A History of the Federal Reserve, Volume 2 (59 page)

Governor Henry Wallich, a member of the subcommittee, noted correctly that “the problem with the funds rate is that . . . it tends to shift to the role of objective. . . . Inadequate control of the aggregates has at times been the result” (supplementary comment of Governor Wallich, Board Records, December 15, 1976, 1). He recognized that initially the funds rate would be less stable. After an initial period, however, other short-term rates would probably cease to move closely with the funds rate and would react only mildly to a jumpy funds rate (ibid., 2).
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This issue returned several times. A report from the subcommittee reviewed the issue again in 1977 and reached the same conclusion (memo, Reserve Requirement Policy Group to Board of Governors, Board Records, August 19, 1977). When the System in 1979 announced its intention to control nonborrowed reserves instead of the funds rate, it did not eliminate lagged reserve accounting. It did permit much larger changes in the funds rate, but banks could borrow reserves as needed to meet required reserves. The Board kept the discount rate well below the funds rate much of the time, so borrowing was subsidized and banks had an incentive to err on the side of deficient reserves. The Board and the FOMC again reviewed contemporaneous reserve requirements, but it did not adopt contemporaneous accounting until after it ended its experiment with reserve control.

In 1978, the Board reduced reserve requirement ratios by 0.5 percentage points for demand deposits at banks with deposits of $10 million or less and 0.25 for other banks. Vice Chairman Stephen Gardner objected that the addition to reserves was permanent. This repeated an old error. With the funds rate unchanged, the estimated $550 million reduction in required reserves had no monetary effect. The action was most likely taken to encourage banks to retain membership, although that was not mentioned. After the reduction, reserve requirement ratios ranged from 7 to 16.25 percent. The Board also eliminated reserve requirements for foreign deposits beginning October 5, 1978. This increased the appeal of eurodollar deposits at a time when depreciation of the dollar created resentment in Europe (Annual Report, 1978, 68–69).

The Board took a large step toward reform in June 1978 by voting to recommend that all depository institutions with transaction balances of $5 million or more be required to hold required reserves whether mem
bers of the System or not. It took this action “to provide for greater competitive equality among financial institutions and to correct the loss of Federal Reserve member banks by reducing the burden of membership” (letter, G. William Miller to Henry Reuss, Board Minutes, July 6, 1978, 1). The Board would charge members for the services the System provided and would pay some interest on reserve balances.

191. The subcommittee accepted Wallich’s point, but it did not change its conclusion. “After a learning period under a reserve target, it seems probable that the banks and the public would become less sensitive to day to day fluctuations in the funds rate. On the other hand, the predictability of the relationship between reserves [and interest rates] might well deteriorate somewhat” (memo, Subcommittee on the Directive to FOMC, Board Records, D
ecember 15, 1976, 3).

The House Banking Committee proposed to extend reserve requirements to all commercial banks but exempt thrift institutions. It also exempted the first $100 million of deposits. The Board disliked these provisions. It offered to exempt $25 million and claimed that with this provision only five thrift institutions would be required to hold reserves. Congress did not act for two years.
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Collateral
and
Settlement

The diminished stock of gold and gold certificates and rising levels of reserves and deposits required a change in interbank settlement. In 1972, the Board adopted monthly reallocation to maintain a common ratio of gold certificates to Federal Reserve notes outstanding. Officials could approve interim adjustments, if they appeared desirable.

In 1975, the operations staff recommended that monthly gold transfers cease. Reserve banks other than New York would change once a year. New York would pay for withdrawals and receive deposits from the Treasury. Once a year, the Interdistrict Settlement Fund would reallocate securities in the System Open Market Account to balance accounts. Gold would remain as collateral for the note issue, but securities would be the principal collateral (memo, Maurice McWhirter and Alan Holmes to FOMC, Board Records, April 11, 1975). Step by step, gold lost its monetary role and main provisions of the 1913 Federal Reserve Act disappeared.

Supervisory
Powers

The Board issued many regulations about holding company powers, truth in lending, community reinvestment, and other topics. It enlarged the desk’s authority to purchase bankers’ acceptances. Many of these regulatory actions were of minor significance.

In a lengthy memo on May 7, 1975, the Board’s staff joined the desk in discussion of the System’s ability to change the shape of the yield curve. The issue arose under the usual pressure from Congress to assist the hous
ing industry by buying long-term securities to lower long-term rates. The basis of this belief is itself open to question; mortgages are a nominal valued asset, housing a real asset. And mortgage rates are nominal values. Any effect on mortgage rates does not assure an effect on housing (Meltzer, 1974).

192. The System published a proposed schedule pricing its services in November 1978. The bankers on the Federal Advisory Council (FAC) responded and accepted the principle that the System should charge enough to cover its costs (Board Minutes, addendum for February 1–2, 1979).

The memo recognized that “the expectations theory now generally accepted as the best explanation of the term structure of interest rates and empirical tests of changes in the maturity distribution of securities held by the public suggest that even very large desk purchases of Treasury coupon issues exert only limited, short-lived effects on levels of long-term rates and their relation to short-term rates” (memo, Stephen Axilrod and Peter Keir to FOMC, Board Records, May 7, 1975, 1). The memo pointed out that during periods of high demand for long-term credit, the short-term effect may be useful. If they smooth rate changes, operations may reduce expected future rates and, thus, current interest rates. Also, the staff argued, even a small change in Treasury rates could widen the spread between Treasury and corporate bonds and induce a shift of buyers to corporates and an increase in corporate debt (ibid., 16).

An increase of this kind would be unlikely to persist. Once bondholders learned that the change in relative yields was temporary, it would be unlikely to reoccur. The expectations theory of the term structure is not a complete explanation of the yield curve, but observed departures are not likely to be exploitable except in rare cases.

In May and June 1978, the Board considered proposals to retain members. The main changes called for payment of interest on bank reserves at a rate 1.5 percentage points below the average yield on government securities with a limitation on total payments equal to 7 percent of the total net earnings of the Reserve banks. Since the System paid most of its earning to the Treasury, the cost would be borne by the Treasury. The Board also proposed to establish universal reserve requirements for all transaction accounts. That would remove one of the main advantages of non-member status. The first $5 million of deposits would be exempt from reserve requirements to assist small banks. Congress wanted much higher exemptions (letter, G. William Miller to Henry Reuss, Board Minutes, June 29, 1978).

Board members expressed concern that loss of members reduced effectiveness of monetary policy. These statements make clear that they did not understand that monetary policy influenced the economy by changing relative prices, the amount of money relative to the stocks of financial assets and real capital, and expectations of inflation. None of these factors depend on the number or proportion of member banks or the volume of required reserves.

A memo from Arthur Burns to Alan Greenspan as Council chairman gave the Board’s reasoning. The memo asked the administration to oppose the sections of the Financial Reform Act of 1976 considered by the House Banking Committee that spring. The bill proposed to create a Federal Banking Commission to assume the bank regulatory and supervisory functions of the Board of Governors and the Comptroller of the Currency.

Burns wrote, “If the legislation passes in its present form, it could well frustrate the conduct of monetary policy and do serious injury to our nation’s economy” (memo, Burns to Chairman of CEA, Burns papers, Box B_B23, March 8, 1976, 1). His explanation is an assertion that “there is a vital interaction between monetary policy and bank supervision. . . . The interaction is so strong that actions by this new Federal Banking Commission, either deliberately or inadvertently, could frustrate monetary policy and destroy the effectiveness of the Federal Reserve” (ibid.). He did not say that a banking agency would likely be subject to congressional pressure to allocate credit.

One example that he gave was that the Banking Commission could frustrate Federal Reserve efforts to increase or reduce money and credit by changing lending standards in the opposite direction. He argued also that supervision and regulation were critical for decisions made at the discount window.

Burns’s arguments are unconvincing. A purchase of securities by the FOMC would, as before, change the stock of reserves, relative prices, and expectations. The Federal Reserve continued to make these arguments on the several occasions when interest in a banking agency rose. To date, Congress has not created a banking agency.
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Legislation

To meet the requirements of the Government in the Sunshine Act, the Board approved a regulation that permitted observers to attend those parts of Board meetings that did not discuss information that the bill permitted to be kept from public scrutiny. The latter included material from foreign governments and central banks, banking problems, and monetary policy changes. The law required the Board to keep minutes or transcripts of the
parts of the meeting that remained open to the public and to announce all meetings to the public in advance (Annual Report, March 7, 1977, 123).

193. Senator Proxmire was a leading proponent. The issue arose again in March 1978. Chairman Charles Schultze opposed the legislation partly because all of the banking agencies opposed. This would mean “substantial” political problems. “Very significant opposition would arise from some banking groups, most state banking supervisors, and Congressmen with connections to the banking industry” (memo, Stuart Eizenstat and Charles Schultze to the president, Schultze papers, March 8, 1978, 4). The memo also recognized the risk that Congress would impose many regulatory restrictions on the allocation of credit.

Foreign
Banks

The International Banking Act of 1978 placed regulation of all foreign banks in the United States under the control of the Board. The legislation required branches of foreign banks to meet the same reserve requirements as domestic banks and gave them access to the discount window on the same terms. The act exempted banks operating in the United States prior to the legislation. Most major West German, Swiss, and Japanese banks were therefore exempt.

The System began to use matched sale-purchase transactions with foreign banks beginning in 1968. With the oil price increase in 1973 and after, several oil-exporting countries wanted assistance in managing their dollar deposits. The Federal Reserve adapted the repurchase agreement to acquire the deposit and simultaneously contract to return it at a fixed future date.

A main appeal of foreign accounts to the System was that they permitted the System to manage bank reserves “unobtrusively.” The System took part in the transaction “whenever it needed to absorb reserves but did not wish to intervene overtly in the market.” At that time, central bankers considered secrecy to be useful.

The staff recommended that the System authorize the transactions. A lengthy memo from Paul Volcker, then president of the New York bank, explored the positive and negative aspects before recommending continuation (memo, Volcker to FOMC, Board Records, June 14, 1977).

Effective February 23, 1979, the Board adopted a policy statement about the supervision of foreign bank holding companies’ operations in the United States. The guiding principle was “national treatment” of each country’s holding companies. The Board increased examiner surveillance of transfers between the parent and the subsidiary, including quarterly reports on transactions. This action recognized the growth of foreign-owned holding companies and their diversity. Recycling profits from the sale of drugs or other illegal transactions had increased.

CONCLUSION: WHY INFLATION PERSISTED

Arthur Burns defended Federal Reserve independence repeatedly. Unfortunately, he held a narrow view of independence. He would not discuss proposed monetary policy actions at the Quadriad, and he resented efforts by President Nixon and his staff to influence his actions. Although he made many speeches about the dangers of inflation, he did not continue
anti-inflation policy when unemployment and interest rates rose or when congressional pressure for more expansive policies increased.

The simple explanation of why inflation persisted and rose on average through the 1970s is that the Federal Reserve did not sustain actions that would end it. “That was basically political” (Axilrod, 1997, 20). It started several times. It was aware that its actions increased inflation. Periodically it brought the inflation rate down, notably in 1976 during the Ford presidency. It did not maintain independence. The election of President Carter on a promise of more job creation and more expansion ended disinflation. Although Burns criticized the new administration’s fiscal plan, the Federal Reserve did not want to be accused of undermining the expansion.

There were many reasons for not insisting on independence and low or zero inflation. At the time, the public did not regard inflation as a major problem, and many in the Congress reflected that attitude. Except for the start of the Ford administration, reducing unemployment dominated reducing inflation in policymakers’ minds. The Ford administration’s program to “whip inflation now” gave way under popular and congressional pressure once recession started. Congress and successive administrations interpreted the Employment Act of 1946 as a commitment to full employment. Successive administrations and the Federal Reserve defined full employment as a 4 percent unemployment rate long after demographic changes falsified that definition. Low inflation was not mentioned explicitly in the act.
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In his 1979 Per Jacobsen lecture to the IMF in Belgrade, Burns recognized that he lacked political support for slowing money growth to end inflation. He was not willing to insist on independence to carry out the central bank’s responsibility to maintain the value of money. His failure was not the first time the Federal Reserve had chosen not to rely on its statutory independence to change policies. In the late 1940s, it chafed under the policy of pegging interest rates, but it did not act until after Senator Paul Douglas showed support for independent monetary policy. The Federal Reserve under Martin engaged in policy coordination, thereby financing a rising budget deficit by issuing money.

The Federal Reserve also lacked a coherent framework. Arthur Burns was a distinguished empirical economist with little interest in economic models. His successor, William Miller, was a businessman with limited knowledge of monetary economics. Yet the record shows that some mem
bers of FOMC recognized the main errors and weaknesses in the Federal Reserve’s framework repeatedly. The FOMC chose monetary targets. It recognized that maintaining a narrow constraint on nominal interest rates prevented the manager from achieving the monetary target. It did not change because it would not accept greater interest rate variability and higher rates. Members pointed out at times that when it missed its annual target, it started from the new level, thus building in the inflation implied by excess money growth.

194. President Carter suggests that he wanted to reduce inflation but found little support in the Democratic-controlled Congress. He described the “stricken expressions” on the faces of the leadership when he talked about balancing the budget (Carter, 1982, 65–66).