A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  At his confirmation hearing, Volcker distinguished between real and nominal interest rates and explained that to reduce interest rates permanently, the Federal Reserve had to reduce inflation. He made the usual statements about the existence of non-member banks as a problem for monetary control and the changing nature of “money.” But in response to a direct question, he described control of money growth as “indispensable . . . if we’re going to have price stability. . . . If the growth of money is excessive over a period of time, we’re going to have inflation” (Senate Committee on Banking, Housing, and Urban Affairs, 1979, 12). Volcker added later that he saw no reason to use credit controls.

  ANALYSIS AND BELIEFS

  Several models or frameworks for analyzing the economy and monetary policy dominated systematic thinking at the time. The more popular Keynesian framework gave no special emphasis to money or money growth. Prices rose for many reasons, and inflation was the measured rate of price change. A leading Keynesian economist, James Tobin (1980a) summarized Keynesian thinking about macroeconomics.7 The economy had an inflationary bias; any effort to stabilize the rate of inflation required a sacrifice of real output. To reduce the bias and the loss of output from disinflation, government had to use incomes policy (ibid., 69). As a member of the Council of Economic Advisors in 1961–62, Tobin proposed and introduced wage-price guidelines in the United States. Despite the many failed attempts to use incomes policies at home and abroad, he and many others held to this view in 1980.

  6. Pressures to ease rose in 1982. Congressmen Jack Kemp and James Wright (the majority leader) called for Volcker’s resignation in 1982. Senator Edward Kennedy, Congressman Henry Reuss, Senator Robert Byrd, and thirty others introduced legislation requiring lower interest rates.

  Tobin’s analytic framework had five main features: (1) Prices are marked up over costs, particularly labor costs. (2) Changes in aggregate demand change prices, wages, output, and employment by changing the tightness of product and labor markets as measured by unemployment and operating capacity. (3) According to Okun’s law, it takes a 3 percent change in GDP to change the unemployment rate by one percentage point. (4) At low unemployment rates, inflation increases and at high unemployment rates, inflation decreases, but the rate of decline is slower than the rate of increase. At the non-accelerating inflation rate of unemployment (NAIRU), inflation remains at the expected rate and the unemployment rate is constant. (5) Tobin saw little professional consensus on the relative effectiveness of fiscal and monetary policies and the proper indicator of monetary policy. He was pessimistic about the costs of the disinflation policy and highly critical of the Volcker policy (Tobin, 1987).

  The Phillips curve was a core relation in this framework. It predicted that anti-inflation policy would increase the unemployment rate. Medium-term, this was not true; on average inflation and the unemployment rate rose in the 1970s and subsequently both declined in the 1980s. For medium- and longer-term policy, the positive relation was more important. Monetarists and rational expectationists explained the positive relation as a reflection of the dominating influence of expectations of inflation resulting from monetary expansion and policy errors. Volcker accepted this explanation. Subsequent studies showed that the forecasts had large errors principally because expected output or full employment output could not be measured accurately (Orphanides and van Orden, 2004; Stock and Watson, 1999).

  Tobin (1983, 297) remained critical of the disinflation policies adopted in the United States and the United Kingdom at the end of the 1970s. “Like Okun, I would expect the process to be lengthy and costly, characterized by recession, stunted recoveries, and high and rising unemployment.” He speculated that it would take ten years. As late as 1981, he urged incomes policies during a transition long enough to unwind the previous history of contracts, patterns, and expectations (ibid., 300).

  7. Goodfriend (2005) has an excellent summary of Tobin’s framework.

  A major difference between monetarists and Keynesians concerned the role of government. Keynesians saw the government’s role as one of managing the economy to minimize social cost of change. Government had a leadership role in adjusting aggregate demand up or down to achieve optimal results. Monetarists emphasized long-term institutional prerequisites for stability. If institutions gave proper incentives to the private sector, the economy would adjust. Although there were differences about the relative importance of fiscal and monetary actions and about the economy’s response to policy actions, the major difference was about the role of government. To monetarists, the economic system adjusted toward full use of resources if policies encouraged stability.

  Monetarists agreed that reducing inflation would be socially costly. Failure of past attempts reinforced beliefs that disinflationary policies would stop once unemployment rose. Monetarists differed from Keynesians, however, by claiming that the Federal Reserve could reduce the social cost by increasing its credibility. Increased credibility affected price and wage adjustment by changing beliefs and anticipations of future inflation.

  Monetarists accepted parts of the framework described by Tobin but emphasized the role of money growth for inflation and the long-run neutrality of money. Following Milton Friedman, they argued that inflation could not be reduced unless money growth declined relative to growth of real output, a proposition accepted by Volcker (Mehrling, 2007, 178). In the long run, the equilibrium levels of unemployment, output, and other non-monetary variables would be the same (after adjustment of tax rates) as before the disinflation. For the monetarists, price levels could change for many reasons, but sustained changes in the rate of price change resulted from excessive money growth—sustained growth of money in excess of output growth. They viewed the Federal Reserve’s job as preventing sustained price level changes. They restricted the term “inflation” to sustained changes in the rate of price change.8

  Monetarists blamed Federal Reserve policy for procyclical monetary actions and for increasing the amplitude of both recessions and inflation. They offered evidence that—measured by money growth—policy was expansive during periods of increasing aggregate demand and inflation and contractive in recessions. They traced much of this problem to the misinterpretation of member bank borrowing and interest rate changes. The Federal Reserve interpreted the rise in nominal interest rates during periods of economic expansion as evidence of restrictive monetary policy despite rising money growth; it took the decline of interest rates in recessions as evidence of easier policy despite a decline in money growth. Also, Federal Reserve spokesmen interpreted an increase in borrowed reserves as contractive. Monetarists wanted the Federal Reserve to avoid procyclical actions by controlling money growth, including the effect of borrowing. They recognized that if the Federal Reserve changed interest rates to control money growth, interest rate control would be effective and counter-cyclical. But they did not emphasize the last point and insisted on the importance of controlling money directly. However, they did not give sufficient attention to deregulation in the 1980s that made monetary aggregates less reliable indicators of the thrust of policy action.

  8. Brunner, Cukierman, and Meltzer (1980) model permanent or persistent changes. Their model shows why unemployment and inflation can rise together, unlike the standard Phillips curve. And the model shows that a permanent disinflation can occur only if the public becomes convinced that policy will not bring back inflation.

  These monetarist criticisms of Federal Reserve actions emphasized the problem of using a short-term interest rate or money market conditions to describe monetary policy and to characterize the thrust of monetary policy as easier or tighter. A nominal interest rate must be judged against some benchmark such as sustained money growth relative to the growth of output or relative to the expected rate of inflation. Otherwise it contains little information about policy. Later, Taylor (1993) proposed an interest rate rule for judging the thrust of current policy actions that several central banks use. The Taylor rule advises the central bank to compare
the nominal short-term rate to prevailing conditions, including current anticipations. Monetarists also insisted on the importance of policy persistence. The public had to be convinced that the Federal Reserve would persist in an anti-inflationary policy when unemployment rose, as they expected it would. If the public became convinced that low inflation would return, the social cost of reducing inflation would fall. Using this reasoning, Cagan (1978b) estimated a more rapid response to disinflationary policy than Tobin or Okun. The staff econometric model also predicted a more rapid response than Tobin.

  Differences in the expected response of inflation to sustained disinflationary policy divided economists at the time. Nordhaus (1983, 254) described the Keynesian view of inflation. “Inflation is taken to be the sum of inertial, cyclical, and volatile or random forces. The inertial element is the inherited ‘underlying’ rate of inflation, particularly from wages, which changes slowly in response to experience and expectations.”9 Inertial inflation was slow to adjust downward. Nordhaus described the principal cost of chronic inflation as the constraint imposed on economic activity. “The main reason policymakers have been unwilling to set higher targets for output and employment is simply their fear that higher targets would risk increasing inflation. . . . unemployment rates in the 2 to 3 percent range, and hence output 8 to 10 percent higher would surely have been much closer to the ideal output” (ibid., 265).10

  9. Academic literature at the time was dominated by models with rational expectations. The then current vintage had little or no effect of policy actions on real variables. President Mark Willes (Minneapolis) mentioned this work at times, but he did not get a response.

  By adopting the new procedures and undertaking a sustained effort to reduce inflation, the Federal Reserve staff accepted several main criticisms of the monetarists.11 At Ohio State University on April 30, 1981, Stephen Axilrod and Peter Sternlight from the Federal Reserve debated Robert Rasche and Allan Meltzer from the Shadow Open Market Committee.12 The topic was “Is the Federal Reserve’s Monetary Control Policy Misdirected?” (Axilrod et al., 1982, 119–47). The debate brought out agreement on objectives and the means to reach them. The Federal Reserve accepted that it had to control money growth to control inflation, a position it had denied in the past.

  Important differences remained about how to improve monetary control, particularly how to forecast the money multiplier more accurately and control quarterly or semiannual money growth more effectively. Federal Reserve staff repeated their claim that tighter control of money growth required unacceptable fluctuations in market interest rates. Axilrod and Sternlight mostly refused to recognize publicly that part, probably a large part, of the interest rate volatility resulted from restrictions they imposed such as lagged reserve requirements.13 Axilrod, however, accepted that variability would be reduced and control improved if the Federal Reserve made institutional changes. He did not suggest why they failed to do so. And he accepted the monetarist proposition that medium- and long-term control of money growth was most important for control of inflation. This was progress at least at the verbal level.

  10. Fischer (1983, 275) commented, “The neo-Keynesian synthesis of the late 1960s was that inflation was not a serious problem. . . . [D]isagreements within the profession on the relative importance of inflation and unemployment is a source of differing views on desirable policy.”

  11. Milton Friedman (1982) summarized the changing position of the Federal Reserve on the possibility of monetary control.

  12. The Shadow Open Market Committee was a group of academic and business economists that met semiannually to critique monetary policy. Meltzer was co-chairman.

  13. Although he did not say so in the debate, Axilrod made this argument each time the FOMC asked him to discuss lagged reserve requirements. The Board did not consider returning to contemporaneous reserve ratios until pressed to do so by members of Congress (Friedman, 1982, 111).

  PERSONNEL CHANGES

  Both Board members and reserve bank presidents changed during the disinflation. Table 8.1 shows the changes. Lyle Gramley was a career Federal Reserve staff member who returned as a governor after serving on the Council of Economic Advisers. Frederick Schultz was a Florida banker; he served as vice chairman. Anthony Solomon had worked with Volcker in the Nixon administration, and Gerald Corrigan was a Volcker protégé.

  A NEW POLICY14

  Both the Board and the FOMC were divided in 1979, as they had been for some time. One group wanted more restrictive policy action to reduce inflation. The other expressed concern about a possible recession. By early August, when Paul A. Volcker became chairman, many forecasters thought a recession was coming. Others thought it had started. The preliminary report of second-quarter GNP showed a 3.3 percent decline at annual rates, in part as a result of the oil price rise and the wealth transfer to the oil exporters. “By not tightening, the Committee compounded its earlier errors, allowing inflation to accelerate further only to postpone and raise the cost of restoring stability” (Orphanides, 2004, 171).

  Volcker thought that a recession was likely, but before becoming chairman he had repeatedly said that inflation was a bigger concern. He dissented from the directives during the spring because he wanted more restraint. At his confirmation hearing, he repeated his concern about inflation, emphasized the central role of money growth for inflation, and expressed concern about the persistence of inflationary expectations.

  14. An extended discussion of the policy change is Lindsey, Orphanides, and Rasche (2005).

  Preparing for a Quadriad meeting in late September, Charles Schultze expressed concern about the increase in interest rates during Volcker’s chairmanship. He recognized “the dilemma facing economic policy generally and monetary policy in particular” (memo, Schultze to the president, September 25, 1979, 4–5). Growth of monetary aggregates had increased, but rising interest rates “have a delayed impact on the economy” (ibid., 5). Policy increased the risk of rising unemployment rates in 1980. Disinflation had not started but he urged the president to probe when Volcker could “begin easing a bit” (ibid.), although disinflation policy had not begun.

  Volcker’s concern was inflation. The FOMC used a federal funds rate target but also announced objectives for growth of M1 and M2. Its directives to the desk aimed to reduce money growth, and it had voted between meetings to raise the federal funds rate target to between 10.5 and 10.75 percent to keep M1 and M2 growth at annual rates between 2.5 and 6.5 and 6.5 and 10.5 percent respectively. At the August 14 FOMC meeting:

  [t]here was little disagreement with the proposition that for the near term modest measures should be taken to direct policy toward slowing growth of the monetary aggregates. Control of monetary growth was regarded as essential to restore expectations of a decline in the rate of inflation over a period of time. (Annual Report, 1979, 183)

  FOMC members were aware both that their statements lacked credibility and that market participants paid attention to reported growth of the monetary aggregates, but the statement showed the beginning of a change in members’ thinking.

  In February 1979, the FOMC had agreed to hold growth of M1, M2, and M3 to ranges of 1.5 to 4.5, 5 to 8, and 6 to 9 percent for the four quarters of 1979. The proposed slow growth of M1 reflected an anticipated shift to NOW accounts.15 At the August 14 meeting, the committee voted to raise the range for the federal funds rate by one-half point to 10.75 to 11.25 and to make the limits conditional on moderate growth of M1 and M2. President Robert Black (Richmond) and Governor Emmett Rice dissented. Black wanted slower money growth; Rice expressed concern about recession. He wanted policy to remain unchanged. Volcker, aware of the political problem, favored a less inflationary policy, but he wanted to “keep our ammunition reserved as much as possible for more of a crisis situation when we have a rather clear public backing for whatever drastic action we take” (FOMC Minutes, August 14, 1979, 22–23). On August 30, the FOMC voted to raise the upper end of the funds rate band to 11.5 percent, citing high mon
ey growth as the reason. Rice again dissented.

  15. NOW accounts were negotiable orders of withdrawal, similar in many respects to demand deposits, but they paid interest. New England banks began issuing NOW accounts. Legislation, discussed below, extended their use to the rest of the country.

  If Congress had doubts about Volcker’s intentions, they should have been dispelled by his testimony on September 5. He told the House Budget Committee about some of the costs of inflation. Unlike the Keynesians, he considered the costs higher than the costs of reducing inflation. One of the costs Volcker cited in his testimony was “the capricious effects on individuals” (Volcker, 1979, 738). A more specific cost cited was the reduction in after-tax returns to corporations. This return “averaged 3.8 percent during the 1970s . . . as compared to 6.6 percent in the 1960s. At the same time, the uncertainty about future prospects associated with high and varying levels of inflation tends to concentrate the new investment . . . in relatively short, quick payout projects” (ibid., 738–39). And he listed other costs including increased sensitivity, and more rapid response, of wages, exchange rates, prices, and interest rates.

  He added that earlier in the postwar years, the response lag was longer, so real incomes increased more before inflation rose. Actions “all too likely to produce more inflation will in fact have only a small and short-lived expansionary effect. . . . [O]ur current economic difficulties are tightly interwoven. They will not be resolved unless we deal convincingly with inflation” (ibid., 740; emphasis added). This reasoning dismissed the Phillips curve tradeoff as irrelevant to current outcomes.