A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  59. During July the Board removed special deposits and other parts of the credit control program.

  After credit controls. The Board’s staff expected the decline in GNP to continue for the rest of the year. This forecast, too, proved incorrect. Real GNP remained unchanged in the third quarter (0.3) and rose at a 5.2 percent rate in the fourth. Beginning in June, money growth turned strongly positive (see Chart 8.6 above). By August, industrial production began to rise; it increased at a 13 percent average annual rate in the last five months of 1980. The brief, sharp recession was over.

  Gradually and for some reluctantly, the FOMC reduced the funds rate. The discussions showed that for several members, control of money growth was one of several objectives, not the most important means of controlling inflation.60 Roos (St. Louis), supported by Guffey (Kansas City), objected. “We are getting right back to setting interest rate ranges and the stabilization of interest rates. . . . I think we’re turning the corner, all for the worse, to right back where we were” (ibid., 42).

  Volcker took an eclectic, pragmatic position. “When I look at all these risks, what impresses me is that the greatest risk in the world is not whether we miss our targets or not. I don’t want to miss our targets, but we have to put that in perspective of what is going on in the rest of the world. I don’t think we can avoid some judgment about what we should do to minimize those risks” (ibid., 28). He also repeated his skepticism about forecasts of money growth and interest rates that he made at almost every meeting. “I yielded to nobody in my skepticism about these things. I am equally skeptical of anyone else’s projections—maybe even more so, if that’s possible” (ibid., 29). But he did not propose greater emphasis on longer-term projections or improved monetary control.61

  60. There was not a clear consensus. Henry Wallich expressed the position of several others by describing the policy as an interest rate control policy. “The money supply is a means of getting [desired] interest rates. . . . [I]f we say that we don’t want interest rates to move outside a certain range then it seems to me that we’ve made the judgment that interest rates are to prevail up to a certain point” (FOMC Minutes, May 20, 1980, 12). Earlier in the discussion, Solomon asked Volcker whether the manager increased nonborrowed reserves to compensate for lower borrowing. Volcker replied, “It’s possible” (ibid., 11–12). Teeters and Wallich also expressed concern about the depreciation of the dollar, citing criticism of U.S. policy by the IMF.

  61. The markets recognized that the Federal Reserve had gone back to managing the funds rate. Henry Wallich said, “I keep hearing about market perceptions that we have moved back to a funds rate objective with a very narrow range.” Paul Meek from the desk staff replied, “Yes, I think there has been some feeling in the market to that effect” (FOMC Minutes, July 9, 1980, 8).

  Volcker’s behavior and his explanation contrasts with what he told Congress the previous February. “The 1979 experience . . . underscores how limited our ability is to project future developments. It reinforces the wisdom of holding firmly to monetary and other economic policies directed toward the evident continuing problems of the economy—of which inflation ranks fi rst—rather than reacting to possibly transitory and misleading movements in the latest statistics or relying too heavily on uncertain economic and financial forecasts” (statement to the Joint Economic Committee, Board Records, February 1, 1980, 2). In a break with tradition, and in an implied criticism of the Carter and Nixon administrations, he rejected the idea that inflation could be reduced by cooperative action by labor unions and businesses. “Experience here and abroad confirms that such programs cannot be the backbone of an anti-inflationary policy. And let us also appreciate, and avoid, the risk that such programs may lull us into thinking that they are a substitute for monetary and budgetary discipline; in that event, the net effect would be counterproductive” (ibid., 15–16). Volcker also proposed letting the oil price increase to reflect its scarcity.62 Oil had remained under price controls since the Nixon general price controls.

  At the July meeting, FOMC members had to reach a first conclusion about the projections of growth, inflation, the unemployment rate, and the monetary aggregates for 1981. They could revise their projection in February, but the initial announcement affected public and market anticipations. Members were more reluctant than usual to announce their views. Nationwide NOW accounts would become effective in January 1981. Payment of interest on household deposits would change some of the monetary aggregates. Non-member banks, thrift associations, and credit unions had to hold reserves equal to member bank reserves, but some could hold their reserves at the Federal Home Loan banks, at the Credit Union National Association, or at member banks. In turn these institutions held larger reserves at the reserve banks. Correctly estimating the effect on reserves was difficult, even impossible. The large decline in money during the second quarter might continue or reverse. In July the Board ended the 2 percent supplementary reserve requirement ratio imposed in November 1978 (Annual Report, 1980, 77–80). In the real economy, the oil shock, productivity growth, and the recession made forecasting unusually difficult. The new operating procedures and the greater weight given to lower inflation affected anticipations, but the members were uncertain about the magnitude and timing of the effect.63

  62. The administration continued to invoke wage-price policy, but Federal Reserve officials had changed positions. Partee said, “On wage-price control, I would get rid of that program as soon as possible. I think it is totally discredited in the country” (FOMC Minutes, July 9, 1980, 43).

  The uncertainties that concerned FOMC members and staff were fully justified. By July 1981, the Monetary Control Act added more than 8,000 weekly reporting banks and 8,500 quarterly reporting banks as holders of required reserves. The act included also the Public Sector Adjustment Factor, requiring the reserve banks to price payment services to cover costs and imputed private sector profits. This was the price paid to the large banks for accepting the Monetary Control Act (Guenther, undated, 3). The act also removed state usury ceilings, many of which prevented lending because they did not adjust to inflation. To protect states rights, the states could choose to reenact the ceiling. All depository institutions became subject to a 12 percent reserve requirement ratio for transaction accounts. At institutions with less than $25 million of transaction deposits, the ratio was 3 percent. These changes, too, affected the supply and demand conditions for different deposits.64

  All of the reserve banks had submitted their forecasts for 1981 with and without a tax cut in 1981. Table 8.2 shows the substantial difference in FOMC forecasts and forecasts by the Council of Economic Advisers. The table shows that the Board’s staff forecast and the median forecast by the presidents were not far apart, but both differed from the CEA. Since the CEA forecast was their last forecast before the presidential election, they may have wanted to show economic recovery and a decline in the unemployment rate; in any case, the CEA showed a much stronger recovery in 1981 than the presidents or the staff.65 The CEA forecasts were not as optimistic as the forecasts President Carter had received earlier from the CEA.

  63. Several members remarked that the past practice of accepting misses in the money growth targets and using the higher level as the base for the next target had greatly reduced the credibility of their announcements and made it imperative to correct excesses and shortfalls. But they didn’t change.

  64. Following legislation such as the Monetary Control Act and subsequent banking legislation, bank and thrift mergers and failures reduced the number of financial institutions. After several efforts to charter a banking regulatory agency, against the wishes of the Federal Reserve, Congress accepted an agreement between the Treasury and the Federal Reserve giving the Federal Reserve more responsibility.

  The Federal Reserve forecast was pessimistic about inflation. It anticipated 8 percent or more. The CEA was even more pessimistic about inflation. These announcements did not add to public confidence in the program.


  The FOMC faced a dilemma. If it provided enough money growth to remain consistent with the CEA forecast, money growth targets would have to rise. Raising the target however, would further reduce the credibility of the anti-inflation policy. After extended discussion, the FOMC decided to keep unchanged the targets or objectives for 1980—4 to 6.5 percent for M1B and 6 to 9 percent for M2—but to stress the uncertainties and avoid specifying numerical values or ranges for 1981. Volcker was aware that members of Congress wanted quantitative estimates, but he was not prepared for their reaction. Senator Proxmire, writing for the Banking Committee, asked the FOMC to reconsider. His letter pointed to the discussion in the Senate committee report prepared at the time the Senate considered Humphrey-Hawkins legislation. The report spoke of “numerical monetary targets for a fixed calendar year” (FOMC Minutes, July 25, 1980, 1). The FOMC agreed to restate its many uncertainties but to announce growth rates 0.5 percentage points below the 1980 targets (ibid., 6–7).66

  65. By law the Federal Reserve had to explain how its policy would achieve the government’s forecast. At about the time of the July meeting, the Board’s staff did some computations to estimate the probability that the Board’s policy was consistent with the administration’s targets for unemployment and inflation. The staff used its econometric model to compute the probability that both unemployment and inflation fell within one percentage point of the 1980 and 1981 targets. The probabilities were 18 and 7 percent for the two years (staff memo, Board Records, July 7, 1980).

  66. This excerpt from the FOMC’s record suggest some of the uncertainty in the Committee.

  Ms. Teeters. . . . We’ve been bringing the rate of money supply growth down for the past four years and inflation has been going up. What is a non-inflationary rate of growth in the money supply?

  Mr. Roos. There is a lag though, Nancy, isn’t there?

  Mr. Rice. We don’t know. We will keep bringing it down until we find out.

  Ms. Teeters. We don’t know.

  Chairman Volcker. It must be lower than what we’ve had.

  Mr. Partee. Or we have to do it longer. (FOMC Minutes, July 9, 1980, 76)

  Some of the difference of opinion at this and other meetings appears to reflect differences in the way members analyzed or thought about inflation. Some, like Governor Teeters, used a Phillips curve, so they believed that lower inflation required higher unemployment, especially in the short-run. Others put greatest weight on expectations and credibility. They believed that once the public and markets became convinced that the System gave priority to reducing inflation, inflation rates would fall and unemployment would fall also. The FOMC never explicitly discussed issues of this kind and, as was typical in the past, made no effort to resolve analytic differences. The big change was that, to greater or lesser extent, emphasis shifted from the unemployment rate to the inflation rate. There was general agreement at last that the Federal Reserve was responsible for inflation. Differences about the cost in unemployment that individual members accepted remained and were never explicitly discussed.

  With federal funds trading at 9 percent in July, the Board approved two one percentage point reductions in the discount rate, adding to the belief in financial markets that the anti-inflation policy had ended at least temporarily. By September 2, all banks posted a 10 percent discount rate. Rescinding the two percentage point addition to reserve requirement ratios at large banks also signaled easier policy in July. The reductions weakened the dollar exchange rate; the Federal Reserve and the Treasury sold foreign exchange.

  Lyle Gramley took the position vacated by Phillip Coldwell at the July meeting. In August, William Ford (Atlanta) and Gerald Corrigan (Minneapolis) joined the FOMC meeting.67

  End of the Recession

  The National Bureau of Economic Research dated July as the trough of the 1980 recession. In August, the Board’s staff recognized that auto sales increased in July and that the rate of economic decline slowed. By midSeptember, based on August data, it raised its forecast for the third quarter and anticipated that “the trough in activity will be reached soon, if it hasn’t already occurred” (FOMC Briefing, FOMC Minutes, September 16, 1980, appendix). The staff underestimated the strength of the recovery, however.

  The Standard & Poor’s index of equity prices turned in May. By August, it was 30 percent above its previous year’s level, and the index of industrial production rose 14 percent. Treasury bill yields, after reaching a peak at 15.5 percent in March, declined to about 6.5 percent in June. By late August, these yields had rebounded to near 10 percent.

  67. Once again, there was a leak to the press. Volcker threatened to reduce the number permitted to attend, but as on several previous occasions, the threat was reluctant and empty.

  Despite the decline in interest rates, policy remained procyclical as in past recessions. Growth of money and credit declined; growth of the real monetary base remained negative throughout the recession and did not start a sustained rise until the trough in July. Expected real long-term interest rates are an exception; they declined from April to July. Chart 8.4 above shows some of these data.68

  Beginning in July, the expected real interest rate began to rise. By yearend it had increased almost three percentage points. Judged by these rates, policy became severely restrictive and, as Chart 8.4 above shows, it became more restrictive in 1981, during the expansion early in the year and the recession that started in July.

  Once again, growth of the real base tells a different story, more consistent with events in the economy. Although real base growth remained negative throughout 1981, it reached a trough in April 1980, then started to increase, with one brief setback, until May 1981. It then began a sharp decline foreshadowing the next recession.

  The short 1980 recession had, at most, a modest effect on expected inflation. The measured rate of CPI increases reached a peak in March. The twelve-month moving average was 13.7 percent in that month. By August 1980, it was down to 12 percent. Much of the decline in the rate of increase represents the passing through of the one-time oil price increase. Average hourly earnings and the Society of Professional Forecasters’ inflation forecast show no evidence of a decline.69

  Divisions became more pronounced within the FOMC. In the first eight months, there had been five dissents, three of them by Henry Wallich who often favored a more restrictive policy, and two dissents favoring less restriction at the May meeting. After August, there were dissents at all six regular and telephone meetings. The vote in September and October was eight to four, with all the dissenters favoring tighter policy. The very rapid money growth during the third quarter made it difficult to hit the annual target of 4 to 6.5 percent for M1B. Most of the dissenters wanted more effort to achieve the target; they feared higher inflation and reduced credibility and believed both made it more difficult to reduce inflation. Beginning in November, Nancy Teeters dissented at the next four regular and special meetings. She favored lower interest rates and expressed concern about the recovery.

  68. Prodded by Governor Henry Wallich, the staff prepared a number of estimates of real interest rates and after-tax real interest rates. The latter assumed that the corporate tax rate was the relevant tax rate, a very doubtful procedure in view of the many tax-exempt institutions and the growing holdings of U.S. debt by foreign investors. The authors used four measures of expected inflation, including the average of the past three years, current inflation, and the Livingston survey. As in Chart 8.4, they found that real long-term rates were relatively high in 1980 compared to previous recessions (using three-year average inflation). As in the several charts used in the text here, the authors found “no easily discernible pattern in real rates during the initial quarters of an expansion” (“The Behavior of Real Interest Rates in the Postwar U.S. Economy,” Board Records, July 2, 1 980, 7). Short-term real interest rates were negative during the 1980 recession in most, but not all, the authors’ charts.

  69. At the time, the Shadow Open Market Committee expressed considerable
skepticism about the Federal Reserve’s commitment to its policy of controlling money growth in the first year (policy statement, Shadow Open Market Committee, September 22, 1980). The committee recommended elimination of lagged reserve accounting, prompt adjustment of the discount rates to market rates, and other changes in operating procedures. The House Banking Committee also called on the System to fix the discount rate to a market rate (FOMC Minutes, August 15, 1980, 12).

  Volcker tried to find a compromise that would draw a majority. At one point, he expressed the difficulty as he saw it.

  As one market caller put it to me the other day, if the money supply really goes up very sharply for a couple of weeks, we will have big increases in long-term interest rates. I think that is descriptive of the kind of dilemma we are in. I don’t know how we get out of that without going through a painful process of deflating the inflationary expectations, which are not deflated yet. And I don’t know how they get deflated without deflating the economy more than one would like to see it deflated. I don’t have a ready answer to that. (FOMC Minutes, January 8–9, 1980)70

  In February, Volcker told Congress: “Dealing with inflation has properly been elevated to a position of high national priority. Success will require that policy be consistently and persistently oriented to that end. Vacillation and procrastination, out of fears of recession or otherwise, would run grave risks” (Federal Reserve Bulletin, 1980, 214).