A History of the Federal Reserve, Volume 2 (98 page)

Robertson said he wanted to avoid repeating the December clash with the administration. Daaneand Brimmer favored 0.5, Shephardson thought that 1 percentage point would be better because 0.5 was anticipated. The market would expect another increase later. Maisel proposed selective controls as an alternative. He wanted to reject the requests publicly.

The following day, the Board had requests from New York, Cleveland, Chicago, and St. Louis requesting a 5 percent rate. Shephardson opposed because the increase was too small. Daane hesitated on political grounds. “Every economic ground said to increase the rate; his reluctance was because such an action would be harmful to relationships with the Administration” (ibid., July 15, 1966, 3). Maisel opposed. He wanted a coordinated program. Brimmer wanted to delay the increase because Britain had increased its discount rate to strengthen its exchange rate. Robertson opposed any increase. The Board disapproved the requests without objection.
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Anxious to tighten without affecting the politically potent housing and thrift industries additionally, the Board wanted to reduce the relative advantage of commercial banks. Increasing reserve requirements on time deposits would raise bank costs, but small member banks would then be at a disadvantage in the market for household deposits that were relatively important to them. They too were politically active and influential. Concerned about increased loss of deposits at either small banks or thrift institutions and possible failures, the Board agreed to serve as lender of last resort to savings and loans, savings banks, and insurance companies. Also, they agreed to lend to the Treasury so that it could relend to the Home Loan Banks to support their members. This is the first explicit recognition that the System was the lender of last resort to the financial system. It was only one hundred years after Bagehot (see volume 1, chapter 2).

Torn between the several competing claims for attention, the Board decided out of political concerns that it needed more powers. The chosen solution was to seek legislation permitting the Board to set reserve requirement ratios according to bank size. On June 27, the Board responded to congressional pressure by raising reserve requirement ratios for time deposits from 4 to 5 percent at all banks with over $5 million in time deposits, effective July 14 and 21 at reserve city and country banks respectively. Smaller banks and all savings deposits remained at 4 percent. At the same time, the Board applied reserve requirement ratios and interest rate ceilings to promissory notes that had been exempt from these regulations.
Effective September 8 and 15, a second increase raised the time deposit reserve requirement ratio from 5 to 6 percent. The Board acted “to exert a tempering influence on bank issuance of time certificates of deposit and to apply some additional restraint upon the expansion of bank credit to businesses and other borrowers” (Annual Report, 1966, 173). The Board’s action responded to the increase in yields on municipal and corporate bonds to the highest level since the 1920s and early 1930s and the political effect of reduced state and local spending growth. The Board attributed the high yields to its restrictive policy and the massive selling of municipal bonds by banks. The reasoning remains unclear. Restricting banks’ access to time deposits encouraged not fewer but more bond sales.
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29. On July 19, it disapproved Boston’s request for a 1 percentage point increase, and on July 22 Philadelphia’s request for a 0.5 increase.

Instead of increasing the discount rate, the Board repeated its 1929 policy error of restricting access to the discount window. Governor Mitchell asked the Board’s secretary, Robert Holland, to rewrite regulation A to state that “the System’s discount facilities should not be made available to member banks to make adjustments incident to run-offs of certificates of deposit unless certain management policies were agreed to by the borrowing member bank” (Board Minutes, August 17, 1966, 4–5). The reserve bank presidents objected to the Board’s letter, but the Board was under pressure from Congress. It justified its action as a move to remove distortions. It did not consider asking Congress to remove regulation Q (Maisel diary, February 9, 1967, 17).

The Board had maintained that borrowing was a privilege and not a right of membership, and it used persuasion to restrict access by frequent or prolonged borrowers. This action was different in kind. It attempted to control credit and money by restricting its lender of last resort function; in effect, it made CDs more costly to member banks to help non-member thrift associations. Presented as a means of restraining “the growth of credit . . . to fully reach the objectives of current monetary policy, which were of a general tightening” (ibid., August 19, 1966, 14), it did nothing of the kind. It simply shifted expansion from banks to non-banks. Most importantly, it appeased congressional critics.

The Board was now involved in allocating credit to different uses, a policy inconsistent with the fungibility of money and credit. Governor
Robertson correctly described the aim as giving preferential treatment to banks that did not dump municipal bonds. The draft proposal called for “additional adjustment assistance credit” (borrowing) with extended duration if a bank agreed to restrict its loans (Board Minutes, Meeting with reserve bank presidents, August 23, 1966, 8).

30. On September 21, 1966, the Board also obtained authority from Congress to raise reserve requirement ratios on time and savings deposits to a 10 percent maximum and to purchase federal agency issues as part of its open market operations. The legislation also permitted the Board to post different maximum rates of interest for smaller time certificates. The Federal Home Loan Bank Board received authorization to enforce ceiling interest rates on deposits at its member thrifts. On the day the president signed the legislation, the Board lowered to 5 percent the ceiling rate for CDs of less then $100,000. The maximum rate for larger CDs remained at 5.5 percent. The legislation expired in one year but was renewed.

The new regulation brought out the classic split between the market concerns of the reserve banks and the Board’s political concerns that was present from the start of the System. President Hayes opposed the Board’s recommendation. He recognized the central flaw. If the volume of reserves remained unchanged, credit would be available from other lenders. “Large corporations would be able to obtain elsewhere funds denied by the banking system” (ibid., 7). Further, he saw the proposal as a large, cumbersome scheme that was difficult to administer. He preferred to use open market operations to tighten credit, and he expected discounts to increase if that were done.

Other presidents were also skeptical about the proposal, or regarded it as unnecessary. Several presidents asked how they could distinguish between traditional borrowings under regulation A and the borrowings described in the memo. President Hickman pointed to the “danger in trying to guide the banks too closely in their asset management” (ibid., 24). Most preferred a higher discount rate to a change in regulation A.

Board members emphasized problems in the municipal bond market arising from banks’ decisions to sell municipal bonds to supply customer loans. On August 30, Governor Shephardson reported on a telephone conversation with Chairman Martin. Martin, as always seeking consensus, expressed concern about a radical change in regulation A and the split between the reserve banks and the Board (ibid., August 30, 1966, 8). Martin’s concern shifted the emphasis to developing a joint program. The result was a program to restrain business lending and a letter on September 1 to all member banks, signed by the reserve bank presidents, announcing the new program. The letter urged banks to reduce loan expansion and hold more municipal bonds. Member banks were told “to use the discount facilities . . . in a manner consistent with these efforts” (ibid., Attachment C, September 1, 1966, 2–3). In effect, the letter warned banks that loans would be available for longer periods than normal only for banks that adjusted by reducing loans instead of selling securities
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(Sherman, 1983, 39). To reinforce the Board’s allocative powers, Congress enacted legislation per
mitting banks and other financial institutions to reduce interest rates paid on certain types of deposits (ibid., 40).

31. Parts of the letter presumed that bankers knew the use to which credit would be put. This was a reversion to the real bills doctrine that misled the Board in the 1920s. “In considering a request for credit accommodation, each Federal Reserve Bank gives due regard to the purpose of the credit and to its probable effects upon the maintenance of sound credit
conditions, both as to the individual ins
titution and the economy generally” (Federal Reserve Bulletin, September 1966, 1339).

As the economy slowed, the problem ended. On December 23, the Board terminated the restrictions on borrowing. Prime grade municipal bond yields, with maturities from two to five years, had fallen from 4.10 percent in early September to 3.70 to 3.85 in December, 0.4 percentage points. Yields on government bonds of the same maturity declined by 0.67 to 0.72 percentage points. The program probably had little effect.

The main reasons for declining bond yields were slower economic growth and increased monetary base growth. Industrial production reached a peak in October, then declined irregularly until July 1967. The decline was modest. Real GNP growth slowed but did not turn negative. Unemployment rates remained between 3.6 and 3.9 percent throughout the period of slower growth. These were the lowest unemployment rates since 1957.

There is no clear relation between the measures of monetary contraction and the broad measures of real output and employment during this period. One likely reason is that prices adjusted promptly, more promptly than in succeeding downturns. Dating the start of monetary restriction to June 1966 suggests only a six- to nine-month lag before inflation fell. Despite expanding fiscal spending for Vietnam and the Great Society, the rate of price change responded rapidly. Table 4.3 shows the inflation data.

The reversal in policy and inflation was no less rapid. By fourth quarter 1967, Table 4.3 shows inflation had returned to the levels at the beginning of 1966. The turn in inflation followed the turn in monetary base growth by three calendar quarters.

Administration fiscal policy supported the more restrictive policy by withdrawing the 7 percent investment tax credit that had remained in effect throughout the expansion. The aim was to slow investment spending. Wilbur Mills of the Ways and Means Committee supported the change, unlike his response to the surtax. He told Gardner Ackley, “Just have the President tell me what he wants, and we’ll go to work” (memo, Ackley to the president, WHCF, Box 1, LBJ Library, August 17, 1966). On September 8, the president requested suspension of the investment credit until January 1968. At the same time, he requested some modest reductions in non-defense spending. Earlier, the administration accelerated some tax payments and increased the payroll tax by $1.5 billion beginning January 1967.

The Economic Report concluded that “after March, monetary and fiscal policy provided adequate restraint” (Council of Economic Advisers, 1967, 50). This ignores the $16.9 billion increase in federal and state government spending, including $10.9 billion in defense spending, between first and fourth quarter 1966. These increases followed increases of $10.7 billion and $5.5 billion in these spending categories during the previous quarters (ibid., 1967, 47).

The president’s economic advisers in the cabinet and Council had agreed quickly on repeal of the investment tax credit. They had greater difficulty agreeing on the administration’s main fiscal initiative—a surtax on income tax payments. In part, their hesitancy reflected the views of business and labor.
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Congress was hesitant; and the president remained concerned that Congress would insist on domestic spending cuts as part of any package. Both were reluctant to act based on a forecast.

On May 11, budget director Charles Schultze warned the president that “serious inflation is almost certain unless taxes are raised.” Then he added that not raising tax rates would set off “a true wage-price spiral” (memo,
Schultze to the president, WHCF, Box 55, LBJ Library, May 11, 1966). Not everyone agreed on the timing. From Minnesota, Walter Heller urged the president to “get ready now” for a temporary income tax boost to be used when the president believed the timing was right.
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32. In a May 5 memo, Ackley summarized the position taken at the President’s LaborManagement Advisory Committee. Of the fifteen expressing an opinion, six favored and four opposed or wanted to wait. Five were undecided. Several of the business members said they expected the economy to slow in the second half of the year. Ackley added that a majority of the advisory council would have favored a tax increase “if it were not for resistance from Bill Wirtz and me” (memo, Ackley to the president, WHCF, Box 55, LBJ Library, May 5, 1966). Sproul wrote to Hayes, reporting on the views of prominent businessmen and members of the Labor Management Committee. “Ackley is said to be sort of neutral against a tax increase . . . there is some support in the Labor-Management Advisory Committee”` (letter, Sproul to Hayes, Sproul papers, Correspondence 1966, May 6, 1966). Sproul reported that Douglas Dillon, David Rockefeller, and Robert Roosa had urged Secretary Fowler to increase tax rates. Fowler opposed at the time and did not change until the following year. He felt so strongly that he would not sign memos on fiscal policy written as part of the Troika process (consisting of the CEA, the Treasury, and the Budget Bureau) (Okun in Hargrove and Morley, 1984,301).