A History of the Federal Reserve, Volume 2 (34 page)

Secretary George Shultz and Council members Paul McCracken and Herbert Stein recognized in 1971 that a price and wage control program carried the risk that monetary and fiscal policy would be overly expansive (Hargrove and Morley, 1984, 356). Nevertheless, that was what they urged.

In addition to policy errors, administration economists relied on faulty data. They believed that the economy had idle capacity that later data revisions removed. They believed that with idle capacity and a 6 percent unemployment rate at the start of 1972, their stimulus program would create jobs not inflation. Stein later recognized their error. “We all thought, ‘we’re a long way from full employment . . . and the inflation rate is low’” (Hargrove and Morley, 1984, 396).

Once the election was over and members recognized the consequences of their actions, the administration reversed course. The president proposed reductions in government spending, and he tried to impound $12 billion in spending that Congress had authorized. He determined to hold fiscal 1974 spending to $269 billion.
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Money growth declined also. From a peak twelve-month rate of increase of 9.3 percent in July 1973 annual base growth fell to less than 6 percent in late 1975 after controls relaxed or ended. Chart 7.4 above shows that annual growth of the real base turned negative in the fall of 1973. It remained negative for almost two years. Chart 7.10 compares real base growth to the real interest rate. Real base growth reached its trough in January 1975, two months before the National Bureau recorded a trough to the recession. As in several earlier recessions, real ten-year interest rates (using predicted inflation) remained in a narrow range. These rates declined modestly before the recession, remained in a narrow range during the recession, again declined modestly before the trough, and rose during the early months of recovery. Chart 7.10 shows these data.

The Council of Economic Advisers forecast for 1973 that inflation would fall to 2.5 percent and that real growth would approach full employment, still considered a 4 percent unemployment rate. Instead, the four-quarter average increase in the GNP deflator reached more than 8.25 percent and rose 10 percent (annual rate) in the fourth quarter. Real GNP rose 3.5 percent, but in the last three quarters, the average rate fell to 1.4 percent. The unemployment rate remained about 5 percent. Despite the commitment
to reduce inflation, the Society of Professional Forecasters raised the expected four-quarter inflation rate from 3.7 percent to 5.4 percent between fourth quarter 1972 and 1973. A year later, it reached 7.7 percent. Hourly wage growth increased from 6.3 to 8.1 percent, and ten-year interest rates rose 0.5 percentage points to 7.4 percent.

22. He achieved his spending limit, but Congress resisted his unprecedented use of impoundment. They removed this power. Earlier in October 1972, Congress increased social security payments by 20 percent just before the election and for the first time indexed social security benefits so they would increase with prices automatically.

Food price increases that began with large grain purchases by the Soviet Union ended with the new harvest. Oil price increases began at about the same time. At first oil prices more than doubled to $5 a barrel. By year-end 1973, the oil price reached $11.65 a barrel. Instead of allowing domestic gas and oil prices to reflect market prices, the administration maintained price controls. These controls began in August 1971, so they froze prices when heating oil was relatively cheap seasonally and gasoline relatively expensive. Subsequent supply problems reflected this policy. Heating oil became scarce in the winter, when its price usually rose.
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The National Bureau dates the peak of the expansion in November 1973 and the trough of the recession sixteen months later in March 1975. The recession was the longest since the Great Depression and the deepest since 1937–38. Real output fell 4.9 percent, more than in any postwar recession
to date (including 1981–82). The unemployment rate reached 9 percent in May 1975 after the recession ended.

23. On October 23, 1973, most members of OPEC, led by Saudi Arabia, imposed a boycott on exports to the United States and the Netherlands, demanding a change in their policy of supporting Israel and to punish the United States for supplying weapons to Israel in the 1973 war. The boycott had little effect on supply. Oil shipments shifted. The United States received its oil from non-Arab producers.
The boycott soon ended.

Prior to the recession, the FOMC could not agree on appropriate policy or how to conduct it. Policy called for controlling growth of monetary aggregates by controlling growth of RPDs (reserves against private deposits) to reduce inflation; the members never discussed how much unemployment they would accept to reduce inflation. In practice, differences persisted.
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At its August 20 meeting, the FOMC recognized that part of the recent surge in wholesale prices reflected the early end of the June 13 price freeze on July 18. Interest rates had increased during the summer as money growth slowed. In July, the Board removed interest rate ceilings on consumer time deposits of $1000 or more and four years maturity. It raised ceiling rates on shorter maturities. At the end of July, the System decided to rescue a Treasury offering by purchasing $350 million of a $500 million issue. The Treasury purchased almost half of the twenty-year bond issue for its trust accounts.

To offset growth in RPDs that was more rapid than expected, the FOMC raised the maximum federal funds rate from 10.25 to 11 percent. As in its later experience from 1979 to 1982, the spread between the federal funds and discount rates induced a surge of borrowing to more than $2 billion in August.
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The staff forecast called for much slower growth, 1.2 percent average real growth for the four quarters of 1974. “The dilemma that the Committee faces . . . is in deciding how to weigh the very real prospect that growth in the economy will be slowing to minimal levels against the very real risk that there may be enough remaining strength to keep unacceptable pressure on critical resources and hence on our structure of costs and
prices” (FOMC Minutes, August 21, 1973, 21). In response to a question, Charles Partee, a senior staff member, said he expected a recession in late 1974 (ibid., 30). The staff report urged the FOMC to choose between higher employment and lower inflation. The member’s responses show their thinking. President Hayes (New York) wanted to slow inflation before it became embedded in wages. “He did not see much evidence that high interest rates were in themselves bringing demand pressures under control thus far.” And he described the increase in nominal rates as “severe restraint” (ibid., 14–15). However, he failed to mention that real rates of interest had changed very little and were modestly lower (Chart 7.10 above). Governor Brimmer thought a recession was likely to come sooner than most expected. “The issue before the Committee would be not whether but how soon monetary policy should be eased” (ibid., 32–33). Burns, Hayes, and Francis disagreed. As usual before the recession started, they gave priority to inflation control. Burns said that “reduction in the rate of inflation would require an environment of tighter budgets and a relatively restrictive monetary policy” (ibid., 39).

24. The Board also increased marginal reserve requirements from 5 to 8 percent on certificates of deposit and commercial paper on May 16. The new requirements became effective June 7 but applied to the increase after May 16. At the same time, the Board removed the ceiling rate on all ninety-day single-maturity time deposits of $100,000 or more. On May 21, the Board sent a letter to large banks asking that “the rate of credit extension be appropriately disciplined” (Annual Report, 1973, 88–89). The federal funds rate rose, but annual monetary base growth also rose. The Board increased reserve requirements by 0.5 percentage points on June 29. It exempted the first $2 million of a bank’s deposits to pacify members of Congress who wanted to protect small banks and to reduce the loss of members. With bank credit continuing to grow rapidly, on September 7, the Board increased the marginal reserve requirement from 8 to 11 percent. Three months later, the Board restored the 8 percent marginal requirement.

25. The System intervened in the foreign exchange market in July to stop dollar depreciation. The August rise in market rates reversed the decline. The System repaid the $273 million swap in August with an $8.5 million profit. Coombs was elated and urged more frequent, more visible, and larger interventions.

Governor Bucher believed “the Fed had overreacted in the past and had created undesirable shocks in the economy” (ibid., 61). President Coldwell (Dallas) wanted to lower growth of RPDs and ignore M
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, but Governor Holland thought the Committee should focus on interest rates. And Governor Daane wanted to remain restrictive, but he didn’t believe the System could achieve a precise target.

President Balles brought expectations into the discussion. He quoted a newspaper article saying that “the Federal government doesn’t want to see the economy suffer either a recession or more inflation. If there is a choice, however, federal officials lean heavily toward more inflation” (ibid., 67). He thought that some measures of money had to slow. Part of the problem was the narrow range kept on the federal funds rate. Governor Brimmer responded that “policymakers faced with a choice between more or less inflation and more or less unemployment were inclined to accept a little more inflation” (ibid., 73).

Divided on several dimensions, the FOMC was unlikely to agree on decisive action. They made no effort to discuss the reasons for disagreement; they agreed to make no change. Chairman Burns summarized the comments as favoring M
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growth of 1 to 4 percent, RPD growth of 11 to 15 percent, and the funds rate between 10 and 11 percent. The Committee changed RPD growth to 11 to 13 percent. It voted ten to one, with one absence. Darryl Francis dissented because of the narrow range for the federal funds rate. He did not believe the desk would hit the money target. Burns had recognized that “failure to bring the monetary aggregates under
control in recent months fundamentally resulted from a failure to control RPDs” (ibid., 53). Yet he did not set a wider range for the funds rate or support Francis’s effort to do so.

Soon after the meeting, data showed that RPD growth remained above the target. The desk responded by raising the federal funds rate by 0.25 to 10.75 percent, and the Board on September 7 increased reserve requirements against large-denomination CDs.
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Industrial production followed a very variable path during the fall, then fell 19 percent in December. Stock prices generally declined. The average annual increase in the CPI rose above 8 percent in November. The federal funds rate reached a peak in September and declined gradually, suggesting less restraint. As usual, policy moved procyclically. Monetary base growth declined from 9 percent in July to 7 percent in December, suggesting increased restraint.

The Federal Reserve faced stagflation, defined as falling output and rising inflation. On the staff’s analysis, this was a puzzling outcome. Inflation was supposed to decline along the Phillips curve as output fell relative to potential. After the September 18 FOMC meeting, market rates dropped precipitately, and money growth fell below the target. At a special meeting on October 2, the FOMC voted six to five to permit a modest further decline in the funds rate. The minority wanted a larger move. A week later, at another special meeting, after Chairman Burns returned from Africa, the FOMC met (by telephone) again. The asymmetry in Burns’s policy is evident. Although he had hesitated to respond to rising inflation, he warned the members that the FOMC “would be failing to meet its responsibilities to the economy and to the nation” (FOMC Minutes, October 10, 1973, 5). He favored providing “reserves aggressively” (ibid., 3). The funds rate would fall from 10.5 to 10. The Committee deleted the word “aggressively” and voted unanimously to make the policy change.
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26. On September 14, the Shadow Open Market Committee (SOMC) held its first meeting. Its initial statement said “economic policies could have been better in the past and can be better now.” It proposed gradual reduction in money growth to a non-inflationary range, and it criticized the Federal Reserve for failing to adopt a long-term plan to lower inflation at lowest cost. Karl Brunner and I, with help from William Wolman and A. James Meigs of the Argus Research Corporation, organized the meeting. The SOMC continued to meet semiannually into the twenty-first century. Karl Brunner died in 1989, and I left in 1999. The SOMC hoped that its semiannual meetings would suggest that the FOMC give less attention to short-term changes.

27. Burns’s policy reversal is informative about his concerns. He wanted to lower inflation without increasing the unemployment rate. Usually he dismissed short-term changes in money growth as non-informative, mainly random fluctuations. At this meeting, he seized on the brief decline in money growth to urge an aggressive expansion. He told the FOMC: “He had strongly advocated the highly restrictive monetary policy that had in fact been pursued in
recent months. It now appeared that the objective—to moderate the growth of the monetary aggregates—had been achieved. . . . [T]he narrowly defined money supply had shown virtually no growth over the third quarter. . . . If the System were to allow the period of very low or negative growth in the money stock to continue much longer, . . . it would be failing to meet its responsibilities to the economy and to the nation” (FOMC Minutes, October 10, 1973, 4–5). “Mr. Daane remarked that he had not seen the kinds of significant changes in the economic situation that would warrant a sharp change in monetary policy” (ibid., 7–8).