The Interest Ceiling

June 29, 1959

The President, the Secretary of the Treasury, and the chairman of the Federal Reserve Board are all urging Congress to remove the present legislative ceiling of 4¼ percent on the interest rate that the government can pay on its new issues of bonds with a maturity of five years or more. The reform is urgent. Some long-term Treasury bonds have already been selling in the open market at prices that yield about 4½ percent. The government cannot sell new long-term bonds at yields below going market rates. The only effect of the present limit is to force the government to finance its needs through short-term borrowing. But this merely drives up rates (on which Congress has been wise enough not to put any ceiling) on short-term borrowing, and forces the government to keep coming back to an uncertain market every few months.

Some of the Democrats in Congress have been cool to the suggestion that the rate ceiling on long-term bonds be removed. They are full of counter-proposals, typical of which is that the Federal Reserve System support or buy in long-term government bonds at prices that would keep their yields 4¼ percent or below. Such proposals would not only destroy once more the hard won independence of the Federal Reserve Board, but they would be violently inflationary.

HOW INFLATION COMES

The Federal Reserve System was forced to peg the government bond market through the second world war and until early in 1951. One result was a huge inflation. As Secretary Anderson explained the process anew in his recent testimony: The Reserve banks would buy Treasury securities, paying for them by creating deposits in the Treasury’s name. As the Treasury paid out this money to individuals, the Treasury checks would be deposited in individual banks, thus adding to those banks’ reserves because such checks are the equivalent of cash. This increase in the banks’ reserves would provide for a multiple addition to the banks’ lending and investing power. Direct sale of Treasury issues to the Federal Reserve, in short, would “provide the basis for a highly inflationary expansion of the money supply.”

The purchase of government securities by the Federal Reserve System is inflationary even when it buys short-term securities. But the situation would be much worse if it supported long-term securities also. Federal Reserve economists have pointed out that when the system buys, say, three-month bills, longer maturities are also affected in at least some degree by substitution or arbitrage transactions. In any case, increased bank reserves, which increase by a multiple factor the supply of funds available for loans and investments, are provided just as effectively by operations in bills as by operations in bonds. And there is a further consideration. The purchase of long-term bonds might have to be endless and astronomical to hold down the long-term interest rate. Such bond purchase, therefore, would ultimately be enormously more inflationary than bill purchase.

A FALSE ‘SAVING’

Some congressmen honestly think they are saving the taxpayers’ money by forbidding higher interest payments on government bonds. But the inflation they would force through Federal Reserve buying to keep down the bond yields means, as the President has put it, that “the additional cost to the government alone for increased prices of the goods and services it must buy might far exceed any interest saving.”

The irony is that the very congressmen who are now complaining about higher interest costs for the government are among those who have done most to bring them about. By insisting on artificially cheap money in the past, they increased the present extent of inflation. Part of the interest rate that the government must now pay for long-term borrowing is in effect an insurance premium that lenders are asking as a hedge against further depreciation of the dollar.

The chief contribution that Congress can now make is to balance the budget, remove fears of further inflation, stop agitating for cheap money, and let the Treasury meet whatever competitive rate is necessary to sell its bonds.