A History of the Federal Reserve, Volume 2 (106 page)

The press interpreted the move as modest because New York and Chicago did not participate. Market and press reaction irritated some Board members. On August 27, with four banks holding out, Brimmer urged the Board not to approve a rate differing from current policy or allow an old rate to continue indefinitely “because the banks failed to act” (Board Minutes, August 27, 1968, 9). His position drew no support from the other governors. Martin argued that it was a System, not a centralized organization. That imposed costs, but it had benefits also. He preferred the decentralized system and was reluctant to “down grade the job of the directors” (ibid., 11).

Although only two small regional banks had reduced discount rates by August 19, the FOMC voted to “facilitate orderly adjustments in money market conditions but did not use its power to force recalcitrant banks to lower their discount rates” (FOMC Minutes, August 19, 1968, 20). The FOMC expected rates to fall. Uncertainty surrounding the Russian invasion of Czechoslovakia pushed rates higher.

With consumer prices rising at a twelve-month rate of 4.2 percent, more than 1.5 percentage points above the previous August, the discount rate reductions gave a clear signal that the System would not follow an antiinflation policy. Market rates did not respond as anticipated to the reductions in the discount rates.
⁹⁸
The FOMC staff interpreted the increase in rates as evidence of market disappointment at the small reduction in the discount rate. They neglected the effect of rising prices on interest rates and the fact that consumer prices increased at the highest rate since 1951. Most of all, they misinterpreted the effects of their actions; they ignored arguments for more restrictive policy from Francis (St. Louis) and Coldwell (Dallas). Based on their Keynesian beliefs, they chose to prevent the anticipated recession.

In September, the FOMC attributed a rise in market rates to disappointment about the size of the discount rate change and speculation by government security dealers. In October, they said increases in interest rates showed disappointment that most banks had reduced the prime rate only by 0.25 percentage points to 6.25 percent (Annual Report, 1968, 199).
Bank credit continued to rise rapidly. Although free reserves increased from −$415 in April to −$120 in September, the federal funds rate was the same in both months. Annual growth of the monetary base reached 6.5 percent in October, the largest annual rate of increase since January 1952.
⁹⁹

98. New issue Treasury bill rates rose 25 basis points from August 10 to August 31, after all banks had acted. Government bond yields rose also. By late October, bills yielded 5.4 percent, about the same rate as in April before the tax surcharge was expected to pass.

The Board and the administration had similar forecasts for the second half of 1968. The administration forecast, prepared by the so-called Troika process, predicted real growth at a one percent annual rate for the second half of 1968 and zero for the first half of 1969.
¹⁰⁰
With that forecast, unemployment would increase to 4 percent in fourth quarter 1968 and as much as 5 percent in second quarter 1969. Inflation would fall gradually to about 2.5 percent by mid-1969. The memo emphasized the need for monetary accommodation to avoid a recession. Lower interest rates would stimulate housing and maintain economic activity (memo, Troika to the president, CF, Box 3, LBJ Library, August 5, 1968). A letter from Martin expressed general agreement but differed on the increase in housing starts, the reduction in government spending, and the decline in inflation. In each case, the Board’s staff was less optimistic than the administration. But they agreed on the direction: slower growth, rising unemployment, and lower inflation. Maisel (1973, 189) reports the Board’s forecast for nominal GNP growth as 6 percent annual rate for the second half of 1968.

Actual results reported at the time differed markedly from the Troika forecast. Real GNP grew at annual rates of 3.4 and 2.4 percent in the two half years following the surtax. The GNP deflator rose at rates of 4.5 and 4.8 percent, and the unemployment rate remained at 3.4 percent, then rose very modestly to 3.5 percent in June 1969. Nominal GNP rose at a 7.8 percent annual rate in the second half of 1968 (Council of Economic Advisers, 1971).
¹⁰¹

At the September FOMC meeting, Martin gave his reason for a more pessimistic outlook on inflation than the Troika. He said that the admin
istration and the Federal Reserve had delayed too long in responding to inflation. “He thought it would be asking too much of the available tools of monetary policy to expect them to deal with the inflationary psychology that had resulted from that delay” (FOMC Minutes, September 10, 1968,

99. At the IMF–World Bank meeting at the end of September, European participants complained that “inflation would not be stopped unless the Federal Reserve kept the creation of the money supply or bank credit much more severely in hand” (Maisel diary, October 9, 1968,4).

100. The Troika process combined efforts of the Budget Bureau (later the Office of Management and Budget), the Treasury Department, and the Council of Economic Advisers. It had three stages. The three professional staffs prepared a forecast that was approved or adjusted by the agency deputies and, finally, by the principals. This became the administration forecast and was used in the spending estimates.

101. Revised data show real GNP growth slowing to 1.4 and 2.4 percent in the two periods and the deflator rising to 5.4 and 5.2 percent. Lagged reserve accounting became effective in September 1968. Banks based required reserves on deposits two weeks earlier. This eased the banks’ problem but made short-term control of monetary and credit aggregates more difficult.

68). Nevertheless, he thought the current stance was “about right” (ibid.,

69). He continued to believe that interest rates would fall.

By October, Martin’s policy had lost some adherents. Hayes urged “a check on credit growth . . . to bring it back down to a rate of about 6 percent per annum” (FOMC Minutes, October 8, 1968, 33). Hickman (Cleveland) and Kimbrel (Atlanta) joined him in dissent. Martin was not persuaded. “It was his impression that monetary policy had been about as effective as could have reasonably been expected” (FOMC Minutes, October 8, 1968, 75). He favored an unchanged policy. “A move toward firming now, on the eve of a Treasury refunding, was likely to be misconstrued and to set in motion a train of events that could be difficult to cope with. . . . [T]he less the Committee did by way of overt action at this time the better it would be” (ibid., 75).

There are two possible interpretations of Martin’s statement. The first puts more weight on a possible concern that the economy would slow too rapidly. His letter to the president commenting on the Troika forecast expressed doubt that the economy would achieve the low real growth rates or reduction in inflation in the administration forecast. Although he did not mention recession, this seems a likely concern. The second interpretation is a political concern. The administration, particularly Okun, kept reminding Martin of the need for a more expansive policy and possibly suggested a change in the Federal Reserve Act. Martin had agreed many times that the surcharge would lower interest rates. Raising rates, even under the changed circumstances, would appear to break a quasi-commitment just before the presidential election. Thus, torn between his long-standing concern about inflation and his political concerns, he favored no change.

The next meeting came when the Treasury was in the market. Bank credit growth had remained strong, and the manager had responded by letting the funds rate rise. The staff forecast called for continued rapid credit growth. Hayes opposed Martin. On five occasions in recent years, the FOMC had acted during a Treasury operation. His proposal to tighten received support, but the FOMC would not abandon or modify its even keel policy. Hayes’s was the only dissent.

Maisel (diary, October 9, 1968, 8–9) states the two main positions at the FOMC. On his interpretation, the difference perhaps reflected values but more certainly reflected differences in analysis. Both groups wanted the same result, lower inflation; they differed on the conditions for obtaining it.

At the moment, a majority of the Committee would accept a 4.5 percent unemployment rate and would recognize that it might take two years or more to get down to a 2 percent growth in the consumer price index and relative stability in wholesale industrial prices.

I think the people who want to tighten now . . . would be willing to run at unemployment of between 5 and 6 percent for quite a period in the hope that this would slow the price increases down to the 2 percent cpi, flat industrial price index within six or nine months rather than the two years or so which might be possible under the lower rate of employment.

Notable in his statement is the acceptance of 2 percent inflation, the same goal the Federal Reserve and some other central banks accepted in the 1990s.

In November, the staff reported that the strong expansion continued. Surveys indicated a higher rate of increase in capital spending in 1969 than in 1968. Even keel had ended. Still Martin hesitated. “He thought a good case could be made for firming. But he had concluded—with reluctance—that policy should not be firmed now because he thought it
was
too
late
for
such
action.
It would be asking too much of current monetary policy to expect it to deal with the inflationary psychology that had resulted from the cumulative heritage of past failures of public policy” (FOMC Minutes, November 26, 1968, 91–92; emphasis added.). This time four members, all presidents—Hayes, Hickman (Cleveland), Kimbrel (Atlanta), and Morris (Boston) dissented.
¹⁰²
The meeting summary reported that the majority still expected the economy to slow. They were concerned also about turbulence in the foreign exchange market. The British pound was under pressure again, and the German government had recently announced that it would lower the border tax rebate of the value added tax to reduce exports but would not revalue (see Chapter 5). The dissenters emphasized both domestic credit growth and inflationary pressures and the need to strengthen the dollar.

One reason for Martin’s hesitation to act was overt pressure from the administration. At Okun’s suggestion, President Johnson appointed a task force to consider changes in the Federal Reserve System. The task force’s report in early November 1968 proposed to weaken the role of the reserve banks by excluding them from the FOMC, as suggested earlier by the Commission on Money and Credit and by Eccles in 1935. With the Board members much more amenable to persuasion, the administration would gain influence over monetary policy.

102. Frank E. Morris replaced George Ellis as president of the Boston bank on August 15, 1968. He served until 1988.

Hayes chaired the December 17 meeting in Martin’s absence. The staff now estimated that real GNP growth would slow less than previous forecasts for the fourth quarter, and inflation would rise. Unemployment was reported at the lowest level in fifteen years. The staff continued to forecast slower growth in 1969.

Market interest rates “had risen sharply further . . . as the steady stream of statistics reflecting strength in the economy heightened concern about inflationary pressures and enhanced expectations of a firmer monetary policy” (Annual Report, 1968, 221). Banks had not waited for the Federal Reserve to act; they increased prime rates to 6.5 percent, reversing reductions in September. Bond yields rose to new highs. Estimated growth of money and the credit proxy reached 11.5 percent (annual rate) in November. Annual growth of the monetary base reached 7.15 percent in December. The market expected the Federal Reserve to respond.

Prior to the meeting, nine federal reserve banks voted to increase the discount rate. Board members indicated that they expected to increase the discount rate by 0.25 percentage points following the meeting. The FOMC then voted for firmer money market conditions. The federal funds rate reached 6 percent for the week ending December 18, an increase of 0.16, and 6.25 percent the following week. These were the highest nominal rates since the Board began collecting data in August 1954. With 4.6 percent reported inflation, real interest rates remained modest.

The Board received requests for a discount rate increase on December 12 but postponed action until after the FOMC meeting. Chairman Martin reported that he warned President Johnson that an increase was imminent. The president had indicated that he preferred that no action be taken. Some members wanted to increase reserve requirements at the same time.

Governors Daane, Maisel and Sherrill favored an increase of 0.25 percentage points to 5.5 percent; Robertson, Mitchell, and Brimmer believed that this would not signal a policy change. They believed the circumstances called for a larger increase (Board Minutes, December 16, 1968, 12–15).
¹⁰³

The Board learned that British reserve losses were likely to force the pound to float. This concern supported those favoring the smaller change in the discount rate. A majority did not support higher reserve requirement ratios. The Board approved the 5.5 discount rate unanimously, effective December 18. Governors Robertson, Mitchell, and Brimmer noted
that they voted for the small increase because no other change could pass. Martin was absent and did not vote.

103. Maisel was very critical of the handling of international policy. “Coombs is given almost complete discretion. He reports after the fact to the Board and does not give any explanation as to what he is attempting to do” (diary, December 13, 1968, 7). Maisel added that Coombs supplied reserves to ease the euro-dollar market when the Board tried to tighten domestically.

Trading
Employment
for
Lower
Inflation?

The SPF regular report became available in fourth quarter 1968. It showed no decline in the inflation rate expected one quarter ahead until the second half of 1971. The S&P index of stock prices reached a local peak in December 1968 that it did not surpass until March 1973, despite a nearly 50 percent increase in nominal GNP during the interval. By June 1969 it had declined 13 percent. This suggests expectations of lower real earnings growth not lower inflation.

In Hargrove and Morley (1984, 307), Okun explained the failure of coordinated policy action.

I would still say that the big error we made at that point was in assessing the strength of the underlying state of private demand rather than in underestimating the danger that the fiscal program would put on or in underestimating the stimulus that would be provided by monetary policy. . . . [T]here was much more vigor in the capital boom than we had anticipated. We were wrong.

[Morley:] “Were you and the Fed coordinating your policy? You were in agreement with what they were doing?

[Okun:] If anything, we were pushing them harder for more easing, and we were off.

[Morley:] So the idea was to touch the brakes and then let the economy go on.

[Okun:] . . . Yes, this was a big change in fiscal restraint. . . . It did appear as though that would permit a further easing of monetary policy and still give us a slowdown. We got a slowdown in real economic activity. We didn’t get as much of a slowdown as we expected.

The more significant link of the chain, which became evident in 1969 and 1970 more than in 1968, was that a slowdown and even a recession didn’t do much to slow inflation, and that was the bigger surprise.

There is no doubt that the forecast was too confident about the effect of a temporary increase in tax rates accompanied by lower interest rates. Maisel (1973, 189–91) claimed that the error that the Federal Reserve made was coordination and policy procedures, not mainly forecasting.

In the fourth quarter, the economy was 1 percent higher than expected, but this amount was critical to an economy balanced on
the knife edge of infla
tion. Instead of the predicted 3.9 percent unemployment rate, unemployment fell to 3.4 percent, which was enough to send the economy into an inflationary spiral.