A Shot in the Arm

December 2, 1957

The sudden reduction of Federal Reserve discount rates from 3½ to 3 percent was tantamount to a proclamation that the policy of monetary restraint is at least temporarily abandoned. The action was a victory for the forces attacking “tight money” and pressing for resumption of inflation. It raises once more some fundamental questions about monetary policy.

It is now generally recognized, even by the Federal Reserve authorities themselves, that the reduction of the discount rate from 2 percent in 1953 to 1½ percent in mid-April 1954 was a mistake. It led to a sharp upward spurt in bank loans, and hence to an inflationary expansion of the money supply. It had to be reversed a year later, by the first of seven successive increases—some of which would not have been necessary except for the unwise reduction.

It was once considered the orthodox rule of sound central banking that the rediscount rate should be kept above the rate to prime borrowing customers of the great city banks. This was on the theory that if a member bank overextended itself and had to borrow from the Fed, it should pay a penalty rate rather than make a profit on the transaction. Until recently the Federal Reserve authorities did make it a policy to keep the discount rate at least above the rate on three-month Treasury bills. But Treasury bills were still selling at an average yield of 3.47 percent in mid-November. This did not justify a cut in the discount rate below 3½ percent.

DISCOUNT RATE RULES

A year ago the Bank of Canada announced that until further notice it would adjust its discount rate weekly to maintain it at ¼ of 1 percent above the latest rate on treasury bills. If our Federal Reserve authorities adopted this rule, they would at least make it clear that they were merely following the market and not making money tight out of pure cussedness.

It is often argued that under the American system the discount rate has a merely token importance as compared with open-market operations. This is largely true. This year, for example, member banks have been borrowing an average of less than $1 billion from the Fed as compared with their total reserves of about $19 billion and their total loans and investments of about $139 billion. Yet a sound discount rate should at least be consistent with open-market policy and reflect market interest-rate realities. To cut the discount rate mainly for the “psychological” effect, to give the economy a shot in the arm, is to set a dubious precedent. Was this the most appropriate time—just after the consumer price index had risen for thirteen consecutive months to a new high record—to send up a new inflationary signal?

WHAT MONETARY POLICY?

The new discount-rate reduction raises once more the whole question of just what should be the objectives of Federal Reserve monetary policy. Under a gold standard the primary objective was clear: It was to protect the integrity of the currency by maintaining gold convertibility at all times. Under a paper standard and a Keynesian ideology the objectives become confused. The Employment Act of 1946 declares that “it is the continuing policy and responsibility of the Federal government to use all practicable means . . . to promote maximum employment, production, and purchasing power.” Many interpret this as a standing order for inflation. Chairman Martin of the Federal Reserve Board has suggested that Congress should declare “resolutely—so that all the world will know—that stabilization of the cost of living is a primary aim of Federal economic policy.

A much better solution would simply be repeal of the Employment Act of 1946. But if that mischievous law is kept, it should at least be amended to add the requirement of price stability as an offset to the heavy inflationary bias in the law as it now stands. This is the kind of problem we create when we abandon the gold standard.

Regardless of the monetary objectives ultimately adopted, it remains to be seen whether the reduction in the discount rate will achieve its major objectives. If the unions persist in pushing up wage rates, the cut will lead to more inflation without necessarily leading to more employment.