A History of the Federal Reserve, Volume 2 (105 page)

At the last FOMC meeting before the surcharge, June 18, the Federal Reserve recognized that interest rates had fallen “substantially” in the previous three weeks in anticipation of fiscal restraint. Increased borrowing had reduced free reserves, so the manager considered the markets to be “tight” despite the decline in rates. Table 4.5 shows the changes in interest rates.

Passage of the surtax brought long-term rates back to their lows for the year. Short-term rates remained considerably above early levels but below the May readings. The Federal Reserve concluded that it should permit rates to fall. “The Committee concluded that if Congress acted . . . open market operations should seek to accommodate any resulting declines in short-term rates and to cushion any upward pressures on such rates that might emerge subsequently” (Annual Report, 1968, 165–66). The staff expected much slower growth in real GNP but not much immediate change in inflation or wage increases if the tax increase passed. Nevertheless, some members, fearing excessive restraint, favored easier policy. The unanimous decision was to resist any upward pressure and accommodate any decline.
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By July 15, a day before the next FOMC meeting, long- and mediumterm rates were litt
le changed from June. Short-term rates had increased. Okun told the president that the FOMC was split. Some “recognize that,
if they wait for really hard evidence that the economy has cooled off, their easing may be too late” (memo, Okun to the president, WHCF, Box 2, LBJ Library, July 15, 1968, 3). Joseph Califano, the Domestic Policy Adviser, explained to the president that “there is no point in talking to Martin until we have done something about prices and wages” (Califano to the president, CF, Box 43, LBJ Library, July 18, 1968). Another group expressed concern that “overt monetary easing might offset the big boost to world confidence in the dollar. . . . They also fear that a drastic easing would be
viewed
as
undoing
the
anti-inflationary
effect
of fiscal restraint” (ibid., 3; emphasis added). Califano would have liked a discount rate cut, but he expected no more than a modest increase in free reserves.
⁹⁰

88. Okun quotes Martin as repeatedly telling the president “If you can get the tax bill, I can back off on interest rates. I can’t do it until you do” (Hargrove and Morley, 1984, 304).

89. At the June 18 meeting, Martin voted to break a tie between those who favored allowing rates to move with the market, even if they moved up and those who favored intervention to assure that rates declined. In the end, all the committee members agreed to the more activist policy (Maisel diary, June 19, 1968, 12–15).

The July FOMC meeting began with the usual discussion of foreign operations and pressures. Neither Coombs nor the members mentioned the tax surcharge or cited any evidence that the surcharge had changed the international position of the dollar. The discussion focused on recent French riots, France’s gold losses, and its sudden willingness to expand its swap line with the United States.
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The staff’s domestic report emphasized uncertainty about strikes and the effect of the tax cut. It suggested “a sharper slowing of economic activity for the remainder of the year” than foreseen earlier (FOMC Minutes, July 16, 1968, 31). The current forecast called for growth to stop and unemployment to rise (ibid., 32) with no increase in consumer or investment spending and a sharp reduction in inventories. Then the staff added: “at a minimum, it now seems
certain
that the restraints on aggregate demand will act to preclude any further upward twist in the inflationary spiral. In fact, the prospects for some slackening in price pressures seems favorable” (ibid., 33; emphasis added.) The report pointed to the 1966 decline in inflation to support its forecast.

The report concluded with a warning intended to change policy. “The prospective economic picture strongly suggests that the present fiscalmonetary mix could lead to an abrupt halt in the expansion of production, incomes, and employment” (ibid., 34). The report proposed to stimulate construction by reducing interest rates (ibid., 34, 37, 39). It urged the committee to change policy to keep “faith with Congress and with its previous commitments” (Maisel diary, July 16, 1968, 4–5).

90. Johnson returned the memo to Califano with a note telling him to have Okun talk to Fowler to get Fowler to talk to Martin.

91. The riots in Paris threatened at one time to bring down the government. Between March and December 1968, France had to sell $1.4 billion of gold, about one-fourth of its stock, to defend the franc parity. On August 10, 1969, after selling an additional $33 million, France devalued the franc about 12 percent, from 5.55 to 4.94 per dollar.

Hayes (New York) urged caution. The response to the surcharge depended on whether it fell more on consumption or saving. He spoke of the “vital necessity, on both domestic and international grounds, of checking the rampant inflationary forces . . . and accordingly I conclude that we should not change policy at this time” (ibid., 47). He added that a slowdown might come but a recession was doubtful. “All of us have worked long and hard for a sound fiscal program. Now, we have it, let’s stop, look and listen before altering course on monetary policy” (FOMC Minutes, July 16, 1968, 49).

The committee divided. Francis (St. Louis) and Kimbrel (Atlanta) wanted a tighter policy. Brimmer, Maisel, Mitchell, Galusha (Minneapolis), and Robert Black (speaking for Aubrey Heflin, the Richmond president) wanted some version of easier policy. The most Keynesian members, Brimmer and Maisel, strongly favored ease. The rest wanted some version of no change with qualifications to lean one way or the other. Martin’s consensus was for no change while accommodating less firm conditions that developed in the market. Hayes agreed reluctantly.

The principal intellectual difference was between those who favored policy coordination and those who wanted to reinforce fiscal tightening. Francis (St. Louis) made a strong statement for reinforcing the fiscal change. He did not accept the claim of fiscal “overkill,” nor did he “believe that the new fiscal program was restrictive enough to bring an end to the inflationary spiral unless the rate of monetary expansion was significantly abated” (ibid., 50). He predicted that if 7 percent money growth continued, nominal GNP would rise 9 percent to about $925 billion in second quarter 1969.
⁹²
Then he added the first clear statement in the minutes relating nominal interest rates to anticipated inflation and real rates to productivity growth. “The level of nominal interest rates depended to a great extent on expectations regarding inflation. If the public anticipated future price rises of 3 percent a year, then nominal interest rates of 7 percent meant real interest of 4 percent, a very low rate in view of the current high productivity of capital” (ibid., 53).
⁹³

Maisel argued forcefully for coordination. “The largest fiscal restraint package in history had just been passed. It did not make much sense to him to vote for the same monetary polic
y after that package had passed as was voted before. A no-change decision today would make superfluous all the Committee had said about the necessary relationship between
monetary and fiscal policy” (ibid., 64). To counteract the restrictive effects of the fiscal package on the economy, he suggested that total deposits should grow at an 8 or 9 percent annual rate. He considered that a neutral monetary stance (ibid., 65). The staff proposed two options. One kept the federal funds rate at 6 percent. The other lowered it to 5.75 percent. Maisel wanted 5.5 percent followed by a 0.25 percentage point reduction in the discount rate.

92. His forecast was much closer than the staff’s. Actual GNP was $923.7 billion, with M
₁
growth of about 6.5 percent.

93. Like many others at the time and later, he neglected the effect of taxes on interest rates. Feldstein (1982) brought out these effects.

Galusha (Minneapolis) openly recognized political pressures on the Federal Reserve. Usually such pressures were not admitted. He thought it would be “unwise . . . both economically and (perhaps more important) politically” (ibid., 83) to delay easing.
⁹⁴
More than other presidents, he wanted to lower rates. The Board would soon use this argument to push through a discount rate reduction.

The FOMC held its regular meeting on August 13 and six days later a special telephone meeting called by Hayes in Martin’s absence. The August 13 meeting voted to keep money market conditions unchanged unless growth of bank credit exceeded projections. The staff raised its forecast for the third quarter but continued to believe that the economy would slow “considerably in the months ahead as a result of the new fiscal restraint measures and a marked reduction in inventory accumulation” built up for a steel strike (Annual Report, 1968, 179). The report noted, but downplayed, recent increases in inflation.

The manager had responded to the rapid growth of the bank credit proxy by tightening the money market. Bank borrowing reached $670 million, an exceptionally high value. The staff expected the recent 16 percent rate of increase to slow to about 6 percent.
⁹⁵

Several Board members used the August 13 meeting to urge the presi

94. The committee had an intense discussion of the practice of announcing the interest rate at which the New York bank would do repurchase agreements (RPs). With some objections from Hayes (New York), the FOMC voted to set the RP rate at the discount rate and reduce the manager’s discretionary authority. The FOMC voted at the July meeting to reduce the RP rate to 5.5 percent, the current discount rate. In April the Board had approved an experimental program permitting the account manager to set a flexible rate on repurchase agreements with non-bank dealers in government securities. The next month, at the urging of Governor Robertson, the Board’s staff evaluated the experiment. Instead of tying the RP rate to the discount rate, the manager fixed the rate 0.25 below the federal funds rate as a general rule but varied it on occasion. The staff report found that market participants interpreted changes in the RP rate as policy actions. This raised an issue about whether the manager should have authority to adjust a rate perceived as a policy change without approval by FOMC (Board Records, April 26 and May 29, 1968).

95. President Clay (Kansas City) pointed to a recurring problem. “The System seemed to lose control of bank reserves and credit expansion during such periods [of Treasury financing] and the result sometimes deviated sharply from what was intended” (FOMC Minutes, August 13, 1968, 56).

dents to reduce discount rates. Martin made the odd claim that “he was concerned as other members were about the high current rates of bank credit” but the discount rate was “out of line” because the market expected greater monetary ease (FOMC Minutes, August 13, 1968, 82). Brimmer and Maisel wanted a 0.5 percentage point reduction in the discount rate. Others favored only 0.25.

For the first time in many years, there was a clear division between the reserve banks and the Board that was reminiscent of the System’s early days, when the Board forced changes in the discount rate in 1919 and 1927. Then members of the Board viewed the reserve bank governors as bankers, and the reserve bank governors viewed the Board members as motivated by politics. In 1968 political concerns had a role, but the major difference was the weight given to inflation and prospective unemployment.
⁹⁶

One bank president who voted, Galusha (Minneapolis), had pressed for greater ease. The Board sent Governor Daane, a former vice president of the Minneapolis bank, to the bank’s meeting on August 15 to encourage the directors to vote for a lower discount rate. The directors voted for a 5.25 percent rate instead of the 5 percent rate that Martin and Daane proposed. Despite the Board’s pressure, directors at Philadelphia and New York voted to keep the rate unchanged. At Philadelphia, some directors “indicated that they would be willing to countenance a certain degree of economic downturn in order to bring inflation under control” (Board Minutes, August 15, 1968, 2). This was heresy at the Board. The New York directors also put most stress on the continuing inflation.
⁹⁷

Martin, Maisel, and Brimmer wanted a 5 percent rate, but the Minneapolis directors had voted for 5.25, and a four-to-three majority of the Board favored that rate. Martin asked for, and got, unanimous approval of the 5.25 percent rate, effective August 16. Richmond followed three days later,
but two weeks passed before Atlanta, New York, St. Louis, and San Francisco voted for the reduction. Later, Martin blamed the staff forecast. “That was the days of the quadriad, and the staff was too much involved with the administration. And I don’t think Martin was too forgiving” (Axilrod, 1997).

96. Governor Mitchell “did not feel any action was really required.” If the discount rate was reduced, he preferred a modest reduction of 0.25 percentage points to 5.25 percent (Board Minutes, August 14, 1968, 17–18). This differed from the administration’s position. Okun told the president: “Some of the district banks were clearly dragging their heels. Moreover, none of them was prepared to move more than a quarter of a point even though the Fed Board had invited a decline of half of a point” (memo, Okun to the president, WHCF, Box 51, LBJ Library, August 31, 1968). Okun praised Martin for “his unusual ability to achieve a consensus among often widely disparate views” (ibid., 2). He urged President Johnson to consider reorganization to either vest all authority in the Board or subject the bank presidents to the same appointment and confirmation procedures as Board members. This was not the first or last time that an administration official wanted to reduce independence to increase administration influence over monetary policy.

97. Maisel attended the Philadelphia meeting. He urged a reduction, but President Bopp opposed it. The bank’s board members thought that inflation was the more serious problem (Maisel diary, August 16, 19
68, 9).