A History of the Federal Reserve, Volume 2 (42 page)

The subcommittee opined that adopting an NBR target gained little if the FOMC continued to seek control of money for a two-month period. It proposed to abandon the NBR target.

President Balles (San Francisco) drew a more appropriate conclusion. The committee should seek balance between short-run interest rate stability and keeping monetary aggregates within a twelve-month growth range chosen once a quarter. He wanted to let interest rates fluctuate more than in the past to improve control of money growth and inflation (ibid., tape 3, 16–18).

The subcommittee report and subsequent discussion again failed to get the FOMC to look ahead far enough to control money growth and inflation. Even after it gave up tight control of the funds rate in 1979–82, it did not act on the information learned from the Partee committee study or on Balles’s conclusion. The focus remained on the short-term. Another missed opportunity!

President Carter’s first budget director was a Georgia banker, Bert Lance. Lance was a fiscal conservative who opposed the proposed 1977 stimulus package. An alleged scandal about his banking practices before he joined the administration forced him to resign in summer 1977.
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He was exonerated later. President Carter (1982, 12) believed that Lance knew less about economics than other advisers but was better able to deliver information because of their long relationship.

Other members of the economic advisory group were Treasury Secretary Michael Blumenthal, a businessman; Stuart Eizenstat, a Georgia lawyer who served as Chief Domestic Policy Adviser; and Council chairman Charles Schultze. These four became part of the Economic Policy Group (EPG). Carter added others to the group, so it became unwieldy and ineffective. He blamed Blumenthal for its ineffectiveness. This contributed to his decision in 1979 to replace Blumenthal as treasury secretary with
G. William Miller (Carter, 1982, 19–22). One part of his concern was the inability to get a uniform recommendation. He often had to decide between alternatives. For this, too, Carter blamed Blumenthal’s lack of leadership. He thought the EPG was ineffective under Blumenthal, but it improved when Miller became treasury secretary (Carter, 1982, 19–22). Miller liked the change to Treasury and did an effective job of managing the financial transaction that released the hostages held by Iran.

77. At the Shadow Committee meeting in March 1977, Beryl Sprinkel and I expressed concern about the end of the disinflation policy. Sprinkel, a bank officer, knew Lance and arranged a meeting with him in May 1977. The argument that got Lance’s attention was that a stimulus policy in 1977 would likely require an anti-inflation policy that would increase unemployment in 1979–80, when President Carter would run for reelection. Lance asked us to stay in touch and come back, but he left soon after.

Before the inauguration, the economists responsible for international economic policy expressed concern about the effect of the stimulus package and a larger fiscal deficit on net national saving and the exchange rate. Shortly after the inauguration, the new president sent Vice-President Walter Mondale and some economists to talk to the principal countries with payments surpluses—West Germany and Japan—about coordinating policies. The main idea was that if all three expanded spending, relative positions would remain about the same and the dollar would not devalue.

All three countries had excessive unemployment. The response by Japan was cautious but generally positive (Biven, 2002, 103). The response in Germany was negative. Chancellor Helmut Schmidt pointed out that although exchange rates might remain stable, worldwide inflation would be the “inevitable result” (ibid., 99; Volcker and Gyohten, 1992, 145–48).
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Nevertheless, Germany’s efforts to reduce its budget deficit stopped in 1977–78, and the Bundesbank allowed money growth to exceed its preannounced targets. But the German official position remained opposed to greater policy coordination with the United States. It attributed the “high current account deficits in the United States . . . not to any low level of demand, but to massive public sector debt as well as to the consequent low level of savings in the country” (Kitterer, 1999, 199).

President Carter’s personal style influenced policymaking also. He thought it was his responsibility to be fully informed about details of all policy positions, so that he did not require the assistance of an aide (Carter, 1982, 17). He recognized also that he sent too many recommendations to Congress at one time (ibid., 23). And he felt very much the outsider in Washington and believed that leaders of Congress had not campaigned for him. As a “southerner, born-again Christian, a Baptist, and newcomer,” he believed he had no obligation to major lobbying groups and former Democratic leaders (ibid., 6–7). He described his economic aims as a balanced budget, lower inflation, and deregulation of trucking, airlines, communi
cation, banking, finance, and oil and gas prices (ibid., 45). These aims did not please many congressional Democrats (ibid., 66). And he blamed his failures also on the oil price shock.

78. Schmidt asked for the estimated effect of the stimulus package on inflation in the United States. “When [Fred] Bergsten replied it was expected to raise the inflation rate by only 0.3 percent Schmidt is reported to have been ‘incredulous’” (Biven, 2002,
99).

FEDERAL RESERVE ACTIONS, 1977–78

The election removed a government that gave much attention to reducing inflation and brought in a government that gave priority to reducing unemployment. See Table 7.10 and Charts 7.1 and 7.7 above.

Actual and expected inflation rose. The unemployment rate remained unchanged. The 1979 oil price increase was a one-time increase that overstates the underlying inflation rate. The Federal Reserve responded by increasing the federal funds rate. By December 1978, federal funds adjusted for expected inflation exerted disinflationary pressure.

At the start of the period, several reserve banks requested discount rate reductions. The Board rejected six requests in December 1976 and three in January 1977. It pointed to evidence of a strengthening economy.

Early in December 1978, President Carter announced that he chose a businessman, G. William Miller, to replace Arthur Burns as chairman of the Federal Reserve. Burns, who had done much to sustain and increase the Great Inflation, was replaced in part because he was considered too much an anti-inflationist. Schultze also complained that Burns was more than willing to comment on administration policy at Quadriad meetings with the president but unwilling to tell the president what the Federal Reserve would do (Schultze, 2005). Schultze wanted more policy coordination; Burns guarded Federal Reserve, and his own, independence as a principle he insisted upon despite often yielding to administration pressure. This created an unsatisfactory outcome. He did not control inflation and did not gain the trust and confidence of the Carter team. Most of all, Carter did not get along well with Burns, as he later said.

Table 7.11 shows planned and actual federal funds and short-term money growth targets during the rest of Burns’s term as chairman. The minutes give M
₁
growth and the funds rate as ranges, usually one-half percentage point for the funds rate and four to six percentage points for M 1 growth.

As before, the manager always came close to the federal funds target, although usually modestly below. The manager and the FOMC did not respond forcefully to the much wider discrepancies between actual and planned money growth. Particularly in April, July, and October, money growth was highly inflationary. Reactions remained mild.
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79. The New York bank staff compared the use of the federal funds rate and nonborrowed reserves as operating targets. The main conclusions were that (1) either could be used to
control monetary aggregates, (2) neither target was better than the other, (3) the federal funds rate target permitted greater money market stability, and (4) market interest rates would be more variable, if nonborrowed reserves became the principal target. The memo questioned whether money market stability was advantageous (Richard Davis to Paul Volcker, Federal Reserve Bank of New York, Archives Box 110282, August 15, 1977). The memo does not say how the comparison was made, but it does not suggest that the variability of interest rates under a nonborrowed reserve target and interest rate targeting achieved the same monetary growth. A reserve target required an increase in interest rate volatility compared to past practice. The memo shows also that Volcker had considered some of the issues that arose in 1979–82 years before he changed procedures. The memo does not discuss the effects on the maintained rate of money growth or how to lower inflation.

In 1977, the Board also approved two increases in the discount rate; one on August 29 raised the rate to 5.75 percent; the other on October 25 set a 6 percent rate.
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On January 6, 1978, the Board approved a 6.5 percent discount rate. The rise in interest rates shown in Table 7.11 suggests, and the Board’s announcement stated, that the adjustments recognized market actions that had occurred previously. Beginning in May, the Board rejected discount rate increases ten times before the August increase and three additional requests before the October increase.

The reserve banks were ahead of the Board in seeking to slow inflation. As the Board noted: “In proposing those increases the directors of the Federal Reserve Banks in question stressed the outlook for rising prices and the
desirability of providing a signal of the System’s determination to continue pursuing an anti-inflationary monetary policy” (Annual Report, 1977, 142). The Board expressed concern that an increase in the discount rate would be “misconstrued as an indication of a major shift in monetary policy” (ibid.). The underlying reason was that despite an average increase of consumer prices of more than 6.5 percent (annual rate) per month between May and August, the unemployment rate remained between 6.9 and 7.2 percent. Despite his anti-inflationary rhetoric, Burns again failed to respond effectively to inflation. In the meetings, he often proposed less expansive policies, but he did not fight for them. The FOMC responded weakly to monthly money growth rates as high as 18 percent annual rate. Burns was not alone. Dissents from FOMC decisions remained rare in this period. John Balles (San Francisco) expressed concern in January about rapid growth of M
₂
, but did not follow through. Phillip Coldwell dissented in June because he wanted a 0.25 percentage point reduction in the lower bound on the funds rate. Coldwell dissented again in July, joined by Jackson and Roos (St. Louis). Each favored a less expansive policy. But Governors Lilly and Wallich dissented in September because they believed monetary policy was too restrictive. At the time, growth of M
₁
for the year ending in third quarter 1977 “had exceeded by a considerable margin the upper limit of the range set at its meeting in early November 1976” (ibid., 292). However, at the same meeting Frank Morris (Boston) and Larry Roos (St. Louis) dissented for the opposite reason. They regarded as inadequate the policy response to the money growth rates reported at recent meetings. Morris and Wallich also dissented in October, one again favoring faster money growth, the other slower. Roos dissented again in December, and Lilly, Morris, and Partee dissented in early January from a decision to raise the upper limit on the funds rate by 0.25 to 7 percent principally to strengthen the dollar.

80. Governor Wallich dissented from the August increase because of “hesitation in some key indicators of economic activity and the associated uncertainty about the duration of the economic expansion” (Annual Report, 1977, 150).

At the May 1977 meeting, the FOMC began to increase the federal funds rate. The average rose to 5.4 in May from 4.7 percent in April. At the time, both the twelve-month-average consumer price increase and average rate of monetary base growth were 6.5 percent. Expected inflation increased to 6.5 percent. M 1 growth from May to July averaged about 4 percent using the revised definition of M 1 that included NOW accounts and other transaction balances.

Burns urged a reduction in the M
₁
target to 0 to 4 percent with federal funds at a 5.5 percent midpoint. Volcker and Wallich proposed −1 to 4 percent, but Burns did not want a negative number. Six members wanted the lower bound on the funds rate at 5 percent; four wanted the upper bound at 6 percent. By unanimous decision the FOMC accepted 5.25 to 5.75, Burns’s midpoint and also his range for M
₁
growth.

The narrow range and unanimous vote understate the division within the Committee. Willes (Minneapolis) said that businessmen needed continued evidence of he System’s willingness to combat inflation. He wanted “a significant step toward moderation in the rates of growth in the aggregates” (Burns papers, FOMC, May 17, 1977, tape 3, 16). Partee responded, opposing the degree of monetary “tightness” that Willes called for. “We also have the objective of maintaining reasonable growth . . . [W]e’re talking about a growth rate of around six percent or perhaps a shade below which we need unless we’re to accept this unemployment rate as a permanent thing” (ibid., tape 3, 11–20).

Partee noted that the Committee had tightened in the spring of 1975 and again in 1976 but reversed policy soon after. He believed they did no harm. Earlier, Partee mentioned a congressional response, a topic that rarely became explicit. “What would be a Congressional response to a higher unemployment rate?” Burns cut off the discussion (ibid., tape 2, 11–12). Others mentioned the effects on wages, prices, and interest rates from an increase in expected inflation, a sign that FOMC members started to give attention to anticipations of inflation in the private sector. Guffey mentioned speculation in farm real estate, a major problem for the farm sector after 1979.

The modest move to a higher federal funds rate at first had no effect on longer-term rates. By October the ten-year rate began to rise, in anticipation of rising inflation. By year-end, it increased forty basis points, from 7.4 to 7.8 percent. It continued to rise in 1978 to 8.7 percent in July 1978. By that time twelve-month CPI inflation was 7.5 percent and rising.

The FOMC never discussed and never decided how much unemployment they would accept to reduce the inflation rate. They had different objectives and rarely expressed a clear view.
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Their votes and discussion are the main clues to their beliefs. For example, Burns talked often about the objective of price stability or reduced inflation, but he recognized and perhaps overemphasized the political constraints. In January 1977, he urged the members to “consider the degree to which, if any, our monetary policy should contribute to unwinding the inflation fr
om which our economy has been suffering since the mid-1960s. . . . [N]o other branch
of government . . . has anything approaching an articulate policy for bringing down the rate of
inflation” (ibid., January 17–18, tape 7, 1). Then he expressed concern about the unemployment rate, the new administration, the new Congress, and the possible interpretation of an anti-inflation action as an effort to frustrate the efforts to expand employment. That covered all the possibilities. He proposed leaving the annual target for M
₁
growth unchanged at 4.5 to 6.5 to limit that criticism, but he proposed lowering the bottom of the M
₂
and M
₃
ranges by 0.5 percentage points. Morris (Boston) argued that the proposal lacked substance, suggesting it was mainly cosmetic.

81. One of the rare exceptions was a brief discussion in February 1977. Morris (Boston) said that “there is a need for the Committee to make policy in a longer term time frame than we’ve been accustomed to in the past. I thought I would ask if the staff has a concept of what the optimum growth path ought to be for the economy over the next few years” (Burns papers, FOMC, February 15, 1977, tape 1, 10). A brief discussion followed, but action did not change.