A History of the Federal Reserve, Volume 2 (107 page)

While the forecast was certainly one of the factors that influenced monetary policy in the wrong way for the next four months, I doubt that it played as important a role as many believe. Even without it, monetary policy would have relaxed some, partly because there was an implicit agreement with the Administration, Congress, and the concerned public that this time fiscal policy would carry the ball. . . .

With hindsight, it is evident that measurement problems again plagued the Fed during this period. Most of our discussion was still centered on money market conditions. . . . The fall in the funds rate seemed insignificant; they hovered near 6 percent, whereas they had been 4 percent only a year before. . . .

Even though bank credit grew considerably faster than my target, I failed to fight to curtail it because I mistakenly ascribed its growth to data that were erratic and which I thought would reverse.

Maisel summarized the lessons learned from the experience (ibid., 191–92). First, forecast errors are unavoidable and are large relative to the changes that are reported. “Failure to develop the necessary policy flexibility and response to forecasting variance can lead to unfortunate results” (ibid., 191). Second, little progress had been made in developing a better measure of policy thrust. “There was still only slight agreement on a proper set of targets or measures. . . . [T]he Committee and the markets still concentrated most of their attention on money market conditions” (ibid., 191–92). Third, “There was a failure to develop operating procedures and guides that would have made it possible to reach the selected targets” (ibid., 192). He could have added the problem of identifying permanent or persistent changes.

Both Okun and Maisel omit the most basic failure—economics is not the science that provides reliable quarterly forecasts. Economists could not accurately adjust the economy using a simple Keynesian (or other) model to coordinate policy actions to move along a stable Phillips curve. Not only were the forecasts inaccurate and control imperfect, the expectations set off by the policy action worked against the attractive but unattainable goal in practice of slowing the inflation rate without causing a recession.
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The
evidence from 1966 through 1968 showed that the Federal Reserve responded promptly and decisively to a threat of recession or higher unemployment and slowly and hesitantly to observed increases in inflation. This asymmetry was reinforced by the short-term nature of policy actions and relative neglect of their long-term consequences.

104. The 1969 Economic Report (7) described the policy objective: “Enough restraint must be provided to permit a cooling off of the economy and a waning of inflationary forces. But the restraint must also be tempered to ensure continued economic growth.” Critics called this “fine-tuning” and denied that it could work in the current state of knowledge.

Fifteen years later, with some of the participants at the time still present, although several in different positions, an exchange reopened these issues prior to the August 23, 1983, FOMC meeting.

Mr. [Henry] Wallich. Well, if one could engage in some fine-tuning, one could say we’d raise the rate of money growth for a year because the tax increase will have some downward impact on the economy. The decline in interest rates that comes from that will not completely offset it, so there is some net downward response by the economy. If one dares to fine-tune, monetary policy can offset that [response]. But we must not get trapped into a permanently higher rate of money growth. Everybody understands that that means more inflation. . . .

Mr. [J. Charles] Partee. This can get to be very complicated though, Henry. It depends on the kind of tax increase. You remember in 1968 when we very, very desperately wanted a tax increase to help finance the war in Vietnam, we got a 10 percent surtax in the middle of 1968 and then the Chairman or the Board or the Committee—I’m not sure who—came as close as they could to promising a reduction in interest rates if that 10 percent surtax went in. It went in and I’ll be darned if interest rates didn’t start to go up rather than down. And it was a great, great political problem. So, we do have in modern history a representation of the kind of trap that I’m sure Paul Volcker has very much in mind.

Mr. [Lyle] Gramley. And the worst part of that story is that we led the parade with a decline in the discount rate. We kept—

Mr. Partee. We went out to Minneapolis and got them to cut it.

Mr. Gramley. We kept trying to pump in enough money to make sure that interest rates didn’t go back up. The 10 percent surcharge had no fiscal restraint effects at all. The monetary stimulus had a lot. We ended up with the worst of all possible worlds. (FOMC Minutes, August 23, 1983, 33–34)

This was the precise point made by the Andersen-Jordan article (Andersen and Jordan, 1968), to which the Board’s staff reacted very negatively. The paper estimated the relative responses to money growth and budget spending and tax changes. It found much stronger and more reliable responses
to money growth. This supported the monetarist position and irritated Keynesian economists at the Board and elsewhere.
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Using a short-run, fixed Phillips curve, Okun described the policy objective as gradually slowing the economy down to about “2 percent growth for a couple of quarters . . . [keeping] the unemployment rate 4.1” (Hargrove and Morley, 1984, 308). The means of achieving lower inflation was to move “down that curve [a Phillips curve relating unemployment to inflation] just as we went up that curve. Why can’t we get back to where we were in 1965, the good old days? That’s exactly what we thought would happen. That’s exactly what didn’t happen” (ibid., 308).

This was not the last time that policymakers would make a major error by relying on the stability of the short-run Phillips curve relation. The principal reason in this period was that the public had learned that policymakers placed greater weight on avoiding a rise in unemployment than avoiding higher inflation. The experience in 1965, the Federal Reserve’s response to the tax surcharge, and administration rhetoric about “fiscal overkill” strongly suggested that policy would not tighten enough or remain tight long enough to reduce inflation permanently. Whatever modest decline in measured inflation occurred, the public now expected it to be temporary. The long-term inflation rate was expected to persist and might even rise if monetary stimulus increased.
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This change in expected inflation shifted the Phillips curve, contrary to Okun’s forecast for the Council.

Policy failure in this period was not entirely the result of staff errors. Chairman Martin did not put much credence in economists’ forecasts; he probably gave little weight to them at the time. Chart 4.10 shows that free reserves rose after June 1968, but the rise was modest, about a $300 million increase from the April low point to the local peak in September. This was much less than in 1967. Martin believed the Federal Reserve had eased, but not aggressively. We know from Okun’s comments that Martin resisted pressures for greater ease. No less important was the implicit commitment
Martin had made to President Johnson to continue policy coordination by easing to prevent recession and offset fiscal overkill.

105. Some Board staff members—Frank deLeeuw and John Kalchbrenner—published a paper directly critiquing the Andersen-Jordan paper (deLeeuw and Kalchbrenner 1969). This was the first time such a critique had been written by Board staff about research at a reserve bank (interview with Jerry L. Jordan, December 16, 2002). At the time of the interview, Jordan was president of the Cleveland Federal Reserve Bank. In 1970, the FOMC discussed the conflict between St. Louis’s emphasis on money growth and other views within the System. Although some Board members deplored these differences, most favored competition in ideas (FOMC Minutes, June 23, 1970, 26–28).

106. Brunner, Cukierman, and Meltzer (1980) later showed the importance of the distinction between permanent or persistent and transitory or temporary changes in inflation for “stagflation,” the coexistence of inflation and unemployment. The Board staff did not recognize this source of error.

Behind the commitment lay a belief that the public, the administration, and Congress would not accept a significant increase in unemployment to reduce inflation. Dislike of inflation was not yet strong enough to induce the public or the political parties to pay much cost to reduce it. As President Eisenhower remarked in the 1960s, Republican administrations had to avoid repetition of the Great Depression. Democratic administrations placed more weight on temporary job losses than on permanent reductions in inflation. Much academic literature supported that view by claiming that the only cost of inflation was the loss in value of cash balances and the increased frequency of financial transactions. This ignored the costs of inflation resulting from the tax system and other institutional arrangements. Fischer (1981) later developed these costs. See also Feldstein (1982).

Further, staff forecasts were not the only source of information. Darryl Francis (St. Louis) warned repeatedly about the inflationary consequences. Although not a voting member, Francis took an active part in policy discussion at the time. At the August, September, November, and December meetings, he warned that monetary policy was overly expansive.
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Despite
these warnings, Martin and most of the FOMC remained focused on free reserves and interest rates, not on money growth.

107. Examples from the August and December meetings suggest the strength and prescience of Francis’s remarks. “The view that the recently adopted fiscal package would, by itself, adequately restrict total demand and cure the inflationary problems was overly optimistic. Monetary actions had continued to be excessively stimulative, negating the desirable antiinflationary impact of the fiscal package” (FOMC Minutes, August 13, 1968, 75). He rejected
the conventional view. “The greater concern about a possible recession than about present and prospective inflation seemed unwarranted” (ibid., 77). “Mr. Francis commented that inflation was continuing at a 4 percent annual rate, and expectations of future inflation appear to be heightening. . . . There seemed little question that a restrictive monetary policy had to be pursued. . . . But an apparent conflict arose between the desirability of taking effective action against inflation and the desirability of preventing a further rise in interest rates” (FOMC Minutes, December 17, 1968, 51–52).

Was it simply chance that the Federal Reserve waited until December to tighten policy? The Federal Reserve is often reluctant to act decisively in either direction during the months before an election. By December 1968, the FOMC knew that there would be a different political party in the White House. Its actions could not change the political result, and the incumbent Johnson administration was less concerned about the consequences of a more restrictive policy whose effects on employment would not be felt on their watch. The new administration would have to deal with that.

A
Policy
Change

Following the decision to tighten at the December 17 meeting, the Board voted to increase the discount rates to 5.5 percent. This reversed the August reduction of 0.25 percentage points. It is the shortest interval between a discount rate change and its reversal in Federal Reserve history up to that time, a tacit recognition of a policy error.

The Federal Advisory Council had warned the Board in September that the “recent [August] reduction in the discount rate might have been ‘premature’” (Board Minutes, September 17, 1968, 32). Two months later, the FAC warned that it could see little evidence of response to the tax surcharge. Governor Maisel reported that some businessmen believed that the unemployment rate would have to reach 5.5 percent to bring inflation under control (Board Minutes, November 19, 1968, 26). He asked for their views. The FAC members divided. Some agreed, but several said that an increase of that magnitude was “unacceptable” to the public and to both political parties (ibid., 26). They did not urge a more restrictive policy.

Most of the reserve banks had resisted the discount rate reduction in August. By December, they were ready to reverse the reduction or do more. On December 12, Richmond, Chicago, and Dallas voted to restore the 0.25 percentage point reduction, and St. Louis voted to increase by 0.5 to 5.75 percent. New York indicated a strong interest in joining, if the Board approved an increase.

Martin notified President Johnson of a coming discount rate increase.
With about a month remaining in his term, Johnson did not object. His last Economic Report continued emphasis on coordination of fiscal and monetary actions, but now the aim was to slow the economy by extending the tax surcharge for another year and a monetary policy of moderate restraint (Council of Economic Advisers, 1969, 9–10).
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