A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  80. Governor Wallich dissented from the August increase because of “hesitation in some key indicators of economic activity and the associated uncertainty about the duration of the economic expansion” (Annual Report, 1977, 150).

  At the May 1977 meeting, the FOMC began to increase the federal funds rate. The average rose to 5.4 in May from 4.7 percent in April. At the time, both the twelve-month-average consumer price increase and average rate of monetary base growth were 6.5 percent. Expected inflation increased to 6.5 percent. M 1 growth from May to July averaged about 4 percent using the revised definition of M 1 that included NOW accounts and other transaction balances.

  Burns urged a reduction in the M1 target to 0 to 4 percent with federal funds at a 5.5 percent midpoint. Volcker and Wallich proposed −1 to 4 percent, but Burns did not want a negative number. Six members wanted the lower bound on the funds rate at 5 percent; four wanted the upper bound at 6 percent. By unanimous decision the FOMC accepted 5.25 to 5.75, Burns’s midpoint and also his range for M1 growth.

  The narrow range and unanimous vote understate the division within the Committee. Willes (Minneapolis) said that businessmen needed continued evidence of he System’s willingness to combat inflation. He wanted “a significant step toward moderation in the rates of growth in the aggregates” (Burns papers, FOMC, May 17, 1977, tape 3, 16). Partee responded, opposing the degree of monetary “tightness” that Willes called for. “We also have the objective of maintaining reasonable growth . . . [W]e’re talking about a growth rate of around six percent or perhaps a shade below which we need unless we’re to accept this unemployment rate as a permanent thing” (ibid., tape 3, 11–20).

  Partee noted that the Committee had tightened in the spring of 1975 and again in 1976 but reversed policy soon after. He believed they did no harm. Earlier, Partee mentioned a congressional response, a topic that rarely became explicit. “What would be a Congressional response to a higher unemployment rate?” Burns cut off the discussion (ibid., tape 2, 11–12). Others mentioned the effects on wages, prices, and interest rates from an increase in expected inflation, a sign that FOMC members started to give attention to anticipations of inflation in the private sector. Guffey mentioned speculation in farm real estate, a major problem for the farm sector after 1979.

  The modest move to a higher federal funds rate at first had no effect on longer-term rates. By October the ten-year rate began to rise, in anticipation of rising inflation. By year-end, it increased forty basis points, from 7.4 to 7.8 percent. It continued to rise in 1978 to 8.7 percent in July 1978. By that time twelve-month CPI inflation was 7.5 percent and rising.

  The FOMC never discussed and never decided how much unemployment they would accept to reduce the inflation rate. They had different objectives and rarely expressed a clear view.81 Their votes and discussion are the main clues to their beliefs. For example, Burns talked often about the objective of price stability or reduced inflation, but he recognized and perhaps overemphasized the political constraints. In January 1977, he urged the members to “consider the degree to which, if any, our monetary policy should contribute to unwinding the inflation from which our economy has been suffering since the mid-1960s. . . . [N]o other branch of government . . . has anything approaching an articulate policy for bringing down the rate of inflation” (ibid., January 17–18, tape 7, 1). Then he expressed concern about the unemployment rate, the new administration, the new Congress, and the possible interpretation of an anti-inflation action as an effort to frustrate the efforts to expand employment. That covered all the possibilities. He proposed leaving the annual target for M1 growth unchanged at 4.5 to 6.5 to limit that criticism, but he proposed lowering the bottom of the M2 and M3 ranges by 0.5 percentage points. Morris (Boston) argued that the proposal lacked substance, suggesting it was mainly cosmetic.

  81. One of the rare exceptions was a brief discussion in February 1977. Morris (Boston) said that “there is a need for the Committee to make policy in a longer term time frame than we’ve been accustomed to in the past. I thought I would ask if the staff has a concept of what the optimum growth path ought to be for the economy over the next few years” (Burns papers, FOMC, February 15, 1977, tape 1, 10). A brief discussion followed, but action did not change.

  Burns replied to the criticisms by defending the small change in M2 and M3 growth. “It will take us ten years [to return to price stability]. Ten years if we’re lucky” (ibid, tape 8, 2).82 Governor Coldwell pointed out that they did not achieve the annual targets. “I don’t hear many Committee members, perhaps excluding President Balles, who keep reminding us that our short-run ought to be somewhat consistent with our long-run targets” (ibid., tape 8, 4–5).

  With the obvious divisions, the short-term focus, and the absence of a common, coherent framework and an agreed objective, the System was ill-equipped to end inflation. Political concerns and weak independence heightened the problem.

  In March, the FOMC missed another opportunity to consider the longer-term effect of its actions. Governor Wallich said the FOMC would improve its policy “the earlier we face up to the prospect of rising interest rates” (ibid., March 15, 1977, tape 4, 4). Burns opposed. “We ought to be very cautious about any anticipatory movement that we make. And we’re capable of responding and responding very promptly without anticipating these very short-term adjustments” (ibid., tape 4, 7). Of course, this neglects changes in maintained anticipations.83

  Political concerns affected Burns’s decision about the choice of annual targets for money growth. He told the FOMC that before President Carter announced his energy policy he proposed to reduce M1 growth by 0.5 percentage points. Uncertainty changed his proposal to “a much milder recommendation.” He eliminated the proposed reduction (ibid., April 19, 1977, tape 5, 4). Then, remembering his repeated concern about inflation, he warned: “There is never a good time to lower the monetary growth ranges, yet unless we work at it . . . I don’t see much future for our economy” (ibid.).

  82. Although the staff used a model, Burns had little confidence in econometric models. “I have managed to get to my present age without paying much attention to what these equations have to say. . . . I see no reason for learning these things at the present time” (Burns papers, FOMC, June 21, 1977, tape 1, 24–25). His successors, Volcker and Greenspan were also disinclined to accept model forecasts.

  83. Burns publicly opposed President Carter’s fiscal program. In March, he told the FOMC, “I don’t think it is going to make any difference one way or another as far as the real economy goes.” He explained that higher interest rates and inflation would offset any positive real effect (Burns papers, FOMC, March 15, 1977, tape 1, 17). He also opposed Carter’s energy program, describing it as overly complicated, likely to increase uncertainty and reduce growth (ibid., April 19, 1977, tape 3, 23–24).

  For the first time, Wallich recognized that the measured rate of price change included one-time price changes resulting from “external shocks.” He wanted the committee to decide whether to accommodate the shock or ignore it. His analysis showed the lack of clarity about inflation and price level changes. Accommodating the shock—not responding—“would just build the price increase into the economy permanently as a continuing rate of inflation” (ibid., tape 6, 2). The oil shock was a price level change that would increase the rate of price change temporarily as it passed through. Actions to offset the price level effect was a long step toward taking the price level as the goal instead of the sustained, expected rate of inflation.

  President Black urged a reduction in the proposed money growth rates. The present is about “as good a time as we are likely to get” (ibid., tape 6, 4–5). But he voted for Burns’s proposal. Only Partee dissented from the very mild move because of uncertainty, withdrawal of President Carter’s proposed $50 rebate, and the continued high unemployment rate.

  At the time, the unemployment rate was about 6 percent. The full employment rate was no longer 4 percent. Mayo thought it was 5.5 percent. The s
taff used 4.86 percent, a precision that amused the members. As with most decisions, the Committee did not attempt agreement on full employment or reconciliation of diverse opinions.

  Wallich concluded from his observations that high unemployment did not reduce inflation. This denied the relevance of the Phillips curve relating the two, a main hypothesis in the staff model. “Our projections say that doesn’t have that effect and I think we could begin trying something else” (ibid., September 20, 1977, tape 3, 18). He proposed an incomes policy, similar to the policy the administration used without obvious benefit.

  Sometimes the committee chose a money market directive. At others, it chose an aggregates directive. The difference was in the degree of control or the width of the range for the federal funds rate. Although this decision brought out frequent differences of opinion, the data do not show any major differences in outcomes.

  The Committee required four votes to reach agreement in September. Burns proposed M1 growth of 2 to 7 or 3 to 7, M2 at 4 to 8, and a 6.125 mean funds rate. Roos wanted M 1 at 0 to 5, didn’t care about M 2 , but his mean funds rate was 6.5 percent. Wallich proposed M 1 at 2 to 9 percent, M2 5.5 to 9.5 and the funds rate at 6.125. Eastburn had M1 at 0 to 7, M2 at 0 to 9, and the funds rate at 6.25. Very similar values for the funds rate covered a wide range for proposed money growth. No one suggested reconciling these numbers or discarding some combinations as unlikely.84

  The first vote on Burns’s proposal was seven to five in favor. He wanted more support. He raised the maximum growth rates and the funds rate. Votes changed but the division remained seven to five. When he changed the proposal to a money market directive, the vote became eight to four. Burns accepted the seven-to-five vote on his proposal and criticized the members’ inflexibility.

  Some of the presidents wanted the Board to reduce reserve requirement ratios, principally to retain members. As the opportunity cost of reserves rose, member banks converted to non-member banks. Between 1970 and 1977, 133 state member banks gave up membership, more than 10 percent of the total. The number of non-member banks increased by 1,116. In 1977, 69 banks converted from member to non-member status, followed by 98 in 1978 (Board of Governors, 1981, 490, 495).

  At Burns’s last FOMC meeting, February 28, 1978, the staff reported that the consumer price index rose at a monthly rate of 0.8 percent in January, almost twice the monthly average for the previous six months. “Considerable concern was expressed that the rate of inflation might accelerate significantly as the year progressed. . . . Such price behavior . . . would pose difficult questions concerning the appropriate role of monetary policy” (Annual Report, 1978, 132). Yet the committee kept the projected rate of M1 growth unchanged at 4 to 6.5 percent for the year after rebasing to accept the excess growth in 1977. After some discussion, the Committee accepted the proposed rate unanimously.

  The February meeting showed a marked change in members’ comments. The majority recognized the need to reduce inflation and lower money growth. Even Burns was explicit about the need to control money growth. They recognized also that Federal Reserve credibility was low. Several favored rebuilding credibility before attempting to lower money growth, but they did not offer a plausible set of actions. They recognized that achieving the announced yearly money growth rate was important. Instead of reducing projected money growth, the FOMC voted to maintain the growth rate unchanged.85

  84. At the August meeting, Volcker expressed “a sense of futility” in picking money growth rates given errors ranging up to 15 percent and differences in the alternatives of only 0.5 (Burns papers, FOMC, August 16, 1977, tape 4, 22).

  85. Wallich complained, “We think we want to avoid triggering the funds rates because if it goes down it hurts the dollar and if it goes up it hurts housing . . . But we don’t really gain anything, we just postpone” (Burns papers, tape 5, 9, February 1978). Burns disagreed.

  Why did the Federal Reserve renew inflationary monetary policy? Unlike some of their predecessors, Committee members recognized that rapid money growth caused inflation. That was why they selected money growth targets, even if they did not meet them. Doubtless there are many reasons in a nineteen-person committee. Three stand out.

  First was the relative weighting given to the employment and inflation objectives. With Congress and the administration controlled by Democrats many of whom gave more weight to unemployment than to inflation, the FOMC acted as if they could control inflation only when the unemployment rate was relatively low. Opinion polls showed that reducing the unemployment rate was most important to the public at the time. Congressional opinion probably reflected the polling data.

  Members of the administration shared these views. They wanted to get the economy to grow faster and lower the unemployment rate. They urged Burns to coordinate his actions with their goals. One of several occasions came at a breakfast in June 1977. Schultze reported to Carter that Burns was “sensitive” about administration criticisms of the interest rate increases in April and May. He urged Burns to keep monetary growth compatible with their planned economic growth. Burns explained that he was willing to be flexible, but Schultze concluded that he would not “prevent substantial interest rate increases” (memo, Schultze to the president, Schultze papers, Carter Library, Box A96018, June 10, 1977).86

  Preparing for a Quadriad meeting in November 1977, Schultze wrote to the president about the state of the economy and topics to discuss with Burns. A main point was that monetary velocity had slowed from about 6 percent early in the recovery to a 2 percent rate in 1977. The Federal Reserve had announced that M 1 growth would be between 4.5 and 6 percent for the year ending third quarter 1978.

  If velocity continues to rise at a slow pace, a relatively high growth rate of money will be needed to accommodate satisfactory growth in output. . . . To meet our growth targets, nominal GNP will have to grow about 11 percent from 1977 to 1978 (5 percent real growth and 6 percent inflation). If velocity grows by 2 percent, M1 growth of 9 percent would be needed. If the Fed tries to hold growth of M1 within its target range, and velocity increases are small, interest rates will rise very sharply and the recovery will be damaged” (memo, Schultze to the president, Schultze papers, Carter Library, November 9, 1977, 3–4; emphasis in original)87

  86. Schultze wanted policy coordination. His idea of coordination differed from Ackley’s in the Johnson administration. For Schultze, coordination meant “really talking together frankly” (Hargrove and Morley, 1984, 483). He believed Burns would not be frank or open whereas Volcker, who pursued a more independent policy than Burns, was willing to discuss his plans.

  Schultze made no mention of the failure of the Federal Reserve to meet its many targets.

  Schultze also advised the president that the Council had lowered its forecast of 1978 growth because of reduced growth in mid-1977. He urged the president to ask Burns how the Federal Reserve would respond to the administration’s tax reform bill. “A tax cut can keep the pace of expansion from lagging if money and credit are permitted to increase fast enough to keep the higher growth rate of the economy from pushing up interest rates (ibid., 1–2; emphasis in original). Agreeing to coordination was unlikely to appeal to Burns, though he would probably do it when the time came.

  The substance of the memo suggests the weights that the Carter policymakers gave to real growth and inflation. With a reported unemployment rate of 6.8 percent at the time, reducing unemployment was the main goal. Schultze told the president: “A weaker economy next year because of inadequate growth of money and credit will affect prices very little, and real output and employment a lot (ibid., 4; emphasis in original). The unemployment rate declined to 6 percent by the following November; the annual rate of increase in consumer prices rose from 6.4 to 8.5 percent. A new surge of inflation was under way. The increase in inflation began before the oil price increase.

  In a memo to Treasury Secretary Blumenthal, written at the same time, Schultze was more explicit about his concerns. Unless policy gave greater sti
mulus, he expected “a stagnation of overall unemployment in the 6.5 percent area; no improvement and more likely a worsening of unemployment for blacks and other minorities; a continuation of inflation in the 6 to 6.5 percent neighborhood” (memo, Anti-inflation Component of a 1978 Economic Program, Schultze papers, Carter Library, November 9, 1977, 1). He described the economic and political consequences as “severe,” and he urged “a meaningful anti-inflation program” (ibid., 2).

  Schultze proposed a voluntary program that combined tax reduction and wage-price guidelines. If an employer certified that wages and benefits increased by no more than 6 percent, employees’ taxes would be reduced up to 1.5 percentage points up to $20,000. For each 1 percent that employers reduced their weighted average rate of price increase, the government would reduce corporate tax rates by 1 percentage point up to a maximum of 2 percentage points. “The objective behind the approach is to break the momentum of the current price-wage spiral in 1978 and lay the groundwork for moderate union settlements and price increases in 1979” (ibid., 3–4).