Bond Parity without Inflation

October 4, 1948

The present pegging of the government bond market by the Federal Reserve Banks, in order to hold the price up to par and keep the yield down to 2½ percent, is today the principal inflationary danger in our economy. The most important argument of those who insist on continuing this inflationary support policy is that if government bonds were left to a free market they would fall to a discount that would threaten the solvency of our banking system. Insofar as this fear has substance, there are several ways in which such a consequence could be prevented.

A substantial budget surplus and a continuous retirement of the public debt (at an average rate, certainly, of not less than $2,500,000,000 annually over the next decade) is at least an essential part of any solution of the government-bond problem. But it is far from the whole solution.

The economist Benjamin M. Anderson has proposed that the outstanding debt should be funded by offering private investors new long-term government bonds at rates of interest “that will really attract them.” To protect the banks in this change of policy, he suggests that banks holding long-term government bonds “be allowed to exchange them for new issues at the higher rates of interest, at a discount of, say, 2 percent as compared with cash subscribers, leaving them with some loss but not with losses that would ruin their depositors.” One drawback to this proposal is that the Treasury could not know in advance precisely what long-term rate of interest would be most economical and yet high enough to prevent the specter of a substantial discount on bank-held government bonds from arising all over again at a later time.

This difficulty is not insurmountable. One way of meeting it would be for the Treasury to offer to exchange outstanding long-term bonds for coupon bonds with a fluctuating rate of interest. Such bonds would provide, for example, that at the beginning of each six-month interest period the coupon rate would be changed to correspond (to, say, the nearest eighth of 1 percent) to the actual yield on the bonds at their market price at the end of the preceding six-month interest period. By this automatic device the new bonds could always be held very close to par. Their market value, in fact, ought not to fluctuate in a much wider range than those of six-month certificates.

On such a bond, it is true, the Treasury could not know in advance precisely what average interest rate it would have to pay over the following fiscal year. This uncertainty, however, would be no greater than that already attached to the Treasury’s short-term financing. And the risk that the government would be obliged to pay higher interest rates is a very minor evil compared with the further inflation that a continued effort to avoid paying higher interest would inevitably produce.

Such variable-coupon bonds, of course, would not be offered to raise new funds but only as a conversion privilege to holders of outstanding long-term bonds—only in exchange, say, for outstanding bonds with a maturity more than five years off. New orthodox fixed-interest long-term bonds could later be put out for non-bank investors at favorable opportunities, and the proceeds used to retire outstanding variable-coupon bonds. Neither the Federal Reserve Banks nor the member banks should be permitted to buy any more of the variable-coupon bonds or, in fact, any government security with a maturity longer than five years. And the Federal Reserve bond-pegging policy should, of course, be halted.

A detailed proposal for a fluctuating-coupon bond, I find, was put forward in early 1942 by a business analyst, W.W. Townsend. The object of his proposal at that time, however, was to enable the country’s banking system to absorb with safety the maximum volume of bonds to finance the war. The purpose of such a plan at present would be to make it clearly safe for the country’s banking system to stop buying outstanding bonds and to sell long-term government bonds as rapidly as nonbank investors could take them up.