A History of the Federal Reserve, Volume 2 (88 page)

He [President Johnson] didn’t want any increase in rates and he wanted me to assure him that there wouldn’t be. I couldn’t do that, of course. I had already made up my mind that we needed an increase in rates. So I did my best to break this to him as gently as possible but wasn’t so very successful in that he was absolutely convinced that I was trying to raise the rate and pull the rug out from under him. I said “Mr. President you know that I wouldn’t do that to you even if I could.” He said, “Well I’m afraid you can.” And I said, “Well, I want to tell you right now that if I can [raise the rate] I will, because I think you’re just on the wrong course. I’ve been perfectly fair with you. I was over here early this year.” (Martin papers, Interview I, May 8, 1987, 9).

Despite increases in long-term rates in August and September, no action followed for several months. In July, Ellis (Boston) dissented because he wanted a firmer policy. In late August, Trieber (New York) did the same. Martin “was in complete agreement with the consensus . . . for no change in policy” (FOMC Minutes, August 31, 1965, 68). Hayes argued for a tighter policy in September including a discount rate increase. Balderston, Shephardson, and Ellis (Boston) favored a discount rate increase after the Treasury completed its financing. Martin did not think the timing was right. The vote was nine to three for no change. Maisel, Mitchell, and Robertson dissented because interest rates had increased despite a policy of no change. They wanted policy ease to roll back the increase.

At a Quadriad meeting early in October, Ackley and Fowler urged Martin to delay any increase in interest rates until the evidence was clearer. Ackley proposed waiting until January, when the new budget data became available. Fowler argued that “risks of tightening are greater than the risks of overstaying present policies.” He called the danger of overheating “tenuous,” and he wanted the administration to oppose changes in the prime rate (memo, Fowler to the president, October 6, 1965, Confidential Files, Box 41, LBJ Library, 1–2).

Martin’s memo for the Quadriad meeting tried to shift discussion from interest rates to credit growth. He noted that regulation Q ceiling rates caused credit to flow outside the banking system, and he warned of “rising expectations, evidenced in financial markets and real investment.” A slight increase in interest rates would help to extend the expansion and improve the balance of payments (memo, Martin to the president, ibid., October 6, 1965).

Martin’s views did not prevail. A week later at the FOMC, he read his memo to the president. FOMC members split. Some agreed with Martin but wanted to wait for the Treasury to complete its financing. Others opposed because they saw no sign of inflation. Faced with a divided commit
tee and administration opposition, Martin not only did not insist, he voted against an increase. This was not a new position. He had delayed acting in 1957 to wait for consensus. After warning the committee about the danger of waiting too long, he explained why the FOMC should not change policy. He made no mention of Federal Reserve independence.

As Chairman, he had the responsibility for maintaining System relations within the Government—for getting the thinking of the President and members of the Administration, and for apprising them of the thinking within the Committee—and he had made that one of his principal concerns during the fourteen years he had held his present office. Last week he had given the President a paper expressing his personal views . . . [H]e had talked with the Chairman of the Council of Economic Advisers, with Treasury officials, and with the President. They had all expressed the view that it would be unwise to change monetary policy now. The President had not taken a rigid position on the matter—he had not suggested that the Committee should abdicate its responsibility for formulating monetary policy . . . At the moment, however, the Administration was strongly opposed to a change in policy. . . . With a divided Committee and in the face of strong Administration opposition he did not believe it would be appropriate for him to lend his support to those who favored a change in policy now. (FOMC Minutes, October 12, 1965, 68–69)

The president was not much concerned about Martin’s warnings about spending and the deficit. He spent much of the fall of 1965 pushing enactment of new spending programs for education and the environment (Califano, 2000, 70, 81).

In September, Martin had agreed to let the Federal Reserve staff participate in a joint effort with the staffs of the other Quadriad members to study where the economy was headed.
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The report in November concluded that the Federal Reserve “should not tighten for the remainder of the year” and reconsider action when the budget and GNP estimate for 1966 became known (Okun oral history, tape I, 24). Monetary tightening should wait for
GNP to reach $720 billion, a 5 percent increase from 1965 and almost two percentage points above the standard forecast (ibid., 24).
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312. The staff members were Daniel Brill, Federal Reserve, Charles Zwick, Bureau of the Budget, Paul Volcker, Treasury, and Arthur Okun, Council of Economic Advisers. Martin not only rejected the report, he suppressed it. Members did not receive copies, and we could not find a copy in the Federal Reserve’s records. Okun recorded that Governor Maisel “testified in pain some months later that he’d just found out about its existence, and he had never seen it” (Okun oral history, tape I, 25). Okun records Brill as saying: “‘I’ll bet we’ve made monetary policy for the rest of the year. . . . A lot of guys on the Board are predisposed not to take action anyway; it gives them a good consensus excuse’” (Okun oral history, tape I, 25). Maisel’s diary (December 3, 1965) records his anger at learning that Martin suppressed the report. He testified at a congressional hearing, angering Martin.

Martin knew that the budget estimates understated the increase in defense spending and that Johnson had suppressed the planned increase. He knew also that contrary to standard practice, the Budget Bureau would not discuss the budgetary projections with him or his staff. Martin distrusted President Johnson and was inclined to give more attention to markets than to economists’ forecasts.
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Government bond yields began to rise in August and had increased twenty basis points by mid-November to the highest level since 1960. This was a large increase by the standards of the time.

Too
little,
too
late.
On November 4, the Treasury’s issue of eighteenmonth 4.25 percent notes was not well received, allegedly because of concerns about rumors of increased spending for Vietnam. Between August 1 and December 1, yields on three- to five-year Treasury issues rose forty-two basis points to 4.52 percent (Annual Report, 1965, 190). In the month of November, the System bought $5.5 billion of one- to five-year securities, mainly the new note issue, and sold Treasury bills or let them run off.

The market had signaled that interest rates should rise. With few brief exceptions, the federal funds rate had remained above the discount rate since March. Data available at the time showed rapid growth in the monetary aggregates (Table 3.12).

313. Actual GNP reached $749.9, a9.5 percent increase of which 5.8 percent was real and 3.8 percent was inflation (deflator). The forecast error was 6 percent.

314. Martin claimed that he liked Johnson but, in his oral history, he said, “He was one of the greatest liars I’ve ever known, and ‘liar’ is the only word I can use for it because he would have no hesitation in lying about the most trivial things” (Martin oral history, tape I, 5–6). Bernstein (1996, 364) reports on the Quadriad meeting in October. “Martin wanted to know how much additional the government was going to spend, particularly by McNamara on the war.” Johnson mentioned $3 to $5 billion although he knew that this was far below the planned increase. Martin said he was leaning toward higher rates. Johnson opposed an increase, saying it would hurt small farmers and businessmen. Ackley and Budget Director Charles Schultze agreed. Martin looked the president in the eye and said, “If we thought you were right, we’d all do the same thing. But the question is, whose crystal ball is right?” To lower the budget estimates, Secretary McNamara assumed the war would end on June 30, 1967. This avoided budgeting for longer-lived equipment (Califano, 2000, 111). The actual increase in defense spending was $10 billion to a total of $67 billion in fiscal 1967.

Martin had another source warning about inflation, the Federal Advisory Council. Members explained the strength of investment spending as an attempt to substitute capital for rising labor costs (Board Minutes, September 21, 1965, 3).
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In November, the FAC repeated its September warning: “The Council is concerned with increasing evidence of the development of inflationary pressures, the continued strong demand for bank loans . . . Consequently, we believe the Board should be prepared to move in the direction of further restraint, including a tightening of reserves and an increase in the discount rate” (Board Minutes, November 16, 1965, 22).

Martin was, finally, ready to accept the challenge. The administration remained opposed.
³¹⁶
At the FOMC meeting on November 23, the staff proposed that if the FOMC tightened policy, it should reduce reserve growth and keep regulation Q ceiling rates unchanged. This would force a reduction in CDs and bank credit. Hayes proposed the opposite, an increase in ceiling rates and the discount rate (Maisel diary, December 3, 1965, 3–4). Nine of the twelve presidents either opposed a discount rate increase or wanted to wait (FOMC Minutes, November 23, 1965). Martin said that the market’s “expectations were just as much that the President would not allow any interest rate changes as to the contrary” (ibid., 84). Martin “wanted to raise the discount rate in order to free the interest rates from domina
tion by the President and he was more interested in this than he was in tightening the amount of money” (Maisel diary, December 3, 1965, 15). He opposed an increase in reserve requirement ratios because he did not want to reduce availability. His aim was to show that the System had not yielded to the administration (Maisel diary, January 18, 1966, 2–3).

315. One member warned: “The banking system might not be able to take care of its share of the job [of lending] unless there was some adjustment in the tempo of the economy or some adjustment in the rate structure” (Board Minutes, September 21,1965,9). Some banks had raised prime rates earlier but rescinded the increase under pressure from the president and the Council. The Council was responsible for wage-price guidelines. The banks clearly wanted the Federal Reserve to act so that they could follow.

316. President Johnson and Secretary Fowler continued to oppose the increase. When they discussed the prospective budget deficit on November 28, Fowler warned Johnson that “if the deficit goes beyond the $8 billion level, you’ve got to very seriously entertain the prospect of monetary action.” Johnson then told Fowler that no one knew the correct estimates except himself and Charles Schultze, the Budget Director. Fowler said: “This is the first time I’ve heard anything beyond $108 or $109 [billion].” Johnson told him that Schultze was trying to reduce spending from $125 to $115 billion with revenues projected to be $107 billion, or a deficit of $8 billion.

Earlier in the discussion, Johnson asked Fowler if he had thought about replacing Martin. Fowler told him that he had considered Paul Volcker, but he was unsure. “We want a sure vote, not a reasonable fellow who will try to steer us down the right path. We’ll just want a fellow that just goes along” (Oval Office Conversation, Henry Fowler and Lyndon B. Johnson, tape 6511.08, LBJ Library, November 28, 1965). At about this time, Ackley sent a memo to the president warning him that “too small a budget would invite fiscal drag; one too large could propel the economy forward at a pace threatening inflationary pressures in an economy close to full utilization” (memo, Ackley to the president, November 25, 1965, WHCF, Box 1, 3). The memo also exulted that the economy had expanded more than anticipated. Despite measures of capacity utilization at 90 percent and unemployment at 4.3 percent, Ackley saw no reason for concern about inflation. The most likely reason is that he thought 4 percent was full employment and that prices would not rise until the unemployment rate was below 4 percent.

Maisel warned Ackley that the discount rate would increase.
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Martin had already told him. The president was at his ranch in Texas recovering from a gall bladder operation. On November 29, the president’s assistant relayed an urgent telegram from Ackley to the president in Texas warning that Martin intended to approve a discount rate increase the following week. The telegram quoted Maisel as urging the president to tell Governor Daane to oppose any increase until January (telegram, Califano to President, November 29, 1965, WHCF, Box 50, LBJ Library). A few days later Ackley followed with a memo claiming that he (Ackley) had failed to distinguish between real and nominal interest rates and arguing that the voluntary restraint program on bank lending to foreigners was an effective substitute for higher interest rates in reducing the capital outflow.
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The president responded by inviting the Quadriad to his ranch the following Monday.

Martin decided to act before the Texas meeting. On December 3, the Board voted four to three to raise the discount rate by 0.5 percentage points at New York and Chicago. In the next ten days, all reserve banks adopted the 4.5 percent rate. Robertson, Mitchell, and Maisel dissented. Dewey Daane cast the swing vote supporting the increase. Following the vote the Board voted to increase regulation Q ceiling rates to 5.5 percent.

The opponents used a number of arguments. Robertson said that inflation was not inevitable. Higher rates might bring on recession and would raise the cost to the Treasury of marketing its debt in January (Board Minutes, December 3, 1965, 2).
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Robertson proposed instead to (1) slow the
issue of bank promissory notes by making them subject to regulation Q ceiling rates;
³²⁰
and (2) allow banks to borrow reserves to cover the loss of time deposits because regulation Q ceiling rates were below market rates. In a reversion to Riefler-Burgess notions, he explained that increased borrowing “should serve to moderate somewhat the rate of advance in bank credit” (Board Minutes, December 3, 1965, 3). He also opposed increasing regulation Q ceiling rates.

317. Maisel also sent a memo to the Board members opposing a discount rate increase and urging coordination with administration policy. Martin told him that this violated Board norms, a tradition against memos or caucuses outside meetings (Maisel diary, December 3, 1965,6).

318. “Interestratestodayarehigh—not low” (memo, Ackleyto the president, December 2, 1965, WHCF, Box 50, LBJ Library).

319. This is an odd argument for a central banker to make for two reasons. First, central banks are independent to avoid the use of monetary policy to finance the government debt at concessional rates. Second, it is hard to think of any justification for delaying an interest rate increase until after the government sold its bonds. Maisel’s diary (December 3, 1965, 9) complained that Martin called the Board meeting suddenly on a Friday afternoon and did not say that the discount rate increase would be on the agenda. He did not have time to prepare. Also, Martin neglected to tell the Board that Ackley had asked him to wait and told him that he would urge the president to support the increase in the State of the Union message. These
and other procedural complaints became public in Maisel’s testimony at a hearing called by Congressman Patman.