A History of the Federal Reserve, Volume 2 (116 page)

Policy
Action
in
the
Recession

Maisel (1973, 250) described discussion at the February 10 meeting as “the most bitter debate I experienced in my entire service on the FOMC.” He might have added that it initiated a period of confusion and uncertainty. This was Burns’s first meeting, so he had not established a leadership position. Most members recognized that the economy was in recession, but members differed about its anticipated duration and depth. Hayes called a decision to ease “premature and unwise” (FOMC Minutes, February 10, 1970, 45). He wanted the System’s main goal to be lower inflation. Robertson, Brimmer, and Coldwell (Dallas) sided with Hayes. Burns thought a depression was possible, a gross mischaracterization of a mild recession. He wanted moderate growth in money and credit. On a vote of nine to three, the FOMC chose “somewhat less firm conditions in the money market” with a proviso to resist any significant change of money and credit “from a moderate growth pattern” (Annual Report, 1970, 105). Hayes, Brimmer, and Coldwell dissented, citing “the strength of inflationary expectations” (ibid.).
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The core issue in the policy debate was between those who wanted counter-cyclical policy in part because they believed that failure to respond to rising unemployment would jeopardize antiinflation policy later and those who, remembering the promise they made
in the fall, wanted to continue anti-inflation policy even if it required a deep recession.

170. The change would become apparent in the Board’s 1970 Annual Report. In October, Stephen Axilrod prepared an essay for the
Federal
Reserve
Bulletin
to explain the changed procedures. He minimized the extent of the change by making it appear as another step in the evolution of operations that began in 1966 with introduction of the proviso clause or that had long existed because of the System’s recognition that money, bank credit, and interest rates were all relevant. He noted, however, that the new procedures lengthened the time horizon over which money market changes affected changes in the monetary aggregates. The time horizon was now longer “than simply the interval between FOMC meetings” (Axilrod, 1970a, 12). Axilrod’s essay also alluded to a possible shift from procyclical to counter-cyclical actions. “An unexpected and undesired shortfall in business and consumer demand for goods and services would be accompanied in the short-run by a greater decline in interest rates than would otherwise be the case” (ibid., 14). He recognized the main point, stressed by Poole (1970), that the best response to a shift in aggregate demand was to induce an opposite shift in aggregate demand by changing money. And he recognized that open market policy must “evaluate the extent to which such shifts are transitory or more permanent” (ibid., 16). Regrettably, the FOMC did not make the change to a counter-cyclical policy or regularly distinguish permanent from transitory changes for many years.

171. Burns rejected both directives proposed by the staff. Instead of changing wording, as Martin had done, he wrote his own, intermediate between the two (FOMC Minutes, February 10, 1970, 83). On February 20, the Board again delayed regulations affecting commercial paper. This time the reason given was to avoid further tightening.

Paul McCracken, chairman of the Council of Economic Advisers, believed that continuous adjustment, fine-tuning the economy, built instability (Hargrove and Morley, 1984, 323). Burns agreed. He thought “it was undesirable in general for the Committee to shift its policy stance from month to month on the basis of the latest readings of uncertain indicators” (FOMC Minutes, April 7, 1970, 52).
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To those who wanted to tighten policy because of rising inflation, Burns warned that Congress was about to act against “the problem of recession in the economy and of depression in the housing industry . . . [I]t would only be a matter of time before the Federal Reserve would find itself in the position of some Latin American central banks” (ibid., 52). Burns’s statement broke the policy logjam. Some went along reluctantly, but a majority supported the new chairman. Once again, the FOMC responded to the slowing economy by abandoning its anti-inflation policy, reinforcing the belief that inflation would persist. Markets now had evidence from 1967, 1968, and 1970 under two administrations and two chairmen that preventing inflation had lower priority. The action in February 1970 repeated the 1968 policy error.

An unusual feature of open market operations during this period was acceptance of the relatively large weekly variation in the federal funds rate under the policy of trying to maintain moderate growth of monetary aggregates.
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Monthly changes in the monetary aggregates varied widely, however. The money stock rose at an annual rate of 11.5 percent from February to March and 12.5 percent from March to April but less than 3 percent for the first quarter average (computed from the mid-point of the previous quarter). Total deposits, the bank credit proxy, showed a similar pattern— large monthly variation around a relatively modest quarterly growth rate (Annual Report, 1970, 117, 124).

At the April 7 meeting, Burns criticized Hayes and others who wanted stronger action against inflation. He claimed inflation came from “costpush,” mainly from wage increases that reduced supply and raised prices. Presaging his later insistence that the old rules no longer worked, he absolved the Federal Reserve (and himself) from responsibility and favored
less use of monetary policy to reduce inflation. “It was a mistake for the Federal Reserve to attempt to deal with cost-push inflation through monetary policy. He said that either the country learned to live with cost-push inflation or direct controls would have to be used to get rid of it” (Maisel diary, April 7, 1970, 36).
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172. Early in March, the manager reported on six months experience lending securities to dealers. He concluded it strengthened the market for government securities and proposed increasing the limit on borrowing by a single dealer.

173. There were several large swings. For example, the weekly average funds rate declined from a peak of 9.39 percent on February 18 to 7.45 percent at the end of March. By late April, the rate increased a full percentage point to 8.43 before falling in May to 7.64. Long Treasury rates also shifted up and down but by smaller amounts: February 14, 6.48; April 4, 6.32; May 30, 7.21.

The reference to price and wage controls follows Governor Robertson’s comment that “if there were a resurgence of inflation it would probably prove impossible to cope with it through general stabilization policies, and direct controls would be required” (FOMC Minutes, April 7, 1970, 48). Burns agreed. “Excess demands had largely been eliminated and the inflation that was occurring . . . was of the cost-push variety. That type of inflation, he believed, could not be dealt with successfully from the monetary side. . . . One had either to live with it or begin thinking along the lines Mr. Robertson had mentioned” (ibid., 50–51).

A few days earlier, Burns received a summary of the replies to a letter he sent in February to all reserve bank directors. Most expected inflation to continue at a slower rate. “The most frequent reason given for expecting a continuation of inflationary pressures was the belief that union leaders would continue to press successfully for wage increases with the consequent cost-push effect on prices” (memo, Summary of responses to Chairman Burns’s letter, Board Records, April 2, 1970). Only about 10 percent believed that reducing inflation required wage and price controls.
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At its April meeting, the FOMC held a lengthy discussion about whether reserve or monetary growth measures should be treated as projections or targets. If treated as projections, the manager would use the federal funds rate as a target and presume that the projected reserve or money growth would be reached. He would adjust the federal funds rate only if money growth deviated by more than one percentage point from projections. If reserve or money growth became the target, the manager would change
the federal funds rate when he missed the target. The federal funds rate would be an instrument and reserve or money growth the target.

174. Burns responded to Robertson, Daane, Hickman (Cleveland), Swan (San Francisco), Kimbrel (Atlanta), and others who complained about the budget deficit that they “were looking at the wrong figures” (Maisel diary, April 7, 1970, 36). He told them that the proper measure of fiscal stimulus was the full employment budget and that it was appropriately stimulative during the recession but would turn restrictive in 1971. He later reverted to the standard central bank position.

175. At about this time, in an effort to increase control, Burns sent a memo to members of the Board noting that the Board’s Rules Regarding Employee Responsibilities and Conduct did not apply to Board members. He proposed a committee to develop guidelines for “the content and circumstances of public speeches, . . . relations with the press, maintaining the confidentiality of inside information” etc. (memo, Guide to conduct for System officials, Board Records, April 7, 1970). He suggested a voluntary agreement by Board members and reserve bank presidents.

The FOMC divided, but Burns decided to use money and bank credit growth as targets. Staff forecasts of weekly growth rates for the next six weeks, then monthly for the quarter, were available in the blue book. Now, the FOMC had an objective that went beyond the next meeting, although the committee could change the projected path at that meeting. As noted, the FOMC did not vote to announce the new procedures. However, Hayes gave a news conference soon after. He warned that the money market rates would vary more than in the past but that movements would be contained.

The System began the new procedure by raising the federal funds rate, perhaps the first time the manager decided on an overt change explicitly to control money and bank credit growth. This effort came at a time of new military operations in Cambodia that set off riots on college campuses and increased uncertainty in financial markets. The System ended by supplying more reserves, in part to prevent failure of a Treasury financing.
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Monetary base growth rose to a 7.4 percent annual rate, substantially above the 4.8 percent twelve-month rate. The decision to abandon the target suggests that Burns was unconvinced about the desirability of the new procedures, and it supported members who believed the target had to be a money market variable.

The FOMC soon took a step back from monetary control. It changed the directive issued at the May 5 meeting to “clarify the Committee’s intention that . . . deviations from the expected paths of various aggregative reserve measures was to be used as a supplement to—but not as a substitute for— data reflecting money market conditions in making decisions” (Annual Report, 1970, 125).
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Francis (St. Louis) dissented.

176. “When it became apparent soon after the April 7 meeting that both money and bank credit were expanding more rapidly on the average than desired by the Committee, System open market operations were directed to achieving somewhat firmer conditions in the money market. Later . . . it was found necessary first to moderate developing tendencies toward undue firmness and then to calm market unsettlement” (Annual Report, 1970, 124).

177. The minutes hint at the way the manager implemented the policy of targeting monetary aggregates. “A reference to ‘bank reserves’ as well as ‘money market conditions’ is suggested in the statement of instructions to help make clear that in reaching his operating decisions the Manager is expected to keep an eye on the path of changes in the whole family of reserve aggregates. The staff understands that deviations from the path are expected to be used as information supplementing—not substituting for—developments in money market conditions as a guide to possible Desk operations” (FOMC Minutes, May 5, 1970, 50 n. 1). The problem that the manager and the FOMC faced arose from the short-term focus. Growth of the monetary aggregates have relatively large weekly and monthly variances. The manager would have to vary interest rates up and down to adjust to weekly deviations of money growth
from target, annoying market participants and increasing their costs. This was not likely to last, and it did not.

The principal reason given for the change was the “spectre of possible financial panic in the eyes of some market observers” (FOMC Minutes, May 5, 1970, 14). The concern had multiple causes, but the important new elements included the president’s decision to extend military operations to Cambodia and the response at home and abroad. As in 1953, heightened uncertainty came at a time when bond dealers had relatively large holdings of government securities in anticipation of falling interest rates. Borrowing in the long-term market remained heavy, putting upward pressure on rates. Release of the FOMC’s January minutes added to the uncertainty by creating “puzzlement over the market implications of greater reliance on monetary and credit aggregates”
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(ibid.). To meet the aggregate targets, the manager had increased the federal funds rate by 0.5 percentage points. Coming at a time when dealers expected interest rates to fall, “a very substantial interest rate reaction occurred” (ibid., 15).

The FOMC would not agree to issue a statement explaining the new procedures. Dealers asked whether even keel was still in effect and what would be done during a Treasury financing. The only answer was a suggestion that the staff write a report that, if approved, would appear in a future Federal Reserve Bulletin. The FOMC did not make a decision at the time. This exacerbated the uncertainty that an announcement of the new procedures, and their limits, could have avoided.

Several members were pleased by the manager’s response to slow growth of the aggregates. Burns criticized the members for giving “insufficient attention” to unemployment (ibid., 45). At 4.8 percent the unemployment rate already was above the 4.3 percent average the Council of Economic Advisers predicted for the year. Although Burns had voted in April to target reserve growth and money, he disliked the result and did not want to accept higher interest rates and higher unemployment to reduce inflation. “He thought it would be a disastrous mistake to tighten monetary policy at this time, but . . . relaxing would also be a serious mistake” (ibid., 46).
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The annual index of stock prices declined beginning in January 1969.
By January 1970, these prices were 21 percent below the level of the previous January. They continued to fall at a slower rate until May. The Cambodian incursion, expected inflation of 6.2 percent, continued recession,
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and other uncertainties reduced the Standard & Poor’s index by 12 percent in May to a level last seen seven years earlier, when consumer prices were 20 percent lower.

178. The FOMC was prepared to make longer-term (weeks) loans direct to the Treasury, if the market remained in flux. In the recent sale of an eighteen-month note, attrition was 50 percent of the issue. The manager said that attrition would be above 50 percent currently. Attrition of this magnitude was always a concern.

179. Soon after, Burns changed the weighting and now disregarded his opposition to frequent policy changes. “The greatest danger we could face would be in a relaxation of policy” (FOMC Minutes, May 5, 1970, 46). He referred to concerns that the administration would give up its anti-inflation policy.