A Bear by the Tail

August 30, 1948

On Aug. 9 the Treasury announced that interest rates on its one-year certificates would be raised to 1¼ percent from the then-existing rate of 1⅛. Three days later Federal Reserve Banks in nine of the twelve districts raised their rediscount rate from 1¼ to 1½ percent. These were belated moves.

Secretary Snyder described the government’s action as a “further anti-inflationary move.” This was overstating the case. No inflation on record has ever been stopped with a rediscount rate of 1½ percent or short-term rates to private borrowers running as low as 2 percent. It is only because we have become accustomed in late years to infinitesimal short-term interest rates of a fraction of 1 percent that rates of 1½ and 2 percent can be solemnly described as “anti-inflationary.”

The importance of the increase is purely symbolic and psychological. As Thomas B. McCabe, the new chairman of the Federal Reserve Board, put it: “Each increase in the rediscount rate repeats the warning that credit is in need of continued restraint.”

But what the Administration is at last doing in the realm of tightening interest rates is inconsistent with what it has been doing in the government bond market. In the year ending Aug. 18 the Federal Reserve Banks bought $6,690,000,000 additional government bonds. The effect of such purchases was described by Chairman McCabe in his recent testimony before the Senate Banking and Currency Committee:

“The result of these purchases of government securities by the Federal Reserve Banks is to supply additional reserve funds to banks. . . . These new reserves in turn provide the basis for an increase in bank credit that may be many times the amount of new reserves obtained. . . . The effect has been to increase significantly, and it may be dangerously, the money supply. . . . If the policy of maintaining the 2½-percent yield level on long-term Treasury bonds is continued . . . additional reserve funds would be made available to banks which, unless otherwise offset, could sustain a further very large inflationary expansion of bank credit. . . . Further credit expansion will add to the pressure for rising prices. Continued credit expansion will store up trouble for the future and make the inevitable adjustment more dangerous for the stability of the economy.”

When the support of government securities at present levels is admitted to be so dangerously inflationary, why is it continued? Why did the Federal Reserve authorities even oppose a restoration of the former Federal Reserve Bank reserve ratios of 35 and 40 percent, which would have put a future curb on such support? Chairman McCabe explains: “The system has made a public commitment to support the 2½-percent yield level on long-term government bonds for the foreseeable future.” Why did it make this commitment? Well, it is always politically embarrassing to have government bonds selling below par. More important, the banking system is loaded up with government bonds. Many fear that its very solvency would be threatened if these bonds were allowed to fall below a moderate discount in the market. There are various ways in which this problem might be dealt with. I hope to discuss them here in a later article. But I can reveal in advance that none of them is free from awkward aspects. This should not come as a surprise. If a reckless inflation could be stopped at any time in an easy and pleasant way, the case would not be so strong against embarking upon it in the first place.

One thing is certain. We can only make the termination more difficult and dangerous the longer we attempt to put it off. The Administration has a bear by the tail. It must either recklessly continue to support government bonds at an interest yield of 2½ percent, and make them the basis for bank reserves and further credit inflation, or it must halt this process by some method that is bound to have its unpleasant features. Competent and responsible fiscal and monetary managers would have seen this dilemma coming. They would not have embarked upon easy short-run policies with an attitude of “après nous le déluge.”