A History of the Federal Reserve, Volume 2 (79 page)

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 a
s 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 M
₁
and M
₂
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 se
ems 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 inflation 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 M
₂
9 percent, but higher growth rates were “acceptable” (ibid., 79). The vote was eight to four with Teeters dissenting because she wanted more M
₁
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).

The same concerns about misinterpretation and permanent versus temporary changes continued in the discussion of the annual targets. Volcker favored keeping them unchanged because “we don’t know how to change it without possibly getting ourselves in more difficulty” (ibid., p. 83). The decision warned about difficulties with M 1 and did not state a range. The range for M
₂
remained at 8.5 to 9.5. Volcker’s statement warned that the upper part of the range would be acceptable and desirable in a context of declining interest rates. Then the FOMC added that it would accept even more rapid growth of the aggregates if uncertainties continued to increase liquidity demands. The 1983 preliminary targets would continue the 1982 ranges.

Following the meeting, weekly bill rates and the federal funds rate dropped, and long-term rates fell modestly. By July 16, ten-year Treasuries were one-half percentage point lower and bill rates more than one
percentage point lower than at the meeting. On July 19, the Board approved a 0.5 reduction to 11.5 percent in the discount rate followed by a reduction to 11 percent on July 30, 10.5 percent on August 13, and 10 percent on August 26. The two percentage point total reduction followed a long series of deferrals and disapprovals starting in March. The federal funds rate accompanied the discount rate reductions. The monthly average declined from 14.15 percent in May to 10.12 percent in August. By late August, Treasury yields reached 12.5 percent, the lowest value since January 1981. The FOMC signaled to Congress and the market that it wanted lower interest rates. Volcker and the Board believed the market supported the decision to reduce interest rates. The unemployment rate reached 9.8 percent in August. Following the interest rate reductions, monetary base growth rose to 9 percent in July from a 6.5 percent average for the year to that date.

129. Seeking support for increased money growth, Volcker quoted from Friedman and Schwartz (1963) that uncertainty raises the demand for money (FOMC Minutes, July 1, 1982, 34). President Ford (Atlanta) strongly opposed easier policy, warning that the market would give it a political interpretation. Roos gave him some support, but he voted for easier policy. Wallich warned against easing, and Corrigan called a policy change “totally unappealing.”

It is an understatement that Volcker was cautious about mentioning the policy change. In his July Humphrey-Hawkins testimony in the Senate, he did not mention the policy change to lower interest rates. He pointed to the decline in inflation, a reason interest rates could decline, but he did not draw that conclusion. He told the committee that “the evidence now seems to me strong that the inflationary tide has turned in a fundamental way” (Volcker papers, Federal Reserve Bank of New York, Box 97657, July 20, 1982, 2). And he suggested cautiously that the recession was ending. But his forecast showed the FOMC much less optimistic than the administration—forecast growth for 1982 was 1 to 4 compared to 5.2 percent.

The market’s response emboldened those who favored a policy change. When the FOMC next met on August 24, Mexico was in “financial difficulty.” The Treasury advanced $600 million, the Europeans $925 million, and the Federal Reserve voted $325 million in addition to the $700 million, it had approved earlier
¹³⁰
(FOMC Minutes, August 24, 1982, 5).

Peter Sternlight then reported on some continuing domestic problems. Continental Illinois’s certificates of deposit (CDs) were no longer considered top grade because of losses due to Penn Square. Lombard-Wall, a securities dealer, was in bankruptcy, causing problems for Chase Manhattan’s CDs. And the M
₁
money stock fell in July instead of increasing as
anticipated. The desk bought $2.9 billion early in the inter-meeting period. Later it sold back some of its purchases, but it added net $2.1 billion to its holdings between meetings (ibid., 4).
¹³¹

130. Governor Partee asked about the collateral behind the loan, citing earlier precedents. He expressed doubt about Mexico’s ability to repay. Volcker replied that Mexico would have to undertake a “very draconian adjustment program” that had not been agreed to yet. The System’s collateral was an agreement with the IMF that also had not been settled. “Oil revenues are an ultimate backstop” (FOMC Minutes, August 24, 1982, 5). Congress had not approved the Treasury’s loan. The FOMC voted unanimously to make the loan.