It's Neither Difficult Nor Unique To Fight the Fed
(AP Photo/Amanda Andrade-Rhoades)
It's Neither Difficult Nor Unique To Fight the Fed
(AP Photo/Amanda Andrade-Rhoades)
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With consumer and wholesale prices surging, the Federal Reserve was under severe pressure to do something about the economic situation. Its top officials went to the White House, to the Treasury Department, testified in front of Congress. The message sent to politicians in each venue was the same; monetary policymakers’ hands were increasingly tied.

By August 1948, the US CPI had been in a sustained rapid increase for several years already. It began back in the summer of 1946 when the post-war boom heated up. European demand for goods and materials far outstripped the Continent’s ability to supply them given its unreconstructed war devastation.

The competition for American industrial output grew fierce, and consumer prices – pushed by widespread goods shortages here in the US – reflected this basic imbalance. For the CPI, an annual rate of increase of 1.7% in February 1946 quickly became 11.6% in a matter of six months.

Prices kept going; by March 1947, the rate of change had managed 19.7%! From less than two to just about twenty, all of it in a span of only thirteen months. Wholesale prices had skyrocketed about 25%, too.

More distressing, while consumer prices decelerated throughout that year and into the next, through the first half of 1948 the CPI seemed to settle down, unfortunately up around 9%. President Truman wasn’t happy. Treasury Secretary John Wesley Snyder was increasingly agitated. Those in Congress demanded someone do something.

Federal Reserve Chairman Thomas McCabe took the opportunity in August 1948 to visit with the House Banking and Currency Committee. He assured its members the Federal Reserve’s top people were equally as frustrated and disappointed. McCabe also warned that unless his institution was granted more authority, there was no way it wouldn’t get worse:

“In view of the pressure of current demands, the continued shortages of many goods, the limited capacity for increased output, and the available accumulations of liquid assets, 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.” [emphasis added]

The US, he claimed, was in real danger of hitting the Big One. Sure, deflation during the Great Depression and all that, but money had built up during the admittedly lackluster recovery and then built up some more as World War II raged across the planet. By the time it ended with much of the world in ashes, the undamaged US (apart from the human costs) featured the industrial capacity along with stored up monetary reserves to let loose.

The supply shock would be in danger of being overcome and overtaken by traditional excess currency taking the CPI to new heights.

It was the same scenario those at the Fed had been warning about since the mid-thirties. So, Tom McCabe pleaded with Congress for emergency authorization to allow his institution to raise reserve requirements for banks all across the land (he also asked for permission to restrict consumer credit issued by banks, too).

He was adamant about it, testifying bluntly, “We are convinced that, so long as the present situation lasts, it is important to restrict further credit expansion and to promote a psychology of restraint on the part of both borrowers and lenders.”

The House then Senate obliged, sending an authorization bill supported by Snyder for Truman to sign, which the President did immediately.

Reserve requirements on demand deposits, that is the amount of liquid liabilities (either vault cash or bank reserves, a book entry balance with the Fed), had been maintained at 20% for reserve and central reserve city banks (an old legal and technical classification by function and status) while 14% for country banks. The requirement on the former had been permitted to rise to 24% by the middle of 1948.

McCabe sought, and was granted, temporary authority to go as high as needed (forgetting 1937) under the assumption the more liquid assets these bigger banks were legally required to set aside, the less credit they could extend. Less credit, less money, less inflation.

But there was an enormous complication: Treasury bonds. Because of its truly abhorrent performance during the early stages of the Great Depression, responsible for much of its Great Collapse phase after 1929, the Federal Reserve had been reformed into an afterthought, more of secondary regulator stocked with screwups.

Following the equally disastrous use of reserve requirements in launching the 1937-38 depression-within-a-depression, unadvisedly and incorrectly chasing the Big One Inflation a full decade before, the Fed during the war years was downgraded to little more than a Treasury trading fixer; to use bank reserves and Open Market operations as a means to promote smooth government debt auctions and the market(s) for its securities.

And even then, it hadn’t ever been needed. Though both short-term and long-term Treasury rates (bills and bonds) had been arbitrarily single-out, ceilings applied to both, thresholds for their yields beyond which the Fed obligated itself to purchase whichever instruments, no such purchases had been necessary.

The system and market readily absorbed even the vast issuance needed to finance the war.

Under the circumstances of ’48, however, this subservience to Treasury threatened to undermine the Fed’s rediscovered voice warning about inflation. With the ability to raise reserve requirements on banks, this would, theoretically, allow the central bank to restrict credit before consumer price acceleration due to real economy supply/demand imbalance became full-blown inflation, the money kind.

However, if any of this was true, then surely the Treasury market would blow up as banks rushed to sell their vast holdings of those assets (bank credit after the thirties and forties consisted of almost all Treasury debt). But since the Treasury Department still called the shots and demanded the Fed defend UST prices, the Fed would be buying what banks were expected to be selling thereby raising the level of bank reserves as it did.

More “money” for more inflation, therefore without the reserve requirements an inflationary spiral was said to be inevitable.

In fact, McCabe’s group wanted to be able to sell their holdings of UST’s to further restrict bank reserves (selling bonds out of SOMA meant taking reserves from banks for the purchase). Even so, they were willing to compromise so long as reserve requirements could be used upon Federal Reserve discretion.

At the FOMC’s June 1948 meeting, the Committee heard instead how prices in the bond market were “unexpectedly” strong regardless of its stance(s). In typical style, an unflinching certitude in the face of overwhelming contrary evidence which predominates “monetary” policy to this very day, this Treasury market strength was quickly dismissed as something other than the simple and straightforward challenge to all these official beliefs:

“Mr. Miller responded that the rise in prices largely reflected psychological influences, but that there was no real strength in the market, and that increased offerings would probably drive prices down. He also stated that the dealers had a position of about $130 million in restricted issues and that, if the System should undertake to sell from its holdings during a period when the market lacked fundamental strength, the dealers, fearing a substantial market decline, would immediately undertake to sell their holdings which would certainly drive prices down which made it undesirable to attempt any large amount of sales from the System account.”

The reason the FOMC gave up Treasury sales in ’48 was that they really believed the Treasury market would implode without the yield caps. As FRBNY President Allan Sproul said in January of that year, “I am not a believer in more and more Government controls, certainly, but this is one control which I would not want to try to let go, voluntarily, under present circumstances.”

Unless, of course, the Fed was wrong about inflation and bonds.

The recession of 1948-49 began within months, firmly established by November 1948; though it should be pointed out the downturn in prices (wholesale and consumer) started in the same month of August 1948 when Mr. McCabe was pleading with the House’s currency committee. Whereas the CPI’s annual rate had been 9.9% in July, it was a full percent lower the following month.

By January 1949, the CPI’s rate was back under 2% even though the Fed barely used its newfound reserve (and consumer credit) controls.

Quite naturally, bond bids flourished and rates not only kept low they went ever lower. Mr. Miller had been correct in that the pre-recession rise in Treasury prices had indeed “largely reflected psychological influences”, only he was sorely mistaken in assuming this psychology was misplaced; on the contrary, it had been an accurate discounting of real economic conditions and developments.

It just didn’t match the Fed’s view.

Writing for the NBER in 1956, Benjamin Caplan stated, “The commonly accepted view is that it was an inventory recession. What this means is that the forces which initiated the downturn had their major impact on the accumulation of inventories.” In short, the supply shock wore off as goods became more available in Europe and here in America. Price pressures abated as inventory was restocked and then overstocked.

As for judging the Federal Reserve’s role in the whole affair, Congress’s Joint Economic Committee wrote in 1959 that:

“Monetary policy in 1949 probably had little effect in either prolonging the recession or in promoting recovery.”

This statement was made in response to its review which noted how the central bank continued its inflationary bias well into 1949, pursuing a “tight” monetary policy even as the economy spent quite a few months in recession – a “tight” policy which included the longed-for sale of Treasury bonds, an opportunity afforded policymakers by the fact the bond market psychology had been correct the entire time and bids at high prices remained perfectly plentiful.

Contrast those with contemporary views which write history very differently. In 2012, for example, the QE era, NBER researchers Michael Bordo and Joseph Haubrich (NBER WP-18194) succinctly summarize the modern, Fed-centric interpretation:

“The recovery [from ’46 recession] ended in 1948 with Fed tightening to fight inflation, leading to a mild recession from 1948 to 1949.”

What a difference the post-Volcker lens makes. Nowadays, we’re led to believe it really was inflation with monetary policymakers like Thomas McCabe saving the day – and the bond market – from worse destruction in just the nick of time. The Fed goes from mistaken passive bystander to hero of the day by modern recall.

Here’s another contemporary viewpoint, this from 1991 (Barry Eichengreen, Peter M. Garber; NBER): “The 1948-49 recession brought a fortuitous [inflation] respite.”

McCabe was right about inflation, fortunately for America some recession tripped it up before it got going?

No, the Fed has always presented this inflation bias (including, by the way, 1930), sadly, just as it had happened in 1937 and would repeat once more in 1950 and 1951 (when in the latter year the Fed would actually gainindependence from Treasury for the same freedom to stamp out the same inflationary pressures…that also didn’t exist).

Even in a 2003 FOMC memo specifically reviewing yield caps and inflationary environments, the authors hedged on the effectiveness of the program given the actual possibilities presented by bond yields while still toeing the modern line:

“In spite of the jump in inflation, long-term interest rates remained low throughout 1946 and the first half of 1947 - either because the rise in prices was perceived as transitory, or because of a belief that the Federal Reserve would act at some point in the future to restrain inflation.”

The Volcker Fed Cult insists it is always the latter, when pre-Volcker such an idea would have been literally laughed at (see: Edwin Dale’s February 1969 The New York Times article specifically titled, Laughing At The Fed).

The picture of this omniscient, all-powerful central bank is a modern fiction. From one mistake to another, lurching between the greatest depression and deflation before fearing post-depression inflation after which never came; only to then fail to see and respond to actual and greater inflation twenty years after the above lasting nearly twenty more.

It would only be the Great “Moderation” when the Fed could step out from its own sordid historical shadows – and only because the eurodollar did the work Alan Greenspan staked its claim to. Thus, August 2007, the eurodollar exits and the Federal Reserve went right back to its original type.

The Year 2022: shortage of goods, CPI rates sky-high (though not near double-digits), and a hawkish Fed near certain inflation risks are predominant and largely on the basis of, get this, consumer psychology (expectations). The FOMC has flirted with yield caps.

Flat yield curve, eurodollar futures inversion going nuclear recently, markets today like 1947 and 1948 betting heavily against policymakers.

One of these is predisposed to “psychological influences”, alright, which is another way of saying they really have no idea what they are doing. They never have. It’s neither difficult nor unique to fight the Fed.

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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