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[SUBCOMMITTEE PRINT]
SOME GENERAL FEATURES OF THE
FEDERAL RESERVE'S APPROACH
TO POLICY
A STAFF ANALYSIS
SUBCOMMITTEE ON DOMESTIC FINANCE
COMMITTEE ON BANKING AND CURRENCY
HOUSE OF REPRESENTATIVES
88th Congress, 2d Session
Printed for the use of the Committee on Banking and Currency
U.S. GOVERNMENT PRINTING OFFICE
28-046
WASHINGTON : 1964
COMMITTEE
ON
BANKING
AND
CURRENCY
W R I G H T P A T M A N , Texas, Chairman
C L A R E N C E E. K I L B U R N , New York
A L B E R T RAINS, Alabama
W I L L I A M B. W I D N A L L , New Jersey
A B R A H A M J, M U L T E R , New York
E U G E N E SILER, Kentucky
W I L L I A M A. B A R R E T T , Pennsylvania
PAUL A. FINO, New York
LEONOR K. SULLIVAN, Missouri
F L O R E N C E P. D W Y E R, New Jersey
H E N R Y S. REUSS, Wisconsin
S E Y M O U R H A L P E R N , New York
THOMAS L. ASHLEY, Ohio
JAMES I I A R V E Y , Michigan
CHARLES A. VANIK, Ohio
OLIVER P. BOLTON, Ohio
WILLIAM S. M O O R H E A D , Pennsylvania
W. E. (BILL) B R O C K , Tennessee
R O B E R T G. STEPHENS, JR., Georgia
R O B E R T T A F T , JR., Ohio
FERN A N D J. ST G E R M A I N , Rhode Island
JOSEPH M. M c D A D E , Pennsylvania
H E N R Y B. GONZALEZ, Texas
S H E R M A N P, L L O Y D , Utah
C L A U D E PEPPER, Florida
B U R T L. T A L C OT.T, California
JOSEPH G. MINISII, New Jersey
D E L CLAWSON, California
CHARLES L W E L T N E R , Georgia
R I C H A R D T. H A N N A , California
B E R N A R D F. GRABOWSKI, Connecticut
CHARLES II. WILSON, California
C O M P T O N h WHITE, JR., Idaho
JOHN R . STARK, Clerk and Staff Director
Sons E. BARRIERE, Professional Staff Member
O R M A N S . F I S K , Minority
Staff^Member
SUBCOMMITTEE ON DOMESTIC FINANCE
W R I G H T P A T M A N , Texas, Chairman
H E N R Y S. REUSS, Wisconsin
W I L L I A M B. W I D N A L L , New Jersey
CHARLES A. VANIK, Ohio
JAMES H A R V E Y , Michigan
C L A U D E PEPPER, Florida
OLIVER P. BOLTON, Ohio
JOSEPH G. MINrSH, New Jersey
W . E. (BILL) B R O C K , Tennessee
CHARLES L. W E L T N E R , Georgia
R O B E R T T A F T , JR., Ohio
R I C H A R D T . HANNA, California
CHARLES H. WILSON, California
11
LETTER OF TRANSMITTAL
FEBRUARY
7,
1964.
To the Members oj the Subcommittee on Domestic Finance:
Transmitted herewith for the use of the subcommittee is a staff
analysis of Federal Reserve policy action. More specifically, it
examines the basic notions that guide the Open Market Committee
in its transactions which, of course, are fundamental in determining
the volume of the money and credit.
Although part of a larger study which is expected to be available
for printing in the near future, this analysis, dealing as it does with
the Open Market Committee and the fundamental monetary functions that it performs, is being made available separately at this
time because of its relevance to the current hearings on the Federal
Reserve System.
Sincerely yours,
W R I G H T P A T M A N , Chairman.
IN
LETTER OF TRANSMITTAL
JANUARY 3 0 , 1964.
H o n . W R I G H T PATMAN,
Chairman. Committee on Banking and Currency,
House oj Representatives, Washingtonf D.C.
D E A R M R . C H A I R M A N : Transmitted herewith is one chapter of the
study entitled "An Analysis of Federal Reserve Monetary Policymaking" that is being prepared for the committee. The following
chapter, "Some General Features of the Federal Reserve's Approach to
Policy," contains an evaluation of some of the basic notions that guide
the Federal Reserve in determining the nature and extent of policy
actions. The role of this chapter in the study can best be understood
by a brief description of the total study, the general guidelines along
which our analysis has proceeded, and the main conclusions that
emerge from our analysis.
As you know, 50 years have passed since the Congress established
the Federal Reserve System and delegated to it, under a broad mandate, the constitutional powers vested in Congress under article I,
section 8. In the ensuing years, the original mandate was modified
in a major way by congressional approval of the Banking Acts of 1933
and 1935, the Employment Act of 1946, and of international agreements. Along with these changes and the social and political changes
that they reflect, there have been major modifications in the powers
and structure of the Federal Reserve System, in the scope and complexity of credit and financial markets, in the institutional arrangements that transmit Federal Reserve policy operations to businesses
and households, and in the mechanisms on which the Federal Reserve
relies to carry out the mandates or directions given by the Congress.
This study attempts to appraise Federal Reserve operations in the
light of the congressional mandate. It will be concerned with four
basic questions: (1) What are the Federal Reserve's conceptions of
the mechanism transmitting its policy actions to the monetary system?
(2) What are the principal ideas composing the Federal Reserve's
conceptions? (3) How do these ideas affect the observable policy
behavior of the Federal Reserve authorities? How do they shape
their objectives and the manner of operating the available policy
instruments? (4) What relevance can be assigned to the conceptions
guiding the Federal Reserve's policy behavior? Has the Federal
Reserve based its ruling conceptions on a systematic body of tested
propositions about the nature of the monetary process? Are the
dominant notions guiding policy actions sufficiently well conceived
and adequately appraised to carry the heavy burden of policy actions
induced by their pervasive and entrenched influence?
Our understanding of the prevailing notions and viewpoints of the
Federal Reserve is based on a careful reading of the published record,
the statements made by members of the Federal Open Market Committee, and by members of the research staff of the Board of Governors
v
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LETTER OF TRANSMITTAL
and the Reserve banks. Our knowledge lias be?en enhanced by
detailed discussions with members of the research and operating
staffs and by members of the Federal Open Market Committee, and
by responses to a set of questions mailed to the Presidents of the 12
Reserve banks and to each member of the Board of Governors.
The study attempts to use the information obtained from the varied
sources to develop what we believe is the prevailing state of Federal
Reserve understanding of the process connecting policy actions with
the money supply. Chapter I will summarize the material in the
study ami indicate the main findings. The enclosed chapter II,
discusses some of -the fragments that represent a large part of the
Federal Reserve conception of the monetary .process. Most of these
fragments are based on judgment, personal experience or direct
observation; few, if any, have-been critically examined, fully articulated, or compared to alternative conceptions. We find that the failure of the Federal Reserve to develop and test a frame of reference has
led to inappropriate policy decisions, incorrect evaluation of events
occurring in the money and financial markets, and the choice of
inadequate instruments or targets for policy actions. Further, we
find that these failures render monetary policy less successful in
carrying out the congressional mandate than it would otherwise be.
In this chapter, an attempt is made to explicate concepts, such as
"tone," "feel," "credit," and "liquidity," that play a dominant role in
Federal Reserve thinking and discussion of the monetary mechanism.
We find that these concepts are inadequately defined in Federal
Reserve discussions and often have meanings that vary from context
to context. Moreover, we suggest that the repeated use of these
vague and elusive concepts has hindered the development of an
adequate explanation of the response of the money supply to changes
in the rediscount rates, reserve requirements against time and demand
deposits, and open market operations.
Further, we suggest that two basic features of the System's orientation help to explain the failure of the Federal Reserve to develop a
coherent explanation of the monetary process or a rational foundation
for policy action. (1) The Federal Reserve is organized and operated
in a way that places overriding importance and focuses principal
attention on week-to-week, day-to-day, and even hour-to-hour
changes in the money and securities markets. (2) The viewpoint of
the System is frequently that of an individual banker rather than'
that of a regulating authority for the monetary system and for the
economy as a whole. We find that these two features help to clarify
a number of prevailing Federal Reserve views and actions; e.g., the
System's explanation of the effect of member bank borrowing, the
concern with essentially random and often self-reversing changes in
the money market, the importance attached to daily changes in
reserve positions, the concern about temporary redistributions of
reserves from one class of banks to another, and similar features that
pervade and shape the System's policies.
While there are many loose or disconnected strands that appear in
Federal Reserve discussions of the monetary mechanism, one conception appears to have dominated Federal Reserve policy operations
in the postwar, postaccord era. We refer to this conception as the
"modified free reserves doctrine" or "the doctrine centered on free
reserves." Chapters III and IV will trace the development of this
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LETTER OF TRANSMITTAL
doctrine from its origin in an older frame of analysis and will provide
evidence that it has dominated Federal Reserve thinking in the past
decade.
Two principal sources of evidence furnish the dividing line between
the two chapters. Chapter III is entitled "The Federal Reserve's
Attachment to the Free Reserve Concept: Evidence From Published
Statements." Published sources and responses to the Committee's
questionnaire are used in our attempt to explain the role assigned
within the System to the magnitude free reserves and its relation
to bank credit expansion. These interpretations are buttressed by the
evidence in the following chapter, "The Federal Reserve's Attachment
to the Free Reserve Concept : Evidence From Announced Changes in
Policy." The latter chapter considers the evidence from the published
Record of Policy Actions and compares indicated changes in policy
to a moving average of free reserves. We find that there is a close
correspondence between decisions to change or modify policy and the
moving average of free reserves.
A principal conclusion of this portion of the study is that movements of free reserve quite frequently precede rather than follow decisions of the Federal Open Market Committee. The published records that we have examined strongly suggest that decisions to change
or modify policy are often ratified by the Federal Open Market Committee rather than determined bv that body. This finding is quite
consistent with our view that the Federal Reserve has failed to develop
an adequate understanding of the process connecting policy actions
with the money supply. As a result, members of the Committee are
heavily dependent on the Manager of the System Open Market
Account for interpretations of the events occurring on the market
and are unable to assess adequately his operations or appraise their
meaning.
The evidence generally supports our contention that the Federal
Reserve has relied primarily on the "modified free reserve doctrine"
during the postaccord period. In chapter V, we attempt to assess the
extent to which policy operating according to the modified free reserve
doctrine exercises a decisive or an important influence on the money
supply or on bank credit. Our findings are largely negative. We
find very little correspondence between the Federal Reserve view of
the factors influencing the money supply and the monthly or annual
changes in the stock of money. Further, our evidence suggests that
the "degree of control" exercised over bank credit by the Federal
Reserve is smaller than for the money stock. Again, the evidence
strongly supports our contention that the Federal Reserve has failed
to develop an adequate framework for the policy actions required to
carry out the congressional mandate.
Our findings from the test of the Federal Reserve conception are
sufficiently negative that they raise questions about the existence of
adequate control of the money supply, useful for policy purposes.
Partly for this reason, we present the outline of an alternative conception of the monetary process in chapter VI. We attempt to
show that several important features of the monetary mechanism are
^eluded from, or incorrectly incorporated in, prevailing Federal
Reserve views. We then test the proposed alternative conception
and show that it exhibits substantially closer relation between policy
°perations and changes in the supply of money.
yxn
LETTER OF TRANSMITTAL
Chapter VII concludes our study with suggestions for changes in
the administrative arrangements for policymaking and in the nature
of the policy operations themselves. Our suggestions are designed
to retain many of the excellent features of present Federal Reserve
operations, particularly their remarkable, demonstrated ability to
judge promptly postaccord turning points. But such judgments
must be accompanied by appropriate action, if they are to have an
important influence on the monetary and economic system. To
correct some of the recorded deficiencies in Federal Reserve operations, we will suggest for consideration a reorganization of the Federal
Open Market Committee and some changes in policymaking procedures.
It is not novel to criticize policymakers, particularly Federal
Reserve policymakers. With hindsight, one can frequently, if not
always ask: Why did they not move faster? Why did they increase
this or that measure by only a few percent rather than by a few more
or a few less percent? This study is not directly concerned with
criticism of particular actions. It is focused instead on the deficiencies
and triumphs of present policy arrangements. We have not asked
the question: "Was monetary policy adequate in the postwar, postaccord period?" We believe that there is a more important series of
questions that has not been asked very often: Are the procedures for
making monetary policy adequate? Does the Federal Reserve have
adequate information in sufficient time to make appropriate decisions?
Does the Federal Open Market Committee or the Board of Governors
have an adequate understanding of the mechanism connecting monetary policy operations with the money supply? It is to these questions that this report is primarily addressed. As we have noted,
chapter II sets out the main lines of this inquiry. Chapters I and
III to VII will be mailed to you in the near future.
In completing this study, we wish to acknowledge a large debt to
Clark Warburton whose published descriptions of Federal Reserve
policy and ifcs consequences are in many ways unique. We were
often heartened, on arriving at an interpretation of the reasons for
Federal Reserve procedures, to find that he had arrived at the same
interpretation much earlier and that his detailed studies of policymaking in the prewar and preaccord periods interpreted the often
puzzling behavior or remarks of the Federal Reserve in muck the
same way as our studies of the postwar and postaccord periods. We
would particularly like to mention his papers 1'Monetary Control
Under the Federal Reserve Act," Political Science Quarterly, December 1946, and "Monetary Difficulties and the Structure of the Monetary System," Journal of Finance, 1952.
We also wish to publicly thank Miss Thelma Johnson for her fine
cooperation in preparing this manuscript for publication.
Finally, we want to thank the members of the Board of Governors,
of tli© Federal Open Market Committee, and those members of the
staffs that we interviewed or who responded to our questions. Although our report is at times severely critical of the manner in which
policy decisions are made, these criticisms should in no case be interpreted as a personal reflection on any of the individuals involved. We
have been deeply impressed with the integrity of the individuals that
we met, the forthright answers that we have received and the courtesy
that was granted to us at all levels of the Federal Reserve System
yxn
LETTER
OF
TRANSMITTAL
with which we have had contact. Our criticisms are intended only as
a statement of our belief, supported by evidence, that the analysis
that currently furnishes the foundation for monetary policymaking
is seriously deficient in many important respects, and that after 50
years, the Federal Reserve has not yet provided a rational foundation
for policymaking. Indeed, that is the chief finding of our study.
K A R L BRUNNER.
ALLAN H . MELTZER.
28-046—64-
2
THE FEDERAL RESERVE'S APPROACH TO POLICY
Monetary policy operates directly on the discount rate, reserve
requirements against demand and time deposits and the Federal
Reserve Banks' portfolio of securities. The administration of the
discount window and the supervision of banks are, at times, included
as part of monetary policymaking. These policy instruments are
expected to modify the money supply and to alter the level of interest
rates and other magnitudes on the credit market. The effect that
actually emerges from the use of policy instruments by the Federal
Reserve depends crucially on the nature of the process through which
these instruments operate.
The interacting behavior patterns of banks and the public are the
central elements in the process connecting particular monetary policy
actions with the money supply or the credit markets. Only an
appropriate knowledge about the structure of this process enables us
to state with some confidence what the actual outcome of any policy
action will be. Similarly, an adequate understanding of the nature
of monetary processes is required to interpret the events that are
recorded in" the form of interest rates, the position of the banking
system, or the supply of money. Such understanding not only permits
evaluation of the consequences of Federal Reserve operations in the
context of prevailing institutional arrangements, but also forms the
foundation lor analysis of the effect on the monetary process of changes
in institutional arrangements. An understanding of the central features of the monetary process is required to evaluate the desirability
and the effects of changes in the legal and institutional arrangements
that presently prevail.
Whatever understanding we may possess about the nature of
monetary processes and the operations of credit markets is reflected
in a more or less clearly articulated frame of reference, conception,
or theory. Such conceptions mav be shaped by personal experience
and directlv related to personal observations that have occurred
frequently "in the past. Still long and persistent exposure to
"experience" does not guarantee the relevance of the conception or
its usefulness for analysis of events or policy actions. "Personal
experience" is not an Wirlomeration of brute facts; it is a set of
selective impressions shaped by ideas and notions or a vague frame
reference that has been acquired previously. Such ideas or
notions operate like a filter on the stream of accruing impressions that
we call experience. Some impressions are disregarded while others
are admitted to enlarge our "personal experience." Even the most
articulate conceptions "based upon" long personal experience require
a critical examination to judsre their relevance and validity.
The requirement for a critical evaluation holds quite generally
™r all conceptions about the structure of our environment whether
they are based on the most abstract theory, on personal experience,
on some other foundation. A particular frame or view must show
1
2
FEDERAL RESERVE'S APPROACH TO POLICY
its mettle by repeated exposure to observations in competition with
rival conceptions. Such competitive evaluation will eventually
decide the comparative validity of any particular frame of reference
under consideration. This is the only reliable procedure for obtaining
a rational foundation for policy decisions.
In this chapter, we consider some of the fragments that represent
a large part of the Federal Reserve conception of the monetary process.
Most of these fragments are based on judgment, personal experience,
or direct observation; few, if any, have been critically examined,
full}7 articulated, or compared to alternative conceptions. Failure
to develop and test a frame of reference has led to inappropriate policy
decisions, incorrect evaluation of events occurring in the money and
financial markets, and the choice of inadequate instruments or targets
for policy actions. These failures render monetary policy less successful in carrying out the congressional mandates than it would otherwise be.
It is not our intejition to survey completely the inadequacies of the
Federal Reserve conception. Nor is it our concern to point to particular periods in order to suggest that policy should have been a little bit
"tighter" here, a little bit "easier" there. Our principal interest is
the development of a systematic frame of reference that represents the
principal guidelines for policy action that have emerged within the
Federal Reserve after 50 years of judgment and experience. We can
then test this frame of reference or conception by exposure to data
and by comparison with an alternative conception. Moreover, we
can consider the extent to which inadequacies and errors in the Federal Reserve conception have been the source of major mistakes in
policy and in the interpretation of events in the money and credit
markets.
First, brief consideration is given to the Federal Reserve's stated
view of its role in the monetary system. Then an attempt is made to
show how some particular features of the Federal Reserve's frame of
reference have been the cause of major errors in analysis and have
prevented the development of an adequate conception. Finally,
some consequences of the Federal Reserve's misconceptions are discussed in the context of some particularly unfortunate policy decisions.
THE SYSTEM'S V I E W OP ITS ROLE
The Federal Reserve authorities" described ih a well-known report
to a congressional committee how they view their position and obligations. The Board of Governors is presented as a rulemaking and
quasi-judicial agency of Congress. It was established by Congress
"to regulate the volume, availability, and cost of money in the public
interest." Furthermore, Congress recognized "the need for independence of judgment in the exercise of these functions." The Board
and the Federal Open Market Committee are expected to act "according to" their own best judgment." The Federal Reserve authorities
aline their position to a clarifying statement concerning the Federal
Trade Commission made by the Supreme Court. Under this interpretation the Federal Reserve authorities acknowledge "the congressional intent to create a body of experts who shall gain experience by
length of service." The Board of Governors further acknowledged
that "it has an obligation through educational work to foster public
3
FEDERAL
RESERVE'S APPROACH TO
POLICY
understanding of monetary policies and the relation of money and
credit to economic conditions and development." 1
In summary, we note that policy should be based on the best judgment of policymakers acquiring knowledge about the structure of the
process to be manipulated and conveying their accumulated knowledge
to the public. In view of the requirements of rational policymaking,
it is reasonable to interpret the Federal Reserve's position as aij obligation to provide a coherent conception describing the causal nature
of monetary mechanisms. We find it therefore surprising indeed that
the Board has played a minor role in developing the necessary understanding of our monetary system and in supplying a comparatively
reliable foundation for its assessments of evolving situations and
decisions.
There is a relatively large research organization at the Board of
Governors and in each of the Reserve banks, and there are 13 regular
monthly or bimonthly publications reporting current news or factual
discussions of a number of financial topics. In addition, numerous
publications on special topics are issued, yet neither the policymaking
officials nor any of the,staffs have provided a fully articulated statement of the relation of policy actions to the money supply or the
pace of economic activity. Although spokesmen for the System have
shown an occasional awareness of the importance of the causal factors
affecting the supply of money, there has never been a detailed analysis
of the mechanism through which open-market operations, changes in
the discount rate, or changes in reserve requirements modify the state
of the monetary system. The Board's research division has undoubtedly collected much information about banks and credit markets.
Bui the relevance of this mass of data caixnot be judged in the absence
of a coherent conception systematically weaving this information
into a meaningful pattern. Collection and preparation of data not
guided by an explicit analytical frame often leads to a pointless
accumulation of data.2
SOME E V I D E N C E OF T H E A B S E N C E OF A SYSTEMATIC
FRAMEW R OKK
That the Federal Reserve has furnished the public with information about many of its operations can hardly be denied. It has
clearly been more faithful to this view of its role than to the requirement to provide a systematic frame of analysis with which the information could be interpreted. This fundamental fact associated with
Federal Reserve policymaking can be recognized through diverse
clues occurring in discussions, in the public record, and in numerous
statements bearing on the nature of policy actions and the assessment
of monetary events. To our knowledge, Riefler's discussion, published
1 "Monetary Policy and the Management of Public Debt" (Washington, D.C.: Joint Committee on the
Economic Keport, 1952), pt. 1, pp. 242.
and 2ft5. This st'idy will bo referred to as the "Patman report,"
K sho"M be noted that at least one high-ranking Federal Reserve official considers this report as the best
statement describing the Federal Reserve's views and positions.
J Two examples may illustrate this point. The Federal Reserve Bulletin for, July 1JJ03 eontained an
article ''Measures of Member Hank Reserves." A series of seasonally adjusUd data on required reserves
is presented in this article. The data are computed on the assumption that reserve requirements prevailing around July 1063 wire applicable to the i*,-riod covered by the data. As a result, the series reflects
primarily the movements of total d e b i t s and variations in their distributional patterns. It is di;licult
to visualize how this series can be meaningfully used to represent the behavior of required reserves as an
lnpred ient of a systematic analysis. Of course, such utilization is not impossible, but there is no indication
of bow these data can IK? meaningfully exploited. A second example is drawn from the flow of funds study*
Great efforts went into the collection and preparation of data with no clear notion about the questions
that could l»e answered with the data, Im|>ortant questions abr,ut the resixmse of tl>e monetary system
to policy actions might have been asked and answered had resources been employed in that direction.
4
FEDERAL
RESERVE'S
APPROACH TO
POLICY
more than 30 years ago, remains the most coherent notion ever formulated by anyone closely related to the policymaking bodies.3
Residues and strands of this notion are still found in the collection of
ideas used in Federal Reserve discussions. But they are accompanied
by other fragments not clearly related to Riefler's work or to any other
systematic consideration of monetary processes.
The variety of conceptions or frames of reference are reflected in
the abundance of "criteria" for monetary policy that are offered at
meetings of the Federal Open Market Committee. These criteria
refer to a variety of magnitudes or entities reflecting the behavior of
banks or the operations on credit markets. Some refer to free reserves, some to short-term rates; others point to reserves, required
reserves, "credit," long-term yields, short-term yields, liquid assets,
et cetera. Even the supply of money is mentioned on occasion.*
This collection of criteria presented at meetings of the Federal Open
Market Committee may well cover important aspects of the monetary
process, but the very mixed nature of these criteria reveals the absence
of a coherent conception.
The character of the Federal Reserve's notions is also reflected in
numerous statements made by high officials or their representatives.
We note, for example, the perennial phrase that Federal Reserve
policy is concerned with "the volume, availability, and cost of money
and credit." On other occasions we read that the "most important
functions of the Board are those affecting the money supply." 5 Of
course, Federal Reserve officials also declare that "monetary policy
is concerned with the overall availability of crcdit." 6 This apparent
confusion about the Federal Reserve's basic purpose is apparently
clarified by assertions that "credit" and "money" are essentially the
same or behave in an identical manner. This,very problem, namely,
the Federal Reserve's inclination to confuse credit and money, will'
be considered in a later section in some detail.
Another aspect may be selected for attention at this point. A
critical reader of the Federal Reserve's publications and pronouncements will find it very difficult to learn what "credit" and "availability" mean. In spite of the frequent usage of the term "credit,"
explicit indications of the many meanings assigned to the term are rare.
Scanning the occurrences of this term and the context for clues of
meaning, we gathered the following list of possible meanings attached
to the term by Federal Reserve officials: the commercial banks'
loan portfolio, the rate of change per time unit of this loan portfolio,
the commercial banks' total portfolio of earning assets, the rate of
change per time unit of this asset portfolio, the total loan portfolio
of all financial institutions, the rate of change per time unit of this
inclusive loan portfolio, total earning assets of all financial institutions
or its rate of change per time unit, and lastly, the rate of change of
financial claims occurring in the balance sheet of any economic unit in
our economy. With such an abundance of meanings at one's disposal
a careless usage of the term easily slips in the context of an argument
» w . W. Ricfler, "Money Rates and Money Markets in the United States" (New York: Harper & Bros *
1930).
* At least one member of the Board regards any relation between growth in the money supply and growth
in gross national product as "erroneous." See the 49th Annual Report of the Board of Governors for the
year 1962, p. 71.
» P Tit man report, p. 246.
t See the answer of the Presidents of the Federal Reserve banks to question I of the questionnaire in the
appendix.
5
FEDERAL RESERVE'S APPROACH TO
POLICY
from one meaning to the other. But statements which hold for one
meaning of the term often do not hold for another.
The ambivalence surrounding the term "availability," typically
associated with money and credit in Federal Reserve discourse, is more
fundamental. It is a matching counterpart of the ambiguous term
"needs" occurring in statements assuring us that Federal Reserve
policy is concerned with the "accommodation of the needs of business."
Both terms are usually used in a context that ignores many of the
better validated portions of contemporary economics- In particular,
the terms are usually associated with notions that deny the relevant
operation of cost and yield factors, or prices and interest rates, as an
important element in market responses. Once we have recognized
the structure of such responses tne danger posed by a careless use
of the "needs-availability" terminology is quite apparent. The
persistent usage of these terms in the Federal Reserve's pronouncements reveals a confused undercurrent of notions, which could not
survive the persistent presence of a deliberate attitude to base policy
decisions on a coherent and critically examined frame; that is, on
validated theory.7
Discussion of the monetary process
Among the notions comprising the Federal Reserve's view some
emerge with great force and frequency. Foremost among these is
the central role attributed to bank indebtedness in the 1920's and to
free reserves or net reserve positions in more recent decades. The
clues provided in Federal Reserve statements and publications are
suflicient.lv definite to permit the development of a detailed analytical
framework capable of explicating a number of vague assertions that
have never been adequately developed or appraised.8 In particular,
it becomes possible to evaluate the assertion that free reserves have
only very short-run operationnl significance while total reserves have
a longer run significance for the monetary process. This statement
can be reconciled with other assertions that systematically associate
the rate of "credit expansion" with the prevailing level of free reserves.
The dominating influence of the free reserve notion of the monetary
process justifies a more detailed discussion. We will present, discuss,
and test the monetary framework that is centered on free reserves in
several chapters. At this stage our interest is in other features of
the Federal Reserve's conception.
Other items of the Federal Reserve's "idea bag" reveal quite clearly
the fragmented, unsupported nature of the views held by the policymaking officials. We have noted that the Federal Reserve authorities
acknowledged in the 1952 Pat mail report that the Board's most
important functions are "those affecting the money supply." This
view rationally requires understanding of the mechanism determining
the behavior of the money supply. Intelligent policy decisions
require a knowledge of the structure of monetary processes at least
7 The answers to question I provided by both the Board and the Presidents still operate with the old formula of "meds accommodation." {fee appendix.) Hut l>oth answer? also reveal a partial awareress of
thv Deration of relative prices: i.e., of appropriate cost and yield factor?, in the supply and allocation of
"credit." But there apjxarF no realization that Fuch awareness render? the "availability-nereis" er^inotation pnintle&O. Numerous references to "accommodation of needs'* occur also in the Federal KCM rve's
answer to question A.l published in the Patmnn report. The context definitely subtests to the reader that
the formula assumes meaning to the Federal Reserve authorities—but, this meaning is never revealed to
the uninitiated.
1 Onr forthcoming paper, "Evolving Federal Hesr rve, Conceptions of the Money Supply Process/' provides
an analytical underpinning for a number of assertions made in this study.
6
FEDERAL RESERVE'S
APPROACH TO
POLICY
sufficient to permit reliable expectations concerning the response of
the money supply to policy actions.
The Board was asked in the Patman report to discuss this essential
question and to state its view of the process by which changes in the
money supply are brought about. Specifically, they were asked to
"discuss tne factors that determine tne quantity of money." 9 The
answer shows little awareness or understanding of the money supply
mechanism. Among the opening sentences we find the assertion that
"the supply of money is responsive in the main to the needs of commerce, industry, agriculture, and government * * * and to the desire
of business and individuals to hold cash balances." The intrusion of
an "accommodation" and "needs" terminology renders the statement
ambivalent and obscure. But it does suggest a translation under
which the public's loan demand and money demand behavior dominate the behavior of the money supply. The remainder of the opening
passage in the Federal Reserve's answer offers no clarification. There
follows a passage of two pages of text under the subtitle "Factors
Affecting the Supply of Money." This passage is understood as an
attempt to elaborate the sentence quoted. We read in the opening
paragraph:
In general, the most important determinant of the aggregate supply of money is the lending or investing activity
of commercial banks, which itself reflects the current demand for credit by private and public borrowers, the public's
desire to hold cash balances, the available supply of bank
reserves and attitude of banks toward lending and investing.
The opening paragraph thus presents a classificatory listing of determining factors: (i) loan-demand, (ii) volume of reserves, (iii) the
banks' desired partition of total assets among cash assets and earning
assets, (iv) the public's desired stock of money.
Two more sections complete the Federal Reserve's description of
the "factors affecting the money supply." One deals with "bank
lending and the money supply" and describes some elementary textbook material exhibiting the connection between the assets and
liabilities of banks. Loan extension is showui to create new deposits
and loan-repayment to destroy deposits. The other section considers
"the influence of bank reserves." These reserves, together with the
public's demand for "credit" are introduced as factors shaping the
commercial banks' portfolio of earning assets. There follows a discussion of required reserves and reserve requirements in the manner of
an elementary textbook and finally an enumeration of "domestic and
international factors affecting the volume of reserves."
An elementary classification combined with an elementary discourse
in textbook style constitutes the Federal Reserve's w^hole answer to
a question that, according to its own previously stated idea, bears on
the basic functions it is supposed to perform. There is no indication
of the detailed nature of the "factors" listed, their behavior patterns,
how they operate in the money supply process and how their interaction determines the money stock. Moreover, it is impossible to
use the framework provided to analyze the response of the money
stock to open market operations, changes in the discount rate or
• Question 28, p. 388.
7
FEDERAL
RESERVE'S
APPROACH TO
POLICY
changes in reserve requirements.10 Furthermore, according to this
conception, variations in the public's division of money holdings
between currency and checking deposits play no significant role in the
money supply process. The events occurring in the last months of
1930, repeated in subsequent;years, and climaxing in March 1933 are
simply irrelevant from the* viewpoint of the Federal Reserve's
descriptions developed* in the Patman report.11
A more recent example may be drawn from the Board's answer to
the questionnaire appended to this study. Under part 6 of question I
we read:
Changes in the money supply result from the prevailing
posture of monetary policy as well as many other factors:
Among the most important of these other factors are the
economy's demands for bank credit, public preferences for
holding liquid assets in particular forms, and the incentives
for banks to make loans and purchase investments.
Again, all we obtain is a classificatory listing which could not possibly
yield any explanation of the responses to policy actions. As a listing
however, it is potentially superior to the previous listing. -The admission of the public's desire to hold liquid tissets in particular forms
could open the way to the* full realization of the importance in the
money supply process of the public's allocation of deposits between
demand and time accounts and of its allocation of payment money
between currency and demand deposits. But similar to the previous
listing, this statement furnishes a vague impression that the public's
"credit" demand and money demand dominate the determination of
the money stock. The discussion developed in later chapters will
show that an evaluation of this assertion in the context of an explicit
analytic frame yields no support for this view. On the contrary,
we will indicate that the accumulated evidence assigns a comparatively
small import to the public's demand for loans or credit and emphasizes
the weight of policy actions and the public'-s desired currency holdings
as the essential features in the monetary process.12
The leverage provided by fractional reserve reguirements
The previous section discussed some features of the Federal Reserve's understanding of the money supply process as a whole. One
topic that recurs frequently in Federal Reserve and textbook discussions of the process is the multiple expansion of bank deposits by the
banking system as a whole. The manner in which this issue is discussed furnishes additional evidence of the absence of a systematic
The second section contains a passage that appears on a casual reading to convey information about
some response patterns: "Since total reserve requirements of member banks actually average about 16
percent, member bank deposits can expand * * * by about 6 times the amount of any increase in bank
reserves." But closer reading should reveal the meagcrness of the information conveyed. It only asserts
that the deposit multiplier docs not exceed the reciprocal of aver age reserve requirements (stated as a decimal). The discussion in the text will subsequently resume this point.
n This is consistent with the Federal Reserve's "policy postures" during these events. The Federal
Reserve is prone to refer to "large" open market purchases mado during this period of the early thirties, but
seems oblivious to the fact that these purchases only modified, but did not offset, the dramatic deflationary
impact of the public's currency demand. It should also be noted that in the Federal Reserve's account of
past policies and monetary history, the effect of currency patterns on the monetary system is treated as
primarily a seasonal problem.
» The Board's answer to question X contains another passage that is noteworthy in the present context.
A fter mentioning a number of factors to l)e considered in evaluating "credit needs," the Board notes: "All of
these factors are weighed in arriving at judgments as to whether the credit needs of commerce and industry
are being met adequately * *
No doubt they are weighed. The important question is how they are
weighed. IIow can relevance be assigned to the weighing in the absence of a coherent, validated frame of
reference? How is it decided that some things are relatively important and others relatively unimportant?
28-046—64
3
8
FEDERAL RESERVE'S
APPROACH TO
POLICY
analysis of factors affecting the money supply. We consider the
question briefly here and return to it in a later chapter.
The reciprocal of the member banks' average reserve requirements
is used by the Federal Reserve authorities as an indicator of the order
of magnitude of tire System's response to open market operations or
changes in reserve requirements. The Federal Reserve's linguistic
practices are rather ambiguous on this issue. It rarely is very clear
whet her the reciprocal mentioned indicat es only the maximal response
possible in a given environment, or whether it indicates the response
reasonably to be expected.13 Both versions occur. The second
version was encountered frequently in oral discussions with Federal
Reserve officials.
The ill'st version is rather innocuous. One may easily accept it,
and even grant that it does convey some meager information. It is
not an empty formula; it excludes possible response patterns from
practical consideration. But the meagerness of the information, that
makes discussion very safe, also renders it almost useless as a guide for
policy decisions. From a policy standpoint, it is important to know
now much the money supply is likely to expand in response to open
market operations. I'nless the maximal response is regarded as likely
to occur, the knowledge that it is the reciprocal of the average reserve
requirements is not very helpful an indicator of the expected changein the supply of money.
We submit that the actual response of the money supply to variations in reserve requirements and open market operations can be
reliably ascertained with sufficient precision tq yield valuable information for policy purposes. The Federal Reserve authorities have ample
resources at their disposal to improve their knowledge on this important issue. If they direct their research staff to supply a firmer
foundation for policy decisions, they will appreciate that the weight
of evidence renders the estimates of a sixfold or sevenfold expansion 14
quite unreasonable. Our studies suggest that the appropriate multiplier for policy operations is no more than one-half the size of the
multiplier suggested.
The concentration of Federal Reserve attention on the reciprocal
of average reserve requirements as an "indicator" of the response of
the monetary system to policy actions is closely allied to the kind of
currency patterns recognized and discussed. A disregard or denial
of the public's desire to allocate assets between currency, demand,
and time deposits leads to the omission of these factors when considering the magnitude of the response of the money supply to changes
in policy action. The principal remaining factor, the average reserve
position of the banking system, is then treated as the only factor
worthy of consideration.
The position of the Board with respect to currency patterns is
quite clear.
The forms in which the aggregate money supply is held
reflect the preferences and conveniences of individuals and
businesses, and althcjii^ji^S^ffect materially the structure
J* An example with
In the "Reply of William McC. Martin, Jr."
Patman Iw-.-tfinp. pp. 3SH-34I.
second version can be found in an article by W.
KlcP.or. "<U* n M:irkft OP^HOTK in Uifif^niS,
Federal Reserve Bulletin, vol. 44, No. ltr
pp. \'m-V2~<\ footnote 2. it idler «*vatuMes thefttffrurt$t$ben market operations on interest rates.
context of hi* arpinw nt, the rvdfiroqal of average resetvfe.requirements is used to measure the response that
typiciliy oecrirs.
llii'ttcr, lUd.
In the
9
FEDERAL
RESERVE'S
APPROACH TO
POLICY
and operations of our financial institutions; tliey do not
ordinarily have great significance from the standpoint of the
adequacy of the overall supply of money.15
A statement of more recent vintage reaffirms the Board's view. Part
5 of the Board's answer to question I (see appendix) elaborates on
the role of currency in the monetary mechanism. The only references
are to seasonal fluctuations and "secular growth." One may easily
grant the Board's fullest awareness of random flows of currency
between the public and the banks. But there appear no clues to
signal an awareness that the public's division of money balances
between currency and checking deposits is neither accidental nor a
purely seasonal process. Most importantly, there is no awareness of
the cyclical component in the public's currency behavior. Nor is
there recognition that the currency patterns have (1) persistently and
quite decisively contributed to shape the cyclic behavior of the
money supply, (2) that in the early thirties, and (3) again in the early
postwar period, these currency patterns dominated the behavior of
the money supply.
Finally, the Federal Reserve's usage of the reciprocal of average
reserve requirements as an "indicator" of system response, combined
with its truncated yiewrs about the currency patterns, prevent any
recognition of the important role of "currency spillovers." Such
spillovers of currency to the public occur as typical and persistent
features of the response mechanism triggered by changes in reserve
requirements and open-market operations. And these spillovers are
a major reason why the response of the money supply to open-market
operations (or changes in reserve requirements) has been on the average
less than 50 percent of the reciprocal of average reserve requirements.16
We could go on to discuss other features of the general Federal
Reserve conception and furnish additional support for the view that
the Federal Reserve has failed to develop a clear or systematic understanding of the money supply mechanism. But such discussion raises,
but does not answer, fundamental questions about the system. Why
has the Federal Reserve failed to develop a coherent notion of the
monetary process? Why does its knowledge of the response of the
money supply to policy operations remain inchoate? Why has the
Federal Reserve, aided by its large research staff, failed to recognize
the importance of detailed evaluations of the notions that guide its
policies?
SOME
REASONS
FOR T H E S Y S T E M ' S F A I L U R E
MECHANISM
TO U N D E R S T A N D
THE
An explanation for the absence of deliberate and systematic evaluation of the monetary mechanism by the Federal Reserve is not hard
to find. TWTO factors appear to be of paramount importance: ( 1 )
The Federal Reserve is organized and operated in a way that places
overriding importance ana focuses principal attention on week-toweek, day-to-day, and even hour-to-hour changes in the money and
securities markets, (2) the viewpoint of the System is frequently that
of an individual banker rather than that of a regulating authority for
the monetary system and for the economy as a whole. This attitude
" Patman report, p. 338.
,
lt
« The problems arising from failure to incorporate the public's desired holdings of currency In the money
supply mechanism will be discussed in ch. 6.
10
FEDERAL
RESERVE'S
APPROACH TO
POLICY
is reflected in a number of prevailing views; e.g., the System's explanation of the effect of member bank borrowing, the concern with essentially random and often self-reversing changes in the money market,
the importance attached to daily changes in reserve position, the
concern about temporary redistributions of reserves from one class of
banks to another, and similar features that pervade and shape the
System's policies.
These statements should not suggest that there is no concern or
interest in longer range problems. On the contrary, we will later
detail the excellent record of the Federal Open Market Committee in
recognizing changes in economic conditions in the postwar period.
But we will present evidence to support the view that the absence of
an explanation of the behavior of the money supply and its response
to Federal Reserve policy often prevents the System from taking
appropriate action to reverse the inflationary or deflationary forces
that it so clearly recognizes.
The Federal Reserve is an organization and like many other organizations it is. likely to devote attention to those tasks that must be
done within a particular time period. In the pressure to solve dayto-day operating problems, extensive research into the monetary
mechanism has been given low priority. Moreover, the efforts of the
research staff have been focused principally on those tasks that are
of concern for the solution of operating problems, e.g., the development of procedures to more accurately estimate daily float or the
demand for currency on holidays.17 Again, like other organizations
"Gresham's law of planning" has been operative: Concern with
daily routine has driven out longer range research activity.18
Concern with daily operations
No clearer illustration of this point can be found than Roosa's
description of the work of the trading desk at the Federal Reserve
Bank of New York.19 A distinction is made between ''defensive" and
"dynamic" operations. The former are concerned with the "avoidance of mechanical disturbances"; the latter are a means of promoting
"economic growth within a pattern of sustained stability." 20 To
accomplish the former, there must be projections of daily float, conferences with the Treasury about the actual or projected balance,
during the next few days, discussions with commercial bankers^
dealers in Government securities and Federal funds about movements
of money into and out of New York, and a host of similar facts about
currency, bank positions, etc.
In marked contrast, we are told almost nothing about the "dynamic" operations other than that somehow they "emerge from the
day's confusion as a dominating force * * * that it has long since become second nature to the operating personnel to handle each with its
defensive and its dynamic aspects joined together." 21 We are not
told clearly what emerges, but the context suggests that some measure
of reserves has been kept within a desired range. We are never told
1T Cf. "Bonk Reserves: Some Major Factors A fleeting Them" (New York: Federal Reserve Bank of
New York, 1953). This is not to suggest that the Federal Reserve should not be concerned at all with shortrange problems, but that the Federal Reserve research staff has focused almost exclusively on such problems*
» March, J. O. and Herbert A. Simon, "Organizations" (New York: John Wiley & Sons. 1958) p 185
V. Roosa, "Federal Reserve Operations in the Money and Government Securities Market" (New
York: Federal Reserve Bank of New York, 1956). See also the statement of R. G. Rouse in "Review of the
ArmualReport of the Federal Reserve System for the Year I960," hearing before the Joint Economic Committee (W ashington: U.S. Government Printing Office, 1961, p. 7).
^
so Ibid., p. 105.
»Ibid., p. 105.
11
FEDERAL
RESERVE'S
APPROACH TO
POLICY
how the System judges the adequacy of the growth of the money
supply, if indeed that judgment is made.
Although the words "dynamic" and "defensive" are not used, the
published reports of the meetings of the Federal Open Market Committee (FOMC) reflect much the same spirit. Unlike the trading
desk, the FOMC does consider the operation of longer term factors.
However, much of the discussion centers on the problems of extremely
short run variations and the need for "defensive" operations to counteract taxpayments, float, gold and currency drains. Decisions are
made about operations for the next few weeks and are taken relative
to the position of the monetary system and money market during the
preceding 3 weeks. Very little discussion is devoted to the longer term
prospects of the economy and even less attention is apparently paid to
the specific monetary actions that could achieve a higher level of'
employment and real income at the end of a given 6-month or 1-year
period.
The reasons for the absence of discussion and plans to implement
a longer range monetary policy are probably varied. But the undeveloped state of knowledge about the relation of money to the pace
of economic activity and the relation of Federal Reserve policy to the
behavior of the money stock contributes to the neglect of longer range
policy. If there is no estimate of the magnitude and tuning of
changes in the money supply in response to open-market operations
or changes in reserve, requirements, there can be no fruitful discussion
of the desired policy actions'over any sustained period.
Thus policy decisions are made with a very short-run focus. The
bulk of Federal Reserve operations are conducted to adjust the reserve
positions of banks to temporary'market conditions. In the process,
policy changes are introduced. But there is no mechanism presently
in use that attempts to make certain that the sum of all of the
changes—the "defensive" plus the "dynamic" changes—will produce
the desired supply of money or anything closely approximating that
sum.
However complex the relation that connects bank reserves with
the supply of money, m o n e t a r y policy must be predicated on the notion
that changes in reserves do produce changes in tbe stock of money.
Whether the changes in reserves arise because of "defensive" or
"dynamic" operations is not the issue. A change in reserves, whatever name or reason is attached to it, altera an important determinant
of the money supply. The result of the almost continuous variation
in the rate of change of the reserve base is reflected in an almost
continuous variation in the rate of change in the stock of money.
Some of these variations are of course seasonal and reflect the conscious policy of reducing seasonal variations in interest rates by
introducing seasonal variations in the reserve base. But one need
only study the month-to-month changes in the stock of money or in
the stock of credit to become convinced that month-to-month variations reflect more than seasonal adjustments.
Table II—1 displays the variations that have occurred in the rate of
change of some selected money and credit magnitudes. The information is divided into the 108 monthly changes during periods when the
economy was moving from a recession trough to a peak of prosperity
and the 46 monthly changes from peak to trough. The dating of
peaks and troughs follows that of the National Bureau of Economic
12
FEDERAL RESERVE'S
APPROACH TO
POLICY
Research and begins with the peak in November 1948. The measure
that we have selected to summarize variability, the coefficient of
variation, is commonly used for this purpose. Its meaning can be
made clear quite easily. If the change in money or credit is approximately the same from month to month, the coefficient of variation will
be quite small, almost zero. But if the changes in money and credit
during periods of recession or periods of recovery are made up of a
series of alternating positive and negative (or large and small changes),
the coefficient of variation will be quite large. If the number is larger
than 1, the month-to-month variations are larger than the average
monthly change.
TABLE II-L.—Measures of variation in the rate of growth of money and credit during
postwar cycles
Item
Monthly change In money supply
Monthly change in member bank loans and investments
Monthly percent change in money supply
Monthly percent change in member bank loans and investments.
Monthly change in money supply plus time deposits..
Monthly average value of free
reserves
-
The statistics in the table tell us something about the variability
of the money supply (demand deposits and currency) and member
bank credit (loans and investments of member banks). For comparative purposes, we have provided a similar measure for the level of free
reserves, one of the primary tools of System policy as we shall note
later in this study. It appears that the level of free reserves has
substantially less variation during periods of recession or declining
activity and substantially greater variation than the other measures
during periods of recovery or rising economic activity. There seems
to be little correspondence between the variability of the level of fre$
reserves and the variability of the measures of money and credit.
Before accepting the above conclusion, we must look behind the
statistical data and consider the economic behavior that they reflect.
First, the monetary mechanism does not operate without lags. The
market response, that is initiated today, based on a misinterpretation
of Federal Reserve policy, is not completely reversed in the.following
week when the weekly Federal Reserve statement suggests that the
action that the market interpreted as a "dynamic" change last week
was really "defensive." The "defensive reserves" that are supplied
to the market pass out of the hands of the initial recipients and may
lead to increases in the supply of money or the stock of credit despite
the fact that some "defensive" action has restored free reserves to
approximately the level prevailing several weeks earlier. Time is
required for the money supply to fall to its previous level. Second,
perceived changes in System policy have some effects on the desired
composition of bank assets between loans and investments. Experienced bankers, suspecting that they observe a change in System
policy, may attempt to shorten or lengthen the average maturity of
their investments, thus inducing changes in interest rates. These in
13
FEDERAL
RESERVE'S
APPROACH TO
POLICY
turn alter the rate of change of the money supply.22 Third, changes
in bank reserves are often used to repay borrowing from Federal
Kcserve banks during periods of recession or declining activity. This
tends to dampen month-to-month variations in the level of free
reserves. During periods of rising activity, banks borrow to replace
some of the reserves that are withdrawn through open market operations. The Federal Reserve may introduce additional variability by
attempting to offset the borrowings of member banks. Finally, the
level of free reserves for all member banks has been positive in both
downswings and upswings, but it is larger in downswings than in
upswings. This accounts for much of the difference in the two coefficients of variation for free reserves.
Whatever the reason for the differences in variability, it seems clear
that the rates of change in the mone3T supply and in the level of bank
credit are highly variable* Moreover, the rate of change of the
money suppl}T is the more variable of the two in periods of downswing,
while the opposite is true in periods of rising economic activity. This
difference in the behavior of the two stocks cannot be explained with
the information that has been introduced thus far, but it will be of
concern in a later chapter.
However, one important reason for the difference is worth noting.
The measure of member bank credit chosen rises on the average at a
greater rate in months of declining activity than in months of recovery; the money suppl}' behaves in precisely the opposite manner.23
Indeed the monthly increase in the money supply is almost twice as
large during periods of postwar recovery-than in periods of postwar
recession. But the monthly change in member bank credit is almost
50 percent larger on the average in the months of recession than in the
months of recovery. This striking difference in behavior will be of
importance in distinguishing between the credit and the money
doctrine.
The Jeel oj the market
The Federal Reserve's discussion of current developments on the
credit markets typically refers to the "feel" and "tone" of the market.
These entities seem to supply the guiding rationale for many decisions.
"Defensive" and "dynamic" actions are said to be welded into a
coherent pattern in response to the "feel" of the market. Indeed,
Roosa tells us that "the trading desk and the money market are
operating largely on the basis of * * * the 'feel' of each day's
24
market * *
Much the same impression about the importance
of "feel" is obtained from the statements of the 12 Federal Reserve
bank Presidents; e.g., in their reply to question II in the appendix.
The primary reliance on "feel" is something of a retrogression in
Federal Reserve operations. Burgess, writing in 1936, conveys the
impression that observable market forces are more important than
"feel."
a The first two reasons are generally recojrtmed. Indeed spokesmen for the System hn.ve used them as
a major reason for justifying the use of dealer repurchase agreements. For example, cf.t Roosa, op. cit.,
pp. 8,Vf?f,.
n The fact that we have used loans and investments for member banks rather than for all commercial
hanks is not the major source of the difference in rates of growth of bank credit, and money. It cm
shown
that the difference between the rate of growth of money and of member bank loans and investments has depended principally on variations in currency. Treasury deposits, and foreign balances.
J>ata on the average monthly changes are presented in fable 11-2. See page 33.
u Tioosa. op. eit. p. 104. See also p. '65 and pp. 75-79. On p. 79 Roosa tells us that "the 'feel' of each day's
situation provides the final nut to action or inaction" in the sense that they modify the information obained
from the statistical projections. The italics have been added to convey our interpretation that "feel" is
dominant over other factors.
14
FEDERAL
RESERVE'S
APPROACH TO
POLICY
If one could set up a balance sheet for the banks in New
York City as a whole * * * a summary of the balance
sheets on "the desks of the executives in the principal banks,
one would know from hour to hour and from day to day the
principle forces which were moving in the money market.25
It should be noted that Burgess, like Roosa, places heavy emphasis
on the importance of "hour-to-hour and day-to-day" changes in the
money market. The difference between them is not about the
importance of "defensive" operations, but about the information that
is most useful for decisionmaking. There appears to be unanimity
among writers experienced in the operations of the System that
extremely short-run operations both should, and do, receive more
attention than the longer run considerations.
Reliance on "tone" or "feel" of the money market as a guide to
Svstem policy are also an important base for decisions at the Federal
Open Market Committee meetings. References to these entities
are an integral part of the discussion that is said to give an indication
of the thinking of the Committee members and to assist the Manager
in interpreting a directive that is typically vague. Not all of the
background suggestions are in terms of "tone" or "feel," but it is not
uncommon for particular FOMC members to advise the Manager to
maintain about the same "tone" that prevailed in the preceding 3
weeks.26 This may help to explain the emphasis that is placed on
"feel" in the Roosa booklet. The management of the System's
account in effect may be assuring the FOMC members that their
instructions are being carried out. But the broader issue is the
question: Are instructions about "tone" or "feel" helpful?
It is surely passible and it may even be correct to argue that the
factors determining the stock of money, or credit, or the degree of
ease and restraint are so complex that; despite Burgess, no single
factor or set of factors can describe the "tone" or "feel" of the market.
Further, any appropriate measure of "tone" may be temporary; the
measure may have to change from week to week, or from year to
year. Dailv judgments mav be the only appropriate guide to policy.
Yhis in essence is the position taken by some members of the F O M C /
Our interpretation of the answers of the 12 Presidents, and our interviews with some members of the FOMC, suggest that this is an
important prevailing view.
Whatever the factors determining the degree of ease or restraint,
most students would agree that ease and restraint change. What is
involved is a much more fundamental point: Can the FOMC guide
the Manager of the System open market account in deciding the
degree of ease or restraint that should prevail at a particular time or
over a particular period? Reference to "tone" or "feel" without any
clear indication of the meaning attached to these words cannot serve
as a guide. The Manager must make a judgment about what the
Committee members had in mind if he is to follow the advice of the
members. This means that the Manager is left with the crucially
important job of determining the appropriate policy, perhaps by
correctly translating FOMC statements into statements about
observable entities. Why? Because there exists no market countern W. R. Burgee, Tht Ftsft* Banks and tht Money Market (New York: Harper & Bros . 1036). p. 186.
8<wal*op. 192.
» Set the t m paragraph of the reply of the 12 Presidents to question II, pt. 1.
15
FEDERAL
RESERVE'S
APPROACH TO
POLICY
part that can be bought or sold that is called "tone." There are
interest rates, securities, bank reserves, etc. Actual policymaking
must operate in these or similar terms.
The position of the 12 Presidents is that the Manager knows what
they mean because he has participated in the discussion, heard their
remarks, and understood the interpretations. Moreover, the argument runs, the reference to "tone" or "feel" occurs in the context of a
particular set of events. Reference is made to the action taken in the
past 3 weeks or in some prior period. Thus the Manager knows the
meaning attached to "tone."
This argument is misleading. Further, it places responsibility on
the Manager or on those members of the FOMC who are willing to
offer guidelines to the Manager in terms of observable market phenomena or on those whose views are given greater weight by the
Manager. Since we will shortly see that the discussion at the FOMC
does not give a clear interpretation of the directive and may often
give a series of conflicting goals, decisions are in fact left to the Manager to a much larger extent than has been suggested in official or
semiofficial statements.
The inherent obscurity of the entities denoted by "feel" and
"tone" renders any judgment about these entities very dubious.
It is difficult to determine the direction of change or to challenge
a statement that the "tone" has become "firmer." Even the consensus of a group of "experience men" adds little if Congress and
the public cannot appraise the validity of the consensus. In practice
one member of the FOMC may suggest that the Manager has not
maintained the "tone" during the past few weeks. He interprets
all of the changes that have taken place as a different "tone"; another
member will disagree; he interprets the "tone" as substantially the
same. Coupled with the fact, discussed more fully below, that the
suggestions to the Manager may conflict when the attempt is made
to apply them, much discretion is left to the Manager. This is
particularly the case if the Manager is the one who interprets the
"tone." Even the use of regular morning conferences between
FOMC members and the Manager does not eliminate the exercise
of discretion by the Manager.27
The foregoing should not suggest that the grant of discretion to the
Manager is necessarily evil. Our concern here is with the reasoning
that gives rise to the allocation of authority and with the correction of
possibly misleading impressions that may have been obtained from
official or semiofficial statements. We believe that the primary reason
f or the prevailing system is the emphasis placed on extremely shorte n considerations—the emphasis placed throughout the Federal
Reserve on "defensive" operations. An explanation of some reasons
jor this concern is the subject of a following section. But is should
ge noted that even if short-run problems are important, it does not
the testimony of Mr. Alfred Hayes, President of the Federal Reserve Bank of New York: "We
rt/f3
Z ^ ^ h a decision that we are going to go out and buy such and such an issue. W e reach a decis on
SSJV?
to try to maintain a certain degree of pressure, a certain general atmosphere of restraint
ease * * *
• w„« _.. i
„ A^i^t™ «« t^rmo nfflpt.ua! rnirrnases or sales.
ine
thVVri ^ 0 U i d say that it is a compound of all kinds of impressions that you get from the volume of traarng,
}Je speed of tradine what Is hanwaitae to prior* • * VT [Italic added.] Review of the Annual Report
R^rVrSysteiX
before the Joint Economic Committee {WashUSGPO, 1961) p M gee a so the testimony of Mr. Robert Rouse, former Manager of the System
teAarket
Account; ibid.', p ^ 7 a n d 3 L Since it is the Manager who is "sitting at the trading desk/'
«the Manager who>interprets
interpretsthe
t tone and decides whether or not action is required.
2S-046—64
1
16
FEDERAL RESERVE'S APPROACH TO
POLICY
necessarily follow that a major policymaking body, the FOMC,
must be concerned with these details. One alternative would be
the explicit delegation of authority for extremely short-run operations to the Manager. This would help to overcome the effect of
"Gresham's law of planning." The FOMC would then be free to
focus on the longer range problems of monetary policy embodied in
the goals of the Employment Act.
A suggested interpretation of jeel and tone
Emphasis on "feel" and " t o n e " result from the very short time
horizon considered by Federal Reserve policymakers. These entities
appear to designate phenomena that become important because of
the choice of time period; that is, because of the overconcentration
on daily or hourly events. If a longer time horizon is taken, the
relative importance of these entities duninishes or vanishes.
Fluctuations in bank reserve positions and the related variability
in the Federal funds market can be looked upon as a series of events
that respond to systematic market forces. Mingled with these systematic events are occurrences that are primarily random or chance
events. If a particular buyer wishes to purchase or sell $20 million
in long-term Government bonds, bond prices will change temporarily.
If the calendar requires that all member banks settle their reserve
deficiences on the date of a Treasury new issue, the Federal funds
market, the market for governments, and the Federal Reserve wire
service are all taxed to handle the existing situation. Market professionals do not interpret price changes that occur at such times as
meaningful indicators of the prices that are likely to occur on the
next day or during the next week. Such price changes are essentially
random events.
The random component in the observations summarizing reserve
positions and the Federal funds market is often such a large part of
the total situation that it is quite difficult to separate random and
systematic events. This is particularly true if we look at daily and
hourly observations. As the time horizon lengthens, the relative
importance of random events dwindles. The systematic component
dominates the observations in the longer run. But the managers of
the banks' money positions, bill traders, and the Manager of the
System Open Market Account must make judgments based upon the
changes that are occurring almost continuously. They must read the
clues and indicators to infer the nature of the events observed. In
our terminology, they must separate the random from the systematic;
that is, they must decide whether the market is moving to a new level
or is fluctuating around its old level in response to a series of chance
events. The interpretation reached by the market professionals
decisively affects the portfolio decisions made at the commercial banks
and at the Federal Reserve bank.
There is no doubt that most of the men making these decisions are
extremely capable professionals who grasp the essential features of
the evolving situation and translate them into a decision or a series
of decisions. But they are rarely required to articulate the procedures that they use to separate the random from the systematic.
It is sufficient for the bank that they respond appropriately to the
hourly and daily perturbations and that they do not make frequent,
17
FEDERAL RESERVE'S APPROACH TO POLICY
serious misjudgments. The successful discharge of their functions
does not generate any pressure, therefore, to channel attention toward
an explicit analvsis of the random process or to articulate the resulting
information. I'he terms "tone" and "feel" emerge in this context
to convey a total impression, on a comparatively inarticulate and
nonanalytic level, of the concatenation of random and systematic
events. The term "feel" is used to suggest the complex set of clues
and behavior indicators observed by market professionals in forming
their judgments about the relative importance of systematic and
random elements. The term "tone" might usefully refer to the
systematic position underlying the total market situation.
These considerations can also be applied to the market for Government securities. Changes in demand and supply conditions emanate
from both s\'stematic and random sources. In either case, the shifting market conditions disrupt established market patterns and create
a situation that requires adjustments in the prevailing prices. But
no market adjusts instantaneously. Time must elapse before
information filters through the market. Resources, particularly the
labor of skilled professionals, must be used to assess this information.
"Discontinuities" in pricing, mostly of minor proportion, emerge in
the period of market adjustment. For example, dealers may "shop
the market" for a particular issue and thereby generate slight
changes in the existing prices. Market participants watch the pattern of evolving "discontinuities," combine this information with
other clues about the condition of the securities markets to interpret
the meaning of the observations. The interpretation made determines the kind of action subsequently taken. Again, "feel" summarizes the clues justifying the given interpretation, and "tone"
refers to the central, systematic position of the ever-changing situation.
The "feel" and "tone" terminology can thus be explained as a
nonanalytic response to a situation tvpically containing a large
random element. Such situations regularly confront the Manager
of the System Open Market Account. He deals directly on the
securities market and is exposed to the continuous impact of signals
that require an evaluation. His preoccupation with "defensive"
operations puts him in much the same position as the money deskmen
or the bill traders. The very nature of "defensive" operations imposes on the Manager the same judgments and decisions; namely, to
separate systematic and random events in the total situation.
If one accepts "defensive" operations as a part of monetary policy,
it would appear useful to grant general authority to the account
manager to engage in such operations. Such authority should be
combined with the responsibility to report regularly to the FOMC
on the scope of these operations and their relation to the "dynamic
operations. The grant of authority would not radically change
prevailing practice, but it might contribute to the removal of lengthy
discussions about temporary changes in market conditions, float
currency drains, et cetera, from the meetings of the FOMC. And it
would direct attention toward what is perhaps the greatest single
weakness in the present operation—the failure to develop an adequate
18
FEDERAL
RESERVE'S
APPROACH
TO
POLICY
understanding of the relation between operations affecting bank
reserves and changes in the stock of money .2S
A
BANKER
VIEW
OP
OPERATIONS
We suggested earlier that a second major reason for the failure
of the System to develop an adequate understanding of the monetary
mechanism was the System's frequent use of a banker's view of
monetary processes. In this section, we will discuss the issue in
more detail, particularly as it relates to the Federal Reserve's discussion of "liquidity" and to the question of money versus credit
as a measure of monetary policy. These subjects will be considered
in the light of the statements that have been made in Federal Reserve
publications. Before doing so, however, it should be noted that our
contention regarding the Federal Reserve's tendency to operate in the
manner of a single bank does not affect all of its operations. For
example, it seems clear that the Federal Reserve does not attempt to
maximize net income.29
The concept of liquidity
The deposits and the reserve position of an individual bank fluctuate
greatly from day to day. Withdrawals of deposits in the form of
currency, the failure of checks drawn by the bank's depositors to be
perfectly matched by checks deposited in the bank, and other factors
contribute to the variations in the reserve position of a particular
bank. An important duty of the management of the bank is to
smooth the fluctuations in reserve position by borrowing reserves
through the Federal funds market or from the Federal Reserve
banks when the reserve position is deficient, by lending reserves or
repaying indebtedness when the bank holds reserves in excess of the
amount that is required and desired.
The prevailing arrangements require that a member bank, classified
as a Reserve city bank or Central Reserve city bank, must have on
hand each Wednesday at the close of business, an amount of reserves
equal to a fixed proportion of the level of deposits held on the average
at the opening of business on each day of the preceding week. For
country member banks, a biweekly period is used for computation of
the average of reserves and deposits. The end of the weekly or biweekly period is referred to as the "settlement day." Saturdays,
Sundays, and holidays are included in the computation of the average
reserves and deposits; i.e., the average is computed for a 7-day period
in the case of Reserve city or Central Reserve city banks. Penalties
may be charged if a bank fails to meet these requirements, and penalties
have, in fact, been collected from some banks. However, a bank
may fail to meet its required reserves on a particular settlement day
by 2 percent of the amount of required reserves without penalty.
But it may not use this option at two successive settlement dates.30
J?*
i S S f f f * 5°Ucy
fltenc^ppl?edT°re
and some detailed evidence to support it see Clark Warburton, "Monetary DifMonetary System" Journal of Finance, 1952.
* * The great errors in
tbe United States since establishment of the Federal Reserve System srcm to me to
inad€guate
economic
information and analysis than to any other single factor," p. M4.
c o n c c r n w i t h overall objectives-employment income, and prices.
^x^J^K
To
tJ if f F e d e r ^ Reserve must operate through monetafy policy.
Improvement in operat e s should have a salutary effect on achievement of goals.
» See the discussion of the use of open market operations in lieu of reductions in reserve requirements as
tbe
4<Revie^f
S The
Annual R e p S r t / ' o p . d t f p
tO aUmeSber b ^ k s 1 1 5
** * tennS 0 f ™ k l y E l e m e n t s , but the general principles * f f l apply
19
FEDERAL
RESERVE'S APPROACH TO POLICY
Purchases and sales of Federal funds are a means by which individual banks that have surplus reserves can attain a more fully
invested position and higher earnings. Their willingness to do so
permits the existing volume of reserves to be distributed in such a
way that banks with actual or expected reserve deficiencies positions
can acquire reserves to cover their shortage. But the willingness to
sell or buy reserves depends upon the price prevailing in the Federal
funds market relative to the prices prevailing on other assets that the
individual bank can buy or sell to reduce its surplus reserves or to
eliminate the deficiency. It is not necessary to have access to the
Federal funds market to redistribute reserves. Redistribution can
be—and is—accomplished by the sale of assets, e.g., Treasury bills,
by banks witli reserve deficiencies. For example, a bank with a
short reserve position can sell bills to a securities dealer. The dealer
may then borrow from a bank with a temporary surplus. Such
transactions are generally made in Federal funds and accomplish
the redistribution in much the same waj- as a direct purchase and
sale in the Federal funds market,
The choice between using the Federal funds market or the bill
market depends upon several factors: (1) the cost of making transactions, (2) the time expected to elapse before the banker plans to
reverse the transaction, (3) the prevailing market interest rates on
Federal funds and Treasury bills, (4) the amount of securities that the
banker holds above those required as collateral for Government
deposits and actual or expected borrowing from the Federal Reserve
bank, and (5) the supply of Federal funds, particularly when the
Federal funds rate is at the discount rate. Thus a bank that expects
the reserve deficiency to be a 1- or 2-day problem will prefer to purchase Federal funds rather than sell Treasury bills, unless the Treasury
bill rate is substantially below the Federal funds rate. The cost of
buying and selling Treasury bills, if bill rates remain unchanged, is
approximately four basis points. This difference generally prevails
between dealer buying and selling prices. Even if the administrative
costs of buying arid selling bills are the same as the costs of buying
and selling Federal funds, it is cheaper for the bank to pay the prevailing Federal funds rate rather than to lose the interest on the
Treasury bill and pay the difference between bid and asked prices.
If the reserve deficiency is expected to persist for a period of weeks
(i.e., the change has been judged to be systematic) there are continuing costs of renewing the Federal funds transaction. These cost
and yield factors are reflected in the choices made by individual banks
concerning the method used to adjust their reserve position.
Cost and yield considerations are reflected in another way. A bank
lacing a given expected loss of reserves during the course of the week
^an elect to wait until late in the settlement period to acquire reserves.
If yields on assets are comparatively high, many banks will prefer to
wait as long as possible before acquiring reserves, i.e., to take a larger
chance that thev will be required to borrow from their Reserve bank or
on the Federal funds market. Under the stated conditions, fewer
banks will have surplus reserves, and those that do will hold smaller
amounts. Bankers will attempt to squeeze just a few more incomeyielding assets into their portfolios as the prevailing rates. Given the
many random factors affecting the reserve position, more banks will be
running the risk of a deficient reserve position near the end of the
20
FEDERAL
RESERVE'S
APPROACH
TO
POLICY
settlement period. Fewer bunks will have Federal funds for sale and
the amounts offered will be smaller. At such times more banks will
desire to buv Federal funds in order to retain their invested positions.
The Federal funds rate will rise, but the discount rate sets a ceiling
above which bankers are unwilling to purchase Federal funds.
More
banks borrow at the Federal Reserve to maintain their portfolio
positions.
, , 1 1
1
Larger banks are usually more fully invested than smaller banks and
may even speculate on the Federal funds rate during the reserve
computation period. Excess reserves of larger banks are substantially
less per dollar of deposits than excess reserves of s m a l l e r banks.
Larger banks rely to a major extent on rapid readjustments in their
portfolio of short-term assets or liabilities to cover deficiencies in
reserve position arising from the granting of loans, the movements of
deposits, and the purchase of securities. Several reasons account for
these differences in reserve patterns between larger and smaller banks.
But the comparatively low marginal cost per dollar of transaction of
the larger bank's operations on the short-term markets appears to
be an important reason. Smaller banks substitute larger holdings of
excess reserves for an allocation of high-priced resources (skilled
professional managers) to produce the rapid rescheduling and reshuffling of short-term portfolios required by a more tightly adjusted
reserve position.
Monthly average free reserves for Central Reserve and Reserve
city banks are generally negative. For the entire 14-year period,
1949-62, the average of monthly borrowings by all such banks lias
been larger than their average measured excess reserves. On the
average, therefore, these banks as a group, borrowed from the Reserve
banks to make their reserve settlement during the 14-year period.
Statistics for country banks show that measured excess reserves
exceed borrowings on the average for the period. Indeed, reported
monthly free reserves of country banks have not been negative during
the entire postwar period. The monthly average free reserves of
country banks were approximately S400 million during 1949-62.
Again, operation of cost-and-yield factors helps to explain the behavior
of individual banks that the statistics reflect. Federal funds transactions and Treasury bill purchases are generally made for a minimum of
$1 million. Smaller banks may frequently find the standard lot beyond the scale of their surplus reserves. Furthermore, when opportunities for small lot transactions emerge, the associated return is
quite small. At a 3-percent Federal funds rate, a $100,000 sale
would yield a gross income of $8.33 per day to the seller. At this
point the marginal return of the transaction mav not cover the
marginal cost. Legal restrictions on loans to individual borrowers
limit the amount of Federal funds that a small bank can sell to a
single buyer without collateral. The preparation of collateral in
order to avoid these restrictions substantially increases the cost to
buyer and seller of making the transaction. " Nevertheless, there is
substantial cyclical variability in the free reserves of country banks.
the S S I S S S ^ J S I h a v e su( J} c l erit collateral on deposit at a Federal Keserve bank to borrow
Si
S S f S J 0 l L s u c h
occasions some banks have paid one-eighth
thI
1 3 m f e ^ ^ S S n n J ® £ r F e d e K1 f \ m d s ' , T h e additional cost for 1 day is probably less than
b a n k ' P art , ic , ul , arly ^ the bank and the Reserve bank an-, not
W e d i ^
S ^ bmkpr o S v i n 0 f
\he r e c o r ; T s o f dal *y Price ranges supplied by the leading Federal
nrnas broker, Uarvm, Bantel <5i Co., reveals very few examples in the 15 years, 194*^62.
52252
FEDERAL
RESERVE'S
APPROACH
TO
POLICY
21
When interest rates on Treasury bills and Federal funds are high, the
free reserves of country banks become relatively small. In fact,
weekly free reserves of country banks have been negative during
periods of relatively high bill yields, as in 1959.
Neither an individual bank, nor the banking system as a whole can
create reserves. That is a privilege granted by Congress to the Federal Reserve System as an exclusive right. Individual banks can and
do distribute the available reserves among themselves. The extent
to which the redistribution takes place reflects the operation of costand-yield factors as they affect- individual banks and bankers.
The foregoing discussion can be summarized by saying that banks
have a demand function for cash assets or reserves that is dependent
on cost-and-vield factors. At any particular point in time, the measured amount of excess reserves that an individual bank holds reflects
the expectations of the banker about forthcoming reserve drains and
the relation of the costs to the revenues that will accrue if more assets
are acquired and more reserves are lost through the clearing mechanism.32
We have perhaps belabored these points but they are essential to
an understanding of the problem of bank "liquidity." Spokesmen for
the Federal Reserve System often talk about measures of liquidity
for the banking system as if the\- were independent of monetary policy
operations and unrelated to prevailing market conditions. At times,
similar references arc made to the "liquidity of the economy." As an
example consider the statement by Mr. Robert Stone, Manager of
the System Open Market Account, describing operations during the
year 1962.
Moreover, attention began to focus on the size of the
expansion in bank credit and total liquidity that had already
occurred. It appeared that monetary polic^y had reached the
limit of its usefulness as a stimulus to economic activity.
Consequently, * * * the System shifted * * * toward slightly
less ease.33
This conclusion ignores the effect of Federal Reserve policy as a
major factor shaping interest rates on time deposits, Treasury bills,
and other short-term assets and thereby encouraging individuals and
businesses to hold their liquid assets in time or savings deposits rather
than in some other form. Furthermore, the statement suggests that
further increases in member bank reserves would have no effect on
interest rates or on the public's demand for money and other assets.
It suggests that as a consequence, it did no harm to move in toward
an allegedly "tighter" monetary policy. This is in part a result of
viewing the effect of monetary policy m terms of broad measures of
liquidity rather than in terms of currency plus demand deposits.
Such broad measures hide within their sum the redistributions of the
public's assets in response to interest rate changes.
The public's reallocation of deposits between demand and time
accounts affects the volume of total deposits, the money supply, and
interest rates on assets typically acquired by banks. The public's
allocation pattern is also sensitively responsive to variations in
*2 Some further discussion of these points may be found in A. H. Meltzer, "The Behavior of the French
Money Supply; 1938-54" Journal of Political Economy, June 1959, Karl Brunner; ' A Scheme for the Supply
Theory of Monev." International Economic Review, January 1961; and A. J. Meigs, Free Reserves and thes «PPly (Chicago: University of Chicago Press. 1902).
w
Federal Reserve Open Market Operations in 1962," Federal Reserve Bulletin, April 1963, p. 431.
22
FEDERAL
RESERVE'S
APPROACH TO
POLICY
interest rates, in particular the rate offered on time deposits, the bill
rate and bond yields. Relatively high interest rates on time and
savings deposits encourage individuals and corporations to maintain
deposits in that form rather than in the form of demand deposits.
Recent actions of the Federal Reserve authorities operated directly
on this interest mechanism, with important consequences for money
supply, "liquid assets" and the structure of interest rates. 1 tie
modification of regulation Q in January 1902 enabled commercial
banks to adjust their time deposit rates to prevailing market conditions. The public responded to this relative rise in the time deposit
rate with a large conversion of demand into time deposits. This m
turn encouraged banks to acquire longer term a s s e t s ; (municipal
bonds and mortgages) rather than to seek loans by lowering interest
rates to business borrowers. And this is reflected in the composition
of bank portfolios at the end of 1962. The sharp rise in total deposits,
the hesitant movement of the money supply, and the relative decline
in mortgage yields and other longer term yields arc the reflections of
the response by banks and the public to the events described. The
Federal Reserve's policy was thus the decisive factor shaping both
the growth in "liquid assets" and the realignment in the structure of
interest rates.
The confusion generated by the references to measures of bank
liquidity without references to the effect of interest rates is amply
demonstrated by other publications of the System. For example, one
of the monthly publications of the System,54 recently discussed the
liquidity of weekly reporting member banks at the end of June 1963.
One measure of liquidity, the ratio of total deposits to total loans
declined during the firsi 6 months of 1963. This fall in liquidity
reflects the banks' adjustment of their asset structure to evolving
market conditions and particularly to prevailing interest rate levels.
Another measure of bank liquidity that is cited, the ratio of U.S.
Government securities maturing in 1 year to total deposits, declined
also. The report finds this decline "less encouraging." The accompanying table strongly suggests that the reporting banks sold
Treasury securities and acquired "other securities," "largely taxexempt municipal bonds, loans to foreign banks, and mortgage loans*
At other times,35 liquidity of banks is defined as:
(1) The ratio of short-term loans to long-term loans, and
(2) The ratio of Government securities to loans.
The components of total earning assets or of total deposits do not
expand and contract at a uniform rate. The composition of both
assets and deposits responds to the prevailing structure of interest
rates. And these interest rates are not independent of Federal
Reserve policy. Quite different signals are given bv the various
liquidity ratios at different times. 'Without a well-conceived frame
of reference, the meaning of the host of liquidity measures remains
opaque. To eliminate the confusion caused bv differences in signals,
studies of the effects of interest rates and other market phenomena
on the quantity of particular types of assets demanded by banks and
£
"SSr'VtMy Ke?™ ^
Federal Reserve Bank of San Francisco. Ancntrt W6S.
o U h e Fedexai RrSrvc Bank
Of N e ^ Y ^ N ^
with^the^eVw
?, rise w i t h t h e s 0 definitions are reflected in the discussions
S d ' W t ^
, Sjethe testimony on the shifting meaning of the words "short-term"
23
FEDERAL
RESERVE'S
APPROACH
TO
POLICY
by nonbanks are required. After 50 years, the Federal Reserve has
only recently recognized the importance of this point.36
Meanings assigned to liguidity
"Liquidity," like credit, does not always have the same meaning
when it is used in System publications. At- least three separate notions seem to be conveyed. First, liquidity is used to suggest a position of the monetary system or the economy which is likely to induce
expansive action at some future date. Second, liquidity is used to
describe a condition that seems to be directly opposed to the first
position. When this meaning is assigned, excessive liquidity is said
to hinder or prevent the effectiveness of monetary policy designed to
expand the economy. The third meaning of liquidity seems to be
inversely related to the risk of capital losses or default losses that are
expected to occur. This notion seems to be closely tied to "sound
credit." We consider each in turn.
Wlien the first meaning is assigned to "liquidity," the discussion
may refer either to the monet ary system or to the economy. A highly
"liquid" economy is considered more likely to experience an increase
or acceleration of aggregate demand. The prevalence of high liquidity in the monetary system appears to be an influential factor in
determining the rate at"which bankers add to their portfolios. When
either the economy or the monetary system is said to be highly liquid,
inflation is often regarded as a likely consequence.
This view of liquidity seems to result from two characteristic
features of the Federal Reserve conception: (1) the concentration of
attention on extremely short-run events and (2) the failure to recognize behavior patterns and market responses that economists refer to
in the concept of demand. The Federal Reserve authorities have
acquired detailed experience about the immediate impact of their
policy action on a bank's reserve position. An initial effect of an
open market purchase by the Federal Reserve is an increase in the
reserves of some group of banks; i.e., bank liquidity is increased.
The particular banks respond to the increased "liquidity" by making
suitable adjustments in their portfolio of earning assets. The magnitude and the type of response depend on the individual banker's
judgment about*the nature of the event and on the prevailing market
yields.
Bankers do not respond in the same way to systematic and random
changes in reserves, as we noted in the section on "tone" and "feel."
Given the level of market interest rates, a larger part of the increase
in reserves will be offered on the Federal funds market if the increase
^ reserves is regarded as a random change. Moreover, when yields
are low, an individual bank chooses to hold a larger portion of the
addition to reserves, whether the change is systematic or random.
The volume of earning assets acquired is smaller for any given injection
of reserves under these conditions. This is a reflection of two basic
influences operating on a bank's adjustment process. One is the
marginal cost schedule associated with acquisitions of earning assets
and the reshuffling of portfolios on settlement dates. This schedule
femains unchanged when interest rates decline. The second major
influence shaping the response is the marginal revenue schedule.
I^icess
Reserves" Perkw of the Federal Fe*em Bank of St. If nit, April 1963
"Ejidgwera^
! » * " > at a Practical
&&Ttbem
each bank a t t e s t s t o p ^
S S f f e 5 * F o r Practical purposes, these reserves are
ma
since the
24
FEDERAL RESERVE'S APPROACH TO POLICY
The fall in interest rates lowers the marginal returns to be expected
from investments and loans.
.
When the individual bank expands its earning assets under the impact of a systematic change in reserves, some reserves are generally
lost to other banks. In the Federal Reserve terminology, an increase
in "liquidity" has generated an increase in "bank credit." Other
banks acquire reserves and become "more liquid." If these reserve
acquisitions are regarded as systematic changes, additional expansion
of bank portfolios results. The process continues until the reserves
originally injected have been absorbed in required reserves and in
the banks' desired holdings of excess reserves.
At every stage of the process, the "liquidity" of some banks is
increased. This is followed by an expansion of "bank credit."
These observations of the extremely short-run dynamics of the
monetary process suggest the meaning of the first, or "overhang,"
notion of liquidity, viz, that greater liquidity means a larger potential
increase in the money supply and bank credit. When the ''overhanging liquidity" is large, the authorities appear to move cautiously
and hesitantly. Further bank expansion is expected to occur eventually. An additional supply of "liquidity" will add to the rate of
potential expansion and perhaps generate inflationary pressures.
Judgment calls for consideration of restraint by the monetary
authorities to prevent "loose money markets."
This interpretation of "bank liquidity" is seriously misleading.
The error does not occur in the description of events that associates
a systematic increase in reserves with the expansion of bank portfolios.
In the very short run, variations in the supply of reserves are correlated
positively with changes in bank portfolios. This typical occurrence
has been correctly observed by the monetary authorities. But, the
day-to-day view of the monetary process that the authorities take
inhibits further consideration of the adjustment process.
Once we acknowledge that banks have a demand for reserves that
responds to changes in the yield of portfolio assets, we are no longer
free to associate a given amount of "liquidity" with a given change
in money supply or bank portfolios. Assume that banks are holding
the amount of reserves that they desire to hold at present yields on
assets. An increase in reserves, that is judged to be systematic,
raises the supply of reserves above the amount that banks desire to
hold. The resulting surplus reserves, the difference between actual
and desired reserves, will lead to an expansion of bank earning assets
and deposits that absorbs the surplus reserves into required and
desired reserve holdings. This process takes time; it is not observable
in the very short-run movements that play an important role in
shaping the Federal Reserve's understanding of the monetary system.
Recognition of increased surplus reserves rather than an increase
in the supply of reserves as the driving force in the portfolio expansion
process leads to a major modification of the Federal Reserve view.
In their terminology, we would say that increased "liquidity" leads
to an increase in "credit" only if surplus reserves increase. If desired
reserves increase step by step with actual reserves, there are no
additions to surplus reserves and no expansion in bank portfolios,
further, if desired reserves increase by more than actual reserves,
banks will reduce earning assests no matter what the measure of
"overhang liquidity" may be.
25
FEDERAL
RESERVE'S
APPROACH TO
POLICY
The first notion of liquidity as a factor generating a potential expansion of credit suffers from a complete disregard of the banks'
demand for reserves and the position of cost-and-yield factors in the
determination of desired reserve positions or of surplus reserves.
The misinterpretation of the very short-run relation between "liquidity" and portfolio adjustment for a single bank is matched on the
aggregate level by assigning a significant role in the process of monetary expansion to some measure of aggregate "liquidity." Variations in "liquidity," however, moan nothing by themselves. Their
meaning depends on a frame of reference usefully explaining the
behavior of the monetary system. A highly "liquid" banking system
frequently occurs during periods of recession when low interest rates
lead to an increase in the desired reserve positions of the banks. In
the absence of additional reserves, banks reduce earning assets and
deposits until actual and desired reserve positions coincide. In this
case, large "liquidity" is the result of a process of contraction and is
without the inflationary significance attributed by the Federal Reserve. Additional increases in reserves, at such times, avoid the
contractive process and permit the banks to adjust desired to actual
reserves.
The interaction of the banks' demand for reserves with the supply
of reserves plays a central role in the monetary mechanism. Disregard of the demand for reserves makes it impossible for the Federal
Reserve to understand and learn from the events of the great depression, leads to the notion that "overhanging liquidity" is inflationary, and prevents the development of a more thorough understanding of the monetary process. In particular, the Federal Reserve
fails to recognize that a bank's desired reserve position moves more
slowly than'the actual supply of reserves in response to evolving
market conditions and the random and systematic forces operating
on th e m on e t arv sys tern.
t The second strand composing the liquidity notion may be inconsistent with the first. In the second view, the prevailing level of
"liquidity" is either an indicator of the effectiveness of monetary
policy or a causal factor making monetary policy effective or ineffective. Large liquidity is said to indicate or contribute toward
ineffectiveness, and conversely. It is conceivable that the first
notion, "overhanging liquidity," and the second are compatible in
Federal Reserve thinking. Increased "liquidity" might contribute to
future inflation and to present "ineffectiveness." Such a view might
help to explain the concern about "loose money markets." However,
speculation along these lines is rarely fruitful. It serves only to
indicate once again that there is an absence of clarity and of an explicit
statement of the position occupied by words like "liquidity m the
Federal Reserve's frame of reference.
, . 4 ,.
One possible frame of reference that was developed withm the
federal Reserve System helps to clarify the second view of liquidity.
Statements like the one made by the present Manager—that liquidity
had reached a level in mid-1962 that made expansive policy actions
useless—may be a residue of some notions developed by U. W . Kiefler
ttore than 30 years ago. Various fragments of Riefler's conception
continue to pervade Federal Reserve thinking37 about liquidity and
other parts of the monetary mechanism. We will discuss this conreadertereferred again to our forthcoming paper for a more analytic treatment of this material.
26
FEDERAL
RESERVE'S
APPROACH TO
POLICY
not developed a coherent frame of reference and consequently could not
possibly have relevant supporting evidence. An alternative conception, discussed in chapter VI, implies the continued effectiveness of
monetary policy in the context considered by Mr. Stone. According
to the alternative conception, a given policy operation is more stimulative when interest rates are high than when rates are low. But m
either case, appropriate policy is "effective," if "effective" means that
open market purchases lead to increases in the money supply.
A third version of "liquidity" appears to indicate the opposite of
risk. Assets with low probabilities of default or of capital loss are
referred to as "liquid" assets. This definition of liquidity is implicit
in statements that interpret an increase in the ratio of long-term to
short-term assets as an increase in "illiquidity."
Currency and Federal Reserve deposits are not subject to either
default losses or losses of nominal values. But such losses do affect
the value of loans and investments and hence the value of bank portfolios. A liquid portfolio; that is, a portfolio containing a large proportion of cash assets and short-term Treasury securities, is associated
with smaller risk. A smaller probability is assigned to the occurrence of any particular capital or default loss. In this manner, expected portfolio losses are inversely related to the prevailing level of
liquidity. A high level of liquidity is thus supposed to lower the
expected loss, reduce the risk.
The Federal Reserve authorities traditionally have been concerned
with the "soundness of credit"; that is, the probability of capital and
default losses by banks. Bank supervision was designed, in the
Federal Reserve view, to h
. 1 1 1 . / /
.
!•,».
on banks. The intention
default losses and capital loi
According to the third strand in the Federal Ileserve's views on
"liquidity" there exists a negative correlation between the level of
liquidity and the capital losses experienced on the average by commercial banks. The deflationary consequences of substantial losses
spurs the Federal Reserve's concern with the "liquidity" of the banking system. This concern appears at times to dominate the Federal
Reserve's interest in the money supply. On occasion it has misled
the Federal Reserve authorities and encouraged inappropriate contractive action. This occurred under the combined effect of the first
and the third strand. Expansionary policy would have raised
"liquidity," induced banks to modify portfolios in a direction involving more risk and greater expected loss. In order to protect
"sound credit" and eliminate deflationary capital losses, a hesitant
attitude concerning open market purchases has prevailed at times.
We submit that the Federal Reserve's concern with "liquidity"
in order to prevent the occurrence of deflationary capital losses absorbs the attention of policymakers in a wrong direction. It has
misled the Federal Reserve authorities to justify measures intended
to protect the banks against "unsound credit." But such protection
of individual banks against the consequences of their own poor
judgment should not be the concern of an agency instructed by Congress, according to the Board, to "control the money supply" and
27
FEDERAL
RESERVE'S
APPROACH TO
POLICY
adjust monetary policy in accordance with the goals of employment
policy.
Monetar}' policy must unavoidably be concerned about deflationary
impulses initiated by defaults of bank loans and capital losses on
bank's investment portfolios. But the successful elimination of such
impulses does not require protection of individual banks against
their poor judgment. It does involve, however, the protection of
depositors. A well constructed monetary system appears to require
Erotection of depositors against the consequences of "unsound credit,"
ut there is no good reason to protect bank management from such
consequences. Protection of depositors and protection of individual
banks are not the same thing and can be clearly separated by appropriate institutional arrangements. With such institutions successfully
operating, the Federal Reserve authorities could usefully disregard
the "quality of bank credit" and the concern for "liquidity" as an
expression of the expected loss associated with a particular portfolio
composition.
The concept of liquidity and the effect of borrowing
The confusion engendered within the Federal Reserve by the
term "liquidity" is observed most readily in connection writh their
discussions of member bank borrowing. As noted above, an individual
bank borrows from the Federal Reserve bank in connection with the
maintenance of its required reserves at the end of the settlement
period. A bank may of course anticipate a shortage and borrow in
advance of the settlement date. Banks may also Borrow for emergency reasons; e.g., crop failures. But most of the dollar volume of
member bank borrowing is made as a part of the process by which
individual banks meet their reserve requirements.
The Federal Reserve regards member bank borrowing as "a negative
element of primary liquidity."39 An individual bank must shortly
repay the amount that it "borrows from a Federal Reserve bank.
But the banking system can be, and has been, indebted to the Federal
Reserve System for long periods of time. Evidence of continuous
borrowing "by groups of member banks wras presented in our discussion
above. We* indicated there that on the average for the period 194962, Reserve city and Central Reserve city banks had negative free
reserves. All member banks as a group have borrowed for prolonged
periods also. For example, member bank borrowing exceeded $400
million in every month from April 1925 to February 1930, with one
exception. More recently, borrowing has exceeded $500 million in
every month but one from March 1955 to December 1957 and from
December 1958 to April 1960. Other periods of expanding or highlevel economic activity show similar borrowTing behavior for banks as
a group.
Why then should member bank borrowing be regarded as an
element of negative liquidity? The reasoning is straightforward for
an individual bank. Whenever a bank must repay the funds bor, 11 Commission on Money and Credit, "The Federal Reserve and the Treasury; Answers to Questions
from the Commission on Money and Credit" (Englewood Cliffs, NJ.: Prentice-Hall, Inc., 1902) p. 7.
See also, "Measures of Member Bank Reserves/' Federal Reserve Bulletin, July 1963, p. S93, where it is
noted that "Member bank borrowing at Federal Reserve banks is generally regarded as a temporary source
or reserves both by the borrowing bank and by the Federal Reserve officials who administer discount operations. This transitory or emergency nature * * * tends to limit the volume of credit that can be supported
by such reserves." "Borrowed funds are different from other factors affecting reserves. A reserve expansion resulting from an increase in member bank borrowing cannot exist for long because borrowings are
temporary sources of funds," Monthly Review, Federal Reserve Bank of Atlanta, September 1963. Additionalreferencesto this point will be provided below in the discussion of free reserves.
28
FEDERAL
RESERVE'S
APPROACH TO
POLICY
rowed from Federal Reserve banks, it acquires the necessary reserves
by retarding the expansion rate of its portfolio of earning assets. In
one way or the other, the bank must readjust its assets and liabilities
to generate surplus reserves sufficient to repay the loan from a federal
Reserve bank. Such readjustment may be accomplished by unloading securities and calling short loans. On other occasions it may
mean that a portion of the reserves acquired after a settlement day is
applied to the repayment of the amount borrowed. Whatever the
precise form of a bank's adjustment to facilitate the repayment of its
debt, the expansion rate of its deposits and earning assets is reduced.
The larger the bank's indebtedness, the g r e a t e r will be the subsequent
(relative) retardation of its expansion rate.
This association was carefully observed and properly noted by the
Federal Reserve authorities. But the authorities seriously erred in
the interpretation of this observed association. This error occurred
at two distinct stages; one pertains to the behavior and position of
individual banks, the other to the behavior of the banking system.
The Federal Reserve authorities have traditionally asserted the
existence of a "tradition among commercial banks against borrowing." Banks were said to borrow only reluctantly. It is quite true
that banks rarely borrow repetitively over sequences of succeeding
settlement days. But this behavior does not necessarily reflect a
tradition against borrowing. Economic analysis suggests an alternative explanation. The pecuniary discouragement to borrow exerted
by the discount rate is supplemented in Federal Reserve practice by a
nonpecuniary—or indirectly pecuniary—discouragement by means of
administrative procedures and pressures. At least, there are continuous suggestions that such pressures might become operative.
These pecuniary and nonpecuniary costs of borrowing arc important
features in the individual bank's borrowing behavior. Moreover,
this explanation also suggests that the "tradition against borrowing"
is not the result of an inherent reluctance on the part of banks, but the
consequence of Federal Reserve policy bearing on discounts and
advances. This tradition must be understood as the result of the
Federal Reserve's administrative procedures designed to shape the
desired attitudes and behavior of commercial banks concerning borrowing from Federal Reserve banks.
Having observed the association between accumulated indebtedness and subsequent retardation of the expansion rate of individual
banks, the Federal Reserve authorities asserted the existence of this
association for the banking system. Many pronouncements have
been made by Federal Reserve officials declaring that a larger indebtedness of commercial banks retards the expansion rate of^bank
credit." 39 On occasion we may also read that an expansion of
reserves based on growing indebtedness is "not sustainable." The
latter notion has never been clarified, and its relation to the asserted
negative association between the System's indebtedness and the
System's expansion rate remains quite unclear. We suspect that the
two statements reflect different and independent notions about the
working of the discount mechanism.
The first statement about the System must be recognized as a
fallacy of composition. The Federal Reserve authorities extend to
the whole system of banks a pattern that has been observed to hold
39
References will be given in the following chapter.
29
FEDERAL RESERVE'S APPROACH TO POLICY
for the short-run adjustment of individual banks. But this pattern
does not hold for the System, however prevalent it is for individual
banks. Whenever an individual bank retards its expansion rates—•
either by contracting earning assets or channeling reserve accruals
into repayments of indebtedness—the position of other banks is
affected. When one bank unloads assets on the market, the reserves
of other banks decline. The reduction of assets by a single bank
induces a transfer of reserves from other banks to the bank that is
reducing assets. Similarly, a bank's deposits and portfolio will
expand by smaller amounts if newly acquired reserves are used to
repay indebtedness. Consequently, some of the reserves lost by other
expanding banks will not be used for asset expansion. The loan
repaying bank will use them instead to repay indebtedness to the
Reserve banks. The retardation of the bank's expansion rate thus
transfers pressure to the reserve positions of other banks and to
other sections of the country. In this way, the pressure is distributed over the banking system. Other banks replace the adjusting
bank at the discount window on the next settlement day, and there
is a turnover in the lineup at the discount window. But the borrowing by other banks replaces the reserves repaid by the adjusting
bank. The new borrowings permit a (relative) acceleration in the
expansion rate of the newly indebted banks; this offsets the (relative)
retardation of the repaying banks. The observed association of an
individual bank's indebtedness with the subsequent (relative) deceleration of its portfolio movements therefore does not imply that
borrowing has a contractive effect on the banking system.
For the banking system, it is the total amount of reserves supplied
hy the Federal Reserve and the demand for reserves by member
banks that is important in judging the market for bank reserves. The
fact that the banking system remains in debt to the Federal Reserve
for long periods means that some of the reserves supplied at the
discount window will remain available and will permit bankers as a
group to issue more deposits. In fact, the reserves supplied through
the discount window to the banking system may increase the amount
of total reserves available to the banking system.
Like any other method of supplying reserves, borrowed reserves permit member banks to supply a larger volume of deposits. An increase
in borrowing, other sources of reserves unchanged, has a positive, not a
negative, effect on the monetary system, since it increases the reserves
in the banking system. An increase in reserves attributable to a
flowing volume of borrowing from the Reserve banks implies that the
(relative) acceleration in expansion rates of borrowing banks dominates the (relative) deceleration of repaying banks. Only confusion
between individual bank behavior and *the behavior of the system
as a whole could lead to the conclusion that increases in member
bank borrowing have a negative effect on the banking system.
The first statement about the system has thus been shown to
emanate from fallaciously attributing properties to the system
which truly hold for individual members. Our discussion indicated
that an increase in reserves, independent of its source, is expansionary.
Inis view is quite consistent with the second statement sometimes
jnade by Federal Reserve officials. The second statement may be
interpreted to mean that indebtedness of banks to Federal Reserve
hanks cannot grow at a constant rate. In particular, expanding
^debtedness cannot assure a maintained growth rate of reserves.
30
FEDERAL
RESERVE'S
APPROACH TO
POLICY
The growth rate of reserves attributable to expanding indebtedness
must eventually decline. This proposition has a radically different
import than the previous assertion considered. In the context of the
Federal Reserve's prevailing views about the operation of the discount
window, the proposition is most likely correct. Growing indebtedness
emanates from two sources, viz, more banks borrow and they may
borrow larger amounts. With an increasing number of banks appearing at the discount window, the probability of more frequent applications by a particular bank increases. Increasing indebtedness thus
implies that both the probability of larger loans and more frequent
applications becomes larger. Consequently, the probability of rising,
administrative pressure applied by the Federal Reserve banks to
indebted and borrowing banks rises. This rising pressure may be
expected to retard the growth of indebtedness. Still, past observations about the behavior of bank indebtedness would suggest that
substantial expansions in bank borrowing occurred without decisive
evidence of a retardation attributable to rising administrative pressure.
But we do not doubt that under prevailing conceptions about the
administration of the discount window^, a retardation generated by
administrative pressure wrould emerge at some point of a continuously
expanding portfolio of discounts and advances. The truth of the
second proposition asserted by Federal Reserve authorities is thus
dependent on its own practices.
The Federal Reserve's misconceived interpretation of the effect of
borrowing on the banking system has important implications. It is a
maior part of the free reserve concept, one of the primary tools that the
Federal Reserve uses to judge the state of the market. By definition,
an increase in borrowing reduces free reserves. A reduction in free
reserves caused by an increase in borrowing is said to have a negative
effect on the rate of change of "bank crediC" Conversely, an increase
in free reserves caused by a decrease in borrowing is said to have an
expansive effect on bank credit.
In short, the Federal Reserve contends that in periods of rapid
expansion in the demand for loans, an increase in member bank
borrowing reduces free reserves and thus "tightens" the banking
system, while an increase in total reserves through purchases in the
open market, borrowing unchanged, eases the banking svstem because it increases free reserves. But if the total reserves available to
the banking system are the same in both cases, the total volume of
member bank deposits that can be supported will be the same in both
cases. Only if the effect of reserve operations, particularly borrowing,
on individual banks are confused with the effect on the banking
system as a whole can analysis lead to the opposite conclusion.40
The pernicious effect of this error in the interpretation of borrowing
will become clearer when we compare the effects of the free reserves
doctrine to an alternative view of the monetary mechanism below.
The banker approach and the Federal lieserve portfolio
The Federal Reserve's view of the liquidity of the banking svstem
affects its own operations in other ways. This is demonstrated "in the
testimony of President Hayes before the Joint Economic Committee.41
The view is expressed that since banks are holders of short-term
securities as a part of their "secondary liquidity," the Federal Reserve
» Commission on Money and Credit, "Answers to Questions," op. cit,, pp. 117*118
« "Review of the Annual Report * *
op. cit., pp. 69, 75.
31
FEDERAL
RESERVE'S
APPROACH TO
POLICY
must hold similar securities as a means of affecting the reserve positions
of banks.
In fact, the Federal Reserve does not generally buy securities from
and sell securities to member banks other than the dealer banks. It
buys from and sells to dealers in Government securities (including
dealer departments of member banks). In the process, it absorbs or
creates member bank reserves and increases or decreases the volume of
securities outstanding in the market. This operation changes both
member bank reserves and the outstanding stock of securities that
banks and nonbanks hold.
Federal Reserve buying or selling changes interest rates on the
securities bought and sold by increasing or decreasing the stock of
securities that the banks and the public must hold and by increasing
or decreasing the reserves supplied. It remains for the market
to distribute the effect of an open market operation over a wide range
of securities. The origin of the securities that the Federal Reserve
purchases—whether they are initially sold to dealers by banks or
nonbanks—has no effeci on the outcome. If the Federal Reserve
had purchased a particular security that was not held by any bank in
the system, the effect would be similar. The reserves of member
banks would be increased and a particular type of security would have
a slightly lower yield and slightly higher price. Other securities are
more attractive to buyers relative to the security used in the open
market operation. A relative increase in the demand for all other
securities lowers their yield until no one wishes to exchange the
security used in the open market operation for any other security. In
the process, the prices and yields of securities with longer or shorter
maturity are affected. The amount of new securities offered and the
amount of bank loans demanded are also changed. Both magnitudes
respond to the variations in the structure of interest rates induced by
changes in bank reserves and in the stock of securities to be absorbed
by the market. In this way the effect of open market operations
begins to be transmitted to the pace of economic activity.
It may be true that the speed of transmission is influenced by the
particular type of security that the Federal Reserve uses in its operations. For that reason, the particular security that the Federal Reserve uses may be of some importance. This problem has not been
studied empirically, so no judgment can be reached. The point of
the discussion here is to suggest that the Federal Reserve is not like
any other purchaser or seller in the security market, though it often
seems to regard itself in that way.
The money versus credit doctrine
Another major fallacy associated with the failure to distinguish
between effects of policy on individual banks and on the banking
system as a whole can best be summarized in the words of a spokesman for the Federal Reserve responding to a written question:42
No difference was meant by the two terms "bank credit
expansion" as used in the May 24 revision of the Federal
Open Market Commit tee's policy directive and "monetary
expansion" as used in the August 16 revision.
The term "bank credit expansion" refers more precisely
to an increase in the total loans and investments of commera
"Review of the Annual Report * •
op. cit., p. 147.
32
FEDERAL RESERVE'S APPROACH TO POLICY
cial banks; that is, in their principal assets. "Monetary
expansion" relates to an increase m the Nation s money
supply, usually defined to include demand deposits of banks
and currency in circulation. Technically speaking, the
terms differ in that "bank credit expansion" approaches
the problem from the bank asset side, while "monetary expansion" approaches it from the bank liability side. Since
demand deposits are at the same time the major component of the money supply and the main, although not the
sole, offsetting liability to bank assets, bank credit expansion
and monetary expansion are essentially two sides of the same
coin.
An individual bank receiving an increase in reserves resulting, let us
assume, from an open market purchase by the Federal Reserve is
faced with the task of allocating the increase in reserves between
earning and nonearning assets. We have previously discussed the
effect of interest rates on this decision. And we have noted that in
the process of acquiring earning assets banks lose reserves to other
banks. From the viewpoint of the individual bank, reserves are
used to expand assets. In the process, money is created because the
loan that the bank makes to a customer is balanced by a new liability,
the deposit of the individual borrower.
Generally the loan remains on the,books of. the lending bank,, but
most of the deposit balance is withdrawn. The prevailing structure
of interest rates will be an important determinant of the use that is
made of the money by those receiving checks written by the initial
borrower. When interest rates on time deposits are relatively high,
a larger proportion of the money that was created will be placed in
time deposits or savings deposits.
The decisions that are made by individuals receiving increases in
their cash balances or their deposit accounts have an effect on the
type of assets that banks will purchase and the rate of expansion of
the money supply and the stock of credit. If the newly created
money is exchanged for commercial bank time deposits, the increase
in required reserves induced by the asset expansion is smaller. The
system can, therefore, acquire additional assets at a much greater
rate than if the newly created money is held as demand deposits.
Moreover, the average time or savings deposit remains in the bank
for a longer period of time than the average demand deposit. For
the individual bank, the risk of reserve deficiencies is thereby reduced
when time deposits increase relative to demand deposits. The bank
is able to "reach for yield," i.e., to acquire a larger proportion of
assets that carry higher market yields, have longer maturities, and
are not traded in markets as highly organized as the market for
Treasury bills. Long-term municipal bonds and mortgages are examples of the types of assets acquired by banks when the composition
of their deposits between time and demand deposits changes in favor
of time deposits.
Thus, while it is true that for a single bank the process of expanding
credit is part and parcel of the process of expanding the money supplv,
it is not true for the banking system as a whole or for the economy.
The stock of credit and the stock of money may change at very
different rates.
33
FEDERAL
RESERVE'S
APPROACH TO POLICY
Furthermore, the desired reserve position of an individual bank and
of the banking system as a whole changes during periods of expansion
and contraction in the economy. As we have noted repeatedly,
such changes in the demand for reserves by banks are a part of the
response to the interest rate changes that occur during periods of
economic expansion and contraction. A given volume of reserves
may be used to support a larger or smaller stock of money depending
on the demand by banks for reserves in excess of requirements.
Table II—2 shows the mean or average change in (1) the money
supply, (2) the money supply plus time deposits, and (3) the total
loans and investments of member banks, bank credit. The table
clearly reflects the fact that the substantial differences in the rate of
change of the money supply and the stock of "credit" that we have just
described are not simply possibilities but occur in practice.
TABLE II—2.—Average rates of monthly change in money and '*credit" during
postwar cycles, November 1948 through February 1961
[Millions of dollars]
Peaks to
troughs
item
Change in money supply
Change in money supply plus time deposits
Change in bank credit... . .
.
„
.
120
533
714
Troughs to
peaks
229
457
491
Supp ose that two individuals are judging Federal Reserve policy
to decide how expansionary the policy has been during a particular
period. If one chooses the rate of change of the money supply
and the other chooses the rate of change of bank credit, they are
likely to reach opposite conclusions. During periods of contraction
in the economy, the credit measure and the money supply plus time
deposits suggest that on the average, the System is permitting or
encouraging a relatively rapid rate of recovery. However, the
nioney supply suggests the opposite conclusion. During periods of
expanding economic activity, the reverse is the case. Judging the
effects of Federal Reserve policy by the changes in the stock of
credit would suggest a relatively "tight policy." Judgments based
on the st ock of money would'suggest that policy was somewhat
easier during the period of expansion than during the period of
contraction.
The fact that the two rates differ does not immediately tell us
w hich i s the better measure.
Nor does it tell us anything about the
extent to which Federal Reserve policy has contributed adequately
to the goals of the Employment Act or the congressional mandate.
But it does help to explain some of the differences between those
judge monetary policy in terms of the stock of money and
Federal Reserve officials who most often refer to the stock of bank
credit, total loans and investments. For if we continue to ignore
the demand factors in the present discussion, it is clear that the
Federal Reserve has permitted on the average a larger expansion m
foe supply of money during months of expansion than during the
Months of contraction in the economy.
Since the rate of change of the money stock and the bank credit
stock are not the same in periods of economic expansion and contrac
34
FEDERAL
RESERVE'S
APPROACH TO
POLICY
tion it is not a matter of opinion or indifference whether we use one
or the other. It is a substantive issue that has important consequences for the understanding of Federal Reserve policy. Only if we
are wedded to the "banker fallacy" and view the banking system m
much the same way that the individual banker views his own operations, are we likely to regard increases in credit and money as the same.
If the Federal Reserve had studied the data on the rates of change
in the supply of money and the stock of credit, they could not have
reached the conclusion that "monetary expansion" and "credit
expansion" are "two sides of the same coin."
Moreover, we have seen in previous sections that the desired reserve
position of commercial banks reflects interest rates prevailing in the
market. And we have argued that the response of the supply of
money to a given change in reserves is affected by prevailing interest
rates. With higher interest rates, the demand for cash balances, or
for excess surplus reserves by banks, is smaller, and the increase in
the money supply resulting from an increase in the reserves made
available by the Federal Reserve is larger.
Once we recognize that the banking system may desire to hold
larger or smaller ratios of reserves to deposits, we can understand why
the rate of expansion of earning assets (credit expansion) is not the
same as the rate of monetary expansion. It is therefore incorrect to
say that the changes in earnings assets or credit are approximately
equal to the changes in demand deposits. By doing so the Federal
Reserve ignores the change in banks' desired reserves because it
implicity assumes that desired reserves remain unchanged and can
be forgotten. It is the sum of earning assets plus reserves that is
approximately equal to total demand and time deposits, not the
earning assets alone. Changes in desired reserves by the banking
system are accompanied by changes in the relative rates of growth of
earning assets and deposits. Failure to distinguish between the desired
reserve position of the banking system and the amount of measured
excess reserves available leads to the erroneous conclusion noted
above—that adding to the available reserves by Federal policy would
have little or no effect on the rate of monetary expansion.
Furthermore, a given volume of total reserves can support vastly
different totals of demand plus time deposits at commercial banks
depending on the distribution between demand and time deposits that
the public chooses to make. Higher interest rates on time deposits
induce the public to hold a larger fraction of liquid assets in time
deposits. Whatever the given total of reserves supplied to the banking system by the Federal Reserve, the fraction of reserves that must
be held as required reserves is smaller. Banks can increase credit*
that is, loans and investments, at a much greater rate than demand
deposits if the public chooses to acquire time deposits by surrendering
demand deposits.
The prevailing structure of interest rates on assets must be considered in the analysis of the monetary process. While interest
rates are not the only determinant of the distribution of liquid assets
into demand and time deposits, they are an important determinant.48
" E. Feige, "The Demand for Liquid Assets: A Temporal Cross Section Analysis " unDubllshed Ph D.
thesis, University of Chicago. 1962; Allan H. Meltzer, "The Demand for M o n e y • > T h e S n w From the
Time Series," Journal of Political Economy, June 1963; Karl Brunner, " T h e S t r i c t m of
System and the Aggregate Money Supply Function/' presented at the Winter meeUncsof the EconomeSic
Society, December 1960. To be published as a chapter in our forthcoming l i o k o i S b
35
FEDERAL
RESERVE'S APPROACH TO POLICY
Failure to recognize the importance of interest rates for the distribution of total deposit balances overlooks an important element in the
monetary mechanism. Recognition of the variation in the ratio of
time to demand deposits as a part of the operation of interest rates
leads immediately to the recognition of an important source explaining the difference between the rates of change in the stock of
money and credit.
The data in table II-2 clearly indicate the importance of choosing
between monetary and credit expansion. Variations in the public's
distribution of money balances between currency and demand deposits and reallocations of deposits between demand and time accounts generate substantially different responses in total earning
assets and the money supply. These factors are of major importance
in explaining the marked differences in the rate of change of the stock
of money relative to the rate of change of credit during periods of
recession and recovery.
If we are to choose a single indicator from these two measures of
"ease and restraint," we want to choose that measure that best reflects the position of the monetary system. The above discussion
suggests that it is the rate of monetary expansion that is the better
measure. Failure of the Federal Reserve (1) to distinguish between
the different rates of growth, (2) to analyze the determinants of desired reserve positions, and (3) to analyze the behavior of and the
factors affecting the demand for time deposits and the demand for
money has led to the use of an inappropriate measure.44
SOME O T H E R CONCEPTIONS AND
MISCONCEPTIONS
To conclude this lengthy, introductory discussion, four policy
decisions have been chosen to illustrate some prevailing notions of
the Federal Reserve. Our purpose is to show that important policy
actions and interpretations of events are based on conceptions that
have not been validated. This does not mean that the conceptions
are invalid or incorrect, though much of the evidence that we have
collected strongly suggests that they are. We are convinced that the
failure to assess the relevance and validity of the underlying notions
had important consequences for the economy and for the ability of
the Federal Reserve to carry out the congressional mandate. In
this section, we attempt to provide some documentation for that
conviction.
The events chosen here are illustrative only. Others could have
been used for the same purpose. Our intention is not to suggest
that policy was "easy" when it should have been "tight" or "tight"
^hen it should have been "easy." "Ease and restraint" do not have
self-evident meaning, as was implicit in our consideration of "credit"
versus money as an indicator of monetary policy. Such terms can
°my be usefully applied within a particular frame of reference. If
that frame of reference or conception is inappropriate, actions taken
to ease the monetary system mav have precisely the opposite result.
Had the Federal Reserve continuously attempted to assess their
understanding of the monetary process, many of the misconceptions
gfrht well have been discarded long ago.
44
See the appendix for a compact statement of the analytic Issues underlying this discussion.
36
FEDERAL
RESERVE'S
APPROACH TO
POLICY
Changes in reserve requirements, 1986-37
In the summer of 1936, the Board raised reserve requirements by
50 percent and again in January 1937 raised them to the limit permitted under the law. Unemployment was above 10 percent at the
time, and economic activity was running at a pace substantially below any reasonable measure of full utilization of resources. >s evertheless, the Board of Governors raised reserve requirements by 100
percent within 6 months. Why was this action taken when the
economy had only partially recovered from a major depression/
Did the notion of "overhanging liquidity," discussed above, lead the
Federal Reserve to believe that this action would prevent some
possible future inflation?
The rationale for the action can be inferred from statements made
by Federal Reserve officials. One of the clearest clues is offered by
Goldenweiser writing after the events.45
After the autumn of 1933 these instruments (i.e., discount
rate and open market operations) were not usable, because
the banks w^ere out of debt and had a large volume of excess
reserves. The banks were, therefore, largely independent of
the Federal Reserve System and could not be influenced by
the System's traditional methods of credit regulation. In an
attempt once more to reestablish contact with the money
market, the System, under authority acquired in 1933 and
1935, increased reserve requirements in 1936 and 1937 * * *.
* * * the Board made it clear that this was not a reversal
of the policy of monetary ease pursued since the beginning of
the depression * * *. The Board's action was precautionary
in character and placed the System in a position where an injurious credit expansion, if it should occur, could be controlled by open market operations and discount policy.
This argument presumes that the situation evolving after 1933
broke a crucial link in the chain connecting the behavior of the money
supply or "credit" with policy actions exercised by open-market
operations or variations in the discount rate. The restoration of an
effectively operating policy required substantial elimination of excess
reserves. This was accomplished by doubling the requirement ratios.
Furthermore, this action was viewed as an attempt to restore the
operational significance of traditional policy instruments without
inducing a contraction in economic activity.
The Federal Reserve's interpretation of the events and of their
actions is an immediate consequence of a peculiar notion concerning
the structure of monetary processes. Under the conception developed
in some detail by Riefler,46 a prominent Federal Reserve official, the
behavior of the banks' volume of indebtedness to Federal Reserve
banks operates as a centerpiece of the whole monetary mechanism.
It can be shown that an appropriate explication of Riefler's notion does
imply that the loss of the Federal Reserve's "contact with the market,"
resulting from a vanishing volume of indebtedness, rendered monetary
policy inoperative. According to this conception, the policy pursued
m 1936-37 was well conceived and quite rational. It was excellently
designed to restore an effective connection between policy and the
o f G o v ^
« W. W. Riefler, "Money Rates * * V ' op. cit.
Studies (Washington: Board
37
FEDERAL
RESERVE'S
APPROACH TO
POLICY
behavior of the monetary system. The ruling conception also implied
the nondeflationary character of the rise in reserve requirements
under the circumstances.47 In their view, "overhang liquidity" was
eliminated to prevent future inflation.
The appropriateness and relevance of the policies pursued hinges
completely on the validity of the underlying conceptions about the
causal structure of the monetary system. The conception ruling at
the time of the Federal Reserve's action was neither preordained nor
obviously true. Xo record shows that this conception had been
critically assessed. Alternative conceptions yielding a radically
different interpretation of the same situation appear to be better
founded. One such conception, for which there is much more
evidence, implies that no restoration of policy effectiveness was
necessary in 1936. and that policy continued to he effectively linked
with the monetary system.
The alternative frame of reference implies that "contact with the
market," as understood by the Federal Reserve authorities, is neither
a necessary nor a sufficient condition for policy actions to be effectively transmitted. This notion has no meaning and relevance
within the alternative frame. Moreover, the increase in reserve requirements, in addition io being unnecessary, generated a serious
deflationary impulse in a situation still dominated by unemployment.
The Federal Reserve's policy in 1936-37 was not necessarily inappropriate. But its appropriateness depends on the validity of the
underlying conception guiding the Federal Reserve's actions. They
have not attempted validation. Yet a major change in policy was
introduced and later justified in terms of a conception that has little
validity or relevance and appears to be incorrect.
The appraisal of policy in 1949
The annual report published by the Board of Governors for the
year 1949 noted that because "the^ System had not been in a position
to exert greater monetary restraint it had less scope for reversal of
policy when the time came to relax credit restraint." 48 This appraisal
of the policy situation confronting the Federal Reserve authorities in
1949 must be accepted as an appropriate interpretation, provided the
underlying conception of the monetary process is justified. The
frame of reference, noted in the previous case, appears to have dominated the policy appraisal in 1949. Again, the volume of bank indebtedness is recognized as a critical link in the chain. Restraining
policy effects are conceived to be positively associated with the magnitude of this indebtedness. It follows then, that the scope for a policy
reversal, replacing "restraint," with "ease," is directly linked to the
preceding "desrree of restraint." And the alleged absence of a seriously
restraining policy before 1949 made it impossible, in the Federal
Reserve's view of things, to generate substantial monetary expansion.
Once more we note how an untested, and very questionable conception
o f the monetarv process had to bear a heavy burden.
A policy
attitude emerged which can only be defended if the underlying conception was justified.
th! v d,elaUed analysis of this conception, which has powerfully influenced interpretations and' ^isions of
S e Federal Reserve authorities will be developed in our forthcoming paper "Evolving Federal Reserve
conceptions About the Structure of the Money Supply Process/'
w Annual report, 1949, p. 4.
38
FEDERAL RESERVE'S
APPROACH TO
POLICY
Ease in 19^9
The Federal Reserve's interpretation of the events occurring after
the peak in November 194S provides a third example. Their interpretation, and the associated action, is reflected in the following quote:
Holdings of securities by Federal Reserve banks were reduced somewhat to meet very strong market demand resulting from decreases in reserve requirements, but not in
sufficient volume to modify a policy of monetary ease.49
Beginning in May 1949, the Board lowered reserve requirements
in successive steps by a substantial margin. Commercial banks responded immediately with an expansion of their desired portfolios of
earning assets. Their response raised the demand for Government
securities and consequently lowered market rates of interest. In
order to prevent a sizable reduction of market rates, the Federal
Reserve unloaded securities from its portfolio. These open-market
sales have been interpreted by the Board as a modifying element in
the context of a basically "easy policy." The assertions quoted from
the "Patman report" are repeated in the annual report of the Board
for the year 1949 and in an answer by the Presidents of the 12 Federal
Reserve banks to the questionnaire reproduced as an appendix to this
study. Both the answer and the annual report clearly convey the
impression that the Federal Reserve authorities engaged in "positively
stimulating" actions to counter the deflationary pressures gathering
in the economy.
A totally different appraisal emerges under a conception of the
monetary process to be outlined in a later section of this study*
Under this alternative conception, the monetary base adjusted for
the cumulated sum of reserves liberated (or impounded) by changes
in reserve requirements occurs as a magnitude of decisive importance.50
It can also be shown that this concept, the "extended monetary base,"
appropriately summarizes the net effect of the Federal Reserve's
"policy posture." It is therefore noteworthy that for every month
in 1949 this magnitude was substantially lower than for the corresponding month in the previous year. On the average for 1949 the
extended base was at least $500 million lower than in 1948. The
effect of the reserves released by the successive reductions in reserve
requirements was thus more than offset by the open-market sales.
The alternative conception implies that these open-market sales were
not just modifying a basically "easy policy," but actually injecting
additional deflationary impulses into the economy. The behavior of
the money supply (see charts in the appendix) clearly reveals that no
1 'positive stimulus" was exerted.
The money supply was lower
throughout 1949 than in the corresponding months of 1948, reflecting
the contractive action exerted by the decline in the base. Also, &
moving 3-month average of relative changes between adjacent months
shows strongly marked declines in the early months of 1949, a clear
break in the deflationary trend in April arid May and a subsequent
acceleration of the deflationary trend until October 1949. Thereafter
a sharp reversal occurred, and there was an accelerated upsurge.
*» The Patman report, p. 292.
. " T h e monetax y base a*i the extended monetary base are described in more detail in ch. VI. The base
is obtained from the table "Member Bank Reserves, Reserve Bank Credit, and Related Items" that apo f t h o J e ( l c r t I R c ? e £7 c Bulletin. To compute the base we add Federal Reserve bank
^
currency outstanding and subtract the sum of Treasury
S
v i f li w L S L w E
and other deposits at Federal Reserve banks, foreign deposits at
Federal Reserve banks, Treasury cash, and "other accounts" of Federal Reserve banks
39
FEDERAL
RESERVE'S
APPROACH TO
POLICY
Further investigations reveal that the highly deflationary policy
of the Federal Reserve authorities was somewhat attenuated by the
persistent conversion of currency into demand deposits by the public.
This reallocation of the public's money balances in favor of checking
deposits reduced the substantial deflationary effects of Federal Reserve
?>olicy. But this offsetting influence was not sufficient to compensate
ully for an inappropriate policy in a period of recession.
Our interpretation of the events in 1949 follows from the alternative
conception of the structure of monetary processes. Our conception
may be completely false, and the Federal Reserve's views may be
completely correct. But this remains to be shown. The large volume
of open-market sales made by the Federal Reserve authorities and the
decline in the money supply during a period in which policy is
described as "stimulating" seem at first glance to speak against their
conception.
Policy in 1053-54
The answer supplied by the Presidents of the Federal Reserve
banks to the second question in the questionnaire appended to this
study contains a reference to the recession terminating in 1954.
Attention is drawn to the free reserves of commercial banks, a dominant concept in the Federal Reserve's frame of reference during most
of the postwar period. The Presidents quite clearly convey the notion
that free reserves above a critical range must be interpreted as an
indication of an expansionary policy. In particular, free reserves in
the range of $500 to S600 million must be understood to reflect an
expansive policy.51
These views emerge from a conception focusing on the causal
role of free reserves with respect to the rate of "credit expansion."
It follows quite naturally that the large increase in free reserves
observed in 1953 and 1954 was understood by the Presidents as part
of a policy of "aggressive" ease.52 When this statement is combined
with other apprasials made by Federal Reserve authorities that bear
on developments before the peak of 1953, one obtains the impression
that Federal Reserve policy acted decisively after the peak to dampen
and counteract the deflationary pressures. Data show that toward
the close of 1952 free reserves reached a postwar minimum of approximately minus SI billion. At the beginning of 1953 free reserves moved
up rapidly and oscillated around minus $600 million for several months.
Toward midyear a large jump occurred. The gravitational center
°f the movement of free reserves increased to approximately $200
million. According to one of the Federal Reserve's standard interpretations a "policy posture" of "active ease" was counteracting the
spreading recessionary tendencies.
At the start of 1954, free reserves increased again, moved during
1954 to the $600 million level, and for several months remained about
that level. Thus we note that from the beginning of 1953 to the
beginning of 1954 there was a rise in free reserves of over $1 % billion.
It is therefore quite understandable that the Federal Reserve
authorities, interpreting these movements of free reserves within their
conception, feel that their policies contributed decisively to break
foe downturn. Their strongly held conception about the role of
*
. . whenever free reserves have been for some time in the area of $500 to $600 mfllfam*)the imoney
^ k e t and bank reserve positions have been easy and credit policy expansive. '
* The reader may wish to consult the chart of the moving average of weekly free reserves in the appendix.
40
FEDERAL RESERVE'S APPROACH TO POLICY
free reserves implied a specific interpretation of the events in 1954 and
shaped the policies actually pursued.
#
Some of the graphs collected in the appendLx, particularly those
showing monthly data on the growth rate of the "extended monetary
base" and the money supply convey a somewhat different story. The
growth rate of the money supply fell from a peak reached in 1952 to
a bottom in April 1954. The annual growth rate collapsed by 50
percent over a period exhibiting a rise of $1.5 billion in the prevailing
level of free reserves. And the deflationary trend in the money supply persisted well into the year 1954. The extended monetary base,
which effectively summarizes the Federal Reserve's policy posture,
explains to a large extent the serious retardation in the growth rate
of the money supply. The extended base grew around the middle of
1953 at a rate of approximately §1.5 billion per year from month to
corresponding month. The growth rate of this fundamental policy
magnitude collapsed thereafter. By the end of 1953, the growth rate
of the extended base had fallen by 66 percent. This decline slowed
in 1954, but the growth rate of the extended base did not reach bottom
until September 1954. According to this index measure of Federal
Reserve actions, policy was dominantly moving in a deflationary
direction during the recession of 1953-54.
Despite the prevailing downward trend in the growth rate of the
extended monetary base, the growth rate of the money supply began
to rise in the spring of 1954. At this point the restraining influences
of Federal Reserve policy was offset by the conversion of currency
into checking deposits. The reallocation of the public's money
balances in favor of checking deposits, a typical phenomenon in
cyclical downswings, compensated for the Federal Reserve's policy
actions.
We hasten to emphasize that our interpretation of monetary events
in 1953 and 1954 is not necessarily the "true" or the "best" explanation. But wre do wish to note that the Federal Reserve interpreted
its policy actions in terms of an unverified framework. That framework does not appear capable of explaining the events of 1953-54
any more than it was capable of providing guidance for policy in
1936-37, 1948-49, or at other times before and after.
PRELIMINARY
CONCLUSION
The foregoing sections have developed the contention that the analysis of the monetary mechanism contained in manv of the Federal
Reserve publications and statements reflects three basic features of
the Reserve System: (1) they have an essentially short-run, day-to-day
orientation; (2) their analysis of the monetarv mechanism runs largely
in terms of the operation of a single bank rather than in terms of the
banking system as a whole; (3) their understanding of the monetary
process consists of a series of unverified strands, often unconnected
and obscure. These three factors are not unrelated. As we noted,
individual bankers and money deskmen must often take a day-to-dav
approach toward the management of their reserve positions. They
often do not express great interest in analvtic frameworks designed to
separate the "systematic" from the "random." But the Federal
Reserve has a very different role in the system and must be equipped
with verified knowledge to effectively carry out the mandate of the
FEDERAL
RESERVE'S
APPROACH
TO
POLICY
41
Congress. Knowledge that is adequate for the banker is often quite
inadequate for the central banker.
A number of specific fragments in the Federal Reserve conception of
the monetary process were discussed in this chapter to provide some
support for our contentions. But knowledgeable readers are aware
that a variety of notions and views compose the Federal Reserve
conception. Careful sifting of pronouncements made by Federal
Reserve officials uncovers statements conflicting with some strands
analyzed in this chapter. In particular, on the question of the
demand for reserves by banks, an interesting evolution can be observed
in recent years.53 But this situation has already been recognized as
a dominant feature of the Federal Reserve's approach, an approach
composed of fragments and pieces of many notions that have not
been integrated into a coherent conception and that have not been
supported by evidence.
One concept that has often been at the forefront of Federal Reserve
statements in the postaccord period, the level of free reserves, has
not been thoroughly discussed in this chapter. In the following two
chapters, we consider the Federal Reserve's analysis of "credit expansion and contraction" and the role played by free reserves in policy
formation and execution. Before doing so, we wish to note that the
System's discussions centering on free reserves are again suggestive
of their general procedures. No clearly stated frame of reference has
been formulated and tested. As outsiders, we can only consider the
mass of Federal Reserve statements, attempt to formulate a coherent
framework, and support our views with evidence from their actions
and behavior as well as their remarks. Much of the discussion in
the two following chapters is devoted to that task.
« Review of the Annual Report * * op. eit. pp. 153-4. See also the reply of the Board of Governors
to question II, pt. 3 and to question V and the reply of the 12 Federal Reserve bank Presidents to question
V In the appendix for statements indicating the importance of the demand by banks for reserves as a factor
in the transmission of monetary policy to the economy. But this explicit acknowledgment of demand
behavior emerged only recently. Also, it occurs in contexts exhibiting fragments quite incompatible with
the demand behavior suddenly acknowledged.
O
@FedFRASER