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Paper Delivered by
Winfield W. Riefler, Assistant to the Chairman
Board of Governors of the Federal Reserve System

Honey and Banking Workshop
Federal Reserve Eank of Minneapolis

May 3, 1958



'A 3, iggfl------ny


It has recently been suggested that the Federal Reserve System could
help to check the recession by buying long-term U. S. Government securities
instead of limiting its market activities to the purchase and sale of bills.
The so-called "bills only"-/ policy was adopted by the Federal Open Market Com­
mittee on the recommendation of the Ad Hoc Subcommittee Report five years ago
in the belief that this policy was conducive to the best functioning of the
U. S. Government securities market.

It is the purpose of this paper to re­

examine this belief in the light of the actual operating experience of the
last five years.

The conclusion reached is that the potential contribution of

direct intervention in the long-term capital market would under any circum­
stances be small and might under certain circumstances not only obstruct the
functioning of the market but also slow up the responsiveness of Federal Reserve
System decisions.
At the time that the current policy was adopted, it was criticized
on the basis of a prevalent misconception that the Federal Reserve System influenced short-term interest rates primarily by buying or selling short-term
U. S. securities, and similarly long-term interest rates by buying or selling
long-term U. S. securities.

The fact that interest rates on short and long-

term securities tended in general to move together when only short-term
securities were purchased or sold was ascribed to the magic of "arbitrage" and
there were expressions of fear that if the System confined its operations to
1 short-term securities arbitrage might not work in a recession crisis or might
1 work so slowly as to leave us with a capital market position where high interest
'rates impeded the desire to borrow long-term capital funds,
l/ Actually "short-term securities, preferably bills."

The actual course of events ' - - e that time has shown that this

oi the System to the money

this implies.

capital markets is not so simple as

Long-term interest rat'; have beer, anything but lethargic,

even though System open market opera t_'~i have been confined almost wholly to

As a result, nobody any longer icubts, in the way they doubted in


the System's ability to influence long-term interest rates decisively

without direct intervention in the


- terra market.

In fact, in the most

recent period, starting in mid-November 1957, the System has been a factor in


one of the sharpest breaks of interest rates, both long and short, on record.

In this case, the initial drop in rates followed the lowering of discount rates

without any marked change in eithsr sh-rrt or long-term holdings of U. 5. securi­
ties in the System portfolio.

It has been widely noted that the basic reason

for this dramatic shift was a complete turnabout in market expectations as to
the direction of monetary policy rather than an immediate increase in the
basic supply of reserves available to tne banks for investment.
In view of this record and these developments, it may be worth while
to set down in detail (a) the various ways in which Federal Reserve System
policy actions actually affect the availability of funds and market rates of
interest, (b) the manner in which thet;^ actions permeate the various sectors
of the money and capital markets, and (c) certaia aspects of the organization
of the long-term open capital markets that create dangers when expectations
of lower or higher interest rates are not firmly based on actual changes in
the supply

of loanable funds relative to the demand.

It .nay also be useful

in this connection to review actual experience of recent years, i.e., to
assess on the basis of empirical evidence developed from the behaviour of the
market, the relative importance of different System operations in affecting

MAY 2


- 3 -

the cost and availability of funds.

Such a background will provide perspective

with which to judge the relevancy of the suggestion that the severity of the
c u rren t

recession might be mitigated by direct System intervention in the

long-term market for U. S. securities.
Impact of System Open Market Operations on Availability of
Capital and Credit and on Interest Hates
All policy actions of the Federal Reserve System exert an ei’
fect upon
the capital and credit markets.

It is not proposed, however, to analyse here

the manner in which Federal Reserve discount policy operates.

This has been

covered in detail in the recently released Annual Report of the Federal Reserve
Board for 1957.

Nor will the effects on the money and capital markets of

changes in the reserve requirements of member banks be reviewed in detail.
Rather, the analysis will be focused on open market operations.
In this focus, Federal Reserve System operations in the Government
securities market can be said to exert three strikingly different types of
influence on prices and yields of outstanding securities.

Open market operations bring about a change in the volume of

issues outstanding in the market that are available for trading and invest­

Federal Reserve Systeri purchases, for example, withdraw securities /

from the market.
that remain.

They tend, consequently, to raise the prices of those


Conversely, Federal Reserve System sales of securities add to

the total volume of investments for which purchasers must be found in the

Such sales, consequently, tend to depress the prices at which

securities can be marketed.

Tne relationship is one to one, i.e., each

dollar of securities bought or sold withdraws or adds a dollar of securities
to those that are available in the market.

These effects are registered most

strongly on the particular issues that are bought or sold, but, as is noted

- a later, the forces of substitution and arbitrage in the market or anticipationsof such effects are such tiiat they will also be reflected in some

degree throughout all maturity sectors of the market.

Federal Reserve System open market operations affect the prices

and yields of U. S. Government securities because they change the volume of
free reserves available to the member banks.
add to the volume of free reserves.

System purchases of securities

Consequently, because we operate under

a fractional reserve system, they add roughly between six or seven times as
much to the total potential demand of the member banks for earning assets,
including both loans and investments.

Conversely, System sales of securities

withdraw free reserves from the market, frequently causing member banks to
borrow reserves through the System's discount window.

Again, because we

operate under a fractional reserve s /stem, these sales decrease the poten­
?tial demand of the member banks for earning assets, either loans or invest­
ments, by an amount equal to a multiple of the sales.
relationship of this type o ' impact is not one to one.

In other words, the
The impact effect is

a multiple of the dollars added to or subtracted from the reserve base.
these impulses toward expansion or contraction


arise from a change in the avail­

ability of reserves, their effects are not concentrated on the security that
happened to be bought or sold by the Federal Reserve.

They are directly dis­

persed, rather, over all types of assets commonly found in bank portfolios.
These effects, furthermore, take place when free reserves change, no matter
what factor is responsible for the change.

To be specific, they are the same

irrespective of whether open market operations are conducted in the short-term
money markets, they are the same irrespective of whether the responsible factor
is a change in reserve requirements, a change in the demand for currency, or
a purchase or sale of gold«

- 5 (3)

Finally, System operations in T. S. securities markets affect

prices and yields in the securities markets, particularly in the short run,
aor.nrding^to the expectations to which they give rise, especially the expecta­
tions of dealers and market professionals.

The System holds the largest

portfolio of U. S. securities by far of any investment institution.
not restricted in its operations by considerations of profit.

It is

When it enters

the market, it always operates for a purpose and it has very great means at
its disposal to accomplish its purposes, far greater means than are at the
disposition of

any individual operator in the market.

Finally, it operates

from the very center of the market with more complete knowledge by far than
any other

t.hg total of investment and financial transactions

currently taking place*
Under these circumstances, market transactors, particularly the
market professionals including the dealers, go to great lengths to try to
ascertain the significance of all System policy actions, but particularly
the significance of operations in the security markets.

As professional par­

ticipants in the market, they are, of course, immediately aware of the occur­
rence of practically all such transactions.

It is vital to them to assess

correctly the potential impact of System operations and to govern their own
operations accordingly.

In deciding on their own operations, they will not

be likely to try to "buck" any trend or level of rates they think the System
is trying to establish.

Rather, they will try to anticipate such trends, both

by closing out positions they expect to become less profitable and by establish­
ing or increasing positions they expect to be favored by the trend.

As a con­

sequence, relatively small operations by the System Account can have major
short-run effects on market quotations when they give rise to firm expectations
among market professionals with respect to the direction of System policy.

- 6 It is important to note, however, that these effects are essen­
tially short-run effects.

Market professionals, including dealers, do not

originate savings or supplies of investable funds nor do they originate de­
mands for investment.

They are essentially middlemen located at the heart of

the market, seeking to anticipate by their trading the prices (or yields) that
will clear the market.

Not infrequently, consequently, the dealers overshoot

the market in trying to estimate the significance of System moves.

They may

assume that a given purchase or sale foreshadows larger changes, say, in the
free reserve position than are actually in contemplation.

In such cases, they

nay take positions and establish, for a period, a level of yields and prices
that cannot be sustained because it is inconsistent with the actual supplydemand situation.

The existence of this possibility is one of the reasons for

the System's adoption of a policy of nonintervention in the intermediate and
long-term sectors of the market.

Operations in bills are much less subject

to comment and possible misinterpretation than operations in longer securities.
They are less likely, consequently, to give rise to false expectations.
Fluidity, Substitutability and Arbitrage
The central open money markets, particularly the market for U. 3.
securities, are characterized by a high degree of responsiveness as between
the various sectors, in the sense that fluctuations of any magnitude in any
one sector are likely to be paralleled by similar fluctuations in other

This phenomenon is often loosely described as resulting from arbi­
It is often said, for example, that movements of yields and prices

originating in the most sensitive and liquid sector of the market, the bill
market, are transmitted to other sectors of the maricet with or without a cer­
tain amount of delay through the operation of arbitrage.

- 7 This ascribes much too much importance to the transactions of the
m a rk e t

professionals who engage i . arbitrage, ilucn more important and basic

to their operations as professionals is the high degree of actual sub­
stitutability that exists for many lenders and man/ borrowers in the credit
. _ ..........
....... m-nri ... ‘
and capital markets. For example, commercial banks operate actively and hold


positions for their own account in all major areas and in all major maturity
sectors of the money markets.

They also finance importantly the operations

of other transactors in those various areas and sectors.

In addition, managers

of investment portfolios such as those of insurance companies and pension and
trust funds, in seeking to maximize income, can operate with very great
flexibility as between different categories of investments and, if it pays,
between different maturity sectors.

Among borrowers, also, there are many

that can adopt a variety of financial plar.s to meet their financial needs.
If they think the terms necessary to obtain more or less permanent funds
will improve, they can postpone coming to the capital market and meet immediate
needs by running down their liquidity or by borrowing at snort term at banks.
The professional finance companies are more or less continuously borrowing
extensive anounts in the long, the intermediate and the short-term markets.
Within limits, at any one tine, they are free to shift the ioajor impact of
their borrowing to those sectors where financial costs appear most reasonable.
Public bodies and Governments are typically present as heavy borrowers in all
maturity sectors, both for new money and for refinancing.

Decause they enter

the markets for large anounts, they are alert for si3: s of congestion as between
the different maturity sectors and are careful to offer their issues in sectors
which appear capable of readily absorbing the offering.

It is these factors

of broad substitutability on both sides of the money and capital markets that





fundamentally for the homogenity and responsiveness that is found


They make possible the arbitrage operations of professional special­


It is these professionals1 operations, however, that account for the

smoothness of the yield curve at any point of time.
With respect to this aspect of markets, therefore, we can make two
relevant observations.

(1) There is a considerable amount of interchange­

ability or substitutability on both the demand and the supcly side of the
organized money and capital markets that tends to generalize pressures or
availabilities from any one sector to all sectors; (2 ) commercial banks are
particularly important in this responsiveness because they operate, and
also finance the operations of others, in all major sectors of the markets.
This casts a little different light on the generalization that changes
in the tone or direction of the money markets are likely to appear first in
the bill market and then to spread to the other sectors of the market.


generalization is true in the sense that it is usually easy to put money to
work in the bill market and also to withdraw it at will without loss.


follows that any change in availability of funds is likely to be reflected
immediately in the bill market.

It does not follow, however, that the fact

that funds have been committed to bills when, say, free reserves are increas­
ing, implies they are thareb^ rendered unavailable for investment in mortgages
or long-term bonds.

Rather, when banks have excess reserves, bank funds are

available for lending or commitment in any area in which the bank chooses to
commit them, taking into consideration the relative return offered and with
due regard to balance in the bank's portfolio.

It i 3 immaterial whether or

not they have meanwhile been placed temporarily in bills.

- 9 The speed with which changes in the availability of reserves will
be reflected in parallel changes in any individual sector cf the market,
such as the long-term sector, will depend has: call./ (a) on the strength of
demand in that sector relative to other sectors, (b) on the attractiveness
of the yield offered in the light of the risk involved, and (c) on the
liquidity position of the banking system, i.e., the size of its highly
liquid asset holdings and the position of its loan deoosit ratios.

Ease in

reserve positions will not quickly be reflected in an increase of commercial
bank investments in the long-term capital market if the banks are worried
about an insufficiency of short-term liquid assets or a high loan deposit

Under these conditions, time is indispensable to allow the increased

availability of reserves to build up bank liquidity through increases in bank
holdings of liquid assets.

Time is also indispensable to permit borrowers,

such as finance companies, with access to the short-term open markets to use
these markets to repay bank loans and thus bring about an improvement in the
loan ratio.
Organization of the Long-term Market
There is a third aspect of the money and capital markets that bears
mention in this connection, namely, the much greater significance that attaches
to any decision to borrow or lend when it is taken in the long-term Kiarket as
compared with a decision covering an equal dollar amount when it is taken in
the short-term market.

This increased significance is, of course, a mathematical

truism resulting purely and solely from the fact that the commitment undertaken

longer in time and, therefore, commits both parties to its terms through

a longer interval.

This is one reason why shorter rates fluctuate so much more

widely than long-term rates— less hangs on whether they do or not.

It is also

- 10 a reason why relatively small fluctuations in long-term interest rates carry
implications and consequences out of all proportion to much larger fluctuations
in short-term rates.

For example, it is generally realized that a fluctuation

of, say, one per cent in interest rates on one-year securities would normally
be associated with a much smaller fluctuation in the interest yield on


It is also generally realized that the relative change in capital values

of the securities in the two maturity areas would be reversed, i.e., that the
market price of the


price of the one-year notes.
large this swing is.

bonds would sizing over a wider range than the market
It is less generally recognized, however, just how

Actually, in the period between the wars, the swing over

the credit cycle in prices of triple A corporate bonds of 30-year maturity ap­
pears to have averaged nearly seven times larger than the corresponding fluctua­
tion in prices of one-year securities.
These differences are reflected in the manner in which approaches are
made to the two markets.

In general, approaches to the long-term r.arkets are

carefully timed, with an eye among other things to avoiding congestion.


ment bankers bringing out new long-term bend issues will try to schedule them,
if at all feasible, to be offered on a day when the calendar is not clogged with
competing issues.

To the extent that long-term borrowing is postponable


has the effect, in a sense, of rationing or tailoring demands for long-term
borrowing to the supply of funds currently available in the market.

It acts

to minimize short-run variations in prices and yields in tne capital markets
by limiting the amounts of long-term funds sought to the supply of funds avail­
able at prevailing yields<
This characteristic of the organization of the long-term markets can
be troublesome.

If professionals in the market misjudge the magnitude of shifts

- 11 -

jji the supply of or demand for investment funds, there may be a delay in the
response of interest rates as quoted in the market until the volume of pros­
pective issues on the calendar clearly indicates the true nature of the basic
supply-demand position.
Empirical Verification
Actual market behaviour is compounded of almost innumerable strands,
so much so that it is difficult to muster direct empirical proof of these
specific propositions.

Nevertheless many of them can be subjected to a con­

siderable degree of factual verification.
(a) If substitutability as betwee .1 different maturity sectors of the
market is characteristic of the behaviour of important elements on both the
demand and supply sides of the market, one would expect the market in general
to move as a whole, i.e., one would e::pect that the broad movements in the
amounts of funds loaned in the long, intermediate and short areas would usually
be in the same direction, and that the broad movements of interest rates in
the various maturity sectors would also be in the sane direction.

One would

expect that divergent movements as between maturity sectors would be less
frequent in occurrence and of shorter duration when they occurred.

This is

completely in accord witii observed market behavicar.
(b) If the effect of arbitrage and dealer portfolio activity is pri­
marily to establish prices and yields that will clear bids and offers in the
different maturity sectors of the market, it would be expected that yield
curves would be continuous rather than discontinuous as between the various

This expectation also accords with the empirical evidence.


sional activity, including arbitrage, results generally in a smooth and con­
sistent yield curve, particularly in the U. S. Government securities market.

- 12 This curve, however, changes its shape from time to time, reflecting the
presence of differential supply-demand pressures in various sectors of
the market.

In other words, substitution and profersional activity have the

effect of linking the various maturities sectors into an organic whole but
not of obliterating completely differential pressures as between them.
(c) If commercial banks with their ability to create money are funda­
mentally important factors in the supply of funds for investment, interest rates
would be expected to be highly responsive to changes in the reserve position
of the commercial banks.

This proposition is in accord with empirical evidence.

(d) In current market reporting, discussion and analysis is confined
preponderantly to noting changes in the demand for and supply of investments
in the various individual markets for bills, certificates, U. S, bonds, municipal
bonds, mortgages, etc., and day-to-day developments are analyzed in terms of
these changes in demand for and supply of specific categories of issues.


if the abstract propositions set forth in the above analysis are correct, a
change in the aggregate volume of free reserves available to the banking system
would be expected to have much more effect upon the availability of funds and,
consequently, upon interest rates in all the various maturity sectors of the
market than would be expected to result from an equal dollar change in the
volume of securities carried in the market.

This would be expected because

the former impact is a multiple one whereas the latter reflects a one for one

In a rough general sense

, the relative impact on interest rates

or security yields of these two factors should be proportional to the reserve

of the commercial banking system.

For example, if the Federal Reserve

System buys or sells a given dollar amount of bills at a time when effective
required reserves average one-seventh of demand deposits, something like

- 13 se v e n -e ig h t h s

of any resulting effect on market yields should reflect

th e

change in the volume of free reserves available to the banks and only onee ig h t h

the fact that the operation was executed in bills and therefore also

changed the volume of bills available for investment in the market.

The same

principles would apply if the open market operations were executed in the long
end of the market*
It is impossible to obtain direct empirical verification of the opera­
tion of these principles from a study of the response of the market to given
open market operations, since such operations exert various types of influence

On the one hand, they add to or subtract from the volume of

free reserves available to the commercial banks.

At the s i i time, however,

they add to or subtract from the volume of securities to be carried in some
particular sector of the market.

In addition, as was noted earlier, the fact

that the Federal Reserve System has entered the market may give rise to expec­
tations which will be reflected in quotations in the securities market.
times these quotations may reflect professional expectations

fu lly


as much or

more than they do changes either in the reserve position of the banks or in
the amount of market-held securities in the various

m a tu r it y



would become progressively nore important if open market operations were con­
ducted in the intermediate or long sectors of the market.

It is most nearly

negligible *./hen open market operations are confined to the bill market.


any case, however, it is impossible, by studying open market operations alone,
to disentangle these three effects.
There are other ways, however, of developing empirical data that is
both comparable and valid.

For example, if, as abstract reasoning would suggest,

- Hi -

s o m e t h in g

like seven-eighths o f the response of the money market at any one

time to an open market operation, in terns of availability of funds, repre­
sents the effect of that operation on the reserve position of the banks,
while only one-eighth reflects the fact that bills were simultaneously put
into or withdrawn from the market, it follows that changes in the general
availability of funds and in interest rates should be roughly the same, or
within seven-eighths of the same for various occasions when there were
comparable changes in the level of free reserves.

This should be true re­

gardless of the cause of the change in the level of free reserves - for
example— whether it ;/as brought about by open market operations, ttfhich simul­
taneously change the volume of securities to be carried in the .aarket or by
changes in reserve requirements which have no effect whatever on the volume
of securities to be carried in the market.

This comparison offers a truly

objective empirical test of the validity of the principles under examination.
The System has now changed reserve requirements on five separate
occasions since the accord.

On each occasion, changes in the availability of

funds and in interest rates have reacted to the resulting free reserve posi­

That reaction, furthermore, has been roughly similar, certainly within

seven-eighths of what would have been expected if the same free reserve posi­
tion had been achieved through open market operations.

This body of empirical

evidence, consequently, also strongly supports the conclusion that would be
suggested by more abstract analysis.
There is still another source of empirical data that may throw light
on this problem, a source of data moreover that is completely free from any
complications arising from changes in market expectations such as are frequently
induced by policy actions on the part of the Federal Reserve System.

It arises

ejection with Treasviry refinancing operations.

The Treasury recurrently

ftakes to refinance its huge outstanding debt as various issues mature,
year more than $20 billion of market-held certificates, notes, and bonds
thus refinanced by exchange for new issues.

Frequently intermediate securi­

ties, and sometimes long securities, have been included in the offers for ex­

Such occasions, consequently, furnish a prime opportunity to develop

empirical data with respect to the effects on the availability of funds and
on interest rates of changes in the maturity composition of market-held debt.
In the big refinancing of early 1958, for example, nearly $10 billion
of market-held debt was refinanced, more than one-third into the 3s of 1969 and
mere than one-sixth into the 3-l/2s of 1990.

This refinancing, in the course

of a very few days, effected a huge redistribution in the market supply of
investments as between the short, the intermediate, and the long maturity

More than $3-1/2 billion of securities were shifted out of the very

short to the intermediate sectors and more than $1-1/2 billion additional issues
were shifted from the very short to the very long maturity sector.

This shift

in the distribution of securities as between the various sectors of the market
was exactly analogoes

to the shift that would have been induced had the Fed­

eral Reserve System Open Market Account undertaken a huge swapping operation in
which it purchased some $5 billion of certificates in the market and simul­
taneously sold some $3-1/2 billion of issues maturing in 1969, and in addition
some $1-1/2 billion of issues maturing in 1990.
As already noted, the effects cf such a huge swapping operation,
had it been undertaken by the System, would have given rise to market expecta­
tions that would have affected quotations independently from any effects
arising out of changes in the volume of securities outstanding in the different

- 16 maturity sectors of the market.

A study of the reaction of the market to

such refinancing operations of the Treasury, consequently, provides concrete
empirical evidence on two problems.

First, what is the nature of the market

response to additions to or subtractions from market-held debt and how much
of the impact of such changes is modified or absorbed by the hi^h degree of
fluidity and substitutability as between the various maturity sectors that
pervade both sides of the market?

Second, how large would direct operations

by the Federal Reserve System in long-term U. S. securities have to be to
exert a significant influence on the availability of long-term funds for invest­
ment, other than

any impacts that might result from changes in market expec­

The answer to these two questions, ss provided t)y the response to
the recent Treasury refinancing, is that substitutability is a very important
market phenomenon, sufficiently important to mitigate appreciably the effects
of very large shifts in the volume of securities outstanding as between the
various maturity sectors of the market.

In this most recent case, for example,

bill rates, which had been dropping for some time previous to the refinancing,
dropped appreciably further as the volume of short instruments available for
investment was diminished by over v5 billion.

They did not, however, drop to

levels that usually prevail when free reserves are above $>£00 million.


term bond yields concurrently, which had also been dropping rapidly, leveled
off as these large volumes of additional securities were absorbed in the
intermediate and long sectors of the market.
reaction upward.

There was, however, no sharp

Concurrently with these reactions, the capital markets

continued to absorb new issues in record volume.
Now, these responses were certainly tangible and definite, as would
be expected on abstract grounds.

At the same time, considering the huge amounts

- 17 of securities involved, the effects both on interest rates and on the volume
of new securities absorbed were distinctly limited.

They suggest that the

Federal Reserve System would have to undertake very large swapping operations
indeed if it wished to use this device to affect appreciably the availability
of funds in specific maturity sectors of the market.

This evidence also

overwhelmingly verifies the proposition that Federal Reserve operations in
the open market achieve their important responses primarily through their
effects on the reserve positions of the commercial banks.
The foregoing analysis indicates the nature of the problems that
would be raised should the System intervene directly in the market for long­
term Government securities.

To recapitulate:

(A) System actions affect quoted interest rates in two
major ways:
(1) *qy altering the supply of funds relative to
demand available in the credit and capital markets;
(2) by inducing a shift in expectations among
market professionals.
(B) System actions influence the supply of investment funds rela­
tive to demand, in two ways, either by changing the volume of reserves
available to the commercial banks for loans or investments, or by
changing the volume cf securities in the market available for invest­

As between these two, the effects of the former are all important

as compared with the latter.

Under present reserve requirements, abstract

reasoning would lead one to expect that something like seven-eighths of
the interest rate response to any given open market operation would reflect

- 18 the effect of that operation on the free reserve position of the
banks and only one-eighth would reflect the fact that the open
market operations had the additional effect of changing the volume
of market-held debt.

These general theoretical expectations are

in accord with the empirical developments.
( . The major fundamental effect of direct operations in long­
term securities would reflect the fact not that long-term securities
were purchased but that reserves were supplied or withdrawn.


same effect would result from operations in bills.
(D) The money and capital markets are so organized as to permit
interest rates, particularly long-term rates, to persist for a time
at lower levels than would be justified by the volume of funds avail­
able for investment.

In this interval, the volume of capital offer­

ings coming to the market tends to be rationed to the level of market

The shift in expectations induced by direct System operations

in long-term securities are apt to be reflected in changes in interest
rate quotations that are out of all proportion to the changes justified
by the volume of reserves absorbed or released.

These rates would not

reflect the true supply-demand position in the market and in a situation
like the present would lead to congestion.
The 1953 decision of the Federal Open Market Committee to confine open
market operations to short-term securities was governed primarily by the desire
to minimize any disturbance to the functioning of the Government securities
market that might result from its own operations.

Since the bill market was

very much broader than any other sector of the market, it was clear that the

- 19 -

possibility of such disturbances could be held to a minimum to the extent
System operations were confined to bills.

While these Committee decisions

were made for operating reasons, they were taken in full confidence that
operations confined to bills would improve and not impair the market effective­
ness of Federal Reserve System policy actions.
justified by the record.

This confidence has been

Experience has proved the wisdom of operations designed

to affect credit and capital market conditions primarily through effecting changes
in the volume cf bank reserves.
The great danger of direct System intervention in the long-term securi­
ties markets at the present time is that the effect on interest rates, arising
out of a shift in market expectations, would probably be disproportionate to
any changes simultaneously induced in the actual supply-demand position of the
capital markets.

The existence of such disproportion, furthermore, would not

be readily or immediately apparent and might not be quickly corrected.

For a

time, the flow of securities offered in the investment markets would tend to be
rationed to the absorptive capacity of the market.
erroneous reading of the economic situation.

This might well lead to an

The failure of offerings to grow

in spite of sharply lower interest rates would require explanation.


lethargy in the capital markets, for example, might be ascribed not to a defi­
ciency of reserves in the commercial banks but to an absence of creditworthy
borrowers or to a let-down in the spirit of business enterprise, or to a
cautious spirit aiaong entrepreneurs.
System policy formation.

This would create great difficulty for

To the extent that long-term interest rates become

dominated by expectations of the future course of System policy actions,
rather than by the current supply-demand position, the System is deprived of
the most important market indicator of the adequacy of its operations.

- 20 Another resort to the record may help to clarify this point.


suggestion earlier in 1958 that the System engage in direct intervention in
the long-term market was motivated mainly by a desire to help clear up a
certain amount of congestion that had developed in the long-term capital market.
At that time, offerings of new issues had been exceptionally large and unsold
issues, particularly state and municipal issues, were at high levels.


instead of intervening directly in the long-term market, the System helped
clear up the situation by lowering discount rates and cutting reserve require­

This poses the problem of which was the preferred approach to the

Had the System directly intervened at that time to purchase long-term
bonds, strong expectations of further reductions in bond yields would certainly
have been roused.

The chances are that the yields of long-term bonds would

have dropped sharply on the appearance of a relatively small volume of System
purchases in the long-term market.

Little actually would have been done,

however, to increase the absorptive capacity of the market.

Now, those lower

long-term yields might well have acted to induce an increase in the desire
of entrepreneurs and others to borrow long-term funds.

Such increased borrow­

ing, however, would have had to be held off the market because not enough re­
serves had been added to increase appreciably the volume of funds available
for investment.

Had this happened, the existing congestion of unsold issues

in the long-term market would have been increased, not diminished, by direct

The decision to lower both reserve requirements and discount

rates, on the other hand, tended to clear up the congestion and at the same
time to promote increased borrowing because it put its primary emphasis on an
increase in the supply of reserves available to the banks.

This increased by

- 21 a multiple the potential supply of bcnk funds available for market investment,
and the resulting pressure on the supply position of the banks led, first,
to a clearing up of the congestion and, subsequently, to lower interest rates*
In summary, the System brings aid to the economy in a time of
recession primarily by increasing actual flows of loanable funds and thus
helping to finance active demands in the .narket for men and materials.


must never forget that this is the ultimate aim of our monetary policy rather
than the achievement, say, of a predetermined level of long-term interest

In other words, the achievement of lower interest rates in these cir­

cumstances represents a means to an end, not an end in itself.

The effec­

tive monetary stimulant to the economy in times of recession is always an
increase in the availability of reserves to the member barks.

Such reserves

increase by a multiple factor the supply of funds that are competing for exist­
ing loans and investments and also help to create a financial environment in
which additional creditworthy enterprises are tempted to borrow.
The really difficult problem for the System always, both in pex'iods
of recession and periods of boom, is to determine as closely as practicable
the volume of reserves that are most appropriate to the economic climate.
Data covering the behaviour of free market interest rates, particularly
long-term rates, read against the background of data covering the volume of
bank credit and of new offerings in the capital markets, furnish a most
valuable guide to such determination.

This is another reason, and a very

important one, for abjuring direct intervention by the System in the long
end of the market.

It is important to preserve the trustworthiness of that