Despite its problems in the 1970s, the members of FOMC never discussed how their actions affected inflation and output or whether they could agree upon a framework for improving performance. They argued many times that lower average money growth was necessary to control and lower the inflation rate; they were unwilling to let interest rate variability increase. No one suggested bold, decisive actions to end inflation.197
197. A former senior staff member suggested reforms after he left the Board. One of his proposals called for disclosure—announcement of policy actions when they were made. He quoted a former Governor, David Lilly, as supporting prompt disclosure. Pierce attributed unwillingness to announce decisions to its “penchant for secrecy” (Pierce, 1979a, 249). Unwillingness to accept responsibility is a reason for the “penchant.”
EIGHT
Disinflation
The policies of the past have failed.
—Ronald Reagan in Council of Economic Advisers, 1982, 10
With the best staff in the world and all the computing power we could give them, there could never be any certainty about just the right level of the federal funds rate to keep the money supply on the right path and to regulate economic activity.
—Volcker and Gyohten, 1992, 166
In July1979, President Carter spent two days at Camp David to reassess his presidency. Things had not gone well. Abroad a hostile government had replaced a friendly government in Iran. Militants soon thereafter seized the United States embassy in Teheran and held the staff hostage. Oil prices had increased, and some forecasters predicted that the price would rise to $100 a barrel, compared to $2 to $3 dollars in 1972. At home consumer prices rose 11 percent for the year and output had not increased for the first two quarters of the year. The unemployment rate was about 6 percent.
Forecasts brought little cheer. Predictions of recession were common; the Federal Reserve staff thought a recession was “imminent” (Volcker and Gyohten, 1992, 165). The Society of Professional Forecasters predicted that inflation would continue at the current 8 to 9 percent rate with nominal GNP rising about 8 percent. That implied zero real growth. The interest rate on ten-year government bonds at 9 percent suggested a real before-tax return near zero or negative. This was the highest reported nominal government bond yield in United States history to that time.
Some of the news conveyed by these data overstated the problem by failing to separate the one-time effect of a rise in oil prices from the persistent effect of excessive monetary growth. The GNP deflator, much less influenced by energy prices, rose 9 percent; hourly earnings increased 7.8 percent in the year ending in July, about the same as in the previous year. Even with these lower rates of inflation, the news was not good.
When President Nixon went to Camp David in 1971, he returned with announcements that the public thought would bring lower inflation and increased employment. President Carter’s return created less enthusiasm. He blamed the public for their “malaise,” although he did not use that word. Instead of announcing that problems required new policies, he asked his cabinet to resign. He soon announced changes. G. William Miller replaced Michael Blumenthal as Secretary of the Treasury. That left a vacancy at the Federal Reserve.
There were strong market pressures to fill the vacancy promptly. Disappointment and lack of confidence in U.S. policy started another run against the dollar. The gold price rose and the trade-weighted dollar fell to a new low. The president and his staff wanted to announce an appointment that would calm fears and reduce uncertainty about the administration’s program. The problem was that the president’s staff also wanted someone who would “cooperate” with them.1 Paul Volcker had strong views strongly held. When he met President Carter for an interview, he was “mainly concerned that the president not be under any misunderstanding about my own concern about the importance of an independent central bank and the need for the tighter money—tighter than Bill Miller had wanted” (Volcker and Gyohten, 1992, 164).
Stuart Eizenstat (1982, 70), the Domestic Policy Adviser, described the circumstances at the time. “With inflation raging and the president’s popularity plunging the president believed the economic situation was dire, and he wanted someone who would apply tough medicine.”
To President Carter’s credit, he appointed Volcker. Inflation was not just an economic problem. Polls showed that the public now listed inflation as a major problem, more serious than unemployment.2 Several authors describe the president as uncertain about the consequences of his choice; Volcker had dissented against the FOMC consensus several times in the spring of that year, as Miller and Schultze knew. And his concerns about inflation were long-standing. Volcker had spoken about inflation and the need to reduce it many times. When he rejoined the Federal Reserve System as president of the New York bank, he told Business Week magazine that “we’ve got to deal with both inflation and recession at the same time” (Volcker papers, Federal Reserve Bank of New York, Box 35581, August 4, 1995). He criticized a policy of shifting primary concern from inflation to unemployment. He claimed that he was not a monetarist, but he accepted that proper monetary policy had to pay more attention to the long-term effects of its actions, particularly growth of the monetary aggregates.
1. Grieder (1987, 45) lists four names of people under consideration: Tom Clausen of Bank of America; Paul Volcker, president of the New York Federal Reserve Bank; David Rockefeller, CEO of Chase Manhattan; and Bruce MacLaury, president of the Brookings Institution. Grieder claimed that the president spoke to Clausen, who declined (ibid., 46). Biven (2002, 239) quotes Lyle Gramley, a former Federal Reserve staff member and, at the time, a member of the Council of Economic Advisers, as saying that Charles Schultze, chairman of CEA, expressed “reservations” about Volcker. Schultze denied that story. He was hospitalized at the time and did not take a position on the appointment (Schultze, 2005).
2. Charles Schultze confirmed the importance of public opinion as a reason for President Carter’s concern (Schultze, 2005, 6). He blamed the oil price increase for the change. “It was the supply side shock inflation that turned the public mood very substantially” (ibid., 15). Robert Samuelson (2004, 21) quotes a survey taken in 1979. “For the public today inflation has the kind of dominance that no other issue has had since World War II. The closest contenders are the Cold War fears of the early 1950s and perhaps the last years of the Vietnam War. But inflation exceeds those issues in the breadth of concerns it has aroused among Americans. . . . In a September 1979 survey, 67 percent of the public said that ‘holding down inflation’ was a bigger problem than ‘finding jobs’ (21 percent).”
Volcker discussed the role of money again after Congress passed Concurrent Resolution 133, stating that the Federal Reserve should maintain long-term growth of money commensurate with the economy’s long-run potential to increase production. Volcker accepted the importance of monetary control. “To my mind, monetary aggregate targets are a useful—even a necessary—gauge of appropriate monetary policy action in bringing inflation under control. But they do not in themselves alter the real problems and hard choices imposed by the economic structure” (“The Role of Monetary Targets . . . ,” galley pages, New York Federal Reserve Bank, Box 35606, December 30, 1977, 10).3
By January 1979, he compared the monetarist and cost-push positions and favored an eclectic approach that combined both. But he now described the monetary approach to inflation control as based on the proposition that “substantial and sustained changes in price performance are accompanied by or preceded by substantial and sustained changes in rates of money growth” (draft January 15, 1979, New York Federal Reserve Bank, Box 35581). He added that this relationship was “well established” for the long term but not generally in the short to medium run. No monetarist would have disagreed.
3. Volcker made clear that he did not favor targeting reserve or money growth without restricting the range within which the federal funds rate could move. But he joined the monetarists in his criticism of the Federal Reserve staff’s
practice of explaining failure to meet reserve or money targets by claiming that demand for money shifted. “Portentously pointing to these ‘shifts,’ without further explanation seems to me something of a confession of ignorance” (Volcker papers, “The Role of Monetary Targets . . . ,” galley pages, Federal Reserve Bank of New York, Box 35606, December 30, 1977).
As his thinking and observations developed during the 1970s, he moved toward a more monetarist position that he later called practical monetarism (Mehrling, 2007, 177). He recognized that ending inflation required control of money, and he recognized that this could be achieved either by targeting reserve growth or an interest rate. What mattered was how much the interest rate changed to achieve desired control. Commitment also mattered. Volcker understood that ending inflation would not be painless or quick. “I had begun thinking about how one could practically adopt some of these monetarist ideas . . . to make policy more coherent and predictable” (ibid.).
President Carter’s summary of his first meeting expressed his own concern about inflation. “He [Volcker] made it plain, and it was mutual, that if he took the job he would want to do it in accordance with my previously expressed policy, that I wouldn’t try to put pressure on him or interfere in his best judgment” (Biven, 2002, 239, based on an interview with President Carter). To his credit, President Carter honored his pledge not to pressure Volcker except for the brief period when he insisted on credit controls.
Several in the Carter administration believed that price and wage controls, guidelines, or incomes policy were an important element of an antiinflation policy. These policies had been in place for several years, and in the summer of 1979, as inflation rose, the administration considered ways to strengthen them. Volcker believed that “if all the difficulties growing out of inflation were going to be dealt with at all, it would have to be through monetary policy. . . . [N]o other approach could be successful without a convincing demonstration that monetary restraint would be maintained” (Volcker and Gyohten, 1992, 164–65).
Volcker became chairman on August 6, 1979. Consumer prices rose at an 11 percent annual rate that month and average hourly earnings rose 7.8 percent. When he left the Board in August 1987, consumer prices had increased 4.2 percent in the most recent twelve months and average hourly earnings rose 2.2 percent. As far as most of the public was concerned, the inflation problem was over for the time.
President Carter gets credit for appointing him and President Reagan for supporting him through a deep recession. But Paul Volcker’s major contribution stands out. Unlike 1966, 1969, 1973, and other times, he persisted in an anti-inflation policy long enough to bring the inflation rate down permanently. Despite the added burden of an oil price increase that raised the reported rate of price change, reported consumer price inflation fell from a peak annualized monthly rate of 17 percent in January 1980 to about 5 percent in September and October 1982, when policy operations changed. Interest rates on ten-year Treasury bonds reached 15.68 percent (October 2, 1981) and remained above 10 percent from July 1980 to November 1985. The unemployment rate remained at 7 percent or above for sixty-eight months from May 1980 to December 1985 and reached a postwar peak at 10.8 percent in November and December 1982.
Skepticism about the persistence of low inflation remained in October 1982. The interest rate on a ten-year Treasury bond remained near 11 percent and the Society of Professional Forecasters predicted inflation near 6 percent. Inflation forecasts did not fall to 2 to 3 percent until 1985–86, when the ten-year interest rate reached 7 to 8 percent. Apparently the public had learned to distinguish between permanent and temporary changes (Friedman, 1957; Brunner, Cukierman, and Meltzer, 1980). It became convinced that the long period of high inflation was over only after experiencing a sustained recovery with low or declining inflation rates.4
Paul Volcker had the background and experience to be a successful chairman. Early in his career he worked at the New York bank, later as its president, and he served as undersecretary for monetary affairs during the collapse of the Bretton Woods system and its aftermath. Foreign central bankers and New York bankers knew him and had confidence in him. He was knowledgeable and strong-willed, and he recognized the importance of reducing inflation. He was also determined and committed to the task. “You needed someone like Paul, a total technical command, political savvy in the best sense within the System and able to go and explain this to the country. . . . I think he was unique, and it wouldn’t have been done this way without him. . . . Now in the end we might have done it one way or another, but they would never have had the nerve to raise interest rates so fast” (Axilrod, 1997, 9). “Paul was a very good chairman at the time . . . [H]e saw the time was right to kill inflation. . . . The President [Reagan] was willing to support him. The public was equally supportive and could get high interest rates from money market funds, so you weren’t going to get flack for driving interest rates up with people stuck with low interest rates on their savings accounts. I thought that was crucial in keeping Congress from the battle” (ibid., 8–9).
Axilrod (2005, 241), who worked closely with Volcker, described him as “an eminently practical person, who very well understood how important it was for the health of the economy and the country to bring inflation down and restore the Fed’s anti-inflation credibility. Moreover, he also had enough political astuteness to grasp that political and social conditions in the country at the time presented him with a window of opportunity for implementing a paradigm shift in policy that might well make the process of controlling inflation more convincing and quicker. In his choice of policy instrument, he was a practical monetarist for a three-year period.”
4. This episode shows that the short-term interest rate does not express all the information in the term structure of interest rates or in asset prices and inflation anticipations. The Federal Reserve can manipulate the short-term rate. Changes in long-term rates, asset prices, and money growth suggest the degree to which market anticipations respond.
No less important, Volcker believed the task of lowering inflation was important for the country and the world. By moving from New York to Washington to become chairman, he gave up $60,000 a year in income, one measure of his commitment to the task.
Volcker’s method of operation was to work with a small staff. Joseph Coyne, in charge of the Office of Public Affairs at the time discussed Volcker’s management style.
Q. He has a reputation of being a man who kept his own counsel, who didn’t talk very much to the other Governors. Several complained that they really felt that they were out of the loop. . . . Is that fair?
A. Yes, that’s fair.
Q. He worked mostly with the staff?
A. He worked mostly with the senior staff. (Coyne, 1998, 9–10)5
Volcker did not come to the Board with a complete plan, and he had not decided to change the FOMC’s operating procedures. He had spoken about the role of money in inflation control on several previous occasions. The Board’s staff, however, had experience with reserve control from earlier efforts in the 1970s. Volcker assigned to Stephen Axilrod and Peter Sternlight the development of a technical control system.
At about the same time, Congress made a major change in regulations affecting interest rates and money by passing the Depository Institutions Deregulation and Monetary Control Act (DIDMCA). The act gradually eliminated interest rate ceilings for banks and financial institutions and empowered the Federal Reserve to require non-member banks to hold reserves. In exchange, non-member banks obtained the privilege of discounting at Federal Reserve Banks. The Federal Reserve had sought a legislated change of this kind at least since 1937 (Meltzer, 2003, 486–87). The change was overdue, but the timing was poor since permitting new types of accounts and removing interest rate ceilings changed the public’s preferred mix of monetary assets in a way that made forecasts of money growth difficult just at the time that the Federal Reserve chose to monitor money growth more closely.
5. From the Axilrod interview:
Q. Well, among the Governors also?
A. Yes, in a way they may have been excluded a bit from direct contact with him because he was more comfortable working with several people. (Axilrod, 1997, 10)
Appreciation of the dollar was a third major monetary event of the period. The Federal Reserve’s trade-weighted index appreciated from 85 to 135, after adjusting for price changes, between 1980 and 1985. Appreciation worked to reduce measured inflation, but it deepened the recession by raising prices foreigners paid for U.S. exports.
The Federal Reserve and political administrations from 1966 on had postponed or interrupted efforts to reduce inflation. Financial markets and the public had become convinced that commitments to end inflation would vanish once unemployment began to increase.6 Skepticism made the task more difficult; it was not enough to reduce the inflation rate temporarily. That had happened before, but it had not lasted. The public and financial markets wanted to see a permanent reduction in inflation, a reduction that persisted through the next expansion.
Past failures imposed two conditions: (1) anti-inflation policy had to continue after the unemployment rate increased; (2) inflation would not rise much during the expansion that followed the recession. Past experience made the task harder, but none of the principals anticipated how costly and painful disinflation would be. In practice, it was more costly than they anticipated but much less costly than predictions made by Keynesian economists at the time.
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