Inviting Inflation

June 20, 1960

The reduction of the discount rate by the Federal Reserve Banks (of the twelve banks only Atlanta and Boston have yet to act) from 4 percent to 3½ percent, following the action of the Open Market Committee in easing money by supplying additional reserves to the commercial bank system, is a step of dubious wisdom.

It was not taken to combat a serious recession. The day before the action was announced, the First National City Bank of New York, in its June letter, had pointed out that: “Lagging industrial activity has not prevented the nation from enjoying record overall levels of employment and income. Industry is going ahead with plans for enlarged plant and equipment expenditures. Construction activity is expanding seasonally. Retail trade, which picked up strongly with the arrival of spring, has been sustained at the higher level.” True, steel-mill operations have been low, but special conditions like this are not to be cured by cheaper money.

On the same day that the Federal Reserve lowering of discount rates was announced, the Federal Bank of West Germany made the opposite decision. It raised its discount rate from 4 to 5 percent, to combat inflation.

GOLD PROBLEM REMAINS

This emphasized the international problems raised by our own action. Our gold problem remains serious. Against our gold holdings of $19.4 billion, short-term liabilities to foreigners reported by American banks come to $19.6 billion. The deficit in our balance of payments, which reached $3.7 billion last year, is still running at an annual rate of some $2.5 billion.

The chief cause of the deficit in our balance of payments is domestic inflation, and consequent diminution of confidence in the dollar. This makes it imperative not only that we halt inflation, but that we follow policies calculated to assure both foreigners and our own citizens that it will stay halted. Yet even apart from the latest Federal Reserve action, we have been mainly doing the reverse. Railroad workers have been officially awarded pattern-setting inflationary wage increases. The Administration is pressing for a bigger foreign-aid program—though foreign aid, both directly and indirectly, tends to increase the deficit in our balance of payments. Higher defense expenditures may be unavoidable; but a Democratic Congress, with an eye on the campaign, is pushing increased “welfare” expenditures—more housing and school subsidies, aid to “distressed areas,” old-age medical-care programs.

THE INTEREST CEILING

One of the most disturbing developments has been the persistent refusal of Congress to remove the 42-year-old legal interest rate ceiling of 4¼ percent on bonds running for five years or more. Contrary to the professed aim of those who insist on keeping the ceiling, it actually increases the interest charges that the Federal government must pay. It prevents the Treasury experts from floating long term bonds when the going rate of interest is more than 4¼ percent, and forces them to glut the market for short-term securities. More serious excessive issue of short-term securities, taken by the banks, tends to increase the supply of money and credit and hence is directly inflationary.

Under policies long followed by the Fed, the main importance of the discount rate has been that of a signal. The lower rate was a deliberate signal that money was going to be made cheaper. The stock market immediately took the hint. In view of our balance of payments, the wisdom of that signal may be questioned. Banks, moreover, should pay a penalty rate for borrowing from the Federal Reserve—i.e., they should be obliged to pay more for reborrowing than they charge their own best customers. This sound rule has been ignored.

And Federal Reserve discretion has proved sadly wrong in the recent past. The Fed has yielded too easily to inflationary political pressures. It was not wise to have a discount rate of only ½ of 1 percent from 1942 to 1946; to keep the rate at 2 percent or less for the next nine years; to cut it from 3½ to as low as 1¾ percent in 1957 and 1958. We cannot indefinitely leave monetary control to bureaucratic discretion or whim. Ultimately we must return to the discipline of the full gold standard.