A History of the Federal Reserve, Volume 2 (26 page)

At the FOMC meeting, Burns expressed concern about a possible recession by the end of the year. He warned the members that “the Federal Reserve had a history of going to extremes” (FOMC Minutes, March 19–20, 1973, 108). Itwas now trying to do something it had not done ever before— slow inflation without bringing on recession. He accepted the higher inflation rate and urged the FOMC to accept a pause in restraint. Seven members agreed, but five disagreed. Robertson, Brimmer, and Hayes suggested changes in the ranges that would make Burns’s proposal acceptable. The compromise called for the federal funds rate to remain between 6.75 and 7.5 percent, M1 growth at 4 to 7 percent near term, and RPD growth of 12 to 16 percent. This proposal passed unanimously. During the period between meetings, deposits grew more slowly than expected, so the manager let the federal funds rate decline to 7 percent.

Burns’s concern about recession was misplaced. Industrial production declined in March, but the decline did not continue. Inflation, not recession, became the problem. Although the federal funds rate was at the highest level ever reached, after adjusting for current or anticipated inflation, the real funds rate was about 3 percent.

The unemployment rate remained in a narrow range around 4.9 percent during the first six months of 1973. Guided by the Phillips curve, the staff described the rise in inflation as “an aberration” resulting from the end of phase 2 controls and dollar devaluation (FOMC Minutes, April 17, 1973, 4–5). They did not anticipate continued inflation at the first quarter rate. The model predicted 4 to 4.5 percent for the next two to three years, based on a 4.5 to 5 percent unemployment rate. In response to a question, Partee agreed that the “tradeoff between unemployment and the rate of advance in prices had become less favorable recently” (ibid., 9). The model forecast could be reconciled with the data only by assuming that the Phillips curve had shifted. He blamed the shift mainly on phase 3.
⁸²

Brimmer and Balles (San Francisco) said that the 1973 surge in the inflation rate was a lagged response to the monetary and fiscal stimulus in 1972. But M 1 and M
₂
growth slowed in the first quarter and were below the FOMC’s objective, so Daane opposed any increase in the federal funds
rate.
⁸³
Hayes agreed with Brimmer and Balles that the System should tighten by lowering the money growth rate, raising the discount rate and the funds rate, and removing remaining regulation Q ceilings. To prevent higher inflation, “firmer wage and price controls were needed . . . [but] controls were not of much use in the absence of appropriate fundamental policies and in the present situation monetary policy was one of the fundamentals” (ibid., 72).

82. In a statement reminiscent of the 1920s, Robert Black (Richmond) thought that prices were “beyond the control of the Federal Reserve.” Partee agreed (FOMC Minutes, April 17, 1973, 10). Statements of this kind remain ambiguous. Was inflation independent of monetary policy, or did it mean that the System would not attempt adequate restriction? Or did Black refer to one-time price level changes?

Balles urged the FOMC to consider ways to improve control of money. He suggested controlling nonborrowed reserves and the monetary base (ibid., 75). The FOMC made no changes. After much discussion, it agreed to seek moderate growth in the monetary aggregates. In April, the funds rate remained unchanged, but M
₁
and M
₂
growth rose more than the FOMC’s desired path of 5 to 5.5 percent.

As market interest rates rose, the prime rate and rates on consumer credit began to increase. Banks raised the prime rate to 6 percent (from 5.25) in December 1972. Early in February, four New York banks raised the rate to 6.25 percent. As head of the Committee on Interest and Dividends (CID), Burns spoke to the bankers and persuaded them to rescind their announcement. Congress had renewal of authority to control prices and wages under consideration, and neither Burns nor the bankers wanted Congress to include interest rates in the bill. By the end of February, however, the 6.25 percent prime rate had become general. CID issued guidelines that permitted banks to increase their lending rates as money markets rates rose, but they were supposed to adjust for the zero rate of interest paid on demand deposits.

Pressed by Congress, especially Congressman Wright Patman, Burns and the CID urged the banks to limit their rate increases. But markets imposed higher marginal costs as open market rates rose. By September 1973, the federal funds rate averaged 10.8 percent, an increase of 5.5 percentage points since December 1972. The prime rate reached 10 percent, an increase of 4 percentage points in the same period.
⁸⁴
These data suggest a possible modest effect of CID efforts, since the lending rate rose less than the borrowing rate. We do not know how other terms and conditions of
the loans changed, whether banks restricted prime rate loans, or whether borrowers shifted to other markets.

83. The FOMC voted to release the 1967 Minutes after deleting some passages in the discussions of foreign currency.

84. Interest rates on three-month certificates of deposits rose from 5.67 to 10.71 percent in about the same period. In April, Burns asked the president to let him resign from the CID. The conflict of interest that some had foreseen was now apparent to all. The Federal Reserve’s standing was hurt by the conflict. The president asked him to stay on, and he remained.

Burns recognized that any success he had in reducing lending rates increased spending and borrowing. He felt powerless to let rates rise, reluctant to hold them down. In April, a Senate bill called for lower interest rates, a rollback of rate increases. The bill failed by only four votes in the Senate (Wells, 1994, 113). The close vote was more than enough to frighten Federal Reserve officials, who were rarely comfortable about relations with Congress. Burns responded by ruling that banks had to split their lending rates. On April 16, the CID established voluntary guidelines for bank interest rates. Farmers and small business with less than $1 million in assets received a lower rate than other borrowers. Two days later, banks raised the prime rate to 6.75 percent.

In the next few months, as inflation rose, the System allowed market interest rates to rise to levels never experienced in the previous sixty years of Federal Reserve history. Although the Board was often hesitant to raise the discount rate, by July it had reached 7 percent, the highest level in Federal Reserve history to that time.
⁸⁵

From May through August–September, the System worked to control money growth and inflation. President Nixon worked to control spending growth. The administration called this “the old time religion”—a program to control inflation by traditional means. Nominal budget outlays in 1973 rose 3.2 percent, a real reduction of at least 5 percent. The budget deficit fell from $20 to $15 to $8 billion between 1972 and 1974, and annual M
₁
growth declined from 8.8 percent in December 1972 to 5.3 percent a year later. It continued to fall. By the end of 1973, industrial production started to fall.

Supplementing fiscal and monetary restraint was the president’s effort to end phase 3 by freezing prices, discussed above. The attempt failed. Phase 4 of the controls program replaced it. This was a reworking of phase 2. That also had little effect; the explanation at the time was that the economy was closer to full employment. In fact, the rate of increase in hourly earnings, which Burns considered central to inflation control, rose during the period of controls and phase 4.

At the May FOMC meeting, Partee put the issue squarely. After forecasting that the rate of expansion would slow, he told the committee:

85. One of many examples of hesitation and reluctance to raise the discount rate came in June 1973. On June 25 and 26, the Board disapproved requests for a 7 percent discount rate ostensibly because the request came too soon after the June 8 increase to 6.5 percent. Three days later, June 29, it approved the 7 percent rate. Consumer prices rose 8.2 percent at annual rate that month.

Inflationary pressures are likely to remain substantial. . . . I do not have much hope that these underlying inflationary forces can be dampened appreciably without profoundly adverse consequences for the economy later on. (FOMC Minutes, May 15–16, 1973, 22)
⁸⁶

The Council of Economic Advisers finally recognized that it had to give up the idea that full employment meant a constant 4 percent unemployment rate (Hargrove and Morley, 1984, 399). Part of “the old time religion” was a willingness to accept larger increases in the unemployment rate as a cost of reducing inflation. Some members of the FOMC did not accept that reasoning. At the May meeting, Eastburn (Philadelphia), Black (Richmond), Coldwell (Dallas), Winn (Cleveland), and Daane expressed concern about too much restraint.
⁸⁷
The GNP deflator rose at an 8.6 percent annual rate that quarter, about the same rate as the CPI.
⁸⁸

Instead of protecting the value of money, the May meeting concerned itself with trivia. It considered a proposal to increase the cost to banks of issuing large CDs by increasing the marginal cost of these deposits. The proposal increased reserve requirement ratios for time deposits to 8 percent. This combined the standard 5 percent and a marginal increase of 3 percent for increases in large-denomination CDs and commercial paper above the average amount outstanding for the week ending May 16. The new requirement became effective on June 7. The Board approved the requirement on May 16. At the same meeting, it reduced the reserve requirement for euro-dollars from 20 to 8 percent, the same as large time deposits. In September, the Board increased the marginal reserve requirement ratio to 8 percent, making the effective requirement on new time deposits 11 percent.

The Board also suspended regulation Q ceiling rates on time deposits of
$100,000 or more with initial maturity of ninety days or more. This was the first liberalization of CD rates since ceiling rates were suspended for maturities of less than ninety days in June 1970.

86. Governor Daane reported that the BIS members, especially the Europeans, were eager to control euro-dollar markets. The United States had made euro-dollar holdings subject to reserve requirements. In 1973, they increased the requirements, raising the cost of eurodollars. See below. Coombs complained that the United States did not intervene to prevent the dollar from falling. All other countries intervened. Coombs never accepted that coordination and intervention could not prevent the readjustment of real exchange rates. Although he recognized that the Watergate scandal reduced the demand to hold dollars, he believed that intervention could offset it.

87. Burns briefed the members about the “political crisis” (Watergate) affecting the country. He warned that it was likely to reduce “confidence.” Stein claimed that the president remained active in policy discussions and had taken the lead in pushing for a second freeze and phase 4 (Hargrove and Morley, 1984, 400).

88. Despite concerns about disintermediation and housing, new housing starts remained at a robust annual rate above 2.2 million in the second quarter. The likely source of error was failure to distinguish real and nominal interest rates.

MacLaury (Minneapolis), Francis (St. Louis), and Black (Richmond) pointed out that corporate borrowers would not be deterred by the small increased cost intended by the proposal. They would borrow in other markets. These critics did not favor controlling credit, because they did not think it could work.

The Board, however, was unwilling to take a decisive action, so it resorted to weak or cosmetic actions. On April 4, it sent the first of several letters asking banks to voluntarily restrict loan commitments. The Comptroller and the chairman of the FDIC sent similar letters to their members. On May 21 and 29, the Board sent letters to member banks urging them to voluntarily restrict growth of loans and certificates of deposits in an effort to control inflation. There is no indication that the Board thought about what would happen to the funds that did not go into time deposits or that the bank did not lend. The episode recalls the mistaken attempt to control credit expansion by exhortation in 1929. Despite the warnings they heard, the FOMC did not take decisive action.

The June 1973 FOMC meeting brought out the division between those who favored a more restrictive policy and members more concerned about a possible recession if policy tightened. The FOMC voted for slower growth of the monetary aggregates. It reduced its objective for money growth in the second half from about 5 to 4.5 percent and reduced its near-term objective to a range of 4 to 8 percent. The top of the range for the federal funds rate rose to 9.25 percent.

Several private forecasts expected a recession in late 1973 or early 1974. Lyle Gramley said the staff expected slower growth but not a recession. By the end of the year, the staff expected growth to fall to 3.5 percent.
⁸⁹
Brimmer asked Partee why they did not expect a recession. Partee replied that they projected an investment boom, an improvement in net exports, and moderate money growth.
⁹⁰

Frank Morris (Boston) explained why he thought the System had to

89. Actual growth of GNP fell to 1 percent annual rate in the second quarter and −0.4 in the third. The fourth quarter reached 3.6 percent, as the staff predicted. They did not foresee the weakness in the second and third quarters. The GNP deflator rose 8.6, 8.4, and 10 percent (annual rates) in the second to the fourth quarter.

90. The dollar had depreciated 17 percent from its Bretton Woods value against a weighted average of sixteen foreign currencies. The staff forecast that nominal GNP would rise 7 percent if money rose 5.25 percent. The implicit rise in velocity was close to trend growth at the time (FOMC Minutes, June 18–19, 1973, 21).

reduce money growth modestly. He thought the basic problem was fiscal. A 6 percent unemployment rate would weaken the consensus between the administration and Congress to reduce growth of government spending. Burns agreed. He thought that “to achieve price stability it was necessary to avoid recessions” (FOMC Minutes, June 18–19, 1973, 34).
⁹¹

The FOMC voted in June and July to tighten further, and between meetings it adjusted upward the tolerable level of the funds rate. Despite sharp differences of opinion, recorded votes were unanimous

The FOMC was not oblivious to the increase in current and anticipated inflation. The staff saw “clear and present danger of further overheating.” They blamed strong economic growth and “monetary aggregates growing at unacceptably high rates” (FOMC Minutes, July 17, 1973, 43). Burns drew the right conclusion: “The basic reason [for rapid monetary growth] was that the System had been supplying reserves to commercial banks at a very fast rate. The rapid growth of the monetary aggregates was a most disturbing development; if it persisted there would be considerable justice to a charge that the System had fostered the inflation now underway” (ibid., 57–58). He wanted growth of M1 and M2 to slow to 3.75 and 4.75 percent for the second half, with 3.5 to 5.5 percent growth of reserves, but he thought this would require near-term 11 to 13 percent growth of reserves.

The FOMC remained divided. Most members wanted to avoid a recession and to reduce inflation, but they differed on the best way to achieve both objectives and on the weights they gave to each. Citing international as well as domestic concerns, Hayes and Daane wanted to tighten more than most others. Burns supported their position. He was now committed to an anti-inflation policy, and he was able to get majority support.

The economy operated at about 96 percent of capacity in the second quarter. Those who opposed a tighter policy thought the economy would slow. They feared a recession and either explicitly or implicitly preferred higher inflation to recession. Since they did not distinguish between real and nominal interest rates, they expressed concern about the consequences of a federal funds rate above 10 percent. Stephen Axilrod warned them that the funds rate could rise to 15 or 20 percent. Peter Sternlight agreed.

Bucher, MacLaury (Minneapolis), Black (Richmond), Holland, and Sheehan, all relatively new appointees, favored less restraint. Sheehan expressed their position best: “Experience suggested that the Government
could not permit the kind of recession that might serve to bring inflation under control without giving rise to political pressures that would result in a massive Federal Government deficit” (ibid., 95).

91. At the time, the staff’s model implied that a 1 percent increase in the unemployment rate would reduce the inflation rate by 0.7 percent within six quarters (FOMC Minutes, June 18–19, 1973, 42). Later experience showed that this estimate was too pessimistic.