A History of the Federal Reserve, Volume 2 (81 page)

Martin and Hayes had laid the groundwork for the next move. Pressures from the Europeans supported their arguments. The Bank for International Settlements annual report urged higher rates. At home, President Kennedy planned a speech on the balance of payments in July. Coombs urged the Federal Reserve to show its independence by acting before the speech.

The Federal Advisory Council (FAC) did not expect higher inflation. It favored a gradually more restrictive monetary policy to reduce the international payments deficit during a period of rising business activity (Board Minutes, May 21, 1963, 4). FAC members noted “a growing concern among informed persons . . . regarding the persistence of the deficit in our international payments” (ibid., 13). It favored a higher discount rate. Someone spoke in favor of making the financial market less attractive to foreign borrowers, a proposal that had support within the administration.

Active discussion continued within and outside the System. The staff of the Council of Economic Advisers did not fear higher short-term interest rates.
²⁴⁸
Its chairman was less certain. Heller accepted that the effects would be modest if the Federal Reserve aggressively purchased long-term and sold short-term securities and the Treasury issued mainly short-term debt. He was concerned that this would not occur. He told the president he preferred no change but “if you do decide to say ‘yes’ on the discount rate boost now, your blessing should be accompanied by an understanding signed in blood that the Fed
will
buy long (real long) and that the Treasury
will
sell and refund short. . . . plus an understanding that if the actions to
boost the bill rate . . . do trigger long-term increases, these actions will be abandoned or reversed”
²⁴⁹
(Heller papers, Monetary Policy, Box 20, July 7, 1963, 2; emphasis in the original).

247. Mitchell bolstered his case by claiming that the Federal Reserve could not change the slope of the yield curve. This statement verbalized the growing belief that the effort to twist the yield curve failed. The slope, he said, depends on the marginal efficiency of capital. Hickman, a long-time student of market rates, corrected him. The marginal efficiency of capital depended on expected future returns. Concerns about the balance of payments altered expected returns. Hickman acknowledged the negative effect on current domestic investment but said the long-term effect would be positive (FOMC Minutes, May 18, 1963, 60–61).

248. A staff memo discussed the proposed increase in discount rates to 3.5 percent as a means of increasing Treasury bill rates to 3.25 to 3.38 percent. The memo suggested that the bill rate would not rise to that level (from 3 percent) without additional action. It proposed additional issues of Treasury bills and System purchases of long-term issues to reduce the impact on long-term rates. The memo anticipated correctly that long-term rates would change very little (memo: “The Domestic Effects of an Increase in the Discount Rate,” Heller papers, Monetary Policy, Box 20, J
une 28, 1963).

Payments
Problems

Policy coordination had proceeded so far that an administration task force evaluated the Federal Reserve’s program and estimated its consequences before it was adopted.
²⁵⁰
It estimated that short-term capital outflows would decline by $250 to $500 million (from $546 million the previous year), with an additional effect from increased confidence in the dollar and the reliance on orthodox policy. Effects on the domestic economy would be modest. Higher interest rates would increase government outlays by $140 to $700 million depending on what happened to longer-term interest rates (“The Effect of an Increase in the Discount Rate,” Board Records, July 8, 1963).

The FOMC received the proposed program the following day. The manager, Robert Stone, reported that the program had leaked and markets had revised anticipations. Early in July, newsletters reported the policy change on which the administration and Federal Reserve staff had worked. Ninetyday Treasury bill rates increased to 3.20 percent, and one-year rates were at 3.5 percent, reflecting the 0.5 percentage point increase in the discount rate that the market anticipated.

The leaked information accomplished most of the objectives. Secretary Dillon confirmed market beliefs by testifying in favor of higher rates. All the Federal Reserve had to do was confirm anticipations. Several members opposed the discount rate increase. Robertson called the plan to raise rates “temporary palliatives . . . It will not fool many foreign central bankers” (FOMC Minutes, July 9, 1963, 46).

Robertson countered Coombs’s repeated statements about a crisis. He had traveled in Europe, met with officials, and attended meetings at the BIS. “Literally everyone we talked with emphasized the long-run strength of the U.S. economy—its competitive ability, its comparatively fine record of cost and price stability. This meant to them that our balance of payments problem was a relatively short-run transitional thing that could be dealt with accordingly” (ibid., 16).

249. Heller added: “I don’t view the ‘independence of the Fed’ as a barrier to full Presidential control of these decisions” (Heller papers, Monetary Policy, Box 20, July 7, 1963, 2). He gave as a reason that the Treasury could take monetary actions through debt management and trust account operations, as Morgenthau had done in the 1930s. Note the indication that the president would decide whether the Federal Reserve raised the discount rate.

250. The memo ended by noting that they did not express a judgment on the desirability of the change and that they might disagree. The memo was signed by Gardner Ackley, CEA; Robert V. Roosa, Treasury; Guy E. Noyes, Federal Reserve; and Charles Schultze, Budget.

Mills thought raising interest rates did “more harm than good” (ibid., 49). He complained that the administration was putting too much burden on the Federal Reserve. Mitchell joined him.

Complaints that the Federal Reserve had been pushed to do most of the work reflected concern that its independence had been compromised. Martin responded by reporting on his activities. He had participated in cabinet-level meetings beginning in April. He had urged changes in military spending and foreign aid in preference to direct controls. A working party had developed the program that had been distributed to them. It relied mainly on Federal Reserve actions supplemented by Treasury debt management operations.

Most of the opponents backed down, perhaps in response to Martin’s plea that the System had to cooperate with the administration, perhaps because markets had already adjusted. By a vote of ten to two, the FOMC agreed to “accommodate moderate growth in bank credit, while putting increased emphasis on money market conditions that would contribute to an improvement in the capital account of the U.S. balance of payments” (ibid., 77). Members understood that the reserve banks would raise their discount rates and the Board would raise regulation Q ceiling rates. Only Governors Mitchell and Robertson dissented.

President Kennedy called a meeting of the Quadriad on July 15. The president asked Chairman Martin “whether it was Federal Reserve policy to prevent a rise in long-term rates. Chairman Martin stated ‘yes,’ Federal Reserve policy would be aimed in that direction; he could not predict with certainty that the effect of the action would be confined to short-term rates, but the Federal Reserve would make a major effort to achieve that goal” (Draft Notes on Quadriad Meeting with the president, Heller papers, Monetary Policy, Box 20).
²⁵¹

Seven banks requested discount rate increases to 3.5 percent. With Robertson dissenting, the Board voted to approve the increase effective July 17. By July 26, all banks posted the new rate. On July 17, the Board approved a ceiling rate of 4 percent on time deposits with ninety days or more to maturity. Only four governors were present. All voted for the increase.
²⁵²
This was the only time since the British devaluation in 1931 that the Federal Reserve raised discount rates solely to support the exchange rate.

251. The president also urged Chairman Martin to announce support for his proposed tax cut. When Martin testified in Congress a few days after the meeting, he made no mention of his commitment to keep long rates down. According to one report, “Heller was furious” (Kettl, 1986, 100). He called another meeting of the Quadriad to reinforce the point and the Federal Reserve’s commitment.

252. Robertson approved reluctantly because other rates had increased. Failure to raise the ceiling rate would prevent banks from holding their time deposits, especially negotiable certificates of deposit (Board Minutes, July 17, 1963, 14–15). The Board had considered elimination of the ceiling or setting the rate above the market. Bankers were divided, with
a large majority in favor of the ceiling. This reduced the chance for new legislation (Board Minutes, February 19, 1963, 12). Many bankers complained that raising ceiling rates lowered credit quality because banks would take more risk (ibid., May 16, 1963, 13). Governor Mitchell shared this view (Board Minutes, October 10, 1963, 15). The decision favored the banks, not the public.

Although Martin soon after denied that he had made a commitment to the administration on monetary policy, there is no denying administration involvement in the discount rate increase (FOMC Minutes, July 30, 1963, 55). Even if he did not make a formal commitment, the change had been discussed with administration officials as part of a package before it was brought to the bank presidents. In 1956, Martin had resisted administration pressure to keep the discount rate unchanged, and in 1965 he would resist such pressure again. Now, he sacrificed independence to cooperate with the administration, most likely because he shared its concern about the payments imbalance and used the joint effort to get agreement to both tighten and supplement monetary policy.
²⁵³

The following day, July 18, President Kennedy sent a message to Congress about the balance of payments. He repeated his commitment to freer trade and capital movements, the $35 gold price, and tariff reduction (later called the Kennedy round), and he took steps to reduce the excess cost of freight for exports relative to imports
²⁵⁴
(Kennedy, 1963). The principal action was a request to Congress for an interest equalization tax to raise the cost of foreign borrowing in U.S. capital markets on securities with more than three years initial maturity.
²⁵⁵
Coombs reported that the higher discount rate “brought about a significant improvement in dollar exchange rates on the following day. This favorable reaction has been almost obliterated, however, by the Presidential message . . . calling for
an interest equalization tax” (telegram, Coombs to Board, Board Records, July 29, 1963).
²⁵⁶

253. He resisted the idea that policy was restrictive. “It had recently been following a slightly less stimulative policy” (FOMC Minutes, July 30, 1963, 55). Back in March, he told the FOMC, “If the System does not have the support of the administration we will be defeated psychologically almost at the start on moves that monetary policy might make on the balance of payments” (ibid., March 5, 1963, 84).

254. He also extended for an additional two years the $100 duty-free exemption on tourist purchases abroad. The exemption had been $400.

255. The tax did not apply to bank loans. This omission was corrected in 1965 by a “voluntary restraint program.” The president asked to exempt securities of developing countries and Canada. The rate of tax was 15 percent on equity shares and 2.75 to 15 percent on debt, depending on the bond’s maturity (Kennedy, 1963). The tax applied to the value or face amount of the issue. A $100 long-term bond provided $85 to the issuer and $15 to the U.S. government. This increased the interest rate about one percentage point. In 1964, legislation required commercial banks to report foreign loans and commitments (Annual Report, 1963, 199–200).

The interest equalization tax added a new layer of exchange controls. Earlier, the administration used subsidized loans from the Export-Import Bank, tied purchases financed by military or foreign aid, agreements with foreign governments to make equipment purchases to offset the cost of U.S. troops stationed abroad, and reduced government purchases abroad.
²⁵⁷
Table 3.9 lists some principal measures proposed or adopted in the 1960s.

256. The rest of the telegram is about Coombs’s support operations in the gold and foreign exchange markets, often accompanied by foreign central bank dollar purchases. The amounts seem small: $12 million in the Swiss franc market, $4.5 million out of $35 million spent by the Bundesbank, and $12.5 million in France (which failed to keep the dollar exchange rate off the floor).

257. The Council of Economic Advisers (1963, 264) collected data on transfers abroad. From 1946 through 1962, the United States spent $80 billion (net) on foreign assistance programs, an average of $5 billion per year. In the years of concern about payments abroad, 1960–62 inclusive, the average was $4.4 billion. These data include military supplies and
services. Excluding these items, the total transfer was $51.3 billion (excluding currency claims).