A History of the Federal Reserve, Volume 2 (92 page)

Volcker did not want to expand. He agreed that dollar appreciation had become a problem. “We could have gone out and eased policy, more than policy already was eased. I didn’t want to do that, because I didn’t think we had won the game yet, expectations were so fragile” (Mehrling, 2007, 183).

By the end of 1984, the United States’ current account deficit— essentially the excess of imports over exports—reached $100 billion. Responding to these pressures and concerns, Baker and his deputy, Richard Darman, began discussions with the Japanese that ended at the Plaza Hotel in New York on September 21, 1984. At first, the discussions focused on both macroeconomic policies and exchange rates, but agreement was difficult to achieve. At the Plaza, five finance ministers and central bank governors agreed to attempt an orderly depreciation of the dollar.
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As Table 9.3 shows, the dollar had depreciated substantially during the first half of 1985, before the agreement. The aim was to coordinate intervention policy and further depreciate the dollar. Volcker said, “The Plaza was basically a Treasury-inspired operation, which I was not terribly keen about” (Mehrling, 2007, 185). He described it as a “get-the-dollar-down operation” (ibid.).

The agreement created excitement in the press and financial markets and its implementation required frequent meetings and official consultations with press attention. Proponents of intervention and currency “zones” were delighted. And at the end of the intervention period, the dollar was lower particularly against the yen. The precise effect of the Plaza agreement and subsequent agreements is difficult to separate from other influences. One reason is that intervention was limited. Also, monetary policy changed in a way consistent with depreciation of the dollar.

Coordinated intervent
ion appeals to many, as it did to Baker.
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The
Plaza agreement illustrates some of the problems. First, the Plaza meeting did not agree on changes in fiscal and monetary policies. Although the United States wanted Germany and Japan to increase aggregate demand, and they wanted the United States to reduce its budget deficit, the agreement did nothing of the kind. As in the 1977–78 discussions, Germany especially was unwilling to adopt coordinated macro-policies. The idea of coordinated policies has a superficial appeal that vanishes when a government has to tell its parliament that it wants to increase tax rates or reduce spending to help foreigners. Or, a government is reluctant to ask for more fiscal stimulus and risk inflation to accommodate another country. Germany had finally agreed reluctantly to fiscal stimulus in 1978. They did not believe the coordinated intervention produced the promised results. And they worried about the “clear risk that the authorities could miss their ultimate medium-term objectives for non-inflationary growth” (Dudler, 1989, 9). They remembered that although the July 1978 agreement was advanced as a means of keeping exchange rates stable, by November 1978 the Carter government had to intervene to defend the dollar.

39. Gyohten (Volcker and Gyohten, 1992, 235) claims that Congress had 400 bills to restrict imports or to place surcharges on Japanese exports to the United States. Many of these actions pointed to Japan’s restrictions on imports, including especially beef, tobacco, and rice. The Japanese claimed the problem was the large United States budget deficit. Volcker claimed that Prime Minister Thatcher told President Reagan that he had to do something about the dollar. The pound was close to $1 (Mehrling, 2007, 184).

40. Those of Britain, France, West Germany, Japan, and the United States.

41. Humpage (1991) is an excellent introduction to issues about the effectiveness of sterilized intervention. Balbach (1978) provides a detailed analysis of many alternatives.

Second, within the United States policy coordination often appeared to mean using monetary policy to finance fiscal deficits. Volcker was familiar with the coordination in the 1960s that began the Great Inflation. He did not want to sacrifice Federal Reserve independence to the Treasury and was wary of Treasury efforts to influence monetary policy. He expressed concern about the risk of inflation following rapid depreciation of the dollar.

Third, behind the bold talk about coordinated policy, there was little consensus about the aim of policy and about who would intervene and how much each would spend. The Germans claimed that the problem was mainly a U.S.-Japan problem. Dudler (1989, 11) reports the internal view. The Bundesbank “was determined, however, to reject binding exchange rate commitments which would have forced major central banks to indefinitely defend narrowly perceived target ranges for the biggest currencies.” It favored inflation control over exchange rate management. The Germans wanted much greater appreciation of the yen than the mark. The United States did not want the agreement to call for depreciation of the dollar, so it referred to appreciation of other currencies. Volcker insisted on inserting “orderly” before “appreciation.” He did not want to commit to a large change (Funabashi, 1989, 15).
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However, a paper circulated at the meeting stated that “a 10 to 12 percent downward adjustment of the dollar
from present levels would be manageable over near term” (ibid., 17). It is not clear how those who objected to dollar depreciation could agree to that statement. The depreciation reached these objectives before the end of 1985.
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42. Funabashi was a Japanese journalist who interviewed most of the principals in these agreements.

Fourth, reports of the discussion did not mention real exchange rates. All of the discussion was about nominal rates. A discussion of real exchange rates would have brought economic policy to their attention. This did not happen. Ministers did complain to their counterparts about their policies, but they never agreed on what should or could be done. This is a weak link in any coordination effort.

Fifth, the meetings did not discuss the difference between sterilized and unsterilized intervention. This is surprising because the G-7 had authorized and read a report by an international committee, the Jurgensen report, that emphasized this distinction. The report concluded that sterilized intervention has little if any effect. Volcker and Funabashi suggest the probable reason for neglecting the distinction was that finance ministers and central bankers thought the distinction was “academic.” That was an error. Sterilized intervention does not change the monetary base or the money stock, so it does not change the expected rate of inflation, interest rates, or the exchange rate. Coordinated intervention, even if sterilized, signals that the governments or central bankers may think exchange rates are misaligned. Markets may go along with them for a while, particularly as in 1985, when the dollar had depreciated substantially prior to the agreement.

In the 1980s, the Federal Reserve and the Bundesbank always sterilized their intervention. Both were independent and suspicious of efforts by the government to influence monetary policy. The Bank of Japan was not independent at the time and did not sterilize all of its sales of dollars. For that reason alone the yen appreciated more than other currencies. The Japanese government expressed concern frequently about the risk of controls on trade by the United States Congress.
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The Plaza meeting talked about $18 billion of intervention but did not set a target for the next few weeks to the end of October. The United States spent $3.2 billion. Other central banks in the G-10 spent $7 billion (ibid.,
23). The Plaza agreement did not include an agreement on interest rates. West German rates moved very little in 1985, but short-term Japanese rates rose by one percentage point to 7.36 percent by the end of the year. The federal funds rate rose modestly, from 7.9 in September to 8.27 in Decem
ber. The Board was reluctant to reduce the discount rate. Mainly it followed market rates. In Germany, the Bundesbank announced a monetary target, so it could adjust its exchange rate only by departing from its announced target. At times, it did.

43. Baltensperger (1999) discussed this period in the Bundesbank’s history. He does not give much attention to the agreement as an influence on Bundesbank policy.

44. During the fall of 1984 and the winter of 1985, I was a visiting scholar at the Bank of Japan. Policy officials expressed concern about the risk of trade restrictions. They were concerned also that the strong dollar encouraged their export industries, such as automobile and consumer electronics, but other parts of their economy were less dependent on export markets. They expressed concern about distortions.

When the Federal Reserve met in early October, Sam Cross of the New York bank reported on events following the Plaza agreement. The agreement was a surprise, but the ministers’ statement was vague. At first the dollar fell 3 to 4 percent without any central bank intervention. Since there was no stated objective, the dollar began to appreciate. Heavy intervention, particularly in Japan, persuaded the speculators that the yen would appreciate. By October 1, official intervention by the central banks reached $2.5 billion, of which the United States contributed 15 percent. Germany remained more reluctant to intervene because changes in the mark’s value disrupted its relations with the European currencies that had pegged to it.

What did intervention achieve? The dollar declined as shown in Chart 9.1 above. It is not clear if much can be attributed to exchange rate policies. Unsterilized Japanese intervention appreciated the yen. Baker’s aim had been to reduce the current account deficit. Table 9.4 shows that the current account deficit rose through 1986 before declining modestly. The deficit was about the same in 1988 as in 1985. By 1988, the exchange rate policy had ended. Possibly lagged effects of the agreement had some influence on the deficit.

In February 1986, the Federal Reserve asked the regional banks to report on the effects of dollar depreciation. The overall summary states: “All of the summaries [by each reserve bank] of these reports began with a sentence like that from Boston. ‘First District businesses have seen little, if any, impact from the decline in the value of the dollar, with respect to either input prices or, in the case of manufacturers, their firm’s ability to
compete in domestic and foreign markets’” (Board Records, February 4, 1986, 1). The most common explanation of the lack of response was delay. Some did not think the depreciation was permanent. A main reason for the lack of change was concentration on the exchange rate and failure to coordinate interest rate policy to achieve a reduction in the real value of the current account deficit.

The failure to agree on fiscal coordination, the absence of improvement in the current account deficit, and the decline in oil prices led Baker to make new efforts to coordinate. At the start of 1986, he urged countries to reduce their interest rates. The central bankers opposed (Funabashi, 1989, 45). As the economies slowed in early 1986, the Board received multiple requests to reduce the discount rate from 7.5 to 7.25 or 7 percent. The Board deferred action eight times, usually citing conditions in the foreign exchange market as one reason.

Oil prices declined from a peak of $26 a barrel to $12 at the end of 1985. The Saudis contributed by increasing production. The rate of increase in consumer prices followed, reflecting the fall in oil prices. But banking problems in the southwest increased as oil companies failed and homeowners defaulted on their mortgages. Soon thereafter, the Soviet Union defaulted on its debts.

Bordo and Schwartz (1991, table 1) report intervention by the United States for 1985–89. They show large purchases of marks in mid-October 1985 and no purchases from November 1985 to March 1989. The United States neither purchased nor sold during 1986 but sold marks and yen in 1987 and 1988. January 1987 was the peak month ($20 billion) for intervention done mainly by Germany and Japan to slow the depreciation of the dollar (ibid., table 3).

The more important change during the period was the increase in growth of the monetary base and money. The increase was greater in the United States than in Germany and Japan in 1985–86, so the dollar depreciated relative to the mark and the yen. More rapid expansion of the United States base began in May 1985 and continued until 1987. Twelve-month growth rose from 5.8 to 10.7 percent; the monthly average federal funds rate declined. A decline in oil prices contributed to the reported decline in measured inflation.

Discount
Rate
Action

In February 1986, Charles Partee completed his term. President Reagan appointed Manuel Johnson to replace Partee and Wayne Angell to replace Lyle Gramley, who left in September 1985. Both began service early in February. Reagan appointees—Johnson, Angell, Martin, and Seger—now
made up a majority. The weights they gave to inflation and expansion differed from Volcker’s at times. This was true especially of Preston Martin.

With the economy slowing, the Board voted four to three on February 24 to reduce the discount rate to 7 percent. Volcker was in the minority. His concern was the belief that unilateral action by the Federal Reserve would cause the dollar to plunge and bring back inflation. The only previous time that the Board outvoted the chairman was in 1978, when Miller served as chair.

Volcker was angry. He was not accustomed to strong opposition and did not like it. Rumors spread that he would resign. Wayne Angell and Preston Martin were not prepared to continue a conflict, so they reversed their votes. The Board agreed to delay the discount rate action up to ten days while Volcker tried to obtain coordinated reductions in Japan and Germany.

The Board’s action and reversal did not remain secret. Market commentary sided mainly with Volcker. The White House staff wanted the reduction mainly for domestic reasons in a year with a congressional election. Many stories at the time suggested that the Treasury encouraged the four members of the Board.

A few days later, February 27, Volcker reported on his conversations with foreign central bankers.
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No one agreed to cut, but he believed they would do so. On March 6, the Board believed that other central banks would coordinate their actions. It voted unanimously to reduce the discount rate to 7 percent. Germany reduced to 3.5 percent and Japan to 4 percent. The press release cited the common action and the decline in market interest rates. At 7 percent, the discount rate was temporarily above the federal funds rate.

The economy continued to slow in April. Three banks proposed to reduce the discount rate to 6.5 percent. The Board deferred action, citing the desirability of international coordination. Concern about accelerating the decline in the dollar overcame concern about the economy. The delay was only four days. On April 18, the Board reduced the discount rate to 6.5 percent. It cited the decline in market rates, the weakening economy, and probable action by foreign governments. Governor Rice dissented.

On March 21, Preston Martin resigned to return to California. He had requested assurance that he would replace Volcker as chairman, when Volcker’s term ended in August 1987. Secretary Baker would not make
the commitment. In August, Manuel Johnson became vice chairman and Robert Heller replaced Martin as a member of the Board.

45. On February 19, Volcker testified to the House Banking Committee. “A sharp depreciation in the external value of a currency carries pervasive inflationary threats” (quoted in Funabashi, 1989, 48). The dollar had fallen to 180 yen, about
25 percent in a year.