The policy change appreciated the dollar against the European currencies. “The increase of U.S. interest rates and the exchange rate, as well as their volatility, gave rise to vociferous complaints. . . . [T]he principal objection was to the level that interest rates reached in 1981” (Solomon, 1982, 356). The European countries were forced to choose between higher interest rates and currency depreciation. The latter raised energy costs because oil was priced in dollars. Important, also, was the swing in the current account deficit as United States imports fell. By the second half of 1980, the United States’ current account temporarily showed a surplus. Among the Europeans struggling with recessions, high nominal interest rates and declining imports were unpopular.
At the time and for many months, the market and the public remained skeptical about the response to the policy change. Short-term interest rates rose as expected, but the market expected higher short-term rates to persist, so long-term interest rates rose also. The three-month Treasury bill rate rose from 10.43 percent on October 5 to a local peak of 12.60 on October 26. It did not fall below 10.43 until May 1980. The ten-year constant-maturity Treasury bond, on the same October dates, rose from 9.53 percent to 10.89 percent. The long-term rate continued to rise, reaching 13.20 percent in February 1980, and did not temporarily fall below 9.53 until June 1980. Forecasts of expected inflation one quarter ahead reached a peak at 9.98 percent in second quarter 1980, but forecasts for four quarters ahead continued to increase until fourth quarter 1980. Using the inflation forecasts to compute real interest rates suggests that these rates remained modestly positive. But confidence in the Federal Reserve’s ability or willingness to keep its commitment remained low.35
FOMC members recognized the skepticism. This time they intended to continue the anti-inflation policy until inflation remained lower permanently. President Carter did not criticize the policy publicly during his campaign, President Reagan emphasized policies for growth and low inflation. Principal members of Congress, too, provided support.
34. Lindsey, Orphanides, and Rasche (2005, 207) quote Volcker’s comment on the MacNeil/Lehrer Newshour on October 10, 1979. “I am not saying that unemployment will not rise. I am saying that the greater threat over a period of time would come from failing to deal with inflation rather than efforts to deal with it.”
35. Henry Wallich and Scott Pardee (manager of the international account) commented on European attitudes in November 1979. Wallich’s statement emphasized the importance of lower inflation. Commitments were not enough. “I think inflation coming down will be the most convincing single thing” (FOMC Minutes, November 20, 1979, 3). Domestic market participants made the same point. It proved to be correct.
The shift from interest rate to reserve targets, or the wider band on interest rate ranges, helped to implement and call attention to the change. Research suggests that the Federal Reserve’s commitment to reserve targeting was less than many of them said (Cook, 1984).36 A more transparent, coherent policy of controlling total reserves or the monetary base would have lowered the cost of reducing inflation. But persistence in a disinflation policy was the critical factor. As several members of the FOMC and the senior staff commented at the time, markets wanted to see what the FOMC would do when unemployment rose, when unemployment remained high, and when recovery came. Would inflation remain low in the next recovery? Would disinflation be permanent or, once again, a temporary break in a rising trend?
Policy actions and the anticipations they generated changed several times during the disinflation. Some of the public believed that Federal Reserve actions would lower inflation. Others had the opposite response; expected inflation rose at least for a time. Goodfriend (1993) called these episodes “inflation scares” and used the spread between long- and shortterm interest rates to identify the scares. Chart 8.2 shows several periods when long-term rates increased relative to short. Periods such as spring of 1980, when the System abandoned its policy during the brief, sharp recession, or the fall of 1981 (with increased credibility in early 1982) or skepticism about the willingness to persist in disinflation during the summer of 1982 stand out in the chart.
36. Later, in an influential paper, Goodfriend (1991) analyzed interest smoothing in a model of Federal Reserve behavior. He showed that interest rate smoothing could generate an inflation process of the kind that occurred in the 1970s.
Chart 8.2 suggests that the public distinguished between the one-time increase in price level (or a temporary rise in inflation) and changes in persistent inflation. The oil price increase in 1978–79 raised short-term rates relative to long-term rates. The spread started near zero in 1979 and drifted lower as short-term rates rose and long-term rates remained in a narrow range until the October policy announcement. The announcement raised short-term rates relative to long, suggesting that the market’s initial response was perhaps uncertain as to its meaning and persistence.
The four-quarter anticipated inflation rate in the SPF survey rose slightly in fourth quarter 1979 to 8.2 percent, approximately equal to the increase in the deflator in fourth quarter 1979 but below the four-quarter average for 1980. Measured inflation rose after the announcement; the twelvemonth rate of consumer price increase reached a peak of 13.70 percent in March 1980, but the deflator did not reach a peak (12.1 percent) until fourth quarter 1980.
Policy Actions, the First Phase
Volcker spoke to the American Bankers Association convention on October 9, three days after the policy change. He outlined the changes, warned them to avoid loans that financed speculation in commodities, gold, or foreign exchange, and described the background to the new policy. He detected “a dramatic swelling of national concern about inflation,” and he called attention to congressional support for monetary targets (Board Minutes, October 6, 1979, 5–6). The speech carefully distinguished monetary and other factors affecting prices, including energy and slow productivity growth, but he did not absolve policy of responsibility. “We can no longer blithely assume we can ‘buy’ prosperity with a little more inflation because the inflation itself is the greater threat to economic stability” (ibid., 9–10).
The initial implementation of the policy change was discouraging. M1 growth for October reached a 14 percent annual rate, far above the 4.5 percent target for the fourth quarter. Axilrod estimated that bank borrowing reached $3.1 billion, twice the FOMC’s estimate. He expected it to increase further. The federal funds rate rose to 17 to 18 percent, far above the FOMC’s range and the highest rates ever recorded to that time. Trading was light (FOMC Minutes, October 22, 1979, 1).
In the first of many partly reinforcing actions, the FOMC telephone conference chose to keep to the nonborrowed reserve path and allow the federal funds rate to stay at 15 percent or above. That meant that borrowing would remain high. Willis Winn (Cleveland) and several others proposed an increase in the discount rate. Larry Roos (St. Louis) and Mark Willes (Minneapolis) proposed announcing the targets for total reserves and the monetary base, but Volcker rejected both proposals. A higher discount rate would “push market rates up further.” He opposed giving the market more information. “We have more targets than we can meet already” (ibid., 9).
The result was a shift back to an interest rate target, keeping the ceiling at 15 percent and satisfying the demand for reserves by permitting banks to borrow from the discount window at less than the market rate. For the month of October, borrowing averaged $2 billion, twice the level of the previous January and $700 million more than in September.
Between October 26 and the next FOMC meeting on November 20, the Board rejected or deferred twenty requests for a 0.5 or 1 percentage point increase in the discount rate. The usual reasons were that the Board wanted to avoid higher interest rates and, in November, because money growth slowed from the torrid October pace. No one mentioned that persistent reductions in borrowing would assist in reaching the money growth targets. Instead, the Board backed away from its money targets. “Flexibility was necessary . . . rather than set
ting precise, fixed growth levels of the money supply by statute” (Board Minutes, November 9, 1979, 3).37
Volcker had difficulty getting people to understand the new procedure. The first question the public asked was “Are you going to stick with it?” He explained that interest rates could decline “when the economy declines particularly if the inflation rate is falling” (FOMC Minutes, November 20, 1979, 24). Years of experience had led the public to interpret any decline in interest rates as easing and any increase as tightening. Communication that the policy had changed was difficult and made more so because the FOMC was itself less than certain about what it was willing to do and how long it would continue to subordinate control of interest rates to control of reserves and money growth.
37. Adding to the uncertainties, in November the Iranians occupied the U.S. embassy in Teheran and held the Americans captive. This also affected uncertainty about future oil prices. At the January FOMC meeting, Volcker explained to the presidents how he interpreted their requests for discount rate changes under the new operating procedures. “If you’re sending the Board a message about the discount rate, you’re sending us a message on where you think market rates should be . . . [t]his is why we didn’t act in October and November. . . . It was our judgment that at least in the short run, it wasn’t going to close the gap but was just going to put the market rates up further” (FOMC Minutes, January 8–9, 1980, 80). As Volcker noted, his argument depended on traditional Federal Reserve beliefs about banks’ reluctance to borrow as in Riefler (1930).
Even a relatively hawkish member like Governor Coldwell showed ambivalence very early in the program by using interest rates to evaluate policy thrust. “I’d like to keep the Committee’s focus on the inflation side for the moment. I do think the chances of [recession] are high next year; and we will have to face the problem of to what extent we allow the rates to go down next year” (FOMC Minutes, November 20, 1979, 19).
After listening to the November discussion and the large amount of time spent debating small differences, President Roos (St. Louis) said: “I think we have to set longer term targets and be prepared to do what is necessary to achieve those longer-term targets. One thing that I think would be devastating . . . [would be to] worry about whether we ought to reduce the upper limit of the fed funds rate from 15.5 to 14.5 percent” (ibid., 27).
M1 growth ran ahead of the target range in October but slowed in November. By November, year-to-year growth of industrial production had fallen to zero. Money growth ran below target; borrowing declined, so the manager added to the path for nonborrowed reserves. When the FOMC met in early January 1980, many expressed satisfaction with the outcome.
What should they do next? Some wanted to announce money targets for the next three years. Willes (Minneapolis) and Roos (St. Louis) made the case for credible announcements to give the market as much information as possible and reduce expectations of inflation. The majority, led by Nancy Teeters, argued that the System had too little information and would have to change its path. They wanted no announcement beyond the one-year growth rates required by Humphrey-Hawkins.
Monetary innovation added to the difficulty of choosing a path and announcing it to the public. The staff prepared new definitions of money to take account of NOW accounts, automatic tellers, money market funds, and other new instruments. M1A and M1B replaced M 1 ; they differed mainly by the amount of NOW accounts. These were expected to increase, if Congress voted to permit the change. That made it difficult to specify growth rates. Following new legislation, the staff expected a large one-time change. The composition of other monetary aggregates also changed.38 However, only M1A and M1B were available weekly, so they received most attention from the Board’s staff, the manager, and the marketplace.
38. M1A and M1B differed by adding into M1B NOW accounts, automated teller balances, credit union share balances, and demand deposits at mutual savings banks. M2 added savings and small time deposits, overnight repurchase agreements, euro-dollars, and money market mutual fund shares.
A December memo from Charles Schultze expressed surprise that the economy avoided a recession. He noted that slow productivity growth had raised costs and prices but kept unemployment low. He expected recession in 1980 with mild recovery late in the year. Oil prices received most attention; he forecast an increase to $29 a barrel, but interest rate increases would cause a decline in housing starts and automobile sales. The forecast decline in GNP was 1.3 percent for the year followed by a small, 1 percent, increase in 1981. His forecast of the GNP deflator was 9 percent in 1980 and 9.3 percent in 1981; the forecast unemployment rate rose in both years to 7.8 and 8.7 percent respectively (memo, Schultze to the Economic Policy Group, Schultze Papers, December 13, 1979).
The Board’s staff also forecast a recession in 1980, but it predicted a larger decline of 2.25 percent, followed by slow growth of 1.25 percent in 1981. The projected increase in oil prices was 60 percent in 1980. The inflation forecast called for 8 percent inflation in 1980 and slow decline thereafter. The actual inflation rate (deflator) was 9.9 percent, and real growth was near zero. Data for 1980, however, reflected President Carter’s use of credit controls and the public’s reaction.
Chairman Volcker expressed concern about inflationary expectations at the January meeting. “All the financial data are within our immediate objectives [but] I don’t think we’ve made as much expectational progress . . . as conceivably might have been hoped” (FOMC Minutes, January 8–9, 1980, 32). The ten-year constant maturity bond yield continued to increase slowly. Between October 5 and January 4, it had increased one percentage point to 10.5 percent. Quarterly data on expected inflation from the Society of Professional Forecasters had increased also. In first quarter 1980, the expected increase in the deflator was almost 10 percent.39
Chart 8.3 compares actual and expected inflation from the Livingston survey. Forecasts show no evidence of heightened credibility. Forecasts for 1981 made in 1980 eventually exceeded actual inflation. Forecasters remained skeptical that the new program would succeed. Interest rate reduction in the spring of 1980 probably reduced credibility. Many observers saw it as a repeat of the response to a rising unemployment rate that ended previous attempts to reduce inflation.
What should the FOMC do? The more hawkish members, Coldwell and Wallich, wanted to reduce the M1 growth rate to 4 percent. Partee and Teeters opposed any additional increase in interest rates as the economy headed into recession. The compromise called for 4.5 percent money growth with the federal funds rate range unchanged at 11.5 to 15.5 percent. Although the Committee was divided, the vote was unanimous.
39. Volcker anticipated increases in the CPI for the next three months including some large increases (FOMC Minutes, January 8–9, 1980, 32). Monthly CPI inflation rates rose from 12.6 percent in December 1979 to 17.1 percent in January and March 1980. March 1980 was the peak monthly and twelve-month rate of reported CPI inflation.
The new procedure and the high variability of money growth forced some desirable changes in operations. The staff set monetary targets for a quarter ahead that, it believed, were consistent with its annual target. The FOMC gave attention to the credibility of its announcements of annual targets. Several expressed concern that “few people in the financial markets . . . believe that we’re going to stick with the policy we announced October 6th” (ibid., 66).40
The FOMC could not decide on the relative weight to place on interest rates and money growth. Lawrence Roos (St. Louis) wanted to ignore rate fluctuations to concentrate exclusively on money growth. Most others disagreed. The staff argued that interest rates and availability of credit affected decisions, so they could not be ignored. Henry Wallich wanted to avoid negative real rates in recession, and Robert Black (Richmond) expressed concern about effects on the exchange rate and foreigners’ interpretations of policy.
40. President Morris (Boston) accepted part of the monetarist claim that traditional policy was procyclical. “Traditionally, following our earlier pol
icies, we have supplied very little monetary growth in the early part of a recession. We have encouraged a sharper decline in the economy thereby. We lagged in reducing interest rates and then when the unemployment rate got really high, we turned around and produced very rapid rates of growth in the money supply. That led to very big swings in the economy, which I think are counterproductive in the long run to controlling inflation” (FOMC Minutes, January 8–9, 1980, 72).
The FOMC did not reconcile the different positions. Although it did not discuss how much fluctuation in interest rates it would tolerate, it made public the inter-meeting interest rate band in the delayed publication of the directive. This neglect, or deliberate omission, made the policy less transparent than it could have been. Although FOMC members worried about credibility, they would not agree with Mark Willes’s frequent statements that, in effect, warned that to be more effective the System had to decide upon and announce a coherent strategy.
Goals and Control Procedures
The Federal Reserve did not announce or choose a long-term goal for inflation. Nor did it specify whether its goal was to end the sustained rate of inflation resulting from excessive aggregate demand or, in addition, to prevent the price level increase resulting from the oil shock. In fact, they did not distinguish the two in their discussions.41
A History of the Federal Reserve, Volume 2 Page 51
