A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  49. For months newspapers printed a chart comparing the 1929 and 1987 stock market declines. The difference in policy ended the point of the comparison after a few months.

  Lack of an agreed objective and a commitment to achieve it was a major problem.50 Previous experience with coordinated policies suggests the importance of a common objective and adequate means of achieving it. The gold standard from the 1870s to the start of World War I is an example of effective coordination through markets. Participants accepted a common objective—to keep exchange rates fi xed—and a means of achieving the objective—buying and selling gold at a fixed price. Countries accepted primacy of the external value of their currency and permitted money stocks, interest rates, employment, and prices to vary as required by the exchange rate. The nations that agreed to stabilize exchange rates at the Louvre were not willing to relinquish control of interest rates and employment. The agreement had to break down, as it did in October 1987.

  Other attempts at policy coordination through the gold exchange standard of the 1920s, the tripartite agreement of the 1930s, and the Bretton Woods Agreement lacked the commitment to a mutually agreed objective and full reliance on markets to achieve the objective. As earlier chapters show, the United States in practice did not respect the commitment to a fixed exchange rate under Bretton Woods, and surplus countries would not adjust their exchange rates enough to remove payments imbalances.

  Proponents of target zones in the 1980s pointed to the virtues of increased exchange rate stability but said little or nothing about domestic consequences of maintaining permanently misaligned real exchange rates. Discussion was mainly about nominal, not the more important real, exchange rates.51 Baker’s program incorporated this weakness and Baker was either unwilling or unable to get agreement on the objective of policy coordination. As Volcker and Tietmeyer recognized at the time, successful coordination required monetary policy to achieve nominal exchange rate stability by forgoing use of monetary instruments to achieve low domestic inflation and stable growth. They never agreed to do that, so the program did not succeed.

  50. Even when finance ministers agreed to maintain exchange rate bands, they were reluctant to make them precise. Funabashi quotes Baker as saying, “Don’t let us be too precise,” a position that echoed German concerns. Nigel Lawson reaffirmed the position (Funabashi, 1989,183).

  51. The dollar depreciated 40 percent nominally and 30 percent in real terms in the two years after the Plaza (Volcker and Gyohten, 1992, 269).

  After the experience with intervention, Henry Gonzales, chairman of House Banking, proposed that the General Accounting Office audit the Exchange Stabilization Fund (ESF) and the Federal Reserve’s foreign currency operations. The report would remain confidential, but Congress would know how much intervention occurred and how much the account gained or lost.

  Gonzales questioned the large purchases, a 165 percent increase in the ESF in two years. He recognized that the Federal Reserve enabled large purchases by “warehousing” for the Treasury. But Gonzales understood that “warehousing” was a thinly disguised loan and that the ESF purchases were expenditures made without congressional approval. He recognized also that there was not much evidence that the exchange operations stabilized exchange rates. Congress declined to act, however.

  END OF DISINFLATION

  By spring 1986, the twelve-month average rate of consumer price increase had fallen to about 1.5 percent, the lowest rate since the early 1960s. These rates included the one-time decline in the level of oil prices, so they overstate the sustained decline. SPF forecasts of annual inflation fell to 2.5 to 3.5 percent in 1986. The unemployment rate continued to fall until it was below 6 percent by 1987. When Paul Volcker left the Board in August 1987, the unemployment rate was 6 percent, and twelve-month consumer price inflation was 4.2 percent.

  Other adjustments to the end of high inflation included the end of regulation Q. Oil prices fell to less than $10 a barrel in 1986 contributing to the decline in measured inflation. The decline in long-term nominal and real interest rates began. Ten-year Treasury yields fell below 11 percent in May 1985 and below 10 percent in November 1985. From summer 1986 to spring 1987, ten-year nominal rates remained between 7 and 8 percent, with real yields about 3.5 percent.

  The Great Inflation was over, and markets recognized that it was over. Although sustained inflation did not fall below 2 percent until 1997, the market acted on the belief that the high inflation of the late 1970s would not soon return.

  The Federal Reserve had renewed its credibility as an anti-inflation central bank. It took a significant step in that direction in 1986, when the economy experienced slow growth in the last three quarters of that year. It lowered the federal funds rate and increased money growth, but inflation did not increase. Concerns that high inflation would return dissipated as the dollar declined without restoring inflation.

  Problems remained. Financial fragility, bank failures, and problems in agriculture continued. Inflation remained above its long-term average and the unemployment rate remained above the consensus estimate of full employment. The imbalance between saving and investment maintained the large current account deficit. Restoring steady growth with low inflation left much to do, but markets began to reflect belief that the Federal Reserve could continue on that path. It had taken three years to lower the inflation rate to about 4 percent. It took an additional four years, to about 1986, to see expected low inflation incorporated in wages, interest rates, and the exchange rate.

  MONETARY POLICY IN 1985–86

  The FOMC remained uncertain about the proper way to conduct policy. It did not want to remind the public about its flawed policies in the 1970s, so it did not set a federal funds rate target. It did not find monetary targets reliable in the short term, so it set them as the law required but did not adjust to meet them. That left borrowing, a return to the 1920s policy procedure of affecting interest rates indirectly. But the desk found that achieving that target was difficult. These procedures remained until after Alan Greenspan replaced Paul Volcker as chairman in August 1987. The Greenspan FOMC eventually set a narrow band around a federal funds rate target, but it adjusted the target as needed to maintain low inflation and relatively stable growth. Labor and product markets rewarded its success by reducing variability of inflation and growth.

  Discussion of policy operations returned several times in the 1980s. President Robert Black and Vice President J. Alfred Broaddus Jr. of the Richmond bank proposed an explicit inflation target to “maintain the credibility of the Committee’s longer run program to reduce inflation” (note, Black to FOMC, Board Records, February 6, 1987, 1). An inflation target would direct attention to the longer-term consequences of policy actions. That did not fit well with Volcker’s operating tactics.

  A memo from Michael Prell to the Board discussed the staff’s use of the Phillips curve to forecast inflation. The memo recognized that “[i]n the long-run, money growth is the key determinant of inflation” (memo, Prell to the Board, Board Records, July 1876,1, 1). His memo distinguished onetime price level changes and persistent inflation. A chart comparing price acceleration and the unemployment rate showed a negative relation for the period 1954–85. The points are scattered over the page; the unemployment rate explains only 30 percent of price increases.

  Despite Prell’s memo, the staff continued to rely on the Phillips curve. Many FOMC members, including Volcker and later Greenspan, did not find the forecasts useful.

  The FOMC remained divided. A lengthy discussion of operating procedures at the March 29, 1988, meeting considered a memo from Donald Kohn and Peter Sternlight (Board Records, March 25, 1987). The memo cited the loose relation between the funds rate and borrowing as the principal disadvantage. Since a main purpose was to manage the federal funds rate indirectly this problem seemed large in part because the market misread the System’s intentions. Also, when the funds rate remained in its expected range, there was “little scope for market forces to show through.”5
2

  As usual, the discussion at the meeting was divided and inconclusive. A majority favored continued use of borrowing as their target. In late 1989, they decided to target the federal funds rate, and that decision remained.

  Uncertainty about the economic future often dominated discussion during these years, reinforcing uncertainties about the policy instruments. “I don’t attach a lot of weight to small changes in this forecast, whether it’s prices or GNP within the ranges that are set. I don’t think we know what GNP is going to be in this quarter. Things have less than an ebullient tone to them so I think: ‘Fair enough: one might think of easing slightly if the dollar gave one room to do that.’ I am not sure it does right at the moment” (Paul Volcker, FOMC Minutes, November 4–5, 1985, 21).

  Policy actions tried to balance objectives for growth, employment, inflation, and the exchange rate without clear understanding of their interaction. Henry Wallich, after years on the Board, recognized that reliance on short-run changes was a source of error including procyclical actions that deepened inflations and recessions. “We have always leaned toward finetuning. When the economy is going down, immediately one sees what one could do by monetary policy if one doesn’t think too much about the long lags. . . . What we do now in May may have effects early next year, at which time the problems we face may look quite different. There has been a proclivity at the Federal Reserve to push harder later in the cycle. . . . [O]ne tries hard to postpone the evil day and push back the moment when the economy flattens out so that we do not have to go into recession. . . . [I]nstead of a mild growth recession, one may get a real recession a little later” (FOMC Minutes, May 21, 1985, 14–15).

  Wallich’s statement might have started a discussion of the best way to conduct monetary policy in a highly uncertain environment. A possible conclusion might have been that it was better to give priority to low and stable inflation and limit responses to short-run changes by setting longterm objectives and directing actions to that end. That didn’t happen. The only response to Wallich’s statement was a question from Volcker about what price Wallich would propose currently to pay for lower inflation. He and others ignored the more basic point. As usual, the members did not discuss their longer-term objectives or how to achieve them.

  52. An attached memo by Anne-Marie Meulendyke from the New York operating staff reviewed the history of different targets used from the 1950s to the 1980s. It pointed to the need for procedures that controlled reserves or money over a longer period. But it pointed to the usual criticism that such procedures required large changes in the federal funds rate.

  Concern about dollar appreciation produced an agreement among five countries—Germany, Japan, U.K., France, and the United States—to act in concert to hinder further appreciation. In mid-January, Secretary Regan warned the markets that intervention policy had changed from neglect to greater activism. At a telephone conference, Volcker discussed the Federal Reserve’s responsibilities under the changed policy. He expected intervention to increase. Purchases of foreign currencies would be shared with the Exchange Stabilization Fund as in the past.

  Apparently, the FOMC’s role was to set limits on aggregate holding of international reserves and quotas for principal currencies—marks, yen, pounds sterling. Existing limits seemed adequate, so the FOMC did not vote. No one objected. Governor Partee usually opposed intervention, but he thought the situation was extreme. For the rest of the year, the FOMC received reports of intervention, but there was little discussion. At times the manager, Sam Cross, reported that foreign central banks complained that they intervened more heavily than the Federal Reserve.

  The dollar continued to appreciate. In the three days from February 27 to March 1, 1985, the European central banks led by the Bundesbank sold $4.1 billion of dollars. The Federal Reserve bought $257.5 million of marks jointly with the Treasury. Cross reported that “the results were first judged to be inconclusive. On the one hand, the momentum of the dollar’s rise was broken . . . On the other hand, many were impressed that the dollar did not fall precipitously under the pressure of heavy intervention” (FOMC Minutes, March 26, 1985, 2). Later, as evidence increased that economic growth was slowing, and financial failures in Ohio and later Maryland became known, the dollar resumed its long depreciation.53 From a peak around 3.5 marks per dollar in early March the dollar reached 3.2 marks in mid-March. This was about the level in January, when the finance ministers agreed to intervene.

  53. In the two months from mid-January to late March, central banks intervened with $10 billion. They considered this massive, but the exchange markets traded hundreds of billions a day at the time.

  The most contentious issue about targets for monetary aggregates in 1985 was the extent to which the FOMC wanted to reduce inflation below 4 percent. Wallich and Gramley were in favor, but the proposal lacked general support. One problem was that the members had little confidence in the implicit forecast of monetary velocity. Frank Morris (Boston) said, “It seems to me that all we can do is assume that we’re going to get trend velocity, anything else is pure speculation.” Volcker responded, “The trouble is that we don’t know what the trend is” (FOMC Minutes, February 12–13, 1985, 48). Volcker remained humble about how much could be known about the future.

  Financial Fragility

  Financial problems worsened during the winter. On March 1, 1985, the Board issued regulations to increase capital standards first proposed in July 1984. At the same time, it authorized the director of the Board’s Division of Banking Supervision and Regulation to issue preliminary notices if a state member bank or holding company had insufficient capital. The final notice required Board action (Board Minutes, March 1, 1985, 3–7).

  In January, the Board became concerned about the solvency of deposit insurance agencies. The Federal Savings and Loan Insurance Corporation (FSLIC) eventually had to close as claims for payments rose. The Federal Deposit Insurance Corporation (FDIC) remained open, but insurance premiums increased. In January, the Board considered and approved increases in net worth for FSLIC-insured institutions proposed by the Federal Home Loan Bank Board (FHLBB). But both Boards were late in taking action. Part of the problem arose from the long-term portfolios of most savings and loans. Net worth would be slow to improve. In its letter to FHLBB, the Board commented that “we strongly support your efforts to tighten the capital requirements for FSLIC-insured depositories, and our questions concern whether the actions specifically proposed go far enough” (letter, Volcker to Edwin J. Gray, Board Minutes, January 2, 1985, 12).54

  The FHLBB proposal revived interest in risk-related deposit insurance. Risk-taking institutions paid the same insurance charges as others. The incentive to take on risky investments increased as net worth declined. FHLBB proposed increased capital, improved and standardized accounting procedures, and better examination and supervision. Available resources limited examinations. The Board considered using private audits. One member commented that the public now believed that the regulators accepted “too big to fail.” The main decision called for increased capital including use of subordinated debt, but the Board delayed implementation.

  54. “Aggressive growth, even when capital is low is, of course, facilitated by the explicit and implicit protections afforded by FSLIC insurance and Home Loan Bank membership” (letter, Volcker to Edwin Gray, Board Minutes, January 2, 1985). Clear recognition did not lead to strong actions to protect taxpayers.

  In February, the FDIC proposed to send a letter to directors of all member banks urging strong action and threatening loss of membership. The Board’s concern was that banks in agricultural areas would be subject to the threat because of their condition (Board Minutes, February 11, 1985, 6).

  Failures and threats of failure increased beginning in March. A Florida securities dealer, ESM, suffered large withdrawals. The state of Florida could not quickly provide assistance. ESM applied to the Federal Reserve. Although some members expressed concern that ESM was certain to fail, and that loans w
ould not save it, the Board approved the loans (Board Minutes, March 7, 1985, 2).

  The next day the Board learned that the collapse of ESM hurt several Ohio savings banks. All had deposit insurance with the Ohio Deposit Guarantee Fund, a private insurance fund that insured 81 state chartered savings institutions. The report advised that the fund could not pay the losses and would fail. News of the problems at one of the banks, Home State, led to a run on others similarly insured. In the next two months, the problem spread to banks in Maryland, Massachusetts, and North Carolina that had private insurance.

  The Board worked diligently to prevent failures. When the governor of Ohio closed the banks and allowed limited deposit withdrawals, the Federal Reserve agreed to lend enough to permit the withdrawals. Out-of-state banks acquired many of the failing institutions.

  The Board did not follow the classical position set out by Bagehot more than a century earlier. He advised the central bank to lend freely to the market, against collateral at a penalty rate. The Board lent at standard rates to prevent banks from failing. Later many of the institutions were sold or merged. To its credit, the Board took an active role and did not repeat the errors made in the Great Depression.

  The Board asked the Federal Advisory Council (FAC) to discuss regulation and supervision at its September meeting. FAC was critical of existing procedures. Regulators’ responsibilities overlapped. Their rules differed. Capital standards differed. No single rule applied to all institutions. The rule should be conditional on portfolio risk and problem assets. Off– balance sheet risks should be included. Also, regulators should concentrate on safety and soundness and reduce emphasis on social and political issues. FAC proposed improved quality of examiners (Board Minutes, September 6, 1985, Supplement 1–2).