A History of the Federal Reserve, Volume 2 (35 page)

Policy eased again on October 16. The federal funds rate remained near 10 percent from October to December. The professional forecast of inflation rose to 5.4 percent, an increase of 1.75 percentage points in a year. The oil embargo was in effect, and oil prices had increased when the FOMC met for the November meeting. Burns said he was “less confident about the direction of monetary policy” (ibid., November 20, 1973, 83). He thought that current economic problems were not primarily monetary. “Monetary policy might be able to play a marginally constructive role . . . but it could not offer a solution to the problems that the nation was on the threshold of experiencing” (ibid., 84–85).

Morris (Boston) disagreed. He thought a recession was likely, and he wanted more stimulus to offset the energy problem. “In addition to an easier open market policy, he would urge that some more overt easing action be taken” (ibid., 87). Burns resisted, and he prevailed, so Morris dissented. Reported money growth rose above the short-run targets. The FOMC voted on November 30 to let the excess growth remain and to keep money market conditions unchanged. Thus, they augmented the effect of the oil price increase on the price level by raising the inflation rate.

The initial staff estimate of the effect of the rise in oil prices was optimistic (memo, Effects of Oil Supply Cutbacks, Burns papers B_B3, December 1, 1973).
²⁸
It did not consider the substantial costs created by price controls and waiting lines. Matusow (1998, chapter 9) describes the many mistakes made to prevent energy prices from rising.
²⁹
President Nixon’s concerns about the Watergate investigation and his desire to retain popular support probably contributed to the decision. Controls on energy prices remained until ended by President Reagan in 1981.

The rise in oil prices raised import costs. The value of imports rose
almost $15 billion, 25 percent, in 1973. Exports increased more than $20 billion. The United States had its largest current account surplus in nominal dollars since 1947 and the first net inflow of private capital since 1968. The strong surge in exports helped to sustain output growth in the fourth quarter. The staff expected continued strong export growth in 1974 and forecast that nominal GNP would rise 8 percent in 1974 if money growth remained at 5 percent. The staff did not expect a recession at its November meeting even though the National Bureau later dated the start of the recession in that month. As often happened before and after, the forecast was wide of the mark, and it missed the start of a steep decline.

28. Barsky and Killian (2004) cast doubt on the importance assigned to the oil shock in inflation and output in the 1970s. They show that the timing is a problem. They accept that a fixed-weight consumer price index would increase with the oil price, but they find little support in the deflator. “There is no convincing empirical evidence that oil price shocks are associated with higher inflation rates in the GDP deflator” (ibid., 124). There is an effect on the price level.

29. Matusow (1998, 267) gives a vivid description of the rage some drivers developed when they had difficulty buying gasoline. The Council of Economic Advisers favored decontrol, but political concerns prevented it. “Our failure to deregulate was one of the great mistakes” (Stein in Hargrove and Morley
, 1984, 403).

Not so for the basic analysis of the oil shock. Ralph Bryant of the Board’s international staff understood what had happened. He told the Committee that “this will be a very special kind of recession, and it is not at all clear whether orthodox anti-recession policies will be appropriate” (FOMC Minutes, December 17–18, 1973, 41). Bryant saw the analytic problem as estimating the primary effects of reduced supply and the induced effects of uncertainty on demand. In addition, countries would have to finance large changes in their international payments.

The staff forecast was less accurate. It assumed that policy remained unchanged, but the budget deficit would rise as the economy slowed. Output growth would be about zero for the year. The outlook for employment and growth had been poor before the oil shock. It would be poorer, and inflation would rise.

Burns gave his view. He did not accept the staff forecast, but he recognized with them that the oil shock differed from an ordinary recession and called for different actions. He gave three reasons. “The continuance of sharp inflation clearly required caution and some restraint in carrying out a policy of monetary easing. The need for caution and restraint was also indicated by the energy shortage; . . . it was doubtful whether it [monetary policy] could overcome the short-run limitation on the nation’s capacity to produce. Finally, . . . the sharp divergence was likely to occur in the fortunes of individual communities. . . . [A]t a time of energy shortage, monetary policy—instead of aiming to bring recession to an end—should merely aim to keep the recession becoming deeper than the restricted capacity to produce in itself required” (ibid., 70–73). This was a correct appraisal. He favored a slight easing.

Release
of
Information

Renewed dissatisfaction with its operating procedures and growing external criticism of its results induced a new study and a lengthy discussion after the November FOMC meeting. Burns described the criticism: “it was
issuing virtually meaningless directions to the Desk, that it was engaged in an exercise in obfuscation, and that it was following muddleheaded procedures” (FOMC Minutes, November 20, 1973, 78). The problem, as Burns described it, arose from misunderstanding. “The Committee did adopt specific targets, but . . . it could not reveal them for a time because of possible market effects” (ibid., 78–79). He proposed to provide the information after the fact, when the market could not profit from trading on the information.

Members were divided on this issue, as on most others. All favored giving more information but differed on what they should give and when. There were short-run targets, long-run targets, and revisions to targets. Some wanted to release information after three months, others after six months. Neither Burns or other members mentioned the benefits from giving correct information to the market.

Those expressing caution made two main arguments. Additional information would give the critics more information. They would see the difference between projections or plans and outcomes.
³⁰
Also, giving more information would allow market participants to predict what the Federal Reserve planned to do and profit from it.

Surprisingly, no one suggested that the FOMC should improve its procedures and its control of inflation or that their problem arose in part from the lack of effective control. No one urged an end to quarterly control or concentration on longer-term outcomes. Some argued that the targets were not policy decisions, so they did not have to reveal them; Governor Holland described this as “sophistry” (ibid., 73).

At a more fundamental level was the Committee’s understanding of the role of information. The discussion emphasized political and public relations problems and neglected efficiency. Several of those who wanted to release full information, with a lag, wanted to silence criticism. They did not argue that announcing targets would induce the market to help achieve the System’s goals. The FOMC was in transition on this issue, as on many others. The old tradition allowed central banks to be secretive. But this tradition arose under the gold standard and public support for a balanced budget (except in wartime.) These restrictions were generally
believed to be adequate to limit the damage a central bank could do. After abandoning the gold standard rule and accepting some responsibility for employment, growth, and inflation, the central bank inevitably became subject to democratic political pressures. Having lost its rule, and subject to the unpredictable actions of central bankers, the public wanted more information to protect itself. The central bank did not yet recognize that by releasing information and acting to ac
hieve its targets, the market would help to achieve its targets and avoid mistakes or misinterpretations costly to both sides. Only in 1994 did the Federal Reserve start to announce its short-term objective.

30. Robert Mayo (Chicago) gave a succinct statement of this concern. “The record of misses would be interpreted too narrowly and used in new attacks by hostile critics in the Congress. That record could be described by those critics as providing evidence that monetary policy and the Federal Reserve as an institution were inept; that the Federal Reserve staff was incompetent; and that the Federal Open Market Committee should be modified or abolished” (FOMC Minutes, November 20, 1973, 80). Mayo did not mention the benefit of more accurate information to the market and thus to the System. No one suggested that random elements made short-run control difficult.

Discussion at the November 1973 meeting did not reach a conclusion. FOMC members did not have common beliefs about how monetary policy affected the economy, which variables made good targets, or how the desk should operate to meet the targets. Without some common framework, differences were hard to reconcile. The members did not attempt to do so.

Burns stopped the discussion but returned to it in December. At the time, the FOMC published the RPD target in the Record of Policy Action and in the report of the meeting. Burns proposed to include short-term targets for M
₁
, M
₂
, and the funds rate also. Some wanted to add long-run targets; others wanted to release long-run targets but not short-run. Coldwell thought money targets got too much attention; he wanted to suppress them. Daane wanted to eliminate RPDs from the record and to limit statements to qualitative references. Like several others, he was embarrassed by the size of the errors they made.

Governor Mitchell did not accept that releasing more quantitative information would help the public understand what they did. Then he described the problem. “The basic problem—that such records would not articulate the Committee’s theory about the manner in which monetary policy worked—was a consequence of the fact that the Committee as a whole did not have such a theory, although individual members might” (FOMC Minutes, December 18, 1973, 15–16).

No one responded to Mitchell. The Committee voted nine to two (Hayes not voting) to publish quantitative information on all of the short-run targets. Daane and Mayo dissented. None of the long-term targets would be published.
³¹

The FOMC reopened discussion of publishing long-term targets the
following April. A study prepared by Gary Gillum of the Philadelphia bank said that the choice of long-run targets constituted a policy decision and, therefore, they had to be published by law. The memo also answered the criticism that publication of six-month targets after three months could disrupt markets by giving speculators information about future actions. Gillum argued correctly that better information would improve market efficiency (memo, “The Place of Long-Run Targets in the Policy Record,” Board Records, April 9, 1974).

31. The staff issued its “First Report on Lagged Accounting” on August 13, 1973. It would return to the topic several times in the next decade. The conclusion of all the reports was similar. “If reserve aggregates are used the contribution of lagged reserve accounting is, if anything, negative” (First Report, Federal Reserve Bank of New York, Box 110282, August 13, 1973, 1). The staff did not agree on the magnitude or whether there was a long-run
effect. But they did agree that it significantly reduced their ability to manage a total reserve or RPD target between meetings and that it increased short-run interest rate variability.

Beset by problems arising from the Watergate break-in, President Nixon was more concerned than ever with the political. He reappointed Burns for a second four-year term as chairman but gave little attention to monetary policy. Burns, for his part, devoted much time and attention to preventing Congress from passing Congressman Patman’s bill calling for a regular audit of the Federal Reserve by the General Accounting Office (now known as the Government Accountability Office). The audit called for examination of administrative and financial transactions, including open market purchases and sales.

Burns’s efforts to defend independence from audit contrasts with his willingness to respond to congressional and administration pressures to inflate. The Federal Reserve called on banks, current and former reserve bank directors, and other allies to lobby members of Congress. Burns was willing to have an audit of administrative operations. The Senate did not act, and the issue was put aside, not without much resentment from the proponents about the intense lobbying (Wells, 1994, 130).

In 1975, Congressman Patman tried again to restrict Federal Reserve independence by reviving his proposal to require the Federal Reserve’s budget to become subject to congressional appropriations. In practice, the Federal Reserve banks received the earnings on the government debt in their portfolios. The Board assessed the reserve banks semiannually to pay its expenses. The rest of the banks’ income returned to the Treasury. The proposed legislation would have ended that system.

The legislation also set a ceiling on Board and bank spending, required Senate confirmation of bank presidents, and required the president to include representation of labor and consumer interests when choosing members of the Board. In his testimony against the legislation, Burns explained that independence was critical for successful monetary policy but could not be absolute. “The System is duty-bound to implement the will of Congress expressed in legislation” (Burns’s testimony on S.2285,
Box 35607, Federal Reserve Bank of New York, October 20, 1975, 4). The legislation did not pass.

Henry Reuss replaced Wright Patman as chairman of House Banking after the 1974 election. He introduced a bill requiring the Federal Reserve to maintain at least 6 percent money growth. This was the start of legislation that became the Humphrey-Hawkins legislation requiring the Federal Reserve to announce targets for monetary aggregates twice a year. Reuss’s bill also called for credit allocation. Burns was highly critical. It lost in committee on a twenty-to-nineteen vote.

Policy
Actions

In August 1973, the price of a barrel of crude oil increased from $3.56 to $4.31. The price rose again in January 1974, this time to $10.11. As soon as oil price increases began, the Boston bank requested a lower discount rate. Between October 1 and year-end, Boston requested a 0.25 reduction to 7.25 percent five times. The Board rejected each of the requests without dissent. Its reasoning is unclear. At the time the federal funds rate remained between 9.5 and 10 percent.

Burns’s analysis recognized that a supply shock called for a different response than a reduction in demand. He did not recognize, or at least mention, that the price change was a change in relative prices, not an increase in the maintained rate of inflation; implicit in his analysis, however, was recognition that the main effect was on the level of output.

Table 7.3 shows what happened after the oil shock and the policy decision. The federal funds rate declined moderately, as Burns proposed, but growth of the monetary base declined, tightening policy and adding the effects of monetary restriction.

The Standard & Poor’s (S&P) index shows the public reaction to the oil shock, the 15 percent decline in industrial production, the rise in prices and expected inflation, and monetary contraction. The stock price index declined 40 percent, wiping out nominal gains since 1963. It did not again reach the January 1973 nominal value until 1980. The Society of Professional Forecasters raised its four-quarter inflation forecast by 3.6 percentage points, much less than the increase in the deflator or growth in money wages. Real wages fell as part of the permanent adjustment to the supply shock.

Most of the FOMC members praised Burns’s analysis.
³²
With Hayes dissenting, they voted for a short-run funds rate of 8.75 to 10 percent and
M
₁
growth of 3 to 6 percent. They committed to “foster financial conditions conducive to resisting inflationary pressures, cushioning the effects on production and employment growing out of the oil shortage, and maintaining equilibrium in the country’s balance of payments” (FOMC Minutes, December 17–18, 1973, 105). This was an error. The oil price rise transferred wealth to the oil producers. It forced a reduction in real wages and profits that the Federal Reserve could not prevent.

32. The administration also analyzed the oil price increase as a supply shock. Secretary Shultz told the international energy conference in February 1974 that the problem was not monetary or financial and could not be offset by financial actions. He urged continued or
increased aid to the poorest countries and the development of arrangements to recycle the increased revenues of the oil-exporting countries.