A History of the Federal Reserve, Volume 2 (125 page)

Maisel, in discussion with Burns, critiqued Burns’s view that the money growth of more than 10 percent in the first seven months of 1971 “had raised expectation so rapidly that they were having an inflationary impact on the economy and they were raising interest rates. Therefore, if the rate of [money] growth was slowed down, interest rates would fall” (Maisel diary, August 13, 1971, 78–80). Maisel argued that this was monetarist reasoning and “now known to be wrong.”

Maisel’s explanation was that until recently business and the administration “had improperly assumed that there was no cost-push and that, as a result, when demand-pull disappeared, prices would come down rapidly. The inflation would be ended. . . . [T]he experience of the past six months had shown business that this was wrong. . . . [P]art of the increase in inflationary expectations had simply been a recognition of this fact now by investors and business who had not recognized it previously” (ibid., 78–79). This explanation allowed wage-price policy to lower expectations by lowering inflation. It could explain an additional increase in inflation and expectations only by assuming that unions or workers had not yet used all their market power.

Maisel told Burns that a 6 percent average money growth rate was too low. If the System didn’t expand money enough “to take care of wage-price push, you would get high nominal and high real rates . . . with a great deal of unemployment” (ibid., 80).

Maisel did not report that Burns either accepted or rejected his reasoning. He thought that Burns “ partially buys the monetarists’ views that money must come out in prices rather than the opposite view that the increase in money may be demanded by the increase in prices”
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(ibid., 79). The only agreement that he reported was that the administration “will attempt to blame the Federal Reserve for whatever happens in the economy particularly if inflation is continuing” (ibid.). The last was a continuing concern.
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235. The latter was the argument used by officials of the German Reichsbank in 1922–23, when they generated hyperinflation.

236. At about this time, the Lockheed Aircraft Company faced bankruptcy. Burns feared that Transworld Airlines, Eastern Airlines, and others would follow. Both had made substantial deposits for delivery of a new Lockheed plane. Burns proposed a permanent $2 billion fund to guarantee corporate loans up to $250 million (Wells, 1994, 69). The Board endorsed Burns’s proposal for a permanent agency but did not take a stand on the narrower proposal (Board Minutes, July 3 and August 3, 1971). Congress passed a narrow proposal, a $250 mil
lion guarantee for Lockheed, by a margin of only one vote in the Senate. Wells (ibid., 70) reports that the experience changed Burns’s view about bailouts for large corporations. He served on a three-person board with the Secretaries of Treasury and Commerce. “He became unhappy with Lockheed, which missed its timetable, fell short of performance goals, and became involved in a scandal” with the Japanese government. Haldeman (1994, 335) reported that Governor Reagan of California supported the assistance because “if we lost the vote, it would be critical to our chances in California in ’72.”

REGULATORY AND ADMINISTRATIVE ACTION, 1965–71

The years of rising inflation were also years of increased regulation. The relation was not entirely accidental. Many of the regulations responded to consequences of rising inflation. The Board was slow to increase ceiling rates on time deposits, as shown in Chart 4.13 above. Banks developed new ways to borrow that avoided both ceiling rates and reserve requirements. Increases in ceiling rates enabled banks to compete more effectively with other thrift institutions for time deposits, so in 1966 regulation spread to savings and loan associations. Laws against payment of interest on bank reserves and bank deposits became more costly to depositors as inflation rose. Banks and their customers had a common interest in economizing on cash balances and bank reserves.
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Banks responded also by withdrawing from Federal Reserve membership.

Growth and development of financial institutions created new opportunities for political intervention and new problems. The Federal Reserve returned frequently to consider regulatory changes to rein in growth of commercial paper and euro-dollars. Trade expansion and increased overseas investment by U.S. corporations induced banks to establish branches abroad. Government programs to restrict capital outflow added to the Board’s regulatory burden.

After many years of effort by System officials, Congress gave the Board power to regulate one-bank holding companies. Between 1956 and 1970, the number of holding companies increased from 428 to 895 and the number of their branches increased from 783 to 3260 (Board of Governors, 1976). In the same period, the number of banks rose from 11,815 to 13,100, but the number of member banks fell from 6456 to 5773, reflecting higher costs of membership in an inflationary era. The Federal Reserve was successful in reducing the number of banks that charged check collection fees to their customers; the number of non-par banks fell from 1754 to 501.

237. Axilrod explained that the staff and some of the members believed that controlling money meant control of credit and that regulation Q kept bank credit under control. “There was a body of opinion that was fairly strong for a long time that what was important wasn’t the money supply, what was important was bank credit” (Axilrod, 1997).

Release
of
Information

To commemorate its fiftieth anniversary in 1964, the Federal Reserve began to deposit records of the FOMC from 1936 through 1960 at the National Archives. Other records followed as part of a program to make available to scholars and other interested parties information on central banking. This first step was a notable departure from traditional central bank secrecy.

Two years later, Congress approved the Freedom of Information Act (FOIA), which opened to the public the files and records of many government agencies. The Federal Reserve wanted to be exempt from FOIA, but it did not fully succeed. The law permitted exemption for national defense and foreign policy. The latter permitted the System to exempt international transactions. Special treatment of commercial information allowed the System to delay release of domestic open market information for several weeks. A court ruling eventually supported this argument.

The Board was able to exempt large parts of its information about individual banks obtained by examiners or personnel, or contained in interagency or intra-agency memoranda. In a break with the past, it agreed to release more promptly the material on open market operations and foreign currency transactions that had hitherto appeared in the Board’s Annual Report. Release would be made ninety days after a meeting.

The reserve banks are not part of government, so they are not subject to FOIA.
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Reserve banks have records and information about open market operations and other activities that involve the Board. Each bank established procedures for separating requests for the two sources (memo, Alan Holmes to Securities Department, Box 007973, FOMC, New York Reserve Bank, July 5, 1967).

Regulations
Q
and
D

As the cost of interest rate regulation rose, banks and financial institutions sought ways to circumvent the rules without violating them. Lawyers and bureaucrats make regulations. Markets decide if and when to circumvent them. The Board soon found that it had to use time and other resources to resolve many issues. The Board was aware that money market funds by
passed their regulations. It took small steps to help the banks and thrifts, but it did not step back to consider the general problem (Brimmer, 2002, 18).

238. In the San Francisco National Bank case, a judge ruled that the Federal Reserve Bank of San Francisco was not liable for damages arising from the bank’s failure. The judge ruled that the Federal Reserve Bank was an agency of the federal government under the Tort Claims Act. The reserve bank had loaned more than $9 million to San Francisco National. Out-of-court settlement prevented the appeal from being heard (Board Minutes, February 19, 1968, 3–
8; October 28, 1968, 5).

Time deposits were subject to regulation Q ceilings and to reserve requirements under regulation D. To avoid these costs, banks began borrowing on promissory notes. Since the notes were not time deposits, they were not subject to regulations D and Q.

To close what it regarded as a loophole, the Board proposed to amend regulations Q and D to define promissory notes and other forms of indebtedness as deposits. If the note had an original maturity within less than thirty days, it was deemed a demand deposit. No interest could be paid. Discussions with the Interagency Coordinating Committee, consisting of the Federal Reserve, the Treasury, the Federal Deposit Insurance Corporation (FDIC), the Comptroller of the Currency, and the Federal Home Loan Bank Board (FHLBB), began in January 1966. The Comptroller objected to proposals that would make promissory notes subject to deposit regulation. He told the group that if a national bank challenged the ruling, he would join with them against the Board.

The rule as written at the time would include repurchase agreements and promissory notes. Alan Holmes, the account manager, objected that the proposed rule would be disruptive because it would eliminate payment of interest on any debt with maturity of less than ninety days. Banks would have to refinance $2 billion of repurchase agreements. The legal counsel, Howard Hackley, pointed out that promissory notes and repurchase agreements were different instruments serving the same purposes. It would be difficult to write rules prohibiting one and permitting the other (Board Minutes, January 11, 1966, 2–22).

The Board tried to resolve the issue by regulating promissory notes explicitly. On June 24, the Board raised reserve requirements on time deposits in excess of $5 million at any bank and, effective September 1,1966, included promissory notes as deposits. On August 17, the Board increased the reserve requirement ratio to 6 percent.
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“To help forestall excessive interest rate competition among financial institutions,” on July 15, 1966, the Board lowered the maximum rate on multiple maturity time deposits. A deposit issued for (say) 90 days and renewable at the same interest rate for another 90 days could receive a
5 percent interest rate compared to 5.5 percent on a 180-day certificate. If the renewal lender had the option of calling for payment in 30 days, the rate dropped to 4 percent (Board Minutes, July 15, 1966, press release).

239. The new regulation was only a few months old before a bank attempted to circumvent it. The Edge Act (foreign) subsidiary of Morgan Guaranty Trust (New York) issued promissory notes in exchange for foreign loans. The bank endorsed the notes and sold them under repurchase agreements. Morgan Guaranty claimed that these were not deposits under the new regulation, and therefore not subject to reserve requirements. The Board rejected the claim (Board Minutes,
March 27, 1967, 10).

Apparently the Board had not yet learned that each new regulation encouraged search for ways to circumvent it. The Board’s early (1922) definition of a deposit distinguished only between deposits, trust funds, and capital. Funds received in trust or as capital remained free of reserve requirements. The September 1966 redefinition of “deposit” to include promissory notes reduced banks’ reliance on such notes. The new definition included all “funds to be used in its banking business, except any such instrument (1) that is issued to another bank, (2) that evidences an indebtedness arising from a transfer of assets that the bank is obligated to repurchase, or (3) that has an original maturity of more than 2 years and states expressly that it is subordinated to the claims of depositors” (memo, Definition of “deposit” in regulations D and Q, Correspondence Box 240, Federal Reserve Bank of New York, February 3, 1969, 1–2.).

The first two exceptions provided opportunities for avoiding regulations Q and D. One of the New York banks began issuing “participation certificates” that gave the holder claim to a share of the bank’s loan portfolio but guaranteed to repurchase the certificate. This met the second exception, so the bank could offer interest rates above the regulation Q ceiling. In September 1968, the Board redefined deposits to cover these transactions. Banks purchasing the certificates would be deemed to hold deposits (ibid., 2).
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In 1966, the Board also requested new legislation to permit it to set different ceiling rates for different classes of accounts, for different amounts, different maturities, “according to the nature and location of the institutions, or the account holders, or any other reasonable basis” (ibid., 2). The legislation would apply to the Federal Deposit Insurance Corporation, the Federal Home Loan Bank Board, and the Board of Governors.
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The Board returned again to consider reserve requirements graduated by size of deposit instead of the bank’s location. The Board had considered this topic since the 1930s without adopting it. This time proponents wanted to slow credit expansion at large country banks. Population move
ments had encouraged economic and bank expansion in formerly rural areas, but a principal reason for using graduated reserve requirements by size was to lower the cost of membership for small and intermediate banks.

240. Exemption of foreign branches of U.S. banks created difficulties also. Banks opened branches in the Bahamas and elsewhere; the Board required banks to stipulate that the branch would not be used to transfer deposits from the United States.

241. At one point, the Board considered defining a time deposit by the size of the deposit because it wanted to regulate large deposits separately for political reasons. Legal counsel explained that the Board did not have that authority (Board Minutes, March 25, 1966, 4–5). In addition to problems arising from the number of instruments that would be affected by any new regulation, the Board learned about laws of several states that would affect banks in the state adversely.