A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  121. All Savers Certificates permitted financial institutions to offer one-year tax-exempt certificates. Congress approved when it voted for the Reagan tax reduction. The certificates expired beginning in October 1982. The Board’s staff believed that much of the money had come from bank deposits. Neither the staff nor the Committee had any idea how much of the money would again become part of M1. Axilrod also emphasized a change in the interest elasticity of M1.

  122. Grieder (1987, 438) pointed out that Volcker did very little to enforce lending standards on international loans. As banks reached 10 percent country limits, the Federal Reserve permitted banks to evade the limits. Grieder (ibid.) quoted William McChesney Martin’s comment that “Volcker was ‘very good’ in conducting monetary policy but ‘a complete flop on bank supervision.’”

  At the July 1 Board meeting, Volcker got approval of a $700 million loan to Mexico under the swap line. In October, the FOMC renewed the loan. Before that, the System had made overnight swaps to give the appearance that Mexico had sufficient dollar reserves to maintain its payments. “We would transfer the money each month on the day before the reserves were added up, and take it back the next day. . . . [T]he ‘window dressing’ disguised the full extent of the pressures on Mexico from the bank’s lenders and from the Mexicans themselves” (Volcker and Gyohten, 1992, 199).

  The $700 million loan had two purposes. Mexico wanted to delay going to the IMF until September 1982, after its election. Also, the Federal Reserve was concerned that a crisis in Mexico would quickly spread to other heavily indebted countries. “Bank loans to developing countries had increased more than 50 percent in three years to more than $362 billion at the end of 1982, one-third of which was held by American banks” (ibid., 198).

  The problem arose as part of the recycling of payments to the oil-exporting countries. These countries deposited their receipts in major banks by offering them directly or on the euro-dollar market.123 The money market banks borrowed the euro-dollars and lent them developing countries. Their loans were for longer term than their euro-dollar deposits, so the banks were at risk. Defaults by the developing countries could wipe out their capital. The world recession slowed the growth of exports, and the high real interest rates increased borrowing costs. The threat of widespread default, perhaps starting in Mexico, added to concerns about financial fragility.

  Loans to Mexico by nine major U.S. banks were about $60 billion, about 45 percent of the banks’ capital. Loans to all of Latin America equaled about twice the banks’ capital (ibid., 198). The Treasury and the Federal Reserve arranged with foreign central banks to join in lending $1.85 billion, about half from the United States. Soon after, the lending banks agreed to a “standstill”; Mexico would not be expected to pay until they arranged an IMF loan, and the banks agreed not to withdraw from Mexico.

  On June 14, the French and Italian governments devalued the franc and the lira. The French devaluation was the first of several resulting from the efforts of President François Mitterrand to pursue an expansive policy with a partly open capital market and a fixed exchange rate against the mark and other European currencies. Following the devaluation, the Saudi king died. The Treasury accepted that markets were disorderly, so the Federal Reserve bought $21 million in marks and $9 billion in yen. Other central banks intervened also, buying $6 billion according to the Federal Reserve report (FOMC Minutes, July 1, 85).

  123. Recall that euro-dollars are U.S. dollar-denominated assets of banks outside the United States.

  After more than two years, some members of the FOMC wanted to end what remained of the money control experiment. At the May FOMC meeting, Governor Teeters made the strongest statement in opposition to continuing. Pointing to the number of recent failures and the variability of interest rates, she attributed the failure of long-term rates to decline to the risk premium to pay for variability. The economy had not recovered. Unemployment was above 9 percent. “We are in the process of pushing the whole economy not just into recession, but into depression . . . I think we’ve undertaken an experiment and we have succeeded in our attempt to bring down prices. . . . But as far as I’m concerned, I’ve had it with the monetary experiment. It’s time to put this economy back together again” (FOMC Minutes, May 18, 1982, 27).

  Others did not go as far as Teeters, but Gramley, Rice, and Partee wanted to ease policy, and Morris wanted to dispense with an M 1 target. Boehne spoke in favor of lowering the funds rate to 10 to 15 percent. Defenders of the disinflation policy—Roos, Black, Ford, and others—argued that the way to get long-term rates down was to persist in the restrictive policy. Ease was what the market expected; it would foster concerns about renewed, higher inflation.

  Volcker clearly began to shift to an explicit interest rate target. He no longer favored reliance on M 1 . NOW accounts made it difficult to interpret. He favored 8 percent growth in M2 because that seemed consistent with nominal GNP growth of 8 percent. “I am not going to [be greatly upset] if M2 growth comes out at 8.5 percent instead of 8 percent or even 9.5 percent . . . or if M1 continues to run somewhat high. . . . I would at this point take the chance of easing the pressures on bank reserve positions. . . . If it turns out that figures are more favorable in terms of restrained growth, we could move aggressively pretty promptly (ibid., 34; emphasis added) The FOMC voted eleven-to-one to lower the funds rate to the 10 to 15 percent range.124

  124. Nancy Teeters voted no. This was Preston Martin’s first meeting. He attended the March meeting but could not vote because he had not been sworn in. Volcker described the change years later. “The Mexican crisis was brewing. The economic recovery had not appeared. I thought, ahah, here’s our chance to ease credibly. So we took the first small step” (Mehrling, 2007, 183).

  The problems that drew most comment were the failure of real rates to decline and the economy to improve. Ten-year Treasury rates were 13.5 percent at the time of the meeting. The SPF forecast of inflation was down to 5.9 percent, so using this estimate the real rate was an extraordinary 7.5 percent. Real GNP fell 5.9 percent in the first quarter; it rose a sluggish 1.2 percent in the second quarter and fell 3.2 percent in the third.

  Many in Congress supported the disinflation policy, but as the 1982 election approached some became restless. Congressman Henry Reuss sent a letter informing Volcker that the House Budget Committee had adopted a budget resolution urging coordination of monetary and budget policy. Specifically, the resolution called on the Federal Reserve to “reevaluate its monetary targets in order to assure that they are fully complementary” (FOMC Minutes, May 18, 1982, 42). The letter assumed that the proposed deficit reduction was permanent and large and approved by both houses.

  Reuss then reminded Volcker that the Constitution gave the monetary power to Congress. The Federal Reserve was the agent of Congress. He wanted assurance that the Federal Reserve would accede to the directive from Congress. Volcker told the FOMC that he saw no reason to vote. “I will tell him that it’s clear in the minds of the members of the Open Market Committee that indeed we follow the law” (ibid., 43).

  In his letter to Reuss, Volcker did more than accept that the Federal Reserve would follow the law. He advised Reuss that it would be a mistake for Congress “to indicate or direct a specific concern for monetary policy, such as a precise monetary target” (letter, Volcker to Reuss, Board Records, June 8, 1982).

  Volcker brought up the resolution at the July 1 meeting. It called for the Federal Reserve to reconsider its monetary targets if Congress made a sizeable, permanent reduction in the deficit. Most of the members argued that permanently reducing the deficit would lower interest rates, but money was neutral so money growth should not increase. Partee argued that the economy was below capacity, so money growth could increase. Volcker was most in favor of increasing money growth, pointing out several times that many economists accepted policy coordination, but Wallich said that coordination meant the Federal Reserve should permit lower interest rates brought about by deficit reduction but
should not increase money growth.

  A few months later, Congressman Wright Patman sent a letter enclosing proposed legislation that would require the FOMC to send a report to Congress within seven days of any decision to change the trend rate of money growth. Volcker had breakfast with Patman, so there is no record of a reply.

  Senator Robert Byrd opposed the policy experiment from the start. By spring 1982, he found members concerned about high unemployment and interest rates in an election year. They joined him in proposing that Congress tell the Federal Reserve to target interest rates so as to keep the real rate below 4 percent. In the House, Congressman Jack Kemp called for Volcker’s resignation. He and other proponents of a return to the gold standard sponsored Byrd’s measure. The possible combination of conservative Republicans and liberal Democrats working to restrict Federal Reserve independence showed the growing resistance in Congress. Fortunately, Chairman Jake Garn and Senator William Proxmire on the Banking Committee did not go along. Senator Howard Baker and others tried to bargain with Volcker. If they reduced the deficit, they wanted the Federal Reserve to lower interest rates.125

  At the White House, James Baker, a main adviser, worried about the coming election. He dropped hints about legislation reducing System independence. At Treasury, Secretary Donald Regan, a frequent critic, considered legislation restoring the Treasury Secretary to the Board and FOMC, as in the original Federal Reserve Act.126

  Volcker knew he had support in Congress from the chairmen of the banking committees and many others. And the Federal Advisory Council supported both policy action and the goal of reducing long-term growth of money (Board Minutes, May 21, 1982). Nevertheless, Volcker had to be concerned that James Baker, chief of staff in the White House, had tired of failed forecasts of recovery and was concerned about Republican prospects in November. He wanted lower interest rates. The prospect that the administration might support one of Congress’s proposals was a significant threat.

  Congressman Reuss mentioned legislation that he would sponsor as part of a bill to raise the debt ceiling. The legislation Reuss proposed would require the System to follow the resolution calling for coordination with deficit reduction. Legislation was more troublesome than a resolution. “If Congress had a law that told us to do something, we’d have to do it. But a resolution is a much more tricky thing to handle. . . . I would propose to point out in a letter that it would be a very difficult matter if they got very precise in a resolution. It would be a departure, I think, without precedent, if there were really a precise resolution” (ibid., 43). Later Volcker added, “We should not, in my opinion, prejudge precisely what we would do without even knowing what the resolution is” (ibid., 44).127

  125. The Federal Reserve remembered 1968. Congress passed a tax increase in an election year to reduce the deficit. The projection claimed that the new taxes would lower the deficit by $100 billion over five years. Actual deficits remained between $185 and $225 billion from 1983 to 1986.

  126. Some legislation supported the System’s goals. Congressman George Hansen introduced legislation requiring the Federal Reserve to make zero inflation the goal of monetary policy and to prohibit support of interest rates on government securities. Gramley responded, opposing the legislation as a restriction on flexible monetary policy. Unlike the response to similar legislation in the 1920s, Gramley’s letter accepted the desirability of a price stability goal.

  Congress passed the resolution calling for coordination “if Congress acts to restore fiscal responsibility . . . in a substantial and permanent way” (FOMC Minutes, June 30–July 1, 91). The discussion that followed brought out differences in belief about policy coordination and the role of fiscal policy. Volcker, who probably wanted to ease, insisted: “There is a respectable body of economic opinion that says there is some degree of tradeoff between fiscal policy and monetary policy . . . Now, individual members of the Committee may not believe that theory, but it’s not a totally unrespectable body of economic doctrine.” Wallich, who did not want to ease, argued that in the long run money is neutral. “More money therefore means higher prices not higher output.” But, Partee, who wanted to ease, rejected Wallich’s argument because “we’re so much below an optimal utilization rate” (ibid., 93).

  The members then discussed “crowding out” of investment by deficit finance. They did not agree whether it was a current problem or would affect investment only after the economy recovered. Most believed that continued deficits raised long-term interest rates, so rates would fall if Congress reduced the deficit. But they didn’t clarify whether the resulting reduction in interest rates constituted an easier monetary policy or whether the Federal Reserve should further reduce interest rates. This issue had troubled the System in 1968. It had not resolved it. Monetary velocity would decline as interest rates declined; there were differences of opinion about whether that would be enough to satisfy Congress or to constitute monetary ease. Political concerns had an important role. Those who favored easier policy argued for increasing money growth. Wallich and Solomon argued against.

  The main theme of the policy discussion was to lower interest rates even if money growth exceeded the money targets. The staff reported some signs that the recession was ending, but the unemployment rate at 9.6 percent continued to rise. The staff forecast unemployment at 9 percent with real GNP growth at 3 percent in the next six quarters. Actual wage and consumer price increases ran about 6 percent, well below the peak. The dollar continued to appreciate; it rose above its value before August 1971, when President Nixon permitted the dollar to float.

  127. The Board continued to defer decisions calling for a lower discount rate. During February, it deferred increases to 13 percent four times before disapproving an increase on March 1. From March to July, the Board deferred or rejected reductions.

  Balles reported concerns about rising bankruptcies. He described bankers in the San Francisco district as “more worried than I’ve seen them worried in my adult life” (FOMC Minutes, June 30, 1982, 4). He and Boehne wanted to raise the money targets for 1982 and reduce them for 1983. Preston Martin wanted to ease without changing the target.

  FOMC members gave many gloomy reports and warnings about possible crises—bank and saving and loan failures, bankruptcies. Partee mentioned that the next stage of tax reduction would release $40 billion, but he cited many offsets. Even Wallich, one of the more optimistic members, favored a cautious increase in the money targets for that year (ibid., 7). Even Roos was willing to let money growth for the year exceed the target.

  A main problem was that M1 and M2 grew above the target range in the first half of the year. No one wanted to increase the interest rate to bring them within the target range. The members divided between those who wanted to raise the target for money and those, concerned about loss of credibility at election time, wanted to keep the targets but exceed them. Mexico’s problems and its debt to the System added to the pressure on the FOMC.

  Solomon described the change that occurred at the meeting. “This is the strangest FOMC meeting that I’ve attended. There seems to be a whole change or shift in mood. . . . [D]uring the depth of the recession there was a much tougher attitude than I hear today. . . . [I]t seems to me that it’s important . . . that there not be an impression in the markets of a sudden reversal or shift toward easing. It would be very politically suspect. They see the pressure on us with widespread speculation now that we will ease. And yet at the same time there’s a doom and gloom atmosphere out there and very little expectation that interest rates will fall” (ibid., 52; emphasis added).128

  Caught between the two positions—political pressures, legislator threats, and fear of a crisis on one side and concern about their credibility and the need to maintain the appearance of independence on the other— Volcker made a first small change in policy to lower rates.129 Like most of the others, he wanted lower rates. Like some, he feared a market interpretation that the FOMC had succumbed to political pressure that would end with fears of i
nflation and higher long-term rates. He moved cautiously. He proposed to keep the same range as before, 10 to 15 percent for the funds rate “without changing the wording but with the knowledge that I would feel very hesitant [to accept it] if in fact the market produced rates of 15 percent continuously for any period of time” (FOMC Minutes, July 1, 1982, 58). But, concerned about a possible financial crisis, he warned, they would “have to respond to it” (ibid., 57). And though he recognized that “we all . . . would love to see interest rates down . . . the question is how much we can do” (ibid.). Credibility of the anti-inflation policy mattered; the market had to accept the change. The M 1 target was “about 5 percent” and M2 9 percent, but higher growth rates were “acceptable” (ibid., 79). The vote was eight to four with Teeters dissenting because she wanted more M1 money growth, 6 to 6.5 percent, and Black, Ford, and Wallich wanted a less expansive policy. Volcker summed up his position. He did not want to reverse a decline in rates. “The problem is not the desirability of getting interest rates down; the question is whether by reaching too fast for that objective we may not be able to keep them down” (ibid., 66).

  128. Frank Morris opposed proposals for a cap on the federal funds rate. His statement supports the position taken by those who claim the Federal Reserve targeted reserve growth to avoid taking blame for the increase in interest rates. “One thing we’ve learned in the last few years is that the presence of an intermediate target . . . has sheltered the central banks—not only ourselves but the Germans said the same thing at that meeting in New York [as did] the British and the Canadians and others—from a direct responsibility for interest rates, and I think that has contributed to a stronger policy posture. . . . And while I think we’re following the wrong intermediate target [M 1 ] I believe it would be a big mistake to start doing without one” (FOMC Minutes, July 1, 1982, 56).