A History of the Federal Reserve, Volume 2 (100 page)

The easing policy continued until May. The FOMC then shifted to a policy of maintaining money market conditions but not easing further. Chairman Martin described the FOMC’s actions during the winter as seeking “an easier, but not an easy, policy” (FOMC Minutes, January 10, 1967, 76). Governor Maisel raised two issues. First, he proposed to reverse procedures; the FOMC should choose credit and reserves as its primary targets and make interest rates a subsidiary guide. “By adopting interest rates or money market conditions alone, the Committee was likely to pay too much attention to most recent events” (ibid., 47). Second, Maisel asked whether FOMC should give more attention to interest rate levels or changes.

Maisel’s effort to focus on medium- to longer-term goals drew little re
sponse. Mitchell dismissed it with a peculiar argument that supported the opposite conclusion from the one he drew. “He thought the basic problem lay in the short-run because the lags in transmitting the effects of policy changes . . . were rather substantial” (ibid., 51).

42. President Johnson reappointed Martin as chairman. The Board requested that he waive the requirement that Governor Shephardson retire at age sixty-five, but the president did not do so. He kept his commitment to Martin by permitting Shephardson to remain at the Board to continue planning a new building (later called the Martin Building) at unchanged salary. The same arrangement had been used for Adolph Miller in 1936. Subsequently, the president appointed William Sherrill to fill the unexpired term. Ackley supported Martin’s reappointment because “the policy of the Federal Reserve would be determined by the majority of the Board” (Maisel diary, April 4, 1967, 1).

43. For once a member of the staff made the point explicit. “If a reduction in reserves required against savings deposits was simply offset by open market operations, nothing would appear to be gained” (Board Minutes, Febru
ary 27, 1967, 32).

Martin described the members “for the most part to be in agreement” (ibid., 76), but three members—Trieber (New York), Irons (Dallas) and Shephardson—dissented from the decision, citing weakness in the balance of payments and uncertainty about the administration’s fiscal policy. The dissents reflected different weights on objectives. The staff report showed inflation slowing as measured by falling wholesale prices and a 0.1 percent increase in consumer prices. The main evidence of continuing inflation was a rise in unit labor costs, attributed in part to slower productivity growth (Annual Report, 1966, 95). The main reason for greater ease was the near-term prospect for the economy. The dissenters agreed on the near-term outlook but noted that “longer-run prospects for the economy were not weak” (ibid., 100).
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Free reserves rose following the meeting. This was the only sign of increased ease in the data that the staff monitored.
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The federal funds rate remained unchanged, but the inflation rate for February was below the January rate, so the real (inflation adjusted) federal funds rate rose.

The proviso clause was one way of imposing longer-term aims of monetary policy on daily or weekly operations.
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Beginning in 1966 the staff began to provide the members with forecasts of output, inflation, and other variables, and estimated the volume of total deposits (credit proxy) associated with the forecast and the equilibrium interest rate consistent with the forecasts. Brill’s memo suggests that the staff was highly uncertain about the relationships and the accuracy of their estimates and forecasts. He recognized that bank credit could change because of reallocation from other types of credit, that short-run changes could reverse quickly, and that many of the variables of interest could be measured inaccurately or not at all
for the three-week period between meetings (memo, Directives and Staff Projections, Daniel Brill to George Mitchell, Board Records, October 11, 1967). Instead of searching for more stable long-term relations, the Board’s staff concentrated on developing data on balance sheet changes (the flow of funds) and estimating a large-scale econometric model to exploit these data and forecast future values.
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44. In January, Secretary Fowler proposed to the president that the administration ask again for relaxation of the 4.25 percent ceiling rate on government bonds with five years or more to maturity. He rested his case on the desirability of extending average debt maturity, then less than five years. Ackley agreed with the desirability of extending average maturity but opposed the proposal because the timing was wrong (memo, Ackley to the president, WHCF, Box 51, LBJ Library, January 26, 1967).

45. Growth of the monetary base and the money stock increased after January.

46. Brunner and Meltzer (1967) opened the analytic issue of choosing the optimal intermediate indicator to judge whether policy deviated from the path consistent with the long-term objectives of maximum output growth consistent with price stability under the uncertainty that policymakers faced. The bank credit proxy attempted to provide an intermediate indicator of that kind (memo, Directives and Staff Projections, Daniel Brill to George Mitchell, Board Records, October 11, 1967).

George Ellis (Boston) opened discussion of a discount rate reduction in February, by suggesting that the discount rate had become a “prop holding up market rates” (FOMC Minutes, February 7, 1967, 47). Martin opposed a reduction. Overreaching “could be self defeating” (ibid., 80). A reduction might have to be reversed soon. He also opposed Maisel’s proposal to substitute medium- and long-term interest rates for the credit proxy in the proviso clause. Maisel’s proposal received no support from other members.

Boston reopened the discount rate issue by voting to reduce its rate from 4.5 to 4.25 per cent on March 27. The Board could not decide whether a 0.25 percentage point reduction was enough, so it postponed the vote until after the April 4 FOMC meeting. Martin spoke in favor of 0.5 percentage point reduction to 4 percent, but if the directors voted for 4.25 percent, he could accept a split rate temporarily.
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Following the meeting, ten banks voted to reduce the rate to 4 percent. Atlanta asked for 4.25 percent, and St. Louis kept its rate at 4.5 percent. Governor Brimmer said he would not approve a 4.5 percent rate, and several other governors agreed (Board Minutes, April 6, 1967, 7). The Board approved the 4 percent rate and deferred approval of Atlanta and St. Louis. Within a week all banks posted the 4 percent rate. The federal funds rate fell from 4.55 to below 4 percent following the announcement. West Germany and Canada followed the reduction immediately.

At about this time, Homer Jones, first vice president at the St. Louis bank, wrote to Robert Holland, secretary of the Open Market Committee. For the first time since the early 1930s, someone in the System pointed out that interest rates could decline because of low demand for credit. A decline of that kind should not be confused with easier policy.
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A few weeks
later, Sherman Maisel proposed lengthening quarterly FOMC meetings to provide more time for discussion of economic forecasts or projections and “to get a clear picture of various views on where the economy was going and what proper goals for System policy ought to be during the coming period” (S. J. Maisel to the Board, Board Records, May 29, 1967). This was one of several efforts that Maisel made to develop a more explicit, more coherent policy framework that looked beyond the money market and the next three weeks. The Board approved the proposal for further discussion at the FOMC. No action appears to have been taken.

47. The econometric model was a joint product of members of the Board’s staff and Professors Franco Modigliani of MIT and Albert Ando of the University of Pennsylvania.

48. Among the reasons for Martin’s changed position was the rise in market rates at the end of February. On February 24, bill rates were 0.14 percentage points above January– February lows, but Aa corporate rates and new municipal bond yields rose 0.26. Ackley told the president that “they all seem to favor giving some signal to show that they are still moving toward easier money” (memo, Ackley to the president, WHCF, Box 51, LBJ Library, February 25, 1967). The administration restored the investment tax credit in March. Martin testified for restoration of the credit.

49. “I fear that all our resolves to ease money market conditions may be no more than
keeping up with the deterioration in the demand for loan funds—that all the declines in interest rates reflect this det
erioration of demand rather than anything we are positively doing” (letter, Homer Jones to Robert Holland, Board Records, March 9, 1967). There is no sign that the letter affected policy interpretations.

In April and May, monthly consumer prices rose at a 2.4 and 3.6 percent annual rate, and unit labor costs were 4.7 percent above a year earlier, the largest increase in almost a decade. Productivity growth had slowed to about 2 percent from the faster growth earlier in the decade, so the implied inflation rate was about 2.5 percent (see Chart 3.1). “In contrast to the developments in short-term markets, long-term interest rates had risen considerably . . . reaching levels well above the highs of late February” (Annual Report, 1966, 124). The staff interpreted the rise in yields as a response to the volume of new bond issues and optimism about recovery. There is no mention of inflationary expectations affecting interest rates and the volume of long-term borrowing. There is discussion of the rapidly rising budget deficit.

The spread between short- and long-term rates increased, surprising and puzzling the staff and most of the members. Their main explanation was that the borrowing had increased because corporations believed that the cyclical lows had been reached.
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Chart 4.7 above suggests that, although nominal rates increased, real long-term rates declined with actual and anticipated inflation. The System’s rapid response to recession contrasted with its sluggish and hesitant response to inflation. When policy started to ease in February, the unemployment rate was 3.8 percent, considered low, with consumer price inflation at 2.8 percent, considered high at the time. The System’s actions may have been appropriate based on their forecasts and projections, but the asymmetry in their response gave a warning about their priorities.

Citing “even keel” considerati
ons, the FOMC took no action on May
2. Three weeks later, the members expressed concern about continued increases in long-term yields, despite “some dampening of earlier market optimism” (ibid., 30). The staff reported rapid growth of the money stock and anticipated further increases. The committee agreed to purchase longterm securities, instead of bills, to reduce bond yields and, perhaps, raise short-term rates “for balance of payments reasons.” But it voted to keep money market conditions unchanged. Between April and November 1967, it increased its holdings by almost $6 billion, 12 percent of the existing monetary base.

50. The Treasury again asked Congress to raise the ceiling on bonds with over five years original maturity. Maisel accused them of neglecting the economic consequences and the expectations aroused by their request (Maisel diary, May 24, 1967, 2).

Darryl Francis (St. Louis) dissented, citing the highly stimulative monetary and fiscal policies. He told the committee that “with total demand at a high level and likely to increase rapidly in coming months, with fiscal actions so expansionary, and with recent large increases in supplies of money and credit, he felt it was time to avoid overreacting to the pause in total demand of last fall and winter” (FOMC Minutes, May 23, 1967, 81). No one joined him.

A few days later, Ackley and Arthur Okun met the governors at their regular luncheon at the Board. Ackley described the Board as “as troubled as we are about what has been happening to long-term interest rates and the threat that housing will be clobbered again” (memo, Ackley to the president, WHCF, Box 51, LBJ Library, May 26, 1967). The Council members came “prepared to push them hard on why they weren’t buying long-term bonds and whether they shouldn’t consider reducing the discount rate” (ibid.). Ackley was delighted to learn that they had started buying longterm bonds that week and had considered reducing discount rates. He told the president that the Board thought that “the market is convinced a boom is coming and that no tax action will be taken” (ibid.). The Board wanted the president to call at once for a tax increase in the fall.
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Maisel conjectured that if Congress approved the tax surcharge, four or five Board members “would be willing to see monetary policy eased as soon as the tax increases passed” (Maisel diary, June 20, 1967, 7).

In June, money growth reached a 13 percent annual rate. “In the six months through June 1967, time deposits had risen at an annual rate of 17 percent, the money supply almost 7 percent, and the bank credit proxy, 12 percent” (Annual Report, 1967, 147). The staff expected the proxy to in
crease at a faster rate from June to July. “In the course of the Committee’s discussion considerable concern was expressed about the recent high rates of growth of bank credit and the money supply, particularly in view of the prospects for more rapid economic expansion later in the year” (ibid., 147). Forthcoming Treasury operations suggested an even keel. The main issue about policy was whether the directive should call for continued purchases of coupon securities. The vote was seven to three to remove the reference, with Brimmer, Maisel, and Mitchell in the minority and Martin and Daane absent.

51. At the time, the unemployment rate was 3.8 percent. It remained at 4 percent or less for the entire slowdown. Stock prices had increased for seven months and were 20 percent above their previous low. Prices had risen, and money growth was excessive, but Ackley wanted more stimulus. The sustained low unemployment rate suggests that business managements did not expect a prolonged slowdown. The Freedom of Information Act now required the FOMC to publish its decisions within ninety days.