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V For release upon delivery. UBKARY FEDERAL RESERVE POLICY^ An Address,by Oliver S. Powell, Member, h Board of Governors of the Federal Reserve System, tBefore the Fifth Study Conference of the Alabama Bankers Association, University of Alabama, Tuscaloosa, Alabama. August 6, 1951»^i 7:15 p.m. FEDERAL RESERVE POLICY At a Study Conference such as this, the topic assigned to me for discussion could be treated in an abstract or textbook manner. However, I chosen to speak of Federal Reserve policy in action as applied to today's Petitions. The title of this talk might have been labeled, "Learning to Live National Defense". Outside of actual war-time conditions, the United States for generations has found it possible almost to forget defense against °u1:sicie enemies and to devote its energies completely to developing a higher ^ndard of living at home. Now we find ourselves the most powerful non-com- ^ttist country in the World, able to depend on other countries for protection onlv </ m nat very limited ways and faced with the problem of rebuilding a strong ional defense. The problem resolves itself into one of increasing the production of ^ense items while maintaining the supply of civilian goods at as high a level as possible. If the total demand for goods exceeds the supply, prices go ^ p * This is inflation. It hurts the civilian economy and increases the the defense program. kfroad fv. The restraints against inflationary price advances must cover a xr ont. 8riC0Ura G First o.f all is an adequate tax program. ged to increase their savings. °Uraged. Second, people should Abnormal profit margins should be If commodity prices can be held in check, further rounds of should be avoided. Above all, individuals and businesses houid^creases \ encouraged not to buy more than their normal requirements. s This address deals with one particular phase of inflation restraint, -"that administered by the Federal Reserve Board and the related Voluntary ed;Lt ^straint Program. Early in 1950 the recovery of business from the minor recession of 19^9 had brought the level of production, consumption and employment to a high plateau. Production was almost at capacity, a point beyond vhich it is difficult to expand except by the slow processes of population growth, m °re factories and improved industrial techniques. invasion and it set off a rush of panicky buying. Then came the Korean Remembering the shortages that developed during World War II, we rushed to the stores and bought ^normal quantities of merchandise—everything from sheets and coffee to television sets and autos. winter. There were two waves of buying—autumn and There was also an unprecedented increase in residential building. This buying rush caused retailers and manufacturers to step up their purchases and production rates, and there was a sharp increase in employment. T he inevitable result of all this was a sharp rise in prices, and another r ound of wage increases. It is important to analyze the sources of buying power which made Possible this abnormal buying movement which was superimposed on a high le vel of peacetime trade. There were three principal sources of buying Power $ First, current income. fr The sum total of wages, rents and income om invested capital which normally just about equals the production of 8°ods and services at stable price levels. Second, the use of savings by drawing down savings accounts, cashing savings bonds and spending funds which had remained idle in checking a °counts awaiting a suitable time for use. Third, borrowing against future income. Consumers' borrowings to automobiles, household appliances and-houses; business firms borrowings to increase inventories or to pay higher prices for inventories or to extend credit to consumers, or to expand plants. The combination of these three sources of buying power, coupled with the greater activity of deposit accounts,when used to purchase a quantity of goods and services that could not expand with equal rapidity has caused a sharp price rise0 This situation would have called for restraining action at any tir ne. It became much more essential to invoke restraints under today's conditions of growing national defense. The gap between available goods for civilian consumption and the supply of purchasing power promises to be even larger as the months go on. f Within a year we are likely to see a million ewer employees engaged in making civilian goods. The amount of raw materials available for civilian goods production will probably be less next year "than today because of defense requirements. Already smaller allocations anc * greater restrictions in many strategic materials have been announced. with full employment, counting as employees those producing civilian k°°ds, the workers in defense industries and people in military service, th e national income might be as much as twenty-five billion dollars above current levels. This guess is on the assumption that no further price in- creases occur. The probable gap between income and available civilian goods w °uld cause tremendous pressure for higher prices, even with no expansion bank credit and various forms of consumer borrowing against future income. In addition to the inflation gap in current income versus the supply of civilian goods there has also been much use of savings for current expenditure. Savings are in many forms. I shall mention only two. -h- The simplest illustration is the idle bank account. A phenomenon the last ten years is the extent to which personal and corporate savings have been allowed to remain idle in commercial bank accounts. Reposing there, with no checks drawn, the monetary work done by those deposits is zero, Su xf suddenly people and firms decide to spend those funds, the money PPly begins to work more actively, exerting a pressure toward higher prices, an d mind you, without any increase in the amount of bank credit. oi: This chain events has played a large part in the rise of prices in the last year. Another kind of dis-saving is the conversion of Government bonds into cash, or more usually into bank deposits for current spending. I do n °t refer to tax notes and other short-term Government obligations, used for temporary employment of funds that have been earmarked for later use. ref I er to long-term securities bought by individuals as a means of employing "^eir savings; e . g . , savings bonds. I also refer to Government securities k°ught with the savings of others by insurance companies, savings banks, Pen sion funds and trust companies. In the case of savings bonds, the Government redeems the obliga- tion and sells a new security to obtain the redemption funds. If banks buy th 6 new securities, bank deposits are created. If other Government securi- ties are sold before the redemption date to obtain funds for current spendor for other employment of savings, someone must buy the bonds. buys them, it creates deposits; If a if the Federal Open Market Committee them, it creates bank reserves. Now, let us turn to the third source of buying power — a Sains-t future income. K r ° ean incident. borrowing The use of credit increased sharply after the Loans at all banks in the United States increased $11 billion between June 30, 1950 and March 28, 1951. increased $ - 1 / 2 billion in the last half of 1950. Consumer credit Residential mortgage lending increased by $2 billion, using annual rates, between the Spring of 1950 and the Spring of 1951. Security issues by municipalities and corporations to obtain new capital have been floated at an annual rate of billion. Of course there is overlapping in these figures, and some Mortgages and securities are bought with savings, but the. figures serve to point out that borrowing for the purpose of spending today has been an important factor in the rise in commodity prices. As a backdrop for the problem of credit restraint, I want to take back to some elementary economics. Since we are dealing with the Mechanics of inflation, we should recall that an increase in prices occurs (!) when the money supply increases more rapidly than the volume of business or (2) when the rate of turnover of money increases to a point ^ere the monetary work done by the money supply is greater than needed the Nation's business. This story really starts back in 193U with the devaluation of th ® dollar. That event immediately created an enormous increase in gold ^serves which are the base of the bank credit pyramid. In the next few ^ars after devaluation, world events caused a tremendous inflow of gold in to the United States, adding further to the basic gold reserves. th *t time on, the problem of monetary authorities has centered largely From ^ound the management of these large gold reserves in such a way as to preVe h ^t undue manufacture of credit and an inflation in commodity prices. This °lds true today in spite of the gold exports in the last year and a half. -6- Many of our monetary problems would probably not have happened without this plethora of gold reserves. The forced feeding of excess re- serves into the banks to support the bond market would have been more difficult and doubtless would have ceased much sooner. The recent titanic struggle against unneeded bank credit expansion would have been greatly reduced. h There just would not have been the excess reserves and banks would ave automatically limited loans. For most of the history of modern finance this was the traditional situation in banking. There was a respite from the gold reserve problem during World War Ii. i n f a c t we were very thankful to have such large gold reserves, for these reserves made it possible for the banks of the United States to purchase Government securities in huge quantities to provide for money for war, ° v er and above the amount provided out of national savings and taxes. How- ®ver, at the close of the war the Nation found itself with bank investments a ^d bank deposits greatly increased. As these bank deposits went to work the purchase of civilian goods, price advances occurred as soon as controls were removed. These price advances would have been much greater except for a kittle-understood development in the behavior of bank deposits. th e fact that the turnover of bank deposits had declined steadily from the ^20« s until 19b$. f This was In the 1920's an annual turnover of demand deposits rom 31 to 37 times was considered normal for leading cities. By 1 9 t h i s turnover had been reduced to 16 so that a dollar of deposits was doing only ha lf of the monetary work that it did in the 1920's. There wassome increase deposit turnover during the post-war years, and a sharp increase since th e Korean War to a turnover rate above 23 turns a year. However, if the -7- ownggs of bank deposits were to use these deposits with the efficiency shown in the 1920's, prices could increase substantially from present levels without any further increase in bank loans, investments or deposits. Thus, when we try to restrain credit we find that the rope has considerable slack—a potential increase in the turnover of money, gold reserves that permit further credit expansion and in the background a high level of liquid savings just one stage removed from cash. Furthermore, bankers are well aware of the time lag that is involved in slowing down the machinery of credit. However, the general public ^oes not understand the extent to which firm and practically irrevocable commitments are made by credit institutions for the future financing of business. of Sa Let me give you a few examples. The merchant who orders a supply &oods must be assured before he orders that his bank will lend the neces- *y money to pay for the goods when they arrive. Cotton, tobacco, and §rain buyers must arrange for lines of credit at the beginning of the cropmoving season in order to plan their buying operations. make Insurance companies commitments to mortgage bankers to purchase stated amounts of mortgages, assurance enables the mortgage bankers to lay out programs of solicit- ln g and purchasing mortgages. Investment bankers underwrite stock and bond *ssues, a function which is vitally important in the provision of new Ca Pital to business. 8Uc In fact few kinds of business could operate without h assurances of funds to complete transactions. At times lines of credit granted by banks are little used; but line the s of credit are there, firmly promised by the banks and available to customer at his discretion. Last Fall the great expansion in bank credit was to a large extent merely the fuller use of lines of credit which had been promised to businessmen long before Korea. As an example, °ne bank had outstanding normal lines of credit for its customers amounting to ^120,000,000 at the time of the Korean incident. However, at that time only ^30,000,000 of those lines had actually been borrowed. During the succeeding year, the loans of this bank doubled whereas its commitments for lines of credit increased only 10 per cent. The monetary authorities have made important moves in their field of 1 action to counteract the inflationary effects of the many factors which have described. (1) Last August, the discount rates of the Federal Reserve Banks were raised somewhat and short-term money rates were allowed to rise. (2) The consumer credit regulation was reestablished. While the ^establishment of this regulation has not brought about any drastic reduction i n the total of consumer credit outstanding, the total has declined by million since last December. (3) A new regulation dealing with real estate credit was imposed, is still too early to appraise the restraining effect of Regulation X 8i nce builders are working on the backlog of orders received before Regula- tion X was announced, as well as on more recent orders. (h) In January 19£l reserve requirements of member banks were r *ised to substantially their upper legal limits. i One of the most important tools of inflation restraint was prac- tically out of use for this purpose for several years. This was the employ- ment of open market operations, which were devoted almost solely to maintaina pegged price for long-term Government securities. The Federal Reserve Open Market Committee first announced in the depression years that a major objective would be a stable or orderly bond market. This was at a time when the Federal Government was borrowing heavily to provide funds for various kinds of relief. the public debt. Then came World War II with its huge expansion of The Federal Reserve played an important part in this financing by providing the banks with excess reserves with which to buy Government bonds. Then came the post-war years. Almost everyone expected a sharp depression as had happened in 1920-21 after World War I. Hindsight proves this to have been an error in judgment but it was a factor in causing the Federal Reserve authorities to continue their easy money, excess reserves, Pegged bond market policies. w With one or two minor exceptions this policy as maintained until this Spring when the pressure of inflation made a change to a more flexible attitude toward the bond market necessary. The pegging of the Government bond market had deep-seated effects, holders of long-term bonds instead of treating those securities as true investments came to consider them equal to cash in liquidity. In fact they were the equivalent of cash so long as they could be sold to the market at a fixed rate and the market could be sure that it could sell them to the Federal Reserve Banks at the same price. This caused the Federal Re- serve Banks to manufacture bank reserves at the whim of the holders of Government securities. The recent reduction in prices of long-term Government bonds has had far-reaching effects in the control of inflation. Holders of those securities have been reluctant to dump them on the market and as a result -10Su pplies of funds for mortgage loans and for many other types of credit have been reduced. Skeptics of this change in the administration of the Federal Open Market account have overlooked two aspects of the money Market: First, low rates had been in force for so many years that they have been built into the financial structure. Any change to a hi^ier level of long-term money rates forces far-reaching adjustment in financial c °romitipents. Second, the direction of movement in the money market is important factor entirely aside from the level of money rates. ev When- er rates are rising, until the money market reaches reasonably firm ground at a higher level, it is natural that many financing plans are P°stponed. To complete the picture of moves toward inflation control in th Pr e monetary and credit field, there is the Voluntary Credit Restraint °gram. hor This program is in essence nothing but enlistment of the collective se sense of all kinds of lenders to sort out the kinds of credit which s hould have priority under today's conditions and in that way to avoid Governmental regimentation of credit which, at best, must be a clumsy af fair. The Board of Governors of the Federal Reserve System and the Managements of all of the Federal Reserve Banks are eager to have the v °luntary plan succeed and are lending all possible assistance. As one banker who is taking a leading part in the Voluntary Pro- er A am expressed it, "This is the greatest adventure in American finance." t the same time it is a prodigious undertaking. Recall that there are ^ 0 0 0 banks, more than i|00 life insurance companies, about 3,000 investment bank ers and dealers and many thousands of other types of lenders. All of these lenders must be educated in the funamentals of the Program to a point where they not only give their complete cooperation but so that they do not unwittingly extend credit of an undesirable character. It is only by this complete understanding that we can overcome the "competitive drive" for business, which though desirable from the earnings standpoint of the lender, is nevertheless needlessly inflationary under today's conditions. This Program has been inaugurated under the provisions of Section 708 of the Defense Production Act. The authority to set up the Program was delegated to the Federal Reserve Board, which body consulted with the Federal Trade Commission and obtained the approval of the Attorney General of the United States for the Program on March 9, 1951. The first step was for the Federal Reserve Board to request all lenders in the United States to take part in the Voluntary Program. For this purpose a letter was sent to some 90,000 lenders, the broadest list available to the Federal Reserve Banks. of The next step was the appointment a national Committee by the Federal Reserve Board. The national Committee has set up regional committees to deal v 'ith problems in five major lending fields: commercial banking, life in- surance, investment banking, savings and loan, and mutual savings banks. Considerable progress has been made in other directions. The n ^tional Committee has issued six bulletins on credit problems in rela- 1j ion to the Voluntary Credit Restraint Program, the subject of inventory loans. The first bulletin dealt In view of the rapid increase in 1 nventories, particularly at the retail and wholesale level, the Committee Voided that this was its number one problem. Bulletin No. 2 dealt with -12- credit for plant expansion. According to Government estimates, business firms were planning to spend about billion on plant expansion in 1951. Miile part of this money would come out of corporate savings, a large part w °uld need to be financed by borrowing. Furthermore, regardless of the sources of funds, it seemed very doubtful to the Voluntary Credit Restraint Committee that expenditures of this magnitude, aside from those directly Elated to defense, could be carried through without exerting undesirable inflationary pressures. an The third bulletin dealt with borrowings by states d municipalities, the fourth with real estate credit and the other bulletins dealt with international finance and security loans. Progress has also been made in collecting better statistics to Measure the developments in the credit field. The largest banks in the United States have already begun reporting weekly to the Federal Reserve Banks ca a detailed breakdown of their loans so that the national Committee n ascertain periodically the cross currents due to the rising volume of defense lending and the desired decrease in other types of loans. Excellent figures are being received from life insurance companies, and other data are being refined and coordinated. It is much too early to make a worthwhile appraisal of the e ^ectiveness of the governmental and voluntary inflation restraints. st e We i U have ahead of us the major portion of the scheduled governmental *penditures for defense. At the same time, the industrial plant of the United States is expanding and at some future time will probably be adequate to take care of any peacetime Government defense expenditures and in ad- dition to supply sufficient civilian goods so that the danger of inflation w ill be reduced or removed. At the present time, indications are that with listing restraints the inflationary and deflationary forces are fairly well in balance. Wholesale commodity prices have leveled off at a point about 3 Per cent below the peak of last March. Wa ys. Consumer prices are moving side- The volume of industrial production continues high although apparently th e July rate will be slightly under that of June. be en running at a level rate for the last few months. Retail trade has also In the field of Cr edit, business loans at the larger banks have declined moderately (by million) during the past four months. This represents a net change the rising volume of defense loans somewhat more than offset by Se asonal decreases in loans to trade and to commodity dealers. The banking and other statistics of the next few weeks will have Un Usual significance. nee During that period we shall learn the extent of credit 3ed to move this year's crops and to finance the Autumn increase in general business. At the same time, Government defense expenditures are scheduled to continue their increase. raw Heavier cutbacks in allocations of materials for civilian production will be in force. The construction in ^Ustry will depend less on its backlog accumulated before Regulation X invoked, and the real effects of that regulation will become more ^Parent. th As insurance companies and savings banks work out from under eir volume of commitments to purchase mortgages and other securities, the N a t i o n between current accumulations of savings and the needs of the Ca Pital markets will become much clearer. From the standpoint of the group c °hstituting this audience, I strongly recommend that you study the current formation coming out weekly in the banking periodicals so that you and y ° U r institutions may keep abreast of trends as they develop.
@FedFRASER