Owen Humpage & Ellis Tallman FRBA Workshop on Economic History
May 15, 2017
Returning to Normal
The views expressed herein are those of the authors and are not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of
Governors of the Federal Reserve System.
Introduction• Monetary policy has fiscal consequences (Sims 2016).
~ A complete separation (independence) is impossible.· Political economy issues can arise.
~ Under normal circumstances fiscal consequences are small. ~ When balance sheet is large and government debt ratio is high
(and rising) the consequences can be large.
• Following “normalization principles.”~ The Fed balance sheet will return to “normal” in several years. ~ Over the same time, federal deficits will likely increase and the
debt burden will likely be rising.
• Do historical precedents—WW1 and WW2—offer any lessons for what might be coming?
World War I• Declaration of War in April 1917.
~ Change in priorities: help Treasury fund the war.
• Governance Structure:~ Treasury Secretary McAdoo was Chairman of the Federal
Reserve Board. ~ Comptroller of the Currency Williams was member of the
Board.
• Treasury policies drive Federal Reserve actions. ~ Fed becomes fiscal agent (1915).
· Maintain order in financial markets. · Keep cost of funding low.
~ Overman Act; Treasury can take over Fed.
WWI: Balance Sheet Increases • Discount window to support sale of Treasury debt.
~ Lending on US Treasury collateral.~ Preferential interest rates – June 12, 1917 until mid-1921.
· Set below discount rate on eligible collateral. · Set below interest rate on Treasury debt. (chart 1)
• Fed intentionally increases balance sheet. ~ A policy choice with widespread Fed support throughout
the war. ~ Real bills doctrine influenced how Fed acted.
· Fed does not hold Treasury debt on its balance sheet. · Distributes debt to public.
0
1
2
3
4
5
6
7
8 Percent
Treasury Bonds
Treasury Notes
Chart 1: FRBNY Discount Rates on 16 – 90 Day Paper
Commercial Paper
June 1921
Temporally suspended
WWI: Balance Sheet Increases • Discount window to support sale of Treasury debt.
~ Lending on US Treasury collateral.~ Preferential interest rates – June 12, 1917 until mid-1921.
· Set below discount rate on eligible collateral. · Set below interest rate on Treasury debt.
• Fed intentionally increases balance sheet. ~ A policy choice with widespread Fed support throughout
the war. ~ Real bills doctrine influenced how Fed acted.
· Fed does not hold Treasury debt on its balance sheet. · Distributes debt to public.
WWI: Balance Sheet Size• Nominal Terms – a “reasonable” comparison.
~ 1916 $1.2 billion; 1918 $5.3 billion; 1919 $6.3 billion. ~ 1920 $6.3 billion; 1921 $5.1 billion – a sharp contraction.
• Notable increase relative to GDP. (chart 2)~ 2.7% in 1916 to 7.9% in 1918. ~ Peaks at 8.3% in 1919 but then fall to 5.9% in 1924.
• Similar Patter relative to M2. ~ From 5.4% in 1916 to 18% in 1918. ~ Peaks at 18.7% in 1919 but then falls to 12.6% in 1924.
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1916 1917 1918 1919 1920 1921 1922 1923 1924
Prop
ortio
nChart 2: Balance Sheet Size Relative to Aggregates
Balance Sheet Relative to M2 FR BS to GDP
Left scale
8
Right scale
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1
Monthly Observations
Federal Reserve Total Assets Relative to M2 (NBER)
9
October 1920
October 1918
WWI: Balance Sheet Composition
• Gold inflows & embargo on outflows enable a relatively unrestrained increase in the balance sheet. ~ Embargo lifted in mid-1919 leading to outflows. (chart 3)
• Sharp rise in member-bank borrowing. ~ Borrowing increases from about 25% of balance sheet in early
1918 to 40% in October 1918.
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7
13-Jul-17 13-Jul-18 13-Jul-19 13-Jul-20 13-Jul-21 13-Jul-22 13-Jul-23 13-Jul-24
Chart 3: Federal Reserve System Assets:July 1917 to January 1925
Gold Reserves Nongold Reserves Bills discounted and loans Short-term Govt Securities
Long Term Govt Securities Due from other Feds (transit) Uncollected Items Other assets
June 9, 1919 – End of gold export embargo
11
War ends Recession
WWI: Balance Sheet Liabilities
• Federal Reserve Notes increase. (Chart 4)~ Main liability to increase as balance sheet expanded.~ Relatively minor increase in bank reserves.
• Limited bank credit contraction when Fed increased rates.
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/09/
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/192
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6/19
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1924
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/12/
1924
Billi
ons
of U
S $
Chart 4: Federal Reserve System Liabilities:July 1917 to December 1924
Reserve deposits Federal Reserve notes Capital paid inGovernment deposits Deferred availability items All other liabilities
13
Post War Financial Stability• 1919 “unlimited demand for credit,” “speculation in
commodities,” “no incentive … to produce cheaply.”
• Treasury Secretary Carter Glass:~ Preferred “moral suasion” or “direct pressure” to limit credit to
“speculative” enterprises. ~ Preferred to avoid discount-rate increase.
• FRBNY Governor Benjamin Strong:~ Raising interest rates only way to slow credit accumulation. ~ Discount rate vs. Stock Index. (chart 5)
• Preferential rates remain in force –heavy borrowing. (chart 1)
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Inde
x (A
pril
1917
=1.
0)
Perc
ent
Chart 5: NY Fed Discount Rate vs Stock Index LevelNY Fed Discount Rate (left scale) Stock Index (right scale)
15
0
1
2
3
4
5
6
7
8 Percent
Treasury Bonds
Treasury Notes
Chart 1: RBNY Discount Rates on 16 – 90 Day Paper
Commercial Paper
June 1921
January 1920
June 1920
May 1921
Post War Financial Stability• Gold outflows when embargo ends in June 1919.
~ Reserve ratio (notes & deposits) falls to 40.6%.~ Fear about leaving the gold standard.
• Sharp hike in discount rate: (chart 1)~ Up 1.25% to 6% in January 1920 and to 7% in June 1920. ~ Preferred rates remain in force. ~ Discount window borrowing expands until early 1921. ~ Balance sheet contracts (chart 3). ~ Composition of discount window changes in 1919
• Recession begins in January 1920; ends in July 1920.
0
1
2
3
4
5
6
7
8 Percent
Treasury Bonds
Treasury Notes
Chart 1: RBNY Discount Rates on 16 – 90 Day Paper
Commercial Paper
June 1921
January 1920
June 1920
May 1921
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3
4
5
6
7
13-Jul-17 13-Jul-18 13-Jul-19 13-Jul-20 13-Jul-21 13-Jul-22 13-Jul-23 13-Jul-24
Chart 3: Federal Reserve System Assets:July 1917 to January 1925
Gold Reserves Nongold Reserves Bills discounted and loans Short-term Govt Securities
Long Term Govt Securities Due from other Feds (transit) Uncollected Items Other assets
June 9, 1919 – End of gold export embargo
Discount rate 7%
Discount rate 6%
19
War ends Recession
Preferential rates end
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1916 1917 1918 1919 1920 1921 1922 1923 1924
Prop
ortio
nChart 1: Balance Sheet Size Relative to Aggregates
Balance Sheet Relative to M2 FR BS to GDP
Left scale
20
Right scale
Post War Fiscal Policy
• Reduction in balance sheet after 1919. ~ Beginning in FY1920, federal government primary surplus until
1930.~ Federal debt fall peaks at 32% of GDP in 1921 and 1922, then
falls until 1930.
• Fed balance sheet policy as part of “independence”.~ Initiatives by Strong get monetary policy to be driven by Fed
and not Treasury. ~ Balance sheet reduction – part fiscal (Treasury debt reductions)
and response to Fed interest rate policies.
WWII: Interest Rate Control
• Federal Reserve is more independent.
• Federal Reserves agrees to help finance the War. ~ Debt-management concerns trump inflation concerns.
• Federal Reserve adopts a yield-curve policy. ~ Cap long-term Treasuryies at 2.5%. ~ Peg T-bills at 0.375%; cap certificates at 0.75%.~ Cap other rates in a consistent manner. ~ A low and steep yield curve.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
1940 1942 1944 1946 1948 1950 1952
Percent
15 year7-9 year9-12 month3 month
September 1945
Chart 6: Select Interest Rates 1940-1952
April 1942 June 1947 Accord
WWII: Balance Sheet• Federal Reserve’s balance-sheet expands.
~ Investors prefer now-liquid long-term rates and sell bills/ certificates to the Fed.
~ Fed does not intervene in long-term market. ~ Almost all short-term Treasuries.~ Balance sheet expands:
• reaching 22 % of GDP in 1940 — Gold .• reaching 41 % of M2 in 1940 — Gold.
• Fed continues debt-management policies after 1945. ~ Treasury refinance operations. ~ Concern about bank balance sheets—capital losses on long-
term Treasuries
SOMA vs. Balance Sheet
• System Open Market Committee (SOMA)~ Contains only assets shared by the Federal Reserve System. ~ Contains no gold or other assets held on the balance sheet of
specific reserve banks. ~ These are held on the consolidated balance sheet.
• Distinction is not so important today, but was more important during WW2 and, especially during WWII.
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30
1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951
Billions of dollars
Bills
Certificates
Bonds
Notes
Chart 7: SOMA 1941-1951
Agreement with
Treasury
War ends T-bill peg ends
Accord
WWII: Balance Sheet• Federal Reserve’s balance-sheet expands.
~ Investors prefer now-liquid long-term rates and sell bills/ certificates to the Fed.
~ Fed does not intervene in long-term market. ~ Almost all short-term Treasuries.~ Balance sheet expands:
• reaching 22 % of GDP in 1940 — Gold .• reaching 41 % of M2 in 1940 — Gold.
• Fed continues debt-management policies after 1945. ~ Treasury refinance operations. ~ Concern about bank balance sheets—capital losses on long-
term Treasuries
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24
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32
36
40
44
48
1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953
Percent
Required Reserves
Percent
Balance Sheet Size Relative to GDP and M2
GDPM2
Federal Reserve System Assets 1939-1953
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10
20
30
40
50
60
1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953
Gold Reserves Reserves other than gold Bills discounted and bought
Short-term US Government Securities Long-term US Government Securities Cash items in the process of collection
Industrial Advances All other assets
Billions of DollarsWar ends AccordUS enters
war
Federal Reserve System Liabilities 1939-1953
0
10
20
30
40
50
60
1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953
Reserve deposits w/o Govt. dep. Federal reserve notes Capital paid in
Government Deposits Deferred availability items All other liabilities
Billions of Dollars
WWII: Balance Sheet• Federal Reserve’s balance-sheet expands.
~ Investors prefer now-liquid long-term rates and sell bills/ certificates to the Fed.
~ Fed does not intervene in long-term market. ~ Almost all short-term Treasuries.~ Balance sheet expands:
• reaching 22 % of GDP in 1940 — Gold .• reaching 41 % of M2 in 1940 — Gold.
• Fed continues debt-management policies after 1945. ~ Treasury refinance operations. ~ Concern about bank balance sheets—capital losses on long-
term Treasuries
WWII: Post War Strategy
• Fed seeks to flatten yield curve. ~ Treasury permits increase in short-term rates beginning in
1947. ~ Investors (banks) liquidate holding of long-term debt. ~ Fed buys long-term Treasuries; sells short-term Treasuries. ~ Portfolio composition changes.
• Fed-Treasury Accord in March 1951. ~ 1949 Congressional support for a Fed focus on monetary policy.~ Korean War inflation fears.
• Fed does not
0
5
10
15
20
25
30
1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951
Billions of dollars
Bills
Certificates
Bonds
Notes
Chart 7: SOMA 1941-1951
Agreement with
Treasury
War ends T-bill peg ends
Accord
WWII: Post War Strategy
• Fed seeks to flatten yield curve. ~ Treasury permits increase in short-term rates beginning in
1947. ~ Investors (banks) liquidate holding of long-term debt. ~ Fed buys long-term Treasuries; sells short-term Treasuries. ~ Portfolio composition changes.
• Fed-Treasury Accord in March 1951. ~ 1949 Congressional support for a Fed focus on monetary policy.~ Korean War inflation fears.
Post-Accord Policy
• Fed does not entirely withdraw for debt management. ~ Supports Treasury plan minimize bondholder loss. ~ Supports Treasury offerings in 1951 – 1952.
• Fed adopts “bills only” for credibility. ~ controversial with Fed and among economists.~ ends with Operation Twist in 1960.
• Fed adopts “even keel” ~ No change in monetary policy during Treasury financing
operations.~ Ends in mid-1975, when Treasury adopts auction techniques.
Fiscal Policy
• Beginning in FY 1947, federal government runs a primary fiscal surplus (except in 1953) until late 1960s.
• Federal debt burden falls until 1975.
• Benign economic outcomes and more moderate reduction in balance sheet than for WW I.
• Fiscal debt contraction and more monetary-policy “independence” with Fed Treasury accord
Current Issues and Lessons from Past
• Likely outcome for near term: Fed will contract the balance sheet as federal debt expands – interest rates may rise.
• Lessons? During the wars, the Fed balance sheet and federal debt moved together.
~ As they expanded, Fed kept the costs cost of issuing and servicing the Treasury’s debt low.
~ As they contracted, Treasury surpluses reduced debt outstanding, facilitating Fed balance-sheet reduction.
Current Issues and Lessons from Past
• Not comparable to current outlook – fiscal dominance? ~ Fed LSAPs and other policies verged on fiscal policy. ~ No direct fiscal dominance of monetary policy in contrast to
world wars.~ Balance-sheet reduction during fiscal-debt expansion may have
fiscal consequences that challenges to monetary policy independence from fiscal sources.
~ Fiscal expansion during a balance-sheet contraction makes challenges the credibility of monetary action (see Sims 2016).
Current Issues and Lessons from Past
• WW II – Treasury views excess reserves as close substitute for Treasuries.
~ Treasury – minimizing its debt cost – favored financial repression
~ Not an option today with interest on excess reserves paid by Fed.
~ Does paying interest of excess reserves create an unacceptable fiscal challenge?
Current Issues and Lessons from Past
• Another lessons? Speed of return to normal matters. om WW1
~ WW1 discount window supported balance sheet growth· Steep increase in discount rate. · Rapid reduction of balance sheet. · Severe recession followed.
~ WW2 gradual balance sheet reduction. · More benign economic outcomes.
Owen Humpage & Ellis Tallman FRBA Workshop on Economic History
May 15, 2017
Returning to Normal
The views expressed herein are those of the authors and are not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of
Governors of the Federal Reserve System.
Returning to NormalIntroductionWorld War IWWI: Balance Sheet Increases Slide Number 5WWI: Balance Sheet Increases WWI: Balance Sheet SizeSlide Number 8Slide Number 9WWI: Balance Sheet CompositionSlide Number 11WWI: Balance Sheet Liabilities Slide Number 13Post War Financial StabilitySlide Number 15Slide Number 16Post War Financial StabilitySlide Number 18Slide Number 19Slide Number 20Post War Fiscal PolicyWWII: Interest Rate ControlSlide Number 23WWII: Balance SheetSOMA vs. Balance SheetSlide Number 26WWII: Balance SheetSlide Number 28Federal Reserve System Assets 1939-1953Federal Reserve System Liabilities 1939-1953WWII: Balance SheetWWII: Post War StrategySlide Number 33WWII: Post War StrategyPost-Accord Policy Fiscal Policy Current Issues and Lessons from Past Current Issues and Lessons from Past Current Issues and Lessons from Past Current Issues and Lessons from PastReturning to Normal
