A History of the Federal Reserve, Volume 2 (82 page)

Volcker’s summary noted that Humphrey-Hawkins legislation required the choice of a target. A majority favored M
₂
. “On balance, I think we’re left with what would be termed an eclectic, pragmatic approach. It’s going to involve some judgment as to which one of these measures we emphasize, or we may shift from time to time. . . .

“There was some question . . . of explicit interest rate targeting. I don’t think we have to go to that” (ibid., 39–41).

Volcker accepted the M
₂
target for the present, but it was “a more qualified target than we’ve had before” (ibid., 43). Their approach was now “eclectic, pragmatic” (ibid., 41). In response to a question about how they could avoid inflation if they did not follow a rule, Volcker said they had to depend on “internal discipline” (ibid.). He emphasized the difference. The FOMC accepted reserve targeting to bring down inflation. “We were preoccupied with that need for disciplining ourselves and disciplining the economy. . . . The risks have shifted” (ibid.). But he would not admit to targeting interest rates.

International
Actions

The first cracks in the international payments system came in May 1982, when Mexico borrowed $600 million under its swap agreement. This was the start of an effort to hide Mexico’s financial problem by borrowing on the swap line just before releasing its monthly financial statement, then repaying. It gave the appearance of adequate currency reserves at the Bank of Mexico and may have misled some private lenders.

The Mexican government talked about undertaking an austerity program but wanted to delay until after its July presidential election.
¹³⁸
Volcker believed that in September President López Portillo would make his farewell speech. “The new president would do something in the beginning of September” (Volcker, 2001, 8). Board members questioned Volcker about risk and repayment. He told them that Mexico planned to go to the IMF after its election, but he did not have a firm commitment.

The Federal Reserve had to choose between two unattractive alternatives. Either they made the Mexican loan or Mexico would default on its
debt. The first put the Federal Reserve at risk, but it postponed and perhaps prevented a crisis. Failure to lend meant heavy losses by large money center banks as well as others. Grieder (1987, 684) puts Mexico’s outstanding debt at $80 billion and the share held by the nine largest U.S. banks equal to 44 percent of their capital. Even the prospect of default was likely to reduce or eliminate the money center banks’ ability to borrow on certificates of deposits. A scramble for liquidity seemed likely. The Federal Reserve estimated that as many as 1,000 banks had lent to Mexico.

138. Federal Reserve governors were cynical about the promise. Preston Martin said, “I think we’re defining austerity as halting construction of four office buildings” (FOMC Minutes, May 18, 1982, 12).

In late June, the Federal Reserve increased its Mexican loan to $700 million. Neither Volcker nor the Mexican government had a long-term plan to prevent default. Even after the election, it did not offer a plan. By lending, it permitted lenders to reduce or eliminate their loans. Most were shortterm. As they came due, some lenders withdrew. And the more astute or better-informed Mexicans sold pesos and deposited dollars in U.S. banks. Federal Reserve loans financed these transfers.

The Mexican election did not resolve Mexico’s problem. Volcker told the FOMC on August 24 that Mexico needed more assistance to avoid default. Working with others, the Federal Reserve and the Treasury arranged $3.5 billion in additional loans and a willingness of commercial banks to roll over their loans. Some small banks did not go along, pushing the problem on to the money center banks.

Governor Partee questioned the use of the swap line, reminding the members that “we are precisely in the situation the Committee was somewhat concerned we might be in when that swap was first approved some fifteen years ago” (FOMC Minutes, August 24, 1982, 5). Volcker agreed. Repayment would require “a very draconian adjustment program” by Mexico (ibid.). The present swap was “secured . . . by a Fund agreement that doesn’t exist yet” (ibid).

Members asked about other countries. Volcker told them that Argentina had the most serious problem after Mexico. It did not have a swap line, and most of its loans were to non-U.S. banks.

The Federal Reserve, and Volcker personally, took an active role in the discussions that followed. All of the problem countries defaulted, but the IMF prevented them from stopping interest payments to the banks. Regulatory rules required the U.S. banks to write down the loans if interest payments stopped. Instead, the banks rolled over the loans, and the IMF made additional loans to the countries. The money did not go to the countries; it went to the banks to pay interest due. The countries’ debt rose.

Volcker and the IMF chose to put the solvency of the banks ahead of the debtor countries’ growth. For the rest of the decade income in the debtor countries stagnated. Volcker and the IMF never developed a procedure for
ending this arrangement by writing down the debt.
¹³⁹
In 1989, the U.S. Treasury began to resolve the problem by offering the Brady plan, which reduced the debt.

The Volcker policy also put the interest of financial markets and banks ahead of the interests of the developing countries. The latter reduced their exports from the rest of the world. The United States was a major supplier, so much of the burden fell on U.S. farmers and manufacturers. Writing down the debt and lending to sustain the debt market would have been a less costly solution. Once again, the Federal Reserve neglected Bagehot’s advice.

CONCLUSION

Volcker’s statements as well as data leave little doubt that monetary policy changed in the summer and fall of 1982, even if Volcker hesitated to say so explicitly. The System’s public statements emphasized the difficulties in interpreting money growth, given the changes in regulation and the expiration of All Savers Certificates. Internal discussion gave greater weight to continued recession, rising unemployment (to above 10 percent), risks to money center banks caused by exposure to a Mexican (and other) default, risks to Federal Reserve independence, and the international effects of historically high interest rates. For these reasons, Volcker and others gave priority beginning in June 1982 to lowering interest rates. Internally, Volcker was more forthright. He answered those who thought the policy change mistaken because it reduced credibility just before an election.

I don’t myself perceive that the risks of misinterpretation are as great as some people think. Obviously they are there. . . . [F]ollowing a mechanical operation because we think that’s vital to credibility and driving the economy into the ground isn’t exactly my version of how to maintain credibility over time. Credibility in some sense is there to be spent when we think it’s necessary to spend it and we can carry through a change in approach. . . . We are dealing with the real world and assessing where the risks are. (FOMC Minutes, October 5, 1982, 50; see also Cukierman and Meltzer, 1986)

Volcker then described the risks, including the political risk to the Federal Reserve, if the recession continued or worsened. He acted for a combination of reasons, including political and economic concerns, and domestic and international risks.

139. As an acting member of the President’s Council of Economic Advisers, I proposed a writedown of the debt in the 1989 Economic Report of the President. This met strong opposition from the Treasury Department, so only a part of the recommendation remained in the published report. After the 1988 election, the Treasury accepted the writedown.

If we get this one wrong, we are going to have legislation next year without a doubt.
¹⁴⁰
We may get it anyway. . . . I think I know where the risks are. I’m not sure how it looks just in strict electoral terms, since the question has been raised, to sit here in some sense artificially doing nothing and then have to make a big move right after the election. . . . I’d prefer that this problem didn’t arise now. If business conditions looked a little better and interest rates were a little lower—and I wouldn’t care where the interest rates were if economic conditions looked a little better—and if we weren’t going to have to deal with a succession of sick foreign countries in this time period, if the dollar were not rising into the wild blue yonder right now, and if I thought that all these accumulating problems that we face could wait for a while, we’d have a much easier decision. . . . I don’t know what is going to happen in a number of directions over the next four weeks. (FOMC Minutes, October 5, 1982, 50–51).

The anti-inflation program became possible because President Reagan and, with the exception of credit controls, President Carter did not interfere. Leading members of Congress supported the policy, and those affected most—the homebuilders—reluctantly accepted the importance of reducing inflation. After three years, facing elections with rising unemployment rates and an incipient international crisis that threatened the United States’ financial system, political support wavered and waned. Legislation proposed restricting Federal Reserve independence or requiring it to target and reduce interest rates.

From the 1920s on, the System always responded to the threat of legislation. It was not helpless or without support. But Volcker did not wish to have a test of political strength. Inflation had fallen; the monthly CPI change for November and December 1982 was negative, and the twelve-month moving average fell below 4 percent, nearly ten percentage points below the peak. The December moving average was the lowest since 1973.

Volcker was cautious. He did not want to revive inflation or appear to make obvious policy changes before the November 1982 election. He lowered interest rates beginning in July, and watched the market and public reaction. The Federal Advisory Council told the Board in November that its policy was “appropriate”; it cited the current state of the economy, the level of unemployment, and the rate of inflation. “Moreover, we do not detect any significant loss of credibility on the part of the Fed in its fight on inflation” (Board Minutes, November 5, 1982, 5). However, the FAC warned
that “stricter monetary targeting should be resumed in an early stage of a recovering economy” (ibid.).

140. Volcker talked to Senator Byrd in August. The senator said he would not introduce legislation if interest rates continued to decline (Grieder,
1987, 514).

Although there was talk of inflation, the stock market boomed and longterm interest rates fell. That response encouraged continued ease and continued effort to forestall a banking crisis.

The market reaction has two possible explanations. One interpretation is that expectations of inflation had fallen in step with inflation. An alternative explained the positive market reaction as a response to the lower risk of a domestic and international financial crisis and a cyclical recovery in profits and output together with high, though reduced, inflation expectations.

Evidence supports the second interpretation. The SPF index put expected inflation near 6 percent at the time, a very high rate for peacetime. The ten-year Treasury bond rate remained above 10 percent until November 1985, three years later. In the interim, it remained between 10 and 14 percent, so real interest rates were 6 to 10 percent. These historically high real rates suggest that markets wanted to see sustained recovery without a return of high inflation. Some FOMC members shared the view that real rates would not decline until the recovery was complete without a return to inflation. By 1985, the economy had recovered. The unemployment rate had fallen to 7 percent, while inflation remained below 4 percent.

Goodfriend and King (2005, 982–83) report the wide gap between actual and published Phillips curve estimates of the output loss from disinflation. Okun (1978) summarized six Phillips curve estimates as showing that output would average 9 to 27 percent below capacity each year of the three-year disinflation. The total deviation of output would be 27 to 81 percent. The actual deviation was 20 percent, not small but smaller than even the most optimistic estimate based on published Phillips curves. The Reagan tax rate reduction limited the loss of output. The administration’s aggressive response to the air controllers strike helped also by reducing demands for wage growth.

The actual loss was almost certainly larger than required, and the recession probably lasted longer than necessary. The Federal Reserve’s control of money was imperfect and often absent. Its signals were hard to read. It did not make any of the institutional changes needed to improve monetary control until after it gave up monetary control. Better control procedures would not have removed all the random fluctuations in reserves and money, but lagged reserve requirements prevented the staff from controlling total reserves, as they reported to the FOMC several times. When reserve requirements had to be met, either the Federal Reserve supplied the reserves by open market operations or the banks borrowed the reserves. By keeping the discount rate often far below open market rates, the System
favored borrowing. That left decisions about total reserves to the banks and reduced monetary control.

At least as important, institutional changes made it difficult to interpret money growth. Deregulation was long overdue, but its timing made growth of monetary aggregates difficult to interpret. The Federal Reserve was unfortunate in choosing to target money growth just at the time that the financial sector responded to deregulation. And it put too much emphasis on monthly or quarterly changes. As the charts show, growth of the real monetary base is a more reliable indicator during the period. The FOMC did not use it. Academic economists were probably too quick to conclude that the System could not control money. That conclusion puts too much emphasis on short-term changes.

A principal result was that the System made it much more difficult for the market to believe that the Federal Reserve was in control and would continue to reduce money growth until inflation slowed or ended. The System had abandoned anti-inflation policy on several previous occasions. Irregular base and money growth made its policy difficult to interpret. Table 8.11 shows the changes in real base growth and real ten-year Treasury yields dated at turning points in real base growth. Over a three-year period, base growth changed direction five times, often by relatively large amounts. On average, the change in direction occurred about every five months during the first two years. Anyone watching real base growth or real interest rates for evidence that the recession was about to end would have been uncertain until the prolonged increase in real base growth that began in September 1981 continued in 1982. See also Chart 8.5 above.

Although some members at times recognized that transitory changes in reserves, money growth, output growth, and measured inflation distorted current period data, few proposed to center attention on underlying permanent changes. Volcker and many others recognized at times that their goal was a lower trend rate of inflation, but they made no effort to emphasize the permanent trend or to ignore transitory changes. Their
most important change was to put little weight on the unemployment rate, a decision that did not have unanimous support.