A History of the Federal Reserve, Volume 2 (80 page)

Policy
Evaluation

In March, the staff reported the results of a series of studies requested by Chairman Martin of the effects of policy on the balance of payments and on foreign countries. The studies responded to the growing European demand for higher U.S. interest rates. The common assumptions in the studies were (1) a 0.5 percentage point increase in short-term interest rates achieved over a six-month period, (2) the same or larger increase achieved in three months or less, and (3) a “spectacular program designed to halt a sizeable actual or threatening run on the dollar”
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(Domestic Effects of Assumed Monetary Policy Programs” Board Records, March 1, 1963, 2–3). The staff memos provide a view of the ways in which key staff analyzed policy actions and reveal many of their concerns about the payments imbalance.

The staff used a simple Keynesian model, starting with changes in cost and availability of credit on particular spending categories and allowing for multiplier effects on other spending categories. The paper expressed uncertainty about quantitative responses to policy actions. As a result, the analysis gave more attention to market mechanics and uncertainty about market responses than to effects of relative price changes on assets, liabilities, output and the balance of payments. Instead, it noted that “opinions regarding the influence of interest rates (and other credit terms) on borrowing and spending have shifted in recent years” (ibid., 17). The Federal Reserve would supply less credit, so “credit-financed expenditures” would decline (ibid., 26). Thus, the domestic economy would decline along with the payments deficits. There was no mention of effects on the price level or on the real exchange rate and thus on exports and imports. The analysis ended with the short-run cost of reduced output and did not consider how a declining price level or lower inflation worked to restore full use of resources.
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241. The paper by Robert Solomon refers to expectations of price increases and adds: “This fact in itself tended to elevate interest rates, as lenders demanded higher nominal rates in order to protect real rates of return on credit instruments” (Domestic Effects of Assumed Monetary Policy Programs.” Board Records, March 1, 1963, 5). This is the most explicit statement of its kind to this time that I have found in System documents.

242. A separate paper in the study considered the effects on the balance of payments. It mentioned a price level decline as a cyclical response to reduced output but did not analyze the general equilibrium effect. The author concluded that a 0.5 percentage point increase in short-term interest rates would lower the payments deficit by $500 million to $1 billion in a year (Effects on the Balance of Payments, Board Records, March 1, 1963, 37). The author considered only the effects on lending and borrowing. Other papers in the study discussed European reactions to the policy change and the response of the euro-dollar market. One paper concluded that European rates would rise, so the balance of payments response was uncertain. A subsequent paper suggested that the elimination of the deficit would “have to
come gradually . . . mainly through changes in relative prices and costs, and in the relative attractiveness of investment opportunities here and abroad” (“The U.S. Balance of Payments Situation in Early 1963,” Board Records, March 25, 1963, 2). It is the only paper that uses that reasoning. The paper notes that Fren
ch inflation following the 1958 devaluation was likely to reduce the French surplus.

The memos on domestic and balance of payments effects of higher interest rates served as the background material for the March 25 meeting of the Cabinet Committee on the Balance of Payments. In a separate memo, the Council of Economic Advisers did not oppose higher interest rates, but it urged caution because the domestic economy remained weak. To mitigate these effects, it urged more Treasury borrowing in short-term securities, more Federal Reserve purchases of long-term debt, and an increase in regulation Q ceiling rates to bring more time deposits to banks. The Council recognized, however, that because of “expectations about future changes in interest rates, it might not prove possible to insulate the long-term market fully from the effects of higher short-term interest rates” (memorandum to Cabinet Committee on Balance of Payments, Board Records, March 26, 1963, 5). The Council statement suggests that members recognized that, since long-term rates are an average of expected future short-term rates, twisting the yield curve to lower long rates was not likely to succeed. The memo added, however, that “every effort should be made to do so” (ibid., 5).

Federal
Reserve
Response

Despite the Council’s concerns, the focus given to the payments deficit strengthened Hayes’s and Martin’s position. In early May, the FOMC voted six to five to tighten policy, and in July the System increased discount rates to 3.5 percent and ceiling rates on time deposits to 4 percent.
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The domestic economy had not fully recovered. Unemployment rates remained at about the level reached the previous December and similar to the previous year. Growth in the first quarter at 5.5 percent annual rate included inventory building in anticipation of a steel strike. To spur investment spending the administration rewrote the Treasury’s Bulletin F rules to spur investment by increasing depreciation rates, and it introduced an investment tax credit. Mitchell, Bopp, and Robertson urged delay of the rate increase. Swan (San Francisco) in a reprise of the 1920s urged the members to wait for credit demand to increase (FOMC Minutes, May
7, 1963, 30).

243. W. Braddock Hickman became president of the Cleveland bank on May 1, succeeding Wilbur Fulton. Hickman was a financial economist who had done major studies of bond defaults. His appointment strengthened the group favoring higher interest rates. Although he could not vote at the time, he favored the rate increase.

Pressure from European critics to take more action grew more intense. Young reported on a recent meeting at the OECD. European critics faced with inflation wanted the United States to present a “comprehensive program” for the payments deficit. Forewarned, spokesmen presented a longterm plan that relied on “the work-out of fundamental competitive forces, supplemented by redistribution of aid and defense burdens and gradual reduction of the capital outflow through reciprocal credit and capital market adaptation. For the shorter-run . . . further tying of aid, more stringent control of governmental expenditures abroad, additional debt prepayment and defense expenditure offsets” and other programs in place at the time (FOMC Minutes, May 7, 1963, 21). The Europeans did not hear plans for higher interest rates, and they objected to the pace of change—“two to three years or even longer” (ibid., 21).
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They did not propose revaluation, and they objected to tying military assistance to purchases in the United States.

There was no time for discussion of the chairman’s summary of European recommendations. They agreed to make this topic first on the agenda at the June meeting. This gave the FOMC time to act.

Martin made a strong argument for firming policy. He cited European criticism and his fear of an imminent crisis. To reassure members concerned about the domestic economy, he said that he was not tightening; he was “pulling a little on a rope that was already very loose. . . . [T]he Committee would decide later that this was not the direction in which it should have moved . . . If the Committee waited too long, however, it might have to deal with an active problem of inflationary pressures. . . . [I]nflationary pressures might well undermine the existing level of activity and lead to a decline in employment” (FOMC Minutes, May 7, 1963, 61). Bopp (Philadelphia), Clay (Kansas City), Mitchell, Robertson, and Scanlon (Chicago) voted no. Mills was absent.

The intense debate produced a small change. The directive called for “a slightly greater degree of firmness in the money market than has prevailed in recent weeks” (ibid., 63). The manager reported that interest rates on federal funds were at 3 percent with Treasury bill rates at 2.88 to 2.92 percent. The monthly average of the federal funds rate did not change until August, but Treasury bill rates rose 0.22 percentage points in the next two months. Monthly average free reserves moved down from $350 million in April to between $308 and $318 million for the next three months.

Mitchell attacked the policy change at the next meeting. It was taken
to “make an overt sign that it [the Federal Reserve] is willing to yield to ‘international monetary discipline.’ If this was the purpose of the recent action, it seems to me to have been a serious mistake” (FOMC Minutes, May 28, 1963, 38). Most others did not agree. Even those who voted against the policy decision did not want to reverse it.
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244. The European members also criticized use of foreign-denominated bonds instead of borrowing from the IMF and becoming subject to its monitoring.

Proponents of a restrictive policy were dissatisfied also. Coombs wrote a memo to Martin and Hayes making his best case for additional steps. He warned that “we have now reached a critical phase. The dollar has become vulnerable to a break in confidence which might occur almost without warning and with devastating consequences” (memo, Coombs to Martin and Hayes, Board Records, June 12, 1963, 1). The problem as he saw it was that the payments deficit was not cyclical or episodic; it was structural. United States policy did not address the structural problem. Instead, the United States borrowed in various ways, postponing the problem and enlarging it.

Success in managing crises had convinced participants in the foreign exchange market that central bank cooperation would manage the problem. Coombs was scornful. “It would be foolhardy to imagine that we can long maintain this disparity between the surface calm of the exchange markets and the turbulent undercurrents being generated by a continuation of heavy United States payments deficits which Europe is reluctant to finance” (ibid., 5). He favored the usual mix—reductions in foreign aid, military spending, and foreign investment. The Federal Reserve had no responsibility and no authority to act on these measures. Coombs recommended higher long-term interest rates to encourage U.S. companies to finance foreign direct investment overseas and deter foreign borrowing in the United States. Coombs urged higher short-term rates and regulation Q ceilings to reduce the flow abroad and attract foreign deposits.

The Board’s staff memo agreed with Coombs’s statement of the problem, disagreed with some of his numbers, and doubted the effectiveness of raising short-term rates. “It would tend to mask the U.S. deficit on ‘basic’ account and thereby make it more difficult to pursue vigorously and consistently policies directed to a fundamental remedy” (memo, Furth to Young, Board Records, June 14, 1963, 2). Short-term improvements, Furth said, convince Congress and others that the problem has lessened. “If drastic monetary measures are deemed too high a price, the solution must be
found in other fields . . . and cannot be sought in modest variations in interest rates” (ibid., 4).

245. Mitchell noted that long-term rates were historically high and that money growth remained low. He voted against continuing the policy. Mills criticized the policy also, arguing that “the United States was the anchor to which all other economies were tied” (FOMC Minutes, May 28, 1963, 44). But he did not join Mitchell. It was too late to change. Shifting back and forth would be worse.

Furth’s logical argument did not fully persuade Martin. Although he knew that small changes in interest rates could not solve the problem, he wanted to avoid the crisis that he, like Coombs, believed was near at hand.
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In June, Hayes urged increased rates for discounts and time deposits. Mills disagreed. Higher interest rates would require higher rates abroad. “It might offer some temporary relief to the balance of payments problem, but only up to the point that our foreign allies . . . defend their reserves against the losses of gold and dollars” (FOMC Minutes, June 18, 1963, 33). As an alternative, he cited a recent statement by Paul Samuelson in favor of dollar devaluation (FOMC Minutes, June 18, 1963, 33–34). Martin acknowledged “increasing sentiment for devaluation or for credit controls . . . credit controls would spark nationalism worldwide. The United States is the last citadel of non-discriminatory trade and convertible currencies, and its leadership in the world rests on this. . . . Increasing interest rates would boost confidence. Economists . . . had never quite come to grips with the notion of confidence . . . [T]he market is never logical and people are never logical” (FOMC Minutes, June 18, 1963, 54–55).

Policy was too easy, Martin said. Devaluation or credit controls should be a last resort. Something had to be done. Martin, then, made a point that he would make publicly two years later. “It was hardly appropriate to start talking about tight money until net free reserves gave way to net borrowed reserves. . . . No matter whether one looked at the stock market or the real estate market, small business activities or some of the fringe activities of defense operations, there was a speculative movement around the country that was in a way reminiscent of the 1929 period. . . . [Martin] hoped that he was too pessimistic” (FOMC Minutes, June 18, 1963, 55–56).

Many members were skeptical. Others thought higher rates were the wrong remedy either because they believed that the administration had to curtail its foreign outlays or because they opposed slowing the recovery. By a vote of seven to three, they retained the policy directive: “Accommodate moderate growth in bank credit, while putting increased emphasis on money market conditions that would contribute to an improvement in
the capital account of the U.S. balance of payments” (ibid., 56). Hayes and Balderston dissented because they favored less ease. Mitchell dissented for the opposite reason. He wanted to roll back the tighter policy adopted on May 7.
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246. Martin did not accept Phillips curve reasoning. He testified that “there was even serious discussion of the number of percentage points of inflation we might trade off for a percentage point increase in our growth rate. The underlying fallacy in this approach is that it assumes we can concentrate on one major goal without considering collateral, and perhaps deleterious, side effects” (Hearings, Joint Economic Committee, February 1, 1963, 5–6).