A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  Later research showed that the output gap has not been measured precisely and perhaps cannot be. Using a large number of different models, Staiger, Stock, and Watson (1997) reported that they could not distinguish several different measures of the natural rate. The clear implication is that the Phillips curve model is not a reliable way of predicting inflation in the short run. Unfortunately, there is no systematic alternative that makes reliable predictions. This raises a fundamental question: Why does the Federal Reserve give so much attention to unreliable short-term changes in output and unemployment that include transitory elements? This concentration on short-term changes and the heavy weight given to unemployment changes caused much of the inflation problem of the 1970s.4 Chairman Martin’s statement at the start of the chapter recognizes part of that problem.

  Serious as were the errors in Phillips curve forecasts of inflation, other errors contributed to the poor performance. These included excessive concern for short-term changes and failure to distinguish between persistent and temporary or transitory disturbances when implementing policies.5 This was particularly true in responding to the price level effects of rising food and oil prices in 1973–74. Stein explained these responses as responses to public and political pressures to “do something.”6 Also, mistaken policies defended or imposed by politically potent groups or their representatives often made rational policy unattainable. Matusow (1998, Chapter 9) gives several examples following the first oil shock. Consumer gasoline prices remained frozen, but wholesale oil prices could increase. And import quotas restricted supply. Despite long gasoline lines and other inconveniences, oil price controls remained until 1981.

  4. Feldstein (1997) computed the gain from ending inflation allowing for the cost in unemployment during the transition. He found the gain to be positive. Abel (1997) strengthened Feldstein’s result using a general equilibrium model.

  5. Burns (1974, 1–2) testified that “[w]e have come to recognize that public policies that create excess demand, and therefore drive up wage rates and prices, will not result in any lasting reduction in unemployment.” Unfortunately, he did not always act as if his statement was true. I am grateful to David Lindsey for supplying the quote.

  6. As Stein put it,

  The decisions at the top are very much constrained by what the public wants, or by an administration’s perception of what the public wants, which I think is often quite wrong but is very important in their decision making. (Stein in Hargrove and Morley, 1984,407)

  And

  The Director of the Cost of Living Council and the new Federal Energy Administrator were unwilling to raise the [oil] price, mainly for fear of the political reaction. (Stein in Hargrove and Morley, 1984, 403)

  None of these explanations accounts for the persistence of inflation and its increase during the 1970s. There is no doubt that the Federal Reserve made errors; the problem is to explain why it continued to make the same or similar errors.7

  When Gerald Ford replaced President Richard Nixon, he declared inflation to be the main policy problem. One of his early efforts, known as the WIN program (Whip Inflation Now), was more a public relations effort than a policy initiative. The program began just as output started to fall. As unemployment rose, the administration shifted its emphasis. It asked for tax reduction, and the FOMC lowered the federal funds rate. That ended the anti-inflation effort and the WIN program. But it reinforced the strengthening view that anti-inflation programs would not last long enough to end inflation.

  For the Federal Reserve, this meant reduced credibility. Burns, like Martin before him, made many strong statements about the evils of inflation. His actions increased inflation on average. The low credibility encouraged Congress to act. It passed resolutions and later the Humphrey-Hawkins Act, which required the Federal Reserve to announce monetary targets to aim for lower inflation.8 It did not achieve the projections. Even worse, it built its positive errors into its projections.

  President Ford’s experience with the WIN program was not a unique event. It was one of three parts of the main problem. The Federal Reserve, Congress, and successive administrations put less weight on rising inflation than on rising unemployment. Rising unemployment called for more stimulus, an end to the anti-inflation program. After gaining this experience, the public doubted that the Federal Reserve would persist, so they chose brief spells of unemployment to wage reduction. Wages became more sticky, reinforcing loose talk about stagflation and contributing to the mistaken belief that guidelines or controls were needed. Second, the Federal Reserve overemphasized short-term, often random changes and neglected the longer-term consequences of its actions. Controlling inflation required patience and persistence that it did not have at the time. Also, it lacked both a longer-term objective and a means of reaching it. Third, control procedures were harmful. The FOMC persistently misinterpreted interest rate declines as evidence of ease and increases as tightness. This error gave its actions a procyclical bias. And it failed to establish adequate procedures for controlling money growth.9

  7. In 1973 Karl Brunner and I organized the Shadow Open Market Committee, with assistance from James Meigs and William Wolman of Argus Research, to point out policy errors and propose alternatives. Membership at the time included Robert Rasche, Anna J. Schwartz, James Meigs, William Wolman, and Homer Jones. The group met every six months to comment on policies and errors.

  8. Arthur Burns testimony to Congress in 1974 is one of many examples. “A return to price stability will require a national commitment to fight inflation this year and in the years to come. Monetary policy must play a key role in this endeavor, and we, in the Federal Reserve recognize that fact. We are determined to reduce over time the rate of monetary and credit expansion to a pace consistent with price stability” (quoted in Broaddus and Goodfriend, 1984, 3). The quote shows that Burns understood that he had to control monetary emissions if he was to lower inflation.

  Some members of FOMC understood the need for regaining credibility by sustaining anti-inflation policy. No reader of the minutes or transcripts can fail to see that there was not much agreement on the need for commitment of this kind. By 1978, there were three distinct groups. One proposed sustained anti-inflation policy. The second was unwilling to risk recession even as the reported inflation rate rose to 8 or 9 percent. Burns was usually part of this group. A third group remained in the middle of the two. The result was considerable talk but no sustained action.

  Starting in 1973, the principal currencies floated, not always freely. But it is the first period in modern history with no major currency fixed to a commodity. Gold lost its position in the international system. Learning to operate without a reserve currency tied to a commodity or with a fixed exchange rate proved difficult for central banks. Oil shocks, recycling of oil revenues, and later the Latin American debt crisis and the anti-inflation policies in several countries increased exchange rate variability. Many observers decried the instability of floating rates, and many sought evidence of excess burden. Western European countries especially established arrangements for a joint float, often without restricting policies in the individual countries. It took years before governments accepted the discipline that fixed exchange rates required. Table 7.1 shows price and wage changes during 1973–79 in leading industrial countries.

  Average annual inflation rates ranged from less than 5 percent in Germany to 15 percent in Italy. Since all of the countries experienced the same oil shock, that shock cannot explain the very different behavior of inflation in these countries.

  9. In 1973, the Congressional Joint Economic Committee proposed some changes in monetary policy. At the time, the CPI rose 11 percent for the month and the unemployment rate was 4.9 percent. The proposed changes called on the FOMC to not permit interest rates to rise above present levels. “If possible interest rates should be reduced” (JEC Report, 1973, Box 35602, New York Federal Reserve Bank, March 26, 12). The report also urged a standby credit allocation system to assist home buyers, local gover
nments, and small businesses. Also, the report called on the System to buy mortgages and state and local securities. There was more, but the general direction is clear. Inflation control was of lesser interest.

  Arthur Burns remained chairman of the Board of Governors until replaced by G. William Miller in April 1978. Miller had little experience with monetary policy. He had served as a director of the Boston Federal Reserve bank. His appointment owed much to his work in the presidential campaign and his friendship with Vice President Walter Mondale. He left the Federal Reserve to become Secretary of the Treasury in August 1979. Table 7.2 shows the personnel changes during 1973–79.

  Two notable appointments, Henry C. Wallich and Paul A. Volcker, joined the FOMC during this period. Wallich was a Yale professor at the time of his appointment with years of practical and academic experience. He had worked as an international economist at the New York Federal Reserve bank and served as a member of the Council of Economic Advisers in the Eisenhower administration. In 1958, he joined the Treasury as head of tax analysis. In March 1974, he joined the Board of Governors, replacing Dewey Daane. He strongly opposed inflation but did not always favor control of money growth.

  Paul A. Volcker became president of the New York bank in August 1975. He had a long experience in the System, beginning in 1949 at the New York bank and later in the bank’s research division under the direction of Robert Roosa. Roosa brought Volcker to the Treasury in 1962. He worked in both Democratic and Republican administrations, rising to Undersecretary of Monetary Affairs in the Nixon administration. Volcker was always an anti-inflationist.

  Turnover of Board members increased during the period. Some complained that Board salaries did not adjust for inflation, so their real incomes fell. One seat, occupied by Governors Robertson, Holland, Lilly, Miller, and Volcker, changed four times during the six-year period. For the first time, two of the new governors, Holland and Partee, came from the senior staff, and one governor, Coldwell, was a reserve bank president at the time of his appointment. Many of the appointees were professional economists or experienced in financial markets.

  Miller claimed that the president accepted his suggestions for appointments to the Board while he was chairman. He recommended Nancy Teeters, the first female member, Emmett Rice, the second black, and, just before leaving, Frederick Schultz, a Florida banker. Schultz became vice chairman of the Board.

  Congress made several changes in financial regulation that broadened the Federal Reserve’s regulatory and supervisory activities and enlarged its staff by about 50 percent. Bank holding companies expanded by acquiring non-banking subsidiaries. The Board in 1970 assumed responsibility for one-bank holding companies. Truth-in-lending legislation and consumer credit protection became main activities. The Freedom of Information Act and other programs required increased transparency and information. To house the expanded staff, the Board supervised construction of the new Martin building, which opened in 1974.

  Of the changes Congress authorized in this decade some altered the banking and financial systems permanently. By the end of 1979, nearly 2,500 bank holding companies held 70.6 percent of banking assets (O’Brien, 1989, 51). Growth of non-bank financial institutions and inflation eroded regulation Q and restrictions that separated banking and other financial firms. By the end of the 1970s, the burden of several costly regulations became apparent. Deregulation began.

  THE ECONOMY IN 1973–79

  Rising inflation was the main economic event of the period. Chart 7.1 shows the percentage change in the deflator for private consumption during the 1970s. The two peaks roughly coincide with increases in oil prices, but it is less clear that oil price increase caused most of the price increase properly measured. Unlike the consumer price index, the deflator is much less affected directly by oil prices, and its peak rates of inflation remained well below the rates recorded by the consumer price index. The consumer price index, however, was widely used to adjust wages and other contracts and it was widely quoted at the time.

  It is true, nevertheless, that the peaks in oil price increases shown in Chart 7.2 correspond to the peaks in general measures of the price change. Part of the increase resulted from the world increase in aggregate demand in 1973 stimulated by expansive policies in several countries.

  Real growth in the United States made a large contribution to robust world growth in 1972. Chart 7.3 shows this surge and the recession that followed. It was the deepest recession of the postwar years to that time. Inflation continued at a high level during the recession, so there was much talk about “stagflation,” inflation at a time of high persistent unemployment. By this time producers and consumers had learned that anti-inflation policies did not persist once unemployment rose, so they were hesitant to change their beliefs about long-term inflation. Measures of anticipated inflation remained at about a 5 percent annual rate, and ten-year Treasury bond yields remained about 7 percent.

  Chart 7.3 also shows the real interest rate computed from the ten-year Treasury bond and the anticipated rate of inflation from the Society of Professional Forecasters. The rate moves in a very narrow range. In contrast, growth of the monetary base, especially the real value of the monetary base, fluctuated over a wide range. Real base growth rose during the boom in 1972, fell in advance of the recession in 1973–74, and rose during most of the expansion during the middle of the decade. Chart 7.4 shows these data.

  Chart 7.5 shows the surge in the base growth compared to output growth in 1973–74, its subsequent collapse in 1974–75 and the new surge at the end of the 1970s. Inflation rose, pushed by excessive monetary stimulus and lax monetary and fiscal policies. By contrast, inflation remained low in 1963–64, when the base and real GDP rose at about the same rate.

  Productivity growth declined during the 1970s as shown in Chart 7.6. The relatively high nominal base growth maintained through the decade and falling productivity growth contributed to average inflation over the decade. As in Nordhaus (2004), slower productivity growth was in part the result of the oil shocks during the decade. Variable inflation contributed also by making it difficult for producers to make long-range plans and by focusing their attention on short-term gains. Federal Reserve actions reinforced these tendencies.

  The civilian unemployment rate in Chart 7.7 follows the same general path (with opposite dips) as productivity growth. The unemployment rate fell as productivity and real growth rose, and it rose during recessions, when growth of productivity and real output fell. Chart 7.7 shows the peak in the postwar unemployment rate at 9 percent. In 1982, the unemployment rate reached a higher peak, 10.8 percent, near the end of the recession that ended the high inflation period.

  Much economic theory of the cost of inflation discusses the cost of a fully indexed inflation. All prices adjust fully to the anticipated inflation rate. The 1970s inflation was far from that theoretical construct. Congress did not index personal income tax rates until the 1980s. Interest rates on time and demand deposits remained controlled. The government controlled energy prices. The controlled rates and prices did not adjust to inflation.

  One consequence was that it was privately profitable to use talent and personnel to develop alternatives that avoided regulation. These innovations introduced variability into monetary aggregates and eventually their redefinition. A second consequence was that savings and loan institutions faced long periods in which the yield on their portfolios remained far below the interest rates permitted to be paid on their liabilities even though these rates remained below open market rates. The savings and loans suffered loss of income and deposits. Inflation and their decisions about risk taking eventually destroyed many of them at substantial cost to taxpayers.

  Finally, Chart 7.8 points out a major change in the use of resources. Beginning with the start of President Johnson’s Great Society spending in 1965–66, transfer payments as a percentage of personal income doubled in less than a decade. The change in administration in 1969–70 slowed the growth rate for a short time. The rate of i
ncrease rose following the slowdown until the proportion reached more than 12 percent of personal income. This surge reflects the introduction and growth of many so-called poverty programs but also transfer programs for health care. These programs shifted resource use from production to consumption and probably contributed to slower productivity growth as resources were drawn to the new federal programs. The small changes in the last half of the 1970s reflect mainly changes in income. A new, smaller surge in transfer payments occurred at the end of the 1980s.

  The data summarized here, particularly data on the Great Inflation, encouraged an extensive literature on the causes of the inflation by both political scientists and economists. Before turning to the details of the period, we examine some of these explanations.10

  Tufte (1978) offered a political interpretation. Based on work such as Kramer (1971) and many later studies, he showed that election outcomes depend positively on unemployment, real disposable income, and similar variables and negatively on inflation. Quoting Nordhaus (1975, 185), Tufte argued that “politically determined policy choice will have lower unemployment and higher inflation than is optimal.” Barro and Gordon (1983) reached a similar conclusion in a different model by assuming that the desired unemployment rate is below the so-called natural rate.

  One problem with these models is that they explain policy outcomes for a period restricted to the Great Inflation. They explain neither the period before nor the one after the Great Inflation. To explain observed changes in the inflation rate, the models require improbably large changes in the so-called natural rate of unemployment. They suggest why it can be politically costly to reduce an inflation that has started, but they do not adequately explain either why inflation ended or, once ended, why it did not return. Second, the political models explain what politicians prefer, but they avoid an explanation of why an ostensibly independent Federal Reserve cooperated.11