A History of the Federal Reserve, Volume 2 (30 page)

The estimation proceeded as before. There are four variables representing the monetary base and its three principal sources—discounts, gold stock, monetary base, and government securities. (For more discussion on the procedure, see the Appendix to Chapter 2.) Data are monthly from October 1971 to December 1980. Estimates are again based on 2 lags, 11 seasonal dummies, and a constant.

SEVEN

Why Monetary Policy Failed Again in the 1970s

“The history of money demonstrates the difficulties which men have to distinguish the permanent from the temporary.” . . . [M]aking this distinction is a constant imperative.

—William McC. Martin, Jr., quoting Karl Bopp, in Eastburn, 1970, 35

Econometric models play an important role at the Federal Reserve Board. . . . That said, the economic environment is a forbidding one for models: appropriate specification and identification of models is elusive; data are faulty and subject to revision; the economy is in a constant state of flux; and events not contemplated at the time of model design frequently buffet the economy.

—Reifschreider, et al., 1996, 47

The years 1973 to 1979 were the least successful period for postwar Federal Reserve policy. Consumer price inflation rose from an annual rate of 3.6 percent in January 1973 to 10.7 percent in July 1979. Part of the increase represents the temporary effect of oil price increases. Although Federal Reserve officials may have distinguished “the permanent from the temporary,” they did not act on that information.
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The policy failure had both political and economic causes. Arthur Burns, who served as chairman of the Board of Governors until spring 1978, lacked both the courage and the conviction to restore low inflation or price stability. He believed that inflation was endemic in a modern economy, and though he started at times to reduce inflation, he did not persist when unemployment rose above 6 or 7 percent. Like his predecessor, Martin, he
spoke often and forcefully about the dangers of inflation, but his actions generally were much less forceful. His successor, William Miller, was a business executive. He had little professional experience and knew little about monetary policy. Both chairmen gave too much heed to perceived political constraints and too little to the costs of inflation.

I. Conventional estimates put the one-time oil price increase at one-third of the inflation rate. That leaves 7 percent as the maintained inflation rate in 1979.

Political pressures were only one of the reasons for rising inflation. The FOMC made several errors and had some bad luck. The oil price increase was non-monetary and did not require a monetary response. Error or misinterpretation caused them to treat the decline in output as a recession instead of a permanent loss of wealth and output, in effect a response to a tax paid to foreign oil producers that transferred wealth. Also, the main effect of the oil price increase was on the price level; the increase in reported rates of price change was temporary. The job of the central bank was to prevent the relative price change from spreading to non-energy prices. Once oil prices stopped rising, inflation would converge to or near its previous rate of change if monetary policy did not ease. Ignoring the difference between the temporary and persistent rate of price change or responding to the loss of output contributed to inflation. Countries that did not make this error, notably Germany and Switzerland, had much lower inflation rates (Issing, 2005, 334).
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The different inflationary responses suggest that policy responses to the decline in output following the increase in the relative price of oil was an important determinant of the size of subsequent inflation. What of the oil price increase itself? A study by Barsky and Killian (2004) concluded that in the United States the dominant inflation impulse came from monetary policy. The oil price increase raised consumer prices relative to the deflator because of the greater weight given to this price in the CPI. But the effect on measured inflation was temporary; the rate of increase rose then fell back.

Policymakers were slow to recognize that productivity growth had slowed. Reduced real growth called for slower money growth to avoid raising the inflation rate. Productivity growth is highly variable, so it seems right to assign some of this error to bad luck, especially since decades of research have not explained the productivity slowdown satisfactorily.
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The Board’s staff and the FOMC used a Phillips curve relating inflation negatively to the output gap (the difference between actual and potential— full employment—output) to predict inflation. Orphanides (2001) showed that the output gap as reported at the time was subject to large persistent
errors caused mainly by errors in estimating potential output. The gap reported at the time was generally much larger than the gap in the data as revised later. Staff
estimates, therefore, implied lower inflation than actually occurred. This persistent error misled policymakers at the FOMC and in the administration and encouraged excessive expansion.

2. A staff study by Pierce and Enzler (1974) analyzed the oil price increase as a permanent change in the price level. Like much of the best staff work, this did not affect the FOMC.

3. A recent study (Nordhaus, 2004) using industrial data finds the slowdown concentrated in energy-intens
ive sectors.

Later research showed that the output gap has not been measured precisely and perhaps cannot be. Using a large number of different models, Staiger, Stock, and Watson (1997) reported that they could not distinguish several different measures of the natural rate. The clear implication is that the Phillips curve model is not a reliable way of predicting inflation in the short run. Unfortunately, there is no systematic alternative that makes reliable predictions. This raises a fundamental question: Why does the Federal Reserve give so much attention to unreliable short-term changes in output and unemployment that include transitory elements? This concentration on short-term changes and the heavy weight given to unemployment changes caused much of the inflation problem of the 1970s.
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Chairman Martin’s statement at the start of the chapter recognizes part of that problem.

Serious as were the errors in Phillips curve forecasts of inflation, other errors contributed to the poor performance. These included excessive concern for short-term changes and failure to distinguish between persistent and temporary or transitory disturbances when implementing policies.
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This was particularly true in responding to the price level effects of rising food and oil prices in 1973–74. Stein explained these responses as responses to public and political pressures to “do something.”
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Also, mistaken policies defended or imposed by politically potent groups or their
representatives often made rational policy unattainable. Matusow (1998, Chapter 9) gives several examples following the first oil shock. Consumer gasoline prices remained frozen, but wholesale oil prices could increase. And import quotas restricted supply. Despite long gasoline lines and other inconveniences, oil price controls remained until 1981.

4. Feldstein (1997) computed the gain from ending inflation allowing for the cost in unemployment during the transition. He found the gain to be positive. Abel (1997) strengthened Feldstein’s result using a general equilibrium model.

5. Burns (1974, 1–2) testified that “[w]e have come to recognize that public policies that create excess demand, and therefore drive up wage rates and prices, will not result in any lasting reduction in unemployment.” Unfortunately, he did not always act as if his statement was true. I am grateful to David Lindsey for supplying the quote.

6. As Stein put it,

The decisions at the top are very much constrained by what the public wants, or by an administration’s perception of what the public wants, which I think is often quite wrong but is very important in their decision making. (Stein in Hargrove and Morley, 1984,407)

And

The Director of the Cost of Living Council and the new Federal Energy Administrator were unwilling to raise the [oil] price, mainly for fear of the political reaction. (Stein in Hargrove and Morley, 1984, 403)

None of these explanations accounts for the persistence of inflation and its increase during the 1970s. There is no doubt that the Federal Reserve made errors; the problem is to explain why it continued to make the same or similar errors.
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When Gerald Ford replaced President Richard Nixon, he declared inflation to be the main policy problem. One of his early efforts, known as the WIN program (Whip Inflation Now), was more a public relations effort than a policy initiative. The program began just as output started to fall. As unemployment rose, the administration shifted its emphasis. It asked for tax reduction, and the FOMC lowered the federal funds rate. That ended the anti-inflation effort and the WIN program. But it reinforced the strengthening view that anti-inflation programs would not last long enough to end inflation.

For the Federal Reserve, this meant reduced credibility. Burns, like Martin before him, made many strong statements about the evils of inflation. His actions increased inflation on average. The low credibility encouraged Congress to act. It passed resolutions and later the Humphrey-Hawkins Act, which required the Federal Reserve to announce monetary targets to aim for lower inflation.
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It did not achieve the projections. Even worse, it built its positive errors into its projections.

President Ford’s experience with the WIN program was not a unique event. It was one of three parts of the main problem. The Federal Reserve, Congress, and successive administrations put less weight on rising inflation than on rising unemployment. Rising unemployment called for more stimulus, an end to the anti-inflation program. After gaining this experience, the public doubted that the Federal Reserve would persist, so they
chose brief spells of unemployment to wage reduction. Wages became more sticky, reinforcing loose talk about stagflation and contributing to the mistaken belief that guidelines or controls were needed. Second, the Federal Reserve overemphasized short-term, often random changes and neglected the longer-term consequences of its actions. Controlling inflation required patience and persistence that it did not have at the time. Also, it lacked both a longer-term objective and a means of reaching it. Third, control procedures were harmful. The FOMC persistently misinterpreted interest rate declines as evidence of ease and increases as tightness. This error gave its actions a procyclical bias. And it failed to establish adequate procedures for controlling money growth.
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7. In 1973 Karl Brunner and I organized the Shadow Open Market Committee, with assistance from James Meigs and William Wolman of Argus Research, to point out policy errors and propose alternatives. Membership at the time included Robert Rasche, Anna J. Schwartz, James Meigs, William Wolman, and Homer Jones. The group met every six months to comment on policies and errors.

8. Arthur Burns testimony to Congress in 1974 is one of many examples. “A return to price stability will require a national commitment to fight inflation this year and in the years to come. Monetary policy must play a key role in this endeavor, and we, in the Federal Reserve recognize that fact. We are determined to reduce over time the rate of monetary and credit expansion to a pace consistent with price stability” (quoted in Broaddus and Goodfriend, 1984, 3). The quote shows that Burns understood that he had to control monetary emissions if he was to lower inflation.

Some members of FOMC understood the need for regaining credibility by sustaining anti-inflation policy. No reader of the minutes or transcripts can fail to see that there was not much agreement on the need for commitment of this kind. By 1978, there were three distinct groups. One proposed sustained anti-inflation policy. The second was unwilling to risk recession even as the reported inflation rate rose to 8 or 9 percent. Burns was usually part of this group. A third group remained in the middle of the two. The result was considerable talk but no sustained action.

Starting in 1973, the principal currencies floated, not always freely. But it is the first period in modern history with no major currency fixed to a commodity. Gold lost its position in the international system. Learning to operate without a reserve currency tied to a commodity or with a fixed exchange rate proved difficult for central banks. Oil shocks, recycling of oil revenues, and later the Latin American debt crisis and the anti-inflation policies in several countries increased exchange rate variability. Many observers decried the instability of floating rates, and many sought evidence of excess burden. Western European countries especially established arrangements for a joint float, often without restricting policies in the individual countries. It took years before governments accepted the discipline that fixed exchange rates required. Table 7.1 shows price and wage changes during 1973–79 in leading industrial countries.

Average annual inflation rates ranged from less than 5 percent in Germany to 15 percent in Italy. Since all of the countries experienced the same
oil shock, that shock cannot explain the very different behavior of inflation in these countries.

9. In 1973, the Congressional Joint Economic Committee proposed some changes in monetary policy. At the time, the CPI rose 11 percent for the month and the unemployment rate was 4.9 percent. The proposed changes called on the FOMC to not permit interest rates to rise above present levels. “If possible interest rates should be reduced” (JEC Report, 1973, Box 35602, New York Federal Reserve Bank, March 26, 12). The report also urged a standby credit allocation system to assist home buyers, local governments, and small businesses. Also, the report called on the System to buy mortgages and state and local securities. There was more, but the general direction is clear. Inflation control was of lesser interest.