321. Memorandum from Heller to President Kennedy, April 61
SUBJECT
- Monetary Policy Today—The Uneasy Truce between Domestic and Balance-of-Payments Considerations
The stubbornness of our balance-of-payments deficit—combined with our reluctance to tap IMF or other multilateral monetary sources, or to inhibit foreign capital issues in the U.S.—has heightened interest in tighter money. Undoubtedly, higher U.S. short-term interest rates [Typeset Page 1434] would hold and attract some funds, to the benefit of the balance of payments. But these effects are not clear-cut, and there would be costs in a diminished flow of funds into domestic long-term investments. This memo considers current developments and the benefits and costs of monetary tightening for balance-of-payments purposes.
1. Current situation
Since the Fed’s modest credit tightening of last December, the Treasury bill rate has held at around 2.9 percent. Although “free reserves” are still running around $300 million, the rate on “Federal funds” has been tight against the ceiling of the 3 percent discount rate most of the time since January, an indication of considerable money market tightness. The rates on long-term Government bonds and “municipals” are up slightly, but corporate bonds and home mortgage rates continue at or a bit below their rates of 3 months ago.
A recent freshet of rumors and dope stories—starting with the Lee Cohn article—has confidently predicted higher rates of interest for balance-of-payments reasons. For example, Sylvia Porter’s bond letter for March 29 reports: “The scales weighing the relative importance of international considerations against monetary requirements of the domestic economy seem to be tipping without hesitation toward the B-of-P side which implies higher costs of money. . .”
[Facsimile Page 2]Rumor has it that Treasury (and even some say CEA!) is pressuring the Fed for tightening. But this has apparently had only a minor effect so far on investor expectations, possibly because of offsetting references, as in the April 1 Aubrey Lanston letter, to “the rather humorous report by a financial writer that the Treasury and Fed are at odds again, this time with the Treasury supposedly pressuring the Fed to tighten money.”
In our Cabinet Committee on the Balance of Payments, it appeared for a time (perhaps erroneously) that the Treasury favored early “probing” in the direction of tighter money. But at last Wednesday’s meeting, Secretary Dillon, in Chairman Martin’s presence, clarified the Treasury’s position:
1. He suggested that no tightening action be considered until a new Canadian Government has a chance to consider our request that Canada reduce its discount rate from 4 to 3 percent.
2. He indicated that, in any case, it does not now seem advisable to move toward tighter money before enactment of the tax program.
2. The international impact of tighter money
The basic attraction of tighter money is the expected reduction of net capital outflow. The Treasury and New York Fed staff have estimated that a ½ percent rise in short-term rates would save as much as $700 million in capital outflow in the next two years. This estimate [Typeset Page 1435] found little support from other members of the Balance of Payments Committee, and even the Washington staff of the Fed may not fully support it. We believe it to be a considerable overestimate. Moreover, Secretary Dillon indicated that well over half of the savings could probably be achieved by a change in the Canadian discount rate.
Also, the estimate depends on the proposition that the major continental countries—especially Germany—will not follow our lead and raise their own short-term rates. We have some assurances from our OECD Working Party-3 that they would cooperate on this score, but we also know that banking pressures on the Continent are strong for a boost in rates if we tighten money here.
[Facsimile Page 3]In addition, in light of the U.K.’s relatively weak position, it is important that we not take credit action here that would attract funds from the U.K. money market.
3. Domestic impact of tight money
If balance-of-payments difficulties do drive us to tighter money, it would become extremely important for the Fed and the Treasury to make every possible effort to insulate our longer-term rates from the impact of higher short-term rates. After abandoning “bills preferably” early in 1961, the Fed engaged in fairly vigorous and successful twist operations, i.e., buying long-term bonds and selling short-terms. The Fed has continued to purchase some longer-terms in 1962 and even in 1963, but the amounts have been relatively small. It is true that long rates have stayed down, and that the Treasury has been able to lengthen average maturities without serious untoward effects. But if credit is tightened further, more vigorous Fed “twist” operations would be desirable—and the Treasury might have to slow down its maturity lengthening moves—to hold long-term rates close to the present levels.
Our staff calculates—tentatively, to be sure, but not without some foundation in economic experience—that an added ½ percent rise in the short-term rate (from roughly 3 to 3½ percent) might lead to a ¼ percent rise in long-term rates, on the average. Though the effects are not easy to trace and measurement is necessarily subject to large margins of error, the restrictive effect of a ¼ percent increase on housing, plant and equipment investment, and State-local capital outlays could easily cut GNP by $4–$5 billion. This may seem small, but if it were to occur now, it would in time add 0.2 to 0.3 percent to the unemployment rate (and it would add to the ire of Patman, Douglas, Reuss, Premier, and Russell Long).
4. Conclusion
Monetary tightening cannot be excluded from consideration as part of a carefully structured package to protect our balance-of-payments [Typeset Page 1436] flanks. But we urge that its limitations and costs be carefully weighed against its benefits. We urge further that it be saved for use in 1964—and then only if the domestic economy is healthy [Facsimile Page 4] enough and the balance of payments sickly enough to justify it. If Congress backs you up in a truly expansionary fiscal policy, with favorable affects on output and employment, we can realize higher rates on both equity and borrowed capital as a natural consequence of economic expansion—that’s the best way to have higher interest rates help the balance of payments.
- “Monetary Policy Today.” No classification marking. 4 pp. Kennedy Library, National Security Files, Kaysen Series, Balance of Payments, Cabinet Committee, 7/62–2/63, Box 363.↩