A History of the Federal Reserve, Volume 2 (101 page)

Hayes recognized “the strong underlying case for some firming of policy in the light of inflationary risks, the balance of payments situation, and the need to moderate the growth of bank credit and deposits” (FOMC Minutes, July 18, 1967, 55–56). In Martin’s absence he stated the consensus as keeping policy unchanged. He gave four reasons. First, excessive growth of demand was “only a forecast rather than a present reality; second . . . even a modest firming of policy would run the risk of a dangerous overreaction in financial markets; third, it would . . . disturb the prospects for quick action on taxes; and, finally, . . . insufficient time to change policy . . . before even keel considerations become a factor” (ibid., 56). Even keel prevented any action, but the majority agreed on a one-way proviso clause. The desk would permit slower growth of credit and money, if it occurred.

On August 3, the president requested enactment of a 10 percent tax surcharge, effective October 1. Congress delayed nine months before passage. By that time the annual rate of consumer price increase had reached 4.5 percent, on its way higher. Monetary base growth was above 6 percent. The unemployment rate soon reached 3.4 percent, the lowest rate since 1951–53. Unemployment did not approach that level again until 2000.
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The reasons for the delay in getting the surtax approved show three major obstacles to using fiscal policy for short-run stabilization. First, the policy advisers had to be convinced about the need for restraint and the appropriate timing. Ackley and his colleagues vacillated, as did others in the administration. A strong, consistent message from all of his advisers might have moved the president to be more forceful, but that strong consensus was slow to form.
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Second, Wilbur Mills, chairman of the House
Ways and Means Committee, was reluctant to introduce the bill partly because it lacked support and partly because President Johnson would not agree to the spending reductions that Mills believed necessary to get enough votes to pass the bill. Third, President Johnson hesitated to cut back his Great Society programs. “The President was entirely convinced that he couldn’t get it, that it would be a mistake to ask for it, and that it would boomerang in terms of substantial cuts in his social programs. . . . [H]e believed he couldn’t afford to lose a major battle on a major issue of policy” (Ackley in Hargrove and Morley, 1984, 254).
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52. Ackley recognized the policy error. He explained that Chairman Mills of the Ways and Means Committee would not accept forecasts that the economy would pick up in the second half of 1967. His later recollection was that “we never backed away from our recommendation; but it was not the best time to be going public with this fight.” Then he added, “I guess we were not pushing very hard” (Hargrove and Morley, 1984, 257).

53. “In that period, [1966] Fowler was not signing Troika memos, not signing memos jointly with Ackley urging tax increases” (Okun, in Hargrove and Morley, 1984, 302). Even in 1968, the advisers divided. Okun described Fowler as willing to take “any cut in domestic
spending to get the tax increase. . . . Zwick really was dragging his heels on any significant expenditure cut . . . [T]he agency heads whose program would have been gored by a spending cut did not see the same urgency in the tax surcharge that Fowler and I did” (ibid., 303) Charles Zwick replaced Charles Schultze as budget director.

In retrospect, several of the principals joined others in blaming the inflation on President Johnson’s secrecy about the increase in expenditures for Vietnam. The claim is that they would have urged the president to request the tax surcharge. The record shows that even after the increased spending was known, Congress was unwilling to increase tax rates, and the president was unwilling to reduce social spending.

These were not the only reasons. The FOMC and the administration economists gave excessive emphasis to the budget deficit and too little attention to money growth. Despite unemployment below 4 percent, they were not willing to insist strongly on the need for restraint. Their analysis was wrong, and their policy and recommendations reflected the error. And, as usual, they ignored both real interest rates and money growth.

Delay in getting a tax increase and commitment to policy coordination had decisive influences on Federal Reserve decisions. In September, Martin told the FOMC: “With fiscal policy strongly stimulative pending action on the President’s tax program, the simple logic of the economic situation implied the desirability of changing monetary policy, as it probably had as much as two months ago. But the overriding need at this point was to get some restraint from fiscal policy through a tax increase, and in his judgment
that
would
be
less
likely
if
Congress
came
to
believe
that
adequate
restraint
was
being
exercised
by
monetary
policy.
.
.
.
[A] modest operation would not result in any major gains; at the same time its significance was likely to be greatly exaggerated, thus
exposing
the
System
to
misrepresenta
tion
of
its
position
on
the
question
of
the
appropriate
mix
of
fiscal
and
monetary
policy
(FOMC Minutes, September 12, 1967, 73–74; emphasis added). A majority of the FOMC agreed with Martin’s position.
⁵⁵
Policy coordination worked perversely.

54. One of Mills’ ways of pressuring the president and the administration was to open hearings, hear witnesses, sense the atmosphere, and shut down the hearings if he didn’t believe the bill would pass without more concessions from the administration. Both Okun and Ackley describe the president as unusually passive about the bill, leaving the negotiations to Secretary Fowler. Passivity seems not correct. Califano (2000, 112) reports that Congressman Mills and Senator Russell Long told him that a tax increase could not be passed.

At the time of the September meeting, the staff reported that industrial production had recovered its modest loss during the slowdown. Unemployment fell; housing starts rose strongly in July, and the outlook called for a strong expansion in GNP. Inflation continued to increase. Nevertheless, the FOMC followed Martin and voted nine to three for no change. Hayes, Francis (St. Louis), and Scanlon (Chicago) dissented but did not agree on the alternative. Francis said that fiscal stimulus would remain strong even if Congress passed the surtax. He wanted “significantly firmer money market conditions” (Annual Report, 1966, 166). Hayes and Scanlon wanted a small first step toward “moderately less easy conditions” (ibid., 166).
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The following day, Martin testified for the surtax before the House Ways and Means Committee. There can be no doubt that he saw the risk of inflation. On this occasion, as on several others for the next four months, he warned Congress about the dangers of inflation, strains in the international monetary system and in the mortgage market (Martin speeches, September 14, 1967, 11–12).

The FAC favored a “considerably less expansive” fiscal policy achieved mainly by reducing spending but they did not oppose a tax increase. They wanted less expansive monetary policy but expressed concern about another credit crunch (Board Minutes, September 29, 1967, 27).

Expansion and inflation continued. The FOMC voted to maintain prevailing money market conditions, and Francis continued to dissent at the next two meetings. Others recognized the inflation risk, the strong recovery, and the balance of payments problem. At the October 3 meeting, Hayes stated the consensus. “Most members seemed to believe that there
were strong economic grounds for taking some firming action today. It was clear, however, that after weighing various other considerations the majority thought it would not be desirable to change policy at this time” (FOMC Minutes, October 3, 1967, 99).
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55. Maisel described the division within FOMC. By maintaining rapid growth in money and credit, the economy would grow at 8 percent in 1968, 5 percent real and 3 percent inflation. With more restrictive policy, real growth would fall to 2 to 3 percent and inflation to 2 percent. A slight majority of the presidents would choose slower growth and less inflation. A majority of the Board preferred higher growth with higher inflation (Maisel diary, August 15, 1967, 6). Despite the surcharge actual growth, fourth quarter to fourth quarter, was 3.6 percent with inflation 5.8 percent.

56. The start of an automobile workers’ strike was one reason for some of the votes for no change. Maisel’s diary (September 13, 1967, 4–5) reported that the division of opinion was much closer, six to five against a tighter policy, before Martin spoke. Four of the presidents favored a tighter policy, and five of the Board opposed. Again, coordination and political concerns got in the way of appropriate monetary policy. Martin argued that the president would feel “betrayed” if the FOMC tightened. Mitchell and Swan (San Francisco) shifted their votes.

The reasons for not acting covered a wide range. Some cited the auto strike, near-term Treasury financing, and “the highly critical position of sterling” (ibid., 45). The reasons always included “the extent to which action by it [the Federal Reserve] may enhance or impede the chances of getting a tax increase” (ibid., November 24, 1967, 33).

Francis pointed out that even keel policy led to excessive money growth. “Failure to restrict the present excessive expansion of money and bank credit was sometimes justified on the grounds that there must be no interference with Treasury financing. To his mind, this was a pernicious doctrine. . . . [I]t meant that when the Federal budget was excessively stimulative and was running deficits, . . . monetary actions were also excessively stimulative” (FOMC Minutes, October 24, 1967, 34). Francis did not take the next step by recommending securities auctions instead of fixed price issues. Even keel would then be unnecessary.
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Martin recognized the problem but would not do anything to relieve it. For him, the deficit caused inflation, not the Federal Reserve. “Large deficits in the budget are rapidly generating inexorable forces that might prove more important than any decisions the committee would take” (ibid., 66). He also feared a return to conditions in the summer of 1966 and wanted to avoid a repetition, particularly the political response by the thrift institutions, the homebuilders, and their representatives in Congress. Although he spoke in apocalyptic terms, as in most of 1965, he favored a policy of no change.
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57. By this time, Secretary Fowler was pressing hard for the surtax. On October 19, he warned the president that “without the tax surcharge interest rates will rise markedly above today’s already high levels. . . . It is difficult for me to understand why anybody who was concerned with high interest rates last year can do anything but strive for the early enactment of your tax proposals this year” (memo, Fowler to the president, WHCF, Box 51, LBJ Library, October 19, 1967). But Congressman Mills and Senator Long remained unconvinced about the need for higher tax rates; Mills preferred spending reductions, particularly spending on the Great Society programs.

58. Francis also commented on some of the other reasons for delay. He recognized the critical problems of the British pound. The best policy for the United States was to have a long-term strategy to lower interest rates in the U.S. instead of preventing an increase for the next few weeks. He also rejected the argument that tightening in 1966 produced severe problems for the construction industry. The Committee “had done a good thing that should be repeated as called for, not . . . a bad thing which must be avoided at all costs” (FOMC Minutes, October 24, 1967, 35–36). These arguments did not persuade the other members to vote with him.

59. An example is “The moment of truth for Federal Reserve and Governmental policy
was approaching” (FOMC Minutes, October 24, 1967, 66). A few weeks earlier, Martin and Robertson told Secretary Fowler about pressures to tighten from the regional federal reserve banks. “They further indicated their judgment that it would be a mistake to . . . change from a policy of monetary ease at this time” (memo, Fowler to the president, WHCF, Box 2, LBJ Library, October 9, 1967). Fowler’s response included some market commentary that read in part that the House Ways and Means Committee “‘temporarily’ tabled the tax proposals and decided that ‘further consideration [will] be deferred until such time as the President and the Congress reach an understanding on . . . more effective expenditure reduction and controls as an essential corollary of a tax increase.’” The vote for Congressman Mills’s motion was twenty to five.

In late October, renewed weakness in the pound gave a new reason for delay in raising the short-term rate. The market did not wait. Convinced that Congress would not pass the tax bill and that the Federal Reserve would not act, investors in long-term bonds raised rates nearly 0.5 percentage points in three months, suggesting that the market expected inflation to increase. The only action the Board took aimed at speculation; it tightened stock market margins by including convertible bonds under margin requirements.

By December 12, the automobile workers had a new contract, the British had devalued the pound by 14.3 percent on November 18 to $2.40, and the GNP deflator was rising at a 6.5 percent annual rate for the quarter. The federal funds rate had remained at about 4 percent since April, but longterm bond yields had risen by 60 basis points to 5.4 percent. This was the highest average yield on government bonds since 1920.

The Federal Reserve increased the discount rate by 0.5 percentage points on November 18 in response to the British devaluation. The discussion divided those who wanted to increase the rate by 1 percentage point from those who wanted 0.5. The Board rejected New York’s request for 1 percentage point. New York agreed to the smaller increase “with a strong protest” (Maisel diary, November 20, 1967, 6). Open market rates rose following the discount rate increase and some rates on large bank CDs were back at the 5.5 percent ceiling.

Martin at last conceded that he had waited too long for the surtax that had not come. He repeated some of his earlier arguments. The proper time for an increase had been months ago but that would have made “Congressional action on taxes less likely” (FOMC Minutes, December 12, 1967, 97). It was too late to prevent inflation. “The horse of inflation not only was out of the barn but was already well down the road” (ibid., 98). Coming into an election year, Congress increased social security benefits and raised the minimum wage and federal pay.

The reason for acting in December was to show the market that the FOMC “was not unwilling to act to resist inflationary pressures. That, to
his mind, was more important than the matter of the scale of the action” (ibid., 97). The FOMC voted for only slightly firmer conditions fearing repetition of the effects on housing and the need to increase regulation Q ceiling rates.