The Federal Reserve Amendments of 1917: The Beginning of a Seasonal Note Issue Policy

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SEVERAL STUDIES HAVE FOUND that the seasonal behavior of interest rates diminished after 1914, the year the Federal Reserve began operations (for example, Shiller 1980, Miron 1986, and Clark 1986). Mankiw, Miron, and Weil (1987), Miron (1988), and Barsky, Mankiw, Miron, and Weil (1988) suggest that the Federal Reserve was responsible for the change in interest rates, while Shiller (1980) and Clark (1986) suggest that the Federal Reserve had little or no effect. Because seasonal movements are believed to reflect real economic activity, the underlying issue in these studies is whether anticipated monetary policy can affect the real sector of the economy. By analyzing what the Federal Reserve actually did during the first few years of operation, I will show that monetary policy between 1914 and 1917 was not seasonal and, in effect, was fairly restrictive. Discount operations were limited relative to the resources of the Federal Reserve, and, when notes were issued, the district banks tended to deposit gold with agents such that new notes were substantially offset by gold deposits. It is argued that gold inflows caused by World War I, not the establishment of the Federal Reserve System, are responsible for smoothing interest rates in the United States between 1914 and 1917. [1] After the passage of the 1917 amendments to the Federal Reserve Act, however, money growth became seasonal and it is possible that Federal Reserve policy influenced the seasonal movement of interest rates.

The 1917 amendments, signed into law on June 21, 1917, by President Woodrow Wilson, greatly increased the note issue power of the Federal Reserve. Under the Federal Reserve Act of 1913, Federal Serve agents, who represented the Federal Reserve Board, were required to retain eligible commercial paper as collateral equal to 100 percent of the value of notes issued and Federal Reserve district banks were required to maintain an additional 40 percent gold reserve against notes in circulation. In effect, a one dollar Federal Reserve note was backed by a minimum of forty cents of gold and one dollar to eligible commercial paper. In practice, the twelve district banks repurchased commercial paper from their Federal Reserve agents using gold, leaving the agents with gold instead of commercial paper as backing for notes issued. The gold deposited with agents was a constraint on the issuance of new notes because it could only be released to the district banks if a corresponding amount of notes were withdrawn from circulation. The 1917 amendments relaxed the new note issue constraint by allowing district banks to count gold held by agents as part of their 40 percent gold reserve requirement. This simple accounting change had an immediate effect on the gold backing of notes and the amount of notes issued. The gold backing of notes fell from 100.4 percent on June 1, 1917, to 78.2 percent on June 22, 1917. Notes in circulation rose from $464.8 million on June 1, 1917, to $1,246.5 million on December 28, 1917, while they had increased by only $244.9 million for the seven-month period preceding the passage of the 1917 amendments.

The 1917 amendments were passed to help finance U.S. participation in World War I. When the United States entered the war, on April 6, 1917, it was estimated that the first year's expense would be $4 billion, with $2 billion to be raised from bond sales. If the general population failed to support the war effort, the financial burden would fall on the Federal Reserve. The 1917 amendments, along with amendments passed in 1916, permitted the district banks to issue notes that were backed, although indirectly, by government bonds. I suggest that without the 1917 amendments the resources of the twelve Federal Reserve district banks could not have supported a $2 billion bond issue.

The paper first examines the operating behavior of the Federal Reserve between 1914 and 1917. During this period, there were many institutional constraints that had to be relaxed for the Federal Reserve to operate effectively. …