The contentious idea that still challenges the Fed

The writer is an FT contributing editor

On April 1 1970, Andrew Brimmer, a Federal Reserve governor, gave a speech over lunch at the Fairmont Hotel to members of the San Francisco Bond Club, a fraternity of bankers and lawyers.

The speech provoked a response Brimmer later described as “vigorous”. Robert Morris Associates, a banking industry advocacy group, dedicated a full issue of its trade publication to a rebuttal, and invited Brimmer to its annual conference in Los Angeles the next year to defend himself.

Brimmer’s argument, still contentious today among bankers and at the Fed, was simple. The same credit conditions affect different banks in different ways, which in turn affects different kinds of loans in different ways. A rate rise might not curtail credit for large businesses at all, but could have a significant effect on residential loans or municipal bonds. These differences were clear in the data he presented over lunch at the Fairmont. They are still clear today, though not quite in the same way.

What alarmed the bankers at Robert Morris Associates, however, was Brimmer’s suggestion that the Federal Reserve do something about these differences — discourage some loans as it tightened, while continuing to encourage others. Even today, when you suggest to someone at the Fed that a central bank should take responsibility for the composition of loans, you will be informed that this is credit allocation, and the Fed does not do that.

The problem with the phrase “credit allocation” — which surged in use after Brimmer’s speech — is that it is just that: a phrase. There is no law of physics or economics preventing the central bank from allocating credit. It’s just something the Fed would rather not do. When Fed policymakers recorded in their minutes in 2019 that they prefer to buy Treasuries in their open market operations to avoid credit allocation, they were in a way still responding to Brimmer.

To have a sitting Fed governor stop by for a speech was probably a coup for the San Francisco Bond Club. Brimmer, the first black governor at the central bank, arrived with what for the club was a welcome message: the Fed’s tightening cycle was hurting municipal bonds disproportionately.

The contraction in municipal bond issues, however, was only one part of what Brimmer saw as a larger problem. Even as the Fed had tightened in 1969, business loans continued to rise, almost as much as they had in 1968. But loans to households and state and local governments had dropped.

The difference, he argued, was in the size of the lender. Larger banks could sell commercial paper or even tap the eurodollar markets abroad to raise cash. They tended to have existing relationships with bigger businesses, and had reason to keep those relationships alive. Smaller banks didn’t have the same access to capital markets, and so their own existing customers — households and local businesses and governments — could feel it as the Fed pinched.

Brimmer proposed that Congress authorise the Fed to assess different reserve requirements on different kinds of loans, making the cost of the loan higher for, say, business loans than for residential mortgages. The board of governors objected to the idea. Arthur Burns, the chair at the time, even testified against it in Congress.

But Brimmer’s idea survives as a small piece of the 1977 update of the Federal Reserve Act, instructing the central bank to make sure all of the credit aggregates — different types of loans — grow in a way that keeps the economy productive over the long run. The Fed doesn’t ever talk about this part of its charter. But right now, as it tightens, different credit aggregates are acting weird again. Whether it likes it or not, the Fed is already allocating credit.

According to the Fed’s data on commercial banks, the rate of growth in residential real estate loans has continued to rise at smaller banks, even as it tapered off at larger ones in the middle of 2022. Growth in commercial and industrial loans soared at small banks at the beginning of the pandemic, then dropped; it has since recovered at a lower rate than at the big banks. Credit card loans show higher seasonal variation at the big banks, and a stronger response to the most recent credit cycle. And as the Fed pushed and then pulled liquidity over two cycles of quantitative easing, bigger banks were much more likely to sit on their cash; the interventions didn’t seem to encourage them to make new loans.

Each of these differences will have its own explanation. The problem is that the differences exist, and the Fed doesn’t seem to be interested in ever having the tools to address them. It can’t. It might lead to credit allocation.