A History of the Federal Reserve, Volume 2 (92 page)

Some banks evaded regulations. Whenever market rates approached ceiling rates, the Board had to consider these efforts to avoid or circumvent regulations. In 1965, the administration proposed legislation authorizing the FDIC and the Federal Reserve to penalize banks that violated the ceilings. The FDIC was eager to enact the legislation. The Board hesitated. Its main concern was the treatment of fees paid to brokers that collected deposits for resale to banks. Proposed legislation gave the Board and the FDIC authority to waive restrictions on fees. Congress did not act on the bill.

To avoid regulation Q ceilings, reserve requirements, and deposit insurance fees, major banks began to increase their liabilities by selling promissory notes. Governor Robertson wanted to classify the notes as deposits to bring them within existing regulations. The Board’s legal department ruled that the definition of “deposit” could be extended to include notes
³⁴⁸
(Board Minutes, September 14, 1965)

The Board had a practical problem. The Comptroller would treat promissory notes at national banks as borrowings, not deposits. State member banks would be at a disadvantage. Some argued, however, that this was a clear circumvention of the Board’s regulations and should not be permitted. Governor Shephardson responded that “as he had observed on many occasions, particularly in connection with Regulation Q problems, unfortunately the Board was faced with many frustrations in being responsible for administering laws that could not be effectively enforced. . . . Unless the Board was resolved to make a fight on the whole broad spectrum [of evasions], the alternative was to continue along the lines it had followed thus far” (ibid., 21–22). Martin agreed, and the discussion ended.

GUIDEPOSTS

The guideposts first appeared in the 1962 Economic Report of the President (Council of Economic Advisers, 1962) as a general admonition to keep nominal changes in worker compensation bound by productivity changes. Price changes would then reflect costs plus markups. If costs
rose at the trend rate of productivity growth, and markups remained stable, prices would be stable also. The reasoning behind the guideposts is similar to the discussion of price changes in the Joint Economic Committee’s 1959 study of 1950s experience,
Employment,
Growth
and
Price
Levels.
The job of the guideposts was to remind employers, employees, and the public of this standard.

348. The First National Bank of Boston started the practice by selling $1 million of unsecured notes in September 1964. The Board’s initial response classified the notes as borrowings (not deposits). Other banks considered following, raising concerns for some Board members. The reserve banks did not favor action.

Behind this exhortation lay a belief that a modern economy could not reconcile full employment and price stability because (mainly) industrial workers demanded wage increases in excess of productivity growth. This was called “inflationary bias,” and the claim was that the bias existed in the pricing of both industrial products and workers’ compensation. The Economic Report of the President (Council of Economic Advisers, 1966, 88–89) reviewed this argument and recognized other causes including overly expansive fiscal policy. Keynesian economists wrote the report, so monetary policy was not mentioned as a cause of inflation.

The most obvious economic flaws in this argument were failures to distinguish between one-time and continuous changes and between relative and absolute price changes. Labor or producer power could be used once, perhaps a bit more if labor or producers had to discover how much power they had. Inflation bias referred to price changes, not levels. Inflation continued for more than a decade, a fact that was difficult to reconcile with inflation bias. Further, even if guideposts prevented a company or industry from raising its prices, the additional demand created by monetary or fiscal expansion remained. Unless the public added sufficiently to its money holdings, spending on securities or goods and services would not be affected by guideposts. Some individual prices would be controlled, but other prices, and the price level, would rise.

Ackley’s messages to the president about inflation often listed the individual commodity or service prices that seemed likely to increase. He believed that “guideposts help put some of the blame for inflation where it belongs. There are always plenty of people trying to put it all on the government” (memo, Ackley to Bill Moyers, June 21, 1965, WHCF, Box 23, LBJ Library, 3). As an alternative to guideposts, Ackley proposed more vigorous anti-trust policy, easing entry into construction unions, and “other highly unpopular measures” (ibid., 5).

The obvious political flaw in the argument was that exhortation and announcement proved insufficient. Enforcement became necessary and, increasingly, required the president to pressure unions and corporations or industries. Ackley acknowledged that in 1965 “service professions had greater wage increases and unions then sought to catch up with nonunion labor in 1966, and that’s when the breakdown began” (Hargrove
and Morley, 1984, 259). This contradicted the claim about inflationary bias by reversing the direction of changes and putting the (largely) non-union service sector first. And Ackley agreed public sector wages rose relative to private sector wages (ibid., 262).

The political problems arose most sharply once the president became involved. Failure forced the president to back down.
³⁴⁹
Looking back, Ackley recognized the political error. “It was a mistake to have this function in the Council of Economic Advisers, and probably a mistake to involve the President in it so closely.” He did not recognize that efforts to shift the supply of output or labor would have to be repeated until the administration and the Federal Reserve reduced real aggregate demand to equal aggregate supply.

CONCLUSION: WHY THE GREAT INFLATION STARTED

The years from 1961 to 1965 are some of the very best years in Federal Reserve history. Median income in 1960 prices rose 15 percent, almost 3 percent a year. Until 1965 inflation remained subdued. As the economy recovered from the 1960 recession, the civilian labor force increased 8 percent as unemployment fell and the economy created more than 5 million new jobs.

Fifteen years of inflation and slow growth followed. The mild inflation of 1965 continued sometimes faster, sometimes slower until a reported peak of 13.7 percent in 1980. Another fifteen years passed before the return of above average growth and low recorded inflation.

The Great Inflation started while William McChesney Martin, Jr., was chairman of the Board of Governors. Martin was not a wild radical eager to confiscate the wealth in outstanding bonds and fixed nominal values. He was not a radical of any kind. On the contrary, he was a symbol of conservative fiscal policy and “sound” finance. His contemporaries often portrayed him in caricature wearing a high starched collar and looking like a refugee from the nineteenth century. He gave many speeches warning about inflation and denouncing unbalanced federal budgets, balance of payments deficits, and fiscal profligacy.

Martin seems a most unlikely person to preside over monetary policy at the start of the Great Inflation. Yet until January 1970 he was in a position to stop it. He failed to do so. When he left office, broad-based measures of
prices had increased 5 to 6 percent in the previous year, an unusually high rate of inflation for a relatively peaceful period.

349. Ackley cites a confrontation with airline machinists that the president lost. “The mistake, I believe, was in building it up as a big issue . . . [W]e would have been so much better off if we had never entered into a public fight. Once we got into a public confrontation with them, we either had to win or we took a very serious defeat” (Hargrove and Morley, 1984, 262). Ackley did not have any attractive proposals for avoiding problems of this kind.

Inflation increased further in the 1970s, after Martin retired. The reasons for the start of inflation and its later increase overlap to a degree, but it helps to separate them because costs of preventing inflation from starting differ from the costs of stopping an established inflation. This concluding section to the early 1960s considers the reasons the Great Inflation started.

Inflation was not new in 1965, and it was not new to Martin. He had successfully ended the inflation that followed the Korean War. By late 1952, average annual increases in consumer prices reached 1 to 2 percent. Inflation continued to fall until it became modestly negative in 1954–55. Again, in 1959–60, average annual consumer price inflation fell to 0 to 2 percent from 3 to 4 percent in 1957–58.

Terminology about inflation is often confusing. Throughout this text inflation means a
sustained
rate of price increase. Another definition is often found; inflation refers to any increase in the price level. Using this definition, writers refer to cost-push inflation or food price inflation. These usages combine one-time price level changes and sustained rates of change. In both the price level rises. The difference is that one-time price level changes, though they may be spread over time, come to an end without a policy change. Sustained price increases are monetary in origin and end with a reduction in money growth.

The start of the Great Inflation was a monetary event. Monetary policy could have mitigated or prevented the inflation but failed to do so. The intriguing questions about the 1960s inflation are: Why did the Federal Reserve permit inflation to return in 1965? Why did it not repeat the actions that ended inflation twice in the 1950s?

The detail in the chapter suggests not one answer but several. Three seem most important. First is Martin’s leadership and beliefs. Second, neither Martin, nor his colleagues in the FOMC, nor the staff had a valid theory of inflation or much of a theory at all. And some of their main ideas were wrong. Third, institutional arrangements hindered or prevented taking timely effective action and increased inflation. Beliefs and arrangements worked together to allow inflation to start and to continue.

Martin’s
Leadership
and
Beliefs

Martin was a highly respected chairman. He believed passionately in the independence of the Federal Reserve, and he had the courage to insist upon its independence when pressured by President Johnson or by presidential staff and officials. In his oral history, he described fully and at length the
pressure from the president to rescind the discount rate increase in 1965 and his resistance to presidential pressure at other times.

However, at times, Martin responded to administration pressure by hesitating or delaying action. Although he had concluded much earlier that he had to tighten policy to avoid higher inflation, he urged delay in October 1965. His reason was coordination. He told the FOMC that he, as the minutes record it, “had the responsibility for maintaining System relations within the Government . . . and he had made that one of his principal concerns during the fourteen years he had held his present office” (FOMC Minutes, October 12, 1965, 68–69).

He was not confrontational, dogmatic, or unwilling to change his mind. He admitted mistakes and respected Board members who disagreed with him. If a majority did not agree with him about a policy change he would often wait months until a majority formed.

In the System’s early years, the Federal Reserve and the government followed classic nineteenth-century practices. The central bank was independent of government, although at times restricted by gold standard rules. The government did not intervene in Federal Reserve decisions despite two members on the Board; the Federal Reserve operated independently and divulged little information.

By the 1950s standards had changed. Central banks controlled one part of the policy “mix” that affected the level of employment, output, and prices. Although no longer represented on the Board, successive administrations recognized that the public expected government to maintain high employment rates and avoid inflation. The Employment Act of 1946 codified this practice.

The meaning of central bank independence changed and with it the goal of monetary policy. In an oft-quoted remark, Martin defined independence indirectly by saying that the Federal Reserve had to take away the punch bowl while the party was getting started. The more formal statement described the Federal Reserve as independent within the government, not independent of the government. To those like Martin, who made that statement, it went beyond recognizing that the Federal Reserve was the agent of Congress—that Congress had delegated its constitutional responsibility to coin money and regulate its value and could withdraw it.

The March 1951 Accord freed the Federal Reserve from Treasury control of interest rate levels but gave it co-equal responsibility for debt management. The Treasury had to price its issues in the light of current market interest rates. The Federal Reserve’s role was to prevent the market from failing to accept a Treasury issue; in practice that meant it supplied enough
reserves to keep interest rates from rising around the time the Treasury sold its offering. It called the action an “even keel” policy.
³⁵⁰

Martin explained several times that Congress voted the budget and approved deficit finance. The Federal Reserve was not empowered to prevent the deficit or refuse to finance it. Central bank independence stopped well short of that.
³⁵¹
Therefore, he complained often about the size and frequency of budget deficits but the Federal Reserve provided the reserves to finance them. And it rarely felt able to remove the additional reserves after it supported the Treasury’s offering.

In the early 1960s, Martin regarded unemployment as structural, not responsive to expansive monetary and fiscal policies. Kennedy administration economists blamed restrictive fiscal and monetary policies, including “fiscal drag,” the tendency of the budget to reach balance before the economy reached full employment. They wanted permanent tax reduction supported by an expansive monetary policy to finance the deficit. Martin did not agree with the analysis or the policy, and he later accepted that he had been wrong about the stimulative effects of tax reduction. But he agreed that the Federal Reserve should assist in financing the deficit because Congress approved it. Thus, he accepted “coordination.” Later, when deficits increased in size and Treasury offerings became larger and more frequent, the Federal Reserve had fewer days on which it could increase interest rates and more debt issues to help manage. Thus it sacrificed operational independence.

Martin often said that monetary policy
alone
could not prevent inflation or achieve balance in international payments. Given his belief that the Federal Reserve shared responsibility for successful deficit finance, his statement was true.

Some of his successors showed that inflation could be reduced
even
in a period with large deficits. In the 1980s, the federal government ran large, persistent deficits. The Federal Reserve had an independent policy and did not assist in deficit finance. One important change in this context was the end of the Federal Reserve’s “even keel” policy of holding shortterm interest rates constant when the Treasury sold notes or bonds. By the
1980s, the Treasury auctioned its securities and let the market price them instead of leaving the Treasury to set a price that the Federal Reserve felt bound to support.

350. The problem was very apparent in the last half of the 1960s. Precise starting and ending dates for even keel operations are not always given. In the twenty-four quarters from 1966:1 to 1971:4, there are eighteen reported even keel operations, sometimes more than one. Every quarter from 1966:3 to 1968:2 had an even keel operation. Professor William Yohe of Duke found that the FOMC voted for even keel at eleven of eighteen meetings in 1959 and 1964 (letter, Yohe to Meltzer, August 8, 1967).

351. Cukierman (1992) presents several definitions of independence and compares central banks.