The Board also suspended regulation Q ceiling rates on time deposits of $100,000 or more with initial maturity of ninety days or more. This was the first liberalization of CD rates since ceiling rates were suspended for maturities of less than ninety days in June 1970.
86. Governor Daane reported that the BIS members, especially the Europeans, were eager to control euro-dollar markets. The United States had made euro-dollar holdings subject to reserve requirements. In 1973, they increased the requirements, raising the cost of eurodollars. See below. Coombs complained that the United States did not intervene to prevent the dollar from falling. All other countries intervened. Coombs never accepted that coordination and intervention could not prevent the readjustment of real exchange rates. Although he recognized that the Watergate scandal reduced the demand to hold dollars, he believed that intervention could offset it.
87. Burns briefed the members about the “political crisis” (Watergate) affecting the country. He warned that it was likely to reduce “confidence.” Stein claimed that the president remained active in policy discussions and had taken the lead in pushing for a second freeze and phase 4 (Hargrove and Morley, 1984, 400).
88. Despite concerns about disintermediation and housing, new housing starts remained at a robust annual rate above 2.2 million in the second quarter. The likely source of error was failure to distinguish real and nominal interest rates.
MacLaury (Minneapolis), Francis (St. Louis), and Black (Richmond) pointed out that corporate borrowers would not be deterred by the small increased cost intended by the proposal. They would borrow in other markets. These critics did not favor controlling credit, because they did not think it could work.
The Board, however, was unwilling to take a decisive action, so it resorted to weak or cosmetic actions. On April 4, it sent the first of several letters asking banks to voluntarily restrict loan commitments. The Comptroller and the chairman of the FDIC sent similar letters to their members. On May 21 and 29, the Board sent letters to member banks urging them to voluntarily restrict growth of loans and certificates of deposits in an effort to control inflation. There is no indication that the Board thought about what would happen to the funds that did not go into time deposits or that the bank did not lend. The episode recalls the mistaken attempt to control credit expansion by exhortation in 1929. Despite the warnings they heard, the FOMC did not take decisive action.
The June 1973 FOMC meeting brought out the division between those who favored a more restrictive policy and members more concerned about a possible recession if policy tightened. The FOMC voted for slower growth of the monetary aggregates. It reduced its objective for money growth in the second half from about 5 to 4.5 percent and reduced its near-term objective to a range of 4 to 8 percent. The top of the range for the federal funds rate rose to 9.25 percent.
Several private forecasts expected a recession in late 1973 or early 1974. Lyle Gramley said the staff expected slower growth but not a recession. By the end of the year, the staff expected growth to fall to 3.5 percent.89 Brimmer asked Partee why they did not expect a recession. Partee replied that they projected an investment boom, an improvement in net exports, and moderate money growth.90
Frank Morris (Boston) explained why he thought the System had to
89. Actual growth of GNP fell to 1 percent annual rate in the second quarter and −0.4 in the third. The fourth quarter reached 3.6 percent, as the staff predicted. They did not foresee the weakness in the second and third quarters. The GNP deflator rose 8.6, 8.4, and 10 percent (annual rates) in the second to the fourth quarter.
90. The dollar had depreciated 17 percent from its Bretton Woods value against a weighted average of sixteen foreign currencies. The staff forecast that nominal GNP would rise 7 percent if money rose 5.25 percent. The implicit rise in velocity was close to trend growth at the time (FOMC Minutes, June 18–19, 1973, 21).
reduce money growth modestly. He thought the basic problem was fiscal. A 6 percent unemployment rate would weaken the consensus between the administration and Congress to reduce growth of government spending. Burns agreed. He thought that “to achieve price stability it was necessary to avoid recessions” (FOMC Minutes, June 18–19, 1973, 34).91
The FOMC voted in June and July to tighten further, and between meetings it adjusted upward the tolerable level of the funds rate. Despite sharp differences of opinion, recorded votes were unanimous
The FOMC was not oblivious to the increase in current and anticipated inflation. The staff saw “clear and present danger of further overheating.” They blamed strong economic growth and “monetary aggregates growing at unacceptably high rates” (FOMC Minutes, July 17, 1973, 43). Burns drew the right conclusion: “The basic reason [for rapid monetary growth] was that the System had been supplying reserves to commercial banks at a very fast rate. The rapid growth of the monetary aggregates was a most disturbing development; if it persisted there would be considerable justice to a charge that the System had fostered the inflation now underway” (ibid., 57–58). He wanted growth of M1 and M2 to slow to 3.75 and 4.75 percent for the second half, with 3.5 to 5.5 percent growth of reserves, but he thought this would require near-term 11 to 13 percent growth of reserves.
The FOMC remained divided. Most members wanted to avoid a recession and to reduce inflation, but they differed on the best way to achieve both objectives and on the weights they gave to each. Citing international as well as domestic concerns, Hayes and Daane wanted to tighten more than most others. Burns supported their position. He was now committed to an anti-inflation policy, and he was able to get majority support.
The economy operated at about 96 percent of capacity in the second quarter. Those who opposed a tighter policy thought the economy would slow. They feared a recession and either explicitly or implicitly preferred higher inflation to recession. Since they did not distinguish between real and nominal interest rates, they expressed concern about the consequences of a federal funds rate above 10 percent. Stephen Axilrod warned them that the funds rate could rise to 15 or 20 percent. Peter Sternlight agreed.
Bucher, MacLaury (Minneapolis), Black (Richmond), Holland, and Sheehan, all relatively new appointees, favored less restraint. Sheehan expressed their position best: “Experience suggested that the Government could not permit the kind of recession that might serve to bring inflation under control without giving rise to political pressures that would result in a massive Federal Government deficit” (ibid., 95).
91. At the time, the staff’s model implied that a 1 percent increase in the unemployment rate would reduce the inflation rate by 0.7 percent within six quarters (FOMC Minutes, June 18–19, 1973, 42). Later experience showed that this estimate was too pessimistic.
To a degree, the System was in the same position as in the pre-Accord period. In the 1940s, it knowingly risked inflation because it did not have political support before the Douglas hearings and the Korean War. Now, it risked higher inflation because Congress, the administration, and most likely the public would respond to a recession by demanding expansive policy actions. Inflation would increase.
The FOMC voted for Burns’s six-month target growth rates for the aggregates but eased his near-term target for RPDs and federal funds. Francis (St. Louis) dissented. He agreed with the six-month money targets, but “the desired growth rates would not be achieved as a consequence of the constraint on the federal funds rate to 9 to 10.5 percent” (ibid., 104).
At the August meeting, Burns repeated Francis’s message. Failure to control money growth, he said, “fundamentally resulted from a failure to control RPDs” (FOMC Minutes, August 21, 1973, 53). But the federal funds rate did not change, and Francis dissented for the same reason as in July.
To the extent that the FOMC had a long-term strategy, it was to avoid recession. Lyle Gramley, a member of the staff and later a member of the Board, expressed the strategy succinctly:
The urgent task is to assure that aggregate demand slows somewhat further, and then remains at a modera
te pace long enough for the inflationary process of recent years to unwind. But it is equally urgent to accomplish this without precipitating a recession. If economic activity weakens too much next year, the pressures to reopen the monetary spigot would almost certainly become too powerful to resist. (FOMC Minutes, September 18, 1973, 73)
Alas, the staff and the members did not know how to reduce inflation while avoiding recession. They were not alone. The FOMC proposal was very similar to the 1969–70 policy of slowing inflation while letting the unemployment rate rise to 4.5 percent, but no higher. It had not worked. A repeat effort suggests that Gramley (and others) continued to believe that they could manage inflation by keeping the unemployment rate slightly above its erroneously estimated equilibrium value.
On the international side, the trade-weighted dollar depreciated sharply in the spring and summer, falling 30 percent against the mark between January and July. Pressure to intervene rose. Coombs proposed a $5.95 billion increase in swap lines to bring the aggregate to $17.68 billion, an increase of 51 percent. The FOMC approved the increase and gave a subcommittee (Burns, Hayes, and Mitchell) authority to act on its behalf. On July 9, the FOMC held a telephone conference. The dollar had fallen an additional 10 percent against the mark and the franc and by lesser amounts against other currencies. The subcommittee had approved intervention and sharing risks with the Europeans. Only Francis (St. Louis) opposed the interventions. He said that the United States had embargoed grain exports when others wanted to buy grain and failed to make progress in reducing inflation. Hayes, Burns, and Daane supported intervention, claiming that the problem was lack of confidence and concern that the United States did not care about the exchange rate. Following the intervention, the dollar rose.
The federal funds rate reached a local peak in September 1973 at 10.78 percent for the month. Ten-year Treasury bonds peaked at almost 9 percent in August, and twelve-month monetary base growth reached a local peak in July. By year-end 1973 the twelve-month increase in consumer prices reached 8.4 percent, more than 5 percentage points above the December 1972 average. President Nixon decided to follow a less inflationary strategy (Matusow, 1998, 283). Burns received the signal. By March 1974, the federal funds rate started to rise to a new local peak in July at 12.9 percent, almost 4 percentage points above its February value.
Chart 6.4 compares these and later changes in the federal funds rate to the reported rate of increase in consumer prices. Through most of the early 1970s, the funds rate followed the inflation rate and generally is above the reported inflation rate. By the middle of the decade this was no longer true. The rise in the inflation adjusted (or real) funds rate suggests monetary policy tightened in 1973. Data for growth of the real monetary base gives the same interpretation. Although the funds rate declined beginning in August 1974, growth of the real value of the monetary base, shown in Chart 6.5, did not change direction until early 1975 coincident with the recession trough.
Discount rates. Despite many requests for changes, the Board did not approve any discount rate changes in 1972. The discount rate remained at 4.5 percent. Between January and March all the requests asked for lower rates, usually a reduction of 0.25 but sometimes 0.5. Only Philadelphia, St. Louis, and Kansas City made these requests. The Board turned down the requests, in part because borrowing remained low, in part because the Board expected interest rates to rise.
Beginning in September, all the requests asked for increases of 0.25 or 0.5. The reserve banks cited rapid money growth and concerns about inflation. The Board often divided, but there was only one dissent, by Governor Brimmer, on September 1. The Board’s expressed reasons for denying the requests included several references to the Committee on Interest and Dividends. Burns urged his colleagues not to increase an “administered rate” (the discount rate) when his committee urged banks to keep their administered rates unchanged. Several members expressed reluctance to use the discount rate to lead market rates.
Burns’s argument against discount rate increases is a clear case of the conflict of interest that several feared in 1971, but the conflict lasted only a few months. By December, the elections were over, and opinions had changed. Market rates had increased. The main issue was timing. Burns proposed that the Board wait until mid-January, after the Treasury financing. On January 15, 1973, the Board raised rates by 0.5 to 5 percent. The requests cited concern about the rate of economic expansion.
The Board also approved discount rate increases in February (0.5), March-April (0.25), May (0.25), June (0.5), July (0.5), August (0.5). After the August 14 increase, the discount rate was 7.5 percent, an increase of 2.5 percentage points in little more than half a year. These most unusual actions followed market rates and reported inflation. By August, the federal funds rate was 10.5 percent, consumer prices had increased 7.2 percent in a year, and the ten-year Treasury bond yielded more than 7 percent. The relatively low discount rate acted as a subsidy to member bank borrowing. Borrowing doubled from $1.05 billion in December 1972 to a peak of $2.2 in August 1973. Increased borrowing contributed to base growth. Twelve-month base growth reached 9.3 percent in June, a rate of increase last experienced at the end of World War II. In July, the Board increased regulation Q ceiling rates by amounts from 0.25 to 0.75, depending on the maturity.
Effective April 19, 1973, the Board revised regulation A on discounting by member banks. It approved longer-term borrowing to meet seasonal needs. Banks without access to national money markets, mainly small banks, could borrow for periods up to ninety days and could renew the loan for the season. The amendment also reaffirmed the System’s commitment to lend in emergency or unusual circumstances.
Margin requirements. From December 1971 to April 1972, the Standard & Poor’s index of stock prices rose 17 percent. At a meeting early in April, the staff expressed concern about the speculative character of the increase. It urged the Board to consider an increase in margin requirements. The staff memo noted that since the reduction of margin requirements from 65 to 55 percent in December 1971, credit extended by brokers had increased 35 percent and the number of margin accounts had increased by 60,000. The Board took no action.
The S&P index fell in May, but stock market credit rose. The Board divided over whether there was a problem. Burns thought that stock market credit had not grown out of line with other credit, but Governor Sheehan was “shocked” by the increase and wanted to increase margin requirements (Board Minutes, June 7, 1972, 4). Both Sheehan and Robertson wanted to raise margin requirements to 70 percent (from 55). Mitchell and Daane favored 65 percent. Burns favored the smaller increase but deferred action to consult the SEC and the Price Commission.92
Part of the System’s problem arose from money illusion. Neither the staff nor the members distinguished real and nominal changes. The S&P index passed its 1968 peak in nominal value in March 1972. Consumer prices increased almost 20 percent in the interval, so the real value of stock prices remained well below values at the start of the inflation. The non-indexation of tax rates and depreciation explains much of the loss in real value (Feldstein, 1982).
Between June and November, margin credit increased about 3.5 percent, the S&P index by 6.5 percent. A majority of the Board—Mitchell, Daane, Bucher, and Brimmer—opposed a change in margin requirements at that time. Brimmer especially noted that there was no evidence of a significant increase in stock market credit. “In his opinion, changes in margin requirements should not be geared to the behavior of stock prices—but the actual use of stock market credit to purchase or carry securities” (Board Minutes, November 11, 1972, 11). He might have added that the 1934 Securities and Exchange Act said the same.
Burns wanted an increase. He spoke to SEC Chairman William Casey, who warned that some brokerage firms had financial problems and that an increase in margin requirements might harm them by reducing trading volume. Nevertheless, Burns said he favored “a preventive approach” and wanted to show that the System was acting against inflation. Robertson agreed. Acting now could
reduce expectations of inflation. Neither explained how that would work or why they did not act more directly. Credit to purchase shares could be obtained in many ways.
With Brimmer dissenting, the Board approved an increase in margin requirements from 55 to 65 percent effective November 24. Stock prices reached a peak in December 1972 and continued to fall until December 1974. At that point, the S&P index was back to its March 1963 nominal value. The decline owed much more to inflation, the oil price shock, uncertainty about the functioning of government resulting from the Watergate scandals, and the resignation of the president in August 1974.
Regulation Q. As market rates rose, the Board relaxed or ended ceilings for large CDs; it did not change the rates on small (below $100,000) CDs until July 5, 1972. On July 5, the Board approved increases of 0.5 to 0.75 on passbook saving accounts and consumer CDs. Also, it removed the ceiling rate for four-year CDs with a $1000 minimum denomination. At the time, deregulated six-month large negotiable CDs paid 9 to 10 percent.
92. “Registered margin credit at broker-dealers and banks” reached a local peak in December 1972; the outstanding balance in May or June 1972 was between 45 and 50 percent higher than a year earlier (Board of Governors, 1981, table 23, 184). The Board’s only action at about this time was a technical adjustment to the rule permitting substitution of securities in margin account collateral.
A History of the Federal Reserve, Volume 2 Page 21
