Meltzer, History of Federal Reserve, v. 2, Part VII, Great Inflation 1970s, Arthur Burns, Recession 1973-1975, floating exchange rates, price controls

Monetary policy confusion:

The Federal Reserve System still didn't know how to do its job, it now conceded. After six decades of efforts to displace and improve upon the results of the gold standard rules based market mechanism, it was still uncertain of its tools and their impacts.
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Monetary inflation was the primary cause of price inflation, not the oil price surge. Nations like Germany and Switzerland that were more exposed to the oil cartel did not engage in monetary inflation and fared far better in terms of price inflation and general economic performance.

What should its policy targets and indicators be? Should it rely on its discount rate or target the federal funds rate or bank reserves in its open market operations? What should be the deviation permitted for the last two, and should focus be on the immediate or somewhat longer time period?
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The Federal Reserve System (the "System") was wielding powerful but very imprecise tools. The System did not fully understand the connection between policy moves and intermediate variables. It did not understand the relationship between intermediate variables and changes in economic activity since even the intermediate variables were much shorter than the six months or longer lag between policy shifts and observable economic impacts. How should the System balance short term considerations against longer term unintended consequences - especially when economic forecasts and projections of monetary aggregates and reserves were so frequently and substantially wide of the mark?
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Indeed, the System couldn't even accurately measure bank reserves without sometimes large subsequent revisions. Were changes in reserve statistics transitory or persistent? The accuracy of seasonal adjustments was limited, and the lagged impacts of previous policy moves would overlap current policy moves. Even as the differences between real and nominal interest rates increased with the increased rates of price inflation, real interest rates were still not applied to policy decisions.
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The System still failed to distinguish short term price surges from chronic price inflation. This, too, caused the System to increase instability instead of moderating it. Instead of accepting the oil price shocks as permanent one-time reductions in economic productivity, the System tried to overcome their impacts with floods of money, thus getting both chronic inflation as well as the loss of productivity and purchasing power. They changed a one time price surge into a chronic rate of price increase.
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Monetary inflation was the primary cause of price inflation, not the oil price surge. Nations like Germany and Switzerland that were more exposed to the oil cartel did not engage in monetary inflation and fared far better in terms of price inflation and general economic performance.
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The System was still increasing economic instability instead of increasing economic stability.

Realization as to how difficult it would be to reverse price inflation and the economic contraction needed made everyone hesitate to begin the task - a delay that made matters much worse.

System monetary policy was still frequently failing to moderate the business cycle. One study indicated about 50% success, but another study indicated 100% pro-cyclical impacts of initial responses. The System was still increasing economic instability instead of increasing economic stability. It needed additional tools - contemporary accounting for bank reserves and techniques for estimating the multiplier for relating reserves to money.

"The Great Inflation continued and increased in these years for two main reasons. First, political concerns weakened whatever independence the Federal Reserve had just at the time when an independent central bank was most needed. The Federal Reserve accepted the political goal of achieving low unemployment even if it risked increased inflation, as it did. Second, analytic errors and inappropriate operating procedures supported these choices. Both problems continued for the rest of the decade."

And then there was "Goodhart's Law!" Whenever authorities find a financial relationship that they can use for regulatory purposes, the relationship will change as market participants react to the regulatory effort.

"Proponents of ease drew support, or took comfort, from prevailing Keynesian doctrine that taught that it was possible to trade off a bit more inflation to reduce unemployment and that the tradeoff could be improved by controlling prices and wages. They favored government-administered guidelines and guideposts, and they welcomed the president's decision to adopt price and wage controls. Surprisingly, Arthur Burns, who had earlier pointed out the flaws in this reasoning, became the main proponent of controls or guidelines in this period."

The failure of the Phillips curve was the most prominent contemporary example of 'Goodhart's law.' There are several prominent recent examples. Reliance on auditor and rating agency reports for regulatory purposes generated such powerful conflicts of interest within those professions as to undermine the reliability of the reports. The regularity of housing price increases burst when increasing political efforts to allocate credit into the housing market in reliance on that price regularity created a housing inventory bubble.

Burns tried to control price inflation during the 1972 election year by controlling a few key variables without restraining the monetary inflation needed to boost the economy. Building on this monetary inflation, price inflation flowed easily around all the controls.
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Initially, price inflation was viewed as a minor irritant by Keynesians. They asserted that it would be easily reversed when it occurred. When it occurred, the realization as to how difficult it would be to reverse and the extent of the economic contraction needed made everyone hesitate to begin the task - a delay that made matters much worse. Price inflation would peak at 10.7% in July, 1979. (Today, Keynesians again disparage fears of price inflation.)
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Confidence in the Phillips curve tradeoff between inflation and unemployment proved spectacularly unwarranted.

Keynesian economists wielding macro-econometric models persistently overestimated their capabilities. Their forecasts underestimated price inflation levels by wide margins. Their conceit and hubris played a major role in policymaking errors.
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Confidence in the Phillips curve tradeoff between inflation and unemployment proved spectacularly unwarranted. The System staff used a simple Keynesian model with a non-vertical, long-run Phillips curve. Mathematical economists began the 1970s with pretensions of near-scientific certitude and ended it in humiliation and admission of complete lack of the competence needed to offer economic forecasts. (They now offer admittedly inaccurate "projections" that only the media and the politicians are foolish enough to rely upon.)
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Rate regulation could not dampen the market interest rate volatility caused by inflation, and that volatility increased the costs of the regulations.

675 banks left the System in the dozen years up to 1972. Rising interest rates increased the burdens of leaving reserves with the System that earned no interest. The vast majority of new banks were operating under state charters.

"Financial markets increasingly accepted the challenge of regulation to find ways to legally avoid restrictions. Slowly the [System Board of Governors] learned that lawyers and bureaucrats make regulations but markets decide how to circumvent them."

Banks offered negotiable order of withdrawal - "NOW" - accounts to circumvent regulations that barred the payment of interest for demand accounts. Rate regulation could not dampen the market interest rate volatility caused by inflation, and that volatility increased the costs of the regulations. By the 1980s, there were numerous circumventions so efforts at rate regulation ended.
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Great Inflation boom and bust:

Consumer prices were increasing at a 4.6% annual rate in March, 1973. The GNP deflator for the first quarter was increasing at a 6% annual rate.
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The monetary authority was now blatantly monetizing debt. The fears of the founders of the System were realized as the unfettered monetization of debt drove the nation relentlessly into higher and more ruinous levels of price inflation.

There were several particular causes for this price inflation. They included most prominently yet another crop failure in the Soviet Union. The Soviets were forced to acquire large amounts of grain from the U.S. which had also had a small crop, so prices rose sharply. Even as late as the 1970s, substantial fluctuations in agricultural exports were still capable of having a powerful influence on the domestic economy.

The publisher of FUTURECASTS online magazine explains, among many other things, the role played by agricultural factors prior to and during the Great Depression in Blatt, "Understanding the Great Depression and the Modern Business Cycle" (2009).

However, the primary cause of this price inflation was the expansive budgetary and monetary policies of 1972 and prior years and the inflationary impacts of the controls. Price inflation rates were revealed as the controls were terminated.
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Gold had ceased to be collateral for Federal Reserve notes. It was replaced by securities. The monetary authority was now blatantly monetizing debt. The fears of the founders of the System were realized as the unfettered monetization of debt drove the nation relentlessly into higher and more ruinous levels of price inflation. Meltzer, History of the Federal Reserve, v. 1, Part I, "The Search for Monetary Stability (1913-1923)." A rapidly devaluing dollar pushed up the cost of imports and no longer provided any shield from the inflationary consequences of Keynesian policies. The Middle East war and oil embargo did not come until later in the year. A weak dollar could no longer protect the nation from the impacts of international crises. See, Meltzer, History of the Federal Reserve, v.2, Part VI, "Nixon Devalues the Dollar (1969-1973)."
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Nixon belatedly stepped up to the plate now that the election was behind him. He reduced budget outlays to a 3.2% nominal growth rate - constituting at least a 5% reduction in real - inflation adjusted terms. The rate of expansion of the budget deficit declined substantially. With political cover from Nixon, the System could join the effort. It increased bank reserve requirements and raised the discount rate to 7% that July, the highest level in System history.
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The official definition of "full employment" began to change to something above 4% unemployment. Higher unemployment levels had to be tolerated if inflation was to be restrained. The System tinkered with higher bank reserve levels for time deposits. Regulation Q interest rate ceilings for large time deposits had been suspended. Those who ridiculed credit controls were winning the argument.
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However, the Watergate scandal was by this time rapidly eroding Nixon's popular support. He responded to rising inflation rates by renewing controls on prices, but not on wages or on agricultural commodities. Burns enthusiastically supported the price controls. With controls on wholesale and retail food prices but not on agricultural commodities, there were immediate shortages on supermarket shelves and a further loss of public support.
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This (obviously harebrained) price freeze lasted only 35 days. Under controls, price inflation had risen sharply, which was revealed when the controls were abandoned. Controls were retained only on oil prices (which naturally thus left energy prices and supplies as an apparently intractable problem).
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Consumer price inflation rose to 8.4% on an annual basis in December 1973, and soared to double digit levels in 1974. Inflation expectations increased, pushing up long term interest rates. Treasury bill rates hit 8.4% in the third quarter of 1973. Unemployment declined only to 4.8%.
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The discount rate had been pushed up to 7.5% by August, 1973, but this was well behind the price inflation power curve and member discounts surged to $2 billion - the most since 1921. The federal funds rate soared to 10.5%.

"Judged by the traditional measures -- member bank borrowing, free reserves, and the federal funds rate -- 1973 is one of the most aggressive periods of restraint in Federal Reserve history to that time. The [System Federal Open Market Committee] repeatedly raised the federal funds rate to keep growth of reserves against private deposits within the range it selected based on staff estimates of money growth. Yet the period has to be judged as a policy failure. The inflation rate continued to rise."

The movements of economic factors such as the federal funds rate and the growth of bank reserves and money never behaved as they were supposed to according to System econometric models. All the forecasts upon which monetary policy was being based kept proving false.

The perception was growing that even a 5% unemployment rate would not hinder price inflation.

Confusion reigned within the System. The movements of economic factors such as the federal funds rate and the growth of bank reserves and money never behaved as they were supposed to according to System econometric models. All the forecasts upon which monetary policy was being based kept proving false. The staff kept finding excuses for their failures in supposedly unpredictable random events, so like the mad scientists in Gulliver's Travels, they kept repeating month after month the same failed Keynesian efforts in the belief they would this time succeed.
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Inconsistent objectives (an age-old problem for System policy implementation that Congress can never resist making worse) persistently tripped up System policy efforts. The System could not control both the bank reserves and the funds rate, as controls on one undermined targets for the other. Shortfall or excess in money growth rates were repeatedly attributed to demand shifts, calculated by the demand function in staff econometric models. (However, the demand function was just a mathematical artifact, unrelated to reality.) Amazingly, their econometric models did not attribute any inflationary impact from money growth.
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Nobody was willing to endure recession to regain control over inflation. Nobody knew whether the 4% unemployment rate definition of non-inflationary full employment was actually achievable on a sustained basis. The perception was growing that even a 5% unemployment rate would not hinder price inflation.
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Keynesian inflation expectations achieved an amazing 100% rate of inaccuracy, sometimes by huge margins, during 9 of the 10 years of the decade.

There was widespread confusion among government, academic and professional economists, most of whom were burdened with ridiculous Keynesian concepts and simplistic mathematical models on the one hand and the hubris of unfounded almost scientific levels of certitude on the other. Government economists persistently failed to provide accurate forecasts of inflation, economic growth or anything else. Their inflation expectations achieved an amazing 100% rate of inaccuracy, sometimes by huge margins, during 9 of the 10 years of the decade.

This was during a dozen year period when the published forecasts of the publisher of FUTURECASTS online magazine were achieving a 100% rate of accuracy. See, Futurecasting record 1 (1966-1978). It would be nice to claim brilliance for this achievement, but it was actually quite easy - given the gross stupidity of Keynesian economic theory and policy. All that was required was a simple evaluation of when and how Keynesian policies had to fail.

The Middle East war and oil embargo towards the end of 1973 resulted in a surge in oil prices and a further surge in price inflation. The dollar was officially devalued another 10% in February 1974 and was officially floated in March. Keynesian policymakers no longer had gold to shield them from the inflationary impacts of their policies.

Many Keynesians were too stupid to realize the extent to which gold shielded them from the impact of their policies. Others were in intentional denial. To this day, intentional denial and blatant stupidity remain obvious characteristics of Keynesian policy advocates.

At least Burns was by now seeing the light. He was willing to attribute long term price inflation to money growth. The money stock - M1 - was growing at an 8.2% rate early in 1973. Congress and politically powerful unions effectively rendered interest rate increases politically impossible, so the System kept the printing presses rolling to monetize enough debt to keep them down. As usual, the "independent" System was scared to death of congressional reactions that might undermine its "independence."
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Yet once again, monetary authorities responded with jawboning - "moral suasion" - when they were stymied as to what else to do. Banks were asked to voluntarily restrict loan commitments. There were yet once again serious efforts in Congress to legislate interest rates. Burns was paralyzed by political pressure. Market interest rates kept responding to inflation as they must - rising to the highest levels in the 60 year history of the System. (What a magnificent triumph for the human administered alternative to the rules based gold standard market mechanism!)
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Restraining inflation would mean recession with higher unemployment and larger budget deficits. Recession would be met with increased deficit spending and greater rates of monetary inflation to help finance the deficits. Instead of moderating the inflationary business cycle, Keynesian policies were making the business cycle increasingly volatile and vicious.

Market interest rates rose to new heights in response to System efforts to maintain lower interest rates, and bank interest rates were forced to follow. Federal funds hit 10.8% by September 1973 - an increase of 5.5 percentage points since the previous December. The prime rate hit 10% - up 4 percentage points. Three month CDs were paying 10.7%. Even at 7.5%, the discount rate was still behind the inflation power curve. As a result, member bank borrowing from the System doubled in eight months to August, 1973, and peaked at $2.2 billion. Base money growth hit 9.3%, the fastest rate since WW-II.
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Burns accurately focused on the System as the source of the rapid rates of money and price inflation. That summer, he supported a tighter policy. By this time the economy was roaring ahead at approximately 96% of capacity.
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Dollar devaluation stood at 17% against 16 major currencies. The dollar fell 30% against the mark in 6 months. By the middle of 1973, it was in free fall. Gold prices on foreign markets were, of course, rising against all fiat currencies. This degree of exchange rate volatility was disrupting commerce and thus could not be tolerated. The System began to intervene to support the dollar and the System Federal Open Market Committee (the "FOMC") tightened money growth rates.
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However, the System was still stuck with the basic conflict in its prime objectives. Restraining inflation would mean recession with higher unemployment and larger budget deficits. Recession would be met with increased deficit spending and greater rates of monetary inflation to help finance the deficits. Instead of moderating the inflationary business cycle, Keynesian policies were making the business cycle increasingly volatile and vicious. Yet once again, restraining inflation while avoiding recession was proving beyond human capabilities. The business cycle was indeed an inherent part of a healthy capitalist market economy, and turned particularly volatile and vicious in response to efforts to avoid it.
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1973-1975 recession:

As always, it was austerity that proved effective in combating price inflation. As always, the price for the degree of austerity required to combat chronic price inflation was a severe recession.
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The complex factors involved in the inflationary surge of 1973 and the economic contraction of 1974 are reviewed by Meltzer. The monetary inflation of 1972 was the major player in getting the price inflation ball rolling. The oil price shock and the failure of major foreign harvests that pushed up food prices by 14% were also major factors but were not monetary factors requiring a monetary policy response. The food price surge was temporary and was ended by the next year's harvest. The oil price surge was in the nature of a tax and should have been accepted as such or countered by a reduction in domestic taxes.

Meltzer ignores the fact that even the oil price shock was primarily a monetary phenomenon. With the dollar in rapid decline and negative real interest rates, oil in the ground was worth more than oil produced. During the 1982 Middle East war, when real interest rates were high and the dollar was rapidly strengthening and price inflation was in rapid decline, there was no oil embargo. Oil produced was more valuable than oil in the ground.
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A strong dollar is a significant shield against shocks coming from abroad. Will the dollar in 2010 be strong enough to fend off any shocks coming from abroad?

Oil prices began rising in August 1973. From $3.56 per barrel they rose to $10.11 in January, 1974. The S&P stock index plunged about 40% - back to 1963 nominal levels. The index did not fully recover until 1980 just prior to an even greater fall during the 1980-1982 recession. In real - inflation adjusted - terms, of course, its performance was far worse.
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The emphasis of monetary policy shifted to fighting inflation in 1973. Base money supply growth in real - inflation adjusted - terms began to decline sharply in 1973 and was in negative territory by the end of the year. In nominal terms, it declined from a 9.3% rate to less than a 6% rate late in 1975. In real terms, it hit bottom in the middle of 1974, more than 3% in negative territory. It began to recover early in 1975 not because of changes in nominal money growth but because of a substantial decline in inflation rates. Economic recovery began three months later.
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The long term bond markets accurately reflected these substantial shifts.

"As in several earlier recessions, real ten-year interest rates -- using predicted inflation -- remained in a narrow range. These rates declined modestly before the recession, remained in a narrow range during the recession, again declined modestly before the trough, and rose during the early months of the recovery."

Interest rates had to be permitted to rise in response to the 1973 surge in price inflation. This included both rates charged to borrowers and controlled rates offered to depositors. Some deposit rate ceilings were removed altogether. The System scrambled to keep up. The federal funds rate maximum was raised to 11% - far above the discount rate - resulting, as might be expected, in massive member discounting with the System to obtain funds that could be lent at the higher market rates.
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The System also intervened in foreign exchange markets in July 1973 to stop the decline in the dollar. Aided by the rising interest rates, this intervention was a major success, and the System was able to unwind that position at a profit in August. Increases in bank reserve requirements were also imposed. Economic recession began in earnest in December 1973, catching System staff analysts completely by surprise.
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Burns was already in panic mode. Even before December, he was urging rapid expansion of the monetary aggregates. The oil price shock was augmented by monetary inflation incurred in the effort to shield the economy from the impact of rising oil prices - an impossible objective. At first, staff analysts thought the impact would be modest, but the oil price controls implemented to reduce that impact inevitably were counterproductive - and the noxious impacts lasted into the early 1980s along with the controls.
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As monetary inflation rates dipped below price inflation rates, the federal funds rate soared to 13% in March, 1974. Monetary policy was finally ahead of the inflation power curve and did not begin to ease up in real - inflation adjusted - terms until early in 1975, which coincided with the trough in the resulting recession. By that time, Nixon was gone - resigned in August 1974 - and Gerald Ford was president.
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The nation had entered its longest and deepest recession since WW-II by the final quarter of 1973. It lasted 20 months into the beginning of 1975 according to the calculations of the Commerce Department's National Bureau of Economic Research. First quarter 1974 saw GNP declining at a 6.3% annual rate while price inflation as measured by the GNP deflator was surging towards 11.75% in May. Industrial production was declining at a 50% annual rate by December 1974. Price inflation was on a wild roller coaster ride, rising to double digit levels in 1974, then falling below 6% before rising again into double digit levels in 1979 and 1980.
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In 1974, legislation finally removed the irrational New Deal prohibition against private ownership of gold, so at least citizens of the U.S. again had an effective liquid asset with which to shield their wealth from inflation.
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The recession began to puncture all manner of credit bubbles in 1975. The Franklin National Bank failed in N.Y. and the Herstatt Bank failed in Germany. Real estate investment trusts that borrowed in the short term credit markets and lent long term began dropping like flies. (Does this sound familiar - like "wholesale banking" during the Credit Crunch?) Financially overextended borrowers included airlines and feed lot operators.
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Federal funds surged to 13.5% in July, 1975. Unemployment - a lagging indicator on the way up as well as on the way down - had initially risen only to 5.5% from 4.8%, but hit 7.2% by December 1974. It peaked at 9% two months after recovery had begun. The 1980-1982 recession would be deeper, with unemployment at 10.8%. However, rising unemployment doomed the anti-inflation effort in the mid 1970s. Despite falling interest rates, recovery didn't begin until March 1975 - and 1976 was a presidential election year. Gold was at $160.75 in June, 1975.
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Bills imposing audits, subjecting System expenditures to the congressional appropriations process, mandating interest rate policy, requiring Senate confirmation of Reserve Bank presidents, and imposing credit allocation schemes, were again introduced in Congress.

The failures of monetary policy were becoming obvious and supported criticism of the System. Congressional critics again introduced bills to limit System independence - such as it was. Bills imposing audits, subjecting System expenditures to the congressional appropriations process, mandating interest rate policy, requiring Senate confirmation of Reserve Bank presidents, and imposing credit allocation schemes, were again introduced. Congressman Wright Patman (D. Fla.) remained a particularly persistent foe.
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Budget autonomy was critical for the System. It covered its own expenses with earnings from its portfolio and returned the rest - over 90% - to the Treasury.
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Meltzer goes at great length - about 150 pages - into the intellectual ferment both inside and outside the System. Aggregate economic statistics turned out to be far less solid than they seemed. Later studies challenged 1970s measurements for the "output gap" supposedly existing after output falls below trend during a recession. The 4% supposedly natural rate of unemployment used for full employment calculations has been viewed as clearly too low, and should have been adjusted upwards.

"The Federal Reserve faced stagflation, defined as falling output and rising inflation. On the staff's analysis, this was a puzzling outcome. Inflation was supposed to decline along the Phillips curve as output fell relative to potential."

Output "gap" and Phillips curve calculations are clearly invalid. They are just additional simplistic figments of fevered Keynesian imaginations.

The importance of monetary inflation was still amazingly denigrated by Keynesians as late as 1974. The work of Milton Friedman and Anna J. Schwartz was well known but ignored. See, three articles beginning with Friedman & Schwartz, "A Monetary History of the U.S. (1867 - 1960)" Part I, "Greenbacks and Gold." Those who brought the subject up had little impact. Nixon economists understood the importance of monetary growth but yielded to the political imperatives of the 1972 election.

"Growth of the [monetary] base in excess of output growth leads the inflation rate throughout the period. Excess growth of the base would have been a useful statistic for future inflation. The Federal Reserve Board staff gave it little weight."

"Inflation did not fall permanently until public opinion polls showed the public willing to bear the cost. Then it became acceptable politically to shift more weight to inflation control and less to unemployment when choosing monetary policy actions."

Why did so many of these errors persist for the 15 years through the 1970s? Anti-inflation policies were implemented in 1966, 1969, 1973 and 1979, but not carried through. Unlike the staff economists, Meltzer emphasizes, most of the System policymakers were neither economists nor ideologues. The answer, as ever since WW-II, flows from public expectations of full employment and the political pressures of public expectations.

"Inflation did not fall permanently until public opinion polls showed the public willing to bear the cost. Then it became acceptable politically to shift more weight to inflation control and less to unemployment when choosing monetary policy actions."

Keynesian policies had generated the worst and longest recession since WW-II, and the worst was still to come. Arthur Burns would remain the central figure at the monetary policy helm through most of the Great Inflation decade of the 1970s.

"Arthur Burns, who served as chairman of the Board of Governors until spring 1978, lacked both the courage and the conviction to restore low inflation or price stability. He believed that inflation was endemic in a modern economy, and though he started at times to reduce inflation, he did not persist when unemployment rose above 6 or 7 percent." (Or when presidential election years approached!). "Like his predecessor, Martin, he spoke often and forcefully about the dangers of inflation." (As does Ben Bernanke today!) "[But] his actions generally were much less forceful. His successor, William Miller, was a business executive. He had little professional experience and knew little about monetary policy. Both chairmen gave too much heed to perceived political constraints and too little to the costs of inflation."

Typical of periods of chronic inflation, the business cycle worsened over time. Inflation didn't fall as low as in 1972 despite the severity of the 1973-1975 recession and unemployment stayed above 1973 levels despite the massive monetary and price inflation of the last half of the decade.

From 1966, the stock market, too, vacillated in a wide band, but constantly lost ground to inflation.

Personnel turnover among System policymakers increased markedly as their salaries failed to keep pace with inflation. Henry C. Wallich joined the Board and the FOMC in March, 1974. Regulatory responsibilities and staff expanded substantially. Bank holding company regulation, consumer credit protection and truth in lending requirements and the Freedom of Information Act all increased the workload. Rapid changes in the financial system made various controls increasingly ineffectual and increasingly costly, leading ultimately to deregulation.
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Typical of periods of chronic inflation, the business cycle worsened over time. Inflation didn't fall as low as in 1972 despite the severity of the 1973-1975 recession and unemployment stayed above 1973 levels despite the massive monetary and price inflation of the last half of the decade.
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From 1966, the stock market, too, vacillated in a wide band, but constantly lost ground to inflation. Tax rates were not yet indexed to inflation, so tax burdens soared.

"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."

Inflation adjustments were being routinely included in commercial agreements in expectation of renewed inflation.

Ford did not try to control System monetary policy. Burns asserted that budget restraint was a prerequisite for restraint of monetary and price inflation. He advised at least $5 billion in cuts from a federal budget that had ballooned to $332 billion, and a balanced budget by 1976. However, his program also called for what we now call "industrial policy" objectives and a government jobs program.
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Congress refused to accept Ford administration initiatives either before or after the 1974 congressional election, which resulted in a substantial majority for liberal Democrats in Congress. The deepening recession was viewed by the public as a responsibility of the Nixon and Ford administrations. Ford shifted quickly from fighting inflation to fighting recession. By now, inflation adjustments were being routinely included in commercial agreements in expectation of renewed inflation.
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However, Burns, too, was now more concerned with unemployment than with inflation. FOMC members were as usual torn between the need to fight inflation and the need to fight unemployment. Neither objective was achieved.
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By the spring of 1975, the monetary aggregates were again growing in real - inflation adjusted - terms. Bank reserve requirements were reduced and economic recovery began in April 1975. Growth was vigorous but unemployment stayed stubbornly high. Despite recovery and numerous Ford vetoes of spending bills, Congress ran budget deficits that increased from $5.5 billion in 1975 to $60 and $76 billion in the next two years. The deficit was the highest on record in nominal terms.
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The System could not control the growth of monetary aggregates without raising interest rates, and higher interest rates always drew the ire of Congress and its constituents.

Funds rate stability had become an objective instead of just an instrument of control of the monetary aggregates.

The System did not want to be accused of undermining administration plans or congressional policies. It did not want to be accused of causing rising interest rates or unemployment. It did not have the political cover it needed to take unpopular but necessary actions.

Congress was directing more attention to money growth rates and longer term - annual - objectives. Monetary targets were frequently being missed by wide margins - by an astounding average of 3% from 1973 to 1977.
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Money growth estimates were very imprecise and variable on a monthly basis. There were numerous seasonal adjustment techniques, each of which gave different results. The monetary targets could not be hit unless greater variability in the federal funds rate was permitted. The FOMC would not permit this. The federal funds rate was the only meaningful financial factor that the FOMC had a firm grip on. The System could not control the growth of monetary aggregates without raising interest rates, and higher interest rates always drew the ire of Congress and its constituents. Burns and other FOMC members were not willing to make the change.
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However, it was the averaged monetary aggregates - especially M1 - that correlated well with both real and nominal GNP. System staff concluded that to control inflation and improve outcomes, "the FOMC had to take a longer view and pay more attention to persistent evidence showing money growth rates above or below target." The FOMC took no action on this conclusion.
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Board governor Henry Wallich persistently criticized the emphasis on the federal funds target. Funds rate stability had become an objective instead of just an instrument of control of the monetary aggregates. Meltzer agrees with this criticism.

"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 - - - subverted efforts by Congress to improve monetary control."

Meltzer also points to serious problems of misspecification and faulty estimates that undermined staff calculations. Of particular importance was failure to consider longer-term interest rates and the opportunity costs of holding money which rose sharply as price inflation became worse.

"The simple explanation of why inflation persisted and rose on average through the 1970s is that the Federal Reserve did not sustain actions that would end it."

"[The] record of the 1970s showed that inflation and unemployment rose together, on average, propelled by expectations of inflation."

Burns had been burned during the Nixon years and was now more cautious with monetary policy. Ford did not pressure him to increase monetary inflation. Base monetary growth remained in a 6% range. The discount rate was reduced just to 6.25% early in 1976. The federal funds rate declined to barely under 5% at the November election and to 4.65% in December 1976. Price inflation was brought down substantially, but was still 4.7% by the end of 1976. However, unemployment was still 7.8%, and Ford lost the election to Jimmy Carter.
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The FOMC had no explicit means of achieving longer-term money targets, reconciling the short- and long-term targets, adjusting to the frequent target misses, or reconciling the short-term targets for monetary aggregates and the federal funds rate.

The federal funds rate remained the System's principal target and was successfully maintained within its target range, but the influence of the federal funds rate over the monetary aggregates kept declining. Financial innovations like NOW money market accounts were changing the definition of M1 and the other monetary aggregates. The System was missing its M1 money target more than half the time.
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The FOMC had no explicit means of achieving longer-term money targets, reconciling the short- and long-term targets, adjusting to the frequent target misses, or reconciling the short-term targets for monetary aggregates and the federal funds rate. Most important, whether the longer-term target for reducing inflation would cause higher rates of unemployment than the FOMC was prepared to accept was generally ignored.
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The preliminary economic data was still frequently subject to substantial later revisions but was nevertheless relied upon for monetary policy and led to frequent policy errors. Preliminary evidence of slowing economic growth during the final quarter of 1976 was later revised sharply upwards, but the discount rate and bank reserve requirements had already been reduced. The Great Inflation was again accelerating.
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The "monetary base" frequently referred to by Meltzer includes currency and bank reserves. The "money stock" frequently referred to by Milton Friedman includes currency and demand deposits, and is thus generally a broader measure than monetary base. Financial reform in the 1980s, however, fudged the distinction between demand and savings accounts and other time deposits and money market funds and much else, rendering the money stock - and M1 - ambiguous designations.
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The Keynesians were determined to manage the economy in a way that would achieve "full" employment levels. As usual, they failed. There were $23 billion in stimulus bills for 1977 and 1978. Total budget deficits for Carter's four years reached $226.8 billion, federal spending increased 44% - 13% in real - inflation adjusted- terms - but still unemployment levels rose - along with price inflation. Burns was a loyal soldier in the effort. He expressly recognized the limits of System independence and an obligation to facilitate congressional objectives even if this meant monetizing debt.

"Despite Burns's frequent strong statements about the evils of inflation, his policies continued to finance inflation and fostered inflationary expectations.

With inflation accelerating during 1977, monetary targets were lowered and the federal funds rate allowed to rise to over 6.5%. Monetary growth vacillated widely, generally above targets, but the funds rate was closely controlled. The Reserve Banks were ahead of the Board, repeatedly requesting discount rate hikes. The discount rate was increased - reluctantly - in several steps, to 6.5% in January 1978. The 1977 Federal Reserve Reform Act requiring greater System transparency and regular reports to Congress reflected broadening dissatisfaction with monetary policy.
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G. William Miller succeeded Arthur Burns as chairman of the System Board in April, 1978. He served until August, 1979. Paul A. Volcker became president of the N.Y. Fed in August, 1975 and succeeded Miller as System Board chairman in August, 1979. Policy controversies and doubts continued to afflict the FOMC members.
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Long-term interest rates began climbing at the end of 1977 reflecting increasing inflationary pressures. By the middle of 1978, the 10 year bond was at 7.8%. The FOMC kept its focus on immediate problems and short term targets, so never got around to discussing the long term impacts of inflation or the unemployment levels that a determined austerity program must cause. Meltzer repeatedly criticizes this focus on the short-term. Burns repeatedly fulminated against inflation but did little to combat it.

"With the obvious division, 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 problems."

Price inflation has many consequences generally ignored by those who denigrate concerns about it. (See, "Understanding Inflation.") In 1978, productivity growth declined. Real estate speculation increased as people sought to shelter their wealth from inflation and even profit from it. The opportunity costs of System reserve requirements increased as interest rates rose, causing a substantial decline in System membership.
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The CPI was soaring at about a 9.5% annual rate by the end of Burns' term. There was fear of the loss of System credibility and concern over excessive money growth, but even now, nothing was done to actually combat price inflation. The public, Congress and the administration were all still most concerned with unemployment. Nevertheless, unemployment was still stubbornly close to 7%.
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Unemployment finally declined - to 6% - towards the end of the year. Many now rationalized that 6% unemployment was the actual natural rate of unemployment.
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Unions and business were astoundingly still being blamed by the Keynesians in the Carter administration for price inflation. Any possibility was grasped to deflect blame from administration and congressional policies. Yet once again, wage and price controls or guidelines and jawboning were being proposed. Burns and the System had never developed effective procedures for controlling money growth since that would have meant less control of the federal funds rate. The System still feared wide swings in interest rates.
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Meanwhile, the balances of international payments and trade were sharply deteriorating and the dollar was dropping at double digit rates against major currencies like the mark and yen. The Keynesian remedy was for all nations to adopt Keynesian stimulus and thus depreciate together That would keep relative exchange rates steady as all lost purchasing power together. (Brilliant! This was actually done during the Credit Crunch - leading up to the European sovereign debt crisis).

Deterioration in international accounts is one of the many inevitable weaknesses of Keynesian policies and one of the sources of price inflation that has nothing to do with unemployment levels. This was pointed out more than four decades ago by the publisher of FUTURECASTS online magazine. See, Blatt, "Dollar Devaluation" (1967), and "Capital as Purchasing Power."

The policies that were required to support the dollar just happened to be the same as those required to maintain fixed exchange rates and restrain price inflation.

Keynesians persistently blamed the business sector and unions for price inflation, but the public was no longer buying this nonsense.

Benign neglect was proving increasingly untenable as the domestic inflation rate picked up and the dollar collapsed. System and Treasury interventions in international exchange markets were increasing in frequency and scope. A major intervention was needed early in 1977 to stabilize the dollar, and the intervention in November 1978 was greater in real - inflation adjusted - terms than anything needed under Bretton Woods. Massive currency swap lines were expended, $10 billion in foreign currency denominated bonds held as reserves were sold and reserves of marks, Swiss franc and yen were expended. $3 billion was borrowed from the IMF and monthly gold sales were increased. The Board increased the discount rate to 9.5% and the federal funds rate target was also increased as were bank reserve requirements.
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The policies that were required to support the dollar just happened to be the same as those required to maintain fixed exchange rates and restrain price inflation (which is no mere coincidence). The dollar strengthened immediately, but the actual impact is unknowable due to the December 1978 revolution in Iran and subsequent oil price increase. CPI inflation surged to 10.6% in January 1979. Oil prices rose to $39.50 per barrel in April 1979 from $14.85 a year earlier. Carter's wimpy anti-inflation program dissolved.
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Keynesians like Charles Schultze, chairman of the Council of Economic Advisers, desperately now grasped expectations theory to explain how inflation and unemployment could coexist. Keynesians persistently blamed the business sector and unions for price inflation, but the public was no longer buying this nonsense.

"The main reason [Schultze] gave was that in modern economies prices and wages are not very sensitive to modest and short-lived periods of economic slack. 'Once an inflation has been underway for a while, workers and employers behave as if it will continue. - - - It therefore is very difficult to use the traditional tools of monetary and fiscal policy to bring inflation to a halt once it has begun in earnest.'"

Schultze asserted that public intolerance of high unemployment made it politically impossible to maintain an austerity program long enough to regain control of inflation. This was the view that had increasingly permeated the monetary policy establishment during the last two decades. Ronald Reagan would prove that real presidential leadership - especially a willingness to spend political capital for the benefit of the nation - could accomplish the impossible.
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The rigidity of Regulation Q savings deposit interest rate limits was nevertheless destroying the Federal Home Loan banks that it was intended to favor. The result was widespread failures, predictably at great taxpayer expense.

Congress was increasingly imposing its will on the "independent" System. The 1978 amendment to the Federal Reserve Act increased the emphasis on price stability, but left primary emphasis on full employment. A wish list of other objectives was included such as balanced growth and full parity income for farmers - but the economic tides kept flowing in and out despite the best efforts of the gallant legislators. The System already had far more on its plate than it could handle. Repeal of these provisions came in 2001, leaving only the semi-annual oversight hearing provisions.
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System regulatory responsibilities were also expanded by enactment of the Truth in Lending Act, the Community Reinvestment Act and the Equal Credit Opportunity Act. The latter two were the modest forerunners of credit allocation schemes that ultimately expanded sufficiently to produce the housing and credit bubbles of the Credit Crunch. Under congressional pressure, the System bought $2.9 billion in Federal National Mortgage Association issues - in effect monetizing Fannie Mae debt and further allocating credit into the housing markets.

With such massive taxpayer support and implicit taxpayer guarantees, Fannie Mae and Freddie Mac came to dominate their market and played a major role in the boom and bust of the Credit Crunch - at a cost already of well over $140 billion and rising rapidly. This is the ultimate fate of all markets into which "government option" agencies are inserted. Assertions of "fair competition" are risible. Proponents of the "public option" in the health care market fully intend to provide it with sufficient advantages and its private insurer competitors with sufficient mandates and tax and regulatory burdens to make the public "option" the only option.

However, Congress finally had to surrender with respect to Regulation Q interest rate ceilings on time deposits. Meltzer provides extensive coverage of this sorry effort at government economic micromanagement and the insuperable problems it posed for the System as a regulatory agency. As market interest rates responded to inflation by rising ever higher, the effort to legislate low interest rates increasingly succumbed to market realities. Financial flows found ways to move around, over and under the regulation. The rigidity of Regulation Q savings deposit interest rate limits was nevertheless destroying the Federal Home Loan banks that it was intended to favor. The result was widespread failures, predictably at great taxpayer expense. Congress put Regulation Q out of its misery after 1980.

"The Board and other regulators never found a satisfactory way to maintain interest rate ceilings during a period of rising interest rates and a growing difference between regulated and open market rates. The gap between the regulated rates and the open market rates invited innovation to avoid regulation."

G. William Miller served as Board chairman for only 17 months before leaving to become Treasury Secretary. In that time, CPI inflation rose from about 6% to 11% and unemployment stayed stubbornly around 6%. The GNP deflator - less affected by the oil price surge - rose to 8.5%.
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Miller got along well with Congress and had several major legislative achievements. Domestic branches of foreign banks were brought under regulations similar to those of domestic banks, reserve requirements were imposed on nonmember banks, and Regulation Q and other interest rate controls continued to be phased out.

In the volatile financial world of the Great Inflation 1970s, rigidity was doing immense damage. Such controls "work" only in calm periods when they are not needed.

Efforts to maintain low interest rates predictably continued to result in sharply rising interest rates.

That inflation was the nation's "most serious domestic problem" was admitted by the Carter administration in October, 1978. Carter's remedy was to posture - with more jawboning and voluntary restraint, some modest budget cuts and a government pay freeze of minor import, and some useful emphasis on deregulation. The dollar continued to fall and efforts to maintain low interest rates predictably continued to result in sharply rising interest rates.
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The Board staff was now watching an augmented M1, which included savings deposits at commercial banks, NOW accounts and demand deposits at mutual savings banks as well as circulating cash and demand deposits at commercial banks. Despite the invariable inaccuracy of econometric forecasts, the administration and the System persistently relied upon them for policy decisions. (The Obama administration and Congress still do - even though now they are just called "projections" and remain equally unreliable.)
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The public now turned against inflation and the Carter administration, but Carter could provide nothing but fig leafs. By the summer of 1979, CPI inflation was around 14% on an annual basis, the federal funds rate was at 10.3%. M1 money growth soared well into double digit levels - well above System targets - providing fuel for price inflation. The federal funds rate, although considered alarmingly high by the Carter administration, was actually well into negative territory - well below the rate of price inflation.
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FOMC members "continued to make strong statements and take weak actions." Paul Volcker viewed the FOMC money targets as a "farce." Carter was becoming desperate - desperate enough to consider Volcker to replace Miller as System Board chairman. (See, History of the Federal Reserve v. 2 Part VIII, "Volcker Imposes Monetary Austerity (1979-1986).")

Monetary policy under Arthur Burns	Great Inflation - 1970s	Recession of 1973-1975
Gerald Ford administration		Jimmy Carter administration