US Treasury Twist

This week we talk about money policies, yield curves, and government bonds.

We also discuss the Fed, the Treasury Department, and a WWII accord between them.

Recommended Book: Paved Paradise by Henry Grabar

Transcript

In April of 1942, a few months after the United States entered World War 2, the US Treasury Department asked the Federal Reserve to help it borrow a truly staggering amount of money, and as cheaply as possible. The Fed agreed, committing itself to holding short-term Treasury bill rates at three-eighths of 1%, while also capping the yield on long-term government bonds at 2.5%.

This was a type of yield curve control. Rather than allowing the market to decide how much interest the government would pay, the Fed decided that price and promised to enforce it.

That helped finance the war, because the Treasury knew its borrowing costs wouldn’t spiral out of control at a moment when it needed to spend unprecedented sums on ships, planes, weapons, soldiers, and all the other machinery of an ongoing global conflict.

The downside was that the Fed lost control of an important monetary policy lever.

Bond prices and yields move in opposite directions, so keeping yields below a certain level meant the Fed had to stand ready to buy bonds whenever their prices dropped. It couldn’t decide in advance how many it would buy, or how much money it would create in the process. The market would thus forth decide that, instead.

Consequently, the Fed became, in some ways, an extension of the Treasury’s debt-management operation, its inflation-related responsibilities made secondary to the government’s need for cheap financing.

That arrangement persisted after the war ended, despite the return of inflation, and President Harry Truman’s administration pushed to maintain it during the Korean War, as well.

Fed officials resisted, though, with inflation running at more than 8%, and after a very public, very contentious standoff, on March 4, 1951, the Treasury and the Fed announced that they had reached what became known as the Treasury-Fed Accord.