Sprinkel, Regan, and Jordan pressed Volcker and the Federal Reserve to maintain a steady, gradual decline in money. When Volcker spoke publicly, he used similar language, but the Federal Reserve did not adopt any of the procedural changes that would have smoothed money growth, and the monthly money growth numbers varied over a wide range.105 After slowing in March, money growth surged in April. Despite a rising unemployment rate and slower growth of hourly earnings and consumer prices, the FOMC raised discount rates from 13 to 14 percent on May 4 and increased the ceiling for the federal funds rate at a telephone conference on May 6. Federal funds again traded at 18 to 19 percent. Money growth reached a 14 percent annual rate in April, and ten-year Treasury bonds rose to a local peak at 14.46 percent on May 8.
102. Perhaps because there was now very little to do as manager of foreign transactions, Scott Pardee resigned in July to accept a position at a dealer firm. Sam Cross replaced him.
103. Congress had approved legislation to phase out ceiling rates on deposits, but the Board continued to enforce ceiling rates in 1981. The Comptroller uncovered a blatant example of evasion by Citibank. On July 8 the Board voted unanimously to impose the largest civil penalty ever charged a banking institution, $350 thousand. In addition, the Board voted to publicly announce the fine and the reasons for the decision. The Board’s rules permitted banks to offer up to $5 as a premium for a deposit up to $5000 and $10 for larger deposits. The Comptroller found that some Citicorp employees knowingly violated these guidelines.
104. The remaining dissent objected to the “unrealistic sense of precision” in stating money growth rates (Annual Report, 1981, 145–46).
“Members commented on the considerably greater strength in activity in the first quarter [of 1981] than had been expected, and they continued to stress the difficulties of economic forecasting currently and the importance of adhering to longer-term objectives” (Annual Report, 1981, 110). With the unemployment rate in the neighborhood of 7.5 percent throughout the spring and summer, this was a major step toward increased credibility. But they did not change procedures to reduce forecasting errors, and they made no new effort to focus on longer-term goals. Several members gave much greater attention to current changes in the federal funds rate than to the maintained money growth path. To reduce the very rapid money growth in April, the May 18 meeting set a 3 percent growth rate for M1B and agreed to accept slower growth, if the federal funds rate remained in the 16 to 22 percent range.106
105. Privately, several members were skeptical about the administration’s policies. Anthony Solomon (New York) asked rhetorically if the president would abandon his tax reduction and defense increase in the interest of a balanced budget. Vice Chairman Schultz and Governor Partee talked about the upbeat approach taken by the president and the administration.
“Mr. Schultz: If they would talk in a little more practical way, I think it would help.
“Mr. Wallich. I think they believe this. I have heard this now for a week from Beryl Sprinkel. Everything will be easy, if the Fed just keeps the money supply . . .
“Mr. Boehne. . . . If we have problems, it’s the Fed’s fault.
“Mr. Wallich: That’s exactly it” (FOMC Minutes, May 18, 1981, 25).
Roos (St. Louis) reminded them that the monetarists said there was no painless way out of the inflationary excesses, but the others paid no attention.
106. Volcker was clear about his intention. “Suppose we have a happy day and those late May figures come in rather low and it looks as if, indeed, we may come in lower than 1 percent for May and June with interest rates not rising and maybe falling. . . . I myself would be rather happy. And, therefore, I would not want to be pushing out money if the growth rate happened to come in, let’s say, at zero in May and June, if interest rates were already stable or declining” (FOMC Minutes, May 18, 1981, 37). When June came, however, he changed his mind. “Up until now, we’ve reduced the reserve path somewhat to reflect the [3 percent] ‘or lower’ part of the directive. There is a question of whether we should continue doing that, given the current situation, and I don’t think we should” (FOMC Minutes, June 17, 1981, 1). Money growth fell 3 percent in May and rose less than 1 percent in June; the April–June average was 4 percent. The funds rate remained at a 19 percent average in July.
Once again, the contrast between procedures and decisions is apparent. The Federal Reserve continued to act against inflation as it had never acted before. The federal funds rate rose above a 17 percent monthly average for the third (and last) time. Between May and August 1981, it remained between 17.8 and 19.1 percent for four months.107 Maintaining these extraordinary rates despite 7.5 percent unemployment must have convinced skeptics that policy had changed. Annual growth of the monetary base reached a local peak in April at 8.16 percent. By October, it had fallen below 5 percent, and the annual rate of CPI inflation permanently fell below 10 percent. Federal Reserve policy began to show results.
By July, Volcker cautiously suggested that “there are some signs of progress on inflation and inflationary psychology. . . . [I]t’s still in the maybe stage. . . . [H]ard as it is to say, . . . the lesser risk in the long run is taking a chance on more sluggishness in the short run rather than devoting all our efforts to avoiding the sluggishness in the short run” (FOMC Minutes, July 7, 1981, 35). Responding to the recession would put them “back into the kind of situation we were in last fall where we had some retreat [increase] in inflationary psychology and the latent demands in the economy immediately reasserted themselves. Then we would look forward to another prolonged period of high interest rates and strain and face the same dilemmas over and over again” (ibid., 35). Although they were likely to overshoot the annual M2 target, he proposed no change in objective for the year. After much discussion, the FOMC agreed without dissent.
Chart 8.8 supports Volcker’s interpretation. Although the GNP deflator is highly variable during this period, its peak at 12.1 percent came in fourth quarter 1980. Growth of hourly compensation also reached a local peak in that quarter. As Chart 8.8 shows, growth of hourly compensation slowed steadily in 1981 and 1982. The twelve-month moving average increase in consumer prices fell below 9 percent for the first time in three years.
The Federal Advisory Council (FAC) supported the policy stance. At its April 30, 1981, meeting, it urged the Board to “avoid a repetition of 1980 when explosive growth of the money supply occurred for five or six months. To allow such an occurrence again would greatly hinder the badly needed restoration of the financial markets’ confidence that a proper monetary policy will be carried out” (Board Minutes, April 30, 1981, 6). It urged the Board to de-emphasize the federal funds rate. In November, FAC congratulated the Federal Reserve on its strengthened credibility.
A major difference between 1980 and 1981 was the support of the administration and the Congress. There was not much pressure to change policy. President Reagan was firmly committed to low inflation and price stability. His main monetary action was appointment of the Gold Commission to satisfy the proponents of a return to gold. Anna J. Schwartz became executive director. The commission members included Federal Reserve governors who opposed the idea, so it was unlikely to conclude that the United States should return to the gold standard.
107. The June 1981 rate of 19.1 percent is the highest in Federal Reserve history.
A surprising feature of the decline in inflation was the speed with which it occurred.108 Although the Federal Reserve began its anti-inflation program in October 1979, it had to start over again in the fall of 1980. Part of the decline in consumer price inflation resulted from the end of the oil price increase, but compensation was much less affected, so it provides a more accurate measure of progress. See Chart 8.8 above. And with the unemployment rate above the natural rate, it occurred without much change in the unemployment rate—7.5 percent in October 1980 and 7.9 percent in October 1981. Thereafter the unemployment rate continued to rise as the inflation rate fell.
The majority chos
e to stay the course. Looking forward to 1982, in July 1981 the Committee lowered the target M1 growth rate to 2.5 to 5.5 percent and kept M2 planned growth at 6 to 9 percent as in 1981. It discarded M1A and renamed M1B as M 1 . Teeters dissented. She objected to the decision to reduce M 1 growth.
108. Blinder reports an estimate by Otto Eckstein, a leading Keynesian economist and forecaster. Eckstein claimed that lowering inflation by one percentage point would require ten years of high unemployment (Blinder, 2005, 283). This implies that reducing inflation from 8 or 9 percent to 4 or 5 percent would take about forty years!
The Board prepared for a possible financial crisis. In July, it accepted in principle a proposal from the Federal Home Loan Bank Board that the System offer extended credit to members of their system, not including thrift institutions. After rejecting proposals for higher rates for extended credit, the Board on August 20 approved a proposal from Dallas to increase discount rates for borrowing for longer term and to assist thrift institutions with “sustained liquidity problems” (Board Minutes, August 20, 1981, 3).109
During the summer, some reserve banks pressed repeatedly for a reduction in the surcharge for large borrowers. The Board did not agree until September 21, when it reduced the surcharge from four to three percentage points. Governor Wallich dissented because the change might be interpreted as easing. To forestall that interpretation, the Board tightened the rule. Originally banks with deposits of $500 million had to pay a surcharge if they borrowed four weeks in a calendar quarter. Thereafter, the surcharge applied to a moving quarter. On October 9, the Board reduced the surcharge to two percentage points. The economy had slowed, and member bank borrowing was 50 percent of its May peak.
As the economy and money growth weakened, several reserve banks continued to urge either eliminating the surcharge or reducing the discount rate. The Board deferred the proposals until October 30, when it reduced the discount rate to 13 percent. Two weeks later, it removed the surcharge, but it voted to keep the discount rate unchanged. The federal funds rate had fallen below the discount rate, and borrowing had fallen from $2 billion in June to $600 million in November. By December 3, the discount rate was at 12 percent.110
The National Bureau of Economic Research dates the 1981–82 recession from July 1981 to November 1982. Unemployment rose steadily from 7.2 percent of the labor force at the start to a postwar peak of 10.8 percent in November and December 1982. This was the highest unemployment rate in the postwar years. Although the recession was deep, two of the five quarters show positive real GNP growth. Table 8.10 shows data for real GNP growth and inflation.
109. The Board set the rules for pricing reserve bank services. The Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) required the reserve banks to charge for services to member banks. For example, the Board retained control of pricing for automated clearinghouse (ACH) transactions and wire transfers. Later in 1981, it established rules to maintain competitive pricing with the profit-making private sector. To compensate for profits and taxes paid by the private sector, the Board required reserve banks to charge a 16 percent adjustment factor in 1982.
110. Starting in August the Board again discussed a return to contemporary reserve accounting at several meetings. In late October, it agreed to submit a proposal for public comment. It made no change at the time.
Growth of the M1 money supply continued to be variable, but the general direction was toward slower growth. By March 1982, the twelve month moving average was below 6 percent, where it remained until September 1982. The federal funds rate declined very slowly. Despite the recession, it remained 14 percent through the winter and spring of 1982. The Federal Reserve was determined to avoid repeating the 1980 error in anti-inflation policy, so it did not reduce the rate.
The relatively high real interest rate and slow growth of money despite the recession increased the Federal Reserve’s policy credibility. Unlike in all recessions since the 1960s, the Federal Reserve gave principal weight to reducing inflation, not to rising unemployment. By December 1981, Vice Chairman Schultz found on a trip to New York that “the credibility of the Federal Reserve is much higher than it has ever been before” (FOMC Minutes, December 21, 1981, 22). But, he reported, if they shifted to a more expansive policy, the market would react strongly, and credibility would be lost.111
Volcker gave many speeches during this period emphasizing a few prominent monetarist themes. The fight against inflation had to continue. Previous efforts failed because the Federal Reserve relaxed policy too soon. And the new message: “Inflation is destructive of our economic goals of stronger growth in real incomes, productivity and employment” (Volcker papers, Board Records, September 25, 1981, 2). Inflation was not a “pep pill” that permanently increased employment and output. “Failure to carry through now in the fight on inflation will only make any subsequent effort still more difficult” (ibid.). His aim was to bring down “excessive growth in money and credit to the point where the supply of our dollars does not outrun the supply of real goods and services” (ibid., 3). He always added the importance of support from fiscal policy. And he recognized the importance of maintaining low inflation once it had been reduced.
111. Support for reliance on monetary aggregates continued to weaken. Frank Morris, a member of the Maisel Committee on the Directive in the 1960s and 1970s, found the M’s hard to interpret. Even Volcker remarked, “I think we have had a problem with interest rates. If anything, we should have paid more attention to them rather than less” (FOMC Minutes, December 21, 1981, 48).
The homebuilders were greatly affected by high interest rates and recession. Private housing starts had fallen from 1.8 million in September 1979 to 0.84 million in January 1982 when Volcker spoke to their convention. This was the lowest level since the summer of 1967 that had caused much discomfort and political reaction. It was rare for housing starts to fall below one million; this time it was below a one million rate for six months, and it remained below for several months to come.
Volcker recognized the problem. The year 1981 was “the most depressed in decades” (Volcker papers, Board Records, January 25, 1982, 1). He accepted, and claimed the public accepted, that the job of ending inflation fell to monetary policy. “But I think it is also fair to say that absence of consistent help from other policies can make the job more difficult” (ibid., 2).
Then came a cheerful note. “We can see multiplying and encouraging signs that inflation has begun to subside—that we are turning the corner. . . . Any slackening of our commitment to see the effort through could only jeopardize prospects for full success” (ibid., 3). Changes in expectations and behavior had to occur. These “will work to unwind the inflationary process, perhaps faster than most economists have assumed” (ibid., 4). He was aware of the challenge to avoid a resurgence during the recovery. The key test will be sustaining the gains during a period of recovery and expansion” (ibid., 5).112 Despite their heavy losses, the homebuilders gave him two standing ovations (Coyne, 2005, 315).
Reported growth of M1 from December 1980 to December 1981, at 2 percent, was far below the target of 3.5 to 6 percent, and M2 growth at 9.5 percent was only 0.5 percentage points above its band. For 1982, the FOMC tentatively agreed again to a target band of 2.5 to 5.5 percent for M 1 and 6 to 9 percent for M 2 .
The economy ended 1981 with the unemployment rate at 8.5 percent and rising. Hourly earnings had fallen from their peak but they rose 7.2 percent in the year to December. The twelve-month moving average of consumer prices was down to 8.6 percent, three percentage points below the previous December. Double-digit inflation, it turned out, was over; the expected four-quarter inflation rate was 7.5 percent according to the Society of Professional Forecasters. More disinflation had to occur before the Federal Reserve could claim success.
112. Unlike Burns, Volcker did not blame labor unions for inflation. “Higher wage costs did not spearhead the inflation of the past decade. Labor and management were in large part ref
lecting inflationary forces originating elsewhere” (Volcker papers, Board Records, January 25, 1982, 5).
The year 1982 was a transition year. The FOMC ended targeting nonborrowed reserves. The Board lowered the discount rate from 12 to 8.5 percent. The federal funds rate declined from a 13.22 average in January to 8.95 percent in December. And the twelve-month average consumer price inflation fell from 8.1 in January to 3.8 percent in December. Consumer prices fell in December at a 4.9 percent annual rate.
Early in the year, the Board’s staff forecast called for recession to end and recovery to begin in 1982 with continued decline in inflation for the next three years. Unemployment fell slowly in their forecast but would remain above 8 percent with no inflationary money growth. Recovery was expected to start in the spring, but despite progress in reducing inflation, real interest rates remained historically high.
Annualized M1 growth was nearly 12 percent in January. President Balles (San Francisco) asked whether they were “intuitively trying to keep interest rates down” (FOMC Minutes, February 1, 1982, 23). Axilrod evaded the question by commenting on shifts in the demand for money. Gramley pointed out that the January bulge provided most of the M1 required to meet their annual target. He favored abandoning the M1 target. Others proposed to raise the base from which the money growth rate started or widen the band and aim for the top. Volcker reported that Congressman Henry Reuss proposed a 3.5 to 6 percent M1 band, as in 1981. Congressman George Hansen introduced regulation requiring the Federal Reserve to maintain zero inflation.
A History of the Federal Reserve, Volume 2 Page 59
