A History of the Federal Reserve, Volume 2 (83 page)

Despite these impediments, the effort succeeded to a considerable extent. Inflation did not end, but it fell to levels that had not been sustained for a decade. The FOMC and Paul Volcker deserve our praise for this achievement and for sustaining the disinflationary policy until inflation fell. The minutes show that Volcker had support from a few governors and presidents throughout, but he also had opposition much of the time. Success depended on his persistent concern to reduce inflation, and his firm belief that failure would make stability more difficult to achieve.

The 1979–82 disinflation demonstrates the importance of credibility in the implementation of monetary policy. As Goodfriend and King (2005) emphasize, the public did not fully believe that the Federal Reserve would keep its commitment to end inflation.
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Too many previous attempts were followed by the inflation rate heading to a new peak. The Federal Reserve added to the problem by failing to distinguish between a large one-time increase in the price level, resulting from the 1979–80 oil price increase, and the maintained rate of inflation. Reported rates of inflation would have declined even if the Federal Reserve maintained its earlier policy stance. The Federal Reserve succeeded in reducing the underlying maintained rate of inflation, however.

Continued high real interest rates suggest that more had to be done to convince the public that inflation would not return. Volcker’s lasting influence was (1) to increase the weight on inflation and lower the weight on unemployment, in the Federal Reserve’s objective function and (2) restore System credibility for controlling inflation. Central bankers in other countries made similar changes at about the same time. Central banks apparently learned that disinflation was costly to society and to them because they were blamed for the surge in unemployment rates and loss of output during disinflation.

The Federal Reserve did not yet have a consistent, transparent means of implementing policy. Procyclicality and excessive attention to near-term changes remained. There was ample reason, therefore, for skepticism about whether the reduction in inflation was permanent.

141. Hardouvelis and Barnhart (1989) used a Kalman filter to measure changes in credibility. They found that the public restored credibility slowly. Apparently, credibility depended on sustained reduction in inflation, not on announcements or the decision to abandon reserve control.

NINE

Restoring Stability, 1983–86

Mr. Wallich. . . . We have evidence of a very strong monetary expansion. On the other side is a high real interest rate. Which of the two really drives the economy?

—FOMC Minutes, March 28–29, 1983, 43

Chairman Volcker. I don’t think we know what GNP is going to be in this quarter.

—FOMC Minutes, November 4–5, 1985, 21

Inflation was greatly reduced but not eliminated by the end of 1982. The GNP deflator for fourth quarter rose at a 3.6 percent annual rate, down from a peak of 12.11 percent two years earlier. Real growth followed money growth, not the real interest rate. A strong recovery had begun.

The years of high inflation were over, but inflation and disinflation left problems behind. Four major problems continued in the 1980s. First, real interest rates remained far above historic norms. Foreign governments and banks that borrowed during the years of negative real interest rates could not earn enough to pay the borrowing cost or retire the debt. Beginning in 1982, borrowers began to default, causing large potential losses at major banks at home and abroad. IMF and Federal Reserve policy protected the banks at the expense of growth in the debtor countries and to a lesser extent at home. Second, domestic banks also faced large losses on loans to real estate and energy companies. Adjustment to reduced oil prices, reduced home building, and historically high real rates on mortgages left many banks facing loan losses. Third, the dollar appreciated in the early 1980s, stimulating imports and reducing exports. Reducing the dollar exchange rate later became a goal of the Treasury, assisted by the Federal Reserve. This involved agreement with other leading countries, especially
West Germany and Japan. This problem occupied the Federal Reserve in the 1980s. Fourth, the FOMC wanted to prevent a return of high inflation. It was uncertain about how to do that. Policy was judgmental, based mainly on Volcker’s judgments.

It is not possible to date precisely the end of the inflation. By 1986, long-term interest rates, exchange rates, and changes in wages and other prices no longer incorporated high expected inflation. This evidence of the adjustment of expectations is a good measure of the end of inflation. As Governor Wallich noted above, money growth and real interest rates in 1983 gave very different signals about the future. Base growth had increased from a 5.3 annual rate at the end of 1981 to 8.3 at the end of 1982. By the spring and summer of 1983 twelve-month average base growth was above 10 percent. But yields on ten-year Treasury notes reached 10.6 percent as he spoke and rose further as the year progressed. The SPF expected inflation for the next four quarters fell to 5 percent in first quarter 1983, so the anticipated real yield was about 5.5 percent. It rose with the rise in nominal yields and a further decline in anticipated inflation.

The extraordinary real returns reflected both skepticism about the Federal Reserve’s ability or willingness to further reduce inflation or even to keep it from rising and the strong recovery from a deep recession. The high real rate was apparently balanced by an even higher expected return, especially to consumption in the event. The unemployment rate reached 10.8 percent at the end of 1982 and 10.3 percent in March 1983, when Wallich spoke. Experience in the 1960s and 1970s gave ample reason to believe that the Federal Reserve would again respond to the increased unemployment by inflating; hence consumer spending increased in anticipation of higher inflation.

Disinflation was incomplete. The economy was far from stable growth with low inflation. Interest rates reflected pervasive uncertainty and skepticism. The real trade-weighted exchange rate had increased 36 percent between third quarter 1982 and first quarter 1983, so the current account had moved to a large deficit.

The high rate of money growth reflected to an unknown extent the desired increase in real balances following the decline in inflation. Equations for the demand for money could not reliably separate the increase in money balances that the public wished to hold at the lower prevailing and anticipated rate of inflation and the desired reduction in money balances that presaged a return to higher inflation as reflected in the long-term rates.

The FOMC recognized that there was more to be done. It was more uncertain than usual about what to do and how to do it. Memories of the problems with an interest rate target and existing high real rates made an
interest rate target unattractive. But the steep decline in monetary velocity and the continuing response to deregulation reduced support for a monetary target.

Wallich doubted that the monetarist predictions would be correct. Rapid money growth implied a strong economic advance followed later by higher inflation. “If I were to follow through the monetary implications of the recent monetary upsurge, I would have to say that the monetarist view is that half a year later the real sector would begin to move strongly. If that were the case, then we’d see something stirring now and certainly have very strong second and third quarters, which we don’t seem to expect, and a couple years later prices would begin to expand” (FOMC Minutes, March 28–29, 1983, 43).

His analysis was right, his forecast partly wrong. As in all previous periods since 1920, when real base money growth and real long-term interest rates gave opposite forecasts, the economy followed real base growth. This time was not an exception; it differed only in the unprecedented level of the real interest rate. Despite these rates, real GDP, pushed along by rapid money growth and the permanent tax cuts, rose at an average rate of 8.3 percent in the four quarters starting in second quarter 1983. At the time Wallich spoke, real first-quarter GNP growth was 3.5 percent followed by 9.3 percent in the second quarter. The deflator rose from 3.2 to 4.7 percent between first and fourth quarter 1983.

The Federal Reserve responded by raising the federal funds rate more promptly than in the past. The rate rose from 8.5 percent in February 1983 to 9.6 percent in February 1984, about as much as the deflator. But the funds rate continued to rise, reaching 11.6 percent in August 1984.

This rapid response hides the uncertainty that was a dominant feature of FOMC meetings. The members had a much clearer view of their responsibilities but a murky view of how to achieve them. It took several years to develop an operating procedure that improved their ability to maintain steady growth and low inflation.

Treasury officials during the early (1981–85) Reagan administration opposed exchange market intervention. Many at the Federal Reserve disliked this policy, but the Treasury controlled exchange market operations. Treasury Undersecretary for Monetary Affairs, Beryl Sprinkel, announced that the market would set the exchange rate. He limited intervention to a few periods of market disorder.

A major issue of the period resulted from the large deficits in both the budget and the current account. A popular and widely discussed explanation blamed the latter on the former, the so-called twin deficit problem. It was easy to demonstrate arithmetically that the current account deficit
equaled the difference between private saving and investment plus the budget deficit. An increase in the budget deficit, with private saving and investment unchanged, increased the current account deficit. This was true ex post.

The problem with this explanation, as every economist should know, is that both deficits are endogenous variables that are dependent on responses to policy, interest rates, output, and other variables. The same forces that affect the two deficits also affect private saving and investment. For example, an increase in productivity growth increases output, raising tax collections and imports. The budget deficit declines and the current account deficit increases. Other things unchanged, the ex post relation will show that the current account deficit equals the difference between private saving and investment plus the budget deficit. But in this case investment rises, making it possible for the budget deficit to decline while the current account deficit rises. Data for the 1980s and 1990s show that the two deficits often moved in opposite direction. During the productivity surge in the late 1990s, the budget deficit became a surplus, but the current account deficit increased.

Meltzer (1993) studied changes in the trade-weighted real exchange rate using the analysis outlined in Friedman (1953). The principal factors affecting the exchange rate were the increase in military spending and the (lagged) increase in real money balances. Rearmament drew on domestic resources but also foreign resources, and imports substituted for domestic output devoted to rearmament. When the increases in defense spending slowed or reversed, changes in the real exchange rate reversed also.

Chart 9.1 shows the rise and subsequent decline in the real exchange rate. Disinflation and rearmament brought the real exchange rate to a peak in first quarter 1985. In the second quarter, the exchange rate reversed course, declining more than 6.6 percent. The new Treasury secretary, James Baker, reached agreement with other principal countries to intervene, so intervention thereafter reinforced dollar depreciation by the market. By fourth quarter, the rate was back to the level two years earlier, in third quarter 1983. The dollar continued to decline for the next two years. The Louvre agreement early in 1987 attempted to bound the nominal rate, but after a worldwide stock market collapse in October 1987 governments abandoned the effort. Chart 9.1 shows that the exchange rate remained in a narrower range to the end of the decade.

Chart 9.2 shows annual consumer price inflation. The chapter de
tail discusses the adjustment to reduced inflation and the rise in 1983–84 that sustained concern for a time that high inflation would return
. The chart shows that the inflation rate stabilized at 2 to 3 percent only in the 1990s.

Chart 9.3 compares a well-known inflation forecast made a year in advance to reported inflation. The forecast consistently overestimated inflation in this period, perhaps reflecting skepticism about the Federal Reserve’s willingness or ability to maintain low inflation.

In the 1970s, monetary policy usually reacted quickly and decisively to the unemployment rate. Fortunately, the stronger-than-anticipated recovery in 1983 lowered the unemployment rate by 2.8 percentage points. Thereafter, the rate continued to fall until the end of the decade. Chart 9.4 shows these data. The continued decline in the unemployment rate was one of the factors that eventually reassured the public and the markets that the Federal Reserve was less likely than in the 1970s to increase inflation.

Chart 9.5 shows the response of long- and short-term interest rates to policy and other variables. Long-term rates did not remain below 10 percent until 1985–86. The skepticism noted earlier is especially apparent in the movement of long-term rates in 1983–84. In July 1984, the ten year government bond rate again reached 13.8 percent. As Chart 9.5 shows, this was the beginning of the end of the exceptionally high rates, but two years passed before ten-year rates returned to single digits. The interest rate data confirm the uncertainty that the pubic shared with the Federal Reserve as the latter worked to establish that monetary policy would not repeat past mistakes.

Productivity growth,
the rate of change of
output per hour, typically
rises following a recession, then falls back to its trend rate. Chart 9.6 shows this pattern, a steep rise in 1983 and 1991. By the late 1980s the average rate outside of recoveries fluctuated around 1 percent. Difficulties in forecasting variable productivity growth are one reason forecasting output growth and inflation is not very accurate.