A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  The FOMC’s November decision called for a reduction in the federal funds rate and an increase in money growth. Paul Volcker and Philip Jackson dissented because they were uncertain about current conditions and, Volcker added, uncertain about the outlook for New York City. David Eastburn dissented for the opposite reason. He wanted a more expansive policy. “Too much emphasis on money market conditions had misled the Committee in the past” (Annual Report, 1975, 244). He wanted less emphasis on money market conditions.

  Money growth rates declined after year-end 1975. The manager reduced the funds rate. Uncertainty about the reason for slow money growth, problems of seasonal adjustment in December–January, and evidence of continued economic growth limited the Committee’s response to money growth. On December 24, the Board announced a small reduction in reserve requirement ratios, from 3 to 2.5 percent, on time deposits with 180 days to 4 years initial maturity. The new requirement became effective on January 8. The staff estimated that the reduction released $380 million in reserves, but as usual, the release was temporary; at unchanged interest rates borrowing declined. On January 5 the Board cited the release of reserves as a reason for delaying requests from Kansas City and San Francisco to reduce the discount rate. Eleven banks requested a reduction to 5.5 percent. The Board approved on January 16, 1976, citing a desire to bring the discount rate closer to open market rates. At the time, the federal funds rate was below 5 percent. Governor Coldwell dissented; he preferred a reduction of 0.25 because he thought the 0.5 reduction would signal a move toward greater ease.

  Monthly average federal funds rates in 1976 remained in a narrow range between a low of 4.77 percent in February and a temporary high of 5.48 percent in June. In November, the month of the election, the funds rate was 4.95 percent.

  At each meeting the FOMC set a one-year rate of growth in M1 and M2, a rate of M1 and M2 growth for the current period, and a federal funds rate target. The manager always hit the funds rate target, but frequently missed the money target. The modest rise in the federal funds rate in May and June may be a mild response to relatively rapid money growth in April and May. I find no evidence, however, that the one-year targets for money growth had any influence on the funds rate target. Perhaps most surprising is the absence of any effect of the unsuccessful attempt at monetary control in 1976 on the procedure adopted in 1979. The main difference in the two periods was the tight control of the funds rate in the earlier period. Control of money growth did not improve.

  Table 7.9 shows the planned and actual rates of M1 growth up to the 1976 election. The FOMC always choose an M2 range, but I have omitted these from the table. Also, the FOMC chose annual targets for M3 and the bank credit proxy (total deposits).

  The FOMC planned a four percentage point money growth range most of the year. Money growth was outside that range in six of the eleven months. Burns and the Committee recognized that control was unsatisfactory, as discussed below, but the Committee did not change its operating procedure or permit the federal funds rate to fluctuate over a wider range. The real federal funds rate was negative.

  In February, Burns announced the proposed money growth rate for 1976 as 4.5 to 7.5 percent, a reduction of 0.5 in the lower bound. Since the FOMC also moved the base from the third to the lower fourth quarter 1975 value, it signaled an interest in continuing to lower inflation. Burns’s testimony reinforced this message.63

  At the April meeting, some members urged the FOMC to lower the upper bound on one-year money growth by as much as one percentage point to show its intention to reduce inflation. The committee reduced only the upper bound and only by 0.5. The discussion showed more interest in reducing inflation than was typical of FOMC discussions. But it occurred while the economy recovered and the unemployment and inflation rates both declined.

  63. As reported at the time, annual average M1 growth in 1975 was 4.4 percent, but much of this growth reflected rapid growth in the second quarter. In early March, the Shadow Open Market Committee expressed concern that the rapid deceleration of money would reduce growth of output and lead to more expansive policies and higher inflation. The SOMC favored a gradual policy, an end to shifting the base for projections (base drift) each quarter, and specific reforms to improve monetary control.

  There were only two dissents in 1976. A strong report of first-quarter expansion (7.5 percent) and reported rapid money growth encouraged the FOMC to increase the federal funds rate at the May meeting. Governor Coldwell dissented because he regarded the increase as excessive and likely to require a reversal. He thought the strong money growth was transitory.64 Paul Volcker dissented at the July meeting from a decision to widen the band on the funds rate from 5.25–5.75 to 4.75–5.75. He thought increased money growth in July was transitory. The funds rate averages in July, August, and September were 5.21, 5.29, and 5.25 percent.

  In July, members recognized that delaying action to change policy would bring them close to the presidential election. MacLaury (Minneapolis) and Guffey (Kansas City) proposed to slightly increase the money growth rate in July; the Committee voted to do so. This time, however, neither Burns nor the FOMC proposed to repeat the 1972 expansion. Occasional comments suggest the election was a consideration, but the minutes have few explicit statements. The FOMC did reduce the federal funds rate in October and after the election in November and December, but the belief at the time was that economic growth had slowed. Burns told the July meeting that “over the next few years we should get our monetary growth ranges down to a level where they are consistent with general price stability” (Burns papers, FOMC, July 19–20, 1976, tape 7, 8).65 Unfortunately, actions did not correspond. The projected ranges showed good intentions that were not realized.

  The staff estimated that growth in third quarter 1976 reached 4.5 percent and that the deflator rose 5.2 percent. Revised subsequently, real growth was 1.7 percent and inflation increased to 5.9 percent. These data are one of many examples of the often wide divergence between early reports and later revisions, especially for real growth. The divergence again raises the question: Why did the FOMC respond to the preliminary data? As Orphanides (2001, 2003a, 2003b) has shown, use of preliminary data was a main source of error in choosing policy actions.66

  64. Coldwell dissented also from the decision on March 15–16 to eliminate publication (after five years) of the memoranda of discussion. (These are the records I refer to as minutes.) The FOMC agreed to put more information into the annual records of policy actions published in the Board’s Annual Reports. The chairs of the Senate and House Banking Committees criticized the decision and asked the FOMC to reconsider. In July, the FOMC voted eleven to one to reaffirm its decision. Governor Coldwell dissented again.

  65. Following Burns’s statement, members discussed the market’s response to shortterm changes. Balles (San Francisco) and Burns described the market’s response as irrational. Burns added that the FOMC and the desk also respond irrationally to new data (Burns papers, FOMC, July 19–20, 1976, tape 7, 16). No one suggested basing policy on longer-term changes, but Balles proposed smoothing data using moving averages.

  The staff projected an increase in real growth in the quarters ahead. None of the members disagreed with the projections, although some expressed uncertainty about the timing of the increase and the effects of an automobile manufacturing strike then under way (Annual Report, 1976, 259). The projection differed from the claim by the Democrats’ candidate for president, James Carter, who suggested that a slowdown was under way and proposed more fiscal stimulus. Some FOMC members favored small fiscal stimulus, but the Committee preferred tax reduction to spending increases.

  After rejecting proposals for reductions in the discount rate in September and October, the Board approved a 0.25 point reduction to 5.25 on November 19. Eleven banks asked for the reduction. St. Louis joined the following week. The action followed the market in recognizing slower real growth in the fourth quarter, the decline in market rates, and the belief that growth would slow in 1977. In Dec
ember the Board turned down several requests for additional discount rate reductions. But it slightly reduced reserve requirement ratios for demand deposits by 0.5 points to 7 and 9.5 percent for deposits of 0 to $2 million and $2 to $10 million and by 0.25 points for all other demand deposits. The staff estimated that the action released $550 million in reserves, but with unchanged interest rates, the manager absorbed the additional reserves. The move intended to reduce the loss of members by reducing membership costs.

  Soon after these moves, the staff recognized that the 1976 slowing of industrial production and economic growth was temporary. By yearend, the staff described the very large increase in industrial production (19.8 percent annual rate) in November as larger than could be explained by the end of the auto workers’ strike.67

  66. The FOMC voted in August to continue open market operations in agency securities. It claimed these operations were “useful in achieving the Committee’s reserve objectives” (Annual Report, 1976, 252). The more likely reason was pressure from Congress to intervene in the agency market, especially housing market securities.

  67. Purchase of federal agency issues became controversial. Burns recognized that congressional pressure to aid the housing industry was a main reason for purchases. Coldwell opposed strongly. Volcker recognized the political pressures but urged restraint, especially for FNMA purchases. Burns concluded that it was not worth a fight with Congress (Burns papers, FOMC, August 17, 1976, tape 6, 8). The issue returned in November, when several objected to the purchase of transit bonds for Washington, D.C. Some in Congress asked why FOMC could help Washington but not New York, pointing up the problem arising from credit allocation.

  THE 1976 ELECTION

  James Earl Carter narrowly defeated Gerald Ford in the 1976 election by 1.7 million votes out of 86 million. With inflation (deflator) at 7.1 percent and a new administration, the anti-inflation program ended. Four years later the deflator reached 12 percent, partly a result of a second large oil price increase.

  During the campaign, and after, Carter’s principal advisers tried to hark back to the successful experience of the Kennedy administration’s program to “get America moving” after the very restrictive policies of the late Eisenhower administration (Biven, 2002, 27). Although candidate Carter did not offer an explicit program, he emphasized the long and deep recession in 1974–75 and the slow recovery. He promised full employment by 1979 and expressed much less concern about inflation (ibid., 29, 34, 36). He explained that he had never been asked about inflation during the campaign, only about employment (Carter, 1982, 65).68

  Comparisons to the 1960s neglected an important difference. The Kennedy program came after a successful anti-inflation program had convinced all but the most skeptical that the United States would not inflate. Also, it came at a time of faster productivity growth. These factors reduced both actual and expected inflation. Few, if any, in 1961 believed that peacetime inflation rates would reach 8 to 10 percent. Few in 1977 doubted that these inflation rates could return.

  Several Carter administration economists, like the Kennedy administration economists, believed that they could use wage and price guideposts to limit inflation. In a magazine interview, Carter told the editors what he understood from his advisors. “My economic advisors and I agree that until you get the unemployment rate down below five percent, there’s no real danger of escalating inflationary pressures” (quoted in Biven, 2002, 36). He wanted “more humane and economically sound solutions to cooling inflation” without increasing unemployment (ibid.). In a speech to the AFL-CIO, he accused the Ford administration of using “the evil of unemployment to fight the evil of infl ation—and—having the highest combination of unemployment and inflation in the twentieth century” (ibid., 37). Four years later, Ronald Reagan used the same argument against Carter.

  Labor unions objected to strong interference in wage setting, so the administration adopted a modest guidepost program. As inflation rose, guideposts became more explicit but no more effective. Stuart Eizenstat, the Domestic Policy Adviser, described the guidepost policy as enough “to make all constituencies mad without accomplishing the result” (Eizenstat, 1982, 79).69

  68. President Carter attributed part of his difficulty in getting his programs through Congress to his position as an outsider. As a “southerner, born-again Christian, a Baptist, and a newcomer,” his election owed little to traditional Democratic groups in Washington (Carter, 1982, 11).

  Two problems arose. First, the administration’s economists were unwilling to accept a temporary increase in unemployment to gain a permanent reduction in inflation, and the public in 1976–77 was not greatly concerned about inflation. By 1979, concern had increased. Second, administration economists underestimated the rate of inflation. Forecasts of inflation, based on the Phillips curve relating inflation to the unemployment rate, were inaccurate. Table 7.10 shows the forecasts and realizations of inflation in 1977–79. All three forecasts underestimated the inflation rate, in part because of one-time increases in food and oil prices, in part because of mistaken beliefs about the natural rate, but also because monetary base growth from 1977 to 1979 averaged 8 percent or more.

  Part of the forecast error resulted from the unanticipated oil price shock. Chart 7.11 shows the two sharp increases in consumer price inflation following the two large oil price increases in the 1970s. The oil price increases in 1973 and 1979 came at a time of rising inflation. In contrast, Chart 7.12 shows the much smaller increases in nominal wage growth in 1973–74 and 1978–79. Together, the two series imply a substantial decline in real wages in both periods. Despite repeated claims by Arthur Burns and others about the role of labor unions, labor unions did not recover their losses. The oil price increases were a tax paid to foreigners that had to be borne by wages and profits. The different response of wages to demand stimulus and supply shocks suggests the importance of separating these persistent and transitory effects in discussing and responding to price increases.

  At a more fundamental level, Carter’s choice of advisers included mainly people who believed that the economy had to be closely managed. This fit well with Carter’s predilections. In contrast to Greenspan, Simon, and President Ford, they did not believe that they could rely on a robust private sector to restore full employment at low inflation if government adopted non-inflationary policies. They were Keynesians with a strong belief that their task was to manage the details because without their intervention, the private sector would be unstable. A briefing paper for President-elect Carter told him: “There have been few spontaneous recoveries in the years since World War II” (quoted in Biven, 2002, 125). Advisers explained that several econometric models showed declining growth in 1977. They were wrong. The 1977 recovery is evidence against the Keynesian view.

  69. President Carter’s adviser from his years as governor of Georgia warned him that wage-price guidelines were ineffective unless supplemented with general macroeconomic policy. Carter replied: “I understand from this what will not work. What will?” (quoted in Biven, 2002, 54).

  To expand output and increase employment, the Carter administration proposed to reduce corporate taxes, increase depreciation allowances for small businesses, give a $50 rebate to households on 1976 income taxes, increase revenue sharing for state and local governments, and create additional public service jobs at a total cost of $15 billion. Ray Marshall, secretary of labor, proposed public employment programs. This did not appeal to Schultze, but it did to Carter. President Carter was torn between his alleged fiscal conservatism and the political pressures from the liberal side of his party (Hargrove and Morley, 1984, 463).70 By spring, congressional opposition, recovery, economic expansion, and the unpopularity of the $50 rebate changed the program (Hargrove and Morley, 1984, 480; Carter, 1982, 12). In April President Carter dropped the rebate and the business tax cut. Congress adopted an employment tax credit in place of public service jobs, increased the standard income tax deduction for individuals and gave assistance to state and
local governments. The stimulus package transferred $6 billion in 1977 and $17 billion in 1978. The original proposal had $15 billion in each of 1977 and 1978 (Biven, 2002, 82).

  Arthur Burns openly opposed the administration’s program. Burns believed that budget deficits and labor unions were major causes of inflation.71 He wanted a lower budget deficit and stronger guidelines for wage increases. This open conflict with the administration was not forgotten when his second four-year term as chairman of the Board of Governors expired in February 1978.

  70. Charles Schultze served as budget director during the Johnson administration. He is a highly regarded economist, active in the Democratic Party. Several of Carter’s advisers described him as a fiscal conservative. In fact, budget deficits for the four years 1977–80 reached $226.8 billion. Total federal outlays rose 44 percent in nominal terms and 13 percent in real terms between 1977 and 1980. Outlays increased by one percentage point relative to GNP. This growth is not conservative compared to experience up to that time, but it is modest compared to budget and deficit increases during the Reagan administration.

  71. The Shadow Open Market Committee in March warned that the new administration had shifted priorities. The committee said that this change would bring higher inflation. In September, it warned that money growth had returned to the high levels of 1968, 1972, and 1973. Government spending growth increased also. After the fact, Stuart Eizenstat said that their biggest mistake was underestimating inflation at the start of the administration and failure to act against it (Eizenstat, 1982, 79). Eizenstat was chief Domestic Policy Adviser to the president. Later, he favored price and wage controls as a short-term response to the 1979 oil price increase.