Monetarists argued that the proper goal was to end excessive aggregate demand by immediately slowing the rate of increase in the monetary base to a steady 6 percent rate (Shadow Open Market Committee, 1979 and 1980). The oil supply shock would pass through the economy; the price level would remain higher but the result would be a one-time increase spread over time. By trying to prevent the one-time price level increase, the Federal Reserve would use monetary policy to offset a real shock. This would require additional loss of output.42
The FOMC discussed lagged reserve accounting at its February 1980 meeting. No one disputed that lagged accounting made control of money under nonborrowed reserves target more difficult. The Board’s staff report repeated and strengthened its earlier conclusions: it favored contemporary reserve accounting. However, most of the presidents believed that member banks generally favored lagged reserve accounting. The account manager, however, “came out feeling that there is not all that much advantage to it” (FOMC Minutes, February 4–5, 1980, 4).
41. To respond to frequent complaints about the opacity of their control procedures, the Board’s staff prepared a memo describing procedures more fully. The memo emphasized the judgments that the staff had to make when deciding on the reserve path. Their procedure involved estimating the currency drain, the spillover into non-member bank deposits and into CDs that were not part of M1 or M2. One of the weakest links was the estimate of borrowed reserves. The staff assumed that borrowed reserves would remain “close to the level prevailing around the time of the FOMC meeting, though varying a little above and below that level” (memo, “The New Federal Reserve Technical Procedures for Controlling Money,” Federal Reserve Bank of New York, Box 97657, January 30, 1980).
42. Economic theory does not conclude that price level stability—rolling prices up or back following one-time shocks—is preferred to constant expected inflation. The latter leaves the price level to vary as a random walk but maintains zero expected inflation for long-term planning.
The members divided on the issue. Those who spoke in favor usually added that they would not act immediately. Congress had under consideration legislation that would increase System membership. They did not want a ruling that agitated the banks. The FOMC took no vote and made no change.
In February 1980, Volcker testified again at Joint Economic Committee hearings. He reinforced and reiterated his main themes—infl ation control had to have priority. This time he emphasized that forecasts were not very reliable. A major failing in the past came from “relying too heavily on uncertain economic and financial forecasts” (Volcker papers, Board of Governors, February 1, 1980, 2). He attributed many of the failures to “transitory and misleading movements in the latest statistics” (ibid.).43 But neither he nor his successors followed a strategy that minimized short-run influences on their actions.
The 1980 Recession
The National Bureau of Economic Research set January 1980 as the start of a mild six-month recession. Real GNP declined 2.5 percent, and the unemployment rate rose to a peak rate of 7.8 percent. Using a common unofficial measure of recession, two consecutive quarters of negative growth, the 1980 experience does not qualify as a recession.
Both the administration and the Board staff expected a recession at the February meeting. The staff was pessimistic about the depth of the recession, but they expected a larger decline in reported inflation, from 11.4 percent in 1980 to 8.6 percent in 1981.
The changed attitude on the FOMC became apparent. Despite the prospect of recession, the FOMC majority favored slower money growth. Governors Teeters and Partee favored an easier policy, but went along with the consensus. Many spoke about the uncertainty caused by redefinition of the aggregates, the oil shock, hostages in Iran, an election year tax cut, and differing outlooks for economic activity and inflation. But their own credibility and public commitment to slow money growth and inflation was a strong force favoring slower money growth.44
43. Later, he described forecasts as equally likely to be right or wrong. He emphasized control of monetary aggregates, lags in response, and determination to continue anti-inflation policy (Volcker papers, Board of Governors, Summer 1980).
Several favored a wider band on growth of the aggregates to recognize their uncertainty and increase the prospect of meeting their targets. Mark Willes (Minneapolis) made the opposite case. “If the time pattern of the economy is very unpredictable, then there’s no way we can respond to change it in a predictable way and, therefore, we ought not to be responding. We ought to respond less rather than more, the greater the uncertainty about the outlook” (ibid., 51). He favored picking a long-run non-inflationary path for money and keeping to it. His comment drew no response. Most of the others argued as usual over small differences in the annual growth rates for the various aggregates. The Committee, with two dissents, voted for a quarterly target of 5 percent for M1B and 6 percent for M2. Governors Wallich and Coldwell dissented because they wanted a more restrictive policy for the next quarter. They agreed with the annual targets of 4 to 6.5 and 6 to 9 percent for M1B and M2 growth.
The Board’s Humphrey-Hawkins procedures required the System to announce its macroeconomic projections for the current and following year. The projections gave a range for inflation and real growth. The unusual feature was a relatively deep projected recession in 1980, as much as −5 percent for the year with a slow recovery in 1981. The FOMC expected the unemployment rate to rise to 8.5 percent by year-end 1980 with little change in 1981. The actual rate was 7.2 percent in December. Projections of inflation proved more accurate and no less pessimistic. For 1980 and 1981, the projected ranges reached 9 to 10 and 7.75 to 9.5 percent. Actual changes in the deflator were 9.5 and 8.6, in the middle of the projections.
Money grew more rapidly than anticipated in February. On February 22, the FOMC held a telephone conference to authorize an increase in the upper limit of the federal funds rate to 16.5 percent. A group that only narrowly approved an 11 percent discount rate in September for fear of recession voted unanimously for an upper limit of 16.5 percent for the federal funds rate after the recession started.
44. The February meeting came before President Carter asked for credit controls. Governor Frederick Schultz commented: “In the area of consumer credit, more and more banks are cutting back on the availability of consumer credit and are increasing the price and other factors. . . . Sears and Penneys and others have recently made those kinds of announcements” (FOMC Minutes, February 4–5, 1980, 43).
The monetary aggregates continued to increase above their short-term targets, and the federal funds rate approached the ceiling as the manager worked to reduce reserve growth. At a March 7 telephone conference, Volcker asked the FOMC to ratify an increase in the ceiling rate to 17.5 percent that he had made and to approve an 18 percent ceiling. The main issue was whether the lower bound should remain at 11.5 percent. Those most concerned about unwillingness to respond to recession wanted to avoid raising the lower bound. The FOMC cancelled its approval of the 17.5 percent ceiling and unanimously agreed to the wider band, 11.5 to 18 percent until their scheduled meeting on March 18. The funds rate was now four percentage points higher than ever before.
The discount rate remained at 12 percent, the rate set the previous October. With the federal funds rate at 17 percent, borrowing soared from $1.2 billion on average for January to $2.8 billion in March. The Board finally agreed to a one percentage point increase effective March 15 for nine reserve banks. By March 19, a uniform 13 percent discount rate was in effect. The action was late and insufficient. Heavy borrowing continued because the subsidy of about four percentage points made it desirable for banks to obtain reserves from the discount window.
For the week ending February 29, the ten-year note yielded an average rate of 13.2 percent. During February and March, the rate remained between 12 and 13 percent. Treasury bill rates reached a local peak of 15.37 percent on March 7. Banks could profitably borrow from reserve banks to hold Treasury bills.
To put these interest rates in perspective, compare them to peaks in Macauley’s yields on American railroad bonds, 6.37 and 6.52 percent in 1865 and 1869 for longer-term yields. For shorter-term yields, at the earlier peak in 1873, a year of panic, stock exchange call loans averaged 14.2 percent. Of course, these are nominal yields. In 1981 consumer prices rose at 16 and 17 percent annual rates in February and March, and the Federal Reserve minutes report rising anticipations of inflation and skepticism about the effectiveness of the System’s policy. Market participants are an impatient lot. After five months of rising inflation rates, they were not reticent about making their concerns known.
Chart 8.2 above compares long- and short-term nominal interest rates during the years of rising inflation. The negative spread in early 1980 has similar order of magnitude to the spread during the 1970s recession. On this measure, Federal Reserve policy is about as restrictive as in 1973–74 but not more so. Long-term rates rose with short-term rates but less than short-term rates. Nevertheless, the rise in long-term rates and the size of the increase disappointed Volcker and his colleagues (Volcker and Gyohten, 1992, 170).45
Chart 8.4 compares annual growth of the real value of the monetary base to the inflation-adjusted (real) long-term interest rate. The two series move toward restriction in 1979 and early 1980 under the common influence of a rising expected inflation rate. Comparison with the 1970s recession (or the 1950s and 1960s) shows more accurately the severity of the restrictive policy. Real monetary base declined at a 6 percent rate. Real long-term rates hardly changed in the 1970s; in 1980, this measure of the real rate rose sharply to about 6 percent or more.
Chart 8.5 brings out more fully the effect of inflation. While the Federal Reserve struggled with little success to control the monetary aggregates, rising inflation sharply lowered their real growth. Judged by growth of the nominal base, the new monetary policy accomplished little. Annual growth of the nominal base rose from 7.7 percent in October to 8.2 percent in March. Real base growth, however, turned negative early in 1979 and continued to decline until March–April 1980. Thereafter, the real value of the monetary base continued to fall, but the rate of decline slowed. The chart shows the persistence of policy. Real base growth remained negative for 3.5 years. It did not become positive until mid-1982, just before economic recovery at a time when nominal base growth rose and the real rate (Chart 8.4) declined.
45. Lindsey, Orphanides, and Rasche (2005, 209–10) quote Volcker and other FOMC members as satisfied with the progress and the “success” of the new procedures in January 1980. This is probably a reference to slower money growth. They also report the support of Senators William Proxmire and Jake Garn of the Banking Committee for the aggressive policy. Proxmire expressed hope that the FOMC would continue the policy in a presidential election year.
The unemployment rate started to rise in the new year, but the rise was modest, reaching 6.3 percent in March. Unlike previous recessions, the rise in the unemployment rate did not create substantial pressure on the president and his administration. High nominal interest rates did. Principal members of Congress remained committed to an anti-inflation policy, but some criticized alleged monetary orthodoxy and blamed it for the level of interest rates. They hoped to slow spending at lower interest rates. They urged the president to use the powers granted in the 1969 Credit Control Act to ask the Federal Reserve to control consumer credit.
Responding to the criticism, on March 14, 1980, the Board split the discount rate by authorizing a three percentage point surcharge for banks with more than $500 million in deposits. With the funds rate at 17 percent or higher, the subsidy to borrowing remained. The Board renewed the basic discount rate at 13 percent to help smaller banks. Some members wanted a higher basic rate, but the majority opposed. The main reasons were concerns about congressional pressure, agricultural credit, and the slowing economy. The surcharge remained in effect until May 6, when eight banks voted to remove it. Henry Wallich opposed the decision. He believed that the market would interpret the decision to eliminate the surcharge and reduce the federal funds rate as an end to the anti-inflation policy.46
The idea of using credit controls spread. Thomas Timlen, acting president of the New York bank, reported on a meeting with business executives. They urged the System to control credit directly—not just any credit, or all credit, but consumer credit. They wanted limits on the “ability of consumers to borrow” (FOMC Minutes, March 7, 1980, 5).
Volcker opposed credit controls. He spoke publicly about his opposition. “I am not in favor of taking any direct measure to control consumer credit, or indeed, any other type of credit” (Volcker papers, Federal Reserve Bank of New York, address to the National Press Club, January 2, 1980, Box 97657, 3). He offered several reasons why controls would be hard to administer and ineffective. He asked: how could the Federal Reserve restrict people from using their credit cards?
A year before, on March 13, 1979, Charles Schultze prepared a memo on credit controls. He recognized the problems of administering controls, the disproportionate effect on lower-middle income groups, and the loss of employment in automobile production if controls increased down payments or shortened maximum duration of loans. He was not positive, but he did not recommend against controls (memo, Schultze to the Economic Policy Group, March 13, 1979, 7–8).
At a congressional hearing in December, Congressman John Cavanaugh asked Volcker about reserve growth, pointing out that the reason the System had difficulty controlling money growth came from the failure to control reserve growth. Volcker replied that the System controlled nonborrowed reserves. Cavanaugh asked whether borrowing also supported money growth. Volcker replied that borrowed reserves were different than nonborrowed, using the flawed Riefler-Burgess reasoning. “Banks are reluctant to borrow, and the mere fact of borrowing will exert some restraint” (Clark, Wall Street Journal, December 9, 1980, 1). Then, he added, “Relatively little borrowing doesn’t exert much restraint. Relatively large borrowing exerts a lot of restraint. We now have—are back in the position of having a relatively large amount of borrowing, and there is a lot of restraint on the market.” As Clark noted, the large volume of borrowing resulted from the wide gap between the discount rate and the federal funds rate.
46. On April 14 the Board voted down a request from the Cleveland bank to increase the discount rate by two percentage points. On June 12, the Board reduced the discount rate to 10 percent, and it renewed the surcharge at two percentage points. The Board again began to raise the discount rate on September 15. Governor Teeters opposed. By year-end, the discount rate was back to 13 percent with a three percentage point surcharge.
The FOMC spent the winter raising the federal funds rate to contain money growth. Growth in February was far above target. Members expressed as much concern about the effect on market psychology and their credibility as on inflation, although the two were clearly related. Despite the recession, the dominant thrust at the March 18 meeting was to slow money growth; the FOMC agreed to let the federal funds rate vary between 13 and 20 percent.
Paul Volcker summed up the position that many of his colleagues took. “The worst thing we can do is to indicate some backing off at this point when we have an announced anti-inflation program.47 We have political support and understanding for what we have been doing. People don’t expect it to be too easy. . . . I would not give all that much weight to the degree of support we’re going to get if this is dragged out indefinitely and we have to go through this process once again” (FOMC Minutes, March 18, 1980, 36).48
Since the staff tried to control growth of nonborrowed reserves, banks borrowed at the discount window to acquire reserves. The manager’s report recognized the problem. “The level of borrowing remains one of the more difficult elements to cope with in our reserve targeting approach” (Report of Open Market Operations, FOMC Minutes, appendix, March 18, 1980, 2). Nevertheless, the Board continued to subsidize borrowing by holding the discount rate far below the federal funds
rate. Volcker gave one plausible reason—concern that an increase in the discount rate here would encourage foreign central banks to raise their interest rates (FOMC Minutes, March 18, 1980, 7).
Credit controls. Prodded by the congressional Democrats, labor unions, and others, on March 14 the president addressed the public on television. He announced additional reductions of $13 billion in spending to reduce the prospective budget deficit, and he told the Federal Reserve to impose credit controls on borrowing. Most of his economic advisers opposed, but the decision was made for political reasons to provide an alternative to high interest rates (Biven, 2002, 247).49
47. Governor Partee summed up the opposing position. “I would hate to have somebody ask me what I was doing during the crash and have to remark that I was defending our credibility” (FOMC Minutes, March 18, 1980, 34). Partee was the most outspoken advocate of low interest rates during the recession.
48. When Senator Byrd (West Virginia), the majority leader, criticized Federal Reserve policy, the chairman of the Banking Committee, Senator Proxmire, defended the Federal Reserve and pointed out that small depositors were big losers because interest rates were below the inflation rate. “There is no way you can do it without more unemployment, without some business failures you would not otherwise have, without serious farm losses” (quoted in Grieder, 1987, 150). The next day Byrd became more supportive.
The Federal Reserve opposed but did not resist. It drafted the new regulations. Schreft (1990, 33) claims that the Federal Reserve planned for the controls in February, before the president acted. Paul Volcker participated fully in the detailed budget discussions and in the credit controls decision;50 the members were not surprised.
A History of the Federal Reserve, Volume 2 Page 52
