A History of the Federal Reserve, Volume 2 (79 page)

PROSPERITY WITHOUT INFLATION, 1963–64

The country entered 1963 with output rising, inflation low, the stock market soaring and base money growth moderate. Only the unemployment rate, between 5.5 and 6 percent, and the balance of payments deficit disturbed the administration and the Federal Reserve. A three-month average of free reserves had fallen by $100 million between November and February, but the federal funds rate had remained unchanged.

The FOMC began the year by proposing “more moderate growth in bank credit and the money supply, while aiming at money market conditions that would minimize capital outflows” (FOMC Minutes, January 8, 1963, 57). It recognized “the unsatisfactory level of domestic activity, the continuing underutilization of resources, and the absence of inflationary pressures” (ibid., 58). The policy decision kept money market conditions unchanged.

Governor Robertson’s dissent reopened discussion. Robertson wanted more effort to “stimulate a lagging economy” (ibid., 66). He opposed maintaining the Treasury bill rate unchanged if it interfered with reserve growth. Ralph Young, who wrote the directive, explained that recently money growth had increased more rapidly than in the past four years. If recent rates of growth continued, “they would result in some kind of explosion at some point” (ibid., 66).

The staff report cautiously favored President Kennedy’s proposed tax cut but recognized that the FOMC was skeptical and suggested that “we have some basis for maintaining at least a modicum of skepticism as to whether any likely tax cut will be as efficacious as is contended” (ibid., 15). This reflected Martin’s views. He was not enthusiastic about the proposed tax cut when he spoke to the Business Council, a group of chief executives of large corporations. Heller urged the president to encourage Martin to support the administration’s program (Heller papers, Box 19, monetary policy, January 27, 1963).
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Heller wanted more than Federal Reserve support. At the time, he had little interest in independent monetary actions. To increase his own influence, he urged Kennedy to persuade Martin “to consult with the President and his major economic policy advisers before making significant policy changes” (ibid., 2). Heller recognized that Martin usually informed Secretary Dillon about his decisions, but Dillon often agreed with Martin.
Heller wanted more influence for the Quadriad, and he wanted Martin to appoint “one liberal or moderate intellectual” as a director of each Federal Reserve bank.
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234. Frederick Deming (Minneapolis) compared effects on spending to production incentives, later called supply-side effects. He considered government spending and the deficit, not the tax cut, to be the main source of stimulus (FOMC Minutes, January 19, 1963, 43).

Martin’s four-year term as chairman ended in February 1963. Dillon strongly supported his reappointment. Heller opposed at first, but accepted the outcome because of Martin’s reputation in the financial markets at home and abroad. The president told Martin that he recognized that Martin did not always agree with administration policy, but he welcomed his independent views.

The FOMC minutes do not mention administration pressure from meetings of the Quadriad or with officials. Martin may have passed these comments outside the meeting but they do not appear in the minutes. Through the winter and into the spring, the committee remained divided about what, if anything, the System should do. Most members agreed that the balance of payments deficit resulted from foreign aid, overseas military spending, and other non-monetary causes. That did not prevent demands for higher interest rates to squeeze domestic spending. Martin warned of an international crisis if nothing were done within the next three or six months” (FOMC Minutes, February 12, 1963, 48; March 5, 1963, 82). Hayes wanted higher interest rates, despite continued “sluggish domestic performance.” The balance of payments situation requires “a more determined attack than any that has yet been undertaken” (FOMC Minutes, February 12, 1963, 20).

Until late March, members believed the recovery remained sluggish. Reports showed industrial production falling in December and January.
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When the data showed recovery, several members dismissed the evidence as precautionary inventory accumulation in anticipation of a steel strike. The Federal Advisory Council (FAC) noted weak investment, uncertainty about government tax policy and its policy toward business. The FAC expressed concern about the balance of payments, but it favored easier policy (Board Minutes, February 19, 1963, 19).

235. He suggested Robert Solow or James Tobin as examples (Heller papers, Box 19, monetary policy, January 27, 1963). Solow later served as chairman of the Boston Federal Reserve bank. The memo came at about the time that Kennedy reappointed Martin without Heller’s support. Heller later said that he came to Washington “thinking we ought to end the independence of the Federal Reserve . . . [but] after working with the Fed under both Presidents [ended] with the conviction that it isn’t too bad an arrangement, provided there is good will, competent people, and reasonably systematic consultation” (Heller oral history, tape II, 10).

236. Current data show annual rates of increase in industrial production of 0, 8.75, and 13.63 percent for the three months ending in February. This is one of many occasions where preliminary data misled FOMC members. The staff reported increased production at the April 16, 1963, meeting.

Bryan (Atlanta), Mitchell, and Robertson favored more expansive policies, even if it meant lower short-term interest rates. Bryan dismissed Hayes’s and Martin’s arguments for higher rates. Using monetary policy to reduce the payments deficit “would require substantial interest rate increases” (FOMC Minutes, March 5, 1963, 51). There was no consensus and no change in policy.

Hayes continued to express concern about future inflation and the payments deficit. He recognized that tighter money has risks, but “they are minor risks in comparison with the growing danger to the dollar’s international standing” (ibid., 47). He proposed changing the directive to reflect slightly firmer policy. Mitchell responded that he could accept “any suggestions [for the directive] . . . except those of Mr. Hayes” (ibid., 57).
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For the first time since the mid-1940s, the gold reserve requirement behind notes and bank reserves began to bind. In January the System’s gold reserve ratio was 32.2 percent, but the Boston bank’s reserve ratio fell to 25.7 percent, fractionally above the 25 percent minimum.
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The rules called for Boston to sell enough of its securities to other reserve banks to bring its reserve ratio up to the System average. To do so, Boston would have to sell $152 million. Boston held only $74.9 million in unpledged securities. If Boston sold all of them, the System would be unable to sell securities because Boston could not participate.

The desk resolved one problem by lending Boston about $5 billion, raising its gold reserve ratio to 28 percent. This violated the allocation rules and pointed to the need for an amendment. In March, the FOMC changed the securities’ allocation formula to permit, but not require, adjustments to reach the System average. At the same time, it changed reallocations from quarterly to monthly and permitted the System to allocate more securities to reserve banks with a relatively high proportion of notes to notes plus deposits and offered no securities to a reserve bank if an allocation would create a reserve deficiency
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(FOMC Minutes, March 5, 1963, 18).

The experiment in foreign exchange market swaps continued to grow. Coombs asked for permission to make purchases or sales up to $25 million in the forward market without the FOMC’s prior approval. These op
erations would be used to reverse a swap commitment in advance based on the special manager’s judgment that an advance purchase or sale was advantageous. Robertson objected to “tinkering with market forces” but did not oppose because the size limit was low (ibid., 34).

237. At the March meeting Hayes gave up the struggle over who appointed the manager. “He saw no purpose in pursuing the matter further. . . . [A]lthough he would go along with the current procedure, he did so with some reluctance” (FOMC Minutes, March 5, 1963, 5).

238. Overall, the System held almost $16 billion in reserves. Dollar liabilities to foreigners had reached $20 billion (Chart 3.14 above).

239. The reallocation would equalize the average reserve ratios of the twelve reserve banks (based on data for the first twenty-three days of the preceding month). Reallocation could not lower a bank’s reserve ratio below 28 percent (FOMC Minutes, March 5, 1963, 20–21). The last restriction would soon require additional changes.

The limit on swap arrangements reached $1.3 billion, more than double the initial commitment made a year earlier. Martin continued to refer to swaps as an experiment but did not favor evaluation. Mills questioned the usefulness of the experiment and expressed concern about “the U.S. becoming a handmaiden of assistance to a number of its foreign allies” (FOMC Minutes, March 5, 1963, 15). Robertson concurred. At the time, the French press had the opposite complaint, that a recent increase in the swap agreement was a French loan to the United States (ibid., 30).

The surplus countries had monetized many of the dollars received at their central banks, resulting in higher rates of inflation abroad. Table 3.8 compares rates of consumer price change in the United States and principal foreign countries. These price changes include more than the prices of internationally traded goods, but they suggest that real exchange rate adjustment had occurred.

Young’s report of European attitudes and criticisms made at the late February meeting of the OECD mentions concerns about inflation abroad caused by annual money growth rates of 10 to 12 percent; but he did not mention the effect on real exchange rates that moved the system toward balance. He described the meeting as “highly critical of U.S. financial policy” (FOMC Minutes, March 5, 1963, 41). Surplus countries were most vocal, but they offered few useful suggestions. The [OECD] chairman’s summary said that “there was agreement that U.S. payments equilibrium had to be reached soon, but without steps that might interfere with domestic expansion or otherwise do harm to the U.S. or the world economy” (ibid., 44). Critics agreed that interest rates should rise, but they differed as to whether the rise should precede or accompany the proposed tax cut.
The United States pressed for a review of capital controls in France, Italy, and West Germany that hindered capital outflow.

The OECD did not consider exchange rate adjustment, so they had to rely on relative inflation abroad to adjust real exchange rates. Devaluation of the dollar would have speeded adjustment. Six continental countries— Belgium, France, Germany, Italy, Luxembourg, and the Netherlands— had formed a common market, the first step toward the later European Union. The Common Market attracted foreign investment, particularly from the United States. Investment abroad joined growing European exports, military spending abroad, and foreign aid to raise the amount of dollar outflow that had to be compensated by changes in relative prices, if exchange rates remained fixed. The surplus countries disliked inflation; neither they nor the United States proposed an acceptable alternative. Discussion had moved away from the threats and counter-threats of the previous summer but had come no closer to a mutually acceptable arrangement.
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Attention soon shifted away from the United States to another in the series of British payments problems. Speculation in the press and the market considered the prospect of another British devaluation. The £3.5 billion of foreign balances in London, mostly owed to Commonwealth members and accumulated during WWII, complicated the problem. Devaluation would reduce the value of these claims and precipitate heavy withdrawals. To offset this effect, Britain could increase the size of its devaluation, thereby increasing the foreigners’ losses but reducing the British obligation. A larger than necessary devaluation encouraged the expectation that the pound would not depreciate further. A small devaluation followed by the withdrawal of sterling balances was likely to do the opposite.

Many observers urged the British government to float its currency
(Economist,
March 2, 1963, 773–75). Instead, the government raised interest rates to 4.5 percent on advances to discount houses but left the Bank rate at 4 percent. British bill rates rose. The British asked for and received $250 million in loans from other countries; the loans postponed a sterling crisis but did not resolve the long-term problem.

240. President Kennedy appointed a commission, chaired by Roger Blough of U.S. Steel, to recommend ways to reduce the payments deficit. Allan Sproul was a member. The commission proposed that correction be made a national priority and stressed the need to reduce private and public capital outflow, but it opposed controls on private capital outflow. It favored domestic tax reduction to raise rates of return at home, accompanied by reductions in government spending and more European assistance in the defense effort. Kennedy immediately asked about restrictions on foreign borrowing in the U.S. market (letter, Sproul to Hayes, Sproul papers, May 7, 1963).