A History of the Federal Reserve, Volume 2 (109 page)

There were three difficulties in implementing the program. First, the administration relied heavily on slower but steadier money growth, but it did not control money growth. Martin remained as chairman until the end of January 1970, and he did not agree about the importance of money growth or the System’s ability to control it.
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Arthur Burns, who took his place in February 1970, wanted to adjust money market conditions to the fiscal deficit, not money growth (Matusow, 1998, 51). This continued the coordination policy of the past. Second, both the administration and the Federal Reserve were surprised by the very slow response of inflation. Both failed to recognize that the 4 percent unemployment rate was no longer a relevant target. Like most academic economists at the time, they did not recognize that previous failures to stop inflation strengthened beliefs that the administration would not persist when unemployment rose, especially
before an election. Third, by rejecting price and wage guidelines, the administration gave an easy target to critics who claimed that ideology prevented it from using techniques that reduced the cost of lowering inflation. Critics brushed aside McCracken’s claim that the evidence from all developed countries showed that guidepost policies had not worked (Hargrove and Morley, 1984, 347). The administration retreated from this position gradually by acting in the construction industry, with chain store executives, and on copper and steel prices. But the president faced dissension within his cabinet and from Arthur Burns, his counselor at the time, for rejecting more general measures (Wells, 1994, 40).
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Attention to guideposts focused attention away from the requisites of an effective program.

119. Okun and Stein use almost the same words to describe their surprise at learning that “we don’t have an adequate inflation theory or inflation forecasting mechanism within the profession” (Hargrove and Morley, 1984, 307, 364). McCracken expected “possibly a mild decline in the economy, . . . [and] an upturn somewhere around the second quarter or the middle part of the next year” (ibid., 342). Lower inflation would take longer.

120. The new administration had a very different idea about the role of government. Instead of seeing government policies as a way of disciplining an unstable private sector, President Nixon and his principal economic advisers talked about government policy as a destabilizing element in a relatively stable private economy. This had two direct consequences. First, the administration initially opposed pressures for intervention in price and wage setting processes. Second, the new administration eschewed efforts to use policy actions to make frequent policy adjustments, called “fine-tuning” by McCracken (Hargrove and Morley, 1984, 323).

121. Burns believed that monetary velocity was unstable, a view held by many at the Federal Reserve. “I wish the world was as simple as the Friedmanites and Keynesians wish to make it, but it never has been and, I dare say, it never will be” (letter, Burns to Edwin Nourse, January 30, 1970, quoted in Wells, 1994, 25). Burns was a highly respected developer of a business cycle analysis that was atheoretical. He and his associates at the National Bureau of Economic Research had studied the statistical properties of hundreds of time series and analyzed their comovements, leads, and lags.

Guideposts and controls grew in popularity. Businessmen wanted the government to reduce wage growth and labor costs. Unions and many consumers wanted price controls. Congress responded in August 1970 by authorizing the administration to impose mandatory price and wage controls at the president’s discretion.
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Federal
Reserve
Discussions,
1969–70
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The FOMC gave more attention to total deposit growth, called the bank credit proxy, in this period than earlier or later. It could not decide how to respond if it missed the current target or objective. If the proxy grew
faster than the target, action reducing its growth raised concerns about a credit crunch. Failure to act raised concerns that the System was about to ease policy and lowered its credibility
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(FOMC Minutes, March 4, 1969, 47–48). This was the wrong time to make this choice. With interest rates at the regulation Q ceiling, data on time deposits were distorted, as Governor Mitchell recognized (Maisel diary, January 24, 1969, 10). Banks lost large certificates of deposit but acquired euro-dollars to maintain lending.

122. As noted earlier, Burns had been an outspoken critic of the Kennedy and Johnson guidelines. In the White House, and even more at the Federal Reserve, he irritated President Nixon by becoming a leading proponent.

123. Inflation was not high among the problems mentioned by the public to pollsters. Starting in 1970 the Gallup organization asked regularly what respondents regarded as the most important problem facing the country. Data from early 1970, with annual CPI inflation at 6 percent, show that only 14 percent named inflation or “the high cost of living” as one of the most important problems. The percentage rose and fell with inflation in the 1970s. It did not remain persistently above 50 percent until 1980–81. I am indebted to Karlyn Bowman for supplying these data.

124. At a Board meeting in early January, an extraordinary discussion took place in which Martin discussed problems at the Board and the policy failures of the past few years. Maisel started by criticizing the way the Board dealt with international monetary policy. He said that Daane and Solomon acted without instructions, and policy was not discussed. Martin responded by describing his “feeling of difficulty and frustration in coordinating the Board. . . . ([H]e said that I [Maisel] had been characterized as a doctrinaire liberal.) . . . He also indicated that he felt there were major problems with the Board. Governor Brimmer gave too many speeches, Governor Robertson was too adamant in his views and stuck to them too strongly. . . . He indicated that probably he should have gone off the Board in ‘67. . . .

“[H]e felt that Burns was too inflexible. . . . [H]e felt this was true of all the economists on the Board. . . .

“Martin said he thought the Treasury team would be better than the last. He had a low opinion of the knowledge and job performance of Fowler, Barr, and Deming even though he liked them all personally. He felt that, too, had diminished his historical stature by the part he had had to play in the gold negotiations and at Bonn” (Maisel diary, January 24, 1969, 20–22).

By late February, the Board had to consider raising the regulation Q ceiling. At the FAC meeting, the large banks supported an increase. They had no liquidity and would soon have to sell long-term securities at a substantial loss in order to service their customers. Smaller banks feared that the large banks would use the increased ceiling to draw deposits from them. The Board feared a return of the 1966 credit crunch if banks began to sell municipal bonds. Perhaps for this reason, Martin favored an increase in the ceiling rate (Maisel diary, February 20, 1969, 30).

The Board received conflicting advice from all sides. It remained uncertain about next steps. Mitchell favored more attention to money growth because “market psychology and the market’s interpretation of System policy seemed increasingly to be influenced by changes in M
₁
” (ibid., 49). The manager denied the claim and repeated that money was hard to control in the short run. Several members, including Martin, urged the FOMC to be patient.
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He told the Joint Economic Committee that he was now optimistic that inflation would be controlled (Martin speeches, February 26, 1969,1).

The administration was concerned but willing to wait. A staff memo
prepared for a Quadriad meeting in March was one of several memos at the time arguing the need for patience, while suggesting further reductions in government spending and renewal of the surtax. Even with these changes, the projected inflation rate (deflator) would fall only from 4 percent at the end of 1968 to 3.5 percent in fourth quarter 1969 and a bit lower in 1970. At the meeting the president agreed to request renewal of the surtax.

125. The System was aware that its credibility was at stake. Businessmen made the point frequently and, on occasion, someone would refer explicitly to credibility. For example, Chairman Martin mentioned the government’s “credibility gap.” At the February meeting of the FAC, the members’ statement said, “Businessmen wanted to see tangible results rather than to hear promises, which they found largely unfulfilled in recent years” (Board Minutes, February 18, 1969, 4). In response to a question about time certificates of deposit, the FAC complained about the speed with which the Federal Reserve had tightened (raised interest rates). But it favored continued restraint. Three months later the FAC said, “There is a continuing skepticism in the business community that the objective of price stability will be accorded priority if unemployment should increase significantly” (Board Minutes, May 20, 1969, 7).

126. “Holmes replied that in his opinion it was not feasible to attempt direct control of short-run movements in the money stock . . . [E]fforts at close control . . . could involve drastic medicine” (FOMC Minutes, March 4, 1969, 50–51). Other members of the FOMC expressed concern that the manager ignored the proviso clause requiring a change in money market conditions if the credit proxy deviated considerably from its desired range. A study by the Board’s staff found that the proviso clause had caused a change by the manager on seven occasions between May 10, 1966, when the FOMC first used the clause, and December 1968. On two occasions in 1966, the manager eased. On the other five, all in 1968, he tightened (memo, Normand Bernard to Robert Holland, Board Records, March 20, 1969).

In testimony to the Senate Banking and Currency Committee, Martin at last recognized that “the way to get interest rates down is to end the inflation that has been raising them” (Martin speeches, March 25, 1969, 1). He then reversed course, attributing the rise in interest rates to the “high rate of technological progress occurring in both the U.S. and abroad” (ibid.). However, he returned to the effects of inflation by concluding that “expansive monetary policies may not
[sic]
lower interest rates; in fact they may raise them appreciably. This is the clear lesson of history that has been reconfirmed by the experience of the past several years” (ibid., 9).

The Board was not willing to raise the regulation Q ceiling rate to reflect inflation out of concern for political pressures from regional banks, savings and loans, and Congress. Large banks borrowed euro-dollars to support loans. The Board was divided about what should be done. Brimmer wanted to put reserve requirements on euro-dollars. Remembering 1966, Martin viewed euro-dollar inflows as a safety valve for the large banks as suppliers of bank credit. At one point, with a majority of the Board in favor of raising reserve requirement ratios, he adjourned the meeting without taking a vote (Maisel diary, March 7, 1969, 37).

Through April, the FOMC found few signs that its policy was working to slow the economy and reduce inflation. Heavy borrowing by U.S. banks in the euro-dollar market promptly transmitted domestic policy to other countries. These countries complained about the increase in interest rates, their inability to control domestic money growth, and the reflow of eurodollars that they expected when rates fell in the United States (ibid., April 29, 1969, 38). They were learning the hard way about the policy trilemma; countries could not expect to control inflation, fix exchange rates, and permit capital flows. It would take a while before they agreed to give up fixed exchange rates.

To convince skeptics that the Board intended to maintain its restrictive interest rate policy, eleven reserve banks increased their discount rates to 6 percent for the first time since 1929, effective April 4. Boston followed a few days later. At the same meeting, the Board increased reserve requirement ratios on demand deposits by 0.5 percentage points, to 17.5 and 13 percent at reserve city and country banks respectively but retained a 0.5 percentage point difference for banks with deposits under $5 million.
Changes became effective on April 17. Governor Maisel dissented, citing the slow growth in monetary aggregates and the rise in interest rates during the year. Maisel (1973, 243) explained that many of those who voted for the change believed that they could affect expectations without changing interest rates or monetary aggregates. With the interest rate unchanged, the change in required reserves would be matched by an increase in total reserves.
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They expected the market to get an announcement effect that would convince it that the Federal Reserve would stay the course.

The Board had discussed a discount rate increase since January 24, when the St. Louis bank first requested the change. St. Louis renewed its request several times. It was rejected or not acted upon on January 27 and February 17 and 24. In February, Dallas requested a 5.75 percent rate, and in March Richmond and Kansas City joined St. Louis; Chicago requested 6.25 percent. With the federal funds rate at 6.3 percent in January and 6.79 percent in March, the discount rate increases seem pro forma, but the Board did not act at first, out of concern for the effect on regulation Q ceilings and the political consequences.

Discussion of the discount rate change showed several different approaches to the inflation problem. The staff proposed an increase of 0.5 percentage points to 6 percent, citing rapid growth of the credit proxy, with no change in reserve requirement ratios or regulation Q ceilings. Governors Mitchell and Daane wanted an increase in reserve requirement ratios, regulation Q ceilings, and the discount rate for its “psychological” or announcement effect. Mitchell believed the Board had a credibility problem; the public did not believe that it would persist in its anti-inflation policy (Maisel diary, April 3, 1969, 51). Maisel opposed; he disliked substituting psychological for economic arguments. The monetary aggregates had grown appropriately for several months and projections showed that they would continue to do so. He was “unwilling to accept the psychological feeling of bankers and the investment community as a proper goal. . . . [I]t seemed to me that the Board was changing its strategy . . . by attempting to act on psychology directly” (ibid., 52). Brimmer wanted higher reserve requirement ratios and discount rates but not an increase in regulation Q ceilings. Sherrill wanted to only raise the discount rate. Robertson was eager to raise reserve requirements but was reluctant to raise the discount rate. Since ten banks had asked for an increase, he said the Board had to agree. He did not want to raise regulation Q ceilings.

127. CEA staff noted that the change in reserve requirements increased required reserves by $660 million for the week ending April 23, 1969. The System supplied $900 million (seasonally adjusted) mainly by open market purchases and increased discounting (memo, Andersen to McCracken, Communications with Fed and Burns, Nixon papers, May 1, 1969).