Thursday, December 4, 2008

Not My Dad's Fed

I went to work for the Fed in 1964, when William McChesney Martin, Jr. was Chairman. He would be surprised at the activism of today's Fed as it drops the equivalent of napalm on the dangerously frozen peaks of our financial landscape. Back then I was a financial economist in the Division of International Finance headed by Ralph Young, editor of the third edition of The Federal Reserve System: Purposes and Functions, 1954. (The first edition was drafted by the great Bray Hammond in 1939.)

The marble building at 21st and C Streets hasn't changed much since 1964. But three things definitely have - the link to gold, the size of Fed assets and the reach of the Fed into financial markets.

1. Link to gold broken. Back in 1964, the Treasury bought gold at a fixed price of $35 an ounce from private owners of gold, forbidden 30 years earlier from holding gold for speculative purposes. Purposes and Functions, 3rd edition says (97-99):
Gold is the ultimate basis of Federal Reserve credit and gold movements are an important factor in member bank use of Federal Reserve credit. The power of the Reserve Banks to create money is limited by the requirement of a 25 percent reserve in gold certificates against the total of deposits and issued Federal Reserve notes. All gold that enters the monetary mechanism becomes reserve money of the Federal Reserve Banks in the form of gold certificates. In practice most of their reserves are represented by a credit in a gold certificate account on the books of the Treasury.
The last connection between gold held by the Treasury and Federal Reserve Bank deposits was ended by President Nixon in 1971, under the pressure of the OPEC-led oil shortages. This also ended the gold standard and removed the cornerstone of the Bretton Woods system.

2. Increase in Federal Reserve assets. Fed assets from 1920 through 1953 are shown in Purposes and Functions, 3rd edition. They rose from $6 billion to $53 billion in 33 years.

Combined Assets, Federal Reserve Banks ($bil.), Year-End
Asset Category 1920 1930 1940 1953
Gold certificate reserves2.062.9419.6921.34
U.S. Govt. securities0.290.73 2.1825.89
Discount loans to member banks 2.69 0.25 0.000.42
Subtotal 5.04 3.92 21.87 47.65
Other assets1.21 1.28 1.28 5.18
Total 6.25 5.20 23.1552.83

Source: CityEconomist based on data from The Federal Reserve System: Purposes and Functions, 3rd ed., 187.

Fast forward to November 2008. Fed assets were growly slowly toward the $1 trillion mark until the freeze hit and Fed assets (Reserve Bank credit) more than doubled from a year earlier, to $2.17 trillion as of December 3. The President of the Dallas Federal Reserve Bank opined in early November that Fed assets will reach $3 trillion by the end of 2008.

3. Market Operations

A "bills only" policy was abandoned in 1961, but a "bills preferably" goal still made sense because open market operations to pursue monetary policy are easiest to manage in the most liquid part of the market, the short end. In recent weeks, however, the Fed's efforts to defrost bank vaults have driven the return on Treasury bills to zero and the Fed has no choice but to operate at longer maturities.

Former Fed Governor Laurence Meyer is speaking to the New York Association for Business Economics on December 17. The title of his talk is: "Monetary Policy: Whatever It Takes." That says it all.