Governor Jackson and President Balles proposed the opposite alternative—controlling longer-term measures of money growth.171 Governor Wallich suggested that this would have a better chance of success if the FOMC would permit the funds rate target to change more often. He thought that the funds rate should not be an objective of policy; it would become an instrument. He doubted that this could be done (ibid.).
The discussion did not reach a firm conclusion, but it showed that several FOMC members understood why their operating procedures did not control inflation. Burns and others were not willing to make the necessary changes, so policy continued much as before. Burns concluded that both monetary aggregates and interest rates mattered for monetary policy.
Vice Chairman Volcker pointed out that the FOMC did not know whether failure to control the aggregates resulted from the reserves multiplier or the funds rate constraint. He wanted better information (ibid., tape 5).
Burns ended the meeting by eliminating RPDs and telling Axilrod to prepare an article for the Bulletin. Axilrod replied that “the evidence would show that the committee chose to adhere to the FF [federal funds] rate constraint rather than the RPD target” (ibid.). This statement seemed to infuriate Burns. He replied sharply that “this was not a criticism of the Committee; it was evidence of the Committee’s practical wisdom” (ibid.). He told Axilrod to write it objectively and to recognize that the FOMC acted wisely!
Neither Burns nor a majority of the committee accepted nonborrowed reserves as replacement for RPDs. They postponed a decision. Burns did not think much would change. The concerned public already believed that they did not give enough attention to reserve growth.172
171. President Balles’s position was based on research at the San Francisco reserve bank. Balles asked his staff to determine whether the relation of M1 to GNP had deteriorated. To his expressed surprise, the staff presented evidence that “all of the monetary aggregates tested gave roughly similar results in predicting both nominal and real GNP for the period 1960–74 as a whole. In this sense no other aggregate was significantly superior to M1” (memo, James L. Pierce to Burns, Burns papers Box B-B81, April 3, 1974, 1). The memo concluded that the Board’s staff obtained the same result using other techniques. Later, San Francisco repeated its study and concluded that emphasis should shift to M2. The Board’s staff repeated the test. The Board’s equations show very little deterioration in either M1 or M2 variants (memo, staff to James Kichline, Burns papers, Box B_B114, June 3, 1977, 2).
172. Burns then asked whether monetarist economists would criticize the decision to drop RPDs. He accepted that they would. “We’ve gotten criticism from the monetarists no matter what we do. It’s their destiny to criticize, it’s their place in life” (FOMC Minutes, special meeting, March 29, 1976, tape 5). Also at the April 1976 meeting, Burns asked Holland to find an economic historian to write the Federal Reserve’s history. Holland left the Board the next month to become president of the Committee for Economic Development without completing the assignment.
Reserve Management
As part of the reconsideration of operating procedures, the System revisited lagged reserve accounting. Two main questions arose. First, would a return of contemporaneous reserve accounting improve control of the monetary aggregates? Second, would this change be costly to banks and discourage membership in the System?
The answers to both questions were yes, although arguments were made on the other side. Staff of the New York bank argued that elimination of lagged reserve accounting would increase interest rate variability. Market participants judged policy stance by the level of the funds rate, so their information would be less certain, and monetary control would suffer (memo, Paul Meek and Charles Lucas to FOMC, Board Records, February 17, 1976). Board staff reached the opposite conclusion. “For the purpose of controlling the monetary aggregates in the short run of a month or two via reserves, theoretical considerations and empirical evidence suggest that contemporaneous reserve accounting would be more effective than the existing reserve accounting system with a two-week lag. Linkages between reserves and the monetary aggregates in the short-run are loose in both cases, though less so without lagged reserve accounting” (memo, Reserve Requirement Policy Group to Board of Governors, Board Records, April 13, 1976, 1). The memo added that contemporaneous accounting would “probably reduce somewhat the amplitudes of movements in the funds rate over the longer run” (ibid., 1). Then it added that it had taken a survey of bank attitudes. Large banks with many branches strongly opposed a return to contemporaneous reserve requirements because it increased their costs of reserve management. They would likely hold more reserves.173 It cost nothing to provide them.
The staff favored contemporaneous reserve requirements whenever they considered or reconsidered the issue. The Board always rejected their advice until 1984, when they returned to contemporary reserve accounting after it no longer mattered for control. The issue was important only during periods of monetary control using a reserve target. The record suggests that at the FOMC banks’ opposition to their higher costs outweighed the social benefit of improved monetary control. This was clearly a misreading of Federal Reserve responsibilities.
173. The Federal Reserve introduced the two-week lag in 1968. The main reasons were (1) to moderate the decline in the funds rate on Wednesday settlement days caused by banks selling their surplus reserves and (2) difficulties in hitting the free reserve target because of large revisions in required reserves and vault cash after settlement. Prior to the change, member banks could offset reserve deficiencies in one settlement period up to 2 percent of required reserves by carrying the deficiency over to the next period, but there was no carryover provision for surplus reserves.
The New York staff also ran an experiment on the use of a nonborrowed reserve target. Based on its findings, the Subcommittee on the Directive recommended against using a reserve objective in the directive because it “would not improve the Committee’s ability to achieve short-run objectives for the monetary aggregates” (memo, Subcommittee on the Directive, Board Records, December 15, 1976, 5–6). The subcommittee recognized, however, that the main problem was failure to change the funds rate. Governor Wallich pointed out again that the System treated the funds rate target as a policy objective, not as an instrument for achieving control of monetary aggregates consistent with stable growth and low inflation. Further, Wallich said, these System actions encourage the market to put excessive weight on changes in the funds rate as policy indicators. Using the funds rate as an instrument, he said, would increase its volatility. Then he concluded, “I believe that good control of the aggregates, even at the cost of an unstable funds rate, would be superior to a well-controlled funds rate with the aggregates in danger of going out of control” (ibid., 2). President Balles agreed and added: “The pendulum has shifted too far towards interest rate stability at the cost of significant undershoots or overshoots from time to time in our twelve-month growth range for the monetary aggregates” (ibid.). He favored a nonborrowed reserves target.
Burns devoted much attention to the size of errors made in forecasts of reserve and money growth. Stephen Axilrod disagreed. A large part of the Board’s problem came from its short-term focus. He claimed that if the objective was to have 6 percent M 1 growth six months ahead, “I could do it better by telling you what nonborrowed reserves to hit than what FF [federal funds] rates to hit” (FOMC Minutes, March 29, 1976, tape 3).
The staff of the Philadelphia Reserve bank also studied the reasons the FOMC found it difficult to control money growth reliably. It concluded that the main problems were weak linkage between the short-term and medium-term targets and large errors in the two-month projections for the aggregates. Underlying the short-term monetary control problem were “the constraints of modest week-to-week changes in the federal funds rate” (memo, “Perspectives on Controlling Monetary Aggregates Over Time,” New York Reserve Bank, Box 110282, November 21, 1978, 4).174
174. The memo c
ites a study by Gary Gillum, then at the Philadelphia bank, that showed that M 1 projections for 1973 to 1977 appeared unbiased but had an average absolute error of 3 percentage points at annual rates.
These studies, and others done within the System, show that the principal technical reasons for poor monetary control were well understood both at the Board and several of the reserve banks. Richard Davis at the New York bank advised Paul Volcker that “nonborrowed reserves might prove a more effective means of hitting monetary targets by freeing the Committee from the burden of substantial direct responsibility for the short-run behavior of the money market” (memo, Richard Davis to Volcker, New York Reserve Bank, Box 110282, August 15, 1977, 2).
Lack of understanding cannot explain the System’s failure, and I find it implausible to believe that lack of control was inadvertent. The FOMC was unwilling to take effective action and, as we shall see, subverted efforts by Congress to improve monetary control.
The “Missing Money”
As noted earlier, Arthur Burns explained in testimony before the Banking Committee in 1975 that economic recovery and expansion would not require rapid money growth. He expected a rise in average growth of monetary velocity because the public’s confidence would increase, so they would reduce average money balances. Base money growth fell from about 8 percent annual rate in much of 1974 to less than 6 percent in early 1976. It remained below 6.5 percent until late in 1976. By autumn 1976, the annual rate of consumer price increase was below 5 percent, less than half the 1974 rate of increase. This was Burns’s most persistent effort to reduce inflation.
In January 1976, the staff began to inform the FOMC that money growth, particularly M1, had fallen below the staff’s expectations and forecast despite their efforts to reduce the funds rate. The staff’s M 1 forecast was off by 6.25 percent at the end of 1975 (FOMC Minutes, January 18, 1976, 55). The staff made no connection to Burns’s prediction about velocity (FOMC Minutes, March 15–16, 1976, 56–57). They attributed the decline to a shift in the demand for money.
A retrospective memo showed that reported quarterly average growth of M 1 and GNP were, respectively, 4.9 and 13.6 from first quarter 1975 to first quarter 1976, so velocity growth was 8.7 percent compared to a 3 percent postwar average. In 1976 and 1977, average velocity growth was 3.7 percent. If there was a puzzle, it was limited to one year175 (memo, John Paulus to Board of Governors, Burns papers, Box B-B81, January 13, 1978, 2). Paulus gave three possible explanations. First, regulators had changed the rules to make savings accounts closer substitutes for demand deposits. Payments could be made by drawing against saving accounts. Second, higher nominal interest rates in 1973–74 increased incentives to economize on cash balances and adopt more efficient payment systems. Third, technical changes in payment systems brought many new techniques for more efficient payments. These changes were more important for businesses than for households. Staff estimates suggested that business experienced the largest part of the decline in average cash balances (ibid., 4–5).
175. Revisions later reduced average GNP growth to 10.6 percent for the four quarters of 1975 (Department of Commerce, October 1988, 99).
At the time, the staff was most concerned by the persistent error in their estimates of the demand for money. Their estimates came from an equation, based on Goldfeld (1976), that had worked well in earlier periods but not in 1975. In retrospect, the Board’s staff misstated and overstated the problem. First, the staff acted as if their demand equation was correctly specified so errors could only mean that the world had changed. Second, their framework implied that by setting the (or an) interest rate, the FOMC determined reserves and could ignore the supply side. At times, some recognized that the multiplier connecting reserves to money changed, but changes in growth of the money stock received little attention. The staff did not consider that some of the problem came from the imprecision of their estimates of the supply of money consistent with the FOMC’s chosen federal funds rate. Or, when the staff recognized this problem, they could not convince the FOMC to change procedures. Also, the model gave little attention to anticipations.
Our interest is not in the details as perceived at the time. The incident shows the intense concentration on short-term changes, part of the reason for neglecting medium- and longer-term changes. Also, it shows the neglect of the money stock and its determinants and the conviction that staff equations correctly specified economic behavior.
Goldfeld (1976) studied the source of the error without changing the staff’s conclusion. Laumas and Spencer (1980) changed the specification of the demand equation by replacing current income with permanent income. This removed part of the problem. Lucas (1988) and Hoffman and Rasche (1991) argued that there was no evidence of instability using specifications other than Goldfeld’s. And Ball (2002, 18) concluded that the problem arose because the Board’s equation did not properly specify the opportunity cost of holding money.
Chart 7.16 suggests the importance of specifying the appropriate opportunity cost. The chart compares the logarithm of base velocity to the reciprocal of the long-term interest rate on government bonds, quarterly, for more than forty-five years. The scatter shows a relatively stable relation. Points for the middle 1970s, the period of “missing money,” lie at the upper left and show no evidence of instability.
Striking evidence of the stability of the relation comes from comparison of the years of rising and falling interest rates and inflation. As long-term rates declined, velocity moved back along the path it followed when inflation rose.
The Board’s staff, and most outsiders, usually disregard the effect of the long-term rate on the demand for money. This neglects the public’s expectations of persistent inflation and other permanent changes except as they change the current short rate. It assumes that the short rate fully reflects expectations at longer maturities. In practice, the long rate and other relative prices affect the public’s decisions to hold money instead of bonds or real capital. This is a more general problem than the “missing money” episode, and it leads at times to misinterpretation.
Humphrey-Hawkins Legislation
Early in 1975, Congress citing its constitutional power to coin money and regulate its value adopted Resolution 133 instructing its agent, the Federal Reserve, to
(1) pursue policies in the first half of 1975 so as to encourage lower long term interest rates and expansion in the money and credit aggregates appropriate to facilitating prompt economic recovery; and
(2) maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” (memo, staff to FOMC, Board Records, April 10, 1975)
The resolution was unusual in several ways. First, Congress called on its agent to do a better job. Individual’s complaints about the Federal Reserve were common; statements by the Congress were rare. Second, the resolution strengthened the role of price stability in the Federal Reserve’s mandate. Interpretations of the 1946 Employment Act usually emphasized primacy of full employment. Third, Congress instructed the Federal Reserve to avoid excessive long-term growth of its monetary aggregates, partly endorsing monetarist criticism of the Federal Reserve.
Other sections of Resolution 133 required the Board to appear before the Banking Committee semiannually to present its objectives and plans for the next twelve months. The resolution began regular oversight hearings. Regrettably, few in Congress are informed enough to enter into a useful dialogue with the Board’s chairman. The oversight hearings did not prevent the Federal Reserve from continuing to follow inflationary policies for several years. And the hearings did not get the Federal Reserve to give greater weight to the longer-term consequences of its actions.
Burns worked to weaken the resolution and succeeded in modifying it. Once the resolution passed, several members of FOMC and the Board’s staff urged cooperation with Congress, reluctantl
y in some cases.
Continued dissatisfaction with economic performance, the high and variable rates of inflation and unemployment, the level of interest rates, and the heightened uncertainty of economic life brought additional legislation. The FOMC undermined the intent of Resolution 133 by failing to achieve the money growth rates it announced and by setting the new growth rate without compensating for over- or underperformance. Members of the FOMC discussed their record, and some proposed procedures for correcting “base drift.” None was adopted.
Senator Hubert Humphrey and Congressman Augustus Hawkins introduced legislation that eventually became the Full Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins Act. Humphrey began the process at a 1976 hearing on the thirtieth anniversary of the Employment Act of 1946. He commented, “It is my judgment that that law has, from time to time, been conveniently ignored” (Joint Economic Committee, 1976, March 18 and 19,155). He left no doubt that he believed that Congress had to adopt new legislation to achieve “full employment with reasonable price stability” (ibid.).
A History of the Federal Reserve, Volume 2 Page 43