A History of the Federal Reserve, Volume 2 (84 page)

Chart 9.7 compares two forecasts to actual values of real GNP/GDP growth. The green book forecast is made by the Board’s staff, the SPF by private forecasters. The chart shows that the two are broadly similar and both differ much more from actual growth than from each other. The Federal Reserve at first persisted in adjusting its actions to its forecasts despite evidence of frequent, large, and persistent errors. Volcker then adjusted his actions to reports of actual data. The chart shows that errors in forecasts of GDP during the disinflation were exceptionally large, but sizeable errors were not unusual. Errors were exceptionally large in 1983, a period of great uncertainty.

A principal reason for these errors was reliance on a Phillips curve to separate output growth and inflation. The inflation forecasts in Chart 9.8 show again that the forecast error was often much larger than the difference between the two forecasts. The persistence of pos
itive and negative errors in the 1970s or the 1980s is notable. The Federal Reserve and the
SPF persistently underestimated the inflation rate when the inflation rate rose in the 1970s, then persistently overestimated inflation as it fell in the 1980s and again in the 1990s.

During the early 1980s foreigners continued to purchase and hold 15 to 20 percent of outstanding Treasury debt. Chart 9.9 shows that foreigners financed a sizeable part of the large Reagan era budget deficits. One of the likely reasons that researchers do not find much of an effect of budget deficits on domestic interest rates is that substantial foreign purchases substitute for increased domestic purchases. The chart shows that foreigners became larger holders in the 1990s and in the new century during years of budget surpluses in the late 1990s and the renewed deficits after 2001.

PERSONNEL

Two Board members left in the early 1980s. Governor Lyle Gramley resigned after little more than five years of a fourteen-year term. President Reagan appointed Wayne Angell to the position. Angell served from February 1986 to February 1994, then resigned to work in the financial services industry. In July 1984, Martha Seger, a Michigan economist, joined the Board, replacing Nancy Teeters, who resigned to accept an appointment as a corporate economist. Seger resigned in 1991 after more than 6.5 years
as a governor. In 1993, Seger paid a civil fine for violating the one-year ban on lobbying after resigning. She arranged and attended a meeting with the Board in August 1991 as a director of Kroger and Co. During his eight years, President Reagan appointed all seven governors, the first president since Franklin Roosevelt to do that. Table 9.1 lists personnel changes from 1983 through 1985.

On June 18, 1983, President Reagan reappointed Paul Volcker to four more years as chairman. This was a surprise. Several of the administration heavyweights—James Baker and Donald Regan especially—found Volcker difficult to work with and insistent on independence. Although Volcker reduced interest rates, he did not agree to ease policy before the 1982 election, responding belatedly from the administration perspective. What would he do in 1984? They were not sure, and they wanted a more agreeable chairman who would at least listen with more understanding of their wishes. But Volcker had support from the bankers, financial markets, and President Reagan for his success in reducing inflation and also from budget director David Stockman. And he was helped by his opponents’ inability to agree on an alternative.

Volcker did not request reappointment in 1987. Coyne (1998, 14) said he thought Volcker could have had reappointment if he had asked. “He always said he would never ask for a job.” Greenspan (2007, 98–99) reports that James Baker interviewed him for the chairmanship in March 1987, months before Volcker decided to leave. Speculation at the time suggested that Volcker often disagreed with the majority of the Board appointed by President Reagan. Volcker was accustomed to making decisions with advice from the senior staff, not the other governors. The governors could affect the decision made at the meeting. Between meetings, Volcker had authority to act.

Five bank presidents began five-year terms in 1983–85. E. Gerald Corrigan, a Volcker protégé, moved to New York from the Minneapolis bank,
and Karen Horn was the first woman appointed as a bank president. Larry Roos and William Ford, two leading monetarists, retired.

POLICY ACTIONS 1983

The FOMC had given up on monetary targeting without a clear idea about whether the change was permanent. The members recognized that monetary velocity had fallen. They did not have a good explanation of the reasons, and they never mentioned the decline in inflation as a reason for holding more money balances per unit of income, thus lower velocity. The most common explanation was a sense that the new types of deposits now included in M
₁
had lower velocity, but the staff did not present evidence at the meetings. Nevertheless, they accommodated the increased demand for money.

What should replace the monetary target? The FOMC in 1983 could not agree and was often divided. It did not want to return to an interest rate target. Many expressed concern that an interest rate target would expose them to another surge of inflation. Others expressed concern that the market would interpret return to an interest target as the end of anti-inflation policy.
¹
A few members disagreed. They said that in practice the desk used a funds rate target; they urged that the desk make it explicit (FOMC Minutes, February 8–9, 1983, 27). In fact, members proposed different targets and indicators as in the 1950s. Most wanted “flexibility.” In practice this meant that they did not want a precise target and would respond to new information. Uncertainty and ambivalence often left the decision to Volcker.

The Humphrey-Hawkins legislation required the FOMC to announce a money growth target. When Volcker testified to the Senate Banking Committee on February 16, 1983, he announced a 4 to 8 percent range for the year to fourth quarter 1983. He did not tell Congress explicitly about flexibility or the uncertainty about the appropriate target. He told them that “some allowance should be made . . . for the uncertainties introduced by the existence of the new deposit accounts” (Monetary Policy Report to Congress, Federal Reserve Bank of New York, Box 97657, February 16, 1983, 27). The Federal Reserve, he said, would watch to see if “velocity behavior is resuming a more predictable pattern” (ibid., 28). He continued to insist,
however, that “inflation requires appropriate restraint on growth of money and liquidity,” but he quickly added that the short-term relation between money and spending “may be loose” (Volcker papers, Federal Reserve of New York, Box 97649, May 16, 1983, 14).

1. Thornton (2004) summarizes the literature on the choice of target after October 1982. He argues that the Federal Reserve used an interest rate target after October 1982. Others choose later dates, 1987 or 1991. The FOMC chose a band for the federal funds rate in 1982–83 and after, but it had done that in 1979–82. The minutes make clear that the target was borrowed reserves most of the time until the late 1980s. In 1994 and thereafter, the FOMC announced a funds rate target and kept the actual funds rate very close to the target. This was not so in the 1980s, particularly in the first half of the decade.

Commitment to achieve the money targets was no greater than before. Many on the FOMC did not think they had a role. At the December 1982 meeting, President Black (Richmond) proposed a federal funds rate target. Volcker opposed. He distinguished “between having an explicit interest rate target and having . . . some limits of tolerance on what interest rate change one wants” (FOMC Minutes, December 20–21, 1982, 41).

What was the desk supposed to do? In practice, the Committee’s decision at the time was a return to the 1920s program of setting a target for member bank borrowing, very much like the 1950s choice of free reserves. David Lindsey (2005, 15) was responsible for estimating borrowing. Wallich (1984, 11) claimed that after October 1982 the target was borrowed reserves. This acted as a loose target for the federal funds rate. The reason is that to the extent that the staff (Lindsey) had a useful analytic expression for borrowing, borrowing depended on the difference between the federal funds rate and the discount rate plus a random error. The error was often large, and at times the equation was not stable. Nevertheless, it offered a choice. The FOMC could set the funds rate and accept the level of borrowing or set borrowing and allow the funds rate to vary within a wide band.
²

As was typical in the 1950s, the FOMC did not discuss the relative merits of different choices until much later. The minutes make clear repeatedly that Volcker did not want an interest rate target, mainly out of concern for the likely market interpretation that policy would repeat the errors of the 1970s. Unlike the 1950s, however, there was a thorough discussion of individual preferences at the February FOMC meeting.

The staff opened the discussion of long-run targets, noting the large inflow into new accounts now included in M
₂
. They ruled out M
₂
as a reliable target for the present mainly because the new bank money market deposit accounts had become a component. Volcker then asked the members whether they needed or wanted monetary targets. At least twelve favored an M 1 target with a wide range to increase “flexibility.” Partee and several
others said that they no longer targeted reserves. “We just target on net borrowed reserves—that is the funds rate” (FOMC Minutes, February 809, 1983, 28). Teeters and others favored a monetary target primarily for political reasons; it protected the System when it raised interest rates.

2. A memo from Donald Kohn to the FOMC discussed the borrowing target. “There is considerable looseness in the relationship between intended borrowing and the federal funds rate especially over the short-run.” He went on to describe the several factors that affect the short rate but not borrowing and conversely. An example was the decline in borrowing after Continental Illinois Bank borrowed heavily. Others did not want to appear troubled (Board Records, 1987, July 1
, 2).