Cheap Money Means Inflation

December 12, 1955

The Federal Reserve Board is to be congratulated on its courage in approving an increase in the discount rate from 2¼ to 2½ percent. Only a firm rein on interest rates can prevent a new spiral of inflation.

This mild action was promptly denounced, not only by Democrats in Congress but even by some bankers and businessmen. “Money was tight enough already,” complained one banker; “they’re going to make it unavailable.” If one takes comparisons for the last twenty years alone, a 2½ percent discount rate (the rate at which member banks can borrow from the Federal Reserve Banks) may indeed seem high. It is the fourth increase this year, and the highest discount rate since 1934.

But our generation has become so accustomed to cheap money that we have lost our perspective. In 1929 the discount rate of the Federal Reserve Bank of New York was raised to 6 percent. It had averaged around 4 percent for the preceding decade. It had been as high as 7 percent in 1920. Nor is the present discount rate high compared with official discount rates in the rest of the world. Money has been getting tighter everywhere. A recent compilation by the London magazine The Banker showed that in early August the discount rate in Britain was 4½ percent; in Germany, 33½ percent; in Sweden, 3¾ percent; in Denmark, 5½ percent.

In fact, if the Federal Reserve System were operating on pre-Keynesian policy it would today be charging a much higher discount rate. The late Benjamin M. Anderson, who was for many years economist of the Chase National Bank, declared in discussing the belated increase of the rediscount rate in 1920: “The Federal Reserve System should have held to the orthodox rule of keeping the rediscount rate above the rate to prime borrowing customers at the great city banks.” Today this rate is 3½ percent. The purpose of this “orthodox” rule was, of course, to penalize and discourage borrowing from the Federal Reserve Banks rather than to encourage the commercial banks to overlend to their own customers and then to reborrow at the Federal Reserve at an actual profit to themselves.

I do not mean to suggest that the Federal Reserve System could return overnight to this traditional rule, so long neglected. But it is time for us to recognize more clearly the direct causal connection between artificially low interest rates and inflation. Many bankers and economists talk and write today as if the sole cause of present-day inflation were a budget deficit financed by unloading government securities onto the banking system. But the inflation will be brought about, even without a budgetary deficit, whenever interest rates are kept too low in relation to the supply of and demand for real savings. This leads to overborrowing, and an increase in the money supply which pushes upwards on prices.

Some reasons why the Federal Reserve Board has now increased the discount rate are clear. The board is concerned about the upward pressures on the price level of steel, other primary metals, and building materials. Most of our economy is already operating practically at full capacity—at “full employment” of available men and resources. Any further increase in loans would tend merely to push up prices rather than lead to any further expansion in output.

Consumer spending has been rising more rapidly than consumer income. Installment credit and mortgage debt are at record levels. In September total consumer credit outstanding was at $34.3 billion, compared with $28.9 billion a year previous, and with $8.4 billion at the end of 1946. The stock market has been buoyant. Industrial companies have been announcing the most ambitious expansion programs on record. The country’s money supply (total bank deposits and currency outside of banks) stood at the end of September at $215 billion—an increase of $7 billion over the year before. Total bank loans stood at $78.4 billion—an increase of $11 billion over those of September 1954.

It was time for the government to take its foot off the accelerator.