A History of the Federal Reserve, Volume 2 (7 page)

During the period discussed in these volumes, the Federal Reserve paid little or no attention to growth of the monetary base. Chart 1.7 shows long- and short-term interest rates for the period. The Federal Reserve used short-term rates as a target either directly or indirectly (free reserves, member bank borrowing, money market conditions) during most of the period. The period October 1979 to July or October 1982 is an exception.

Annual average short-term rates reflect mainly Federal Reserve actions. Rates on three-month Treasury bills varied from less than 1 percent in 1954 to more than 14 percent in 1982. Inflation expectations dominate longterm rates. Annual average of rates on ten-year constant-maturity Treasury bonds ranged from 2.4 percent (1954) to 13.9 percent (1982).

Interest rates typically rise during periods of economic expansion and decline in recessions. For most of the period, the Federal Reserve interpreted the rise or fall in interest rates, particularly short-term rates, as an indicator of its policy. When market rates declined, it interpreted the decline as an easier policy; when rates rose, it interpreted the rise as more restrictive. Usually, it slowed growth of the monetary base and money when rates fell and permitted faster growth when rates rose. Consequently, measures of money growth usually moved procyclically instead of countercyclically.

Chart 1.8 shows the substantial changes in ownership of the federal debt. As government deficits rose after 1964, the Federal Reserve “coordinated” its policy actions by financing a rising share—from 9 percent in the 1950s to almost 17 percent of a much larger debt in 1973–74. By 1985, the share taken by the Federal Reserve was again below 9 percent.

Foreigners financed a large share of large budget deficits in the 1970s and even larger deficits in the 1980s. The chart suggests a main reason. The jump in the foreign share in 1970–71 suggests that foreigners preferred to buy Treasury securities instead of permitting their exchange rates to appreciate against the dollar. The foreign share declined when the dollar appreciated in the early 1980s. It then began to rise again as the dollar fell relative to foreign currencies in the 1980s, especially in 1985 and 1986.

Growing foreign accumulation of Treasury debt eased pressure on the Federal Reserve to finance budget deficits and inflate. Interest rates, exchange rates, and inflation rates reflected the changing shares.

THE HISTORICAL CHAPTERS

Chapter 2 covers the years 1951–60, mainly the years of the Eisenhower administration. President Truman appointed William McChesney Martin, Jr., as chairman of the Board of Governors in 1951. Presidents Eisenhower, Kennedy, and Johnson reappointed him at the end of each four-year term. He retired in 1970.

Martin reorganized the Federal Reserve System. The System we now have is very different from the original. Martin eliminated the Executive Committee of the Federal Open Market Committee (FOMC), which made operating decisions about open market operations. To give greater role to the presidents of the regional banks and reduce New York’s role, he increased the number of FOMC meetings from four to seventeen a year and worked to get the reserve bank presidents to take an active part. Also, he transferred the choice of manager of the open market account from the New York bank to the FOMC. Each of these steps increased the Board’s role and reduced New York’s. From its earliest days, Washington and New York struggled over control of the System. Martin settled the issue with Washington in charge. His moves gave the System greater cohesion but also made it more susceptible to political pressure.

In the 1930s and 1940s, the Federal Reserve’s main concern was debt management. The March 1951 accord with the Treasury reduced that role. Gradually the System’s main concern became support of the goals of the Employment Act, especially full employment. Inflation concerned Martin, and in the 1950s he worked to prevent it. In this he was greatly helped by the Eisenhower administration’s support for budget balance except in recessions. Forceful Federal Reserve and administration action after the 1958 recession reduced the budget deficit, money growth, and inflation.

Martin also firmly supported the Bretton Woods system and accepted the importance of the fixed $35 gold price. The Federal Reserve had a supportive role, but Martin led the Federal Reserve into a cooperative arrangement to assist the Treasury by financing foreign exchange purchases and by arranging “swap agreements” with many foreign central banks.

Martin often described the Federal Reserve as “independent within government,” a phrase that meant to him that the Federal Reserve would not fail to support Treasury financing operations. It could raise interest rates to prevent inflation caused by excess aggregate demand by private agents, but it would not force the government to finance budget deficits solely out of domestic and foreign saving.

To free itself from pressures to support the market for long-term debt, the Federal Reserve adopted the bills-only policy. It supported long-term markets only when there was a risk of failure of a Treasury issue. These interventions were infrequent. The policy had many critics in Congress and elsewhere who claimed that it contributed to higher long-term rates. After bills-only, the System made few purchases or loans on long-term debt until 2008.

Martin concluded that budget deficits caused inflation. He had little interest in economic theory, and he did not encourage or want economic
theory used to guide monetary policy. His main concern was the money market. Instructions to the desk during these years were imprecise to give more influence to the manager.
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Members of the FOMC used different measures to gauge the thrust of policy actions and did not attempt to reconcile them.

Chapters 3 and 4 cover the years of the Kennedy-Johnson administrations, the years up to 1965 in Chapter 3, 1965–69 in Chapter 4. Restrictive policies in 1959 ended inflation but caused a recession. The economy recovered in the early 1960s. Inflation remained low. The Kennedy administration promoted growth by instituting an investment tax credit, faster depreciation schedules, and the much-discussed 1964 tax reduction passed after Kennedy’s assassination.

Problems continued. European currency convertibility strengthened the European currencies and increased a gold outflow from the United States. President Kennedy often expressed concern, and his administration introduced lending restrictions and promoted a policy of “twisting the yield curve” by lowering long-term rates to induce domestic expansion and raising short-term rates to attract foreign deposits and strengthen the dollar. The Federal Reserve abandoned bills-only and cooperated with the administration, but not enough to satisfy some of the administration’s economists. The Johnson administration was less concerned about the gold outflow. Whenever the problem seemed acute, they introduced or strengthened controls on foreign lending.

In the 1962 report of the Council of Economic Advisers, the Kennedy administration claimed that inflation would start to rise before the economy reached full employment. They proposed guidelines for wage and price increases to suppress the rise in inflation. Reliance on guidelines or guideposts shifted attention away from Federal Reserve policy as a cause of inflation.

Kennedy administration economists wanted policy coordination. They especially wanted a voice and influence on Federal Reserve actions. Martin cooperated, believing he gained a voice in administration fiscal policy. He knowingly reduced Federal Reserve independence because he believed that the Federal Reserve could not control inflation if the administration ran large deficits. Eventually, he learned that coordination worked one way; the Federal Reserve adjusted its actions to the administration. When the Federal Reserve wanted the administration to increase tax rates to reduce the budget deficit, the Johnson administration and Congress were slow to act.

21. Transactions for the open market account are made in New York. The trading desk does the transactions.

When Congress finally approved a tax surcharge in 1968, the Federal Reserve lowered market rates to soften the expected effect on the economy. By the end of that year, Martin realized he had made a mistake. Inflation increased; the Great Inflation was under way.

The simple Keynesian model (Ackley, 1961) dominated thinking by the administration and the Federal Reserve staff. Although Martin did not share these beliefs or ideas, he did not offer an alternative. He distrusted most academic research, especially monetarist claims about money growth. Although he made many speeches opposing inflation, the inflation rate rose to 6 percent at the end of his term.

Chapter 4 discusses the emergence and growth of domestic inflation. Chapter 5 considers international aspects. Financing budget deficits at home produced inflation; financing them abroad put pressure on the dollar exchange rate. Controls produced temporary respites. By March 1968, the United States and foreign governments agreed to end sales of gold to non-government or central bank entities. This was the beginning of the end of the fixed exchange rate system.

Federal Reserve and administration officials repeated that there were three problems—liquidity (too many dollars to sustain dollar exchange rates), adjustment (the need to change exchange rate parities), and confidence (belief or anticipations that the Bretton Woods system would continue unchanged). The United States opposed any change in the dollar price of gold or devaluation of the dollar. Only Germany and the Netherlands appreciated their exchange rates by small amounts. Most others complained about inflation, called imported inflation, but preferred inflation to appreciation of their currency. Cooperation to maintain the system was lacking.

Creation and later issuance of the special drawing right (SDR) were the main international policy action to remedy problems of the Bretton Woods system. Ignoring the adjustment problem and misaligned exchange rates to concentrate on the liquidity problem is hard to understand or defend. The system had surplus liquidity. The main reason given for the attention to SDR creation was that in some distant future, if the United States stopped running payment deficits, a new source of liquidity would be needed. Gold production would not be sufficient.

SDRs never became an important means of settlement. In August 1971, the United States allowed the dollar to depreciate against gold and foreign currencies. After introduction of a surtax on imports and considerable wrangling, governments agreed to a new set of exchange rate parities. The agreement began to unravel in the winter of 1973. Thereafter, exchange rates floated, a few freely; most were managed by central banks.

President Nixon took office in January 1969. In 1970 he appointed Arthur Burns as chairman of the Board of Governors. The president promised to reduce inflation without a recession. A recession started in November 1969. The Federal Reserve soon gave up its efforts to reduce inflation and worked to reduce unemployment. Coming after a similar response to slowing economic growth and housing in 1966–67 and the tax surcharge in 1968, markets correctly interpreted these actions as evidence that the Federal Reserve gave more importance to avoiding a rise in unemployment than to preventing inflation. Anticipations of persistent inflation rose.

Burns was the most politically involved chairman since Marriner Eccles in the 1930s. He sacrificed Federal Reserve independence to the interests of the administration. He believed that labor unions and the welfare state made inflation difficult to control using monetary policy. FOMC supported his actions. Most of the members accepted that their first responsibility was to avoid an unemployment rate above 4 percent.

Congress challenged the Nixon administration to use price guidelines or controls to slow inflation. Arthur Burns was a leading advocate using a flawed argument that controlling prices would reduce inflation. Facing a reelection challenge for failing to use controls, the president reversed his often-stated opposition. Chapter 6 traces the decision to use controls and float the dollar in August 1971. It was a political success but a disaster for inflation control. Inflation reached new heights once controls ended. An increase in food and energy prices exaggerated the sustained consumer price index (CPI) inflation rate.

After President Nixon resigned, Gerald Ford encouraged the Federal Reserve to slow inflation. A recession interrupted the effort, but the reported inflation rate declined. Ford lost the 1976 election to James Earl Carter. The new administration chose to follow a more expansive policy. Chapter 7 traces policy developments at the end of the 1970s.

Carter administration economists renewed the use of guideposts and exhortation to prevent wage and price increases. These efforts failed again. Administration economists worked to get Germany and Japan to agree to coordinated expansion. Their idea was that exchange rates would remain bounded. Germany did not agree until the summer of 1978.

This policy failed also. By late 1978 inflation had increased. The dollar exchange rate fell. After a renewed attempt to use non-monetary means, the Federal Reserve raised interest rates. The dollar strengthened.

Another large increase in the price of oil pushed measured inflation to the peak shown in Chart 1.1 above in 1978–79. Public pressure, including polling data, encouraged President Carter to replace the Secretary of the
Treasury with G. William Miller, who had replaced Arthur Burns at the Federal Reserve. Paul A. Volcker became chairman of the Board of Governors.