The Federal reserve system's "Operation Nudge"

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THE FEDERAL RESERVE SYSTEM'S

"OPERATION NUDGE"

By
OLIVER GILLAN WOOD, JR.

A DISSERTATION PRESENTED TO THE GRADUATE COUNCIL OF
THE UNIVERSITY OF FLORIDA
IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE
DEGREE OF DOCTOR OF PHILOSOPHY

UNIVERSITY OF FLORIDA
December, 1965

ACKNOWLEDGMENTS

The author would like to express his sincere appre-

ciation to the following members of his supervisory committee

for their cooperation and assistance: Dr. C. Arnold Matthews,

Dr. Ralph H. Blodgett, Dr. Robert S. Cline, Dr. Irving J.

Goffman, and Dr. Milton Z. Kafoglis. He is especially grate-

ful to the chairman of his supervisory committee, Dr. C.

Arnold Matthews, for many valuable suggestions and guidance

during the preparation of this dissertation.

The author would like to thank Dale L. Moody and Thad

B. Green, of the College of Business Administration Computing

Laboratory, for processing data used in this study, and Dr.

Roy L. Lassiter for several helpful suggestions concerning the

statistical procedures employed. He would' also like to take

this opportunity to express his gratitude to Dr. John B.

McFerrin for his counsel during the author's residence at the

University of Florida.

Finally, the writer wishes to acknowledge his indebted-

ness to his wife, Shirley, for her encouragement and for typing

the manuscript in its various stages.

TABLE OF CONTENTS

Page
ACKNOWLEDGMENTS . . .

LIST OF TABLES . . * vi

LIST OF FIGURES .. . . ...... ix

Chapter

I INTRODUCTION . . ........ 1

Problems Confronting the Central Bank
in Early 1961 . * 1
Purposes, Method, and Scope of the Study 5
Significance of the Study * a 8

II PROBLEMS CONFRONTING THE FEDERAL RESERVE
IN EARLY 1961 ... .. . . 9

The Balance-of-Payments Deficit . 10
The Recession of 1960-61 . 31
The Gap Problem and the Growth Problem . 40
Price Stability .. .... . 47
Concluding Observations . . 48

III THE ADOPTION AND THEORETICAL BASIS FOR OPERATION
NUDGE . . .# .. 52

The Adoption of Operation Nudge . 54
Factors Which Influence the Term Structure
of Interest Rates ..... . 66
Ways in Which the Federal Reserve May
Execute Operation Nudge * * 75
Concluding Observations . . 81

IV OPERATION NUDGE AND INTEREST RATES,
1961-64 *. * * * 83

Operation Nudge and Interest Rates
in 1961 . . . . 84
Operation Nudge and Interest Rates
in 1962 .* . . * 97

iii

TABLE OF CONTENTS--Continued

Chapter

Operation Nudge and Interest Rates
in 1963 . *
Operation Nudge and Interest Rates
in 1964 . . .
Conclusions Concerning the Impact of
Operation Nudge Upon the Term
Structure of Interest Rates .

V SHORT TERM CAPITAL MOVEMENTS AND THEIR INTEREST

SENSITIVITY . . . .

Introduction . . . .
Imperfections and Problems Encountered
in Working with the Data on Short-
Term Capital Movements . .
An Overall View of U. S. Short-Term
Capital Movements, 1957-64 .
Five Categories of U. S. Short-Term
Capital Movements and Their
Sensitivity to Interest Rates .
Conclusions Concerning the Interest
Sensitivity of U. S. Short-Term
Capital Movements . .
Foreign Short-Term Capital Movements,
1957-64 . . . .
Five Categories of Foreign Short-Term
Capital Movements and Their
Sensitivity to Interest Rates ..
Conclusions Concerning the Interest
Sensitivity of Short-Term
Liabilities to Foreigners . .

VI LONG TERM CAPITAL MOVEMENTS IN THE U. S.
BALANCE OF PAYMENTS . . .

Introduction . . . .
Direct Investment Overseas . .
U. S. Purchases of Foreign Long-Term
Securities . .
Factors Influencing the Sale of New
Foreign Issues in the United States
Long-Term Bank Loans to Foreigners. ..
Foreign Purchase of U. S. Long-Term
Securities . . .
Recent Efforts to Encourage Foreign
Purchases of U. S. Long-Term
Securities . . .
Concluding Observations . .

103

109

116

.

Page

. 120

S. 120

. .. 123

S. 128

. .. 133

S. 165

. 168

S. 174

S. 194

.. 198
. 198
S. 202

S. 206

S. 215
. 232

S. 237

. 250
252

TABLE OF CONTENTS--Continued

VII MONETARY EASE AND ECONOMIC EXPANSION, 1961-64

Introduction . .
Economic Expansion, 196164 .
Changes in Bank Reserves, the Money
Supply, and Time Deposits .
Growth of Bank Loans and Investments
Impact of the Easy Money Policy Upon
Three Major Sectors of the Economy
Concluding Observations . .

* S S
* 5 5

* S
* S 5

* S S
S S S

VIII SUMMARY AND CONCLUSIONS . .. ..

APPENDIX . . . . .

BIBLIOGRAPHY . . . .. ....

Chapter

. .

Page

254

254
255

259
269

275
292

294

305

309

LIST OF TABLES

Table Page

1 U. S. Balance of Payments, 1946-49 . .. 13

2 U. S. Balance of Payments, 1950-55 . . 15

3 U. S. Balance of Payments, 1956-60 . . 19
4 U. S. Treasury Bill Yields, 1960-64 . 85

5 U. S. Government Bond Yields, 1960-64 . 86
6 Aaa Corporate Bond Yields, 1960-64 . 87

7 Aaa State and Local.Government Bond
Yields, 1960-64 . ...... .. 88

8 Annual Changes in Ownership of U. S. Govern-
ment Marketable Securities, By Maturity,
1960-64 . . . . 92

9 Maturity Distribution of Outright Trans-
actions of the Federal Reserve System,
1959-64 . . . . 94
10 Annual Changes in Total Short-Term Claims,
1957-64 .. .. . . 130
11 Annual Changes in Bank Loans to Foreign
Banks and Official Institutions, 1957-64 . 134

12 Annual Changes in Bank Loans to All Other
Foreigners and Collections Outstanding--
"Trade Credit," 1957-64 . . . 136

13 Annual Changes in Other Bank Short-Term
Claims (Principally Bankers' Acceptances),
1957-64 . . . . 1
14 Annual Changes in Total Bank Foreign Currency
Claims, 1957-64 . . . 148

15 Annual Changes in Bank Foreign Currency Claims
(Deposits), 1957-64 . . . 149

16 Annual Changes in "Other" Bank Foreign Currency
Claims, 1957-64 . . . 150

17 Annual Changes in Total Claims of U. S.
Nonfinancial Concerns, 1957-64 . . 157

18 Annual Changes in Short-Term Liabilities
to Foreigners, 1957-64 .. . .. ... 169

19 Annual Changes in Bank Deposit Liabilities
to Foreign Banks and Foreign Official
Institutions, 1957-64 .. . . 179

20 Annual Changes in the Amount of U. S.
Treasury Bills and Certificates Held by
Foreign Banks and Official Institutions,
1957-64 . . . . . 180
21 Annual Changes in "Other" Liabilities to
Foreign Banks and Official Institutions,
1957-64 . .. . . 181
22 Annual Changes in Private Foreign Short-Term
Liabilities, 1957-64 . .. .. 183

23 Annual Changes in Bank Dollar Liabilities to
All Other Foreigners, 1957-64 . . 186

24 Annual Changes in Total U. S. Treasury
Bills and Certificates Held by All Other
Foreigners, 1957-64 . . .. 188

25 Annual Changes in "Other" Bank Dollar
Liabilities to All Other Foreigners,
1957-64 . . .. . 189
26 Annual Changes in Short-Term Bank Liabilities
Payable in Foreign Currencies, 1957-64 . 192

27 Annual Changes in Short-Term Liabilities of
Nonfinancial Concerns, 1957-64 . . 193

28 Total U. S. Private Capital Exports, 1957-64 201

29 U. S. Direct Investment in Major Areas,
1950-64 ... . .. . . .. 204

30 Net U. S. Purchases (-) of Foreign Long-Term
Securities, 1958-64 . . . 207

31 New Issues of Foreign Bonds and Stocks in the
United States, 1958-64 .. . .... 208

vii

Table

Page

Table Page

32 Net U. S. Purchases (-) of Foreign Stocks,
1958-64 . . . . 209

33 Net U. S. Purchases (-) of Foreign Bonds,
1958-64 . . . .. 213

34 New Issues of Foreign Securities in the United
States, Grouped According to Seller's Status
Under the IET . .. . . 229

35 Annual Changes in Long-Term Bank Loans to
Foreigners, 1958-64. . . .. 233

36 Net Purchases of U. S. Long-Term Securities
by Foreigners, 1958-64 . . 238

37 Net Purchases of U. S. Government Bonds and
Notes by Foreigners, 1958-64 . . 240

38 Net Purchases of U. S. Corporate Bonds by
Foreigners, 1958-64 . . . 243

39' Net Purchases of U. S. Domestic Stocks by
Foreigners, 1958-64 . .. . 247
40 Gross National Product, 1958-64 . . 256
41 Annual Changes in the Major Components of
GNP, 1961-64 . . 257
42 Member Bank Reserves, 1959-64 . . 261
43 Money Supply and Time Deposits, 1959-64 .. .* 265
44 Loans and Investments of Commercial Banks,
1959-64 . .. . . 270
45 Funds Supplied Directly to Credit Markets,
1959-64 . . . . . 271
46 New Housing Starts, 1955-64 . . 277

47 Net Acquisition of Mortgages by Sector,
1959-64 . . . . 280
48 New Issues and Yields on State and Local
Government Securities, 1957-64 . . 283
49 U. S. Balance of Payments, 1961-64 . .. 307

viii

LIST OF FIGURES

Figure Page

1 Yields of Taxable Treasury Securities,
1960-64 . ... . ...... 117

CHAPTER I

INTRODUCTION

Problems Confronting the Central Bank in Early 1961

At the beginning of 1961, those officials in the

Federal Reserve System who were responsible for formulating

monetary policy were in a very unenviable position. The

economy was in the midst.of its fourth postwar recession,

and an increase in the outflow of short-term capital had

enlarged the balance-of-payments deficit. Traditionally,

if a central bank is confronted either by a decline in

domestic economic activity or by a deficit in the balance

of payments, the task of recommending an appropriate monetary

policy is not difficult.

The orthodox policy for an economic downturn is one

which produces low interest rates and an easy availability

of credit. Such a policy should stimulate domestic economic

expansion by encouraging an increase in consumer spending

and investment in homes, in State and local government capital

facilities, and in plant and equipment. The orthodox policy

for a deficit in the balance of payments is one which produces

high interest rates and a limited availability of credit.

Theoretically, such a policy should discourage the outflow of

capital, encourage an inflow of funds from abroad, promote an

expansion of exports by lowering prices, and decrease imports

CHAPTER I

INTRODUCTION

Problems Confronting the Central Bank in Early 1961

At the beginning of 1961, those officials in the

Federal Reserve System who were responsible for formulating

monetary policy were in a very unenviable position. The

economy was in the midst.of its fourth postwar recession,

and an increase in the outflow of short-term capital had

enlarged the balance-of-payments deficit. Traditionally,

if a central bank is confronted either by a decline in

domestic economic activity or by a deficit in the balance

of payments, the task of recommending an appropriate monetary

policy is not difficult.

The orthodox policy for an economic downturn is one

which produces low interest rates and an easy availability

of credit. Such a policy should stimulate domestic economic

expansion by encouraging an increase in consumer spending

and investment in homes, in State and local government capital

facilities, and in plant and equipment. The orthodox policy

for a deficit in the balance of payments is one which produces

high interest rates and a limited availability of credit.

Theoretically, such a policy should discourage the outflow of

capital, encourage an inflow of funds from abroad, promote an

expansion of exports by lowering prices, and decrease imports

by reducing income.

'.-n confronted simultaneously by a recession and an

outflow of short-term capital (as the Federal Reserve was in

1960-61), the appropriate monetary policy to follow is not

clearly set forth in the textbooks on central banking. On

the one hand, if an easy money policy were followed, domestic

economic expansion would be encouraged; however, the balance-

of-payments deficit could increase if such a policy induced

short-term capital to flow out of the country and encouraged

an expansion in imports and a decrease in exports. Greater

deficits would probably lead to larger gold sales, which, in

turn, might seriously impair the ability of the Federal Reserve

to increase the money supply. Furthermore, continuing de-

ficits and the loss of gold could reduce the confidence that

foreigners have placed in the dollar as a reserve currency

and as an international medium of exchange. On the other

hand, while a tight money policy might result in smaller de-

ficits in the foreign account, it could retard economic re-

covery.and produce greater unemployment. In view -of the

recession, the slow rate of growth, and the high level of un-

employment present in 1961, it was clear that a restrictive

monetary policy was not an appropriate course of action to

follow. Thus, the Federal Reserve in early 1961 was caught

in a dilemma: to pursue a policy which would strongly favor

either the domestic or the international objective could re-

sult in some costly consequences.

It should be mentioned that this dilemma was not

entirely without precedent in the history of the Federal

Reserve. in 1925, when England decided to return to the gold

standard, the Federal Reserve subordinated the domestic

objective and pursued a policy which would assist the Bank of

England in achieving a smooth transition to its old standard.

The Federal Reserve deliberately maintained a low discount

rate so th:.t capital would not tend to flow out of England

and, therefore, hamper efforts to reestablish the gold

standard. Galbraith in The Great Crash1 and many other

critics have maintained that the low interest rates and the

easy availability of credit during the mid-twenties en-

couraged a very large investment in plant and equipment. The

unused capacity created by these outlays (as well as in-

adequate agre gate demand) made it very difficult to promote

an increase in investment spending during the early 1930's.

Besides the recession and the outflow of short-term

capital, the Federal Reserve was confronted also in early

1961 with the problem that both actual and potential Gross

National Product (GNP) had not been increasing at a desirable

rate since 1955, and that the rate of un-employment had not

approached the generally accepted full employment mark of 4

per cent since early 1957. An easy money policy is, of course,

the traditional means for dealing with these problems.

During 1960, the Federal Reserve had attempted to

promote an expansion in the domestic economy by purchasing

lar.a quantities of short-term securities, primarily Treasury

John Kenneth Galbraith, The Grea t Crash (Boston:
Houghton Mifflin Company, 1961), Chapters II and III.

bills. In fact, since 1953, most of central bank's open

market operations had been conducted in bills--the famous

"bills only" policy. Many economists, however, maintained

that by continuing to supply reserves through the purchases

of bills, the System placed downward pressure upon short-

term interest rates and, therefore, encouraged the outflow of

short-term funds. Most of these critics called for open

market operations in all maturity sectors. Finally, on

February 20, 1961, the Manager of the System Open Market

Account, at the direction of the Chairman of the Open Market

Account, made the following announcement:

The System Open Market Account is purchasing in the
open market U. S. Government notes and bonds of vary-
ing maturities, some of which will exceed five years.

During recent years transactions for the System
Account, except in correction of disorderly markets,
have been in short-term U. S. Government securities.
Authority for transactions in securities of longer
maturity has been granted by the Open Market
Committee of the Federal Reserve System in the light
of conditions that have developed in the domestic
economy and in the U. S. balance of payments with
other countries.

The Committee also gave the Manager of the Open Market

Account permission to engage in "swap" transactions, that is,

buying securities in one maturity sector and selling in

another in order to effect changes in the interest rate

1"Open Market Committee Announcement," Federal Reserve
Bulletin, 47, No. 2 (February, 1961), 165.

structure. The financial press labeled the new policy

"operation nudge" because it primarily entailed an attempt

to "nudge" short-term rates up to discourage the outflow of

short-term funds, and to "nudge" long-term rates downward to

encourage investment spending and expansion on the domestic

front. Thus, the Federal Reserve did not choose to neglect

either the domestic or the foreign problem, but attempted to

deal simultaneously with both of them.

Purposes, Method, and Scope of the Study

The aim of this study is to analyze the course of

action initiated by the Federal Reserve in early 1961 in

order (1) to determine whether or not it is feasible to

"twist" the yield curve, and (2) to evaluate whether or not

this policy has helped to achieve equilibrium in the balance

of payments and to encourage domestic economic expansion.2

The method that will be employed to determine the

feasibility of operation nudge will involve a consideration

of the various factors which influence the term structure of

rates. It must be determined whether or not there is a

theoretical basis for the attempt to twist the yield curve

1Board of Governors of the Federal Reserve System,
Annual Report, 1961, pp. 41-43. Later on, the Federal Reserve
attempted to influence the term structure of interest rates by
changing the discount rate and by raising the maximum per-
missible rate payable on time and savings deposits. For pur-
poses of this study, operation nudge will be defined as all
Federal Reserve policy actions which are designed to in-
fluence the term structure of interest rates.

2This study does not pretend to deal with all the
approaches to solving the balance-of-payments deficit, but only
those problems which led to operation nudge and which it was
designed to attack.

(Chapter III). At present, opinion appears to be divided

over the feasibility of operation nudge. Some economists be-

lieve that the forces of arbitrage will negate any attempt to

t;'ist the yield curve, while others contend that operation

nudge has had an impact upon the term structure of rates.2

Examination of the success of the central bankYs new

policy in twisting the yield curve between 1961-64 will in-

volve an analysis of the Federal Reserve's policy actions

during this period together with changes in the term structure

of rates (Chapter IV). In order to evaluate the success of

the central banks new policy in achieving equilibrium in the

balance of payments, it will be necessary to examine the

interest sensitivity of short- and long-term capital movements

(Chapters IV and V). This examination will entail an analysis

of the various types of capital movements in conjunction with

ch.-le:s in interest rate differentials between the United

States and other countries. Where scatter diagrams reveal that

there might be some linear association between the variables,

correlation analysis will be performed. Finally, the evalua-

tion of the success of Federal Reserve's attempt to promote

economic expansion will involve an investigation of the changes

For example, see James R. Schlesinger, "The Sequel
to Bills Only:," Revieiw of Economics and Statistics, XLIV,
No. 2 (May, 19627), i-i 4-89

2See Harry G. Johnson, "Major Issues in Monetary and
Fiscal Policy," Federal Reserve Bulletin, 50, No. 11
(November, 1964), a09-10; and Warren L. Smith, "The Instru-
ments of General.Monetary Control The National Banking
Review, I, No. 1 (September, 19634, .

in bank reserves, the money supply, time deposits, and bank

loans and investments. In addition, it will be necessary to

determine the impact of the central bank's policy upon several

important areas such as residential construction, State and

local government expenditures, and business investment

(Chapter VII).

The position of this writer is that operation nudge

was significantly responsible for the change in the term

structure of interest rates between 1961 and 1964. During

this period, short-term rates rose markedly, while the rates
1
on corporate bonds, municipals, and mortgages declined. How-

ever, the rate on U. S. Government bonds rose about one-

fourth of a percentage point. Concerning the success of

operation nudge in achieving its objectives, it appears that

only a small part of the total outflow of short-term capital

is sensitive to interest rate differentials; however, the

capital movements that are interest sensitive declined after

U. S. short-term rates rose. In addition, it appears that

the ready availability of credit, not the relatively low

U. S. long-term rates, is the major cause of the large out-

flow of long-term portfolio-capital in recent years. Finally,

it is believed that the central bank's efforts to prevent

long-term rates from rising and to keep credit readily avail-

able made an important contribution toward the increased rate

of economic expansion between 1961 and 1964.

The average yield on all corporate bonds declined,
while the rate on Aaa corporate bonds rose slightly.

Significance of the Study

The results of this study may prove useful since re-

search of the economic and financial literature fails to un-

cover any studies containing an analysis of operation nudge

along the lines proposed in this work.1 In the spring of

1962, Gaines and Van Cleeve debated summarily the relative

success and failure of the policy in an article in Banking.2

Any conclusions that they reached at such an early date after

the inception of the policy would not be as useful as those

reached after more time had elapsed.

An analysis of operation nudge also has current rele-

vance because the problems of how to promote economic ex-

pansion and to decrease the balance-of-payments deficit still

persist, in spite of determined efforts to develop solutions.

At present, it appears that the monetary authorities plan, at

least for the near future, to continue the policy of main-

taining high short-term rates while at'the same time attempt-

ing to prevent long-term rates from rising. Thus, this study

might be useful in evaluating the desirability of continuing

operation nudge.

1This does not mean to imply that work has not been done
on such problems as the interest sensitivity of capital move-
ments, the impact of monetary policy upon various sectors of
the economy, and the balance-of-payments deficit. To be sure,
all of these problems, especially the deficit, have received
considerable attention in recent years, and many articles and
books attest to this fact.
2Tilford C. Gaines and Robert R. Van Cleeve, "Success
and Failure of Operation Nudge," Banking, LIV, No. 10 (April,
1962), 8-12.
3Much headway has been made, however, in dealing with
both problems.

CHAPTER' 1I

PROBLEMS CONFRONTING THE FEDERAL RESERVE
IN NEARLY 1961

In early 1961, the Federal Reserve was faced with a

number of problems. Of immediate concern were the balance-

of-payments deficit, which had been worsened by the outflow

of short-term capital, and the recession, which developed so

soon after the previous dot.-turn that many observers felt

that the economy never completely recovered. As pointed out

in the introduction, the recession and the outflow of short-

term capital created a dilemma for the Reserve authorities

because either an easy nor a tight money policy appeared to

be appropriate for dealing simultaneously with both problems.

Besides these problems of a more pressing nature, the

Federal Reserve was very much concerned in early 1961 with

the failure of aggregate demand to keep pace with potential

output during the previous six years and with the need to

expand further the nation's productive potential. The first

problem may be termed the "gap problem" because there was a

c:.p between actual and potential GNP, while the second problem

may be labeled the "growth problem."l In addition, the rate

of unemployment since 1957 had been disturbingly high. About

-Some economists might prefer not to view the two
problems separately, but to consider the lagging rate of in-
crease in actual and potential output as the "growth

the only'encouraging sign in the economy at the beginning of

the year was the relative stability of prices.

The purpose of this chapter is to examine the back-

ground and causes of the principal problems confronting the

central bank in early 1961. This will aid in understanding

why operation nudge was undertaken and in evaluating the

relative success of the policy between 1961 and 1964.

The Balance-of-Payments Deficit

Development of the problem

The deficit in the balance-of-payments during 1960

was not a new problem for the United States.1 Since 1950,

the nation's foreign account had been in deficit each year

except 1957, when a small surplus occurred. There was very

little public discussion of the payments difficulties until

1958, when a loss of $2.3 billion of gold dramatized the
seriousness of the problem. During the Presidential campaign

problem." It should be pointed out, however, that if actual
output kept pace with potential output, the problem of how
to increase potential output would still remain. Therefore,
it seems helpful to view the two problems separately, even
though the same policy prescription might help to solve both
problems.

lIn the last decade, there has been a large number of
books written about the nation's balance-of-payments .diffi-
culities. Several of the most important works are: Hal B.
Lary, Problems of the United States as World Trader and Banker
(New York: National Bureau of Economic Research, 1963);
Seymour E. Harris (ed.), The Dollar in Crisis (New York:
Harcourt, Brace and World, Inc., 1961); and Robert Triffin,
Gold and the Dollar Crisis (Rev. ed. New Haven: Yale Univer-
sity Press, 1961).
An excellent bibliography of the balance-of-payments
problem is contained in U. S. Department of Commerce, U. S.
Balance of Payments, 1964, pp. 37-44.

of 1960, the balance-of-payments deficit received much
attention with both candidates outlining programs to deal

with the problem.

The aim of this section is to review briefly the

development of the balance-of-payments problem since World

War II. A complete analysis of this complex problem is be-

yond the scope of this study, but an attempt will be made

to point out important changes and trends in the underlying

components of the nation's foreign account. Chapters V and

VI will contain a more detailed discussion of short- and long-

term capital movements, two of the principal causes of the

deficit since 1958.

For the purpose of reviewing the developments in the

balance of payments, it will be helpful to divide the postwar

years into three periods: (1) 1946-49, (2) 1950-55, and (3)

1956-60. The first period stands out because during each
year, the nation experienced a surplus in its foreign account.

The second period may be viewed as a distinct unit because

during this time, there was no drastic change in the behavior

of the basic components of the balance of payments and because

there was a deficit in the balance of payments each year. The

year 1956 is a logical benchmark for the third period because

it was the first year in which the outflow of private capital

reached serious proportions. The year 1960 is the terminal

year for this period simply because it was the year prior to

the inception of operation nudge.1

Developments in the balance of payments between 1961
and 1964 will be discussed in the Appendix.

1946-49.--The most significant features of the
nation's balance of payments between 1946 and 1949 were the

size of the export balance, the large unilateral transfers,

and the outflow of government capital. During this period,

exports of goods and services exceeded imports by $31.7

billion (Table 1). One reason for the large export surplus

was that the United States was the only supplier of many of

the items needed by nations attempting to rebuild their

industrial facilities. Another reason for the favorable

balance of trade was the relatively slow increase in imports.

This was due, in part, to the fact that many countries were

in the process of rebuilding their production facilities and
1
simply did not have a large stock of goods to export. As

these nations placed their new facilities into operation,

they were able to increase their exports to the United States

and to reduce their need for goods and services from this

country. By 1950, because of declining exports and increas-

ing imports, the export surplus had dropped to $1.8 billion.

The primary purpose of the large outflow of govern-

ment capital and the sizable unilateral transfers during the

early postwar years was to assist in the reconstruction of

the wartorn countries of the world. Since most of these

nations did not have the means to earn foreign exchange, the

1Moreover, there was a strong demand in the domestic
economy for items such as new automobiles, homes, consumer
durables, and other goods which were not available in the
import market. After the large pent-up demand for these items
was.satisfied, Americans became more and more interested in
the expanding selection of new foreign products.

TABLE 1

U. S. BALANCE OF PAYMENTS, 1946-49
(In billions of dollars)

1946 1947 1948 1949
Exports of goods and services 14.7 19.7 16.8 15.8
Merchandise 11.7 16.0 13.2 12.1
Services and military sales 3.0 3.7 3.6 3.7
Imports of goods and services 7.0 8.2 10.3 9.6
Merchandise 5.1 6.0 7.6 6.9
Services and military expenditures 1.9 2.2 2.7 2.7

1. Balance on goods and services 7.7 11.5 6.4 6.1
2. Unilateral transfers -2.9 -2.6 -4.5 -5.6
3. U. S. private capital, net .4 -1.0 .9 .6
Direct investment .2 .7 .7 .7
Other long-term .1 .1 .1 .1
Short-term .3 .2 .1 .2
4. U. S Government capital, net -3.0 -4.2 -1.0 .7
5. Foreign capital other than
liquid funds .3 .1 .2
6. Errors and omissions .2 .9 1.2 .8

Deficit (-); surplus (+) 1.3 4.6 1.0 .2

Gold exports (+); imports (-) .6 -2.9 -1.5 .2
Liquid dollar assets .7 -1.7 .5 *

Source: U. S. Department of Commerce,
Supplement, 1963, p. 3.

Balance of Payments Statistical

aExcluding transfers under military grants.
bExcludes military transfers and pensions.
Note: Details in this and all other tables in this study may not add to totals
because of rounding. *Less than $50 million.

large volume of funds helped to relieve the "dollar short-

age." It is important to note that a sizable part of the

dollar transfers was used to finance exports from the United

States. Because of the declining export surplus and because

of the continued high level of U. S. aid, the overall surplus

in the balance of payments fell to $200 million in 1949, and

was perhaps an indication to some observers that danger lay

ahead in the balance of payments.

1950-55.--In 1950, the nation's balance of payments
dropped to a deficit of $3.5 billion and remained in deficit

for the next seven years. During 1950, exports were $2

billion less than in 1949, while imports were $2.4 billion

higher the previous year's total (Table 2). Three factors

were primarily responsible for the decline in exports and the

rise in imports: (1) the increased capability of foreign

nations to produce goods and services that previously had to

be imported, (2) the outbreak of the Korean War, which in-

creased the need for foreign purchases, and (3) the worldwide

devaluation of 1949, which reduced the price of exports of

the devaluing countries and made imports more expensive in

these countries. Together, the adverse changes in exports

and imports produced a decline of $4.4 billion in the balance

of trade, which, in turn, was largely responsible for the

A dollar shortage is "a situation in which foreign
nations wish to obtain more dollars to buy United States
goods than are available at current exchange rates. ."
Walter W. Haines, Money, Prices, and Policy (New York: McGraw-
Hill Book Company, Inc., 1961), p. 752.

TABLE 2

U. S. BALANCE OF PAYMENTS, 1950-55
(In billions of dollars)

1950

1951

Exports of goods and services 13.8 18.7
Merchandise 10.1 14.7
Services and military sales 3.7 4.6

Imports of goods and services 12.0 15.1
Merchandise 9.1 11.2
Services and military expenditures 2.9 3.9

1. Balance on goods and services 1.8 3.6
2. Unilateral transfers" -4.0 -3.5
3. U. S. private capital, net -1.3 -1.0
Direct investment 6 .5
Other long-term .6 .4
Short-term .1 .1
4. U. S. Government capital, net .2 .2
5. Foreign capital other than
liquid funds .1 .1
6. Errors and omissions .5

Deficit (-); surplus (+) -3.5 .3

Gold exports (+); imports (-) 1.7 .1
Liquid dollar assets 1.8 .4

~_ __ __ ~_

TABLE 2--Continued

1952 1953 1954 1955

18.0 16.9 17.8 19.8
13.3 12.3 12.8 14.3
4.7 4.6 5.0 5.5

15.8 16.6 15.9 17.8
10.8 11.0 10.4 11.5
5.0 5.6 5.5 6.3

2.2 .3 1.9 2.0
-2.5 -2.5 -2.3 -2.5
-1.2 .4 -1.6 -1.3
- .9 .7 .7 .8
- .2 .5 .3 .3
- .1 .2 .6 .2
- .4 .2 .1 .3
.2 .2 .2 .4
.6 .3 .2 .5

-1.0 -2.2 -1.6 -1.1

- .4 1.2 .3 *
1.4 1.0 1.3 1.1

Source: U. S. Department of Commerce,
ments Statistical Supplement, 1963, p. 3.

Balance of Pay-

aExcluding transfers under military grants.
bExcludes military transfers and pensions. *Less than
$50 million.

payments deficit.

In 1951, the deficit fell 03.2 billion primarily

because of an increase in exports to other nations involved

in the Korean War. During the next two years, the deficit

increased again, largely due to the continued rise in imports

and the decline in exports.

In 1954, an increase in exports and a decline in

i-ports helped to reduce the balance-of-payments deficit.

The recession in 1954 and decreased purchases of war-related

material from overseas helped to reduce imports for the first

time in the postwar period. In 1955, even further improve-

ment was experienced in the overall balance of payments

primarily because of an increase in the inflow of foreign

capital and in the "errors and omissions" component.

Between 1950 and 1955, the total deficit was o9.7

billion. During this period, foreigners purchased $2.7

billion of gold and increased their liquid dollar assets by

$7 billion. Because of the continued demand for dollars to

serve as an international reserve and as a medium of exchange,

foreigners were unanxious to convert a large part of their

dollars into gold.

From reports and other information on foreign trans-
actions, the Department of Commerce attempts to reconcile the
total volume of receipts and payments between this country
and the rest of the world. Because it is virtually impossible
to account for all the transactions which take place, total
debits do not equal total credits. In order to eliminate
this discrepancy, a balancing entry is made for "errors and
omissions."' Many economists believe that this item consists
primarily of unrecorded short-term capital flows.

1956-60.--In 1956, even though the balance of trade
improved by $2 billion, most of this gain was offset by a

$1.8 billion increase in the outflow of private capital, two-

thirds of which was in the form of direct investment (Table 3).

Of the $2 billion in direct investment in 1956, almost $1.2

billion represented outlays for petroleum facilities; $400

million for manufacturing plants; $100 million for mining and

smelting facilities; and $300 million for trade facilities and

other types of investment.1 The large overseas investment by

the petroleum industry represented a three-fold increase over

the amount invested during the previous year. In 1956, over

80 per cent of the outlays for petroleum facilities was in

three areas: $363 million in Latin America; $343 million in

Europe; and $302 million in Canada.2 By comparison, in 1955,

direct investment by the petroleum industry in these areas

was as follows: $56 million in Latin America; $54 million

in Europe; and $161 million in Canada.3 Three factors appear

to have been mainly responsible for the increase in petroleum

outlays: first, the realization that oil resources in the

United States were rapidly being depleted; second, the pros-

pect that demand for petroleum products would continue to

rise; and third, the Suez Crisis in mid-1956 demonstrated

the possibility that oil resources in the Middle-East could

1Balance of Payments Statistical Supplement, 1963,
p. 181.
2Ibid.

3Ibid., p. 180.

TABLE 3

U. S. BALANCE OF PAYMENTS, 1956-60
(In billions of dollars).

1956

Exports of goods and services 23.6
Merchandise 17.4
Services, military sales and
income on investments 6.2

Imports of goods and services 19.6
Merchandise 12.8
Services, military expenditures,
and income on investments 6.8

1. Balance on goods and services 4.0
2. Unilateral transfers -2.4
3. U. S. private capital, net -3.1
Direct investment -2.0
Other long-term .6
Short-term .5
4. U. S. Government capital, net .6
5. Foreign capital other than
liquid funds .6
6. Errors and omissions .5

Deficit (-); surplus (+) .9

Gold exports (+); imports (-) .3
Change in liquid dollar assets,
IMF position, and convertible currencies 1.2
Advance repayments to government
Advances on U. S. military exports, net

TABLE 3--Continued

1957 1958 1959 1960

26.5 23.1 23.5 27.0
19.4 16.3 16.3 19.5

7.1 6.8 7.2 7.5
20.8 20.9 23.3 23.2
13.3 13.0 15.3 14.7
7.5 7.9 8.0 8.5

5.7 2.2 .1 3.9
-2.3 -2.3 -2.4 -2.3
-3.6 -2.9 -2.4 -3.9
-2.4 -1.2 -1.4 -1.7
.9 -1.4 .9 .9
.3 .3 .1 -1.3
-1.0 -1.0 .4 -1.2

.5 .9 .4
1.2 .5 .4 .8

.5 -3.5 -3.7 -3.9

.8 2.3 .7 1.7
.3 1.3 3.0 2.2

Source: Balance of Payments Statistical Supplement,
1963, Survey of Current Business, and Federal Reserve
Bulletin.
Less than $50 million.

be cut-off; hence, further exploration and development of

oil resources in other areas would be wise.

The Suez Crisis also contributed toward the $2 billion
improvement in the trade balance in 1956. Because Europe was

in danger of being denied petroleum products, shipments of

these items to this area jumped from $527 million in 1955 to

$872 million in 1957.2 In addition, Europeans were fearful
that shortages would develop in stocks of certain finished

goods and raw materials; therefore, they also stepped up their

purchases of these items.3

In 1957, there was a surplus of $500 million in the
foreign account--the only one to occur during the 15-year

period, 1950-1964. A $5.7 billion export surplus (the

largest of the decade) and a $1.2 billion "errors and

omissions" entry were largely responsible for this surplus.

Part of the "errors and omissions" entry could represent an

inflow of foreign short-term capital, resulting from fears

which lingered after the Suez Crisis had subsided.

In 1958, the balance of payments slipped to a deficit
of $3.5 billion, principally because of a $3.4 billion decline

1William B. Dale, The Foreign Deficit of the United
States: Causes and Issues (Menlo Park, California: Inter-
national Industrial Development Center, Stanford Research
Institute, 1960), p. 7.
2Ibid.

3Ibid.

in exports (a natural development following the Suez build-

up).1 Also contributing to the deficit was a $500 million
increase in the outflow of "other long-term" private capital.2

About $350 million of this amount represented an increase in

the sale of new foreign securities in this country. Slightly

over half ($179 million) of the increase in new foreign se-

curities sold in this country was accounted for by the in-

creased sale of securities issued by international organiza-

tions such as the World Bank.3 It will be argued in Chapter

VI that the availability of funds in this country, rather

than the level of the interest rate, is .the principal reason

that foreigners and the international organizations prefer to

sell their securities in the United States.

The deficit would have been even larger in 1958 if

direct investment overseas had remained at its 1957 level.

During 1958, U. S. corporations invested $1.2 billion less in

overseas facilities than they did during the previous year.

In view of the large outlays in 1957 and because there was

recession in the domestic economy during part of the year, the

decline in direct investment was to be expected.

U. S. Congress, Joint Economic Committee, Staff
Report on Employment, Growth, and Price Levels, 86th Cong.,
1st Sess., 1959, p. 443. Cited hereafter as the Eckstein
Report.

2The category "other long-term" private capital is
comprised mainly of long-term portfolio investment and long-
term bank loans.

3Balance of Payments Statistical Supplement, 1963,
pp. 23-24.

In 1959, the deficit rose to $3.7 billion primarily
because of a $2.1 billion decline in the export surplus. This

decrease more than offset a $900 million increase in the in-

flow of foreign capital and a $500 million decrease in the

outflow of portfolio capital.

After viewing the declining export surplus between

1957 and 1959, some economists contended that the United
States' products were being priced out of world markets. The

facts are that between 1951 and 1958, the U. S. share of ex-

ports relative to that of other industrialized nations fell

from 19.4 to 18.6 per cent, while the United Kingdom, Germany,

Japan, and all other industrialized nations expanded their
2
share from 42.4 to 49.2 per cent. Of this 6.8 percentage

point increase for other industrialized countries, 6 points

were accounted for by increased exports from Germany and

Japan. While the decline in total exports might not be large

enough to cause alarm, the decline in the United States'

share of world exports of iron and steel products from 20 per

cent in 1954-56 to 15.1 per cent in 1958 was reason for con-

cern. This decline indicated that European and Japanese

steel producers had made large inroads into a market which

long had been dominated by U. S. producers.

1See Gottfried Haberler, "Domestic Economic Policies
and the United States Balance of Payments," The Dollar in
Crisis, ed. Seymour E. Harris, pp. 63-72; and Richard N.
Cooper, "The Competitive Position of the United States," The
Dollar in Crisis, ed. Seymour E. Harris, pp. 137-64.

2Eckstein Report, p. 453.

The contention that rising wages and prices in the

United States relative to those in Eruope were responsible for

the decline in the overall trade balance is difficult to sub-

stantiate. During and prior to 1955, there were times when

general wage levels in the United States rose faster than

those in Europe. Between 1955 and 1958, however, wages rose

less in the United States than in five major European countries

(United Kingdom, Germany, France, Italy, and Belgium).1 Even

after adjustment for productivity and fringe benefits, only

Italy had lower unit industry wage costs than the United

States.2

With respect to prices, the change in the price

indexes in the United States in comparison with those in the

five European countries just mentioned reveals that this

country's record is relatively good. A study of the ratios

of the 1958 consumer price indexes to the average index in

1954-56 for the five European countries listed above shows
that only Belgium had a better record than the United States.

However, an analysis of the ratios of the 1958 wholesale price

indexes to the average index in 1954-56 for the same countries

reveals that wholesale prices in Belgium, Germany, and Italy

rose less than those in the United States.3 Thus, movements

1Ibid., p. 462.
2Ibid. It should be pointed out that Italy had a very
high rate of unemployment during the 1950's.
3Ibid. The ratio was 106.6 for the United States,
100.7 for Belgium, 105.3 for Germany, 100.7 for Italy, 121.1
for France, and 107.7 for the United Kingdom.

of the general price indexes do not support the hypothesis

that U. S. goods were priced out of world markets.

General price indexes, however, may disguise the move-

ment of prices of individual products. This is well illus-

trated by the fact that between 1954 and 1959, wholesale

prices in the steel industry rose much faster than the increase

in the overall wholesale price index.1 On the basis of 1953=

100, the wholesale price index of steel in 1959 stood at 97 in

Belgium, 101 in France, 109 in Germany, and 136 in the United

States.2 Hence, it would appear that the rise in steel prices

in the United States relative to the increase in steel prices

in these other countries may be one of the principal reasons

for the decline in the United States' share of world steel

exports.

The small export surplus in 1959 prompted President

Eisenhower to urge American exporters to intensify their

efforts to sell U. S products overseas. This drive to ex-

pand American export markets contributed toward an export

surplus of $3.9 billion in 1960. In spite of this marked
improvement in the trade balance, the deficit in the balance

of payments reached $3.9 billion in 1960, the highest total

since 1919 (the first year in which reliable balance-of-pay-

ments statistics became available).

One of the principal reasons for the deficit was the

1The relative stability of prices for farm products,
processed foods, and textile products and apparel helped to
prevent the rise in the overall wholesale price index'from
matching the rise in steel prices between 1954 and 1959.
2Ibid., p. 464.

$3.9 billion outflow of private capital, also a.record for

the period since 1919. Most of the increase in the outflow

of private capital resulted from a sharp rise in the outflow

of short-term capital.1 Of the 41.3 billion outward move-

ment of short-term funds, almost $1.1 billion flowed out

during the last half of the year ($467 million in the third

quarter and $598 million in the fourth quarter). Because the

outflow increased during the last half of the year when the

differential between short-term yields in this country and

other money centers was particularly wide, many observers

felt that much of the outflow consisted of so-called "hot

money" leaving in search of higher yields.2 As will be

shown in Chapter V, approximately 46 per cent of the move-

ment of short-term capital in 1960 appears to have been

associated with higher short-term interest rates in other

money centers.

A large part of the increased outflow of short-

term capital appears to have been for the purpose of financ-

ing U. S. exports and imports and trade between other foreign

countries. In addition, a small part of the outflow may have

represented funds transferred overseas for working capital

purposes. There is also evidence that some funds were shifted

A more detailed discussion of the nature and causes
of the outflow of short-term capital will be presented in
Chapter V.

2Herbert Bratter, "'Hot Money' is Back," Banking, LIII,
No. 6 (December, 1960), 37-38, 126, 128.

abroad to speculate against the dollar. Although traditionally

it has been believed that the migration of short-term capital

is prompted primarily by higher interest rates, the evidence

appears to indicate that in 1960, much of the outflow of short-

term funds was caused by other factors.

Also contributing to the deficit was an increase in

the outflow of U. S. Government capital and a negative entry

of $800 million for "errors and omissions." It is quite

likely that much of this "errors and omissions" total re-

presented the unrecorded outflow of short-term funds.

Between 1956 and 1960, the deficit was financed by

an $8.0 billion increase in short-term dollar liabilities to

foreigners and by the sale of $3.6 billion of gold. It is

important to note that while foreigners sold $1.1 billion

of gold to the United States between 1956 and 1957, they pur-

chased $4.7 billion of gold from this country between 1958

and 1960. Thus, after 1958, foreign owners of dollar balances

displayed a much greater desire to convert part of their hold-

ings into gold.

Implications of the deficit for the central bank

Before the balance-of-payments problem became very

serious, the principal task confronting the central bank was

to create a monetary environment conducive to domestic economic

growth without inflation. With the deepening of the balance-

of-payments deficit, this task was made much more difficult in

several ways.

First of all, the loss of gold which was a result of

deficits in the 1950's meant not only a loss of part of this

nation's international monetary reserves, but also a part of

the central bank's reserves against its deposit and note

liabilities.1 Until March 3, 1965, the Federal Reserve had

to maintain a gold reserve of 25 per cent against its deposit
2
and note liabilities. At the close of 1960, the Federal

Reserve needed $11.6 billion in gold reserves, while it had

$17.5 billion in its gold certificate account; therefore,
"free gold" (total gold reserves less required gold reserves)

amounted to $5.9 billion. Three years earlier, at the end of

1957, "free gold" amounted to $10.2 billion. If "free gold"
had continued to decline at this rate during the next few

years, it would have greatly reduced the Federal Reserve's

ability to increase bank reserves. Without the necessary

means to expand reserves, the central bank could not have

lIn the United States monetary system, the Treasury
is custodian of the nation's gold reserves. When gold is
acquired, the Treasury either issues gold certificates or
credits the gold certificate account of the Federal Reserve.
For a discussion of the relationship between gold and reserve
banking, see the Board of Governors of the Federal Reserve
System, The Federal Reserve System: Purposes and Functions
(Washington: U. S. Government Printing Office, 1963),
Chapter IX.

2By an amendment to the Federal Reserve Act on March
3, 1965, Congress removed the 25 per cent gold reserve re-
quirement against the central bank's deposit liabilities.
Gold is now held in reserve only against Federal Reserve notes.
This amendment released about $4.6 billion of gold from the
cover function and increased the amount of "free gold" from
$3.7 to $8.3 billion. Removal of the gold reserve requirement,
however, did not influence directly the balance-of-payments
deficit; it only gave the nation more time in which to find a
solution to the payments problem while at the same time
temporarily removing the constraint upon domestic monetary
policy created by the gold losses.

provided for increases in the money supply and in bank credit.

This, of course, would have had an adverse effect upon

economic growth.

In addition to hampering the central bank's ability

to provide for the expansion of the money supply, the loss

of gold had the immediate effect of reducing the money supply

and member bank reserves. To illustrate, suppose that a

foreign central bank had dollars on deposit at a U. S.

commercial bank, and it wanted to purchase a given quantity

of gold. First, the foreign central bank must transfer the

required amount of dollars to its account at the Federal

Reserve. This transfer results in a reduction in bank de-

posits at the commercial bank and a reduction in bank reserves.

The Federal Reserve then transfers the required amount to the

Treasury's account, reduces the gold certificate account, and

transfers the gold bullion to the foreign central bank.

The reduction in the money supply and in bank re-

serves has a deflationary impact upon the economy similar to

that caused by the Open Market Committee's sale of securities.

In order to offset the decline in member bank reserves caused

by the sale of gold, the central bank must either purchase

securities in the open market or reduce reserve requirements.

In practice, because it is convenient, the System usually

purchases securities.

Besides these problems created for the central bank

by the loss of gold, the deficit in the balance of payments

may also force the bank to consider altering the posture of

its monetary policy for the purpose of dealing with the causes

of the deficit. To what extent the central bank should sub-

ordinate its domestic objectives to achieve an equilibrium

in the balance of payments is a question which has been de-

bated for many years. For a deficit in the balance of pay-

ments, the classical prescription is a restrictive monetary

policy. Such a policy should bring higher interest rates, a

decreased availability of credit, reduced imports, and a

smaller outflow of capital. There is also a possibility that

prices would fall and perhaps stimulate exports. There does

not appear to be many economists who advocate a restrictive

monetary policy to solve the current payments problem. Such

a policy would probably bring higher unemployment and a lower

rate of growth in the domestic economy, and few people would

be willing to pay this price.

Because the economy was in a recession during the last

half of 1960, it seems clear that a tight money policy was

inappropriate, even if it did appear that a part of the out-

flow of short-term capital was due to the relatively low short-

term rates in this country. When the Federal Reserve adopted

operation nudge in early 1961, it was attempting to prevent

the further outflow of short-term capital by boosting short-

term rates. Other than this change, though, the central bank

continued to pursue the easy money policy that it had initiated

The Commission on Money and Credit recommended that
general monetary and fiscal policies should not be used to
attain equilibrium in the balance of payments. See Commission
on Money and Credit, Money and Credit (Englewood Cliffs,
N. J.: Prentice-Hall, Inc., 1961), p. 227.

early in 1960.

There are several reasons why the continuation of a

stimulative monetary policy appeared to be a wise decision.

First, it would facilitate and might even encourage greater

investment in new plant and equipment. This could help to

make American exports more competitive in world markets.

Second, there were indications that only a part of the move-

ment of short-term capital was the result of interest rate

differentials in favor of other money centers; therefore,

invoking a tight money policy to prevent this outflow would

have been unwise. Third, since early 1960, prices had not

been advancing as much as they had during previous years,

hence, there was less need to pursue a restrictive monetary

policy to fight inflation. Finally, a stimulative monetary

policy was definitely more appropriate in view of the re-

cession, the gap problem, and the lagging rate of economic

growth.

From the discussion in this section, it is clear that

the worsening balance-of-payments deficit provided some new

problems for the central bank. Although the monetary

authorities were not in favor of subordinating the domestic

objective in order to attain equilibrium in the balance of

payments, they did attempt to prevent the further emigration

of short-term capital by embarking upon operation nudge.

The Recession of 1960-61

The recession of 1960-61 was the fourth of the post-

war period. Other recessions had occurred in 1948-49, 1953-54,

and 1957-58.1 The recession began so soon (25 months) after

the trough of the 1957-58 recession that many economists be-
lieved that the economy never completely recovered. In his

1962 Economic Report, President Kennedy said, "The task before

us is to recover not from one but from two recessions." The

National Bureau of Economic Research (NBER) placed the cyclical

peak of expansion at May, 1960, and the trough of the recession
at February, 1961. Between the peak and the trough, GNP de-

clined 2.2 per cent in constant (1961) prices or $5.6 billion

(annual rate) in current prices.

Causes of the downturn

Arthur F. Burns, President of the NBER and former

Chairman of the Council of Economic Advisers during the

Eisenhower Administration, attributed the incomplete recovery

and the recession to three developments: (1) the sudden shift

in Federal finances from a deficit in 1959 to a surplus in

1960; (2) the tightening of credit conditions by the Federal

Reserve during the last third of 1958 and during 1959; and

For a more complete discussion of the postwar re-
cessions, see Wilfred Lewis, Jr., Federal Fiscal Policy in
the Postwar Recessions (Washington: The Brookings Institu-
tion, 1962); and F. D. Holmans, United States Fiscal Policy,
1945-59 (London: Oxford University Press, 1961).
2The expansion phase of the cycle lasted 45 months
following the 1948-49 recession and 35 months following the
1953-54 downturn. U. S. Congress, Joint Economic Committee,
Hearings on the Economic Report of the President and the
Economic Situation and Outlook, 87th Cong., 1st Sess., 1961,
p. 322. Hereafter cited as Hearings on the 1961 Economic
Report of the President.

3Economic Report of the President, 1962, p. 4.

(3) the 1959 steel strike. Each of these developments will
be described in turn.

Between 1959 (I) and 1959 (III), the deficit in the
Federal consolidated cash budget2 decreased from $17 billion
3
to .2 billion (annual rates and allowing for seasonal factors).

By 1960 (II), however, there was a surplus of $7 billion.

This meant that during a period of five quarters, the economy

had to absorb an increase of $24 billion in tax revenues re-

lative to Federal expenditures. Such a sudden shift in

Federal finances had an adverse effect upon aggregate demand

and, therefore, helped to retard the economic expansion.

Iost of the swing toward the budget surplus between:

1958 (II) and the end of 1959 was caused by the movement of
the built-in stabilizers such as the individual income tax,

the corporate profits tax, unemployment compensation, excise

taxes, and employment taxes. For example, as personal income

rose following the recession, more income was taxed at higher

marginal rates and, hence, tax receipts rose proportionately

Arthur F. Burns, "Examining the New 'Stagnation.
Theory," Morgan Guaranty Survey (iMay, 1961), pp. 2-5.
2The "cash budget" more accurately reflects the amount
of funds drawn from the economy and paid into the economy.
For a discussion of the cash budget, see Philip E. Taylor,
The Economics of Public Finance (3rd ed.; New York: The
pacmillan Company, 9T), pp. 42-46.

3Burns, p. 2.
4On an annual basis, the cash budget had a deficit
of ..13.1 billion in 1959 and a surplus of $800 in 1960.

more than income. The impact of all the stabilizers produced

a sharp rise in revenue.1

Part of the swing from a deficit to a surplus was

caused by discretionary changes. As part of an economy wave

which swept Congress and the White House, defense purchases

declined $1 billion (on a national income basis and at season-

ally adjusted annual rates) between 1959 (II) and 1960

(II).2 During the same period, federal grants fell by $500
million.3 Both the President and the Secretary of Treasury

went on record as favoring a budget surplus. President

Eisenhower stated in his January, 1960, economic message to

Congress that a large surplus and a reduction in the federal

debt would help to fight inflation and strengthen the dollar.4

Secretary Anderson, in a speech before the American Finance

Association in December, 1959, defended budget surpluses on

the ground that they offset deficits created during recession

years.5 In 1960, however, Congress was not as enthusiastic

about budget restraint as the President and the Secretary of

Treasury, and it increased appropriations in most categories

Lewis, pp. 237-39.
2bid.

3Most of this decline represented a cut-back in
highway grants.

4Economic Report of the President, 1960, p. 6.

5U. S. Treasury Department, Office of the Secretary,
Annual Report of the Secretary of Treasury on the State of
the Finances, 1960, p. 282.

except foreign aid.1

The steel strike which lasted from July to October,

1959, was a second development which contributed toward the
incomplete recovery and the recession. During the spring

and early summer, in anticipation of a strike, steel users

increased their inventories, and this build-up helped to

create a boom psychology. "Once the strike came and continued

to drag on, it caused both concern and confusion in the busi-

ness community and led to some hesitation in placing orders

for investment goods."2 By the time the strike ended, steel

users, who in the meantime had an opportunity to review their

inventory policies, found new ways to economize in their

inventory management.3 Thus, in these ways, the steel strike

helped to weaken the economic expansion.

A third development which contributed toward the

abortive expansion was the Federal Reserve's shift to a re-

strictive monetary policy soon after recovery commenced.

Attesting to this fact were increases in the discount rate,

interest rates, and borrowings at the Federal Reserve banks.

.In addition, the money supply decreased during the final ten

months of the expansion.

The cyclical turning point of the 1957-58 recession

1Lewis, p. 240.

2Burns, p. 5.

3 bid.

is listed by the NBER as April, 1958.1 During April, the
discount rate was lowered from 2 1/4 to 1 3/4 per cent, where

it remained through September.2 In September, the rate was
raised to 2 per cent, and in November, it was increased to

2 1/2 per cent. The discount rate was raised to 3 per cent
in March, 1959, 3 1/2 per cent in May, and to 4 per cent in

September. Thus, between September, 1958 and September, 1959,

the discount rate was raised 2 1/4 percentage points--the

sharpest increase during any 12-month period since 1919-20.
The rapid increase in Treasury bill rates in 1958
and 1959 is another indication of the tightening credit

conditions. Between January, 1958, and June, 1958, bill rates
plummeted from 2.44 to .88 per cent. Then almost as suddenly
as they fell, bill rates rose from .88 to 2.81 per cent be-
tween June and December, 1958. In 1959, these rates continued

their upward climb and by December stood at 4.57 per cent.

Between January and April, 1958, yields on Government
bonds exhibited their characteristic stickiness and only de-
clined from 3.24 to 3.12 per cent. Between April and the end

Lewis, p. 211.
2The rates cited in this section are those in effect
at the New York Federal Reserve Bank. After a rate change
has been approved by the Board of Governors, there is usually
a short lag before all Reserve banks change their rate.
3Board of Governors of the Federal Reserve System,
Historical Chart Book (Washington: U. S. Government Printing
Office, 1964), pp. 26-27.

Federal Reserve Bulletin.

of the year, however, long-term rates rose to 3.80 per cent.

These rates continued their upward trend in 1959 and closed

the year at 4.27 per cent. Burns pointed out that during

this expansion, long-term rates "advanced faster than during
a comparable stage of any business cycle during the past

hundred years."l

The rapid increase in borrowings at the Reserve banks

during the last few months of 1958 and during 1959 also attests

to the Federal Reserve's tight money policy. In August, 1958,

the System, by not providing more reserves, permitted reserve

positions to be tightened by the seasonal demand for credit.

Banks responded to tighter credit conditions by increasing
their borrowings at the Reserve banks. Between July and

December, 1958, member bank borrowings at Reserve banks in-

creased from $142 million to $557 million. By June, 1959,

the total had climbed to $921 million.2 Throughout the re-

mainder of 1959, the level of borrowings declined slightly,
closing the year at $906 million. As the demand for credit

eased during the first half of 1960, some of the pressure on

reserve positions was removed and, as a result, the level of
member bank borrowings declined. By June, 1960, borrowings

had dropped to $425 million, and there were free reserves

($41 million) for the first time since November, 1958.

The change in the money supply is another indicator

Burns, p. 5.
2At that time, since excess reserves amounted to
$408 million, member banks had net borrowings of $513 million.

of the degree of credit restraint.1 Between the end of 1957,
and the end of July, 1958, demand deposits (seasonally ad-

justed) and currency rose $4.4 billion. From July, 1958, to

July, 1959, the money supply increased $5.1 billion. How-
ever, between July, 1959, and May, 1960 (the cyclical turning
point), the money stock fell $5.2 billion.

Thus, as indicated by the changes in the discount
rate, interest rates, member bank borrowings, and the money

supply, monetary and credit conditions tightened very quickly
following the trough of the 1957-58 recession. The presence
of inflationary pressures in the economy was apparently the

principal reason that the central bank invoked such a re-
2
striotive monetary policy. Attempting to achieve price
stability was not without a cost, however, because it appears
that the tight money policy helped to prevent the economy from

fully.recovering from the recession. Even though the trough

of the recession did not occur until May, 1960, new housing
starts, which many economists believe are sensitive to credit
conditions, declined from a peak of 1,613,000 units (season-
ally adjusted annual rates) in April, 1959, to a lowoof 979,000

units in December, 1960.2 It seems quite likely that the
tight credit conditions in effect in 1959 were partly responsible

The money supply is defined officially as currency
outside banks and demand deposits.
2'A Year of Recession and Recovery," Federal Reserve
Bulletin, 45, No. 2 (February, 1959), 114.
3Federal Reserve Bulletin.

for the decline in housing starts occurring 13 months before

the cyclical turning point.

The shift from a tight to an easy money policy

During the early months of 1960, the Reserve authori-

ties were cognizant that the pace of economic expansion had

slackened.1 Accordingly, the System began to ease reserve

positions by absorbing only a part of the required reserves

freed by the usual seasonal inflow of currency and the decline

in demand deposits. As it became more apparent that the rate

of expansion was slowing, the System stepped up its security

purchases in the open market. By June, because of the decline

in the demand for credit and the central bank's efforts to

ease reserve positions, there were free reserves for the

first time in 20 months.

In 1960, the Federal Reserve did not wait as long as

it did during the previous recession to reduce the discount

rate.2 In June, 1960, the rate was lowered to 3 1/2 per cent,
and in September, it was reduced to 3 per cent.

As a result of the less active demand for credit and

the easier reserve positions, Treasury bill rates dropped from

their recovery high of 4.57 per cent in December, 1959, to

,2.30 per cent in July, 1960, and remained near that level

A review of the Open Market Committee's policy actions
in 1960 is presented in the next chapter.

2The discount rate was raised from 3 to 3 1/2 per cent
in August, 1957, even though July was later established as
the cyclical turning point. In November, the rate was re-
duced to 3 per cent.

during the balance of the year. A large part of this decline

occurred between May and June, as bill rates fell from 3.29

to 2.46 per cent. As mentioned earlier, the outflow of

short-term capital increased sharply after June. One of the

reasons for part of the outflow appears to have been the drop

in U. S. short-term interest rates.

Thus, with the almost simultaneous occurrence of the

recession and the increase in the outflow of short-term capital,

the central bank was caught in a dilemma. If the bank had in-

voked a tight money policy in an attempt to prevent the further

outflow of short-term capital, such a policy would not have

been conducive to recovery. On the other hand, by continuing.

to supply reserves through the purchase of Treasury bills

during a period of recession, the bank was adding further

downward pressure to short-term rates, and therefore, it was

running the risk of encouraging a larger outflow of "hot

money." The Federal Reserve, though, chose to continue to

follow its policy of bills only until February, 1961.

The Gap Problem and the Growth Problem

The gap problem

Economic recovery in 1961 involved much more.than

the cyclical problem which was described above. Since 1955,

there had been a growing gap between actual and potential

GNP.1 This gap is an estimate of the "extent to which the

1The gap problem was discussed at length in "The
American Economy in 1961: Problems and Policies," a state-

economy suffers from underutilization of resources. It is
closely linked to, and strongly correlated with, the rate of

unemployment. ."

Before 1956, large gaps between actual and potential

output tended to occur only during, and immediately following,

periods of recession. Usually they disappeared, and they

even became negative during a few months of 1953 and 1955.2

In the 1957 recession, the gap widened to almost 8 per cent

of potential GNP., As the economy recovered from the recession

in 1958, this gap narrowed, but it remained near 5 per cent.

In comparison, the GNP gap during 1956 and early 1957 averaged

approximately 2 per cent. During the spring of 1960, the gap

widened to approximately 6 or 7 per cent. In 1960, it was

estimated that the GNP gap amounted to $30-35 billion, or

about $500 per American household.3

As mentioned above, the rate of unemployment is closely

correlated with the GNP gap. Between 1955 and the first half

of 1957, the rate of unemployment remained slightly above 4 per

meant by the Council of Economic Advisers (CEA) before the
Joint Economic Committee at the Hearings on the 1961 Economic
Report of the President, pp. 309-92; and Economic Report of
the President, 1962 and 1963.
Potential GNP is the total output that could be pro-
duced with reasonably full employment (4 per cent).

1Michael E. Levy, Fiscal Policy Cycles and Growth,
"Studies in Business Economics' (No. 81; New York: National
Industrial Conference Board, 1963), p. 18.
2Hearings on the 1961 Economic Report of the President,
p. 323.
3Ibid., pp. 323-25.

cent. In the recession of 1957-58, unemployment rose to as
high as 7.4 per cent of the labor force. During the 25-month

expansion period following this recession, the rate of un-

employment dipped below 5 per cent in only one month.1 As the

pace of economic activity slackened after May, 1960, the rate

of unemployment increased, and by the end of the year it

amounted to 6.8 per cent of the labor force.2 Thus, there is

a very close relationship between changes in the GNP gap and

changes in the rate of unemployment. It follows that if the

gap could be narrowed, the rate of unemployment would decline.

It is important to realize that the GNP gap is only

an estimate because potential output cannot be observed

directly.3 On the basis of its studies of trends in the labor

force and in productivity, the CEA in 1961 estimated that

potential output was growing at a current rate of 3.5 per

cent. In order to calculate the GNP gap, the Council pro-

jected a trend line rising at 3.5 per cent per year from the

actual output series of mid-1955. This point was chosen be-

cause there was prosperity and stable prices during 1955. In

Ibid., p. 322.

2Economic Report of the President, 1962, p. 231.

3For a discussion of the alternative methods of esti-
mating potential GNP, see Levy, Chapter 5.

4This is comprised of a "rise in the labor force that
follows a 1.5 per cent per year upward trend and a secular in-
crease in real gross national product per man averaging 2 per
cent per year." Hearings on the 1961 Economic Report of the
President, p. 325.

addition, the rate of unemployment was only slightly above 4

per cent. The CEA projected the trend line through 1960
and discovered a GNP gap of 8 per cent for 1960 (IV). Using

a different method, Knowles calculated that the GNP exceeded

8 per cent at the end of 1960.2 Finally, the CEA found a

statistical relationship between real GNP and unemployment

which "indicates that a fall of 2.4 percentage points in the

unemployment ratio--from 6.4 to 4.0 per cent--would yield an

estimated rise in real GNP of about 8 per cent."3 Thus, it

seem reasonable to conclude that "an 8 per cent figure for

the gap in the fourth quarter of 1960 is grounded in per-

suasive evidence."4

The growth problem

While the gap problem is the failure of actual GNP to

keep up with the 3.5 per cent annual increase in potential

GNP, the growth problem is "that this 3.5 per cent annual in-

crease falls short of an adequate rate of growth in our

capacity to produce."5 In his economic message to the Congress

CEA, "Two Views on Basic Economic Questions," Morgan
Guaranty Survey (August, 1961), p. 3.

2James W. Knowles, The Potential Growth in the United
States (Study Paper No. 20), U. S. Congress, Joint Economic
Committee, 86th Cong., 2nd Sess., 1960, pp. 36-37.
3Hearings on the 1961 Economic Report of the President,
P. 327.
4CEA, Morgan Guaranty Survey (August, 1961), p. 4.

5Ibid.

on February 2, 1961, President Kennedy stated that the 3.5

per cent growth rate was not high enough. "Our potential

growth rate can and should be increased. To do so, we pro-

pose to expand the nation's investment in.physical and in

human resources, and in science and technology."l On June, 28,

President Kennedy contended that an annual growth rate of 4.5

per cent is "well within our capability."2

Accelerating the capacity to produce (providing that

it is matched by adequate demand) will help to fulfill some

of the unsatisfied needs in the domestic economy and to resist

additional threats to freedom overseas.3 At home, it is esti-

mated that approximately "30 percent of the families and un-

related persons have less than $1,000 of money income per

person. An increase in per capital production would

greatly reduce the number of low income persons. In addition,

there is a need to devote more resources to the improvement of

education, to the expansion of medical facilities, and to the

expansion of the nation's parks and forests. Additional re-

sources for these needs can be created by economic growth.5

The United States already shoulders much of the burden

1New York Times, February 3, 1961, p. 10.

2Economic Report of the President, 1962, p. 114.

3Ibid., p. 109.

4Ibid.

5$Ibid., p. 110.

of defending freedom throughout the world. In order to con-

tinue devoting a large amount of resources to defense and

providing aid to the developing countries, the nation needs

to increase its production capability. Finally, an expand-

ing economy will demonstrate to the world that a predominately

free enterprise system can provide a higher standard of living

for its people than a regimented system.

The role of monetary policy in dealing with the
gap and growth problems

The gap problem exists because demand has not kept

pace with increases in potential output, while the growth pro-

blem exists because potential output has not been increasing

at an adequate rate. Consumption expenditures comprise the

largest element in the total demand for goods and services.

Many economists believe that fiscal policy is better suited

than monetary policy for stimulating consumer spending. This

is because consumption depends primarily upon income, and an

increase in government expenditures or a reduction in income

taxes immediately increases income in the hands of consumers.

The amount of spending generated by the increase in income

will depend upon the marginal propensity to consume of the

income recipients.

On the other hand, the impact of easier credit condi-

tions and lower interest rates upon consumption is not as

large or as direct as that produced by fiscal measures. One

reason for this is that the proportion of consumer spending

financed by credit is small. Credit is used to finance a

large part of the expenditures on consumer-durables; however,

purchases of these goods comprise less than 20 per cent of

total consumption. Another reason that an easy money policy

may have a smaller impact upon consumption is that "much

consumer credit is insensitive to terms of credit."2 Con-

sumers may or may not borrow more in response to easier credit

conditions.

Increased investment expenditures would help to solve

both the gap and growth problems.3 These expenditures would

boost demand and increase the nation's production capability.

An easy money policy may facilitate and possibly stimulate an

increase in investment by increasing the availability and lower-

ing the cost of credit. In addition, through the acceleration

principle, an easy money policy may indirectly induce an in-

crease in investment by facilitating and possibly stimulating

1Paul B. Trescott, Money, Banking and Economic Welfare
(New York: McGraw-Hill Book Company, 1960), p. 149.

2Ibid.

3The need for greater investment is shown by the fact
that capital stock per worker increased only 1.9 per cent
annually between 1954-60, in comparison with an increase of
3.5 per cent per.year between 1947-54. This decline in the
rate of growth in the stock of capital available to each worker
was reflected in a decline in the rate of increase in output
per worker from 3.3 per cent per year between 1947-54 to 2.1
per cent per year between 1954-60. Economic Report of the
President, 1962, p. 129. In addition, the average age of the
stock of equipment has increased since 1955, while the average
age of plant has declined slightly--but steadily--since 1945.
Hearings on the 1961 Economic Report of the President, p. 337.

an increase in demand for finished products.1 Finally,

monetary policy can help to encourage investment "through con-

tinuous efforts to safeguard the value of the dollar and to

create a climate of financial stability in which savers can

have confidence in the future value of their investments. .. ."2

Price Stability
Perhaps the only encouraging sign in the economy in

early 1961 was the relative stability of prices. Between
1960 and 1961, the wholesale price index (WPI) declined .4

point and the consumer price index (CPI) rose 1.1 points

[1957-59=100 By comparison, the WPI rose 2.8 points between
1956-57, 1.4 points between 1957-58, .2 point between 1958-59,
and .1 point between 1959-60. The CPI increased 3.3 points

between 1956-57, 2.7 points between 1957-58, .8 point between

There is some question concerning the precise impact
of monetary policy upon investment. This matter will be dis-
cussed further in Chapter VII.
2"A Year of Recession and Recovery," Federal Reserve
Bulletin (February, 1959), p. 118.
3Because the problem of inflation had eased in 1960,
and did not appear to pose an immediate threat in early 1961,
the Federal Reserve was able to continue to follow an easy
money policy, while at the same time attempting to raise short-
term rates. Since the problem of inflation was not one of the
major considerations in the decision to undertake operation
nudge, a discussion of the various causes of inflation and the
role of monetary policy in fighting inflation will be omitted.
One of the most widely acclaimed studies of inflation is
Charles L. Schultze, Recent Inflation in the United States
(Study Paper No. 1), U. S. Congress, Joint Economic Committee,
86th Cong., 1st Sess., 1959. For a survey of the major theories
of inflation, see Norman F. Keiser, Macroeconomics, Fiscal
Policy, and Economic Growth (New York: John Wiley and Sons,
Inc., 1964), Chapter 18. See Commission on Money and Credit,
Money and Credit, pp. 13-23, for an excellent discussion of
the problem of inflation.

1958-59, and 1.6 points between 1959-60.1
Between early 1956 and the end of 1959 (except during
part of the 1957-58 recession), it seemed to some economists

that the Federal Reserve was overly concerned with the pro-

blem of inflation because most of the System's actions and

statements were generally oriented toward this problem.2 Few

would argue that the price increases which took place during

this period were not excessive and undesirable, and that the

central bank should not have taken action to stem the infla-

tionary trend. Hart and Kenen contend that the "System may

have been 'right' in 1956-1957, when it maintained

tight money to combat inflation, perhaps to the deteriment

of economic growth."3 However, as mentioned earlier, the

Federal Reserve's attempt to prevent inflation in 1958-59

was partly responsible for the incomplete expansion follow-

ing the 1957-58 recession.4

Concluding Observations

In early 1961, the Federal Reserve was confronted
with a deficit in the balance of payments, a recession in the

Federal Reserve Bulletin.

2See, for example, Holmans, p. 271.

3Albert Gailord Hart and Peter B. Ken.en, Money, Debt,
and Economic Activity (3rd ed.; Englewood Cliffs, N. J.:
Prentice-Hall, Inc., 1961), p. 443.
4Between 1956 and 1960, there was much discussion
about the Federal Reserve's conflict of objectives--that it
was very difficult to prevent inflation and to encourage
economic growth simultaneously.

domestic economy, and with the fact that for six years, the

rate of unemployment had remained above the 4 per cent mark.

Furthermore, there was a pressing need to close the GNP gap

and to increase the rate of growth of the nation's productive

capacity.

The deficit in the balance of payments was worsened

considerably during the last half of 1960 by the outflow of

short-term capital. While a major part of this capital was

used to finance exports from the United States, a large

amount appeared to have left the country because short-term

yields were higher in other money centers.

Although the NBER lists May, 1960, as the beginning of

the fourth postwar recession, it was clear several months

earlier that recovery from the previous recession was not

proceeding at a desirable pace. The Federal Reserve received

part of the blame for the incomplete recovery and the re-

cession because it shifted to a very restrictive monetary

policy during the early months of the expansion in an attempt

to prevent further price increases. Early in 1960, as the

demand for credit weakened, the Federal Reserve eased reserve

positions. As a reflection of the less active demand for

credit and of the easy money policy, short-term interest

rates declined very sharply between January and May, 1960,

but remained relatively stable throughout the balance of the

year.

During 1960, the Federal Reserve continued to adhere

to its bills only policy. By supplying reserves through the

purchase of Treasury bills, the System added further downward

pressure to short-term rates and, therefore, helped to sustain

short-term interest rate differentials between the United

States and other money centers. It would appear that the

central bank's actions were partly responsible for the out-

flow of short-term funds seeking higher yields abroad.

Besides the cyclical downturn, the Federal Reserve

was concerned over the tendency for aggregate demand to lag

behind aggregate supply. The high rate of unemployment pre-

sent in the economy since 1955 was a clear reflection of this

gap. Even if the gap problem were solved, the presence of

many unsatisfied needs in the economy demanded that efforts

be made to increase the rate of growth of potential output.

About the only encouraging note in the economy in early 1961

was the relative stability of prices.

In conclusion, the simultaneous occurrence of a re-

cession and an outflow of short-term capital made the formu-

lation of an appropriate monetary policy very difficult. Until

the Federal.Reserve undertook operation nudge, it had not

attempted to alter its policies in order to prevent the out-

flow.of short-term funds. Because of the recession, of the

need to reduce the rate of unemployment, and of the need to

increase the rate of economic growth, it is the opinion of

this writer that the central bank was wise in continuing its

easy money policy after it became apparent that part of the

outflow of short-term capital was caused by low interest rates

in this country. It is believed, however, that the System

51

Should have abandoned its bills only policy much earlier to

relieve some of the downward pressure on short-term rates.

CHAPTER III

THE ADOPTION AND THEORETICAL BASIS
FOR OPERATION NUDGE
Following the famous Accord between the Federal Re-
serve and Treasury in March, 1951, and until February 20,

1961, the Federal Reserve conducted virtually all of its

open market.operations in Treasury bills. This was called

the bills only policy, but since the System indicated that

if necessary, it would purchase long-term securities, "bills

preferably" may be a more accurate description of the System's

policy.1

Supporters of the policy contended that if the Open

Market Committee operated primarily in short-term issues,
Government security dealers could take positions in the market,

thereby helping to create a securities market with more

1Ralph A. Young and Charles A. Yager, "The Economics
of 'Bills Preferably,'" Qarterly Journal of Economics,
LXXIV, No. 3 (August, 1960), p. 341. For further discussion
of the bills only policy, see Daniel S. Ahearn, Federal
Reserve Policy Reappraised, 191-1959 (New York: Columbia
University Press, 1963), especially Chapters IV-VI; W. W.
Riefler, "Open Market Operations in Long-Term Securities,"
Federal Reserve Bulletin, 44, No. 11 (November, 1958), 1260-
74; Dudley G. Luckett, "'Bills Only': A Critical Appraisal,"
Review of Economics and Statistics, XLII, No. 3 (August, 1960),
301-306; and Warren L. Smith, Debt Management in the United
States (Study Paper No. 19), U. S. Congress, Joint Economic
Committee, 86th Cong., 2nd Sess., 1960, Chapter V.

"breadth, depth, and resiliency."l In addition, proponents

of the bills only policy maintained that it was unnecessary

to conduct operations in long-term securities because through

the forces of arbitrage, the impact of transactions in the

short-term sector would be transmitted throughout the yield
2
curve.

On the other hand, critics of bills only held that

the policy reduced the effectiveness of open market operations;

therefore, the central bank could not make its maximum con-

tribution toward economic stability.3 It was argued also that

open market operations in bills "have only a delayed influence

upon long-term interest rates."4 Finally, many observers

believed that by continuing to supply reserves in 1960 through

"In strictly market terms, the inside market, i.e.,
the market that is reflected on the order books of specialists
and dealers, possesses depth when there are orders, either
actual orders or orders that can be readily uncovered, both
above and below the market. The market has breadth when these
orders are in volume and come from widely divergent investor
groups. It is resilient when new orders pour promptly into
the market to take advantage of sharp and unexpected fluctua-
tions in prices." U. S. Congress, Hearings before the Sub-
Committee on Economic Stabilization of the Joint Committee on
the Economic Report, United States Monetary Policy: Recent
Thinking and Experience, 83d Con,., 2d Sess., 1954, p. 265.

2Riefler, p. 1260-74.

3See, for example, Sidney Weintraub, "Postscript on
'Monetary Policy,'" Review of Economics and Statistics,
XXXVIII, No. 2 (May, 1956), 228; Commission on Money and Credit,
Money and Credit, pp. 63-64; and Ahearn, Chapter VI.

4Otto Eckstein and John Kareken, "The 'Bills Only'
Policy: A Summary of the Issues," Money and Economic
Activity, ed., Lawrence S. Ritter (2nd ed.; Boston: Houghton
Mifflin Company, 1961), p. 276; See Ahearn, Chapter V for
evidence of imperfect linkage between short- and long-term
rates.

the purchase of bills, the Open Market Committee placed down-

ward pressure upon short-term rates and, hence, encouraged

the outflow of short-term capital.

One of the purposes of this chapter is to describe

how operation nudge evolved in the Open Market Committee and

to present the reasons given for and against its adoption.

Another aim of this chapter is to determine whether or not

there is a theoretical basis for the Federal Reserve's efforts

to alter the term structure of rates. In order to accomplish

this task, it will be necessary to examine the major factors

which influence the term structure of interest rates and to

show how the Federal Reserve's policy actions will affect

these factors.

The Adoption of Operation Nudge

Although the Federal Reserve began to conduct its

open market operations with the objective of twisting the

interest rate structure in February, 1961, the problems with

which the technique were supposed to deal developed earlier.

According to the NBER, the recession began in May, 1960, and

Department of Commerce data on capital movements show that

the outflow of short-term capital became a serious problem

during the third quarter of 1960. The Open Market.Committee,

however, moved to ease reserve positions early in 1960, which

was before the downturn started. Commenting on the action

taken by the central bank during 1960, the special committee

appointed by President Kennedy in the fall of 1960 to analyze

the current economic situation in the United States said:

"It is our opinion that the Federal Reserve System has timed

its changes in policy expertly in this recession."l Although

"international developments" were not mentioned in the policy

directive of the Federal Open Market Committee until October

25, the "Record of Policy Actions" of the Committee reveals

that the group discussed the capital outflow at its meeting

on July 26, 1960.3 In order to understand more fully the cir-

cumstances surrounding the Open Market Committee's change in

operating technique in February, 1961, it would be helpful to

review briefly the Committee's policy actions between early

1960 and early 1961.

Open Market Committee's policy actions during the
year preceding the adoption of operation nudge

The Open Market Committee's policy directive in effect

at the beginning of 1960 had not been changed since the

Committee's meeting on May 26, 1959. It called for open market

operations with a view "to restraining inflationary credit ex-

pansion in order to foster substainable economic growth and

1Hearings on the 1961 Economic Report of the President,
p. 723. Members of this committee were Allan Sproul (Chair-
man), Roy Blough, and Paul W. McCracken.

policy directives are issued by the Federal Open
Market Committee to the Federal Reserve Bank of New York as
the Bank selected by the Committee to execute transactions
for the System Open Market Account.

3It is possible that capital movements were discussed
at an earlier meeting, yet not mentioned in the "Record of
Policy Actions."

expanding employment opportunities."l

At the meeting on February 9, 1960, the Committee

unanimously agreed that further restraint should be avoided

in view of the fact that recovery was not proceeding as

rapidly as desired. The Committee, however, voted not to

change the current directive.2

At the March 1 meeting, the Committee unanimously

voted to change the policy directive "so as to provide that

open market operations should be conducted with a view 'to

fostering sustainable growth in economic activity and employ-

ment while guarding against excessive credit expansion.'"3

This action was taken because "some of the earlier exuberant

expectations were not being fully realized and that excesses

in commitments and in credit extensions were not developing."4

At the April 12 meeting, it was the consensus of the

Committee that open market operations should seek to ease

reserve positions further. With this in mind, the Committee

voted unanimously to renew its present directive.5

On May 24, the Committee changed the directive to pro-

1Board of Governors of the Federal Reserve System,
Annual Report, 1960, p. 25.

2lbid., pp. 40-41.

3Ibid., p.-41.

*4Ibid., p. 42.

51bid., p. 50.

vide for open market operations with a view "to fostering

sustainable growth in economic activity and employment by

providing reserves needed for moderate bank credit expansion."l

This action was taken after a review of the various economic

indicators revealed that earlier gains made in several sectors

of the economy had not continued.

On July 26, the Committee noted that the gold outflow

had increased, and that short-term capital was moving abroad

in response to higher interest rates. In addition, it re-

cognized that the demand for credit was not vigorous and that
2
there were signs of weakness in some sectors.

By a vote of seven to four on August 16, the Committee

loosened the monetary reins further. The policy directive

was changed "to provide that open market operations should be

conducted with a view 'to encouraging monetary expansion for

the purpose of fostering sustainable growth in economic

activity and employment.'"3 Although the Committee noted the

continuing deficit in the balance of payments, it did not

take this into consideration in the formulation of its policy

directive.

On October 4, the Committee showed concern that "the

short-term capital outflow had intensified, apparently due in

part to the spread between short-term rates of interest in

1Ibid., p. 54.

2Ibid., p. 60.

3Ibid., p. 61.

the United States and the higher rates elsewhere."l Although

the existing policy directive was not changed, the Committee

"hoped that downward influences on short-term rates could be

minimized."2

At its meeting on October 25, the Committee appended

the words "while taking into consideration current inter-

national developments" to its current directive.3 The group

again voiced hope that its objectives could be accomplished

with a minimum of downward pressure on bill rates. It added,

though, that providing additional reserves took precedence
4
over a further decline in the bill rate. The Committee also

noted that in the future it may be advisable to operate in

securities other than bills.

During late October and in November, the Open Market

Committee purchased $315 million of short-term Government

securities other than Treasury bills.5 The Reserve authorities

explained that these purchases "were made at a time when the

spread between rates on short-term Treasury bills and on

securities maturing in 9 to 15 months was usually wide."6

lIbid., p. 66.

2Ibid., p. 67.

3Ibid.

4Ibid., p. 69.

5Ibid., pp. 9-10.

6"Credit and Money in 1960," Federal Reserve Bulletin
47, No. 2 (February, 1961), 131.

This appears to be the first time since bills only was

established that the Federal Reserve acknowledged that it

was conducting open market operations with the intention of

directly influencing the interest rate structure.

At its meetings on November 22, and December 13, the

group took account of the continuing outflow of capital and

of the dilemma that was developing concerning how to increase

reserves without placing further downward pressure on short-

term rates.1 The general policy directive was not changed,

however, and "the rather general hope continued to be ex-

pressed that System open market operations could be so con-

ducted as not to contribute to any significant reduction of

short-term market rates below prevailing levels."2

In reviewing the Committee's policy changes for 1960,

it is encouraging to see how quickly the group adjusted its

policy directive as the economic climate changed. -It seems

reasonable to conclude that the rapidity with which reserve

positions were eased helped to make the 1960-61 downturn the
least severe of the postwar recessions.

It does appear, however, that the System's refusal to

take steps that might narrow the short-term interest rate

differential between the United States and other money centers

was unjustifiable. As will be shown in Chapter V, a large

part of the outflow of short-term capital in the last half

lIbid., pp. 70-74.

2Board of Governors of the Federal Reserve System,
Annual Report, 1961, p. 72.

of 1960 represented funds owned by nonfinancial concerns.

It is believed that this capital is sensitive to interest

rate differentials; therefore, the magnitude of this outflow

might have been reduced if the Federal Reserve had abandoned

the bills only policy in mid-1960 instead of delaying until

February, 1961.

At its first meeting in 1961 (JanuarylO), the Open

Market Committee voted to renew its current policy directive.

Some members suggested that the System "'mop up' more of the

ease that had prevailed" and endeavor "to assure a short-term

interest rate level conducive to checking the outflow of funds

and possibly reversing it."1

On January 24, much the same attitude prevailed as

at the January 10 meeting. There was concern over the

dilemma that had been created for monetary policy by the

balance-of-payments deficit and the recession. Governor

Robertson stressed that conditions should be eased further

because of the slack in domestic economic activity.2

At the February 7 meeting, Governor Robertson re-

iterated his position outlined at the previous meeting and

added that when the economy recovered, interest rates would

rise, and the outflow would be reversed. While the Committee

did not change its basic policy directive for open

market operations, it did authorize the New York Federal

llbid., p. 36.
2Ibid., p. 37.

Reserve Bank to acquire "intermediate- and/or longer-term

U. S. Government securities having maturities up to 10 years,

or to change the holdings of such securities, in an amount

not to exceed $500 million." The Committee went further

than merely authorizing that purchases be made in the inter-

mediate and long-term sectors. The group stated that under

the new directive, it was possible to conduct offsetting

transactions, that is, to sell bills and to buy bonds simul-
2
taneously, or within the interval of a few days. This change

was adopted by a vote of ten to one, with Governor Robertson

dissenting. The Committee hoped that the revision "might

facilitate the implementation of current monetary policy."3

As a means of maintaining the bill rate, the possibility of

decreasing the availability of reserves to the banking system

was considered and rejected by the Committee. Thus, although

the announcement that the System was going to purchase long-

term securities was not made until February 20 (the date of

initial operations in longer-term securities), the decision

to abandon bills only was made at the meeting on February 7.

The Committee's justification of operation nudge

In justification of its decision, the Committee

stated that

!Ibid., p. 40.

2Ibid., pp. 41-42.

31bid., p. 40.

purchase of securities in the intermediate- and longer
term areas, as contrasted with the short-term area,
offered the possibility of supplying reserves without
creating direct pressure on short-term rates. Also,
such purchases, by having a moderating influence on
long-term interest rates relative to short-term rates,
might have the effect of facilitating the flow of
funds through the capital and mortgage markets, there-
by encouraging the progress of recovery. Accordingly,
the combination of domestic and international circum-
stances confronting the Committee seemed to call for 1
a high degree of flexibility in open market operations.

While some members of the Committee were uncertain about the

feasibility of conducting operations simultaneously in

different sectors of the market, most of them believed that

a "determined effort was warranted."2

Besides the reasons given above for undertaking opera-

tions beyond the short-term sector, the Committee offered

another explanation for its action. The group felt that

the conduct of operations outside the short-term
sector of the Government securities market might
contribute to determining whether the criticisms
of the System's policy of confining its open market
operations to short-term securities, except in the
correction of disorderly markets, was warranted.
Likewise, it was envisaged that the procedure might
throw some light on the possibility.of influencing
longer-term rates while maintaining the short-term
rate level.3

Ibid. Italics added.

2Ibid.

3Ibid., p. 41. While this statement indicates that
criticism of the bills only had a part in persuading the
Committee to change its policy, Representative Curtis seems
to have received a slightly different impression after hear-
ing Chairman Martin's testimony before the Joint Economic
Committee. Representative Curtis stated:

"It is the changing times and changing circumstances
which you have pointed out to us that have brought
about the need for the change in approach rather
than any adverse criticism that might have been

Perhaps what stands out most about the Committee's

change in policy, besides the change itself, was the fact

that the reasons given for the new course of action were

couched in such uncertain terms. It is evident that the

Committee was not at all sure that the policy would be

effective, and it even indicated that operations outside the

short-term sector were in the nature of an experiment.

Some doubts as to efficacy of operation nudge

Besides casting the lone dissenting vote, Governor

Robertson gave several reasons why the Committee should not

abandon bills only. In a statement to the Committee,

Governor Robertson explained

(1) that the established operation procedures and
policies of the Committee were, in fact, the pro-
duct of careful empirical and analytical study;
(2) that they had proved in practice to be sound,
both in terms of monetary policy and in terms of
fair dealing with the market; (3) that in deviating
from its established policies the Federal Open
Market Committee was in effect asserting, without
reason, that it had made a critically incorrect
judgement eight years ago and had pursued incorrect
operating practices since; and (4) that critics of
present methods of operating in the market were rely-
ing on the simplest theories of determination of
market interest rates and making allegations on
postulates having little if any basis in empirical
fact. In his opinion this departure from established
operating techniques would not constructively in-
fluence market rates, and he gathered from the dis-
cussion that not many (if any) at the table were
confident of such a result.1

directed against the policy, although criticism is
always helpful to trying to understand the problem."
Hearings on the 1961 Economic Report of the President,
P. 479.
1Board of Governors of the Federal Reserve System,
Annual Report, 1961, p. 42.

He added that the Committee was running the risk of under-

mining confidence that foreigners had placed in the new

Administration after it had promised to maintain a stable

dollar.

Perhaps some of what Governor Robertson said is true.

To be sure, operating simultaneously at opposite ends of the

securities market in order to twist the yield curve was

an untried technique. The stickiness exhibited by long-

term rates during the 1957-58 and 1960-61 recessions, how-

ever, would seem to provide a "basis in empirical fact" for

trying to speed the decline of long-term rates.

Exactly one month after the Open Market Committee's

decision to purchase long-term securities, Chairman Martin

testified before the Joint Economic Committee. Senator

Bush questioned Chairman Martin concerning the possibility

that attempting to lower long-term rates might backfire and

lower short-term rates.1 Chairman Martin acknowledged that

this could happen and stated that

we all recognize that arbitrage works at times in
the market. How fast it may move or how actively
it may move is a matter of judgement, but certainly
what the Federal Reserve is trying to do here is to
accept some leadership responsibility, recognizing
that we cannot control or make interest rates, but 2
that we can try to lead these two contradictory goals.

Representative Patman, who has been concerned with
banking and monetary matters for over thirty years, remarked
to Chairman. Martin during the hearings that he noted that
there had been some changes in monetary policy during recent
months. "You have become somewhat flexible." It was in-
deed surprising to note that Representative Patman did not
question Chairman Martin further about operation nudge.
Hearings on the 1961 Economic Report of the President, p. 473.

2lbid., p. 476.

Senator Bush then questioned whether or not simul-

taneous operations in the short- and long-term markets would

be successful.

I am somewhat confused by the recent action of the
Fed, and by the conflicting efforts to ease money in
the longer term category and firm it up in the shorter
term category. I can appreciate the need for holding
funds in this country that may be attracted overseas by
higher interest rates. But I am very much afraid that
we have an awfully difficult situation facing us to
squeeze down the spread between long- and short-term
interest rates, and that this may be self-defeating
in the end because if insurance companies and pension
funds and investors of that kind can see a high enough
yield in the short market they will go in there and wait
until they can get a better yield than the long market.
It seems to me I have seen that happen many times in
practical investment circles. I simply express some
apprehension about this business of making water run
up and down hill at the same time.1

In summary, there were certainly theoretical grounds.

for apprehension about the change in policy since operation

nudge was apparently supported by a theory almost diametri-

cally opposed to that underlying bills only. In the bills

only policy, it was asserted that confining open market

operations to the short-term sector "would provide ample in-

fluence through the normal linkage of markets and arbitrage

on all maturity sectors and would, therefore, be sufficient

to make monetary policy fully effective."2 However, the

attempt to raise short rates while at the same time keeping

Ibid.

2Ahearn, pp. 97-98. Ahearn pointed out a basic incon-
sistency in the Federal Reserve's two major arguments for bills
only. "The argument that 'bills only' would improve the
functioning of the Government securities market because it
minimized direct impacts of monetary policy on long-term bond
prices and yields implied poor linkage between the short- and

long rates from increasing implies that there is poor linkage

and imperfect arbitrage between the various sectors. In view

of this uncertainty concerning the impact of open market

operations upon the term structure of interest rates, there

is a definite need to examine the various factors which in-

fluence the structure of rates, and more specifically, how

operation nudge may be expected to affect the yield curve.

Factors Which Influence the Term Structure
of Interest Rates

The series of interest rates on debt with varying

maturities create what is called the term structure of interest

rates.1 Four main factors condition the relationship among

interest rates according to maturity. They are (1) the

liquidity of the outstanding debt, (2) expectations regarding

future interest rates, (3) portfolio preferences of insti-

tutional investors, and (4) the maturity composition of the

outstanding debt.2 A number of theories incorporating one

long-term sectors of the market and tardy transmission of
credit policy impulses in the short-term sector. Yet the
argument that 'bills only' operations could quickly and
effectively influence long-term bond prices and yields implied
just the opposite about linkage between the short and long
sectors of the market. Whatever the true state of linkage
was, it could not have been both good and bad at the same
time." p. 98.
lWhen the yields on debts with varying maturities are
plotted and connected, they form a "yield curve." In this
study, the yield curve and the term structure of rates will
be considered as synonymous.
2Board of Governors of the Federal Reserve System,
The Federal Reserve System: Purposes and Functions, p. 116;
and Stephen A. Axilrod and Ralph A. Young, "Interest Rates
and Monetary Policy," Federal Reserve Bulletin, 48, No..9
(September, 1962), 1121-1127.

or more of these factors have been advanced as explanations

of the term structure of rates.1 In addition, there have been

numerous empirical attempts to ascertain the importance of the

various factors which influence the yield curve.2 Primarily

as a result of. this research, there appears to be a growing

recognition that unicausal explanations of the term structure

of rates (such as the expectations hypothesis) are inadequate.3

Because operation nudge involves primarily an attempt

to alter the structure of rates rather than to change the

general level of interest rates, the principal forces which

determine the level of rates such as expectations, the amount

of savings, the money supply, investment demand, and liquidity

preference will not be discussed.4 It must be recognized,

however, that these forces may indirectly affect the structure

of rates if a change in the level of rates causes the expec-

1The expectations theory is perhaps best known.
2Many of these studies will be cited below.

3Board of Governors of the Federal Reserve System,
The Federal Reserve System: Purposes and Functions, p. .116;
Burton G. Malkiel, "The Term Structure of Interest Rates,"
American Economic Review, Papers and Proceedings, LIV, No. 3
(May, 1964), 532; John H. Wood, "The Expectations Hypothesis,
the Yield Curve, and Monetary Policy," Quarterly Journal of
Economics, LXXVIII, No. 3 (August, 1964), 457-70; Reuben A.
Kessel, The Cyclical Behavior of the Term Structure of Interest
Rates (Occasional Paper No. 91; New York: National Bureau of
Economic Research, 1965), p. 3; Richard A. Musgrave, The Theory
of Public Finance (New York: McGraw-Hill Book Company, Inc.,
1959), PP. 598-99; and Joseph W. Conard, An Introduction to
the Theory of Interest (Berkeley: University of California
Press, 1959), Part Three.

For a discussion of the factors which influence the
general level of interest rates, see Axilrod and Young,
pp. 1110-1121.

nations of borrowers and lenders to be altered. To illustrate,

if the level of interest rates has been low and if the market

participants expect a general rise in rates, lenders will

tend to move into short-term issues in order to avoid capital

losses associated with a rise in long-term rates and in order

to be ready to move into long-term issues after rates have

risen. On the other hand, borrowers will tend to favor long-

term issues in order to avoid paying higher rates in the

future. The behavior of these market participants will tend

to lower yields in the short-term sector and to raise yields

in the long-term sector. The expectation of a fall in the

level of rates will have an opposite effect upon the yield

curve. Thus, changes in the general level of rates may pro-

duce changes in the term structure of rates if expectations

are altered. However, it is believed that the main influences

upon the term structure of rates are those which were outlined

at the beginning of this section.

L.louidity of the outstanding debt

"The liquidity of a debt may be defined as its ability

to be turned into cash on short notice on definite and favorable
2
terms"2 Other things equal, short-term debt is more liquid

than long-term debt because "(1) the period until the debt

liquidates itself at maturity is shorter, and (2) fluctuations

Ibid., p. 1124.
2-
2J. M. Culbertson, "The Term Structure of Interest
Rates,"q uarterly Journal of Economics, LXXI, No. 4 (November,
1957), 491.

in prices of short-term debt are characteristically smaller

than those of long-term debt, and thus the price at which the

debt can be sold is more certain."1 Because of the superior

liquidity of short-term debt, yields on these issues will tend

to be lower than those on long-term debt. The magnitude of

this liquidity premium will be "affected by changes in the

maturity structure of debt supplied to lenders, in lender

attitudes toward liquidity, and in other factors affecting

the liquidity balance in the economy."2

Scott's recent study lends additional support to the

influence of liquidity upon the term structure of rates.3

Using the average maturity of the marketable debt as an in-

dex of the liquidity structure of asset holdings, Scott cal-

culated multiple regressions with and without this variable

as a partial determinant of short-term and long-term rates

and the differential between these rates. He found that the

inclusion of this variable made a significant contribution

toward explaining changes in short- and long-term rates and

their differential.

llbid.

2Ibid., p. 489.

3Robert Haney Scott, "Liquidity and the Term Structure
of Interest Rates," Quarterly Journal of Economics, LXXIX,
No. 1 (February, 1965), 135-45.

4Ibid., pp. 136-41.

ExDectations

The expectations approach to the term structure of

interest rates, which was originally formulated by Irving

Fisher and later refined by J. R. Hicks and Friedrich A. Lutz,

is one of the most popular explanations of the term structure

of rates. In its simplest formulation, this theory states

that "maturity choices of borrowers and lenders are determined

by their expectations as to future rates and that behavior of

market participants will cause long-term rates to equalize

with the average of short-term rates expected over the future."2

Expectations explain, in part, why the yield curve

sometimes may tend to be flat or even slop downward. If the

average level of rates is relatively high, the market partici-

pants may expect that rates will fall; therefore, borrowers

will tend to prefer short-term debt, while lenders will tend

to move into longer-term issues. This action will add upward

pressure to short-term yields and downward pressure to long-

term rates.

Empirical verification of the expectations hypothesis

has been hampered because of the difficulty of measuring the

relationship between the term structure of rates and expecta-

1Irving Fisher, The Theory of Interest (New York:
The Macmillan Company, 1930), p. 210; J. R. Hicks, Value and
Capital (London: Oxford University Press, 1939), p. 144; and
Friedrich A. Lutz, "The Structure of Interest Rates," Quarterly
Journal of Economics, LV (November, 1940), 36-63.

2Axilrod and Young, p. 1124.

tions of future rates.1 Meiselman2 was "the first investigator

to employ an operational test of the expectations hypothesis

that does not depend upon accurate foresight for its validity."3

He was able to demonstrate that expectations, whether correct

or not, affect the structure of interest rates. Kessel found

that a combination of expectations and liquidity preference

may be used to explain the term structure of rates.

Portfolio preferences of institutional investors

Another important factor which influences the term

structure of interest rates is the portfolio preferences of

the various institutional investors. Portfolio preferences

are determined largely by the nature and potential variability

of the liabilities of these institutions as well as their pro-

spective commitments.5 For example, commercial banks tend to

1Culbertson, p. 488 and Scott, pp. 135, 144. For a
summary of the important empirical studies of the expecta-
tional factors, see Kessel, Chapter I.

2David Meiselman, The Term Structure of Interest Rates
(Englewood Cliffs, N. J.: Prentice-Hall, 1962).

3Kessel, p. 12.
4"The great rise in institutional investment--in the
form of life insurance companies, investment trusts, and more
recently, pension funds--cannot but have a profound effect on
the pattern of demand for various types of debt." Musgrave,
p. 598.
5"The preference between short and long commitments is
not wholly a matter of expectation. It depends as well upon
the needs and obligations of particular lenders or borrowers,
and these needs and obligations depend upon market conditions."
Ibid.

invest primarily in short- and intermediate-term issues be-

cause a large part of their liabilities are short-term and

may fluctuate widely. On the other hand, the liabilities of

life insurance companies are mainly of a long-term nature;

therefore, these institutions tend to invest primarily in

long-term securities. Because of this tendency for institu-

tional investors to concentrate their purchases within a

particular maturity range, a certain amount of market segmen-

tation has developed.

Since January, 1962, there has been an important shift

in the composition and potential variability of the liabilities

of commercial banks. Primarily because most banks increased

the interest rate paid on time and savings deposits, there has

been a large inflow of financial savings to these institutions.1

By November, 1964, the volume of time deposits (seasonally

adjusted) exceeded the volume of demand deposits (seasonally

adjusted).2 Because time and savings deposits tend to fluctuate

less than demand deposits and since the interest cost on time

and savings deposits has risen, it would be expected that banks

would alter their portfolio preferences and make more longer-

term loans and investments. It will be shown in the following

chapter that banks have increased their holdings of long-term

1Between the end of 1961 and the close of 1964, time
deposits rose $43.7 billion while demand deposits increased
$8.1 billion.

2At the end of 1964, there was $126.5 billion time and
saving deposits and $125.2 billion in demand deposits. Federal
Reserve Bulletin.

loans and investments and that these acquisitions apparently

have had a significant impact upon the term structure of

interest rates.

The impact of market segmentation upon the term

structure of interest rates will depend also upon the "im-

portance of various institutions as buyers or sellers of

securities at different periods of time or at different stages

in the economic cycle." During the postwar period, short-

term rates have tended to rise in periods of economic expan-

sion, while in downswings, short-term yields have tended to

decline. An important reason for this movement of short-term

rates over the business cycle is the investment activities of

commercial banks. In upswings, when there is a rising demand

for credit, banks usually decrease their holdings of short-

term issues in order to satisfy the demand for loans. Selling

pressure upon short-term securities tends to push the yield on

these issues upward. In downswings, though, when credit de-

mand is slack, banks usually add to their holdings of short-

term issues, which would tend to press the yield on these

issues downward.

Scott analyzed the institutional preferences for

Government securities of varying maturities at the close of

1952 and on September 30, 1959.2 He found that between these
two dates commercial banks, mutual savings banks, and life

1Axilrod and Young, p. 1123.

2Scott, pp. 141-43.

insurance companies essentially had not changed their pre-

ferences for securities with certain maturities. Scott con-

cluded that

the market faced by the Treasury is, then, a segmented
market in which different classes of investors expose
their preferences for different maturities. Treasury
authorities constantly examine these separate but inter-
dependent markets in much the same way that any market-
ing organization does in an effort to place the debt in
the hands of those prepared to pay the most for it.1

atu.rity composition of the outstanding debt

Culbertson was one of the first economists to empha-

size that changes in the maturity composition of the outstand-

ing debt will affect the term structure of rates. He stated

that

once it is admitted that such changes in the maturity
structure of demand for funds [structure of supply of
debt] do occur, and that the maturity structure of debt
holdings is not a matter of indifference to lenders--that
funds are not perfectly mobile between debts differing
in maturity--it is clear that such changes must be one
factor influencing the maturity structure of interest
rates existing at any moment.2

As mentioned above, the demand for debt in the various

sectors tends to be imperfectly elastic. This fact together

with a shift in the supply of private debt caused by changes

in business and financial developments will tend to create a

"structure different from that which would exist with the same

pattern of available debt if a longer period of time were

Ibid., p. 142.

2Culbertson, p. 502. Culbertson states that changes
in the maturity composition of the outstanding debt is a short-
run influence upon the term structure of rates, pp. 490, 502.

allowed for adjustment."l For example, changes in the amount

of inventory accumulation or stock speculation would be re-

flected in short-term borrowing, while changes in business

fixed investment would be reflected in the supply of long-

term debt.2 Thus, since changes in the supply of private

debt coupled with market segmentation apparently can alter the

term structure of rates, it should follow that changes in the

maturity composition of the public debt can also alter the

yield curve. In fact, Musgrave suggests that "compensatory

changes in the supply of public debt" may be used to offset

changes in the term structure of rates caused by changes in

the supply of private debt.3

Ways in Which the Federal Reserve May
Execute Operation Nudge

The above discussion suggests several ways in which

the Federal Reserve might attempt to raise short-term rates

and/or to lower long-term rates. It could sell short-term

securities, purchase long-term securities, simultaneously

sell short-term issues and purchase long-term issues, raise

the discount rate, lower legal reserve requirements, or

change the maximum permissible rate payable on time and sav-

ings deposits. The aim of this section is to show how each of

these actions will tend to influence one or more of the factors

which determine the term structure of interest rates.

llbid., p. 490.

2Ibid., p. 503.

3Musgrave, p. 598.

Open market operations

Through open market sales of short-term securities,

the Federal Reserve can apply upward pressure to short-term

rates in two ways. First, the sale of short-term issues will

reduce bank reserves which, in turn, will result in a multiple

contraction of the money supply. If the demand for money does

not decrease in such a manner as to offset the decline in the

money supply, short-term rates will tend to rise. Second,

open market sales will increase the supply of short-term issues

which, together with the relatively inelastic demand by certain

institutional lenders for these securities, will tend also to

add upward pressure to short-term yields.

Through open market purchases of long-term securities,

the central bank can apply downward pressure to long-term

yields. Because of the relatively inelastic demand for long-

term securities, a reduction in the effective supply of these

securities will tend to press the yield on these issues down-

ward.

The Federal Reserve may wish to nudge short-term yields

upward and to nudge long-term yields downward simultaneously.

This task could be accomplished by selling short-term issues

while, at the same time, purchasing long-term securities. If,

as a result of these transactions, the money supply remains

unaltered, the change in the term structure of interest rates

will result primarily from the change in the maturity composi-

tion of the outstanding debt.

It is unlikely that the liquidity of the outstanding

debt will be altered very much by the Federal Reserve's

efforts to influence the term structure of rates through open

market operations.1 Axilrod and Young point out, however,

that

if the investing public comes to believe that
longer-term obligations would fluctuate less in price
than before and become more readily marketable, as
compared with short-term, then the term structure of
rates would be affected as the public began to invest
more in longer-term obligations to meet their liquidity
needs.2

If the public does attempt to satisfy more of their liquidity

needs by purchasing longer-term debt in lieu of shorter-term

issues, upward pressure would be applied to short-term rates

and downward pressure would be exerted upon long-term rates.

If expectations do not change and are the dominant

influence upon the term structure of rates, a change in the

maturity composition of the outstanding debt as a result of

open market operations would not by itself alter the term

structure of rates. If, however, the public expects that a

change in the maturity composition of the outstanding debt

will change the yield curve over the short-run, "they may

act in that expectation and thereby help bring the change

about."3 In actual practice, it is impossible to predict

accurately how open market operations designed to twist the

yield curve will affect expectations. Expectations might

Axilrod and Young, p. 1125.
2Ibid., pp. 1125-1126.

3Ibid., p. 1126.

change in such a manner that the initial impact of open

market operations upon the term structure of rates may be

either nullified, amplified, or allowed to endure.

While it seems clear that the Federal Reserve can

alter the term structure of rates through open market opera-

tions, it must be recognized that the flexibility of borrowers,

lenders, and investors limits the extent and duration of the

impact of the Federal Reserve's operations upon the structure

of rates to the short-run. In the long-run, the ability of

these market participants to issue and to acquire debt of

varying maturities will limit the extent to which short-term
2
rates can be raised relative to long-term yields. If short-

term rates rise, some borrowers will issue a greater propor-

tion of long-term debt, while some lenders and investors will

tend to favor short-term debt.3 The action of these market

participants will tend to offset some or all of the initial

increase in short-term rates and the decrease in long-term

rates. According to Axilrod and Young, in time, "the rate

structure will tend to adjust to reflect more lasting in-

fluences."

1This does not mean to imply that the Federal Reserve
will make only one attempt to twist the yield curve. The
Federal Reserve can continue to observe changes in the struc-
ture of interest rates and can attempt to influence the rate
structure through open market operations or its other control
techniques.

2Axilrod and Young, p. 1135.

3Ibid.

4Ibid., p. 1126.

Changes in the discount rate

The Federal Reserve attempts to keep the discount rate

"in close alignment with short-term interest rates in order

to avoid giving member banks either too much or too little

incentive for using a facility that is intended to meet bank-

ing contingencies and temporary needs for reserve funds."l

The discount rate, however, may be administered in such a

manner as to influence the term structure of rates. For ex-

ample, if the discount rate and the Treasury bill rate are in

close alignment, an increase in the discount rate above the

bill rate will mean that it is cheaper for member banks to

obtain reserves by selling Treasury bills from their portfolios

than it is to borrow funds at the Federal Reserve. If banks

are faced with an active demand for credit, then these insti-

tutions will tend to sell some of their Treasury bills, thereby

adding to the effective supply of outstanding short-term se-

curities. This action will tend to raise short-term rates

relative to long-term rates, at least in the short-run. In

time, however, the movement of lenders and investors into

short-term issues and of borrowers into longer-term issues

will tend to offset the initial impact of the increase in the

discount rate.2

1Board of Governors of the Federal Reserve System,
The Federal Reserve System: Purposes and Functions, pp. 124-
25.
2
An increase in the discount rate will tend also to
affect expectations, which are a determinant of both the
level and structure of interest rates. It is impossible, how-
ever, to predict the manner in which the level and structure
of rates will change if an increase in the discount rate
causes a change in expectations.

Changes in legal reserve requirements

Lowering legal reserve requirements on demand and

time and savings deposits will probably tend to affect the

level more than the structure of interest rates. This is

because with lower reserve requirements, the existing amount

of reserves can support a larger volume of bank credit and

deposits, and as mentioned earlier, the supply of credit and

money primarily influence the level of rates. It is quite

possible, however, that the banking system's ability to ex-

tend a larger volume of credit might affect its portfolio pre-

ferences and, hence, the structure or rates. If the banking

system is able to extend a larger volume of credit, it may

choose to acquire a greater proportion of long-term issues

which would tend to add downward pressure to long-term rates.

Changes in the maximum permissible rate payable on
time and savings deposits

An increase in the maximum permissible rate payable

on time and savings deposits will tend to attract a larger

volume of financial savings to commercial banks and to cause

a shift of some funds from demand into time deposits. If the

volume of time and savings deposits increase relatively to

the volume of demand deposits, such a change will probably

alter the portfolio preferences of these institutions. When

banks realize that they will be obligated to pay a higher

interest rate on a larger volume of deposits, they will

probably seek to invest a greater proportion of their deposits

in assets that have a high and stable yield, in other words,

long-term investments. This action will exert downward

pressure upon long-term yields. In addition, if the rate

payable on time and savings deposits is above that payable on

Treasury bills, the probable preference of individuals and

businesses for time and savings deposits in lieu of Treasury

bills or some other short-term investment will tend to add

upward pressure to short-term rates. Thus, it would appear

that an increase in the maximum permissible rate payable on

time and savings deposits might have an effect upon the term

structure of rates similar to that produced by open market

swap operations.

Concluding Observations

It became increasingly evident to the Open Market

Committee during the last half of 1960 and in early 1961 that

it could not continue to supply reserves to the banking

system by purchasing only Treasury bills. This is because

such purchases would add downward pressure to short-term rates,

thereby encouraging short-term capital to flow out of the

country. The Committee finally decided in February, 1961,

to depart from its established policy of bills only and to

supply some reserves through the purchase of long-term se-

curities. In addition, it began to sell short-term issues

with the hope of raising short-term rates.

An examination of the various factors which influence

the term structure of interest rates together with some of

the various means through which the Federal Reserve may affect

the factors which determine the shape of the yield curve in-

dicates that there is a theoretical basis for the central

bank's attempt to alter the structure of interest rates. By

increasing the liquidity of the long-term debt, by creating

the expectation that short-term rates will rise, by increasing

the proportion of short-term debt relative to long-term debt,

and by increasing member bank's preferences for long-term

securities, the Federal Reserve can add upward pressure to

short-term rates and downward pressure to long-term yields.

In time, however, part or all of the initial impact of these

actions upon the term structure of rates may be offset if

expectations and the portfolio preferences of the institutional

investors are altered. Because the term structure of interest

rates is a reflection of so many variables, it is impossible

to predict the extent or duration of the Federal Reserve's

policy actions upon the structure of rates.

CHAPTER IV

"OPERATION NUDGE" AND INTEREST RATES, 1961-64

In the last chapter, four main influences upon the

term structure of interest rates were identified and dis-

cussed. They are: (1) liquidity of the outstanding debt,

(2) expectations, (3) portfolio preferences of institutional

investors, and (4) the maturity composition of the outstanding

debt. Operation nudge began as an attempt to twist the yield

curve by varying the maturity composition of the outstanding

debt through open market swap operations. Later, the System

changed Regulation Q to permit higher interest rates on time

and savings deposits and raised the discount rate. It will

be shown in this chapter, that both of these actions had a

significant impact upon the yield curve and may properly be

considered as part of operation nudge.

The main purpose of this chapter is to examine the

influence of the System's actions upon the structure of

interest rates between 1961 and 1964. Because of the presence

of many other factors which might have had an effect upon

interest rates, it will, of course, be impossible to state

precisely the extent to which operation nudge was responsible

for changes in the shape of the yield curve. It is hoped,

however, that by analyzing changes in interest rates along

with the extent and direction of the Federal Reserve's open

market transactions and its other policy actions, some under-

standing of the System's influence upon the structure of rates

may be obtained. An attempt will also be made to point out

instances where other factors, such as changes in the portfolio

preferences of institutional investors had a significant in-

fluence upon the term structure of interest rates.

Operation Nudge and Interest Rates in 1961

At the beginning of 1961, the two main problems con-

fronting the Federal Reserve were the recession in the domestic

economy and the balance-of-payments deficit, which had been

worsened by the increase in the outflow of short-term capital.

As described in some detail earlier in this study, by con-

tinuing to supply reserves through the purchase of Treasury

bills, the central bank placed additional downward pressure

upon short-term rates, and this action may have prompted a

larger outflow of short-term funds. Since late-October, 1960,

the Open Market Committee had purchased a small amount of

short-term securities other than bills, but as shown in Table

4, the Treasury bill rate continued to decline throughout the

remainder of 1960. When preliminary year-end reports on short-

term capital movements during the last quarter of 1960 re-

vealed that this outflow had reached a record height, it was

evident that additional steps would have to be taken to keep

short-term rates from declining further. Thus, the Open

Market Committee decided in February, 1961, to undertake opera-

tions in securities with a maturity of five or more years.

During the recession 1960-61, both short- and long-

TABLE 4
U. S. TREASURY BILL YIELDS,

1960 1961 1962 1963 1964

January 4.44 2.30 2.75 2.91 3.53
February 3.95 2.41 2.75 2.92 3.53
March 3.44 2.42 2.72 2.90 3.55
April 3.24 2.33 2.74 2.91 3.48
May 3.39 2.29 2.69 2.92 3.48
June 2.64 2.36 2.72 3.00 3.48
July 2.40 2.27 2.94 3.14 3.48
August 2.29 2.40 2.84 3.32 3.51
September 2.49 2.30 2.79 3.38 3.53
October 2.43 2.35 2.75 3.45 3.58
November 2.38 2.46 2.80 3.52 3.52
December 2.27 2.62 2.86 3.52 3.86

Source: Federal Reserve Bulletin.
aRate on new issues.

1960-64a

TABLE 5
U. S. GOVERNMENT BOND

YIELDS, 1960-64

1960 1961 1962 1963 1964

January 4.37 3.89 4.08 3.88 4.15
February 4.22 3.81 4.09 3.92 4.14
March 4.08 3.78 4.01 3.93 4.18
April 4.17 3.80 3.89 3.97 4.20
May 4.16 3.73 3.88 3.97 4.16
June 3.99 3.88 3.90 4.00 4.13
July 3.86 3.90 4.02 4.01 4.13
August 3.79 4.00 3.97 3.99 4.14
September 3.82 4.02 3.94 4.04 4.16
October 3.91 3.98 3.89 4.07 4.16
November 3.93 3.98 3.87 4.10 4.12
December 3.88 4.06 3.87 4.14 4.14

Source: Federal Reserve Bulletin.
Note: Averages of daily figures for bonds maturing or callable in 10 years
or more.

TABLE 6
Aaa CORPORATE BOND YIELDS,

1960-64

1960 1961 1962 1963 1964

January 4.61 4.32 4.42 4.21 4.37
February 4.56 4.27 4.42 4.19 4.36
March 4.49 4.22 4.39 4.19 4.38
April 4.45 4.25 4.33 4.21 4.40
May 4.46 4.27 4.28 4.22 4.41
June 4.45 4.33 4.28 4.23 4.41
July 4.41 4.41 4.34 4.26 4.40
August 4.28 4.45 4.35 4.29 4.41
September 4.25 4.45 4.32 4.31 4.42
October 4.30 4.42 4.28 4.32 4.42
November 4.31 4.39 4.25 4.33 4.43
December 4.35 4.42 4.24 4.35 4.44

Source: Federal Reserve Bulletin.
Note: Averages of daily figures. For a list of the bonds used in calculating
these average yields, see Moody's Bond Survey (December 28, 1964), p. 344.

Aaa STATE AND LOCAL

TABLE 7
GOVERfUI;E1T BOND

YIELDS, 1960-64

1960 1961 1962 1963 1964

January 3.49 3.15 3.21 2.95 3.09
February 3.40 3.14 3.08 2.99 3.08
March 3.34 3.23 3.03 2.97 3.14
April 3.30 3.27 2.98 2.97 3.12
May 3.34 3.25 2.98 2.99 3.09
June 3.33 3.35 3.06 3.09 3.10
July 3.31 3.35 3.10 3.10 3.08
August 3.10 3.33 3.10 3.09 3.08
September 3.09 3.33 3.01 3.13 3.09
October 3.20 3.28 2.94 3.15 3.11
November 3.14 3.27 2.89 3.17 3.08
December 3.12 3.32 2.93 3.12 3.01

Source: Federal Reserve Bulletin.
Note: General obligations only, based on Thursday figures. For a list of the
bonds used in calculating these average yields, see Moody's Bond Survey. (November 9,
1964), p. 427.

term rates remained well above the levels reached during the

previous recession.1 After declining during the first half

of 1960, both short- and long-term rates remained compara-

tively stable throughout the remainder of the year. The

relative stability and relatively high level of these rates
2
may be attributed to the mildness of the downturn, to the

fact that the discount rate was not reduced below 3 per cent,3

and to investors' expectations that the Federal Reserve would

shift to a tight monetary policy soon after recovery began.

If the monetary authorities did decide to pursue a more re-

strictive monetary policy, this would tend to force interest

rates up and capital values down. To avoid the possibility of

suffering a capital loss, many investors chose not to purchase

securities, especially long-term issues. This meant that much

of the usual downward pressure upon interest rates present

during a recession was absent.

Short-term interest rates declined to .88 per cent
during June, 1958, and long-term rates fell to 3.12 per cent
in April, 1958. Unless otherwise indicated, the rate on
Treasury bills and U. S. Government bonds will be used as
measures of the general level of short- and long-term interest
rates, respectively.
2"The Means of Economic Progress," Federal Reserve
Bulletin, 48, No. 2 (February, 1962), 138.
3"Interest Rates in the Current Cycle," Federal Re-
serve Bulletin, 48, No. 9 (September, 1962), 1103-104.

4Commercial banks, in particular, avoided long-term
issues. During the 1957-58 recession, banks invested heavily
in long-term securities and, subsequently, when loan demand
picked up, they had to sell these issues at sharply reduced
prices. "Monetary Expansion During 1961," Federal Reserve
Bulletin, 48, No. 2 (February, 1962), 144.

	Copyright
	Title Page
	Acknowledgement
	Table of Contents
	List of Tables
	List of Figures
	Introduction
	Problems confronting the federal...
	The adoption and theoretical basis...
	Operation nudge and interest rates,...
	Short term catpial movements and...
	Long term capital movements in...
	Monetary ease and economic expansion,...
	Summary and conclusions
	US balance of payments, 1961-6...
	Bibliography
	Biographical sketch
	Signature page

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