On March 4, 1951, the Federal Reserve System and the Treasury announced the following agreement: The Treasury and the Federal Reserve System have reached full accord with respect to debt-management and monetary policies to be pursued in furthering their common purpose to assure the successful financing of the Government's requirements and, at the same time, to minimize monetization of the public debt. To facilitate implementation of this agreement, certain long-term securities which had been in excess supply in the market were converted into nonmarketable securities by an exchange offering of the Treasury. Following the announcement the Federal Reserve continued for a while to purchase substantial amounts of Treasury bonds, but gradually the prices at which these bonds were purchased were reduced. System buying of bonds declined in amount and eventually ceased. Federal Reserve purchases of short-term securities were promptly discontinued and subsequently System operations were small, except when necessary to aid Treasury refunding operations or to meet temporary money market needs. Short-term rates rose sharply at first and subsequently fluctuated around the Federal Reserve discount rate, largely in accordance with changes in market forces. Temporary reserve needs of banks were met to an increasing extent through borrowing at the Federal Reserve. Under these policies it was possible to conduct open-market operations more flexibly in accordance with the credit needs of the economy, with occasional support to Treasury financing, and to exercise more effective restraint on loan expansion to private borrowers. Further discussion of open market operations and policy is given elsewhere in this set of answers, namely, the replies to Questions A-3, C-17, C-18, F-29, F-30, and F-31, and also in the answers by the Chairman and the Vice Chairman of the Federal Open Market Committee in reply to questions submitted to them. 17. What is the rationale of the present assignment of authority over open market operations to a body other than the Board of Governors? Why should the allocation of responsibility for open market policy differ from the allocations with respect to discount rates and reserve requirements? Do you consider these differences desirable? Why, or why not? The rationale of the present assignment of authority over open market operations to a body other than the Board of Governors of the Federal Reserve System may be said to be the result of historical development and of compromise between divergent views. When, during the early twenties, it was recognized that open market operations by the individual Federal Reserve Banks had a direct bearing upon the effectiveness of discount rates, upon national credit conditions, and upon the Government securities market, a nonstatutory System Open Market Committee composed of five Governors of the Reserve Banks was set up for the purpose of coordinating open market purchases. The need for an open market committee was given statutory recognition by the Banking Act of 1933, which established a Committee consisting of 12 members selected annually by the boards of directors of the Federal Reserve Banks. Two years later, when the Banking Act of 1935 was under consideration in Congress, sharp differences of opinion emerged as to the composition of the Open Market Committee and the nature of its responsibility. On the one hand, there were those who felt that, in view of the importance of open market operations as an instrument of credit and monetary policy, final authority with respect to such operations should be vested in the Federal Reserve Board, which already possessed final authority over discount rates and over changes in reserve requirements. Others felt that the Federal Reserve Banks, whose funds were used in the making of open market purchases, should have the majority representation on the Open Market Committee. As the bill passed the House, it provided that the Board of Governors should have final authority over open market operations, but that the Board should be required to consult with an Open Market Advisory Committee. The Senate bill, on the contrary, provided for an Open Market Committee with final authority over open market operations to be composed of three members of the Board of Governors and two members representing the Federal Reserve Banks. As a compromise, the conference committee agreed upon a Committee of 12 members consisting of the 7 members of the Board and 5 representatives of the Reserve Banks. It may be urged, of course, that it is illogical to distribute credit regulation authority over two separate though interlocking bodies and that, in the interests of a single national credit and monetary policy and for practical administrative reasons, the determination of open market policy, as well as the determination of discount rates and changes in reserve requirements, should be vested in the same agency of the Government. It may also be urged that authority over open market operations, along with all other authority to regulate credit, should be vested in the Board of Governors of the Federal Reserve System as the agency primarily charged with responsibility for credit policies and, therefore, the agency to which the public looks for leadership in the formulation of such policies. For other reasons, it might be urged that these authorities should be vested in the Open Market Committee. The present arrangement, however, under which open market operations are placed under the jurisdiction of a committee representing the Reserve Banks as well as the Board is consistent with the basic concept of a regional Federal Reserve System. It provides a means whereby the viewpoints of the Presidents of the Federal Reserve Banks located in various parts of the country, with their technical experience in banking and with their broad contacts with current credit and business developments, both indirectly and through their boards of directors, may be brought to bear upon the complex credit problems of the System. It promotes System-wide understanding of these problems and closer relations between the Presidents and the Board in the determination of System policies. In practice the open market policies of the Open Market Committee and the credit policies of the Board have been coordinated and the existing arrangement has worked satisfactorily. It is believed desirable that the Federal Reserve Banks should participate to the greatest extent practicable in the consideration and formulation of open market policies, and there appears to be no compelling reason in the public interest for disturbing the present arrangement. It is recognized, however, that this is a matter on which there may be justifiable differences of opinion. MONETARY POLICY AND MANAGEMENT OF PUBLIC DEBT 295 18. Can open market policy, discount policy, and reserve requirement policy pursue different general objectives, or should these various instruments always be directed toward a common policy? When differences of viewpoint among the different policy-determining groups must be compromised in order to adopt a common policy, what are the factors of strength and weakness in the position of each of the parties to the compromise-i. e., the Board of Governors, the Federal Reserve Bank President members of the Federal Open Market Committee, and the boards of directors of the Federal Reserve Banks? To achieve the maximum contribution of credit and monetary measures to stable economic progress with rising standards of living, open market policy, discount policy, and reserve requirement policy should be directed toward a common general objective. In working for this common objective, however, each of these instruments of credit influence is designed to operate through different, though interrelated channels. Special credit conditions may arise and necessitate the use of one or another of these instruments in ways which appear to be, or actually are, partially offset by the concurrent use of other instruments. Applicable situations arose during the postwar period of transition from war finance; they might develop in the future in connection with assuring the success of Treasury financing operations or in connection with financial tensions occasioned by unusual nonmonetary events, such as an international incident threatening actual war. Complementary functioning of open market and discount policy. As to the specific objectives of each of these general credit instruments, open market policy and discount policy have come to function as complementary instruments in influencing short-run changes in credit conditions with the broader purpose of long-run economic stability and welfare. Discount policy as a restrictive instrument-is most effective when excess bank reserves are low, when many banks are unable or unwilling to make adjustments in their reserve position by means other than borrowing from the Federal Reserve, and when many individual banks are discounting with, or obtaining advances from, the Federal Reserve Banks. In these circumstances, open market policy may work to supplement and reinforce discount policy. Thus, in periods when general economic and business conditions call for credit restraint, it is desirable for the Federal Reserve to reduce its portfolio of Government securities, either by open market sales or by run-off of maturing issues, in order to put pressure on bank reserve positions and to make it necessary for some banks to borrow from the Reserve Banks. At times when demands for additional credit are strong, sufficient restraint on expansion may be exercised if the Federal Reserve merely refrains from open market operations, thus making it necessary for member banks to borrow additional reserves required. Tightness in the availability of reserve funds makes the discount rate effective and puts the Reserve Banks in a position to increase the cost of borrowing at Reserve Banks, should a further measure of credit restraint prove necessary. As explained in the reply to Question F-35, continued Reserve Bank indebtedness, regardless of cost, is avoided by banks, and when indebtedness is incurred, it temporarily causes them to restrict lending or liquidate securities in order to repay such indebtedness. When the discount rate penalty. to which they are subject in borrowing is increased, banks are even less inclined to remain in debt. In periods calling for conditions of credit ease, the Federal Reserve System can purchase Government securities, thereby creating additional bank reserves and enabling the banking system to reduce its indebtedness. This also reduces the restrictive effects of borrowing and of the discount rate. At some stage the easing effect of open market operations on bank reserve positions and on general credit conditions may then be reinforced by a reduction of discount rates, with the result that it becomes less expensive for banks to borrow. The System thus can make its short-run policy of credit restraint or ease effective by coordinating the use of open market and discount policy. Since the early twenties the Federal Reserve has made it a practice to adapt its general instruments of credit policy to the maintenance of orderly conditions in the money market, and during immediate prewar years and also in recent postwar years such adaptation has involved use of the open market instrument for keeping orderly conditions in the Government securities market. During much of the postwar period, when inflationary pressures were strong, open market operations were for the purpose of supporting Government security prices and such operations were necessarily in conflict with broader objectives of long-range economic stability. Orderly markets mean markets without "air pockets," that is, markets where there is a degree of continuity between demand and supply at going or moderately changed prices. Orderly markets preclude erratic movements of prices and yields of securities that have no justification in terms of general economic and credit conditions, but they do not preclude broad movements that reflect changes in basic underlying forces. Open market operations to assure orderly conditions in the Government securities market may be undertaken frequently but ordinarily in relatively moderate volume. Thus, for example, they may be used to facilitate Treasury financing operations or to cushion the disturbing effects on bank reserves and interest rates of such developments as large seasonal currency movements and periodic tax payments. If Government securities are available on terms that make them attractive to the market, they will not require open market operations in a volume that would be in conflict with the credit and monetary objectives appropriate to the period. On the rare occasions when this may not be true, say in the case of the outbreak of a war or an economic crisis, the Federal Reserve System, as well as other Government instrumentalities, must have the tools at hand and the will to use them so that the necessary stabilizing action can be taken through monetary and other measures. The Federal Reserve System was established to provide greater flexibility of credit and money to meet varying needs of the economy and to avoid the money stringencies and panics that formerly recurred because of rigid structural limitations upon the supply of credit and money. In view of the importance of smoothly operating money and securities markets to the effective functioning of the economy, Federal Reserve operations to maintain orderly conditions in these markets are generally helpful. Such operations should not and need not defeat policies directed toward fostering stable economic progress and growth. Specific objective of reserve requirement policy.-Change in reserve requirements in theory and in use is the newest of the general credit instruments and has the most widespread effects on individual banks. It may apply to all member banks or to all members in one or two of three legally defined groups, and requires important changes in customary ways of conducting bank operations. The fact that Federal Reserve increases in reserve requirements do not affect nonmember banks (except to some extent where State bank authorities may prescribe similar increases) may present administrative difficulties in their application under some circumstances. Considering that the reserve requirement instrument has been available for only a decade and a half, it is clear that much is yet to be learned from experience about its use. On the restrictive side, an increase in reserve requirements may be the most appropriate means of offsetting large increases in the volume of bank reserves that occur as a result of such factors as a persistent and sizable gold inflow or substantial purchases of Government securities by the Federal Reserve made under exceptional circumstances. When the authority was written into the law by the so-called Thomas Amendment, it was conceived as having primarily such a purpose. Experience has shown that the reserve requirement authority is not well adapted for restrictive use in regulating short-term changes in credit and monetary conditions. For instance, if the excess reserve position of the banking system as a whole is narrow, an increase in reserve requirements would oblige many member banks to adjust by borrowing at Reserve Banks or by selling Government securities. This is true even though many individual banks would meet the increase by a variety of other means, including reducing their excess reserves or balances with correspondent banks, or adopting a more restrictive loan and investment policy. However, an increase in reserve requirements at a time when total excess reserves in the banking system are low is likely to bring with it, within a limited period of time, heavy and urgent selling pressure on the Government securities market. When selling becomes widespread, potential private buyers may tend to hold off purchases in the expectation of a more favorable price level and this may result in substantial Federal Reserve open market operations to prevent disorderly market conditions. If member banks as a group sought to adjust their reserve positions to higher reserve requirements by sales of Government securities, virtually the entire amount of sales might need to be bought by the Federal Reserve. The net result would be: (1) a transfer of earning assets from member banks to Federal Reserve Banks; (2) temporary shock to the banking community; and (3) some impingement on bank liquidity positions; but (4) assuming only a moderate increase in reserve requirements, perhaps only a limited amount of lasting restrictive effect on over-all bank credit expansion. What this illustrates is that the restrictive use of the reserve requirement instrument in regulating short-term changes in credit and monetary conditions frequently necessitates open market operations which have the appearance of being at cross purposes with the action |