A History of the Federal Reserve, Volume 2 (112 page)

The staff forecast a recession. No one challenged the forecast. But a majority was unwilling to ease monetary policy. Thus, policy actions were procyclical, as was often the case under a free reserve or interest rate target. The difference this time was that a majority agreed for different reasons to reject increased ease.

The dominant new element at the November meeting was evidence of slower growth in consumer spending. Bopp (Philadelphia) expressed the modal interpretation of rising interest rates despite slower spending growth. “Financial markets are clearly registering doubts about the Committee’s ability and willingness to maintain the restraint necessary to stop inflation. . . . A policy of restraint severe enough and held long enough to shift expectations might prove too much to avoid a recession. On the other hand, if the Committee were to ease visibly now, he felt certain that inflationary forces would be even more difficult to cope with. . . . [H]e failed to see what the Committee could do now that would not make for difficult times ahead.” Nevertheless, he believed that continuing under the current restraint was less dangerous than moving to ease (FOMC Minutes, November 25, 1969, 79–80). Martin concurred. He had “reached the conclusion that there was no way out of the present situation that would not involve serious difficulties” (ibid., 89). This was a decided change from his position six weeks earlier.

Hugh Galusha (Minneapolis) questioned the Board’s announcement of its proposal to apply regulation Q to commercial paper sold by bank holding companies. “The System had already gone rather a long way in restricting banks in their historic role as financial intermediaries. And to what end had never been clear, at least to him” (FOMC Minutes, November 25, 1969, 64). Galusha’s statement challenged those who claimed that commercial paper, euro-dollars, and other unregulated instruments weakened monetary policy. None replied.

The FOMC had lost much of its innocence. It now recognized the mistakes it had made by permitting rapid monetary expansion in 1967 and following the surtax in 1968. Policy coordination had worked for the political benefit of the Johnson administration but not for them. The members saw more clearly than ever before that inflationary anticipations affected interest rates. And several saw clearly that there was no easy, painless, low-cost way of reducing inflationary expectations. Past mistakes would prove costly to correct. Failure to pay the cost now would defer the cost and probably increase it.

The learning from these experiences would soon be tested. The No
vember meeting was the last meeting before the economy reached a peak. Many of those, like Bopp and Martin, who insisted on maintaining a very restrictive, procyclical policy would soon have to decide how to respond to the recession that their actions helped to bring on.
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THE 1969–70 RECESSION

The National Bureau puts the peak of the 106-month expansion in December 1969. By the time the FOMC met that month, the economy was about to start an eleven-month recession. The Bureau graded the recession as mild, about the same as the 1960–61 recession that preceded the long expansion. Industrial production fell 6.8 percent, 1 percentage point less than the average postwar mild cycle. The unemployment rate rose to 5.9 percent, 2 percentage points above the rate at the NBER peak. Consumer price inflation declined only 0.50 percentage points. The Federal Reserve had not learned that a temporary policy change would have little effect on inflation, but the public apparently had learned to wait for evidence that anti-inflation policy would continue.

Real base growth had fallen for a year prior to the start of the recession. It turned negative in July 1969. Real interest rates, adjusted by anticipated inflation, rose on average from 3.4 percent in January 1969 to 5 percent a year later. Unlike many previous recessions, both series showed policy tightening until the new year, then easing. Although real base growth remained negative until August 1970, by early 1971 both series had returned to the levels of January 1969. Chart 4.11 shows these data.

Policy action, judged by real monetary base growth, began to ease after January 1970, very soon after the start of the recession. Despite the many protestations and commitments to stay the course until inflation fell, policy change was neither hesitant nor slow to arrive. Within a year nominal monetary base growth doubled, from 4 to 8 percent. This brought it back to the level at the start of tightening. Chart 4.12 shows that nominal and real base growth changed together; the inflation rate changed very little. Officials were aware, and had repeated many times, that an early shift to an easier policy would reinforce beliefs that they would respond more aggressively to unemployment than to inflation. In their words, market psychology would sustain inflation. This was obfuscation; their policy action
sustained inflation. Interest rates show the market’s skepticism. Although the federal funds rate fell from 9 percent to 4.8 percent a year later, longterm Treasury yields fell only to 6 from 7 percent.

144. Martin asked the bank presidents to comment on the Board’s proposal to place bankendorsed commercial paper under regulation Q ceilings. Those who spoke opposed or asked for a delay. Scanlon (Chicago) said that the proposal would induce banks to “increase their euro-dollar borrowings to offset commercial paper losses” (FOMC Minutes, November 25, 1969, 67). He urged the Board to raise interest on large-denomination CDs if they approved their proposal.

The decline in short-term rates eased the problems caused by the large gap between market rates and regulated rates. The inflow of dollars borrowed in the euro-dollar market reversed. Chart 4.13 shows the sizeable
change in market rates relative to ceiling rates that induced banks to first borrow heavily in the euro-dollar market and then repay.

The January 15 meeting was Martin’s last. He retired at the end of January after nearly nineteen years as chairman. Two of his major aims had been to maintain domestic price stability, or low inflation, and to preserve the $35 gold price and the fixed exchange rate system. He failed at both. Although the SPF predicted 3 percent inflation for 1970; the actual inflation rate was 6 percent; the fixed exchange rate system was near its end. Gold had been embargoed for all but central banks and they were discouraged from converting dollars. The balance of payments remained in deficit; the surplus on goods and services had fallen from $8.6 billion in 1964 to $1.9 billion in 1969, Martin’s last full year. Inflation was a major factor reducing the trade surplus and the adjustment of the real exchange rate that would have extended the Bretton Woods system. Acknowledging this at a farewell luncheon with the Board, Martin said, “I’ve failed” (Bremner, 2004, 224). After President Nixon floated the dollar, he said: “It represents a failure of United States economic policy—a failure to restrain inflation and failure to improve the balance of payments” (ibid., 235).

Despite his earlier insistence on the importance of maintaining a restrictive policy, Martin used his last meeting to respond to the recession by proposing an easier policy.
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The staff report recognized that the economy
had not grown at the end of 1969. It predicted sluggish growth in spending and a further decline in inventories during the first half of the year.

145. Maisel’s diary (February 16, 1970, 26) reports that a move toward easier policy would
have been made at the December meeting but Martin had “just talked to President-elect Nixon and the Quadriad and had urged on them the need for tighter fiscal policy. Therefore, he had to say wait.” Maisel does not comment on the difference between Martin’s views following this meeting and his response in 1968 when tighter fiscal policy called for easier monetary policy (lower short-term rates). In December 1969, Hayes wrote to Board members about the deposit outflow and expected increased outflow of deposits from thrift institutions. He urged an increase in ceiling rates (letter, Hayes to Board of Governors, Correspondence Box 240, December 19, 1969). At about this time, the Board supported an increase in deposit insurance to $20,000 per account (from $15,000). Also, the Board sent a letter to all reserve bank presidents telling them to extend emergency credit assistance to non-member banks, mutual savings banks, and thrift associations, in some cases directly and in others by lending to the Treasury for relending to the Home Loan Banks (letter, Robert Holland to Hayes, Correspondence Box 431.2, Federal Reserve Bank of New York, December 24, 1969).

Divisions in the FOMC remained. Robertson wanted to continue the anti-inflation policy. In a prophetic statement, he told the committee that “if we give in too soon, we may well find that we have to begin the whole painful inflation-fighting job over again” (FOMC Minutes, January 15, 1970, 99). Several members recognized that they could not count on fiscal restraint. Galusha (Minneapolis) and Hayes were most critical of the administration’s failures to reduce current and prospective deficits. Hayes blamed “fiscal actions taken and initiatives not taken” (ibid., 47) for growing cynicism about the administration’s commitment to reduce inflation. The reference was to his belief that the administration would not keep tight control of spending in fiscal 1971 and its acceptance of a reduction in the surtax rate from 10 to 5 percent for the second half of fiscal 1970. In February, after the administration announced its 1971 budget, his concerns eased.
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After considerable discussion, the FOMC voted unanimously to maintain firm conditions in the money market. For the first time it adopted growth in money as a policy indicator and instructed the manager to change money market conditions if monetary growth deviated from a 2 percent annual rate (Maisel diary, January 15, 1970, 5). Hayes, Coldwell (Dallas), and Clay (Kansas City) continued to oppose any change. Daane and Brimmer wanted tighter policy despite the recession and the staff forecast of zero real growth and rising unemployment in the first half of the year (ibid., 4, 6). Martin agreed to the change. “Since it was his last meeting, he would look for a way of unifying the Committee” (ibid., 6). The agreement called
for a two-way proviso clause aiming at 2 percent money growth for the quarter.
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146. The Tax Reform Act of 1969, enacted on December 30, increased personal exemptions from $600 to $625 in 1970 and to $650, $700, and $750 in the next three years, increased the standard exemption from 10 to 15 percent in the three years starting in 1971, reduced the maximum tax rate on earned income to 50 percent, but repealed the investment tax credit. President Nixon and his advisers could not get congressional support for their attempts to reduce the deficit (Matusow, 1998, 53–54).

The Board continued its concerns about deposit losses at small banks and thrifts and the use of commercial paper to circumvent regulation Q ceilings by large commercial banks and bank holding companies. Congressional pressure heightened their concerns. A letter from Congressman Emanuel Celler accused the Board of “discriminating against bank subsidiaries and in favor of bank parent companies” and called the alleged discrimination “intolerable” (letter, Celler to Martin, Correspondence Box 240, Federal Reserve Bank of New York, January 8, 1990). Celler urged the Board to delay regulation of commercial paper for ninety days.

Two weeks later the Board raised ceiling rates but postponed regulation of commercial paper, as Celler and others had urged. The Board’s press release emphasized the desire to bring bank deposit rates into closer proximity to open market rates and to limit the change to “moderate size so as not to foster sudden and large movements of funds” (Press Release, Board Records, January 20,1979.). The increase was 0.5 for thirty to eighty-nine days for consumer accounts and 0.75 percentage points for large certificates. The new rates on these certificates ranged from 6.25 percent for thirty to fiftynine days to 7 percent for six months and 7.5 percent for one year or longer.
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This was the first increase in the rate on passbook savings since 1964.

Personnel
Changes

Arthur Burns became chairman of the Board of Governors on February 1, 1970. He served two terms as chairman. Although six years of his
fourteen-year term as a member remained in 1978, he left the System on March 31, 1978, when President Carter did not reappoint him as chairman. He was the first economist to serve as chairman, a recognition of the growing complexity of monetary policy and the increased professional role in policy. He also had a close relationship with President Nixon.

147. Maisel commented: “The debate was so confused that the Manager felt that he did not have to try for an expansion through any change in money market conditions as long as some of the estimates showed that the money supply was rising. . . . The staff was mixed . . . as to whether the FOMC wanted conditions changed affirmatively.” The money market remained tight (Maisel diary, February 16, 1970, 26).

148. Maisel’s diary (January 15 and 20, 1970) describes the difficulty in reaching agreement among the members of the Board and between the Board, the Home Loan Bank Board, and the Federal Deposit Insurance Corporation (FDIC). The Home Loan Bank Board wanted to delay any change, while the FDIC wanted higher rates than the Board proposed. Within the Board a main issue was whether to use their new power to subject bank-issued commercial paper to time deposit reserve requirements under regulation D. Robertson wanted to include euro-dollars with commercial paper, but the Board did not agree. He dissented, an unusual action on a vote of this kind.

Brimmer and Robertson wanted to put commercial paper under regulation Q ceilings. According to Maisel (diary, February 16, 1970, 27), they wanted to tighten more. Mitchell and Maisel opposed because they wanted to ease, not tighten, and “because we thought it was wrong” to use reserve requirements instead of regulation Q ceilings. Martin wanted to act because he had told Chase Bank and some others that “he would see that the other banks didn’t do it [issue commercial paper]” (ibid.).