The Economy: The Year of Tight Money And Where It Will Lead

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The Fed can be faulted, though to a much lesser degree than the Administration, for being slow in using another of its regulatory tools — the money supply — and later on for overusing it. Despite their waning hopes that Johnson would raise taxes, the Fed's governors kept rapidly increasing the supply of money during the first part of 1966. Businessmen, eager to expand their overworked plants, hired more employees and built inventories, went on a borrowing spree and were willing to pay a premium price for money. Loans to business — which usually flatten out during the first half — actually jumped by $7.5 billion, or almost 10%.

Sequence of Squeeze. With inflation becoming a reality as prices jumped, the Federal Reserve at midyear made a hairpin turn. It shifted from expanding the money supply at a 6% annual rate to contracting it by a 2% rate, doing so by selling Government bonds to sop up cash. From April to August, the money supply — currency in circulation and demand deposits in banks — dropped from $171.6 billion to $166.9 billion. The reverse was particularly jarring because, simultaneously, loan demands were greatly stepped up as a result of two moves by the U.S. Treasury — which does not always coordinate too well with the Fed.

First, as part of a long-term program to put corporate collections on a pay-as-you-go basis, the Treasury in April speeded up taxes — increasing by hundreds of millions of dollars the quarterly amounts that corporations had to ante up in 1966. Second, in June, the Treasury ordered corporations to pay their withholding taxes for employees twice a month instead of only at each month's end. While these two actions did not really boost taxes but simply made for earlier payment, they had the cosmetic effect of temporarily making the budget deficit appear smaller than it was. Corporations borrowed billions from the banks to pay for the speedup. In effect, the banks had been obliged to finance the narrowing of Johnson's budget deficit.

Day by day the money shortage worsened, and at one point the nation came uncomfortably close to a money panic. Prime interest rates went up four different times, shooting from 4½% in late 1965 to 6% in mid-1966 — equal to an increase of 33% in twelve months. A wave of hedge-borrowing and money hoarding swept the country. Figuring that money would become steadily scarcer and costlier, corporate treasurers borrowed more than they needed. In June, the Chase Manhattan Bank raised interest rates on most consumer loans for the first time since 1959, to 5½% "discounted" (in effect 10½%), and other banks quickly followed. Bargain-hunting consumers rushed to borrow at 5% on their insurance policies, and insurance executives appealed to banks for new reserves — putting more pressure on the banks.