A History of the Federal Reserve, Volume 2 (96 page)

FOMC debates revolved around three or four major points. The groupings could be characterized as “hawks” and “doves” with the characterization being almost a complete opposite of the December 3 vote to raise the discount rate. Most of those who voted for the discount rate [increase] then spent the period through June holding that the amount of restriction applied should be minor and should be increased only gradually. On the other hand, those who had voted against the discount rate increase, when they agreed by the end of December that restraint was proper and when they saw that the administration was going to attempt to allow monetary policy to handle the situation rather than using fiscal policy because of the premature monetary action, these doves now became hawks. They urged that the System determine where it wanted to go and move in that direction more rapidly. (Maisel diary, FOMC Summary, February 9, 1966, 3)

Maisel explained what he meant by the last sentence. The doves did not have a strategy for monetary policy. They proposed “raising interest rate cost only gradually with no clear picture of what was expected from net borrowed reserves increase or the interest rate increase” (ibid., 5). They lacked any way of relating their proposed changes to aggregate spending. The hawks related spending to bank credit and total reserves, so they wished to limit growth of reserves and credit.
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Pressure from President Johnson continued. One day Martin was asked to come to the White House. The president said, ‘“I want to tell you that you took advantage of me and I’m not going to forget it because here I am, a sick man. You’ve got me into a position where you can run a rapier into me and you’ve run it.’ I thought this was just silly. From my standpoint it was.” Martin placed the timing in the same year, 1965. Sometime after the president acknowledged that Martin had been right. “‘Well, Bill, you know, you are right in your judgment. But I just don’t agree with you.’ I said ‘Mr. President, that’s your prerogative. And it’s mine’” (Martin oral history, May 8, 1987, I, 16–17).

12. Using data available at the time, Maisel reported that total reserves increased at a 6.3 percent annual rate from December 1965 to June 1966, four times the rate from the previous June through November. Money supply rose at a 7.5 percent rate. Bank loans to business rose at a 34 percent annual rate during this period. Maisel listed as doves Hayes, Ellis (Boston), Irons (Dallas), Daane, and Martin; the hawks were Maisel, Robertson, Mitchell, Shephardson, and Brimmer after he replaced Balderston (Maisel diary, February 9, 1967, 5–6). In June, Darryl Francis supplemented Maisel’s statement. The Board had increased
nominal interest rates, but the inflation rate increased also. “When one adjusted market interest rates for the decline in the value of the dollar . . . interest costs had not risen at all” (FOMC Minutes, June 28, 1966, 65).

The Federal Reserve recognized the threat to its domestic and international objectives. The minutes report rising prices, reduced idle capacity, upward revision of GNP data, and growth of employment. At its February 8 meeting, it voted to “resist the emergence of inflationary pressures and to help restore equilibrium in the country’s balance of payments by
moderat
ing
the
growth
of
the
reserve
base,
bank
credit
and
the
money
supply”
(Annual Report, 1966, 130; emphasis added). The committee voted unanimously to reduce reserve availability gradually. Differences of opinion seem more muted, but Martin and Hayes would not agree to Robertson’s proposal to introduce a “proviso clause” authorizing the desk to adjust the free reserves target if reserves increased too rapidly.

The account manager’s report designated the February 8 meeting as the start of transition to a firmer policy. Free reserve fell from $8 million in December to −$62 million in January and −$111 million in February. The federal fund rate rose from 4.3 percent in December to 4.6 percent in February. As in many previous and subsequent occasions, these changes misled officials.
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The change in free reserves was an increase in borrowing; so more reserves became available and monetary base growth continued. The increase in short-term interest rates was less than the increase in the (annualized) inflation rate, so real rates fell. Moreover, the December increase in regulation Q ceiling rates permitted banks to increase time deposits, so bank credit rose rapidly also.

The Federal Reserve persisted in its error. At the March 1 and April 12 FOMC meetings, the members voted unanimously to reduce reserve availability. And again borrowing increased and free reserves fell to −$250 to −$300 million. The federal funds rate rose slightly.

A member of the staff, Charles Partee, later a member of the Board of Governors, summarized the outlook. “Recent rates of gain appear unsustainable in a physical sense and, accordingly, pressures on costs and prices seem to be intensifying” (FOMC Minutes, March 22, 1966, 25).
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One reason for caution was concern that higher market interest rates would force the Board to consider another increase in regulation Q ceil
ing rates. Several believed that a higher ceiling rate would increase bank credit expansion by reducing average reserve requirement ratios and enabling banks to attract time deposits from other thrift institutions. Wayne (Richmond) expressed concern that, if permitted, New York banks “could not be relied on to exercise prudence in setting time deposit rates” (ibid., 61). And Robertson argued that “it may be that only by holding the line on regulation Q that we finally calm down the bank credit expansio
n” (ibid., May 10, 1966, 93).

13. Merritt Sherman (1983, 35) wrote an internal history of the 1960s. Although written long after the events, he described monetary policy in early 1966 as an effort to “blunt the inflationary impact of credit-financed spending.” He used the increase in nominal interest rates and the reduction in nonborrowed reserves as evidence.

14. Chief economist Daniel Brill quoted this description of economic conditions. “Prices are up; quality is down. Costs are up; profits are down. Lead-time is long; labor is short. But business is very good” (FOMC Minutes, April
12, 1966, 17).

Positions changed. Perhaps congressional pressure and the confrontation with President Johnson caused Martin to hesitate to tighten aggressively. He now became even more hesitant, whereas Maisel and Robertson became more willing to tighten. In January, they sent a memo to the president warning him that still higher interest rates were coming. They described the December increase in discount rates, which they had opposed, as “probably . . . not . . . sufficient to cope with inflationary forces. . . .

[I]t will be necessary to curb more sharply the availability of money and credit or reduce spending power through taxation” (memo, Sherman J. Maisel and J. L. Robertson to the president, WHCF, Box 50, LBJ Library, January 18, 1966, 3).

Ackley, too, had second thoughts. He continued to criticize the timing and the effects on expectations. But he now concluded that “to help keep prices in bounds while defense spending forges ahead, some further restraint from monetary policy may be needed in the months ahead” (Ackley to the president, WHCF, Box 50, LBJ Library, January 18, 1966).
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In March, following increases in open market rates, major banks raised the prime lending rate to 5.5 percent. The president had criticized earlier increases and gotten a rollback. He asked Ackley to render an opinion on whether he should repeat this effort. Ackley asked Governors Maisel, Brimmer, and Robertson. All of them said the president should not comment. Then Ackley added, “All of them felt that monetary policy has now gone as far as it should go in the direction of restriction. As I understand it, this is also the present view of Chairman Martin” (memorandum for the president, WHCF, Box 50, LBJ Library, March 11, 1966). Brimmer and Maisel volunteered that further restriction should come from fiscal policy. Martin shared this view.

As in 1965, coordination had become a reason for not responding promptly to the threat of inflation. Martin and others on the Board and
the FOMC waited for a tax increase, or other fiscal restriction, that did not come until 1968. Hayes told the FOMC that the threat of inflation called for a coordinated policy involving fiscal, monetary, and wage restraint. “It is clearly undesirable to place too much of the burden on monetary restraint alone, we are justified in moving rather cautiously in the hope that the Administration will decide on more restrictive tax and spending policies. . . . We should not rule out the possibility—particularly if fiscal policy moves are not forthcoming—that a supplementary
voluntary
domestic credit restraint program may be required” (FOMC Minutes, March 1, 1966, 60; emphasis added).
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15. It is hard to find much support in the memo for Ackley’s earlier criticisms. He noted that corporate and municipal bond yields had increased by 0.02 to 0.05 and that growth of credit had not slowed in December.

On March 15, 1966, Martin wrote to the president to explain what monetary policy had achieved and to urge him to increase tax rates. But Johnson believed that to get Congress to approve a tax rate increase, he would have to reduce spending on poverty programs and his Great Society. He was not prepared to take that step.
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Waiting for a coordinated response was not the only reason for policy failure. Misinterpretations and error played a role also. Most members of the FOMC did not distinguish between real and nominal rates. They thought that at 4.5 percent, the discount rate was a high rate, the highest since January 1930.

16. President Johnson received mixed signals from his advisers. Although back in Minnesota, Walter Heller continued to advise President Johnson and favored an income tax surcharge. A memo on the pros and cons urged a prompt temporary 5 percent increase in tax rates across the board to raise $4 billion (memo, Heller to the president, CF, Box 44, LBJ Library, December 24, 1965). He forecast productivity growth of 3 percent and a 2.1 percent increase in the deflator (memo, Heller to the president, WHCF, Box 23, LBJ Library, December 31,1965). The results for the year reversed his forecast, productivity rose 2.4 percent and the deflator 2.8 percent (Council of Economic Advisers, 1971). The CEA forecast inflation at less than 2 percent. By March, the CEA wrote to the president, “The economy is breaking all reasonable speed limits. . . . No let-up is in sight on the advance of demand” (memo for the president, “The Economics of a Tax Increase,” CF, Box 44, LBJ Library, March 12, 1966). All three CEA members—Ackley, Arthur Okun, and James Duesenberry—signed the memo. It warned that industrial prices rose at a 2.5 percent annual rate from September to January and that “jawboning” could not work without fiscal support. The CEA recommended $4 to $7 billion in additional revenue. Soon after, Secretary Fowler urged a public announcement of the need for additional measures. Most advisers welcomed the discussion but opposed any announcement of the meeting.

17. A memo from budget director Charles Schultze responded to the president’s request to reduce spending by $2 billion. Schultze explained that most spending was for fixed commitments, so the $2 billion reduction “would have to fall very heavily on a number of important programs” (memo, Schultze to the president, WHCF, Box 22, LBJ Library, January 24, 1966). Poverty programs were at the top of a list that included construction and work on the supersonic transport (never built). Two months later, the Council of Economic Advisers advised the president that, despite increased military spending, “the fiscal 1967 Budget does not supply fresh new economic stimulus” (memo, Okun to the president, WHCF, Box 22, LBJ Library, March 17, 1966).

Other misinterpretations also contributed to policy failure. Maisel (1973, 77–86) reports on the lack of agreement about the thrust of policy in the winter and spring of 1966.
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Those who judged monetary policy by free reserves or money market conditions believed that policy had tightened; those who watched growth of money or monetary aggregates drew the opposite conclusion. The discount rate increase “created a rush for credit. . . . Borrowers stormed into banks to obtain money,” anticipating additional increases in interest rates (ibid., 78). Maisel explained that the issue was not about whether policy should restrict spending. “I began to suspect that the Fed might be committing some of the errors our critics accused us of. . . . Our problem was to convince the others that the level of net borrowed reserves was not, by itself, an adequate measure of policy; that it had to be supplemented by another measure” (ibid., 82).
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Martin yielded slightly to the dissidents at the April 12 meeting by referring to the “trends in aggregate reserves.” Instead of setting free reserves, he instructed the manager to follow a proviso clause—tighten “reserve conditions if the aggregates rose sharply” (Annual Report, 1966, 142). The federal funds rate rose briefly following the meeting but then fell back. A sustained increase did not begin until after the next meeting, May 10, 1966.

As a number of young economists filled positions in the growing staff, pressure rose to introduce the methods taught in graduate schools such as econometric forecasts and economic models. Maisel became the spokesman for these methods at the Board. Gradually, Martin yielded.
²⁰
By the spring of 1966, Riefler’s rule disappeared; forecasts of economic activity and financial conditions became part of the staff presentations at FOMC.

The administration was not idle, but it was unwilling to take decisive action against inflation. Instead, the president asked businesses to reduce planned capital spending and hinted about a tax increase. He acceler
ated tax payments and postponed repeal of some excise taxes. President Johnson took personal interest in many issues, including the increase in particular commodity prices. He seemed to believe that he could control inflation by limiting increases in specific prices. When food prices rose in the winter, he noted on a memo: “Get Ackley to list all commodities and elements in price index that may be looking upward and get Wirtz [Labor], Freeman [Agriculture], and Udall [Interior] and Katzenbach [Justice] busy” (memo, Joseph Califano to the president, WHCF, Box 28, LBJ Library, December 17, 1965). A few weeks later, Agriculture Secretary Freeman notified the president that he had suggested that the military reduce use of bacon and other pork products, butter, wheat, and eggs (memo, Orville Freeman to president, WHCF, Box 28, LBJ Library, January 22, 1966).

18. Maisel (1973, 77) explained that, as a new member in 1965, he received “volumes of documents and descriptions of what the Fed did, but there was no explanation of how monetary policy was made and how it operated.” “Members of the FOMC argued over the merits of a policy without ever having arrived at a meeting of the minds as to what monetary policy was and how it worked” (ibid., 78).

19. “At the February 1966 meeting of the FOMC, the directive had been changed. . . . Those of use who were anxious to slow the rapid increase in credit thought the Committee had come around to our view. It turned out we were wrong. The manager continued to furnish reserves, even more rapidly than before. . . . Money market conditions were tighter” (Maisel, 1973, 82).

20. Martin did not accept that these methods improved operations and usually did not give them much weight. Always a consensus seeker, he yielded to pressure from the staff, from the 1964 Patman hearings, and from recognition that models had become the basis for policy discussion in Washington.