A History of the Federal Reserve, Volume 2 (26 page)

Martin defended the decision, citing the limits that he always placed on Federal Reserve independence and the need to assist in Treasury finance. At the Senate Banking Committee hearing on Martin’s reappointment as governor and Chairman, Douglas was critical also of the 1955 decision to raise the discount rate four times instead of increasing reserve requirement ratios. The latter had the effect of transferring additional earnings to the Federal Reserve and later to the Treasury. Martin explained that “our policies are not directed to rewarding or punishing banks” (memo, Reserve Board Policy, Board files, January 20, 1956, 1). Douglas remained dissatisfied and abstained on the vote to reconfirm Martin.
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Responding
to
Inflation
and
Variable
Growth

At the end of 1955, the FOMC looked back on a year of high and rising economic activity with a general feeling of confidence. Most of the members expressed concern about the easier market conditions following support of the Treasury offering, although there is no evidence in free reserves or short-term interest rates of more than a small change.

A 19 percent increase in real expenditure for plant and equipment was the major source of the 1955 boom. By early 1956, the boom began to slow. Growth in 1956 was highly variable, weak in the first and third quarters, stronger in the other two quarters. Unemployment was much less variable, remaining between 3.9 and 4.3 percent throughout. The Federal Reserve changed its direction several times, first recognizing the slowdown early in the year, then the renewed acceleration of investment and output and, still later, renewed deceleration followed by acceleration at year-end. A steel strike during the third quarter temporarily restrained industrial produc
tion and output and contributed to inventory building followed by destocking. In November, the directive recognized “international conditions” for the first time in the postwar years.

136. The vote was twelve to zero to confirm. At a later hearing, Martin discussed relations with the administration. The issue was the contentious 1956 increase in the discount rate, but it suggests the extent of coordination and independence at the time.

In February of that year [1956], Governor Balderston and I had a meeting with Secretary Humphrey and there was a disagreement as to the nature that the economy was developing. We were so convinced; we discussed it with various people, and in a series of meetings from about the middle of February until the last week in March the position of the Federal Reserve . . . was . . . to go up in the discount rates. . . . [T]here was no “meeting of the minds. . . . [W]e acted.” (Senate Committee on Finance, 1957, 1362)

At the hearing, Douglas asked Martin for the names of the FOMC members who voted to support the Treasury issue. Martin agreed to supply the names if the FOMC members agreed. Later, he forwarded the names to the Senate committee.

Inflation reappeared. The annual rate of consumer price increase rose from 0.25 percent at the start of the year to 3 percent at the end. The disparity between the rise in the consumer prices index and GNP deflator narrowed. Both showed evidence of inflation. One common interpretation attributed the rise to wage pressures that raised production costs. Sproul considered two possible outcomes. Higher prices “might encounter consumer resistance which would have a dampening effect on production and employment, or . . . it might generate an inflationary spiral (Sproul papers, FOMC comments, March 27, 1956, 1).
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For the first time, Sproul recognized publicly that the Employment Act created conflict over what the Federal Reserve should do. “Should it expand to try to head off a decline in production and employment[?] The second and more difficult case would raise questions as to whether the central banking system should make credit so dear and difficult to obtain as to cause a decline in production and employment as the lesser of two evils. We haven’t yet had to run head-on into the philosophy of the Employment Act of 1946 to that extent and it wouldn’t be easy, so maybe we had better hope that some degree of economic responsibility on the part of management and labor will avoid presenting us the problem in serious form” (ibid., 1–2).

Others did not comment and may not have shared Sproul’s view. Martin and others argued that the System had to finance part of the Treasury deficit but could control inflation resulting from private actions. Sproul’s statements suggest some doubt about the System’s willingness to create unemployment to stop price increases.

The Federal Reserve’s response to changing conditions left no imprint on member bank borrowing or growth of the monetary base. Monthly average borrowing remained in the $700 to $800 million range, and annual growth of the monetary base fluctuated around 1 percent. The monthly average for the federal funds rate rose steadily from January through September, then remained just below 3 percent. With inflation rising, expost real interest rates declined during the year. If we accept the Livingston Survey, Chart 2.10 above, forecasters did not anticipate inflation. Even a
reported 3 percent inflation rate did not raise anticipations above 1 percent.
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These data suggest, therefore, that the rise in inflation was largely unanticipated.

137. Sproul does not explain why prices would continue to rise. He may have believed that workers would try to restore real wages, but this point was never made. Arthur Burns at the Council urged the Federal Reserve to ease, despite the inflation. On this and other occasions during his years at the Council, he did not hesitate to pressure Martin and the Federal Reserve. Later, as Martin’s successor, he objected vigorously to “interference” by the administration.

Rising nominal short- and long-term interest rates and rising inflation reduced desired money balances per unit of output and raised monetary velocity. Expost, the rise in monetary velocity explains by far the largest part of the 5.5 percent reported increase in nominal GNP for 1956.

Slow growth at the start of 1956, a presidential election year, alarmed the president and some of his advisers. Arthur Burns at the Council of Economic Advisers wanted an easier policy at the first sign of slower growth in January. Others in the administration joined in the public criticism of the Federal Reserve, and Congressman Patman held hearings on the conflict (Kettl, 1986, 89). Later, Burns admitted that Martin had been right (Hargrove and Morley, 1984, 104).
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Eisenhower remained in the background but encouraged the effort. When the conflict became public, he supported the Federal Reserve’s independence, and the conflict ended.
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The administration’s concerns about Martin and the Federal Reserve did not prevent renomination and reappointment, effective February 1956, to a full fourteen-year term as a governor and a new four-year term as chairman. Martin’s principal critics at Senate hearings on his reappointment expressed two main concerns: the Federal Reserve would be too independent and would forget that it was a creature of Congress; and the
bills-only policy kept long-term interest rates too high, thereby reducing investment.
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138. Chart 2.10 compares actual inflation to the anticipations in the annual survey taken one year before. The Livingston survey taken in 1957 did not show much response to the 1956 data. Croushore (1997) surveyed the literature on bias and rationality of the Livingston Survey. He concluded that both bias and rationality of forecasters’ anticipations were not easily supported or rejected for the entire data set. Forecasts for the 1950s, however, appear systematically biased downward by about one percentage point (ibid., 6).

139. Burns claimed that his relations with Martin remained cordial. “[I]t’s hard to have a clash with Bill Martin” (Hargrove and Morley, 1984, 104). His relation with Secretary Humphrey was less pleasant. There were many clashes based both on personality and substance.

140. The Joint Economic Committee (1956a) held hearings on the discount rate change at which Secretary Humphrey and Chairman Burns testified against the increase. At Eisenhower’s urging, Humphrey told Martin before the meeting that he should resign instead of opposing the president. Martin replied that he would resign if his leadership were to be opposed by the administration and informed the Board about his possible resignation. Humphrey and Burns continued to press the president to criticize Martin, but Eisenhower, after talking to Martin and receiving a promise to ease credit if the economy slowed, decided against. He said later that “overruling of the financial experts with a purely political judgment” was not in order (quoted in Saulnier, 1991, 87). Eisenhower subsequently responded to questions from the press on April 25 and May 4. On both occasions, he expressed confidence in the Federal Reserve and added, “I personally believe that if money gets . . . too tight, they will move in the other direction” (FOMC Minutes, May 9, 1956, 24–25). The minutes of this meeting include excerpts from Eisenhower’s press conferences. Some business leaders criticized the increase also (Bach, 1971, 260).

Martin’s desire to build a consensus slowed the System’s response to economic weakness. The FOMC first noted public comments about an economic downturn at its January 10 meeting. Young dismissed the comments as overly pessimistic and without empirical support. Others were less certain. Delos Johns (St. Louis) favored less restraint because growth had slowed. Joseph Erickson (Boston) and Oliver Powell (Minneapolis) reported slower growth also (FOMC Minutes, January 10, 1956, 2, 10, 16, 21). These were minority views. The FOMC took no action.

Policy change received more support two weeks later. The FOMC recognized uncertainties in agriculture, housing, and automobile markets. Perhaps in response to administration criticisms, Martin disagreed with the consensus at the meeting (FOMC Minutes, January 24, 1956, 7–8). He favored some easing to a level of free reserves close to zero, an increase of $250 million. The committee agreed to return to the directive in effect in June 1955.
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It continued the instruction to restrain inflation but added that the manager should also take “into account any deflationary tendencies in the economy” (FOMC Minutes, January 24, 1956, 21). Free reserves remained unchanged in February.
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141. Senator Paul Douglas did not vote for Martin’s reconfirmation. Douglas opposed the bills-only policy and criticized Martin for unwillingness to respond to congressional criticisms of the policy. Douglas repeated Martin’s own words back to him: “I have had typed out this little sentence which is a quotation from you. ‘The Federal Reserve Board is an agency of the Congress’” (U.S. Senate, Committee on Banking and Currency, 1956, 5). Several senators criticized the departure from bills-only in 1955. At the same hearing, Senator Fulbright said, “I do not believe there is any real independence” (ibid., 67). Martin defended the System but repeated that his view of independence within the government meant that “it is our endeavor to see that the Treasury is successfully financed. . . . neither the Treasury nor the Federal Reserve benefit by having the Treasury fail” (ibid., 22).

142. Martin made the following statement suggesting dissatisfaction with free reserves as a policy target but not offering a substitute: “We may say that we should maintain the pressure we now have in the market but I do not believe we or the public knows what the degree of pressure is that we are maintaining” (FOMC Minutes, January 24, 1956, 17). Martin went on to argue that the manager should have more flexibility—“putting our foot on the brake pedal but not pressing on the brakes” (ibid., 17). He was reluctant generally to cede authority to the manager but unable, or unwilling, to go beyond picturesque imagery to issue precise instructions. Martin then referred to the November election and the pressure to ease policy. “[W]e ought to make it plain that we are not being influenced by political considerations . . . But that is just digging the System’s grave so far as effective policy is concerned” (ibid., 18). The reference is unclear but probably refers to criticisms of bills-only. Martin stated that he referred to the ability to carry out policy, not a political threat to formal independence.

143. In February, Martin testified on the renewal of authority to purchase limited amounts of securities directly from the Treasury. He presented a table showing the amounts outstanding since March 1942, when the authority began. The maximum amount outstanding was $1.3 billion in March 1943. Usually the amounts were much smaller, and there are several
years in which no borrowing occurred (Martin testimony, Board Records, v. 1, Statement, February 29, 1956).

Martin stated the consensus at the February 15 meeting as requiring no change in the directive but the trend should be toward ease, rather than restraint. Robertson, who favored restraint, challenged the interpretation, one of the few times this happened in Martin’s tenure as chairman. The committee voted to keep the directive unchanged but did not discuss Robertson’s objection or Martin’s response. This left the decision to the manager or to the New York bank. Most weekly average market interest rates remained unchanged until April.
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The Federal Advisory Council did not share the concern about growth. Members told the Board that they expected the high level of activity to continue, and they warned that prices might rise. Higher minimum wages enacted by Congress would raise wages across the entire wage structure (Board Minutes, February 21, 1956, 13).
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Adding to concern, the Board’s staff reported that growth of industrial production and gross national product had stagnated and the prices of industrial materials had increased “substantially” in the past year (FOMC Minutes, March 6, 1956, 27). Conditions in the economy seemed mixed. The staff favored an increase in discount rates and fewer open market purchases. The Treasury had an offering, so the FOMC did not approve a change in policy until the March 27 meeting.
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144. The committee agreed to permit the International Monetary Fund to invest $200 million in U.S. Treasury bills, to treat the purchases in the same way that it treated purchases by foreign governments, and to prevent such purchases or sales from affecting policy objectives.

145. In November, Governor Robertson proposed that the Board ask Congress to amend the Federal Reserve Act to permit member banks to count vault cash as part of required reserves (Board Minutes, November 1, 1955, 10). The Board asked the Federal Advisory Council to comment on the change. The change was in their interest, so they voted eleven to one to make it. When adopted the proposal would reverse the 1917 decision by amending Section 19 of the Federal Reserve Act. The Board’s proposal sought to use a defense emergency as the reason for the change. The reserve bank presidents favored the change, but they did not want to limit the change to a defense emergency (Board Minutes, January 25, 1956, 2–4). The Board agreed to submit a request for legislation. The change did not become effective until 1959–1960, when the Board, in steps, allowed vault cash to be counted as part of reserves. The Board could not anticipate the importance of the change; it occurred before automated teller machines (ATMs) became available. By the 1980s, many banks could satisfy their required reserve holdings with the vault cash in their ATMs. In effect, the required reserve ratio was no longer a binding constraint.

146. The committee voted to allow the New York bank to continue operations in the bankers’ acceptance market. Robertson objected strenuously on the grounds that intervention interfered with the development of a free market. No one seconded his motion to terminate operations. A memo that the manager prepared for the meeting partly supported Robertson’s position. The memo noted that System activity in the acceptance market had negligible effects on trade finance. Operations had helped dealers hold acceptances, especially when the market
was under “strain,” but rates had not become more flexible. Dealers pressed for purchases when market rates started to rise (memo, Rouse to FOMC, Board files, March 2, 1956, 1–7). The March 6 meeting also reappointed the manager. Martin voted for the appointment but noted that he objected to the procedure under which the New York directors chose the manager and promised to have a committee meeting to recommend new procedures. This issue had been left unresolved since the 1952 ad hoc committee report.