The FAC proposed reform of deposit insurance that introduced more market discipline. It favored risk adjusted premiums with rebates for conservative institutions. It criticized recent actions. “Greater market discipline can be accomplished by a very clear statement that absolutely no deposits above the statutory limit (currently $100,000) will be paid from the insurance funds in the event of failure” (ibid., 4). Then the FAC added, “Free market discipline will be effective only if a decision is made and explicitly communicated that depository institutions will be allowed to fail except where systemic risk prevails in the opinion of the regulators or other public interest factors are overriding” (ibid.).
Despite the proviso at the end, the FAC statement puts bankers in favor of failure and against bailouts. Within a few years, Congress adopted two significant changes in rules to reduce risk and give a larger role to market disciplines.
In 1989, Congress approved FIRREA, the Financial Institutions Reform, Recovery, and Enforcement Act. This act embodied congressional efforts to attribute problems in the thrift industry to malevolent owners and operators. There were such operators, but their contribution to the problem was much smaller than the press and members of Congress claimed. Regulation Q, inflation and disinflation, and the undiversified portfolios of most mortgage lenders played a much larger role. Like a depository institution, thrifts borrowed at short-term to lend at long-term, so periods of stress were inevitable. Reflecting congressional beliefs, FIRREA increased the number of individuals subject to enforcement actions. But it also lowered the “standard of harm” needed to support issuance of cease-and-desist orders. And it increased penalties for violations, thereby increasing incentives for responsible behavior (Brunmeier and Willardson, 2006, 24).
Two years later, Congress passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA). FDICIA represented a major change in regulatory policy toward market incentives and market discipline in place of prohibitions and requirements. The main new feature called for structured early intervention. Instead of waiting for failures to happen, regulators could require an end to dividend payments or closure of the institution before net worth disappeared. This provision watered down the proposal by George Benston and George Kaufman leaving many decisions to policymakers’ judgment instead of mandating a response. Congress talked about restricting “too big to fail,” but many observers believe it did not succeed (Broaddus, 2000; Stern and Feldman, 2004). Stern and Feldman conclude that FDICIA made only a small change in policymakers’ incentives (Stern and Feldman, 2004, 157). In the next banking crisis, 2007–9, the Federal Reserve and FDIC did not invoke FDICIA. Stern and Feldman’s prediction was correct.
Watching and Worrying
During most of 1985, the FOMC expressed concerns about uncertainty and did almost nothing. M1 grew rapidly during much of the year, a source of worry and reinforcement of concern about inflation. The FOMC kept the federal funds rate between 7.5 and 8.5 percent, allowing a modest decline as the economy slowed in the spring. As usual, nominal base growth declined with the funds rate. Judged by monetary base growth, policy remained slightly procyclical.
At the July meeting, President Edward Boehne (Philadelphia) addressed the uncertainty that concerned most of the members. “One prudent way to move forward, if we really don’t know quite what to do, is to go forward staying about where we are, keeping a very open mind about what we do three, four, five weeks from now, depending on how the economy comes in and the money numbers come in” (FOMC Minutes, July 9–10, 1985, 31).
Volcker replied, “That’s about the way I would read it, yes” (ibid.). Several others supported the proposal. No one suggested setting a mediumterm target. Almost everyone agreed to ignore rapid money growth. The main issue in contention was whether to rebase the annual target for M1 growth to accept earlier growth. By 1987, the annual increase in the CPI reached 4.25 percent.
Volcker frequently expressed concern about the effect of dollar depreciation on the price level and the measured rate of inflation, but he and others also noted rising protectionist pressures. Like Secretary Baker, they favored depreciation to improve the trade balance and reduce protectionist pressures. The dollar had fallen 17 percent in three months to July 1985, so the concern was immediate. If they recognized that depreciation would at most affect the price level not the maintained rate of inflation, they did not say so.55 Thus, they missed an opportunity to make clear their objective to themselves and others. Did they want to prevent the price level from rising? Or was their concern mainly with the sustained rate of inflation? Did they let the price effects of depreciation remain, or did they force other prices down to offset the price level effects of a rise in import prices?
Robert Black (Richmond) remarked that “the relationship between the level of borrowed reserves and the growth of M1 is very tenuous and we keep getting fooled by that. . . . I would like to see us insert in our operating instructions to the Desk something more explicit” (ibid., August 20, 1985, 26). His proposal did not fit with Volcker’s eclecticism, and the Committee ignored it. Gerald Corrigan described their approach: “We’ve advanced from pragmatic monetarism to full-blown eclecticism” (FOMC Minutes, October 1, 1985, 33).
55. Volcker: “Well, if I could blink my eyes and wake up tomorrow with a lower dollar and no accompanying change in attitudes . . . I might argue that that is a good thing. But that is an impossible scenario. The question is: How do we get a lower dollar if that is what we inevitably have to get over time without throwing inflation off course, interest rates off course, and without overshooting on the down side” (FOMC Minutes, August 20, 1985, 37).
Eclecticism did not lead to any firm conclusion about what to do. Volcker summarized his judgment at the time as “no great desire to change things aggressively. . . . I don’t know where we are on the economy; it’s not looking very good. I do know the exchange rate is awfully high and I surely wouldn’t want to push it any higher. I would rather do the reverse. I don’t know what’s going on with M1 or M2 or M3. I know they are giving out different signals, but I don’t feel very religious about M1 at this point” (FOMC Minutes, May 21, 1985, 34).56
For the year 1986, M1 far exceeded its pre-announced range, but M2 and M3 remained within their ranges, though near the top. Table 9.5 shows these ranges and the results recorded at the time.
In practice, no one paid attention to M3. Members commented on M1 and M2 during the year, but those aggregates had minimal effect on policy actions. The models used by the staff to forecast the aggregates underestimated the size of changes. The velocities of each of the aggregates continued to decrease from 1981 to 1986 as expected inflation declined (memo, Donald Kohn to FOMC, December 10, 1986, chart 1).
The steady annual increase in velocity so apparent in data for the 1970s disappeared in the 1980s. The Board’s staff (and many others) tried to explain the change by considering the redefinition of the various aggregates following deregulation. M1 now included a large proportion of interestearning deposits, and these deposits grew most rapidly in the 1980s. Staff estimates suggested that the response to interest rates increased in the 1980s. The spread between the rates for deposits and open market rates rose markedly in the 1980s; in 1986 open market rates declined by 200 basis points while rates offered by banks on NOW accounts declined only 60 basis points (ibid., 3).
56. Volcker chose a borrowing target. Roger Guffey (Kansas City) asked what the federal funds rate would be. Volcker responded with irritation, “[Y]ou ask this question every time, Roger, and I’m not a prophet” (FOMC Minutes, May 21, 1985, 42). Lyle Gramley suggested a target for the federal funds rate. Preston Martin responded, “Shame on you, Governor Gramley!” (ibid., 43).
Surprisingly, the staff did not consider the effect of the change in inflation. Rising inflation in the 1970s reduced desired cash balances, increasing monetary velocity. Lower inflation in the 1980s did the opposite. The change was a one-time change spread over time as the public learned or believed that
the decline in inflation was likely to persist. Over the fifteen years beginning in 1990, M1 velocity declined on average at a much lower rate than in the early 1980s, about 1.6 percent a year; M2 velocity was about unchanged.
Even the most persistent advocates of targets for monetary aggregates could not explain their behavior or forecast the size and growth of the new components. The FOMC lowered the federal funds rate when real growth was negative (−0.8). The funds rate declined from 8.14 percent in January to 6.56 percent in July. Growth turned positive in the third and fourth quarters but remained below 1.5 percent annual rate. The funds rate continued to decline, reaching 5.85 percent in October. Although Volcker claimed that his target was borrowed reserves, these do not show a comparable pattern. By early 1987, the growth slowdown ended, and the federal funds rate was back to about 6.5 percent. It remained between 6.5 and 7 percent until Volcker left in August 1987.
The Board reduced the discount rate four times in 1986, from 7.5 to 5.5 percent. The first reduction was the now famous decision in March to coordinate the reduction with Germany and Japan. The vote was four to three, with Volcker in the minority. Volcker wrote out his resignation, but Governors Angell and Martin agreed to delay the reduction as noted earlier (Coyne, 1998, 11–12).57 The second reduction, coordinated with the Bank of Japan, came on April 18, after deferring a reduction four days earlier. The remaining reductions on July 10 and August 20 were made without coordination. All four changes followed prior reductions in open market rates. Some reserve banks proposed an additional reduction to 5 percent after July 10, but the Board did not agree. Dallas, hurt by the oil price decline and agricultural distress, usually led these efforts, sometimes joined by other reserve banks. At 5.5 percent, discount rates reflected the decline in inflation and market interest rates.
The decline in interest rates came too late for troubled banks mainly in agricultural and oil producing areas. In 1986, 189 banks ceased operations. Most of them were non-member banks. This compares to an average of 8 a year from 1980 through 1984 (Board of Governors, 1991, 527–28). Problems at the banks also affected thrift institutions. The problems continued for several years.
57. Coyne (1998, 14) thought that “[t]hings were never the same.” Volcker left eighteen months later. “The four votes came from President Reagan’s appointees and were prompted by White House staff” (ibid.).
Long-Term Securities
At the end of the bills-only policy in 1960, the Federal Reserve portfolio held $24 billion of coupon securities, 89 percent of its portfolio. Over time, the amount held increased, but the proportion declined. At the end of 1985, system holdings reached $92 billion, 48.6 percent of the portfolio (memo, Normand Bernard to FOMC, Board Records, August 13, 1986, 9).
Paul Volcker asked why the System continued to purchase coupon securities. The account manager prepared a memo giving pros and cons. The principal advantages claimed were the information the desk received about the market and the enhanced market liquidity resulting from System purchases. (The latter is unlikely.) The main disadvantage arose because the System did not sell coupon issues. Their portfolio was, therefore, less liquid. Members’ opinions divided, but no one strongly supported either position. The account manager wanted to continue, and no one objected strenuously. Pressure from Congress was probably the most important reason for buying and not selling.
OTHER REGULATORY MATTERS
Financial fragility, legislative changes, and innovation continued to force regulatory change. The 1980s were very different from the 1930s. Deregulation became more attractive and tight regulation less attractive. Gradually the regulators recognized that every regulation offered an opportunity to profit from circumvention. Although regulators and Congress were not ready to repeal the Glass-Steagall Act, they began to move in that direction.
The Depository Institutions Deregulation Act mandated that ceiling rates for time deposits end on March 31, 1986. After that date, only the prohibition of interest payments on demand deposits and reserves remained of deposit interest rate regulation. The Board removed reserve requirements on some savings and money market deposit accounts at banks. It removed a $150,000 ceiling for business savings accounts, provided there were no more than three telephone transfers a month.
In June, the Board expanded the list of activities permitted to bank holding companies. The list now included consumer finance counseling, tax preparation, commodity trading, credit bureau and collection services, and appraisal of personal property. The Board also granted a limited amount of insurance activity to the holding company. Later, this authority expanded.
The Board expanded the definition of primary bank capital to include perpetual debt. A bank could use preferred stock and perpetual debt as primary capital up to one-third of capital.
The Board recommended that Congress revise the Bank Holding Company Act to broaden holding company powers and reduce regulatory burden. It asked Congress to permit holding companies to underwrite municipal revenue bonds, mortgage-backed securities, commercial paper, and mutual funds. It suggested also that Congress consider insurance and real estate brokerage and insurance underwriting. These proposals were a first step toward ending the separation of investment and commercial banking required by the Glass-Steagall Act.
The Garn-St. Germain Act of 1982 permitted banks to make interstate mergers and acquisitions of financially troubled thrift institutions and failed commercial banks. The Board asked for amendments that reduced some restrictions and permitted acquisition of failing as well as failed banks. In a letter to Senator Riegle, chairman of Senate Banking, Volcker urged legislation to alter or remove Glass-Steagall restrictions.
Proceeding piecemeal within the context of a statute written in quite different circumstances can not assure results that are consistent with the public interest in promoting competition, serving consumer needs, and protecting the banking and financial systems.
Because of these concerns, all of the members of the Board join in expressing our strong recommendation that the Congress act on these and other banking issues as early as possible in the next Congress. (letter, Volcker to Riegle, Board Minutes, December 24, 1986)
CONCLUSION: WHY INFLATION DID NOT RETURN
A main, at times the main, objective in the years 1983–86 was to prevent the return of high inflation while maintaining expansion. There were two inflation “scares.” The System successfully reversed the first in 1983–84, thereby contributing to its credibility and the subsequent decline in long rates. The second in 1987 occurred in Germany and Japan as well. It appears related to the effort to coordinate expansion while maintaining a fixed exchange rate.
Two main changes occurred. First, the Volcker FOMC, Volcker himself, and his successor Alan Greenspan put greater weight on inflation control. Interest rates increased at times during recessions or periods of rising unemployment if needed to control inflation. By 1994 the Federal Reserve finally accepted monetarist criticism and adopted counter-cyclical policies by reducing money growth during expansions and raising it during contractions. The Federal Reserve was less influenced by the idea that low interest rates always meant policy was expansive. No less important, FOMC members said repeatedly that low inflation encouraged and even facilitated high employment and economic growth. The facts supported them; the economy had three expansions of above average length in the twenty-five years after 1982. And the volatility of output and inflation declined, contributing to the belief that monetary policy had at last succeeded in restoring and maintaining economic stability.
Since the passage of the 1946 Employment Act, the Federal Reserve operated under some version of the “dual mandate” that after passage of the Humphrey-Hawkins Act became an explicit concern for both unemployment and inflation. Spokesmen for the Federal Reserve continued to accept the dual mandate, but the mandate was not precisely stated. In the early years, unemployment received most weight. Inflation became an objective when the inflation rate rose but only as long as the unemployment rate did
not rise above 6 or 7 percent. After Humphrey-Hawkins and the disinflation, the Federal Reserve and other central banks recognized that the policy of abandoning inflation control to seek lower unemployment had brought more of both. The policy change sought to lower both by reducing inflation, keeping it low, and relying on clearer signals from relative prices and real returns to maintain growth and employment.
Second, market participants responded to excessive stimulus or perceived inflation by selling bonds, raising long-term interest rates, and bringing on an “inflation scare.” The Federal Reserve responded to the scares. In this way, market behavior reinforced Federal Reserve actions and conversely (Goodfriend, 1993). By 1994, the FOMC was confident enough about its operations and secure in its ability to resist pressure to lower interest rates to announce its interest rate decisions as they made them. This required agreement on process—that they targeted the federal funds rate. It showed also that there was much greater understanding that the FOMC’s success could continue if the market understood its actions, as rational expectations implied. With that recognition came heightened interest in communications, transparency, and rejection of the old idea that fooling the market was important or useful.
For an economist, it would be ideal to conclude that the Federal Reserve successfully applied modern economic theory to control inflation. Alas, it was not true. Members of FOMC did not have a systematic approach based on analysis and evidence. Much of the time, members did not know what the operating target was. They voted for a target, but Volcker was eclectic. He did what seemed to him right at the time.
A History of the Federal Reserve, Volume 2 Page 74
