A History of the Federal Reserve, Volume 2 (47 page)

The November increase in interest rates was part of a coordinated policy action to strengthen the dollar. After reaching a local peak at 107 in June 1976, the trade-weighted average value of the dollar declined gradually for a year. It then fell from 103.8 to 86 between September 1977 and October 1978. During the same period, it declined almost 10 percent against the mark. Responding to domestic and foreign concerns, the administration and the Federal Reserve took steps to strengthen the dollar by raising the discount rate and the federal funds rate.
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The percentage point increase in the discount rate was the largest increase in forty-five years. International concerns got the Federal Reserve to respond to inflation in a way that domestic factors did not.

The November increase in the discount rate was the seventh increase that year. The discount rate rose from 6 percent to 9.5 percent. Expected inflation remained between 7 and 8 percent. Most of the increases followed the market. A 0.5 percentage point increase on August 18 was an exception; the increase was a policy move to strengthen the dollar and reduce inflation.

Several governors dissented in 1978. In January, Governors Partee and Lilly thought higher rates threatened the recovery, so the vote was four to two with one absentee. On April 24, Governors Wallich and Jackson dissented from a decision to disapprove a 0.25 increase. They favored the August and November increases to strengthen the dollar.

With prices rising more than 9 percent, Vice-Chairman Gardner and Governor Teeters dissented from the October 13 decision to increase the discount rate by 0.5 to 8.5 percent at eleven banks. They claimed monetary restraint was sufficient.

The FOMC and the Board staff at the time blamed the increase in
inflation on individual price increases. For example, at the April meeting,
the record cites “reduced supplies of meats and increases in payroll taxes and in minimum wages” for the rise in inflation during the first quarter (Annual Report, 1978, 157). Or, “expectations of a high rate of inflation seemed to be growing and, as a result, actions of businessmen and consumers might tend to make their expectations self-fulfilling” (ibid., 162). Later in the same meeting, the record refers to money growth. “Since the fourth quarter of 1976 the rate of growth of M
₁
had exceeded the 6.5 percent upper limit of the longer-run range in every quarter except the one just ended” (ibid., 163). Subsequently in May, “committee members were deeply concerned about the recent acceleration of inflation and about prospects for prices” (ibid., 175). They voted for a 0.5 increase in the funds rate “to moderate growth of the monetary aggregates” (ibid., 177). One member recognized the monetarist complaint. “If further significant actions were not taken in the present circumstances, current monetary policy might be found in retrospect to have been procyclical” (ibid., 177).

106. On June 27, Vice President Walter Mondale sent a memo recommending appointment of Nancy Teeters as the first female Board member. The memo reported that the screening committee had considered nearly 100 women. The president asked to interview Teeters. He appointed her on August 28, and she took the oath on September 18. She completed Arthur Burns’s remaining term (to 1984).

107. The international section of this chapter discusses the November program to strengthen the dollar.

Mark Willes (Minneapolis) dissented, as he did at most meetings that year. “He favored more vigorous measures to reduce the rate of monetary growth” (ibid., 180). For this and other dissents and his remarks at the meeting, he was warned to be more flexible.
¹⁰⁸

Some members of FOMC questioned the role of the short-term (twomonth) targets for money growth. Credibility had been shredded by failure to achieve the targets. The members agreed that the manager could not be expected regularly to achieve two-month growth rates in M
₁
and M
₂
within the specified ranges for various reasons—“including the lag between changes in the federal funds rate and changes in these growth rates and the brevity of the period to which the operational paragraphs of any single directive applied. . . . The purpose of the 2-month ranges was to provide the manager with an indicator for determining when changes in the funds rate were appropriate” (Annual Report, 1978, 189). The committee dropped the statement that “the committee ‘expects’ the 2-month growth rates to be within the indicated ranges” (ibid., 189). However, the members affirmed that they intended to hold money growth within the one-year targets. They failed to do so in many years and, as noted, did not adjust the following year’s projected growth rates for the excess or deficiency in the previous year.
¹⁰⁹

108. “The first time I started speaking out in meetings, one of the very senior staff people on the Board . . . took me aside and said, ‘you need to understand the way this works. You’re going to be more effective if you say your piece, but then kind of go along. . . . ‘And I just said, . . . ‘I’m going to say what I think is right’” (Willes, 1992, 4).

109. Pierce (1978) and Weintraub (1978) found that short-run targets had no effect. The FOMC changed its directive at this (June) meeting. It now read: “If, giving approximately
equal weight to M 1 and M 2 , their rates of growth appear to be significantly above or below the midpoints of the indicated ranges, the objective for the funds rate shall be raised or lowered in an orderly fashion within its range” (Annual Report, 1978, 191). Clearly, the FOMC recognized the source of its problem. Their failure was unwillingness to act forcefully.

New regulations permitted owners to transfer funds from saving to deposit accounts, the automatic transfer service (ATS). Growth of M 1 became more uncertain. The staff gave estimates of M 1 adjusted and unadjusted for ATS, but they had no record on which to base the estimates. Axilrod explained that both measures of M
₁
conveyed useful information about short-run GDP changes. Partee pointed out that the Committee on the Directive found it difficult to relate near-term M
₁
growth to longer-term (annual) M 1 growth rates (ibid., 26–29).
¹¹⁰

Chart 7.14 shows that the CD (certificate of deposit) rate was above 10 percent when the ATS ruling occurred. Regulation Q ceilings for ninety days to one year held the rate to 5.75 percent. The maximum ceiling rate, 8 percent, required a deposit of seven years or more. Banks and financial institutions offered unr
egulated higher rates on so-called money market accounts and purchased CDs to pay the higher rates. A financial institution could buy an unregulated CD of $100,000 or more and sell small money market accounts that permitted the purchaser to share in the rate on the large CD less a fee to the institution. The accounts were not insured by the
federal government, but the default risk was small. Although it took about a decade for the change to occur, money market accounts and inflation drove out regulation Q ceiling rates. Congress did not outlaw the accounts because consumers found them attractive.

110. At about this time, Congress amended Humphrey-Hawkins to require semiannual reports to Congress instead of quarterly.

To take account of these changes, the Board’s staff created a new measure of transaction balances originally called M
₁
B, that included as additions to M
₁
savings deposits at commercial banks, NOW accounts at nonbank thrift institutions, and demand deposits at mutual savings banks. Shifts between demand deposits and the new additions would not affect the aggregate. This was the first formal recognition of a problem that would hinder efforts to control money growth.
¹¹¹

The attempt to coordinate policies internationally failed to maintain exchange rates. Within a few months, rising inflation in the United States and ineffective policies led to a sharp depreciation of the dollar. Misled by nominal interest rates, the administration worried about “tight money.” A week after the October 17 meeting, the administration announced voluntary numerical standards for price and wage increases. The market responded unfavorably, believing the policy change weak and likely to be ineffective. The public had learned a main lesson about guideposts—they don’t control inflation. On October 31, the FOMC delegated authority to Chairman Miller to act in concert with the administration to strengthen the dollar and reduce inflation “if he determined that the arrangements with the U.S. Treasury and with certain foreign monetary authorities were substantially as contemplated” in the FOMC’s discussions (ibid., 238).

As noted earlier, the announcement on the morning of November 1 increased the discount rate by one percentage point to 9.5 percent, the largest increase since 1933, and imposed a supplemental reserve requirement of two percentage points on time deposits of $100,000 or more. Also, the swap lines with West Germany, Japan, and Switzerland increased by $7.6 billion (to $15 billion), and the United States agreed to “a program of forceful intervention in the exchange markets in coordination with foreign central banks to correct recent excessive movements in the exchange rate” (ibid., 239).
¹¹²
After these actions, the dollar reversed its October decline. Growth of the monetary aggregates declined in December. The manager’s instructions at the December 19 meeting let the funds rate decline from
10 percent to the lower limit, 9.75 percent. Chairman Miller proposed to leave the rate unchanged, and the FOMC agreed unanimously.
¹¹³
But the Board tabled discount rate requests from Chicago and Dallas because money growth had fallen. The decision to table came on a three-to-two vote; Partee and Teeters voted to reject the requests.

111. Nancy Teeters dissented from the modest increase in the funds rate out of concern for the effect of the many increases in interest rates since April (Annual Report, 1978, 238).

112. Treasury actions and background to the changes are below in the section on international monetary decisions. The dollar fell 1.6 percent against an average of G-10 countries between Friday and Monday, October 30 (before the monetary changes).

At the December FOMC meeting members made three significant observations. Henry Wallich noted the bias in inflation estimates later analyzed by Orphanides (2001). According to Wallich, “we also seem to have a built-in bias toward a low inflation forecast” (FOMC Minutes, December19, 1978, 11). He produced data showing the staff’s persistent underestimate. Mark Willes commented on the reason the FOMC had lost credibility. The public “don’t believe us when we say we are going to stick with it. They think at the least sign of trouble we are going to back off and I think that’s too bad” (ibid., 14). And President Roos asked whether the Committee set its economic objectives or its monetary objectives first. “Have we actually, in our practices, ever discussed or agreed upon what our ultimate economic objectives would be and then attempted to make our monetary policy decisions consistent with the achievement of these objectives?” (ibid., 55).

No one followed up. Each of the points was a starting point for studying why their policies failed to produce the outcomes they hoped for. The comments remained on the record, but so did the failure to respond.

In December 1978, the oil-producing countries again raised prices. Oil prices (West Texas spot) increased from $14.85 a barrel in December 1978 to $32.50 a year later and to $39.50 by April 1980. Monthly rate of increase in consumer prices in the United States rose (at annual rates) from

5.3 percent in December 1978 to 10.6 percent in January 1979. That ended any remaining chance that labor unions would reduce their demands to the 7 percent guideline proposed in the president’s October program. And it ended any prospect that Congress would approve selective tax reduction for groups that followed the administration’s guidelines.

Schultze proposed more policy coordination. In preparation for the December 14 Quadriad meeting, he proposed that the president tell Chairman Miller that the 1980 budget (submitted in January 1979) would be tight. Too much monetary restraint would work with spending restraint to cause a recession. It would then be “politically difficult . . . to persist with stringent budgetary policies” (memo, Schultze to the president, Schul
tze papers, Carter Library, December 13, 1978). His preliminary forecast called for 2 percent growth in 1979, increasing modestly in 1980 if inflation declined.

113. On November 19, 1978, Stephen S. Gardner, the Board’s vice-chairman, died. He served less than three years and had been ill and absent from many of the meetings in 1978. His death reduced the number of Board members to five. Phillip Jackson
resigned after 3.4 years of service on Nov
ember 17.

Within a few weeks, Schultze and Blumenthal decided that policy was too expansive. “At the turn of the year in 1978–79, Blumenthal and I carried on a leaked campaign in the press to try to pressure Miller into tightening up. The leaked stories told that administration officials think the Fed ought to tighten up—normally it’s the other way around . . . We got a very nasty note from the president at one time in effect saying lay off” (Hargrove and Morley, 1984, 485).
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Schultze saw the administration’s problem in 1979 as the “very difficult task of cooling off a stubborn 12 year old inflation without (i) a recession; (ii) mandatory controls, or (iii) dismantling our assistance to those who really need it” (memo on the president’s State of the Union speech, Schultze papers, Carter Library, January 17, 1979, 1). Then he explained why inflation persisted and why recessions and controls did not work. “No democratic nation can stick with such policies long enough to do the job. . . . Sharp recessions inevitably lead to renewed pressures for large-scale stimulus and there go the anti-inflation policies” (ibid., 1–2). There was no thought that presidential leadership could change these beliefs.

Schultze did not add the problems of forecasting accurately, a problem that plagued him during his term. Third quarter 1977 is an extreme example. The Council’s first forecast called for a 3.9 percent increase in real GNP. The Council revised the number several times. In the final report, real growth reached 7 percent. This was not the only error of this magnitude. The Reagan Council’s forecast for 1983 called for a modest recovery. Actual growth reached nearly 10 percent. These experiences, though worse than average, again raise the question: why did the Federal Reserve and the administration base policy heavily on short-term forecasts and neglect longer-term consequences?

Federal
Reserve
Action,
January
to
August
1979

Fischer (1984, 46) reproduced an index of public concern about inflation. After rising steadily from 1974, the index reached a peak in 1979, about 2.5 times its 1974 value. There is reason to question what the index mea
sured, but there is no reason to doubt that the public wanted lower inflation in 1979.

114. Schultze attributed Carter’s response to populism and the dislike of higher interest rates. Perhaps Carter’s behavior can also be explained by a concern for Federal Reserve independence. The only previous effort by an administration to get the Federal Reserve to raise interest rates was in 1922, when Secretary Andrew Mellon urged the Federal Reserve to stop bond purchases by individual reserve banks. At that time, Mellon was ex officio, a member of the Federal Reserve Board.