A quick look backward & forward, 1950-2000 - A Review of Federal Reserve Policy

Business Economics, July, 1991 by Francis H. Schott

This paper sketches economic events and policies of the past four decades and ventures a forward glimpse at the 1990s. The Federal Reserve's role and performance receive special attention. The 1950s and early 1960s witnessed success in generating growth with price stability. In the late 1960s and early 1970s, Vietnam and the first oil shock (1973) created inflationary forces with which successive Administrations and the Fed coped half-heartedly, but the

second oil shock (1979) and a sharply declining dollar jolted the Fed into a tough and eventually successful anti-inflation stance in 1979-82. The 1980s saw the country's longest peacetime expansion, but the financial system weakened severely through excessive leveraging and imprudent investing. The required restoration and the necessity for increased international policy coordination are key challenges for the 1990s.

THIS HISTORY OF the past four decades is outrageously selective and idiosyncratic. To compound the felony, there will also be some crystal-ball gazing at the next decade.

THE 1950s

Our story starts out with a bang, the Treasury-Federal Reserve Accord of 1951. Prices of government securities had remained virtually stable throughout the early post-World War 11 years after having been fixed for the duration of the war by Federal Reserve action to aid in the financing of the war. Yields on Treasuries ranged from 3/8 of 1 percent for short bills to 2 1/2 percent for long bonds. (The Fed's discount rate was 1 1/2 percent!)

The Federal Reserve had grown increasingly restive in these early postwar years. Wartime-generated liquidity plus heavy additions in 1945-50 led to inflation, in sharp contrast to the much-feared return to prewar stagnation. With the Korean War becoming an obvious aggravation of inflation, the case for restoring flexibility, to monetary policy was overwhelming. The Fed's future chairman, Bill Martin, then an Assistant Secretary of the Treasury, skillfully persuaded a very reluctant President Truman (through Treasury Secretary Snyder, Truman's close friend) that variability of Treasury securities prices was the lesser evil compared with major inflation, and the Treasury-Federal Reserve Accord was struck in March 1951.

The consequences of restoring an active role for monetary policy were certainly beneficial for the country. Economic growth was good and inflation tamed for the remainder of the 1950s, except for the flareup in connection with the Korean War. The Fed was aided, to be sure, by the conservative fiscal policy of the Eisenhower administration (the only two budget surpluses of time postwar era!).

Still, there were shadows. The chief one no doubt was the frequent recurrence of recessions, beginning in 1948-49 and continuing in 1953-54 and again in 1957-58. No one could really explain recessions, and there was a constant and much-discussed fear that the Big One, a la 1929-32, might come back. Under the overwhelming influence of Keynesianism, much of the blame was laid upon fiscal policy, although the Federal Reserve began to make a good scapegoat.

I was convinced then, and remain so to this day, that there is a clash between price stability and full employment that very few in the public arena ever care to address squarely,. In the late 1950s, Charles Schultze began to make his truly deserved excellent reputation by studies of the cost push ("Recent Inflation in the U.S.," joint Economic Committee (JEC) Study Paper #1, Washington, D.C. 1959). In a world dominated by the U.S. on the outside, and heavily influenced at home by politically powerful heavy-industry unions, their wage demands tended to outstrip productivity before full employment was reached, and wage pressure then spread throughout the economy. This clash forced the Fed to make an unpleasant choice between inflation and full employment, but the need for such a choice was not widely acknowledged in Washington. Liberal economists and politicians, sensing the truth but unwilling to face the dilemma squarely, sought an answer in government intervention, i.e., an incomes policy. (In more recent years, the big industrial unions and oligopolistic producers have lost power in an economy open to foreign competition, but the dilemma continues. Services are more important now, and many of the domestic ones, such as hospital, education and civil service work, still have unions that force up wages before full employment is reached.)

The 1960s

At our speed of travel, that brings us to the 1960s, but a decade-by-decade account of history does not work for the 1960s. Instead, the first half of the decade is, in effect, a continuation - perhaps culmination - of the 1950s, while the second half became a prelude to the 1970s. The Vietnam escalation starting in 1965 made the difference.

When John F. Kennedy campaigned in 1960 on the slogan of "getting the country going again," the recession of 1960-61 was the fourth in twelve years. That recession, however, was a turning point in demonstrating the inflation-curbing power of fairly substantial and prolonged unemployment. It would not have been so had the Kennedy Administration not turned out to be quite conservative, unwilling to take chances on an early rekindling of the cost-push inflation of the 1950s. Recognizing, however, that the inflation cure was painful, the search for alternatives led to a combination of jawbone incomes policy with a slow-to-be-fulfilled promise of a fiscal stimulus in the form of the 1964 (post-Kennedy) tax cut.