Bank was considered logical inasmuch as Reserve Bank
officials were more familiar with local conditions and therefore
what the regional discount rate should be. The Board of Governors had the authority and duty to review the rate established
by the Reserve Banks. Several of the presidents stated their
boards of directors resented Board interference in making suggestions as to what the discount rate should be.
A similar question brought up for discussion was whether a
Reserve Bank desiring to rediscount with another Reserve Bank
should apply to the Board of Governors or make its application
directly to the Reserve Bank. Some of the presidents thought the
application should go to the Board of Governors; others thought
it should be made directly to the Reserve Bank subject to approval of the Board.
Another source of frequent controversy was the division of
authority between the Federal Reserve agent appointed by the

FEDERAL RESERVE POLICYMAKING

Board of Governors and the president appointed by the Reserve
Bank's board of directors subject to approval by the Board of
Governors. A frequent complaint among the presidents was that
letters and interpretations of the Board mailed to Federal Reserve agents were either not passed along, or if so only after considerable delay, to the president of the Reserve Bank who had to
implement them.
These illustrations suffice to make clear that System officials
were initially preoccupied with problems of organization and
operations. But there were other factors that tended to divert
official thinking away from monetary policy.
Member banks had ample reserves as a result of gold imports
and lower reserve requirements for national banks under the
Federal Reserve Act. There was little reason for member banks
to rediscount at the Reserve Banks. Reserves of the Federal Reserve Banks also were growing, and by the spring of 1917 the
combined reserve ratio was around 80 per cent. A shortage of
literature on central banking made it more difficult for inexperienced officials to gain a working knowledge of policy issues and
problems. Principles developed by the Bank of England were
apparently known to several Federal Reserve officials but were
not considered appropriate to conditions in the United States.
ROLE OF A CENTRAL BANK

Despite preoccupation with operating problems, officials were
concerned as to the appropriate role and functions of the new
central bank. Discussions at official meetings revealed several
ideas but no consensus as to the System's aims and responsibilities.
On one thing there seemed to be a consensus; the Federal
Reserve should be administered for the common welfare—the
good of all. It should never permit itself to become the instrument
for promotion of the selfish interests of any private or sectional
group. Some thought the System should try to be a "steadying
influence" at all times, protecting business from the harmful
stimulus and consequences of ill-advised credit expansion, and
from unnatural credit stringencies and exorbitant interest rates.
In order to be in a position to perform this stabilizing influence,

LAUNCHED ON THE EVE OF WAR

resources of the Reserve Banks should be invested in short-term
liquid paper which could be readily converted into cash in time
of need. Management of the Reserve Banks should strive for
better adaptation of the credit mechanism to the needs of industry, commerce, and agriculture. Accommodating commerce and
business was soon to become the most important peacetime objective of Federal Reserve policy. Another view expressed was
that the Reserve Banks should not be regarded as emergency institutions, their resources kept idle for use only in times of difficulty. They should try to anticipate emergencies and do what
they could to prevent them.
PREWAR VIEWS ON POLICY

In the initial years, most of the discussion about policy related to
discount rates with occasional reference to other aspects of policy.
Objectives

The only specific statement about policy objectives in the Act was
that discount rates should be established, "with a view of accommodating commerce and business; . . . ."
Officials followed a narrow interpretation of accommodating
commerce and business. They believed a major aim of policy
should be making credit available for "legitimate" business purposes at reasonable rates. This concept of the objective of policy
had two significant implications: the volume of Reserve Bank
credit should respond to the needs of commerce and business, and
it envisaged a passive policy. System officials did not consider it
their responsibility to take positive actions to initiate credit and
monetary expansion or contraction.
Structure of discount rates

It is not surprising that early discussions of policy dealt mainly
with discount rates. Rates at which eligible paper would be discounted for member banks had to be established when the Reserve Banks opened for business. Then, too, the discount rate, or
Bank Rate, as it was called in England, had been the primary
tool of central bank policy.

FEDERAL RESERVE POLICYMAKING

Divergent views arose immediately among Federal Reserve
officials, not only as to lines of authority in establishing the discount rate but also as to the structure of discount rates and principles that should govern changes in the rate. These differences
reflected diffusion of authority among a large number of officials,
lack of understanding as to the unique role of a central bank in
contrast to commercial banks and other private financial institutions, and absence of well-developed principles governing discount rate policies that appeared appropriate for the United
States.
Reflecting largely market practices, the tendency was to establish a structure of discount rates. There was general support for
preferential rates on shorter maturities such as 10- to 30-day
paper. Lower rates for short maturities conformed to market
practices and might also encourage the use of "liquid" paper.
Some officials favored a preferential rate on certain types of
eligible paper. A lower rate on bankers acceptances was considered desirable, not only because of their high quality but to
encourage development of an acceptance market in the United
States. A broader acceptance market, by facilitating financing,
would encourage United States exports.
In the fall of 1915, the Board of Governors exerted considerable pressure on the Reserve Banks to establish a preferential
rate on paper drawn to finance staple agricultural products, especially cotton.3 The principal reason given was that a preferential rate would tend to support the price of cotton and other
staple commodities, and benefit producers and shippers of agricultural products. One official thought it would be a good public
relations move for the new institution.
Most Reserve Bank presidents, however, were strongly opposed
to a preferential rate on a certain type of paper. In thefirstplace,
preferential rates would be discriminatory, and in effect would
give preferred treatment to certain classes of people and types of
business. Second, such rates would be difficult to administer. For
example, a staple commodity in one region might not be so re3
Some officials thought the pressure stemmed mainly from the Secretary of the
Treasury (and ex officio Chairman of the Board); they thought he had succumbed
to pressure by influential Congressmen from agricultural regions.

LAUNCHED ON THE EVE OF WAR

garded in another. Third, preferential rates might encourage
speculative holding of staple commodities from the market instead of a smooth flow from producer to consumer. Finally, establishing rates to influence prices of certain commodities was not a
proper function of the Federal Reserve System.
This initial trend toward preferential discount rates based on
maturity and certain classes of paper did not last long. When the
United States entered the war, preferential rates were established
on Government paper which soon became the primary means of
access to Reserve Bank credit. In the postwar period, once the
Treasury's financing problems were out of the way, preferential
rates were removed except for somewhat lower rates on bankers
acceptances to encourage development of an acceptance market.
Discount rate policy

The discount rate structure was soon overshadowed in policy discussions by the more significant question of how to determine an
appropriate level of discount rates and when rates should be
changed. Principles and guides referred to in early discussions of
discount rate policy varied widely. Some were relevant to central
bank policy; others were not.
Some officials believed the discount rate should be slightly
above market rates for commercial paper to discourage memberbank borrowing for profit. This view reflected the influence of
the Bank of England's policy of a penalty rate for the lender of
last resort. Federal Reserve officials, however, were aware that
different institutional conditions in the United States made it extremely difficult to apply this principle. There was also concern
over the attitude of member banks toward discounting. Many
member banks looked upon the new Reserve Banks as a source of
credit that could be leaned on in time of need; hence they could
pursue a more liberal credit policy than formerly. A discount rate
that would enable member banks to meet legitimate credit demands of their customers at a reasonable rate but without stimulating excessive or unsound expansion was frequently mentioned.
There were other ideas on the discount rate. One proposal was
that it should reflect supply and demand, the rate being raised as
the volume of rediscounts at the Reserve Bank increased and vice

FEDERAL RESERVE POLICYMAKING

versa. The Reserve Bank's reserve ratio was also mentioned.
There seemed to be a consensus that discount rates should vary
among Reserve Districts as needed to meet regional conditions.
Some suggestions reflected complete misunderstanding of the
functions of a central bank. One such proposal was that the discount rate should enable the Reserve Bank to keep its resources
employed and thus provide earnings. Another was that the discount rate should be somewhat lower than the rate large city
banks charged their correspondents.
Open market and foreign operations

The Board of Governors gave the Reserve Banks authority to
make purchases in the open market in December, 1914. Some of
the Reserve Banks made purchases before the end of the year.
Most of the others soon began purchasing certain eligible paper
and securities in the open market. Such purchases did not reflect
an intention to use open market operations as a tool of monetary
policy.
The primary objective of early open market purchases was to
acquire additional earnings to help pay expenses. Several Reserve Bank officials said they planned to keep funds not absorbed
by rediscounts invested in municipal warrants, bankers acceptances, and Government obligations. Nevertheless, monetary
effects of open market operations were recognized as early as
1915. For instance, one Reserve Bank in its annual report to the
Board of Governors in 1915, stated it intended to go into the open
market, when necessary, to make its rate effective. Another Reserve Bank reported the same year that its influence on interest
rates, and credit expansion and contraction was more likely to be
exercised through open market operations than member-bank rediscounts because only a small volume of rediscounts was
anticipated.
Steps toward centralized purchases were initiated in 1915.
New York was the primary market for eligible paper and securities, and it was soon recognized that the Reserve Banks in making
purchases independently were often competing against each
other. To avoid bidding against each other, some Reserve Banks
asked the Federal Reserve Bank of New York to purchase munici-

LAUNCHED ON THE EVE OF WAR

pal warrants and other eligible paper for them. This was the
initial step toward centralized purchases, with the paper and
securities being allocated among the Reserve Banks according to
an agreed formula.4 Each Reserve Bank, even though participating in centralized purchases, reserved the right to make purchases
independently. Some officials thought a Reserve Bank should act
as a dealer in Government securities for member banks in its district, buying from those desiring to sell and selling to those
wanting to buy.
Policy toward gold and foreign operations soon came up for
discussion. The outbreak of war in Europe and stepped-up purchases in the United States resulted in a substantial inflow of
gold. Federal Reserve officials wanted to prevent this gold from
serving as the basis for an abnormal expansion of loans so that
when gold began to flow out (as they thought it would sooner or
later) there would not be a violent contraction of credit with
adverse effects on business.
Techniques discussed for mobilizing gold into the Reserve
Banks included: paying out Federal Reserve notes for gold, and
proposing an amendment to the Federal Reserve Act to permit
Federal Reserve notes to be backed 100 per cent by gold. The
Board of Governors also recommended an amendment to give
the Board authority to raise reserve requirements in emergencies.
The purpose was to enable the Board to check any tendencies
toward excessive loan expansion in prolonged periods of ease.
Early in 1916, there was considerable discussion of whether the
Federal Reserve Banks should plan to engage in foreign operations. The President of the Federal Reserve Bank of New York
brought up the question at the Conference of Presidents and discussed it with the Board of Governors. The objective of foreign
operations as then visualized was to make investments abroad
when profitable, or when desirable for other reasons. It was suggested somewhat later that the reserves of the United States might
be better protected if the Federal Reserve had a large fund abroad
in foreign bills to draw on in case demands were made for gold.
4
For a while the Federal Reserve Bank of New York was compensated for the
expense incurred in making purchases and allocations among participating Reserve
Banks.

FEDERAL RESERVE POLICYMAKING

Some officials thought arrangements might be worked out
which would enable the Federal Reserve to influence foreign exchange rates and gold flows. To conduct such operations an agent
might be selected and an office provided in the Federal Reserve
Bank of New York. He would be under the supervision of the
Board of Governors and the President of the Federal Reserve
Bank of New York.5
UNDERWRITING WAR FINANCING

Federal Reserve officials had little opportunity to crystallize their
thinking on the role of Federal Reserve policy before the United
States entered the war in the spring of 1917. Soon after the declaration of war, the Secretary of the Treasury transferred important
fiscal agency functions to the Reserve Banks. He also asked each
Reserve Bank to serve as a central agency in its district for organizing and promoting the sale of Treasury bonds, as well as
handling subscriptions, payment, and delivery of the securities.
The new fiscal agency functions resulted in a sharp rise in
volume of work handled by the Reserve Banks. Recruiting and
training additional staff needed to handle the soaring volume of
work absorbed much of the time and thought of System officials.
It was a serious limitation on the time that could be devoted to
study and development of Federal Reserve policy.
Treasury financing

Treasury officials soon developed the basic principles followed in
financing the war. Short-term Treasury certificates of three to six
months maturity were issued as funds were needed in anticipation
of receipts at tax-payment dates and from periodic flotations of
5
Of historical significance is the fact that successful operation of the gold settlement fund inspired the Board of Governors to propose, in 1918, that an international
gold fund be established to avoid shipments of gold from one country to another.
The idea was that participating nations would deposit their share of the gold fund
in a Government bank so that transfers could be made through the fund without
physical transfer of gold, thus avoiding transportation charges, loss from abrasion,
and loss of interest while gold was in transit. The Board thought such a fund would
be a great advantage to world trade and suggested that initially, participation
should be limited to the United States, its Allies, and a few of the leading neutral
nations. It was expected that participation might later be extended to practically
all countries.

LAUNCHED ON THE EVE OF WAR

Liberty Bonds. These certificates served two principal purposes.
They were an interim source of funds, pending receipts from
more permanent forms of financing. It was also expected that
these short-term certificates would absorb savings as they accumulated; in effect, enable taxpayers and buyers of Liberty
Bonds to distribute payment over the several months interval
between tax-payment dates and between flotations of Liberty
Bonds.
Treasury officials relied primarily on patriotism, vigorous sales
promotion, and a ready availability of credit at low rates to sell
the amount of securities needed in helping finance the war. The
Secretary of the Treasury vigorously objected to the view that the
financing should be done at market rates. Borrowing at market
rates would increase the cost of the war and make it difficult for
essential industries to obtain credit on reasonable terms.
In order to sell Treasury securities bearing low coupon rates,
Treasury officials wanted credit readily available at low rates.
Beginning with the first bond flotation, institutions and individuals were urged to borrow, if necessary, in order to buy Government securities. The Secretary of the Treasury wanted Federal
Reserve officials to adjust discount rates to the rates on Treasury
securities, and wanted those borrowing to buy securities to be
able to carry their bank loans at little or no net cost; i.e., the rate
on the loan being about the same as the coupon rate on the
securities pledged as collateral.
Federal Reserve policy

The newly assigned fiscal functions in which the Federal Reserve
served as agent of the Treasury probably had some influence on
System thinking as to the role of Federal Reserve policy. War
financing was regarded as the responsibility of the Treasury and
the Government. For example, the Annual Report of the Federal
Reserve Board for 1917 stated: "The Federal Reserve Board is
not responsible for the financial policy of the Government, except
in so far as the Secretary of the Treasury may choose to call upon
its members for service in an advisory capacity." The primary
objective of Federal Reserve policy was to facilitate Treasury
financing. The Chairman of the Board of Governors stated with

FEDERAL RESERVE POLICYMAKING

reference to System policy and financing the defense effort:
"Everything else was thrown into the background. The Board
necessarily was obliged to follow the policies of the Treasury
Department and the Government." Secondary objectives were
to make credit readily available to essential industries, curtail its
use for nonessential purposes, and to maintain the financial
strength of the Reserve Banks.
Discount rate policy was directed toward making credit readily
available for the purchase of Treasury securities. Preferential
rates were established on advances to member banks collateralled
by Government securities. The preferential rates were kept in line
with the coupon rates on Treasury obligations, usually below the
coupon rate on current issues. In addition, the Board of Governors authorized the Reserve Banks to discount notes of nonmember banks collateralled by Government securities, when
endorsed by a member bank, if the proceeds had been or were
to be used to purchase Treasury obligations. The Federal Reserve Bank of New York established a 2 to 4 per cent discount
rate on one-day advances as a means of restoring to the market,
funds temporarily withdrawn by Government operations.6
Federal Reserve authorities urged curtailment of credit for
nonessential purposes in order to conserve credit as well as goods
for production and other activities essential to the war effort.
Banks were asked to make credit readily available for Treasury
financing and for essential production, but to curtail its use for
other purposes.
6
The Board of Governors, at the request of the Secretary of the Treasury, administered foreign exchange regulations and passed on proposed new issues of securities.
In November, 1917, the Secretary, with approval of the President of the United
States, designated the Board of Governors as agent of the Secretary in administering
foreign exchange regulations. A committee of the Board met daily to consider and
pass on applications. The major consideration was whether the proposed transaction
was necessary to obtain essential commodities and therefore whether it was in the
national interest.
In January, 1918, the Secretary of the Treasury requested the Board to assume
the responsibility of passing upon proposed new securities issues and capital expenditures. A subcommittee of the Board was formed to discharge this responsibility and
an advisory committee was established consisting of people from the trade. The
principal tests applied to proposed new securities issues were whether the offering
was timely with respect to Treasury financing operations, and whether the proceeds
were to be used in ways that would be in the public interest. In April, 1918, a Capital Issues Committee was created by an Act of Congress and thus superseded the
subcommittee of the Board of Governors.

LAUNCHED ON THE EVE OF WAR

Use of moral suasion to conserve credit for Government financing and essential production reflected a desire to maintain
financial strength. It was considered a means of having more
credit available for high-priority uses. The policy also reflected
a desire to avoid completely unrestrained credit expansion. There
appeared to be fairly general recognition among Federal Reserve
officials that rapid growth of credit during the war was one cause
of rising prices, but opinions differed as to its importance. Some
believed the shortage of basic materials and commodities in relation to swollen domestic and foreign demands would have generated a substantial rise in prices even if there were no increase
in bank credit.
Support via discount window

Federal Reserve policy made Reserve Bank credit readily available at the discount window at relatively low rates. In addition,
member banks were encouraged to borrow from the Reserve
Banks to the extent necessary to purchase their quota of Treasury
securities and to enable the banks to make loans to their customers for the same purpose. Federal Reserve officials along with
commercial bankers urged individuals and business firms to buy
their quotas even if they had to borrow a substantial part of the
purchase price.
Federal Reserve policy, in effect, provided strong support
for the prices of Government securities although not at a rigid
pattern as in World War II. Credit was readily available to purchase and to carry the securities at little or no net cost.

POST-WORLD WAR I:
BOOM AND DEPRESSION

Deflation for the sake of deflation, or of correcting injustices
wrought by inflation, is not one of the purposes of the Federal
Reserve System.
—John Perrin1

Once World War I was over, discussion turned toward an appraisal of the effects and implications of war financing policies.
Officials recognized that borrowing to finance the war had resulted in substantial credit expansion, but they did not think
Federal Reserve policy had been a significant factor. They
stressed that credit expansion was inevitable to the extent that
savings fell short of meeting the Government's borrowing needs.
Savings did fall short and therefore no reasonable interest rate
would have enabled the Government to meet its borrowing needs
without credit expansion. Had the Federal Reserve followed the
traditional policy of maintaining discount rates above market
rates, the Treasury's difficulties would have been increased without any substantial effect on credit expansion.
Neither was credit expansion a major cause of the large wartime demand for goods and services. In their opinion it reflected
mainly high wages and soaring profits—not expansion of credit.
Under these conditions it was easy for producers to add cost increases to selling prices.
Looking to the future, there was general agreement that transition from war to peace would bring numerous problems and readjustments, including depression and unemployment. Many
Government contracts for goods and services would be cancelled;
industries producing for war would have to convert to civilian
1
Chairman and Federal Reserve Agent, Federal Reserve Bank of San Francisco;
statement made October, 1920.

POST-WORLD WAR I: BOOM AND DEPRESSION

production; cutbacks in production accompanying reconversion,
and demobilization of returning soldiers would result in substantial unemployment; and readjustments would bring declining
prices. There was still a large overhang of undigested Government securities being carried on credit, and a large amount of
Treasury financing yet to be done.
In the foreign field, Government loans to foreign countries
during the war totaled about $9 billion, and only a limited
amount of funds was available for more loans. To retain the existing volume of exports, it might be necessary to extend credit for
the purchase of United States goods. Foreigners held large deposits in United States banks and there was concern that once
restrictions were removed some balances might be shifted to other
countries, resulting in an outflow of gold. German indemnity payments would also be a disturbing factor in international financial
operations.
BOOM, NOT DEPRESSION

The end of the war was soon followed by a surge of spending,
credit expansion, speculation, and rising prices; not unemployment and depression, as widely expected. Official discussions and
reports in 1919 were studded with such terms as extravagant and
wasteful spending on luxuries and nonessentials, and an orgy of
speculation in securities and commodities. The Board of Governors in its Annual Report stated that 1919 was characterized
by:
. . . an unprecedented orgy of extravagance, a mania for speculation, overextended business in nearly all lines and in every section of the country, and
general demoralization of the agencies of production and distribution. . . . It
was universally realized that there would be sooner or later reaction and
readjustment, . . . .2
The President of a Federal Reserve Bank stated that a tendency
toward speculation began to develop and "by gradual stages it
worked up and matured into a veritable orgy of extravagance,
waste, and speculation; there was, in fact, a competition to buy
2 Annual Report of the Federal Reserve Board, 1920, p. 1.

FEDERAL RESERVE POLICYMAKING

anything at almost any price. This culminated in the early
summer of 1920."
As to the credit situation, there was a large overhang of Government securities being carried on credit. Credit was also being
used for speculation in securities and for extravagant spending on
luxuries and nonessentials. Many member banks were borrowing
excessively from the Reserve Banks. One Reserve Bank official
said the attitude of member banks was, "to open vigorously the
credit throttle, Federal Reserve Banks being relied upon to
manipulate the steering wheel. There was apparently a vague
idea that brakes were not required." The predominant view
among System officials was that the credit problem associated
with the postwar boom was primarily one of misuse of credit for
such purposes as speculation and extravagant spending for
luxuries and nonessentials.
The President of the Federal Reserve Bank of Boston thought
the problem was more pervasive. He emphasized that it was not
the use of credit for speculation and nonessential activities alone
that had contributed to the boom. Credit was being used to bid
for materials and to build up inventories in essential as well as
nonessential industries. The result was rising prices, still more
bidding for materials and inventory, which in turn stimulated
making future contracts in anticipation of higher prices. The
whole process was cumulative. Speculation, in the sense of action
taken in anticipation of higher prices, permeated the entire economy. It was not restricted to securities or certain types of commodities. His views are summarized by the following excerpts
from the minutes of November, 1919:
I think the greatest harm is done by the low [discount] rate, because it causes
a constant increase in prices. You take our industrial concerns in Boston, and
they are urged to take contracts away ahead, continuously further ahead, for
their material which they produce. * * * Well, what can he do to protect himself? Money is cheap, credit is easy, and he goes ahead, perhaps, and buys his
raw material, all he will need for a year, and the contract is effective, and he
takes it. He goes into the market to buy his material, and he puts the price up
on himself, and when you get all the concerns offered these contracts, because
prices are going to be higher in six months or a year, and everybody bidding for
that material to protect himself, you get a constantly advancing price, and I
believe that the fundamental reason for that is that, whatever else may go up,

POST-WORLD WAR I: BOOM AND DEPRESSION

credit is cheap and plentiful. The mere fact that it is cheap is evidence that it
is plentiful, and I believe that that is what the effect is principally from low
rates, and I think that is the greatest harm. * * * I would not stop at a slightly
higher [discount] rate if it was necessary to stop it. I would adopt a policy of
high rates. I would like the people to understand that that was the policy of the
Federal Reserve Banks, and I should advance those rates until I got control of
the situation.3
Policy objectives

Policy formulation was influenced by two main objectives: assisting the Treasury with its difficult postwar financing problems,
and dealing with the credit situation.
Federal Reserve officials recognized that the end of the war did
not terminate the Treasury's financing problems. In addition to
new borrowing, substantial refundings were needed to get the
outstanding debt in more manageable form.
The second objective was to get rid of "excessive" borrowing,
both by member banks and their customers, without curtailing
credit for "legitimate" business. The problem, in the opinion of
a majority of the officials, was to prevent extension of credit for
speculation and other nonessential purposes, and to bring about
liquidation of such credit already outstanding. Referring to
speculative uses of credit, one Federal Reserve official stated near
the end of 1919: "For the longer this volume of credit remains in
use in excess of our requirements for producing and distributing
goods and carrying on the usual business of the country, the
longer will be delayed a return to more normal business and price
conditions."
These objectives called for conflicting actions. Continuation of
low rates was desirable in order to facilitate Treasury financing
and to avoid inflicting losses on those holding Government securities with borrowed funds. Some form of restraint was needed
to prevent credit from feeding the boom. Conflicting objectives
and disagreement as to the type of action that should be taken
were major influences on System policy during the postwar
expansion.
3
Proceedings of a Conference of the Federal Reserve Board with the Governors
of the Federal Reserve Banks, November 19-21, 1919, Vol. II, pp. 249-250,
253-254.

FEDERAL RESERVE POLICYMAKING

Continue the preferential rate?

Early in the postwar period, there was considerable discussion as
to how long the preferential rate on advances to member banks
collateralled by Government securities should be maintained.
There seemed to be general agreement that, with the war over,
more consideration should be given to the System's main responsibility of pursuing policies appropriate to the private credit
situation. But there was little sentiment for removing the preferential rate on Governments in the near future. One Reserve Bank
president, strongly in favor of getting member banks to liquidate
their indebtedness as soon as possible to restore a more "normal"
credit situation, stated the optimism of some officials reminded
him of the fellow who fell out of the 20th story window of a building and as he passed the 10th story said, "I'm all right so far."
Despite an awareness of the unhealthy credit situation and
developing boom, the preferential rate was maintained through
1919. Several factors were decisive in the prolonged delay in
terminating it. Most important, perhaps, was the resolute resistance of the Secretary of the Treasury. He stressed that removal of the preferential rate or any increase in the discount rate
would seriously interfere with Treasury financing. Moreover, an
increase in the discount rate would be ineffective; curtailing use
of credit for speculative and other nonessential purposes could be
better achieved by "direct pressure" in administering discounts
and advances. Not until early 1920 did Treasury officials think
debt management problems were well enough in hand for discount rate policy to be directed toward other objectives.
Another important reason for delay in removing the preferential rate or in raising the discount rate on commercial paper was
a strong conviction among Federal Reserve officials that they had
a moral obligation not to "pull the rug out" from under those
who had responded to official urging to borrow and buy Government securities. There was also fear that an increase in discount
rates would result in widespread liquidation of Government
securities and possibly drastic declines in securities prices.
As the Treasury's financing problems became less pressing and
as the business boom accelerated, sentiment in favor of terminating the preferential rate increased. At the Presidents' Conference

POST-WORLD WAR I: BOOM AND DEPRESSION

in April, 1920, only three of the 12 presidents favored discontinuance. But as time passed there was growing recognition that the
preferential rate was the effective rate because member banks
pledged collateral that was entitled to the lower rate. By the fall
of 1920, the presidents agreed that a uniform discount rate for all
classes of paper should be established in the near future.
Direct pressure

Divergent views as to the role of credit and problems of implementation led to sharp disagreement as to how "excessive" credit
expansion could best be curtailed.
Those who visualized the credit problem primarily as misuse
rather than too much, logically favored a selective approach—
attempting to prevent extension of credit for speculative and nonessential uses. They advocated direct pressure, the Reserve Banks
refusing to make discounts and advances to member banks for
other than legitimate and productive purposes. One System
official expressed the opinion that while quantitative controls are
useful, intelligent and discriminating policy that withholds credit
when it is to be used for nonproductive purposes but does not
withhold it to feed production is far better.
Another main argument for direct pressure was that an increase
in the discount rate would not be effective. In the fall of 1919, the
Secretary of the Treasury in a letter to the Chairman of the Board
of Governors urged that the Board take charge of policy and insist that the Reserve Banks exercisefirmdiscrimination in making
advances, in order to prevent abuses of Reserve Bank credit facilities instead of relying too much on higher rates. He said the speculative mania in securities, land, and commodities had developed
to such an extent that the credit structure was gravely threatened.
The Secretary gave several reasons why the discount rate
would not be effective under existing conditions. First, a higher
rate would fall lightly on the borrower for speculative purposes
because he operates in anticipation of a large profit. Second, a
materially higher discount rate might penalize and discourage
the commercial and industrial borrower, curtail production, increase the shortage of goods, and thus increase commodity
prices. Rising prices would stimulate, not retard, speculation.

FEDERAL RESERVE POLICYMAKING

Third, an increase in the discount rate would have a "grave
effect" upon the Government's finances. Moreover, when the
Government's debt was small and owned by permanent holders,
possession of eligible paper was strong presumptive evidence of a
member bank's right to borrow; however, this was no longer true
with a large postwar debt which was widely held. Finally, with
the international gold standard having been abandoned, the discount rate would operate solely on the domestic situation. A
higher rate would not curb imports or stimulate exports; hence
it would have no significant effect on gold flows.
Case for the discount rate

One of the principal arguments for using the discount rate to curb
expansion was a practical one; it was impossible to control use of
credit by direct pressure through administration of the discount
window. Member banks borrow to replenish reserves, and reserve positions are impaired by a variety of transactions including
loans already made. Use of the proceeds has usually been determined before the bank asks for an advance. Moreover, even if
initial use could be regulated, secondary uses could not. Reserves created by advances to a bank with no speculative loans
might well be transmitted via the money market to banks with
speculative loans. Neither is it possible to distinguish between
essential and nonessential uses of credit, an important reason
being that the type of paper offered to the Reserve Bank is no
indication of the use to be made of the proceeds.
There were other practical disadvantages of direct pressure via
the discount window. Refusing advances to member banks that
had already entered into commitments might cause serious difficulty, even failure, whereas an increase in rate would discourage
future commitments. Direct pressure would reach only those
member banks that were already overextended and borrowing
from the Reserve Banks. Competition would seriously impair the
effectiveness of direct pressure because of fear that refusing to
make loans for certain purposes might result in customers going
to another bank which would make the loans.
Those favoring use of the discount rate contended an increase
would restrict speculative and nonessential uses of credit. One

POST-WORLD WAR I: BOOM AND DEPRESSION

Reserve Bank president who thought much of the problem was
use of credit for extravagant and wasteful spending favored the
discount rate. He thought direct pressure was impossible to implement, but he also believed an increase in the discount rate
would effectively curb use of credit for speculation. He stated the
first response of New York money-market banks to pressure on
their reserve position was to call some of their loans to brokers
and dealers.
The most logical argument for use of the discount rate instead
of direct pressure was the minority view that low rates were the
real source of the credit problem. Cheap and liberal credit encourage anticipatory buying, advance commitments bid up
prices, and rising prices stimulate demand for and a further expansion of credit. An increase in the discount rate would be interpreted as a signal that credit was likely to be less plentiful as
well as more expensive; as a result, business firms would be discouraged from making advance commitments and building up
inventories. Significantly, this argument for rate action stressed
availability as well as cost of credit.
HOW TO DEAL WITH EXCESSIVE MEMBER BANK BORROWING?

Substantial support within the System for direct pressure and
strong opposition to a rate increase led to a search for methods of
curtailing the boom without a general increase in discount rates.
The Board of Governors, in a letter of July 10, 1918, to the presidents of the Reserve Banks, had stated the Board was in agreement with the consensus expressed at the Presidents' Conference
that excessive rediscounts could be controlled by such techniques
as requiring additional collateral and informing member banks
they had reached their limit. The Board preferred these methods
to a change in discount rates. In fact, the Board had refused the
recommendation of one Reserve Bank to advance its discount
rate as a means of controlling excessive borrowing.
Additional collateral

Some Reserve Banks required more than 100 per cent collateral
for certain advances to member banks. Sometimes the purpose

FEDERAL RESERVE POLICYMAKING

was safety. For example, one Reserve Bank required a margin of
at least 20 per cent on advances collateralled by cotton because
of the situation in the cotton industry.
But some Reserve Banks used additional collateral as a means
of discouraging excessive member-bank borrowing. The larger
the amount of borrowing the higher the margin of additional
collateral required. At times a number of member banks were
putting up as much as 100 per cent additional collateral. In extreme cases of excessive borrowing, additional collateral was
sometimes required in order to reduce the amount of paper the
banks had available for discount.
Moral suasion

Reserve Bank officials also asked member banks to use discretion
in extending credit. One Reserve Bank sent a circular to all of its
member banks requesting them not to make speculative loans,
including loans to hold commodities for higher prices. Several
Reserve Bank officials thought moral suasion had good effects in
their districts, but the majority believed moral suasion alone was
not sufficient.
Some Reserve Bank officials held conferences with excessive
borrowers and used examiners' reports to see whether the banks
were making loans for speculation or similar purposes. If found
to be making improper use of Reserve Bank credit, the banks were
asked to liquidate some of these loans instead of borrowing from
the Reserve Bank.
In the spring of 1920, the Board of Governors asked the Reserve Banks to submit a written report of methods employed to
keep informed on how member banks were using Reserve Bank
credit. Even though the Reserve Banks tried to keep up with the
loan and investment policies of their member banks, the presidents were unanimous that it was not practical in peacetime to
try to distinguish between essential and nonessential uses of
Reserve Bank credit.
Progressive discount rates

The Board of Governors suggested as early as 1918 that Reserve
Banks establish a normal line of credit for each member bank and

POST-WORLD WAR I: BOOM AND DEPRESSION

apply graduated discount rates to borrowing in excess of that
line. After considering the disadvantages of graduated rates,
they decided it would be preferable for Reserve Banks to use
moral suasion with member banks borrowing apparently excessive amounts. But in its Annual Report for 1919, the Board
recommended to Congress an amendment to the Federal Reserve Act giving authority to establish graduated discount rates.
The authority was granted in April, 1920.
Four Reserve Banks—St. Louis, Kansas City, Dallas, and
Atlanta—established progressive rates effective in April and
May, 1920. The usual surcharge on amounts borrowed in excess
of the basic line ranged from 1/2 per cent to 21/2per cent above
the regular discount rate. Unusually high surcharges were paid in
only a few cases, and only on small amounts; however, critics
sometimes cited without qualification extremely high discount
rates paid by some member banks.
The presidents of the Reserve Banks agreed that the basic line
should reflect a member bank's fair share of total borrowing from
the Reserve Bank. A member's fair share, according to the presidents, should represent its contribution to the lending power of
the Reserve Bank, namely the sum of its required reserve plus
capital paid into the Reserve Bank. It was agreed, however, that
each Reserve Bank should determine the basic line for its member
banks; that the method need not be absolutely uniform in all districts. The Reserve Banks which established progressive rates exempted loans against Government securities from computation
of the basic line, and some exempted loans against agricultural
paper.
Official discussions revealed significant differences of opinion
within the System as to the desirability of progressive discount
rates. One of the principal arguments for progressive rates was
that moral suasion and careful administration of the discount
window were not fully effective because member-bank officials
always insisted they were borrowing for legitimate purposes. In
the words of one of the Reserve Bank presidents, "no words are
as persuasive as one and one half per cent." Another advantage
was that the cost was increased only on excess borrowings of
member banks. Progressive rates enabled a Reserve Bank to

FEDERAL RESERVE POLICYMAKING

maintain a low basic discount rate which would be helpful to
business and agriculture.
Some Federal Reserve officials were strongly opposed to progressive rates. A significant weakness for those favoring a selective
approach was that it did not discriminate between productive
and nonessential uses of credit. Some Reserve Bank presidents
thought a progressive rate had less influence on member-bank
borrowing than the possibility that a Reserve Bank might refuse
to lend. In addition, establishing a basic line might serve as an
invitation for member banks to borrow up to that amount. Exempting from the basic line, advances against Government securities and in some cases agricultural paper seriously reduced
the effectiveness of progressive rates. Some member banks
avoided the surcharge by borrowing from correspondents in
Reserve Districts which did not have progressive rates.
A serious inherent weakness of progressive rates apparently
received little attention. The basic line provided no evidence
that borrowing up to that amount would be for appropriate
purposes. Neither was borrowing in excess of the line any indication of inappropriate borrowing. The penalty was automatically
applied on the basis of quantity without regard to the reasons for
borrowing. Rule was substituted for discretion in administering
the discount window. It is not surprising that the four Reserve
Banks abandoned their progressive rates within a few months.4
4
Two additional proposals for imposing restraint may be of interest to historians
even though they did not receive serious consideration. A member of the Board of
Governors suggested establishing a ceiling on Federal Reserve note issues. When the
ceiling was reached, a Reserve Bank could get additional Federal Reserve notes only
by convincing the Board that more notes would contribute to production and would
be in the public interest. He thought controlling the note issue was the chief function
of the Board and alleged that the ceiling on note issue would stiffen the will power of
officials, enable the Reserve Banks to deal more effectively with member banks, and
thus provide a more effective method of controlling expansion.
The proposal had little support among other Federal Reserve officials. They believed credit could be regulated more effectively by using the discount rate and discount policy as needed. One member of the Board stated the opposition well in saying that a ceiling on note issue would be like a doctor saying to his patient, "Stop
shivering with the ague; from now on you are entitled to only one shiver a day."
In 1920, a proposal was made that the Board of Governors levy a tax on the portion of Federal Reserve note issues not covered by gold (under Section 16 of the Act)
to help restrain expansion. The intention was that Reserve Banks with large reserve
ratios would pay out gold and gold certificates instead of paying a tax on Federal
Reserve notes. The resulting decline in reserve ratios would make a restrictive policy
more acceptable to the public.

POST-WORLD WAR I: BOOM AND DEPRESSION

A NEW PROBLEM: DEPRESSION

Treasury officials informed the Federal Reserve that early in 1920
debt management operations would no longer require that discount rate policy be directed toward facilitating Treasury financing. The fact that the gold reserve ratio of the Federal Reserve
Banks was approaching the legal minimum was believed to be
another reason for Treasury acquiescence to a more restrictive
discount rate policy. The discount rate was increased sharply,
the final increase to 7 per cent by some Reserve Banks being made
before midyear. The postwar boom reached its peak before
mid-1920 and was followed by depression and falling prices.
Federal Reserve officials, who had been striving to find some
way to curtail the boom without making credit scarcer and more
expensive for Government and for business, were confronted with
a new problem. The key to understanding Federal Reserve policy
in the depression is the views of System officials as to the causes of
business fluctuations.
Why depression?

Federal Reserve authorities were aware of well-defined cycles in
business activity. The Annual Report of the Board of Governors
for 1921 described cycles in business: rising business activity and
increasing production; excessive expansion and speculation followed by panic and forced liquidation; a long period of slow
liquidation, business depression, and stagnation; and revival.
A member of the Board stated early in 1919: "The most serious
part of inflation is, after all, the aftermath. We sow the wind to
reap the whirlwind. Somehow or other we have got to come down
off the perch." The president of a Reserve Bank stated with reference to the deflation and depression of 1920-1921, "Nature brought
it on." The consensus of System officials was that deflation and declining prices were the aftermath of war and were inevitable;
that no institution or individual could have prevented either the
boom and rising prices or the subsequent decline.
History demonstrated not only that depression always follows
war and inflation, but the more intense the boom the more severe
the reaction. The Annual Report of the Board for 1921 stated:

FEDERAL RESERVE POLICYMAKING

. . . if the flow of the incoming tide can be controlled so that the crest may
not be reached too rapidly nor rise too high the subsequent reaction will be less
severe and the next period of industrial and commercial activity and general
prosperity will be marked by saner methods, greater achievement along constructive lines, and by a longer duration than any which we have had before.5

Thus the intensity of the postwar boom meant that readjustment
and deflation would be more severe.
The above theory of the business cycle was in good standing.
There was a general belief that the real injury was done during
the period of credit expansion, not during credit contraction
which was considered curative. Professor Sprague of Harvard
University, one of the most highly esteemed economists of the
time, stated with reference to the depression of 1921: "A period
of readjustment and liquidation was inevitable. Liberal credits at
low rates in 1920 would have deferred its advent somewhat, but
with the certain consequence that the difficulty and losses incident to readjustment would have been materially enhanced."6
Policy objectives
The depression of 1920-1921 was the first opportunity for Federal
Reserve authorities to formulate policy relating to domestic conditions solely on the basis of their own beliefs. During the war and
the postwar period until early 1920, policy had been directed
toward facilitating Treasury financing. The postwar boom had
just about reached its peak when Treasury officials agreed that
policy need no longer be directed mainly toward Treasury debt
management operations.
What goals shaped System policy during the depression? Were
actions directed toward forced liquidation and deflation as sometimes charged?
The answer is a definite no, according to the official record
of policy discussions and other statements of officials just prior to
and during the depression. The quotation at the beginning of
this chapter is a statement made in a joint conference of the three
policymaking groups: Board of Governors, presidents of the Reserve Banks, and Federal Reserve agents of the Reserve Banks—
5
6

Page 99.
Agricultural Inquiry, Hearing, op. cit., Vol. II, p. 468.

POST-WORLD WAR I: BOOM AND DEPRESSION

in the fall of 1920. The Annual Report of the Federal Reserve
Board for 1919 stated that credit expansion must be checked but
that deflation "merely for the sake of deflation and a speedy return to 'normal'—deflation merely for the sake of restoring securities values and commodity prices to their prewar levels without regard to other consequences, would be an insensate proceeding in the existing posture of national and world affairs."7
The primary objective of System policy followed logically from
the theory officials had as to the nature and causes of business
fluctuations. It was necessary to get rid of the excesses built up
during the boom and to restore credit to its "proper" role of financing production and the orderly distribution of goods to consumers. To achieve this objective required orderly liquidation of
the excesses and preventing extension of new credit for speculative and nonessential purposes.
"Orderly liquidation," a term frequently used by System
officials in this period, referred to readjustments regarded as
essential for recovery, proceeding neither too slowly nor too
rapidly. If liquidation is too slow, distress and agony are unduly
prolonged. If rapid and too drastic, liquidation might precipitate
the dumping of topheavy inventories on the market, disorderly
decline, and excessive hardship and losses.
A second and closely related problem of implementation was
to limit new extension of credit to productive uses. The intention
was not necessarily over-all credit contraction; it was an orderly
liquidation of credit for speculation, for holding excessive inventories, and other nonessential purposes. New credit should be
extended only for productive purposes, and the total increase
should not exceed the rise in total volume of production.
These two methods of trying to achieve the primary goal,
officials were careful to point out, did not mean they were striving
for deflation per se or to roll back prices to some former level.
They were in agreement that regulating the level of prices was
not one of the functions of the Federal Reserve System. But
orderly liquidation would tend to moderate the price decline, and
restoring sound credit conditions would result in a "healthy
price level."
7

Page 72.

FEDERAL RESERVE POLICYMAKING

Discount policy

Administration of the discount window was an important method
of encouraging orderly liquidation. Discussion of this phase of
policy lends strong support to the view that officials were seeking
orderly but not forced liquidation.
At a joint meeting of the Board of Governors and presidents of
the Reserve Banks in April, 1921, there was not a single spokesman in favor of direct pressure to force liquidation of loans. The
consensus was that any attempt to compel liquidation would
bring a further decline of prices, depreciation of the value of collateral, and thus undermine outstanding loans. It was better to
try to carry borrowers until market conditions improved and
their loans could be repaid. A member of the Board, who was an
ardent advocate of the real-bills doctrine, stated that at times like
this "direct action, unless applied . . . with utmost discrimination and the fullest knowledge, . . . is little short of destructive
and almost criminal." He said the time for direct action was to
prevent development of a bad situation, not to correct it. A Reserve Bank president stated in the spring of 1921, "we think it
little short of a crime to force the liquidation of commercial commodities at this time, . . ."
A go-around at this April, 1921, meeting revealed that some
Reserve Banks had been working with excessive borrowers in an
effort to get their indebtedness down to a more reasonable basis;
but none had asked the banks to force their customers to liquidate. Reports indicated that member banks sometimes used the
Reserve Banks as a crutch to put pressure on large and persistent
borrowers to pay up. In fact, a few presidents said member-bank
officials had asked them for statements they could use with their
large borrowers, but the requests were refused. The fact that
member banks were using the Reserve Banks to get some of their
large and persistent borrowers to pay up was believed responsible
for much of the public criticism that the Federal Reserve was
forcing liquidation.
Discount rate policy

Discount rate policy was also directed toward restoring a
normal situation in which use of credit would be confined to

POST-WORLD WAR I: BOOM AND DEPRESSION

production and orderly marketing of goods and services. In the
spring of 1921, at joint conferences of the Board of Governors
with the presidents and a Class B director from each Reserve
Bank, there was extended discussion of discount rate policy and
whether rates should be lowered. A large majority opposed a reduction at the time. Liquidation was not yet complete. Reduction
of discount rates would have little effect on the volume of borrowing from Reserve Banks and might be interpreted as a signal of
"loosening up." A number of officials expressed fear that lower
rates would only stimulate use of credit for speculation and other
ill-advised purposes rather than for legitimate business. Lower
rates might also delay needed liquidation and readjustments.
Many country banks were over-loaned to help customers carry
agricultural products which they did not want to sell at sharply declining prices. The consensus was that the Reserve Banks should
work with these banks to help them get out of a difficult situation.
A small minority favored lowering the discount rate. They
thought liquidation was mostly complete and a lower rate might
encourage expansion.
The theory that depression was a period of liquidation and readjustment essential for a sound business recovery led to a passive
rather than a positive Federal Reserve policy. Maintaining discount rates at a high level was considered desirable, both to encourage liquidation of credit excesses built up during the preceding boom and to discourage the use of new credit for nonessential purposes. Bagehot was often quoted in support of a
policy of making credit readily available but expensive. There
was no sentiment for low discount rates to stimulate recovery. A
sound recovery could occur only after essential readjustments had
been completed. The Chairman of the Board of Governors, in the
spring of 1921, said the Federal Reserve System did not intend to
try to correct the existing situation by encouraging a new credit
expansion, new inflation, or by the adoption of some nostrum or
artificial remedy.
Other policy thoughts

Apprehension in 1921 that gold imports and a rise in the reserve
ratio of the Reserve Banks might result in pressure for a reduction

FEDERAL RESERVE POLICYMAKING

in discount rates led to suggestions for offsetting the effect on reserves. One proposal was for Reserve Banks to pay gold coins and
gold certificates into circulation. Most Reserve Bank presidents
were opposed. They thought gold coins and gold certificates paid
out would come right back. Moreover, they were opposed to this
method of trying to justify a certain discount rate policy.
Another suggestion was to leave some gold in the Bank of
England under earmark where it would not count as reserve of
the Reserve Banks. This proposal also gained little support.
In the fall of 1921, there was considerable discussion of the disorganized state of foreign exchange markets. The President of the
Federal Reserve Bank of New York thought some method of
stabilizing foreign exchange rates had to be worked out as a prerequisite to any real revival of world trade, and that responsibility
for doing something rested primarily on the Federal Reserve
System. In his opinion, disorderly foreign exchange markets reflected mainly currency inflation in many countries; government
budget deficits; imposition of reparation payments on Germany;
and possible insistence that foreign governments make their payments of interest and principal to the United States at a faster
rate than ordinary processes of trade would permit. He thought
several foreign countries—Switzerland, Holland, Denmark,
Sweden, Norway, Japan, and England—had their finances in a
condition so that it might be possible to stabilize their exchange
rates.
In his opinion, one of the best approaches might be establishment of a fund to trade in foreign exchange. The central banks of
some of the major countries might join with the United States in
establishing a fund—perhaps of about $300 million. A relatively
small amount of buying or selling appropriately timed could have
a substantial influence on exchange rates. Hence operations in
small volume would probably suffice to stabilize exchange rates
for countries with balanced budgets and stable currencies.

PIONEERING IN POLICY:
OBJECTIVES AND GUIDES

The gold standard went in abeyance in 1914. . . . The
Reserve system really had nothing, therefore . . . to guide it
when it had to face the first serious test after the war. . . .
[It] was a good deal like a ship at sea without . . . rudder
and compass to guide it. All the old paraphernalia had become
. . . useless, and nothing new had been devised. . . .
1 think it is to the everlasting credit of our Federal reserve
system that it soon recognized the need for new instruments of
regulation and began to set about their construction.
—Adolph C. Miller, 19261

The next few years, following the depression of 1920-1921, was
an era of pioneering in central banking thought. There were three
main reasons for the unusual progress during this period.
The war and its aftermath had swept away the environment in
which central banking thought had developed. Prewar objectives
and guides had been built around the international gold standard. They were oriented toward the balance of payments, foreign
exchange rates, and protecting the gold reserve. The gold standard had been abandoned and System officials recognized that the
old objectives and principles were not appropriate in the new
environment. It was their task to try to develop objectives and
policies that would be appropriate.
A second reason was that Federal Reserve officials were relatively free from pressing problems for the first time since the beginning of the System. From 1914 to 1921, they had been preoccupied with a series of problems: organizational, jurisdictional,
and operational issues involved in launching the new System in
an environment disrupted by war; assisting the Treasury in its
1

Member of the Board of Governors.

FEDERAL RESERVE POLICYMAKING

war and postwar financing operations; development of the postwar inflationary boom; and finally the severe postwar depression,
widely regarded among System officials as the inevitable aftermath of war and the ensuing boom. Now they were in a position
to concentrate on the policy role and responsibilities of a central
bank. An important step in this direction was the annual conferences of the three policymaking groups: Board of Governors,
presidents of the Reserve Banks, and Federal Reserve agents of
the Reserve Banks—which were devoted primarily to papers and
discussion on various aspects of Federal Reserve policy.
Third, the postwar boom and depression, especially the latter,
were sobering experiences for policymakers. They did not think
credit policy was to blame, but the public was not so generous in
its appraisal. There was widespread criticism of the Federal Reserve. Several Federal Reserve officials were grilled at length in
a Congressional inquiry in 1921, and many influential members
of Congress thought Federal Reserve policy was largely responsible for the depression. This criticism left a deep impression on
System officials and undoubtedly was a strong motive for exploring much more thoroughly just what the Federal Reserve could
and should do.
One of the first tasks was to reappraise the role of the Federal
Reserve. What should it try to achieve? What tests could be used
to determine timing of actions needed to achieve objectives?
POLICY OBJECTIVES

Perhaps for the first time, central bank policy was oriented toward
domestic economic conditions instead of the balance of payments
and the gold reserve.
Accommodating business

From the beginning of the System, accommodating commerce
and business usually entered into policy discussions. Officials considered accommodating business at reasonable rates to be one of
the functions of the Federal Reserve Banks. Following World War I,
accommodating business began to acquire a special meaning
among System officials; it also became a more important objec-

PIONEERING IN POLICY: OBJECTIVES AND GUIDES

tive. In the spring of 1923, the Board of Governors stated that
accommodation of commerce and business should be the principal objective of open market operations.
System officials gave considerable thought to developing tests
or standards that could be used to determine when business was
being accommodated in a satisfactory manner. The result was
development of a particular philosophy as to the role of credit.2
The primary function of credit was to help finance production
and the orderly distribution of goods from producer to consumer.
It was appropriate, therefore, that credit be extended for production, storage and marketing of goods and services. Accommodating business also included meeting seasonal and other temporary
needs for credit and currency, and it soon became established
Federal Reserve policy to facilitate adjustments to short-term
stresses and strain such as arise at quarterly tax-payment dates
and during the crop-marketing season.
But officials were careful to point out that certain uses of credit
were not consistent with their concept of accommodating commerce and business. Credit should not be used for speculative
purposes. According to the Board's Annual Report for 1923,
"the economic use of credit is to facilitate the production and
orderly marketing of goods and not to finance the speculative
holding of excessive stocks of materials and merchandise." Speculative purposes embraced use of credit to hold goods, real estate,
or securities in anticipation of higher prices.
A second use inconsistent with the concept of accommodating
business was extending credit that results only in higher prices
instead of more production. As stated in the Annual Report:
"When production reaches the limits imposed by the available
supplies of labor, plant capacity, and transportation facilities—
in fact, whenever the productive energies and resources of the
country are employed at full capacity—output can not be enlarged by an increased use of credit and by further increases in
prices." An increase in credit was not justified if it only resulted
in one business being able to produce more and another produce less.
2
A good analysis was given in the Annual Report of the Federal Reserve Board,
1923, pp. 29-39.

FEDERAL RESERVE POLICYMAKING

A corollary of the objective of providing credit only for production and the orderly distribution of goods was prevention of
inflation and deflation. Depression was visualized as the inevitable result of an inflationary boom; and booms were generated
by improper uses and excessive expansion of credit. Consequently,
confining credit to productive uses, as defined above, would automatically prevent inflation and depression; however, should depression occur, this theory called for a passive Federal Reserve
policy aimed at facilitating orderly liquidation and readjustment.
Aggressive ease to stimulate recovery was considered undesirable.
But as the effects of Federal Reserve actions, especially open
market operations, became more fully understood the attitude
regarding a passive policy during a slump began to be modified.
Open market operations could be used at the Federal Reserve's
own initiative to put additional funds in the market. By the mid1920's, some officials believed an easy money policy should be
used in depression to promote recovery, just as restraint should be
used to curb a boom.
Price stability

Postwar boom and deflation focused attention on economic hardships imposed by price fluctuations. The relation between the
volume of credit and prices was a topic of not infrequent discussion, and proposals were made outside the System that price
stability should be a major objective of Federal Reserve policy.
In 1926, a bill was introduced in Congress to make stabilization
of the price level a statutory objective.
Federal Reserve officials, in extended internal discussions and
in testimony at Congressional hearings, expressed vigorous opposition to price stability as a declared objective. They agreed
that credit had some influence on prices and that price movements were a factor to be considered in formulation of policy.
But they were practically unanimous in their opposition to making price stability a statutory objective.
The core of their opposition derived from a belief that price
stability was the result, not the cause of economic stability.
According to their theory of business fluctuations, Federal Reserve policy would make its best contribution toward price stabil-

PIONEERING IN POLICY: OBJECTIVES AND GUIDES

ity when directed toward maintaining sound credit conditions as
described above.
Federal Reserve officials had several more specific objections.
They believed the price level was determined largely by nonmonetary factors over which they had no control. Therefore, to
make the Federal Reserve responsible for price stability would
mean the System was doomed to failure in achieving a statutory
objective. Second, establishing price stability as a declared objective would be certain to lead to misunderstanding and unjust
criticism of the Federal Reserve. Remembering 1921, officials
were fearful that farmers and other producers would expect the
Federal Reserve to keep prices of their products stable, and in the
event of a decline the System would be held responsible. Furthermore, the fact that the System could not achieve the established
objective would in itself result in criticism. Third, changes in the
price level register an accomplished fact. Credit policy should
take into consideration factors that work before a change in the
price level occurs. The need is for timely action which often
should be taken before the chain of events is reflected in the price
level. Finally, some officials emphasized that no statistical mechanism or formula is an adequate goal of credit policy. One Reserve
Bank official said: " I do not think that the discount policies of the
reserve bank should be determined by watching a chart or an index of the price level." There were too many elusive factors that
should be considered to fit them into any mechanical formula.
GUIDES TO POLICY

Goals to be aimed at was only the first step in policy considerations. Papers were given and extended discussion was devoted to
guides or tests that would indicate actions needed to achieve objectives. The problem was twofold: conceptual and analytical in
the sense of determining what would be effective guides in our
economic and financial environment; and development of information needed in order that the guides might be used.
Rules not feasible

Federal Reserve officials seemed to be in complete agreement that
effective policy could not be formulated according to some simple

FEDERAL RESERVE POLICYMAKING

rule or mechanical formula. In the early twenties, some economists proposed that rules should be worked out for changing the
discount rate so that the public could know what to expect. There
was a consensus among Federal Reserve officials that automatic
adjustment of the discount rate according to rule or formula was
not feasible. One official pointed to experience as demonstrating
that developing skill in weighting different factors and varying
the weights as conditions change is the most important element
in policy formulation. Judgment, not rules, is essential in evaluating the various factors and determining which are the more significant under changing circumstances. Even though objectives
remain the same, actions to achieve them will vary according to
changes in business and credit conditions.
Use or quality of credit

Use of credit was an important guide referred to in policy discussions but somewhat less important as an actual determinant of
actions taken because quantitative tools could not be used to
regulate specific uses. If misuse is regarded as a major cause of
trouble, then use being made of credit is naturally an important
guide as to whether some kind of action is called for.
Some Federal Reserve officials believed that the primary responsibility of a central bank was to maintain sound credit conditions. An important test, the primary one for some officials, was
whether credit was being used for speculation in inventories,
securities, or real estate. If quality of credit could be preserved,
quantity would take care of itself. For example, a member of the
Board of Governors stated: "To me the most simple formula of
operating the Federal reserve system to give the country stability
. . . is to stop and absolutely foreclose the diversion of any
Federal reserve credit to speculative purposes."
Few Federal Reserve officials disagreed with the above concept
of sound uses of credit. A large number, however, recognized
serious practical difficulties in trying to implement such a policy.
As explained earlier, the quality or character of the paper offered
at the discount window was no indication of the use to be made
of the reserves so obtained. Some officials went further, stating
that maintaining the quality of paper would not necessarily pre-

PIONEERING IN POLICY: OBJECTIVES AND GUIDES

vent excessive expansion of credit. One Reserve Bank official
pointed out as early as 1922 that the quality of paper offered is
essentially the same in extreme inflation as in deflation. The total
volume of credit could double with little change in either the
volume of physical production or in the quality of the paper.
Hence a better test or guide than mere quality was needed.
Other guides
In groping for guides that would be helpful in formulating policy
to achieve domestic objectives, System officials were pioneering.
It was only natural that discussion ranged over a number of
guides.
Prices, although rejected as an objective, were considered a
useful guide in policy formulation. But some officials cautioned
that price trends should be used with care. In our type of economy there is a general tendency for prices to rise somewhat in a
period of business recovery; the rise reflects improved demand. An
increase in price is the signal for more production of a commodity.
A rise in prices in itself, therefore, is not an adequate test for
credit restraint. As long as production is increasing and responding to the price signal, the situation is not too disturbing. The
danger point comes when prices are rising but physical output
is not. Making more Reserve Bank credit available under these
circumstances is both making possible and supporting the
price rise.
Uses of credit, relation of credit expansion to volume of production, and price trends were some of the fundamental intermediate-term guides. But more immediate guides were also
discussed. Market rates of interest had long been discussed in
connection with discount rate policy. A penalty rate was accepted in principle but was recognized as impractical because
rates differed too widely, both as to type of paper and regionally.
Nevertheless, market rates were usually considered in determining whether a change in the discount rate was desirable. One
consideration was a relationship to market rates that would
enable member banks to borrow at reasonable rates to meet legitimate business demands, but a rate that would discourage borrowing for purely speculative purposes. Officials of the Federal

FEDERAL RESERVE POLICYMAKING

Reserve Bank of New York thought that normally a good relationship was to have the New York discount rate between the
market rate for commercial paper and the rate for bankers
acceptances. The relation between market rates in New York
and leading foreign financial centers such as London became a
significant factor in the twenties. In order to assist other countries
to stabilize their foreign exchange rates and return to the gold
standard, officials tried to avoid establishing a discount rate that
would attract foreign funds and complicate the stabilization
efforts of foreign countries; however, the minutes clearly reveal
that assisting foreign countries was secondary to domestic
economic conditions in policy formulation.
The volume of borrowing at Reserve Banks was another guide
both for discount rate and open market policies. Experience indicated that when member-bank borrowing in the principal financial centers rose substantially, market rates tended to rise above
the discount rate and there was real pressure for reducing loans.
When borrowing dropped to a very low level, market rates declined below the discount rate and there was a tendency toward
credit inflation. A view prevalent among officials, including
the Board's director of research, was that abundant credit at low
rates—especially if for a prolonged period—would likely lead to
marginal uses and a deterioration in the quality of credit. In the
mid-twenties, about $50 million was regarded as a comfortable
level of borrowing at the Federal Reserve Bank of New York
because at that level there was neither marked pressure for
liquidation nor too much ease.
The reserve ratio of the Reserve Banks, although frequently
mentioned, was not an important determinant of policy during
the twenties. An interesting proposal was made early in the
decade by a member of the Board of Governors to separate the
reserve against Federal Reserve notes from that against Reserve
Bank deposits. Gold imports and exports would be reflected in
the reserve against notes, making the reserve ratio against deposits a more sensitive indicator of internal expansion and contraction of credit. Most of the Reserve Bank presidents, although
sympathetic to having the reserve ratio a more sensitive indicator
of business and credit conditions, opposed adoption of the pro-

PIONEERING IN POLICY: OBJECTIVES AND GUIDES

posal. They were afraid public reaction might be that this was
"juggling the reserve figures" with the result that confidence in
the Reserve Banks would be impaired.
RESEARCH AND STATISTICS

Federal Reserve officials recognized that in addition to certain
short- and intermediate-term guides a large amount of background information was needed. Sufficient data to diagnose the
state of the economy were a prerequisite for formulating policy
directed toward domestic economic goals.
In the early postwar period, plans were made to develop a
series of indices that would reflect changes in business activity,
production, trade, employment, prices, and other significant
business and financial activities. Suggestions and advice were
solicited from such well-known economists as professors Irving
Fisher of Yale, Allyn Young of Harvard, and Wesley G. Mitchell
of Columbia in developing the statistical program. Walter
Stewart, who became director of the Board's Division of Research
and Statistics in 1922, made a major contribution in the development and expansion of research activities. The Board also urged
the Reserve Banks to expand their statistical work. In order to
help coordinate and promote a System-wide program, occasional
conferences were held which included representatives of the research staffs of the Board and the Banks. Members of the Board's
research staff visited the Reserve Banks to become more familiar
with their research and statistical work, and in the mid-1920's a
member of the Board's research staff was given the special assignment of keeping informed on research activities in the Reserve
Banks.
The primary purpose in expanding the research program was
to provide information needed for wise policy decisions. A member of the Board stated that by 1923 the System had developed
enough information and had gained enough experience so that
the Board had sufficient confidence to explain the working principles of policy formulation in the Annual Report for 1923.
By the mid-twenties a substantial amount of information was
being presented at meetings devoted to policy formulation. The

FEDERAL RESERVE POLICYMAKING

Board's acting director of research and statistics stated: "The
central aim in working upon these problems is to obtain results
that can be used by the Federal Reserve Board and by the officers
of the Federal reserve banks as a part of the basis for policy decisions." Reports on business and financial developments submitted at meetings of the Open Market Investment Committee,
for example, included such topics as credit developments, loans
and investments of weekly reporting banks, trends in Reserve
Bank credit, money rates, money in circulation, gold movements,
interest rates in the United States as compared with those in
major foreign countries, and a review of the economic situation
in Europe. Unfortunately, progress in developing, interpreting,
and analyzing statistical material outpaced its use by System
officials.3
FOREIGN OPERATIONS

Establishment and development of relations between the Federal
Reserve System and foreign central banks was given consideration both by the Board and the presidents of the Reserve Banks in
the early years of the System. There was general agreement that
establishment of such relationships was desirable and in the
public interest.
Early in the twenties there was renewed consideration of
foreign operations and the role the Federal Reserve System
should play in helping restore international financial stability.
Memoranda were prepared in 1923, for example, reviewing
foreign operations of central banks and analyzing the role the
Federal Reserve System might play. It was pointed out that prior
3
A secondary use of material developed in the research program was publication
of a national summary of business conditions prepared by the Board's staff, and
monthly reviews prepared by the Reserve Banks. The purposes of these publications
were frequently discussed at meetings of System officials. The consensus was that the
publications should present a factual review of business and credit developments
nationally and in the Reserve Districts. There were differences of opinion as to
whether these publications should serve as a means of informing the public of the
functions and operations of the Federal Reserve System. Some were vigorously
opposed to any attempt to explain current Federal Reserve policy on the basis that
"too many spokesmen" would lead to confusion. Others, especially some Reserve
Bank presidents, thought the monthly reviews could make a useful contribution by
explaining some of the problems confronting the Federal Reserve and the policies
it was pursuing.

PIONEERING IN POLICY: OBJECTIVES AND GUIDES

to the war, central banks tried to exercise a stabilizing influence
on foreign exchanges, the flow of gold, and the volume of credit.
The central bank would usually acquire a portfolio of foreign
bills on gold standard countries when foreign exchange rates
were at a low level. When the rate moved up, the central bank
could sell some of its holdings of foreign bills and thereby prevent
or retard gold exports. The general feeling was that the Federal
Reserve Banks should continue close relations with important
foreign central banks. It was also agreed that more effective control over gold movements and foreign exchange rates could be
achieved by cooperation among central banks than by transacting business through private banks.
The Federal Reserve System, especially the President of the
Federal Reserve Bank of New York, played a leading role in
working out arrangements in the twenties to help foreign countries stabilize their currencies and return to the gold standard.
Some of the techniques employed were a forerunner of recent
operations of the Federal Reserve and the Treasury in defending
the dollar.
The Federal Reserve System extended credit to several foreign
central banks to assist foreign countries to stabilize their exchange
rates and to facilitate their return to the gold standard. The
largest amount was the arrangement with the Bank of England.
In 1925, the Federal Reserve Bank of New York entered into an
agreement, to run for two years, to furnish the Bank of England
up to a total at any one time of $200 million of gold. If any part
of the $200 million were used, the Bank of England agreed to
give the Federal Reserve Bank of New York a credit on its books
in sterling for the equivalent of the dollars used. A portion or all
of this balance credited to the Federal Reserve Bank of New York
might be invested from time to time in eligible sterling bills and
held for the Reserve Bank's account. The interest rate charged
the Bank of England for the amount of credit used was to be 1 per
cent above the discount rate of the Federal Reserve Bank of New
York for 90-day commercial paper; however, the rate should not
be less than 4 per cent or more than 6 per cent. If the discount
rate of the Federal Reserve Bank of New York should go above
6 per cent, the Bank of England would then pay the discount

FEDERAL RESERVE POLICYMAKING

rate. The Federal Reserve was protected against loss by a provision that the exact amount of dollars in terms of gold furnished
the Bank of England should be repaid in dollars in New York
plus interest at the agreed rate. The British Government also
guaranteed the obligation of the Bank of England to repay. The
arrangement was approved by the Board of Governors, and all
of the Reserve Banks agreed to participate. As it turned out, no
part of the $200 million credit was actually used.
Arrangements were made with several foreign central banks
whereby the System agreed to purchase from them up to certain
amounts of prime commercial bills. The System also engaged in
foreign exchange transactions at times. If properly timed, purchases or sales in small amounts would provide a stabilizing influence on exchange rates and exert some influence on the inflow
and outflow of gold. In influencing goldflows,these transactions
were considered as a supplement to—not a substitute for—
changes in the discount rate. Foreign exchange operations were
considered an especially useful supplement to the discount rate
at times when an increase in the rate sufficient to check a gold
outflow might raise interest rates, cause a sharp contraction of
credit, and thus have serious adverse effects on the domestic
economy.

PIONEERING IN POLICY:
USE OF THE TOOLS

It should be remembered that the injection of Reserve Bank
funds into the money market [by open market purchases] acts
as a stimulant to it and the resale of such securities has the
reverse effect.
—Open Market Investment Committee, 1923

Along with goals and guides, considerable thought was given to
how the tools might best be used to achieve System objectives.
Early in the twenties, officials recognized there were two channels
through which Federal Reserve funds could be supplied to the
market. The discount window supplied funds at the initiative of
borrowing member banks. Open market operations supplied or
absorbed funds at the initiative of the System.
The discount rate and discount policy were the means of
influencing the flow of funds through the discount window; in
fact, these were the only methods of regulating the flow of credit
that were considered prior to the twenties. Open market operations, initiated to help develop a market for bankers acceptances
and to bolster Reserve Bank earnings, soon came to be recognized
as a significant instrument of Federal Reserve policy. Papers were
prepared by officials and discussed at policy meetings as to use of
the discount rate, open market operations, and coordination of
these twin instruments.
DISCOUNT RATE

Discount rate discussions dealt mainly with the desirability of
preferential rates, effects of discount rate changes, and effectiveness of the discount rate as compared with discretion in administering the discount window.
43

FEDERAL RESERVE POLICYMAKING

Preferential rates

Federal Reserve officials had established a preferential discount
rate on Government securities to facilitate Treasury financing
during the war. At times, a preferential rate had been used to
encourage the development and use of certain types of paper.
In 1923, the Under Secretary of the Treasury proposed a
preferential discount rate on Treasury certificates and bankers
acceptances. He contended that paper which had acquired a
regular status in the open market should have a preferential rate
over ordinary customer loans of commercial banks. Inasmuch as
the Treasury had been trying to develop a market for its certificates and the Reserve Banks had been trying to broaden the
market for bankers acceptances, preferential rates would help
promote a broader market for both, and would encourage banks
to adjust their reserve positions in the market, leaving Reserve
Banks with only marginal demands to be met.
Federal Reserve officials were generally opposed to the Under
Secretary's proposal. Experience demonstrated that a preferential rate becomes the effective discount rate because member
banks use paper carrying the lowest rate. Several were opposed
as a matter of principle. A uniform discount rate for all types of
paper was considered desirable in order that all member banks
have access to Reserve Bank credit at the same rate. Unless
justified by some unusual situation such as war, a preferential
rate was a form of discrimination inconsistent with the public
functions of the Federal Reserve System. Preferential rates on
certificates and acceptances would also tend to discriminate
against country banks because customarily only city banks held
these types of short-term paper. In a vote taken at a presidents'
conference, only one president favored the Treasury proposal.
A preferential discount rate was thus rejected as an instrument
of policy, its use being confined to facilitating Treasury financing
during a war.
Effects of rate changes

Widespread criticism that the Federal Reserve was to blame for
the depression of 1920-1921 was still vivid in the minds of policymakers. Even though they believed deflation and depression were

PIONEERING IN POLICY: USE OF THE TOOLS

an inevitable aftermath of the war, they were anxious to avoid a
recurrence. This was undoubtedly a motive in taking a careful
look at the effects of changes in the discount rate. Two main lines
of thought developed as to effectiveness of rate changes.
One view was that the discount rate was relatively ineffective
in regulating the volume of discounts and advances to a member
bank. In the United States it was impractical to keep the discount
rate above the lending rate banks charged customers. Consequently, the rate was no real deterrent to borrowing. Neither was
reduction in the rate effective in retarding or checking liquidation. Once under way, liquidation would continue until there was
general expectation that prices would not go lower. Reserve
Banks would have to rely mainly on discretion to prevent excessive borrowing by member banks. The principal value of the
discount rate was not in regulating discounting at Reserve Banks
but as a signal of official opinion as to anticipated credit demand.
An increase in the discount rate, for example, served as a precautionary signal which in turn tended to cause banks to be more
careful in making loans to their customers.
The opposing view was that the discount rate as a cost does
influence the volume of member borrowing. Even though the
rate is typically below bank-loan rates to customers it represents
the cost of obtaining additional Reserve Bank credit. An increase
in cost tends to discourage member-bank borrowing, whereas a
decrease encourages borrowing. In the opinion of some presidents, experience demonstrated this was true.
An even more important argument was that discretion could
not be relied on to regulate total volume of credit for the country
as a whole. In a period of expansion, each loan application
received by member banks might well have the appearance of a
proper demand for credit. Approving only those loans which
appeared to be for legitimate purposes would not result in appropriate control of the total volume of credit. The same problem
arises in using discretionary control of the discount window by
the Reserve Banks.1
1
In debating effectiveness of the discount rate at the annual joint conference of
the three policymaking groups in the fall of 1922, two officials with opposing views
referred to their correspondence with a "well-known and highly esteemed" professor in one of the leading universities in support of their positions. It turned out
that both had been corresponding with the same professor.

FEDERAL RESERVE POLICYMAKING

These divergent views on the discount rate reflected two fundamental and related differences: the individual bank versus the
banking system, and use versus quantity of credit. Those favoring
discretion approached the problem from the standpoint of regulating borrowing by an individual member bank. The discount
rate was ineffective for this purpose because it was typically
below bank lending rates. And if ineffective for individual banks
it was also ineffective in regulating total credit.
Those favoring the discount rate were thinking mainly in terms
of the banking system and aggregate credit. Admitting that discretion was sometimes essential to prevent excessive borrowing by
individual member banks, it was not a suitable means of regulating total credit because even if extension of credit were confined
to legitimate uses, the total might still become excessive in relation to physical output. Lurking underneath was the old controversy of use versus quantity as an appropriate goal of credit
policy.
In the fall of 1927, a survey was made as to the effects of a
change in the discount rate on loan rates member banks charged
their customers. Several Reserve Banks sent out letters and questionnaires to all of their member banks; others checked through
their bank relations men calling on member banks. The results
indicated that a change in discount rate had no noticeable effect
on customer loan rates of country banks. There was usually some
effect on rates of larger banks, especially rates closely tied to
market rates, such as brokers' loans, stock-market loans, and
rates on acceptances. Apparently, a change in the discount rate
was often used by large borrowers to negotiate a lower rate; they
would threaten to borrow elsewhere unless the bank reduced its
rate. Respondents reported an increase in the discount rate sometimes resulted in a fairly prompt rise in customer rates charged
by large city banks.
DISCOUNT POLICY

Discount policy was often used with reference to principles governing administration of the discount window. Despite differences of opinion as to whether discretion was an effective means
of regulating total volume of credit, there was agreement that it

PIONEERING IN POLICY: USE OF THE TOOLS

should be used to prevent excessive borrowing by individual
banks.
Many member banks continued to borrow heavily from the
Reserve Banks in the early twenties, not infrequently to carry
Government securities acquired in War Loan and Victory Loan
drives. This large volume of member-bank borrowing focused
attention on discount policy.
In the fall of 1923, a "go-around" revealed that most Reserve
Banks kept close watch on borrowing, especially member banks
that borrowed excessively. Some Reserve Banks still used a basic
line calculated for each member bank as a guide, scrutinizing
more carefully banks borrowing in excess of this line. One Federal
Reserve Bank adjusted its loans to member banks for seasonal
variation to get some idea of whether banks were borrowing more
than their normal seasonal requirements. Practically all of the
Reserve Banks tried to keep informed as to reasons for borrowing,
use to be made of the proceeds, financial condition of borrowers,
and similar information. Most Reserve Banks relied on direct
methods rather than the discount rate to regulate borrowing of
individual member banks. As one Reserve Bank official stated, it
was necessary to treat each case individually, "we must treat the
patient in the bed and not in the book."
Professor Sprague of Harvard University was asked to make a
study of member-bank borrowing, and submitted a report in the
fall of 1925. He reported a large number of member banks still
borrowing as a result of what happened in 1918 to 1920. One of
the problems was to educate member-bank officials as to appropriate borrowing from a Reserve Bank. He suggested that officials emphasize that using Reserve Bank credit to supplement a
bank's own capital is not appropriate.
There was general agreement that borrowing to meet seasonal
and other temporary or emergency needs was appropriate; borrowing to take advantage of a rate differential or continuous
borrowing to supplement a bank's own resources was not.
OPEN MARKET OPERATIONS

A major step in the decade of the twenties was the development
of open market operations as an instrument of monetary policy.

FEDERAL RESERVE POLICYMAKING

The significance of this tool was discovered largely accidentally.
As discounts and advances declined in 1921 as a result of the
depression, the Reserve Banks began buying Government securities to bolster earnings. But it soon became apparent that these
purchases were having significant monetary effects, and that open
market operations should be governed by policy considerations—
not by earnings.
Early goals and guides

Once open market operations were considered a tool of monetary
policy, discussion turned toward the purposes for which this new
tool should be used. By the latter part of 1923, a twofold objective
had emerged. First, they should be used to help stabilize the
business situation by putting additional funds into the market
when business liquidation is going too fast, and withdrawing
funds when business is too active or speculative. Second, open
market operations were a suitable tool for offsetting seasonal
stringencies, and other temporary disturbing forces such as
Treasury operations at tax-payment dates.
These objectives in turn focused attention on information that
would be helpful in determining when and in what quantity purchases and sales should be made in the market. One of the major
guides for open market operations in the twenties was the reserve
position of member banks, especially the money-market banks in
New York City. Movements of funds through the market were
sooner or later reflected in reserve positions of the money-market
banks. The Federal Reserve Bank of New York watched reserve
positions closely, making an hourly tabulation of the more
important factors affecting them. Among the factors included in
reserve estimates were wire transfers, clearing-house balances,
exports and imports of gold, and inflows and outflows of currency.
These estimates and other information provided a reasonably
good indication of whether the New York money market was
likely to have a net gain or net loss of reserves for the day.
A second indicator of conditions in the money market was the
call-loan rate. This was a sensitive rate because money-market
banks used the call-loan market to adjust their reserve positions.
When short of reserves, banks called loans, thus forcing the rate

PIONEERING IN POLICY: USE OF THE TOOLS

up. When they had excess reserves, they were anxious to make
new loans and the call-loan rate tended to decline.
Another guide followed in the twenties was borrowing by member banks, especially in the principal financial centers such as
New York and Chicago. A report of the Open Market Investment Committee in 1926, for example, stated that experience had
shown that when member banks in New York City were borrowing $100 million or more, there was real pressure for reducing
loans. But when borrowings were negligible the money market
was usually easy, with market rates dropping below the discount
rate. Other guides referred to in the twenties were the general
level of interest rates and movement of foreign exchange rates,
the latter indicating the probability of gold imports or exports.
Recommendations of the Open Market Investment Committee
were usually in quantitative terms. For example, in the fall of
1923 the Committee recommended purchases up to $100 million.
There was some preference for conducting operations in shortterm securities because their prices fluctuated in a much narrower
range than longer-term securities.
Effects of open market operations

As with the discount rate, System officials tried to determine
the effects of open market operations. Were the effects limited to
financial centers or did they spread throughout the country?
Most of the presidents thought they had some effect in their
districts. The first effect was likely to be a reduction in borrowing
from the Reserve Bank. Lower rates and easier credit, initially in
New York City where the bulk of the purchases was concentrated, made borrowing in the market more attractive to large
business firms. This put downward pressure on bank rates in the
large financial centers and then tended to spread to other cities.
As one official summed it up in 1926, the effects were felt first
and with the greatest impact in the financial centers, and then
spread over the country with diminishing intensity.
A few officials thought open market operations had certain
advantages over the discount rate. They had the advantage of
being more flexible and therefore could be used at times when an
increase in the discount rate might be too drastic. Open market

FEDERAL RESERVE POLICYMAKING

operations were not followed by the public and hence had less
psychological impact than a change in the discount rate. Because
of these advantages, some thought open market operations were
a suitable tool for probing the market when evidence was not yet
sufficient for a definite and overt move toward restraint or ease.
A member of the Board of Governors had serious reservations
about open market operations. He thought this tool should be
reserved for "rare occasions" when its use was necessary. Reserves supplied by open market operations were much more
likely to be misused than reserves supplied through the discount
window. Purchases release funds to the market without any restrictions as to use. Initially, the funds go mainly to moneymarket banks and unless business demand is sufficient to absorb
them, the banks put the funds into the call-loan market. In his
opinion supplying reserves when business demand for credit is
slack is practically an invitation for banks to use them for speculative purposes. He thought open market purchases in 1927, by
creating excess funds which banks put into call loans, provided
the basis for the subsequent speculative stock-market boom.
In contrast to open market operations, reserves supplied
through the discount window are in response to a demand.
Moreover, most member banks are reluctant to borrow from a
Reserve Bank and therefore are unlikely to do so in order to make
speculative loans. For this reason, he thought reserves supplied
through the discount window were much less likely to be misused
than reserves supplied by open market operations.
Centralization and supervision

Effective use of open market operations as a tool of monetary
policy was seriously handicapped by decentralized control. Officials soon recognized that purchases and sales of Government
securities would have to be centralized and coordinated.
In a sense the initial step was taken in October, 1920, when the
Conference of Presidents of the Reserve Banks appointed a standing committee to study and keep informed on market conditions
and practices in bankers acceptances. The committee was expected to develop uniform practices and policies for the Reserve
Banks, suggest buying rates and, in general, work toward broad-

PIONEERING IN POLICY: USE OF THE TOOLS

ening and developing an open market for acceptances. The committee appointed a secretary who had an office in the Federal
Reserve Bank of New York. Each Reserve Bank telegraphed a
weekly report to the secretary, giving information on rates at
which the Reserve Bank had purchased bills, the amount purchased, the amount of repurchase agreements and rates at which
they were negotiated, and the general demand and supply situation for acceptances in its district.
In 1922, the Conference of Presidents established a committee
on centralized execution of purchases and sales of Government
securities. The committee originally consisted of the Presidents of
the Federal Reserve Banks of Boston, Philadelphia, Chicago, and
New York, and later the President of the Federal Reserve Bank
of Cleveland was added.
There were two main reasons for establishment of the committee. An important one was a vigorous complaint by Treasury
officials that the Reserve Banks were creating artificial conditions
in the Government securities market and thus making Treasury
financing more difficult. In fact, Treasury officials wanted the
Reserve Banks gradually to dispose of the Governments they had
acquired and get out of the market altogether. A second reason
was that Reserve Banks were competing against each other. Most
of the purchases were made in New York City because it was the
principal money-market center. The committee's task was to
develop more orderly procedures and bring about better coordination of purchases in order not to interfere with Treasury
operations and to avoid competition among the Reserve Banks.
The Federal Reserve Bank of New York was designated to make
purchases and sales, purchases being allocated among participating Reserve Banks according to an agreed formula.
Even though Reserve Bank officials recognized the need for
centralized operations, they were unwilling to give up the right
of the Reserve Bank to buy and sell for its own account. Practically all Reserve Bank presidents insisted that ultimate decision
as to purchase or sale of securities rested with the board of directors of each Reserve Bank. In October, 1922, the committee
entered the field of policy, with approval of the presidents, by
making recommendations to the Reserve Banks as to the advisa-

FEDERAL RESERVE POLICYMAKING

bility of purchases or sales. In order not to interfere with Treasury
financing, the committee urged the Reserve Banks to stay out of
the market when the Federal Reserve Bank of New York was
executing orders for Treasury account and during a Treasury
financing or refunding operation.
In 1923, the Board of Governors abolished the committee
formed in 1922 and established the Open Market Investment
Committee with the same membership, under the supervision of
the Board. The Board laid down certain principles that should
govern open market operations. First, the time, manner, character, and volume of such operations by the Reserve Banks should
be governed "with primary regard to the accommodation of
commerce and business, and to the effect of such purchases or
sales on the general credit situation." Second, in selecting open
market purchases, careful regard should be given to the effect on
the market for Government securities. Except for repurchase
agreements in Treasury certificates, the Board recommended
that purchases be mainly in eligible commercial paper. In
November, 1923, at the request of the Federal Reserve Bank of
New York and with approval of the Board of Governors, the
Open Market Investment Committee took over supervision of
foreign transactions to help promote a uniform policy.
The new committee was a step forward in centralization of
open market operations. The procedure was for the Open Market
Investment Committee to meet and make recommendations as to
open market policy. Recommendations were then submitted to
the Board of Governors for approval. Once approved by the
Board, each Reserve Bank still reserved the right to participate
or not to participate in the recommended operations. Essentially,
this same procedure continued until the Open Market Committee was completely reorganized under the Banking Act of 1935.
The problem which lingered on into the twenties was the Reserve
Banks insisting on their right to buy and sell long-term Government securities as needed for earnings and to execute transactions
with member banks in their districts. Practically all Reserve
Bank officials recognized, however, that such transactions tended
to nullify the work of the Open Market Investment Committee,
and the volume was not significant after 1924.

PIONEERING IN POLICY: USE OF THE TOOLS

The Chairman of the Board of Governors suggested in the fall
of 1928 that the Open Market Investment Committee be discontinued and an Open Market Policy Conference, consisting of a
representative from each Reserve Bank selected annually by the
board of directors, be established in its place. No action was
taken, however, until the spring of 1930, when a joint meeting of
the Open Market Investment Committee (including informally
representatives from all of the Reserve Banks) with the Board
agreed that the Open Market Investment Committee should be
discontinued. An Open Market Policy Conference, consisting of a
representative from each Reserve Bank, was established in its
place.
The Conference was to meet with the Board of Governors at
the call of the Chairman of the Board, who was also Chairman of
the Conference. The primary function of the Open Market Policy
Conference was to develop and recommend policies and plans
with regard to open market operations. The recommendations of
the Conference, if approved by the Board, were to be submitted
to the Reserve Banks. Any Reserve Bank dissenting from the
recommended policy was expected to give its reasons to the Board
and the Chairman of the Executive Committee of the Policy
Conference.
An Executive Committee of five members was given power to
act in the execution of policies recommended by the Open
Market Policy Conference and approved by the Board of Governors. The Executive Committee appointed for the first year
consisted of the President of the Federal Reserve Bank of New
York as Chairman and representatives (actually presidents) of
the Federal Reserve Banks of Boston, Philadelphia, Cleveland,
and Chicago.
Repurchase agreements

Use of repurchase agreements with dealers was approved by the
Board of Governors, both as to legality and principle, in 1921
and again in 1925. The agreements were usually for a maturity
of up to 15 days.
Initially, repurchase agreements were used to help dealers
carry an inventory of acceptances and securities in times of

FEDERAL RESERVE POLICYMAKING

stringency when credit was not available from the usual sources
at reasonable rates. The ultimate objective was to encourage
development of the market for acceptances. By the mid-twenties,
however, repurchase agreements were being used as a tool of
monetary policy—a convenient method of supplying funds to the
market temporarily.
RESERVE REQUIREMENTS

In the twenties, reserve requirements were thought of primarily
as a means of increasing the safety of deposits. But as early as
1923, one official stated the real function of reserve requirements
was to prevent too much credit expansion.
A Reserve Bank official proposed a revision in 1925 that would
have made reserve requirements a means of influencing credit
expansion and contraction. He suggested that the requirement be
divided into two parts: a certain percentage against demand and
time deposits, and a certain percentage of the banks' indebtedness to the Reserve Banks. The requirement against borrowing
from the Reserve Bank would be levied on a graduated scale, the
percentage rising as the proportion of borrowing to the member
bank's capital increased. For example, the requirement might be
10 per cent when borrowing is 50 to 100 per cent of the bank's
capital, rising to 50 per cent when borrowing is 400 to 500 per
cent of capital. He thought this plan would correct a shortcoming
of fixed reserve requirements in that it would automatically tend
to restrain overexpansion in a boom and encourage expansion in
a recession.
The search for some method of curbing speculative use of
credit with a minimum of harmful effects on business led to a
proposal in 1928 that the Board of Governors be given authority
to raise reserve requirements for member banks in reserve and
central reserve cities. Some officials thought raising reserve requirements in reserve and central reserve cities would hit most of
the banks making stock-exchange loans.
COORDINATION AND TIMING

As the monetary effects of open market operations were recognized, the question arose as to how this new tool might best be

PIONEERING IN POLICY: USE OF THE TOOLS

coordinated with the discount rate. Most of the thinking was in
terms of exercising restraint. Stabilization in the early twenties
was visualized mainly as a problem of preventing an inflationary
boom. This was also considered the best means of avoiding the
depression which would inevitably follow.
Proper coordination of open market operations and the discount rate could provide more effective restraint than either used
separately. Open market operations, which the public did not
regard as a signal of System intentions, were useful for probing
the market to get some idea of the strength of credit demands.
This tool was also more suitable than the discount rate for making
an initial move pending clearer evidence of a need for more or
less restraint. A tentative decision that more restraint was probably desirable could be implemented by selling securities, absorbing reserves, and forcing member banks into the discount window
to borrow. Once it became clear that further restraint was
needed, the discount rate could be increased. And the increase
would be more effective because banks were having to borrow.
Some suggested the opposite sequence—raise the discount rate
and then follow with sales of securities to make it effective. This
sequence was based on the belief that open market operations
were more effective than a change in the discount rate.
For instance, open market operations were used to probe the
strength of credit demands in the latter part of 1922 and in 1923
when prices were moving upward. According to a member of the
Board of Governors, officials were uncertain as to whether the
price rise reflected only a natural readjustment following the
sharp decline in the depression of 1920-1921. To test the situation, securities were sold to take funds out of the market. The
resulting increase in member-bank borrowing from the Reserve
Banks was regarded as evidence that the volume of credit in use
was needed, at least in the judgment of member banks. Some
thought member banks would not borrow from the Reserve
Banks to make speculative loans. A second effect of the open
market sale of securities was to put member banks in a position so
that the discount rate would be more effective.
Coordinated use of these twin instruments was also believed to
be more effective in depression than either used separately. Open

FEDERAL RESERVE POLICYMAKING

market purchases, by putting additional funds into the market,
had a direct stimulating effect on business activity. The funds
supplied also enabled member banks to pay off some of their
debts to the Reserve Banks. Because of member-bank reluctance
to be in debt at the Reserve Bank, debt reduction might increase
their willingness to lend more than lowering the discount rate.
Another type of coordination discussed related to purposes for
which funds were supplied. Borrowing at the discount window
might be used to meet seasonal needs, with open market operations being used to offset temporary deficiencies and surpluses.
Open market purchases might also be used to supply some of the
reserves needed to support credit expansion required by economic
growth.
Proper timing was soon recognized as an important aspect of
using the tools effectively. There was considerable discussion of
the importance of timing in the early twenties. One official said
it had been a common and painful observation to hear that a
certain action would have been proper had it been taken three
or four months ago. In his opinion, blunders and mistakes of the
past were often due to System officials being doubtful and uncertain, which in turn resulted in part from a complex organization
and fairly wide diffusion of responsibility. Uncertainty as to one's
responsibility contributes to hesitation.
Timing of restrictive action was believed to be especially
important in combatting inflation. This same official stressed that
inflation is an insidious process; it does not begin as inflation but
develops and grows into it. He stated: "If you wait with action in
the matter of credit expansion until you see signs clearly that the
development of inflation is unmistakable, then you have overwaited." There was general agreement that prompt action was
likely to be much more effective.
"BETWEEN THE DEVIL AND THE DEEP SEA"

A dilemma began to emerge in the mid-twenties which was to
frustrate and preoccupy officials for the remainder of the decade.
The flow of credit into the stock market and growing speculation
began to arouse official concern as early as 1925. Widespread

PIONEERING IN POLICY: USE OF THE TOOLS

criticism that the Federal Reserve had allowed credit expansion
to get out of hand following the war—even though System officials thought for good reasons—created a strong desire to avoid
a similar thing happening again. Hence there was a general inclination to try to nip speculation in the bud as soon as it emerged.
But officials were confronted with a situation calling for conflicting actions. There was no boom in business activity. In fact,
production was well below capacity, and agriculture which had
suffered severe deflation in the postwar depression was again experiencing declining prices.
Thus the dilemma confronting policymakers: tighten credit
and raise interest rates to discourage speculation with resulting
adverse effects on business and agriculture, or ease credit and
lower interest rates to bolster agriculture and business activity
with the resulting risk of encouraging speculation. This was the
situation that led a Reserve Bank president to state to a Congressional committee in 1926: "There you are, between the devil and
the deep sea."
Officials were agreed as to the twofold goal they should strive
for: to curb the flow of credit into speculative uses without making
it scarcer and more expensive for business and agricultural purposes. But there was sharp disagreement as to action that should
be taken.
One group, which included a majority of the Board of Governors, strongly favored direct pressure in administration of the
discount window. Three main arguments were given in favor of
this method. First, use of credit for speculative activities of any
kind was clearly contrary to the intent of the Federal Reserve Act
that Reserve Bank credit should be restricted to productive uses
in industry, commerce, and agriculture. Second, effective regulation of the quality or proper use of credit would automatically
result in the right quantity, thus avoiding booms and depressions.
Third, raising the discount rate high enough to curb the flow of
credit into the stock market would almost immediately precipitate a crisis with harmful effects on business and agriculture. In
fact, the majority of the Board of Governors thought that by 1929
the call-loan rate was so high and speculation so rampant that
the discount rate could no longer be used effectively. The only

FEDERAL RESERVE POLICYMAKING

effective method of curbing speculation without hurting legitimate business was to refuse advances to member banks using the
proceeds for speculative loans. For these reasons, the Board refused to approve recommendations for an increase in the discount rate made weekly by the Federal Reserve Bank of New
York during the period February 14 to May 23, 1929.
Another group disagreed with the selective approach both on
theoretical and practical grounds. Misuse of credit, such as for
speculative activities, was only a part of the problem. Too much
credit regardless of pattern of use could lead to a boom and inflation. Direct pressure was impractical because the use member
banks make of borrowed reserves could not be determined. Even
if the initial use of borrowed reserves could be regulated, subsequent uses could not. An illustration often given was that an advance might be made to a member bank with no security loans,
but ordinary commercial transactions might shift the reserves to
member banks making large amounts of speculative loans.
Neither would careful examination of a member bank's loan
portfolio accurately reveal customer use of loan proceeds. Loans
made against securities did not necessarily indicate use of credit
to purchase or carry securities. Such loans were often for business
purposes. Hence attempts to regulate use of credit for speculation
without restricting it for other purposes were doomed to failure.
The dilemma together with these widely divergent views of
how best to deal with it led to a policy of watchful waiting. Speculative activity gathered momentum and attracted an everincreasing flow of credit into the stock market. The System began
imposing modest restraint early in 1928 through sales of securities
and higher discount rates. In the late summer of 1928, the Board
suggested a preferential discount rate for agricultural paper and
a preferential buying rate for bankers acceptances in order to
facilitate the marketing of farm products and help cushion the
restrictive impact on agriculture. But because of strong opposition, especially by presidents of the Reserve Banks, the preferential discount rate was not established. In the late summer of 1929,
System officials again tried to soften the impact of growing restraint on agriculture and business by buying bills in the open
market to provide reserves to meet increased demand for credit

PIONEERING IN POLICY: USE OF THE TOOLS

during the crop-marketing season. With the same objective in
mind, it was agreed that the Federal Reserve Bank of New York
should increase its discount rate from 5 to 6 per cent, but increases at the other Reserve Banks should be delayed until after
the seasonal credit demands of agriculture and business had
been met.

THE GREAT DEPRESSION

Very large loans at very high rates are the best remedy for the
worst malady of the money market when a foreign drain is
added to a domestic drain.
— Walter Bagehot

The decade of the thirties was less productive than the twenties in
the development of central banking theory and techniques.
Federal Reserve officials were burdened and preoccupied with
two major problems—a severe financial crisis and depression in
the early thirties, and economic stagnation and huge excess
reserves in the latter half of the decade.
Officials manifested grave concern over the depression, increasingly so as evidence began to emerge indicating that the
country might be in the throes of an unusually severe deflation
and decline in business activity. The developing situation and the
implications for Federal Reserve policy were the principal topics
of discussion at the meetings of policy groups throughout the
depression period. Official records leave no doubt of a dedicated
desire to pursue a policy that would contribute to sound business
recovery. On the whole, analysis and diagnosis of the business and
financial situation were good except that the severity of the
decline was not anticipated, especially in its early stages.
There was also fairly general agreement as to what was happening. But as to causes of the depression and what the Federal
Reserve should do to help bring about recovery, disagreement
soon developed.
A policy of passive ease to facilitate orderly liquidation and readjustments was favored by one group, consisting mainly of
Reserve Bank presidents. For various reasons they opposed
aggressive ease to promote recovery. Others, particularly a few
60

THE GREAT DEPRESSION

members of the Board of Governors and the president of one of
the Reserve Banks, favored a policy of more active ease. They
thought that sooner or later a plentiful supply of funds and low
rates would take hold and help stimulate recovery in business
activity.
Federal Reserve policy during the depression passed through
three general stages.1 In the first stage, from the stock market
crash to the spring of 1932, the principal aim was to make credit
available at reasonable rates to help cushion deflation. In the
second stage, from the spring of 1932 to the spring of 1933,
amendment of the Federal Reserve Act to make Government
securities eligible as collateral against Federal Reserve notes
ushered in a more aggressive open market policy directed toward
building up substantial excess reserves to induce credit expansion
and stimulate business. In the third and final stage, the objectives
were to maintain large excess reserves and to cooperate with the
Government's national recovery program.
PASSIVE EASE
When the speculative bubble burst in the fall of 1929, there was
a consensus that sharp liquidation in the stock market was a serious threat to business stability, especially since there were already
some indications of a possible recession.
Ready availability of credit

The initial response, generally favored by policymakers, was twofold. First, the System should do "all within its power" to assure
the ready availability of credit for business purposes at reasonable
rates. Acceptances and, if necessary, Government securities
should be purchased to avoid any increase and possibly to bring
some reduction in member-bank indebtedness to the Reserve
Banks. Second, the Reserve Banks should follow a liberal discount
and lending policy to member banks during the emergency situation. In conformity with the policy of making credit readily avail1
In view of the interests of students of central banking in this period of monetary
history, policy views are given in somewhat more detail and the chronological order
of their development is adhered to more closely than in the remainder of the study.

FEDERAL RESERVE POLICYMAKING

able, holdings of Government securities and acceptances rose
about $450 million in the last quarter of 1929. The increase seems
small in terms of current magnitudes, but in relation to required
reserves was roughly equivalent to an increase of about $4 billion
at the present time. The discount rate was also reduced.
For the first few months, policy formulation was on the basis of
an ordinary recession. In late January, 1930, the Board of Governors arranged a joint meeting with the presidents of the Reserve
Banks. The consensus was that business was in a recession, the
extent or duration of which could not then be determined. The
panicky feeling manifested earlier had subsided. Funds had been
made available, market rates were lower, and liquidation was
progressing in an orderly way. As to policy, there was general
agreement that any firming of rates should be prevented, but
more ease was not desirable. The majority thought it would not
be effective to try to stimulate business when it was in a downward trend. In their view it would not be desirable "to exhaust
our ammunition now in what may be perhaps a vain attempt to
stem an inevitable recession."
Disagreement over policy
The depression took a more serious turn than was anticipated
early in 1930. The consensus, following a careful review of the
situation in the latter part of May, was that business, agriculture,
and trade were seriously depressed both here and abroad. As for
policy, developments should be watched very carefully and the
System should be prepared to act promptly if conditions warranted.
The worsening business and credit situation provoked a basic
disagreement over policy in mid-1930 which continued during
most of the depression. A small majority of the Board of Governors and Reserve Bank presidents favored buying up to $25 million of Government securities each week in the first two weeks of
June. The aim was to make funds somewhat more readily available in the hope that it might encourage new business undertakings and thereby increase demand for surplus products overhanging the market. In the latter part of June the Executive
Committee of the Open Market Policy Conference rejected by

THE GREAT DEPRESSION

a four to one vote the Chairman's proposal that purchases of
Government securities at about $25 million a week be continued.2
The group favoring somewhat more ease thought that inasmuch as the situation was getting worse instead of better, the
System should do everything possible to establish easy money
conditions favorable to business recovery. Discount rates and the
buying rate on acceptances had been sharply reduced. The discount rate of the Federal Reserve Bank of New York had been
lowered from 6 per cent in the fall of 1929 to 21/2per cent by the
latter part of June. Short-term market rates had also declined
sharply, rates on prime commercial paper and call loans having
dropped from 6 1/4 per cent and 8.6 per cent, respectively, in
September, 1929, to 3.5 per cent and 2.6 per cent in June, 1930.
Believing that the supply of short-term funds was ample and at
low rates, additional open market purchases was the most promising step available to the System. One possible benefit of buying
more Government securities was an improved bond market, an
increased flow of capital funds to business, and more purchasing
power for the surplus supply of commodities on the market.
Under existing conditions, there was no danger that the further
ease contemplated would stimulate a revival of speculation. In
short, moderate purchases of Governments would not do any harm
and it might do some good.
There was substantial opposition to the proposed program of
additional open market purchases, based largely on the theory
that the depression was the result mainly of nonmonetary causes
such as overproduction and excess capacity in a number of industries. Therefore, cheaper and more abundant credit would not
stimulate business recovery. Instead, more ease might encourage
increases in productive capacity, defer essential readjustments,
and retard recovery. This view was well stated in a memorandum
submitted to the Open Market Policy Conference in September,
1930, by a Reserve Bank president. According to the memorandum:
2
The Open Market Policy Conference, composed of a representative (actually
the president) of each Reserve Bank, resulted from reorganization of the Open
Market Investment Committee. The Conference met with the Board of Governors,
subject to the call of the Chairman of the Conference. The Executive Committee
consisted of five members of the Conference.

FEDERAL RESERVE POLICYMAKING

If we understand the reasoning correctly, the policy of buying Government
securities isjustified by some argument as this—we are in a period of depression
characterized by falling commodity prices and a deplorable volume of unemployment. This condition cannot be corrected without an increase of building
activity. Building activity will be brought about by low rates for long-time
loans. Low rates for long-time loans will only come with a strong and active
bond market. Therefore we should bring about this condition of the bond
market by making short-time credit so cheap that banks and investors will be
driven to the bond market to utilize their funds. . . .
This over-production did not manifest itself until a year ago, because, under
the stimulus of instalment selling and an unreasoning belief in long-continued
and unprecedented prosperity, over-buying kept pace with over-production. The
consequences of such an economic debauch are inevitable. We are now suffering them.
Can they be corrected by cheap money? We do not believe they can. We believe that the correction must come about through reduced production, reduced
inventories, the gradual reduction of consumer credit, the liquidation of security
loans, and the accumulation of savings through the exercise of thrift. These are
slow and simple remedies, but just as there is 'no royal road to knowledge,9 we
believe that there is no shortcut or panacea for the rectification of existing condiditions. We do entertain, however, the belief that the declines in commodity
prices and in employment have about run their course, and that the foundations
for business revival have already been laid.3
T h e president of another Reserve Bank advised the Board of
Governors that his Bank did not want to participate in a recent
purchase of $50 million of Government securities for the following
reasons:
a. With credit cheap and redundant we do not believe that business
recovery will be accelerated by making credit cheaper and more
redundant.
b. We find no reason to believe that excessively cheap money will promote or create a bond market, seeing evidence in the recent past to
the contrary, and, further, do not consider the promotion or creation
of a bond market one of the functions of the Federal Reserve System.
c. We believe there may come an opportune moment to put money into
the market when that action will have a beneficial effect and feel that
if, at such a time, our open market portfolio of Governments is excessive there may be hesitation to increase it}
3
From a memorandum submitted to the Open Market Policy Conference,
September 25, 1930.
4
Letter to the Board of Governors, June 16, 1930.

THE GREAT DEPRESSION

Federal Reserve authorities kept close watch on the developing
situation and became increasingly concerned as business and
credit conditions continued to deteriorate. The memorandum
submitted to the meeting of the Executive Committee of the Open
Market Policy Conference in late December, 1930, analyzed the
situation as follows: severe depression had continued with business activity still declining; a series of bank failures, especially the
more spectacular ones, had shaken public confidence; declining
bond prices had depreciated bank investment portfolios and impaired the capital of some banks, country banks being especially
hard hit; there had been extraordinary demand for currency;
many banks were dumping securities to get in a more liquid position, and banks generally were reluctant to make commitments
except for very short term; and the bond market was almost completely closed to new issues.
Heavy deposit withdrawals were putting some banks under
increasing strain. Early in 1931, one Reserve Bank president suggested that it would be desirable to give Reserve Banks authority
to discount notes collateralled by listed bonds under proper safeguards in order that they could better assist banks encountering
runs. Sometimes in such emergency situations Reserve Banks had
bought Government securities directly from the banks; however,
this was not consistent with the policy of centralized open market
operations adopted by the Open Market Policy Conference and
the Board of Governors.
Continued deterioration in the business and credit situation led
to careful consideration of policy at the April, 1931, meeting of
the Open Market Policy Conference. The Chairman's report to
the Conference stated, with reference to open market operations
since the stock market crash in the fall of 1929, they "were not
pursued with the idea that thereby any vigorous stimulant might
be given to business or finance, but rather with the idea of removing in a period of reaction and depression the pressure which
had been placed upon the market in 1928 and 1929," especially
by high interest rates and a restricted supply of funds.
Even though open market operations had not as yet been used
mainly for the purpose of stimulating expansion, there was concern as to why gold imports had not had the usual expansionary

FEDERAL RESERVE POLICYMAKING

effect on bank loans and investments expected under the gold
standard. There were several obstacles to the desired expansionary effect:
An expansion offoreign lending requires that investors should be willing to
purchase foreign bonds. An expansion of domestic commercial credit requires
that businessmen should be willing to borrow. An expansion of long-term bank
investments to provide capital which is in demand here and abroad, requires
that banks which have recently taken huge losses in securities, and upon which
the lesson of liquidity has been enforced by sad experience, should be willing to
purchase bonds.5

After extended discussion of what could be done in order that
gold imports might have their traditional effect, a threefold program was agreed upon. The first step was a reduction in the billbuying rate to as low as 1 per cent, if necessary, in order that the
System could maintain or even increase its bill holdings despite
gold imports which had totaled about $400 million in the past
15 months. Second, the reduction in the bill-buying rate should
be followed shortly by a decrease in the discount rate. Third, if
necessary, the System should resort to further purchases of
Government securities.
It was hoped that this program would eventually encourage
banks to expand their loans and investments. The Reserve Bank
president who made the proposal stated that, "this policy sooner
or later would necessarily, because of its effect upon the shorttime money rates, encourage banks and depositors in banks, in
spite of their present liquidity, to employ their money, which now
is becoming relatively so unprofitable." The Open Market
Policy Conference approved the program, and authorized the
Executive Committee, if and when it appeared necessary or advisable, to purchase up to $100 million of Government securities.
The Conference of Presidents also recommended in April, 1931,
that the Federal Reserve Act be amended so that in an emergency
Reserve Banks could make advances to member banks on their
own promissory notes secured by noneligible collateral. Such
advances should be subject to rules and regulations prescribed by
the Board of Governors, and the maturity should be limited to
5

The Chairman's report to the Open Market Policy Conference, April 27, 1931.

THE GREAT DEPRESSION

15 days or less. The presidents favored this amendment in order
that Reserve Banks would be better able to meet the credit needs
of member banks, especially in cases of heavy deposit withdrawals.
By late summer of 1931, a series of financial disturbances at
home and abroad were intensifying the financial crisis and the
depression. A worldwide drop in commodity prices had thrown
the international trade of many countries out of balance, increased the burden of foreign debts, and reduced national
income. Foreign trade of the United States had been cut to less
than one-half the 1929 total. Deposit withdrawals and bank
failures continued. Member banks were striving for more liquidity and were not putting excess reserves to use. Officials thought
the situation sufficiently serious to justify consideration of "every
sound remedy." With the discount rate of the Federal Reserve
Bank of New York at11/2per cent, the market rate on prime commercial paper 2 per cent, and the call-loan rate11/2per cent in
August, 1931, about the only additional step available was open
market purchases. Some favored substantial purchases even
though growing lack of confidence might cause banks to hold the
additional reserves as excess.
But opposition to purchases of Government securities was also
growing. Some who had favored additional purchases thought
that loss of confidence would likely cause member banks to hold
the funds as excess reserves. Several presidents were becoming
seriously concerned over the reserve position of their Reserve
Banks. Because of runs and the internal drain on reserves, they
thought the Reserve Banks should maintain a liquid position.
Sudden demands by member banks might prove embarrassing
if the System's resources were tied up in Government securities.
Moreover, purchases of Government securities usually resulted in
a reduction in member-bank discounting, and tended to impair
the System's free gold position. A reduction in member-bank discounts meant less eligible paper available as collateral for Federal
Reserve notes. With a shortage of eligible paper, Reserve Banks
would have to substitute gold in order to issue Federal Reserve
notes. Concern over their low and deteriorating reserve positions
in the face of growing member-bank demands for currency and

FEDERAL RESERVE POLICYMAKING

advances strengthened opposition to additional purchases of Government securities. Some Reserve Bank presidents, apprehensive
about their dwindling reserves, refused to participate in further
purchases. They put a higher priority on conserving their ability
to meet emergency needs of member banks than on putting additional reserves in the market which, in their opinion, might be
held as excess reserve anyway.
Restraint to meet financial crisis

The United States experienced an extraordinary financial crisis
in the fall of 1931. Prices of U. S. Government securities dropped
precipitately; bank failures increased; and banks were emphasizing liquidity. The securities markets were almost completely
closed to new financing, and the banking situation constituted a
serious obstacle to business recovery.
The internal crisis was complicated by an external drain as
well as serious disruption of international trade and finance. The
largest gold export movement in the country's history up to that
time was combined with heavy domestic withdrawals of currency.
The United States lost about $700 million of gold in the latter
part of September and in October, but the ability of foreigners
to get gold brought a rapid restoration of confidence in the dollar.
As a result of the credit crisis, however, funds lay idle for want of
reputable borrowers; purchasing power in international markets
was curtailed; industrial countries ceased to buy desired quantities of foods and raw materials; and countries producing primary
products were unable to buy manufactured goods.
Federal Reserve officials reacted to this acute credit crisis in
the traditional way—increases in discount rates and a policy of
lending freely. Walter Bagehot was quoted at length in support of this policy. His admonition (note the quotation at the beginning of the chapter) that a central bank facing both internal
and external drains should lend freely but at high rates to discourage unnecessary borrowing was still widely accepted. The
discount rate was raised to discourage unnecessary borrowing but
more important perhaps to protect the gold reserve. There was
general agreement that the gold standard should be maintained.
Prompt action appeared necessary to halt the gold drain.

THE GREAT DEPRESSION

To implement the principle of lending freely, the consensus
was that the Reserve Banks should pursue a liberal policy toward
member banks in difficulty; such banks should be encouraged to
borrow freely from the Reserve Banks when necessary to meet
emergency situations. One official stated: "The present [is] a time
when liquidity should be used rather than preserved."
Late in 1931, the gold outflow ceased and the demand for currency subsided somewhat. System officials, aware of the heavy
deflation that had occurred and the severity of the depression
gripping the country, explored what the Federal Reserve could
do to prevent further deflation and help bring about some improvement in the business situation. In mid-January, 1932, it was
agreed that the discount rate should be reduced; the System
should cooperate fully with the Treasury in its borrowing program, estimated at $1.5 billion in the first half of the year; and
Government securities should be purchased when desirable, not
to exceed a total of $200 million.
Renewed outflow of gold and the declining free gold reserve
position led System officials to defer carrying out this program. In
late February, there was an extended discussion at a joint meeting
of the Open Market Policy Conference and the Board of Governors of the desirability of moving ahead with the program
agreed on in January. Some members of the Board and the president of one of the Reserve Banks were strongly in favor of purchasing Government securities. One Board member favored
purchases on a larger scale than the program approved in
January. He said there "was never a safer time to operate boldly
than at present." But there was strong opposition, especially
among the presidents. Apprehension over the dwindling free gold
position swelled the ranks of the group opposed to open market
purchases.
MORE ACTIVE EASE

Passage of the Glass-Steagall Act in February, 1932, ushered
in a policy of more active ease. The System embarked on a program of substantial purchases of Government securities to build
up excess reserves, which later was supplemented by efforts to

FEDERAL RESERVE POLICYMAKING

encourage banks to put reserves to use. Discount rates were also
reduced.
The Glass-Steagall Act, by relieving some of the anxiety over
the System's gold reserve position, was an important factor leading to a more active open market policy. The Act permitted
Government securities as collateral against Federal Reserve notes
except for the 40 per cent minimum gold reserve requirement.
The Reserve Banks were thus able to improve their gold reserve
position by substituting Government securities for gold held as
collateral in excess of the 40 per cent minimum requirement because of the shortage of eligible paper. The Act also permitted
Reserve Banks to make advances to member banks against ineligible assets under certain conditions.
The program of purchasing Government securities was carefully reconsidered. Several officials thought the open market
program had had at least limited success. With the improved
gold reserve position, it was decided to initiate a more active open
market policy. The objectives of enlarged purchases were "to
check the unprecedented liquidation of bank credit which was
exerting a seriously depressing influence on business and prices";
to "enable member banks to pay off indebtedness and accumulate some excess reserves," thus lessening the pressure for liquidation; and to "exert some influence in the direction of a recovery
in business and in commodity and in bond prices." From the end
of February to the middle of July, 1932, System holdings of
Governments rose over $1 billion.
The immediate target of open market operations shifted from a
certain quantity of purchases to building up and maintaining excess reserves.6 In June, 1932, it was agreed that open market
policy should be directed toward maintaining excess reserves of
between $250-300 million. Purchases should also be timed so that
System holdings of Governments would show some increase from
week to week in order to avoid any uncertainty on the part of the
public as to whether the program had been changed. Actually,
excess reserves averaged about $270 million in the third quarter
6
Ease of implementation was one reason for changing the directive to maintaining a certain amount of excess reserves; otherwise a telephone conference of the
Executive Committee was often necessary to decide on the amount to be purchased
each week.

THE GREAT DEPRESSION

of 1932 and nearly $500 million in the fourth quarter—equivalent, in terms of required reserves, to excess reserves at present of
over $3 billion and $5 billion, respectively.
Officials realized that success of the enlarged open market program would depend on use of excess reserves by member banks.
Several methods of encouraging use of reserves were discussed,
such as national and regional conferences. It was agreed that the
program and its purposes should be discussed with member
banks. A second method of encouraging use of reserves was establishment of district committees. In May, 1932, the Federal Reserve Bank of New York appointed a committee of district bankers and businessmen to help develop ways and means of making
effective use of funds made available by the program of open
market purchases. The Board of Governors approved of the committee and suggested that similar committees be established in
the other Reserve Districts.
After July, the System's portfolio of Government securities remained at about the same level for the rest of the year even
though there was no change in the policy of more active ease. A
return flow of currency and gold imports resulted in a substantial
rise in excess reserves.
The effects of the open market program was a subject of frequent discussion, especially since its desirability was a subject of
controversy. Some, especially those who had consistently opposed
substantial purchases from the beginning of the depression, did
not think they were effective in promoting recovery. As excess reserves began to build up, failure of member banks to put the reserves to use became an influential argument against additional
purchases. Others thought the effects were confined to the large
financial centers.
But the advocates of a more active program pointed to several
beneficial effects. Even though the securities were purchased in
New York and the initial impact was on reserves of New York
City banks, the easing effects were much more widespread.
Treasury operations and ordinary business transactions shifted
these funds to banks and other institutions throughout the country. The funds supplied by purchases resulted in easier conditions
in the money market and lower market rates. Another beneficial

FEDERAL RESERVE POLICYMAKING

effect of the purchase program was a reduction in member-bank
indebtedness and assistance in meeting the reserve drain resulting
from currency withdrawal and at times gold exports.
COOPERATING WITH THE RECOVERY PROGRAM

At a joint meeting of the Board of Governors and the Open Market Policy Conference early in January, 1933, the situation was
carefully reviewed, and it was decided that the policy of maintaining substantial excess reserves should be continued. With
member-bank indebtedness at a low level and the forces of deflation having subsided in the latter part of 1932, officials thought
open market policy could be less concerned with immediate objectives such as contributing to safety in enabling banks to meet
deposit withdrawals and in dealing with the forces of deflation.
A statement adopted at the joint meeting indicated the shift in
emphasis: "The larger objectives of the System's open market
policy, to assist and accelerate the forces of recovery, are now
assuming importance."
But what appeared to be a trend toward recovery was soon to
be interrupted by a deepening financial crisis and a bank holiday
in early March. Following the bank holiday and a comprehensive review of System policy, there was general agreement that
the Federal Reserve should cooperate in every way possible to
help carry out the Government's national recovery program.
There was a consensus that with excess reserves still substantial, it
was not desirable to buy Government securities to increase bank
reserves.
The Open Market Policy Conference, however, agreed that
the Executive Committee should be given authority to make such
purchases as might be necessary to assist the Treasury in its financing. There was apprehension that if the Treasury could not
do its financing successfully in the market, it would be forced to
seek accommodation directly from the Reserve Banks. The Conference recommended that the Executive Committee be authorized to purchase up to $1 billion of Governments, if necessary, to
make it possible for the Treasury to meet its requirements. The
Executive Committee was also given authority to shift maturities

THE GREAT DEPRESSION

—engage in swap transactions—in order to promote a better rate
relationship among maturities and to tone up the market for
Treasury issues.
The Board of Governors approved the recommendation of the
Conference but without the limitation that purchases were to be
for the purpose of assisting the Treasury. The Board thought it
might be desirable to make purchases for other purposes. In fact,
one Board member favored an "energetic" program of purchases
on the basis that substantial purchases immediately would be
more effective than the same amount spread over a longer period.
Substantial purchases of Government securities were made and
excess reserves rose rapidly during the summer. By early fall,
excess reserves were so large that most officials thought there was
no need for further purchases to supply reserves or ease credit;
however, it was agreed that purchases should continue for a while,
primarily to reflect continued cooperation with the national recovery program.
In October, there was a full-scale review of policy. Excess reserves were about $760 million, member-bank indebtedness to
the Reserve Banks was at the lowest level since August, 1917, and
short-term interest rates were at an all-time low. There was general agreement that additional purchases were not needed for
monetary reasons. Instead, the problem was primarily one of
achieving more effective use of reserves and funds already
supplied.
A resolution adopted by the Open Market Committee, following extended discussion, pointed out that open market operations
had not yet achieved the intended objectives and the reasons why:
Open market operations, as a means of stimulating business recovery, are
ordinarily designed to force banking funds, first, into the short-time money
market, and subsequently, as short-time rates are lowered, into the intermediate- and long-time capital markets. In the present instance, it seems clear
that neither of these major purposes is yet accomplished.1

The resolution pointed out that there were grave obstacles to
the use of both short- and longer-term credit. Failure of short7
Memorandum entitled "Memorandum of Open Market Policy," submitted to
the Federal Open Market Committee at its meeting of October 10, 1933.

FEDERAL RESERVE POLICYMAKING

term credit to expand reflected unwillingness on the part of both
borrowers and lenders. Business firms were unwilling to borrow
because they had had several years of unprofitable operations and
had suffered a huge shrinkage in value of assets. Banks, after having been subjected to waves of deposit withdrawals and failures
for several years, were pursuing a policy of extreme liquidity. The
flow of credit into intermediate- and longer-term uses was blocked
by lack of confidence. The capital issue market was completely
stagnant and the capital goods industries were responsible for
over 60 per cent of the unemployment.
The conclusion was:
In our judgement, these conditions indicate that the effectiveness of open market operations, in so far as banking and credit factors are concerned, will depend
in large measure upon the early adoption of a broader program, designed to
strengthen confidence and to encourage the flow of credit, both short-time and
long-time, into uses which make for a well-balanced and enduring recovery}

The policy of buying Government securities to build up and
maintain excess reserves ended in the latter part of 1933. There
was little need for purchases in the remainder of the decade as
gold imports pushed excess reserves to higher and higher levels.
In reviewing open market operations for the period 1930-1933,
the Board concluded:
. . . the placing of reserve funds in the market through the purchase of
United States Government securities has been an effective means of preventing
exceptional demands upon the member banksfrom tightening the credit situation
and that these funds have been a powerful means toward the establishment and
maintenance of ease in the short-term money market. Although the abundant
credit provided was not effectively employed by business, it would appear that
the maintenance continuously of a substantial volume of excess reserves through
open-market purchases helped to arrest a powerful deflationary movement and
created conditions propitious to business recovery?
8
9

Minutes, Federal Open Market Committee, October 12, 1933.
Annual Report of the Federal Reserve Board, 1933, p. 21.

A NEW PROBLEM:
EXCESS RESERVES

. . . the special problem created by the continuing excess of
reserves has had and will continue to have the unremitting study
and attention of those charged with the responsibility for credit
policy in order that appropriate action may be taken as soon as
it appears to be in the public interest.
—Annual Report of the Board of Governors, 1935

The Federal Reserve's position with respect to credit and the
money market was fundamentally altered during the remainder
of the decade. Before the end of 1933, excess reserves of member
banks reached $800 million. Large gold imports following devaluation of the dollar pushed excess reserves above S3 billion
late in 1935. By the end of the decade excess reserves were above
$5 billion even though reserve requirements were close to the
maximum authorized under the law. Excess reserves in relation
to required reserves in the mid-thirties were equivalent to about
$21 billion excess reserves early in 1965; at the end of the decade
they were the equivalent of nearly $16 billion.
Excess reserves were so large that the System could not exert
real restraint, should the need arise. The discount rate was ineffective because member banks rarely needed to borrow. Open
market operations were ineffective because System holdings of
securities ranged around $2.5 billion during most of the period
from 1933 to the end of 1939.
APPRAISAL OF THE SITUATION

There was extended discussion of the business and credit situation
in the latter part of 1935. The consensus of the Board of Governors and Open Market Committee was that business and
75

FEDERAL RESERVE POLICYMAKING

financial conditions were continuing to improve but the economy
was still far short of full recovery. There was no evidence of overexpansion in use of credit or in business activity. Gold imports
had pushed member-bank reserves far beyond present or prospective credit requirements for sound business expansion. In this
situation, the primary objective of Federal Reserve policy "is
still to lend its efforts to a furtherance of recovery."
Federal Reserve officials were apprehensive, however, about
several aspects of the economic situation and their implications
for the future. Their concern centered around three main points.
First, as long as the channels into private capital investment
remained blocked and the Government debt continued to expand
there was grave danger that excess reserves would result in an
increase in bank holdings of Government securities and the
desired spill-over of funds into private channels might not occur.
As a result, commercial banks might become more and more
heavily loaded with Government securities.
Second, should excess reserves continue to flow primarily into
commercial bank investment in Governments, experience in
other countries indicated that eventually a point is reached when
banks are unable or unwilling to absorb more Government
securities. In that event, the Government would be forced to
request the Reserve Banks to buy Government securities in the
market, borrow directly from the Reserve Banks, or issue some
form of inconvertible paper money. Financing a Government
deficit through the banking system or through the issue of paper
money, if long continued, usually led eventually to rapidly rising
prices and inflation.
Third, the situation differed from Government deficit financing
which had usually led to uncontrollable inflation, in that the
Government's extraordinary expenditures were the result of depression. In depression, in contrast to a boom, some expansion of
credit is essential and it is the duty of the central bank to
facilitate it.
Officials were disturbed as to the significance of these developments because past experience or accepted theory of central
banking provided no guidance as to their implications for future
policy. Before the war, the generally accepted rule of central

A NEW PROBLEM: EXCESS RESERVES

banking had been that the discount rate should be increased
when there was an outflow of gold; yet when the Federal Reserve
applied this rule in the fall of 1931, some thought the rate increase probably served more to add to the deflationary movement
than to check the outflow of gold.
Neither theory nor experience was a useful guide as to proper
policy when there were substantial excess reserves. Large excess
reserves and a steadily mounting Government debt could sooner
or later lead to inflation, but there was not sufficient evidence of
these developments to justify a reduction in holdings of Government securities and reversal of the policy of monetary ease.
Officials believed that for open market policy to be successful it
should be part of an over-all program, including removal of
obstacles and restoring confidence, to promote the flow of funds
into the private capital market, and to increase availability and
lower the cost of mortgage money.
Large excess reserves and unusually low short-term market
rates, led some officials to suggest liquidating some of the System's holdings of Government securities.1 In fact, in the spring of
1935, one Reserve Bank requested permission to reduce its portfolio of Governments. Most officials, however, were opposed.
They thought low market rates reflected not only the large supply
of excess reserves, but small demand for credit and preference of
banks and other lenders for open market investments instead of
loans. There was no reason for any action to raise rates so long
as there was no prospect of an excessive use of funds by borrowers.
There was a large volume of excess reserves, but no evidence of
excessive use of bank credit. Another advantage of retaining Government securities holdings was to have a portfolio available as
an instrument of restraint should an inflationary situation develop.
EXCESS RESERVES: A DILEMMA

The large and growing volume of excess reserves was rapidly
depriving the System of its capability to regulate credit and the
money supply. The economy, still short of full recovery, called for
1
Dealers' quotations on three-month U.S. Treasury bills in 1935 ranged from
0.15 to 0.20 per cent.

FEDERAL RESERVE POLICYMAKING

continuation of the easy money policy. The dilemma: how
absorb or immobilize enough excess reserves to restore System
control over credit without adverse effects on business recovery.
There was unanimous agreement that the System should continue to pursue an easy money policy. Widespread increases in
business activity indicated real progress toward recovery, but
there was still large-scale unemployment, little private investment, and total output was substantially below the pre-depression
level.
On the other hand, there was increasing concern over the
System's inability to restrict credit expansion should the need
arise sometime in the future. The discount rate was ineffective
because member banks rarely needed to borrow from the Reserve
Banks. By the end of 1935, excess reserves were much larger than
the System's portfolio of Government securities; hence liquidation of the entire portfolio would not put the System in a position
to exercise effective restraint. Maximum use of the new authority
to raise reserve requirements would leave a substantial margin of
excess reserves. There was general agreement that excess reserves
should be reduced, but the crucial question was whether it could
be done without jeopardizing business recovery.
System officials devoted much thought and discussion to the
unusual situation—partial business recovery, huge excess reserves, and potential dangers inherent in its position of impotence. The Federal Open Market Committee at a three-day
meeting in the latter part of October, 1935, adopted unanimously a resolution summarizing its views. The more pertinent
parts are given below:
The Committee reviewed the preliminary memorandum submitted by the
Chairman and discussed at length business and credit conditions and the banking position in relation to them. It was the unanimous opinion of the Committee
that the primary objective of the System at the present time is still to lend its
efforts towards the furtherance of recovery. While much progress has been made,
it cannot be said that business activity on the whole is yet normal, or that the
effects of the depression are yet overcome. Statistics of business activity and
business credit activity, both short and long term, do not show any undue expansion. In these circumstances, the Committee was unanimously of the opinion
that there is nothing in the business or credit situation which at this time necessitates the adoption of any policy designed to retard credit expansion.

A NEW PROBLEM: EXCESS RESERVES

But the Committee cannot fail to recognize that the rapid growth of bank deposits and bank reserves in the past year and a half is building up a credit base
which may be very difficult to control if undue credit expansion should become
evident. The continued large imports of gold and silver serve to increase the magnitude of that problem. Even now actual reserves of member banks are more than
double their requirements, and there is no evidence of a let-up in their growth.
That being so, the Committee is of the opinion that steps should be taken by the
Reserve System as promptly as may be possible to absorb at least some of these
excess reserves, not with a view to checking some further expansion of credit, but
rather to put the System in a better position to act effectively in the event that
credit expansion should go too far.
Two methods of absorbing excess reserves have been discussed by the Committee: (a) the sale of short-term Government securities by the Federal Reserve
System, and (b) the raising of reserve requirements,2

Selling Government securities to absorb excess reserves involved two significant risks. Sales might be a shock to the bond
market and induce a wave of selling by banks. A second hazard
was that even though accompanied by a public explanation,
sales of securities might be construed by the public as a major
reversal of credit policy because up to that time sales had been
used as a means of restraint. A majority of the Committee opposed sales of Government securities because of the risks involved.
Raising reserve requirements also involved risks. This was a
new and untried tool, and higher requirements might restrain
desirable expansion of credit. Before employing this method, the
Committee suggested that the Board of Governors make a thorough study of the amount and location of excess reserves by
districts and class of bank to determine the extent to which an
increase in reserve requirements might interfere with loan and
investment expansion by member banks. The Committee recognized that in making suggestions regarding reserve requirements
it was going beyond its own immediate jurisdiction, but thought
open market policy could not be determined independently of
other Federal Reserve policies.3
The Board made a study to determine the impact of a possible
increase in reserve requirements on the reserve position of individual member banks. Using call-report data for November 1,
2

Annual Report of the Board of Governors, 1935, pp. 231-232.
It should be noted that the Board of Governors constituted a majority of the
12-member Open Market Committee as reorganized by the Banking Act of 1935.
3

FEDERAL RESERVE POLICYMAKING

1935, they found that 47 per cent of country member banks,
33 per cent of central reserve city members, and 30 per cent of
reserve city banks had excess reserves of 100 per cent and over of
required reserves. Member banks with excess reserves of less than
25 per cent of required reserves accounted for only 19 per cent of
country members and about 35 per cent of central reserve and
reserve city banks. Only 112 member banks had insufficient
excess reserves and correspondent balances combined, to meet a
50 per cent increase in reserve requirements.
Reserve requirements was the method favored to absorb excess
reserves and the Board of Governors raised requirements by
steps, from August, 1936 to May, 1937, to the maximum permitted under the law.4
At its meeting on January 30, 1937, when the final increases
were decided upon, the Board prepared a press statement for
release the following day, explaining that the increases were not
intended as a move away from an easy money policy. The purpose was to reestablish System control over reserves and the
money supply. The principal reasons for raising reserve requirements are covered in the following excerpts from the statement:
The Board estimates that, after the full increase has gone into effect, member
banks will have excess reserves of approximately $500,000,000, an amount
ample to finance further recovery and to maintain easy money conditions. At the
same time the Federal Reserve System will be placed in a position where such
reduction or expansion of member bank reserves as may be deemed in the public
interest may be effected through open-market operations, a more flexible instrument, better adapted for keeping the reserve position of member banks currently
in close adjustment to credit needs. . . .
The present is an opportune time for action because . . . excess reserves
are widely distributed among member banks, and balances with correspondent
banks are twice as large as they have generally been in the past. . . .
Another reason for action at this time is that . . . 'it is far better to
sterilize a part of these superfluous reserves while they are still unused than to
permit a credit structure to be erected upon them and then to withdraw the
foundation of the structure.'5
4
Effective in late December, 1936, the Treasury also initiated a new policy of
sterilizing the effect of gold imports on bank reserves. The increase in member bank
reserves arising from payment for the gold by Treasury check on a Reserve Bank was
offset by the Treasury withdrawing the funds from its tax and loan deposits or from
the market. Previously, the Treasury had issued an equivalent amount of gold certificates to the Reserve Banks to restore its deposit in the Reserve Banks which had been
drawn down by payment for the gold.
5
Annual Report of the Board of Governors, 1937, pp. 196-197.

A NEW PROBLEM: EXCESS RESERVES

The Federal Open Market Committee undertook to stabilize
the Government securities market in the spring of 1937—increases in reserve requirements were effective in March and
May—in order to facilitate member-bank adjustments needed in
meeting the higher requirements. A small number of banks
increased their sales of Government securities, principally longterm bonds on which they had profits instead of short-term
issues. As long-term rates began to rise, the System bought longterm Governments to help stabilize the market. Purchases of
bonds in March and April totaled about $200 million, the reserve
effect being partially offset by a reduction in holdings of shortterm issues. The yield on long-term Governments rose from
about 2 1/2 to about 2 3/4 per cent in early April and then began
to decline. Excess reserves, after the final increase in reserve
requirements became effective May 1, were about $900 million.
Whether System officials were temporarily successful in achieving their twin goals of absorbing excess reserves to restore some
measure of System control but without adverse effects on business
is, at least for some people, debatable. The System was in a better
position to exercise some control over bank reserve positions because excess reserves, although still large, were reduced to less
than one-half of Federal Reserve holdings of Government securities. But the effects on business have been a subject of controversy.
Some critics have alleged that the increase in reserve requirements was an important cause of the recession which began in
mid-1937.6
The increase in reserve requirements brought excess reserves
within the boundary of Federal Reserve control for only a short
time. Gold imports continued and had pushed excess reserves
above System holdings of Government securities by mid-1938.
By the end of 1940, excess reserves had soared to almost $7 billion, and the Board of Governors, presidents of the Reserve
6
Available data suggest that adverse effects, if any, were largely of psychological
origin. For example, after the final increase in reserve requirements had become
effective in May, 1937, just prior to the onset of the depression, excess reserves
were over $900 million (equivalent in terms of required reserves to over $3 billion
excess reserves in January, 1965); member-bank borrowing from Reserve Banks,
monthly average, was $16 million; the discount rate of the Federal Reserve Bank of
New York was11/2per cent; dealers' quotations on three-month U.S. Treasury bills
averaged 0.41 per cent and market yields on three- to five-year U.S. Treasury notes
(tax exempt) averaged 1.48 per cent; the call-loan rate was 1 per cent; and the market rate on four- to six-month prime commercial paper averaged 1 per cent.

FEDERAL RESERVE POLICYMAKING

Banks, and Federal Advisory Council joined in submitting a
report to the Congress. The report pointed out that the System's
powers were inadequate to cope with the problem of excess
reserves. The principal recommendations may be summarized as
follows:
1. Congress should provide means for absorbing a large part
of existing excess reserves (about $7 billion) as well as additions
that may occur. Specific proposals that might be considered
were: raising the legal maxima for reserve requirements; giving
the Federal Open Market Committee power to make further
increases in reserve requirements sufficient to absorb excess
reserves provided the requirements should not be raised to more
than double the recommended statutory maxima and empowering the Committee to change reserve requirements for any or all
classifications of member banks; and making the proposed reserve requirements applicable to all commercial banks.
2. Sources of potential increases in excess reserves, such as
authority under the Thomas inflation amendment to issue
$3 billion of greenbacks, further monetization of foreign silver,
and the power to issue silver certificates, should be removed.
3. Means should be found to prevent further growth in excess
reserves and in deposits arising from future gold acquisitions.
Gold imports should be insulated from the credit system and
should not be restored to it except after consultation with the
Open Market Committee.
4. Financing both the ordinary expenditures of the Government and the defense program should be from existing deposits
rather than by creating deposits through bank purchases of
Government securities.
5. As national income increases, a larger and larger portion
of defense expenses should be met out of taxes rather than by
borrowing; and once the country approaches full utilization of
its economic capacity, the budget should be balanced.
A NEW OBJECTIVE EMERGES

The large volume of excess reserves and continued economic
stagnation altered official thinking about use of the tools. The
discount rate would not be effective so long as member banks did

A NEW PROBLEM: EXCESS RESERVES

not need to borrow. Open market operations were not very
effective either, as we have seen, under conditions prevailing in
the late thirties. There was no need for purchases to supply
reserves, and sales were not regarded as a suitable method of
absorbing excess reserves because of the danger of an unfavorable
impact on the money and capital markets and hence on economic
recovery. Furthermore, the System's portfolio was too small to
absorb a major part of excess reserves. Open market operations
had been rendered almost completely ineffective as a tool for
altering bank reserve positions and thereby influencing bank
credit and the money supply.
With excess reserves having rendered normal use of the System's tools ineffective, the question arose as to what could be
done to influence the economy. As a result of the unusual combination of circumstances in the latter part of the thirties, open
market operations gradually came to be used for a new intermediate objective—to help stabilize the Government securities
market instead of to alter reserve positions.
In December, 1934, the Open Market Committee had authorized the Executive Committee to make swaps among maturities
in the System's portfolio, up to a total of $100 million, if desirable
in helping maintain stability in the Government securities market
or in connection with Treasury financing operations. At the same
time, a member of the Committee raised questions as to whether
open market operations should be confined to short-term Government securities, whether further shifts from short- to long-term
securities should be made at appropriate times, and whether the
System should be prepared to support the Government securities
market "vigorously and independently" without waiting for
requests from the Treasury.
The role of the Federal Reserve System in the Government
securities market became a topic of frequent discussion. Early in
1935, Treasury officials, concerned over the extremely rapid rise
in Government bond prices, inquired whether the System could
exert some restraining influence on excessively rapid price fluctuations in order that the market would be in a sound condition for
the Treasury's March financing. Treasury officials contended
this was more logically the responsibility of the Federal Reserve
than the Treasury because it involved regulation of the money

FEDERAL RESERVE POLICYMAKING

market. Some Federal Reserve officials, however, were concerned
as to public reaction should a policy of cushioning Government
securities price movements require sales from the System's portfolio. The state of the Government securities market had become
significant because it was the dominant factor in the money
market. System officials agreed that it was not desirable to peg
Government securities prices at any point, but that it might be
desirable in certain conditions to cushion movements in either
direction. The System bought some long-term bonds in the
spring of 1935, in order to help maintain an orderly market.
When reserve requirements were increased in the spring of
1937, the Federal Open Market Committee authorized shifts in
the System's portfolio "with a view to preventing a disorderly
market." In April, 1937, the Executive Committee was directed
to make such purchases and sales as may be necessary "to preserving an orderly market." In April, 1938, to avoid a too rapid
or too extensive rise in bond prices, the Executive Committee was
again authorized to conduct open market operations for the
purpose of maintaining orderly market conditions.
The huge volume of excess reserves led System officials to the
conclusion that they had a better chance of exercising a stabilizing influence on the economy by using open market operations to
maintain a stable Government securities market instead of to
influence bank reserves. Government securities had become the
dominant segment of the securities market, and banks had
acquired substantial holdings of Governments. Maintaining an
orderly Government securities market tended to stabilize the
capital market and banking, thus facilitating the flow of credit
into business and investment uses.
This shift in the intermediate objective of open market operations resulted in a change in composition of the System's portfolio
of Government securities. Short-term securities were considered
better suited to prompt and possibly large sales or purchases to
absorb or supply reserves. But a better distribution of maturities
was needed when the objective was maintaining orderly conditions in the Government securities market. Reflecting this shift in
emphasis, the System began, in 1939, to increase substantially its
holdings of longer-term Governments.

WORLD WAR II:
PEGGED RATES

Another joint aim of the Treasury and the Federal Reserve
was to maintain prices and yields on Government securities close
to existing levels for the duration of the war.
—Annual Report of the Board of Governors, 1942

As war clouds gathered in Europe in the late thirties, the authorities began to consider what the System's role should be in assisting
the Treasury finance a stepped-up defense program. A special
meeting of the Conference of Presidents was called in September,
1938, to consider policies and programs the System might adopt
in the event of an outbreak of war in Europe. The consensus was
that the Federal Reserve should maintain a reasonable measure
of liquidity in the Government securities market and announce a
uniform policy of lending to member banks on the par value of
Government securities offered as collateral. There was a series of
meetings between Federal Reserve and Treasury representatives
in the first part of 1939 to consider mutual problems and policies
in case of war. There was agreement that in the event of war,
steps should be taken to stabilize the Government securities
market.
A question which arose was whether the System and the
Treasury should participate in stabilization of the Government
securities market. It was agreed that the System would participate equally with the Treasury in purchases of Government
securities until the Treasury had invested approximately $100
million available from trust funds. Thereafter all purchases
should be made by the System. The System's reasoning was that
after purchases of approximately $100 million the Treasury
would have to draw on the stabilization fund. The result would
be, in effect, to create an open market portfolio in the Treasury
85

FEDERAL RESERVE POLICYMAKING

that might interfere with the System's ability to control credit.
The System had adequate authority to purchase Government
securities to stabilize the market and the consensus was that it
should assume that responsibility.
How open market operations could be used to stabilize a
seriously disturbed market was also discussed. The conclusion
was that the System should make purchases at scaled-down
prices until certain agreed minimum prices for the day had been
reached, then with the cooperation of the principal dealers in
Government securities, trading would be stopped as far as possible for the day. On subsequent trading days, purchases would
be resumed at the minimum prices of the preceding day and the
same procedure followed. The Open Market Committee thought
it should be made clear that short selling during any period of
disturbed conditions would be strongly objected to.
Following the outbreak of war in Europe, System responsibility
to assist the Treasury in financing the defense effort was given
more extensive consideration. Early in 1941, the Open Market
Committee instructed the Executive Committee to have studies
prepared on the System's role in Treasury financing operations.
Memoranda were prepared and circulated among officials, and
the System's role in war financing became a major topic of discussion at policy conferences.
Four alternatives regarding System policy in war financing
were presented to the Open Market Committee for consideration
and discussion in the fall of 1941: allow market rates to fluctuate
freely in response to changing supply and demand; try to maintain an orderly market for Government securities; if new powers
were granted,1 tighten credit and let interest rates rise; or establish a pattern of rates, to be agreed on from time to time with
Treasury officials, which the System would support. There
seemed to be considerable sentiment for establishing a pattern of
rates in order to avoid one of the difficulties of World War I
financing, namely, rising rates which afforded an inducement for
investors to defer purchases of new Treasury issues. But it was
1
As explained in Chapter 6, pp. 81-82, excess reserves were so large that the
System submitted a special report to Congress explaining the nature of the problem
and making certain proposals regarding new powers to deal with it.

WORLD WAR II: PEGGED RATES

recognized that this alternative involved the problem of whether
the System could maintain a pattern of rates and at the same
time effectively combat inflation.
WAR FINANCING

The day after the Japanese attack on Pearl Harbor the Board of
Governors, after consultation with the presidents of the Federal
Reserve Banks, made it clear that as in World War I the primary
objective of Federal Reserve policy would be to facilitate financing
the war. The statement issued included the following:
The System is prepared to use its powers to assure that an ample supply of
funds is available at all times for financing the war effort and to exert its influence toward maintaining conditions in the United States Government
security market that are satisfactory from the standpoint of the Government's
requirements.2

The principal question was how this objective could best be
achieved.
Role of the central bank

System officials agreed that in time of war the primary responsibility of a central bank was to facilitate financing the expenditures involved in national defense. The primary goal of Federal
Reserve policy was to assure that funds needed in financing the
war would be forthcoming. Preventing inflation, although desirable, was secondary.
System policymakers believed the Federal Reserve had a subordinate role in an over-all program designed to finance the war
without inflation. The major problem was to divert income as
well as productive facilities to the war effort.3 For example, the
Chairman of the Board of Governors, referring to the fact that
2

Annual Report of the Board of Governors, 1941, p. 1.
The Board of Governors, by Executive Order of the President of the United
States, was directed to control consumer credit during the national emergency. The
Board issued Regulation W, effective September 1, 1941, prescribing minimum
down payments and limitations on maturities. The main purposes of the regulation
were to curtail demand for selected consumer durables as diversion of productive
resources to national defense limited their supply, and to restrict general expansion
of consumer credit.
3

FEDERAL RESERVE POLICYMAKING

national income was about $110 billion, stated that "upwards of
50 billions of civilian dollars must be drawn into the war effort
and not left to compete in the market place for the shrinking
supply of civilian goods. Otherwise, the rising tide of national
income would rapidly bid up prices and precipitate a ruinous
inflation." To the extent that the required amount of income was
not diverted to war financing by taxation, it should be diverted
by Government borrowing out of current income. Borrowing
from the banking system would create more money without
adding to the supply of goods. Federal Reserve credit control,
although important, had only a supplementary role to Government policies in preventing inflation.
Pattern of rates

The anchor of System policy to facilitate Treasury financing was
establishment and maintenance of a pattern of rates on Government securities. A pegged rate structure, it was believed, would
assure the Treasury of a market for its securities and would
remove any incentive for investors to defer purchases in order to
get a higher rate.
Discussion of interest rates that would be appropriate in the
event of war began in the late thirties, as already mentioned. In
mid-1941, one Federal Reserve official suggested that a21/2per
cent rate on long-term Government securities should be established for the duration of the emergency. The feasibility of
establishing a pattern of rates for different maturities of Government securities was seriously discussed in the latter part of 1941
and explored in joint meetings of System and Treasury officials.
System officials did not want to make a commitment to support
a given pattern of rates regardless of the type of financing program the Treasury might pursue. They wanted such a commitment to be contingent on the Treasury adopting a borrowing
program designed to attract as much nonbank funds as possible.
Early in 1942, the System submitted to Treasury officials a suggested long-term program of Treasury financing, which had the
general approval of the Open Market Committee, including the
presidents who were not official members.
The major points in the program were:

WORLD WAR II: PEGGED RATES

1. The Treasury should issue securities tailored to meet the
requirements of different classes of investors in order to attract the
maximum amount of nonbank funds. Special issues should be on
tap in order to keep Treasury financing in the open market and
sale of Treasury securities to banks to a minimum.
2. If open market financing were kept to a minimum the
Federal Reserve would do everything in its power to assure the
success of such financing.
3. The Treasury should undertake to finance the war at a rate
not to exceed21/2per cent; in the event of a public statement
by the Treasury, no reference should be made as to maturity of
long-term bonds in order to provide more flexibility.
4. The point at which support would be given to the market
by the Federal Reserve would be determined in discussions with
the Treasury from time to time.
5. The System preferred that rates on shorter maturities remain flexible in order better to adapt to changing conditions.
Treasury officials were reluctant to agree to a long-term program of financing, preferring to make decisions as each financing
arose. System authorities, although cognizant that it would not
be feasible to decide on detailed terms of all future issues, were
anxious to have an agreement on certain basic principles that
would be followed. For one thing, they wanted agreement on
establishing a21/2per cent long-term rate for the duration as a
benchmark, rates on other maturities being fixed according to
existing market rates.
An agreement was reached with Treasury representatives in
March, 1942, with respect to a temporary program of war
financing. Federal Reserve authorities agreed to support the
Treasury bill market at approximately existing rates, support
beginning when the rate reached1/4of 1 per cent and then to be
applied with increasing strength as the rate approached 3/8 of
1 per cent.4 The general market would be maintained on about
the existing curve of rates but this did not mean support for
specific issues that might be out of line with the yield curve.
4
For an explanation of the divergent views of Federal Reserve and Treasury
authorities over short-term rates and the volume of excess reserves, see Chapter 11,
pp.145-148.

FEDERAL RESERVE POLICYMAKING

Open market policy was directed at two major wartime objectives: maintaining the existing structure of rates on Government
securities, and maintaining an adequate supply of reserves to
facilitate Treasury financing. This twofold objective was reflected
in the Open Market Committee's directive to the Executive
Committee in May, 1942, to conduct such transactions "as may
be necessary for the purpose of maintaining about the present
general level of prices and yields of Government securities or for
the purpose of maintaining an adequate supply of funds in the
market; . . . ."
Disagreement over the volume of excess reserves that should be
maintained, explained in more detail later, led to a compromise
regarding short-term rates. Briefly, the Treasury's position was
that a large volume of excess reserves was essential in order to
maintain the rate pattern and assure the success of its borrowing
operations. The System's position was that large excess reserves
were neither necessary nor desirable so long as open market
operations were used to maintain the rate pattern. Open market
operations required to maintain the rate structure would automatically provide the amount of reserves needed.
System officials, even though they preferred somewhat higher
short-term rates, agreed to establish a posted buying rate of 3/8
per cent on U. S. Treasury bills. The posted buying rate was
established to increase the fluidity of bank reserves and facilitate
prompt adjustment of bank reserve positions; to encourage banks
and other institutions to invest liquid funds in Treasury bills; and
to stabilize the bill market. Later in the year, the System added
a repurchase option—the seller being given the option of repurchasing Treasury bills of like amount and maturity at the same
rate of discount. The repurchase option was designed to encourage investment of idle funds and a wider distribution of Treasury
bills. The practical effect was to make bank holdings of Treasury
bills the equivalent of reserves.
Other System policies

The discount rate was lowered to 1 per cent, and loans to member
banks collateralled by Government securities maturing within
one year were given a preferential rate of 1/2 per cent. Low

WORLD WAR II: PEGGED RATES

discount rates and a preferential rate on Governments were
additional methods of assuring member banks of ready access to
reserves in order that they might better perform the functions of
purchaser and distributer of Treasury securities.
Federal Reserve authorities tried to discourage nonessential
uses of credit in order to help hold down total credit expansion
and the pressure on limited productive resources. As already
stated, the purpose of Regulation W was to curtail use of credit
to purchase civilian goods in short supply. Selective controls, such
as consumer credit and margin requirements on stock market
credit, differed from general controls, according to System
officials, in two major respects. First, they limit the amount of
credit users can demand for specified purposes; they are selective
in their impact. Second, they do not affect the total volume and
cost of credit inasmuch as credit not used for regulated purposes
may be made available for nonregulated purposes.
Federal Reserve officials, in cooperation with other bank supervisory authorities, instructed bank examiners to urge bankers to
be selective in making loans; to curtail loans for accumulation of
inventories of civilian goods and other nonproductive purposes.
They also warned of the dangers inherent in making loans to
buy real estate at rising prices.
Problems with pattern of rates

Maintaining the pattern of rates became increasingly difficult. As
some Federal Reserve officials pointed out, a policy of maintaining substantial excess reserves, a fixed pattern of rates, and urging
banks to keep fully invested was inconsistent and contradictory.
Easy access to reserves encouraged banks to keep fully invested.
But to the extent banks kept fully invested, it was impossible to
keep a large volume of excess reserves outstanding.
As investors gained confidence in the Federal Reserve's willingness and ability to maintain the rate pattern there was a growing
tendency to "play the pattern of rates." With all maturities
almost equally liquid, there was a strong inducement to sell
lower-yield, short-term securities and reinvest in higher-yield,
longer maturities. To maintain the pattern of rates, the Federal

FEDERAL RESERVE POLICYMAKING

Reserve was compelled to buy short-term Governments which
investors were unwilling to hold. The question facing the Federal
Reserve was whether to make a strong effort to maintain a
pattern of rates established in a period of economic stagnation
when the volume of excess reserves and other idle funds was
unusually large, when the demand for credit was limited, and
when preference for liquidity was high; or whether the pattern
should be modified to provide a rate structure that would be
easier to support.
Several suggestions to help alleviate the situation were discussed. System officials continued to press for an upward adjustment in short-term rates in order to narrow the spread between
short- and long-term yields. A narrower spread would offer less
inducement for playing the pattern of rates and tend to reduce
the volume of reserves created by System purchases of Treasury
bills and other short-term issues. Treasury officials were opposed
to higher short-term rates. They did not want to disturb a market
which had enabled the Treasury to do its financing so successfully.
Another proposal, by a System official, was to purchase bills
directly from the Treasury to supply reserves in periods of
Treasury financing. He thought direct purchases would enable
the System to bypass the market and better gear reserves supplied
to the amount needed to facilitate a Treasury offering. But others
pointed out some disadvantages. Direct purchases might arouse
public concern about the Government's credit standing; and it
was doubted whether direct purchases from the Treasury would
make possible a better synchronizing of reserves supplied with
reserves needed to facilitate a Treasury financing operation.
As an alternative to raising short-term rates outright, it was
suggested that the Treasury might issue a 3/4 percent, ninemonth certificate which the System would stand ready to buy
under a repurchase option. The policy of maintaining rates on
maturities of less than nine months would then be terminated.
But this proposal also had serious disadvantages. Some officials
thought a new type of security would upset the market. More
important, it would not solve the problem of playing the pattern
of rates because investors were already moving into longer
maturities which afforded larger profit opportunities.

WORLD WAR II: PEGGED RATES

As implications of the support policy became more widely
recognized and as confidence increased that the rate pattern
would be maintained, investor demand was concentrated in
higher-yielding, long-term issues. The result was to exert strong
pressure toward a level rate structure because under the support
policy all maturities were liquid. The policy of keeping banks
supplied with ample reserves in order that they could be the
market of last resort for Government securities intensified the
pressure.
MORE RESEARCH

Marked changes in business, and in banking and credit accompanied the war. The need for more information on current and
prospective changes in the economy led to an expanded and
better coordinated research program.
Early in the war the Conference of Presidents established a
standing committee on research to help coordinate the research
programs of the Reserve Banks, assist in bringing about closer
cooperation between the research staffs of the Reserve Banks and
the Board of Governors, and to help promote a more effective use
of research facilities within the System. The presidents also
believed that the growing importance of the role of Reserve
Banks as regional centers of information and leadership made it
advisable to develop the Banks5 research facilities. In view of
varying regional impacts of the war, regional studies were needed
to keep informed on district developments and to provide a
better basis for national policies.
Additional steps were taken in 1944 to coordinate research
activities of the System. The System Research Advisory Committee was established to guide and coordinate the research work
of the Board and the Reserve Banks. Another System committee
was established to study the current and prospective position of
banking in view of policies being pursued in financing the war,
and to anticipate possible postwar problems and policies for
dealing with them. System research staffs were also cooperating
with other agencies at the national and district levels.

SQUIRMING IN A
STRAITJACKET

The creation of unnecessary bank credit by the commercial
banking system is the particular concern of those charged with
monetary responsibilities. It can not be a matter of indifference
that at present the country's central banking mechanism lacks
appropriate means, that may be needed, to restrain unnecessary
creation of bank credit through continued acquisition of Government or other securities by the commercial banks.
—Annual Report of the Board of Governors, 1945

System officials, as already noted, had been trying to anticipate
postwar problems long before World War II was over. Studies
were initiated to provide more information on changing business
and credit conditions; the impact of Federal Reserve-Treasury
wartime policies, nationally and regionally; and the implication
of these changes for monetary policy.
Important questions confronting policymakers at the end of the
war were: What should be the objective of open market policy in
the postwar environment; should the System continue to maintain a pattern of rates on Government securities; if so, would this
seriously interfere with effective regulation of credit and the
money supply; and, in the event of conflict, which objective
should take priority?
IMPLICATIONS OF NEW ENVIRONMENT

Despite general agreement that war expenditures should be
financed as far as possible by taxation, about 60 per cent of total
Government expenditures came from borrowing. From June 30,
1940, about the beginning of the defense program, to the end of
1945, the Government raised $228 billion by borrowing. Of this
94

SQUIRMING IN A STRAITJACKET

total, $95 billion, or 40 per cent, was derived from selling Government securities to the commercial banking system. The money
supply—demand deposits plus currency in circulation—increased
more than threefold, from $40 billion to $127 billion. In addition,
highly liquid assets held by the general public soared. Time deposits nearly doubled, and Government securities held by the
public (excluding banks and other financial institutions) were
about eight times larger than in mid-1940.
Inflation potential

There was general expectation that military demobilization and
reconversion from war to civilian production would result in substantial unemployment and recession. These fears did not materialize, however, one reason being the substantial volume of
money and liquid assets at the disposal of the public.
Federal Reserve officials were aware of the large inflation potential created in financing the war. The public had at its disposal large resources in money and other liquid assets. Current
income was at a high level. Wartime controls, and to some extent
depressed conditions in the thirties, had built up a huge backlog
of demand for civilian goods. The combination of pent-up demand supported by a high level of income and accumulated
purchasing power was likely to unleash a tremendous flow of
funds into the market for civilian goods. The country's money
supply and purchasing power were—and would likely continue
to be for an indefinite period—far in excess of the supply of goods
available for money to buy at stable prices.
To deal effectively with this inflationary situation called for a
broad approach directed at the basic sources of inflationary pressure. Of first importance, according to System officials, was to relieve the shortage of goods by rapid attainment of full production.
The Government's excess cash balance should be used to retire
outstanding debt, especially securities held by commercial banks,
because it would tend to reduce the money supply. Vigorous
efforts should be made to achieve a budget surplus in order that
debt reduction might continue. Preventing excessive expansion
of bank credit and creation of new money, the particular re-

FEDERAL RESERVE POLICYMAKING

sponsibility of the Federal Reserve System, was regarded as only
one part of an over-all program needed to combat the inflation
potential existing at the end of the war.
Dilemma of the Federal Reserve

The Federal Reserve faced essentially the same dilemma as at the
end of World War I. System officials could maintain the unusually low wartime rate structure which would facilitate the
Treasury's large financing operations but in a postwar environment of vigorous demand would likely result in strong inflationary pressures; or they could restrict credit expansion to try to
prevent further inflation, with the result that rising interest rates
would make Treasury financing more difficult and would inflict
losses on holders of Government securities who had been urged to
buy Treasury obligations in order to help finance the war.
System officials recognized that choosing either horn of the
dilemma would result in undesirable consequences. Maintaining
basically the existing rate pattern would seriously impair ability
to regulate reserves and credit with existing powers. It would encourage monetization of the debt by enabling lenders to sell lowyield Government securities at supported prices and put the proceeds in higher-yielding loans and investments. The wide spread
between short- and long-term rates encouraged holders of
Governments to sell short-term securities and invest in longerterm Treasury issues, which afforded a higher yield and which
were almost equally liquid under the policy of maintaining the
pattern of rates. System creation of reserves would be largely at
the initiative of holders of Government securities.
But abandoning the support policy in order that restraint could
be applied more effectively would also have adverse effects. Effective restraint by traditional methods would probably result in a
substantial rise in interest rates and a sharp decline in prices of
Government securities. Wide fluctuations in interest rates were
considered inappropriate in the postwar environment of a vast
Government debt widely distributed among institutions and individuals, and large Treasury refunding operations. This view

SQUIRMING IN A STRAITJACKET

was well summarized in the Annual Report of the Board of
Governors for 1945:
A major consequence in attempting to deal with the problem of debt monetization by increasing the general level of interest rates would be a fall in the market
values of outstanding Government securities. These price declines would create
difficult market problems for the Treasury in refunding its maturing and called
securities. If the price declines were sharp they could have highly unfavorable
repercussions on the functioning of financial institutions and if carried far
enough might even weaken public confidence in such institutions.
The Board, therefore, does not believe that the problem . . . could be
dealt with effectively by increased interest rates unless they were so high as to be
a deterrent to necessary production, apart from the serious consequences to the
Government security market.1

Possible repercussions were such as to preclude sharply rising
interest rates, according to a member of the Board:
. . . the System had ample authority to deal with the existing situation by
actions which would increase rates, but that in view of the vastly different conditions existing at the present time which were not contemplated when the authority was given, action by the System to increase rates would be entirely unjustified.2

There was general agreement that the System should maintain
the pattern of rates and try to deal with the postwar situation
within that framework. Several methods of providing more effective control over bank reserves and credit without abandoning
the support policy were explored.
One method frequently advocated by some was more flexibility
in the rate structure at the short end. With large holdings of
Government securities and a broad securities market, lenders
would be sensitive to small changes in interest rates. And more
flexibility in short-term rates would enable the System to exercise
more control over bank reserves.
A second possibility was to ask Congress for additional powers
which would be appropriate in the new environment. One proposal reiterated during the next few years was authority to impose
1
2

Page 7.
Minutes, Federal Open Market Committee, February 28, 1946.

FEDERAL RESERVE POLICYMAKING

a special Government securities reserve on commercial banks in
order to reduce bank sales of Governments. Two types of special
reserve requirements were discussed: a ceiling on commercial
bank holdings of long-term marketable Government securities
which would enable the System to reduce or even check banks
shifting out of short-term into higher-yield, longer-term issues; a
special reserve of Treasury bills and certificates equivalent to a
specified percentage of net demand deposits to immobilize shortterm Governments and thereby reduce the need for support
purchases by the Federal Reserve.
A third suggestion was that the Board might be given additional power to raise reserve requirements, the higher requirements to be applicable to all commercial banks. A major shortcoming of this proposal, however, was that under a policy of
maintaining a pattern of rates, the major effect of an increase in
reserve requirements would be to shift Government securities
from commercial banks to the Federal Reserve Banks. Inasmuch
as the System would be supplying sufficient reserves at low rates
to meet the new requirement, the increase would have little
restrictive effect on member banks.
A fourth possibility was a voluntary agreement with commercial banks to check further monetization of the debt. This
type of agreement had proved effective at times in other countries but was not considered feasible here because of the large
number of commercial banks.
TWO BASIC APPROACHES EMERGE

Studies and discussion of the implications of the postwar environment for monetary policy soon resulted in two basic approaches.
There was no disagreement that it was the responsibility of the
Federal Reserve to prevent excessive bank credit expansion, but
there were basic differences as to how this goal might best be
achieved. One view was that existing tools were not appropriate
in the new environment; consequently, the Board should ask
Congress for new and more suitable powers. Others, however,
thought existing powers could be used effectively.

SQUIRMING IN A STRAITJACKET

Need for new powers
Some policymakers thought existing powers were not adequate
for an effective monetary policy in the new environment. In the
first place, the two principal sources of inflationary pressure were
a high level of income together with a large volume of liquid
assets built up during the war, and a shortage of goods to meet
the huge demand generated by this large volume of purchasing
power. Consequently, restricting credit expansion and the creation of new money, although essential, was a relatively unimportant part of an effective over-all program to combat this type
of inflation.
Second, a flexible interest-rate structure was not considered a
suitable method of trying to curb private credit expansion. A
moderate rise in rates would have little effect in curbing private
demand for credit, and a sufficient increase to be effective would
have a serious impact on the Government securities market.
Moreover, trying to deal with the problem by rate action would
overemphasize the role of credit policy in relation to other
policies needed to combat the inflationary situation.
Thus the Board of Governors should make a special report to
Congress, explain the changes that had rendered existing powers
inappropriate, and request new powers that would be suitable in
the new environment. The new power believed to be appropriate
and effective was to require commercial banks to hold a special
reserve of Government securities against net demand deposits.
The expectation was that this special reserve would enable the
System to maintain a pattern of rates and at the same time
exercise some control over reserves.
There was some discussion of whether the System should have
permanent authority to regulate consumer credit. Desirability of
this authority depended in part on other methods of control
available to the System and in part on the nature of the over-all
program adopted to combat inflation. Policy discussions indicated System officials were about evenly divided as to whether
permanent authority to regulate consumer credit should be
sought.

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FEDERAL RESERVE POLICYMAKING

Use of existing powers
Others were skeptical of the need for new powers; they believed
existing tools could be used effectively. The large Federal debt
outstanding was widely held, and the market for Government
securities was broader and more sensitive than before the war.
Therefore, "if some minor flexibility were introduced in the rate
structure . . . it would have a greater retarding effect than in
the past." Restoring flexibility in short-term rates would enable
the System to sell short-term issues to absorb reserves created by
support purchases of longer maturities. Thus some control over
reserve creation could be restored while maintaining the pattern
of intermediate- and longer-term rates.
Confidence that introducing flexibility into the short end of the
rate structure would be effective was the principal argument for
relying on existing powers, but there were other reasons. One was
skepticism as to whether the proposed new powers would be
effective under a policy of maintaining a rigid pattern of rates.
Monetary restraint, to be effective, must make credit less readily
available and hence more costly. The leading spokesman for
using existing powers stated that for a policy to have any right to
be called monetary policy or monetary control:
. . . it must aim toward making credit less easily available and therefore
more costly, and that this could not be done with a frozen pattern of rates. . . .
an increase in the rate on certificates from 7/8 to 1 per cent or 11/8per cent
would not be a large increase nor a large price to pay if it would help combat
inflation, and . . . it would restore flexibility in the rate structure and get
away from a frozen pattern of rates.3

Another drawback to relying on new powers was that getting the
required legislation through Congress would likely take considerable time.
ATTEMPTS TO REGAIN CONTROL

Policy discussions from the end of the war until the accord in 1951
dealt mainly with how existing powers might be used more
effectively within the limitations imposed by the support policy.
3

Minutes, Federal Open Market Committee, June 10, 1946.

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101

Those believing new powers were essential were willing to go
along with using existing powers because, if proved inadequate
as they believed, Congress would be more likely to grant a
request for new powers. It was a period of squirming in a straitjacket—of searching for some way to reduce the amount of
reserves created by purchases of Government securities required
in maintaining the pattern of rates.
Modification of rate pattern

An increase in short-term rates, while maintaining the pattern on
intermediate- and long-term rates, was the focus of policy discussions for most of the period until early 1951. The primary purpose was to restore more effective control over creation of reserves, and thereby over the supply and availability of credit.
Some officials believed that higher rates would make shortterm issues more attractive and that investors would be more
willing to hold them. The spread between short- and long-term
rates would be narrowed, thus making it less profitable to play
the pattern of rates. As a result, System purchases required to
support short-term rates would be reduced. In addition, the
System could sell short-term issues to offset reserves created by
support purchases of longer maturities.
An increase in short-term rates would also tend to diminish
willingness to lend. A narrower spread between short- and longterm rates would provide less inducement to shift into higheryielding loans and investments. Also, banks and other financial
institutions would be more reluctant lenders if, to obtain the
funds, they had to sell short-term securities at a lower price.
Treasury officials were strongly opposed to even modest increases in interest rates (as explained in more detail in Chapter 11). They contended that fractional increases in rates would
disturb the Government securities market and complicate their
financing problems without having any significant influence on
the demand for credit. The small restrictive effects that might be
achieved did not warrant the risks involved for the Treasury.
These divergent views of Federal Reserve and Treasury officials led to a prolonged controversy over more flexibility in shortterm rates. System officials persisted in their efforts to get

102

FEDERAL RESERVE POLICYMAKING

Treasury agreement to moderate increases. Treasury officials
wanted to maintain the status quo. Modification of the rate
pattern thus proved to be a slow and halting process.4
Restructuring the debt
A second approach to reducing reserve creation while supporting
Government securities prices was debt management policies that
would allow more freedom for Federal Reserve action. System
officials in their discussions with the Treasury had long emphasized the importance of tailoring Treasury issues to attract nonbank buyers. The aim was to decrease monetization of the debt,
both by increasing the proportion of new issues placed with
nonbank investors and by diminishing the incentive for existing
holders to shift into other investments.
The principal proposal was greater use of nonmarketable
securities which it was believed would not require support. Suggestions were made to the Treasury from time to time that it
would be desirable to give holders of long-term restricted bonds
an opportunity to convert into an attractive nonmarketable bond.
A long-term nonmarketable bond might also be issued at times
to attract savings.
System officials differed somewhat as to the advantages that
would be derived from nonmarketable securities. Some thought a
long-term restricted marketable bond would pull in more nonbank funds than a nonmarketable bond; however, until the support policy could be modified or terminated, the possibility that
4
One result of the controversy over short-term rates was the self-imposed tax on
the portion of outstanding Federal Reserve notes not covered by gold. Treasury
officials thought removal of the 3/8 per cent posted buying rate on Treasury bills
should not be considered unless some method could be worked out for the Treasury
to recapture the additional earnings that would accrue to the Reserve Banks as a
result of the higher rate on short-term Treasury securities and increased cost of
carrying the Government debt. Federal Reserve officials discussed three possibilities:
imposing an interest charge on Federal Reserve notes not covered by gold; restoration of the franchise tax; and absorption by the Reserve Banks of fiscal agency expenses of the Treasury. Some Federal Reserve officials had a strong preference for
reimposition of the franchise tax, but this would require legislation—and how soon
Congress could be expected to act, if at all, was uncertain. It was finally agreed, after
discussions with not only Treasury officials but certain members of Congress as well,
that the Board of Governors would use its authority to levy an interest charge on
Federal Reserve notes not covered by gold as collateral. The interest charge was
levied early in 1947, so as to take approximately the same amount as the former
franchise tax—90 per cent of the net earnings of the Reserve Banks after payment
of dividends.

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103

substantial System purchases might be required to maintain the
long-term rate was a serious disadvantage.
A second objective in the System's proposals was to diminish
interference of debt management operations with the timing of
Federal Reserve actions. The Federal Reserve had long followed
the policy of an even keel, unless the need was urgent, at the
time of a Treasury financing operation. The frequency of refunding operations required in managing the huge postwar debt left
relatively little time for System actions if the policy of no change
during a Treasury financing were adhered to. To give more
flexibility in timing its actions, System officials recommended
that maturities of Treasury certificates be concentrated on four
dates during the year.
EVENTS LEADING TO THE "ACCORD"

Until 1949, the System had confronted the problem of trying to
find ways to restrict inflationary pressures within the limits of
maintaining a pattern of rates. In recession, the problem was to
increase reserves and encourage credit expansion to promote
recovery.
Hobbled in recession, too

The support policy proved to be a handicap in dealing with
recession also. Declining business activity and a growing margin
of unused resources called for an easy money policy to encourage
credit expansion and bolster total demand. With the demand for
bank credit weak, banks tended to invest some of the reserves
made available in Government securities. Government securities
prices rose and yields fell. Under these circumstances, maintaining the pattern of rates compelled the Federal Reserve to sell
Governments to check declining rates.
But selling Government securities absorbed reserves; hence the
vicious circle. System purchases to supply reserves and stimulate
recovery put downward pressure on market rates; System sales
of securities to check declining rates absorbed reserves. The
support policy proved to be a "millstone around the Federal
Reserve neck" in dealing effectively with recession as well as
with a boom.

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FEDERAL RESERVE POLICYMAKING

The serious difficulty encountered in dealing with the 19481949 recession stimulated discussion as to the advisability of
substantial modification of or even discontinuance of the support
policy. A period when Government securities prices were rising
instead of falling would be a propitious time, if a change were
to be made.
There was general agreement among Federal Reserve authorities that modification of the policy of maintaining a rigid rate
structure to permit more flexible monetary policy was essential.
There was disagreement, however, as to how far they should go.
Some wanted to get away from the support policy entirely, including the long-term rate, as soon as possible. Others were
opposed to abandoning support of the long-term rate. The decision of the Open Market Committee, reflected in the following
press statement released June 28, 1949, did not mean the support
policy was to be abandoned; it meant only that under existing
circumstances open market operations were to be directed toward
maintaining an appropriate supply of reserves instead of maintaining a rigid level of intermediate- and long-term rates.
The Federal Open Market Committee, after consultation with the Treasury,
announced today that with a view to increasing the supply offunds available in
the market to meet the needs of commerce, business, and agriculture it will be
the policy of the Committee to direct purchases, sales, and exchanges of Government securities by the Federal Reserve Banks with primary regard to the general business and credit situation. The policy of maintaining orderly conditions
in the Government security market and the confidence of investors in Government bonds will be continued. Under present conditions the maintenance of
a relativelyfixedpattern of rates has the undesirable effect of absorbing reserves
from the market at a time when the availability of credit should be increased.5
Growing inflationary pressures

The outbreak of hostilities in Korea in mid-1950 and soaring
defense expenditures increased inflationary pressures. Both a
Government deficit and strong private demand were giving a
thrust to credit expansion. System officials manifested increasing
anxiety over their responsibility to prevent credit expansion
which was feeding inflation. Treasury officials, on the other hand,
5

Minutes, Federal Open Market Committee, June 28, 1949.

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105

became more concerned about any steps that might upset the
Government securities market and make more difficult Treasury
financing of mounting Government expenditures.
The effect of the Korean situation and its implications were to
harden Federal Reserve and Treasury officials in their respective
positions. The Federal Reserve wanted the Treasury to tailor its
financing program to tap as much nonbank funds as possible, and
to agree to a rise in short-term rates. Treasury officials were
vigorously opposed to both. According to their studies, nonbank
funds would not be available and hence they were unwilling to
offer securities designed to attract such funds. Neither would they
agree to a rise in short-term rates because "this was no time" to
upset the Government securities market.
Convinced that Treasury officials would not agree to an increase in short-term rates or to the issue of a long-term bond to
attract nonbank funds, the System decided it should take immediate action to restrict credit expansion. It was also agreed that
the Secretary of the Treasury should be informed of the decision
and that a statement should be released to the press. Accordingly,
the following statement, issued jointly by the Board of Governors
and the Federal Open Market Committee, was released August 18,
1950:
The Board of Governors of the Federal Reserve System today approved an
increase in the discount rate of the Federal Reserve Bank of New York from
11/2per cent to 13/4per cent effective at the opening of business Monday,
August 21.
Within the past six weeks loans and holdings of corporate and municipal
securities have expanded by 1.5 billion dollars at banks in leading cities alone.
Such an expansion under present conditions is clearly excessive. In view
of this development and to support the Government's decision to rely in major
degree for the immediate future uponfiscaland credit measures to curb inflation,
the Board of Governors of the Federal Reserve System and the Federal Open
Market Committee are prepared to use all the means at their command to
restrain further expansion of bank credit consistent with the policy of maintaining orderly conditions in the Government securities market.
The Board is also prepared to request the Congress for additional authority
should that prove necessary.
Effective restraint of inflation must depend ultimately on the willingness of
the American people to tax themselves adequately to meet the Government's
needs on a pay-as-you-go basis. Taxation alone, however, will not do the job.

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FEDERAL RESERVE POLICYMAKING

Parallel and prompt restraint in the area of monetary and credit policy is
essential.6

Even though there was general agreement within the System
that more effective steps should be taken to restrict private credit
expansion, there was still disagreement as to whether the longterm2/1/2per cent rate should be maintained. One view was that
effective restraint could not be restored without flexibility over
the entire rate structure. Others believed it was essential that the
System maintain the21/2per cent rate during the emergency.7
What the Federal Reserve should do, in view of its primary responsibility of regulating private credit expansion and its desire
to cooperate with the Treasury in so far as possible in meeting the
Government's financing requirements, continued to be the major
topic of discussion during the remainder of 1950 and in early
1951. The burden involved in the decision was increased by the
fact that other Government officials became involved in the
controversy.
The report of the Subcommittee on Monetary, Credit, and
Fiscal Policies of the Joint Committee on the Economic Report
issued in January, 1950, contributed to a better understanding of
the problems involved. The report also recommended that a
flexible monetary policy should be restored. Late in 1950, the
President of the United States was disturbed by an article in a
New York metropolitan paper to the effect that there was
speculation as to whether the Federal Reserve was undercutting
Treasury financing. He wrote the Chairman of the Federal Open
Market Committee that the situation referred to was a dangerous
6

Annual Report of the Board of Governors, 1950, p. 88.
The basic difference of opinion as to the effectiveness of greater flexibility in shortterm rates which emerged early in the postwar period still prevailed. For example,
the President of the Federal Reserve Bank of New York thought that greater flexibility in short-term rates would provide considerably more control over reserve creation
and hence credit expansion. Others, notably the former Chairman of the Board of
Governors, favored higher short-term rates but did not think they would have much
effect in curbing credit expansion. Supporting the prices of long-term bonds during
a period of expansion would make reserves readily available. As previously, the
former Chairman favored using existing powers available to the System other than
abandoning support of the long-term rate. If existing powers proved inadequate,
as he believed they would, the System should then present the situation to Congress with a clear explanation of the problems and alternatives—terminating support of Government securities or obtaining additional powers such as the special
reserve plan.
7

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107

one and urged that the policy of maintaining prices of Government securities be continued. He thought that with the tense
international situation and mounting defense expenditures,
maintaining stability in the Government securities market and
confidence in the Government's credit should have top priority.
Federal Reserve officials agreed with these general objectives;
the only disagreement was as to the best methods of achieving
them.
Early in February, 1951, there was a three-day meeting of the
Open Market Committee devoted almost exclusively to what the
Federal Reserve should do with increasing inflationary pressures
and strong opposition to any modification of the support policy.
The Committee approved a letter to the President explaining its
position. The letter made four main points.
First, the System should do all in its power to preserve the purchasing power of the dollar because any policy which eats away
the dollar's purchasing power would undermine confidence in
the credit of the United States and the public's willingness to buy
and hold Government securities. Second, the basic problem confronting the System was more effective control of bank reserves.
Reserve creation had been generating a rising tide of money and
there was no effective way of stemming this tide that would not
reflect itself in interest rates. Third, the charge that the Committee favored high interest rates per se confused the issue; the objective was more effective regulation of the creation of money, which
of course would be reflected in interest rates. Fourth, the System
should try to work out with the Secretary of the Treasury as
promptly as possible a program which would safeguard and
maintain public confidence in the values of outstanding Government bonds, and at the same time protect the purchasing power
of the dollar.
The Committee also approved a letter to the Secretary of the
Treasury suggesting a program for discussion. The basic premise
was that only by restricting credit expansion could erosion of the
value of the dollar be avoided and strength of the economy maintained in the critical period confronting them. As to the specific
program, the Federal Reserve would buy the longest-term, restricted bonds in such amounts as necessary to prevent them from

108

FEDERAL RESERVE POLICYMAKING

falling below par.8 If substantial support were required, the
Treasury should offer at an appropriate time a long-term bond
with a coupon sufficiently attractive so that investors would hold
it, and outstanding long-term restricted bonds would be exchangeable for the new bond. The System would purchase shortterm securities only to the extent needed to maintain an orderly
market, and banks would be expected to obtain reserves primarily by borrowing from the Reserve Banks. This proposed program
had the unanimous approval of the Open Market Committee.
There were frequent discussions, both at the staff and official
levels, between the Federal Reserve and the Treasury in the latter
part of February, 1951, in an effort to reach some agreement on
future policies. In the absence of the Secretary because of illness,
the Assistant Secretary of the Treasury was designated to represent him in discussions with Federal Reserve authorities.
THE ACCORD

An agreement on future policies was reached and the following
joint statement was released to the press March 4, 1951:
The Treasury and the Federal Reserve System have reached full accord with
respect to debt management and monetary policies to be pursued in furthering
their common purpose to assure the successful financing of the Government's requirements and, at the same time, to minimize monetization of the public debt.9

The agreement, popularly referred to as the accord, was
designed to achieve a twofold objective: to reduce to a minimum
creation of bank reserves through monetization of the public
debt, and to assure financing the Government's needs.
There were four main provisions designed to achieve these objectives. First, the Treasury agreed to offer holders of outstanding
long-term, restricted 2 1/2 per cent bonds an opportunity to exchange them for a long-term nonmarketable23/4per cent bond.
The purpose was to remove long-term restricted issues from the
market and reduce the need for interim support. The System in
turn agreed to support outstanding21/2'suntil April 15, 1951, up
to total purchases of $200 million. Second, the Federal Reserve
8
9

Restricted as to bank ownership.
Annual Report of the Board of Governors, 1951, p. 98.

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109

agreed to maintain an orderly market in Government securities
but this did not involve a commitment with respect to par on any
issue. Third, the Board of Governors would not approve any
change in the discount rate for the rest of the calendar year without prior consultation with Treasury officials, unless there were
impelling circumstances. Fourth, the Board of Governors requested cooperation of the Treasury in seeking early supplemental legislation to enable more effective restraint on expansion
of bank credit.
On March 8, 1951, System officials, after consultation with the
Treasury, decided to let the Government securities market stand
on its own. The Vice Chairman of the Open Market Committee
said this was the first day in more than ten years that the market
had been entirely without support from System open market
operations. The Executive Committee of the Open Market Committee, meeting that afternoon, included in its instructions to the
Federal Reserve Bank of New York to make such purchases, sales,
or exchanges of Government securities, "as may be necessary, in
the light of current and prospective economic conditions and the
general credit situation of the country, with a view to exercising
restraint upon inflationary developments, to maintaining orderly
conditions in the Government security market, to relating the
supply of funds in the market to the needs of commerce and
business, . . . ."
The accord marked a milestone in the history of Federal Reserve policy. For the first time since the mid-thirties, the System
was in a position effectively to regulate reserves and the money
supply. Excess reserves were so large for several years prior to
World War II that open market operations were ineffective as
a means of fundamentally altering reserve positions or of influencing interest rates. With the outbreak of World War II, open
market operations were directed toward maintaining essentially
the existing pattern of rates on Goverment securities to facilitate
Treasury financing. And, as already explained, inability to
obtain Treasury agreement resulted in the rate pattern being
maintained with only minor flexibility in short-term rates until
March, 1951. The accord thus removed the straitjacket imposed
by the policy of pegged rates for nearly ten years.

RETURN TO FLEXIBILITYALMOST

Under present conditions, operations for the System account
should be confined to the short end of the market (not including
correction of disorderly markets).
—Federal Open Market Committee, March, 1953

The return to a flexible monetary policy in 1951 confronted
Federal Reserve policymakers with a new situation. None of the
members of the Board of Governors or the presidents of the Reserve Banks had served in these policymaking positions for any
appreciable period when Federal Reserve policy was uninhibited
by either large excess reserves or supporting a pattern of rates.1
Moreover, restoration of flexibility coincided with a general resurgence of faith in monetary policy as an instrument of economic stabilization.
Newly acquired freedom in policy formulation together with
inexperience of officials in such an environment ushered in an era
of study and reappraisal. Policymakers were concerned with such
problems as making the transition to an unsupported Government securities market, how monetary tools could be used most
effectively in the new environment, and a re-evaluation of objectives and guides.
TRANSITION TO A FREE MARKET

System officials were anxious to effect a smooth transition to an
unsupported market and to cooperate with the Treasury in carrying out the provisions of the accord. The Federal Reserve with1
Only one had served prior to the mid-thirties, a member of the Board of
Governors having served since June, 1933.

110

RETURN TO FLEXIBILITY—ALMOST

111

drew support from the Government securities market in accordance with its agreement with the Treasury. By the fall of 1951,
the Open Market Committee had abandoned all minimum prices
at which support would be given the long-term restricted bonds;
once again the market was on its own except that open market
operations would be used, if necessary, to maintain an orderly
market for Government securities.
Termination of the support policy required that System officials and market participants adjust to a free market. Official discussion shifted from how effective control of reserves and credit
could be regained to how it should be used. Soon after the return
toflexibilitya policy of "neutrality" began to emerge. The meaning and tests that might be useful in implementing it were topics
of frequent discussion in 1952. The major objective of neutrality
was to keep Federal Reserve intervention at a minimum, afford
maximum opportunity for market forces of demand and supply
to operate, and encourage revival of a free market in Government
securities.
How could the policy of neutrality be implemented? What did
it mean in the actual conduct of open market operations? Some
officials interpreted neutrality rigidly. They thought the System
should stay out of the market under ordinary conditions. But the
majority of the Open Market Committee thought this interpretation was too narrow. Supplying reserves needed to support an expansion in total output or to offset gold and currency flows was
consistent with a neutral policy.2 The one test of neutrality which
gradually gained acceptance was whether or not an open market
purchase or sale was to supply or absorb reserves.
Probing for principles that should govern open market operations led officials to consideration of how reserves should be supplied—by open market operations or through the discount
window. In the latter part of 1952, a member of the Open Market
Committee suggested that it would be helpful to project reserve
needs well in advance. Such projections, even though necessarily
inaccurate, would provide the basis for fruitful discussion of the
2
One official stated neutrality should include sales to absorb excess reserves but
not the sale of bonds that had gone to a slight premium, because the latter might be
misinterpreted as System intervention in the market.

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extent to which reserves should be supplied by open market
operations and by borrowing at the discount window.
Despite the decision to abandon a supported Government
securities market, System policy with respect to Treasury financing continued to be a source of concern. Federal Reserve officials
wanted to facilitate Treasury debt management operations in
so far as possible without interfering with monetary objectives. After a year or more of experience with an unsupported
market, however, there was still some support for Federal Reserve "conditioning" the market for Government securities.
System officials were afraid that in trying to facilitate Treasury
financing operations the market would assume that the Federal
Reserve was reverting to its former practice of supplying banks
with all the reserves needed to make Treasury financing a
complete success. Some Treasury officials thought that at times
the System was not giving as much support as it should.
These views intensified the desire not only to avoid policies or
actions that might lead to expectations or demands for more
System intervention in the market, they encouraged officials to
look for ways to reduce intervention. One possibility was to encourage banks to seek additional reserves through the discount
window. Another was to reappraise open market policy during
periods of Treasury financing. In the fall of 1952, for example,
questions were raised as to whether during a Treasury operation
the System should purchase maturing issues and, if so, at what
premium; whether it should purchase new securities on a whenissued basis after the subscription books close; and whether it
should engage in swap transactions—the sale of other securities
and purchase of maturing issues. Here was another area in which
intervention might be reduced.
OPEN MARKET OPERATIONS

Centralization of authority in the Federal Open Market Committee and a growing volume of open market transactions had led
to suggestions, even prior to the war, that the Committee should
be better informed on operations and relations with dealers. In
March, 1940, the Chairman of the Open Market Committee

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appointed a committee of three—two members of the Board of
Governors and the President of the Federal Reserve Bank of New
York—to study the whole question of responsibilities of the Open
Market Committee with respect to the Government securities
market, as well as its relations with dealers and the market. But
because of the spread of the war in Europe it was agreed that the
special committee should be discharged.
Early in 1943, another special committee was appointed to
make a study of relationships with Government securities dealers
and the market. The Chairman of the Open Market Committee
stressed that these relations were the responsibility of the Committee and should not be left solely to the Manager of the Open
Market Account. The Committee should at least formulate a
general framework of principles to guide such relationships.
The Federal Reserve Bank of New York was invited to prepare
a statement of existing relationships with dealers. When completed the statement was to be sent to members of the Executive
Committee of the Open Market Committee, which in turn would
make a report to the full Committee.
In the fall of 1943, the Executive Committee submitted its report. The report approved existing relationships between the
Federal Reserve Bank of New York and the dealers, but recommended that future procedures and relationships should be
governed by formal rules and regulations adopted by the full
Committee.
After considerable discussion, the Open Market Committee
decided in 1944 to formalize rules and regulations governing
System transactions with Government securities dealers. The
Manager was directed to execute transactions for System Account
only with brokers and dealers in Government securities who met
certain qualifications. Knowledge and experience of management,
integrity and observance of high standards of honor, willingness
to make a market under all ordinary conditions; and volume and
scope of business, amount of capital and financial condition were
among the qualifications to be considered. To qualify, dealers
would also have to agree to furnish the Federal Reserve Bank of
New York information such as the total amount of money borrowed, par value of all Government securities borrowed, long and

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short positions in Government securities, volume of transactions
in Government securities, and whether acting as dealer for its own
account or as a broker.
Ad hoc subcommittee

Shortly after the accord, another study of open market operations, including the whole question of qualified and unqualified
dealers, was suggested. In May, 1951, the Chairman of the Open
Market Committee requested and was given authority to appoint
a special committee to make a study of the scope and adequacy
of the Government securities market and the System's relation
to the market.
The study was delayed until the spring of 1952 so that it could
be based on more experience with an unpegged market. The ad
hoc subcommittee consisted of the Chairman of the Open Market
Committee, another member of the Board of Governors, and the
president of a Reserve Bank. The subcommittee employed an
officer of one of the large money market banks in New York as a
technical consultant.
Report of the subcommittee

The report of the ad hoc subcommittee, submitted in the latter
part of 1952, dealt mainly with relations with the Treasury, with
Government securities dealers and the market, and operating
techniques. It made two basic recommendations of major significance for monetary policy.
Of first importance for monetary policy were the proposals regarding relations with dealers and the Government securities
market. The following quotation gives the subcommittee's findings and recommendations on this point:
The Subcommittee finds that a disconcerting degree of uncertainty exists
among professional dealers and investors in Government securities with respect
both to the occasions which the Federal Open Market Committee might consider appropriate for intervention and to the sector of the market in which such
intervention might occur, an uncertainty that is detrimental to the development
of depth, breadth, and resiliency of the market. In the judgment of the Subcommittee, this uncertainty can be eliminated by an assurance from the Federal
Open Market Committee that henceforth it will intervene in the market, not to
impose on the market any particular pattern of prices and yields but solely to

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effectuate the objectives of monetary and credit policy, and that it will confine
such intervention to transactions in very short-term securities, preferably bills.
The Subcommittee feels most strongly that it would be wise to give such an
assurance.
The Subcommittee finds two outstanding commitments that may require intervention by the Federal Open Market Committee in other than the very shortterm sectors of the market, and that may add to or subtract from reserve funds
available to the market for purposes other than the pursuit of monetary policies
directed toward financial equilibrium and economic stability. These commitments are, first, the directive to the management of the Open Market Account
to 'maintain orderly conditions' in the market for U.S. Government securities,
and second, those arising from the practice of purchasing rights on maturing
issues during periods of Treasury financing, and also on some of these occasions
of purchasing when-issued securities and outstanding securities of comparable
maturity to those being offered for cash or refunding.
With respect to the first of these commitments, the Subcommittee recommends
that the Federal Open Market Committee amend its present directive to the
executive committee by eliminating the phrase Ho maintain orderly conditions in
the Government securities market,' and by substituting therefor an authorization to intervene when necessary 'to correct a disorderly situation in the Government securities market.' . . . The Subcommittee recommends also that such
intervention be initiated by the executive committee only on an affirmative vote
after notification by the Manager of the Account of the existence of a situation
requiring correction.
With respect to the second, the Subcommittee recommends that the Federal
Open Market Committee ask the Treasury to work out new procedures for
financing, and that as soon as practicable the Committee refrain, during a
period of Treasury financing, from purchasing (7) any maturing issues for
which an exchange is being offered, (2) when-issued securities, and (3) any
outstanding issues of comparable maturity to those being offered for exchange.
The Subcommittee feels that such qualifications as are implicit in these two
recommendations would not seriously impair the constructive effect of a general
assurance from the Committee that its intervention henceforth will be limited to
the effectuation of monetary policies and will be executed in the very short sector
of the market. It recommends most strongly that such assurance be given as soon
as its existing commitments have been appropriately modified.3

The philosophy underlying the subcommittee report is clear.
System intervention in the Government securities market should
be held to a minimum because uncertainty among dealers and
market participants as to when and in what maturity sector the
Open Market Committee may intervene is detrimental to
3

Minutes, Federal Open Market Committee, March 4-5, 1953.

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FEDERAL RESERVE POLICYMAKING

"development of depth, breadth, and resiliency of the market."
This uncertainty could be eliminated by assurance that the Open
Market Committee would not intervene to impose any particular
pattern of prices and yields, but solely to effectuate the objectives
of monetary and credit policies; and such intervention would be
confined to transactions in very short-term securities, preferably
bills. In addition, confining System transactions to very shortterm issues would minimize effects on prices and yields of longerterm securities, permit the market to reflect the natural forces of
demand and supply, and furnish a signal of the effectiveness of
credit policy aimed primarily at the volume and availability of
bank reserves. Moreover, arbitrage transactions would soon
spread the effects of operations in short-term securities to other
maturity sectors.
System intervention could be further reduced by using open
market operations only to correct disorderly conditions instead of
to maintain orderly conditions in the Government securities
market. In addition, using operations to correct a disorderly situation in the market would avoid any danger of imposing any particular pattern of prices and yields on the market. System
operations in the market would also be appreciably reduced by
refraining during a Treasury financing from purchasing any
maturing issues for which an exchange is being offered, whenissued securities, or any outstanding issues of comparable maturities to those being offered for exchange.
The subcommittee recommended that in addition to adopting
these "ground rules" regarding open market operations, the
Open Market Committee should so inform the market. This
assurance as to System intentions would dispel some of the prevailing uncertainty and would be especially helpful when market
participants are trying to adjust to an unpegged market. The
depth, breadth, and resiliency of the Government securities
market would be improved, with the result that open market
operations would be a more effective tool of monetary policy.
The subcommittee also thought there should be a change in
the Federal Open Market Committee's procedures with the
Treasury. During the war and postwar periods the Committee
had followed the practice of making detailed suggestions to Treas-

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ury officials regarding types and terms of securities to be offered
in forthcoming Treasury financing operations. This practice was
encouraged by the support policy because as underwriter the
Federal Reserve had a direct interest in the terms of Treasury
offerings. Unattractive terms or securities meant that the System
would be compelled to buy whatever amount the market was
unwilling to absorb.
Now that the support policy had been terminated, the subcommittee thought the System should no longer initiate detailed suggestions to Treasury officials on debt management operations.
Debt management decisions were the responsibility of the Treasury. Hence, System officials should provide information on current monetary policies and when solicited by Treasury officials,
discuss the credit and monetary implications of the Treasury's
debt management proposals.
Bills usually

The Federal Open Market Committee adopted the basic principles of the ad hoc subcommittee report. The Committee agreed
that the System should no longer take the initiative in making
detailed recommendations to the Secretary of the Treasury regarding specific Treasury offerings. A new approach was deemed
appropriate now that the System no longer had the responsibility
of supporting pegged prices for Government securities. The Secretary of the Treasury should be kept informed of the credit
policies of the System and assured of the willingness of the Open
Market Committee to have its representatives consult with
Treasury officials when desired concerning credit policy or debt
management problems.
The Open Market Committee agreed in general with the subcommittee's recommendations regarding the System's relation to
the Government securities dealers and market. Using open
market operations solely to effectuate the objectives of monetary
and credit policy, and confining transactions to short-term
securities, would minimize the impact on prices of longer-term
issues and promote development of a broader, more self-reliant
market in Government securities. The Committee moved promptly
to put the principles of the ad hoc subcommittee report into

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FEDERAL RESERVE POLICYMAKING

effect by unanimously adopting the following policies governing
open market operations at its March, 1953, meeting:
(7) Under present conditions, operations for the System Account should be
confined to the short end of the market {not including correction of disorderly
markets);
(2) It is not now the policy of the Committee to support any pattern of prices
and yields in the Government securities market, and intervention in the Government securities market is solely to effectuate the objectives of monetary and credit
policy {including correction of disorderly markets);
{3) Pending further study and further action by the Committee, it should refrain during a period of Treasuryfinancingfrom purchasing (7) any maturing
issuesfor which an exchange is being offered,(2)when-issued securities, and {3)
outstanding issues of comparable maturity to those being offered for exchange.4

The three policies adopted in March were made, in effect,
continuing operating policies in September, 1953. The Open
Market Committee approved a motion that these policies be
followed until superseded or modified by further action of the
Committee. It adopted a fourth continuing directive in December, 1953: "Transactions for the System account in the open
market shall be entered into solely for the purpose of providing
or absorbing reserves (except in the correction of disorderly
markets), and shall not include offsetting purchases and sales of
securities for the purpose of altering the maturity pattern of the
System's portfolio."5
Adoption of the fourth continuing policy directive did not reflect a change in the objective for which open market operations
were to be used so much as an effort to prevent swap transactions.
The Executive Committee at its November, 1953, meeting had
authorized some swap transactions to achieve a better maturity
distribution of the System's Treasury bill portfolio. Larger holdings of bills maturing early in the year would facilitate absorption
of reserves created by the seasonal return flow of currency. A majority of the Open Market Committee, however, opposed swap
transactions on the basis that they would create confusion and
uncertainty and thereby militate against the objective of a
better functioning Government securities market.
4
Annual Report of the Board of Governors, 1953, p. 88; also minutes, Federal
Open Market Committee, March 4-5, 1953.
5
Minutes, Federal Open Market Committee, December 15, 1953.

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By the end of 1953, the Federal Open Market Committee was
firmly committed to a policy of minimum intervention in the
Government securities market—a policy commonly referred to as
bills only. In a period of less than three years, open market
policy had shifted from one extreme to the other—from intervening as necessary to maintain a pegged market, to fostering
a free market with a minimum of System intervention.
Dissenting view

The range of disagreement among Federal Reserve officials over
the bills usually policy was narrower than is generally assumed.
There was agreement that open market operations should normally be conducted in short-term securities which was much the
broader segment of the market, and that the Treasury should do
its financing at competitive rates and not rely on the Federal
Reserve System for support. But there was opposition by a small
minority, especially the Vice Chairman of the Open Market
Committee, to certain aspects of the new policy.
In the first place, uncertainty among dealers as to the maturity
sector in which the System might intervene was not considered
an important reason for the alleged lack of depth, breadth, and
resiliency. Instead, the uncertainty derived primarily from a
flexible monetary policy and the Treasury's debt management
program. Second, the effects of operating in the short-term sector
do not always spread promptly to other maturity sectors; hence
it may be desirable at times to conduct open market operations
outside the short-term sector in order to affect directly intermediate- and longer-term rates. Third, confining open market
operations solely to the purpose of supplying and absorbing reserves prevents use of this tool for other purposes that may be
important at times in achieving monetary objectives. Fourth,
adoption of the continuing operating policies, in effect, put improvement in the Government securities market ahead of the
System's primary responsibility for monetary and credit policies.
Finally, public commitments, such as announcement of the continuing policies, impair the Committee'sflexibilityto take whatever action seems most appropriate under particular circum-

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stances. On this point, the leading dissenter expressed himself
as follows:
What I have been objecting to as a matter of principle—and still object to—
is trying to write into a 'constitution' of the Open Market Committee, as one
member called it, a prohibition against actions deemed undesirable by particular members of the Committee, holding particular views, at a particular
time. We can't afford a freeze of ideas or practices.6
Supervision and techniques

The Banking Act of 1935 corrected a weakness that had previously impaired effective use of open market operations, by centralizing control in the Federal Open Market Committee. The
full Committee met regularly four times a year to formulate
policy and prepare a general directive to the Executive Committee of five members. The Executive Committee met more
frequently and issued a directive to the Manager of the Open
Market Account.
In mid-1954, another step was taken toward more effective
supervision with the inauguration of a three-way telephone conversation among officials of the Board of Governors, the Federal
Reserve Bank of New York, and the other Reserve Bank whose
president was serving on the Executive Committee. The purpose
of this telephone meeting, usually held in the morning of each
business day, was to provide for a more systematic exchange of
information regarding the reserve position of banks, actual and
prospective market developments, and open market operations
needed, if any.
In 1955, at the suggestion of the Chairman, the Open Market
Committee decided to abolish the Executive Committee and hold
meetings of the full Committee about every three weeks. The expressed purpose was to have a broader and more active participation in formulation of open market policy, and all Reserve Bank
presidents were invited to attend the meetings. These meetings
became a forum for discussion of monetary policy, not just open
market policy. The change represented a significant step in policy
formulation and coordination of the tools of Federal Reserve
policy, even though final responsibility was still distributed
among different policymaking groups.
6

Minutes, Federal Open Market Committee, September 24, 1953.

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The bulk of open market transactions is for the purpose of offsetting the effects of market factors such as float, Treasury operations, and currencyflows.The day-to-day effect of market factors
on bank reserve positions is sometimes substantial. Hence the
need at times to supply or absorb reserves promptly.
In mid-1954, the question was raised as to whether it would be
possible to have delivery and payment the same day the securities
transaction is consummated. The regular procedure called for
delivery and payment the following day. Investigation by the
Manager of the Open Market Account indicated that delivery
and payment the same day would be feasible, and he was given
authority to engage in "cash transactions"—delivery and payment the day of the transaction. Cash transactions are especially
useful when officials want to supply or absorb funds immediately.
Repurchase agreements, which had been used in the early history of the System primarily to help dealers finance their position
when funds were not available at reasonable rates from other
sources and to help develop and broaden the market for bankers
acceptances, fell into disuse during the thirties and during World
War II when the System had the 3/8 per cent posted rate on
Treasury bills. Early in 1948, renewed authority was given the
Manager of the Open Market Account to use repurchase agreements to supply funds to the market temporarily in periods of
unusual tightness.
In recent years, repurchase agreements with nonbank dealers
have been used more frequently, and the sole purpose has been
to implement Federal Reserve policy. Repurchase agreements
are an especially suitable tool for putting funds into the market
temporarily, and when the market is unusually sensitive. They
avoid whipsawing the market with outright purchases followed
in a day or so by sales.
ADMINISTRATION OF THE DISCOUNT WINDOW

There was little need for member banks to borrow during the
period 1934-1951, and the discount window fell into disuse. The
return to a more flexible open market policy revived interest in
the discount window on the part of both Federal Reserve officials

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FEDERAL RESERVE POLICYMAKING

and member banks. Use of the discount window came in for
considerable study and reappraisal, especially in 1953 and 1954.
The Board of Governors revised Regulation A, governing loans
and discounts by Federal Reserve Banks, effective in February,
1955.
Review of the role of the discount window resulted mainly in
clarification rather than adoption of new principles. The most
significant change was a revision of the statement of general principles governing administration of the discount window. In announcing the revision of Regulation A, the Board of Governors
stated that "the most important change is the revision of the foreword (General Principles) to Regulation A. The revised foreword
is designed merely to restate and clarify certain guiding principles
which are observed by the Federal Reserve Banks in making advances and discounts in accordance with the applicable provisions
of the Federal Reserve Act and of Regulation A."
The revised statement of general principles did not make any
change in uses that had long been considered appropriate. In
general, these purposes were borrowing for short periods to meet
reserve deficiencies, thus affording time, if necessary, to make
such adjustment in assets as may be required; borrowing to meet
seasonal needs that could not reasonably be anticipated; and
borrowing for longer periods to meet unusual situations or emergencies. On the other hand, continuous borrowing, in effect using
Reserve Bank credit to supplement the member banks' own resources; borrowing to finance speculative activities or investments; or borrowing to scalp a profit from a rate differential or to
secure a tax advantage were regarded as inappropriate uses of
Reserve Bank credit.

OBJECTIVES AND GUIDES

The return toflexibilityafter such a long lapse and in a markedly
different environment led to reconsideration of objectives and
guides. A spirit of reappraisal prevailed, but results consisted
mainly of refinements rather than development of new objectives
and guides.

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Objectives

Price stability and smoothing out upward and downward swings
in total business activity had long been ultimate goals or objectives of Federal Reserve policy. But severe depression and then
stagnation in the thirties had demonstrated that stability in itself
was not enough. Stability with a large margin of unused resources
was not a satisfactory objective. Congress in the Employment Act
of 1946, set up what is commonly referred to as "full employment" as a goal of economic policy.
Federal Reserve officials accepted reasonably full employment
of labor and other productive resources as one of the objectives of
Federal Reserve policy. In the words of one official, "the art of
central banking is to approach the brink of inflation without
falling in or being pushed in." He pointed out that the brink of
inflation is not clearly discernible because near-capacity, full
capacity, and overcapacity are indistinct. Moreover, too much
money and too easy credit may lead to increases in prices instead
of increases in real income even at near-capacity operations. In a
practical sense, the objective was to have production and employment as close to capacity as possible without generating a
significant upward movement in prices.
Neither was stability at high but stagnant levels of production
and employment considered adequate. A rising level of total output is essential if the standard of living is to be maintained with a
growing population. Growth as well as stability was a desirable
goal.
In the fall of 1953, the Open Market Committee agreed that a
policy of active ease should be continued and that "reserves
would be supplied to the market to meet seasonal and growth
needs, . . . ." Later in the year the Committee inserted into its
directive to the Executive Committee that open market operations should be directed, among other things, "to promoting
growth and stability in the economy by actively maintaining a
condition of ease in the money market, . . . ." Discussion did not
indicate, however, the sudden discovery of a new major objective.
In projecting probable future reserve needs, allowance was made
for a growth factor in the money supply, such as 3 per cent. Incorporation of growth in the directive apparently reflected only

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FEDERAL RESERVE POLICYMAKING

the adjustment of policy instructions to a particular phase of the
cycle.
It was not long, however, until orderly or sustained growth did
become an accepted and frequently discussed objective. The goal
was not some specific rate of annual growth. Instead, monetary
policy should be used not only to avoid booms and depressions,
but also to facilitate a sustainable rate of growth in total output.
It should aim at keeping total demand in balance with an expanding capacity to produce, at stable prices.
Worsening of the balance-of-payments deficit in the latter part
of the fifties revived another objective that had not been a determinant of monetary policy for many years—helping defend the
external value of the dollar. Thus there were four generally accepted policy objectives: price stability, maintaining reasonably
full use of labor and other productive resources, sustained economic growth, and protecting the external value of the dollar.
Guides

The return to a flexible monetary policy emphasized the need for
guides that would be helpful in deciding when action should be
taken. Several short-term guides have been considered since the
return to flexibility.
Under the policy of neutrality, a substantial part of reserve
needs was met through the discount window. In fact, some officials thought all temporary and a large part of seasonal reserve
needs should be met in this way. Thus the level of member-bank
borrowing was watched closely in policy formulation. In the
spring of 1953, for example, one of the immediate aims of policy
was to keep member-bank borrowing at about $1.5 billion. This
level of borrowing, it was thought, would exert about the right
amount of restraint on member banks and at the same time would
minimize the need for System intervention in the Government
securities market. If borrowing rose above the target level, additional reserves would first be supplied by repurchase agreements;
if necessary, the System would then make outright purchases of
Government securities.
Using a certain level of member-bank borrowing from the
Reserve Banks as an immediate guide was regarded as unsatis-

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factory by some officials. It was inconsistent to pursue a policy of
keeping banks in debt at about a certain level, such as $1.5 billion, and then try to prohibit continuous borrowing. Moreover,
administering the discount window to prevent continuous borrowing meant that maintaining a given level of borrowing over
time was likely to result in increasing restraint.
Recession and a shift of policy from restraint to ease focused
attention on excess reserves as well as volume of borrowing. During the recession of 1953-1954, staff members began using the
term "free reserves" in statements at meetings of the Open
Market Committee. Free reserves, reflecting both excess reserves
and borrowing, became the principal guide used in Committee
discussions in 1954.
Use of some reserve measure as a guide was the logical result of
the decision in late 1953, that open market operations should be
conducted solely for the purpose of supplying or absorbing reserves. Reserve measures, including free reserves, were projected
several weeks into the future, and some Committee members
began suggesting a certain range of free reserves as a guide for
operations until the next meeting. A desire to express the Committee's directive to the Manager of the Account in more specific
terms also encouraged use of some quantitative target such as net
free or net borrowed reserves.
Several difficulties were soon recognized in using a free reserve
target as a guide. Inability to project free reserves accurately
because of wide fluctuations in such factors as float and Treasury
operations made it difficult to achieve a range such as $100-150
million in daily average free or borrowed reserves, at least without conducting open market transactions that otherwise would be
undesirable. The degree of ease or restraint, it was pointed out, is
influenced by distribution as well as volume of free reserves.
Country banks hold more excess reserves than banks in financial
centers, and are likely to be less prompt in putting newly acquired reserves to work. A serious limitation of a free reserve
guide is that it affords no indication of whether banks are using
reserves. Use of reserves made available depends on a variety of
factors influencing willingness of banks to lend and invest. Economic stagnation and fear in the thirties which led member banks

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FEDERAL RESERVE POLICYMAKING

to hold huge excess reserves is an extreme illustration of how environment may influence willingness of banks to use reserves
made available.
There has been considerable progress since the accord in developing and refining quantitative indicators as guides. More
data on bank reserve positions are available and with less time
lag. Various aspects of reserve positions are considered, such as
net free and net borrowed reserves, non-borrowed reserves, total
reserves, and member-bank borrowing. Projections of reserve
positions, and the principal factors affecting them, have been
improved. Other sensitive indicators of money-market conditions,
such as federal funds rate, Treasury bill rates, dealer loan rates,
and dealer borrowing, are watched closely. But officials are fully
aware that short-term money-market indicators, although helpful, are far from adequate. They must look beyond such immediate guides.
Reserves and other sensitive money-market indicators are only
the first link in a chain of responses that may be set in motion by
Federal Reserve actions. Trends as well as short-run changes are
useful guides in policy formulation. A growth factor is incorporated in reserve projections to provide some indication of
whether over time the actual reserve base is expanding at a
reasonable rate. A change in reserve position has little effect unless it influences bank loan and investment policies. Consequently, trends in such factors as bank loans and investments,
the money supply, longer-term interest rates, consumer and
capital expenditures, were considered to be significant intermediate-term indicators of possible responses to actions taken
and whether further action is needed.
Another type of intermediate guide which often crops up in
policy discussions is unhealthy credit situations and other maladjustments. In the upward swing of the cycle, officials are alert for
developments such as speculative activity in the stock market, in
inventories, or in real estate. Rates of credit expansion and
trends in terms in key areas, such as automobile financing, real
estate, and business credit, are watched carefully. A crucial question is whether total demand is pressing against capacity to pro-

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duce to such an extent that additional credit would result mainly
in higher prices instead of more output.
Along with efforts to develop and refine quantitative guides
were attempts to define more clearly commonly used policy
terms. A good illustration of the latter was a written characterization of the terms active ease, ease, neutrality, and restraint submitted by one of the members to the Open Market Committee
early in 1955.
Active ease was characterized as maintaining a volume of excess reserves large enough to assure ready availability of bank
credit for all borrowing needs that meet ordinary standards of
creditworthiness; the discount rate at a low level; short-term,
money-market rates far enough below the discount rate so that it
is cheaper to obtain reserves in the open market than at the discount window; relatively low market rates at all maturities with
a tendency toward a continuing decline in rates; and with member banks borrowing from the Reserve Banks only intermittently
and in small volume.
Ease is a condition in which bank reserves and bank credit
are readily available to meet creditworthy demands. For the
banking system as a whole, there is no need for rationing of funds
among particular uses because of insufficient credit to go around,
there is no pressure on banks to find uses for a continuously increasing supply of reserves. The discount rate remains at a low
level; the tendency toward a decline in market rates of interest is
checked; the more sensitive money-market rates, such as the
federal funds rate and the Treasury bill rate, move up toward the
discount rate so that at times borrowing at the discount window
may be more advantageous than obtaining reserves in the open
market. Individual member banks borrow with some frequency
in response to expanding credit demands but a sustained and
growing volume of borrowing is soon relieved by open market
operations.
A policy of neutrality is one in which bank reserves are sufficient to meet creditworthy demands. Market factors are permitted to reflect themselves in reserve positions of banks which
would mean in most instances no continuous cushion of excess

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FEDERAL RESERVE POLICYMAKING

reserves and elimination of free reserves in the aggregate. Any
appreciable change in economic conditions or over-all credit
demands would be reflected fairly promptly in more sensitive
rates of interest, and in the event of tightening tendencies, sensitive money-market rates would be expected to move above the
discount rate. Should these tightening tendencies continue, the
discount rate would be moved up toward the middle of its range.
There might be a moderate volume of member-bank borrowing
much of the time, but continuing pressure on the banking system
as a whole would be relieved sufficiently by open market operations so that a large volume of member-bank borrowing would
be unnecessary.
Restraint implies an open market policy with respect to reserves that creates a general awareness that bank credit is not
available in sufficient volume to meet all demands. The pressure
of total demand against a restricted supply would cause interest
rates to rise. The discount rate is raised to the higher levels of its
range, and sensitive money market rates should be close to or
above the discount rate at all times. Member-bank borrowing
from the Reserve Banks would rise substantially and would be
moderated by open market operations only if the apparent degree
of restraint was becoming too great. Reserves continue to be
available at a price. The objective is not to shut off bank credit
or even bring a net reduction, but to limit growth as necessary to
avoid inflationary pressures from the monetary side.
Even though earnest efforts have been made to develop shortand intermediate-term guides, policy discussions reveal clearly
an awareness that wise decisionmaking is ultimately a matter of
informed judgment. Knowledge of the effects of System actions
is too imperfect and the environment in which the central bank
operates too volatile for policy formulation by rule or formula to
be effective. Informed judgment, based on quantitative indicators and all other relevant information available, is still the principal ingredient of sound policy formulation.

10.

DEFENDING EXTERNAL
VALUE OF THE DOLLAR

After prolonged study and discussion of the role of the dollar
in the international payments system, the Federal Open Market
Committee, in early 1962, decided to undertake open market
transactions in foreign currencies.
—Annual Report of the Board of Governors, 1962

Defending stability of the internal value of the dollar has long
been an important determinant of Federal Reserve policy. But
until recently defending its external value had not been a significant influence since the early thirties.
A persistent balance-of-payments deficit since 1949 has been
putting a mounting supply of dollars at the disposal of foreigners,
and a return to convertibility of the major currencies in 1959
made it possible to shift funds from one international financial
center to another. The continuing deficit, weakness of the dollar
in foreign exchange markets, and loss of gold set the stage for the
possibility that rumors or an international crisis might touch off
a flight from the dollar. The Treasury began intervening in foreign exchange markets in the spring of 1961, and initiated other
defenses to help maintain the external value of the dollar. Federal
Reserve authorities, to help defend the dollar, terminated the
bills usually policy, began operations in foreign exchange, and
participated in other arrangements to help improve the international monetary system.
DILEMMA: DOMESTIC VS. EXTERNAL GOALS

The recession of 1960-1961 brought Federal Reserve officials face
to face once again with the problem of monetary objectives calling for conflicting actions. Total demand, production, and em129

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FEDERAL RESERVE POLICYMAKING

ployment were declining. Unemployment was rising, and the
wholesale price level was stable. The objectives of reasonably full
use of productive resources and sustained economic growth
clearly called for an easy money policy. An ample supply of reserves was needed to encourage credit expansion, bolster total
demand, help check the recession, and stimulate recovery.
But the United States was in difficulty with its international
balance of payments. Productive capacity in war-torn countries
had been restored with modern plant and equipment; United
States producers were facing keener competition in world markets. Large military and foreign-aid expenditures abroad resulted in a substantial deficit on Government account, and there
was a substantial net outflow of private long-term capital. Higher
short-term interest rates in leading financial centers abroad induced an outflow of short-term funds from the United States.
The deficit in the balance of payments, which averaged over
$3 billion annually from 1958 to 1960, was putting a mounting
supply of dollars at the disposal of foreigners. The balance-ofpayments problem called for holding the price-wage line, and a
tighter money policy to reduce availability of credit and raise
interest rates to help check the flow of capital abroad.
Federal Reserve policymakers faced a dilemma. Should they
pursue an easy money policy to check recession and stimulate
recovery, or a tighter money policy to help correct the balanceof-payments deficit?
Sources of the balance-of-payments deficit provided guidelines
that were helpful in arriving at a decision that would be in the
public interest. The deficit did not reflect an inflated wage-price
structure that prevented United States producers from competing
successfully in world markets. The United States has long had a
substantial surplus on goods and services; in fact there has been
a surplus every year in the present century. A major part of the
outflow of private long-term capital was in the form of direct investments. The large deficit on Government account, averaging
around $5.6 billion annually, reflected primarily military expenditures abroad and foreign economic aid.
The deficit was not the type for which a tight money policy has
long been regarded as the traditional remedy. Our substantial

DEFENDING EXTERNAL VALUE OF THE DOLLAR

131

trade surplus was proof that United States producers were able to
compete successfully in world markets. Neither were net outflows
of private long-term capital and Government payments abroad
the result of an easy money policy in the United States. Eliminating the deficit required a much broader program than a restrictive monetary policy. Yet monetary policy had a role to play: it
was essential to prevent an increase in prices which would seriously impair our competitive position; and higher short-term
rates would diminish the incentive for short-term funds—which
are more sensitive to interest-rate differentials—to flow abroad.
ANOTHER RETURN TO FLEXIBILITY

In the latter part of 1960, the Federal Reserve began working
toward a twofold objective: continue to supply ample reserves to
foster recovery, and minimize downward pressure on short-term
interest rates in order to assist in the program to reduce the balance-of-payments deficit. But supplying reserves for an easy
money policy by buying Treasury bills and other short-term
securities would put substantial downward pressure on shortterm rates.
Departures from bills usually

In October, 1960, the Federal Open Market Committee began a
series of departures which eventually ended in termination of the
bills usually policy adopted in March, 1953. Seasonal needs
meant that the System would have to supply a large amount of
reserves to maintain the desired degree of ease; however, shortterm rates were considerably lower than abroad. This combination of circumstances led the System to purchase short-term
Government securities other than Treasury bills for the first time
since 1958, in order to avoid putting direct downward pressure
on the bill rate.
The Open Market Committee took another step away from
bills usually in February, 1961. It gave the Manager of the Open
Market Account authority to buy up to $500 million of Government securities with maturities up to 10 years and to alter the
maturity composition of the System's portfolio by selling short-

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FEDERAL RESERVE POLICYMAKING

term and buying longer-term maturities. Swap transactions
might be desirable should sales of short-term securities be needed
to affect short-term rates at a time when the System did not want
to absorb reserves.
The plan was to make moderate purchases in the 1- to 5 1/2-year
maturity sector first and later in51/2-to 10-year maturities.
Federal Reserve officials stressed that the purpose of conducting
operations in intermediate and longer maturities was not to set
any particular level of short- or longer-term rates. Supplying
reserves by purchases outside the short-term area would relieve
the direct downward pressure on short-term rates and thus help
stem the outflow of short-term funds. To the extent that purchases outside the short-term sector softened intermediate- and
long-term rates or prevented them from rising as much as otherwise, the flow of funds into the capital and mortgage markets
would be encouraged. The objective of open market purchases
outside the short-term sector was summarized in the Board of
Governors' Annual Report for 1961, as follows:
" . . . purchasing of securities in the intermediate- and longer-term areas,
as contrasted with the short-term area, offered the possibility of supplying reserves without creating direct pressure on short-term rates. Also, such purchases,
by having a moderating influence on long-term interest rates relative to shortterm rates, might have the effect of facilitating the flow of funds through the
capital and mortgage markets, thereby encouraging the progress of recovery.
Accordingly, the combination of domestic and international circumstances confronting the Committee seemed to call for a high degree of flexibility in open
market operations.1

The Committee agreed that its decision to depart, at least
temporarily, from the longstanding policy of confining operations
to short-term securities preferably bills, and not to engage in swap
transactions, should be made public. On February 20, 1961, the
date of initial operations in longer maturities, the Chairman of
the Committee authorized the Manager of the Open Market
Account to issue the following press statement:
The System Open Market Account is purchasing in the open market U.S.
Government notes and bonds of varying maturities, some of which will exceed
5 years.
1

Annual Report of the Board of Governors, 1961, p. 40.

DEFENDING EXTERNAL VALUE OF THE DOLLAR

133

Price quotations and offerings are being requested of all primary dealers in
U.S. Government securities. Determination as to which offerings to purchase
is being governed by the prices that appear most advantageous, i.e., the lowest
prices. Net amounts of all transactions for System Account will be shown as
usual in the condition statements issued every Thursday.
During recent years transactions for the System Account, except in correction
of disorderly markets, have been made in short-term U.S. Government securities. Authority for transactions in securities of longer maturity has been
granted by the Open Market Committee of the Federal Reserve System in the
light of conditions that have developed in the domestic economy and in the U.S.
balance of payments with other countries.2

In March, 1961, the Open Market Committee removed the
restriction that limited purchases to maturities of up to 10 years,
one reason being that more flexibility in open market operations
would afford a better opportunity to evaluate effects of operations
outside the short-term sector. The special authorization to operate in longer-term securities was renewed at each meeting of the
Committee until December.
Termination of bills usually

In December, 1961, the Federal Open Market Committee voted
to discontinue the three continuing policy directives adopted in
March, 1953. There were several reasons for taking this step,
according to official records.
In view of the United States balance-of-payments position,
greater flexibility might be needed in the future in adapting
System operating techniques to changing circumstances. This
was perhaps the dominant reason. A second reason was that the
directives which were designed to clarify the role of open market
operations and thereby assist in making the transition from a
pegged to an unsupported Government securities market had
served their purpose. The transition had been successfully made
for some time. Third, when the three continuing directives were
adopted, the full Committee met regularly only four times a year.
The Executive Committee was abolished in mid-1955, and the
continuing directives were no longer needed as guidelines for the
Executive Committee.
2

Ibid., p . 43.

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FEDERAL RESERVE POLICYMAKING

Some members of the Committee were opposed to discontinuing the operating directives. Formalized guidelines were considered desirable even though modifications might be needed
occasionally to meet certain situations. Dropping the directives
might have adverse effects on the Government securities market.
In any event, operations in all maturities would impair the usefulness of the market as a signal of changes in natural supplydemand conditions. Some of the opposition to discontinuance reflected a belief that the experiment with operations outside the
short-term sector had not been successful. Reference was also
made to one of the "classical canons of central banking," namely,
that a central bank should operate only in high-quality, shortterm paper.
FOREIGN EXCHANGE OPERATIONS

Early in 1962, the Federal Open Market Committee decided to
launch an experimental program of operations in foreign exchange to supplement Treasury operations in foreign currencies
which had been under way since early 1961. Representatives of
the Committee conferred with Treasury officials to develop working relations with the Treasury and to explore guidelines for conducting foreign exchange operations.
The Committee designated a senior officer of the Federal Reserve Bank of New York as Special Manager of foreign currency
operations. A subcommittee, consisting of the Chairman and
Vice Chairman of the Open Market Committee and Vice Chairman of the Board of Governors, was authorized to give instructions to the Special Manager for foreign currency operations
within the guidelines issued by the Open Market Committee if a
decision should be necessary before the entire Committee could
be consulted.
There were three principal reasons for the decision to initiate
foreign exchange operations. The importance of an efficient and
orderly international payments system to the United States and
the rest of the free world made it imperative that the central bank
of the world's leading industrial and financial power take an active part in efforts to maintain and improve the system. Second,

DEFENDING EXTERNAL VALUE OF THE DOLLAR

135

there was need to supplement the relatively small resources of the
Stabilization Fund available to the Treasury for defending the
dollar from speculative attack in foreign exchange markets.
Third, officials believed that the world payments system called
not only for multilateral cooperation through the International
Monetary Fund and other international institutions, but also for
bilateral cooperation among monetary authorities of the leading
trading nations. Finally, helping to stabilize the dollar in foreign
exchange markets was part of a central bank's responsibility for
maintaining monetary stability. Such operations were regarded
as a central bank function in most major countries.
The Open Market Committee emphasized that official intervention in foreign exchange could not be a substitute for fundamental action to eliminate the United States balance-of-payments
deficit; however, until the deficit was eliminated it was important to minimize the danger that political and economic disturbances might generate speculative pressures and unsettle foreign
exchange markets. Treasury operations in 1961 had shown that
timely intervention could do much to moderate such pressures.
There was some opposition to System operations in foreign exchange. One objection was that stabilizing foreign exchange
markets was more properly the responsibility of the Treasury and
it would be unwise to have two agencies engaged in these operations. Another was that central bank intervention might impair
private market processes and do more harm than good.
Objectives and guidelines

In February, 1962, the Open Market Committee approved general objectives and guidelines to govern transactions in foreign
exchange. One of the main objectives was to help safeguard the
value of the dollar in foreign exchange markets, avoid disorderly
conditions in the markets, and help make the present system of
international payments more efficient. This was especially important in view of the persistent balance-of-payments deficit and
large foreign holdings of dollars which rendered the dollar more
susceptible to possible speculative attack. A second objective was
to further monetary cooperation with central banks in other
countries maintaining convertible currencies, with the Inter-

136

FEDERAL RESERVE POLICYMAKING

national Monetary Fund and with other international institutions. Third, in cooperation with these institutions, to help
moderate temporary imbalances in international payments that
may adversely affect monetary reserve positions. Finally, contemplated foreign exchange operations might make possible, in
the long run, growth in liquid assets available in international
money markets to help meet the needs of an expanding world
economy.
System officials also had more specific aims in engaging in foreign exchange operations. One was to offset the effects of temporary disturbing forces on United States gold reserves and dollar
liabilities. Such operations could also be used to temper and
smooth out sharp changes in spot and forward exchange rates
considered to be disequilibrating in their effects.
The principal guideline for transactions in spot exchange was
to cushion or moderate temporary fluctuations which tend to
create market anxieties, undesirable speculative activity, or excessive leads and lags in international payments. Sharp increases
in international political tensions, unusually large interest-rate
differentials between major markets, and market rumors that
stimulate speculative transactions are among the factors that may
cause instability in foreign exchange markets.
Transactions in forward exchange are likely to be desirable
when forward premiums or discounts, inconsistent with interestrate differentials, are giving rise to disequilibrating movements
of short-term funds. Transactions to supplement existing market
facilities in providing forward cover may be useful in encouraging
retention or accumulation of foreign dollar holdings.
Another guideline was that, as a general practice, purchases
and sales of foreign exchange should be at prevailing rates.
Swap agreements

Thus far, Federal Reserve operations in foreign currencies have
centered around reciprocal credit agreements negotiated with
foreign central banks. Each party to the agreement is protected
against loss should there be devaulation[devaluation]or revaluation of the
other's currency while the drawing is outstanding. Swap agreements are for relatively short periods, usually three to six months,

DEFENDING EXTERNAL VALUE OF THE DOLLAR

137

although a few are for 12 months and are renewable upon mutual
agreement. As of mid-April, 1965, the System has swap agreements with 11 foreign central banks and the Bank for International Settlements. These arrangements permit the System to
draw up to $2.65 billion of foreign currencies.
The System thus far has used its swap facilities mainly to absorb dollars accumulated by foreign central banks in excess of the
amounts they want to hold, especially if the accumulation results
from temporary forces. Exchanging foreign currencies for unwanted dollars of foreign official institutions is a means of avoiding a concentration of gold losses which might disturb confidence
in the dollar. Foreign currencies, available under swap agreements, have also been sold in the market to counter speculative
attacks on the dollar or to cushion disturbances that threaten to
become disorderly. The volume of Federal Reserve transactions
in foreign exchange, both in the market and directly with foreign
central banks, totaled $1.3 billion in 1964.
As the System has gained experience in foreign exchange operations the tendency has been toward extending the maturity of
swap agreements. Recently, several agreements have been put on
a six-month or one-year standby basis. Drawings under these
agreements, however, have a maturity of three months and renewals are limited in order that every drawing will be liquidated
within a year.
System officials have worked closely with Treasury officials,
both in the formulation of policy and in coordination and execution of foreign currency operations. Officials of both agencies
participate in a daily review and discussion of market developments and operations in foreign exchange. Coordination of System and Treasury operations is facilitated by the fact that the
Federal Reserve Bank of New York acts as agent for both the
System and the Treasury in executing foreign exchange transactions.
The Federal Reserve System has participated with other central banks in promptly making credit available to help defend a
currency under speculative attack. In May, 1962, for example,
when establishment of the par value of the Canadian dollar at
$0.925 resulted in fears of further devaluation, speculative activi-

138

FEDERAL RESERVE POLICYMAKING

ties accelerated the drain on Canadian reserves. The Federal
Reserve System, Bank of England, International Monetary Fund,
and the United States Export-Import Bank promptly placed
over $1 billion at the disposal of Canadian authorities to defend
their currency.
Swap arrangements, central bank credit pools, and the International Monetary Fund permit mobilization of large sums to
deal with disturbing short-term capital flows and speculative
pressures. The assassination of President Kennedy in November,
1963, provided a notable illustration of the effectiveness of such
arrangements. There was serious danger that news of the assassination and rumors which began to circulate would touch off
panic-selling in financial markets. The Federal Reserve immediately placed sizable offers of the major foreign currencies in the
New York market at the rates prevailing just prior to news of the
tragedy. The same afternoon, arrangements were made with
foreign central banks for joint intervention here and abroad to
counter any speculative developments that might occur. The
mere fact that large sums were available to deal with speculative
attacks seemed to help restore confidence, and initial speculative
pressures soon subsided. As a result, actual intervention in foreign
exchange markets by the Federal Reserve and foreign central
banks was on a small scale.
OTHER INTERNATIONAL ACTIVITIES

The London gold market, which reopened in 1954, is the largest
free market for gold in the world. The price in the London market is usually close to the United States price of $35 an ounce
because foreign central banks can buy from or sell gold to the
United States at that price, plus or minus a small Treasury
handling charge, for "legitimate monetary purposes." Nevertheless, sudden speculative buying or selling sometimes pushed the
London price out of line with the United States price, often with
disturbing effects in foreign exchange markets.
A surge of speculative buying in October, 1960, which pushed
the London price to about $40 an ounce, stimulated another form
of central bank cooperation. The Bank of England, with the sup-

DEFENDING EXTERNAL VALUE OF THE DOLLAR

139

port of the United States, began selling gold to bring the price
down to a more reasonable level. Another threat in the fall of
1961 led the United States to suggest that the Federal Reserve,
the Bank of England, and principal central banks of Western
Europe set up an informal selling pool to distribute the burden
of gold sales to stabilize the price. An informal arrangement was
worked out, each central bank agreeing to supply a certain proportion of the gold required. The Bank of England acted as agent
of the group in making sales in the London market.
Early in 1962, the United States proposed that the group be reactivated to coordinate purchases when needed to stabilize the
price against heavy selling pressure. Under the plan adopted, the
Bank of England made the purchases for all participating central
banks. The gold purchased was then distributed among participants according to agreed proportions.
The "gold pool," although on an informal basis, is now prepared to operate on either the buying or selling side of the market
in order to stabilize the price of gold in the London market. It
marks another phase of international cooperation in trying to
protect foreign exchange markets against speculation and other
temporary disturbing forces.
The Federal Reserve has broadened its international activities
in other ways. A Federal Reserve official attends the monthly
meetings of the Bank for International Settlements. The System
is represented on United States delegations to meetings of the
committees and working parties of the Organization for Economic Cooperation and Development. In addition to its foreign
exchange operations and participation in central bank credit and
gold pools, Federal Reserve authorities cooperate closely with
Treasury officials and officials of foreign and international institutions in efforts to improve the functioning of the international
monetary system.

11.

FEDERAL RESERVETREASURY CONTROVERSIES

Large and habitual borrowers are not the best administrators
of the fund to be lent.
—Nicholas Biddle1

The proper relation between the central bank and the Government, especially the Treasury Department, has long been a subject of debate. For this reason, Federal Reserve experience with
Treasury officials on questions of monetary policy during the
past 50 years is of special interest. The purpose of this chapter is
to explain the important differences that arose and the reasons
for the divergent views.
It would be misleading should limiting the analysis to differences of opinion leave the impression that Federal ReserveTreasury relations is one long period of controversy. Generally,
there has been close cooperation to minimize disturbing effects of
Treasury operations on the money market and to time Federal
Reserve actions to avoid complicating the Treasury's financing
problems. Since early in the history of the System, Federal Reserve and Treasury officials have worked closely together to
smooth out the impact of Treasury receipts and disbursements on
bank reserves and conditions in the money market. The Federal
Reserve, as fiscal agent of the Treasury, has handled a growing
volume of transactions involved in the issue, redemption, and exchange of U.S. Government securities. And as for monetary
policy, System officials have long pursued an even keel during
Treasury financing operations.
1

President of the Second Bank of the United States.

140

FEDERAL RESERVE-TREASURY CONTROVERSIES

141

FINANCING WORLD WAR I

Meeting the greatly enlarged Government expenditures incurred
in the war, together with billions of dollars of credit extended to
allied countries, required Treasury borrowing of unprecedented
amounts. Treasury officials were concerned as to their ability to
borrow such huge sums and were particularly anxious that the
first few borrowing operations be an unqualified success. As explained in Chapter 1, Treasury officials decided in 1917 to issue
Treasury securities at relatively low rates, and insisted that the
discount rate be adjusted in harmony with these rates in order
that credit would be readily available to bank and nonbank
buyers of Treasury securities on reasonable terms.
Federal Reserve officials were opposed to some of the Treasury's debt management policies. The Secretary of the Treasury
initially asked the Reserve Banks to buy short-term certificates at
a low interest rate direct from the Treasury. The Reserve Banks
did take practically all of the first $50 million issue at a 21/2per
cent rate; however, System officials were strongly opposed to
direct purchases from the Treasury because of the dangerous inflationary implications. They were also opposed to the Treasury's
low interest-rate policy, and were especially reluctant to establish
the low discount rates requested by Treasury officials. Such low
rates in time of war were considered inflationary. System authorities also stressed the need for greater reliance on taxation and
borrowing from nonbank sources.
Federal Reserve authorities felt compelled to direct System
policies toward facilitating war financing even though they did
not agree with some Treasury policies.2 Inasmuch as war financing was the responsibility of the Treasury and the Government,
they believed it was the System's duty to help carry out the policies formulated by the Treasury.
2
It appears that suggestions to Treasury officials soon came to have less and less
influence. Reportedly, the Secretary of the Treasury (who was then an ex officio
member of the Board) rarely attended meetings of the Board of Governors; instead,
he conveyed his ideas on policy through an Assistant Secretary or one of his own
aides. Sometimes he would send for a Board member to come to his office in order
to impress his views on the Board. See H. Parker Willis, The Federal Reserve System,
New York, Ronald Press Company, 1923, pp. 1222-1224.

142

FEDERAL RESERVE POLICYMAKING

POST-WORLD WAR I

Soon after the Armistice was signed in 1918, Federal Reserve
officials turned their thoughts toward problems likely to be encountered in the postwar period: readjustments accompanying
reconversion from war to civilian production; the large volume
of credit built up on Government securities as collateral; and the
possible impact of the network of war-created foreign indebtedness
and German reparation payments on international trade and
finance. They thought the Federal Reserve should continue to
assist the Treasury until the war-financing program was completed; however, they wanted to restore a more normal situation
as soon as practicable, in which credit would be based on shortterm commercial paper arising from production and distribution
instead of Government securities.
Higher rates

In the spring of 1919, discussion of a higher discount rate as one
means of getting Government securities and Government-secured
paper out of the banking system into the hands of investors
brought immediate opposition from Treasury officials confronted
with an uncompleted borrowing program and management of a
large federal debt. They were vigorously opposed to any increase
in discount rates or to removal of the preferential rate on advances collateralled by Government securities. In their opinion,
termination of war contracts would result in a decline in Government expenditures and then loans would be liquidated regardless
of the discount rate. Moreover, it was unrealistic to think the
Treasury could borrow the large sums required from nonbank
sources by offering higher rates. The only effective method was
to appeal to patriotism.
The Treasury's opposition to using the discount rate to curb
inflation is summarized in the following excerpts from a letter
Secretary of the Treasury Carter Glass wrote to Chairman Harding
of the Board of Governors:
The conditions under which changes in the Reserve Banks' rates of discount
would operate effectively do not exist here today. . . . [An increase] will not result in a curtailment of the importation of goods nor in increasing our exports

FEDERAL RESERVE-TREASURY CONTROVERSIES

143

materially. In the present position of the international balances and of the foreign exchange and because of gold embargoes the Federal Reserve Bank rates
cannot function internationally, and will operate solely upon the domestic situation. In that condition an important further increase in Federal Reserve Bank
rates might have the effect of penalizing and discouraging the borrower for commercial and industrial purposes, thus curtailing production and distribution and
increasing the shortage of goods, and consequently the price of them, and thus, in
turn, stimulating speculation {An increase in rates . . . falls very lightly upon
the borrower for speculative purposes, who figures a very large profit on the
turnover in a day, a week, a month or some other short period.) It might have
also a very grave effect upon the Government's finances. . . .
Therefore, I believe it to be of prime importance that the Federal Reserve
Board should insist upon and that the Governors of the banks should exercise a
firm discrimination in making loans to prevent abuse of the facilities of the
Federal Reserve System in support of the reckless speculation in stocks, land,
cotton, clothing, foodstuffs and commodities generally.
We cannot trust to the copybook texts. Making credit more expensive will not
suffice. . . . The Reserve Bank Governor must raise his mind above the
language of the textbooks and face the situation which exists. He must have
courage to act promptly and with confidence in his own integrity to prevent abuse
of the facilities of the Federal Reserve System by the customers of the Federal
Reserve Banks, however powerful or influential.
Speculation in stocks on the New York Stock Exchange is no more vicious in
its effect upon the welfare of the people and upon our credit structure than speculation in cotton or in land or in commodities generally. But the New York Stock
Exchange is the greatest single organized user of credit for speculative
purposes.3

In short, Treasury opposition to any appreciable increase in
the discount rate was based on the view that it would be ineffective in curbing use of credit for speculation, would have harmful
effects on business, and might seriously interfere with the Treasury's financing and debt management programs. A selective
approach in administering the discount window would be more
effective—a view also held by some System officials, as previously
explained. It was not until the early part of 1920 that Treasury
officials thought their postwar debt management program had
been sufficiently completed so that the discount rate no longer
need be established for the purpose of facilitating Treasury
financing.
3
Letter dated November 5, 1919. Proceedings of a Conference of the Federal
Reserve Board with the Governors of the Federal Reserve Banks, November 19-21,
1919, Vol. I, pp. 6-8.

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FEDERAL RESERVE POLICYMAKING

A difference of opinion over discount rates arose in 1923. The
Under Secretary of the Treasury proposed preferential discount
rates on Treasury certificates and bankers acceptances—the discount rate on all other types of eligible paper, including other
issues of Government securities, to be 1 per cent higher. Preferential rates would encourage development of a market for bankers
acceptances which System officials had been trying to facilitate
and would help broaden the market for short-term Treasury
certificates which the Treasury had been trying to develop. In
addition, preferential rates on these instruments would encourage
banks to adjust reserve positions in the market instead of by
borrowing at the Reserve Banks.
System officials were strongly opposed. One Reserve Bank
president stated: "We had our lesson once and I am amazed that
the proposal should be seriously advanced again." Experience
demonstrated that a preferential rate merely induced member
banks to use paper carrying the lowest rate; the preferential rate
becomes the effective discount rate.
Open market operations

The attitude of Treasury officials toward Reserve Bank purchases
of Government securities apparently was based mainly on the
interests and responsibilities of the Treasury. Occasionally,
Treasury officials asked some of the Reserve Banks to buy Treasury certificates, but in general were opposed to the Reserve Banks
buying Government securities in the open market. As already
mentioned, the Reserve Banks began buying Government securities to bolster declining earnings as their earning assets were reduced by a decline in member-bank indebtedness in the depression of 1920-1921.
Early in 1922, Treasury officials expressed concern over the
growing accumulation of Government securities in the Reserve
Banks. They were afraid that large purchases by the Reserve
Banks at times might push up the prices of Government securities
temporarily, create an artificial market situation, and thus make
it more difficult for the Treasury to select suitable terms on new
issues. Once Reserve Bank purchases ceased, prices might decline.
Should the terms on a new Treasury offering be established dur-

FEDERAL RESERVE-TREASURY CONTROVERSIES

145

ing a period of buoyancy created by Reserve Bank purchases, a
subsequent decline might jeopardize success of the Treasury operation. Unrestricted Reserve Bank purchases to bolster earnings
might also result in inflation and adverse effects on the economy.
System officials recognized that Reserve Bank purchases of
Government securities might create difficulties for the Treasury.
They took prompt action to minimize such undesirable effects.
An even keel policy was suggested during periods of Treasury
financing and in May, 1922, the Conference of Presidents of the
Reserve Banks established a committee to centralize and coordinate Reserve Bank purchases of Government securities, as
explained in Chapter 4.
There was strong opposition, however, to Treasury pressure to
influence open market policy. One official stated that the Federal
Reserve Act put responsibility for credit control in the Federal
Reserve System, not in the Treasury Department. The System
should cooperate with the Treasury, but policy should not be
formulated to conform to its views or interests. It should be
determined on the basis of what is appropriate for the economy
and the country as a whole.
FINANCING WORLD WAR II

Except for the usual differences of opinion to be expected in a free
society, the next controversy between Federal Reserve and Treasury officials over monetary policy developed during and particularly following World War II. As in World War I, Federal Reserve officials were in agreement that policy should be directed
primarily toward facilitating financing the war. System authorities agreed that this time it was desirable to maintain the pattern
of interest rates for the duration. But there were differences over
some secondary issues, such as short-term rates, types of securities,
and the amount of excess reserves that should be maintained.
Short-term rates
Federal Reserve officials wanted to establish short-term rates considerably above the unusually low levels that had prevailed during much of the thirties, a period of economic stagnation and a

146

FEDERAL RESERVE POLICYMAKING

huge volume of excess reserves. They thought a three-month
Treasury bill rate of3/4per cent or possibly higher, as compared
to the existing rate of around1/4per cent, would give a sounder
rate pattern by making short-term issues more attractive investments, thereby enabling the Treasury to absorb more liquid funds
of bank and nonbank investors. A narrower spread between
short- and long-term rates would diminish the incentive to play
the pattern of rates and would be less inflationary. They were
confident that a rate pattern with the bill rate as high as3/4or
even 1 per cent could be maintained.
Treasury officials disagreed. They favored pegging the Treasury bill rate at about the prevailing level of1/4per cent. In their
opinion, maintenance of the21/2per cent long-term rate could be
assured only by keeping short-term rates at about the same level
they had been when the21/2per cent rate was established by
market forces. Low short-term rates would not have any significant inflationary implications, in their opinion, because it would
be necessary to rely on taxation and direct controls to combat
inflation in wartime.
Even though Federal Reserve authorities felt strongly that
somewhat higher short-term rates were necessary, they recognized that primary responsibility for debt management policies
rested with the Secretary of the Treasury. Consequently, they
agreed to accept a directive from the Secretary as to the level of
short-term rates provided he would take responsibility for the
decision. The Secretary accepted the responsibility and asked the
Federal Reserve to maintain the existing pattern of rates, except
as he agreed to its subsequent modification.4
Excess reserves

Closely related to the level of short-term rates was the volume of
excess reserves that should be maintained. Treasury officials insisted on a large volume of excess reserves. Inasmuch as the interest-rate pattern was established when excess reserves were
large, a substantial cushion of excess reserves was the only means
of assuring that the pattern could be maintained. Furthermore,
it was essential that reserves should be provided in anticipation
4

As explained later, a rate of3/8per cent was agreed on for Treasury bills.

FEDERAL RESERVE-TREASURY CONTROVERSIES

147

of needs. Bankers limited their subscriptions for Treasury securities to the amount of excess reserves held. Hence waiting for reserve pressures to arise in the market during a period of Treasury
financing before supplying reserves might have an unfavorable
effect on subscriptions to new offerings. Consequently, Treasury
officials wanted the Fed to supply, prior to a Treasury offering,
the estimated amount of reserves that would be needed. They
contended that large excess reserves would not be inflationary
under war conditions because of direct controls.
Federal Reserve officials were opposed both to maintaining a
large volume of excess reserves and to supplying reserves in anticipation of needs. They pointed out that the System could either
maintain a certain volume of excess reserves with rates being determined by the market, or it could maintain a certain rate structure with the market determining the amount of reserves that
would have to be created to do so. A large volume of excess reserves was not necessary inasmuch as System purchases to maintain the rate pattern would automatically create the necessary
amount of reserves.
Neither was it necessary or desirable to supply reserves in
anticipation of needs in order to promote the sale of Treasury
securities. Banks make initial payment for subscriptions to new
Treasury securities by crediting the Treasury's Tax and Loan
Account; the drain on reserves comes as the Treasury transfers
funds to the Reserve Banks. Thus willingness to subscribe depends on ready availability of reserves, not on a large volume of
excess reserves.
System officials also pointed out that maintaining a large volume of excess reserves was inconsistent with the policy of urging
banks to keep fully invested. To the extent banks accepted this
advice, it was impossible to keep large excess reserves outstanding.
Attempting to do so resulted in a larger proportion of Government borrowing coming from commercial banks. Hence Federal
Reserve authorities wanted to maintain a much lower level of
excess reserves to help minimize bank purchases, but assure banks
that adequate reserves would be readily available to facilitate
Treasury financing.

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The posted 3/8 per cent buying rate and repurchase option on
Treasury bills agreed upon represented somewhat of a compromise between the Federal Reserve and Treasury positions on
short-term rates. The posted rate also shifted some of the initiative over excess reserves to the Treasury. With banks and other
investors less and less willing to hold low-yielding Treasury bills,
an increase in the quantity of Treasury bills issued tended to result in Federal Reserve purchases and creation of reserves. As a
result, Treasury officials generally favored a larger volume of bill
issues than the Federal Reserve because of the resulting increase
in reserve availability.
POST-WORLD WAR II

System thinking as to policy in the postwar period has already
been explained in Chapter 8 and need not be repeated here.
The period from the end of the war to the spring of 1951 was one
of continuing controversy between the Federal Reserve and
Treasury officials over modification of the rate pattern and, to a
smaller extent, over issuing types of long-term Treasury securities
that would require less support.
Federal Reserve authorities wanted to let short-term rates rise
to gain more control over bank reserves and thus enable them to
exert some restraint. But coordination of Federal Reserve policy
with debt management policy was considered essential. If the
Federal Reserve permitted market rates to rise without the
Treasury raising the rates on its new short-term issues, System
officials would be faced with either supporting the new issue and
thereby creating more reserves or being held responsible for the
issue's failure.
The initial move toward somewhat higher short-term rates was
made in mid-1945 when Federal Reserve officials told the Secretary of the Treasury they were considering elimination of the
preferential discount rate on loans collateralled by Government
securities maturing or callable within one year. The preferential
rate was adopted as a wartime measure and hence was no longer
needed. Inasmuch as the Secretary had just tendered his resignation, he thought it more appropriate that the question be dis-

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149

cussed with his successor. The new Secretary of the Treasury
asked System officials to defer such action because of possible
adverse effects on the Government securities market and because
the action might be interpreted as signalling an end to the low
interest-rate policy. The Federal Reserve acceded to his request
and the preferential rate was not removed until the spring of 1946.
The real controversy over permitting short-term rates to rise
began to develop in 1947.5 Early in the year, System officials
agreed that the 3/8 per cent posted buying rate on Treasury bills
was no longer needed and should be terminated at a time when
its removal would exert some restraining influence. Treasury
officials were unwilling to agree to its removal unless some program could be worked out so that a large part of the increase in
interest cost to the Treasury, resulting from higher rates, could be
recaptured from earnings accruing to the Reserve Banks.
There was considerable sentiment within the System in favor
of asking Congress to restore the former franchise tax on Federal
Reserve Bank earnings. A serious drawback to this proposal, however, was uncertainty as to when or whether Congress would act
on a recommendation to restore the franchise tax. The Board of
Governors, after conferring with members of Congress more
directly concerned with this type of legislation, decided to use its
authority to levy an interest charge on Federal Reserve notes outstanding not covered by gold. The interest charge, which absorbs
about 90 per cent of net earnings of the Federal Reserve Banks
after dividends, is paid to the Treasury. In effect, it is the equivalent of the former franchise tax.
Treasury officials were still opposed to removal of the 3/8 per
cent rate, however. They were afraid that any rise in short-term
rates might cause some Treasury securities to fall below par. The
3/8 per cent rate was finally removed in July, 1947.
From the end of 1947 until early in 1951, desirability of permitting short-term rates to rise was an important topic of discus5
In the President's January budget message to the Congress there was a passage
to the effect that debt management policy is designed to hold interest rates at the
present low level and to prevent undue fluctuations in the bond market. Included
also was the sentence: "The Treasury and the Federal Reserve System will continue
their effective control of interest rates." According to the Chairman of the Board of
Governors, the Board had not been consulted about this statement on interest rates.

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sion at practically every meeting of the Open Market Committee
and its Executive Committee. There was general agreement that
higher short-term rates were desirable as a means of regaining
more control over reserve creation and the availability of credit.6
There was also agreement that the System's views should be communicated to the Treasury, usually by letter and personal conference between Federal Reserve and Treasury officials. System
officials were also in general agreement until the latter part of
the period that the Federal Reserve should not act unilaterally
to raise rates without approval and cooperation of the Treasury.
Treasury officials usually replied that the Federal Reserve's proposals would be taken under advisement but, often without further discussion with System officials, announced terms on new
short-term securities at existing rates. This was the general procedure for many of the Treasury refundings during the period.
Repeated efforts brought agreement for only minor increases in
short-term rates.
The recession of 1948-1949, which convinced Federal Reserve
officials that the support policy was a handicap in dealing with
economic slack as well as inflation, and the outbreak of hostilities
in Korea in 1950 were significant events leading eventually to
solution of the Federal Reserve-Treasury controversy.
The inflation threat arising from the outbreak of hostilities in
Korea crystallized instead of softened policy differences between
Federal Reserve and Treasury officials. The System felt a primary
responsibility for curbing inflation because inflationary pressures
were being fed largely by private credit expansion. This feeling
of responsibility was intensified by a statement in the President's
mid-year economic report in 1950 that in restraining inflation,
major reliance should be placed on credit and fiscal policies.
Under these circumstances, there was no real alternative to using
available powers to restrict credit expansion. Federal Reserve
authorities were convinced that effective restraint could not be
applied while maintaining a rigid pattern of interest rates. They
proposed to Treasury officials a more effective program to combat
inflation, including higher short-term rates, an increase in reserve requirements, and a debt management program designed
6
For the explanation of why System officials favored higher short-term rates, see
Chapter 8, pp. 101-102.

FEDERAL RESERVE-TREASURY CONTROVERSIES

151

to attract nonbank funds with securities that would require
less support.
Treasury officials disagreed with these proposals. Their position as to the ineffectiveness of higher short-term rates had not
changed. They were unwilling to bring out a long-term bond to
attract nonbank funds because their studies indicated such funds
would not be available to the Treasury in any significant quantity. Therefore they would have to rely mainly on the banking
system for new funds. In fact, Treasury officials, facing mounting
financing requirements, were strongly opposed to any action that
might unsettle the Government securities market and make their
problems more difficult. The Secretary of the Treasury repeatedly
stressed the importance of maintaining confidence in the credit of
the Government and in doing everything possible to strengthen
it. This required, first of all, avoiding any action that might inspire a belief that a significant change in the pattern of rates was
under consideration. Referring to the Government securities
market, the Secretary said that "every appraisal of the present
situation indicates that the maintenance of stability should take
priority over all other market considerations."
Meetings of the Open Market Committee and the Executive
Committee in the latter part of 1950 and early 1951 were devoted
largely to reviews of recent discussions with Treasury officials and,
in view of Treasury opposition to Committee proposals, what the
Federal Reserve could do to discharge its responsibility for credit
regulation. Frequent discussions with Treasury officials and
earnest efforts to reach agreement on monetary and debt management policies failed. It was only after prolonged efforts had
failed and System officials were convinced that the Treasury
would not agree to a program of credit restraint that they decided
to act without Treasury approval. Eventually, others became involved in the controversy, including the President of the United
States and some members of Congress.7 Special meetings between
7
For a chronological record of documents and events leading up to the accord
see: U.S. Congress, General Credit Control, Debt Management, and Economic Mobilization,
Materials Prepared for the Joint Committee on the Economic Report by the Committee Staff, 82nd Cong., 1st Sess. (Washington: U.S. Government Printing Office,
1951), pp. 50-74; U.S. Congress, Monetary Policy and the Management of the Public Debt,
Hearings before the Subcommittee on General Credit Control and Debt Management of the Joint Committee on the Economic Report, 82nd Cong., 2d Sess.
(Washington: U.S. Government Printing Office, 1952), pp. 942-966.

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representatives of the Treasury and the Federal Reserve, started
in the latter part of February, led to agreement and the accord
announced March 4, 1951.
CORE OF THE CONTROVERSIES

The fact that the major controversies between Federal Reserve
and Treasury officials occurred in postwar periods affords a clue
to the nature of the problem. During both world wars, Federal
Reserve policy was directed primarily toward facilitating Treasury financing, despite the fact that System officials favored less
inflationary Treasury borrowing programs. Debt management
was the responsibility of the Treasury.
Financing the wars created serious postwar problems both for
monetary policy and debt management. The Federal Reserve
confronted a swollen money supply, vigorous private demand for
credit, and strong inflationary pressures. The Treasury confronted large refunding operations to manage the vastly increased
federal debt, and an environment in which investors were much
less motivated by patriotism.
It was only natural that with the war over, each group of
officials considered policies in terms of their own responsibilities.
System officials, although cognizant of the Treasury's problems,
felt an obligation to formulate policy more in terms of their responsibility for preventing inflation instead of facilitating Treasury financing. Treasury officials, even though aware of inflationary pressures, favored policies that would not interfere with debt
management operations for which they were responsible.
With Federal Reserve and Treasury officials facing difficult
problems in their own area of responsibility, and with monetary
and debt management policies impinging on each other, it is not
surprising that divergent views developed over monetary policy.
The Federal Reserve's responsibility of regulating credit and the
money supply to help maintain price and business stability called
for a restrictive policy in both postwar periods. But effective restraint would result in a rise in interest rates from the artifically [artificially]
low wartime levels. As already explained, Federal Reserve authorities were persistent in their efforts following World War II

FEDERAL RESERVE-TREASURY CONTROVERSIES

153

to get Treasury agreement to more flexible short-term rates, the
objective being to regain more control over bank reserves and the
availability of credit.
Treasury officials vigorously opposed an increase in interest
rates at the end of both wars, and for essentially the same reasons.
Higher rates, in their opinion, would not be effective under the
conditions that existed. They would not deter speculative demand
believed to be widespread after World War I; "fractional increases" would have no perceptible effect on the demand for
credit in the post-World War II environment. In other words,
moderate increases would be ineffective in combatting inflation;
increases sufficient to be effective would be too drastic in their
impact on the economy. But higher interest rates would complicate debt management and increase the interest burden of the
large federal debt. Treasury officials thus ruled out higher interest rates as a method of dealing with postwar inflation.
There is no simple rule or organizational structure that will
prevent the type of controversy that has arisen in postwar periods.
The controversy arises from the nature of the two functions—not
the institution or agency performing them. With national economic goals of price stability and a reasonably full use of productive resources, the function of monetary policy in the environment prevailing after each war was to restrict credit expansion to
avoid further inflation. On the other hand, managing a large
war-created debt was easier and the interest cost less if interest
rates remained low and the Government securities market strong.
The necessity of choosing between these conflicting policies arises
from the nature of the two functions; not because performance is
lodged in separate institutions.
The volume of Treasury debt management operations has
grown tremendously in the past half-century. The magnitude of
these operations makes it essential that monetary and debt management policies be coordinated. An understanding or mandate
that both are to be directed toward common national economic
goals would be a step in this direction. Low rates on Treasury securities may appear warranted if the objective is a low
carrying charge on the Government debt; they do not appear
warranted in a period of strong inflationary pressures if the ob-

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jectives are to help maintain business stability and a stable level
of prices. Federal Reserve and Treasury officials with broad economic knowledge and an understanding of each other's problems
and responsibilities also facilitate better coordination of policies.
The period since the accord affords a demonstration that these
officials cognizant of each other's responsibilities can, in a spirit
of cooperation and good will, effectively coordinate their policies
toward achieving common economic objectives.

12. IN RETROSPECT
After the event, even a fool is wise.
—Homer

In historical analysis there is a bias toward being critical: one is
looking back on events that have unfolded with the advantage of
knowing what happened instead of making the decisions looking
toward an uncertain future; and what should be done always
seems much clearer to the outsider than to policymakers who
must take responsibility for the effects of their actions. The
"Monday-morning quarterback" may be wrong, but he is never
in doubt.
The value of historical analysis is not in establishing blame, and
certainly not in trying to appear wise "after the event." It is to
enable us to profit from the experience of others. In this spirit the
author gives his opinion as to some of the highlights and principal
lessons of the first fifty years.
EBB AND FLOW OF POLICY

One of the striking features of the first half-century was the broad
swings in the role of the Federal Reserve and monetary policy.
The first part of the twenties was a period of notable progress;
from the mid-thirties to the spring of 1951, monetary policy was
relatively impotent, and the period since the accord has been one
of reappraisal and resurgence.
High tide

Environmental changes resulting mainly from World War I
ushered in one of the brightest eras in Federal Reserve history—
the first part of the decade of the twenties. The war swept away
the international gold standard, and principles developed by the
155

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Bank of England were not appropriate for the institutional structure in the United States. As one official remarked, the Federal
Reserve was like a ship without a rudder. Being held responsible
by many for the postwar boom and depression was a strong incentive to study carefully the role of the new central bank in order to
develop objectives and policies appropriate in the postwar environment in the United States.
The decision that Federal Reserve policy should be directed
primarily toward domestic economic conditions instead of the
balance of payments and the gold reserve was a milestone in the
history of central banking. Federal Reserve officials, especially
the President of the Federal Reserve Bank of New York, took a
leading role in working out arrangements to help foreign countries stabilize their currencies and return to the gold standard;
but in policy formulation, domestic conditions were always
given priority.
The primary objective of Federal Reserve policy was accommodation of commerce and business, as indicated in the Act, but
accommodation in a particular sense. Credit should be used to
finance production and the orderly distribution of goods from
producer to consumer, but not to build up inventories in anticipation of higher prices—to hold goods off the market—or for speculative activity of any kind, whether in stocks, commodities, or real
estate. Confining the use of credit in this sense, many believed,
would prevent booms and depressions and result in generally
stable prices. In effect, the goal was business and price stability.
The decision to direct policy primarily toward domestic economic goals meant that new guides were needed for policy formulation. The reserve ratio lost whatever significance it had in the
days of the gold standard. The search for guides did not uncover
one or even a few factors believed to be adequate in reaching
policy decisions. Instead, formulating policy to promote general
business stability required a broad range of information as to the
volume and use of credit, and the state of the economy in general.
To provide the information, statistical and research functions
were expanded substantially.
The intellectual ferment about policy extended to use of the
tools. The discount rate had been regarded as the traditional cen-

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157

tral bank tool for influencing credit. It had been so regarded by
Federal Reserve officials, not only because of tradition but also
because Reserve Bank credit was extended by means of discounts
and advances to member banks. Changing the discount rate was
thus the principal means of encouraging or discouraging the flow
of Reserve Bank credit.
Two postwar developments stimulated the doctrine of direct
pressure through administration of the discount window—actually a form of selective control. Excessive borrowing by many
member banks led to serious consideration of how the problem
might be dealt with. Progressive discount rates were given a short
trial and found wanting. Surveys and studies of the effects of discount rate changes indicated the rate was not effective in regulating borrowing by a member bank. It was not practical to keep
the discount rate above commercial bank loan rates. Consequently, it was necessary to rely on administration of the discount
window to prevent excessive borrowing by individual member
banks.
A second and important source of support for direct pressure
came from advocates of the real-bills doctrine. They believed use
of credit for speculation and other nonproductive activities was
the major cause of the postwar boom and subsequent depression.
The lesson was that use of credit for nonproductive purposes
should not be permitted to generate another boom which sooner
or later would be followed by depression. The discount rate was
regarded as ineffective for this purpose because an increase would
not curb speculation but would have harmful effects on legitimate business. Direct pressure—refusal of Reserve Bank discounts and advances to member banks making loans for speculation and nonessential purposes—would be more effective in curbing
misuse of credit without restricting the flow for legitimate business.
Direct pressure, strongly opposed by some as impractical, was
a prominent issue in the twenties. Support for it as a means of
selective regulation later subsided, but administration of the discount window has continued to be an important means of preventing excessive borrowing by individual member banks.
A desire to bolster Reserve Bank earnings led to discovery of
one of the System's major policy instruments—open market

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operations. Some Reserve Banks began buying Government securities in 1921 to augment earnings impaired by the depression.
The monetary effects were soon recognized. Then the System
had two channels through which funds could be supplied: the
discount window at the initiative of member banks, and open
market operations at the initiative of the System. The flow
through the discount window was regulated by the discount rate
and administration of discounts and advances to member banks.
Regulation of the flow through open market operations was
hampered by decentralized control, but a committee was soon
established to centralize and coordinate transactions of the Reserve Banks. These twin instruments of Federal Reserve policy—
the discount rate and open market operations—began to be coordinated so as to make each more effective.
The early twenties was a period in which developments in central banking thought, and in policy and its implementation, were
at high tide. There were rapid strides toward the role of a modern
central bank: focusing policy on domestic goals; broadening the
scope of objectives; exploring possible guides and expanding the
information needed in decisionmaking; and developing and coordinating the tools of Federal Reserve policy.
Low tide

The severe depression of the early thirties followed by persistent
stagnation undermined faith in monetary policy built up during
the new era philosophy in the twenties. Many economists concluded that monetary policy was a weak reed; that fiscal
policy should be the principal instrument for achieving economic
stability. Policy discussions do not indicate that System officials were influenced significantly by this shift in economic
thought.
The mid-thirties marked the beginning of a long period in which
effectiveness of Federal Reserve policy was impaired. Excess reserves built up by an easy money policy in the latter stage of the
depression, and augmented by devaluation of the dollar in 1934
and by large gold imports, seriously impaired the System's
ability to influence credit. The policy of maintaining a pattern
of rates on Government securities during the war and in the

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159

postwar period until the spring of 1951, largely shifted control
over the supply of credit to holders of Government securities.
From the mid-thirties until the early forties, member-bank
excess reserves were so large that the System's tools were rendered
ineffective. The System's portfolio of securities was not large
enough, even if liquidated, to absorb sufficient excess reserves to
exert any significant restraint. The discount rate was ineffective
because banks did not need to borrow. Reserve requirements
were raised to the legal maximum in 1936-1937 to try to restore
the System's ability to influence credit; but the reduction in excess reserves was short-lived.1 Huge excess reserves was a major
reason for using open market operations to maintain stability
in the Government securities market instead of to alter reserve
positions.
Enfeeblement imposed by excess reserves was the result of
forces beyond System control. Impotence from the spring of 1942
to the spring of 1951 resulted from the support policy which the
System considered appropriate. The Federal Reserve and the
Treasury agreed to maintain a pattern of rates on Government
securities for the duration of the war in order to facilitate financing the Government's massive expenditures in World War II.
At the end of the war, for reasons already explained, Federal
Reserve authorities decided to maintain the wartime pattern of
rates except for more flexibility in the short-term sector. There
were three principal reasons for the decision.
A large volume of refunding operations was required in managing the huge federal debt outstanding at the end of the war.
Second, traditional methods of restraint accompanied by widely
fluctuating interest rates were not considered appropriate in the
postwar environment of large and widespread holdings of Government securities. Credit restraint accompanied by substantial
increases in interest rates would not only create difficulties for
Treasury financing; policymakers were fearful that a sharp decline in prices of Government securities might touch off a wave
of selling and possibly undermine the strength of some financial
1
Reserve requirements were reduced somewhat in the spring of 1938 as a result
of the depression but the reduction was only a minor factor in the continued build-up
of excess reserves.

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institutions. Some believed that intermediate- and long-term
rates could be maintained; that moderate flexibility in short rates
would permit effective System control of reserves and bank
credit. Third, Treasury officials were vigorously opposed to any
significant rise in interest rates. It would complicate their problems and, in their opinion, would not be effective in combatting
inflation.
The period from the mid-thirties to March, 1951, was one of
relative stagnation in the evolution of Federal Reserve thought on
policy. During the period of huge excess reserves, official thinking
was focused mainly on the implications of this new experience
and the System's impaired ability to act effectively. During the
war, System officials were preoccupied with problems of war financing. In the postwar period, thoughts were directed mainly
toward obtaining more flexibility in short-term rates, and to
devising some technique that would restore more effective control while continuing to support the prices of Government securities. In both respects, their efforts were largely fruitless.
Resurgence and flexibility

The accord of March, 1951, removed the shackles of the support
policy and marked another milestone in Federal Reserve history. System officials were confronted with the problem of
how to use their restored power and freedom. There followed
an era of study and reappraisal of the principal tools and their
use.
Open market policy soon moved to the other extreme of minimum intervention in the Government securities market. An ad
hoc subcommittee of the Open Market Committee was appointed
to make a thorough study of open market operations and their
implications for the Government securities market. Within two
years after gaining its freedom from the support policy, the
System, in effect, put itself in another straitjacket by adopting
certain continuing operating policies, including the policy of
bills usually.
The philosophy underlying the continuing operating policies
embodied four main points: these policies act as safeguards
against using open market operations to establish or support any

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161

particular rates or structure of rates on Government securities; by
improving the depth, breadth, and resiliency of the Government securities market, they make open market operations
a more effective instrument of monetary policy; funds withdrawn
or injected into the short-term sector soon permeate the
entire market; and open market operations influence the supply
and availability of credit and total demand for output primarily,
if not solely, through their effect on reserves.
There are good reasons for questioning the validity of these
points. Public announcement of the continuing policies tended to
inhibit the Committee from taking whatever action it considered
most likely to be effective under the circumstances. Evidence
available thus far does not support the expectation that reduced
flexibility would be more than compensated for by improved
functioning of the Government securities market.
The third point—that effects of transactions in short-term securities soon spread to other maturities—is inconsistent with the
main contention that adoption and announcement of the ground
rules would dissipate dealer uncertainty about the impact of open
market transactions on prices of longer maturities and thereby
lead to a broader, improved market in Government securities. If
the impact spreads promptly to other maturities, dealer risk in
positioning longer maturities would not be reduced. On the other
hand, if the impact does not soon spread to other maturities, confining open market transactions to short securities, preferably
bills, means foregoing opportunities to exercise greater influence
on intermediate- and longer-term rates. Flexibility and effectiveness of open market operations as a tool of monetary policy would
thus be impaired.
The fourth point that open market operations should be used
solely to supply and absorb reserves reflects too narrow a concept
of this instrument. Granting that the reserve effect may be the
principal one, it does not follow that marginal effects should be
ignored. At times, marginal effects may be of great significance in
helping to achieve System objectives.
Study and reappraisal of policy in an unpegged market led to
less significant changes in other areas than in open market operations. Past policies with respect to the discount rate and adminis-

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FEDERAL RESERVE POLICYMAKING

tration of the discount window were largely reaffirmed. Objectives were broadened somewhat and refined. Sustained economic
growth became a major objective along with price stability and
business stability with a full use of resources. Guides to policy
formulation were further explored and refined, but reliance continued to be primarily on a variety of information needed in
formulating policy to achieve broader objectives.
The pressure of events led to two significant developments in
the early sixties—termination of bills usually and the other continuing directives, and a revival of System operations in foreign
exchange. The bills usually policy did not impair the System's
capability nearly so much as the support policy, but it did impair
the flexibility needed to meet the dilemma of trying to achieve
two desirable but conflicting objectives. A policy of ease was
needed to stimulate recovery from the 1960-1961 recession but
low interest rates, especially short-term rates, encouraged an
outflow of funds and aggravated the balance-of-payments deficit.
Open market operations could be used more effectively in this
situation if the direct effect on rates were diverted from short to
longer maturities. Purchases of longer maturities would relieve the
direct downward pressure on short-term rates, and the downward
impact on longer-term rates would have beneficial domestic effects by facilitating the flow of funds into investment. The Committee abandoned bills usually and the other continuing operating
policies in order to achieve the flexibility needed to meet existing
and prospective conditions.
The persistent balance-of-payments deficit put a substantial
amount of dollars at the disposal of foreigners and rendered the
dollar more susceptible to speculative operations. After careful
study, it was decided early in 1962 that the System should begin
operations in foreign currencies as an additional step to help safeguard the value of the dollar in foreign exchange markets.
The Federal Reserve negotiated swap arrangements—standby
credit agreements—with central banks of the major industrial
and commercial countries. Foreign currencies available under
these arrangements have been used primarily to absorb dollars
that foreign central banks accumulate and otherwise might use
to purchase gold from the United States. At times, operations

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163

have been conducted in both spot and forward foreign exchange
as a means of diminishing the incentive for an outflow of shortterm funds. The System has also participated with other central
banks in putting a pool of central bank credit at the disposal of a
foreign central bank to help defend its currency, and has joined
with other central banks in helping to stabilize the price of gold
in the London gold market.
THE GREAT DEPRESSION

Federal Reserve policy in the severe depression of the early thirties has been criticized by many students of monetary policy.
The essence of the criticism is why didn't the Federal Reserve
pursue a policy of more active ease to check the depression and
promote recovery?
Official records of policy discussions indicate that Federal
Reserve authorities had a pretty good knowledge of unfolding
business and financial developments, but for some time they did
not anticipate the severity of the decline or the developing financial crisis. Consequently, the first phase of Federal Reserve policy,
adopted shortly after the stock-market break in the fall of 1929,
was directed toward making credit readily available at reasonable rates to help check deflation. Discount rates were reduced
sharply and Government securities were purchased in moderate
amounts to enable member banks to repay some of their indebtedness. In the second phase of depression policy—the spring of
1932 to the spring of 1933—the objective shifted to building up
excess reserves in order to encourage banks to expand their loans
and investments. Finally, following the banking holiday in
March, 1933, the program of buying Government securities was
resumed but as a means of cooperating with the Government's
national economic recovery program instead of supplying more
reserves per se. This program was terminated in the fall of 1933.
Now, as to why policymakers did not pursue a more aggressive
policy of ease. An important reason was the theory some policymakers still held as to the nature and causes of depression.
Orderly liquidation of speculative credit built up during the
boom was considered a prerequisite for sound recovery. Others

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believed the depression was largely the result of excess capacity
and overproduction. Too much ease would not be helpful; it
might retard or even prevent the liquidation and readjustments
required for enduring recovery.
A second reason was general agreement that recovery should be
sought within the framework of the gold standard. As depression
deepened, the majority favored more ease and early in 1931 a
threefold program was agreed on: further reduction in discount
rates, lower buying rate on acceptances, and additional purchases of Government securities. Heavy deposit withdrawals continued, and in the fall of 1931 this internal drain was aggravated
by an outflow of gold. The drain on gold reserves was met in the
traditional way—an increase in the discount rate. Protecting the
reserve and safeguarding the gold standard was the principal
reason for the temporary tightening in the fall of 1931.
A third and closely related reason was that responsibility began
to weigh heavily on some officials, especially Reserve Bank presidents, as continued cash withdrawals seriously impaired the reserve position of some Reserve Banks. Some of the presidents
became seriously concerned over the ability of their Reserve
Banks to assist member banks facing runs and to meet other possible emergency needs. There was general agreement that the
Reserve Banks should be liberal in extending credit to banks facing runs. Banking policy, as it was often referred to in those
days, had become more important in the opinion of some than
monetary policy. But as reserve positions became more precarious, officials faced a dilemma: should dwindling reserves be conserved in order to be able to make advances and to issue Federal
Reserve notes to member banks facing runs and for other possible
emergencies; or should the Reserve Banks purchase more Government securities in the hope that deflation would be arrested and
conversion of deposits into cash curtailed?
Government securities purchases usually resulted in a reduction of member-bank indebtedness to the Reserve Banks and
therefore less eligible commercial paper was available as collateral for Federal Reserve notes. A shortage of eligible paper
meant that the Reserve Banks had to substitute gold as collateral
in order to issue notes. Impaired ability to issue notes was serious

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165

at a time when member banks were facing runs. The presidents
of some Reserve Banks, with little free gold left, refused to participate in purchasing additional Government securities. Legislation early in 1932 permitted Government securities as collateral
behind Federal Reserve notes and relieved much of the anxiety
over the diminishing supply of reserves and eligible paper. Open
market purchases were stepped up, and maintaining excess reserves of $250 million to $300 million became an objective of open
market policy about mid-1932.
A fourth factor that discouraged a more aggressive open market policy as the depression deepened was the tendency of banks
to build up excess reserves. The build-up of excess reserves was
regarded by some as evidence of the futility of buying more Government securities until banks used the reserves already supplied.
Only a minority thought building up excess reserves would
sooner or later put enough pressure on banks to stimulate credit
expansion.
Appraising policy formulation during such a severe depression
involves the problem of visualizing the situation in the perspective
of the times. The discount rate of the Federal Reserve Bank of
New York was reduced from 6 per cent in October, 1929, to 2 1/2
per cent in June, 1930, and to11/2per cent by May, 1931. Discounts and advances to member banks, which totaled around
$1 billion prior to the onset of the depression, averaged a little
more than $300 million in the first half of 1930, and declined to
about $230 million in the second half. Prior to the early thirties
the discount window was the principal source of reserves. Rates
on short-term commercial paper dropped from over 6 per cent
in the fall of 1929 to less than 3 per cent by the end of 1930 and
to 2 per cent by mid-1931. Excess reserves averaged $62 million
in the second half of 1930; $99 million in the second half of 1931;
and $377 million in the second half of 1932. These amounts seem
small, but in relation to required reserves were the equivalent, as
of January, 1965, to excess reserves of $550 million, $975 million,
and $4,300 million, respectively.
Federal Reserve authorities did pursue a policy of ease, according to the principal indicators of conditions in the money and
credit markets. Whether more aggressive ease initiated earlier

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would have arrested the depression or substantially diminished
its severity cannot be proved or disproved. There were unusually
deepseated forces at work—depressed conditions in agriculture
and a substantial number of bank failures in the twenties, and
runs on reserves in leading financial centers abroad in 1931. From
the vantage point of hindsight, it appears that more aggressive
ease in the early part of the depression would have been helpful;
however, it is doubtful that it would have substantially dulled the
impact of an unusual conjuncture of forces tending to produce
financial crisis and severe depression.
WAR FINANCING

In both world wars, Federal Reserve policy was directed primarily toward facilitating the huge volume of Treasury operations
required in financing Government expenditures. There were
good reasons. The spirit of the times was that all efforts, including
those of the Federal Reserve, should be channeled toward winning the war. Preventing inflation in wartime, although desirable,
was regarded by System officials as mainly the responsibility of
Government through its fiscal and debt management policies,
and direct controls over prices, wages, and materials. Federal
Reserve officials conferred with Treasury officials on war financing programs, but final decision for fiscal and debt management
policies rested with the Treasury.
Treasury borrowing in both wars was at unusually low rates.
Although the mechanics differed, Federal Reserve policy made
Reserve Bank credit readily available at the low rates. War financing resulted in the build-up of a vast amount of purchasing
power which, once direct controls were removed, generated
sharply rising prices and inflation.
At the end of each war, Federal Reserve officials were confronted with the same dilemma: maintain low rates to facilitate
large postwar Treasury financing operations and to avoid possible serious repercussions from sharply declining prices of Government securities thus continuing to feed the inflationary boom; or
apply effective restraint which by raising interest rates would complicate the Treasury's debt management problems and inflict losses

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167

on many investors who bought Government securities at low
rates to help finance the war.
There is no easy answer to this dilemma; however, three questions deserve serious study. First, is it really in the public interest
to finance a war at unusually low rates of interest? Good reasons
were given for low rates, a major one being to help hold down the
cost of the wars. War expenditures are so huge that savings
wherever possible seem important. But more attention should be
given to the longer-run effects. Interest cost on the debt was only
3 per cent of total Government expenditures during the period
1942 to 1945, inclusive. Higher interest rates on Treasury securities would have made the securities more attractive and stimulated
additional nonbank purchases; less promotional and sales efforts
probably would have been needed to sell the securities.
Much more important, however, is the problem created for the
postwar period. Financing a war at low interest rates may give an
illusion of economy but the price in other respects may be high.
Maintaining in World War II an interest rate pattern established
in a period of economic stagnation and large excess reserves contributed to a large increase in the money supply which was
unleashed as soon as direct controls were removed. Effective
monetary restraint at the end of the war on further expansion
would have resulted in rising interest rates and a reduction in
artificial capital values based on the low wartime rates. Maintaining the rate pattern turned the Federal Reserve into an
"engine of inflation," feeding further upward turns in the wageprice spiral. Hardships imposed by choosing either horn of this
dilemma were really a part of the cost of the low interest rate
policy followed in financing the war. This dilemma could be
avoided only by financing a war at an interest rate structure that
would be appropriate in a noninflationary postwar environment
of vigorous aggregate demand.
A second question which merits serious consideration is
whether it is in the public interest for the central bank to adopt
wartime policies that in effect put reserve creation at the initiative
of the market. In practice, maintaining any rigid pattern of rates,
as in World War II, amounts to posting fixed buying rates for key
maturities of Government securities. Perhaps some program of

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Treasury borrowing to finance a war could be developed that
would enable the Federal Reserve to facilitate the borrowing
program without putting Reserve Bank credit on tap at low rates.
A third question, in the event war financing has been at low
rates, is whether over-all public interest is better served by maintaining the low rates to assist the Treasury and to avoid repercussions from declining Government securities prices, or by exerting
enough restraint to avoid further inflation. Looking back, it appears that in both postwar periods, Federal Reserve authorities
overestimated the dangers and hardships that would be imposed
by effective restraint and the resulting rise in interest rates; they
underestimated the inflationary impact of maintaining the low
wartime rates in the postwar environment. Experience indicates
that hardships imposed by an inflationary rise in prices of goods
and services are probably greater than the burden of higher
interest costs and capital losses to holders of outstanding fixedincome securities. A general rise in prices of goods and services is
a high price tag for maintaining stable Government securities
prices and low interest rates.
ROLE OF RESEARCH

The art of central banking has been described as "reaching adequate conclusions from inadequate facts." Lack of adequate information became much more obvious when the objective of
policy shifted from protecting the gold reserve to domestic
economic stability.
This shift in objectives accelerated development and expansion
of the research and statistics functions in order to provide the
greater amount of information needed in policymaking. And as
policy objectives became broader in scope, the larger the amount
of information needed for sound policy decisions. One of the
principal tasks of the research function has been to provide statistics and other information for policy formulation. The growing
size and complexity of the economy has put increasing demands
on research.
The contribution of research to wise policy decisions extends
beyond information-gathering. Diagnosis of the data and impli-

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169

cations of recent developments for Federal Reserve policy are
also needed by policymakers. Keeping abreast of economic developments and analyzing their significance for policy is a major
function of professional economists. Both the Board and the Reserve Banks enlarged their staffs of economists, especially in the
past 25 years, to provide analytical information that would be
useful in formulating monetary policy.
Theoretical analysis is one of the principal reasons policymakers, provided with the same data and other types of economic
information, often come out with different diagnoses and decisions as to policy that should be pursued.
Central bankers confront somewhat the same type of problem
as the practicing physician. He first gathers relevant information
in order to diagnose the state of his patient's health. Then, drawing on his knowledge of medical science, he prescribes treatment.
His ability to prescribe an effective remedy is limited by the state
of development of medical science as well as by the amount of
relevant information for diagnosis.
The real-bills doctrine provides an outstanding illustration of
the role of theory in Federal Reserve policy formulation. One of
the principles underlying the Federal Reserve Act was that extension of Reserve Bank credit, whether in the form of Federal Reserve
notes or discounts and advances to member banks, should be by
means of short-term, self-liquidating commercial paper. This
type of paper, according to the doctrine, would expand and contract with the volume of legitimate business, i.e., the volume of
production and orderly marketing of goods. Reserve Bank credit
would thus respond to changes in the volume of business activity.
Consequently, confining credit to productive uses would automatically result in the proper quantity of credit. Advocates of the
real-bills doctrine thus favored direct pressure to regulate certain
uses of credit instead of the discount rate which affected the total
quantity of credit.
Experience gradually disproved the basic principles of the realbills doctrine. The quality of paper discounted or put up as collateral for an advance from a Reserve Bank had no effect whatever on use of the proceeds. More important, attempts to confine
credit to productive uses did not result in an appropriate total

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FEDERAL RESERVE POLICYMAKING

quantity of credit. Credit extended for productive use could
expand beyond capacity to produce and thus help generate inflation; a shortage of eligible commercial paper in the Great
Depression handicapped the Reserve Banks and contributed to
deflation. Even though unsound in principle, the theory was an
important influence in policy formulation in thefirsttwo decades
of the Federal Reserve System.
The depressions of 1920-1921 and 1929-1933 also illustrate the
influential role of theory. In the latter part of 1920, Federal Reserve authorities thought that a depression was developing.
But it was generally regarded as the inevitable aftermath of the
war and postwar boom. Moreover, they believed that excesses
generated during the boom, such as large-scale use of credit for
speculative and nonproductive purposes, top-heavy inventories,
and inflated prices had to be removed in order to establish the
basis for sound recovery. Hence the policy prescription of lending
freely at high rates to promote orderly liquidation. Lending freely
was the means of avoiding forced liquidation and its resulting
losses and hardships. High rates would encourage orderly liquidation as funds became available for repayment and would discourage extending new loans for wasteful and nonproductive purposes. Granting this theory of depression, which at the time was
widely held outside as well as inside the System, Federal Reserve
officials prescribed the appropriate policy.
Some policymakers thought depression was caused mainly by
nonmonetary factors such as excess capacity and overproduction. They vigorously opposed aggressive ease to stimulate recovery on the basis that it would not be helpful and might retard
recovery by encouraging further expansion of capacity and by
hampering readjustments essential for a healthy recovery.
Effectiveness of central bank policy is limited more by inadequate development of monetary theory than by lack of ability to
diagnose the health of the economy. Economists disagree as to the
role of money and credit in maintaining stability and sustained
growth, and as to the channels through which Federal Reserve
actions influence total spending and the price level. Some stress
the quantity of money, some interest rates, and others regard
liquidity as the "centerpiece" of monetary policy. The art of cen-

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171

tral banking might well be defined as trying to apply a confusion
of theories to an ever-changing economy to achieve socially
accepted objectives.
DECISIONMAKING PROCESS

The task of policy formulation has become increasingly complex
as objectives have broadened and as the economy has become
more and more intricate. In earlier years, policymakers searched
for rules or formulas that would simplify the task. But experience
indicates there is no substitute for discretion.
Rules and rigidities have never been reliable methods of reaching sound policy decisions. Under the international gold standard
prior to World War I, the reserve ratio was presumed by many to
provide an automatic signal for central bank action. In 1920, four
Reserve Banks adopted progressive discount rates as a means of
preventing excessive member-bank borrowing. Progressive rates
proved unsatisfactory and were soon abandoned. Maintaining
the pattern of rates for several years after World War II and continuing operating policies, including bills usually, governing open
market operations were other notable illustrations of rigidities
that interfered with the flexibility of Federal Reserve policy.
Rules and rigidities, whether to serve as an automatic means of
implementing policy or merely to inhibit change, are inherently
unsound. The implication is that policy can be better formulated
for future conditions that cannot be foreseen than when policymakers confront the problem and have all available information
about the specific situation. At best, rigidities become imbedded
in official thinking and tend to inhibit freedom of action.
Flexibility in thought as well as action is essential for effective
policy. The Federal Reserve System operates in an institutional,
economic, and social environment that is constantly changing.
The reason judgment is essential in policy formulation was well
expressed in the following quotation given by a former System
official:
We can be certain that reliance upon any simple rule or set of rules would be
dangerous. Economic situations are never twice alike. They are compounded of

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FEDERAL RESERVE POLICYMAKING

different elements—foreign and domestic, agricultural and industrial, monetary
and nonmonetary, psychological and physical—and these various elements are
combined in constantly shifting proportions.2
Informed judgment, based on all germane information available,
statistical and analytical, is an essential ingredient of policy
formulation.
Policy in the Federal Reserve System is formulated by the
Board of Governors and the presidents of the Reserve Banks instead of by one person or small group. To the management
expert, the decisionmaking process probably appears too decentralized and unwieldy. It is somewhat cumbersome and is not so
conducive to prompt, decisive action as when authority is highly
centralized. Federal Reserve history reveals several instances in
which strongly divergent views among officials contributed to
delay and compromise actions.
But there are offsetting advantages, especially for an institution
with the responsibility of formulating policy solely in the public
interest. The policymaking procedure taps a broad cross section
of views—public and private, producer and consumer, borrower
and lender, professional economists and men actually engaged in
a variety of economic activities. This blending of a wide variety
of views is an appropriate procedure for the formulation of national monetary policy. It assures that practically every conceivable angle of a problem will be brought to the attention of the
policymakers before a final decision is made. Moreover, the
distribution of authority is a safeguard against the inherent
tendency for one's viewpoint to be influenced by the prevailing
attitude and environment in which he lives and works, whether
the securities market, politics or government. In this connection,
it is reassuring that the minutes of policy discussions show that
Federal Reserve officials—whether members of the Board of
Governors or a Reserve Bank president—have been motivated by
the public interest, not by private or regional interests. This is
as it should be.
2
Allyn A. Young, Harvard University, quoted by Allan Sproul in "The Federal
Reserve System—Working Partner of the National Banking System for Half a
Century," in Banking and Monetary Studies, Deane Carson, Editor (Homewood,
Illinois: Richard D. Irwin, Inc., 1963), p. 68.

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173

The democratic process of frank and free discussion by informed and responsible men is much less likely to lead to colossal
blunders than vesting authority in one man. The disadvantages of
the democratic process, whether in formulating central bank
policy or in running a government, are part of the price we pay
for safeguards against possibly erratic and irresponsible decisions
that sometimes result from highly centralized control.
RELATION TO THE GOVERNMENT

The first fifty years of Federal Reserve history reveal, paraphrasing Nicholas Biddle, that a large and habitual borrower is not a
good administrator of the institution that creates the money. The
major controversies between the Federal Reserve and the Treasury
over monetary policy have always found the Treasury on the side
of lower rates and less restraint. This is not surprising. Responsibility for borrowing and managing a large federal debt provides
an inducement to support a monetary policy that facilitates the
Treasury's financial operations. So it is with private control.
There is an inducement to slant policy toward private instead of
the national interest. Control by a large borrower, public or private, results in a conflict of interest.
The crucial question is what arrangement is most likely to result in Federal Reserve policy being formulated effectively and
solely in the interest of the country as a whole. For the central
bank to be most effective in contributing to the achievement of
national economic goals, policy formulation should be in the
hands of qualified and experienced central bankers.
To provide an environment conducive to formulating policy
solely in the public interest, these central bankers should be insulated from both political and private pressures. The need for
independence from political pressure was stressed by Carter Glass
after he had served as Secretary of the Treasury and ex officio
Chairman of the Board of Governors, and as a member of
Congress:
Moreover, I commend, without qualification of any description, as worthy of
emulation Mr. Wilson's wise determination to refrain from executive interference with federal reserve administration and his refusal to permit politics to

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FEDERAL RESERVE POLICYMAKING

become a factor in any decisions taken. Unless the example thus set by President
Wilson shall be religiously adhered to, the system, which so far has proved a
benediction to the nation, will be transformed into an utter curse. The political
pack, regardless of party, whether barking in Congress or burrowing from high
official station, should be sedulously excluded.3

It is equally important that System officials not be subject to undue private influence. The organizational structure of the Federal
Reserve System reflects attempts of Congress to protect Federal
Reserve policymakers from either undue private or political
pressures.
This arrangement does not mean independence from Government. Congress in creating the Federal Reserve System provided
a comprehensive legal framework governing its operations and
amends this framework as it sees fit. Congress also requires
periodic reports covering the System's policy actions and operations. But within this legal framework, Federal Reserve officials
are given sufficient freedom to formulate policies that in their
judgment will best contribute to achievement of national economic goals such as business and price stability, and sustained
economic growth. It is logical that Federal Reserve authorities,
with training and experience in central banking, are better
qualified than other officials to determine Federal Reserve actions needed to achieve such economic objectives.
3
H. Parker Willis, The Federal Reserve System (New York: The Ronald Press Co.,
1923), p. ix.

EPILOGUE
The past is prologue. The future rests in our hands.
—Anonymous

Historically, central banking is young. Most of the progress made,
both in terms of the number of central banks and more significantly in the scope of their policies and responsibilities, has been
in the past fifty years. It was in this era that central banking
began to play an influential role in helping achieve important
domestic economic objectives. Developments in this period pave
the way for even greater progress in the next fifty years.
But as the focus shifts from past to future, one's vision becomes
blurred and confidence gives way to diffidence. It is impossible to
foretell the evolution and major developments in monetary policy
in the next half-century. Past experience, however, indicates
policy functions and responsibilities of the Federal Reserve System will be shaped mainly by the environment in which the
System operates and the quality of its leadership.
ENVIRONMENTAL FACTORS

It is certain that environment—economic, political, and social—
will exercise a substantial influence on the role and effectiveness
of Federal Reserve policy. It is also certain that one cannot now
visualize even the more sweeping environmental changes of the
future. Nevertheless, some surmises as to changes likely to impinge on the future role of monetary policy seem plausible.
Toward "One World"

The trend since World War II toward closer economic ties among
countries of the free world is unlikely to be reversed, except possibly temporarily. Developed countries are taking a more active
part in aiding underdeveloped countries. Modern transportation
and communication have diminished drastically the barrier of
175

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FEDERAL RESERVE POLICYMAKING

distance; the physical barriers to one world are shrinking at a
rapid pace. Removal and liberalization of controls and convertibility of major currencies permit a freer flow of goods and capital
among free-world countries.
Closer international economic relations are likely to have diverse effects on monetary policy. Currency convertibility, and a
wider use of the dollar in international payments and as a reserve
currency, render the dollar more susceptible to interest-rate differentials, and international tension. Some form of defensive
action may be required more frequently than in the past.
Recent developments in the international field have tended to
impair the effectiveness of Federal Reserve policy in defending
the external value of the dollar. The deficit in the United States
balance of payments arises largely from transactions unrelated or
only remotely related to market forces. The large deficit on Government account—mostly military expenditures abroad and
foreign aid—is determined by noneconomic objectives. A substantial part of the net outflow of private long-term capital is in
the form of direct investments, and is not closely related to
interest-rate differentials. A tight money policy is not so effective
for this type of balance-of-payments deficit as for the traditional
one arising from excess demand, rising prices, and a trade deficit.
The balance-of-payments situation, widespread use of the
dollar as a reserve currency, and increasing international mobility of short-term capital may result in the Federal Reserve being
handicapped more than formerly in using its tools to achieve domestic economic goals. Short-term funds have become more sensitive to international interest-rate differentials. With foreign exchange rates permitted to fluctuate only within narrow limits, the
burden of adjustment to interest-rate differentials tends to fall on
aflowof funds from lower to higher interest-ratefinancialcenters.
With exchange rates pegged, actions to narrow interest-rate
differentials or some form of selective control are the remaining
methods of dealing with a persistent and sizable outflow of shortterm funds. It could be that we may be confronted with choosing
between moreflexibilityin monetary policy or moreflexibilityin
foreign exchange rates, such as permitting a somewhat wider
range of fluctuation above and below par.

EPILOGUE

177

Fiscal and other Government policies

Another change that appears likely is a more effective use of
fiscal and other Governmental policies to help achieve general
economic objectives. Built-in stabilizers, such as a progressive
income tax and unemployment insurance, are an important step
in this direction. Recent tax cuts to facilitate continued economic
growth, the proposal that the President be given standby authority to make limited changes in income-tax rates, and the announced guidelines for wage and price policies are indications
that fiscal and other Government policies may be slanted more
toward stabilization and growth objectives. To the extent this
occurs, the burden on monetary policy may be reduced. Perhaps
in the future there will be less discussion of whether monetary or
fiscal policy should be the principal stabilization weapon, and
more discussion of what mix is best suited to a particular situation.
Role of money and credit

Money and credit are the raison d'etre of central banking. The
pervasiveness of policy depends significantly on the role of money
and credit in the economy. In underdeveloped countries, for example, central banks often have little influence because use of
money and credit is confined to a fairly small segment of total
economic activity, and the money supply is influenced more by
the government's fiscal policy and the balance of payments than
by expansion and contraction of bank credit.
Use of money and credit in the United States has increased
substantially in the past five decades. Extension of specialization
and production for the market place resulted in money being used
as a medium of exchange for the bulk of total output. Use of
credit, once confined largely to producers, is now widely used by
consumers for purchase of durable goods and real estate.
In the future, more of the changes are likely to take the form
of a more intensive use rather than use being extended to other
segments of the economy. Credit terms are likely to be better
tailored to borrower needs, and credit may be used for more
purposes. Mechanics of effecting payment will probably change
drastically. An expert in the field recently predicted that within

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FEDERAL RESERVE POLICYMAKING

25 years or so "automated credit will replace checks as the prime
medium of exchange." Innovations are also likely in the intermediary function of mobilizing savings and allocating them
among alternative investments.
But regardless of the innovations that may come in the mechanics of effecting payment and in performing the intermediary
function, so long as credit remains a device for spending tomorrow's income for today's output it will probably contribute to
fluctuations in purchasing power. If so the role of monetary
policy will be undiminished, but implementation may well be
more complicated.
Monetary theory

History demonstrates that monetary theory has a major influence
on Federal Reserve policy. But with the present status of theory,
the central banker confronts two major difficulties.
The first is a confusion of theories. Some of our best known
academic economists advocate a constant rate of growth in the
money supply; others stress interest rates and the availability of
credit. The report of the Radcliffe Committee on the British
monetary system of a few years ago concluded that liquidity, not
the money supply, should be the centerpiece of central bank
policy.
There is also basic disagreement among economists as to
whether monetary policy can be effective in stabilizing shorterrun swings in business activity. Some think it can and should be
so used; others think it cannot and therefore should be used only
for long-run stabilization.
Which theory or combination of theories should Federal Reserve authorities try to implement? Policy, even though adeptly
implemented, will not be effective if based on an erroneous
theory. Unfortunately, there is no proof that current theories are
more accurate than those that motivated Federal Reserve policies
in the twenties and the Great Depression—policies now severely
criticized by many economists.
A second difficulty is that theories are formulated on the basis
of certain premises and the assumption that other things remain
the same. The central banker, however, is compelled to formu-

EPILOGUE

179

late and implement policy in a world in which economic conditions never remain the same. Economic theory, to be helpful in
policymaking, should be applicable to the economy in which we
live—not an unreal and static economy erected on assumptions.
The unsatisfactory state of development of theory is one of the
more severe limitations on effectiveness of Federal Reserve policy.
Despite the difficulties that abound, progress can and will be
made in further development of monetary theory. Such development should be given top priority and approached from two
angles: intensive study of the effects of Federal Reserve actions
which may reveal certain general principles at work; and efforts
to achieve further development and refinement of theory, using
our growing volume of data and improved statistical techniques
to test their validity. History demonstrates that basic research is
one of the more fruitful avenues to economic and social progress.

FEDERAL RESERVE PERFORMANCE
The role of the Federal Reserve and the potency of its policies
will also be appreciably affected by the skill with which policy is
formulated and implemented.
Objectives and implementation

The future may well bring new objectives of Federal Reserve
policy. In any event, shifts in the weight given current goals are
likely to occur.
Policy may not be oriented so much toward smoothing out
business fluctuations—the dominant goal during most of the
first fifty years. Built-in stabilizers, improved inventory control,
better understanding of the business cycle by businessmen, and
improved use of Government policies to maintain stability may
result in some diminution in the intensity of cyclical swings as
well as a stabilization program that puts less responsibility on
monetary policy.
As already pointed out, current trends indicate that international activities of the Federal Reserve may be more important
than in the first fifty years.

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FEDERAL RESERVE POLICYMAKING

In recent years, sustained economic growth has become one of
the major explicit objectives but has not been a dominant influence in policy formulation. The prevailing view among policymakers has been that in trying to maintain price stability and a
full use of resources the System at the same time was pursuing the
policy best suited to facilitate sustained economic growth. In our
present state of knowledge, this view appears plausible. But too
little is known about determinants of economic growth. Additional knowledge might reveal that monetary policy could make
a more positive contribution.
One of the more fruitful potentials is a more refined use of the
tools of Federal Reserve policy. Except for stock-market credit
and temporary authority to regulate consumer and real-estate
credit, policy during the past three decades has been directed
primarily toward altering the total quantity of credit and aggregate demand. The recent dilemma of business recession and a
serious balance-of-payments deficit inspired attempts to achieve
selective effects within the policy of general ease to promote recovery and expansion. Reserves were supplied in ways to divert
the direct downward impact from short- to longer-term rates.
Lifting the ceiling on rates commercial banks could pay on time
deposits tended to put upward pressure on short-term rates; in
addition, there may have been some stimulative effect on the
flow of saving and rate of investment.
A more adept use of general quantitative tools might enable
the System to achieve selective as well as aggregate effects. This
is an area that needs further study and exploration. Improved
knowledge of the effects of the different tools might make possible
the blending of various selective impacts with general ease or
restraint, a capability that would be especially helpful when
objectives call for conflicting actions.
Leadership the key

Past history teaches that leadership will provide the key as to how
well the Federal Reserve System functions in the coming decades.
The legal framework under which most central banks operate
affords a large measure offlexibility.Hence the role of a central
bank is determined largely by the vision of central bankers.

EPILOGUE

181

Several qualifications are needed for effective policy formulation and implementation. One essential requirement is an understanding of our economy and of central banking. Central bank
policy is designed to influence economic conditions. Consequently, policymakers need to know in addition to central banking the workings of the economy they are trying to influence. A
second quality needed is plenty of courage. Frequently, a central
bank needs to take action that is unpopular. Regardless of the
policy pursued, Federal Reserve authorities will be criticized. If
the policy is one of ease, some will want it easier; others will want
it tighter. Moreover, the burden of responsibility makes for
timidity; it invites delay and even inaction.
Perhaps the most important quality is an open mind and willingness to innovate. It is easy to get into an intellectual rut and to
become an arch defender of doing things in the traditional way.
But progress has come, not from rigidity, dogmatism, or sticking
to tradition; it has come from intellectual curiosity and a readiness to devise techniques to deal with new problems.
The present Chairman of the Board of Governors recently
emphasized the importance of personnel in contrast to form of
organization:
In the last analysis, whether an institution renders good or bad public service
will always depend more upon the character of the human beings engaged in its
operations than upon its organizational form and structure.1
Leaders of ability, motivated by devotion to the public interest
are the best assurance that the Federal Reserve System will perform a valuable public service in the next fifty years.
1

U.S. Congress, The Federal Reserve System After Fifty Tears, Hearings, Subcom-

mittee on Domestic Finance, Committee on Banking and Currency, House of
Representatives, 88th Cong., 2d Sess. (Washington: U.S. Government Printing
Office, 1964), pp. 16-17.

APPENDIX
LIST OF POLICYMAKERS
FEDERAL RESERVE SYSTEM,

1914-1964

MEMBERS OF THE BOARD OF
GOVERNORS, 1914-1964
APPOINTIVE MEMBERS

Name
Charles S. Hamlin
Paul M. Warburg
Frederic A. Delano
W. P. G. Harding
Adolph C. Miller
Albert Strauss
Henry A. Moehlenpah
Edmund Piatt
David G. Wills
John R. Mitchell
Milo D. Campbell
Daniel R. Crissinger
George R. James
Edward H. Cunningham
Roy A. Young
Eugene Meyer
Wayland W. Magee
Eugene R. Black
M. S. Szymczak
J. J. Thomas
Marriner S. Eccles
Joseph A. Broderick
John K. McKee
Ronald Ransom
Ralph W. Morrison
Chester C. Davis
Ernest G. Draper
Rudolph M. Evans
James K. Vardaman, Jr.
Lawrence Clayton
Thomas B. McCabe
Edward L. Norton
Oliver S. Powell

Aug.
Aug.
Aug.
Aug.
Aug.
Oct.
Nov.
June
Sept.
May
Mar.
May
May
May
Oct.
Sept.
May
May
June
June
Nov.
Feb.
Feb.
Feb.
Feb.
June
Mar.
Mar.
Apr.
Feb.
Apr.
Sept.
Sept.
184

Term of officeb
10, 1914-Feb. 3, 1936
10, 1914-Aug. 9, 1918
10, 1914-July 21, 1918
10, 1914-Aug. 9, 1922
10, 1914-Feb. 3, 1936
26, 1918-Mar. 15, 1920
10, 1919-Aug. 9, 1920
8, 1920-Sept. 14, 1930
29, 1920-Mar. 4, 1921
12, 1921-May 12, 1923
14, 1923-Mar. 22, 1923
1, 1923-Sept. 15, 1927
14, 1923-Feb. 3, 1936
14, 1923-Nov. 28, 1930
4, 1927-Aug. 31, 1930
16, 1930-May 10, 1933
18, 1931-Jan. 24, 1933
19, 1933-Aug. 15, 1934
14, 1933-May 31, 1961
14, 1933-Feb. 10, 1936
15, 1934-July 14, 1951
3, 1936-Sept. 30, 1937
3, 1936-Apr. 4, 1946
3, 1936-Dec. 2, 1947
10, 1936-July 9, 1936
25, 1936-Apr. 15, 1941
30, 1938-Sept. 1, 1950
14, 1942-Aug. 13, 1954
4, 1946-Nov. 30, 1958
14, 1947-Dec. 4, 1949
15, 1948-Mar. 31, 1951
1, 1950-Feb. 1, 1952
1, 1950-June 30, 1952

185

APPENDIX

Term of officeb
2, 195118, 1952-Mar. 1, 1965
18, 195213, 1954-Oct. 21, 1954
12, 195417, 195525, 1959-Sept. 18, 1963
31, 196129, 196330, 1965-

Name
Wm. McC. Martin, Jr.
A. L. Mills, Jr.
J. L. Robertson
Paul E. Miller
G. Canby Balderston
Charles N. Shepardson
G. H. King, Jr.
George W. Mitchell
J. Dewey Daane
Sherman J. Maisel

Apr.
Feb.
Feb.
Aug.
Aug.
Mar.
Mar.
Aug.
Nov.
Apr.

Charles S. Hamlin
W. P. G. Harding
Daniel R. Crissinger
Roy A. Young
Eugene Meyer
Eugene R. Black
Marriner S. Eccles
Thomas B. McCabe
Wm. McC. Martin, Jr.

CHAIRMENc
Aug.
Aug.
May
Oct.
Sept.
May
Nov.
Apr.
Apr.

10, 1914-Aug.
10, 1916-Aug.
1, 1923-Sept.
4, 1927-Aug.
16, 1930-May
19, 1933-Aug.
15, 1934-Jan.
15, 1948-Mar.
2, 1951-

9, 1916
9, 1922
15, 1927
31, 1930
10, 1933
15, 1934
31, 1948
31, 1951

VICE CHAIRMENc
Aug.
Aug.
Oct.
July
Aug.
Aug.
Mar.

10, 1914-Aug.
10, 1916-Aug.
26, 1918-Mar.
23, 1920-Sept.
21, 1934-Feb.
6, 1936-Dec.
11, 1955-

9, 1916
9, 1918
15, 1920
14, 1930
10, 1936
2, 1947

Frederic A. Delano
Paul M. Warburg
Albert Strauss
Edmund Piatt
J. J. Thomas
Ronald Ransom
C. Canby Balderston

EX OFFICIO MEMBERSa
SECRETARIES OF THE TREASURY
W. G. McAdoo
Carter Glass
David F. Houston
Andrew W. Mellon
Ogden L. Mills
William H. Woodin
Henry Morgenthau, Jr.

Dec.
Dec.
Feb.
Mar.
Feb.
Mar.
Jan.

23, 1913-Dec.
16, 1918-Feb.
2, 1920-Mar.
4, 1921-Feb.
12, 1932-Mar.
4, 1933-Dec.
1, 1934-Feb.

15, 1918
1, 1920
3, 1921
12, 1932
4, 1933
31, 1933
1, 1936

186

FEDERAL RESERVE POLICYMAKING

Term of officeb

Name

COMPTROLLERS OF THE CURRENCY
Feb. 2, 1914-Mar. 2, 1921
John Skelton Williams
Mar. 17, 1921-Apr. 30, 1923
Daniel R. Crissinger
May 1, 1923-Dec. 17, 1924
Henry M. Dawes
Dec. 20, 1924-Nov. 20, 1928
Joseph W. McIntosh
Nov. 21, 1928-Sept. 20, 1932
J. W. Pole
May 11, 1933-Feb. 1, 1936
J. F. T. O'Connor

PRESIDENTS OF FEDERAL
RESERVE BANKS, 1914-1964d
Name
BOSTON
Alfred L. Aiken
Charles A. Morss
W. P. G. Harding
Roy A. Young
W. W. Paddock
Ralph E. Flanders
Laurence F. Whittemore
Joseph A. Erickson
George H. Ellis

Nov. 25, 1914-Dec.
Dec. 20, 1917-Dec.
Jan. 16, 1923-Apr.
Sept. 1, 1930-Mar.
Apr. 1, 1942-May
May 1, 1944-Feb.
Mar. 1, 1946-Oct.
Dec. 15, 1948-Feb.
Mar. 1, 1961-

NEW YORK
Benjamin Strong, Jr.
George L. Harrison
Allan Sproul
Alfred Hayes

Oct.
Nov.
Jan.
Aug.

5, 1914-Oct. 16, 1928
22, 1928-Dec. 31, 1940
1, 1941-June 30, 1956
1, 1956-

PHILADELPHIA
Charles J. Rhoads
E. P. Passmore
George W. Norris
J. S. Sinclair
Alfred H. Williams
Karl R. Bopp

Nov.
Feb.
Apr.
Mar.
July
Mar.

25, 1914-Feb.
8, 1918-Feb.
5, 1920-Feb.
13, 1936-June
1, 1941-Feb.
1, 1958-

Term of office
20, 1917
31, 1922
7, 1930
31, 1942
1, 1944
28, 1946
4, 1948
28, 1961

8, 1918
28, 1920
29, 1936
30, 1941
28, 1958

187

APPENDIX

Name
CLEVELAND
E. R. Fancher
M. J. Fleming
Ray M. Gidney
Wilbur D. Fulton
W. Braddock Hickman

Term of office
Nov.
Jan.
Nov.
May
May

2, 1914-Jan.
19, 1935-Sept.
1, 1944-Apr.
14, 1953-Apr.
1, 1963-

16, 1935
15, 1944
16, 1953
30, 1963

RICHMOND
George J. Seay
Hugh Leach
Edward A. Wayne

Oct. 5, 1914-Feb. 29, 1936
Mar. 12, 1936-Feb. 28, 1961
Mar. 1, 1961-

ATLANTA
Joseph A. McCord
M. B. Wellborn
Eugene R. Black
Oscar Newton
Robert S. Parker
W. S. McLarin, Jr.
Malcolm Bryan

Nov.
Mar.
Jan.
Aug.
Jan.
Feb.
May
Apr.

16, 1914-Mar.
1, 1919-Dec.
13, 1928-May
16, 1934-Dec.
15, 1935-Feb.
20, 1939-Mar.
9, 1941-Mar.
1, 1951-

1, 1919
31, 1927
18, 1933
19, 1934
13, 1939
28, 1941
1, 1951

Nov.
Mar.
Mar.
Oct.
Jan.

25, 1914-Mar.
2, 1934-Mar.
1, 1941-Mar.
1, 1956-Dec.
4, 1962-

1, 1934
1, 1941
1, 1956
31, 1961

Oct.
Feb.
Jan.
Apr.
Feb.
Oct.

28, 1914-Feb.
5, 1919-Dec.
16, 1929-Mar.
16, 1941-Feb.
1, 1951-Feb.
1, 1962-

5, 1919
31, 1928
1, 1941
1, 1951
28, 1962

CHICAGO
James B. McDougal
G. J. Schaller
C. S. Young
Carl E. Allen, Jr.
Charles J. Scanlon
ST. LOUIS
Rolla Wells
David C. Biggs
Wm. McC. Martin
Chester C. Davis
Delos C. Johns
Harry A. Shuford

188

FEDERAL RESERVE POLICYMAKING

Name
MINNEAPOLIS
Theodore Wold
R. A. Young
W. B. Geery
J. N. Peyton
O. S. Powell
Frederick L. Deming
Hugh D. Galusha, Jr.

Term of office
Oct.
Oct.
Oct.
Mar.
July
Apr.
May

14, 1914-Oct.
1, 1919-Sept.
3, 1927-Mar.
1, 1936-June
1, 1952-Mar.
1, 1957-Feb.
1, 1965-

1, 1919
26, 1927
1, 1936
30, 1952
31, 1957
1, 1965

Oct.
Jan.
July
Jan.
Aug.
Mar.

17, 1914-Dec.
1, 1916-July
1, 1922-Dec.
7, 1932-Mar.
28, 1941-Feb.
1, 1961-

31, 1915
1, 1922
31, 1931
1, 1941
28, 1961

Nov.
Feb.
Jan.
July
Oct.
Apr.
Feb.

2, 1914-Feb.
24, 1915-Jan.
16, 1922-May
1, 1925-Oct.
5, 1931-Apr.
13, 1939-Sept.
15, 1954-

24, 1915
7, 1922
16, 1925
1, 1931
2, 1939
1, 1953

Nov.
Aug.
May
Apr.
Jan.
Oct.
Mar.
Mar.

25, 1914-July
7, 1917-Apr.
16, 1919-Feb.
1, 1936-Dec.
1, 1946-Sept.
17, 1946-Mar.
1, 1956-Feb.
1, 1961-

5, 1917
28, 1919
29, 1936
31, 1945
28, 1946
1, 1956
28, 1961

KANSAS CITY
Charles M. Sawyer
J. Z. Miller, Jr.
W. J. Bailey
George H. Hamilton
H. G. Leedy
George H. Clay
DALLAS
Oscar Wells
R. L. Van Zandt
B. A. McKinney
Lynn P. Talley
B. A. McKinney
R. R. Gilbert
Watrous H. Irons
SAN FRANCISCO
Archibald Kains
James K. Lynch
John U. Calkins
Wm. A. Day
Ira Clerk
C. E. Earhart
H. N. Mangels
Eliot J. Swan

CHAIRMEN AND FEDERAL
RESERVE AGENTS OF THE
FEDERAL RESERVE BANKS,
1914-1936e
Name
BOSTON
Frederic H. Curtiss

Oct.

NEW YORK
Pierre Jay
Gates W. McGarrah
J. Herbert Case

Sept. 30, 1914-Dec. 31, 1926
May 1, 1927-Feb. 27, 1930
Feb. 28, 1930-Mar. 1, 1936

PHILADELPHIA
Richard L. Austin

Oct.

CLEVELAND
D. G. Wills
Lewis B. Williams
D. G. Wills
George DeCamp
Lewis B. Williams
Wm. H. Fletcher

Oct.
Sept.
Mar.
Dec.
Mar.
Jan.

RICHMOND
William Ingle
Caldwell Hardy
Wm. W. Hoxton

Oct. 5, 1914-Feb. 12, 1916
Apr. 1, 1916-Aug. 26, 1923
Sept. 15, 1923-Dec. 20, 1935f

ATLANTA
M. B. Wellborn
Joseph A. McCord
Oscar Newton

Oct. 16, 1914-Feb. 28, 1919
Mar. 1, 1919-Dec. 31, 1924
Tan. 1, 1925-Jan. 15, 1935f

Term of office

189

1, 1914-Mar. 1, 1936

8, 1914-Mar. 1, 1936
8, 1914-Sept.
30, 1920-Mar.
5, 1921-Oct.
19, 1925-Mar.
15, 1933-Nov.
1, 1935-Mar.

30, 1920
4, 1921
22, 1925
15, 1933
27, 1934
1, 1936

190

FEDERAL RESERVE POLICYMAKING

Name
CHICAGO
Charles H. Bosworth
William A. Heath
Eugene M. Stevens

Term of office
Nov. 16, 1914-Dec. 31, 1916
Jan. 1, 1917-Dec. 31, 1930
Jan. 1, 1931-Mar. 31, 1936

ST. LOUIS
William McC. Martin
Rolla Wells
John S. Wood

Oct. 28, 1914-Jan. 16, 1929
Jan. 23, 1929-May 6, 1930
May 9, 1930-Mar. 1, 1936

MINNEAPOLIS
John H. Rich
John R. Mitchell
J. N. Peyton

Oct. 1, 1914-May 20, 1924
Sept. 8, 1924-Jan. 31, 1933
May 15, 1933-Feb. 29, 1936

KANSAS CITY
J. Z. Miller, Jr.
Charles M. Sawyer
Asa E. Ramsay
M. L. McClure
J. J. Thomas
DALLAS
E. O. Tenison
Wm. F. Ramsey
W. B. Newsome
Lynn P. Talley
C. C. Walsh

Oct.
Jan.
Jan.
May
Feb.

16, 1914-Jan.
10, 1916-Dec.
1, 1918-May
1, 1923-Dec.
10, 1936-Mar.

5, 1916
31, 1917
1, 1923
5, 1934g
1, 1936

Nov.
Jan.
Nov.
Mar.
July

16, 1914-Jan.
15, 1916-Oct.
3, 1922-Mar.
15, 1923-June
1, 1925-Mar.

15,
27,
15,
30,
1,

1916
1922
1923
1925
1936

SAN FRANCISCO
John Perrin
Isaac B. Newton

Oct. 13, 1914-Mar. 1, 1926
Mar. 1, 1926-June 22, 1934'

a
Under the provisions of the original Federal Reserve Act the Federal Reserve
Board was composed of seven members, including five members appointed by the
President and two ex officio members—the Secretary of the Treasury, who was
Chairman of the Board, and the Comptroller of the Currency. The original term of
office was 10 years, and the five original appointive members had terms of 2, 4, 6, 8,
and 10 years, respectively. In 1922 the number of appointive members was increased
to six, and in 1933 the term of office was increased to 12 years. The Banking Act of
1935, approved Aug. 23, 1935, changed the name of the Federal Reserve Board to

APPENDIX

191

the Board of Governors of the Federal Reserve System and provided that the Board
should be composed of seven appointive members; that the Secretary of the Treasury
and the Comptroller of the Currency should continue to serve as members until
Feb. 1, 1936; that the appointive members in office on the date of that Act should
continue to serve until Feb. 1, 1936, or until their successors were appointed and had
qualified; and that thereafter the terms of members should be 14 years and that the
designation of Chairman and Vice Chairman of the Board should be for a term of
four years. Source: Board of Governors.
b
Beginning of term represents effective date of appointment.
c
Chairman and Vice Chairman were designated Governor and Vice Governor
before Aug. 23, 1935.
d
Source: Official records. There were some discrepancies in earlier years as to
date the term of office began, apparently reflecting difference between announcement and effective date; effective dates have been used when available.
e
Source: Official records. There were some discrepancies in earlier years as to
date the term of office began, apparently reflecting differences between announcement and effective date of appointment. Effective date of appointment used whenever available. The Banking Act of 1935 changed the duties and responsibilities of
the Chairman and Federal Reserve Agent. Effective March 1, 1936, the position
ceased to be one in which the official devoted his full time to the Reserve Bank.
f
Appointment of successor not effective prior to March 1, 1936,
g
Position vacant from December 5, 1934 to February 10, 1936.

INDEX

INDEX
Acceptances, bankers
Accord, The
announcement
events leading to
provisions of
Ad hoc subcommittee, report of

6, 44, 50-51, 53, 54
108
103-108
108-109
114-117

Balance of payments, United States
Federal Reserve policy
nature of the deficit
Banking Act of 1935
Bills usually
departures from
objections to
philosophy of
policy of
Borrowing, member bank
attitude toward
basic line
preventing excessive

130-131, 162-163
130
120
131-133
119-120, 161
160-161
117-119
16
23-24, 47
21-24, 45-47

Gall loan rate
Capital issues, regulation of
Central bank, credit and gold pools
Central bank, role of
Committee on centralized execution of
purchases and sales of Government securities
Consumer credit, regulation of
Coordination of tools
Credit
availability of
crisis in 1931
quality of as policy guide
Dealers
qualified
relations with.

48-49, 57
12f
137-139
4-5, 87-88, 178
51
91, 99
54-56
21, 61-62, 101, 153
68-69
36-37, 126-127

113-114
112-113, 114-116, 117-118
195

196

FEDERAL RESERVE POLICYMAKING

Debt management
Federal Reserve policy
11-18, 17-18, 20, 96-97, 142-143, 148-149, 166-168
open market operations
51, 111-112, 116-117, 144-145
Decisionmaking process
171-173
Depression, causes of
25-26, 63-64, 163-164, 170
Direct pressure, doctrine of
19-20, 57-58, 157
Discount rate
authority to establish
3
early policy
7-8, 12, 28-29, 68, 164
effects of
19-21, 44-46, 49-50, 75
guides to changes
7-8, 37-38
preferential
6-7,12, 18-19, 44, 90-91, 144
progressive
22-24, 171
Discount window
administration of
28, 46-47, 121-122
support via
13
Federal Reserve System
importance of leadership
180-181
problems of organization and implementation
1-4
relation to Government
173-174
Federal Open Market Committee, organization of
120
Financing, war
issues involved
166-168
World War
I
10-11, 141
World War II
87-90, 145-148
Foreign operations
credit to foreign central banks
41-42, 137-138
early discussion of
9-10
gold pool
138-139
objectives and guidelines
135-136
regulation of exchange rates
12f
stabilization of foreign exchange rates
30, 40-42, 134-136
swap agreements
136-137, 162-163
Franchise tax
102f, 149
Glass, Garter
Glass-Steagall Act of 1932
Gold
London market
pool
reserves and policy

142-143, 173-174
69-70
138
138-139
8, 9, 25, 29-30, 38-39, 67-69, 75-77, 164

INDEX

197

Inflation potential, post-World War II
95-96
Interest charge, Federal Reserve notes
imposed by Board
120f
proposal for, 1920
24f
Interest-rate differential
outflow of short-term funds
131-132, 176
Interest rates, pattern of
establishing of World War II
88-90, 145-146
implications of for policy
86-87, 97-98, 103-104, 150, 167-168
modification of
101-102
problems in maintaining
91-93, 96
termination of
108-109
Leadership, importance of
Monetary theory
Moral suasion
Open market operations
cash transactions
centralization and supervision
early use
early use as tool of policy
effects of
maintaining patterns of rates
objectives and guides
relations with dealers
Treasury attitude toward

180-181
169-171, 178-179
12-13, 22
121
8-9, 50-53, 120
8
47-49, 55-56
49-50
91-93, 103, 145-146
48-49, 83-84, 90, 111
112-118
51, 112, 144-145

Policy, guides to formulation
ease, neutrality, restraint, definition of
127-128
free reserves
125-126
immediate or short-term
124-126
intermediate-term
126-127
quality of credit
36-37,126
rules not feasible
35-36, 128, 171-172
Policy, objectives of
accommodating business
5, 32-34
conflicting objectives
17, 56-59, 96-97, 129-131, 166-167
defending external value of the dollar
135
end of World War
I
17
future trend in
179
orderly liquidation
27, 29, 60, 62
price stability, opposition to
34-35
sustained growth
123-124, 180

198

INDEX

Policymaking, process of
Posted buying rate, Treasury bills
Progressive discount rate

171-173
90, 149
22-24, 171

Real-bills doctrine
28, 169-170
Regulation of foreign exchange and capital issues
12f
Relation of System to Government
173-174
Research and statistics
early development
39-40
expansion and coordination
93
role in policy formulation
168-170
Repurchase agreements
53-54, 121
Reserves, excess
implications for policy
75-79
methods of absorbing
79-80
open market policy (1932-1933)
70-74
report to Congress on problem
81-82
Treasury financing
72-73, 90, 146-148
Reserves, free as guide
125-126
Reserve requirements
early attitude toward
54
use to immobilize excess reserves
79-80
Role of money and credit
33-34, 177-178
Sprague, O. M. W
Stewart, Walter
Support via discount window
Swap agreements
System Research Advisory Committee

47
39
13
136-137, 162-163
93

Treasury, controversy with over
discount rates
19-20, 44, 142-144
excess reserves
90, 146-148
interest rates
101-102,105,141, 145-146, 148-150, 153, 173
open market operations
51,144-145
preferential rates
18, 44, 142, 144

Full text of A Half Century of Federal Reserve Policymaking, 1914-1964

FRASER