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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.
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