A History of the Federal Reserve, Volume 2 (46 page)

In Table 7.12, the measure of the real interest rate, ex post, is positive in only three months, August, November, and December 1978. The inflation data include the one-time price level increase from the oil price shock. Usually the FOMC did not distinguish this transitory effect on inflation, and neither did the administration. Wage increases are another measure of inflation; in April 1978 wages rose 8.3 above the previous April. In 1977, wages increased 7 percent from 1976.

In fact, the Council of Economic Advisers and the Secretary of the Treasury took the highly unusual step in June 1978 of meeting with the Board of Governors out of concern about the increase in interest rates that occurred in the spring. At the time, the ex post real federal funds rate was −4.8 percent.
¹⁰⁰

Schultze explained to the president that “the Board is
very
concerned about inflation. Some members of the Board appear to be prepared to tighten monetary conditions still further; . . . [T]hey seem willing to run some risks with tight money because of their inflation worries—Chairman Miller is under considerable pressure from some of the more vocal and articulate inflation-fighters on the Board. He, himself, is very sensitive to the danger of overdoing monetary restraints” (memo, Schultze to the president, Schultze papers, Carter Library, June 27, 1978).
¹⁰¹

In the rest of the memo, Schultze spelled out his forecast for the economy for the next eighteen months. He expected real growth of 3.75 to 4 percent with productivity growth only 1 percent. This was slower growth than in early 1978. Schultze estimated that the underlying rate of inflation, excluding food and mortgage costs, was between 6 and 6.5 percent. Unit labor costs would rise 7 percent in the next year. He explained that his forecast assumed that M 1 would rise more than the 4 to 6.5 percent annual target and that Congress would approve a $20 billion tax cut, effective January 1.
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100. Schultze had become more concerned about inflation. Early in May, he told the president about his concern and the need to tighten the 1979 and 1980 budgets. The president wrote on his memo: “A new Convert” (memo, Schultze to the president, Carter Library, May 8, 1978, 2).

101. Lyle Gramley attended the June 19 meeting at the Board. “I had some notion before we went that this was not the appropriate thing to do. It would be quite unproductive. And it was. If anything it may well have been counterproductive” (Biven, 2002, 141). Schultze had warned the president about interest rate increases in April. He thought they were appropriate. His concern was that they would continue too long and increase too much.

102. In late May President Carter reduced the proposed tax cut by $5 billion (to $20 billion) and postponed its effective date to January as an anti-inflation measure. He also requested some small spending cuts.

Schultze’s memo indicated concern about additional interest rate increases. He suggested that the president discuss this with Miller at the Quadriad meeting the following day. Charts accompanying the memo showed growth of M 1 well above the 6.5 percent maximum target. Eizenstat was not persuaded. He told the president that the president’s policies can “help avoid inflationary actions.” The private sector was responsible for lowering inflation (Carter papers, May 9, 1978).

A quick reading of the April 18 FOMC minutes would suggest a major division over inflation policy. Verbal disagreements were sharp. But almost all proposals for M 1 growth called either for 4 to 8 or 5 to 9 percent. Similarly, all but one proposal called for either a 6.5 to 7.5 or 6.75 to 7.25 funds rate. The vote called for 6.75 to 7.5 with a conference call if the rate reached 7.25 percent. Within three weeks, the April–May money growth rate reached 13 percent, and the Board staff raised nominal GNP growth to 17 percent in the second quarter.

Chairman Miller described monetary policy as “prudent and decisive” (FOMC Minutes, May 5, 1978, 4). He thought the projected second-quarter GNP growth might be transitory, so he favored leaving the fund rate at 7.25. Ignoring years of delay, he said action would suggest that the committee was “too quick on the trigger” (ibid.). He favored a 0.5 increase in the discount rate the following week. Only Black, Willes, and Wallich favored an increase in the funds rate but only Black and Willes voted against Chairman Miller’s recommendation. Once again, some of the reserve banks were most willing to act.

Although the administration adjusted its anti-inflation actions several times, Schultze did not expect much effect. His forecasts in May 1978 showed inflation unchanged for the next four years at about 6.5 percent. The unemployment rate forecast suggested that unemployment would remain about 5.5 percent. In the critical political year 1980, forecast inflation and unemployment rates were 6.7 and 5.4 to 5.7 percent respectively (Schultze to the president, Carter papers, Box A8013, May 13, 1978, 5).
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Soon after he wrote that worsening inflation required giving inflation control a higher priority. But he opposed fighting inflation with monetary and fiscal policies alone. “Our best hope of getting inflation under control lies in a joint effort by businesses, labor and government to achieve deceleration in the rate of price and wage increases” (draft letter to George Meany, ibid., May 31, 1978).

103. In an interview, Carter said that he believed the economy would be in good shape in October 1980, based on projections received from Schultze and William Miller in May. He expected inflation to decline by 5 or 6 percentage points and the unemployment rate to fall also (Carter, 1982, 59).

Much more than in the past, FOMC members accepted that inflation was mainly a monetary problem. As Orphanides (2001 and elsewhere) emphasized, the level of the so-called natural rate of unemployment used to forecast inflation was uncertain. At the May 1978 meeting, the staff characterized the natural rate as difficult to estimate (FOMC Minutes, May 16, 1978, 6). Their estimate was 5.5 to 6 percent, far higher then the 4 percent rate used for many years. The members did not agree. Wallich thought 5.5 percent too low; Partee thought it too high. The disagreement shows a major reason for low reliability of inflation forecasts based on a Phillips curve.

Coldwell, Balles, and several others agreed with Wallich and urged the committee to slow the economy (ibid., 13–15). Jackson spoke about “a loss of public confidence . . . [that] will damage the economy” (ibid., 33). But Eastburn and Partee remained “pessimistic” about inflation. Partee added that a 1979 recession was now likely (ibid., 18). Axilrod cited some staff work showing that M 1 was a good indicator of future GNP. The divisions within the FOMC remained for the rest of the year, preventing effective anti-inflation actions.

At the June meeting, Chairman Miller proposed a moderate program of disinflation. “If we use a steady and sure hand to restrain the growth of the aggregates and bring it down at a more measured pace, then I think we see conditions for bringing the rate of growth down to a more sustainable level that will counter inflation but avoid . . . recession” (ibid., June 20, 1978, 18). Regrettably, he did not institute procedures to carry out his program.

The FOMC voted for an increase in the funds rate to the 7.5–8 percent range at the June meeting to recognize growing public and administration concern about inflation. Mark Willes (Minneapolis) and Willis Winn (Cleveland) dissented. Winn made a correct forecast: “If the committee did not act now to assure a reduction in the rates of growth of the aggregates, an excessively restrictive policy would be required later on if the committee’s longer-range objectives were to be achieved” (ibid., 191).

On June 30, the Board voted three to two to increase the discount rate from 7 to 7.25 percent. Miller voted against and, against the advice from other governors, allowed his vote in the minority to be published. That had never happened before and it may have heightened concern about his control of policy. Not much happened. Earlier, on May 10, Miller had voted for an increase to 7 percent.

Members continued to make strong statements and take weak actions. In July’s discussion, Governor Partee commented on the continued growth of M 1 in excess of their target. He favored holding M 1 in the 4–6.25 range (FOMC Minutes, July 18, 1978, 26). Mark Willes commented on that: “I
don’t see how we are ever going to deal with the inflation problem unless we do something to bring the rate of growth of money down” (ibid., 27). And Paul Volcker added that because of “so much base drift recently,” the FOMC targets were a “farce” (ibid., 28).

Despite these strong statements, action was modest. With reported inflation running about 9 percent annual rate for several months, the FOMC voted seven to three for a funds rate target of 7.75 to 8 percent and an unchanged 4 to 6.5 percent M
₁
target. Willes complained that the real interest rate was negative and could not be considered restrictive (ibid., 40–41).

The July meeting heard that hourly earnings and producer and consumer prices had increased faster in 1978 than in 1977. Nevertheless, Governors Jackson and Partee dissented from the decision to set annual money growth rates for M
₁
and M
₂
at 4 to 6.5 and 6.5 to 9 percent, as at several previous meetings. Jackson preferred a 4 to 7.5 percent band for M
₁
, and Partee wanted the upper limit at 8 percent. The lower limit was below the projected increase in nominal GNP, so it might require slower growth of real GNP.

The FOMC increased the mean target for the federal funds rate by 0.125. Presidents Baughman, Willes, and Winn dissented. They wanted “more vigorous measures” (ibid., 206).

Willes dissented again for the same reason at the August meeting. This time Governor Partee also dissented to favor an easier policy, citing the “marked slowing in real economic growth that now appeared to be in progress” (ibid., 215).

Partee’s dissent came despite recognition by “all members of the committee” of the “high recent rate of inflation in prices and wages” (ibid., 210). Also, the Committee learned that labor leaders planned “to hold out in forthcoming contract negotiations for sizeable wage settlements” (ibid.). The suggested reason was concern that the administration would adopt mandatory controls.
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104. The archives contain many memos to the president from Schultze, Ambassador Robert Strauss (appointed to administer and get agreement on the voluntary standards), and Barry Bosworth, director of the Council on Wage and Price Stability (COWPS). One set of memos on environmental and health regulations suggests that opposition came not only from business and labor unions but from other parts of the government, in this case the Council on Environmental Quality. It objected to complaints that regulation increased inflation (again treating price level changes as inflation), and it urged the president not to weaken his commitment to environmental and health regulation for economic and especially political reasons. President Carter wrote, “I agree” on the memo. This aroused Schultze, who argued that the memo neglected the principal cost, a reduction in productivity. He urged the president to continue programs to improve regulation, reduce its cost, and deregulate where appropriate (memo to the president, Inflation and Environmental and Health Regulations, Schultze papers, Carter Library, September 18, 1978; memo, Schultze to the president, ibid., September
29, 1978). Shortly after, Labor Secretary Ray Marshall wrote that “the private sector portion of the program is the most critical to bringing down the inflation rate” (memo, Ray Marshall to the president, Carter Library, October 13, 1978, 1). The president wrote, “I agree.”

At last, Wallich and Willes observed that “interest rates adjusted for expected rates of inflation were not high and might even be negative” (Annual Report, 1978, 222). This rare explicit recognition of the difference between nominal and real rates had at most a modest effect on the FOMC’s decision. It raised the mean federal funds rate target by 0.125 to 8.5 percent despite a reported increase in August of 14 percent (annual rate) for M
₁
growth. “It was observed that for an extended period of time M
₁
had been growing at rates in excess of the longer-run range adopted by the committee and that a slowing of growth was necessary in pursuit of the committee’s objective of resisting inflationary pressures while continuing modest economic expansion” (ibid., 222).
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By October, the FOMC knew that President Carter planned to offer a new anti-inflation policy, but they were uncertain about the details. Many FOMC members were pessimistic about inflation control. President Roos pointed out that “we seem never to have really defined what we think would be the [desirable] rate of growth” (FOMC Minutes, October 17, 1978, 23).

Inflation had become a political issue. The administration developed a policy package to reduce inflation without raising interest rates. On October 24, President Carter presented the program to the nation in a nationally televised address. The centerpiece of the program was a stronger set of guideposts, including specific rates of wage and price increase that he asked the private sector to follow. Reductions in government spending, reductions in federal employment, a government pay freeze, and deregulation were additional one-time changes.

The announcement did not draw strong public support. Details aside, it was more of the same approach that had not worked. The biggest change came not in the program but in the president’s explanation of why the country should support the program. The president described inflation as “our most serious domestic problem” (Shouse, 2002, 184).

The new program failed to prevent additional increases in interest rates. Following the announcement, the dollar continued to fall. Within a week, the administration announced a new dollar policy, including a Federal Reserve decision for a one percentage point increase in the discount rate, an unusually large increase. But that action also failed to reduce inflation.

President Carter never had much confidence
that voluntary guidelines
would reduce inflation. We cannot know what he thought about the failures at the time or later, but we do know that he thought the public considered inflation to be the most important domestic problem. The combination of heightened public concern and the failure of his programs may have opened his mind to a more painful but more effective solution when he chose Paul Volcker as chairman.
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105. Willes and Wallich wanted a 9 percent funds rate. This was one percentage point above twelve-month average CPI growth and above SPF estimates of expected inflation.