A History of the Federal Reserve, Volume 2 (33 page)

By 1974 and perhaps earlier, most FOMC members recognized that sustained inflation occurred only if supported by money growth. The House Committee on Banking and Currency took testimony from several Federal Reserve presidents, and it sent a staff member, Robert Weintraub, to question each president and Board member about the reason they believed the country experienced high inflation and high nominal interest rates.

Answers about the cause of inflation varied in detail, but the role of money growth was common. President Francis (St. Louis) said that inflation and high interest rates “stem from the same source—an excessive trend rate of expansion of the Nation’s money stock since the early 1960s” (House Committee on Banking and Currency, 1974, 166). He blamed the Federal Reserve’s actions for the result. Others rationalized the FOMC’s actions citing energy and commodity price changes or unemployment as reasons for the FOMC’s actions. All accepted the long-term influence of money growth as a dominant factor, but several cited short-run concerns. For example, President Mayo (Chicago) said, “No one will deny that inflation is directly concerned with the relationship between the quantity of goods and the quantity of money” (ibid., 195). But he soon retreated to a claim that other “factors outside the influence of the Federal Reserve played a very important role in the unprecedented inflation of 1973 and 1974” (ibid.). His statement is correct only if the definition of inflation includes one-time price level changes in addition to persistent changes. Failure to distinguish between maintained inflation and price level increases contributed to the Federal Reserve’s inept policy. The cost of rolling back the price level increases added greatly to the perceived cost of an anti-inflation policy. Controlling the sustained (monetary) inflation and permitting the price level changes to pass through would have left the price level higher but not the inflation rate.

President Balles (San Francisco) testified that excessive money growth was the principal cause of inflation. He claimed that pressures to support housing construction, concerns about unemployment, and “excessive deficit financing” were background causes (ibid., 98). President Eastburn (Philadelphia) testified that “whatever immediate events may cause prices to rise . . . a higher price level can not be maintained without sufficient money” (ibid., 121).

There is little reason to doubt that FOMC members recognized their role in creating inflation, although many offered explanations defending their actions or sought to justify them. Arthur Burns was less forthright, perhaps trying to shift responsibility away from the Federal Reserve. Even he accepted that “monetary policy must not permit sufficient growth in money and credit supplies to accommodate all of the price increases that
are directly and indirectly attributable to special factors. . . . A monetary policy that accommodates all of these price increases could result in an endless cost-price spiral and a serious worsening of an already grave inflationary problem. The appropriate course for monetary policy is the middle ground” (ibid., 243). Burns said some price increases should pass through, but not all. He then cited the annual 6 percent growth of money as appropriate for the present but too high for the longer-term. Reducing the growth rate “must be achieved gradually to avoid upsetting effects on the real economy” (ibid., 254). This recognized both inflation and the cost of containing inflation as major concerns. Action did not follow recognition.

The 1974 hearings bring out forcefully the political constraints that Congress tried to impose on the Federal Reserve. Congressman Reuss urged credit allocation to priority uses. Burns opposed, urging market allocation, but Andrew Brimmer wrote a letter favoring a system of credit allocation (ibid., 274–76). Other congressmen wanted more assistance to housing and other politically popular uses. Still others used the hearing to complain about the $1.2 billion the Federal Reserve lent to prevent failure of Franklin National Bank. Chairman Patman included several criticisms, including one that contrasted the Federal Reserve’s support of Franklin with the Bundesbank’s refusal to support the Herstatt bank (ibid., 298).
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The hearings and Weintraub’s interviews showed general agreement about the long-term role of money but little agreement about the desirability of monetary control. One central problem that the hearings did not develop was the role of interest rate targets.
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A
remaining
puzzle.
The references earlier in this chapter to Orphanides, Sargent, Taylor, and Romer and Romer offer explanations of the Great Inflation compatible with the more general statement that policymakers ignored economic theories that were available, repeating a similar error made in the 1930s. Indeed the monetarist critique at the time emphasized neglect of long-standing propositions, as Franco Modigliani (1977) later acknowledged.

17. Elsewhere in the hearings, Burns recognized the problem caused by below-market ceiling rates under regulation Q. He did not propose removal and questioned whether it was appropriate to raise the ceiling because it would increase costs for thrift institutions (House Committee on Banking and Currency, 1974, 285).

18. Neglect of money growth and reliance on interest rate changes to interpret policy resulted in procyclical changes in money growth. When output fell and borrowing declined, market interest rates declined also. The Federal Reserve interpreted the decline as evidence that policy had eased, so it permitted money growth to decline. Rising output and borrowing raised interest rates. The Federal Reserve interpreted higher nominal interest rates as evidence of restrictive policy, so it permitted money growth to increase, adding to inflationary pressures.

The remaining large puzzle is to explain why this happened. Why did the Federal Reserve dismiss for years the long-run vertical Phillips curve, procyclicality of monetary policy, and the effect of inflation on nominal interest rates, wages, and anticipations more generally? Why did they ignore the finding of some of their own staff that concluded that the long-run Phillips curve was vertical? Critics pointed out these errors at the time. Propositions that attribute the Great Inflation to analytical errors of one kind or another ought to be supplemented by an explanation of why the error persisted for fifteen years before policy changed. As is well-known, policymakers began anti-inflation policies as early as 1966 and several times after—1969, 1973, 1978–79, and 1980. They were aware of the Great Inflation but, until 1979–82, they did not persist in policies to end it.

My main objection to explanations based on persistent policy errors is that they are incomplete. Federal Reserve officials could observe inflation rates. They knew that their policies had not ended inflation. Most often inflation was above their forecast. Chart 7.9 shows that the forecast errors were too large and persistent to be ignored. Yet the System did not change course. Burns was a distinguished economist, influenced more by data and induction than by deductive theories. Yet he failed to stop the inflation and, at times, saw it rise to rates never before experienced in U.S. peacetime history. Most of the FOMC members were not ideologues or slavish adherents to a particular theory. Several regarded themselves as practical
men, meaning not attached to any particular theory and willing to discard analyses that did not work.

One additional caveat is that the Federal Reserve is not a monolith. Members of the Federal Open Market Committee (FOMC) have independent views. Particularly in the 1960s, they were mostly non-economists. They had considerable difficulty agreeing on how to implement actions, as Maisel (diary, 1973) documents fully. The staff, or part of it, had a model, but insiders who have written about the 1960s and 1970s often emphasize inconsistency in the choices made by the FOMC (Lombra and Moran, 1980; Pierce, 1980, and Maisel, various years).

The international character of the Great Inflation is sometimes advanced as support for explanations based on errors in economic theory. The claim is that many countries made the same errors, particularly denial of the natural rate hypothesis, claiming that unemployment in the long run was independent of inflation. All experienced inflation. Once policymakers everywhere accepted the natural rate hypothesis, time inconsistency theory, understanding of the need for credibility, and rational expectations, inflation declined.

Appealing as this argument is to economists, it fails to separate the start of inflation and its continuance. The start of inflation occurred under the Bretton Woods system of fixed exchange rates. Surplus countries experienced inflation because they would not appreciate their currencies to stop the inflation, and those that did appreciate made at most modest increases until 1971. They were fully aware of the problem; they did not want a solution that reduced their exports or slowed the growth of output and employment. They opposed dollar depreciation. Once the fixed exchange rate system ended, Japan, West Germany, Switzerland, and Austria reduced their inflation rates. Others permitted inflation to continue or increase.

The United Kingdom was the principal deficit country besides the United States. It comes closest to support the policy errors (or preferences) explanation. Policymakers in both U.K. parties accepted and used a simple Keynesian model. The long delay of sterling devaluation from 1964 to 1967 and the policy measures chosen are evidence of the reluctance to slow growth (Nelson, 2003b).

The Great Inflation resulted from policy choices that placed much more weight on maintaining high or full employment than on preventing or reducing inflation. For much of the period, this choice reflected both political pressures and popular opinion as expressed in polls. Many accepted James Tobin’s view that inflation would increase before the economy reached full employment, or they claimed that eliminating inflation required an unacceptable increase in unemployment. Inflation did not fall permanently
until public opinion polls showed the public willing to bear the cost. Then it became acceptable politically to shift more weight to inflation control and less to unemployment when choosing monetary policy actions.

THE 1973–74 RECESSION

Neither the administration nor its critics and outside observers anticipated the 14 percent surge in food prices followed by a surge in oil prices in 1973.
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None predicted the steep decline in output that followed.

The 1973–74 increase in consumer prices was the largest since 1947, following the end of wartime price controls. This time removal of price controls, devaluation of the dollar after 1971, poor harvests abroad, and increases in oil prices added to the underlying rate of measured inflation resulting from the excessive monetary and fiscal expansion of 1972. Although some of the Board’s staff recognized the distinction (Pierce and Enzler, 1974), the administration and the Federal Reserve did not distinguish between these sources of rising prices. Monetary contraction—slower monetary growth—could reduce the maintained rate of inflation driven by growth of aggregate demand by reducing growth of aggregate demand. Using monetary policy to counter the price level increase resulting from one-time reductions in the supply of food or fuel lowered the equilibrium price level by reducing aggregate demand. Reductions in both supply and demand induced reductions in output and employment. A proper policy response to the oil price increase would have recognized that it was a tax on oil users paid to foreign producers. To reduce the loss of welfare, the administration could have reduced domestic tax rates.
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Or it could do nothing about the price level shock and allow it to pass through the economy. It was not a monetary problem, as some FOMC members recognized.
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19. Wells (1994, 111) quotes Burns as offering a political explanation of rapid money growth but not attributing the increase to the election. “Fundamentally, it is the expansion of the money supply over the long run that will be the basic cause of inflation.” To slow its growth, the Federal Reserve had to raise interest rates but, Burns said: “In the United States, 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 extension of the Economic Stabilization Act [controls].” This shows a willingness to sacrifice independence.

20. The source of this error was failure to distinguish between the maintained or persistent inflation rate and other increases in the reported price level. An anti-inflation policy can have different goals. It can keep the maintained rate of inflation at zero and permit price level shocks to drive the price level to fluctuate around an expected zero long-run rate of inflation. Or it can aim for price level stability by offsetting increases and decreases in the price level. The second option probably requires larger changes in output and employment.

21. Members of the staff correctly analyzed the oil shock and other one-time changes as affecting the price level, temporarily raising the rate of price change. See Pierce and Enzler
(1974). I am grateful to David Lindsey for this reference. There is little evidence that the FOMC accepted this analysis or discussed its implication for their response.