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We have been looking at what the Federal Reserve was doing during the 1920s.
November
18, 2012: The Federal Reserve in the 1920s
Today, we will look at interest rates during the 1920s. Remember, there was a
bit of fuss at the beginning of the 1920s, because the dollar had slipped
from its gold parity during World War I. This was remedied in the 1919-1921
period. So, that time is a bit anomalous. From 1922 or so, things had been
more-or-less normalized.
March
25, 2012: The U.S. Dollar During WWI and the Recession of 1920
Here's the source of our data:
http://fraser.stlouisfed.org/publication/?pid=38&tid=21
 
And there it is. What do we see here?
What we today call the "Fed funds rate" is actually the overnight
lending rate between financial institutions, in New York. It is the rate at
which one bank loans money to another, with a maturity of one day. In
practice, this was often rolled over into multiple days, but the lending bank
could ask for its money back at any time. Thus, it is also known as
"call money." In those days, commercial banks apparently didn't borrow
much on an overnight basis. They had much larger reserves in those days, more
than enough for short-term obligations.
March
13, 2011: Bank Reserves 2: Reserves Out the Wazoo
March 6,
2011: Bank Reserves
Thus, the main borrowers for overnight loans were stock brokers. These loans
were made on the floor of the New York Stock Exchange, so they are also known
as "Stock Exchange loans." There was apparently one rate for
newly-initiated loans and another for rollovers.
In the midst of this was the Federal Reserve, which also made loans from its
discount window. The rate of those loans was the discount rate.
As we can see, the Fed's discount rate was generally below the overnight
rate. This was not really as it was intended when the Federal Reserve was
being set up. The idea was that the discount rate would be set well above the
prevailing rate. In practice, this might be about 10%. Thus, nobody would
borrow from the Fed during normal times. However, if there was a liquidity
shortage crisis like 1907, the rate on overnight loans would rise above the
discount rate, and the Fed would make loans. These Fed loans would increase
the monetary base, thus "adding liquidity" and resolving the
liquidity shortage.
However, by the early 1920s, the Fed had already gotten into the habit of
being involved in the lending market on a day-to-day basis. During WWI, the
Fed had been pressured by the Treasury to keep a lid on short-term and
long-term interest rates to allow the Federal government to more easily
finance its big wartime deficits. This of course required daily action. The
Treasury stopped telling the Fed what to do after the war, but by then the
Fed had become accustomed to being regularly involved. Bureaucratic expansion
itself would have prevented any migration to the kind of largely dormant
institution as the Fed was originally envisioned.
These interest rates are not necessarily comparable. The discount rate was
primarily for commercial banks, not brokers. Also, these overnight loans
might have had different conditions, such as being uncollateralized, while
the Fed's lending was apparently collateralized.
The Fed's discount rate was kept at a level that made the Fed competitive
with other potential lenders in the market. This was actually quite similar
to the regular operating conditions of the Bank of England at the time. The
Bank of England was also a private profit-making commercial bank, and thus
made loans regularly. The Bank of England was not at all a dormant
institution that only leapt into action during a once-a-decade crises. The
Bank of England thus also had to keep its discount rate in line with other
banks' lending rates to stay competitive. In practice, the amount of actual
loans made by the Fed or Bank of England was somewhat up to the discretion of
the bank managers. If their rates were competitive and there was regular
demand for borrowing, the Fed or the BoE could decide how much it actually
wanted to lend.
Another thing we can see from this graph is that the Fed certainly did not
manage the overnight lending rate ("Fed funds rate") as it does
today. That rate is highly volatile. Thus, although there was a Fed discount
rate, just as any bank at the time had some official rate that it made loans
at for prime borrowers, there was no interest rate target. The Fed was on a
gold standard system, and thus interest rates at the short- and long-term
ends of the market were left to free market forces.
Here's a little different look at the same thing, which includes more
short-term interest rates of the time.
Now we have added Stock Exchange loans with a 90 day maturity, not just
overnight lending. Also, we have commercial paper (could include banks) for a
4-6 month maturity, and Bankers' Acceptances for 90 days. A bankers'
acceptance was a bank's guarantee on commercial borrowing, apparently used
primarily for international trade.
Note that the volatility of the overnight rate is smoothed considerably once
we get to a 90 day maturity. Some people might expect that the highly
volatile overnight rate -- what we now call the Fed funds rate -- might
translate into increased volatility throughout the lending sphere, as it does
today when the Federal Reserve changes its Fed funds rate target. However,
this was not the case. Most of the volatility is gone by the time we get to a
90 day maturity. The Fed's discount rate doesn't look so low when compared to
prime commercial paper with a 4-6 month maturity, which could have included
commercial paper issued by banks. (Commercial paper is a short-term corporate
bond.) The discount rate represents the Fed's short-term lending rate, but
that doesn't necessarily mean overnight. Rather, these loans could have been
for 90 days or longer, and often were.
Now we are looking at some longer maturities, including long-term government
and corporate yields. The Fed's discount rate was consistently above the
yield on 3-6 month Treasury bills. Note how the volatility of the overnight
broker lending rate is completely absent from the long-term (over ten years)
Treasury bond yield, which is quite flat around 3.50%-4.00%. (It was a little
higher pre-1922.) This describes the general character of market yields with
a gold standard system: quite a lot of volatility on the overnight rate, and
very stable as maturities increase. This is the opposite of today, when the
Fed's interest rate target means that the overnight rate is very stable, but
there is a lot more volatility on the long end, which is the part that counts
for most commerce.
All in all, what I see here is a rather nice example of what the lending
market looks like with a gold standard system, when the Federal Reserve is
not actively managing interest rates. The Federal Reserve at this time was
doing much what the Bank of England did throughout the 19th century, the era
of the so-called "Classical Gold Standard," and what the Bank of
England did again after the gold standard was renewed in Britain in 1925.
However, the Bank of England's example included regular activity in the
lending market via the discount rate. The Federal Reserve was not intended to
be this active, but rather an institution that was mostly dormant -- thus
resolving the conflict and complications that had been an issue with the Bank
of England since its inception. There are actually a number of functions that
the Bank of England was serving: as an issuer of currency, as a "lender
of last resort" to resolve short-term liquidity needs, as a central
clearinghouse for interbank payments, and as a regular, profit-making
commercial bank. The fact that all of these roles were somewhat intermingled
in the Bank of England's operations made the whole thing very complicated for
outsiders -- which was not, perhaps, against the BoE's interests. The British
government themselves tried to sort this out in 1844 by separating the Bank
of England's activities into an Issue Department (to take care of the currency)
and a Banking Department that would operate as a regular commercial bank.
This didn't work out quite as well as hoped, because the Issue Department
only handled the paper banknotes themselves, not the deposits at the central
bank ("bank reserves") which are also a component of base money,
and which was handled by the Banking Department. Thus, the total pound base
money supply was divided between two departments. Complicated. The fact that
hardly anyone can make head or tail of how this system is supposed to operate
is one reason -- a major reason -- why people don't really understand how to
manage a gold standard system today.
January
29, 2012: Gold Standard Technical Operating Discussions 3: Automaticity Vs.
Discretion
January
15, 2012: Gold Standard Technical Operating Discussions 2: More Variations
January
8, 2012: Some Gold Standand Technical Operating Discussions
However, it still worked. The Federal Reserve, it appears to me, was just
doing what everyone else in the world was doing at the time, and what they
had done in the pre-1914 era as well.
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