Page images
PDF
EPUB

situation calls in the highest degree for caution and prudence. During the present stage of the emergency, it is vital to make use of every opportunity for assuring our citizens that those at the head of their Government have a strong and steady hand on the helm. The response of the Nation to the President's courageous action in the Korean crisis was one of the greatest demonstrations of unity that we have ever had in this country. The Nation is now waiting to learn what domestic programs may be needed in order to utilize our full strength in the interests of national defense. When these programs are brought forward, it will take time for the public to assimilate them. In view of these facts, it is of the utmost importance that no action be taken at the present time which could be construed in any sense as anticipating proposals for defense which may later be outlined by the President.

In short, every circumstance at the present time calls for steadiness and manifest strength in the Federal security market as a primary measure of economic preparedness. That is the net of the situation as I see it. And, as you will note, I am sending my thoughts on to you just as they have occurred tome, in order to let you know the course of my thinking as events unfold.

Nevertheless, the Federal Reserve wanted to raise short-term interest rates. The Treasury had been willing to raise interest rates cautiously in the far different environment of 1947-48 and early 1950. But this was a new situation. The Treasury did not know what was ahead-we did not know how great the Government's financial needswould be. It was clear, however, from the day aggression commenced in Korea that a decisive and critical period in the life of the Nation had been reached. From a financial standpoint, the most important thing was to assure the successful financing of whatever was ahead. The Treasury felt that this could not be accomplished if the Government bond market were disrupted.

I was as concerned about preventing inflationary pressures from gaining headway in the economy as anyone else. In fact, I believe I may justifiably say that I was in the forefront in recognizing the inflationary dangers after the outbreak of hostilities in Korea and in recommending measures designed to aid in controlling this situation. Within a few days on July 5-with the approval of the President, I indicated to the Congress that it might be necessary to undertake new tax measures. Later during the hearings held by the Senate Finance Committee, the Senate, on July 12, shelved the tax reduction bill which had been under consideration in order to make way for new measures which would bring in larger revenues.

It seemed to the Treasury that an effective approach to the inflation problem required a broad program operating on many fronts. It required increased tax revenues. It required that the Government cut its expenditures in the nondefense area wherever practicable; and especially that the Government, as well as the public, exercise great restraint in the use of those goods and services which would be needed for our increased defense requirements. It required a strong program to promote greater savings-not just savings in the form of Government securities, but savings in all forms. This, indeed, has been the keynote of the Treasury's savings bond promotional efforts throughout the war and postwar decade. The Treasury has not been concerned with selling savings bonds alone-efforts have been directed toward promoting thrift in all forms. As the necessity for a greatly increased defense program became clear following the invasion of Korea, the importance of savings programs of all kinds also became greatly enhanced.

In addition to larger revenues, cuts in nondefense expenditures, and increased savings, it was clear that the maintenance of sound economic

and financial conditions during a period of heavy defense build-up required a program of other measures such as those asked for by the President and provided by the Congress in the Defense Production Act of 1950. Among these measures were selective controls not already authorized by law which could act in specific areas of inflationary pressures without interfering with essential productive processes in other areas. It was for this reason that the President advocated restraints such as those which operate in the areas of consumer installment credit and real estate credit.

The Federal Reserve agreed with the Treasury that the measures which have just been described should be used to combat inflation. Officials of the Federal Reserve System were in favor of increasing taxes. They encouraged the savings bond program. The System administered the President's program of selective credit restraints, and has done a good job in administering a difficult program.

But the Federal Reserve also felt that great reliance should be placed on traditional measures of general credit restraint which involved a declining securities market and increases in interest rates. It was in this specific area that disagreements between the Treasury and the Federal Reserve arose. The Treasury felt that there were significant reasons why important reliance on these traditional measures of general credit restraint was not appropriate under the circumstances existing after the outbreak of hostilities in Korea.

In the first place, some credit expansion in certain areas of the economy was necessary to facilitate the country's primary objective-the production of essential defense and military goods. In order to be effective in the areas of special inflationary pressures which needed to be restrained during the defense period, measures of general credit restraint might have had a stringently repressive effect upon every area of the economy.

In the second place, the country as a whole had such a large volume of liquid assets that it was insulated to a considerable extent from the effects of general credit restraint actions of the type proposed by the Federal Reserve. It is true that bank credit expansion contributed to the inflationary situation after the outbreak of the Korean hostilities and it is clear that unnecessary loans should have been curtailed. However, credit expansion was only one of the many factors contributing to the rise in the general price level.

The primary cause of the inflationary situation, throughout the entire postwar period, was an unprecedented demand for goods by business and consumers generally. Before Korea, individuals bought goods to fulfill the stored-up demands which had resulted from the shortages of World War II; and industry replaced and expanded plant and equipment in order to meet civilian peacetime needs. After Korea, individuals and businesses, remembering the shortages of World War II, bought goods in anticipation of shortages in the defense period; and requirements for materials and goods were also stepped up sharply in order to meet the expanded military needs of the period. Some of these purchases were financed by an expansion of bank credit--but not all of them, by any means. Bank credit, for example, accounted for only about one-tenth of the 1950 financial needs of business corporations.

In this situation, the Treasury felt that major reliance in controlling inflationary pressures should not be placed on traditional methods of

general credit control. As already stated, the Treasury felt that higher taxes, restraint in nondefense Government expenditures, greater savings, and various selective measures suitable to the defense situation were called for. These, it was felt, were the appropriate ways to combat inflationary pressures under the existing circumstances. The Treasury felt, further, that stability in the market for Government securities was essential, and that the pursuit of policies which would unsettle the market would be unwise.

The differences between the two agencies on the necessity for stability in the Government security market became serious in connection with the Treasury's September-October refunding operation. The refunding announcement was made after the close of the market on August 18. The decision to maintain the 114 percent rate on the two issues of 13-month Treasury notes offered in exchange for the SeptemberOctober maturities was in line with the Treasury's policy of maintaining stability in the Government security market. The Federal Reserve was advised of the intended action of the Treasury, which had the approval of the President as required by law.

The terms of the new issues announced on August 18 were identical with the terms of the issues offered in connection with the last previous refunding operation-the refunding of the issues which had matured on June 1 and July 1. Furthermore, the terms of the new issues were in line with the market on the day of the refunding announcement; and met the needs of the market which required a short-term security at that time. This was frequently overlooked in the public discussions which followed in subsequent weeks.

The Federal Reserve System, however, took action to increase the rediscount rate; and immediately after the opening of trading on Monday, August 21, short-term rates on outstanding issues of Government securities were allowed to reach levels inconsistent with the rate on the refunding offering of the Treasury. Subsequently, the Open Market Committee through its open market operations permitted short-term rates to run up further. (See Chart 2.) The Open Market Account offered Government securities at prices which gave purchasers a higher rate of return than they would receive on the new issues offered by the Government. The result was to make the new Treasury issues unattractive to the market. Obviously, most of the holders of the maturing issues did not wait to exchange them for the new refunding issues, inasmuch as they could buy higher-yielding securities of the same type from the Federal Reserve.

The result of the actions of the Federal Reserve System was a significant financing failure for the Federal Government. Some $132 billion of Government securities was involved. Less than 6 percent of this amount was exchanged for the new issues by private holders. Between the time of the announcement and the dates of the refunding operations, private investors sold over $8 billion of their holdings to the Federal Reserve. Sales of other Government securities from the System's portfolio offset to a considerable extent these purchases of the maturing issues. They did not, however, completely offset the buying operation; and as a result of the Federal Reserve actions, there was a net increase in the System's Government security holdings. In addition to the securities sold to the Open Market Account, private investors turned in over $24 billion to the Treas

[subsumed][merged small][graphic][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][ocr errors][subsumed][subsumed][ocr errors][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed][subsumed]

ury for cash redemption. The cash turn-in was the greatest the Treasury has ever had to finance, and it constituted an important drain on the Government's cash balance.

In the weeks that followed, the Federal Reserve open market operations had the effect of depressing prices on outstanding Government securities further. Then in November, it was necessary for the Treasury to decide upon another refunding offering involving $8 billion of certificates of indebtedness and bonds maturing in December 1950 and January 1951. Because of the decreases in security prices in the intervening period, a higher interest rate was offered than in August in order to price the new issue in line with the market. Holders of the December and January maturing securities were offered 5-year Treasury notes drawing interest at the rate of 134 percent per year. The new issue was in accord with the Federal Reserve recommendation to the Treasury at this time. The Treasury was somewhat dubious about the length of this issue because it did not seem particularly suitable for the holders of the maturing issueswho were largely banks, corporations, and other short-term investors. The Federal Reserve, however, thought it was advisable to extend the maturity. The terms of the issue were approved by the President; and the Chairman of the Board of Governors assured the Treasury of the full cooperation of the System in the refunding operation.

On the first trading day after the announcement of the new issue was made, the Federal Reserve permitted the market to go off sharply-notwithstanding the fact that the issue had been proposed by the Federal Reserve and the Chairman of the Board of Governors had assured the Treasury of the System's full cooperation. The exchange experience in this refunding operation-while considerably improved over September-October-was still far from satisfactory. Only 51 percent of the maturing issues was turned in to the Treasury by private holders for the new issues. The Federal Reserve bought over $22 billion of the maturing securities during the refunding period. Moreover, the cash redemption experience was only slightly better than in September-October. Cash redemptions amounted to 142 percent of the total of the maturing issues; in the previous operation they had amounted to 172 percent. This compared with an average on offerings of this type of about 5 percent in recent years.

The net result of Federal Reserve open market operations from August 21, 1950 through the end of the year was an increase in the System's Open Market Account of over $212 billion. This was debt monetization. It had not existed on net balance in the year and a half prior to August 21, 1950. During that period, the Federal Reserve holdings of Government securities had declined by $412 billion for the calendar year 1949—to a substantial extent the result of Federal Reserve sales of Government securities to absorb bank reserves released by reductions in reserve requirements-and by an additional $34 billion from January 1 through August 18, 1950. (Refer to Chart 1, page 54.)

The events just described affected primarily the short- and mediumterm issues of Government securities, although there was also some downward pressure on prices in the long end of the market. Early in January 1951, however, officials of the Federal Reserve System outlined to the Treasury a program which would involve a reorientation of debt management policy. The program included proposals for

« PreviousContinue »