A History of the Federal Reserve, Volume 2 (31 page)

Finally, on August 8, as the economy reached a peak, the Board approved requests from four banks to raise their discount rates to 3.5 percent, the highest nominal rate since February–March 1933. Governor Vardaman opposed the increase but voted for it to make the vote unanimous (Board Minutes, August 8, 1957, 5). Within the month, all other banks followed. New York and Cleveland came last, two weeks later.
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The August 8 decision came two days after major banks raised their prime lending rates. This removed one of the obstacles, reluctance by some governors to lead the market up. A problem with their argument is that rates on a wide variety of instruments had increased much earlier; Treasury bill rates had been above the discount rate since May. Following the announcement, open market rates rose higher. Federal funds reached 3.5 percent by the end of August; in September, Treasury bill rates were again above the discount rate. Banks continued to borrow $900 million to $1 billion of reserves. With reported inflation at 3 to 3.5 percent, the real value of the discount rate remained near zero. Misled by the nominal rate, the Federal Reserve thought it had acted decisively.

At his reconfirmation hearing in 1956, Martin had described the Federal Reserve’s objective as “leaning against the wind.” Whatever he may have intended, the System was slow to act against rising inflation. The variable growth of output explains part of the delay. Neglect of the difference between real and nominal rates, concern for Treasury refinancing problems, and reluctance to raise rates to levels not experienced in twentyfive years played a role also. The problem of agreeing on effective action returned many times in the next twenty years.

Martin’s style also played a role. He worked by consensus, rarely leading the FOMC by speaking first. He could shade the interpretation, when the committee was close to a consensus, but his procedure did not lead to a decision when the committee divided. In 1957, Hayes and others did not share his views or accept his warnings about the dangers of inflation. There was no consensus and no action.

181. Trieber (New York) explained that the New York directors believed the outlook was “less buoyant.” The policy of restraint seemed “to be achieving its objectives” (FOMC Minutes, August 20,
1957, 11).

Short-term interest rates remained about equal to the inflation rate, but long-term rates rose in the spring and summer partly reflecting the expectation that inflation would continue. The combination of strong domestic and foreign demand for goods, slow growth of the monetary base, rising domestic costs of production, and a 10 percent (about $1) increase in the price of crude oil slowed the economy. Chart 2.11 shows that growth of the real monetary base remained negative for more than a year before the end of the expansion and declined at a rising rate early in 1957. Expost real interest rates fell during 1956 and remained near zero early in 1957; rates rose modestly after the first quarter but remained below 1 percent. Once again, the shrinking value of the real base more than offset the stimulus from falling real interest rates early in the year. Later, the rising real rate modestly reinforced the effect of negative real base growth, slowing the economy and contributing to recession. These measures suggest that monetary policy was again procyclical.

THE 1957–58 RECESSION

The National Bureau chose August as the peak of the expansion. As in 1929, the discount rate increase came too late. Unlike in 1929, however, the recession was brief, lasting only eight months. It was not mild. The National Bureau ranks the severity of the 1957–58 recession in the middle of fourteen recessions from 1920 to 1982 (Zarnowitz and Moore, 1986, Table 7). Industrial production and real GNP fell 13.5 and 3.3 percentage
points respectively. The unemployment rate reached 7.5 percent (after the cyclical trough) and, for the first time in a postwar cycle, remained above 7 percent for six months.

The Eisenhower administration relied heavily on the Federal Reserve and the built-in fiscal stabilizers as the economy slowed, but it substantially increased aid to agriculture, extended unemployment compensation benefits, and accelerated defense spending, reversing reductions made the previous year. Total outlays increased more than $15 billion, 20 percent of 1957 outlays. The result was a $3.3 billion budget deficit in 1958 and $12.1 billion in 1959 (Office of Management and Budget, 1990). The 1959 deficit was 2.5 percent of GNP, about the same as in 1953 (ibid., 17). By the standards of the time, these were large peacetime deficits.

The administration considered, but did not implement, a tax cut. President Eisenhower and Treasury Secretary Anderson expressed concern about the effect of budget deficits on future inflation and their desire for “fiscal responsibility.” They did the unusual—expressing concern for the long-term consequences of actions. They would propose tax reduction only if the recession appeared likely to deepen (Ewald, 1981, 288–89).
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President Eisenhower believed that the system would resume growing without additional stimulus (Saulnier, 1991, 10). The president neutralized political pressure for reduction in individual tax rates by asking Congress to act first on extension for one year of excise and corporate tax cuts approved earlier. By the time Congress acted, recovery was under way (Saulnier, 1991, 114). The Democratic leadership in Congress agreed to act together with the administration or not at all (Stein, 1990, 342–44).
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By spring 1957, R. J. Saulnier, at the Council of Economic Advisers, recognized that the economy had slowed. He urged the Federal Reserve to ease policy, but Martin and others were more concerned about current inflation than about possible future recession (Hargrove and Morley, 1984,
124–25).
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Eisenhower shared their concern.
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Further, Saulnier had a National Bureau perspective about fluctuations and recessions; they were partly a consequence of the previous boom, a natural result of excessive expansion. Contraction, in turn, would be followed by renewed expansion. But he believed, also, that monetary policy had been too restrictive.
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182. Vice President Nixon and Arthur Burns urged tax reduction but they were not successful (Stein 1990, 330, 342).

183. In the January 1958 Economic Report of the President, the Council recognized slow money growth in 1957 but did not assign responsibility for the recession (or use the word) (Council of Economic Advisers, 1958, 6). The president’s message blamed the inflation on business and labor and suggested that wage increases above productivity growth slowed the economy (ibid., v). The administration’s legislative program did not mention a tax cut or fiscal stimulus to moderate the recession. Emphasis was on achieving a budget surplus as the economy recovered (ibid., 55–57). A year later, the report highlighted monetary ease, extension of unemployment benefits, expanded government credit for housing, and other fiscal adjustments but also the resiliency of the private sector in a free economy (Council of Economic Advisers, 1959, 30–42). This list was opposite to the popular Keynesian view in its emphasis on the resiliency of the private sector.

The Federal Reserve responded slowly to the recession. The twelvemonth rate of increase in the CPI remained between 3 and 3.5 percent through the recession, although the rate of increase in the GNP deflator slowed. But the slow response to recession also reflected a delay in recognizing that a recession had started. Until mid-November, 2.5 months after the peak, the FOMC directive continued to call for “restraining inflationary developments in the interest of sustainable economic growth.” Although there was some recognition in September that the economy had slowed, and the FOMC made a small step toward easier policy at the October 22 meeting, it delayed major action until November, three months after the peak (Brunner and Meltzer, 1964, 67).
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At the September 10 meeting, both the staff and the members commented on growing pessimism about the outlook, but Hayes argued that it would be confusing to the market to ease policy so soon after raising the discount rate. Market rates had reached the 1929 level, and short-term
rates were above long-term rates.
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The consensus kept the directive and policy unchanged. Martin commented that they were making progress against inflation.

184. Saulnier described his difference with the Federal Reserve as “not a strong difference” (Hargrove and Morley, 1984, 27). Looking back, Saulnier did not regret that he had not urged a more expansive policy (ibid., 26). Opportunities for exchange of views increased in this period. In October 1957, the administration took a major step toward policy coordination and away from Federal Reserve independence. At Secretary Anderson’s suggestion, Saulnier, Anderson, Martin, and Gabriel Hauge (White House staff) began to meet with the president. This was a forerunner of the Quadriad meetings in the Kennedy administration. The press release recognized the innovation—the first official body to bring the chairman of the Board of Governors to a periodic meeting with the president and his advisers.

185. “We want to do everything that is feasible and practical to stimulate recovery, and at the same time keep our own financial house in order” (Ferrell, 1981, 353). Saulnier gave a more detailed account. The administration wanted to renew some excise tax reductions in March 1958. They did not want to mix these renewals with a tax cut, so they delayed a reduction in personal income tax rates until after the excise tax bill passed. By that time, the recovery had started. Also, Saulnier claimed that he did not expect the decline to continue or cumulate (Hargrove and Morley, 1984, 151–52).

186. “I think monetary policy helped bring it on. But, you know, when you go through a great capital goods boom, you are going to pay for it. It’s an unsustainable rate of increase” (ibid., 151). Statements of this kind suggest an inevitability about recession, a repeat in milder form of language about the Great Depression as “an inevitable consequence” of the previous boom. Later, Saulnier (1991, 99–100) changed his mind and blamed the Federal Reserve for the recession.

187. Romer and Romer (1994, 26) agree that November is the first month with a change in policy, but they describe the Federal Reserve as acting promptly. Boschen and Mills (1995, 43) date the policy change in N
ovember as well.

The Federal Advisory Council reinforced the FOMC’s sentiment. In mid-September, they told the Board that “business will continue strong for the balance of the current year” (Board Minutes, September 17, 1957, 2). The Council also reported a widespread belief that inflation was inevitable. It claimed that companies had increased plant and equipment spending to avoid higher prices (ibid., 13). The Council favored a continuation of the policy of monetary restraint (17).

Three weeks later, Ralph Young’s staff report recognized that the economy had slowed and inflationary pressures had lessened. GNP data for the third quarter showed real GNP unchanged and inflation at a 4 percent annual rate. On average real GNP had not increased for three quarters. Industrial production remained at the June level, but consumer spending was strong.
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Sixteen members favored no change in policy. Two urged greater restraint. Chairman Martin expressed surprise at the near unanimity and did not question it.

Between the meetings on October 1 and 22, the Soviet Union sent the first rocket and manned capsule into outer space. Anticipations of increased defense and space spending raised interest rates and reduced stock prices. The S&P index fell about 7 percent between early and late October. Although industrial production declined slightly, and concerns about inflation abated, the only action the FOMC took was to “resolve doubts on the side of ease.”
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The federal funds rate remained at 3.5 percent until after the November meeting, but free reserves increased.

At last, the staff recognized that “expansive forces had eased, and contractive forces had become more prominent” (FOMC Minutes, November 12, 1957, 5). Hayes added, “At least a mild downturn in business activity is
under way, and there is widespread belief that it will probably continue well into 1958.”
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188. Governor Robertson complained that the manager had allowed free reserves to increase. He accused the manager of not following the committee’s instructions. The manager agreed that free reserves had increased, but he claimed it was unintentional (FOMC Minutes, September 10, 1957, 16–17). In fact borrowing had declined following the increase in the discount rate and the start of the recession.

189. Later data show a 2.4 percent increase in real GNP in the third quarter and an average rate of increase of 1.7 percent for the year (U.S. Department of Commerce, October, 1988). A large decline (6.1 percent annual rate) came in the fourth quarter.

190. Using a scale from +1 to −1, Brunner and Meltzer (1964) mark a small (1/8) policy change based on the FOMC’s statement. Hayes commented that the New York directors thought that the System was slow to act. They wanted a “somewhat less restrictive policy” (FOMC Minutes, October 22, 1957, 13). Hayes suggested that the FOMC begin to ponder discount rate reductions, open market purchases, and lower reserve requirement ratios for central reserve cities.