A History of the Federal Reserve, Volume 2 (85 page)

Martin explicitly rejected the idea that policy could reduce unemployment now and respond to inflation later, the Phillips curve reasoning favored by Heller.

Over the years, we have seen counterposed full employment
or
price stability, social objectives
or
financial objectives, and stagnation
or
inflation. In the last case 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 on other objectives. But we cannot. If we were to neglect international financial equilibrium, or price stability, or financial soundness in our understandable zeal to promote faster domestic growth, full employment, or socially desirable programs, we would be confronted with general failure. (ibid., 5–6)

With the tax cut assured of passage, the 1964 Economic Report instructed the Federal Reserve that “[i]t would be self-defeating to cancel the stimulus of tax reduction by tightening money” (Council of Economic Advisers, 1964, 11). Martin recognized the political pressure to avoid increasing interest rates before the election. His early meetings with President Johnson reinforced his belief that Johnson was a populist who supported his personal view with the economic arguments of Heller and others.
²⁸⁴

The Federal Reserve kept monthly average free reserves between $100 and $150 million most of the time through August. The manager explained the few exceptions as accidents, special events, or a deliberate choice to maintain an interest rate target. Monthly averages of the federal funds rate remained in a narrow band around 3.5 percent until December. Annual growth of the monetary base rose to between 5 and 5.8 percent from about 4.5 percent the previous summer. Thus, the Federal Reserve did what Martin said he would not do, supporting the tax cut with faster money growth, while believing the System had kept policy action unchanged.

Withholding taxes began to reflect lower tax rates early in March, but spending did not respond immediately. Retail sales in March were lower than in February. Auto sales declined (Annual Report, 1964, 81). At the end
of May, the staff reported increased production and sales in April with new orders for durables rising at a 7 percent annual rate (FOMC Minutes, May 26, 1964, 16–17). Further confirmation of expansion came in May with a drop in the unemployment rate to 5.1 percent, the lowest rate since May 1960, but the saving rate remained relatively high until September, seven months after the tax cut passed (Annual Report, 1964, 103). Stock prices continued to decelerate. The peak annual rate of increase reached 20.5 percent in April 1963, fell steadily to 17.1 percent in December and 14.9 percent in May 1964. By October, the rate of increase was below 10%.

284. In case Martin forgot, Heller reminded him and urged President Johnson to do the same. For example on March 2, he sent a memo to Johnson stating, “Martin’s fears of prospective inflation seem to be mounting to a fever pitch” (Heller Paper, Monetary Policy, March 2, 1964). He urged Johnson to hold a meeting of the Quadriad to increase pressure on Martin. Arthur Okun, later chairman of the Council of Economic Advisers, quotes Johnson’s comment on high interest rates: “It’s hard for a boy from Texas ever to see high interest rates as a lesser evil than anything else” (Hargrove and Morley
, 1984, 274).

In February, the unemployment rate began a gradual decline, and pressure from the balance of payments eased. The first quarter of 1964 had a payments surplus for the first time since 1957. The good news did not continue. By June, Hayes suggested reducing the degree of ease to further improve the balance of payments, but he recognized that with low inflation and an improved payments position his proposal would draw little support. By August, he began to urge a tighter policy more forcefully. Chairman Martin supported him along with Balderston, Hickman, Mills, and Shuford. The vote to tighten was six to five, with Shephardson absent. Some proponents cited the increased payments deficit, others the strengthening domestic economy. Harry Shuford (St. Louis) expressed concern about 8.5 percent (annualized) growth in money in June and July. As was often true, free reserves declined in advance of the decision.

Martin told Heller that the FOMC had reduced the free reserve target to $50 million (from $100 million) in response to the preliminary report of the July balance of payments. “They are going to
keep
this
very
quiet
so that the market won’t know that it’s being done” (memo to the president, Heller papers, August 18, 1964; emphasis in the original). The move had little effect on short- or long-term interest rates.

Once the election was over, discussion of further tightening increased. Martin joined Hayes in favoring an additional move, and they were joined by four others. There was a stronger sentiment that recent wage increases, continued economic expansion, rapid money growth, and renewed weakness in the balance of payments supported an increase in interest rates. The main reason for delay was Treasury financing. FOMC took no action, however, at its November 10 meeting.

The Federal Reserve again misread the degree of monetary stimulus by concentrating on free reserves and ignoring growth of money aggregates. It missed the opportunity to stop the inflation at an early stage, as Chairman Burns recognized years later. Annual consumer price increases remained in the 1 to 1.5 percent range, but annual base money growth at 5.5 to 5.75 percent suggested strongly that prices would accelerate if money
growth continued. By the fall of 1964, wage increases in the automobile industry reached 4 to 5 percent at Ford and Chrysler, and there was a strike at General Motors. This was well above the wage guideline. The guideline proved ineffective before the Great Inflation started. At the September FOMC meeting, Hayes remarked, “The long record of price stability may now be in more serious jeopardy than at any time in recent years” (FOMC Minutes, September 29, 1964, 20).
²⁸⁵
The FOMC ignored his warning.

In a memo to the president, Heller denied that the economy would experience inflation in 1964. “We might not be able to prevent some pricewage creep. . . . [I]t won’t be inflation and particularly not the kind that tight money can stop” (memo, Heller to president, Board Records, January 5, 1964.).

Problems
with
the
Pound

Two weeks later, November 24, the U.K. increased its discount rate from 5 to 7 percent to support the pound.
²⁸⁶
The administration wired Prime Minister Harold Wilson that it “had no objection to the U.K. doing whatever it felt was necessary and that the U.S. did not see any reason
on
domestic
grounds
for raising the discount rate in this country at the moment” (Board Minutes, November 23, 1964, 2; emphasis added).
²⁸⁷
Martin added that a discount rate increase “was not precluded” (ibid., 2).

285. Walter Reuther, president of the United Auto Workers (UAW), had rejected the basis for wage guidelines in the Economic Report on two grounds. First, the report compared physical productivity to money wages at several places, suggesting that wages had increased faster than productivity. Real wage increases remained below productivity growth. Second, in a memo that Reuther sent with his note, the UAW staff challenged the measure of trend productivity growth used to set wage guidelines. “Five year moving averages of data . . . fluctuate so widely that consecutive averages of two overlapping five-year periods, having four out of five years in common, can jump by nearly a third—from 2.3 percent to 3.0 percent” (Heller papers, Wage-Price Guidelines, Box 24, January 23, 1964, 3). In March, George Meany, president of the AFL-CIO, attacked the wage guideposts. In May, the AFL-CIO rejected them.

286. The Bank had increased the rate from 4 to 5 percent on February 27.

287. Harold Wilson had been elected prime minister in October. At once, he announced expansive policies and nationalization, but he did not devalue the pound. Within a few weeks, he regretted not having done so. To stem the initial outflow, the government put a 5 percent surtax on imports and sold foreign exchange to support the currency. On November 19, Johnson had a message from Wilson asking for U.S. support. The U.K. had only $300 million of reserves left. Wilson said he planned to raise the discount rate from 5 to 7 percent, but he wanted assurance that the Federal Reserve would not move first. The IMF voted not to lend the U.K. $1 billion. Johnson offered to help with the IMF loan (Johnson Recordings of Telephone Conversations, November 19, 1964, with Don Cook). Johnson later talked to Ackley. Both opposed an increase in U.S. discount rates. If the Federal Reserve acted, they wanted an announcement that it was done for international, not domestic reasons. The administration also got the IMF to make the British loan (Recording of Telephone Conversation, Johnson to Ackley, November 22, 1964).

In fact, Martin told the governor of the Bank of England that he could not commit the reserve banks, but “he personally would favor an increase” (ibid., 3). Over the weekend, he talked to the presidents to tell them about the British decision. Boston and New York planned to raise their discount rates that day. Martin proposed that the Board increase regulation Q ceiling rates. After a lengthy discussion, the Board raised ceiling rates to 4 percent for time deposits with less than ninety days maturity and 4.5 percent for long-term deposits. On a split vote, with Mitchell absent, it kept the rate on savings deposits at 4 percent.
²⁸⁸

The same afternoon, November 23, the Board approved a 0.5 percentage point increase to 4 percent in discount rates at Boston, New York, Chicago, Philadelphia, and St. Louis. The vote was five to one, with Mitchell absent and Robertson opposed. Robertson said that “he saw no economic justifications for raising the rate in this country. The effect on the domestic economy could be potentially bad . . . [and] would not stem an outflow of funds” (Board Minutes, November 23, 1964, 24). He added that it would have a negative effect, and he accused his colleagues of acting because it was easier to tighten policy at that time. Shephardson and Daane disagreed. The action helped the British, they said; by protecting against an outflow here, it encouraged an outflow from countries with payments surpluses. Within a week all reserve banks were at 4 percent.
²⁸⁹

288. Earlier the Board missed a possible opportunity to reduce the harmful effect of interest rate ceilings. It replied to a question from Senator Willis Robertson about the Board’s response to recommendations made by the President’s Committee on Financial Institutions, appointed as part of the administration’s response to the Commission on Money and Credit. One recommendation continued the prohibition against payment of interest on demand deposits. The other proposed changing the ceiling rate on time deposits to stand-by authority and extending regulation to other deposit-taking institutions (Board Minutes, April 13, 1964, 8). Governor Mills opposed stand-by authority, and Governor Mitchell thought the timing was bad. The question arose because the Comptroller of the Currency (James Saxon) opposed any controls, including stand-by authority. The chairman of the Home Loan Bank Board opposed any changes that would reduce the advantage of thrifts over banks. Governors Robertson, Shephardson, and Daane favored a stand-by arrangement but did not want to implement it at that time (ibid., April 29, 1964, 11–13). Chairman Martin favored removing the ceiling entirely. He would accept the stand-by authority but not implement it until “the first reasonable opportunity” (ibid., 15–16). The letter to Senator Robertson reflected this hesitation. The Board recognized “the desirability of moving toward freer markets . . . [but also believed] that unrestrained rate competition could, at times like the present, lead to undesirable consequences in terms of financial soundness and liquidity” (Board Minutes, May 12, 1964, letter, Martin to Robertson). Another mistake!

289. House Banking Chairman Wright Patman complained to the president about the increase, but the president dismissed his complaint because the change had been made to support the dollar against a run. The president added: “Of course, I regret any increase in credit costs at this time” (letter, President to Wright Patman, December 10, 1964, WHCF, Box 282, LBJ Library).

International concerns dictated the timing and the magnitude of the rate increase, but many on the FOMC wanted to raise interest rates, as Robertson suggested. However, Daane had voted against any increase only two weeks before the press release and voted yes this time because the public statement attributed the discount rate increase to international concerns. The increase in maximum regulation Q rates was made to assure “that the flow of savings through commercial banks remains ample for the financing of domestic investment” (Board Minutes, November 23, 1964, 2, press release). This was one of very few occasions when the System, acceding to administration urging, announced a discount rate increase for international reasons.

Ackley did not share the administration’s view. In a memo to the president he described the increases as “unwelcome,” but he gave credit to Martin’s “excellent and unprecedented press conference” for limiting the immediate response of interest rates
²⁹⁰
(memo, Ackley to President, Heller papers, November 24, 1964). Ackley added: “Even these small increases in interest rates have some significance . . . [T]he higher discount rate will cost us production and jobs in 1965. . . . Some academic studies suggest that
losses
for
1965
could
run
as
high
as
$1
billion
in
GNP
and
100,000
jobs”
(ibid., 2; emphasis in the original). He urged a more expansive fiscal policy to offset the rate increase. The administration proposed and Congress approved excise tax rate reduction on autos and air conditioners, effective May 15, 1965. And he wanted the Federal Reserve to announce that the discount rate increase was temporary and would be reversed soon (memo, Ackley to the president, CF, Box 43, November 22, 1964, 2).

The rise in the U.K. bank rate and earlier tax increases stopped the outflow temporarily. The Bank of England, Federal Reserve, and the Treasury arranged $3 billion of emergency assistance, announced on the following day (November 25). The funds came from the U.S. Export-Import Bank, ten central banks in Europe, Canada, and Japan, and an expanded Federal Reserve swap line. The new loan was an addition to a $1 billion loan from
the IMF on November 20. This display of international cooperation and support helped the Bank of England stabilize the exchange rate (Solomon, 1982, 88–89).

290. Gardner Ackley replaced Walter Heller as chairman of the Council of Economic Advisers on November 16, 1964. Ackley had been a member of the Council since August 1962. Ackley’s value judgments fit closely with Johnson’s. He described his views on inflation and unemployment: “Those who sympathize with the least well off, I expect, put a higher value on employment.” He clearly included himself (Hargrove and Morley, 1984, 234). He expressed less concern about inflation. It affected people “whose wealth and income are associated with the ownership of fixed income securities. They tend to be fairly well off” (ibid., 234). (At the time, the steelworkers union pension fund invested all of its assets in government bonds.) Ackley’s memo suggests that, despite earlier Keynesian beliefs, he now believed that monetary actions were extremely potent. Martin held the press conference to satisfy President Johnson, who reacted strongly to the news
(Bremner, 2004, 158).