A History of the Federal Reserve, Volume 2 (72 page)

The Board’s staff continued to underestimate the recovery in 1980–81. But member bank borrowing rose above $2 billion. The FOMC decided to raise the funds rate to 18 percent in late November and increase the discount rate. Teeters dissented.

As year-end 1980 approached, it was clear that the Federal Reserve would exceed its annual targets for M
₁
A and M
₁
B. No one proposed taking steps in December required to hit the targets. Many expressed concern about loss of credibility and its effect on expectations, but none favored a further sharp rise in interest rates.
⁸³

Table 8.4 shows FOMC targets for M 1 and actual money growth using data reported at the time. The data for 1980 are for M
₁
B, the closest analogue to old M
₁
. Despite the collapse of money growth during the credit control period, the System exceeded the target. Actual growth was 10 percent above the upper band. As the table shows, this was not an unusual occurrence. The difference was that now many of the members worried about credibility and markets gave more attention to M 1 growth.

83. At a telephone conference on December 5, the FOMC voted ten-to-two to raise the upper bound on the funds rate without setting a specific ceiling. Volcker said, “M 1 B is certainly going to be over [its annual target]. . . . I think we would get a lot of flak from the other direction for having such a big decline in the number in one month” (FOMC Minutes, December 5, 1980). A third inter-meeting telephone conference the following week reaffirmed the absence of a ceiling. Although Volcker emphasized that the interest rate band always changed to control reserve growth, the staff was more candid. Berry (1980) quoted the account manager, Peter Sternlight: “During at least two periods, the level of rates rather than the level of reserves and the money stock became major factors in Fed money market actions.” Practice was mixed.

Missing the target soon set off discussion about whether 1981 target money growth should start from the actual value or the 1980 target. In earlier meetings, the consensus claimed that the System contributed to inflation by using actual growth each year as the base for the next target. The implication was that they would not continue that practice. Using the data in Table 8.4, the cumulative difference between the target midpoints and actual growth from 1976 to 1979 was six percentage points. Using the actual values had allowed money to grow at a 6.7 percent average annual rate from 1976 through 1980. The difference in 1980 was nearly two percentage points of money growth above the midpoint.

Views differed. The more aggressive anti-inflationists wanted to use the midpoint of the previous target. Others complained this would be too restrictive in 1981. The members did not reach an agreement at the December meeting. By February 1981, the money stock had declined enough to avoid the issue. The FOMC continued to use the previous actual level as a base.

Everyone at the December meeting expressed confusion and uncertainty about the interpretation of money growth, both retrospective and prospective. Nationwide NOW accounts—in effect, interest-bearing checkable deposits—would soon be available and included in M
₁
B. Also, money market accounts would be included in M 2 . The System expected large withdrawals from accounts subject to regulation Q ceilings, but it had no reliable way to estimate how much M
₁
B and M
₂
would change as a result of the Monetary Control Act. What was the size of the substitution effect? Where would the deposits come from? What should the System announce at the Humphrey-Hawkins hearings in February? How would the announcement affect the System’s credibility?

The proposals included use of a reserve target, increased attention to interest rates, and increased support for Henry Wallich’s proposal to target the real interest rate. Support for monetary targets had begun to break down. Governor Gramley, for example, had supported monetary targeting. He now favored shifting back to interest rate control using monetary targets “over a longer period” (FOMC Minutes, December 18–19, 1980, 50). Vice Chairman Solomon supported Gramley and Wallich. “I think we have to pay much more attention to real interest rates” (ibid., 56). The proponents of these changes offered no evidence that it would improve inflation control.

For the first time, Governor Partee recognized explicitly that the System had made a major change in policy by shifting emphasis to reducing inflation and away from the unemployment rate. “We no longer care what unemployment is so long as it’s plenty low. We now say that in addition
to seeing to it that monetary policy doesn’t lead to a situation in which demand presses against inflation, we are going to work to reduce inflation through monetary policy” (ibid., 53). Partee inquired rhetorically how weak they would permit the economy to get, and he recognized that the new administration had much in common with the Thatcher administration in Britain in its determination to lower inflation even at the cost of recession.

Chairman Volcker reinforced the point. “An implicit assumption that we are just avoiding excess demand is not the present policy. We have been put in a position or have taken the position . . . that we are going to do something about inflation maybe not regardless of the state of economic activity but certainly more than we did before in looking at it in the form of avoiding excess demand. It is a very important distinction” (ibid., 61).

Here at last was widespread recognition that the Federal Reserve had accepted responsibility for reducing inflation and would pay the near-term social cost to get the long-term benefit. Like former Chairman Martin, Volcker and others complained frequently about lack of support from fiscal policy and being the only agency concerned enough about inflation to work to reduce it. Unlike Martin and Burns, Volcker accepted the responsibility and carried his Committee, some willingly some unwillingly, with him.
⁸⁴
The Volcker Federal Reserve restored much of the independence within government lost during the Martin and Burns chairmanships.

Despite the sense that the System had to act alone, it “would like to know something a little more definitively about the plans of the new administration” before setting its goal (ibid., 27–28). This was not policy coordination as used in the 1960s. Administration policies would affect economic activity and the System’s success in reducing inflation. In this too, the Volcker Federal Reserve broke with the past.
⁸⁵

On July 16, 1980, Chairman Volcker had given his Humphrey-Hawkins testimony and the System’s forecasts for 1980 and 1981. Table 8.5 shows actual outcomes. Real growth was above the forecast and inflation was within the forecast range. Real wages fell. The recovery came earlier than
anticipated after a very variable start to 1982. The table shows that by 1982, the Federal Reserve was winning its inflation fight.

84. Volcker also cited the government’s assistance to Bache (when threatened by losses on the Hunt’s attempt to corner the silver market) as an example of protection from failure. He argued that this protection did far more to reduce credibility than small misses of the monetary targets (FOMC Minutes, December 18–19, 1980, 62–63). He soon had to confront the problem of losses on foreign loans.

85. Again, Volcker expressed skepticism about forecasts. “The economic forecasting ability of the assembled economic wisdom of the United States in the short run has not been notable. And I don’t know what the increase in GNP will be in the fourth quarter of the year” (FOMC Minutes, December 18–19, 1980, 63). Note that more than two-thirds of the quarter had passed.

Despite Volcker’s many speeches affirming the System’s determination to reduce inflation, Federal Reserve credibility remained low. The Federal Advisory Council (FAC) politely reminded the governors of that problem. At its February 7–8, 1980, meeting, FAC commented:

The Council commends the Board’s continuing efforts to restrain the rate of growth in the monetary aggregates and bank credit expansion. However because of the disparity between past Fed announcements and actual results . . . there is some skepticism in the marketplace that the Fed is resolved to adhere to its stated policies over the long term. (Board Minutes, February 7–8, 1980, 7)

At its May meeting, the FAC praised the Federal Reserve for hitting its money growth targets and permitting interest rates to rise to unprecedented levels. “The Committee has moved aggressively to dampen expectations about future price increases as well as to establish the groundwork for unwinding existing inflation” (Board Minutes, May 1–2, 1980, 6). The FAC expressed concern that the FOMC would permit another seasonal surge in money growth.

This expression of growing confidence in the Federal Reserve did not last. At its September meeting, the FAC complained about policy implementation. Notably, it did not complain about high interest rates or recession.

While the Council approves of the intended thrust of monetary policy, it is concerned over the operations designed to achieve the goal. The intent of the October, 1979 initiatives was to control money growth more closely and, consequently, accept greater interest volatility. Fed operations to date have generated both greater volatility in interest rates and in money growth. . . .

The result of the variability in money growth is a substantial whipsawing of interest rates and also a growing instability in financial markets. High volatility breeds uncertainty, reduces the credibility of Fed policy and raises inflationary expectations. Also, the press reported that the FOMC temporarily shifted from a money growth target to an interest rate target for foreign exchange reasons. (Board Minutes, November 1–2, 1980, 4)

The FAC urged the FOMC to remove all interest rate guidelines and to provide more information about its operations. The FAC repeated this criticism at its December meeting and warned about the Federal Reserve’s low credibility.

Faced with the uncertainty about administration policy, measures of the monetary aggregates and oil prices, the preliminary discussion at the December FOMC meeting showed a wider range of opinions than usual. Usually, the members would choose quarterly average rates of growth for the aggregates consistent with their annual targets. Then they would instruct the manager about near-term ranges for the federal funds rate, the monetary aggregates, and the initial level of borrowings. Axilrod and his staff in Washington and Sternlight and his staff in New York would then choose a path for nonborrowed reserves that they thought was consistent with the targets. A major problem was that the staffs did not have a useful model of borrowing; if they missed the level of borrowing, total reserves and money rose or fell more than anticipated.
⁸⁶
The federal funds rate moved to the top or bottom of its permitted range. The reason for the problem was similar to problems encountered earlier when using a free reserves target because in practice their operation was similar.

The FOMC often had to raise or lower the federal funds rate ceiling or floor, using a telephone conference to change the limit. The range for the federal funds rate was often six percentage points, but interest variability was high, so the FOMC held frequent telephone conferences. And it spent considerable time negotiating ranges for the funds rate.

Unable to get tentative agreement on the annual targets or the short-run targets proposed by the staff, Volcker presented his own proposal at the December meeting. Citing difficulties in making a proper allowance for institutional changes, he proposed to omit targets for M
₁
A and M
₁
B, and suggested a range of 16 to 20 percent for the federal funds rate until the
next meeting. The FOMC widened the band to 15 to 20 percent. Governors Teeters and Wallich dissented for the same reasons they had earlier.

86. Roos (St. Louis) objected that “[t]he Committee very carefully chooses aggregate growth targets and fed funds ranges and then the staff with some verbal guidance but no official guidance from this Committee makes the borrowing assumptions. Sometimes the borrowing assumptions are not consistent with the [monetary] aggregates and fed funds decisions we have made” (FOMC Minutes, December 18–19, 1980, 76). Volcker agreed.