A History of the Federal Reserve, Volume 2 (93 page)

Some economists, members of Congress, and congressional staff proposed auctions several times. The Federal Reserve and the Treasury opposed. This was a costly mistake that helped to start the Great Inflation.

The
Role
of
Economics

Martin often began a conversation by saying, “I am not an economist.” He had little interest in economic explanations of inflation, claimed not to “understand” the money stock, and did not have much confidence in the accuracy of economic data. He saw, correctly, that measurements of shortterm changes were unreliable and were often revised substantially.

Martin did not articulate a coherent theory or explanation of the relation of Federal Reserve policy to economic activity and prices. When pressed, he fell back on an analogy to a river. Policy actions aimed to keep the river within its banks but high enough within the banks that the fields could be irrigated.
³⁵²
In his early years he sometimes mentioned money growth relative to output growth as a long-term measure of ease or restraint. When Winfield Riefler and Woodlief Thomas retired from the senior staff, the importance of excessive money growth weakened.

Other members of FOMC held a wide range of views about economics. Several presidents and Board members were practical men without much interest in explanations of inflation or economic activity. Bryan (Atlanta) and Johns (St. Louis) emphasized money growth and at times proposed procedures for adjusting policy to control money growth, but they never received majority support. A few members of FOMC, and a growing number of senior staff members, accepted some version of Keynesian theory. To the extent that there was a dominant view, in the early 1960s, the members favored making judgments for the next three weeks based on observable data. If it seemed appropriate the decision could be revised at the next meeting. This meant that there was no consensus to act against inflation or unemployment until it occurred and was well established. The fact that Chairman Martin was the leading member of this group contributed to its dominance. This approach failed to adjust policy to longer-term movements in output and inflation.

A by-product of this atheoretical approach was the vague instruction
given to the account manager. Unable to agree on how their actions affected their longer-term goals, the members could not decide how best to implement policy actions. The manager had considerable discretion and, as the minutes show, members frequently differed over whether the manager had followed instructions. The manager’s focus was the money market, so his decisions gave much more weight to current technical details than to longer-range objectives such as inflation. His focus was mainly on transitory movements that affected interest rates. Persistent changes affecting inflation received less attention.

352. Martin used this analogy when I interviewed him as part of the 1964 Patman study and hearings. The analogy appears also in FOMC discussions and his congressional testimony.

Once inflation started the issues changed. Some members accepted that inflation could permanently lower the unemployment rate. Others were more concerned about the temporary increase in the unemployment rate resulting from actions to slow inflation. Several accepted that little could be done as long as the federal government ran budget deficits. Since there was no generally accepted framework relating unemployment, inflation, budget deficits, balance of payments, and Federal Reserve actions, it was hard to reach agreement about what could or should be done. And most members interpreted the Employment Act as giving primacy to minimizing unemployment, maintaining a 4 percent unemployment rate.

The members recognized that they did not have a common framework. After Sherman Maisel became a Federal Reserve governor in 1965, he tried to make policymaking more coherent and systematic (Maisel, 1973). He soon recognized that there was no basis for agreement; members told him that they were unlikely to find a common framework.

The minutes have an occasional remark about anticipations of inflation. There is little evidence of a general understanding that anticipated inflation raised interest rates. The FOMC did not distinguish between real and nominal rates until much later. At the start of the inflation, and for a long time after, members using nominal interest rates overestimated the degree of restraint. Misinterpretation added to the pressures from President Johnson to keep interest rates from rising. They also overestimated the expected growth of output after productivity growth slowed in the mid 1960s.

One way to avoid responsibility for inflation was to find some other cause. Much public and policy discussion blamed labor union demands for starting inflation, treating these wage demands as autonomous events and not as a response to actual and anticipated inflation. Many at the Federal Reserve and in the administration shared this view. This led to the use of guideposts for wage and price increases. The universal failure of guideposts and guidelines to prevent inflation did not change these views. And it did not remind the proponents that non-inflationary policies would
prevent relative price changes from affecting the general price level. Lucas (1972) and Laidler and Parkin (1975) showed that relative price changes would not cause a sustained inflation in the absence of actual or anticipated expansionary policy.

Institutional
Arrangements

Two institutional arrangements had a major influence on Federal Reserve decisions. Martin’s acceptance of policy coordination with the administration prevented the Federal Reserve from taking timely actions. The System delayed acting in 1965 despite Martin’s early warnings about inflation.

Even keel policy also delayed taking policy action, sometimes for months. During even keel periods, usually lasting up to four weeks, the Federal Reserve often added large increments to reserve growth that it did not subsequently reverse. It is, of course, true that the System could have prevented the inflationary impact. It failed to do so because the costs of reversal always seemed large.

Years later Chairman Arthur Burns accepted the importance of even keel policies for the beginning and continuation of inflation.

While the Federal Reserve would always accommodate the Treasury up to a point, the charge could be made—and was being made—that the System had accommodated the Treasury to an excessive degree. Although he was not a monetarist, he found a basic and inescapable truth in the monetarist position that inflation could not have persisted over a long period of time without a highly accommodative monetary policy. (FOMC Minutes, March9, 1974, 111–12)

My conclusion is that three factors—Martin’s beliefs, the absence of a relevant theory, and institutional arrangements—explain why inflation started. Two other questions remain: Why did the inflation continue as long as it did? Why did it end when it did? These questions are considered in subsequent chapters, after reviewing the decisions and the reasoning.

At the end of the war, the administration and Congress adopted the Bretton Woods Agreement, which fixed the dollar price of gold and committed the United States to keep one fine ounce of gold equal to $35. Throughout the early 1960s, under President Kennedy, the Treasury worked hard to develop controls and arrangements like the gold pool to sustain the fixed exchange rate regime. Higher inflation abroad reduced the real dollar exchange rate and the current account deficit.

These measures were mainly successful. Balance in the current account seemed achievable before the end of the decade. President Johnson gave lower priority to the current account than his predecessor. His administra
tion relied more on controls and crisis management and gave little or no attention to the real exchange rate and low inflation. Their main concerns were domestic equality and the war in Vietnam.

Some commentators on the period point to the international character of the inflation. All countries experienced the start of inflation in the 1960s. All of them were members of the Bretton Woods system, so they either accepted the dollar outflow or appreciated their currency. Few chose appreciation, and some added to their inflation by their own policies. Britain is the best example, but France and later Italy followed inflationary domestic policies leading to devaluation. In addition to the Bretton Woods system of fixed exchange rates, a common concern to prevent increased unemployment contributed to the inflation problem abroad. Laidler (2004) offers an international perspective.

The 1960s began a period of financial innovation. The Comptroller of the Currency, James Saxon, supported and encouraged deregulation. The Federal Reserve was slower to act. Although members sometimes recognized that ceiling rates on time deposits should be removed, they did not agree to do it.

four

The Great Inflation: Phase I

Monetary policy should not, and in fact cannot, be focused solely on interest rate objectives— any more than it can ignore them completely. . . .

The immediate goal of monetary policy should be to provide the reserves needed to support a rate of growth in bank credit and money which will foster stable economic growth. It must take into account the international position of the dollar . . . It must be constantly concerned for the full employment of both human and physical resources. It must take into account price developments and the possibility of inflation,
or
the
widespread
expectation
of
inflation,
which would do great damage to healthy growth. . . .

All these things, and many others, must be constantly weighed and balanced by the Open Market Committee . . . We cannot produce
through
monetary
policy
alone,
high or low interest rates, balance of payments surpluses or deficits, rising or falling prices, more or less employment, or a sound or unsound financial structure. We do exert some influence on all these things, hopefully in the right direction.

—William McC. Martin, Jr. (memorandum for the president, Martin papers, undated; emphasis in the original)
¹

The memorandum succinctly summarizes Martin’s main views about monetary policy. There were multiple objectives that had to be weighed and balanced. Even the best judgment could not achieve any precise goal because many other factors affected prices, output, balance of payments, and interest rates. The most one could do was to do one’s best and hope that others would do the same.

By April 1966, Martin had been chairman of the Federal Reserve for
fifteen years, longer than any previous chairman. The economy had entered its fifth year of sustained expansion, much above the National Bureau’s thirty-two—month average for peacetime expansions (Zarnowitz and Moore, 1986, Table 3). Consumer price inflation remained below 2 percent. Lower inflation at home than abroad had reduced the real (price level adjusted) exchange rate.

1. From references to interest rate levels elsewhere in the memo, it was probably written in 1965, before the increase in the discount rate.

Chart 4.1 shows that the trade-weighted real exchange rate appreciated until the mid-1960s. The main reason was lower inflation at home than abroad. By 1967 the period of more stable prices had ended; inflation reached the 2.5 to 3.5 percent range. Rising budget deficits to finance military, domestic, and wartime spending raised the public’s concerns about future inflation. Chart 4.2 compares one measure of anticipated inflation to actual inflation, using the Livingston survey of anticipations. Although the survey systematically underestimated the measured rate of inflation, the survey data show a steady, gradual increase to 3 percent and above by the end of the period.

The current account surplus, though below its 1964 peak, remained large enough in 1965 to cover most capital spending. Chart 4.3 shows that quarterly values of the current account surplus had started a gradual decline that would continue with little interruption for the rest of the decade.

In the 1950s, the Board’s senior staff, some FOMC members, and occasionally Chairman Martin relied on the relation of M
₁
money growth
to growth of real output as a measure of inflation potential. Chart 4.4 smoothes both series to show that in the first half of the 1960s, the two had similar average trends with real growth above money growth. We cannot be sure whether the result was happenstance or whether the FOMC intended to achieve the particular outcome. There is no evidence of any
explicit effort, but senior staff members claimed to set reserve targets by estimating money growth.