A History of the Federal Reserve, Volume 2 (108 page)

The weakness of the pound remained a concern. The staff reported that the British had large reserve losses. An increase in the U.S. discount rate might require them to float. Coombs believed that the British could stand a 0.25 percentage point increase and Governors Daane, Maisel, and Sherrill favored a 0.25 increase. Robertson, Mitchell, and Brimmer wanted stronger action, including an increase in reserve requirement ratios. The only decision at the December 16 meeting was to delay a decision until the FOMC met on the following day. The only agreement was for a 0.25 increase in the discount rate. The announcement noted that the 5.5 percent discount rate was the highest rate in nearly 40 years, but it failed to note that the 12 month inflation rate had reached 4.6 percent, and both the SPF and the CEA expected inflation of about 3.25 percent in the coming year.

The CEA forecast called for growth to slow to 3 percent from more than 4 percent in 1968.
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In the Council’s view, monetary restraint had now joined fiscal restraint. Industrial production slowed at the end of 1968, and real GNP declined modestly in the fourth quarter, so there was some reason to believe that policy would soon lower the inflation rate and increase unemployment.

Governor Daane asked the key question: Was the market convinced that the System would continue its policy of restraint? Would the FOMC persist? Holmes’s answer was disquieting. He said opinions were divided. Some believed that once the economy slowed, the System would ease and not carry the policy through (FOMC Minutes, January 14, 1969, 18). As if to support the skeptics, Frank Morris (Boston) dissented from the policy of “maintaining the prevailing firm conditions” because “it could be
[sic]
compatible with an unduly restrictive monetary policy” (ibid., 76–77). By unduly restrictive, he meant bank credit growth of zero to 3 percent instead of the 5 to 7 percent that he favored.

108. The Johnson administration proposed extending the surcharge after discussions with the incoming administration. Nixon campaigned against the surcharge but decided to leave the option open.

109. The CEA expected growth to fall to 1 percent in the first half, then recover sharply under the impact of a federal pay increase and an easier monetary policy. The Board’s staff agreed on the first half, not the second (FOMC Minutes, February 4, 1969, 19–20). Okun estimated that a full year with the 10 percent surtax would produce $8.5 billion of additional revenue and a $1.9 billion budget surplus (Okun to the president, CF, Box 5, LBJ Library, December 2, 1968).

The January 1969 meeting was the last FOMC meeting before the new administration. President-elect Nixon had criticized inflation during the campaign but had not proposed a definite program. Stein (1990, 138) described Nixon as not very interested in economic policy. “He did not consider economics as an area of his major competence.” He found it boring and believed that the public was concerned about inflation but unwilling to accept higher unemployment to lower inflation (ibid., 134–38).
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President Johnson agreed. He told his aide, Joseph Califano, to invest in land. “This Nixon knows nothing about the economy and it’s going to go to hell” (Califano, 2000, 337).

President Nixon told Stein at their first meeting that “we must not raise unemployment,” still only 3.4 percent (Stein, 1990, 135). In part, this reflected his experience in the 1960 election, when, he believed, rising unemployment cost him the presidency in a very close election. But it also reflected residual concerns about the blame that President Hoover and the Republican party bore for the 1929–33 depression. The Federal Reserve believed it now had an administration more willing to sustain an anti-inflation policy provided the unemployment rate did not rise precipitately or remain above 4.5 percent. As Orphanides emphasized (2001, 2002) the prevailing belief among Federal Reserve staff and administration economists was that a period of unemployment somewhat above 4 percent would gradually reduce the inflation rate. The new Council’s projections no longer were concerned about “overkill.” They showed inflation (deflator) falling from 4 percent in 1968 to 3.5 percent in 1969 at the cost of unemployment reaching 4.4 percent by mid-1970 (Matusow, 1998, 17–18).
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This policy was called “gradualism” in order to distinguish it from a more decisive effort to end inflation quickly and accept a much larger temporary increase in unemployment.

Through June 1969 the FOMC continued to vote for maintaining the same policy stance subject to provisos about credit growth or Treasury financing. Morris (Boston) continued to express concern about excessive
restraint, and Francis (St. Louis), often joined by Governor Robertson, favored increased restraint.
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But even those who favored a firmer policy opposed any increase in regulation Q ceiling rates. Daniel Brill, the Board’s chief economist, explained that markets would “mistakenly regard an increase in ceiling rates as an easing, rather than a tightening, action” (FOMC Minutes, February 4, 1969, 28).
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110. Herbert Stein became a member and later chairman of the Council of Economic Advisers in the Nixon administration. His Ph.D. dissertation and later work developed the idea of built-in stabilizers to shift the budget from surplus to deficit and vice versa as the economy expanded and contracted. Later, this idea led to the so-called full employment budget surplus or deficit used to justify actual deficits when the economy operated at less than full employment. Like the Johnson administration, Nixon’s economists continued the error of setting 4 percent employment as their measure of full employment.

111. Matusow (1998, 18) reports that President Nixon “distrusted his policy of gradualism in part because it assigned to the Federal Reserve and William McChesney Martin the main responsibility for slowing down the economy.” In fact, the president offered Martin the position of Secretary of the Treasury so that he could appoint Arthur Burns in his place. Martin declined. Brimmer (1966) reported that Martin told the Board at the time that he had rejected the president’s offer.

Brill noted this was a confusion caused by concerns about bank credit growth. Higher ceiling rates would permit banks to supply more credit absolutely and relative to other lenders, such as the commercial paper market, and shift more deposits from demand to time accounts. Its principal expansionary effect resulted from the difference in reserve requirement ratios for the two types of deposits. The statement ignored the banks’ response to regulation. They bought financial paper through their holding companies or borrowed euro-dollars. Nevertheless, some members frequently repeated the statement associating higher ceiling rates with monetary or credit ease.
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Throughout this period, members expressed concerns about a renewed “credit crunch,” reminiscent of 1966, and market anticipations of future policy. Reports showed that market participants had accepted that policy would remain restrictive near-term, but many remained skeptical about whether the policy would avoid a “credit crunch” and how long the Federal Reserve would continue the policy in that event or if unemployment rose. FOMC minutes for 1969 contain many statements about the difficulty of convincing the public that the System would persist until the inflation rate fell. Owens and Schreft (1992) discusses credit crunches in these years and banks’ use of non-price rationing.

112. In February, Francis said that for four years the FOMC had been led into “unintended inflationary monetary expansion while following interest rates, net reserves, and the bank credit objectives” (FOMC Minutes, February 4, 1969, 47). Robertson favored an increase in reserve requirements, open market sales, and a discount rate increase, a policy very different from gradualism.

113. The Treasury faced another of its recurrent problems of getting Congress to approve an increase in the debt ceiling. The FOMC discussed actions it would take to help if needed and decided it could make available to the Treasury some of the warehoused foreign currencies it had acquired. This seems a violation of the spirit of the provision barring direct loans to the Treasury.

114. Like most price control programs, practice raised many issues. Should gifts paid to a new depositor be counted as interest? The Board decided no because it was a one-time payment. What should be done about commercial paper that banks used as a substitute for negotiable CDs? The Board extended regulations to commercial paper. In October 1969, the Board proposed to extend regulation to other “non deposit funds” (memo, Proposed rule making regarding certain borrowings by bank affiliates, Correspondence Box 240, Federal Reserve Bank of New York, October 31, 1969). There was, in addition, a regular stream of decisions about what constituted interest, what restrictions to impose on compounding, and what constituted a deposit.

Although the FOMC voted repeatedly to keep policy unchanged, the federal funds rate rose steadily from a monthly average of 6 percent in December 1968 to 8.9 percent in June 1969. During this period free reserves fell from −$290 to −$1042 million, and annual growth of the monetary base fell from 7.2 to 5.7 percent, then to 5 percent in July. It continued to fall.
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Warning of an expected decline in output and profits, the S&P 500 index greeted the new administration by falling 4.2 percent in January, reducing the twelve-month rate of change to −1 percent. By June, the twelvemonth rate of change was −13 percent, and the index continued to fall.

Real GNP rose 5.7 percent in the first quarter but slowed to 0.5 percent in the second. The unemployment rate remained 3.4 percent through May and 3.5 percent through August. Consumer price inflation continued to increase. By June the annual rate of increase reached 5.3 percent from 4.6 percent in December. It was well above the 4.5 percent rate that administration economists had agreed to tolerate. The SPF began to increase the expected inflation rate.

Gradualism, if that’s what it was, did not support the presuppositions of the economists in the new administration. They had expected a less decisive move toward monetary restraint, supported by fiscal tightening to a budget deficit of $500 million for fiscal 1969 (ending June 1969) from a $27.7 billion deficit the previous year. The Johnson surtax provided a large part of the change. Although candidate Nixon criticized the surtax, his advisers convinced him to renew it for another year.
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Congress remained under Democratic control, so it exacted a price. It approved a 10 percent
surtax for six months, but only 5 percent for the following six months. It also removed the investment tax credit, increased taxes on the oil industry, raised the capital gains tax, and removed income taxes from low-income taxpayers. The net effect was a deficit for fiscal 1970 instead of the surplus that the administration hoped to spend or use for its preferred form of tax reduction in election year 1970. Instead, the budget deficit reached $8.7 billion in fiscal 1970 and $26 billion in 1971.

115. Within a few weeks of the new administration’s start, the CEA warned the president that because the Federal Reserve did not use its power to control money, growth the administration should not trust its statements. The memo suggested that the administration could challenge the Federal Reserve’s independence (memo, Stein to the president, Communications with the Fed, Nixon papers, February 15, 1969). This lack of trust continued. A CEA staff memo said, “The Federal Reserve’s operating concepts
threaten
our stabilization program just as they did in every postwar recession and inflation” (memo, Leonall Andersen to Paul McCracken, Communications with the Fed and Burns, Nixon papers, May 1, 1969; emphasis in the original). The memo described the principal source of errors as reliance on money market conditions and the accommodation principle. The latter meant that the Federal Reserve interpreted changes in money as the result of shifts in the demand for money that the Federal Reserve accommodated by leaving the interest rate unchanged.

116. President Johnson announced the proposal to extend the surtax on January 14, 1969. President-elect Nixon issued a statement tentatively supporting the decision as a part of his program to reduce the budget deficit and the inflation rate. A higher budget deficit would add to borrowing and raise interest rates. The statement then added, “If an attempt were made to avoid the rise in interest rates, the result would be more inflation, and this would subsequently
cause
(as it has in the past) still higher rates” (preliminary draft, statement by President-elect Nixon, Nixon papers, undated; emphasis added). This appears to be the first explicit statement from an administration recognizing the positive, causal relation between inflation and market interest rates.

Both the administration and the Federal Reserve had mixed and incompletely formed ideas about how to achieve the common objective of reducing inflation without causing a large recession. Administration economists stressed control of money growth. The chairman of the Council of Economic Advisers, Paul McCracken, hoped to have a fiscal surplus and a tight monetary policy, so he favored a tax increase and the introduction of a value added tax to offset the budget deficit. Arthur Burns, at the time counselor to the president, and Labor Secretary George Shultz opposed any tax increase. They wanted a smaller government. They favored reduced monetary growth and tighter monetary policy to offset easier fiscal policy. McCracken favored a continuation of coordination; if fiscal policy had eased and no tax increase was forthcoming, monetary policy should tighten (Matusow, 1998, 51, 58). The president said that his “concern must not be inflation but recession” (quoted in ibid., 55). Early in 1969, the president promised George Meany, president of the AFL-CIO, that his administration would slow inflation without increasing unemployment (Hargrove and Morley, 1984, 328).
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At the first meeting of the Quadriad on January 23, most of the discussion concerned steps to gradually reduce inflation while minimizing the effect on unemployment. Chairman Martin said, “The System had pulled a boner after the tax increase last year by pursuing for a time an easier monetary policy. This decision heavily reflected projections of their staff that the tax increase might produce an overkill effect, causing substantial slack in the economy. In retrospect this evaluation of prospects was in error” (meeting with the Quadriad, Nixon papers, January 23, 1969). Martin said that policy was now less expansive to achieve approximately 7 percent money growth.
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To the extent the new administration started with a framework a
nd consensus about how to reduce inflation, it differed on only a few points from
the previous orthodoxy. The new administration gave much greater importance to money growth as the factor driving excess aggregate demand and inflation, but like its predecessor it accepted 4 percent unemployment as full employment (ibid., 3, 5), making no adjustment for the age and sex composition of the labor force, the marginal tax rate, and other factors. Both relied on a short-run Phillips curve to show how much the unemployment rate would rise as inflation fell. And both believed that the adjustment to lower inflation could occur within a few months or a year without a recession.
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Where they differed most was on the value of guidelines or guideposts to improve the Phillips curve tradeoff by lowering inflation.
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The Nixon administration disavowed guideposts.

117. McCracken explained to the president that “it was not going to happen” (Hargrove and Morley, 1984, 328; Stein 1990, 143). All his economic advisers considered President Nixon to be knowledgeable about economics but not much interested. Herbert Stein said, “He would rely more heavily on others in the case of economic policy . . . He also didn’t believe it was a terribly interesting subject to the country” (Hargrove and Morley, 1984, 365).

118. A brief discussion of the international position focused on continuing control of foreign investment.