A History of the Federal Reserve, Volume 2 (122 page)

AFTER THE RECESSION

The National Bureau chose November 1970 as the end of the recession, but the auto strike makes the timing uncertain. Industrial production surged 27 percent (annual) rate in December, but part of the surge made up for strike-related declines in October and November. January 1971 had a 9.2 percent increase, before production fell in February and March. The twelve-month average rate of increase did not become positive until May.

Real GNP fell in fourth quarter 1970, rose 11.2 percent (annual rate) in first quarter 1971 but was stagnant in the second quarter. The unemployment rate remained at 5.9 or 6 percent throughout the spring and summer, and the S&P 500 average did not increase until July. For an administration that had been willing to tolerate unemployment of no more than 4.5 percent to reduce inflation, the outcome suggested failure.

The data support those who claimed the recovery was sluggish. The deflator was even more discouraging, rising at 6.7 and 7.6 percent annual rates in the first two quarters of 1971. And despite the slow growth, the current account deficit increase added to the general sense that administration policies were not solving the nation’s problems. Monetary base growth rose in the spring of 1971, and the Federal Reserve increased the federal funds rate beginning in April 1971. The monthly average rate reached a cyclical low of 3.7 percent in March. By July, the rate was 5.3 percent.

As the year 1971 started, the administration recognized that something more had to be done to lower the unemployment rate to 5 percent or less in time for the 1972 presidential election (Maisel diary, January 13, 1971, 3). President Nixon adopted an unbalanced budget with a $15 billion projected deficit. The actual deficit was $23 billion. Like President Kennedy in 1962, his advisers brought him to accept the full employment budget deficit, not the actual deficit, as a proper measure of fiscal position. To make his conversion clear, the president announced that “we are all Keynesians now.” The president’s advisers explained to Burns that they had to run a large deficit because money growth was not sufficient (Maisel diary, June 13, 1971, 3).

At a meeting with the president’s economic advisers, Maisel asked for the administration’s forecast for 1971. Although the official forecast called for GNP to reach $1065 million by the fourth quarter, Herbert Stein privately expressed considerable skepticism. He expected that a fiscal policy that produced the $15 billion deficit they planned would bring nominal
GNP to $1050 million, not $1065.
²¹⁶
To get to $1065, Stein explained, would require more expansive monetary policy, but he was “unwilling to specify what monetary policy they believed was necessary to get on this path” (ibid., 13).

President Nixon was not so constrained. At meetings with his principal advisers, he brought up monetary policy repeatedly, often questioned Burns’s commitment to the administration’s objectives, and made threatening statements.
²¹⁷
He urged Secretary Connally to find “an opponent of Arthur Burns” to fill the next vacancy (Ehrlichman notes, Box 5, July 9 and 20, 1970). The president was upset particularly by Burns’s statements about a wage-price review board. At one time, he refused to have further contact.
²¹⁸

The first half of 1971 was an example of how not to conduct monetary policy operations. The System had several objectives, and the members had different priorities. Some expressed greatest concern about inflation; some gave more attention to unemployment and slow economic growth; some wanted to lower money growth to bring down inflation or respond to the growing balance of payments deficit and complaints from abroad; some wanted to shift emphasis back to money market conditions; and some wanted tighter control of money growth or monetary aggregates. With the FOMC divided along several dimensions, agreement could be obtained only, if at all, by making small changes that accomplished none of the objectives. Adding to the System’s woes were administration complaints that unemployment and inflation were both too high and, if they were receding, they were doing so much too slowly.

Members of the administration blamed the Federal Reserve for the unsatisfactory outcome. Relations declined. Federal Reserve meetings with the Treasury or the CEA became infrequent or ended temporarily. Burns’s insistence on advocating price-wage guidelines, with Board support, exacerbated the bad feeling.

216. The $1065 forecast was based on work by the new chief economist at the Office of Management and Budget, Arthur Laffer. Work at the CEA (and elsewhere) cast doubt on his methods and results.

217. John Ehrlichman’s handwritten notes of these meetings contain many statements such as “time to take the Fed on,” “give Fed a good kick,” or “I’ll unload on him.” Ehrlichman was Domestic Policy Adviser in the White House. The president was less belligerent when he spoke directly to Burns. In a White House tape, Nixon says, “I think that interest rates going down . . . would be something most people would appreciate. People are saying there just isn’t enough demand for money.” Burns responded that they needed to increase money growth but that faster money growth does not guarantee increased spending (White House tapes, conversation 454-4, February 19, 1971).

218. Entirely apart from Burns’s relationship to the White House, the administration had no meetings of sub-cabinet and Federal Reserve officials (the junior Quadriad) from the summer of 1969 to 1971.

Without much understanding of why inflation declined very slowly and unemployment remained unchanged, many accepted that the problem came from cost-push. Those taking this position could point to unemployment, or the gap between actual and potential output, to persuade themselves that inflation could not result from excess demand. Hence, they said, it must come from unions and large corporations exerting their monopoly power. They recognized that long-term interest rates remained high, and even rose. They attributed that to increased credit market borrowing and did not connect increased borrowing to expected inflation. They recognized that the balance of payments deficit had increased. They attributed the increase to an overvalued dollar, and they saw the balance of payments and the exchange rate as entirely administration problems, reflecting mainly large fiscal deficits.

As in the Great Depression, the Board and the FOMC lacked a coherent framework and a coherent explanation of what was happening. By this time the staff had a multi-equation econometric model, but there is not much to indicate that it had an important influence on decisions. Although FOMC members recognized that inflation and unemployment would not be greatly changed in the near-term by their decisions, they continued to operate from meeting to meeting making (usually) small adjustments. Only Maisel and Brimmer proposed working out a consistent, coherent program and agreeing on a sustained policy. Most of the members did not support them.

The problem was easier for market participants. As the minutes noted on several occasions, they observed money growth and the budget deficit. They observed also that both the administration and the Federal Reserve were unwilling to accept a temporary rise in unemployment sufficient to bring down inflation. To the contrary, policy actions showed what policymakers’ words often denied; they would accept inflation, even higher inflation, to bring the unemployment rate down in time for the election. President Nixon was often explicit about his belief that incumbents lost elections because of unemployment, not inflation.

What was true of the group of policymakers was not true of all of its members. Within the administration, views differed not only about the policy but about whether it was working. These differences would, at times, become public. That too contributed to the uncertainty about what would be done.

Table 4.11 gives an indication of policy and market actions in the first half of 1971. Most of the time after March, the FOMC was torn between preventing high money growth and permitting interest rates to rise. In the spring, the committee wanted to act against the wider spread between
short- and intermediate- or long-term rates, but it was uncertain whether that required more monetary expansion or less. It decided to purchase intermediate-term securities, briefly lowering their rates and narrowing the spread, as shown in the table. Annualized consumer price inflation rose until July, but the unemployment rate remained either 5.9 or 6 percent throughout.

Early in the year, the System considered two issues. First, money growth had slowed in fourth quarter 1970. Should the System compensate by expanding more rapidly in the first quarter? Second, should it reduce the discount rate to follow market rates down? Or would that signal imply that the Federal Reserve had ended its anti-inflation policy?

Burns warned that the “administration’s confidence in the System was weakening as a result of the shortfalls that had occurred in the rates of money growth. He was not concerned so much about the loss of System prestige and credibility as he was about the possible impact on other government policies” (FOMC Minutes, January 12, 1971, 37). The reference is to the president’s announcement that he was not concerned about the actual budget deficit as long as the budget remained balanced at an assumed full employment. Burns argued that to restore credibility, the FOMC should ease to make up the shortfall in money growth. Charles Partee, director of the Division of Research and Statistics, supported his chairman by arguing that “the existing slack was so great that reducing it was not likely at this point to add to inflationary pressures” (ibid., 27).
²¹⁹
Data revisions later showed that the slack was much smaller than Partee believed.

The FOMC wanted 5.5 percent M
₁
growth. To make up the shortfall, Burns wanted 7.5 percent growth in first quarter 1971 and 6 percent for
the year.
²²⁰
The committee divided. The compromise called for reducing the federal funds rate from 4.5 to 4.25 percent, a shift back to money market conditions with the expectation that money growth would increase at lower interest rates. The vote was eleven to one, with Francis (St. Louis) dissenting because he wanted 5 percent money growth. Maisel recorded that the actual division was much wider. Francis, Eastburn (Philadelphia), and Clay (Kansas City) wanted a more restrictive policy to reduce inflation. The latter two were not voting members at the time. But Swan (San Francisco), Trieber (New York), Heflin (Richmond), and Robertson shared this view. Galusha (Minneapolis) and Morris (Boston), usually joined Maisel and Mitchell in supporting faster money growth. At the January meeting, Brimmer joined this group. That left only a few voting members in the middle with Burns.

219. This was a strange argument from a staff that used a Phillips curve relating unemployment and inflation to forecast inflation.

Between January and July, the Board approved four changes in the discount rate: three reductions and one increase. Generally, it followed bank rates such as the prime rate or open market rates. On three occasions, it rejected requests for a change in the discount rate. All changes were 0.25 percentage points.

Maisel reports that on several occasions Daane talked to Undersecretary Volcker before voting. Volcker usually voiced his opinion but could only give a Treasury opinion if he spoke to Secretary Connally. Burns disliked Connally, envied his position with the president, and did not want the Board to consult him. Furthermore, he did not want more input and influence from the administration than he already had. The decisive facts in February were that, although the discount rate typically followed the market rate, market rates had fallen steeply, and eleven of the twelve banks had voted for lower rates.

On May 6, the New York directors responded in a classic way to the large outflow of dollars and the decisions by West Germany, Switzerland, Belgium, Netherlands, and Austria to allow their exchange rates to float. New York explained its request for a 0.5 percentage point increase in its discount rate (to 5.25 percent) as a signal to foreign countries that the United States intended to defend the fixed exchange rate system. Coombs (special manager) wanted Germany to maintain its exchange rate and use exchange controls (Maisel diary, May 7, 1971, 37). This seems rather late in the day for a decision to begin using monetary policy to defend the dollar exchange rate.

Although Burns told Nixon that the United States would not practice
“benign neglect” of the balance of payments, he did not urge the Board to raise discount rates. He warned the president that short-term rates would rise, but he thought this action would lower long rates (Ehrlichman notes, Box 5, April 14, 1971). The president gave his view earlier. He told Burns, “You are not going to sit there and save the dollar and let the country go to hell” (White House tapes, conversation 462-13, March 5, 1971).

220. Maisel reports that Burns believed the manager was too much influenced by the New York bank (Maisel diary, January 12, 1971, 5).