A History of the Federal Reserve, Volume 2 (119 page)

The committee chose to concentrate on the money market and instructed the manager to keep the interest rate at or below recent levels (8 percent) and seek a 5 percent growth in M
₁
, slightly above the second quarter rate.

Through the summer, the Board’s staff continued to forecast slow recovery, rising unemployment, but lower inflation.
¹⁹⁵
Burns remained pessimistic about the unemployment rate and the recovery. He joined a minority including Daane, Sherrill, Maisel, and Galusha (Minneapolis) that favored money growth at 6 to 6.5 percent instead of the consensus rate of 5 percent. Francis, Hickman (Cleveland), Brimmer, and Trieber wanted 5 percent or less. They remained disturbed by fear of inflationary expectations. Kimbrel (Atlanta) and Clay (Kansas City) could not vote, but they preferred less than 5 percent money growth. Morris (Boston) and Robertson were in the middle, favoring the 5 percent money growth rate projected as consistent with prevailing money market conditions.
¹⁹⁶
With Mitchell absent, the committee voted eleven to zero for the 5 percent growth rate. It recognized that the change in regulation Q returned more credit to the banking system, so it accepted a very high, but uncertain, growth of the bank credit proxy.

Burns wanted more stimulus. After the vote on the directive, he asked for a second vote to instruct the manager that he should not prevent money growth above 5 percent. The FOMC supported his position in a seven-tothree vote (Maisel diary, July 21, 1970, 100).
¹⁹⁷

Greater attention to the monetary aggregates reopened issues about measurement and control. The internal discussion gives insight on the staff’s understanding. A memo to Burns discussing time deposits argued that regulation Q was powerful for controlling bank credit expansion. The memo recognized that part of the increase substituted non-bank for bank credit or conversely, but it dismissed this substitution by concluding that
full offset is “extremely unlikely” (memo, A. B. Hersey to Burns, Board Records, April 17, 1970). It offered no evidence, and the staff did not all agree with the conclusion, as the memo noted. The memo failed to note that removing regulation Q ceilings would smooth adjustments instead of forcing discrete jumps and avoidance of controls through the euro-dollar, commercial paper, and other markets.

195. Their forecast in July 1970 predicted unemployment at 5.8 percent and inflation at 2.8 percent in second quarter 1971. Actual unemployment was 5.9 percent, up from 5 percent at the time of the forecast. Inflation (deflator) was far away from the forecast at 7.6 percent in second quarter 1971, up 1.7 percentage points in a year. This suggests a possible large problem with the model used to forecast inflation.

196. Burns told Maisel that “the crew around the President all watched M 1 . . . . They had Nixon watching week-to-week movements in the St. Louis figures and Burns had told the President to forget it. Short-term movements meant little” (Maisel diary, July 21, 1970, 99).

197. The Record of Policy Action in the Annual Report does not mention this vote. The staff proposed a definition of “even keel” as no change in Federal Reserve policy between Treasury announcement of financing terms and payment for the securities. The FOMC accepted the definition but did not inquire how it should measure Federal Reserve policy.

Lyle Gramley, later a Board member, explained why the staff preferred to focus on reserves instead of the monetary base. The main reason was that the base included currency, and the staff “did not know much about the sources of short-run changes in currency demand” (memo, Lyle Gramley to Burns, Board Records, March 30, 1970).
¹⁹⁸

Milton Friedman, Burns’s long-time friend, wrote to Burns frequently, at times suggesting procedural changes to improve control of money growth. One letter criticized the use of shifting base periods from which to measure growth of monetary aggregates and proposed using an initial base period uniformly. Governor Mitchell’s responses rejected that proposal because the aberrations in the data were not promptly and easily recognizable (Burns papers, Box B-K12, July 6, 1970). Later, Friedman made several suggestions to reduce variability in money growth—elimination of lagged reserve accounting, calculations of required reserves on a fiveday week (instead of seven days with Fridays receiving the weight of three days), and use of staggered settlement periods with one-fifth of the banks settling each day (letter, Friedman to Burns, Burns papers, Box B-K12, August 11, 1970). The staff response dismissed Friedman’s suggestions as unimportant (Stephen Axilrod to Burns, ibid., August 20, 1970).

On August 17, the Board voted reserve requirements for commercial paper issued by bank affiliates. Burns proposed that the ratio be set at 4.5 percent for both commercial paper and time deposits at banks with time deposits totaling $5 million or more. The reduction from 6 to 4.5 percent on time deposits would release $750 million from required reserves, but the new requirement for commercial paper would add $90 million. Net reserves would rise mainly at New York City banks.

Mitchell did not want to lower reserve requirements at country banks. He preferred a major reform, discussed many times before, to base reserves requirements on bank size instead of location in reserve city or
country banks. The staff showed that about thirty country banks would have higher reserve ratios if the Board set the ratio by size of banks. Burns rejected the idea because of the political pressures that the thirty banks would generate before the November election.

198. This is a common misstatement. The source of the monetary base is the total emission by the central bank for open market operations, gold flows, and several other, mostly minor, sources. Reserves and currency are uses of the base. The sources can be controlled completely by controlling open market operations. Shifts in currency demand can be satisfied by allowing banks to borrow or repay. For a full description of the base see Meltzer (2003, 267–70, appendix B to chap
ter 4).

All Board members except Burns did not want to announce that additional reserves would become available, so they preferred to set both requirements ratios at 5 percent. Burns resisted, but lost. The Board approved the 5 percent reserve ratio on deposits effective October 1 and on commercial paper two weeks earlier.
¹⁹⁹
The staff estimated that the action released millions of reserves, but monthly average reserves rose much less. The Federal Reserve offset part of the addition, but it no longer held the funds rate constant, so the action was a small move toward easier policy.

The staff memo for the August 17 meeting at which the Board made its decision argued that additional stimulus was desirable because the economy was “on dead center.” (Real GNP growth was 5 percent for the third quarter after −0.3 percent in the second.) The difference in existing reserve requirements (6 percent and 0) gave commercial paper a 0.5 percentage point interest rate advantage, encouraging credit expansion outside the banking system or through affiliates (memo, J. Charles Partee to Burns, Burns papers, Box B-B93, August 12, 1970).

New
Efforts
to
Ease

The mild recession continued until November but did little to reduce inflation. There is no evidence suggesting movement along a short-run Phillips curve. In July 1970 consumer prices rose at an annualized rate of 4.1 percent. The twelve-month sustained rate, 5.7 percent, was only 0.2 percentage points lower than at the start of the recession. By the same month the unemployment rate had increased from 3.5 to 5.0 percent. Base money growth, after a brief decline, increased at a twelve-month rate of 5.5 percent. Real base growth turned positive for the first time in a year (see Chart 4.12 above). And real interest rates started to decline (see Chart 4.11 above).

Monetary indicators such as base growth and real interest rates suggested that policy had become more expansive. Those who expected the rising unemployment rate to reduce inflation were disappointed. They had
assured themselves, and others, that a modest increase in unemployment would lower inflation. After more than six months, many began to doubt. Arthur Burns, especially, proclaimed at an FOMC meeting in June and in congressional testimony in July that the old rules no longer worked as they had before. Once a principal critic of the idea that price and wage guidelines could shift the Phillips curve, thereby changing the tradeoff between inflation and unemployment, Burns now became a prominent advocate of the need to change the short-run tradeoff. He had delivered M
₁
growth of 3 to 5 percent in the first two quarters of his term and seemed to expect a more prompt response than he achieved. By the time the inflation rate began to fall, early in 1971, Burns was committed to price-wage guidelines as a necessary adjunct to monetary and fiscal policy.
²⁰⁰

199. The Board acted under the authority granted by Congress on December 23, 1969, authorizing reserve requirements on commercial paper. The Board considered the issue several times in the nine months after Congress acted but could not agree. Part of the disagreement concerned the announcement effect of releasing reserves and the possible interpretation of the move as a step to ease policy. Usually only Robertson supported Burns. Brimmer was most opposed because he wanted a tighter policy. By June, Burns was annoyed enough by the delay to warn that the issue would continue on their agenda until it was decided.

The CEA continued to press for expansion. In October, Paul McCracken wrote to Burns urging faster money growth to get “an increase of 12 to 13 percent in real GNP between mid-1970 and mid-1972. . . . [T]his probably means an increase of 17 to 19 percent in money GNP” (Draft letter McCracken to Burns, Paul McCracken, Box 45, Nixon papers, White House Staff Memos, October 9, 1970).
²⁰¹
McCracken defended his position by claiming that the benefits of lower inflation achieved by delaying the return to full employment “would not be worth the cost” (ibid.).

At each FOMC meeting from August to November, the directive said: “promote some easing of conditions in credit markets.”
²⁰²
Hayes, Brimmer, and Francis dissented in August, and Hayes dissented alone in September and October to record opposition to easier policy. Maisel dissented in November because he regarded as too low the objectives for growth of money and credit that the FOMC chose.
²⁰³

200. Burns stopped talking about the prospects of a depression, but he continued to press for more expansion. He annoyed or angered several members in August by changing procedures in an attempt to get his way in a divided committee. The compromise called for M
₁
growth of 5.5 percent and a federal funds rate of 6.5 percent, a 0.25 percentage point reduction.

201. I have not found that McCracken sent the memo, but it was typical of the recommendation that McCracken and Stein made at the time.

202. Relations between Burns and the president waxed and waned. In September the president invited Burns to join his trip to London. Burns declined because it was an election year. “Some members of the press continue to believe the Fed is under White House control” (Burns to President, Burns papers, Box B-N1, Sept. 16, 1970).

203. The inelegant term “stagflation” came into common use to describe simultaneous occurrence of unemployment and inflation. For Burns, the CEA members in the Johnson and Nixon administrations, and many others, unemployment and inflation should not coexist, at least not for long. Increased unemployment should lower inflation toward zero. This neglected the role of expectations, forcefully pointed out in Friedman (1968b), a paper well known to economists at the time. Later Brunner, Cukierman, and Meltzer (1980) pointed out that temporary efforts to restrain inflation would fail until the public became convinced that
the authorities would tolerate unemployment and persist in restrictive policy until inflation ended. The movements of long-term interest rates, inflation and money wages during this recession suggest little conviction about the administration’s willingness to tolerate rising (or perhaps high) unemployment as the cost of ending inflation. Repeated discussion of inflationary expectations at FOMC meetings also suggests that the public remained skeptical about the permanence of the restrictive policy, as well they should since policy was expansive. The Board’s staff attributed continued high long-term interest rates to demands for credit and not to skepticism.

A strike at General Motors caused additional uncertainty in October. The staff urged greater ease and lower interest rates to increase demand for housing and spending by state and local governments. The FOMC remained evenly divided, but the difference was typically small—a choice between 5 or 5.5 percent money growth. This probably understates differences of opinion because Burns, Maisel, Mitchell, and several others who pushed for 5.5 percent preferred faster growth while Hayes, Brimmer, and some others who urged 5 percent would have accepted less expansion if it had been feasible to get agreement. The first group gave priority to recession and unemployment, the second to inflation, actual and expected.
²⁰⁴

Expected inflation kept long-term rates from falling. Ten-year constant maturity Treasury yields were higher during the summer and early part of 1970 than at the cyclical peak in November 1969. One proposed solution to the expectations problem was to initiate purchases of longer-term securities. This had modest support at the November meeting. A second was to lower the discount rate. The Board voted for a 5.75 percent discount rate on November 10, a 0.25 percentage point reduction. Philadelphia was most reluctant, but it joined the others on December 16. Most of the governors recognized that the move followed the short-term market. Those who favored expansion favored a 5.5 percent discount rate, but others feared announcement effects—a concern about inflationary anticipations. The expansionists prevailed three weeks later. On December 1, the Board reduced the discount rate to 5.5 percent, again following the short-term market. Burns pushed the change hard at the November 17 FOMC meeting, telling the presidents that one bank had requested 5.5 percent so “they had better make it clear to their boards of directors that the Board would shortly take up the question” (Maisel diary, November 17, 1970, 124). Presidents Hayes, Hickman (Cleveland), Eastburn (Philadelphia), and Kimbrel (Atlanta) said they did not want an additional discount rate cut, but five banks supported Burns, so the others fell in line. Bond yields declined following the discount rate changes.

At the November 17 FO
MC meeting, the staff urged the members to
undertake a much more expansive policy by lowering the federal funds rate enough to get 7 to 8 percent M
₁
growth in first quarter 1971. Only Mitchell, Morris, Maisel, and Burns favored the staff recommendation, but there was additional support from some non-voting members. The directive called for moderate growth in money. Maisel dissented because he wanted faster growth of money and credit.

204. Maisel’s diary (November 17, 1970, 122) describes Brimmer as saying that “we ought to take as much depression as necessary to stop prices from rising.”