A History of the Federal Reserve, Volume 2 (38 page)

The manager summed up experience in a difficult year. “The use of aggregate targeting has probably contributed to the clarity of monetary policy discussions, but policymaking itself has not proved easier. Evidence of structural change in the financial system has reduced the policymaker’s confidence in the stability of the linkage between operational instructions and desired long-run economic goals” (Holmes, 1975, 207). Among the major changes he mentioned were the end of ceiling rates for large CDs that made banks more confident about sources of funds, and thus more willing to lend, and belief that inflation would continue. Banks included adjustment clauses in loan contracts and adopted a floating prime rate. The manager did not oppose the use of monetary targets, but he asked for greater flexibility in the choice of particular monetary targets.

At the FOMC meeting, the New York bank began with relatively pessimistic news and forecasts. The Council and the Federal Reserve staff predicted that the recession would continue for the first six months of 1975. In fourth quarter 1974 output declined at a 9.1 percent annual rate. Later revisions changed the decline to 1.6 percent, an extreme example of the cost of reliance on current data.
⁴⁷

The president’s advisers recommended a $91.5 billion tax cut, threefourths to individuals in the form of a one-time rebate. They also proposed an increase in the investment tax credit from 4 to 12 percent for utilities and 7 to 12 percent for all other corporations. The advisers proposed to decontrol oil prices and impose a windfall profits tax on oil companies. There
would be no new spending programs, but the Treasury and the Federal Reserve would prepare legislation for an agency like the Depression-era Reconstruction Finance Corporation to take over failing financial institutions. Congress approved only tax reduction and added additional spending for low-income individuals.

47. Data are from Runkle (1998, 5).
Business
Conditions
Digest
for October 1988 reports the decline as 3.5 percent. Runkle shows that in the sample he used, 1961 to 1996, initial estimates are biased estimates of the final data. For real GNP the difference was as large as the 7.5 percentage point underestimate in 1974 or a 6.2 percentage point overestimate. This raises an issue to which I will return in chapter 10: Why base policy actions on noisy shortterm data? See also Orphanides (2001) and Meltzer (1987).

The Federal Reserve began the year by reducing the federal funds rate target to 6.5–7.25 percent, intending to maintain money growth at 3.5–6.5 percent. On January 20, the Board reduced reserve requirement ratios by 0.5 percentage points for demand deposits of $400 million or less and by 1 percentage point above $400 million effective February 13. The new range ran from 7.5 percent to 16.5 percent based on size of deposits. Also during the first quarter, the Board rejected several requests to reduce discount rates, but it approved 0.5 percentage point reductions on January 3, February 4, and March 7. The discount rate declined from 7.75 to 6.25 percent.

By March, the monthly average funds rate was down to 5.5 percent, a 50 percent decline from the previous September. This was hardly the slow, deliberate ease that Burns claimed he wanted. Growth of the monetary base declined from 7.5 percent for the fourth-quarter average to 6 percent for the first quarter, a tightening of policy. First-quarter M
₁
growth, reported at the time, was 3.9 percent. Once again, the federal funds rate and nominal base growth gave different signals. However, CPI inflation declined, so growth of the real base rose. In the second quarter, the recession ended.
⁴⁸

Keynesian economists had learned about the importance of money growth. In congressional testimony and public statements, they urged much more expansive monetary policy, 10 percent money growth or higher, and predicted dire consequences if the Federal Reserve did not accept their advice.
⁴⁹
Burns resisted. The FOMC M 1 target was 5 to 7.5 percent. He dismissed the Keynesian critics: “Most economists who move from platform to platform these days . . . pay very little attention to the business cycle. They have never studied it thoroughly, or, if they have, they have forgotten what they once knew” (quoted in Wells, 1994, 158). Burns
claimed that in the first year of recovery, velocity growth rose above trend. He relied on velocity growth to end the recession. He was right. Recovery began in April 1975.

48. In the weekly memo to the president on monetary policy dated February 14, 1975, Alan Greenspan and William Fellner noted that the System’s easier policy, including lower reserve requirement ratios, had not raised money growth rates. The memo recognized that the decline in interest rates reflected weak credit demand. “Movements in the monetary aggregates will also tend to
reflect
the business cycle instead of countering it unless the Fed moves vigorously to expand money in periods of falling interest rates and economic decline” (Fellner and Greenspan to the president, Ford Library, WHCF FI Box 1, February 14, 1975; emphasis in the original). Burns’s efforts to reduce inflation brought strong criticism of Federal Reserve policy from the labor unions and some members of Congress. But he also received support from others in Congress (Wells, 1994, 137).

49. Wells (1994, 158–59) cites James Tobin and a “committee of prominent Keynesians” as the authors of these claims.

In March, President Ford met with Arthur Burns to express his concern about money growth and to get Burns’s assessment of the recession and recovery. The president stressed the importance of having recovery in 1975 without a new surge of inflation in 1976 (briefing paper, Greenspan to the president, Ford Library, WHCF FG, Box 156, March 10, 1975).
⁵⁰
Soon after M 1 growth rose.

The Board’s staff recognized by May that the decline in output had slowed or stopped. They did not recognize that recovery began until August. By that time, growth was at a 7 percent annual rate after rising 4 percent in the second quarter.

CONGRESSIONAL INTERVENTION

Reports of deep recession, sustained inflation, historically high interest rates, and a 9 percent unemployment rate brought heightened attention to Federal Reserve policy. Although the Constitution gives Congress power over money creation, few members found the details interesting enough to learn about the processes. Usually they relied on a few interested members to inform them when an issue arose. Periods like the deep recessions of 1920–21 or 1929–33 brought more attention. In the 1970s, many people shared Poole’s conclusion that “the 1972 boom was purchased at the cost of the 1974–75 recession” (Poole, 1979, 482).

These criticisms and the economic problems in 1974–75 renewed public and congressional interest. Burns’s active lobbying against Congressman Patman’s efforts to bring more direct control succeeded. Despite strong resistance, however, Congress passed a resolution in March 1975 over Burns’s strong objections.

Members of Congress expressed annoyance at Burns’s refusal to tell them the planned rate of money growth.
⁵¹
One response was a bill requir
ing the System to make M
₁
grow 6 percent or more in 1975 and to allocate credit toward national priorities. Burns argued that M
₁
was not a good indicator, that velocity changed erratically so that the System could not rely on a specific target.
⁵²
He properly opposed credit allocation as impossible, a new type of real bills notion. The System could not know what the final use of credit would be.

50. As Council chairman, Alan Greenspan held meetings of the treasury secretary, budget director, and Federal Reserve chairman with a small group of business and academic economists. At the February 1975 meeting, I urged Chairman Burns to recognize that monetary base growth was procyclical. He made clear that his concern was to lower interest rates and did not want a large decline required to get an increase in base growth. The March 7, 1975, statement by the Shadow Open Market Committee made the points public. At the White House meeting, Chairman Burns asked me to tell him what would happen if he adopted my proposal that he make up the shortfall of 8.5 billion in M
₁
and return to a 5.5 percent growth rate. Burns’s letter of April 12, 1975, said that would be unwise. In fact, he increased M
₁
about as much as I suggested by the end of March (Burns papers, Box K24, Ford Library, April 12, 1975).

51. Burns’s desire for secrecy and his idea of independence were probably central. However, in an interview, James Pierce, an associate director of research at the time, explained
that the Board’s forecasts did not relate money and output. Lyle Gramley prepared the green book forecasts of the real economy. They were independent of money growth. “Here was the central bank making forecasts without knowing what its monetary policy was. I’d make myself very unpopular going into that meeting saying what’s your monetary policy assumption? . . . They wouldn’t listen because they were old-fashioned business economists”
(Pierce, 1998, 9).

As finally approved, Congressional Resolution 133 required the Federal Reserve to reduce long-term interest rates and to report quarterly to the House and Senate Banking Committees on its planned rate of money growth.
⁵³
This requirement became part of the Federal Reserve Reform Act of 1977. Most commentary on these targets points to the way in which the Federal Reserve evaded congressional intent by announcing four targets for one-year growth—M
₁
, M
₂
, M
₃
, and the Bank Credit Proxy (total deposits)—revising the announcement each quarter, and shifting the base. The last, known as base drift, was probably the most serious. When money growth exceeded the target, the new target started from the overshoot (or undershoot). Thus, maintained money growth bore little relation to the target until the Volcker years after 1980–81.

After some experimentation, the FOMC set its target as the four-quarter rate of change beginning in the most recent quarter. Most, but not all, the errors were excess growth. Table 7.7, adapted from Broaddus and Goodfriend (1984, 7), shows the ranges and the errors for 1975 to 1984.

On average the error was 1.3 percentage points compared to an average 5.6 midpoint, or 23 percent. Most of the errors are positive; actual growth exceeded the target midpoint. Some of the errors arose because of changes in the composition of M
₁
; NOW accounts are an example.

Nevertheless, Resolution 133 was a step toward increased transparency. For the first time in the Federal Reserve’s history, after more than sixty years, Congress tried to supervise its agent more effectively, and the
public had a noisy indicator of intended future System policy. Additional steps eventually produced meaningful increases in transparency at all major central banks. Si
nce the Federal Reserve had not replaced the gold standard rule with an alternative rule, greater transparency was needed to improve private forecasts of inflation or disinflation. The Federal Reserve was able to evade this step, but the issue was now open and would return.

52. In a comment on this section, Jerry Jordan described the outcome of a meeting held at the FOMC about this time. Four recommendations for a target came to a vote. Money growth received seven votes. Three money market measures (federal funds, free reserves, nonborrowed reserves) each received four votes. Burns ruled that a majority opposed money growth, so he eliminated it and revoted on the other three.

53. The legislation owed much to the efforts of the late Robert Weintraub, a staff member of the Banking Committee. Weintraub persuaded Senator Proxmire of the need for monetary targets.

In testimony on May 1, Burns announced a target of 5 to 7.5 percent for M 1 for the year ending March 1976. The announcement of explicit targets was a first. Unfortunately, the Federal Reserve chose to undermine Resolution 133 instead of using it to reduce inflation and maintain price stability.

Internally, members expressed concern about the unreliable control of monetary aggregates. In July 1973 the FOMC reactivated the Subcommittee on the Directive. The subcommittee’s first report, on March 10, 1975, recommended use of nonborrowed reserves (total reserves minus member bank borrowing) in place of RPDs. The claim was that the manager’s control of the instrument would improve. The report recognized that none of the reserve aggregates permitted precise short-run monetary control. It proposed setting a nonborrowed reserve target for the interval between FOMC meetings (memo, Subcommittee on the Directive to FOMC, Board Records, March 10, 1975). This was the apparent basis for choosing nonborrowed reserves as the target when the System adopted reserve targeting in October 1979.

Dewey Daane gave another prominent view of thinking within the FOMC. Daane served as a governor from 1963 to March 1974. A year later, he gave a speech expressing his personal views and responding to many of the Federal Reserve’s critics. His emphasis on fiscal policy errors is familiar from many members’ statements.