A History of the Federal Reserve, Volume 2 (89 page)

Mitchell did not agree. He opposed the increase in the discount rate on political grounds. The Federal Reserve “appeared to be on a collision course with the administration” (ibid., 7) He preferred to negotiate a 0.25 percentage point increase with the administration, but he favored an increase in ceiling rates and would support a 5.5 percent rate on all maturities over fifteen days (ibid., 9).

The recovery was Maisel’s main concern. He favored incomes policy to control prices and wages. “A discount rate increase . . . could be interpreted only as a vote of no-confidence by this Board in the national goal of growth at full employment” (ibid., 16). He warned the Board that the discount rate at New York had not been as high as 4.5 percent since November 1929 (ibid., 17). He dismissed current concerns about inflation. If inflation rose, the Board could act later.

Daane made the case for higher rates based on persistent price pressures, the risk of more general price increases, and the prospect that an investment boom had started. He mentioned a 10 percent increase in business fixed investment as especially troublesome. He added that he worried about “deterioration in our balance of payments not entirely papered over by changing definitions and some strenuous Governmental efforts to achieve postponement of some scheduled outflows into next year’s statistics” (ibid., 11). Then he added that higher interest rates “will contribute to the relative price stability essential to the eventual resolution of our balance of payments problem” (ibid., 11).
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320. The Board had discussed this issue several times. To avoid ceiling rates, reserve requirements, and deposit insurance fees, the First National Bank of Boston issued promissory notes in September 1964. The Comptroller of the Currency ruled that the action was legal. Other banks followed. Robertson proposed redefining deposits to include the notes. The FDIC staff agreed, but the Board delayed because it did not expect the Comptroller to agree, and the Comptroller was also a director of the FDIC. The Comptroller’s opposition meant that he would not enforce the ruling against national banks. This would put state chartered banks at a disadvantage. All but one of the reserve banks opposed also (Board Minutes, September 14, 1965, 7–11).

321. Governor Daane’s expressed concern for the balance of payments contrasts with the administration’s discussions. Fowler, Ackley, and others showed no sign that the improve
ment in the balance of payments reflected the lower U.S. inflation rate and depreciation of the real exchange rate. Ackley seemed to believe that inflation was unlikely and, if it occurred, could be managed by the guideposts. I found no mention of money growth in his discussions of price increases or inflation. Although he does refer to credit growth, the context usually refers to financing business expansion. For the balance of payments, the administration relied mainly on additional “voluntary” controls on bank loans and investment. See below for discussion of voluntary restraint.

Martin spoke last. He warned about the risk to the System’s independence if it acted against the president’s wishes. “There is a question whether the Federal Reserve is to be run by the administration in office” (ibid., 28). He believed the Board had to show that it was independent.

The Board’s announcement emphasized that it wanted to slow excessive demands for credit and maintain price stability. A news story describing the action said, “The Federal Reserve has no intention of imposing a severe ‘tight money’ policy that would render bank loans difficult to get”
(New
York
Times,
December 6, 1965, 6). Nevertheless, President Johnson criticized the decision, publicly expressing his view that it would hurt consumers and state and local governments and complaining that “the decision on interest rates should be a coordinated policy decision in January” (ibid., 31). The
New
York
Times
editorial supported the president on coordination while recognizing that inflationary pressures had increased and the administration had restricted its efforts to pressuring industries and firms not to raise prices (ibid., 36).

Gardner Ackley, the Council’s chairman, used more pointed language (Ackley Oral History, tape II, Johnson papers, 3). But Ackley’s concern was as much the breakdown of policy coordination as the increase in interest rates.
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“The members of the Council were not entirely unsympathetic with Martin’s position. We agreed that some kind of restraint was necessary. We would have much preferred a tax increase rather than tighter money. We not only clearly predicted to the President that monetary policy would tighten considerably farther, but I suppose in a sense we also had a certain amount of sympathy with what the Fed was doing, although we didn’t always express that sympathy strongly or clearly in the President’s presence” (ibid., 4).

Later, Ackley traced policy development under the pressure of war finance as he saw it. Johnson opposed any reduction in spending on his Great Society programs.
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He disliked higher interest rates. That left a tax
increase to pay for
rising costs of war and the Great Society programs. By October, Ackley claimed that the Council knew about spending increases. “It is frequently assumed that at this period the Council of Economic Advisers and perhaps other people were misinformed about some of the facts . . . about the size of prospective government expenditures . . . [W]e had all the evidence we needed to conclude without any question, certainly by November or early December, that a tax increase was absolutely necessary if we were going to avoid substantial inflation in 1966. So the proposal for a tax increase was well formulated and strongly supported by Treasury, Council, and Budget Bure
au in the late fall and throughout this period” (Hargrove and Morley, 1984, 247–48).
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322. Ackley describes Martin as “immune to the [Johnson] treatment. He had worked him over on more than one occasion without appreciable results, and he certainly had expected people in his administration . . . to work on Martin and his Federal Reserve colleagues. I guess he came to see that Martin was just there in the way and that there wasn’t any way to push him aside” (Ackley oral history, tape II, Johnson papers, 3–4).

323. “Those were his children, his babies—he used that phrase many times. Those were what he’d be remembered for” (Hargrove and Morley, 1984, 247).

Some of the president’s advisers claimed that if Martin had not raised the discount rate, the president might have asked for a tax increase early in 1966 (Okun oral history, tape I, 25).
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Dewey Daane explained, however, that Martin knew Wilbur Mills well and “never had any sense that there was the slightest possibility of a tax increase from LBJ” (Hargrove and Morley, 1984, 252).
³²⁶
Johnson (1971, 444–45) confirms this. For Martin, coordination had become a one-way street; the Federal Reserve supported administration policies but had no support for its own concerns.
³²⁷
The president had refused to confirm what Martin knew about the budget. Inflation had started to increase, and the market people whose judgments
Martin relied on more than economists’ forecasts saw this in the large increase in lending to finance war production. He took a temporary respite from coordinated policy.
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324. Ackley then talked about Johnson’s discussion in his autobiography. Johnson reprinted one of Ackley’s memos about a tax increase if the budget reached $110 or $115 billion. “I am reported as saying that the lower figure . . . very probably would require a tax increase and the higher figure certainly would. But the whole point of the exercise was that we knew damned well that neither of these figures was in the least bit accurate” (Hargrove and Morley, 1984, 248). Ackley’s memos in the Johnson Library support neither his claim nor his recollection about timing. The memo to which Johnson referred was sent on December 17, two weeks after the rate increase.

325. This seems improbable. Johnson asked the chairman of the House Ways and Means Committee, Wilbur Mills, whether he would support a tax increase. Mills opposed the increase and said it would be impossible to get it through Congress. Ackley said, “My impression is that Wilbur Mills, in my presence, told him that they would not hold hearings on a tax increase bill” (Hargrove and Morley, 1984, 251).

326. In fact, the budget asked for reinstatement of some of the excise tax reductions approved in June 1965 (automobiles and telephones).

327. It was not just the president. Ackley claimed that he liked Martin, but he did not respect him or his opinions. “Martin was absolutely zero as an economist. He had no real understanding of economics” (Ackley oral history, tape II, Johnson papers, 6). Heller, who continued to advise Johnson after he left the chairmanship of the Council, regarded coordination as a way of influencing, possibly controlling, the Federal Reserve’s actions. Ackley did not believe the Federal Reserve should be independent. “I would do everything I could to reduce or even eliminate the independence of the Federal Reserve” (ibid., 6). This attitude, whether or not expressed, was unlikely to make Martin think that the relation was one of equals coordinating their actions.

The discount rate increase raised criticisms of Martin and the Federal Reserve out of proportion to the steps they had taken. Congressman Patman called for Congress to end Martin’s power. Senator Paul Douglas (Illinois) called the action “as brutal as it was impolite,” and Senator William Proxmire (Wisconsin) said it was a blunder and demanded hearings
(New
York
Times,
December 7, 1965, 1, 74).

The press report of the meeting at the ranch suggested that Johnson and Martin had a difference of opinion, but the “atmosphere [at the press conference] was suffused with sweetness” (ibid, 1). Martin’s account of the meeting was entirely different. Johnson accused him of taking advantage of his illness and harming his presidency. “He was very disagreeable” (oral history, tape I, Martin papers, 14). But Martin did not yield even when Johnson swore at him. Martin’s account explains why he delayed acting, despite his June speech and his many warnings about inflation.
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The rate increases remained in effect. Under intense pressure, Martin courageously maintained the Federal Reserve’s right to independent action, but the action did not stop inflation or slow growth of the monetary base. The monetary base and M
₁
growth continued to increase rapidly as the Federal Reserve attempted to moderate the impact on market rates.

Martin had not raised the discount rate to reduce money growth. At the first FOMC meeting after the discount rate increase his concern was
the shock to the market from the increases in discount and ceiling rates. The FOMC agreed. Part of the market’s uncertainty probably came from growing recognition that inflation had returned (Maisel diary, Summary, February 9, 1967).
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The directive called for moderating the market’s turbulence.

328. At one point, Ackley described Johnson’s attitude toward Martin. “I think in a way he rather liked Martin, but he didn’t think he was a heavyweight and he didn’t fully trust him” (Hargrove and Morley, 1984, 236).

329. Martin repeats his basic story several times. “I went to him in May, I think it was, of that year [1965] and I said, ‘Mr. President, we can’t wait any longer. We’re going to have to raise the rate. It’ll be too late if we wait beyond that.’ He listened to that and he said, ‘Well you’ll give me another chance.’ I said, “I’ll give you another chance but I’m warning you now. I’ve got three members of my Board who are in complete agreement with me, so I’ve got a majority. I want to get this out of the way. You and I have been playing with this since February. Here it is July . . . and I don’t think we can play with it anymore. . . . ’

“He said, ‘I wanted to tell you I think you were precipitous on this.’ I said, ‘But, Mr. President, I warned you on this.’ He said, ‘Yes, you did but I never thought you’d move forward.’ ‘Well,’ I said, ‘I told you why. I couldn’t wait longer, I would have liked to have raised the rate in May. You were adamant against it then.’ . . .

“And then he said, ‘You took advantage of me [when I was sick]. I just want you to know that I think that’s a despicable thing to do’” (Martin oral history, ta
pe I, Martin papers, 15–17).

By late December, the Budget Bureau and the CEA had new budget and deficit numbers. They recognized that inflation was likely and proposed a tax surcharge delayed until spring 1966 (memo, Schultze to president, CF, Box 42, December 27, 1965).

Instead of a restrictive policy to stop inflation, “credit was supplied between December and the end of June at record-breaking rates. The rate of increase in total reserves from December through June was at a 6.3 percent annual rate. This was four times as large as the June–November 1965 period. All other aggregate measures showed similar rates of increase” (ibid., 1).

Those who voted for the discount rate increase argued for minor restriction of credit; those who voted against the increase recognized that the administration had left the problem to the Federal Reserve. Although they believed that fiscal restraint was the preferred policy, they saw that it had not happened. They argued for more monetary restriction citing the growth of the aggregates as evidence of the need for restraint (ibid., 3). Martin and other proponents of moderation relied instead on the decline in free reserves and the rise in the federal funds rate and other short-term rates. Once again, these indicators misled them (see Chart 3.15 above).

By March long-term Treasury yields reached 4.7 percent, a 0.35 percentage point increase after the discount rate increase, and the federal funds rate reached 4.63 percent, a 0.5 percentage point increase. Member bank borrowing increased, and free reserves reached −$255 million in March (from $8 million in December). Governor Maisel (1973, 77–79) drew a correct conclusion. “Federal Reserve doctrine was based on a money market strategy. The Fed used money market conditions simultaneously as a target, or measure, of monetary policy and as a guide for the manager” (ibid., 78). Referring to his introduction to FOMC procedures, Maisel wrote: “Nowhere did I find an account of how monetary policy was made or how it operated. . . . Arguments had been strong and quite clear [in 1965] because they were based primarily on ideological views . . . Frequently, members of the FOMC argued over the merits of policy without ever having arrived at a meeting of the minds as to what monetary policy was and how it worked” (ibid., 77–78). This reinforces Hayes’s arguments above about the difficulties in trying to write a precise directive to the manager.

The misinterpretation of its actions proved costly. By March 1966
the twelve-month rate of increase in the consumer price index reached 2.8 percent, the highest rate in eight years.
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330. Maisel did not start keeping a diary at each meeting, although he took notes. The February 9, 1967, summary covers some meetings from December 1965 to October 1966. The text is based on notes made at the meetings.