A History of the Federal Reserve, Volume 2 (102 page)

This time the bank presidents favored higher rates; the Board members, except Martin, were opposed but unwilling to dissent (Maisel diary, December 12, 1967, 4). The vote was ten to one. Daane was absent, and Maisel dissented. Although the directive called for “moving slightly beyond the firmer conditions that have developed in the money markets” (Annual Report, 1967, 204), Maisel feared that “growth in member bank reserves and bank deposits would be slowed too abruptly, and perhaps succeeded by contraction” (ibid., 205). In the event, base growth continued to rise at a 6 percent annual rate, and the federal funds rate rose about 0.5 percentage points to about 4.5 percent. Consumer prices rose at a nearly 3 percent annual rate.
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Lessons
From
1966–67

Though mild and brief, the 1966–67 slowdown was a turning point. There is no sharp demarcation of before and after, but the response to the slowdown and the rise in inflation anticipations changed both at home and abroad. The slow and hesitant response of the Federal Reserve to rising inflation and its prompt response to the mild slowdown suggested to many that policy was asymmetric; policymakers were more responsive to unemployment than to inflation. Also, the burden placed on homebuilding and the congressional response remained a concern for the FOMC that it tried to avoid repeating. This too made for delay and hesitation.

Market participants recognized the hesitation to act against inflation. At one point, Martin insisted on taking a restrictive step just to show that they were aware of the problem and could act. Foreigners recognized that the United States would not curtail output or risk recession to prevent a capital outflow and continued gold loss. The 1967 British devaluation (see chapter 5), the clear reluctance of the president and Congress to agree on a tax increase or expenditure reduction, rapid money growth, and the public’s experience with past wars raised concerns about the stability of the internal and external value of the dollar.

In the nine months ending September 1967, the United States’ gold stock declined by $158 million. In the next three months, it fell an additional $1012 million. And the rate of outflow increased in the early months of 1968.

60. The Board replaced Howard Hackley as Board counsel and Merritt Sherman as Board secretary. They became special assistants. Ralph Hexter and Rob
ert Holland replaced them.

Martin was not surprised by the asymmetry. He testified, “The zeal with which policies were adopted to deal with a flagging economy has not been matched by commensurate zeal in coping with the emergence of economic overheating” (Martin speeches, Joint Economic Committee, February 14, 1968, 2). Later he added, “It is clear that we have, as a Nation, greater readiness to combat recession than to cope with inflation, despite the grave consequences that failure to restrain inflation could have for our economy, both domestically and internationally” (ibid., 11). Instead of reducing money growth, he urged Congress to pass the surtax.

At home, forecasts of inflation increased. By late 1968, when published forecasts became available, both the Federal Reserve and the Society of Professional Forecasters (SPF) anticipated continued inflation of at least a 3 percent annual rate. These anticipations eventually reached 10 percent or more. Chart 4.9 shows these data.
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As in most other periods, Federal Reserve internal forecasts are close to the SPF forecasts.

FOMC minutes comment on the surprising rise in long-term rates and the faster increase in wages than in productivity. Both suggest that anticipated inflation had increased and that trend real growth had slowed,
although neither change was recognized as evidence of inflation anticipations at the time. There were ample warnings from Presidents Hayes and Francis especially. Chairman Martin was certainly aware that he was in danger of failing to maintain the domestic and international value of the dollar.

61. The SPF initially provided annual forecasts with quarterly forecasts beginning in 1970. A 3 percent annual rate was considered a high rate of inflation at the time. The green book contains staff forecasts.

Martin and the Federal Reserve made four principal errors.
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First, the Federal Reserve tried to coordinate policy with the administration and persisted in doing so long after it became a serious impediment to carrying out its responsibilities. Even when Martin recognized that a tax increase was unlikely, he resisted even mild steps toward restriction, in part because Congress might use tighter monetary policy as an excuse for not raising tax rates.

Coordination was the enemy of central bank independence; the Federal Reserve would not raise interest rates high enough or fast enough to prevent inflation. The administration found it easier to finance its deficits at prevailing interest rates.

Second, under the pressure of events, the Federal Reserve accepted too many objectives as within its responsibility. Housing, the thrift industry, credit, and income distribution became matters of political concern and, in turn, Federal Reserve concern.
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The objective of protecting the internal value of the currency gave way to new and diffused objectives. There were always reasons for delay to avoid one or more of the costs of disinflation. And some of the injured groups were politically active and able to bring their concerns to the Congress and thus to the Federal Reserve.

Third, the Federal Reserve had a short-term focus. It considered action every three weeks, so unpleasant decisions were easily postponed. More importantly, it pursued a money market strategy that responded to most short-term changes and neglected the longer-term effects on the economy. After the problems experienced in 1966, the FOMC adopted a proviso clause intended to limit longer-term effects by having the manager adjust the money market to large changes in money or bank credit. But the
manager generally ignored the proviso clause, as the System eventually recognized.
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62. Okun praised their performance as
“the
virtuoso performance in the history of stabilization policy. It was the greatest tight-rope walking and balancing act ever performed by either fiscal or monetary policy” (quoted in Maisel 1973, 88; emphasis in the original).

63. “The July and September [1966] actions marked a watershed in Federal Reserve policy. Blind faith in the market as a method of properly distributing funds was discredited. . . . Traditional channels of lending exist which cannot be overturned in short periods” (Maisel, 1973, 105). At one point, the Board and other regulators considered an additional reduction in interest rates on small certificates because many savings banks reported losses (memo, Fred W. Piderit, Jr., to Hayes, Correspondence Box 240, Federal Reserve Bank of New York, February 1, 1967).

The FOMC lacked an effective means of controlling the manager. It did not have an analytic framework because members did not agree on how its actions affected its goals, and some did not believe that such a framework was possible. In seeking consensus, it gave weak and ambiguous instructions to the manager. Stephen Axilrod, charged with developing better methods and later Chief of Staff at the Board in the 1970s, described the loose controls.

What were money market conditions? The dealer loan rate this week, the three-month bill rate that week, free reserves the other week. . . . And he [the manager] would come before the committee and say: “It got a little away from me. It was a bit tighter but after all the dealer loan rate went up, or there was a shift in distribution away from the big city banks.” . . . What do you know when you have a different starting point for what’s tighter? (Axilrod, 1997)

The consequence was that the manager had substantial control, and his focus remained on the money market and excluded longer-term objectives.

Assigning the short-term focus to the manager overstates his role. He did what he was trained to do—smoothing the money market for banks and financial institutions. Some members of FOMC, Maisel and Francis especially, complained about the lack of control and the absence of a strategy, but influential members like Martin, Hayes, and several others did not share these concerns. Furthermore, the FOMC permitted money and credit to grow rapidly during even keel periods, when it supported Treasury financing. The short-term increase in reserves became a long-term increase in money and credit. The System could have proposed security auctions, but it didn’t. Those who pointed to the divergent information in interest rates and money remained a minority. They could not influence policy decisions because the majority either did not believe money could be controlled or would not focus on the longer-term implications of the policies they approved.

Fourth, within the Federal Reserve and outside, many economists accepted the idea of a reliable long-run Phillips curve tradeoff. By accepting higher inflation, they believed they could get persistently lower unemploy
ment. And reducing inflation meant, to them at the time, not just a temporary increase in the unemployment rate, but a permanent or persistent increase.
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At the Board, Maisel and Mitchell accepted this idea, and Robertson at the time gave priority to low unemployment, so he voted with them. By 1967, Martin could count only on Shephardson, who left in the spring of that year, and sometimes Daane or Brimmer. The chief economist, Daniel Brill, and many of the staff shared the new view. At the Council of Economic Advisers, Gardner Ackley had a simple KeynesianPhillips curve view. The president detested “high” interest rates. Ackley had a less subtle understanding than either his predecessor or his successor as chairman, Walter Heller and Arthur Okun. Leading members of Congress, Wright Patman, Henry Reuss, and William Proxmire, differed on many points but not in their aversion to high or rising interest rates. Moreover, members of the administration, the FOMC, and the Congress were slow to distinguish between real and nominal interest rates. At the Federal Reserve this error combined with a reluctance to raise interest rates above 6 percent, carried over from the 1920s, and the Federal Reserve was unwilling to ask Congress to eliminate regulation Q.

64. As Maisel wrote, “The staff considered that, although the proviso clause had constrained the degree of accommodation to some extent, its effect in practice had been rather minor. The proviso clause never led to any substantial change in money market conditions.” He concluded, “The movements [of money and credit] were not sensible in terms of the policies the Federal Reserve said and thought it was following” (Maisel, 1973, 230–31).

As Martin put it, the Federal Reserve had let the horse of inflation out of the barn. With strong opposition to raising interest rates and unemployment, it would be difficult to get the barn locked with the horse inside.

Martin was an excellent example of “the independent, conservative central banker” appointed because his greater concern about inflation would discipline society (Rogoff, 1985). Unfortunately, Martin did not succeed because, despite his concerns, his style was to seek consensus and avoid confrontation as long as possible. He was always willing to give the president and others his views about appropriate policy. If they did not agree, he was willing to wait before acting. In dealing with his colleagues at the Federal Reserve and the administration, he waited too long to stop inflation, against his own judgment.
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He probably could have had majority
support on the FOMC by relying on the presidents, but that was not his way of making decisions.

65. Orphanides (2003b, 17 n. 24) gave an additional reason for the failure of the Phillips curve based on measures of the “gap” between actual and potential output. “The analysis failed to take into account that, in real time, gap-based forecasts of inflation are largely uninformative and often misleading.” At the time, the misuse of potential output changed when productivity growth slowed, but the decline in long-term growth was not discussed and probably not noticed until much later.

66. The delay in tightening in 1965 and 1967 are examples. In both cases, policy eased too much soon after the Federal Reserve tightened. The Federal Reserve responded to the 1964 House Banking hearings by appointing an academic advisory committee. At a meeting in the fall of 1967, I recall Milton Friedman pleading with Martin to slow money growth and not restart the inflation that he had recently stopped. Martin listened politely, nodded, but did not respond. Martin was not persuaded by economists. No notes were kept at these meetings. There was rarely agreement among the academics about what should be done, reflecting the
divisions within the academic profession at the time. The division weakened the influence of the monetarist critics.

As a consensus seeker, coordination had great appeal on both analytic and practical grounds. Martin had often said that the Federal Reserve was independent within the government. To him that meant that the Federal Reserve could not raise interest rates high enough to finance the government deficit without inflation. Congress had approved or permitted the deficit, so the Federal Reserve had to assist in its financing.
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Since he believed budget deficits caused inflation, it made practical good sense to him to try to influence decisions about tax and spending policies, even if it sacrificed some independence. He had decided, moreover, that his initial concerns about the 1964 tax cut had been wrong, and Heller had been right. He never reported looking back to see that he had adjusted the Federal Reserve’s actions to the administration, but they did not adjust their policies in a coordinated effort to slow inflation. He had waited for that to happen, but in 1967 he waited in vain.

Furthermore, Martin said repeatedly that monetary policy alone could not achieve low inflation. Others on the FOMC shared that view. The most likely meaning was that the required increase in interest rates would be too large to be acceptable politically. Except for a brief and much criticized use of progressive discount rates in 1920–21, the Federal Reserve had never posted a rate above 7 percent (Meltzer, 2003, 105–7). Martin had ample reason to believe that President Johnson and key members of Congress would not support a substantial increase in interest rates.

The principal reasons for central bank independence are to protect the central bank from political pressures to finance the public sector deficit or support an administration politically. Policy coordination sacrificed independence by strengthening the pressures that independence weakened, and the even keel policy implemented deficit financing by the Federal Reserve.

Two popular beliefs added to the Federal Reserve’s concern about using monetary policy forcefully. First, many economists inside and outside government believed that fiscal actions were powerful and monetary actions relatively weak. Second, many believed that some inflation was endemic in
a modern economy with unions and monopoly elements in key industries like steel, autos, tires, and durable goods. This was a main reason given for guideposts. The record of high growth and low inflation from 1961–65 showed the opposite (as happened again in the 1990s). The 1961–65 evidence did not alter this popular belief.

67. The concern that stopping inflation would require very high interest rates was widely shared. In July 1966, the president asked several people to comment on a criticism of administration policy by Congressman Al Ullman. Sherman Maisel wrote, “Interest rates except at a disastrously high level cannot halt inflation” (Maisel to the president, WHCF, Box 24, LBJ Library, July 13, 1966). Citing the rapid growth of money, bank credit, and business loans, Maisel added that monetary policy had not been “as tight as most believe” (ibid.).