A History of the Federal Reserve, Volume 2 (111 page)

The members remained divided. Some favored more restraint, usually gradual restraint. Others sided with Morris and Mitchell. Martin, remembering his 1968 error, favored no change at that time. “It was important for the System not to get into a position of validating the expectations of numerous skeptics who believed the System would ease its policy as soon as it heard the words ‘recession’ or ‘overkill’” (ibid., 78).

By August, several new divisions had opened. Some wanted the Federal Reserve to tighten more, but “the majority of the FOMC remained gradualist” (Maisel, 1973, 245). The gradualists split into two factions. The larger group wanted to maintain, but not increase, pressure on banks and the money market. Maisel and Mitchell wanted “a midcourse correction” to avoid a recession or reduce its risk (ibid., 245–46). They feared that a recession would shift the majority to favor easier policy, reducing the chances of lowering the inflation rate. “Money market conditions as a target were leading to too tight a policy. Soon it could become too accommodative. The System should shift to monetary aggregates to avoid whip lashing the economy” (ibid., 246). To avoid misinterpretations, they favored an announcement saying that policy would henceforth target the monetary aggregates. They could not convince Martin, but in a few months Arthur Burns became chairman and adopted some of their proposals.
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Chairman Martin did not provide leadership. “He frequently did not speak up. He indicated throughout the earlier period that he was in favor of more restriction. During the summer, he shifted saying that he did not want to show any sign of ease. . . . By the beginning of January, he wanted to move, particularly on Q, but also to make a minimum move through open market conditions” (ibid., 24). In Martin’s view, “the Committee shouldn’t think about the aggregates at all. It should only think about money market conditions and their impact on psychology in the financial markets and, therefore, in the real market” (ibid.).

136. The background memo for the August 28 Quadriad meeting noted that inflation and growth continued. Consumer prices had increased 6.3 percent (annualized) for the year to date. Nevertheless, the memo said: “We may not be too far from the time when economic policy should be relaxed” (agenda for the Quadriad, Nixon papers, August 28, 1969).

Martin believed that a shift toward ease would compound an earlier error and convince the market that inflation would remain or rise. The System had “been misled into premature easing in 1968 by an overemphasis on technical considerations at the expense of proper attention to the psychological environment. Too much emphasis was placed on the prospective $25 billion turnaround in the fiscal position of the Federal Government and not enough on the underlying inflationary expectations which had been building up over an extended period. The mistake had subsequently been compounded for a period of several months by the rationalization that some moderation of the inflationary pressures was imminent” (FOMC Minutes, August 12, 1969, 77–78). The staff concluded that “the majority of the Committee was willing to see considerably more ease as long as the change did not show too clearly in the market!” (Maisel diary, August 14, 1969, 106).

At the time, Burns expressed concern about any additional restriction that reduced real growth below the projected 1 percent or that increased the unemployment rate above a projected 4.5 percent (Maisel diary, August 14, 1969, 107). About this time, the FAC and the Board’s academic consultants were as divided as the FOMC. Some favored a strong anti-inflation policy. Others preferred a more gradual approach (ibid., September 17, 1969, 116).

By September, signs of slower growth had become apparent. Industrial production declined slightly. After rising in October, production began a sustained decline. The unemployment rate reached 3.7 percent, but there was no sign of slower inflation. The GNP deflator reached an annual rate of 6.2 percent for the quarter. Consumer price inflation was 5.6 percent. The staff expected a mild recession in the first half of 1970.

Long-term government bonds reached 6.9 percent in mid-August and were only slightly below that level in mid-September. The federal funds rate remained between 9 and 9.5 percent, well above the inflation rate. The Board’s staff recognized the slowdown as it occurred. They were not alone. The Federal Advisory Council expected growth to continue to slow (Board Minutes, September 16, 1969, 2). The System now faced a test. Would it continue to press for lower inflation or would it shift its policy to prevent a possible recession?

Opinion divided. The FAC by a large majority favored continuing but not increasing pressure, but two members favored a move toward ease. The beginning of a shift in attitudes appeared in the suggestion that moderate inflation of 3 percent might be better than paying to reduce inflation to 1 or 2 percent (ibid., 13). Chairman Martin ended that discussion with
the optimistic statement that reducing inflation would not require a large increase in the unemployment rate.
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The FOMC continued to call for an unchanged policy, with dissents from Governors Maisel and Mitchell in September and Maisel in early October. Although the committee voted to keep policy unchanged, the October 7 meeting had a much more intense discussion than usual. Two issues remained contentious. One was the meaning of unchanged policy. The second was growing support for the use of a monetary aggregate target and continued opposition.

Governor Mitchell pointed out the committee had voted several times for “no change.” He then read a list of six monetary aggregates and concluded that “every aggregate listed showed deterioration in the third quarter” (FOMC Minutes, October 7, 1969, 59). Declines were large. Turning to interest rates, Mitchell reported that fourteen of the twenty-three securities listed in the staff report reached peak rates in September, including all the intermediate- and long-term issues. This was “incompatible with the Committee’s stated posture of ‘no change’” (ibid., 60). Mitchell concluded that “if monetary policy continued to tighten as it had recently the result was likely to be a major recession in 1970” (idem.). He too departed from the Keynesian Phillips curve by suggesting that it might require stagnation in real activity to bring inflation down.

Martin was in the last months of his term. Although he had opposed inflation in his public statements, he faced the prospect that he would leave office with inflation above 5 percent, the highest rate since the Korean War. It seems likely that he tolerated, perhaps encouraged, the much more restrictive policy hoping to reduce inflation before he left office.
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There is no direct evidence to support this conjecture aside from the continued increase in interest rates and decline in free reserves under the “no change” policy that he supported and the committee approved.
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Martin’s comments at the time are difficult to interpret. He did not believe “that the real impact of monetary policy was that important . . . [but] its psychological impact is critical” (Maisel diary, October 8, 1969, 3).

Philip Coldwell (Dall
as) made some of the case for those who opposed
using monetary aggregates to guide policy decisions. Coldwell emphasized two points. First, interpretation of monetary aggregates or interest rates depended on expectations. “With each passing month the force of expectations of further inflation brought potentially disruptive factors closer to the economic horizon” (ibid., 53). Monetary aggregates did not take account of these forces. Second, bank reserves had fallen, but “the impact of that development was mitigated by the rise of the large nonbank credit accommodations and the shift of funds from bank time deposits to direct investments and indirect support of the euro-dollar and commercial paper markets” (idem.). This statement reflected a firm, but erroneous, belief that many held. They thought that growth of credit (lending) outside the banking system showed that the financial sector escaped from restrictive policy. In this view, monetary aggregates did not capture these changes, hence they were misleading or inadequate. That these changes were sustained by ever-increasing interest rates showed not an escape, but the spreading effect of monetary restriction.
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137. Nearly the entire FAC favored an increase in ceiling rates on large certificates of deposit (over $1 million) and the elimination of ceiling rates on these CDs (Board Minutes, September 16, 1969, 22). But there was less agreement about rates on smaller time and saving deposits.

138. Consumer price inflation reached 6 percent in January 1970, the last month of his term. The peak came in February at 6.16 percent. The GNP deflator reached a peak of 7.1 percent in first quarter 1970.

139. Free reserves were less than −$1 billion in October, a reduction of $700 million under the “no change” policy.

In late October, Maisel made a detailed statement of his alternative position, separating the problem of writing an instruction for the manager from the more serious problem of introducing longer-term considerations into the directive and the FOMC’s actions. Maisel noted that growth of the bank credit proxy fluctuated considerably in the short-term because Treasury financing operations moved deposits from private to Treasury accounts. “Thus, for November, a fairly sizeable increase in the proxy was projected, even though November was the middle month of a quarter in which no increase at all was expected on average” (FOMC Minutes, October 28, 1969, 70). He proposed less “stop and go” and more attention to deviations from projected trend.
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140. Coldwell’s were not the only criticisms. The manager said frequently that he could not control short-run changes in the aggregates without permitting large changes in interest rates. He believed that the demand for reserves or base money was very interest inelastic in the short run. Coldwell was mistaken also in his statement about expectations. Persistent high money growth was a main reason for expecting continued inflation. The manager’s explanation of the reasons for not using a monetary target are in Holmes (1969, 71–77).

141. At the October 28 meeting, Martin reported that the president had appointed Arthur Burns as chairman and that Burns had asked him to tell the FOMC that “he would not feel bound by any of its decisions made before his term” (FOMC Minutes, October 28, 1969, 2). Martin had argued against the appointment with President Nixon on grounds that Burns lacked administrative and personal skills and, as an economist, lacked sufficient breadth about banking and financial markets. He repeated this to Burns. Martin and the president agreed to look for other people. The president asked Gabriel Hauge, who declined for personal reasons. “Martin says that if Nixon had twisted hard enough, he could have gotten him” (Maisel diary, October 22, 1969, 1). Martin urged other names, but the president appointed Burns. Martin also said that “he blamed Brill and Okun for the overkill scare in 1968 . . .
and said ‘see don’t trust economists and statistics’—he had done so unwillingly and now regretted it” (ibid., 2).

Heflin (Richmond) opposed further ease as “fine tuning.” He voiced the thoughts of several others by arguing that the System had to change anticipations. This required a firm policy. Francis (St. Louis) replied that if the money stock continued unchanged for another three months “the rate of increase” in total spending “would probably experience such a decline that real production would decline unnecessarily and regrettably” (ibid., 86).

Francis urged 3 percent money growth starting at once. Martin opposed any change toward ease. “He did not agree that the consequences of deviating significantly from some preferred rate [of money growth] for a period of time would be as disastrous as the monetarists believed” (ibid., 90).
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At the next meeting, Francis responded to the argument by Martin and several others placing principal weight on the need to control expectations. “The conduct of monetary policy by attempting to control public psychology directly rather than through control of financial magnitudes had not and would not be successful” (FOMC Minutes, October 28, 1969, 56). The committee should instead take three steps: “resume moderate monetary growth; raise the discount rate in line with market rates; and lift regulation Q ceiling rates, especially for large CDs” (ibid.). Any adverse psychological effect could be dispelled by announcing that the System would maintain moderate growth of money.
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Governor Daane explicitly rejected Francis’s proposals. “There was no basis for relaxation of policy at this point. . . . He felt that fiscal policy is on the verge of a large shift towards expansion” (ibid., 71). Apparently some FOMC members had learned about the risks of policy coordination. He
no longer wanted monetary actions to offset the effects on interest rates of increased government spending.

142. Over the objections of Robertson and others, the FOMC voted to permit the manager to lend securities to government securities dealers. The Treasury was willing to authorize such lending by the Home Loan banks and other agencies but would not lend unissued securities. Robertson pointed out that this removed the finding of necessity.

143. Some Board members and administration officials expressed concern about the distribution of credit. Maisel was most outspoken: “Since we were in an inflation that was caused primarily by corporate spending and corporate price policy, the one area that we should try to hold down was large corporate investment” (Maisel diary, November 13, 1969, 2). He wanted to get more credit to the housing industry by raising ceiling rates. He was concerned about the distributive effect of monetary policy on different sectors, and he complained that Martin ran the System as “a major lobby for hard money” and to favor large banks (ibid., 7). Banks used the commercial paper and euro-dollar markets to support lending. This drained deposits from thrift institutions. The Coordinating Committee of regulators could not agree to raise interest rates because many of the institutions did not want to pay higher interest rates (ibid., December 10, 1969, 7). Congress pressed for action to assist homebuilders by considering legislation that, in Martin’s words, “would provide direct access to Federal Reserve credit to those agencies without limitation as to amount—an unlimited line of credit at the central bank that our laws have denied even the U.S. Treasury” (Martin speeches, Octo
ber 6, 1969, 3).