A History of the Federal Reserve, Volume 2 (110 page)

Chairman Martin’s statement took a strong stand but did not lead. He said that the Board had to fight inflation and “take all necessary action until the inflationary psychology was halted. . . . [T]here was a credibility gap on the part of the Board and the administration—neither was willing to take the hard action required if inflation was to be stopped” (ibid., 53). Then he retreated a bit. Since a majority opposed raising regulation Q ceilings, he favored only the discount rate and reserve requirement increases. The proposed action did not match his statement.

The Board found it easier to agree on the increase in reserve requirement ratios than on the press release. The stumbling bloc was whether the action changed policy. The discussion brought out that the members did not agree on whether this was a policy change. Press interviews confirmed that the Treasury did not regard the action as tightening policy; “if it had meant more tightening, the Treasury or the Administration would have opposed the change, but they did not do so since it was purely psychological” (Maisel diary, April 7, 1969, 57). Writing in the
New
York
Times,
Erich Heinemann interpreted the change as a shift from “gradualism.” He thought that was an error because it neglected the lags in response to slower monetary growth. As Board members noted, growth of the monetary aggregates had slowed.

For the April 29 Quadriad meeting, the CEA staff prepared a table for the president showing recent money and bank credit growth. Table 4.6 supplements these data with annual growth rates of the monetary base.

Base growth showed gradual deceleration, but the other aggregates did not. As the Federal Reserve soon learned, money and credit could change over a large range in the short term with changes in Treasury deposits, float, and other temporary changes. In addition, both bank credit and money were affected in different ways by the regulation Q ceilings. With market rates at the ceiling, banks lost time deposits to their foreign branches and foreign banks and to non-banks at home. This had a large negative effect on credit growth and a smaller positive effect on growth
of demand deposits and money. Banks had to buy back their deposits by issuing commercial paper and acquiring euro-dollars. Raising the ceiling rate would have avoided these changes.

Members were confused. Some feared that increased growth of time deposits would suggest that policy had eased, so they hesitated to make a desirable change. Faulty reasoning or excessive concern for cosmetics prevented appropriate action. In a reversion to the discredited real bills doctrine, Morris (Boston) and Coldwell (Dallas) wanted the Board to urge banks not to lend for corporate acquisitions because the loans were not productive credit. Bopp (Philadelphia), Kimbrel (Atlanta), and Francis (St. Louis) said that this decision was up to bankers, not the Board, and that “productive” credit was not a useful concept (Maisel diary, April 29, 1969, 61).

Soon afterward, the Federal Reserve again discussed restrictions on commercialpaper and euro-dollars to limitthis substitution.
¹²⁸
In May, Governor Robertson urged the Board to expand the definition of “deposit” to include any funds borrowed by a member bank. The Board soon thereafter considered Robertson’s proposal and a proposal to put the commercial paper purchases by bank affiliates under regulation Q. Legal counsel cautioned that the proposal had uncertain legality. Robertson and Brimmer were eager to act. Sherrill argued that Board policy was working and they should not change the regulations (Board Minutes, June 23, 1969, 10–16). The next month the Board took the first step; on a six-to-one vote it amended regulation Q “to narrow the scope of the repurchase agreement exemption from the definition of deposits” (ibid., July 24, 1969, 9). Mitchell dissented.
¹²⁹

This step did not satisfy Board members concerned about banks “evading monetary policy” by issuing commercial paper (Board Minutes, October 22, 1969, 4). The Board did not discuss removal of regulation Q ceilings to restrict rapid growth of commercial paper. The Board’s Legal Division had found a way to make regulation Q applicable to “certain funds obtained by a member bank through issuance of commercial paper” (Board Minutes, September 18, 1969, 11). Discussion proceeded about how this could best be done.
¹³⁰

128. Anyone who added bank related commercial paper to bank loans would not be fooled by the substitution. Several bankers made this point at the May FAC meeting: “Chairman Martin said . . . the real question was whether banks were using these methods to thwart the current restrictive monetary policy. Mr. Graham [a FAC member] said . . . these devices were more alternative than additional sources of funds” (Board Minutes, May 20, 1969, 23).

129. Growth of the M
₁
money supply had fallen to 3 percent in 1969 to May. Projections suggested that with unchanged policy, it would continue at that rate. Board members became impatient and wanted more evidence of lower inflation. Overreaction was a frequent fault in this period.

130. The Board’s data on bank-related commercial paper outstanding begins in April
1969 at $200 million, less than 1 percent of total outstanding commercial paper. By October, it had grown to $3.7 billion, 11 percent of outstanding paper. On September 10, 1968, a Deputy Comptroller of the Currency had informed a bank, by letter, that regulation Q did not apply to bank subsidiaries (Board Minutes, November 4,1969,5).A letter from a leading banker cautioned that euro-dollar rates started to rise in anticipation of the regulation (letter, George Moore to Hayes, Correspondence Box 240, Federal Reserve Bank of New York, November 24, 1969).

On October 29, the Board issued for comment a proposal to apply regulation Q ceilings to interest rates on commercial paper issued by a bank or its affiliates. The Board also discussed applying reserve requirements to commercial paper, but Governors Mitchell and Maisel wanted to obtain legislation before acting because they doubted that the Board’s powers permitted this step.

The Board did not implement any proposals at the time. In response to banks’ concerns, it delayed its decision until January 15, 1970, then delayed again. A majority wanted to apply regulation Q ceilings, but the members could not agree on reserve requirements, in part because the Legal Division was not fully convinced about the Board’s authority.

The Board agreed to increase ceiling rates on time deposits and issue a statement for comment on a 10 percent reserve requirement ratio for commercial paper. Congress had removed the legal issue by granting authority on December 23, 1969. Announcing the change on January 20, the Board took account of Congressman Patman’s telegram expressing concern about a large increase in rates that would hurt non-bank thrift associations.
¹³¹
Governor Robertson dissented because the higher ceiling rates would allow bank credit growth to increase. He wanted a quantitative restriction on the amount of the increase. Without it, the action would be considered expansive for bank credit.

By May 1969, members began to express doubts about “gradualism” openly.
¹³²
They rejected the stable Phillips curve. Some favored a “credit crunch.” Banks tried to avoid monetary policy by using letters of credit, selling assets with puts attached, selling to foreign branches, and issuing commercial paper. Hayes was “convinced that a business slowdown of some considerable duration may be needed if we are to make any real
progress on the cost-price front” (ibid., May 27, 1969, 37). Kimbrel (Atlanta), Robertson, Daane, Mitchell, and Coldwell (Dallas) agreed that a firmer policy was needed. But Martin urged them to wait until July before changing policy.
¹³³

131. Patman’s telegram along with telegrams from various trade associations for the thrift industry called attention to competitive aspects. Patman and others in Congress were very sensitive to effects on housing and mortgage lending. The Board’s announcement said that the “revisions were held to moderate size so as not to foster sudden and large movements of funds” (Board Minutes, January 20, 1970, press release). Rates for thirty to eighty-nine days increased 0.5 percentage points to 4.5 percent. Rates for consumers’ one- and two-year CDs rose 0.5 and 0.75 to 5.50 and 5.75 percent. Large CD rates (over 100,000) increased 0.75.

132. Daniel Brill announced his intention to resign to take a position in the private sector. J. Charles Partee replaced him as research director.

The CEA’s concern was that the Federal Reserve would undermine administration policy by not controlling money growth. Stein described the Federal Reserve’s view as a possible threat. The Federal Reserve, reacting to the administration’s spending, said that the principal reason for inflation in the late 1960s was a large budget deficit. “Moreover the large budget deficit prevented the Federal Reserve from pursuing an even more restrictive policy, because to have done so . . . would have caused intolerable interest rates and credit stringency” (Stein to the president, Nixon papers, WHCF, Box 34, Correspondence, February 15, 1969). This was a variant of the standard Martin explanation that the Federal Reserve had to finance much of the budget deficit that Congress approved. Stein then suggested that “skepticism is growing in the financial community and the lack of confidence is spreading in the Congress. Accordingly the Federal Reserve will be sensitive to the danger of finding itself far out of line with the administration” (ibid.). The threat proved empty.

The St. Louis bank wanted a more aggressive program to stop inflation. Beginning in May, the bank repeatedly requested a 7 percent discount rate, a one percentage point increase. It was not alone. In June, Boston requested 6.5 percent; in July and August, Kansas City and Chicago joined in the request. Despite average federal funds rates of 8.61 and 9.19 percent in July and August, the Board would not approve the changes. Instead, it asked the reserve banks to prevent “inappropriate borrowing.” Maisel claimed that Martin urged rejection of the requests “probably partly for political reasons” (Maisel diary, June 26, 1969, 80).

The Board considered it inappropriate for a bank to borrow from a reserve bank and sell federal funds in the same week. This was borrowing for profit. Discounts reached well above $1 billion. Instead of increasing the discount rate, the Federal Reserve returned to the type of policy action—moral suasion or pressure—that had failed in 1929 (Board Minutes, August 13, 1969, 11). This experience demonstrated again that the System’s claim was false; when the opportunity arose, banks borrowed for profit.
¹³⁴

133. The FOMC considered whether to undertake open market operations in agency securities to assist the housing market. The members were skeptical about whether this was the proper time to undertake such an experiment. However, they feared that Congress would mandate action (FOMC Minutes, May 27, 1969, 87). Martin was “saddened by the fact that the System was involved in a political matter whether it liked it or not” (ibid.).

134. The Board again came under pressure from Congress to buy agency issues to sup
port the housing industry. Robertson, Mitchell and Maisel were sympathetic; the other members agreed that if purchases were made, they should not be used to assist the housing market. A staff memo pointed out some difficulties: many small issues, difficult to resell or trade, and possible legal problems in rolling over such securities at maturity. The Board reached similar conclusions in 2000, when there was concern that the budget surplus would eliminate Treasury debt outstanding (memo, Holmes to FOMC, Board Records, June 18, 1969). In 2008, it appeased Congress.

With money growth continuing to rise, the staff proposed that the FOMC should choose a quantitative target, preferably total bank reserves. They too were divided. Stephen Axilrod’s report supplemented interest rates with quantitative measures; he suggested that policy was too restrictive (FOMC Minutes, July 15, 1969, 34). Governor Maisel, later joined by Francis (St. Louis), believed that maintaining current policy would further increase interest rates. This policy, he said, was unsustainable; he dissented from the decision to maintain money market conditions and complained that the manager ignored the proviso clause. The bank credit proxy had fallen much more than anticipated, but the manager ignored it, as usual (FOMC Minutes, June 24, 1969, 80).

Some of the control problems resulted from the mistaken policy of holding regulation Q ceiling rates fixed. This distorted the credit flows and possibly altered credit allocation. Many at the Board shared Maisel’s view that “raising Q would mean less restraint since we would furnish more reserves and interest rates would fall” (Maisel diary, July 16, 1969, 86). On the contrary, the principal benefit would come from improved allocative efficiency, achieved by an increase in the cost banks paid to acquire CDs. Banks would demand more reserves to cover increased required reserves. The FOMC could choose whether or how much to supply additional reserves.

The monetary aggregates fell sharply in July. By August, the staff suggested that a recession was possible later in the year. It proposed lowering the funds rate from 10 to 8.5 percent, but Hayes disagreed. Suggestions of a slowdown “were disturbingly premature” (FOMC Minutes, August 12, 1969, 30). He opposed an increase in the discount rate, but he favored getting rid of regulation Q ceilings for large denominations. Morris (Boston) disagreed. Policy was not gradual; it was restrictive and likely to produce a recession in 1970 (ibid., 35). Most members disagreed, but Mitchell supported Morris. Continuation of the “current sharp declines in monetary aggregates . . . could lead to disastrous consequences” (ibid., 54). Mitchell feared also that, if the desk eased, the market would conclude that the System would not maintain its anti-inflation stance.
¹³⁵

135. Maisel describes the struggle within the FOMC at this period (Maisel’s diary, August 13, 1969, 03–05). At the May meeting, the staff predicted that growth would slow almost to zero
(0.4 percent) in fiscal 1970, and they maintained the forecast of recession or near recession throughout
. They forecast inflation of 4 to 4.5 percent (Actual growth was −0.8 with inflation at 5.4 percent). Hayes, Coldwell (Dallas), Brimmer, and Clay (Kansas City) were willing to accept a serious recession to fight inflation (ibid., 103). “They continued to call for continued tightening and restraint in every meeting through February 10 . . . they made it clear that there was no way of avoiding sacrifices in terms of lost jobs, lost output, and lost income in order to hold prices down” (Maisel diary, February 16, 1970, 23). Maisel and Mitchell wanted money growth, M
₂
minus CDs, at a 3 percent rate, to avoid a credit crunch and gradually reduce inflation. They argued that money market conditions had to move more than in the past to maintain proper growth of the monetary aggregates and the flow of credit. Robertson leaned toward the inflation hawks. The other members of the committee fell somewhere in between. A principal concern for several members was that the market would interpret reduction in short-term rates or increase in free reserves as retreat from an anti-inflation policy. In the language prominent in later years, the System lacked credibility.