A History of the Federal Reserve, Volume 2 (97 page)

If there was no risk of general inflation, there was no reason to risk congressional cuts in Great Society programs by asking for a tax increase. Further, a tax increase might strengthen opposition to the war (Hargrove and Morley, 1984, 252). As late as February, with consumer prices rising, Ackley reassured the White House staff that “we are not expecting anything properly called inflation in 1966” (memo, Ackley to Bill Moyers, WHCF, Box 28, LBJ Library, February 14, 1966). By April, he had changed his mind. Ackley warned that he expected additional increases in prices of industrial goods and services. Overall prices would rise by 2.5 percent in 1966, and he expected inflation to increase further in 1967, a year with many wage settlements. Failure to act would turn “creeping inflation into a canter” forcing action and risk ending the “Johnson prosperity” (memo, Ackley to the president, “The Prospect for Prices,” WHCF, Box 28, LBJ Library, April 25, 1966).

The preliminary report of first quarter GNP showed the largest increase since the Korean War. One-third of the increase was in the price level. Bank reserves and the M 1 money stock increased at 13.5 percent annual rates in April, and time and saving deposits accelerated also (Annual Report, 1966, 144–45). In early May, prices on the stock exchange fell sharply.

Maisel argued forcefully that despite the call for restrictive policy, since January “each monetary or credit index showed a much sharper growth rate in the past five months than it had in the previous five” (FOMC Minutes, May 10, 1966, 62). He wanted more decisive action and urged the FOMC to state publicly that it wanted to restrain credit but would not raise the discount rate or regulation Q ceiling rates.
²¹
Martin favored a gradual
policy and expressed concern about disrupting the money market. The FOMC voted unanimously for Martin’s policy, but Martin at last accepted Robertson’s proposal to include a proviso clause as a regular part of the directive. If reserve growth (later growth of total deposits) exceeded targets, the manager was told to change the free reserves or money market target.
²²

21. Maisel’s statement included: “When members looked at total reserves or nonborrowed reserves, either of which he took to be the principal measures of the committee’s results . . . In the five months since December 1, the committee had poured more reserves into the banking system than were furnished in the [previous] entire year. . . . The committee
had followed . . . feel of the market, net reserves, or the need to offset shocks, and as a result it had moved in a direction opposite to its real aim” (FOMC Minutes, May 10, 1966, 62–63).

Annual growth of the real value of monetary base had remained between 3.5 and 4 percent during the first five months of 1966. In June, growth slowed and began a precipitate decline, reaching 1 percent in October. Chart 4.7 shows these data. Anticipated real rates on ten-year Treasury bonds continued to increase until August.
²³
During the first eight months of 1966, these yields rose 0.6 percentage points, a 20 percent increase from the January level. Whether judged by growth of real balances or real interest rates, monetary policy tightened decisively in the spring and summer.

Anticipated real rates fell after August. By February–March 1967, this measure had returned to its January 1966 value. The real value of the
monetary base shows a similar pattern easing from 1 percent to nearly 3 percent growth between October 1966 and April 1967. Thereafter, the two series are positively related, the anticipated real rate suggesting less expansion, real base growth slightly more expansion. As on several previous occasions, when the two measures gave different signals, the economy followed real base growth.

22. Maisel (1973, 86) notes that external conditions changed about this time, so the proviso did not restrict actions. Later, “it could have been useful had it been well implemented.” In practice the manager ignored it.

23. I used the Livingston survey as a measure of anticipated inflation until data from the SFP became available in 1968. Most of the change is in t
he nominal interest rate.

Money market measures at first gave similar signals during the summer and fall. Thereafter, measures differed. The manager described the period from the June 7 meeting to September 13 as a time of peak pressure. The federal funds rate rose from 4.98 to 5.80 percent at these meeting dates. It reached a peak in the week ending September 7, before the meeting at which the FOMC shifted from a policy of “supplying the minimum amount of reserves consistent with orderly market conditions” to “maintaining firm but orderly conditions” (Annual Report, 1966, 174, 179). The committee did not approve “the recent tendency toward somewhat less firmness” until the November 1 meeting, when the federal funds rate was back to 5.86 percent. Long-term rates also increased during the fall, from 4.23 following the September meeting to 4.42 in mid-December.

Free reserves and borrowing were the main money market indicators of easier policy. Credit demands slowed with the economy, so banks reduced their loans at federal reserve banks, and free reserves rose along with real base growth. The large increase in free reserves came in 1967. By March free reserves reached +$298 from a low of −$431 in October. The federal funds rate fell gradually to the 4.25–4.75 percent range in March.

With higher and more variable inflation rates, divergence increased between growth of real and nominal values of the monetary base. Chart 4.8 shows these differences. The nominal base declined more steeply in the second half of 1966. The direction of change of the real and nominal base is noticeably different in late 1967 as inflation increased. With that exception, the direction of change is similar, although timing and magnitudes differ.

The Federal Reserve used free reserves or short-term interest rates, not base or money growth, to measure policy thrust. As Maisel called to their attention, the base gave different signals in early 1966, as on other occasions.
²⁴
Table 4.2 shows these differences following the December 1965 discount rate increase.

Table 4.2 shows that during this very brief, but important, turning point for monetary policy, judgments about policy thrusts differed in the spring
of 1966, the summer and fall of 1967, and the winter and spring of 1968. Inflation followed growth of the base and other monetary aggregates, not the federal funds rate.

24. Here is one example. “Despite a
less
expansive stance of monetary policy, money supply and bank credit grew
even
faster
in 1965 than in 1964” (“The Board of Governors of the Federal Reserve System During the Administration of President Lyndon B. Johnson,” Lyndon B. Johnson Library, 32; emphasis added).

Policy
Decisions
and
Actions

The December 1965 increase in regulation Q ceiling rates permitted banks to compete more effectively against other thrift institutions. Thrift institutions attracted deposits at short rates and lent on mortgages at long-term rates. As short rates rose relative to long, many found their profits were first squeezed and then eliminated, and their profitable experiences of the early 1960s ended. Some of the largest thrifts had attracted deposits by offering certificates of deposits (CDs) with higher rates than other money market instruments. When open market rates rose, holders withdrew to the higher rates offered by banks and the market.

The thrifts curtailed lending to homebuilders, so building activity declined more than 40 percent, from a peak annual rate of 1.65 million housing starts in December 1965 to a low of 0.96 million in November 1966. The banks acquired many of the deposits that the thrifts lost but did not replace thrifts as lenders to homebuilders. Their loans went mainly to their business customers.

Thrifts and homebuilders can be found in every congressional district. They complained to the administration, Congress, and the Federal Reserve about bearing the burden of war finance and disinflation (Maisel, 1973, 91–93). They did not want to raise their deposit or borrowing rates because the higher rate would apply to new and old deposits and, more importantly, would increase costs more than revenues. Their regulator, the Federal Home Loan Bank Board, reinforced this position by threatening “to refuse loans to associations which pay more than a certain rate” (memo, Ackley to president, WHCF, Box 50, LBJ Library, June 28, 1966). As Maisel noted, the Federal Reserve relearned the problems of credit distribution that had not been prominent since 1928–29. None of the FOMC members mentioned that homebuilding was most responsive to the temporary increases in real interest that occur during a business cycle.
²⁵

In part to pressure the Federal Reserve into support for thrift institutions and homebuilders, the House Banking and Currency Committee held hearings at which Chairman Martin testified on June 8 and 16,1966. Martin favored direct injection of funds into the mortgage market by an appropriation of additional funds for the Federal National Mortgage Association, a government-chartered corporation that bought mortgages. He also urged Congress to supplement monetary with fiscal policy and to permit the Federal Reserve to graduate reserve requirement ratios by size of bank. He opposed legislation that would double reserve requirement ratios against time deposits (Martin testimony, House Banking and Currency Committee, June 8 and 16, 1966).

In 1929, the Board wrote a letter to member banks warning them that the discount window should not be used by banks that maintained “speculative security loans with the aid of Federal Reserve Credit” (Board Min
utes, February 2, 1929; Friedman and Schwartz, 1963, 290–91; Meltzer, 2003, I, 237). At the time, the Board believed that by controlling the allocation of credit, it could limit growth of credit without changing interest rates. It was reluctant to raise the discount rate above 5 percent, in part out of concern for congressional reaction to high rates and in part from the belief that higher rates would penalize agriculture and commerce with little effect on stock exchange speculators. Banks sold state and local securities from their portfolios to lend to business customers.

25. Some at the Federal Reserve were not enthusiastic about altering policy to assist the thrift industry. “One can, of course, question the extent to which the Federal Reserve should feel itself responsible for these associations, which, through usage and advertising, have encouraged people to believe they are holding deposits subject to immediate withdrawal” (letter, Hayes to Sproul, Sproul papers, Correspondence 1958–66, July 29, 1966, 1–2). Fortunately, the System as a whole accepted responsibility for the financial system, not just banks. Hayes’s letter also took a narrow view of monetary policy, suggesting that certificates of deposit “allowed banks to slip away from Federal Reserve tightening, at least in the shortrun” (ibid.
, 2).

Faced with pressures from Congress, homebuilders, non-bank thrifts, municipal borrowers and others in 1966, several Board members were reluctant to increase the discount rate above 5 percent.
²⁶
Rates on negotiable CDs reached the ceiling. Board members feared that market rates would rise and require an additional increase in the discount rate and regulation Q ceiling rates.
²⁷
Hayes mentioned an increase in discount rates and ceiling rates as a possible move in June, and proposed such a move in July.
²⁸

Unlike 1929, the Federal Reserve in 1966 decided to use allocation to shift credit away from business borrowers. Martin’s opposition ended discussion, but only for one meeting. On July 14, with Martin away for surgery, Vice Chairman Robertson told the Board to expect requests to increase discount rates from several reserve banks. At 5.45 percent, federal funds rates were well above the discount rate suggesting that the market anticipated a 0.5 percentage point increase. Robertson reported that Secretary Fowler opposed an increase and the Federal Advisory Council thought a 0.5 increase would be a “waste of power and serve no purpose” (Board Minutes, July 14, 1966, 9). The FAC believed a one percentage point increase was called for.

26. Joseph Horne, chairman of the Federal Home Loan Bank Board, added to the pressure by criticizing the Federal Reserve for draining mortgage funding from the thrift industry (Bremner, 2004, 176). Many small savings and loans failed or merged.

27. On March 1, the FOMC chose to avoid “further rises in market interest rates to a level that would require consideration of another increase in the discount rate” (Annual Report, 1966, 132–33). On April 12, “relative pressures should not be intensified to the point at which rising market rates would call into question the viability of the current discount rate and the maximum rates permitted to be paid by member banks on time and savings deposits” (ibid., 142). Similar statements occur at other meetings. By June the concern shifted to possible loss of deposits at thrift institutions after the June interest payment date and weakness in housing starts (ibid., 159).

28. The FOMC held a special telephone meeting on July 8 to adopt a policy of smoothing float and reserve flows during a strike by airline employees. New York wanted authority to sell Treasury bills for cash currently combined with simultaneous contracts to purchase the same bills at a specified future date two or three days later (FOMC Minutes, July 11, 1966, 2–4). The main reason for the activity was to avoid the appearance of larger free reserves, suggesting that policy had eased. The committee approved the proposal. Several members were reluctant to adopt a new technique, but they voted for the proposal.