No Good Deed Goes Unpunished: A Brief History of Deficits, Debt and Yield Curve Control

Urgency trumps importance. Whatever the consequences may be in time, short-term need takes precedence in human affairs in general. In the COVID-19 pandemic we have the greatest urgency of our time. It is rational to spend on answers, whatever the cost in the longer term.

It is a high cost, and entirely rational that so much of it is borne by governments. They have a revenue model that no business or individual can match—the statutory authority to tax. So, the bills for healthcare, income support and other social services will be paid at whatever cost. The longer-term consequences are left for tomorrow.

But tomorrow will arrive. The deficits are massive and, funded with borrowing, raise the question of the eventual consequences. We have few precedents to go by. The 1918 “Spanish” flu (which wasn’t Spanish, in fact, but never mind) receives little attention in the government deficit history books for two reasons—the response is greater this time, and in any event the effect upon the federal government’s financial position was overwhelmed by World War I, which ended in that year.

Federal debt as a percent of gross domestic product is shown in the following chart, with the Congressional Budget Office projection in September 2020 following the onset of the pandemic:

Graph showing federal debt as a percent of gross domestic product

Past peaks in federal debt to GDP were mostly associated with wars, including the leftovers from the Revolution. Two financial events—the Great Depression and the Great Recession—had effects upon the federal debt comparable to wars prior to World War II. But that was by far the largest
event until now.

The unprecedented level of debt, and the prospect of it continuing to rise for the foreseeable future, demands answers to how it is to be serviced. One of the factors involved is the cost of that debt, which in turn raises a question about the role of the Federal Reserve, and specifically, about the possibility that the Fed invokes the past practice of yield curve control. That was the Fed’s program during World War II under which they controlled the level of interest rates and thus the cost of debt service. The Fed has already been asked to comment on the idea, and while Chairman Powell has disavowed any intention to do so, it is worth examining the history of the earlier episode for the implications of such a program, should it ever come to pass.

World War II began in 1939 with the German invasion of Poland, followed by defeats of France and Belgium. The possibility of a similar fate befalling Great Britain led President Roosevelt to offer aid in the form of “every assistance short of war,” meaning essentially the supply of weaponry. The U.S. would also supply the financing, for which the Lend-Lease program began in 1941.

At that time, the Federal Reserve’s director of its Division of Research and Statistics, Emanuel Goldenweiser, circulated a memorandum on the Treasury’s financing requirements. The contents were taken up at the Federal Open Market Committee (FOMC) meeting in June of 1941. The salient
passage suggested that “a definite rate be established for long-term Treasury offerings, with the understanding that it is the policy of the Government not to advance this rate during the emergency.” He suggested 2½%.1

Goldenweiser soon after recommended a complementary monetary policy for the Federal Reserve, “under which a pattern of interest rates would be agreed upon from time to time and the System would be pledged to support that pattern for a definite period.” 2

In December, the role of the U.S. suddenly changed from supplier and financier to combatant with the Japanese bombing of Pearl Harbor and Germany’s declaration of war on the U.S. Four years later the war ended, with the surrender of Germany in the spring of 1945, followed by Japan’s surrender in July marking the official end of the war.

Over the course of the war the total U.S. Treasury debt exploded:

Graph showing growth in U.S. government debt from 1942 to 1946

Despite the massive increase in borrowings, interest rates did not change. The Fed’s yield curve control policy fixed the yield curve for the period of the war, with short-term rates of 3/8% and longterm rates of 2½%. Intermediate yields were fixed at levels within this range. As observed by
researcher Kenneth Garbade at the Federal Reserve Bank of New York:

The specific pattern of rates was a matter of financing at the rates that existed in the spring of 1942—there is no evidence of any attempt to identify market-clearing rates appropriate to a wartime economy.3

For the duration of the war, the yield curve control policy was essentially the sole monetary policy of the U.S. The Fed’s balance sheet was thus no longer under its control. It was determined by Treasury borrowings and whatever the capital markets did not want:

Fixing the level of Treasury yields endogenized the size of the System Open Market Account: the Fed had to buy whatever private investors did not want to hold at the fixed rates. As a result, the size of the Account increased from $2.25 billion at the end of 1941 to $24.46 billion at the end of 1945:4

Graph showing growth in Federal Reserve holdings of Treasuries from 1942 to 1945

This put the Fed in the position of being both the dominant participant in the markets, and simultaneously a completely price-inelastic participant. The requirement to fix rates from short- to long-term gave markets the obvious choice of buying the long-term issues at 2½% over short-term
issues, since the longer issues not only yielded more but did not expose holders to the higher level of volatility that would normally go with such holdings.

The distortions in the capital markets were complemented by more severe distortions in the economy from the price controls on a wide variety of goods imposed to suppress wartime inflation. Those predictably led to shortages, and their resulting unpopularity led to the removal of price controls at the war’s end in 1945. In response, the Consumer Price Index rose by over 8% in 1946, 14% in 1947 and 7% in 1948. While inflation subsided after an adjustment period, interest rates intended to suppress the Treasury’s financing became an anachronism after the war ended.

The Treasury nonetheless resisted the arguments of Federal Reserve officials to let rates find their own levels:

A “cold turkey” approach, abruptly terminating support for the fixed pattern of rates, was never seriously considered. Officials feared destabilizing the banking system and undermining efforts at conversion to a peacetime economy. Instead, they pursued a more measured approach, first terminating the 3/8 percent bill rate, then gradually lifting the caps on yields on coupon-bearing securities, starting with 1-year certificates, and for the time being, punting on what to do about long-term bond yields… Treasury officials resisted the decontrol of interest rates every step of the
way, out of concern with the budgetary implications of higher interest rates as well as concern that the economy might slip back into depression.5

Conflict between the Federal Reserve and Treasury persisted through the late 1940s, and was expressed in disagreements over intermediate maturities.

The 2½% long rate was the last to fall. The end, ironically but unsurprisingly, was the prospect of another war. In mid-1950, the FOMC postponed an intermediate rate increase on reports that North Korean forces had crossed into South Korea. In late November, Chinese forces began to engage
American forces in North Korea. The Fed’s response was a move to end the cap on long rates. In response, Treasury Secretary John Snyder and President Truman requested that the Fed express continued commitment to the 2½% level. That prolonged the disagreement until Snyder was admitted to the hospital and Assistant Secretary William McChesney Martin Jr. assumed negotiations with the Fed. The result was what is known as the “Treasury-Federal Reserve Accord” in March of 1951, with the announcement that the two sides had:

“Reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose and to assure the successful financing of the government’s requirements and, at the same time, to minimize monetization of the public debt.”6

In the midst of exigency, such as World War II or the current public health crisis, answering the call with whatever appears necessary is understandable. But the lesson of the 1940s is that it was much easier to engage in yield curve control in the early part of the war than it was to end it a decade later. Time will tell whether the Fed wants to repeat the experiment in pursuit of a different outcome.

1 Federal Open Market Committee minutes, June 10, 1941, pp. 8-9.
2 FOMC minutes, September 27, 1941, p. 7.
3 Garbade, Kenneth. February, 2020. Managing the Treasury Yield Curve in the 1940s. Federal Reserve Bank of New York Staff Report No. 913, p. 7.
4 Ibid., p.8.
5 Ibid., p.12.

John R. Gilbert

John is a Senior Research Consultant whose primary responsibilities include contributing differentiated macroeconomic perspectives as well as providing industry and company research.

In addition, he writes investment commentary, which is published on our website.

John has worked in the investment industry for over 45 years. He was formerly our Director of Research. Prior to joining BFS, he was the Chief Investment Officer at New England Asset Management, Inc.

John has achieved the designations of Chartered Financial Analyst® and Certified Public Accountant.


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