A History of the Federal Reserve, Volume 2 (43 page)

Burns replied to the criticisms by defending the small change in M
₂
and M
₃
growth. “It will take us ten years [to return to price stability]. Ten years if we’re lucky” (ibid, tape 8, 2).
⁸²
Governor Coldwell pointed out that they did not achieve the annual targets. “I don’t hear many Committee members, perhaps excluding President Balles, who keep reminding us that our short-run ought to be somewhat consistent with our long-run targets” (ibid., tape 8, 4–5).

With the obvious divisions, the short-term focus, and the absence of a common, coherent framework and an agreed objective, the System was ill-equipped to end inflation. Political concerns and weak independence heightened the problem.

In March, the FOMC missed another opportunity to consider the longer-term effect of its actions. Governor Wallich said the FOMC would improve its policy “the earlier we face up to the prospect of rising interest rates” (ibid., March 15, 1977, tape 4, 4). Burns opposed. “We ought to be very cautious about any anticipatory movement that we make. And we’re capable of responding and responding very promptly without anticipating these very short-term adjustments” (ibid., tape 4, 7). Of course, this neglects changes in maintained anticipations.
⁸³

Political concerns affected Burns’s decision about the choice of annual targets for money growth. He told the FOMC that before President Carter announced his energy policy he proposed to reduce M
₁
growth by 0.5 percentage points. Uncertainty changed his proposal to “a much
milder recommendation.” He eliminated the proposed reduction (ibid., April 19, 1977, tape 5, 4). Then, remembering his repeated concern about inflation, he warned: “There is never a good time to lower the monetary growth ranges, yet unless we work at it . . . I don’t see much future for our economy” (ibid.).

82. Although the staff used a model, Burns had little confidence in econometric models. “I have managed to get to my present age without paying much attention to what these equations have to say. . . . I see no reason for learning these things at the present time” (Burns papers, FOMC, June 21, 1977, tape 1, 24–25). His successors, Volcker and Greenspan were also disinclined to accept model forecasts.

83. Burns publicly opposed President Carter’s fiscal program. In March, he told the FOMC, “I don’t think it is going to make any difference one way or another as far as the real economy goes.” He explained that higher interest rates and inflation would offset any positive real effect (Burns papers, FOMC, March 15, 1977, tape 1, 17). He also opposed Carter’s energy program, describing it as overly complicated, likely to increase uncertainty and reduce growth (ibid., April 19, 1977, tape 3, 23–24).

For the first time, Wallich recognized that the measured rate of price change included one-time price changes resulting from “external shocks.” He wanted the committee to decide whether to accommodate the shock or ignore it. His analysis showed the lack of clarity about inflation and price level changes. Accommodating the shock—not responding—“would just build the price increase into the economy permanently as a continuing rate of inflation” (ibid., tape 6, 2). The oil shock was a price level change that would increase the rate of price change temporarily as it passed through. Actions to offset the price level effect was a long step toward taking the price level as the goal instead of the sustained, expected rate of inflation.

President Black urged a reduction in the proposed money growth rates. The present is about “as good a time as we are likely to get” (ibid., tape 6, 4–5). But he voted for Burns’s proposal. Only Partee dissented from the very mild move because of uncertainty, withdrawal of President Carter’s proposed $50 rebate, and the continued high unemployment rate.

At the time, the unemployment rate was about 6 percent. The full employment rate was no longer 4 percent. Mayo thought it was 5.5 percent. The staff used 4.86 percent, a precision that amused the members. As with most decisions, the Committee did not attempt agreement on full employment or reconciliation of diverse opinions.

Wallich concluded from his observations that high unemployment did not reduce inflation. This denied the relevance of the Phillips curve relating the two, a main hypothesis in the staff model. “Our projections say that doesn’t have that effect and I think we could begin trying something else” (ibid., September 20, 1977, tape 3, 18). He proposed an incomes policy, similar to the policy the administration used without obvious benefit.

Sometimes the committee chose a money market directive. At others, it chose an aggregates directive. The difference was in the degree of control or the width of the range for the federal funds rate. Although this decision brought out frequent differences of opinion, the data do not show any major differences in outcomes.

The Committee required four votes to reach agreement in September. Burns proposed M
₁
growth of 2 to 7 or 3 to 7, M
₂
at 4 to 8, and a 6.125 mean funds rate. Roos wanted M 1 at 0 to 5, didn’t care about M 2 , but his mean funds rate was 6.5 percent. Wallich proposed M 1 at 2 to 9 percent, M
₂
5.5 to 9.5 and the funds rate at 6.125. Eastburn had M
₁
at 0 to 7, M
₂
at 0 to 9,
and the funds rate at 6.25. Very similar values for the funds rate covered a wide range for proposed money growth. No one suggested reconciling these numbers or discarding some combinations as unlikely.
⁸⁴

The first vote on Burns’s proposal was seven to five in favor. He wanted more support. He raised the maximum growth rates and the funds rate. Votes changed but the division remained seven to five. When he changed the proposal to a money market directive, the vote became eight to four. Burns accepted the seven-to-five vote on his proposal and criticized the members’ inflexibility.

Some of the presidents wanted the Board to reduce reserve requirement ratios, principally to retain members. As the opportunity cost of reserves rose, member banks converted to non-member banks. Between 1970 and 1977, 133 state member banks gave up membership, more than 10 percent of the total. The number of non-member banks increased by 1,116. In 1977, 69 banks converted from member to non-member status, followed by 98 in 1978 (Board of Governors, 1981, 490, 495).

At Burns’s last FOMC meeting, February 28, 1978, the staff reported that the consumer price index rose at a monthly rate of 0.8 percent in January, almost twice the monthly average for the previous six months. “Considerable concern was expressed that the rate of inflation might accelerate significantly as the year progressed. . . . Such price behavior . . . would pose difficult questions concerning the appropriate role of monetary policy” (Annual Report, 1978, 132). Yet the committee kept the projected rate of M
₁
growth unchanged at 4 to 6.5 percent for the year after rebasing to accept the excess growth in 1977. After some discussion, the Committee accepted the proposed rate unanimously.

The February meeting showed a marked change in members’ comments. The majority recognized the need to reduce inflation and lower money growth. Even Burns was explicit about the need to control money growth. They recognized also that Federal Reserve credibility was low. Several favored rebuilding credibility before attempting to lower money growth, but they did not offer a plausible set of actions. They recognized that achieving the announced yearly money growth rate was important. Instead of reducing projected money growth, the FOMC voted to maintain the growth rate unchanged.
⁸⁵

84. At the August meeting, Volcker expressed “a sense of futility” in picking money growth rates given errors ranging up to 15 percent and differences in the alternatives of only 0.5 (Burns papers, FOMC, August 16, 1977, tape 4, 22).

85. Wallich complained, “We think we want to avoid triggering the funds rates because if it goes down it hurts the dollar and if it goes up it hurts housing . . . But we don’t really gain anything, we just postpone” (Burns papers, tape 5, 9, February 1978). Burns disagreed.

Why did the Federal Reserve renew inflationary monetary policy? Unlike some of their predecessors, Committee members recognized that rapid money growth caused inflation. That was why they selected money growth targets, even if they did not meet them. Doubtless there are many reasons in a nineteen-person committee. Three stand out.

First was the relative weighting given to the employment and inflation objectives. With Congress and the administration controlled by Democrats many of whom gave more weight to unemployment than to inflation, the FOMC acted as if they could control inflation only when the unemployment rate was relatively low. Opinion polls showed that reducing the unemployment rate was most important to the public at the time. Congressional opinion probably reflected the polling data.

Members of the administration shared these views. They wanted to get the economy to grow faster and lower the unemployment rate. They urged Burns to coordinate his actions with their goals. One of several occasions came at a breakfast in June 1977. Schultze reported to Carter that Burns was “sensitive” about administration criticisms of the interest rate increases in April and May. He urged Burns to keep monetary growth compatible with their planned economic growth. Burns explained that he was willing to be flexible, but Schultze concluded that he would not “prevent substantial interest rate increases” (memo, Schultze to the president, Schultze papers, Carter Library, Box A96018, June 10, 1977).
⁸⁶

Preparing for a Quadriad meeting in November 1977, Schultze wrote to the president about the state of the economy and topics to discuss with Burns. A main point was that monetary velocity had slowed from about 6 percent early in the recovery to a 2 percent rate in 1977. The Federal Reserve had announced that M 1 growth would be between 4.5 and 6 percent for the year ending third quarter 1978.

If velocity continues to rise at a slow pace, a relatively high growth rate of money will be needed to accommodate satisfactory growth in output. . . . To meet our growth targets, nominal GNP will have to grow about 11 percent from 1977 to 1978 (5 percent real growth and 6 percent inflation). If velocity grows by 2 percent,
M
₁
growth
of
9
percent
would
be
needed.
If the Fed tries to hold growth of M
₁
within its target range, and velocity increases are small,
interest
rates
will
rise
very
sharply
and the recovery will be damaged” (memo,
Schultze to the president, Schultze papers, Carter Library, November 9, 1977, 3–4; emphasis in original)
⁸⁷

86. Schultze wanted policy coordination. His idea of coordination differed from Ackley’s in the Johnson administration. For Schultze, coordination meant “really talking together frankly” (Hargrove and Morley, 1984, 483). He believed Burns would not be frank or open whereas Volcker, who pursued a more independent policy than Burns, was willing to discuss his plans.

Schultze made no mention of the failure of the Federal Reserve to meet its many targets.

Schultze also advised the president that the Council had lowered its forecast of 1978 growth because of reduced growth in mid-1977. He urged the president to ask Burns how the Federal Reserve would respond to the administration’s tax reform bill. “A tax cut can keep the pace of expansion from lagging
if
money
and
credit
are
permitted
to
increase
fast
enough
to
keep
the
higher
growth
rate
of
the
economy
from
pushing
up
interest
rates
(ibid., 1–2; emphasis in original). Agreeing to coordination was unlikely to appeal to Burns, though he would probably do it when the time came.

The substance of the memo suggests the weights that the Carter policymakers gave to real growth and inflation. With a reported unemployment rate of 6.8 percent at the time, reducing unemployment was the main goal. Schultze told the president: “A weaker economy next year because of inadequate growth of money and credit
will
affect
prices
very
little,
and
real
output
and
employment
a
lot
(ibid., 4; emphasis in original). The unemployment rate declined to 6 percent by the following November; the annual rate of increase in consumer prices rose from 6.4 to 8.5 percent. A new surge of inflation was under way. The increase in inflation began before the oil price increase.

In a memo to Treasury Secretary Blumenthal, written at the same time, Schultze was more explicit about his concerns. Unless policy gave greater stimulus, he expected “a stagnation of overall unemployment in the 6.5 percent area; no improvement and more likely a worsening of unemployment for blacks and other minorities; a continuation of inflation in the 6 to 6.5 percent neighborhood” (memo, Anti-inflation Component of a 1978 Economic Program, Schultze papers, Carter Library, November 9, 1977, 1). He described the economic and political consequences as “severe,” and he urged “a meaningful anti-inflation program” (ibid., 2).

Schultze proposed a voluntary program that combined tax reduction and wage-price guidelines. If an employer certified that wages and benefits increased by no more than 6 percent, employees’ taxes would be reduced up to 1.5 percentage points up to $20,000. For each 1 percent that employers reduced their weighted average rate of price increase, the government would reduce corporate tax rates by 1 percentage point up to a maximum of
2 percentage points. “The objective behind the approach is to break the momentum of the current price-wage spiral in 1978 and lay the groundwork for moderate union settlements and price increases in 1979” (ibid., 3–4).

87. Real GNP rose at an average 4.8 percent in the year ending third quarter 1978. The GNP deflator rose at an 8.9 percent average. M
₁
growth was less than 5 percent. The monetary base rose about 9 percent.