A History of the Federal Reserve, Volume 2 (20 page)

Phase 3 was mainly the work of George Shultz, Donald Rumsfeld, and Herbert Stein. Before the president announced the program, they talked with the heads of principal labor unions, corporations, members of Congress, and others. They learned that dissatisfaction with phase 2 had increased and reported that the program should rely more on voluntary compliance. The principal complaint from both business and labor was the “difficulty of obtaining prompt, reasonable decisions” (memo, Shultz to the president, Nixon papers, January 8, 1973, Tab A).

Phase 3 came after the election. The administration intended to make the transition out of controls. Unfortunately, the change to phase 3 was “premised on a view of the price outlook that was far more optimistic than the inflation trend that actually emerged” (Kosters, 1975, 23).

The problems came from bad luck and bad policies. The very expansive monetary and fiscal policies of 1972 began to affect prices in 1973. Bad weather in the Soviet Union increased demand for food crops and produced a rapid increase in food prices. The first evidence came in December 1972 (ibid., 24), but the administration had to decide whether the increase was temporary or persistent and what to do in either case.

At first, it ignored the problem. At a Quadriad meeting on December 11, Stein exulted about rising output and falling inflation. With the election won, discussion turned to inflation. Burns wanted to set a target of 1.5 to 2 percent for calendar 1973, but Stein objected “that so low a goal would seem incredible” (memo, Stein to the president, Shultz papers, Box 3, December 11, 1972). President Nixon sided with Stein. Soon afterward, Burns sent a copy of a speech that made inflation “the most critical problem that we now face.
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And the problem is of such gravity that a broad governmental effort is required to cope with the threat of a new inflationary spiral” (letter, Burns to the president, Burns papers, Box B_N1, December 28, 1972). The letter promised cautious assistance from monetary policy but added that “monetary policy cannot do the job alone, since any such attempt would threaten another credit crunch.” A month later, he told the
president that his staff analysis expressed concern that inflation would increase. He shared their concern (letter, Burns to the president, Shultz papers, Box 4, January 29, 1973).

47. In a letter to Burns commenting on his speech, the president wrote that he agreed that inflation was “the most critical problem we now face” and that “the
only
responsible course is to fight inflation hard, and this is precisely what I intend to do” (letter, Nixon to Burns, Burns papers, Box B_N1, January 5, 1973). The president set an objective of 2.5 percent inflation by year-end. His administration’s forecast called for 6 percent growth and 3 percent inflation.

On June 13, the president ended phase 3 by freezing prices for sixtynine days. This decision again rejected the advice of his principal advisers, especially Shultz and Stein.
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Stein outlined the economic and political dimensions. The economy had been in a very different place in August 1971. There would be more shortages now. Productivity growth had slowed. Prospects for wage increases were better than in 1971. There would be less conviction that controls would be temporary. This would affect compliance and investment.

Stein’s principal political concern was that Congress would approve a comprehensive, temporary freeze, a popular remedy. That would hurt the president’s ability to lead and “the Republicans could be hurt in the 1974 elections” (memo, Stein to the president, Shultz papers, Box 5, April 9, 1973). Although Stein opposed the freeze, he must have known that his reference to the 1974 election would push the president toward the price freeze.

Burns favored the freeze. On June 1, he wrote the president a letter with detailed recommendations for policy changes (Burns papers, B_N1, June 1, 1973). The letter warned of the public’s unhappiness and unease. Like President Carter’s famous 1979 speech warning of public anxiety, Burns, too, blamed inflation for “a crisis of confidence” (ibid., 3).

His first proposal was “reimpose mandatory controls for Tier I [large] firms” (ibid., 4).
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Then he proposed rolling back prices for firms that violated profit guidelines, suspending all agricultural price supports, sales of materials from government stockpiles to lower raw material prices, prohibiting foreign orders for food exports, and other measures affecting wages and imports. To reduce spending, Burns proposed compulsory savings for corporations and individuals. To meet public concerns about energy, he proposed a tax based on horsepower.

In the last paragraph of his letter, Burns added “that the Federal Reserve has been trying hard to bring monetary policy to bear on the problem of
inflation, that our efforts in this direction will continue, but that we will also try to avoid a credit crunch of the 1969 type” (ibid., 7).

48. Shultz became Secretary of the Treasury when Connally left in 1972, and Stein replaced McCracken as chairman of the Council of Economic Advisers at the end of 1971. Shultz resigned and left the administration soon after the freeze.

49. In April Burns had proposed “an immediate 45 days freeze over a broad range of prices.” Following the freeze, he wanted reforms “to reduce substantially the existing abuses of economic power by the labor unions and corporate giants.” He suggested other structural reforms as well (memo, Burns to John Ehrlichman, Burns papers, Box B_B89,
April 13, 1973).

This differed from Herbert Stein’s opinion. Stein (1988, 183) wrote:

It was also part of the exercise that the revival of demand should be restrained. The Nixon team prided themselves on being alert to the error which other governments had fallen into and assured themselves and others that the controls would not seduce them into excessive expansionism.

But they did fall into the trap. . . . The President, on the advice of his economists, decided that government expenditures should be rapidly increased during the first half of calendar 1972 . . . after which they would be restrained.

Federal budget outlays increased almost 20 percent, from $168 billion in 1970 to $200 billion in 1973. Table 6.5 shows annual data for these years. The administration increased spending with assistance from Congress, but it did not control monetary policy. For that it required help from the Federal Reserve and particularly from Arthur Burns.
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FEDERAL RESERVE ACTIONS, 1971–73

The years 1971–73 are among the worst in Federal Reserve history. The Federal Reserve did not “fall into the trap” of excessive expansion under price controls. It entered by choice. Some members voted for expansion to reduce unemployment. Arthur Burns shared this objective, but he also remained committed to the reelection of President Nixon. He may have adapted monetary policy to achieve a political end. If so, he required help from other members of FOMC, and he was able to get it. There were few objections at the time from Congress or FOMC members.

50. Phase 4 followed the brief freeze. It lasted from August 12, 1973, to April 30, 1974. The administration decontrolled wages and prices during this period. Only 44 percent of CPI prices were subject to control at the start of phase 4. This fell to 12 percent at the end (Kosters, 1975, 26–27). Controls on oil and energy prices remained until the Reagan administration. I have not found an explanation of what this phase could accomplish beyond a cosmetic showing of administration concern.

At the last FOMC meeting before the New Economic Policy (NEP), the Board’s staff raised its estimate of GNP for 1971 by $3 billion, all in real output. They projected real growth at 3.8 percent in the second half of the year and 5.3 percent in the first half of 1972. And they expected money growth to slow in the fourth quarter, as it in fact did (Maisel diary, July 29, 1971, 72). Reported real GNP growth remained at 1 percent in the second half of 1971 but rose to 8.5 percent in the first half of 1972.

The Board welcomed the NEP. Many of them believed that cost-push by unions and businesses caused most of the inflation. The freeze would end that and make possible a return to high employment with lower inflation. Markets interpreted the new policy as anti-inflationary. Short- and longterm interest rates fell after the announcement.

Following the start of controls, the staff projected less reported inflation for the second half. It reduced projected inflation from 4.9 to 3.4 percent. The reported rate was 5 percent, very close to the forecast before controls. However, unit labor costs rose very little in the second half of 1971, but they rose more rapidly after controls than before. Table 6.6 shows unit labor costs during these years. In 1973, they rose rapidly.

Maisel (diary, August 25, 1971, 85) described the August FOMC meeting as probably the longest ever. It lasted eight hours. Three topics added greatly to the discussion: the report of the Committee on the Directive, whether or how to implement new procedures, and whether to purchase federal agency issues to assist the housing market.

The Committee on the Directive proposed that the manager should achieve a reserve target subject to a proviso clause that limited interest rate changes. The committee was unanimous, and the Board’s staff supported the proposal. All agreed that the change was a marginal adjustment that would improve control of the monetary aggregates. They did not discuss even keel, changes in Treasury deposits, or other technical issues. The
manager argued that a reserve target should not be the main issue. The desk could improve control of reserves and the aggregates by permitting wider fluctuations in the federal funds rate.

The FOMC took no action on the proposal. It agreed to have additional studies of the effect of a reserve target on interest rates and to return to the discussion after more had been learned. Nevertheless, it directed the manager to moderate growth of the monetary aggregates consistent with a floor of 5 percent for the federal funds rate. Several members expressed concern about staff projections showing a considerable slowdown in money growth during the fourth quarter.

A few presidents, Hayes, Kimbrel, and Clay, wanted monetary policy to “reinforce the President’s move toward less inflation” by slowing growth of money (Maisel diary, August 25, 1971, 90). “Almost everyone else on the Committee agreed that the incomes policy . . . was to reduce the need for monetary restraint but that monetary policy ought not to increase restraint” (ibid.). Words like “ease,” “restraint,” and “neutral policy” continued in use without clear definition or relation to some measurable quantity.
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The Federal Reserve came into the NEP period with high money growth. Monetary base and M
₁
money growth rose at 7.4 and 7.6 percent average annual rates in the first eight months. By August, twelve-month growth rates of the base and money were 8 and 7.2 percent respectively. Most members of the FOMC said they favored slower growth of the aggregates. Nevertheless, they allowed the federal funds rate to fall gradually from 5.57 percent in August to 4.91 percent in November. Free reserves rose.

At the October 19 FOMC meeting the staff forecast M
₁
growth at 2.5 percent for the fourth quarter and 4.5 percent for the first quarter of 1972. They urged a reduction in the federal funds rate to 5 percent or less (Maisel diary, October 21, 1971, 2). Burns spoke first and urged no change. His concern was that if interest rates declined in 1971, they would have to rise in 1972. Rising rates in 1972 “could result in serious difficulties. That possibility worried him a great deal” (FOMC Minutes, October 19, 1971, 49–50). Burns did not explain the source of his discomfort, and no one pressed for an explanation. They probably understood that Congress and
the administration would criticize rising interest rates in an election year. The members divided almost equally but later compromised on a statement calling for “moderate growth in monetary and credit aggregates” (Annual Report, 1971, 189).

51. Under growing pressures from Congress, Burns persuaded the FOMC to purchase agency issues. A large minority opposed, as they had for the five years since Congress authorized the purchases. But Burns had soon to testify about housing. “It would be useful politically if the System were operating in agencies” (Maisel diary, August 25, 1971, 91). The staff report suggested, it would have little effect on housing. Purchases began in September. The Board announced the first purchases and indicated that total purchases of five agencies issues came to $61 million and had about a two-year maturity (memo, Holland to FOMC, Board Records, September 24, 1971). This is one of several examples of failure to distinguish between mortgage credit and the real resources required to build houses.