A History of the Federal Reserve, Volume 2 (72 page)

Domestic
actions.
The Federal Reserve undertook few policy actions in 1961–62. Martin had agreed to keep free reserves about $500 million in 1961. The first reduction came in February 1962, following an increase in the bill rate the previous month. In December, the FOMC again reduced free reserves. The Board reduced reserve requirements for time deposits from 5 to 4 percent in late October.

168. In addition to threats, the government urged Inland Steel and a few others not to follow the price increase. When these companies agreed, the others withdrew their announced increases. This was the first of many efforts to control inflation by influencing relative prices. In retrospect, Walter Heller concluded that administering the guideposts diverted the Council from its main role of advising the president (Hargrove and Morley, 1964, 183–84). He did not conclude that the effort was based on confusion between relative prices and a general price index.

169. Much of the decline was in real business fixed investment. Real investment fell in the second and fourth quarters. This is the expected effect of a decline in stock prices. The stock market values existing assets. When asset prices rise, the demand for new capital (investment) increases because new capital is a close substitute for existing capital. The FAC met early in May. They told the Board that “the conditions under which the steel companies reversed their decision have caused concern in the business community and may delay future capital investment” (Board Minutes, May 1, 1962, 2).

President Kennedy later worked to restore relations with the leaders of the steel industry by appointing Roger Blough, chairman of United States Steel, to head a commission on foreign trade. Kennedy met with Blough regularly to discuss the Commission’s work. Stock prices started to rise steadily in October–November 1962. Real investment resumed its increase early in 1963.

By 1961 most Board members accepted that “price stability is a desirable goal of national economic policy” (Board Minutes, February 14, 1961, 13). Governor Mills objected to including price stability as a goal in the Employment Act because it could require reductions in real growth by slowing money growth. Woodlief Thomas now endorsed the proposed amendment. “More economic growth could be achieved through general stability in the level of prices than if there were wide price swings. Accordingly, he had come to the view that it would be advantageous to have price stability set forth as an explicit goal of government economic policy” (ibid., 4–5). This view did not return for twenty years.

Although the price level remained stable, FAC members expressed concern about inflation throughout the year.
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In November, they clarified their concern. The economy showed few signs of price increases, and labor costs continued to increase, squeezing profit margins. About half of the FAC wanted tighter monetary policy in November (Board Minutes, November 21, 1961, 5, 12).

FOMC members had mixed appraisals of the attempt to lower longterm and raise short-term rates. Mills said the policy had not worked and only confused market participants. He compared total System purchases of $443 million of securities with maturity over one year (out of $847 million net increase in portfolio) to $10.7 billion of new corporate, state, and local securities. Others pointed out that long-term rates had increased with economic activity, but they might have increased more without intervention. The New York desk reported that offerings of securities over one year had fallen markedly from levels in the spring. In a clear statement that policy actions affect inflation after a lag, Mills described the FOMC as “groping to find a . . . policy” consistent with expansion but without “the danger of generating subsequent inflationary pressures” (FOMC Minutes, August 1, 1961, 40). Martin agreed, recognizing the absence of a systematic policy by emphasizing “groping.”

The usual uncertainty under which monetary policy operated increased as the recovery gained momentum. Abroad, the Soviet Union resumed nuclear testing, and tensions leading to the building of the Berlin Wall, separating East and West Berlin, added to concerns. At home, government spending and the budget deficit increased, partly a response to Soviet actions. Prospective labor negotiations and price increases renewed concern
about inflation. Peacetime budget deficits in a prosperous economy were a relatively new phenomenon to which the public had not become accustomed. Administration forecasts that the economy would grow more than 6 percent in 1963, to $575 billion, added to concerns about inflation.
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170. “President Livingston [of the FAC] said he regarded this [inflation] as one of the most serious problems facing the country” (Board Minutes, September 19, 1961, 6). He attributed the increase in stock prices and the “lack of interest generally in fixed income obligations” to increases in expected inflation (Board Minutes, September 19, 1961, 6). The FAC did not ask for a more restrictive policy until later.

A few weeks later, the mood changed. The staff reported that business economists had become skeptical about continued expansion based on reported slower current growth of retail sales, industrial production, employment, and personal income. Defense spending now seemed likely to rise more slowly. This is one of many occasions when policymakers found it difficult to distinguish between transitory changes in economic variables, characteristic of a market economy, and the persistent changes that cumulate as business cycle fluctuations. This time the staff ignored the concerns, and the FOMC voted for no change.

Three weeks later, at the November 14 meeting, a split developed. Mills and Hayes dissented because they wanted a higher short-term interest rate to reduce short-term capital outflow. Mitchell argued that the Treasury bill rate had moved up between meetings despite the continued slack in the economy. As long as slack remained, domestic concerns were more important than the balance of payments. Martin could not find a consensus so he chose to maintain money market conditions, but he did not mention his commitment to Heller.

Members divided also on the use of free reserves. A vocal minority preferred to target total reserve growth, but Martin opposed. He said the market had raised Treasury bill rates, not the System. He preferred to let higher rates remain. Several thought it might soon be time for a tighter policy, but the FOMC should wait a few weeks before deciding to act.

Two days later, November 16, the bond market broke on concerns of a repeat of the 1953 experience, when large purchasers of a new treasury issue started to sell in anticipation of faster economic growth and tighter System policy.
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Long- and short-term rates rose with weekly free reserves at $515 million, slightly above target. The manager asked the Board for
authority to purchase long-term bonds. Martin and Balderston were absent. All the remaining Board members except Robertson voted to permit purchases at Rouse’s discretion.

171. The staff gave its perspective on the role of forecasts in setting policy at that time. The FOMC “should not lean too heavily on projections and forecasts. . . . For some sorts of policy planning, estimates or projections . . . are unavoidable. . . . [I]t is futile to speculate now as to whether or not a GNP of $575 billion in the fourth quarter of 1962 is ‘inflationary,’ and it certainly would be foolhardy to be influenced in current policy formulation one way or the other by such an exercise” (FOMC Minutes, September 12, 1961, 5–6). The staff report added that the “vastly increased liquidity . . . especially in the hands of consumers, constitutes a sort of powder keg of potential spending” (ibid., 6–7).

172. In the week ending November 8, the federal funds rate rose 0.61 percentage points (to 2.75). The Treasury bill and three- to five-year bond rate rose 0.24 and 0.09 percentage points between November 4 and 18. The main policy action was an increase in regulation Q ceiling rates announced on December 1 and effective January 1, 1962 (see text below).

With the end of the automobile strike, output and sales increased rapidly in November, and the unemployment rate fell from 6.8 to 6.1 percent. Inflation did not rise from its low level. Reported money growth reached only 3 percent for the year to November, and the money stock was only slightly above the mid-1959 level. The rising balance of payments deficit continued as a concern.
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Free reserves remained about $500 million, as Martin had promised. Hayes commented on the “increasingly widespread notion” that the System was “wedded to a $500 million free reserve target” (FOMC Minutes, December 5, 1961, 14). There was no response and no change. The consensus on December 19 called for an unchanged policy with bill rates held between 2.5 and 2.75 percent. Treasury bill rates increased after the meeting. A three-week moving average of these rates had increased steadily from 2.382 for the week ending November 18 to 2.603 percent in the week ending December 16, just before the FOMC met. In the next five weeks, the moving average rose to 2.737 percent, near the top of the range the FOMC set.
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Members of Congress kept watch on the FOMC’s decisions and actions. In August 1962, the December actions became the subject of criticism from Congressman Henry Reuss (Wisconsin). Citing changes in free reserves and interest rates, Reuss chided Martin for causing the economic slowdown by raising interest rates and reducing free reserves at the December 19,1961, meeting.
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Perhaps influenced by administration economists, Reuss wanted free reserves to remain at $500 million or above, and he pressed Martin to return to the former level of free reserves and remain there until January. Referring to the president’s decision not to reduce
tax rates in 1962, Reuss said, “With less fiscal ease, we must have more monetary ease” (Joint Economic Committee, 1962,616). Martin agreed to deliver Reuss’s message to the FOMC. He reported the conversation, but free reserves declined further that same month.

173. The staff reported that the data exaggerated the capital account deficit because domestic banks deposited dollars in Canadian banks to lend to domestic borrowers. Hayes replied that the $100 to $150 million monthly flow to Canada was no different from any other outflow. His statement was open to two interpretations. Either the flow to Canada to escape regulation was no different than the flow to other countries, or he denied that regulation had a large effect on the outflow.

174. Trieber now defined “feel of the market” in terms of short-term interest rates, borrowing by member banks, and the cost of dealer financing. This differed from earlier definitions based on the distribution of reserves between New York, Chicago, and other banks.

175. Reuss praised Martin for keeping free reserves near $500 million during most of 1961. “Then on December 19, 1961, a date that will be remembered in monetary history, the Open Market Committee met, and you abandoned that resolution . . . I think it will come to be known as ‘Tight Money Tuesday’” (Joint Economic Committee, 1962, 615). Free reserves fell from about $500 million to an average of $410 in December.

The committee remained divided in 1962. A majority wanted to tighten policy in January to support the dollar. Hayes talked about increasing the discount rate before the forthcoming Treasury auction and, without mentioning Martin by name, proposed that the “System’s spokesman should stress to the Administration the seriousness with which we regard the international outlook and . . . urge a more prompt and rigorous concerted Government program” (FOMC Minutes, January 23, 1962, 12).
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Mitchell directly challenged Hayes, stressing domestic factors. Raising interest rates would not help the domestic economy. Martin tried to balance conflicting pressures by choosing “even keel” and supplying reserves “adequate for credit expansion, while avoiding downward pressure on short-term rates” (ibid., 32). Hayes was not satisfied. He wanted to reverse some of the very slight decline in bill rates during recent weeks, but Martin opposed, saying that “it was easy to see ghosts that might or might not be there” (ibid., 31). After many exchanges, the directive passed with Hayes expressing reservations but unwilling to dissent.

The Federal Reserve held Treasury bill rates between 2.65 and 2.75 percent throughout the winter of 1962. Free reserves declined as banks reduced excess reserves, and growth slowed. The staff remained uncertain about whether the slowdown was temporary, so they proposed no action. The Federal Advisory Council remained optimistic. They told the Board that they expected profits to increase and that there would not be a steel strike (Board Minutes, February 20, 1962, 2). Woodlief Thomas noted that credit and money growth remained sluggish.
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Governor Mills amplified Thomas’s statement. The “theory motivating System open market policy actions postulates forcing an expansion in demand deposits adjusted and time deposits at an annual rate of 4 percent. The theory takes the wholly tenable position that national economic growth . . . depends importantly on
a constant expansion in the money supply defined to include time deposits” (Mills to Koch, “Open Market Policy,” Board Records, April 23, 1962). This is the strongest statement about the role of money in the records to that time. Mills then expressed doubt about the relation during periods of slow growth.

176. On January 23, 1962, President Kennedy asked Congress to raise the pay of the chairman and the governors to $25,000 and $22,000 respectively (from $20,500 and $20,000). In 2000, the equivalent salary would be $142,550 and $125,400, using the consumer price index. The president also asked Congress to make the chairman’s term coterminous with the president’s term.

177. In March, the FOMC again changed the formula for allocating securities in the open market account to require quarterly reallocation that equalized the average reserve ratios of the twelve reserve banks in proportion to the adjustments required over the first eighty-five days of the preceding three months. The formula allowed additional adjustment if a reserve bank’s reserve ratio fell below 30 percent (FOMC Minutes, March 6, 1
962, 18).