A History of the Federal Reserve, Volume 2 (130 page)

Once inflation became entrenched, it required a more persistent commitment to end it. Martin, the Federal Reserve, and administration economists were aware of the cost paid to end a modest inflation after 1958. After four years of stable prices, why did they let inflation continue after it returned?

Bad luck contributed. Growth of output slowed after 1966, just as the money growth rate increased. Many officials continued to believe that higher growth would return. Other beliefs played a larger role. Some of the same factors that contributed to the start also contributed to persistence. Until the Treasury began to auction notes and bonds after 1970, even keel operations contributed to inflation and made disinflation difficult.
²⁶³
George Mitchell, a member of the Board from 1961 to 1976, told Congress that if the Treasury sold short-term debt to the banking system, “we have to supply reserves to the banking system . . . The success of this operation depends on how much pressure the banking system is under. If it is not under much pressure, it would continue to hold the securities and therefore the money supply would rise” (Joint Economic Committee, 1968, 134). He did not say that if banks were under pressure, they would sell the securities and make loans.

At the same hearing, senators tried to get the Federal Reserve to control money growth within a range of 2 to 5 percent. Mitchell denied that money growth was excessive.

Senator [Jack] Miller. I have heard criticisms of the Federal Reserve Board for being responsible for the inflation, as a result of the excessive expansion of the money supply. . . .

Mr. Mitchell. . . . Our conviction is that we have not overused this tool.

Senator Miller. If you have not overused the tool, then where does the inflation come from? . . .

Mr. Mitchell. I think it really comes from the government deficit. (ibid., 135)

Later in the same hearing, Senator William Proxmire questioned Mitchell about the procyclical behavior of the money stock, cit
ing declines in four postwar recessions. Mitchell would not accept the conclusion (ibid., 140). Martin, like Mitchell and many others, claimed that budget deficits
were the principal cause of inflation. At times, the statement of this belief suggests that the inflationary effect of the deficit depends only on the size of the deficit and is independent of deficit finance and money growth. Experience in the 1960s and 1980s can be looked upon as an experiment that tests this proposition in a simple, direct way. Table 4.12 shows that the much smaller budget deficits of the 1960s occurred with rising inflation rates, and the larger deficits of the 1980s accompanied falling inflation rates. A major difference was that the Federal Reserve did not believe it was obliged to finance the 1980s deficits, and it did not do so. Neglecting or ignoring the effects of policy actions on money growth and inflation was a major error in the 1960s and 1970s.

263. Brimmer (2002, 25–26) did not recall any discussion about changing even keel policy.

Federal Reserve decisions in the Martin era were made every three weeks. Much time was spent on what had happened or what might happen before the next meeting. There is no evidence that the Board or the FOMC had an organized way of thinking about the more distant future, as senior staff recognized (Axilrod, 1970b; Pierce, 1980; Lombra and Moran, 1980). Until 1965–66, Chairman Martin followed the Riefler rule that prohibited forecasts. When forecasts began, they often had large errors, discrediting them. Also, the members of the Board and the FOMC did not have a common framework or way of thinking about monetary policy. Neither Martin nor Burns made any effort to develop an agreed-upon way of thinking about how their actions influenced prices, employment, and the balance of payments. Sherman Maisel argued frequently for a more systematic approach without much success. The members did not agree on elementary propositions.

Even if these problems had been resolved and a common framework developed, as Burns (1987) notes, the absence of political and popular support would likely have prevented the System from continuing decisive action. A more appropriate common framework would have avoided the
large policy error in 1968 when the Federal Reserve eased policy and increased the inflation rate because it accepted the Keynesian claim that the temporary surtax was “fiscal overkill.” But it is also true that the Johnson administration and the Federal Reserve were willing to undertake antiinflation monetary policy only after the 1968 election, when the effect would be felt under the Nixon administration.

Martin believed he could maintain Federal Reserve independence while coordinating policy actions with the administration. Although he warned about inflation in 1965, he encouraged no action against it until late in the year because he and his colleagues hoped that President Johnson would raise tax rates instead. Three years later, he eased policy to offset the surtax, a step that he later recognized as an error. Some of his senior staff agreed.
²⁶⁴

Martin was not alone in these errors. He had the support of most of his Board and much of the academic profession. He made little effort to lead the Federal Reserve away from coordinated policy. And there is no evidence of coordination working in the opposite direction—administration policy adjusting to the Federal Reserve’s responsibility for inflation.
²⁶⁵

Policy coordination was not the only error in 1968. Administration and Federal Reserve forecasts attributed a powerful effect to the $10 billion temporary tax surcharge. They could have known better. Economic analysis had established that the main effect of a temporary surcharge would be on saving. A prominent Keynesian economist, Franco Modigliani, testified to that effect a month before the surcharge passed:

If the people know that taxes are going to be put up for just 3 or 6 months, chances are that there would be little change in their consumption because they would look forward to being able to recoup later. Therefore, I think attention should be given to finding measures that have the right incentives. (testimony, Franco Modigliani, Joint Economic Committee, May 8, 1968, 63)

Partly as a consequence of policy coordination, but also in res
ponse to political and public pressure, the Federal Reserve accepted responsibil
ity for housing and income distribution. Although it could not do much about the latter except to reduce reserve requirements for small banks, it moderated its actions to prevent sharp reductions in homebuilding. Adding homebuilding to a list of objectives that included sustained growth, full employment, low inflation, and international balance almost assured failure to reach most or all of the objectives.

264. “Question: Do you think it was a mistake for the Fed to be that closely involved in administration policy? Answer: Yes, because you become less objective” (Axilrod, 1997, 17–18).

265. The House Banking Committee asked economists and policy officials for their opinions on mandating policy coordination, a policy rule, or the present regime. Replies came from 69 respondents. Most (42) favored a coordinated program; 13 favored a monetary rule of some kind; 14 favored no change. I interpret that to mean that the group members did not oppose coordination but did not want it made mandatory. Chairman Okun of the Council of Economic Advisers voted for mandatory coordination. Chairman Martin and Secretary Fowler voted for the status quo (Joint Economic Committee, 1968a, 8).

When Arthur Burns replaced Martin, President Nixon recognized the independence of the Federal Reserve and then added: “I respect his independence. However, I hope that independently he will conclude that my views are the ones he should follow” (Wells, 1994, 41).

This was a forecast of the pressure the president and his advisers kept up. Burns, like Marriner Eccles before him, wanted to be a key presidential adviser while he was chairman. Possibly to satisfy the president’s pressures for lower unemployment or because he shared the president’s priority, Burns maintained relatively high money growth and in 1970–71 frequently and forcefully argued for a wage-price board to slow inflation by exhortation. More likely, as he claimed repeatedly at the time, monetary policy could not be used to reduce inflation. In his Per Jacobsson lecture (Burns, 1987), he showed that he recognized that the inflation was the result of overly expansive monetary policy, but there was little support in the administration, Congress, or the general public for the consequences of the policy that would be required.

Viewed in the abstract, the Federal Reserve System had the power to abort the inflation at its incipient stage fifteen years ago [1964] or at any later point, and it has the power to end it today [1979]. At any time within that period, it could have restricted the money supply and created sufficient strains in financial and industrial markets to terminate inflation with little delay. It did not do so because the Federal Reserve was itself caught up in the
philosophi
cal
and
political
currents that were transforming American life and culture. (Burns, 1987, 692; emphasis added)

Burns did not appeal to mistakes, bad luck, or misinformation. He appealed to philosophical and political beliefs.
²⁶⁶
Unlike Martin, who had more limited understanding of what had to be done, Burns knew “in the abstract” what was required. He was unwilling, or believed the Federal Reserve would be unable, to carry through an anti-inflation program that imposed heavy costs on employment, housing, and output.

266. Burns (1987, 693) recognized “errors of economic or financial judgment,” called them significant, and cited the consensus view in the 1960s and early 1970s that “an unemployment rate of 4 percent corresponded to a practical condition of full employment” (ibid.).

Burns resented White House interference and pressure, but he did not often resist it. He took over a Board all of whose members had been appointed by Presidents Kennedy and Johnson. To varying degrees, a majority preferred to continue inflation rather than increase unemployment. If inflation could be reduced at an unemployment rate of 4.25 or 4.50 percent, they would accept it. But they did not want any higher unemployment rate. There was a minority that wanted more restrictive policy and more action against inflation. The few consistent anti-inflationists such as Hayes, Brimmer, and Francis were exceptions. They gained support when inflation rose but only until unemployment rose above the level the majority would accept. Brimmer (2002, 23) explained at the time that if fiscal policy was the way it was, you would have to tighten monetary policy to the point of inducing a recession. He added that in 1968 the Federal Reserve “didn’t promise a tradeoff [of easier monetary policy] . . . if you get a tax bill but we came pretty close to it” (ibid., 23).

Many other reasons have been used to explain the persistence of inflation: the use of money market targets, failure to distinguish between real and nominal interest rates, and neglect of monetary aggregates (Mayer, 1999; Bordo and Schwartz, 1999; McCallum, 1999; Hetzel, 2003). Nelson (2003b) summarizes this literature and documents the importance of concentrating on cost-push and neglecting monetary policy—the monetary policy neglect hypothesis—both in Britain and the United States.

Orphanides (2003b) casts substantial doubt on claims that the FOMC did not raise nominal rates enough to compensate for inflation. Using the data available at the time, with the real-time smaller output gap, Orphanides showed that nominal rates rose at least one percent for every one percent increase in anticipated inflation. The appearance to the contrary depends on data that became available later, after revisions.

Several of these explanations correctly describe events and interpretations. Federal Reserve officials rarely distinguished real and nominal interest rates when discussing interest rates even if they responded as Orphanides’s estimates suggest. Like many others, they overestimated the effect of the tax surcharge and underestimated subsequent inflation. Chart 4.14 shows that the survey of professional forecasts substantially underestimated inflation also.

Market participants may have relied on these or similar forecasts. We cannot know whether the increase in real rates was partly the result of underestimating future inflation, but that seems a very plausible conjecture. Chart 4.15 shows that the real long-term interest rate rose just as the smoothed real growth rate fell. Subsequently, a decline in real rates in 1970 contributed to the very gradual recovery from the 1969–70 recession.
The 1970–71 FOMC minutes make clear that slow growth and persistent unemployment were the main factors Burns cited to urge the FOMC to increase money growth.

Another factor slowing real growth has received less attention. The risk premium (Chart 4.16), measured by the spread between high-grade and lower-grade bonds, rose after the middle 1960s. The higher real interest
rate for some more risky borrowers in this period incorporated a larger risk premium. The premium continued to increase to a local peak during the recession and declined, as expected, following the recession, but it did not return to the lower levels reached in 1963–65. Slower real growth meant that higher nominal growth occurred as inflation.