A History of the Federal Reserve, Volume 2 (52 page)

Monetary control was not the only problem. At the start of the period, the staff forecast productivity growth at 3 percent per annum and suggested that it might be higher. In fact, it was much lower, adding to the inflationary pressure (Burns papers, FOMC, March 15–16, 1976, 35). At the April meeting, Wallich questioned the staff forecast for interest rates on the grounds that the staff did not take account of expectations. Gramley acknowledged that they did not (ibid., April 20, 1976, tape 2, 3). In January, Gramley warned that “forecasters should not give a great deal of weight to the statistics for a single month (FOMC Minutes, January 18, 1976, 46). The Committee ignored the advice.

The Committee disliked policy reversals. A New York staff study found seven or nine periods when it had to reverse a change in reserve availability or the funds rate during 1973–76. Holmes noted that most of the changes were small. Only two reversals had a market impact (ibid., 46).

Burns expressed concern and stressed the importance of avoiding reversals and financial market disturbances. Reluctance to risk policy reversals was another reason for responding slowly to conditions in the economy. President Mayo (Chicago) made a different proposal. Tight control of the funds rate caused exaggerated market reaction to small changes. He suggested wider fluctuations as a way of avoiding market overreaction to changes (ibid., 55). Coldwell agreed but no others took up the point. And no one proposed to reduce uncertainty by announcing the rate. But President Eastburn (Philadelphia) urged a narrow range for the money target and, as a consequence, more variability in the funds rate (ibid., 69).

The discussion at this meeting shows that several of the members understood a main reason they did not hit money growth targets came from the unwillingness to let the funds rate change. Unfortunately, there was never a consensus for change, particularly in 1976, when the inflation rate had fallen. Persistence then would have ended the inflation, probably at much lower social cost. At the April meeting, Henry Wallich urged a more restrictive policy to slow the expansion and further reduce inflation. Balles, Guffey, and Gardner offered similar or supporting statements. Volcker remarked he was “worried about the inflation thing” (Burns papers, April 20, 1976, tape 7, 10). The FOMC voted unanimously for a small reduction in the federal funds rate—from a midpoint of 5 to 4.875 percent.

Money growth continued to rise. At the May meeting, Burns described the growth rate as “unacceptable” (ibid., May 18, 1976, tape 6, 1). He proposed lowering the bottom of the M
₁
range to 3.5 percent (up to 7.5) but received
no support. Even though Volcker, Wallich, and MacLaury agreed about inflation, they treated Burns’s proposals as too low. With Coldwell dissenting, the FOMC voted for a 4 to 7.5 percent range for M 1 growth.
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The 0.5 percent difference suggests how much rhetoric differed from decisions.

In 1976, prospects for reducing inflation had improved. By the end of 1975, the trade-weighted dollar had appreciated to a point above its March 1973 value, but the dollar had depreciated relative to the mark and the yen.
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This pattern continued through the next two years. Reported inflation and the unemployment rate both declined. By late 1976, consumer prices increased less than 5 percent a year. Disinflation was clearly visible in the data (see Chart 7.1 above).

The Federal Reserve and the Treasury took advantage of the appreciation to agree on a three-year repayment of the debt incurred to the Swiss National Bank, mainly in 1971. Of the $1.6 billion in borrowings at the time (including the BIS), $1.15 billion remained. This sum included $196 million to compensate for devaluation of the dollar (Annual Report, 1976, 280 n. 2). The United States and Switzerland agreed to repayment over a three-year period.
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With the change in administration in 1977, United States policy toward coordination changed completely. The new officials accepted an analysis by Professor Lawrence Klein, presented at an economic conference in 1976. Klein wanted increased fiscal stimulus to reduce unemployment. To avoid the capital outflow resulting from the increased spending, he proposed
that West Germany and Japan, the principal surplus countries, should expand in coordinated step with the United States. The three countries would provide a “locomotive” that expanded world aggregate demand and raised incomes and output in other countries.
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Reports done at the IMF and even the Bank for International Settlements supported this approach (Volcker and Gyohten, 1992, 147). It did not appeal to the strong-minded Helmut Schmidt, West Germany’s chancellor. Schmidt saw the inflationary consequences and forcefully pointed them out to the Americans. Japan, as usual, hesitated but did not reject the proposal completely. However, increased expansion and higher inflation in the United States increased net imports. As Japan’s current account surplus rose, criticism of Japan became shrill (Volcker and Gyohten, 1992, 154). At the London summit in May 1977, Japan agreed informally to achieve 6.7 percent growth. It reached only 5.4 percent, well above the average for G-7 countries but below the informal target. The Japanese government committed to 7 percent growth in 1978, but again fell short.

147. At the May meeting, Partee accused Peter Sternlight of following an even keel policy during the Treasury financing. Sternlight concurred with Burns’s description of a semi-even keel (Burns papers, FOMC, May 18, 1976, tape, 5, 2).

148. The staff reported that the dollar appreciated sharply against the British pound and the Italian lira, both countries with high and rising inflation (see Table 7.13 above). Early in June 1976 the Federal Reserve and the Treasury contributed $2 billion to a $5.3 billion pool of standby credits for the Bank of England.

149. Another example of policy attitudes at the time showed the aversion in many countries to tightening monetary policy or policy coordination. “It was suggested by a representative of [the OECD] secretariat that countries should coordinate their monetary policies with weaker countries taking the lead in tightening (raising interest rates) in order to avoid exchange market disturbances. This suggestion received little support. The representatives of Belgium and Sweden expressed concern about a tightening of German monetary policy. . . . The Swiss, Germans, and Americans generally indicated that they would follow appropriate monetary policies and coordination was unnecessary” (Report on Meeting of Working Party Three, Board Records, May 25, 1976, 7).

A problem arose in settling swap borrowings from Belgium. Devaluation of the dollar raised an issue about sharing the loss on the borrowing. The Treasury insisted on sharing the loss with Belgium; the Belgians insisted that the U.S. bear the loss. Holmes wanted to compromise by accepting most of the $14 million loss, but the Treasury was unwilling. The contract, however, favored the Belgians (Alan Holmes, notes, 1975, New York Federal Reserve, Box 007973 FOMC).

From September 1977 to October 1978, the West German mark, Swiss franc, and Japanese yen appreciated by about 11, 35, and 29 percent. Germany, Japan, and others strongly criticized United States policy, especially the failure to let energy prices rise to market levels and neglect of dollar depreciation.
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Many foreigners charged that Treasury Secretary Michael Blumenthal “talked down” the dollar. They saw this as competitive devaluation.
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At a BIS meeting in January 1978, “Burns said developments in the exchange markets have been a source of considerable anxiety—even anguish—to all of us” (memo, Margaret Greene to FOMC, Board Records, January 9, 1978, 3). He expressed concern about the effect of dollar depreciation on foreign economies, and he told the members that the very recent increase in the discount rate was “governed entirely by international considerations” (ibid.). Most of the members praised Burns’s efforts. Markets were more skeptical; the mark resumed appreciation.

150. Lawrence Klein, a prominent Keynesian economist, served as principal adviser to Governor Carter during the 1976 election campaign. He did not join the administration. A common complaint at the time was the variability of exchange rates. Taylor (2000, 14–15) showed the large increase in variability of nominal and real exchange rates compared to Bretton Woods. Real and nominal exchange rate variability were highly correlated.

151. A sixteen page memo summarizing a conference in May by representatives of the G-7 contains very little about United States’ energy policy (macroeconomic assessment, Schultze papers, May 21, 1978).

152. Solomon (1982, 346) suggests that President Carter discussed dollar depreciation with King Khalid of Saudi Arabia. Shortly after his return from the Middle East, the Treasury announced an active effort to stabilize the exchange rate.

Wrangling and recriminations ended in an agreement at the Bonn summit in July 1978.
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Germany and Japan announced that they would reduce tax rates to raise their GDP growth rates. They joined the locomotive. The United States agreed to control inflation and raise oil prices to international levels by late 1980. When he made the commitment, President Carter did not know how he would implement it. The main problem was political; socalled consumer groups opposed allowing the price to rise. “What Carter intended to promise at Bonn was not completely decided at the time he departed from Washington” (Biven, 2002, 160). A main problem was getting agreement with the Senate to tax oil, especially old oil to prevent oil companies from receiving windfall profits. Domestic advisers urged him to withdraw his promise. International advisers urged him to keep it.

He kept it. In April 1979, nine months after he made the commitment, President Carter announced a phased decontrol of oil prices over twentyeight months beginning June 1. He asked Congress to tax windfall profits, but he did not make decontrol depend on the tax. A year later, in April 1980, he signed the tax bill.

The July decisions at the Bonn summit are often said to represent the high point of traditional Keynesian policy and policy coordination. Germany and Japan agreed to coordinate fiscal expansion and implemented the agreements. Decontrol of United States oil prices was a main achievement. Pressure from other countries facilitated the decision and advanced its timing.

The effects of fiscal expansion are difficult to separate from monetary changes at home and abroad and the second major oil shock at the end of 1978. In the United States, after a slow start in 1979, real GNP rose at a 3.7 percent rate in the third quarter, then fell (−0.8) in the fourth quarter following the start of the Volcker disinflation. In Germany, the Bonn agreement came just as the European Monetary System (EMS) required monetary policy to give greater attention to European exchange rates. Also, the Bundesbank shifted its announcement of the monetary growth rate from annual average to a four-quarter growth rate and reduced the announced growth rate. Bundesbank actions pressed other EMS countries to reduce inflation.
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153. President Carter would not commit to attend the Bonn G-7 summit until Germany agreed to raise its growth target and adopt a more stimulative fiscal policy. The contrast between the United States’ emphasis on growth and Germany’s concern about inflation tells much about the difference in priorities and in outcomes in this period.

154. Beginning in September, the FOMC began discussion of the terms for renewing its swaps with the Bundesbank. The Germans wanted to end the equal sharing of exchange rate losses. They offered, instead, to receive interest on the outstanding balance at the (lower) German interest rate.

Coordinated policy did not avoid exchange rate adjustment. Between May and October 1978, the dollar depreciated by 14 percent against the mark and 23 percent against the yen. From the start of the year to late October, the trade-weighted dollar lost nearly 25 percent of its value. The reported inflation rate approached 9 percent. Foreigners again accused the United States of talking down the dollar’s value. Domestic critics reinforced these criticisms. This encouraged policy changes, especially after the G-10 dollar index fell nearly 4 percent in less than four weeks ending October 24.

The administration’s approach reveals its thinking. On October 24, it announced policy changes intended to strengthen the exchange rate. The three principal changes were fiscal actions to slow aggregate demand, voluntary wage and price standards, and regulatory reform to increase efficiency and competition (Solomon, 1982, 349). President Carter said that monetary policy would be “responsible,” but he gave no indication that the Federal Reserve would adjust its actions or give priority to lowering inflation.

Market reaction was swift and decisive. The day following the policy announcement the dollar fell about 1.7 percent against the mark and the yen. In the week ending October 20, the G-10 index fell another 4 percent. A new program began to take shape. This time, monetary and financial change had a major role. The Federal Reserve and the Treasury increased swap lines by $15 billion. The Treasury announced sales of $10 billion in foreign-denominated bonds with up to five years maturity, borrowed $3 billion from the IMF, and increased monthly gold sales.
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The Federal Reserve raised the discount rate by one percentage point to 9.5 percent and put a supplementary reserve requirement of two percentage points on large time deposits. The dollar index rose 5.3 percent and this time it continued to rise. By November 20, the index was back to its level in early September.

Solomon (1982, 350) wrote that the November 1 program persuaded market participants, foreign governments, and others that “the U.S. monetary authorities were serious about defending the dollar.”
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To reinforce
this view, the authorities bought $6.7 billion in November and December by selling marks, Swiss francs, and yen. The Treasury issued $1.6 billion in mark-denominated bonds.

155. Germany especially preferred sales of foreign-denominated bonds over swaps when the swaps were used to buy dollars. Swaps increased the German money stock but the sale of foreign bonds did not.

156. Toyoo Gyohten (Volcker and Gyohten, 1992, 159) called it a “big success,” citing the depreciation of the yen from 176 to 200. An OECD meeting on November 30 was more critical. Foreign governments praised the change in the U.S. attitude toward dollar depreciation. The foreign members asked why it had taken the United States so long to act and expressed skepticism about whether exchange rate intervention would continue, particularly if the domestic economy slowed (memo, Edwin Truman to FOMC, Board Records, November 30, 1978, 1–2). At the November FOMC meeting, Scott Pardee (the manager) reported that the account sold $4.6 billion between the October and November meetings. $1.1 billion was for
the Treasury. Most of the sales, $3.5 billion, came after the November 1 policy announcement. Pardee was exultant about the program’s success.