A History of the Federal Reserve, Volume 2 (103 page)

Policymakers learned three additional lessons. First, Martin, the administration, and many others, mistakenly believed that exhortation and threats to enforce guideposts for wages and prices were a useful tool to reduce inflation. Experience after 1965 changed some minds. In Hargrove and Morley (1984, 263) Ackley responded to questions about the use of guideposts. “The basic failure of the guideposts is that they were dreamed up by some economists who said: ‘Here it is, boys,’ and we expected people to pay attention to them. It’s a ridiculous way to try to get people voluntarily to adopt them.” But Ackley saw the failure as an inability to get people to follow guideposts when it was not in their private interest.
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He did not see that controlling selected individual prices could at most change the rate of price change temporarily unless fiscal and monetary policy became more restrictive. And he and others did not distinguish one-time changes from the persistent rate of change caused by monetary policy.

Second, both the Federal Reserve and the administration economists failed to distinguish between real and nominal interest rates. They considered interest rates high. In their memos to President Johnson, who disliked high interest rates, they never explained that interest rates had increased, in large part, because the public expected inflation to persist and could be reduced by lowering inflation permanently.

Third, the 1964 tax cut was a major policy victory for the “new Keynesian economics” and the belief that short-term macroeconomic management— often called economic fine-tuning by its critics—could control inflation
and maintain high employment perhaps aided by guideposts for wages and prices. The long delay in enacting the surtax, and the weak response of inflation to the surtax, severely eroded these beliefs. Reducing tax rates is much more popular politically than increasing rates. Both Congress and the president hesitated or refused to act based on economists’ forecasts of what would happen.
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Congress held asymmetric views about taxes. Okun quotes congressional responses to the dire warnings coming from the Council and the Treasury. [Can I] “tell my constituents back home that I did them a favor by taking money out of their paycheck?” (Hargrove and Morley, 1984, 306).

68. In the same passages, Ackley lists some of the tactics used against business such as threats of anti-trust action, imports, and opposition to government contracts. He is critical of the lawyers’ use of some of these threats but not all. The administration sold 300 thousand tons of aluminum from federal stockpiles to force Alcoa to rescind its price increase. To get a rollback of copper prices, it sold 200 thousand tons of copper and sent Averell Harriman to Chile to ask President Eduardo Frei to keep the copper price unchanged (Califano, 2000, 100–102). The administration put export controls on hides to prevent an increase in shoe prices, (ibid., 137). Califano (2000, 137) gives several other examples: color TVs, lamb, household appliances, paper cartons, newsprint, men’s underwear, and others. The president was unable to convince, or successfully threaten, New York Mayor John Lindsay, who settled a transit strike by agreeing to wage increases far above the guideposts (ibid., 118), or to get the machinists’ union to settle for less than a 4.9 percent increase, far above the 3.2 percent guidepost (ibid., 146). The union president boasted that the settlement destroyed the guideposts. The steel industry soon followed. President Johnson had his staff explore his authority to impose mandatory controls (ibid., 146–47).

An interviewer asked: “Given these difficulties with Congress, how do you come down on the feasibility of pursuing a counter-cyclical fiscal policy as a stabilization device?” Okun replied: “Well, it’s limited.” Then he added that “we don’t know as much as we used to think we knew” (ibid., 311)

AN INFLATIONARY EXPANSION

Industrial production began to increase after July 1967. By January 1968, annual production growth reached 3 percent. Measured by growth of industrial production, the expansion was moderate. Real GNP growth reached 7 percent in second quarter 1968, however, with the unemployment rate at 3.5 percent of the labor force.

Consumer price inflation rose from zero in early 1967 to a local peak of 7 percent annual rate in June 1968. The GNP deflator rose 7.9 percent in first quarter 1968. Annual base money growth remained between 6 and 7 percent. The administration’s forecast called for a four-quarter growth of 4 percent and a 3 percent increase in the deflator. The actual values were 3.6 and 5.8 percent.

The Federal Reserve responded by raising the federal funds rate and reducing free reserves. By May, the monthly average funds rate reached 6.12 percent, the highest rate recorded to that time and 1.50 percentage points above the previous December. But the annual rate of consumer price inflation increased 1 percentage point, so the effective change and the real level were much smaller than perceived.

69. ArthurOkun’s summary describes President Johnson’s views. “He kept telling us he was for a tax increase at the earliest possible moment he thought it conceivably could be taken seriously, that you couldn’t sell it on the basis of a forecast, that you had to wait for a little bleeding to take place before you volunteered to sew up the wound” (Hargrove and Morley, 1984, 302). Chairman Mills of Ways and Means held this position strongly. Califano (2000, 244) held a more cynical view. “Most members of Congress preferred cuts in spending for the poor (most of whom don’t vote and none of whom have excess money to contribute to political campaigns) to increasing the taxes of the affluent (most of whom do vote and many of whom make political contributions.)”

The Federal Reserve responded slowly. It was not from lack of knowledge about inflation or balance of payments outflows. At the January 9, 1968, meeting, the staff warned that “prices were rising at a substantial rate; and with demands strong and costs increasing, inflationary pressures were expected to increase in the period ahead” (Annual Report, 1968, 108). Further, the staff expected output to accelerate early in the year.
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Hayes favored additional restraint but thought it should come from fiscal policy. The Board had voted in December to increase reserve requirement ratios for demand deposits at banks with more than $5 million by 0.5 percentage points. The change became effective at reserve city banks on January 11 and at all other banks on January 18.
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Martin opposed additional restraint. The System thought it had done its part. With Treasury bill rates above 5 percent, Martin wanted to avoid repeating the December 1965 conflict with the administration.
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Despite the relatively large rise in inflation and loss of gold, the FOMC decided to wait for the forthcoming budget message and hope for a tax increase.

By the time of the February meeting, several members led by Hayes, Francis (St. Louis), and Maisel had become disturbed by the continued rise in inflation and the System’s failure to slow or stop the rise. Francis asked for “an immediate and substantial move toward restraint” and a reduction in money growth from 6 to 3 percent despite Treasury financing operations (FOMC Minutes, February 6, 1968, 59). Maisel wanted more specific language and a more coherent plan.
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His statement was far ahead of its time in recognizing the role of market anticipations. The term “firm,” he said, “had to be interpreted in terms of . . . market expectations. . . . The Committee should make up its mind as to where it hoped to go over a considerable period in advance . . . He thought the Committee should set goals in terms of expansion of total reserves or of bank credit” (ibid., 73–4). He preferred to set a target for deposit growth. Interest rates reflected “both
the demand and supply of funds. That was why he would reject interest rates as a goal” (ibid., 75). “The Committee is torn. A majority feel that money should be tighter. They are not clear what this means or how far tightening should go” (Maisel diary, February 23, 1968, 9).

70. The staff estimated the liquidity measure of the balance of payments deficit as $3.7 billion in 1967 compared to $1.4 billion in 1966. The liquidity measure reported changes in U.S. reserves net of liquid liabilities to all foreigners. On January 1, President Johnson announced a new program of mandatory and voluntary controls on capital movements. Once again the administration responded with a stopgap instead of a policy to lower inflation.

71. The staff proposed the change at a Board meeting on December 20. The Board divided between an increase applicable to all demand deposits or only to deposits above $5 million. It voted for the lesser change on December 27, 1967.

72. Any increase would “carry implications for the tenability of present regulation Q ceilings, and he would not want to have the question of a possible increase in those ceilings raised at this time” (FOMC Minutes, January 9, 1968, 81).

73. Maisel urged “better quantitative predictions . . . related to a three to six month projection” and a more specific directive including quantitative targets (Maisel diary, February 23, 1968,9).

Committee members recognized the source of some of their problems, but it lacked leadership to correct them. Clay (Kansas City) commented on the excessive growth of reserves during even keel operations. And Galusha (Minneapolis) called for increasing regulation Q ceiling rates, when the Treasury completed its financing.

Martin summarized the consensus. He was pleased that many “would have preferred a firmer monetary posture than had prevailed in the recent period” (ibid., 107). He thought it was important to “continue to press for a tax increase, however questionable the prospects were.” The president had asked again for a 10 percent surtax effective January 1 for corporate taxes and April 1 for personal taxes. Although the staff recognized that the prospective budget deficit would be large even if the tax bill passed, the FOMC voted unanimously to maintain money market conditions. It added the proviso clause that permitted the manager to tighten if bank credit expanded at the projected 7 to 10 percent annual rate.

As in the Great Depression, some members of Congress expected more of the Federal Reserve. Led by Congressman Henry Reuss, they had become alarmed by the rising inflation rate and the Federal Reserve’s vague directives. In March 1967, the Joint Economic Committee wrote:

The committee urges that the monetary authority adopt the policy of moderate and relatively steady increases in the money supply, avoiding wide swings in the rate of increase or decrease . . .

Such rate of increase should be more or less consistent with the projected rate of growth—generally within a range of 3 to 5 percent per year. (Joint Economic Committee, 1968, 16)

The committee repeated and amplified this recommendation the following year. It recognized that exceptions should be made and that the guidelines were not rigid directives (ibid., 17). But the exceptions should not distort seasonally adjusted quarterly averages. “A 3-month period is sufficiently long to allow abnormal and extreme temporary movements to be absorbed in an average” (ibid., 17).

The report proposed that the standard against which Congress should appraise Federal Reserve actions was a 2 to 6 percent annual rate of increase in the M
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money stock. “On occasions when the increase was outside this range, it would be wise for the Congress to take a prompt look at
the Federal Reserve System’s actions” (ibid., 17). The 2 to 6 percent range was not fixed permanently. The range would change with technological progress in the financial and non-financial sectors and in the public’s decisions about the allocation of their wealth between money, other financial assets, and capital.
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Unfortunately, the report had little effect on either the subsequent behavior of the Federal Reserve or congressional monitoring. Congressman Reuss complained that the Federal Reserve ignored the committee’s recommendation. “Was the Fed continuing to create money at the rate of 9 percent—in the face of Joint Economic Committee’s 3 to 5 percent ‘advice’—because of Treasury borrowing, the level of production, expectations about future tax increases, worries about residential construction, or what? What weight was assigned to these factors? We are not told” (Joint Economic Committee, 1968a, 44).
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The Federal Reserve could not answer Reuss’s question because they did not assign weights to the various factors. They simply controlled interest rates and money market conditions and acted as residual buyer to clear the money market at the interest rate they (or the manager) chose. The FOMC made no effort to estimate explicit effects of the various factors affecting interest rates when setting the directive.

Policy differed from the period of pegged rates from 1942 to 1951 by allowing the Federal Reserve to change the interest rate that it pegged. Any peg was temporary and subject to change. But the effect was similar, though
not identical, because the interest rate could change. The Federal Reserve held the interest rate below the market-clearing rate consistent with price stability. Hence money growth and prices rose in both periods.

74. The committee criticized the System for imprecision in its instructions to the manager, failing to have clear objectives, and neglecting to audit its performance. By default, judgments about policy were left to the manager (Joint Economic Committee, 1968, 10). The committee concluded that imprecision was not willful but “an inherent imprecision in the objectives, policy standards, and operations themselves” (ibid., 14).

75. A survey of economists by the House Banking Committee showed the majority in favor of the Joint Economic Committee’s rule (Bach, 1971, 141–42). The Council of Economic Advisers, the Treasury, and, of course, the Federal Reserve opposed the rule. Reuss sent a letter to the Board asking for a response to his proposal. Martin’s response avoided an answer but sent some staff papers opposing the proposal. The staffs of the banks and the Board had considered monetary control. The report was not one to convince skeptics to make the change. The account manager pointed out that the aggregates “are not controllable in the short-run,” and he added that “market participants would not know how to adjust to what was happening” (memo, Brill to FOMC, Board Records, May 16, 1968, 2). He favored a proviso clause based on bank credit, although he usually ignored it in practice. Others proposed using a moving average to damp fluctuations. Stephen Axilrod emphasized that the main difference in operation would be larger fluctuations in interest rates and fewer in reserves. “The odds favor a better policy with continuation of something like present form of doctrine than with the proposed form” (ibid., 10). John Kareken thought that the proposed policy could be destabilizing under certain (unspecified) conditi
ons (ibid., 16).