A History of Conflicting Views

Key Capital Private, Investment Note - Issue #31

A History of Conflicting Views

In the Irish Independent last week, Eric Garcia wrote about the US Federal Reserve cutting rates by 25 basis points and noted that Donald Trump has “staged an unprecedented assault on the independence of the Fed” for several months. While it is true that this vector of attack is unprecedented, particularly the attempted removal of Fed governor Lisa Cook, the tormenting of the Fed chair is an established tradition of US presidents.

Taking a closer look at previous efforts to strong-arm the Fed provides a useful lens through which to view the current impasse and how it may be resolved.

1965 Johnson v Martin

William McChesney Martin Jnr was chairman of the Fed from 1951 to 1970, serving under five presidents. An almost caricature of a sober, bespectacled central banker, over his 19-year tenure, he developed a reputation for being a prudent steward of ‘sound money’. He is now famously remembered for quipping that the job of the Fed was to take away the punch bowl just when the party was heating up.

President Lyndon Johnson had no time for anyone trying to chaperone his party. The Texas democrat required cheap capital to fund a war abroad in Vietnam and the war at home on poverty via the Great Society.

In December of 1965, the two men clashed when Fed chair Martin, keen to head off the inflationary effects of Johnson's spending, increased rates by 50 basis points to 4.5%. Johnson was livid. He wanted to fire Martin, at one point telling his treasury secretary, Henry Fowler, in a recorded phone call, to find a replacement.

“Henry, you all got to think of … where we can get a real articulate, able, tough guy that can take this Federal Reserve place,” Johnson said.

On being informed he couldn’t simply fire the Fed chair, Johnson called Martin down to his Texas ranch to give what LBJ biographer Robert Caro called “The Johnson Treatment” - a mix of threats, flattery, badgering and in the case of Martin, physically throwing him against the ranch wall. The message was clear: the punch bowl was not only to return but spiked for good measure.

To his credit, Martin stood firm, at least initially. The discount rate was held steady, but other monetary levers loosened, reserve requirements were eased, and open market operations became more generous until, finally, in 1967, the discount rate was trimmed back to 4%.

It wasn't until June 1968, two months after Lyndon Johnson had announced he would not seek re-election, that Martin increased rates again to try and tackle a festering inflation problem. The following year, inflation hit an 18-year high of 6.2%.

The Federal Reserve Bank of Richmond wrote on the Johnson/Martin affair: “In retrospect, many scholars now believe that the roots of the 1970s inflationary spiral can be found in the 1960s. The economic historian Allan Meltzer has described 1965 as a turning point in inflation. Robert Hetzel of the Richmond Fed, similarly, noted in his history of the Fed that "an explanation for the Great Inflation must deal with Martin's responsibility." Martin himself seemed to have grasped this, lamenting to his colleagues upon retirement in 1970, "I've failed.”

1970 Nixon v Burns

Watching all this from the sidelines was Richard Nixon, who already had an axe to grind with the Fed. Nixon, as vice president, had narrowly lost the 1960 election and blamed the Fed. With Martin's term due to end in 1970, Nixon sought to place a loyalist at the helm to ensure an accommodative policy. Arthur Burns was, at this stage, an old ally of Nixon. Before the 1960 election, Burns warned Nixon that the economy was in trouble and recommended lowering interest rates to avoid a Republican defeat.

In appointing Burns in 1970, Nixon wasn’t going to let him forget the advice he had given. The pressure campaign began immediately, and although less physically confrontational than LBJ's, it was more insidious, verging on psychological warfare. Nixon applied pressure directly; he met with the Fed chair 160 times during his six years in the White House (for context, Bill Clinton held similar meetings six times in his eight years). But he also utilised the media, planting a false story in the WSJ that Burns had requested a large pay rise (he had in fact requested a pay cut) and other stories proposing the White House take more control of the Fed and another where the White House would expand the size of the Fed to ensure the current administration’s appointees were the majority.

In the wake of this pressure, Arthur Burns capitulated. The discount rate was lowered from 6% to 4.5% in the summer of 1972, and the money supply expanded rapidly. With the economy jolted, Nixon was re-elected in a landslide. In his essay How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes, Burton Abrams notes that “Without invoking political pressure, the surge of expansionary monetary policy leading up to the 1972 election seems hard to explain”.

Whatever ultimately caused Burns to shift policy, its effect was clear. Inflation, which sat at an uncomfortable 3.6% in 1972, rose to 9.6% by ’73, and the remainder of the decade became one of the most brutal inflationary periods in modern economic history.

Summary

Johnson needed lower rates to finance a foreign war and an ambitious domestic agenda; Nixon needed lower rates to banish the ghosts of 1960. Both were relatively short-term goals with clear end dates; Nixon is even on tape as saying he didn’t care what the Fed did after the election (they raised).

Donald Trump’s need for low rates is more structural – the cost of servicing US debt. Which, to put mildly, is much worse now. The lack of a clear end date means the pressure will almost certainly continue beyond Powell’s term as chairperson, and if history is any guide, the president usually gets his way.