A History of the Federal Reserve, Volume 2 (25 page)

President Nixon wanted action. Criticism of the administration from members of Congress and the public demanded action. Weakened by the Watergate scandals and mindful of the popular response to price controls in 1971, the president rejected his advisers’ warnings that price control would not be effective at that time. Inflation was rising, not falling as in 1971. Even John Connally, called back to advise, opposed a new freeze (Matusow, 1998, 230). Not Burns. He urged the president to tighten controls to show the public that the president shared their concerns (Wells, 1994, 115). On June 13, 1973, the president, in a bid for political support, announced phase 4, a sixty-day freeze of prices but not wages. Again, he exempted agricultural prices though they were a main source of price level changes. For a man who professed to abhor price controls, the president seemed eager to use them if they served his purpose.

The freeze did not stop the rise in prices. Controls on wholesale and retail food prices, with agricultural prices uncontrolled, quickly caused shortages. Public reaction was negative. After thirty-five days, the president ended the freeze early.
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The combination of this one-time price level effect, an increase in oil prices later in the year, and the inflation generated by growing aggregate demand brought measured rates of consumer price increases to 8.4 percent by December 1973 and above 10 percent in 1974. Expected inflation in the Survey of Professional Forecasters rose steadily in 1973 and 1974. Long-term interest rates began to rise.

The rise in short-term interest rates in the first eight months of 1973 is extraordinary, but so was the rise in reported inflation. The GNP deflator rose from an annualized 5.2 percent rate of increase in fourth quarter 1972 to 8.4 percent in third quarter 1973. The twelve-month moving average rate of increase in consumer prices doubled from December to August, rising from 3.6 to 7.2 percent. Data suggest that the public treated most of the price increase as a one-time rise. Ten-year constant maturity Treasury yields rose one percentage point, but Treasury bill rates rose from 5 to 8 percent. Adjusted for inflation, bill yields remained about unchanged and ten-year rates fell. The real federal funds rate rose.
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74. Matusow (1998, 222–32) provides a succinct account of prices and the second freeze. Oil prices remained controlled until 1981. Different regulation of retail and producer prices created shortages and long lines at gas stations.

75. The eight-month period is troubling for those who use the unemployment rate to predict the inflation rate. The unemployment rate declined only 0.4 percentage points to 4.8 percent between December and August. Measured inflation rose 3 percentage points. Growth of the monetary base increased one percentage point to 9.3 percent. Growth rates of M 1 and M
₂
fell. Since much of the record increase in reported inflation was a one-time change in the price level from the grain harvest and other one-time changes, it had limited effect on employment and long-term interest rates.

The FOMC saw its task as control of reserve and money growth. It acted aggressively by its previous standards but, as the data show, it was not aggressive enough. Although member bank borrowing rose to $2 billion, the largest borrowing since 1921, the discount rate rose to only 7.5 percent, three percentage points less than the federal funds rate in August 1973. The banks’ prime rate for large borrowers soon thereafter reached 10 percent. Throughout this period, banks could borrow at the discount window and relend in the federal funds market. The reserve banks tried to prevent this operation with some success, but borrowing did not decline until September.

Judged by the traditional measures—member bank borrowing, free reserves, and the federal funds rate—1973 is one of the most aggressive periods of restraint in Federal Reserve history to that time. The FOMC repeatedly raised the federal funds rate to keep growth of reserves against private deposits within the range it selected based on staff estimates of money growth. Yet the period has to be judged as a policy failure. The inflation rate continued to rise.

Several factors contributed to the failure. First was the operating procedure. The staff estimated the growth of reserves and the level or range of the federal funds rate consistent with desired growth of money. Inaccuracy was a problem throughout. Several times, the FOMC had to meet between meetings to increase the band on the federal funds rate. Although the FOMC remained committed to controlling reserve and money growth, subject to a money market constraint, the constraint frequently restricted policy action until it was raised. The result was that the manager maintained the federal funds rate and exceeded the reserve target.

For example, at its May 15 meeting, the FOMC set the desired growth rate of reserves against private deposits (RPDs) at “9 to 11 percent while continuing to avoid marked changes in money market conditions” (Annual Report, 1973, 169). RPDs rose at a faster than expected rate, despite an increase in the federal funds rate. The FOMC met twice between meetings to raise the permitted level of the funds rate. Instead of remaining unchanged, the federal funds rate rose from 7.75 to 8.5 percent. It was not enough. At the June 18–19 meeting, the FOMC changed planned RPD growth to 8 to 11.5 percent and permitted the federal funds rate “to vary somewhat more . . . than had been contemplated at other recent meetings” (ibid., 175). But the constraint continued to bind; RPDs rose at more than an 11.5 percent rate, and the FOMC voted to let the funds rate rise more than it had planned. No one dissented until the July 17 meeting, when Darryl Francis (St. Louis) agreed with the committee’s objectives but said “the objectives would not be achieved because of the constraint on money
market conditions” (ibid., 186). He was soon proved correct. On August 3, there was another inter-meeting increase in the funds rate. Francis dissented again, for the same reason, at the next meeting, August 21, 1973.

Second, throughout the Great Inflation the Board’s staff interpreted errors in forecasting money growth as evidence of shifts in the demand for money, not as random shifts in supply or errors in their models of money supply growth. This permitted them to excuse their errors as unpredictable, random events even when they were repeated month after month as in 1973. The FOMC learned nothing. A related problem occurred in the period from 1979 to 1982, when the FOMC again tried to set a target for unborrowed reserve growth.

Chairman Burns asked the staff to explain why the errors in June and July 1973 were shifts in the demand for money. Its explanation is not reassuring. It started by describing the demand for money as a function of a short-term interest rate and nominal GNP. In the first quarter, GNP and interest rates rose; the model predicted a 6 percent increase in M 1 demand. Demand rose much less, so the staff concluded that the demand for money shifted down. “We take the shortfall of actual M
₁
growth from that predicted from the model as evidence of a downward shift in the money demand function” (memo, Lyle Gramley to Burns, Burns papers, Box B_B80, July 31, 1973). This accepts the demand function as a true representation. The memo acknowledged that Federal Reserve policy could have raised the money growth rate “if the Fed had set out single-mindedly to keep M
₁
growing at (say) 6 percent. . . . But it would have had to drive down interest rates substantially below actual levels to accomplish this” (ibid.). The writer, Gramley, did not recognize that this is a very different argument from his claim that the demand for money shifted. It attributed the shortfall (and subsequent excess growth) to the constraint on short-term interest rates that altered the growth of RPDs and the supply of money. The same error—explaining all excess or shortfall in money growth as the result of shifts in demand—reappears repeatedly.

A related but distinct error was Charles Partee’s argument that easing wage and price controls in January 1973 “might necessitate a somewhat faster rate of monetary growth to finance the desired growth in real output under conditions of greater cost-push inflation than would have prevailed with tighter controls” (FOMC Minutes, January 11, 1973, 70). Here the unwillingness to risk a recession or even slower real growth dominates any concern about higher inflation.
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76. At the February 13 meeting, FOMC members learned that the agreement that month to devalue the dollar against gold from $38 to $42.22 an ounce would cause an 11 percent
loss on its outstanding swap lines. The administration sent Congress a bill to devalue the dollar to $42.22 per ounce of gold. The bill also gave the president authority to raise tariffs. Burns supported the proposal as necessary (FOMC Minutes, February 13, 1973, 4). Also, the Voluntary Foreign Credit Restraint Program ended.

Third, forecasts underestimated both growth and inflation. In February, the staff forecast that the GNP deflator would increase 4.25 percent in 1973 and that nominal GNP would rise 8.5 percent (FOMC Minutes, February 13, 1973, 144, 163). The actual price and GNP increases, fourth quarter to fourth quarter, were 8.3 and 11.9 percent. Partee did not offer a numerical estimate but forecast that “real GNP would grow at satisfactory but not ebullient rate for the remainder of the year” (ibid., 183–84).
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The Council of Economic Advisors believed that fears of inflation were exaggerated. “There is still good room for expansion of non-farm output as evidenced by figures on capacity utilization and unemployment rates of adult male workers. We expect a marked change in the food price situation after mid-year” (memo, Stein to the president, Shultz papers, Box 5, March 2, 1973).
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A few weeks later Stein wrote: “The money value of GNP rose extraordinarily in the first quarter—at an annual rate of about 13 percent. This is almost 30 percent larger than we forecast at the beginning of the year. Most of the increase is in prices, but the increase of real output also surpassed our forecast a little” (memo, Stein to the president, Shultz papers, Box 5, April 17, 1973). He recommended suspension of the investment tax credit and money growth held to 5 to 6 percent.
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77. The staff expressed considerable uncertainty about the effectiveness of so-called phase 3 controls. Burns sent the president a copy of the staff analysis. He urged the president to speak publicly about the “enforcement of desired conduct on wages and prices” (Burns to the president, Nixon papers, Box 33, January 29, 1973). He also urged the president to “appeal to the public to reduce its buying” and suggested a “meatless day each week” to bring down meat prices (ibid., 3). His concern was that rising food prices would increase wage demands. Despite higher inflation, average hourly earnings rose less in 1973 than in 1972. For December of each year, the rate of change for that year was 8.1 and 6.3 percent. The reported 1973 inflation rate includes the start of higher oil prices that could not be predicted early in the year.

78. These changes occurred at a time that the dollar was devalued by 10 percent (midFebruary). Burns considered the devaluation necessary, but he did not like it. He continued to oppose a floating exchange rate (Wells, 1994, 107). In March the dollar floated. That ended the Smithsonian agreement and the effort to fix the dollar exchange rate. Volcker wrote that “despite his enthusiastic support of fixed exchange rates, he [Burns] seemed . . . to have a kind of blind spot when it came to supporting them with concrete policies” (Volcker and Gyohten, 1992, 104). The Council used a 4 percent unemployment rate as the natural rate, so it overestimated excess capacity (Orphanides, 2002). Pierce (1998, 7) pointed out that the Board’s model used to estimate inflation and output did not allow for any effect of money growth until later in the decade.

79. The GNP data showed 8 percent inflation and 6 percent real growth. Consumer expenditure rose at 16 percent annual rate in
these early data.

Taking account of the first quarter results, the Council and private forecasters revised their forecasts. Table 6.8 shows that the forecasts by both government and private forecasters were as much as nine percentage points lower than reported inflation. As noted, part of the difference reflects one-time increases in oil and food prices.

Late in March, Partee summarized the staff position. It expected real growth to fall to 4 percent by year-end, and it anticipated that inflation would rise despite slower increases in food prices. He cautioned against a tough anti-inflation policy on the grounds that the FOMC would not persist in lowering inflation. “As unemployment rose, there would be strong social and political pressure for expansive actions, so that the policy would very likely have to be reversed before it succeeded in tempering either the rate of inflation or the underlying sources of inflation” (FOMC Minutes, March 19–20, 1973, 6). He favored 5.5 percent M 1 growth.
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Robert Black (Richmond) asked a critical question: Should they raise the accepted level of the unemployment rate to 5 from 4 percent? Partee avoided the issue by responding that inflation would continue, according to the model, even at 5 percent unemployment rate (ibid., 28).
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In testimony to Congress, Burns gave a different explanation. He explained that “fundamentally, it is the expansion of the money supply over the long run that will be the basic cause of inflation” (quoted in Wells, 1994, 111). Money growth (M
₁
) reached 8.2 percent in first quarter 1973, but Burns did not urge a much more restrictive policy. He told the BIS members that “there is an acute political problem regarding interest rates. Congress and the unions have become quite concerned about interest rates. Congress could unwisely legislate statutory limits on interest rates or
fail to act promptly to approve an extension of the Economic Stabilization Act” [wage and price controls] (ibid.).

80. The FOMC voted at the March 19–20 meeting to authorize negotiations to increase swap lines with other central banks by up to $6 billion in the aggregate. The swap lines totaled $11.7 billion before the increase.

81. The model used a Phillips curve relating unemployment and inflation. Partee acknowledged that the model had not worked well until they adjusted for “special factors” (FOMC Minutes, March 19–20, 1973, 30). The government did not change its goal for unemployment to 5.1 percen
t until 1976.