A History of the Federal Reserve, Volume 2 (36 page)

The difference between statements and actions is great at this time. The funds rate followed the Committee decision, but the economy did not. Several members made excellent statements about what should be done. Bruce MacLaury (Minneapolis) “anticipated major sectoral
[sic]
dislocations, great uncertainty, and a sharp reduction in consumer demands. While he expected more inflation than the staff did, much of the increase would be a one-time adjustment to higher cost energy. . . . [H]e thought that monetary policy should not do very much about a one-time price adjustment and that it probably could not do very much about cost-push inflation” (FOMC Minutes, December 17–18, 1973, 79–80). John Balles (San Francisco) also recognized that the price increase “stemmed from supply shortages, of which oil was the most spectacular instance. . . . [T]he System had no choice but to validate price increases that stemmed from supply shortages, because a failure to do so would probably result in unacceptable declines in production, income, and employment” (ibid., 84). President Coldwell (Dallas), who described the boom in his region, wanted faster money growth.

That did not happen. Money growth slowed over the next six months. The immediate response was faster growth in RPDs and money in part because the desk purchased securities sold by foreign central banks.
On January 11, the FOMC voted not to adhere to its money target but to maintain money market conditions. By March 1974, it began to raise the federal funds rate to slow money growth. Despite declining output, the federal funds rate rose from an average of 8.97 in February to 12.92 in July. Twelve-month average money base growth remained between 7.2 and 8.1 percent. Table 7.4 compares the monthly average federal funds rate to the twelve-month moving average of the monetary base growth in the first half of 1974. The two measures again gave different indications of policy. Reported inflation continued to rise.

The FOMC minutes for the first half of 1974 show the committee struggling with the one-time effects of the oil shock, concern for recession, and a desire to slow inflation. A typical statement by Arthur Burns during the winter recognized that “the economy was suffering from a shortage of oil and other materials rather than a shortage of money” (FOMC Minutes, January 22, 1974, 109). Then he urged an increase in money growth or made some other statement about ease.
³³
In Table 7.4, movements of the federal funds rate give a correct picture of desired policy action. On a few occasions in February and March, the FOMC had to decide whether to raise the funds rate to slow money growth. Burns recommended holding the funds rate, citing the fragility of financial markets.

Hayes and Francis dissented at the January meeting because they opposed a tilt toward ease. In February, the FOMC raised the short-term M
₁
target from 3–6 percent to 6.5–9.5 percent. Four members dissented. Bucher, Morris, and Sheehan wanted a wider range for M
₁
growth and a lower federal funds rate. Francis wanted slower money growth. Actual money growth exceeded the target. This was one of the occasions when
the FOMC accepted the chairman’s proposal to let money growth exceed the target range.
³⁴
But just before the February FOMC meeting, the Board unanimously disapproved a 0.25 reduction in the discount rate to 7.25 percent. The principal reason was that the slowdown arose from the supply side. The discount rate remained far below the funds rate, so borrowing banks received a considerable subsidy.

33. Stein described the administration’s position as seeking a $5 to $10 billion reduction in spending. The recession prevented efforts to reduce the budget deficit. “We could never have any dispute with the Federal Reserve about how restrictive monetary policy was going to be because they never described their future policy in terms that enabled us to criticize it” (Hargrove and Morley, 1984, 403). The Council favored decontrol of oil prices, but Congress voted controls. “Failure to deregulate [was] one of the great mistake
s” (ibid., 403).

Rhetoric of the period included many unconditional statements about controlling inflation. At times, Burns warned the FOMC about moving to a Latin American inflation. Practice differed, as in February. Concerns about unemployment continued to dominate concerns about inflation and to receive first priority. Challenged to explain the very expansive policy in 1972, Burns asked: “What would you have wanted the Federal Reserve to do in a year like 1972, when the year started out with an unemployment rate of 6 percent and didn’t go below 5.5 percent until November?” (quoted in Pierce, 1979b, 492).
³⁵

With rising inflation, criticism of monetary policy increased. In September 1973, Senator Proxmire sent Burns a letter criticizing monetary policy for erratic growth of money and too high an average rate. Burns wrote a twenty-eight-page reply, the main points of which included his views on the economy and economic policy. The economy “is inherently unstable” (Burns papers, Box B_B81, Money Supply, November 6, 1973, 6). A market economy, left alone, generates “imbalances” and fluctuations. “Flexible fiscal and monetary policies, therefore, are often needed to cope with undesirable economic developments” (ibid., 7).
³⁶
To be effective, policy actions had to be discretionary. One of the reasons he gave was that “when the economy is experiencing severe cost-push inflation, a monetary growth rate that is relatively high by a historical yardstick may have to be tolerated for a time” (ibid., 11). The reason he gave was that high money growth avoided some “adverse effects on production and employment”
(ibid., 12).
³⁷
He did not mention that the Federal Reserve could not restore the loss of income or wealth.

34. On March 18, the Arab oil embargo ended. The staff expected little effect.

35. Otmar Issing (2005, 329–30), chief economist at the Bundesbank, compared Germany’s less inflationary experience. He gives credit to the use of targets for money growth beginning December 1974. Monetary control contributed directlyto control of inflation. Also, it informed price and wage setters that their excessive demands would lead to excess supply and unemployment. VonHagen (1999, 414–19) described the start of this policy. It continued through the 1970s and beyond. Between 1972 and 1979, consumer prices in West Germany rose 27 percent, half the rate in the United States (55 percent) (Council of Economic Advisers, 1983, 286).

36. This is a Keynesian perspective. The monetarist view was opposite. If government policy, especially monetary policy, is stabilizing and predictable, market forces restore or maintain economic stability. The Federal Reserve temporarily adopted the monetarist view in the 1980s.

Consistency was not Burns’s strength. In March, Burns told the FOMC that “he was much impressed by the size of the Federal deficit in the five fiscal years 1970 through 1974 . . . While the Federal Reserve always would accommodate the Treasury up to a point, the charge could be made—and was being made—that the System had accommodated the Treasury to an excessive degree. Although he was not a monetarist, he found a basic and inescapable truth in the monetarist position that inflation could not have persisted over a long period of time without a highly accommodative monetary policy” (FOMC Minutes, March 9, 1974, 111–12).

Burns’s conclusion that the problem was failure to control money growth soon had an effect.
³⁸
In April, the System began to raise interest rates. To bring money growth within its target range, the FOMC agreed to an intermeeting increase in the funds rate to 10.25 percent. The Board approved a 0.5 increase in the discount rate to 8 percent on April 25. The FOMC set its target rate for money growth at 3 to 7 percent with the funds rate between 9.75 and 10.75.
³⁹
Soon afterward, the members approved Burns’s proposal to raise the funds rate to 11 percent. Governor Bucher dissented. The Nixon administration had now changed its policy and would oppose a tax cut.
⁴⁰

Preliminary data for first quarter 1974 showed a 6.3 percent annual rate
of decline in real GNP and an 11.5 percent rise in the GNP deflator. Using this measure of inflation, the real federal funds rate was zero or negative. To slow the growth of RPDs, the FOMC made an inter-meeting increase of 0.25 in the funds rate. By late May, the rate was 11.75 percent.

37. Burns ended the letter by discussing monetary policy in 1972–73. He accepted that “in retrospect, it may well be that monetary policy should have been a little less expansive in

1972. But a markedly more restrictive policy would have led to a still sharper rise in interest rates and risked a premature ending of the business expansion without limiting to any significant degree this year’s upsurge of the price level” (Burns papers, Box B_B81, November 6,

1973, 25). Burns, like Eccles in the 1930s, blamed the lack of Federal Reserve control of nonmember banks for poor control of money. He also asked for better control of government spending. Although Burns discussed variability of velocity as a problem, he did not mention any of the proposals to permit NOW accounts nationally or pay interest on demand deposits. These were under discussion within the System at the time (“Selected Options for Implementing Interest Payments on Deposits,” Federal Reserve Bank of New York, Box 240, 10, January 18, 1974).

38. Burns explained that central banks had to control inflation “because weak governments could not cope with the problem” (FOMC Minutes, March 9, 1974, 139).

39. The FOMC approved the manager’s proposal to submit non-competitive bids at Treasury bill auctions. Previously, the desk had submitted competitive bids at the auction to replace bills in the open market account and on behalf of the Treasury and foreign central banks. Growth in foreign and System holdings since 1970 increased the System’s bid from about 30 to more than 50 percent of the offering. The manager’s main concern was that the desk would not get all the bills it wanted at its competitive bid. The non-competitive bid guaranteed their share at the average auctions price. The FOMC agreed (memo, Alan Holmes to FOMC, Board Records, March 15 and April 8, 1974).

40. At the April meeting, Burns told the FOMC that the administration’s position at the beginning of the year was that a recession must be prevented and that whatever needed to be done would be done (FOMC Minutes, April 16, 1
974, 85).

The FOMC did not permit banking problems to interfere with its efforts to slow money growth. Early in May, the Franklin National Bank (New York) told the Comptroller of the Currency and the Federal Reserve that the bank had extensive losses in the foreign exchange market. The Federal Reserve lent $1.723 billion through the discount window to prevent the bank from failing, and the New York reserve bank took over management of the bank’s exchange portfolio. The loans served only to delay the failure until October, when the regulators merged Franklin with another bank. The Federal Deposit Insurance Corporation assumed Franklin’s debt to the Federal Reserve. The Board cited fear of financial collapse as the reason for sustaining the bank. This showed a misunderstanding of its role as lender of last resort, and it encouraged risky behavior. The proper Bagehotian response would have allowed Franklin National to fail while lending to support the financial system. Failure did not require the bank to close. It required that stockholders and management bear the loss. In fact, the bank’s branches remained as part of the European American Bank.

Negotiations leading to the Federal Reserve loan in May were complicated by concerns that an Italian businessman, Michele Sindona, had a major interest. Hayes and his staff wanted Sindona to provide $40 million of additional equity. Sindona agreed to $30 million at the time and $20 million to be paid later.

Before Franklin failed in October, the New York bank encouraged the Treasury’s Exchange Stabilization Fund to take over Franklin’s foreign exchange portfolio. The Treasury did not agree. The Franklin case went to court where a judge agreed to declare Franklin insolvent. The European American Bank (EAB) acquired most of Franklin’s productive assets in May 1976, in part to cancel a debt and the rest for cash (Franklin National Bank, Box 741A, Federal Reserve Bank of New York, October 25, 1974). European American also assumed deposit liabilities.
⁴¹

Contrast the German resolution. In June, the Bundesbank learned the Herstatt Bank was in a position similar to Franklin National. The bank failed. There was a scramble for liquidity, and interest rates rose. The
Bundesbank and other European central banks prevented any additional failures but allowed Herstatt to fail and liquidate.

41. The loan to Franklin paid an interest rate of 7.52 percent, below the 8.5 percent earned on the System portfolio. At liquidation, the FDIC paid the Federal Reserve the nearly one percentage point of additional interest. The FDIC collected the principal and interest on assets that EAB did not acquire. One result of the Franklin and Herstatt failures was creation of an international Committee on Banking Regulations in Basel (Borio and
Toniolo, 2006, 21).