A History of the Federal Reserve, Volume 2 (27 page)

To a degree, the System was in the same position as in the pre-Accord period. In the 1940s, it knowingly risked inflation because it did not have political support before the Douglas hearings and the Korean War. Now, it risked higher inflation because Congress, the administration, and most likely the public would respond to a recession by demanding expansive policy actions. Inflation would increase.

The FOMC voted for Burns’s six-month target growth rates for the aggregates but eased his near-term target for RPDs and federal funds. Francis (St. Louis) dissented. He agreed with the six-month money targets, but “the desired growth rates would not be achieved as a consequence of the constraint on the federal funds rate to 9 to 10.5 percent” (ibid., 104).

At the August meeting, Burns repeated Francis’s message. Failure to control money growth, he said, “fundamentally resulted from a failure to control RPDs” (FOMC Minutes, August 21, 1973, 53). But the federal funds rate did not change, and Francis dissented for the same reason as in July.

To the extent that the FOMC had a long-term strategy, it was to avoid recession. Lyle Gramley, a member of the staff and later a member of the Board, expressed the strategy succinctly:

The urgent task is to assure that aggregate demand slows somewhat further, and then remains at a moderate pace long enough for the inflationary process of recent years to unwind. But it is equally urgent to accomplish this without precipitating a recession. If economic activity weakens too much next year, the pressures to reopen the monetary spigot would almost certainly become too powerful to resist. (FOMC Minutes, September 18, 1973, 73)

Alas, the staff and the members did not know how to reduce inflation while avoiding recession. They were not alone. The FOMC proposal was very similar to the 1969–70 policy of slowing inflation while letting the unemployment rate rise to 4.5 percent, but no higher. It had not worked. A repeat effort suggests that Gramley (and others) continued to believe that they could manage inflation by keeping the unemployment rate slightly above its erroneously estimated equilibrium value.

On the international side, the trade-weighted dollar depreciated sharply in the spring and summer, falling 30 percent against the mark between January and July. Pressure to intervene rose. Coombs proposed a $5.95 billion increase in swap lines to bring the aggregate to $17.68 billion, an increase of 51 percent. The FOMC approved the increase and gave a subcommittee (Burns, Hayes, and Mitchell) authority to act on its behalf.
On July 9, the FOMC held a telephone conference. The dollar had fallen an additional 10 percent against the mark and the franc and by lesser amounts against other currencies. The subcommittee had approved intervention and sharing risks with the Europeans. Only Francis (St. Louis) opposed the interventions. He said that the United States had embargoed grain exports when others wanted to buy grain and failed to make progress in reducing inflation. Hayes, Burns, and Daane supported intervention, claiming that the problem was lack of confidence and concern that the United States did not care about the exchange rate. Following the intervention, the dollar rose.

The federal funds rate reached a local peak in September 1973 at 10.78 percent for the month. Ten-year Treasury bonds peaked at almost 9 percent in August, and twelve-month monetary base growth reached a local peak in July. By year-end 1973 the twelve-month increase in consumer prices reached 8.4 percent, more than 5 percentage points above the December 1972 average. President Nixon decided to follow a less inflationary strategy (Matusow, 1998, 283). Burns received the signal. By March 1974, the federal funds rate started to rise to a new local peak in July at 12.9 percent, almost 4 percentage points above its February value.

Chart 6.4 compares these and later changes in the federal funds rate to the reported rate of increase in consumer prices. Through most of the early 1970s, the funds rate followed the inflation rate and generally is above
the reported inflation rate. By the middle of the decade this was no longer true. The rise in the inflation adjusted (or real) funds rate suggests monetary policy tightened in 1973. Data for growth of the real monetary base gives the same interpretation. Although the funds rate declined beginning in August 1974, growth of the real value of the monetary base, shown in Chart 6.5, did not change direction until early 1975 coincident with the recession trough.

Discount
rates.
Despite many requests for changes, the Board did not approve any discount rate changes in 1972. The discount rate remained at 4.5 percent. Between January and March all the requests asked for lower rates, usually a reduction of 0.25 but sometimes 0.5. Only Philadelphia, St. Louis, and Kansas City made these requests. The Board turned down the requests, in part because borrowing remained low, in part because the Board expected interest rates to rise.

Beginning in September, all the requests asked for increases of 0.25 or 0.5. The reserve banks cited rapid money growth and concerns about inflation. The Board often divided, but there was only one dissent, by Governor Brimmer, on September 1. The Board’s expressed reasons for denying the requests included several references to the Committee on Interest and Dividends. Burns urged his colleagues not to increase an “administered rate” (the discount rate) when his committee urged banks to keep their administered rates unchanged. Several members expressed reluctance to use the discount rate to lead market rates.

Burns’s argument against discount rate increases is a clear case of the conflict of interest that several feared in 1971, but the conflict lasted only a few months. By December, the elections were over, and opinions had changed. Market rates had increased. The main issue was timing. Burns proposed that the Board wait until mid-January, after the Treasury financing. On January 15, 1973, the Board raised rates by 0.5 to 5 percent. The requests cited concern about the rate of economic expansion.

The Board also approved discount rate increases in February (0.5), March-April (0.25), May (0.25), June (0.5), July (0.5), August (0.5). After the August 14 increase, the discount rate was 7.5 percent, an increase of 2.5 percentage points in little more than half a year. These most unusual actions followed market rates and reported inflation. By August, the federal funds rate was 10.5 percent, consumer prices had increased 7.2 percent in a year, and the ten-year Treasury bond yielded more than 7 percent. The relatively low discount rate acted as a subsidy to member bank borrowing. Borrowing doubled from $1.05 billion in December 1972 to a peak of $2.2 in August 1973. Increased borrowing contributed to base growth. Twelve-month base growth reached 9.3 percent in June, a rate of increase last experienced at the end of World War II. In July, the Board increased regulation Q ceiling rates by amounts from 0.25 to 0.75, depending on the maturity.

Effective April 19, 1973, the Board revised regulation A on discounting by member banks. It approved longer-term borrowing to meet seasonal needs. Banks without access to national money markets, mainly small banks, could borrow for periods up to ninety days and could renew the loan for the season. The amendment also reaffirmed the System’s commitment to lend in emergency or unusual circumstances.

Margin
requirements.
From December 1971 to April 1972, the Standard & Poor’s index of stock prices rose 17 percent. At a meeting early in April, the staff expressed concern about the speculative character of the increase. It urged the Board to consider an increase in margin requirements. The staff memo noted that since the reduction of margin requirements from 65 to 55 percent in December 1971, credit extended by brokers had increased 35 percent and the number of margin accounts had increased by 60,000. The Board took no action.

The S&P index fell in May, but stock market credit rose. The Board divided over whether there was a problem. Burns thought that stock market credit had not grown out of line with other credit, but Governor Sheehan was “shocked” by the increase and wanted to increase margin requirements (Board Minutes, June 7, 1972, 4). Both Sheehan and Robertson wanted to raise margin requirements to 70 percent (from 55). Mitchell and
Daane favored 65 percent. Burns favored the smaller increase but deferred action to consult the SEC and the Price Commission.
⁹²

Part of the System’s problem arose from money illusion. Neither the staff nor the members distinguished real and nominal changes. The S&P index passed its 1968 peak in nominal value in March 1972. Consumer prices increased almost 20 percent in the interval, so the real value of stock prices remained well below values at the start of the inflation. The non-indexation of tax rates and depreciation explains much of the loss in real value (Feldstein, 1982).

Between June and November, margin credit increased about 3.5 percent, the S&P index by 6.5 percent. A majority of the Board—Mitchell, Daane, Bucher, and Brimmer—opposed a change in margin requirements at that time. Brimmer especially noted that there was no evidence of a significant increase in stock market credit. “In his opinion, changes in margin requirements should not be geared to the behavior of stock prices—but the actual use of stock market credit to purchase or carry securities” (Board Minutes, November 11, 1972, 11). He might have added that the 1934 Securities and Exchange Act said the same.

Burns wanted an increase. He spoke to SEC Chairman William Casey, who warned that some brokerage firms had financial problems and that an increase in margin requirements might harm them by reducing trading volume. Nevertheless, Burns said he favored “a preventive approach” and wanted to show that the System was acting against inflation. Robertson agreed. Acting now could reduce expectations of inflation. Neither explained how that would work or why they did not act more directly. Credit to purchase shares could be obtained in many ways.

With Brimmer dissenting, the Board approved an increase in margin requirements from 55 to 65 percent effective November 24. Stock prices reached a peak in December 1972 and continued to fall until December 1974. At that point, the S&P index was back to its March 1963 nominal value. The decline owed much more to inflation, the oil price shock, uncertainty about the functioning of government resulting from the Watergate scandals, and the resignation of the president in August 1974.

Regulation
Q.
As market rates rose, the Board relaxed or ended ceilings for large CDs; it did not change the rates on small (below $100,000) CDs
until July 5, 1972. On July 5, the Board approved increases of 0.5 to 0.75 on passbook saving accounts and consumer CDs. Also, it removed the ceiling rate for four-year CDs with a $1000 minimum denomination. At the time, deregulated six-month large negotiable CDs paid 9 to 10 percent.

92. “Registered margin credit at broker-dealers and banks” reached a local peak in December 1972; the outstanding balance in May or June 1972 was between 45 and 50 percent higher than a year earlier (Board of Governors, 1981, table 23, 184). The Board’s only action at about this time was a technical adjustment to the rule permitting substitution of securities in margin account collateral.

The new certificates proved attractive. Three weeks later, the Board restricted issuance of four-year certificates to 5 percent of a bank’s total deposits. Certificates above the limit could receive no more than 6.5 percent interest. Effective November 1, the Board removed the 5 percent limit but placed an interest rate ceiling of 7.25 percent. The other banking agencies adopted the same restriction.

Membership.
The System tried several times in its history to require membership. This was a major issue for Eccles in the 1930s. It resurfaced in 1972. As interest rates rose, the cost of holding reserves that earned no interest became burdensome for many banks.

Burns wrote a letter to Herbert Stein decrying recent loss of membership. Between 1960 and 1972, 675 banks had left the System through withdrawal or merger. The System acquired 102 state-chartered banks in this period but 1,483 newly chartered banks elected to remain non-members. Burns recognized the principal reason for loss of members was the increased opportunity cost of holding reserves (letter, Burns to Stein, Nixon papers, WHCF, Box 33, November 15, 1972).

Burns did not request compulsory membership. He offered to permit non-members to borrow at the discount window if they held the System’s required reserves. He recognized that the Federal Reserve’s obligation as lender of last resort extended beyond its membership to the financial system.

The weak part of his argument was that requiring non-member banks to hold the same reserve requirement ratios “would facilitate the effective implementation of monetary policy” (ibid., 2).
⁹³
Shifts of deposits between member banks with different reserve requirements, between demand and time deposits, or between member and non-member banks had small, mainly transitory, effects on the magnitude of the money stock produced by changes in reserves or base money. The longer-term effect of the relative growth of non-member banks was to reduce the average reserve requirement ratio for the entire monetary system. This change occurred with sufficient regularity that it should not have posed a control problem.

93. A letter from a former senior staff member, David Lindsey, in the mid-1980s showed that the staff recognized that the argument was incorrect, especially when the FOMC controlled the funds rate.