September 14, 1955 FOMC Minutes

FOMC minutes

(c) In fact I have difficulty with the whole "penalty rate" concept under our conditions. What is to be penalized? It is suggested that we penalize any bank that attempts to borrow from us and use the funds to buy highly liquid paper at a profit, and to remove any incentive for member banks to adjust reserve deficiencies through discounting rather than through disposal of securities in the market. I have diffi culty in seeing how that kind of penalty can be enforced by relating the discount rate to the bill rate. In the broadest sense it is still true that the basic reason for member bank borrowing is to obtain reserves to meet heavy demands for loans, which are made at rates well above the discount rate. In a narrower sense, even if the so-called penalty rate were designed to affect bank investments, it would have to be re lated to the rates on Government securities stretching out well beyond the 90 day bill. (d) I have difficulty also with the actual role of open market operations under the policy suggested. As I understand it open market operations would be used to maintain a volume of negative free reserves sufficient to make market rates of interest highly responsive to the discount rate, but not in such large volume as to raise the bill rate above the dis count rate. Does this mean that the System should maintain a formal penalty rate situation by easing up on reserve pres sure whenever the bill rate tends to rise above the discount rate, or does it mean that the discount rate should be raised again and again, say in a period of increased seasonal demand for credit, to keep it in the proper position with respect to the bill rate? If the first course is followed we are likely to lose rather than gain control of the credit situation and if the second course is followed we would seem to have acquired a built in device for shoving the discount rate up, during periods of credit restraint, with real risk of creating dis orderly conditions in the capital markets. The only time in recent years when the bill rate went substantially above the discount rate was in the spring of 1953. Such increases in at that time might have created conditions the discount rate which would have brought the capital markets to more of a standstill than was actually the case. (e) This leads me to another difficulty. The discount rate has been above the bill rate most of the time during the existing relationship is now the past two years, and been suggested as the appropriate one. We about what has to achieve this a timeless or rigid formula have not needed result. It may be said that it has come about in the wrong has followed open market opera way, that the discount rate think that is more a matter of leading, but I tions instead

of terms and definitions than of unchanging fact. We have had a situation in which bank borrowing has increased but in which most banks are still swayed by their reluctance to borrow over long periods, and we have had a situation in which there has been large scale adjustment of individual bank portfolios as they sold Government securities to ac commodate loans. That, I would say, is what we wanted, If more severe "penalty rates" than have obtained during this period are now envisaged and, if we want to get the discount rate up faster and higher in order to force the banks to sell whatever Government securities they have of whatever maturities, we are really talking about discount rate action and discount rates which could have a demoralis ing effect on all capital markets. (f) I also have some difficulty with a formula which implies that the discount rate should be set uniformly by all Federal Reserve Banks, even though in the past I have been doubtful whether this could be avoided. It may be that recent experience suggests certain tactical advantages, at times, in staggered increases in discount rates. It unfortunate, in any case, unless the grounds were would seem very clear, to adopt a "penalty rate" formula which would further reduce the role of the directors of the individual banks in setting discount rates. 5. What this may all boil down to is the question in my mind we should contemplate tying ourselves down to mind as to whether of action with respect to the discount rate at all times one course is not necessarily the same thing as ex of credit restraint. This possible methods of making the discount rate ploring and using all of conditions. There are times and circum effective under a variety lead more than it has, but in when the discount rate should stances judgment we have to beware of to substitute a formula for attempting abandoning responsibility. which have occurred to me, 6. These are some of the thoughts put forward at the last meet they suggest that the proposals I think before we can weigh them further study and clarification ing need these tentative comments why I wished to make properly, and that is today. of the Federal Mr. Bopp, Vice President Williams stated that Mr. with respect to dis had prepared a statement Reserve Bank of Philadelphia, by Mr. Sproul, and related to the subject discussed count rate policy which the statement as follows: he then read

"MONEY MARKET IMPLICATIONS OF NEGATIVE FREE RESERVES "I. The discount rate, market rates, free reserves and member bank borrowing "Since free reserves are defined as excess reserves minus member bank borrowings from the Federal Reserve Banks, they can be negative only if borrowings exceed excess reserves. Further more, since excess reserves rarely fall below $1/2 billion, free reserves do not reach a negative level until borrowing exceeds that figure. In other words, negative free reserves mean that the money market is dependent directly on the Reserve Banks to a con siderable degree. "Attempts of member banks to reduce this dependence, either because of tradition possibly reenforced by moral suasion or be cause it is made more expensive, will tend to tighten the money market in terms of both availability and cost of credit. "But these attempts to reduce dependence will be frustrated if a specified level of negative free reserves continues to be the goal. A primary effect will be a further rise in market rates. If the discount rate is to continue to be a penalty rate or to lead the market, it will have to be increased again. "We may begin with member bank borrowing of, say, $700-800 million and negative free reserves of $100-200 million. The dis count rate is raised to lead the market--or to make it a penalty rate. But this penalty rate will not reduce borrowing so long as open market operations are designed to maintain negative free re serves at the original level. Market rates, however, may be ex pected to rise because credit has become more expensive at one of its important sources (Federal Reserve Bank discount windows). If the new discount rate is to be kept above market rates, it will have to be increased again. "The point is that the periodic upward adjustments of rates rapid. Too rapid an upward adjustment could create could be very a liquidity crisis. purpose of tightening the market is, of course, "An ultimate question of policy is the speed with which to curb demand, but the the brakes should be applied. Although the central bank operates market, its ultimate purpose is to influence the flow in the money If the existing tone of the of purchases throughout the economy. appropriate to the state of theeconomy, money market is judged to be be changed for the purpose of assuring the discount rate should not "lead" rather than to "follow" market rates. that it will continue to "II. Anticipations and the rate structure the time structure of interest "Although many factors influence as to rates is the market's expectations a pervasive influence rates, rise, the slope will expects rates to future. If the market in the will be lower than (rates on short maturities tend to be positive is that borrowers will The basic reason those on longer maturities). rise takes place, and long terms before the expected wish to issue

the lenders will hesitate to invest in long issues until after the expected rise has taken place. In other words, the expecta tion tends to increase the demand for and to reduce the supply of long-term funds. At the same time, lenders, not wishing to keep funds idle, will tend to invest in short terms, whereas borrowers will borrow on short term only if they secure a rate concession. The expectation of a rise tends to increase the supply of and reduce the demand for short-term funds. "If the market expects rates to rise, it may be difficult to force up short-term rates without "drying up" the long-term capital market to a greater extent than may appear desirable." In the ensuing discussion Mr. Vardaman requested that copies of the statements presented by Messrs. Sproul and Williams be made available to the Committee along with the statements by Messrs. Young and Riefler on August 23. that he assumed that further comments by others could be in Mr. Riefler said that the papers referred to should be made available cluded and it was agreed for further study and discussion by the Committee. his remarks to be critical that he did not intend Mr. Sproul stated in presenting the comments Young but that his purpose of Mr. Riefler or Mr. regarding discount rate was to stimulate thought he had made this morning there could be a discussion at a subsequent meeting in the hope that policy the broadest possible basis. its various aspects on of the problem and Committee would be held the next meeting of the It was agreed that of Presidents of the Conference which time a meeting 4, 1955, at on October also be held in Washington. Reserve Banks would of the Federal meeting adjourned. the Thereupon Secretary