A History of the Federal Reserve, Volume 2 (48 page)

At the first 1979 meeting, on February 6, the staff projected output growth of 2.1 and 1.4 percent in 1979 and 1980 and inflation of 8.1 and 7.4 percent with 6.25 percent growth in M
₁
.
¹¹⁵
Expected productivity growth was 1 percent (FOMC Minutes, February 6, 1979, 5).

Divisions within the FOMC were never greater than in early 1979. Paul Volcker, Mark Willes (Minneapolis), and Henry Wallich urged more restrictive policy to reduce inflation. Nancy Teeters, Charles Partee, and Frank Morris (Boston) were most concerned about a possible recession. Votes were narrowly divided, and most often the decision was to keep the federal funds rate unchanged. See Table 7.11 above. Twelve-month monetary base growth slowed to the 6 to 7 percent range from 8 to 9 percent earlier.

It was at this time that Secretary Blumenthal, joined by Charles Schultze, criticized the Federal Reserve and asked for higher interest rates until the president told them to stop interfering with the Federal Reserve. Blumenthal’s action may have encouraged Chairman Miller to take the unprecedented step of announcing just before an FOMC meeting that there was no reason to raise the funds rate.

Discussions at the FOMC meetings bring out some of the reasons that differences continued. Mark Willes used a rational expectations argument to explain that “we can in fact have less inflation without more unemployment in 1980 if we have policies in 1979 that are . . . firmly held to so that people really believe we are going to follow through on them” (FOMC Minutes, February 6, 1979, 19). Henry Wallich reminded them of the persistent forecast errors. “The rate of inflation is always worse than we think it is” (ibid., 23). Wallich added that “real interest rates are barely positive and they’re negative after taxes” (ibid.).

Nancy Teeters’s statement is representative of those who emphasized the risk of recession. “I think the probabilities are on the side of a reces
sion, but I don’t see it occurring until the end of the year and the early part of next year” (ibid., 13). Paul Volcker also believed a recession was likely, but “the number one problem continues to be concern about the price level” (ibid., 10). Volcker also expressed concern about the dollar when the dollar was weak.

115. Procedures for setting longer-term money growth rates changed at this meeting. Instead of setting a growth rate each quarter for the next four quarters, the FOMC now set money growth for fourth to fourth quarter. In July, the FOMC gave Congress a preliminary estimate for 1980, and it could adjust the 1979 growth rate. Also, the staff proposed redefinition of the monetary aggregates to adjust for the changes in transaction accounts such as NOW accounts. The new M 1 included NOW balances, credit union share drafts, and demand deposits at thrift institutions. The additions increased M 1 by $4.8 billion, 1.36 percent. The staff removed $11.3 billion of demand deposits of foreign banks and official institutions, so the new M
₁
was smaller than the old. The staff also developed M 1 + to include saving balances at commercial banks ($221.6 billion), and it redefined M
₂
and M
₃
(Federal Reserve Bul
letin, January 1979, 17).

Henry Wallich complained about the changing base for the money targets. “We were essentially ratcheting [M
₁
] up by first going to the upper side of it and then by choosing a range that would make the upper side fall in the middle” (ibid., 29).

Chairman Miller often spoke first to give the FOMC what he called guidance. He did not think the monetary aggregates were reliable, especially when NOW accounts and automated transfers distorted the data. And he accepted the staff’s standard explanation that the large and frequent errors in hitting the money targets resulted from shifts in the demand for money. The possibility that the interest rate target was inconsistent with the money target was rarely acknowledged.
¹¹⁶

Miller was much more collegial than Burns or Martin. Although he was famous within the System for putting a “no smoking” sign on the Board table (which the others ignored), he consulted frequently between meetings and was much less inclined to act on his own initiative than Burns or Volcker.
¹¹⁷

The staff’s description of the economy’s position in March 1979 called inflation prospects “dismal and the Administration’s wage-price restraint program . . . in a great deal of difficulty” (ibid., March 20, 1979, Kichline appendix, 1).
¹¹⁸
Paul Volcker expressed most concern about inflation, although he repeated that “the odds are better than 50–50 that we’re going to run into a recession” (by year-end) (ibid., 9). He wanted to increase the funds rate, but a six-to-four majority voted to leave it unchanged. Wallich, Kimbrel (Atlanta), and Coldwell joined him. Frank Morris (Boston) asked
for a counter-cyclical policy move. He recognized that a preemptive move was “unprecedented,” so he proposed that the FOMC reduce the funds rate to 9.5 percent and “explain this unprecedented development of the Fed moving the funds rate down before we’re actually in a recession” (ibid., 30). Morris added that the money supply [growth] had remained unchanged for six months.

116. One of the rare occasions was the March 20, 1979, meeting. David Eastburn (Philadelphia) asked, “How much validity is there to the idea that what is happening to money is supply induced and not demand induced?” (FOMC Minutes, March 20, 1979, 7). Stephen Axilrod at first replied that by setting an interest rate, the manager relinquished control of money. He soon realized that his answer evaded the question, so he added, “whether it’s a demand or a supply phenomenon, it’s very difficult to dissociate the two” (ibid., 8). He might have added “under their procedures.” The staff continued to explain money growth errors as shifts in the demand for money.

117. He described his procedure. “My tendency is not to go off on these things [decisions] without first having a quick phone call so we can get everyone involved” (FOMC Minutes, conference call, July 19, 1978). This was Miller’s last meeting before moving to the Treasury.

118. This view was widely held. The General Accounting Office tried to decide whether guidelines were effective. It concluded that “we could find no convincing evidence that the standards have had any effect on the rate of inflation” (quoted in Biven, 2002, 195–96).

Morris’s proposal to act in anticipation of recession did not attract any followers. Fifteen years would pass before the FOMC in 1994 attempted to move counter-cyclically to prevent an increase in inflation.

Miller had to work to change a five-to-five vote to seven-to-three at the April 17 meeting.
¹¹⁹
Volcker, Coldwell, and Wallich wanted more restrictive policy than a short-term M
₁
range of 3 to 7 or 3 to 8 percent and a 10 percent federal funds rate. Teeters wanted less restraint, and Kimbrel (Atlanta) wanted a “money market” directive, not an “aggregate” directive. At the time that meant that the manager did not change the funds rate until projected two-months growth of the aggregates reached the upper or lower bound. Usually, the chairman held a telephone conference before deciding whether to make an inter-meeting change. On the other side, Mayo, Balles, Black, Partee, and Miller voted for the directive with mixed reasons also.

Miller then announced the number for March housing starts, a number well below the staff estimate. On a new vote the FOMC voted seven to three for a 4 to 8 percent growth for M 1 , 4 to 8.5 percent for M 2 , and a 10 percent funds rate with bounds at 9.75 and 10.5. M
₁
and M
₂
received equal weight when making decisions.

The reasons given for differences varied. Volcker’s main concern was the persistent underprediction of inflation. He believed the expected rate of inflation had increased, so a constant nominal interest rate implied a lower real rate, hence a more stimulative policy. Coldwell and Wallich agreed. Wallich wanted to raise the funds rate until the real rate became positive. Statements of this kind went unchallenged; none of the FOMC argued that interest rates were high, a significant improvement over the past.

The main reason for opposing more restrictive policy was fear of a recession. One of the more sophisticated arguments suggested that if a recession came, the System and the administration would be under pressure to take expansive actions, so inflation would rise in a year or two.

Months of slow money growth was one of the concerns at the April meeting. Ten days later, the FOMC held a telephone conference to respond to a 17.5 percent (annual rate) surge in M
₁
growth during April. The FOMC agreed without objection to move the funds rate target to 10.25 percent.

119. If the vote remained tied, the existing directive remained in effect.

The staff forecast a 10.3 percent rate of increase in the business product deflator (annual rate) in the second quarter. Excluding food and energy price increases that were mainly one-time price level changes (temporary inflation), not persistent inflation, the rate of increase would be 8.25 percent. Using the persistent inflation rate, or second-quarter 1979 expected rate of inflation from the survey, real ten-year Treasury yields were only slightly positive. Despite low real yields, Governor Partee and President Morris forecast a recession.

Volcker objected. “If we’re going to balance these risks of inflation and recession we have to run not too scared that the recession is going to be worse than we expect” (FOMC Minutes, May 22, 1979, 22). He proposed a wider range for monetary growth with a lower value for the acceptable minimum. Partee responded, “I come to exactly the opposite conclusion” (ibid.) He wanted to widen the range for the funds rate by allowing a decline from 10.25 percent. But he wanted to avoid weakness in the monetary aggregates, and he recognized that in the past, policy was procyclical at or near turning points. “To go to an interest rate target now at this turning point in the economy would be exactly the wrong prescription. . . . [W]e ought to have an aggregates target with modest growth. . . . not crunch the economy into . . . a very serious recession” (ibid., 23). His recommendation called for a 0.25 reduction in the funds rate (to 10 percent) and 1 to 5 percent M 1 growth for the next two months. At the opposite pole, Volcker wanted a 10.25 percent (unchanged) funds rate and the money (M
₁
) growth band from “a minus number up to 4.5 percent” (ibid., 28).
¹²⁰

Part of the FOMC had started to change. The rhetoric was more divided than the recommendations, as was often true. The main division was about objectives. Partee, Morris, Teeters, and their group believed that the Federal Reserve’s main responsibility was to prevent recession or reduce the unemployment rate. Reducing inflation was a subsidiary responsibility to be achieved without causing much unemployment. This had been tried without success at the end of the Johnson administration and in the early Nixon administration.

Volcker, Wallich, and Coldwell, to different degrees, put greater weight on reducing inflation and preventing dollar depreciation. They interpreted the Employment Act of 1946 as a mandate to maintain the purchasing power of money. They were willing to tolerate temporarily higher unem
ployment to reduce inflation. They would later add that low inflation reduced uncertainty, improved the quality of information in relative prices, and encouraged investment in long-term capital and productivity growth. Thus, low inflation encouraged economic growth and employment in the longer run.

120. The Senate Banking Committee considered repeal of the Credit Control Act of 1969. Schultze opposed repeal. Although he doubted that the administration would use the authority, he urged retention (letter, Charles Schultze to Senator William Proxmire, Schultze papers, Carter Library, May 22, 1979). Ten months later, the president invoked the act and requested the Federal Reserve to control credit.

Henry Wallich expressed the proposed change in strategy during a recession. “I think we are getting ourselves here in the spirit of [believing that] in a recession we’ve got to accelerate the aggregates. Now, that way, there will never be a reduction in inflation. In a recession interest rates should come down, but at constant rates of expansion of the aggregates; otherwise prices will go up indefinitely” (FOMC Minutes, July 11, 1979, 37).
¹²¹

Under the Humphrey-Hawkins law, the Federal Reserve had to inform Congress in July about any revision to its monetary targets for the current year and its first estimate of the monetary targets for the following year. Miller and many others were very uncomfortable about making forecasts of money growth as much as eighteen months ahead. The several institutional changes affecting the money aggregates, particularly M
₁
, increased their discomfort. The introduction of automatic balance transfers (ATS) received most attention. A depositor could move balances between demand deposits and interest-bearing savings accounts automatically, so the data understated effective demand deposits. The FOMC had estimated earlier in the year that ATS accounts would lower M
₁
growth by 3 percentage points in 1979. In the first six months, the actual reduction in M
₁
growth was 1.5 percentage points. Thus, when reported money growth was 4.5 percent, the public had instantaneous access to an additional 1.5 percent, making effective money growth 6 percent. Forecasting the growth rate of ATS accounts and M
₁
was more uncertain than earlier.
¹²²

Wallich started the discussion by stating a view that he described as widespread. “Wherever I go I sense there is less willingness this time
around to accommodate the OPEC shock monetarily” (ibid., 16). Mark Willes added that “there is very little evidence that monetary policy can do anything to offset an oil price increase in terms of ameliorating its real effects on the economy. . . . [T]he one thing we can have a systematic impact on is the rate of inflation, and that should be our primary objective” (ibid., 20). But Frank Morris stated the contrary view. He thought that a deep recession had started. “I believe we could see the unemployment rate go as high as 9 percent next year rather than the 8 percent the staff has projected. In my view that would be counterproductive to the long-run antiinflation fight. If we have that big a recession, the hope of keeping some constraint on fiscal policy is going to be diminished” (ibid., 17). Those who made this argument never considered that the Federal Reserve did not have to finance the deficit.

121. Mark Willes raised an issue about the staff’s use of the Phillips curve in their model and forecasts. “Implicit in your inflation forecast . . . is a belief that there is a short-run tradeoff between inflation and unemployment. Can you tell me what data there are in the last decade that makes you think that such a tradeoff even exists?”

122. The 1987 Humphrey-Hawkins Act gave the administration a problem also. The act called for a 4 percent unemployment rate and 3 percent inflation by the end of 1983. In a memo to the president, Schultze and Budget Director James McIntyre reported that the goals were “unrealistic” and required assumptions that caused “serious problems for long-term budgetary control. . . . Because both inflation and unemployment are understated, the future year outlay totals are misleadingly low” (memo to the president, Schultze papers, Carter Library, May 19, 1979, 1). The memo told the president that they had to choose between realistic assumptions and assumptions consistent with Humphrey-Hawkins. They preferred realistic assumptions but would include a short section using the alternative assumptions.