Once the United States formally entered the conflict, the system made a firm commitment to support government bond prices. The goal was to promote stability in short-term funding markets and prevent market disorder in the face of uncertainty at the outset of the war. In 1939, shortly before the beginning of the conflict in Europe, the System made some open-market purchases to influence the yields on short-term government bonds. Perhaps the most important actions performed by the System during the war were to control government bond prices to promote stable financial markets and (even more critical) to help reduce the interest rates on financing the extraordinarily large fiscal deficits associated with active participation in the war. Despite the fact that the Treasury relied more heavily on taxation than in World War I and despite increased tax revenue from the substantial expansion of industrial production, the active participation in the war resulted in a sharp increase in the federal deficit. After the decision to actively participate in the conflict, the US government substantially increased its expenditures, confirming previous expectations. Even before the period of active US participation in the conflict, the expansion of the defense program and the decision to help finance allies’ purchases of war material from the United States (under the so-called lend-lease program) significantly increased US government financing needs. The most important challenge for the System was to deal with the possibility of very large fiscal deficits due to increased war expenditures. The outbreak of war in Europe substantially changed the way in which the Federal Reserve System was expected to operate as the nation’s central bank in a period during which US participation in the conflict was imminent.
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