Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Treasury-Fed Accord: A New Narrative Account

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Treasury-Fed Accord: A New Narrative Account

Article excerpt

The fiftieth anniversary of Federal Reserve Independence Day was March 4, 2001. After World War II ended, the Fed continued its wartime pegging of interest rates. The Treasury-Fed Accord, announced March 4, 1951, freed the Fed from that obligation. Below, we chronicle the dramatic confrontation between the Fed and the White House that ended with the Accord.1

1. THE CHALLENGE TO THE TREASURY

In April 1942, after the entry of the United States into World War II, the Fed publicly committed itself to maintaining an interest rate of 3/8 percent on Treasury bills. In practice, it also established an upper limit to the term structure of interest rates on government debt. The ceiling for long-term government bonds was 2 1/2 percent. In summer 1947, the Fed raised the peg on the Treasury bill rate.2 However, the Treasury adamantly insisted that the Fed continue to place a floor under the price of government debt by placing a ceiling on its yield.

After World War II, the predominant concern of public policy was to prevent a return of the Great Depression and high unemployment.3 However, the primary postwar problem turned out to be inflation rather than economic depression. Over the 12-month periods ending June 1947 and June 1948, respectively, CPI inflation was 17.6 and 9.5 percent.

This inflation arose from the end of wartime price controls and ceased in summer 1948. The recession that began in November 1948 temporarily rendered moot the issue of interest rate ceilings. However, the change in the intellectual and political environment begun during the economic depression of the thirties and reinforced by the economic boom of the forties assigned to government an active role in economic stabilization. Inevitably, the Fed would want to establish a role in controlling inflation and dealing with recession. By the time inflation threatened a second time with the outbreak of the Korean War, five years of relative economic stability had made the threat of a return to the depression of the thirties seem less real. Nevertheless, the Fed was not in a position to win a contest of wills with the Treasury and rid itself of the obligation to maintain the price of government bonds.4

Ralph Leach joined the Fed right before the events that provoked open confrontation between the Federal Reserve System and the Treasury. After serving in World War II in the South Pacific, he managed the Treasury portfolios of two moderately sized banks, first in Chicago and later in Phoenix. In both cases, he was an active trader of government securities. He developed a telephone acquaintance with all the major Treasury dealers and joined them in the daily routine of guessing what the actions of the Fed's New York Trading Desk would be.

In spring 1950, the Federal Reserve Board decided to add someone with market experience to its Washington staff. Some of Leach's associates recommended him. After talking with Winfield Riefler and Woodlief Thomas, Leach accepted the position of Chief of the Government Securities Section of the Research Division.5

The Korean War broke out the day before Leach started his new job. Both Riefler and Thomas came to his office to say they felt they had done him a disservice. They feared that war would lead to the continued pegging of the government securities market rather than the development of a free market that would permit an independent monetary policy. In fact, the opposite occurred.

Particularly since its meeting on June 13, 1950, the FOMC had chafed at the straitjacket imposed by the rigid regime of rate pegging.6 After the trough of the business cycle in October 1949, the economy had recovered strongly. Fearful of an economic boom that would revive inflation, at the June meeting New York Fed President Allan Sproul had recommended raising short-term rates by 1/8 percent.7 Although long-term bonds were selling above par (yielding less than the 2 1/2 percent ceiling), everyone knew that the Fed's Rubicon would be a rise in short-term rates incompatible with this 2 1/2 percent wartime ceiling. …

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