Central

The Phelan Act of 1920 sounded simple in principle. It authorized the various Federal Reserve Banks, at that time twelve district branches operating independently, to charge progressive interest rates on the rediscounting activities at their respective windows (the discount rate was the interest charged to obtain collateralized funds from the various reserve banks). Private banks in each district were given a set credit line to be used in the regular course of business. Any borrowing above that amount would be subject to rate gradation according to the Phelan Act.
The rationale for doing so from the perspective of the Federal Reserve was twofold. The banking system was coming off its WWI inflationary boom which would be a strain on liquidity and credit. The reserve system had to be sensitive to that development, but also wished to remain true to Bagehot’s so-called golden rule to lend freely but at a high rate. Thus, if a bank wished to borrow in excess it could, but it had to be prepared to pay up for it.
Each 25% increase in borrowing beyond the set limit would cost an additional one half of one percent above the prior effective rate. If the amount in the previous period was at or below the limit, it would be a penalty rate above policy discount rate. For further excessive amounts, the escalated cost would be added in addition to whatever marginal rate previously in effect.

This post was published at Wall Street Examiner on June 23, 2017.