A History of the Federal Reserve, Volume 2 (123 page)

The Board preferred to have New York withdraw the request, leaving no record. By telephone, New York explained that its directors supported Coombs’s negotiations with the West Germans and preferred to have the request rejected. The four Board members present voted to reject the request.

The next month, June, the Board approved an increase in the discount rate to 5 percent effective July 16. Continuous high unemployment was the main reason given by those who wanted to reject the June requests. The surge in inflation in May and June (Table 4.11 above) and sustained high money growth convinced Burns and others to show independence by signaling their concern about current and prospective inflation.

Burns valued the Federal Reserve’s independence, but neither he nor others on the Board believed that independence permitted them to work against administration policy. They could criticize and suggest alternatives. As we know, Burns worked actively to change the president’s opposition to an incomes, or wage-price, policy. He offered advice on a wide range of other policies, but he complained about the pressure he received from the administration about money growth.

Maisel’s discussion of independence elaborated the view established since Sproul and Martin.

It is up to the President and Congress to determine the national economic goals. While the President is considering these goals, it is proper for the Federal Reserve Board through the chairman or individuals in their speeches to point out the logical policies as they see them to deal with the question of trade-offs, the problem of whether a path is too rapid or too slow, and similar matters. . . .

However, if the Congress and the President agree on the national economic goals then it seems clear that the Federal Reserve has to agree to furnish the necessary sums of money and credit. . . . [E]ven in this case, the Federal Reserve as an independent agency has to make its own determination of how monetary policy can best hope to achieve its goals, but there is a commitment by the Federal Reserve System to help achieve these goals and not try to impose its own goals or to sabotage the goals set by the rest of the government in any form. (Maisel diary, January 14, 1971, 11)

This statement elaborated on “independence within the government, not independence of the government.” Like earlier statements, it left open the choice of interest rate (or money growth) at which the Federal Reserve would direct its actions to achieve the politically agreed objectives. And it was the rate of money growth that was an almost constant issue between Burns and the president or his staff and advisers. Burns’s “clear feeling which he has expressed that the President has gone all out to be re-elected in 1972. As a result he has subordinated inflation control to this idea” (ibid., 10).
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Meeting alone with the president in March 1971, Burns complained about leaks from the administration to the press complaining about him and Federal Reserve policy. Then he insisted on his loyalty to the president. They discussed monetary policy in a way that is hard to reconcile with Federal Reserve independence.

I am a dedicated man to serve the health and strength of our national economy and I have done everything in my power, as I see it, to help you as president, your reputation and standing in American life and history. I’ve never seen a conflict between the two, but I want you to know this . . . the moment a conflict arises, I’m going to be right here. I’ll tell you about it, and we’ll talk it out and try to decide together where to go next. (White House tapes, conversation 470-18, March 19, 1971)

He told the president that interest rates were lower, 3.2 percent compared to 8.1 percent a year earlier. They could be reduced more but, he told the president, “We run the risk of accelerating an international monetary crisis.” Then he turned to domestic policy.

If interest rates go down further through my actions . . . the probability, as I see it, is that they will go up later in the year. In 1972, housing, which is recovering very nicely, would go into a tailspin in 1972. Where would we be as a country, as a party, and you personally? I think it is stupid. (ibid.)

The president talked about their long relationship and urged Burns to meet with Connally. Then he added:

The key to this is first you [Burns] and I stand close together, which we will do. Second, on the Quadriad that . . . [we] knock down discord. . . . I don’t mean that you have to get to 3 percent unemployment.

221. Chairman Burns testified before the Joint Economic Committee that the FOMC “would make all the money necessary to ratify the $1,065 [million] goal,” although they doubted that it would happen (ibid., 24). Arthur Laffer’s forecast of $1,065 assumed 6 percent money growth. Burns statement was a commitment to inflation if necessary that he probably did not intend.

Burns replied, “The direction has to be right” (idem.).

Faced with the pressure from the administration, Burns and the FOMC yielded. Money growth remained above the level that would reduce inflation and above the rate that they set. The FOMC raised its federal funds rate target gradually in 1971 (Table 4.11 above) but not enough to slow money growth. As in many committee actions, no single motive can explain the result. Some may have wished to support the president’s goals; some put greater weight on unemployment than inflation; some went along with the chairman or the majority; and some hoped that they would avoid the consequences or reverse their actions before inflation rose. Those holding the last of these views thought that with unemployment above 4 percent, inflation would not increase because of the slack in the economy, and if it did increase, it resulted from cost-push, not from anything they did.

At the February FOMC meeting the directive called for “resumption of sustainable long-term economic growth, while encouraging the orderly reduction in the rate of inflation and the attainment of reasonable equilibrium in the country’s balance of payments” (Annual Report, 1971, 124). What concerned the members most was whether to lower the federal funds rate by 0.5 percentage points to get money to grow faster than the 6 percent proposed for the year. Hayes, Brimmer, Daane, Robertson, and Francis opposed the reduction. Burns expressed concern “about the political pressure the Board would be under if we didn’t get a 6 percent growth rate and, therefore, felt that we had to make up for shortages” (Maisel diary, February 10, 1971, 21). The compromise was to keep the 3.75 percent funds rate for a week; if money growth was below the 6 percent path at the end of the week, the funds rate would be reduced to 3.5 percent. They agreed to call a special meeting if money growth was below the target after two additional weeks. Only Francis dissented because, as before, he did not want money growth above 5 percent. To reduce intermediate- and long-term rates, the FOMC instructed the manager to purchase coupon issues.
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Money growth rose, so the federal funds rate remained unchanged on average in March. Yields on intermediate-term Treasuries moved down sharply. Much of the move was probably a speculative response to sizable System purchases that soon reversed (Table 4.11). Long-term yields rose slightly. The minutes explain higher yields on corporate and municipal new issues as a response to the “heavy calendar of new offerings” and
made no mention of borrowing to anticipate higher inflation (Annual Report, 1971, 128).

222. Burns asked Maisel how the committee could control the manager. The manager “was more concerned about day-to-day movements in the money market” (Maisel diary, February 10, 1971, 22). Maisel suggested setting a reserve growth target with an interest rate proviso clause. The FOMC did not make this change.

FOMC members could not agree about the response of long-term rates to higher short-term rates. Some thought an increase in short-term rates would lower long-term rates; others argued that long-term rates would rise (ibid., 129–30). The Board’s Annual Report showed a unanimous vote for no change. Maisel (diary, March 12, 1971, 28) reported the actual vote as eight to four, with the minority in favor of tightening. Burns got unanimity by putting a very wide band, plus or minus 4 percent, on money growth.

The March meeting reopened an old issue, bankers’ concerns versus political or national policy. Daane said that at Basel “the central bankers . . . were very much concerned with the ease of money here” (Maisel diary, March 12, 1971, 26). Soon afterward, “Brimmer, Holmes [the manager], and Kimbrel [Atlanta], all indicated that they were told by their banker friends as well as some other observers that we were moving too fast. Interest rates were too low. The bankers were afraid they could not take additional lowering of interest rates. In addition the balance of payments situation was bad and the Committee ought to do something about it. . . . [Presidents] Mayo, Coldwell, and Francis indicated that they too had been under the same pressure and more or less agreed” (ibid., 26).

This was not what Burns wanted to hear or do. Burns responded that “we had to beware of banker opinion. We had to consider the total economy, its growth and particularly unemployment” (ibid., 27). Having expressed his priorities and allied himself with the president, he “made the strongest statement on the balance of payments that I [Maisel] had heard pointing out that basically we were not charged with solving the balance of payments problem. . . . [H]e recognized that we had some marginal things we could do in the balance of payments field but that we ought to recognize that it was not a major responsibility of the Federal Reserve” (ibid., 27).

Burns did not favor floating the dollar. Like Martin before him, he wanted the administration to act. They had no interest. At a meeting later in the day, Maisel asked Herbert Stein about the Council’s view of the balance of payments. “Their feeling was that we should not worry. We would be better off suspending payments and let the dollar or other currencies float. . . . He also indicated that he had talked to Connally, . . . and Connally felt even more strongly that this was true. He felt that we ought not to let foreign central banks dominate our internal situation” (ibid., 28).

In short, neither the administration nor the Federal Reserve intended to honor the commitment to the $35 gold price. There is no evidence in the record that word of this discussion became known, but during the next few
weeks, flight from the dollar increased. On April 6, Coombs reported that $4.5 billion had been acquired by foreign central banks in the four weeks since the March meeting. The pace of dollar inflows to foreign central banks increased. On Friday, April 2, the flow was $1 billion. “Corporation treasurers and other traders were now beginning to hedge against the risk of parity changes” (FOMC Minutes, April 6, 1971, 3).

Burns now reversed the position so forcefully offered at the previous meeting. He favored an increase in the funds rate of 0.5 or 0.6 percentage points above the directive at the March meeting: “He was doing this primarily for balance of payments reasons” (Maisel diary, April 9, 1971, 32). The manager had permitted half the increase before the meeting, so the actual increase was small, too small for Presidents Hayes and Kimbrel (Atlanta). They dissented, Hayes citing “inadequate recognition” of international financial events. Kimbrel wanted slower money growth to avoid “rekindling inflationary expectations” (Annual Report, 1971, 140).

Yielding to pressure from some members of Congress, Burns proposed purchases of government agency issues to assist housing finance. Hayes objected for principled and practical reasons. Yielding to congressional requests to aid a particular sector would “expose the Federal Reserve to strong pressures to provide similar assistance to other sectors” (FOMC Minutes, April 6, 1971, 39). Furthermore, agency securities sold in “highly fragmented” markets. This made operations in these markets difficult.
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Dollar outflow slowed for a few weeks, then resumed. Coombs told the May 11 FOMC meeting that $4 billion had moved abroad in two days, the largest movement to that time. The West German Economics Minister, Karl Schiller, called for a floating rate for the mark.

The New York directors had voted to increase the discount rate to show that the United States intended to defend the dollar exchange rate. Burns thoroughly opposed floating rates, but neither he nor the administration wanted to sacrifice domestic expansion. The Board rejected the discount rate increase, signaling that the United States would not defend the ex
change rate.
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Some European countries joined Germany in a float; others appreciated their exchange rates. See chapter 5.

223. The proposal was one of several to assist the housing market. On March 31, Burns testified on a Senate bill that (1) extended the authority, first granted in 1966, for flexible rates on time and savings deposits and coordination with other regulators, (2) extended the president’s authority to impose mandatory controls on wages, prices, rents, and salaries, (3) renewed authority granted in 1960 to impose selective credit controls, and (4) authorized the Board to require member banks to maintain supplemental reserves against assets to increase credit to six sectors, including housing. The Board unanimously endorsed Burns’s statement favoring a wage-price review board instead of mandatory controls (Board Minutes, March 30, 1971). It did not reject mandatory controls, but it suggested they be used as a last resort. Burns testified against asset reserves, but he continued to receive pressure for assistance to housing. Housing starts had fallen from a local peak of 1.8 million annual rate in January 1969 to less than 1.1 million a year later, but they recovered to 1.9 million in the month he testified.

At the May 11 FOMC meeting, the staff reported rapid wage increases and, despite the rise in interest rates, rapid money growth. Reported money growth for the first quarter reached 8.9 percent, more than making up for the shortfall at the end of 1970. The report for April was 10.9 percent, not the 7 percent now shown in Table 4.11. The staff projected 9 percent for the second quarter if money market conditions remained unchanged. To slow money growth to about 6 percent in the second and third quarters, the staff estimated that the FOMC would have to increase the funds rate from 4.5 to between 6 and 8 percent (Maisel diary, May 11, 1971, 41). That destroyed any chance of majority support.

The usual split reoccurred. To resolve the issue, the FOMC gave “more than the usual degree of discretion” to the manager (Annual Report, 1971, 146). He allowed the funds rate to rise modestly. The market did not perceive a change to a less inflationary policy. Long-term rates rose and inflation increased to a 6 percent annualized rate in May. Stock prices fell, no doubt influenced by the uncertainty about the exchange rate system and higher inflation.
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Maisel described three main control problems of that time. First, they did not know where the equilibrium interest rate was. Second, “what premium should be included in the nominal long-term rate over real?” Third, “we can’t explain why M 1 has risen so fast in the past six weeks. We don’t know if this is temporary or permanent” (Maisel diary, May 21, 1971, 47). At the time, estimated M
₁
growth for May reached 17 percent.

Burns too recognized that the forecasts of money growth were inaccurate and misleading, that control was poor, and that as measured at the time, money growth was 11 percent for the year to date, twice the average rate the FOMC wanted. Although he did not believe that money growth affected inflation as long as there was excess capacity, he disliked the criticism by those who believed otherwise. To improve control, he turned again
to Maisel and the Committee on the Directive, proposing that they consider reviewing the proposal to control reserve growth instead of a money market rate that he had rejected earlier.
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224. Maisel (diary, May 7, 1971, 37) described his view: “This was not a proper use of the discount rate; the domestic cost might be very high.” Burns believed that “the New York directors and the New York Bank believed in high interest rates. They wanted them to go up and were willing to use this as an excuse to get higher rates” (ibid.).

225. The manager faced a dilemma. “He doesn’t know whether the aggregates are temporarily high. On the other hand, he knows that if he is very active trying to keep the federal funds rate high, the long-term market might even become disorderly” (Maisel diary, May 21, 1971, 44). To help the Treasury through the period of market turbulence, the System purchased short-term securities directly from the Treasury. The maximum amount was $610 million on June 10 (Annual Report, 1971, 157). The Board voted in June to support legislation authorizing direct purchases up to $5 billion (Board Minutes, June 15, 1971).