A History of the Federal Reserve, Volume 2 (53 page)

President Carter had been skeptical earlier about his advisers’ recommendations to control inflation without reducing money growth and aggregate demand. The October–November experience demonstrated that outsiders would not regard an anti-inflation or exchange rate policy as credible if it relied mainly on wage-price guidelines. These policies had failed in too many countries, including the United States, too many times. We can not know what President Carter thought, but we know that in less than a year he appointed Paul Volcker to chair the Board of Governors after being told that Volcker intended to reduce money growth and raise interest rates.

The 1978 experience showed that a floating exchange rate could in principle permit the United States to pursue a strictly domestic policy with “benign neglect” of the exchange rate. Politically it had less chance despite the fact that almost all of the dollar depreciation during the period was a change in the nominal value that differed little from the price change during the same period. Table 7.15 compares the decline in the Federal Reserve’s trade-weighted index from its local peak, June 1976, to October 1978 to the change in the consumer price index. The table suggests that domestic inflation played a major role in dollar depreciation; the real exchange rate changed little. The table also shows the sizeable nominal depreciation in 1978 that alarmed the Europeans.

Some of the concern may simply have reflected myopic failure to distinguish between real and nominal changes. All rates did not change together; in particular the mark appreciated approximately 28 percent in nominal terms during this period, so the Germans could (and did) complain about real appreciation, although Germany also experienced infla
tion. The 1976–78 experience showed that, while floating exchange rates increased freedom of action for limited policy changes, large dollar depreciation forced the administration to respond to the exchange rate for political reasons. Indexed, the November rescue package was larger in size than anything done during the Bretton Woods era to respond to international pressures.
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The
Bank
for
International
Settlements
(BIS)

One sign of increased concern about the international effects of central bank policies was the decision to become a member of the BIS. The United States played a major role in establishing the BIS in the 1930s, but it elected not to become a member or to purchase shares. It held observer status.

At the start, the New York Federal Reserve bank furnished the observer, but Congress stripped that power from the New York bank in 1935 and gave it to the Board. The Board discussed joining several times but did not act until the mid-1970s. In a letter to the general counsel of the BIS, the Board’s staff inquired about liability of directors under Swiss corporate law and BIS regulations. And it questioned whether BIS statutes had to be amended to take account of the structure of the Federal Reserve. The Board was not a bank, as specified in the statute; the monetary authority was the System, not the Board; and the operating head was the chairman of the Board of Governors, not the president of a Reserve bank (letter, Theodore Allum to F. E. Klein, Gerald R. Ford Library, February 12, 1976).

When these and other technicalities were resolved, Chairman Burns became the U.S. representative. Henry Wallich became his alternate and usually attended the meetings.

CONTROLLING MONEY AND FURNISHING INFORMATION

During 1976 to 1978 the monthly unemployment rate remained between 6 and 8 percent,
and the twelve-month average rate of consumer price inflation ranged from 5 to 8.5 percent.
¹⁵⁸
Many regarded this performance
as poor. Among the critics, some wanted price and wage controls, some urged a return to the gold standard, and some called for control of money growth. The last group, called monetarists, presented an alternative analytic framework and criticized the Federal Reserve’s procedures. Perhaps the most important technical criticisms were that the Federal Reserve misinterpreted its own policy actions by identifying changes in market interest rates with adjustments to the stance of monetary policy. It interpreted a decline in market interest rates as evidence of monetary ease even if growth of money and credit declined. And it interpreted an increase in interest rates as restrictive even if money growth rose. Also, the Federal Reserve routinely used market or nominal interest rates, instead of real rates, as its indicator of ease and restraint.

157. The November 1 Federal Reserve action was a more decisive step, but it was not the only departure from “benign neglect” of exchange rates. For example at the January 17–18, 1977, meeting, the FOMC voted unanimously to lend up to $1.5 billion of foreign currencies to the Exchange Stabilization Fund for periods as long as twelve months. To get around the prohibition on direct loans to the Treasury, the action was again called “warehousing.” Subject to review each year, the warehousing did not have a terminal date. Also, in December 1977, the FOMC responded to the relatively sharp dollar depreciation by authorizing the account manager to take account of “unsettled conditions in foreign exchange markets” in his operations (Annual Report, 1977, 321).

158. These are two months below 5 percent inflation at the end of 1976. Between December 1976 and December 1978, CPI inflation rose from 4.7 to 8.6 percent.

Gradually, poor or unsatisfactory outcomes and monetarist criticisms encouraged congressional action intended to give more attention to growth of the monetary aggregates. Unfortunately, the discussion almost always presented control of market interest rates and money growth as alternatives. There was no reason why the Federal Reserve could not eliminate its procyclical actions by adjusting the interest rate to reflect the maintained path of the monetary aggregates. In fact, the FOMC’s introduction of proviso clauses specifying some measure of reserves or money growth were steps in that direction beginning in the early 1970s. The clause added a proviso that called for a change in the federal funds rate if money growth was deficient or excessive. One problem was that the account manager or the chairman was reluctant to raise interest rates when money growth or reserves exceeded the proviso clause out of concern about an increase in unemployment. This reflected beliefs about public and congressional attitudes, interpretations of the Employment Act, and the perceived relative social costs of unemployment and inflation.

FOMC members disliked congressional interest in its operations, procedures, and actions, but formally the Federal Reserve is the agent of Congress. Congress could change the Federal Reserve Act if it chose to do so. Heightened congressional interest aroused Federal Reserve concerns. Many of these concerns reflected the belief that the System was a guardian of the currency while members of Congress included (many) inflationary populists. Members did not say on the record that their failed policies and poor performance brought on increased congressional scrutiny and demands for increased oversight. And attempts to control inflation by raising real interest rates also brought the criticism that housing starts declined.

Early
Stirrings

One pressure called on the Federal Reserve to release more information in a timely manner. Several issues about release of information had a long history in the tradition of central bank secrecy. Should the reserve banks share information about discount rate changes? How much information should directors be given when they voted on discount rates? What should the Board release to the public?
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In 1971, a committee of presidents reconsidered these and other issues as part of the decision to make discount policy more flexible.

The committee proposed regular discussion of discount rate policy at FOMC meetings and at the regular meetings of the Conference of Presidents. The presidents requested notification from the Board when it approved a discount rate change at one of the banks. And they asked to receive notice of the Board’s policy actions before they were released to the press and public. The committee also suggested changes in interbank exchange of information. It proposed that each reserve bank notify the Board and all other banks about the views of its board of directors on the discount rate and other policies.

On the difficult issue of information given to directors about Federal Reserve policy, the presidents proposed “some very general indication of the current monetary position of the FOMC, particularly on the occasion of a change in the direction of policy” (memo, Committee on Discounts and Credits to Conference of Presidents, Burns papers, BB25, February 5, 1971, 4). It called on the FOMC to issue guidelines. It permitted presidents to inform the board chair, in strict confidence, of Board decisions about discount rate changes at other banks “when it would appear such action is imminent” (ibid., 6). But other members would not be told except as to the “general nature of the situation in order that they may make a fully considered judgment” about discount policy action (ibid.).

The Board staff accepted most of the presidents’ suggestions. It prepared a letter outlining what presidents could tell their boards about Federal Reserve actions (memo, Robert Holland to Burns, Burns papers, February 5, 1971).

Further stimulus to change in communications came after passage of legislation including the Freedom of Information and Government in the
Sunshine Acts. Following the Freedom of Information Act, a student (Merrill) sued the Federal Reserve to release current information. The Merrill case (discussed below) forced the Federal Reserve to give more thought both to what the laws required and what legitimate reasons it had to withhold information about its actions to protect its ability to operate effectively.

159. The decision about whether the Board or the reserve banks announced discount rate changes was contentious in the 1920s. The Board asserted responsibility because changes became effective only if approved by the Board.

Monetary
Targets

In spring 1975, Congress made a first attempt to instruct the System on ways to improve the conduct of policy. House Concurrent Resolution 133 proposed three major changes: (1) the Federal Reserve was to set a twelve-month target for money growth and announce it publicly; (2) it was instructed to maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production; and (3) Congress increased its oversight by requiring the Board of Governors to report to Congress semiannually at open hearings before the banking committees.

Two correct implications of the resolution were that the Federal Reserve gave too much weight to current developments and too little to the longer-term consequences of its actions. And it neglected the role of money growth and the evidence that sustained inflation resulted from a sustained excess of money growth over real output growth. But the resolution recognized that, in an uncertain world, the Federal Reserve might wish to change its money target and report the reason for the change at the next semiannual hearing.

Two memos, one from the Philadelphia Reserve Bank and the other from the Board staff, took constructive positions on the proposed changes in procedures and response to the Congress. Philadelphia’s memo described the resolution as “a useful affirmation on the part of Congress of the importance of long-term targets and the role of Congress as an overseer of the basic objectives and overall implementation of monetary-policy” (memos, David Eastburn to FOMC, Board Records, April 4, 1975, 1).
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Although Philadelphia criticized specific details in the resolution, it urged the FOMC to “clarify its targets for the Congress and to assist in developing a framework for holding the Fed accountable in hitting its targets” (ibid., 6). The FOMC did not accept this suggestion, and it did not limit its reporting mainly to M
₁
and M
₂
.
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160. Later in the memo, Philadelphia accepted a key criticism. “Congress expects the Committee to lengthen its horizon for monetary policy planning” (memo, Eastburn to FOMC, Board Records, April 4, 1975, 8).

161. Philadelphia warned that “introducing too many aggregates may appear as an evasive tactic . . . to avoid accountability” (memo, Eastburn to FOMC, Board Records, April 4,
1975, 7). Contrast the Board staff’s memo that proposed six measures of money growth (memo, staff to FOMC, Board Records, April 10, 1975, 5).

The FOMC’s Subcommittee on the Directive proposed introducing a new paragraph into the directive giving four-quarter ranges for growth of the monetary aggregates. In a separate paragraph, it would continue to state the federal funds rate target and the short-term money growth rates approved by the Committee. However, the subcommittee did not propose any means of achieving the longer-term money target, reconciling the short- and long-term targets, adjusting to target misses, or even reconciling the short-term targets for monetary aggregates and the federal funds rate. And, most importantly, it did not discuss whether the longer-term target to reduce inflation would cause a larger temporary increase in the unemployment rate than the FOMC was prepared to accept.

The St. Louis Federal Reserve bank strongly favored increased emphasis on monetary growth and longer-term policy, but it expressed concern about the compatibility of fiscal and monetary policies and market interest rates. In a letter to the Board and an article in its Review, St. Louis noted that the proposed M 1 growth rate would require the administration to finance a much larger share of its current deficit in the market. “Our desire is to make it clear that the achievement of the target growth in the monetary aggregates will not be easy, but clearly desirable. We feel strongly that outside pressures on the System will build for us to monetize more debt in an effort to hold down the inevitable rises in short rates and we want, in this rather hypothetical way, to illustrate the implications of such actions” (letter Jerry L. Jordan to Arthur Broida, Board R
ecords, July 23, 1975).

Arthur Burns’s testimony before the Senate Banking Committee tried to weaken Resolution 133 without much success.
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The resolution passed. There is little evidence that it affected the FOMC’s actual performance. It did increase oversight and information about monetary policy by introducing quarterly statements by the chairman at congressional hearings.

At about the same time, Congress approved the Government in the Sunshine Act. The Board tried to be exempt but did not fully succeed. Most policy meetings including FOMC meetings remained closed, but the FOMC voted to make reports of its meetings available to the public forty-five days after the meeting. Very slowly, it reduced the lag over subsequent decades. The release of information and summaries of policy discussion were additional steps from traditional central bank secrecy to greater transparency. The burgeoning academic literature following Kydland and Prescott (1977)
greatly encouraged this development by making more explicit the advantages to society from pre-announced rule-like monetary policy procedures. That came later.

162. This sentence is based on conversation with the late Robert Weintraub, a senior staff member of the committee and a proponent and architect of
Resolution 133.