A History of the Federal Reserve, Volume 2 (78 page)

The decline in the payments deficit reflected both political and economic changes. The government introduced an interest equalization tax to make it more costly for foreigners to borrow in U.S. capital markets. More foreign aid was tied to purchases in the United States, and the military shifted some of its purchases from foreign to domestic producers.

The economic adjustment process was classical. The outflow of dollars raised price levels abroad, in Europe and Japan as well as elsewhere, relative to U.S. prices. This equilibrating mechanism worked despite European governments’ efforts to prevent domestic price increases. Bound by the fixed exchange rate, and unwilling to revalue against the dollar, countries could only accept higher inflation or impose exchange or other controls.
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Karl Blessing, president of the Bundesbank, recognized that the choice was between revaluation and inflation, but the Bundesbank and the German government disliked both. Like the United States authorities, they relied on selective controls—the interest equalization tax for the United States, a 30 percent reserve ratio for foreign deposits at German banks, and, in March 1965, a 25 percent tax on interest payments by German institutions to non-residents (Holtfrerich, 1999, 378).

The Federal Reserve raised the federal funds rate twice by 0.5 percent in August 1963 to 3.5 percent and in December 1964 to 4 percent. Treasury bill rates followed the earlier change but preceded the later change. These market rates were closely related to discount rate increases from November 24 to 31, the latter taken in response to an increase from 5 to 7 percent by the Bank of England effective November 23.
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On both occasions, the Board also increased regulation Q ceiling rates by 0.5 percentage points, first to 4 then to 4.5 percent.

None of these changes reduced the reported growth rates of the monetary base and money. Early in 1963 annualized base growth averaged 4 percent, more than double the rate reached two years earlier. By mid
1965, that average had increased to nearly 6 percent, presaging the inflation that soon brought the low-inflation period to an end.

224. West Germany and the Netherlands revalued in 1961 but did not revalue enough to prevent inflation in costs and prices. German wages rose at an annual 10 percent rate from 1960 to 1962. Unit labor costs rose 14 percent in Germany and 8.6 percent in the United Kingdom and fell 2 percent in the United States (Holtfrerich, 1999, 377–78).

225. Lord Cromer, governor of the Bank of England, proposed that both central banks increase their rates at the same time. Martin explained that coordination of the twelve reserve banks made this difficult but “he personally would favor an increase . . . if Bank rate was raised” (Board Minutes, Novembe
r 23, 1964, 3).

Members of the FOMC continued to instruct the manager using a variety of targets—free reserves, short-term interest rates, growth of bank reserves or reserves against private deposits, and the inevitable “tone and feel.” Often a member would suggest several targets without giving priority to one over another. The account manager, or whoever influenced his decisions, had considerable discretion. If a member complained about the manager’s performance, as often happened, the manager could point to some indicator that justified the outcome.
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The division continued within the FOMC between those who favored tighter policy principally to slow the flow of gold and dollars abroad and those who emphasized the domestic concerns of employment and growth. An unusual characteristic of the period is the large number of dissents from policy decisions. Chairman Martin liked to achieve a broad consensus and often delayed changes he thought desirable to get broader agreement.
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The decline in the outflow of gold and dollars reduced attention in 1964 to external factors. Nevertheless, swap arrangements expanded greatly and were renewed without question. In November 1963, the Federal Reserve began a new “experiment” in “warehousing” to assist Italy to maintain the exchange value of the lira. The new authority allowed the foreign exchange desk at the New York bank to make spot purchases “of currencies in which the Treasury had outstanding indebtedness” (FOMC Minutes, November 12, 1963, 5). The currencies would be sold to the Treasury in exchange for its lira debt. This was called “warehousing” because the intention was to reverse the transaction later. Coombs proposed a maximum of $100 million outstanding and requested authority to purchase above par value.
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He explained that the Treasury’s Stabilization Fund lacked the capital to make the purchases.

Coombs had not asked for general authority and seemed to want only au
thority for one operation. The FOMC granted general authority for all currencies in which the Treasury had debts (ibid., 7). Ellis (Boston) suggested that warehousing “might well provide a routine channel for redeeming outstanding Treasury bonds denominated in foreign currencies” (ibid., 7). The FOMC unanimously approved the program “with the understanding that it [warehousing] was experimental” (ibid., 9). It placed a limit of $100 million on the outstanding total, and it did not restrict the operation to the lira. It took no notice of the fact that its “experiment” in swap operations had grown in less than two years to $1.95 billion. Warehousing also rose and fell; by 2000 the maximum reached $20 billion.
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226. Brunner and Meltzer (1964) made this point in a report to the House Banking Committee during this period. Although there is some discussion in the minutes about improving the directive and giving more specific advice, not much changed at the time. Karl Bopp, the president of a reserve bank (1965,12), gave a more defensive response, dismissing the monetarist approach as “mechanistic.”

227. On one occasion, Martin was explicit. According to the FOMC minutes, Martin stated that “[t]he burden of proof was on those who wanted to make a change in policy . . . [I]f he were doing this on his own his inclination would be toward the kind of policy change that Mr. Mills aptly termed ‘provisional and probationary’” (a cautious move to tighten) (FOMC Minutes, August 18, 1964, 55). Only six FOMC members spoke in favor of tightening at the meeting.

228. The Bank of Italy elected to defend its parity by purchasing above par value. The U.S. Treasury bought the currency at the price the manager paid.

At the end of 1964, Martin looked back to appraise their actions. He “recalled that at the preceding meeting he had agreed with a view . . . that the Committee should never be complacent. However, recently he had reviewed the Committee’s minutes for the past year and he could not help but feel a sense of satisfaction with the course of monetary policy in 1964” (FOMC Minutes, December 15, 1964, 92).

OUTSIDE APPRAISALS

The year 1964 was the fiftieth anniversary of the Federal Reserve’s founding. Congressman Patman held hearings during the winter at which Chairman Martin, other governors, Secretary Dillon, and academic and industry economists testified. Several outsiders were highly critical of the Federal Reserve but did not agree on the source of the problem or its solution. Congressman Patman introduced legislation calling for an increase of the Board of Governors to twelve members, retirement of Federal Reserve stock owned by member banks, transfer of all interest received on government debt to the Treasury, congressional appropriation for the expenses of the Board and the reserve banks, payment of interest on demand deposits, and mandatory support of government bond prices when market yields equaled or exceeded 4.25 percent.
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229. The term “warehousing” seems a term of art to circumvent legal restrictions on direct loans to the Treasury. I have not found a study at the Federal Reserve of the “experiment” to evaluate its effects.

230. Karl Brunner and I served as adjunct staff of the committee. The reports that we prepared (1964) were part of the hearings, but Congressman Patman’s legislative proposals came from other sources. Based on my conversations with him I do not believe he expected these proposals to be enacted. He liked the exchanges with Martin and others and believed that these exchanges were an important part of congressional oversight. The Federal Reserve had to treat the proposals as serious recommendations though they disliked them. Members of the committee had a similar interpretation. Some members of the Banking Committee also held the view that Chairman Patman did not expect the proposals to become law (Subcommittee on Domestic Finance, 1964, 1206). Stockwell (1989, 41–44) discusses the Board’s reaction to these and other congressional hearings.

Governor Daane, however, described the three main points of the hearings as “the relationship and role of the Federal Reserve within the framework of Government, the allegation of banker domination, and the monetary policy process” (Subcommittee on Domestic Finance, 1964, 1192–93). Daane talked about the amicable, cooperative relation between the administration and the Federal Reserve, citing both his earlier experience at the Richmond bank and more recently at the Treasury. “The primary goals of monetary policy are identical to those of Government economic policy: we, too, are governed by the Employment Act of 1946” (ibid., 1193). Recognizing differences in responsibility, “the Federal Reserve is as responsive to the needs of Government finance as it either should be or can be . . . [I]t would be unreasonable to hope for any significant improvement in the technical coordination of monetary policy and debt management through the consolidation of these functions under a single head” (ibid., 1193).
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Daane, of course, denied the old charge that bankers dominated the System. Then, turning to the criticism in the staff report, he rejected the charge that the FOMC or the Federal Reserve suffered from what he called “money market myopia” and “overemphasis of short-term factors” (ibid.). “The weakness of the various operational guides, such as free reserves, member bank borrowings, and various short-term interest rates, are well recognized throughout the System” (ibid., 1195). Daane cited a list of the many measures of economic activity, prices, and production, but he did not suggest how the FOMC or the manager connected its money market operations to these measures.
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REGULATION

The Kennedy administration undertook major reform of the banking and financial policies independent of the changes in macroeconomic policy. Many of the policies they inherited reflected the attitudes of the Great Depression, when safety became a major concern. Innovation or financing
growth and expansion seemed less important than preventing additional failures or financial collapse.

231. Daane does not repeat Martin’s statement about independence
within
the government or its implication that the Federal Reserve could not refuse entirely to finance budget deficits voted by Congress. His more cautious statement leaves open what he means by “responsive to the needs of government.” He did not mention Bretton Woods.

232. Governor Mitchell, on the other hand, recognized that the Federal Reserve had not connected its actions to economic activity. He welcomed “the vigor with which an increasing number of academic economists, including two who have been serving on your staff, are now analyzing the statistical behavior of monetary magnitudes. . . . I, myself, have recently tried to suggest ways in which the effects of monetary action on spending can be traced. The measurement problems are formidable and . . . we have not come nearly as close to achieving usable results as some of the academic people believe” (Subcommittee on Domestic Finance, 1964, 1185).

By the 1960s early postwar concerns of a return to recession or stagnation dissipated. Growing confidence, helped along by low unemployment and a 50 percent increase in per capita income from the best prewar level, helped to change beliefs about the future. Competition with the reviving European and rapidly growing Japanese economies directed attention to facilitating growth. Concerns about Soviet growth heightened that interest. Growing urbanization and a decline in populist concerns about banks and bankers supplemented these pressures for change. No less important were court decisions bringing bank mergers under the antitrust laws.

The principal agent for change was James J. Saxon, the new Comptroller of the Currency appointed by President Kennedy. The Comptroller regulated national banks under the National Banking Act of 1863 and could expand some of their powers. Research, much of it stimulated by the development of a strong research group at the Comptroller’s offices, questioned restrictions on entry, branching, and Depression-era regulation. The Comptroller favored “introduction into the banking industry of new competitive forces with fresh ideas and fresh talents” (Comptroller of the Currency, 102nd Annual Report, 1966, 403). The report viewed regulation as at times preventing the benefits of competition.
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The Comptroller’s rulings extended the powers of national banks. A more cautious Federal Reserve followed. One result was that banks began to offer negotiable certificates of deposits that permitted their customers to invest surplus funds under more favorable conditions. Later, these instruments were freed from interest rate regulation, a first step toward decontrol. Negotiable certificates later became the basis for money market mutual funds that permitted small depositors to escape interest rate regulation.

Congress also acted in 1960 by establishing criteria for mergers and acquisitions as an amendment to the Federal Deposit Insurance Act. In October 1962, Congress permitted the Federal Reserve to exempt for three years deposits of foreign governments and certain foreign institutions from interest rate ceiling regulations.

233. “Many banks have been barred from the complete realization of production economies, and many communities have been deprived of the broader range of banking services which could have been provided to them” (Comptroller of the Currency, 1966, 419). The report showed the number of banks had declined to about half the number in the 1920s, but the number of banking offices (including branches) was about the same as in 1929 (ibid., 421).