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evievr
FED ER A L RESERVE BANK
OF ST. LOUIS

• P . O . B O X 4 4 2 • S T . L O U IS 6 6 , M O.

Page

The Steel Strike and Monetary Developments

118

Financial Security and Price Stability

121

Some Misconceptions in Public Understanding
of Monetary Policy

124

This issue released on N ov e m b er 28

VOL.. 41

• ;Ht>. I t




* N O V E M B E R ’89

The Steel Strike
and
Monetary Developments
I n RECENT WEEKS there was a moderation in
the demand for credit. Many interest rates worked
lower, and bank credit and the money supply in­
creased less than seasonally. Also, the turnover of
money decreased. In view of a smaller production
of goods and services because of the prolonged steel
strike, a contraction in bank loans, money supply,
and velocity of money might have been expected.

The Strike Reduced Activity
The steel strike, which began in mid-July and was
ended for a cooling-off period by an injunction in
early November, can be classed among the most se­
rious in the nation’s history. Over a half million steel
workers had been away from their jobs. In addition,
copper workers have been on strike since August,
directly idling about 40,000 more persons. Also, it is
estimated that by early November shortages of steel
and copper had caused another third of a million to
be unemployed; many others were on a short work
week. Firms in a wide range of industries were affect­
ed, and their number had been growing each week.
Auto assembly lines, appliance and tractor plants,
and construction projects have been shut down.
It is said that the cost of the dispute in terms of
wages, profits, and production lost has already run
into billions of dollars. While the industrial produc­
tion index in June was at the rate of 155 per cent of
the 1947-49 average, by October it was estimated
that the index had fallen to 148, and it is likely that
in early November production was at an even lower
rate than in October. After the strike end it will
probably be several months before steel supplies will
have returned to normal.
Page 118




Demand for Credit Moderated
With more and more of the country's productive
capacity being idled because of the lack of steel, the
demand for credit became less intense. Some of the
credit contraction may have been an adjustment to
heavy anticipatory borrowing prior to the strike. The
smaller demand for funds relative to supply was re­
flected in interest rates. Market interest rates, which
had been rising for over a year, generally remained
unchanged or declined somewhat over the past two
months. Average yields on high-grade corporate
Industrial Production
S e a so n ally Adjusted
Per Cent

Latest data plotted: October, preliminary.
Source: Board of Governors of the F ed eral R eserve System.

Per Cent

bonds were at about the same level in early Novem­
ber as in mid-September. Interest rates on long-term
Government bonds declined from 4.28 per cent on
September 15 to 4.10 per cent on November 13. Over
the same period yields on 3- to 5-year Government
issues fell from 4.86 per cent to 4.62 per cent, and
rates on three-month Treasury bills declined from
4.22 per cent to 4.06 per cent. Interest rates on com­
mercial paper issued by sales finance companies were
marked down from 4% per cent to a level of 4 per
cent.
The recent decline in the demand for credit has
been reflected in banking statistics. During the pe*
riod August 19 to October 28, loans at weekly report­
ing banks rose about $650 million, or 1.0 per cent.
Usually, loans at these banks rise at a much more
rapid rate in the fall, and earlier this year they were
increasing faster than the seasonal pattern. Indica­
tions are that the less-than-seasonal rise in loans did
not result from increased “pressure” on bank reserve
positions. Member bank borrowing from the Federal
Reserve Banks averaged $925 million in the ten
weeks as against $970 million in the previous ten
weeks. Net borrowed reserves (borrowings less ex­
cess reserves) averaged $470 million in the midAugust through October period compared to about
$500 million during the earlier summer period.

Money Supply Declined
Weekly reporting banks reduced their investment
portfolios by $1.3 billion during the August 19-October 28 period, continuing a trend which began over a
year ago. Hence, total credit at these banks fell
about $640 million during a period when it typically
rises. Reflecting the bank credit developments, the
money supply, seasonally adjusted, declined about
$2.5 billion, or 1.8 per cent from the last Wednesday
of July to the last Wednesday of October.
Total Loans and Investments
A ll Com m ercial B a nk s
Billions of D o lla rs

Billions of D o llars

Seasonally adjusted data for last W ednesday of month.

Yields on U. S. Government Securities
Money Supply
Billions of D ollars

1958

1959

Latest d a ta plotted: W e e k E n d in g Nov. 13, p re lim in a ry
Source for all charts on this page:
Reserve System.




Billions of D o lla rs

Board of Governors of the F ed eral

Latest d a ta plotted- O c to b e r, prelim inary.
D em and deposits adjusted and currency outside banks seasonally ad ­
justed for last W ednesday of m onth.

Page 119

In addition to the contraction in the money supply
since the end of July, it appears that the turnover of
money leveled off or declined moderately. With in­
ventory cutbacks, layoffs, and other adjustments re­
sulting from the strike, it is not surprising that the
flow of expenditures would fall relative to cash bal­
ances. Turnover of demand deposits (except inter­
bank and U.S. Government) at reporting banks out­
side the seven large financial centers decreased from
a rate of 25.1 times per year in June and July to about
24.7 times per year in August, September, and Octo­
ber.
A reduction in the money supply is usually a re­
straining influence on economic activity. However,
in view of the fact that the productive capacity of the
country has been materially reduced as a result of
the steel strike, it does not appear that a modest re­
duction in the monetary stock has been restrictive,
even when accompanied by a slightly lower rate of
turnover. The strike has inactivated for a time a
significant portion of our productive capacity, and,
therefore, it takes a smaller flow of spending to pur­
chase the available output.
Reduced business activity because of a strike may
have materially different implications for monetary
policy than when business activity turns down in a
recession. In a business recession, there is idle capacTurnover of Demand Deposits
Reporting Centers

(outside seven la rg e financial cities)

A n n u a l Rate

A n n u a l Rate

ity which is ready to produce if there is a demand
for the products. Under these conditions it is generally
believed that the money supply should be expanded
in order to stimulate demand. In a strike, on the
other hand, the capacity which has been shut down
is not likely to be brought into production by an
increased desire for the products.
In judging whether or not the size of the money
supply is appropriate during a strike, the effect of
strike-induced changes on the Government's fiscal ac­
tions should be considered. A major strike, like a
business recession, brings about unemployment and
lower income. Thus, during the strike, as in a reces­
sion, the progressive tax structure, provisions for un­
employment compensation, and other so-called auto­
matic stabilizers change the relationship of Govern­
mental receipts to expenditures. As corporate and
individual incomes decline, tax receipts fall, and as
the impact of the strike spreads to additional firms,
unemployment compensation payments rise. Hence,
Government expenditures tend to increase relative to
receipts.
In business recessions the stimulating effects of
these automatic devices are widely praised because
they tend to stabilize activity and they take effect
quickly without the need for overt action. During a
strike, when business activity in the nonaffected areas
is at a high level, the automatic stabilizers also come
into play, but since a greater demand for goods prob­
ably will not bring forth significantly more produc­
tion, bidding may be increased for available goods
causing their prices to rise. Hence, the so-called auto­
matic stabilizers (both Government and non-Government) may have a temporary perverse effect on eco­
nomic stability during a strike.

Conclusion

Latest d a ta plotted: Se pte m ber,
Three-m onth m oving averages of seasonally adjusted data.
Source: B oard of Governors of the F ed eral Reserve System.

Page 120




Bank credit and the money supply have declined
at a time when the velocity of money has been slow­
ing. However, because of work stoppages resulting
from the strike a smaller money supply may not be
more restrictive. With less productive capacity avail­
able for supplying the economy with goods and serv­
ices, a flow of spending which was suitable before
the enforced economic contraction may be inflation­
ary during it. Then, too, because the shutdowns are
apt to cause a reduction in Governmental tax receipts
and an increase in Governmental outlays which tend
to have an expansionary effect on activity, a smaller
money supply may be appropriate.

Financial Security and Price Stability

O n e OF THE GREAT DRIVES of social reform
of the past generation has been for financial security.
To protect against economic uncertainty, individuals
have sought steady jobs, joined pension plans, built
up savings balances, and accumulated a large volume
of other claims to dollar assets. It would indeed be a
great irony if after the valiant efforts to supply eco­
nomic security by such elaborate devices much of the
benefits were to atrophy from dollar depreciation.

Growth in Financial Claims
Arrangements have been made through Govern­
mental machinery for a large portion of the popula­
tion to receive social security benefits. At the end of
1958, there were about 110 million persons in the
United States with social security wage credits, and
assets in the Old-Age and Survivors Insurance Disabil­
ity Trust Funds amounted to roughly $25 billion. In
addition, many employers and other organizations
have established private pension plans, and billions of
dollars have been amassed by these pension funds for
future payments.
Assets of life insurance companies in the United
States total about $112 billion at the present time. The
aggregate °f
policies that are now in force in the
country is about $550 billion, as against about $112
billion at the end of 1939. About three persons in
four in the country are now participating in some
form of insurance. People have invested in life insur­
ance with a view that they or their beneficiaries will
receive a measure of financial securitv through bene­




fits in the form of certain dollar payments in the
future.
Also, the public has accumulated vast sums of
money and other assets that are valued in terms of
dollars. On June 30, 1959, the money supply of indi­
viduals and businesses totaled about $140 billion of
which $111 billion was in the form of demand bal­
ances with banks and nearly $29 billion was in cur­
rency and coin. At the same time the public had $65
billion in time deposits in commercial banks, $35
billion in mutual savings banks, and $1 billion in the
Postal Savings System. Share holdings in savings and
loan associations amounted to $51 billion, and invest­
ments in United States Savings bonds also totaled $51
billion. In the aggregate these assets amounted to
$343 billion at mid-year, which compares with roughly
$70 billion at the end of 1939. A main reason for
people accumulating substantial amounts of cash or
items convertible to cash has been to provide financial
security.
Likewise, there has been a huge buildup of other
assets that will ultimately be returned in dollars. Ex­
amples are corporate, municipal, and marketable U.S.
Government bonds, mortgages, and shares in credit
unions. These investments were made with the expec­
tation of obtaining a certain amount of purchasing
power, not mere dollars as such,
A sizable proportion of the families of the country
are dependent upon fixed or relatively fixed incomes.
As retirement age is reached, if not before, most in­
dividuals of the country will be dependent upon fixed
dollar payments.
Page 121

Some Steps to Stability

Liquid Savings

Fluctuations in individual prices may serve a desir­
able economic function by guiding resources into
their most beneficial use. However, an overall rise in
the price level means a reduction in the purchasing
power of those with dollar assets. If the country is
willing to discipline itself sufficiently, there is wide­
spread agreement that the general level of prices can
be kept from continually rising and that stability can
be attained without resort to undesirable direct con­
trols over prices and wages. Of course, differences of
opinion may arise over which general measures to use
and to what extent in order to accomplish price sta­
bility. But there appears to be little doubt that tax
increases, cuts in Government spending, control of
the size of the money supply, and similar measures
can be made effective in halting inflation.
40

’4 5

'5 0

’5 5

’6 0

L a te s t d a t a p l o t t e d : 1 9 5 9 , e s t i m a t e d
Demand deposits adjusted and currency and coin outside banks;
time deposits in commercial banks, in mutual savings banks, and in
postal savings; U. S. Savings Bonds, and shares in savings and loan
associations.
Source: Board of Governors of the Federal Reserve System.

Extent of Inflation
When people place their funds into fixed dollar in­
struments or assume obligations to provide services in
the future for specified sums, they are interested in
getting not just dollars but the ability to buy goods
and services. For people who are providing for old
age, sickness, or other periods of low current income,
it is especially important that rights to future dollars
maintain their purchasing power since these people
will be getting fewer dollars per year than now, and
accordingly, each dollar will be more valuable to
them.
Despite the interest which the public at large has
in avoiding declines in purchasing power of the dol­
lar, there has been an almost steady erosion in the
value of the monetary unit in recent years. As a. result
average consumer prices today are more than twice
as high as they were in 1939 and about %higher than
they were in 1950. The increase has apparently not
been halted. From March of this year to September,
the consumer price index worked up at an annual rate
of 2.4 per cent. Because of inflation during the six
months the purchasing power of the money supply
and savings in major institutions alone decreased ap­
proximately $4 billion, an average drop in buying
power of nearly $25 dollars per man, woman, and
child in the country.
Page 122




In general, inflation results when demands for
goods and services exceed the amount that producers
are willing and able to supply. Attempts to buy more
bid prices upwards. Even when production is at less
than 100 per cent of capacity, prices may work up if
buyers seek a different product mix than is being sup­
plied or if there is monopolistic pricing. In order to
attain price stability actions must be taken which
will equate demands for goods and services with the
supplies available.

V a lu e of the Dollar
In T e rm s o f 1 9 3 9 C o n s u m e r Pric es

L a te s t d a t a p l o t t e d : 1 9 5 9 , e s t i m a t e d

Source: Bureau of L ab or Statistics. Inversion of Consum er Price In ­
dex com puted by F R B , St. Louis,

One method of matching demands and supplies of
goods and services is to vary the Government’s fiscal
policy. An increase in taxes tends to reduce demands
for goods and services. Conversely, a rise in Govern­
mental expenditures increases the amount taken. In
the twelve months ending next June, it is estimated
that the Government’s cash receipts will approximate­
ly match its cash outlays. By contrast, in the last fiscal
year there was a cash deficit amounting to about $13
billion. A substantial cash deficit may have been
desirable as an economic stimulant in early 1958 when
the level of unemployment was comparatively high,
but as capacity is approached in many lines a deficit
tends to be inflationary. The shift from large net Gov­
ernmental outlays to a balanced budget has reduced
upward pressure on prices. By operating at a cash
surplus, that is, collecting more taxes than expendi­
tures, the Government could be even more anti-infla­
tionary.
Another price stabilization weapon is to change the
rate of growth in the money supply of the nation.
With fewer dollars to satisfy liquidity requirements
individuals and businesses tend to spend less; with a
larger money supply demands for goods and services
usually expand. From the last Wednesday of March
1959 to the last Wednesday of September the money
supply of the country, seasonally adjusted, has been
virtually unchanged. During the corresponding six
months last year when economic conditions were rel­
atively depressed the money supply was increased at
an annual rate of 4 per cent.
Actions of businesses and labor in raising prices and
wages may be inflationary, However, it is unlikely
that many individual businessmen or workers will
voluntarily forego additional profit or higher wages
for the benefit of general price stability. Since others
would not do likewise, an individual would be acting
to his detriment. Besides, the profit motive is one of
the strongest for stimulating growth in production and
should be encouraged.
However, it is socially undesirable if businessmen
or labor organizations by taking advantage of a mo­
nopolistic position set prices above the competitive
level. Such actions, although adding to incomes of
the price administrators (business firms or labor), re­
duce real national income and cause unemployment.
The combination of monopolistic pricing, which with­
holds goods and services from the market, and national
economic policies designed to maintain business activ­




ity at near capacity levels, sets the stage for continuous
price increases. A reduction of the monopolistic in­
fluence, through such measures as anti-trust actions,
removes an inflationary pressure.
Also, it might be noted that many struggles by busi­
ness concerns or organized labor to raise profits or
wages have had little effect on the real incomes of the
owners or workers. For instance, an increase in money
wages in one dispute frequently sets a pattern for
other wage negotiations, and a general increase in the
cost of labor is usually passed on in higher prices.
Hence, bigger money wages and larger profits are
frequently offset by a higher cost of living.
It has been argued that an increase in wages which
is matched by a gain in productivity is not inflation­
ary. Higher total wages in real terms must come pri­
marily from greater production, and more output be­
cause of efforts of employees should be rewarded. But
to insist that wages should rise as much as produc­
tivity in lines where improvement in output per man
hour is relatively great because of capital improve­
ments or technological advance may be inflationary.
Better wages in the dynamic industries normally set
the wage pattern for other firms, which meet the in­
creased costs by raising prices. Attainment of general
price stability requires that there be a decline in some
individual prices in lines where productivity rises
fastest. A more rapid rise in the general level of wages
than the average increase in productivity tends to be
inflationary.

Conclusion
During the past three decades a definite movement
toward greater financial security has developed.
There has been a tremendous buildup of savings bal­
ances and other dollar claims as individuals have
sought to provide for their future. Probably never
before in history has so large a proportion of the
population had such a great stake in maintaining the
purchasing power of the monetary unit. However,
inflation has been eating away at the value of the
dollar at an alarming rate.
In view of the great stake that people have in price
stability and the general tools available to control the
price level, it would seem to be a great irony to tol­
erate a further deterioration in the value of the mon­
etary unit. Surely, the same public opinion which
has caused the provisions for economic security will
support a stable dollar in order to maintain that secur­
ity.
Page 123

Some Misconceptions
in Public Understanding
of Monetary Policy
T h e RISE IN THE LEVEL of interest rates in
recent years, and more particularly the sharp rise
since mid-1958, has created considerable public inter­
est in monetary policy.
Public reactions to Federal Reserve policies reflect
sharp differences of opinion with respect to the forces
raising interest rates and the principles guiding Fed­
eral Reserve authorities in this connection. Many
people are generally aware of the reasons for current
monetary policy and accept the rise in interest rates
as the inevitable result of the bulging credit demands
of a boom pressing against a supply of credit which
is necessarily more limited in amount. There are
others, however, who regard the rise in interest rates
with alarm and resentment. They consider the pres­
ent level of rates a product of an inappropriate mone­
tary policy.
The generalizations most frequently used by critics
of current monetary policy are the following:
1. Federal Reserve authorities are deliberately fixing
interest rates at high levels.
2. Rising interest rates, by increasing the cost of borrow­
ing, contribute to inflation.
3. Interest rates are abnormally high as evidenced by the
fact that they are now at a 25-year peak.
4. Federal Reserve authorities have the power to keep
rates down and should use that power.
5. Rising interest rates reflect a policy of excessive mon­
etary restraint which inhibits economic growth and full
utilization of resources.
The purpose of this article is to suggest that these
generalizations in the main reflect (1) public misun­
derstanding of Federal Reserve policy and operations,
and (2) preoccupation with immediate goals without
sufficient regard for longer run consequences.
Page 124




A Review of Federal Reserve
Objectives and Controls
Since many of the above generalizations apparently
reflect some basic misconceptions in the public's un­
derstanding of what the Federal Reserve authorities
are attempting to do and how they are doing it, a
brief review of the objectives and the mechanisms of
credit control seems to be in order.1

Objectives
The primary objective of the System is to influence
the monetary and credit situation so as to encourage
growth and resist both inflation and deflation.
The focal point of Federal Reserve action is the
volume of member bank reserves available for lending
and investing, since generally each new bank loan or
investment, with its simultaneous creation of a new
deposit balance, represents an addition to the money
supply available for spending on goods and services.
In a boom period, the monetary authorities will
attempt to influence member bank reserves so that
the lending ability of commercial banks does not
increase at a faster rate than is compatible with the
economy’s capacity to increase its real product. In
other words, as expanding credit demands of the
economy impose growing pressures on banks to
extend more credit and to seek additional reserves
to meet expanding reserve requirements, the Federal
Reserve System strives to limit the increase in re­
serves and total bank credit to an amount compatible
with sustainable economic growth without inflation.
Since interest rates are the prices paid for credit, it
is not at all surprising that in the boom phase of our
economy the strong credit demands of Federal Gov­
ernment, state and local governments, businesses and
1 For a more detailed description see Board of Governors, The
Federal Reserve System—Purposes and Functions (Washington,
D. C„ 1954).

consumers generate an upward thrust in interest rates.
The supply of credit, limited as it is by the volume of
current savings, accumulated idle balances, and new
commercial bank credit, does not and cannot keep
pace with the virtually unlimited credit demands of a
booming economy.

Instruments of Control
The Federal Reserve authorities have three major
instruments for influencing member bank reserves and
total bank credit—open market operations, discount
policy, and changes in reserve requirements.
Open Market Operations —These are the transac­
tions which increase or decrease Federal Reserve
holdings of U. S. Government securities at the initia­
tive of the System. Purchases of securities supply
reserves to member banks. Sales of securities extin­
guish member bank reserves. These operations may
be used not only to change the volume of bank re­
serves within the framework of a credit policy of
ease or restraint, but also to offset losses or gains in
reserves from changes in such factors as currency in
circulation, gold stock, Treasury balances at Federal
Reserve Banks, and float.
In view of the complexity of forces operating on
member bank reserves and changes in the velocity
of money, a period of monetary restraint may not nec­
essarily be characterized by net sales of Government
securities by the Federal Reserve. The System may
find that it has to feed additional reserves into the
banking system to offset the absorption of reserves
caused by such factors as outflows of gold, increases
in Treasury balances, or increases of money in circula­
tion. In this situation the open market operations,
although aimed at moderating the growth of com­
mercial bank lending, will involve net purchases of
securities to offset the losses of reserves mentioned
above. It is also important to note that net purchases
of Government securities by the Federal Reserve may
be quite consistent with a policy of monetary restraint.
Such a policy permits bank reserve growth compatible
with a noninflationary expansion of bank credit.
The impact of Federal Reserve policy may be bet­
ter judged by observing what happens to total bank
reserves than by looking at purchases and sales of
Government securities. Thus, the most powerful in­
strument of control, and the one that directly changes
the total reserve positions of member banks, is under­
standably masked and quite likely to be ignored by
the public.
Discount Policy —This relates to Federal Reserve
Bank lending to member banks. The initiative in such
credit extensions is taken by individual member banks
when it is necessary for them to build up their re­
serve positions to required levels.




The discount mechanism, as now used, is largely
complementary to actions in the open market. At a
time of credit restraint, for example, open market
operations furnish banks less reserves than they need
to meet existing credit demands. The impact of such
action is generalized for banks as a whole. Neces­
sarily it hits some banks harder than others. Those
individual banks which find their reserve positions
especially hard hit in the process may borrow at the
Federal Reserve Banks as they face prospective re­
serve deficiencies.
Borrowing by any individual bank is a temporary
expedient to carry over until more fundamental chang­
es in asset position can be effected. Under these cir­
cumstances the discount window operates as a safety
valve, not to frustrate the impact of open market op­
erations, but to permit that impact to be spread more
evenly and smoothly over the banking system as a
whole.
The member bank tradition against borrowing, in
addition to Federal Reserve Bank policy on this
matter, normally assures that the discount window
is no more than a safety valve for individual banks.
However, to guard against the use of the discount
mechanism as a means of offsetting restraint through
open market policy, the discount rate may have to be
raised. If, during a period of credit tightness the dis­
count rate is far below the market rate on Treasury
bills, for example, banks find it more desirable from
the cost standpoint to borrow at the Federal Reserve
Bank than to sell off short-term Government securities.
If the discount rate is raised to a level comparable to
the market rates on short-term Government securities,
individual banks facing reserve deficiencies may pre­
fer to sell off their securities rather than borrow from
the Federal Reserve, thus contributing to the intend­
ed tightness in the money markets and passing on the
reserve pressure to other banks whose customers may
buy the securities being sold.
It is important to emphasize that open market op­
erations are the primary instrument of control and
that the discount mechanism and the discount rate
serve to re-enforce the intended impact of open mar­
ket policies. More often than not the rise in the
discount rate will follow the rise in market rates, re­
flecting the monetary tensions created by a bulging
credit demand pressing against a supply of credit
which has not been permitted to grow as fast as the
credit demand.
Reserve Requirements —The Federal Reserve at
its initiative may also diminish or enlarge the volume
of funds which member banks have available for
lending by raising or lowering reserve requirements.
Unlike open market operations, reserve requirement
Page 125

changes affect immediately and simultaneously all
banks in each reserve class. It is a powerful instru­
ment which has usually been employed only when
large-scale changes in the country's available bank
reserves are desired.
Since sharp changes in excess bank reserves are not
desired in a period when the Federal Reserve is at­
tempting only to moderate the growth of reserves,
the System depends on open market operations and
discount policies as the more sensitive and flexible
instruments of credit control.

An Examination of the Criticisms
of Monetary Policy
Does the Federal Reserve Deliberately Fix
Interest Rates at a High Level?

It is equally obvious that the low rates of the 1940’s
and the first year or two of the 1950’s are not appro­
priate benchmarks for appraising the current level
of rates. There we had a period in which monetary
policy was subordinated to the policy of stabilizing
the Government securities markets. That such a pol­
icy made virtually impossible effective control over
commercial bank reserves, demand deposits, and the
money supply appeared to be a consideration second­
ary to the prevailing fear that any upward move­
ment in rates would bring a collapse of the bond
market and perhaps “destroy public credit.”
The most recent comparable period free from se­
vere depression and war was that running from 1920
to 1930. Compared with the interest rates of that
period, the current rates do not appear to be abnor­
mally high, as some believe. During the first 5%years
after World War I yields on long-term Treasury obli­
gations partly exempt from taxation ranged from 5%
to 4S per cent. It may be recalled that that was also a
time when the Federal budget was in balance and
with the Government debt declining from $26 billion
to $16 billion. During the entire 11-year period, the
average yield on long-term Governments was slightly
under 4K per cent (see chart).
Selected Interest Rates
8

8
\ /

W

G o v ernm ent

Page 126




1900

1910

w J

a

A a a Cl o r p o r a t e B o n d s

tv
AV

00

That interest rates are at their highest level since
the early thirties is not to be denied. The implication,
however, that the low levels of interest rates marking

Per Cent

1 C o m m eirc ia l P a p e r

Are Interest Rates Abnormally High?
Often heard today is the statement that current
monetary policy has raised the interest rate to the
highest level in 25 years; that such a rise in rates is
clearly abnormal and one that the monetary authori­
ties can and should avoid.

1900-1959

Per Cent

h

The above review of the basic instruments influenc­
ing member bank lending makes clear that it is the
lending ability of commercial banks and not the inter­
est rate which is the major target of Federal Reserve
credit policy. Unfortunately, from the point of view
of public understanding of monetary policy, the most
important credit control, namely open market opera­
tions, is the least dramatic and least likely to attract
the attention of the public. What the public does see,
however, is that in a period of rising interest rates the
discount rate also rises. Observing no changes in
legal reserve requirements and being unaware of the
credit impact of open market operations, the public
frequently jumps to the conclusion that the rising
discount rate is the instrument and the cause of rising
interest rates. In so doing they fail to realize that
interest rates reflect the interaction of credit demand
and supply forces and that the primary cause of the
sharp rise in interest rates in 1959 has been the greatly
expanding credit demands of a booming economy
pressing against a growing but limited amount of
credit. In this connection it is appropriate to point
out that bank credit is only a portion of the total
credit volume, and that an important limit on total
credit availability is the volume of savings.

the period from the thirties through the early 1950’s
constitute a “norm” is indeed suspect. Clearly, the
depressed years of the thirties, with business flat on
its back and credit demands at a low ebb, do not pro­
vide a basis for judging the rate structure of the pres­
ent day, marked by tremendous credit demands of
Federal, state, and local governments, businessmen,
and consumers.

1920

*a T
1930

1940

1950

1960

Latest data plotted: 1959, estim ated
Source: Board of Governors of the Federal Reserve System. Breaks
in line for long-term Government bonds indicate changes in
series.

Do Rising Interest Rates Raise Costs and
Contribute to Inflation?

ment bonds to support bond prices and thus restrain
the rise in yields.

Much of the criticism of current monetary policy
centers on the interest rate as a cost element confront­
ing government at all levels, businessmen, and con­
sumers. Impressive figures on mounting interest costs
to government are intended to show that increased
public expenditures and related inflationary pressures
are directly attributable to rising interest rates. In
short, the System’s critics charge that monetary re­
straint, instead of holding back inflation, actually pro­
motes it by permitting the rise in interest “costs.”
There is a basic weakness in this position. The
critics ignore the fact that rising costs attributable to
advances in general price levels are much more sub­
stantial than those due to rising interest costs. For
example, state and local purchases of goods and
services are now four times what they were in 1946.
It has been estimated that approximately one-half of
this increase has been due to rising price levels since
1946, while the balance of increased expenditures
stems from a growth in real state and local needs.
Clearly, interest costs which reflect no more than 2 to
3 per cent of state and local budgets are not the im­
portant factors in the aggravated problems of state
and local finance.
It is equally obvious that the cost of servicing the
Federal public debt has not played the most import­
ant part in the mounting Federal expenditures, built
up to a large degree by the sheer magnitude of na­
tional security needs and by the rise in prices in the
years following World War II.
Although rising interest rates are relatively more
important in mortgage financing, it is no less true that
rising wage rates and higher building costs have
played the dominant roles in determining the size
of the mortgage that has to be financed.
The defenders of current monetary policy do not
deny that interest rates are costs, and at times, pain­
ful to the borrower. They do insist, however, that
rising interest rates merely reflect the tremendous
market demand for credit pressing against a limited
supply which, if expanded substantially in a boom
period, would unleash a flow of spending and lead to
a costly rise in prices far more painful and disruptive
than the cost impact of interest rates.

Here again those who support this proposal have
failed to look at all aspects of this problem. They
overlook the fact that to halt the upward trend of in­
terest rates in this expanding period of our economy
would require a tremendous volume of open market
purchases of Government bonds. This could not be
done without promoting inflation and, indeed, with
out converting the Federal Reserve System into an
engine of inflation.

Should the Federal Reserve Attempt to Hold
Interest Rates Down?
Reflecting the feeling that interest rates are too
high and that such rates as costs are contributing
strongly to inflation, many have urged that the Fed­
eral Reserve Board authorize the buying of Govern­




As pointed out earlier, when the Federal Reserve
purchases Government bonds, it increases the reserves
of member banks, and thus their ability to make more
loans, in an amount which is a multiple of the increase
in excess reserves. Actually, each dollar of open
market purchases of Government bonds by the Fed­
eral Reserve makes available about six dollars for
additional loans or investments —a tremendous infla­
tionary factor.
Most of us recall the difficulties involved when the
Federal Reserve System pegged interest rates on Gov­
ernment obligations during and following World War
II. The rates were held down, but a dangerous in­
flation developed under the blanket of direct price,
wage, and materials controls, and when these wartime
controls were removed the inflation broke out under
the pressure of tremendous money demands on rela­
tively scarce goods and services.
Even if the inflationary consequences were accept­
ed, it is doubtful whether the Federal Reserve Sys­
tem could peg interest rates on Government obliga­
tions under normal peacetime conditions. The infla­
tionary influence of such huge increases in credit
would accelerate a further diversion of savings from
investments in bonds and other fixed income obliga­
tions into stocks and other equities. It would lead to
speculative buying of commodities and securities to
beat higher costs and prices in the future. Thus, such
efforts to stabilize interest rates would have a reverse
effect and would push up interest rates in most sectors
of the credit market.

Does Current Monetary Policy Inhibit Growth
and Full Utilization of Resources?
Monetary policy critics frequently point to the ex­
isting volume of unemployment and the absence of
supply shortages as evidence of an expansion potential
that could be realized if monetary restraints were
relaxed. Some critics broaden this position to include
the general proposition that price stability as an ob­
jective of monetary policy is bound to inhibit growth
and the full utilization of resources.
Page 127

A noteworthy feature of this criticism of monetary
policy is that it reflects a preoccupation with shortrun objectives while ignoring the importance of longrun considerations governing Federal Reserve policy,
If the sole objective of monetary policy is to be con­
sidered maximum employment and growth in the
short run, the argument of monetary policy critics is
plausible. If, however, the objective of economic so­
ciety is orderly and sustainable growth over the long
run, the defenders of monetary policy have some
compelling arguments to submit in behalf of a mon­
etary policy geared to the avoidance of longer run
consequences of inflation and violent instability.
Unutilized Resources Not Evidence of Inhibited
Growth —While the problem of unemployment is
never to be minimized, the existence of unutilized
resources in an expanding economy does not neces­
sarily argue for additional injections of credit to sup­
port a higher money demand for goods. In this type
of economy, expansion is cumulative —and at times
explosive —increasing at rates that cannot possibly be
sustained.
If the objective of society is growth at a sustainable
rate, it is quite evident that monetary policy must at
times moderate the bursts of expansion that would
occur in the absence of some restraint. In other words,
it is necessary to impose restraints on demand before
it pushes on to the extreme limits of supply, if the
economy is to avoid violent downturns in production
and employment.
In this case, monetary restraint may be accompa­
nied by an employment and output level lower for a
time than that obtained in a high pressure economy
with no restraints. In the long run, however, eco­
nomic activity, although moderated in the short run
by monetary restraints, can be expected to enjoy a
more sustained and, averaging the boom years with
the others, a higher rate. This is, of course, a longrun argument, and since it is always possible to get
more out of an economy in the short run by running
it at high speed, the advocates of less monetary re­
straint always appear to have a plausible case.
It is also significant that although unemployment in
mid-1959 was substantial—approximately 5 per cent
of the labor force—it was not generally distributed
over the nation. A significant amount was concentra­
ted in declining industries and distressed areas. Such
unemployment does not respond quickly, if at all, to
general increases in demand. Any attempt to remove
such unemployment by large injections of new money
would tend only to strengthen the inflationary pres­
sures on those industries already strong and expand­
ing with little impact on those industries such as coal
mining, textiles, etc., which have been hit hard by
Page 128




long-run shifts in demand and an uneconomic alloca­
tion of resources.
Creeping Inflation Not a Prerequisite of Long-Term
Growth —The history of past relationships between
prices and growth do not support such a claim. At
some times in our history notably in the period 1875
to 1890, a declining price level accompanied an ex­
traordinary rate of growth. It may also be of interest
to point out that the greatest economic strides of any
foreign country in recent years were made by West
Germany with one of the best records of price level
stability.
Critics of monetary restraint often point out that
the upward price movement in the United States from
1933 to the present was accompanied by substantial
growth. This is regarded as evidence that prolonged
inflation is not as harmful as alleged.
Those who accept this as evidence overlook the im­
portant fact that during this period the price increases
were not regarded as inevitable or as a continuing
process. There was always the possibility that prices
might decline.
The idea that inflation—a creeping inflation—is in­
evitable and necessary for growth is one that must
be resisted by the monetary authorities for reasons
well described in the following quotation:
The distortion of investment decisions, the discourage­
ment of saving, the compulsion to speculate, the misallocation of resources, the strengthening of the monopoly
position of firms owning old and low cost equipmentall are familiar dangers that have been pointed out many
times. The inherent instability of an economy in which
everything is worth what it is only because it is expected
to be worth more next year; the fluctuations in the value
of “inflation hedges” produced by the uncertain speed
of the inflation; the need to concentrate all efforts on
staying ahead of the game—all this does not add up to
a satisfactory picture of a stable and rapidly growing
economy. And, as the moralistically inclined may feel
tempted to add, a society in which all contracts and
financial promises are made with the afterthought that
they will be partly cancelled by inflation, does not offer
a morally-elevating picture either.
Few of the critics of inflation would claim that they
can foresee its ultimate consequences. It may lead to
collapse into deep depression, or simply to more inflation
with stagnating growth. Or more likely, it will lead to
price controls imposed under the pressure of impatient
citizens and politicians. The immediate sacrifices that a
policy of stable prices demands seem preferable to any
of these.2
The rejection of creeping inflation as a matter of
policy is a “must” if we are to avoid an economic sit­
uation in which every decision—whether by business,
consumer, or government—is made in anticipation of
rising prices.
2 H. C. Wallich, “Postwar United States Monetary Policy Ap­
praised,” United States Monetary Policy (The American Assembly,
Columbia University, December 1958) p. 102.