Would Treasury Secretary Janet Yellen call Federal Reserve Chairman Jay Powell into her decorated, historic office to demand the central bank rescue the Treasury market? If she did, there’s already precedent. An economy recovering from the worst sort of setback aided by massive fiscal intervention set loose inflation expectations on the rampage.
Many influential people began to fear it was recovering too quickly.
"In response to a request for a statement as to present business and credit conditions Mr. Williams said…in March…he was fearful that the recovery movement was proceeding too rapidly and that it might turn into a disorderly upward movement which might result in price spirals and dislocations which would be distinctly harmful.”
The volume of monetary reserves had massively expanded alongside the increase in business conditions from the previous trough. In fact, the money side achieved proportions like nothing else in the nation’s history; a period of growth so rapid it could scarcely be appreciated at the time.
The prospects for a combination of recovery and consumer price inflation spelled bad news for bonds. The 3-month Treasury bill (dealer quote, secondary market) had traded fairly regularly between 15 and 20 bps equivalent yield for several years. Suddenly, this particular March, the same instrument was being ditched by the market, spiking its rate first to 38 bps (that month) and then 56 bps (the following month).
Longer-term rates rose in sympathy; longer-maturity government bonds somewhere around 2.45% were suddenly yielding 2.80% in a matter of a few weeks.
It was this latter development which flummoxed the Treasury Secretary to the point of calling in the Federal Reserve Chairman for a “chat.” The materials related to the discussions do not explicitly convey the emotions or the temperature of the conversations, the dry stenographic recount of individual words does it anyway.
I wrote about this particular mid-March weekend about five years ago, about how when after being summoned to Treasury, Fed staff members meekly sought to compromise:
“It was not, apparently, well received as Morgenthau and his staff immediately ‘withdrew’ and returned later to demand (my word) a more concrete proposal about what the Fed was going to do ‘to counteract the firming of long-term interest rates which he [Morgenthau] felt was attributable solely to Federal Reserve action.’"
Morgenthau was Treasury Secretary Henry Morgenthau and this was March 1937. The Federal Reserve had just raised the bank reserve requirement for the second time (the first had taken place back in August 1936), and the bond market seemed engulfed by unwelcome chaos unsteadied by the new bank policy as well as the stated reasons for it. With the federal government still heavily indebting itself by the New Deal, it’s easy to imagine how a lack of answers might irritate this specific part of the government’s cabinet responsible for keeping the funds flowing into FDR’s hands.
Treasury staff had been imagining something like a yield cap or what today has been called yield curve control.
“According to Chairman Eccles, Secretary Morgenthau was rather adamant that the Fed use its Open Market Desk to prevent the newly issued 2.5% bonds from trading at all below par. That, he pressed, would be a very bad signal.”
Chairman Eccles was Federal Reserve topman Marriner Eccles who wasn’t at all eager to expand the Fed’s balance sheet any more than the central bank already had.
In 1933, as FDR was inaugurated, the Fed’s Open Market operations had carried out extensive purchases; increasing the total of government securities (both notes and bills) from $641 million to $1.4 billion in just eight months. Though it sounds small to our 21st century ears, this bond buying, equivalent to what’s today called quantitative easing, was enormous in scale.
With the early recovery from the trough proceeding irregularly at best, even though wholesale prices were often rising rapidly (consumer prices were not tracked as closely), the Fed undertook a second round beginning in the middle of 1934, having paused only for about six months. This GDQE2, let’s call it, raised the volume of government securities in stock to $2.0 billion by March 1935.
Another $450 million were purchased from the market in October 1935, GDQE3, sold back to it in March 1936, and then mostly bought back the following two months April and May as the FOMC “fine-tuned” its operations.
While this bond buying activity had added about $1.7 billion to banks’ deposits with the Federal Reserve branches – the offsetting transaction for whenever the central bank purchases an asset from a member bank is an increase in what’s called bank reserves – by far the largest monetary contribution to both the Fed and the banking system came in the form of gold.
FDR had confiscated private gold holdings in 1933, and then promptly devalued the paper dollar (which wouldn’t have been possible absent confiscation; the American people would never have sold their gold for paper currency so drastically devalued from the get-go). For foreign private investors, they could obtain more paper dollars (or dollar-denominated US bank deposits) for their gold so quite naturally real money began flooding the domestic system coming from outside the country.
In 1932, the central bank claimed $3.3 billion in its own reserves, the vast majority gold, and total assets of $6.1 billion (including its reserves). By 1937, Federal Reserve reserves had exploded to more than $9 billion (near triple), while total assets ballooned to nearly $13 billion (more than double).
For the Fed’s member banks, their claims on the Fed (these bank reserve deposits) had been $2.5 billion at the end of ’32 then surging on gold and GDQE up to more than $7 billion in 1937 – most of these actually backed by gold.
Given these preposterously huge monetary increases, historic in nature, you could at least understand also why even if Secretary Morgenthau was miffed about Treasury bond prices in March 1937 Chairman Eccles might have had in mind other problems. Anticipating all these bank reserves, and the ongoing bond-financed fiscal expansion of the New Deal 2.0, to lead decidedly toward the dreaded inflationary spiral, the FOMC would hold fast to its reserve requirement raises (a third hike followed in May ’37).
The error could have been avoided in light of a little more context, observable in, embarrassingly, the credit dispersion of its member banks. Going back to the start of 1930, at the outset of the Great Collapse, the banking system claimed $25.1 billion in loans while owning just $4.1 billion in various government obligations (bills, notes, and certificates of indebtedness).
At the bottom, in March 1933, banks reported just $12.9 billion in loans (the devastating, deflationary credit effects of the money collapse) but now $6.9 billion in government securities (total earning assets, loans and investments together, contracted from $35 billion down to $25 billion; meaning, proportionally, the obvious preference for safe, liquid instruments was even greater).
By March 1937, several clear years into recovery, with massive expansion of reserves, banks still claimed only $13.7 billion in loans (barely more than March 1933) while at the same time owning $12.7 billion in various Treasuries (out of total earning assets of $32.5 billion).
In other words, the entire member banking system had transitioned from 18.3% of its earning assets being held in the form of US Treasuries and bank reserves (deposit balances with the Federal Reserve) to start 1930, and with a high of $35 billion, to 36.8% of only $25 billion in those same highly liquid categories by 1933, to then 59.4% of still only $32 billion in earning assets when in early ’37 the Fed risked angering its Treasury Department masters envisioning inflationary pressures that didn’t actually exist.
The numbers only seemed to support their case if only the narrowest set of them. A wider survey would have revealed much deeper, entrenched deflationary pressures still inhibiting even a recovery seemingly developing a meaningful degree of rapidity for the first time.
To begin with, there was the distribution of money and reserves at once equal and unequal. This had been a particularly vexing issue from the very beginning – of each the Federal Reserve’s as well as the nation’s. Money tended to flow in lumps and by season. In fact, the first purpose of the US’s third central bank, this Fed, was to create a more orderly monetary arrangement (the very title of the Federal Reserve Act of 1913 specifically mentions “to furnish an elastic currency” immediatelyfollowing “provide for the establishment of Federal Reserve banks”).
When examining the prospects for these 1936-37 reserve requirement increases, as is usual bureaucratic procedure (in any time period), the Federal Reserve’s staff had commissioned several studies purportedly examining the structural and technical soundness of its proposed plans. One such concern under scrutiny had been the possibility of unequal reserve distribution; some (legitimate) concern had been expressed as to whether central reserve city banks, for example, would be uniquely insufferable of higher reserve requirements having already and repeatedly expressed their misgivings (according to the notes of George Harrison, FRBNY’s President at the time):
“…some of the central reserve and reserve city banks would feel the shock of an increase in reserve requirements ‘both ways’; in addition to having their own reserve requirements increased, they would be subject to withdrawals of funds by out-of-town banks.”
The Board (FOMC) decided that country banks, these small, out-of-town banks at the bottom of the correspondent system pyramid, “as a group had a large aggregate amount of excess reserves and excess balances with correspondents and could easily meet the increased reserve requirements.” You know what they say about famous last words.
At the end of 1936, the level of interbank deposits (bank liabilities in the form of deposits owed to largely correspondent and respondent banks up and down the system pyramid) had grown to just less than $7 billion (up from $3.3 billion in the middle of ’33). When that second reserve requirement raise hit in March ’37, $600 million was instantly withdrawn!
Another $300 million would disappear by the end of 1937 as would a total of about $1.6 billion in general “other” demand deposits. Such illiquidity birthed the depression-within-a-depression in 1937 which, had it happened on its own rather than being contained inside of the overall Great Depression, it would have ranked among the worst in US history.
As for Secretary Morgenthau, though he had bullied a minor bond buying task out of Chairman Eccles in April 1937 no more than that was ever needed; indeed, these concerns for a Treasury blowout were equally groundless given their basis in such unfounded inflationary bias. Within months, both T-bill and Treasury bond rates would reach new lows (meaning new highs in terms of price).
This demand for liquid instruments extended well into the category of “risky” assets, another factor of this unorthodox (from the mainstream perspective) banking system liquidity curvature which Fed officials completely misunderstood in their bank-reserves-are-driving-inflation rush:
"In discussing the motion, Governor Norris pointed out that while action was not necessary, it was highly desirable as the excess reserves constituted a source of danger. He indicated that even now there was some evidence of inflationary results from the excess reserves, especially in the bond market, where a 2 3/4% bond of a rural county seat could be sold at a premium."
This quote is taken from the December 1935 FOMC meeting when the Board first seriously discussed, and voted down, the reserve requirement changes.
The reason a risky muni of the kind Philadelphia’s Governor George Norris highlighted could fetch such premium demand was the ever-present, unmet liquidity fears of the banking system obviously eschewing any entanglement with any asset that wasn’t immediately saleable – thus, the collapse in lending, which downstream manifested in devastating ways especially to smaller and medium-sized businesses starved for credit as well as business even during “recovery.”
As such, it was never truly recovery and thus never anywhere in the neighborhood of inflationary risk.
The over-infatuation with bank reserves during the 1930’s was itself a consequence of bureaucrats knowing only their numbers rather than the complete extent of their jobs. As Milton Friedman and Anna Schwartz had put it in their 1963 A Monetary History:
“It was widely accepted that monetary measures had been found wanting in the twenties and the early thirties. The view that ‘money does not matter’ became even more widely held, and intellectual study and analysis of monetary institutions and arrangements probably reached an all-time low in the study of economics as a whole.”
I will state that a new all-time low has been subsequently reached over the last half century, with a new bottom surpassing the previous bottom each and every year.
In the current age, how much repeats like the thirties if not quite to the same extent? Inflation always promised, never reachable despite constantly elevating bank reserves. Fits of rising rates that flirt with only the outlines of success and liftoff but never any farther.
More to the point, expressed clearly in the balance sheet construction of modern-day global banks, authorities (monetary and fiscal) know well the size of their own and the level of bank reserves this spawns, but what do they know of the “monetary institutions and arrangements” underlying? Given the results (especially low rates) which only mimic the thirties in nearly every conceivable fashion, the question already answers itself.
As Alan Greenspan said in June 2000 (paraphrasing), inflation is always a monetary phenomenon but the proliferation of financial products means a central bank takes on what may be an impossible task: attempting to guide and even control a monetary system from what limited understanding it possesses of only one small corner of it.
The Fed does bank reserves; it’s always done bank reserves. Clearly, historically, no matter how much those can neither the answer nor the full story.
