A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  Policy Failures

  Under pressure from President Nixon to increase the money growth rate in early 1972, Burns considered reducing reserve requirement ratios in early January. The Board took no action at the time. Soon after it considered a structural change in reserve requirement ratios to recognize that growth of suburbs made the distinction between country and reserve city banks less useful and often inequitable. And the perennial issue of System membership remained and even increased as inflation raised the cost of holding non-interest-bearing reserves.

  Legal issues had often blocked change. The Banking Committees of Congress opposed changes that favored city banks over country banks. The staff in Reserve Bank Operations found a way around Congress; they proposed to amend regulation D by redefining a reserve city to include “all those cities or localities that contain a bank with net demand deposits of over $200 million” (Board Minutes, February 29, 1972, 8). This would avoid a request for congressional action but not the scrutiny of its members. Country banks would have lower reserve requirements than reserve city banks as before. Once a bank reached $200 million in deposits, it would become a reserve city bank; its reserve requirements would increase without Board action.

  Discussion showed how the role of reserve requirements had changed. Initially they recognized geographical differences and the practice, developed under the National Banking Act, for country banks to hold reserves at city correspondents—hence the name reserve city banks. One initial purpose of the Federal Reserve System was to pool and centralize reserves. Increased speed of transportation and communication facilitated pooling at Federal Reserve Banks. The main reasons for differential reserve requirements became political pressure, membership, and a payment for authorization to issue deposits. The Board favored country banks to encourage membership and respond to pressures from Congress.

  The proposed reduction in reserve requirement ratios would release reserves. With a fixed interest rate, the System would sell bills and absorb the reserves. With a total or nonborrowed reserve target, the manager would withdraw the newly released reserves also. Nevertheless, the Board wanted to counter the release. It decided to recognize the faster speed of check collection by amending regulation J to require payment of checks on the day they were presented instead of delaying for a day. This reduced “reserve availability credit” and float. Since float was an interest-free loan to the banks that received credit for reserves due, the move reduced bank reserves.70 Reducing float reduced the monetary base and permitted the Board to show that the change in reserve requirement ratios had not eased monetary policy.71 After further study by the staff, the Board announced both changes on March 27 as proposals for comment.

  69. Charles Goodhart (1984) later formulated Goodhart’s law to explain why control of a target was unsuccessful. The point was that once the central bank used an empirical relation to develop a target, the relationship changed. Market participants would change their behavior. This would not be true if the goal, say price stability, was clear. Countries using inflation targets have not faced the problem described by Goodhart.

  The change hurt non-member banks. They did not get a reduction in reserve requirements, but they lost the interest-free loan. Many were members of the Independent Bankers Association. The association demanded a public hearing. When the Board denied the hearing, it offered “informal consultation,” but the association threatened to sue, claiming loss of wealth by its members without due process. The Board, citing statutes, replied that it was within its regulatory authority. Efforts to get an injunction failed, but the Board delayed the regulations until the court decided.

  On November 9, 1972, the new system became effective. Table 6.7 shows the new requirements when fully implemented effective November 16. The Board modified its original proposal by creating more size categories, and it offered to lend to non-member banks, either directly or through commercial banks. The new ratios replaced the prevailing ratios of 17 percent on the first $5 million of deposits and 17.5 percent thereafter for reserve city banks. For country banks, the ratios had been 12.5 percent to $5 million and 13 percent thereafter. Minimum and maximum ratios remained 10 and 22 percent for demand deposits at reserve city banks and 7 and 14 percent for country banks.

  70. The System counted deposits (and money) as measured by bank balance sheets, not customer balance sheets. Reserves were assessed on collected items. By reducing the time span, banks lost a day of interest-free loan.

  71. It is unclear why Board members considered “easing” a problem. At the time, most favored an easier policy. The press release announcing the two changes recognized that “open market operations would be adapted as needed . . . to neutralize the effects on monetary policy” (“Reserve Requirements,” Board Minutes, March 27, 1972, 3). One possible reason is that some members of Congress would object to reducing government revenue.

  On July 19, 1973, the Board raised reserve requirement ratios on demand deposits by 0.5 percentage points for all deposits over $2 million. Small banks continued to pay 8 percent up to $2 million.

  The Board had put 10 percent reserve requirements on euro-dollar deposits in 1969. The next year, it raised the ratio to 20 percent. In 1972, the Board lowered the requirement ratio to 10 percent.

  Under procedures agreed upon on February 14, the FOMC set a target growth rate of reserves against private deposits. Burns proposed 6 to 10 percent at the February 15 meeting. Second, he proposed the federal funds range of 2.75 to 3.75 percent as a constraint. Third, he set the quarterly average growth of M1 at 7 to 8 percent and 12 percent for M2. Fourth, if the targets were not being met or were incompatible, the manager would notify the chairman, who would decide whether to call a special meeting.

  Burns and Hayes disagreed at every meeting. Hayes did not like reserve targets, and he wanted the federal funds rate to rise faster than it had. At times, Daane, Brimmer or MacLaury (Minnesota) joined him. But Hayes did not dissent after February. The only dissent was Coldwell (Dallas) in July; he expressed concern about reserve and money growth in the light of fiscal expansion and international concerns. As discussed earlier, this followed the British decision to float the pound, the pressure on the United States to abandon the Smithsonian agreement, and the special meeting of FOMC to decide on reactivation of the swap lines to reduce market pressure on the exchange rate.

  Burns repeatedly reminded Hayes that their objective was reserve growth, not the funds rate. By midsummer, several members praised the experiment as a success. Gene Leonard (St. Louis) referred to the praise the System received in the press (FOMC Minutes, July 18, 1972, 29). And Robertson mentioned “the success that had been achieved . . . over the past six months,” although he attributed much of the achievement to chance (ibid., 58). But Hayes, looking ahead, saw three “unfavorable elements . . . excessive fiscal stimulus, the price situation, and the situation in international financial markets” (ibid., 48). Burns replied that “it would be most unfortunate to drop an experiment which thus far had been working quite well” (ibid., 49).72 His evidence was the recovery, not the problem of future inflation. He pointed to new housing starts, on their way to a record year and to real GNP growth.

  72. To control spending growth, President Nixon “impounded” spending approved by Congress. Other presidents had impounded but never to the same extent. These actions angered many in Congress, who saw the action as an increase in executive power over spending and a reduction in their favorite projects. In 1974, Congress passed the Impoundment Control Act of 1974. Among other changes, the act limited the president’s use of impoundment. However, the Nixon administration also proposed revenue sharing with the states under which the states received transfers and had no incentive to restrict demand for transfers.

  In September, with the economy growing strongly, Brimmer and Hayes wanted to slow money growth. They did not dissent, but Robertson and MacLaury (Minneapolis) did. With the unemployment rate above 5.5 percent, Mitchell wanted an accommodative (expansive) policy, but Bu
rns wanted slower growth of the monetary aggregates than in past months. The directive noted that new regulations D and J affecting reserves were scheduled to take effect, so they decided to “give more than customary attention to money market conditions, while continuing to avoid marked changes in conditions” (Annual Report, 1972, 171). The federal funds rate remained near 5 percent.

  September’s renewed emphasis on money market conditions did not end the reserve targeting experiment. The next month Burns tried to institute two changes, one sensible and one not. He told the FOMC that they should set targets for money six months ahead, subject to revision at each meeting. This change was long overdue; it would have forced more consideration of the consequences of their actions and given less attention to transitory changes. The second told the Committee that its “main responsibilities were to set targets and to issue specific operating instructions to the Desk. . . . [H]e did not believe it was desirable for the Committee to engage in lengthy discussions of projection procedures or of the relative merits of the projections made at the Board and the New York Bank” (FOMC Minutes, October 17, 1972, 33–34). If adopted, this would have reduced attention to differences in the medium-term consequences of their actions.

  The members rejected both proposals. Brimmer criticized the absence of prior notice to the members. He said “that the projections were needed to provide information on expected outcomes” (ibid., 47). Burns replied that “the key question concerned actual outcomes” (ibid.). The Committee did not agree to set a six-month target, but Burns got agreement that 7 percent growth of reserves and M2 and 6 percent growth of M1 would be reasonable for the fourth and first quarters. Actual M1 and M2 growth averaged 6 and 9.5 percent mainly because both growth rates slowed markedly in February and March 1973. Fourth-quarter money growth was far above the target.

  In November, Hayes warned that the economy was moving up strongly. He urged caution but not immediate action. In November and December, the FOMC set its six-month targets for M1 growth at 6 or 5 to 6 percent.73

  Revised regulations D and J became effective on November 9. The uncertainty surrounding the effect of these changes may have contributed to a surge in member bank borrowing. Between October and December, monthly average borrowing almost doubled, from $550 million to $1.05 billion. It continued to increase, so the entire change was not just a transitory response to regulation. By March 1973, borrowing reached $1.8 billion with free reserves at −$1.5 billion. The federal funds rate rose from 5 to 7 percent in the same period, an unusually large move at the time. The GNP deflator increased at a 5.2 percent annual rate in the fourth quarter.

  Economic expansion brought substantial increases in real wages and incomes generally. President Nixon won reelection in a landslide; he carried all states but Massachusetts and the District of Columbia with 60 percent of the vote nationally. This was the peak of his economic and political success. The president celebrated his victory by refusing to spend large sums that Congress appropriated and by sending Congress a 1974 budget with a $14 billion reduction in spending. Real spending would decline. And with the election finished, the wage and price panels ended, replaced by voluntary compliance monitored by the Cost of Living Council.

  Burns led the Committee on Interest and Dividends to a solution of their regulatory problem. As often with price controls, political concerns became important. The Committee voted to split the prime rate. On loans up to $350,000 to farmers and small business, lenders had to keep the interest rate below market rates. Although continually monitored, large borrowers paid close attention to the market rate.

  As the administration began to loosen price and wage controls, the inflationary outbreak surprised them. By March 1973, annualized consumer price increases reached 4.6 percent led by a 75 percent annual rate of increase in meat prices. The GNP deflator rose 6 percent (annual rate) in the first quarter. The surge in inflation during the winter came from the expansive 1972 policy actions, the loosening of controls, and the shock to food prices from small grain harvests in the United States, the Soviet Union, and elsewhere. The Soviets replaced part of their poor harvest by buying in the United States.

  73. At the November meeting, Burns mentioned that the Committee on Interest and Dividends had taken “informal action” on the prime rate and that it “might take further actions” on administered rates (FOMC Minutes, November 20–21, 1972, 98). The Committee delayed the increase in the prime rate to 6 percent until December 27. With market rates much higher, Burns did not say what economic effect he expected. Perhaps the move was entirely political to satisfy congressional populists.

  President Nixon wanted action. Criticism of the administration from members of Congress and the public demanded action. Weakened by the Watergate scandals and mindful of the popular response to price controls in 1971, the president rejected his advisers’ warnings that price control would not be effective at that time. Inflation was rising, not falling as in 1971. Even John Connally, called back to advise, opposed a new freeze (Matusow, 1998, 230). Not Burns. He urged the president to tighten controls to show the public that the president shared their concerns (Wells, 1994, 115). On June 13, 1973, the president, in a bid for political support, announced phase 4, a sixty-day freeze of prices but not wages. Again, he exempted agricultural prices though they were a main source of price level changes. For a man who professed to abhor price controls, the president seemed eager to use them if they served his purpose.

  The freeze did not stop the rise in prices. Controls on wholesale and retail food prices, with agricultural prices uncontrolled, quickly caused shortages. Public reaction was negative. After thirty-five days, the president ended the freeze early.74 The combination of this one-time price level effect, an increase in oil prices later in the year, and the inflation generated by growing aggregate demand brought measured rates of consumer price increases to 8.4 percent by December 1973 and above 10 percent in 1974. Expected inflation in the Survey of Professional Forecasters rose steadily in 1973 and 1974. Long-term interest rates began to rise.

  The rise in short-term interest rates in the first eight months of 1973 is extraordinary, but so was the rise in reported inflation. The GNP deflator rose from an annualized 5.2 percent rate of increase in fourth quarter 1972 to 8.4 percent in third quarter 1973. The twelve-month moving average rate of increase in consumer prices doubled from December to August, rising from 3.6 to 7.2 percent. Data suggest that the public treated most of the price increase as a one-time rise. Ten-year constant maturity Treasury yields rose one percentage point, but Treasury bill rates rose from 5 to 8 percent. Adjusted for inflation, bill yields remained about unchanged and ten-year rates fell. The real federal funds rate rose.75

  74. Matusow (1998, 222–32) provides a succinct account of prices and the second freeze. Oil prices remained controlled until 1981. Different regulation of retail and producer prices created shortages and long lines at gas stations.

  75. The eight-month period is troubling for those who use the unemployment rate to predict the inflation rate. The unemployment rate declined only 0.4 percentage points to 4.8 percent between December and August. Measured inflation rose 3 percentage points. Growth of the monetary base increased one percentage point to 9.3 percent. Growth rates of M 1 and M2 fell. Since much of the record increase in reported inflation was a one-time change in the price level from the grain harvest and other one-time changes, it had limited effect on employment and long-term interest rates.

  The FOMC saw its task as control of reserve and money growth. It acted aggressively by its previous standards but, as the data show, it was not aggressive enough. Although member bank borrowing rose to $2 billion, the largest borrowing since 1921, the discount rate rose to only 7.5 percent, three percentage points less than the federal funds rate in August 1973. The banks’ prime rate for large borrowers soon thereafter reached 10 percent. Throughout this period, banks could borrow at the discount window and relend in the federal funds market. The reserve banks tried to prevent this operation w
ith some success, but borrowing did not decline until September.

  Judged by the traditional measures—member bank borrowing, free reserves, and the federal funds rate—1973 is one of the most aggressive periods of restraint in Federal Reserve history to that time. The FOMC repeatedly raised the federal funds rate to keep growth of reserves against private deposits within the range it selected based on staff estimates of money growth. Yet the period has to be judged as a policy failure. The inflation rate continued to rise.

  Several factors contributed to the failure. First was the operating procedure. The staff estimated the growth of reserves and the level or range of the federal funds rate consistent with desired growth of money. Inaccuracy was a problem throughout. Several times, the FOMC had to meet between meetings to increase the band on the federal funds rate. Although the FOMC remained committed to controlling reserve and money growth, subject to a money market constraint, the constraint frequently restricted policy action until it was raised. The result was that the manager maintained the federal funds rate and exceeded the reserve target.

  For example, at its May 15 meeting, the FOMC set the desired growth rate of reserves against private deposits (RPDs) at “9 to 11 percent while continuing to avoid marked changes in money market conditions” (Annual Report, 1973, 169). RPDs rose at a faster than expected rate, despite an increase in the federal funds rate. The FOMC met twice between meetings to raise the permitted level of the funds rate. Instead of remaining unchanged, the federal funds rate rose from 7.75 to 8.5 percent. It was not enough. At the June 18–19 meeting, the FOMC changed planned RPD growth to 8 to 11.5 percent and permitted the federal funds rate “to vary somewhat more . . . than had been contemplated at other recent meetings” (ibid., 175). But the constraint continued to bind; RPDs rose at more than an 11.5 percent rate, and the FOMC voted to let the funds rate rise more than it had planned. No one dissented until the July 17 meeting, when Darryl Francis (St. Louis) agreed with the committee’s objectives but said “the objectives would not be achieved because of the constraint on money market conditions” (ibid., 186). He was soon proved correct. On August 3, there was another inter-meeting increase in the funds rate. Francis dissented again, for the same reason, at the next meeting, August 21, 1973.