A History of the Federal Reserve, Volume 2 (99 page)

President Johnson had repeated several times that he was prepared for higher tax rates if military spending increased substantially. Chairman Martin urged him to act, but Secretary Fowler sent a long memo stating the pros and cons but not recommending any action. In August, Ackley began to urge that the administration make a coordination agreement with the Federal Reserve—“get the Federal Reserve on record promising to adjust the monetary policy screws . . . in return for a new fiscal program” (memo, Ackley to the president, WHCF, Box 55, LBJ Library, August 9, 1966, 3). This idea gained strength as time passed, and the housing market remained weak.
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In December, the administration had to decide on its policy recommendation for 1967. One internal recommendation called for more stimulus to expand spending and offset the slowdown, which had become very visible.
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Others favored a delayed tax increase. Finally, the advisers agreed on a mixture of stimulus and delayed restraint. They proposed to reinstate the 7 percent investment tax credit and put a 6 percent surtax on individual and corporate taxes with an exemption for the two lowest brackets of the tax code, effective July 1, 1967.
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33. This revived an earlier proposal to give the president limited stand-by authority to change tax rates. Attached to the Heller memo was a copy of a letter to the
New
York
Times
that read in part, “The Administration feels that, on balance, the signals don’t clearly call for early fiscal action” (memo, Heller to the president, CF, Box 44, LBJ Library, May 11 and 13, 1966).

34. Secretary Fowler suggested earlier that the Federal Reserve should reduce regulation Q ceiling rates to 5 percent in exchange for a tax increase (memo, Joseph Califano to the president, WHCF, Box 23, LBJ Library, May 7, 1966, 6).

35. Forecasts and recommendations developed through staff to sub-cabinet officials, then to cabinet-rank officials—the Treasury Secretary, Council Chairman, and Budget Director. A similar proposal came to the president from the National Security Council staff member concerned with economic policy, Francis Bator. A memo to the president summarized the positions of members of the Board of Governors and the Council. Governors Maisel and Mitchell opposed any tax increase. The Federal Reserve staff “strongly opposes a tax increase.” Brimmer saw no need but could accept a small ($4 to $5 billion) increase if used to protect the president’s domestic programs. Robertson wanted the tax increases and believed it would help ease money. At the Council, Okun opposed a tax increase because he feared a weak economy. He could accept a July 1 increase. James Duesenberry favored a small tax increase. The memo noted that Okun and Duesenberry “each held the exact opposite view a few days ago.” The memo reports also that Schultze favored a small increase in July (memo, Califano to the president, CF, Box 44, December 23, 1966). Duesenberry joined the Council in February 1966.

36. Arthur Burns, later chairman of the Board of Governors, was one of several witnesses
at hearings on the tax surcharge. In a preview of his views on anti-infl ation policy in the Nixon administration, he said, “Once an inflationary spiral gets underway, I’m afraid there isn’t a great deal to be done constructively. A severe recession would bring it to a halt, but no one wants that” (Joint Economic Committee, 1967, 551).

In July, both Secretary Fowler and Chairman Ackley lobbied Board members Daane, Brimmer, Robertson, and Maisel not to increase the discount rate. The reasoning emphasized political concerns. With Martin and Mitchell absent, only Shephardson was left to support an increase. The Board voted five to zero to turn down the banks’ requests (memo, Ackley to the president, WHCF, Box 50, LBJ Library, July 16, 1966). Coordination now dominated independence for many at the Federal Reserve, so political concerns dominated economics. But they soon found that coordination and politics worked one way. Getting a change to a more restrictive fiscal policy proved more difficult than they expected.

By August, Senators Albert Gore and Russell Long, members of the president’s party, denounced the high interest rate policy and the recent increase in bank prime rates. The House Committee on Banking and Currency passed a bill putting a 4.5 percent ceiling on interest paid on time deposits under $100,000 and 5.5 percent over that limit. Higher rates on large certificates could be established only with the president’s approval. The bill also increased reserve requirements on time deposits to 10 percent.

The Board was disturbed by the political response and the direct intervention by Congress into its (delegated) jurisdiction. It responded by proposing an alternative to the Senate. Instead of removing regulation Q, the bill extended its reach to include the Home Loan Bank Board and its members. Instead of mandating a 10 percent reserve requirement ratio, it authorized the Board to do so if appropriate in its judgment (H. A. Bilby to Hayes, Correspondence Box 240, Federal Reserve Bank of New York, August 4, 1966). When passed in September, the legislation permitted the Board and the Home Loan Bank Board to set different ceiling rates for small and large deposits. The Board wasted no time in implementing the new legislation by lowering the interest rates on certificates of deposit under $100,000 face value. It left the 4 percent interest rate on saving accounts unchanged despite a strong plea from one of the New York banks to raise the rate (letter, George Champion to the Board, Correspondence Box 240, Federal Reserve Bank of New York, October 19, 1966). Initially temporary, the new rules later became permanent.

The Vietnam War and its financing produced a very different result than Korea. Inflation was much greater. The economic scope of the war was not much greater; government purchases for national defense were
twice as large in the Vietnam period, but GNP had increased 2.3 times between 1952 and 1967. A more important difference is the more rapid growth rate of the monetary base. Judged by free reserves or nominal interest rates, monetary policy was much more restrictive during the Vietnam War. Ackley explained to the president, once again, that interest rates on government and corporate bonds were close to the peak 1921 rates, but he neglected to mention that in 1921 the economy was in deflation, not inflation, so real rates were much higher in 1921. Judged by monetary base growth, policy was more inflationary than during the Korean War. Table 4.4 compares data for the two wartime periods.

Fiscal policy contributed to the inflation in two principal ways. President Truman was a fiscal conservative who insisted on budget balance and managed to achieve either a small deficit or a surplus by raising tax rates. The Federal Reserve had smaller deficits to finance and pursued a less inflationary policy. President Johnson ran large deficits in 1967 and 1968. Under the “new economics” of coordinated fiscal and monetary policy, the Federal Reserve would not raise interest rates enough to keep inflation low, so the larger deficit was financed by higher money growth.
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The Federal Reserve began to lower interest rates in the fall. It reduced the ceiling rate for time deposits to 5 percent on time deposits of less than $100,000 but left the rate at 5.5 percent for longer-term deposits. By a 10 to 2 vote on November 22, it changed the directive from “maintaining
steady conditions” to seeking “somewhat easier conditions.” Free reserve rose and the federal funds rate fell.
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37. The difference in inflationary effects of the policy showed up with a lag. By 1953, consumer price were rising at 1 percent or less. In 1968 they rose at 4 percent or more.

Governor Robertson took the lead. “A number of key increases of business activity are softening. Much of this slackening is probably the direct or indirect consequences of restrictive monetary public policies . . . [W]e have had no net growth in bank credit or money supply for three and six months respectively” (FOMC Minutes, November 22, 1966, 86).
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Chairman Martin remained cautious. He favored a change to show that the FOMC “was aware of a change in the basic elements of the economy” (ibid., 90). Unemployment remained low, and the first decline in industrial production came in November, so it was not known at the meeting. However, stock prices had fallen in nine of the previous eleven months.

President Hayes and Governor Daane dissented. They saw no reason for an overt policy change. They agreed that the economy had weakened, but they cited rising defense spending, rising inflation, and a growing balance of payments deficit. The FOMC had adopted a proviso clause per
mitting the manager to adjust his money market targets to larger than anticipated changes in the bank credit proxy—total bank deposits. Both dissenters believed that was sufficient.
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38. The effort to adjust maximum ceiling rates responded to a sharp increase in yields on longer-term securities during the summer. One reason was that banks sold municipal bonds to satisfy loan demand. Since they were normally large buyers of these bonds, and the new supply continued to increase, there were reports of unsettled conditions and days on which there were no bids in the secondary market. On August 3, President Johnson asked for a 10 percent tax surcharge, effective October 1 to reduce the budget deficit and the size of new Treasury issues. On September 13, Congress approved the Financial Institutions Supervisory Act of 1966. The Federal Reserve received authority to buy and sell all federal agency obligations to assist the mortgage market. The act also extended interest rate ceilings to all financial institutions supervised by federal agencies. In the hearings leading to the act, members of Congress and the heads of other agencies criticized the Federal Reserve for failure to give advance notice or coordinate policy with other financial regulatory agencies (House Committee on Banking and Currency, 1966, 280–81, 556). The result was a coordinating committee that included representatives of the Federal Reserve, the Comptroller, the Home Loan Bank Board, and the FDIC.

Federal Reserve officials did not welcome permission to buy agency issues. When Sproul criticized the proposal in a letter to Hayes, Hayes replied agreeing with Sproul. “Some of its proponents undoubtedly think of it as a means of pressuring the System to support the market for this type of obligation. I can assure you that there is no disposition whatever in the System to accept an assignment of this kind, and I hope and trust that we can resist any efforts to change our mind” (letter, Hayes to Sproul, Sproul papers, Correspondence 1966, August 25, 1966). No one mentioned that trying to adjust relative rates of interest was unlikely to have much effect.

39. Beginning with the November 22 meeting, I had the use of Sherman J. Maisel’s diary written at about the time of each meeting. Maisel served as a governor from April 1965 to May 1972. He reconstructed notes for the meetings he attended prior to November 22. The diary is a valuable supplement to the minutes and other official materials. I am grateful to him for making these materials available. After using them, I deposited them at the Board of Governors.

Despite the sharp decline in housing, reported GNP growth increased in the third quarter and inflation rose. In November, the credit proxy (total deposits) declined at a 3 percent annual rate. The FOMC divided eight to four at its December 13 meeting. The majority recognized the rising balance of payments deficit but preferred to rely on the voluntary guidelines for investment and asset acquisition. Shephardson and Irons (Dallas) joined Hayes and Daane in dissent. They expressed greater concern about inflation and the payments imbalance. A more contentious issue arose over a proposal by Mitchell, Robertson, Brimmer, Maisel, and Hickman (Cleveland) to target a moderate rate of increase in the money and bank credit aggregates. “Chairman Martin objected strongly to this proposed amendment. . . . [They] had to use a money market directive” (
Maisel diary, December 13, 1966, 6). Maisel urged that the FOMC vote on the proposal, but Martin refused. Martin also refused to let the public know that policy had eased. “Brimmer made the point that policies of the System ought to be open and published and not told to a few select bankers” (ibid., 7). The chairman’s view prevailed.

By early January 1967, the federal funds rate was 5.14 percent, 0.82 percentage points below its high in mid-November. Free reserves were in the −$800 to −$900 range, usually considered restrictive. As shown in Chart 4.7 above, growth of the real monetary base began to increase, and the index of stock prices rose in November and December.
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Chairman Martin repor
ted these developments to the Joint Economic
Committee, emphasizing the economy’s resilience and the need to restore full use of resources and price stability (Martin speeches, February 9, 1967). Market opinion, reinforced by a small uptick in the federal funds rate, emphasized Martin’s concern about inflation. Long-term rates rose. To counter this interpretation, the Board appeased populist members of Congress by reducing reserve requirement ratios against saving accounts from 4 to 3 percent for banks with less than $5 million in deposits, effective in March (Maisel diary, February 28, 1967, 5). Large banks remained at 6 percent. Robertson explained that one reason for limiting the reduction to small banks was to avoid increasing the capital outflow. If large banks received the additional free reserves, they “might be inclined to pay off borrowings from their foreign branches” (ibid., February 28, 1967, 12). This would appear as a reduction in liabilities to foreign institutions. In mid-March, the FOMC lowered the federal funds rate target to 4.5 percent over Hayes’s objection.
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Robertson and others argued that the move would signal the market and change market expectations. Martin warned about trying to manage expectations. “The real question was the availability of reserves. He would like to have more available” (Board Minutes, February 27, 1967, 27). By reducing the federal funds rate and increasing free reserves, the Board maintained easier policy.
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40. At its November 1 meeting the FOMC authorized the manager to make repurchase agreements using government agency securities. The committee proposed further study of open market purchases of agency securities. Martin notified Gardner Ackley of the change the next morning. Ackley told the president that perhaps “if we do more on taxes the Fed is ready to move on money” (memo to the president, WHCF, Box 282, LBJ Library, November 23, 1966).

41. Urged by the Council, the Board of Governors withdrew the September 1 letter restricting use of the discount window (memo, Ackley to the president, WHCF, Box 282, LBJ Library, December 23, 1966). Bankers on the Federal Advisory Council (FAC) disliked the restrictions on discounting. The rules were uncertain. “The concern was whether the city banks could depend on the Federal Reserve if they needed money in a situation such as seemed likely to occur in the next few months” (Board Minutes, September 20, 1966, 8). Bankers on FAC gave examples of national companies coming to regional markets to borrow and borrowers offering government securities as collateral. If the banks restricted loans, the borrowers would sell the securities; they claimed this would defeat the program. The bankers also complained that the program reduced business lending for new capital spending, so there would be less production in the future. Selective controls had thrown “the whole interest rate structure out of balance” (Board Minutes, November 15, 1966, 23).