A History of the Federal Reserve, Volume 2 (23 page)

One alternative attributes the very expansive 1972 policy to the conflict of interest that Burns faced as chairman of both the Board of Governors and the Committee on Interest and Dividends (CID). The argument is that Burns wanted to avoid congressional action to put controls on interest rates. By letting money grow rapidly, the Federal Reserve kept market rates from rising and avoided interest rate controls.

This explanation has two problems. First, the 1972 FOMC and Board minutes contain few references to the CID. If it was a serious conflict, Burns would have used it to support monetary expansion. Most members of FOMC would likely have supported expansion if required to prevent surrender of monetary policy to a control board. Second, during the period that most concerned the president—fourth quarter 1971 and first quarter 1972—the federal funds rate remained below its August 1971 average. In fact, it did not regain that average until December, after the election. The banks’ prime rate showed the same pattern. There is no sign of a surge in the prime rate that the Federal Reserve or the CID had to counter. Open market rates are more responsive to market pressures. Ten-year constant maturity Treasury bonds do not show a sustained increase until August or September, and these yields did not pass their August 15, 1971, level until May 1973.

The second alternative was suggested earlier. Congress and most FOMC members wanted to reduce the unemployment rate. Many believed that the prevailing rate was far above the 4 percent level that they wanted to reach. Burns shared this belief and it fit well with his desire to help the president gain reelection.

The
Directive

Previous efforts to control money growth were ineffectual and produced general dissatisfaction. Burns again asked the Committee on the Directive to suggest changes. The committee’s third report again recommended a system of targets and indicators (Brunner and Meltzer, 1967). The FOMC would use the staff forecasts and their judgment to set paths for final objectives, inflation and output growth, then relate those paths to an intermediate objective or indicator variable such as money growth. To reach money growth, the FOMC could use as an operating target reserves or money market conditions, but the Committee on the Directive favored a measure of reserves called reserves against private deposits. This measure excluded reserves against volatile government and interbank deposits.

The committee—Governor Maisel and Presidents Morris (Boston) and Swan (San Francisco)—wanted to (1) extend the time period over which the FOMC sets its objectives, (2) permit corrections as new information arrived, (3) issue more explicit operating instructions, (4) improve control of the monetary aggregates, and (5) allow money market variables such as the federal funds rate to fluctuate more widely (Third Report of the Committee on the Directive, Federal Reserve Bank of New York, Archives, Box T10282, FOMC 70–78, January 17, 1972). The proposed directive would instruct the manager to target reserves subject to a ±100 basis point deviation around the expected change in the federal funds rate.

The committee put the burden on the staff to estimate money demand and supply functions to relate interest rates and money in a way that was compatible with the output and inflation objectives.
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The report recognized that the operating target (or “handle” as the FOMC called it in its discussion) could be reserves or an interest rate. It chose a reserve measure because it concluded that demand for money was more variable and less predictable than supply. Anticipating the New York response, the report said that the market would learn quickly that every change in the federal funds rate was not a policy change, and it would adapt to the new regime. No one suggested announcing the change to speed the adjustment, or to explain it to people whose decisions required judgments about policy actions and their consequences.

The New York trading desk responded to the proposal by making its own proposal after explaining its opposition to reserve targeting. Its response put the benefit to market participants ahead of responsibility to control inflation. The main complaint was that the federal funds rate (and money market conditions) would fluctuate over a much wider range and that many of the changes would be capricious, the result of random changes in reserves. The desk argued correctly that it was “the fallibility of projections that is the problem” (“Reserve Targets,” Alan Holmes to the FOMC, Board Records, January 19, 1972, 6). Holmes pointed to sizeable changes in float and argued that it helped the market if the desk offset these changes by changing reserves to keep the funds rate unchanged. “Frequent and violent fluctuations in the funds rate . . . would no longer provide much of a clue as to nonborrowed reserve levels” (ibid., 7).

The FOMC discussed the report at a special meeting on February 14. Maisel’s opening remarks emphasized four points.

66. The New York bank’s copy of the report has penciled comments: impossible, very difficult, or too much to expect next to these staff assignments. Despite the choice of controlling reserves and money, the report did not suggest improving control by changing from lagged to contemporary reserve requirements. The System repeated this error in 1979–82.

First, the FOMC did not have a clear enough picture of the relationship between changes in operating variables . . . and changes in the intermediate monetary variables. Second, there was insufficient understanding of the relationship between changes in the intermediate variables and changes in the economy . . . Third, there tended to be insufficient discussion of developments with respect to the demand for money. . . . Finally, the time period on which the Committee focused in its policy deliberations was often too short. When the Committee set its targets for intermediate variables for only a month or two ahead, it was dealing with a period in which current operations could not have much effect; and it was not taking into account the longer-run implications of its decisions. (FOMC Minutes, February 14, 1972, 5).

This was a very damning statement about an organization that was nearly sixty years old. The claim, especially the last one, was that their procedures were inadequate to achieve their objectives. And to leave no doubt about his intention, Maisel soon added: “It was the Open Market Committee’s practice to try to achieve its objectives for the intermediate monetary variables by calling for gradual changes in the Federal funds rate from meeting to meeting. But that particular control mechanism was a poor one” (ibid.).

The two other members of the directive committee agreed. The only suggestion by Frank Morris called for a narrower band on the funds rate than the ±100 basis points in the committee’s report. Neither president softened the criticism of FOMC procedures and accomplishments. The staff agreed that policy could be conducted more effectively using a reserve target.

The manager, Alan Holmes, described the desk as “less than wildly enthusiastic about shifting to a reserve target” (ibid., 10). He expressed concerns about how it would work in practice and was skeptical about the quality of forecasts of the real economy, projections of the monetary aggregates and reserves. He gave as an example the January 1972 experience. The desk thought it had exceeded the projected growth rate set by the FOMC, but it found that it was well below the projection when it used the new seasonal adjustment factors. “The revision of the 1971 monthly growth rates for total and nonborrowed reserves, which ranged up to 10 percentage points for individual months, had quite disturbing implications for the implementation of reserve targets” (ibid., 12). One part of the manager’s problem was to distinguish persistent and permanent changes. The directive committee gave insufficient attention to this issue. The manager smoothed transitory changes such as float by keeping a constant interest rate and absorbing or providing reserves. A reserve target removed
this solution but did not provide another. Hence interest rates in the short term would change over a wider range. But the manager’s procedure did not distinguish permanent or persistent changes in demand.

These, and other issues about operations in practice, returned again in 1979–82, when the System adopted a nonborrowed reserve target. A particularly important issue required an FOMC decision about how much variability in the federal funds rate they would accept to damp fluctuations in their reserve measure. Although not discussed explicitly, the underlying issue required some decision about how to separate temporary and persistent changes and how much of each to offset. That problem remains.

A related measurement issue received more attention but was not resolved satisfactorily. Some members thought the permitted inter-meeting change in the federal funds rate should be narrower than the Committee on the Directive proposed, but none of these suggestions commented on what this would do to monetary control.

A second major unresolved issue was the time span over which the FOMC kept monetary aggregates on the desired path. Maisel stressed the need for looking and acting over a longer period than the time between meetings. The FOMC could make adjustments at each meeting, but the path would remain unchanged until new information suggested the need for change. This would shift the FOMC’s attention to the longer-term effects of its actions. The manager and several of the members found it difficult to accept this proposal.

New York did not accept it. Hayes argued that Maisel had not provided evidence that the committee proposal would improve control. He then denied that money growth mattered. “It had been nowhere demonstrated that total or nonborrowed reserves had any strong or direct effects on the ultimate goals for the economy” (ibid., 21). He ended with a forceful statement of the New York view—the FOMC should set some broad objectives, propose some intermediate targets for the aggregates and interest rates, and leave discretion to the manager about how to trade off in the markets. “Given the vagaries of projections, and the after-the-fact revisions, it seemed to him a misguided effort for the members of the Committee to attempt to provide detailed guidance four or five weeks in advance for the specific reserve operations that might best serve the underlying objectives” (ibid., 22–23).

Others raised points that had to be resolved. Partee recognized that lagged reserve accounting and lagged effects of prior changes in interest rates would hinder the manager’s efforts to hit a reserve target. As noted in chapter 4, lagged reserve accounting made precise control infeasible. Accurate seasonal adjustment would also prove difficult (ibid., 16–17). Brim
mer asked about even keel operations and management of the Treasury account (ibid., 30–31). Both he and Daane opposed the change. Daane called the proposal “utopian” (ibid., 34). Bruce MacLaury (Minneapolis) also opposed the change, but in a perceptive statement he recognized that some thought “the members were not psychologically prepared to call for changes in interest rates of the size required to achieve the desired growth rates in the monetary aggregates, but they would permit such changes to occur if they could be described simply as a by-product of the Committee’s pursuit of a reserve target” (ibid., 39).
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Most members took a stand. At least ten favored some steps—modest in some cases—in the direction urged by the Maisel committee. Five opposed, including Brimmer, Daane, and Hayes. They chose to stay with the existing procedures, perhaps allowing wider fluctuations in interest rates but retaining an interest rate target. Burns’s summary called for a range for the growth of reserves, a band less than the 200 basis points favored by the directive committee for fluctuations in the federal funds rate, orderly adjustment of the federal funds rate within the band, and judgment by the manager to decide whether the reserve and funds rate targets would achieve the intermediate objectives for growth of M
₁
, M
₂
, and bank credit.

Burns described his summary as an intermediate step (ibid., 48). It did not shift the focus from the money market to longer-term objectives, as the Maisel committee had urged, and it did not propose a procedure for concentrating on the longer-term, persistent pressures for inflation or recession. Another opportunity was wasted. This was unfortunate since Maisel, the principal spokesman for changes, soon afterward completed his term and left the System.
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Discussion of monetary control brought renewed interest in how it would work and what to expect. A staff memo reported the results of a computer simulation to study the effect of variability in money growth.
Using a 6 percent annual M
₁
growth rate achieved at a steady rate and at 10 percent for two quarters and 2 percent for two quarters, the study found that “economic behavior is essentially the same whether money grows at a constant rate or whether money fluctuates around that rate for one or two quarters” (memo, James Pierce to Axilrod, Burns papers, Box B_B114, February 2, 1972, 1). Deviation from path lasting three or four quarters had more sizeable effects.

67. This argument also returned in 1979 when the System again decided to gain more control of money growth. Supporting the report, Frank Morris used 1968 as an example of a money market directive leading the FOMC to resist a rise in interest rates, thereby supplying “more reserves than any member would have thought desirable at the time” (FOMC Minutes, February 14, 1972, 44). His concern was that without a reserve target, the same result would occur in 1972.

68. The following is Governor Brimmer’s description of the presidents at about this time. “All of them (with the exception of St. Louis) remain highly eclectic and pragmatic. . . . and show no signs of being led astray by simple prescriptions” (memo, William Gibson to Herbert Stein, Nixon papers, White House Central Files, Herbert Stein Correspondence, January 3, 1972, 2). This was not a group inclined to accept rule-like procedures.

Chairman Burns asked the staff to “comment on the deficiencies of adopting a fixed rule guiding monetary growth” (memo, Partee to Burns, Burns papers, Box B_B114, Feb. 3, 1972). The response brought out three issues that divided the System and its critics over a fixed money growth rule and discretionary action. First, proponents of a fixed rule wanted the Federal Reserve to focus on medium- to long-term responses. The Federal Reserve countered that the demand for money could change permanently, so the rule would not produce the predicted stability. Second, the Federal Reserve put much greater weight on short-term changes and the need to adjust to them. The critics claimed that if the System did not act, the market would. Third, the System tried to smooth the economy countercyclically. The critics claimed that monetary policy was often procyclical, a source of instability.

Partee’s memo discussed policy at or near turning points in economic activity. His conclusion was that policy was bad or procyclical at four, good or counter-cyclical at four, and fair at one. Three of the four “bad” cases were the recessions starting in 1948, 1953, and 1957. A few months later, William Poole revisited the issue. After examining trends and deviations from trend, he concluded that “a substantial and relatively prolonged drop in money growth preceded every postwar business cycle peak” (memo, Poole to Partee, Burns papers, Box B_B81, November 20, 1972, 3). Policy was procyclical.

The staff later evaluated experience using a reserve target (memo, Axilrod, Pierce, and Wendel to FOMC, Board Records, June 8, 1973). It concluded that the evidence was “mixed” (ibid., 2). Reserve targets have been “helpful,” even allowing for constraints to respond to money market conditions, Treasury finance, and the like. Problems arose with monetary control however, when the multiplier relating reserves to money shifted. The degree “to which RPDs [reserves against private deposits] are helpful is enhanced if the RPD target range is narrow” (ibid., 2). This required larger changes in the federal funds rate.

The 1972 experience was a forerunner of the 1979–82 experience. Regrettably, the FOMC did not learn from the earlier experience how to im
prove monetary control. They did not introduce procedural changes such as contemporary reserve accounting or develop techniques for estimating the multiplier such as those later developed in Rasche and Johannes (1987).
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