The policy consensus started to fracture. Balles wanted the HumphreyHawkins report to show what the FOMC expected. Roos joined him and added that the FOMC should improve its procedures to better achieve its targets. Teeters wanted to abandon the disinflation policy to increase real growth and reduce the unemployment rate. “If we stick to these targets, we end up with no growth for the fourth year in a row and unemployment of 9 percent or above. I think that’s politically very dangerous” (FOMC Minutes, February 1, 1982, 44). Frank Morris wanted to continue disinflation but abandon the M1 target. Members mostly supported either Morris’s or Balles’s positions.
Volcker recognized the control problem but made a sensible response. “Our credibility will be related more to making the right decision than to worrying too much about what the market says about it in the short-run” (ibid., February 2, 1982, 48–49). He remained convinced that the Federal Reserve had to persist in its anti-inflation policy. He favored rebasing the monetary growth rates and opposed raising the announced growth rates to recognize the January bulge. His argument was that an increase in the growth rate would suggest an easier policy; a lower growth rate from the higher base would not. Much of the problem came from the NOW accounts. In his testimony to the House Banking Committee on February 10, he dismissed arguments based on a tradeoff between unemployment and inflation, insisting that lower inflation would bring lower unemployment rates. He dismissed the Phillips curve as a guide. “More inflation has been accompanied not by less, but by more unemployment and lower growth. We have not ‘traded off’ one for the other” (Volcker papers, Federal Reserve Bank of New York, Box 97657, February 10, 1982, 9). Then he added that “inflation itself is the greater threat to economic stability” (ibid., 10).
Volcker was not yet ready to abandon an M 1 target. He did not think they should put much weight on a month or two of disturbing data. He did not want to eliminate the January bulge immediately, but he wanted “to show some resistance” (ibid., 58). Since the FOMC had no way of knowing whether the January bulge was a permanent or transitory change, that seems the correct approach. But it did not satisfy everyone. Roos, with support from Black, wanted to eliminate the bulge, but Axilrod and Volcker argued that they did not know whether the demand or supply function had shifted and whether they would shift back.113
When the Committee turned to short-term policy, they emphasized the uncertainty about short-term projections. The staff explained the high reported growth of M1 as a shift in demand. Under questioning by Roos (St. Louis), Axilrod agreed that it was difficult to forecast the demand for money, and he might have added that it was difficult also to explain what had happened ex post.
To strengthen credibility Volcker proposed letting the federal funds rate rise as high as 14 percent (from 13.2 percent average for January). But there were limits to his concern. After Volcker said “I would worry if the federal funds rate were 16 percent now,” Governor Partee, joined by Presidents Black, Ford, and Balles, suggested eliminating the band on the funds rate (ibid., 65–66). Morris, Boehne, and Volcker objected strongly.
The data hint that despite the discussion at the meetings, the System had an interest rate target. Monthly average federal funds rate remained between 14.15 and 14.94 percent from February through June. This is the only period during alleged reserve targeting with so little variation in the interest rate. Monthly M 1 growth remained low in these months but varied between −3.5 and 6 percent. With consumer prices rising about 7 percent, the real federal funds rate was about 7 or 7.5 percent.
113. An extended discussion showed that the FOMC did not have a consistent interpretation of the short-term positive relation between higher money growth and a higher funds rate. Most members explained the positive relation as a positive shift in demand for reserves, not an expected reduction to reflect higher expected inflation.
The vote was unanimous for a near-term 12 to 16 percent federal funds rate, zero M1 growth, and 9 percent M2 growth.114 The FOMC wanted zero M1 growth in the near term to offset excessive money growth in January.
Discussion of the annual money and credit ranges for the February Humphrey-Hawkins testimony brought out the problems in the economy and the conflicts in the Committee. Teeters urged lower interest rates to prevent failure of many savings and loans, but Volcker opposed because that would require too much ease, and Schultz pointed out that long-term rates were the key to the S&L problem. They depend on the deficit, he said. Voicing the main concern of those who wanted to continue the antiinflation policy, he said that “[i]f we give up, then the inflation problem is just going to explode again and the economy will be in terrible shape. We have to stay where we are and do our job” (ibid., 88).115
Volcker responded by arguing that credibility is a stock that can be used when needed. “We do not build up credibility for the sake of building up more credibility. We build up credibility to get the flexibility to do what we think is necessary.116 If I were concerned now . . . that this change [rebasing the target] is appropriate I would say the heck with that point. My trouble is that I am not convinced [the bulge] is going to stay” (ibid., 89).
Schultz rarely disagreed with Volcker, but he did now. Political pressure had increased. “The president will not do anything about the deficits. . . . [T]he central bank of the United States has far more responsibility than it ought to have. . . . We have not yet changed those inflationary expectations because everybody thinks that we are going to cave in to the political pressure that is going to be on us” (ibid., 90). The last remark recognized that congressional elections would come that year, and that tax reduction increased the deficit in the short-run. References to elections and political pressures are very rare in the minutes or transcripts, whatever influence these events may have had on discussions at lunch, during coffee breaks, or at other times.
114. Just before the vote, Balles made “a strong plea or caveat as the case may be . . . to avoid the big overshoots” in money growth. Volcker responded with a note of despair: “I wish I knew how to do that” (FOMC Minutes, February 1, 71).
115. Kane (1989) has an excellent study of the savings and loan problem.
116. This is the conclusion in Cukierman and Meltzer (1986) using a formal model.
Once Schultz opened the issue, others commented. The president’s counselor, Edwin Meese, had remarked publicly that the president would ask Volcker to discuss current policy. Gramley wanted to act ahead of any meeting with the president to avoid any suggestion that the System responded to political pressure. Nancy Teeters thought the System had to accept responsibility for 9 percent unemployment, but others blamed the administration’s fiscal policy for high interest rates and unemployment. Roos reported that he was asked that question frequently: “Are you fellows going to be able to stand the heat from the politicians during an election year?” (ibid., 95).
Volcker took a vote on raising the M2 growth rate but drew only five supporting votes. He chastised the Committee, calling its decision “silly” for putting so much emphasis on recent monthly or quarterly growth rates (ibid., 105). His testimony would stay with the unchanged M2 growth rate but suggest that they may exceed the range. In his February 10 testimony, Volcker said that the announced growth rates would change during the year if conditions changed.
Fearing the loss of political support, the FOMC had to choose between independence and ease. This time the System chose independence but was cautious about raising interest rates. The federal funds rate rose 1.5 percentage points in February to an average of 14.78 percent. By early February St. Louis and San Francisco proposed an increase in the discount rate from 12 to 13 percent. The Board deferred the decision. Other banks joined the request. The Board continued to defer action until March 1, when it disapproved the change.117 The February meeting was Frederick Schultz’s last. He left the Board on February 11. His successor was Preston Martin, who became vice chairman of the Board on March 31. Although this was President Reagan’s first appointment, his votes were more like
Teeters than Wallich’s or Volcker’s.118 Martin’s background included long association with the California housing industry, often a pressure group favoring lower interest rates.119
117. Innovation in financial markets opened new issues about the scope of regulations and new ways of avoiding regulation. The latter included time deposits used to make third party payments avoiding regulation Q. The Board declared such accounts to be transaction accounts. In February, the Kansas City Board of Trade began to offer futures contracts based on the Value Line stock index. The Board discussed margin requirements because it deemed these contracts a substitute for options contracts. The Board of Trade raised its margin requirements, and the Board did not act.
118. Havrilesky and Gildea (1992, 402) classified thirty-two governors who served during 1951 to 1987 based on their “noncontractionary” votes. Preston Martin is fourth from the bottom, more expansionary than Teeters. Other Reagan appointees, such as Martha Seger and at times Wayne Angell, also favored lower interest rates to support supply-side actions. These were not helpful appointments.
Following tax reduction and a reduced rate of contraction of the real base, real GNP growth turned positive in the second quarter of 1982, but not in the third. In its economic report written at the beginning of 1982, the administration continued its support of Federal Reserve policy. The report expressed a preference for steadier decline in the M1 growth rate, but it did not criticize the Federal Reserve.
Volcker’s short-term gamble succeeded. M 1 growth turned negative in February. Quarterly growth was about 6.4 percent as originally reported. At the March 29–30 meeting, April’s money growth was a major concern. The staff forecast called for 8 to 10 percent followed by slower growth or decline in May and June. Typically, money growth rose in April because the public paid its income tax, and apparently the seasonal adjustment was inaccurate.
The FOMC divided. About half followed Governor Partee by choosing faster M1 growth. Volcker chose to give more weight to M2 and at one point chose a combination of M2 and M1 growth that were inconsistent based on the staff projections. His chief interest seemed to be avoiding a temporary decline in interest rates and increase in money growth that the FOMC would have to reverse.
The remarkable feature of the discussion was the commitment of many members to continue the disinflationary policy despite a 9 percent unemployment rate and a substantially slower inflation rate. After much discussion, the committee voted nine-to-two to keep the federal funds rate in the 12 to 16 percent range and to aim for a 9 percent annual rate of M2 growth and between 3 and 9 percent M 1 growth. The wide range on M 1 growth reflected the great uncertainty about both the monthly seasonal adjustment and the degree to which NOW accounts were used for transactions.
Balles asked why market interest rates remained historically high as the inflation rate fell. Axilrod gave three answers. First, “the world isn’t yet convinced that the rate of inflation isn’t going to get worse when we get out of this rather deep recession” (FOMC Minutes, March 29–30, 1982, 30). Second, variability in short-term rates resulted from efforts to control money. This put a premium in interest rates. Later, Axilrod added that the budget outlook “keeps the public convinced that inflation is not going to get better. . . . [T]he odds are that when we get on the up side of the cycle inflation will get worse” (ibid., 31–32).
119. Contemporaneous reserve accounting again came up for discussion. Volcker gave a clearer statement of his position. “I do not think it is going to make a lot of difference in and of itself. . . . [T]here is a certain logic just in terms of being consistent with our present techniques. My concern is that people will read into it more than it is worth and we would get more flak rather than less” (FOMC Minutes, February 2, 1982, 91).
Evidence soon supported his first answer. The recovery occurred with historically high real interest rates. Later evidence suggested that real interest rates changed very little when the government’s fiscal stance shifted from large deficits (relative to GDP) to budget surpluses in the late 1990s and renewed large deficits after 2001. In fact, real interest rates were lower after 2001 than in the earlier period of budget surplus.
What may be true for other countries has not been true for the United States in the past quarter century. A principal reason for the absence of a strong effect of U.S. budget deficits on real interest rates is that foreign purchases of U.S. securities absorb the additional security sales. Chart 8.9 shows the current account deficit. Capital inflow moves in the same direction, rising when the current account deficit rises and becoming highly positive when the current account deficit is highly positive. If foreigners are willing to finance the current account defi cit—the excess of investment over saving—at world real interest rates, domestic real interest rates need not change. The desire by governments to increase their exports and domestic employment encouraged them to purchase U.S. securities and sustain the capital inflow to the United States.
The FOMC remained divided about monetary policy. Volcker was not yet ready to change policy openly. Although he had become less certain about targeting reserve growth, seasonal adjustment, and the meaning of the monetary aggregates, he was concerned that letting interest rates fall would provide only temporary relief. With clear understanding of the political pressures, he told the FOMC “I’d love to see them come down and stay down. I wouldn’t love to see them come down for a month and then have to go up again. That would kill us for a variety of reasons” (FOMC Minutes, March 29–30, 1982, 49–50).120 His response was to continue the policy of reducing inflation.
Failures of homebuilders, savings and loan institutions, and other firms was a frequent subject of discussion. The members could only deplore the circumstances, including their policy, that brought this outcome. During the 1970s some farmers had borrowed heavily to expand to take advantage of rising commodity prices. Prevailing interest rates pushed them toward bankruptcy. Corrigan (Minneapolis) proposed special loans for farmers but drew little support.
In May, a small securities firm, Drysdale, was unable to pay interest on the government securities it had sold short. Drysdale had gambled on a decline in interest rate by doing repurchase agreements with banks, especially Chase Manhattan Bank, and selling the securities short. Drysdale had about $20 million in capital, but it had $6.5 billion in securities; it owed $160 million in interest payments to nearly thirty brokerage firms.
The Federal Reserve feared a market panic. The New York bank offered to lend to banks facing payments problems. At first, the Chase bank refused to accept responsibility for the interest payments, claiming that it acted only as an intermediary. Market and Federal Reserve pressure convinced it to change that position. That ended the crisis.
The FOMC voted to broaden the terms on lending government securities from the open market account and relax the financing of short sales of securities. The change was temporary, lasting only eight days. The staff estimated that Chase Manhattan would borrow about $1.25 billion of securities, but others would need much less. As usual, the Board did not adopt a general policy to deal with banking and financial market problems.
Beginning of the End
A series of events, economic, market, international, and political, moved the Federal Reserve toward ending the on-again, off-again experiment in monetary control. No one of these events may have been decisive, but together they added to the growing anxiety about the economy and the Federal Reserve’s ability to control it using reserve or money targets.
120. At about this time, March 15, the Shadow Open Market Committee wrote, “The Federal Reserve misleads the public and the Congress by talking as if its main objective were control of bank reserves and money. In practice the Federal Reserve seeks to hold the daily federal funds rate within a narrow range.” I served as co-chairman of that committee.
In our interview, Volcker (2001) cited the difficulties of controlling money, especially in 1982, his reluctance to raise interest rates during a deepening recession, the failure o
f the recession to end, as predicted, in second quarter 1982, and the developing problem of Mexico’s external debt. Axilrod (1997) emphasized the growth of money and the maturing of All Savers Certificates.121
There were other events. The failure of Drysdale Securities and a small Oklahoma bank, Penn Square, raised concerns about the solvency of the banking system. Both had large loans outstanding to major banks—Chase, Continental Illinois, Seattle First. Volcker and the FOMC had heightened concerns about financial fragility. Many savings and loans were close to bankruptcy. Large loans to Mexico by money center banks added to these concerns. Prevailing real interest rates heightened the problem.122
Volcker was clear about the lender-of-last-resort function. “If it gets bad enough, we can’t stay on the side or we’d have a major liquidity crisis. It’s a matter of judgment as to when and how strongly to react. We are not here to see the economy destroyed in the interest of not bailing somebody out” (FOMC Minutes, October 5, 1982, 4). Preston Martin rightly stressed that their assistance should go to the market, not to Drysdale.
Penn Square’s problem came in late June. It had large loans to oil and gas firms. As oil prices fell in 1982, many of the loans became worthless. The Comptroller’s auditors ordered millions of dollars written off. Penn Square was bankrupt.
Penn Square had made more loans than it held in its portfolio. Continental Illinois, Chase Manhattan, Michigan National, and others bought about $2 billion; about $1 billion was sold to Continental. The Federal Reserve made the mistake of lending $20 million to Penn Square to prevent insolvency instead of permitting the failure and defending the market. The assistance was futile; the money was soon gone. William Issac, chairman of the FDIC, would not agree to additional support. He thought Penn Square’s failure would be a warning to other banks, a badly needed warning. He favored closing the bank and paying off the depositors. In the end, Treasury Secretary Donald Regan sided with the FDIC, and despite Volcker’s concerns, the bank closed.
A History of the Federal Reserve, Volume 2 Page 60
