A History of the Federal Reserve, Volume 2 (120 page)

Concerns about unemployment overcame anti-inflation policy. Successive moves toward ease lowered the federal funds rate from 7.8 percent in mid-June to 5.2 percent in late November. At year-end the rate was 4.8 percent. Long-term Treasury bonds fell much less, from 7 percent in mid-June to 6 percent at year-end. Free reserves rose to −$60 million, the highest level since early 1968. Money growth also rose; for the two halves of 1970, M
₁
growth was 3.5 and 6.5 percent at annual rates.

With the end of the two-month General Motors strike, industrial production surged in December. Stock price indexes increased also, continuing the rise that began in July 1970. It took more than an additional year before the nominal S&P index surpassed its previous peak in December 1968. This suggests that the outlook for profits and expansion remained modest. The Board staff forecast called for modest growth also.

Most of the Board’s academic consultants wanted more rapid growth in output and money. There was general agreement that unemployment would increase in 1971. James Duesenberry (Harvard), James Tobin (Yale), Franco Modigliani and Paul Samuelson (MIT), and Robert Gordon (Northwestern) urged the Federal Reserve to adopt a target of about 9 percent for nominal GNP growth to get 5 percent real growth. They wanted 7 to 9 percent M
₁
growth whatever the interest rate might be.
²⁰⁵
Milton Friedman (Chicago) warned that the proposed policy would fail because inflation would increase. The result would be only 3 percent real growth and 6 percent inflation. He urged slower money growth, equivalent to less than 5 percent M 1 growth (Maisel diary, December 2, 1970, 135).

205. The belief that inflation would be lowered without a recession was held widely at the time. Governor Brimmer reported on the November 16 and 17 meeting at the OECD. The OECD’s staff reported that the inflation problem affected all member countries. (They had a fixed exchange rate.) It had proved “more difficult to stem, particularly through demandmanagement policies, than would have seemed likely on the basis of experience in the earlier part of the 1960s. . . . A permanent and significant rise [in unemployment] would not be acceptable; nor would it necessarily be an effective barrier against inflation over the longer run” (memo, Brimmer to the FOMC, Board Records, December 4, 1970, 2). The memo then turned to the importance of lowering inflationary expectations. It concluded that “there was general agreement with the broad lines of the Secretariat’s inflation report” (ibid., 3). Of course, the secretariat did not explain how countries could lower inflation expectations while acting to reduce unemployment.

Tobin’s argument was close to mainstream academic views at the time. The reason he wanted 8 to 10 percent money growth was to reduce longterm rates. He made no mention of inflationary expectations preventing a decline in long-term rates or precipitating an increase on the reasonable belief that the System had abandoned its effort to reduce inflation. Instead, he urged that unemployment above 5 percent “should in the long-run bring prices down to growing by 2 percent or less. . . . Unemployment above 5 percent should cause prices to fall even as output rose” (ibid., 136).

Samuelson, Gordon, and Friedman agreed on one point: “Employment should not be sacrificed for the exchange rate parity.” This was a critical point because European officials complained that as domestic interest rates fell, New York banks repaid euro-dollar credits, increasing the dollar outflow and making it difficult for them to control near-term inflation. European complaints resonated at the Board and the FOMC. The Board discussed several proposals to restrict euro-dollar repayments by offering to auction repurchase agreements with payment only in euro-dollars, or marginally lower reserve requirement ratios for banks that held euro-dollars, and other inducements to encourage banks to hold their euro-dollars. The Board made no decision at the time (ibid., 129–30).
²⁰⁶
A few days later, on November 30, it raised reserve requirements against future euro-dollar deposits from 10 to 20 percent and increased lending ceilings for a few banks so they would not have to repay euro-dollars. This reduced eurodollar repayments temporarily, but it did not stop European inflation.

With Francis dissenting, the December meeting shifted back to money market conditions. The ostensible reason was that end of the strike made the monetary aggregates harder to interpret, but Daane, Hayes, and others always preferred the old procedure that gave more discretion to the manager and required less variability of short-term interest rates.

A more basic problem concerned information and timing. The manager could see the interest rate at any moment during the working day. The number was not subject to revision, seasonal adjustment, or changes in its components. The money stock was available weekly, subject to seasonal correction and revision. Furthermore, the manager knew what to do when transitory changes in currency, Treasury balances, or other variables pressed for a change in interest rates. He supplied or withdrew reserves and allowed money growth to change. If he mistook persistent changes as transitory, money growth rose. Monetary policy became more expansive
than intended. Targeting money growth resolved that problem in principle but created another bigger problem for the account manager—deciding how much of the money stock change to offset.

206. The U.S. payments deficit was $3 billion in the quarter and $9.8 billion for the year. Nearly 70 percent appeared as an increase in West Germany’s reserves.

The basic problem was the difference in relevant time frames, as Axilrod’s paper on the directive had recognized. The manager’s time frame was the very short-term market period. The relevant period for money growth was longer because many short-term changes reversed soon after. The manager was trained to deal with all transitory market fluctuations; only the persistent changes in money growth were relevant. The manager could understand and implement an even keel policy that called for a constant market interest rate during Treasury financing. He supplied any addition to reserves that the market demanded. No one told him exactly how to implement even keel policy with a money growth target. Keeping reserve or money growth constant was not a close substitute for the manager.

The proviso clause attempted to solve the problem by letting the manager adjust for persistent deviations in money growth from a chosen path. He never developed the requisite tools or procedures, and the FOMC did not supply them. The FOMC debated actively whether it wanted money growth at 4.5 or 5 percent, but it spent almost no time on implementation.

Despite these unresolved problems, the manager came close to the preferred growth rates at quarterly frequency. Table 4.10 shows forecast and actual growth rates reported in the FOMC transcripts for the period in 1970 when the FOMC set money growth targets and the revised growth rates reported subsequently. Except for the third quarter, when the Board suspended regulation Q ceiling rates for thirty to eighty-nine days on CDs over $100,000, the manager maintained quarterly money growth rates close to forecast where we have comparable data.

The monetary forecasts were more accurate than the inflation forecasts. The staff predicted inflation of 3.9 in 1970. Actual inflation was 5.1 percent (Lombra and Moran, 1980, 21).

The year ended with further evidence of the division within the Board between those who wanted more expansive policies to reduce unemployment and those who wanted less to reduce inflation. As market rates fell, Boston requested an additional discount rate reduction, to 5.25 percent in late December. The Board declined, partly responding to the discontent of the New York officers and directors over the two previous reductions. The reduction to 5.25 percent was made early in January 1971 (Maisel diary, December 21, 1970, 149).
²⁰⁷

207. At year-end, the Board also considered steps it might take to encourage banks not to let euro-dollar holdings decline. The Board had tried exhortation with modest success. Inter
est rates had fallen in the United States both absolutely and relative to Europe. Hence banks reduced euro-dollar borrowing, increasing the capital outflow. The Board discussed some proposals to subsidize banks that held euro-dollars, but it did not ad
opt any.

The main reason for the January 7 reduction in the discount rate was that the Board followed the market down. Between December 20 and January 7 open market rates had declined so that “almost all boards of directors agreed that it was a proper move simply keeping up with the market” (Maisel diary, January 13, 1971, 4). Soon after, Boston asked for another reduction to 5, again following market rates down. The Board hesitated because it was only eight days since the previous changes. Nevertheless, the gap between the discount rate and the market rate was wider than eight days earlier. Those who opposed agreed that if market rates declined further, the change would be appropriate. “While we were still debating . . . [One of the staff] brought in a ticker item indicating that the prime rate had been moved down by Citibank” (ibid., January 15, 1971, 15). The Board reduced the discount rate to 5 percent effective January 19 at seven reserve banks. The others soon followed.

Market rates continued to fall. Effective February 13, the Board reduced the discount rate for the fourth time in three months. The rate was now 4.75 percent, one percentage point lower than in mid-November. The initial vote was four to two, with Sherrill absent. After further reflection the vote was unanimous.
²⁰⁸

208. Initially, Daane dissented for balance of payments reasons. He left the meeting to
speak to Treasury Undersecretary Paul Volcker, who said “it would be good for balance of payments reasons for Daane to dissent . . . [but] would not be good for domestic reasons. He would get himself into trouble with the Administration. Therefore, it was up to him to decide for himself.” The other dissent was from Brimmer, who did not want to remain the sole dissenter (Maisel diary, February 23, 1971, 23).

PRESSURES FOR WAGE-PRICE POLICY

Shortly after Arthur Burns became Federal Reserve chairman, he began to talk publicly about wage-price policy. As time passed, qualifications about possible ineffectiveness disappeared from his speeches, and institutional mechanisms took a larger role. It seems odd that Burns would abandon his long-standing opposition to wage-price policies, particularly since the change occurred within a few months of his accession to the chairmanship. He noted that unemployment had increased but wage rates and commodity prices continued to rise. Burns had spent his life as an empirical economist, but he offered little evidence to support his position that the economy had changed. An alternative explanation was that the so-called natural rate of unemployment had increased from the 4 percent level assumed at the time. Orphanides (2003a, 656–59) makes this argument persuasively.

His new belief was that so-called cost-push inflation, resulting either from union pressures or more general social pressures, was a new source of inflation and inflation bias. Burns (1978, 92–93) at first joined those who attributed the bias to “social aspirations” for high employment, sustained growth, and rising government spending. A main difficulty with this reasoning was that the Eisenhower-Martin policies in 1959 had brought inflation near zero in 1961–62. Thereafter, inflation remained low for several years. The cost was a peak unemployment rate of 7.1 percent. Both Nixon and Burns believed that this policy cost Richard Nixon electoral victory in 1960. Both wanted to avoid repetition in 1970 and especially in 1972. Burns was reluctant to repeat the experience. The reason was entirely political.

In February 1961, economic expansion resumed and the administration’s expectation of an early upturn was vindicated; but before this happened,
the
nation’s
electorate
decided
in
a
close
presidential
election
to
entrust
power
to
the
Democratic
party.
(ibid.; emphasis added)

Burns later offered an explanation of his changed view.

An effort to offset, through monetary and fiscal restraints, all of the upward push that rising costs are now exerting on prices would be most unwise. Such an effort would restrict aggregate demand so severely as to increase
greatly the risks of a very serious business recession. If that happened, the outcries of an enraged citizenry would probably soon force the government to move rapidly and aggressively toward fiscal and monetary ease, and our hopes of getting the inflationary problem under control would then be shattered. (Burns, 1978, 98)

Burns did not simply opt for the neo-Keynesian position of the Kennedy-Johnson or Nixon CEAs. He rejected their idea that a slight reduction in growth would lower inflation. He thought he had to avoid as counterproductive a “serious business recession.” Although in May he recognized that at home and abroad wage-price or income policies “have achieved relatively little success” (ibid., 99), he soon dropped that cautionary note. By December, and perhaps before, he no longer mentioned past lack of success. His suggestion was to establish a “high-level price and wage review board which, while lacking enforcement power, would have broad authority to investigate, advise, and recommend” (ibid., 114).

In a December speech, Burns explained his new reason for choosing incomes policy. “We are dealing, practically speaking, with a new problem— namely persistent inflation in the face of substantial unemployment—and that the classical remedies may not work well enough
or
fast
enough
in this case” (ibid., 114–15; emphasis added). To amplify “fast enough,” Burns referred to “the limits of our national patience” (ibid., 115). Further, the problem was not due to excess demand; it resulted from rising wage demands that raised costs and prices.

McCracken and Stein at the CEA emphasized what Burns now neglected—that income policies of various kinds had failed everywhere they had been tried in the 1960s. But they made no response to Burns’s main political point—that the public would not accept a sizeable increase in unemployment to reduce inflation substantially. Nor did they say that the administration would accept responsibility for whatever unemployment rate was required to bring inflation down. When they spoke about unemployment, they wanted more monetary growth, not less.

The public’s concern about inflation waxed and waned with the unemployment rate. When inflation was relatively high and unemployment relatively low, public opinion showed support for anti-inflation policy. Once recession started, unemployment became a more important concern for the public and their representatives in Congress. This shifting lexico-graphic ordering of priorities continued through the 1970s.

Pressure for administration action on wages and prices came from many quarters. Large corporations with a unionized labor force wanted the government to “discipline” labor. Many groups complained about the
construction unions.
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Business hoped that government policy would control wages more than prices, eliminating or reducing what they regarded as cost-push inflation. Labor union spokesmen argued for better control of price increases that eroded nominal wage gains. The Democratic Policy Council, chaired by Gardner Ackley, wanted more stimulus and wage-price guidelines. Congress added to this pressure in August 1970 by authorizing the president to impose formal wage-price controls at his discretion.