Just as it had in World War I, in World War II, the Fed pegged interest rates at a low level in order to facilitate the financing of government debt. As was the case after World War I, the Treasury enforced that rate peg well after the end of the war. The Fed struggled internally about whether to challenge the Treasury over its subservience. Resolution replaced indecision in fall 1950 with the entry of the Chinese into the Korean War and the belief in the imminence of World War III.
Both expectations created by historical experience and the intellectual environment worked against a challenge to the Treasury. Based on the experience after the Civil War and World War I, the widespread expectation existed that deflation would follow the war. The juxtaposition of high unemployment in the Depression and low unemployment in World War II created an intellectual consensus in favor of Keynesian ideas. Keynesians believed that any increase in private consumption would fail to counter the inevitable decline in military expenditures after the war and that the Depression would return as a result.
The assumed practical irrelevance of monetary policy constituted an important component of the Keynesian consensus. According to this view, the economy was in a liquidity trap at a low rate of interest in which the public simply accommodated changes in the quantity of money. The velocity of money would vary according to the psychology of investors. The general belief that markets did not work carried over to an assumption that if the Fed did not peg government bond rates, then wild, erratic swings in bond prices would destabilize the government bond market.
Within the Federal Reserve System, there were two dominant individuals: Marriner Eccles, who had been chairman of the Board of Governors since 1934, and Allan Sproul, who had been president of the Federal Reserve Bank of New York since 1941. Eccles had been a close, informal adviser to President Roosevelt and believed that he (Eccles) had originated deficit spending as a tool of countercyclical policy independently of Keynes. After the war, Eccles believed that the government should control inflation through running budget surpluses.
Friedman, Milton and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton: Princeton University Press, 1963.
Hetzel, Robert L. The Monetary Policy of the Federal Reserve: A History. Cambridge: Cambridge University Press, 2008.
Hetzel, Robert L. and Ralph F. Leach. “The Treasury-Fed Accord: A New Narrative Account.” Federal Reserve Bank of Richmond Economic Quarterly 87, no. 1 (Winter 2001): 33-55.
Meltzer, Allan H. A History of the Federal Reserve, Volume 1: 1913-1951. Chicago: University of Chicago Press, 2003.
Written as of November 22, 2013. See disclaimer.