A History of the Federal Reserve, Volume 2 (94 page)

Despite Prell’s memo, the staff continued to rely on the Phillips curve. Many FOMC members, including Volcker and later Greenspan, did not find the forecasts useful.

The FOMC remained divided. A lengthy discussion of operating procedures at the March 29, 1988, meeting considered a memo from Donald Kohn and Peter Sternlight (Board Records, March 25, 1987). The memo cited the loose relation between the funds rate and borrowing as the principal disadvantage. Since a main purpose was to manage the federal funds rate indirectly this problem seemed large in part because the market misread the System’s intentions. Also, when the funds rate remained in its expected range, there was “little scope for market forces to show through.”
⁵²

As usual, the discussion at the meeting was divided and inconclusive. A majority favored continued use of borrowing as their target. In late 1989, they decided to target the federal funds rate, and that decision remained.

Uncertainty about the economic future often dominated discussion during these years, reinforcing uncertainties about the policy instruments. “I don’t attach a lot of weight to small changes in this forecast, whether it’s prices or GNP within the ranges that are set. I don’t think we know what GNP is going to be in this quarter. Things have less than an ebullient tone to them so I think: ‘Fair enough: one might think of easing slightly if the dollar gave one room to do that.’ I am not sure it does right at the moment” (Paul Volcker, FOMC Minutes, November 4–5, 1985, 21).

Policy actions tried to balance objectives for growth, employment, inflation, and the exchange rate without clear understanding of their interaction. Henry Wallich, after years on the Board, recognized that reliance on short-run changes was a source of error including procyclical actions that deepened inflations and recessions. “We have always leaned toward finetuning. When the economy is going down, immediately one sees what one could do by monetary policy if one doesn’t think too much about the long lags. . . . What we do now in May may have effects early next year, at which time the problems we face may look quite different. There has been a proclivity at the Federal Reserve to push harder later in the cycle. . . . [O]ne tries hard to postpone the evil day and push back the moment when the economy flattens out so that we do not have to go into recession. . . . [I]nstead of a mild growth recession, one may get a real recession a little later” (FOMC Minutes, May 21, 1985, 14–15).

Wallich’s statement might have started a discussion of the best way to
conduct monetary policy in a highly uncertain environment. A possible conclusion might have been that it was better to give priority to low and stable inflation and limit responses to short-run changes by setting longterm objectives and directing actions to that end. That didn’t happen. The only response to Wallich’s statement was a question from Volcker about what price Wallich would propose currently to pay for lower inflation. He and others ignored the more basic point. As usual, the members did not discuss their longer-term objectives or how to achieve them.

52. An attached memo by Anne-Marie Meulendyke from the New York operating staff reviewed the history of different targets used from the 1950s to the 1980s. It pointed to the need for procedures that controlled reserves or money over a longer period. But it pointed to the usual criticism that such procedures required large changes in the federal funds rate.

Concern about dollar appreciation produced an agreement among five countries—Germany, Japan, U.K., France, and the United States—to act in concert to hinder further appreciation. In mid-January, Secretary Regan warned the markets that intervention policy had changed from neglect to greater activism. At a telephone conference, Volcker discussed the Federal Reserve’s responsibilities under the changed policy. He expected intervention to increase. Purchases of foreign currencies would be shared with the Exchange Stabilization Fund as in the past.

Apparently, the FOMC’s role was to set limits on aggregate holding of international reserves and quotas for principal currencies—marks, yen, pounds sterling. Existing limits seemed adequate, so the FOMC did not vote. No one objected. Governor Partee usually opposed intervention, but he thought the situation was extreme. For the rest of the year, the FOMC received reports of intervention, but there was little discussion. At times the manager, Sam Cross, reported that foreign central banks complained that they intervened more heavily than the Federal Reserve.

The dollar continued to appreciate. In the three days from February 27 to March 1, 1985, the European central banks led by the Bundesbank sold $4.1 billion of dollars. The Federal Reserve bought $257.5 million of marks jointly with the Treasury. Cross reported that “the results were first judged to be inconclusive. On the one hand, the momentum of the dollar’s rise was broken . . . On the other hand, many were impressed that the dollar did not fall precipitously under the pressure of heavy intervention” (FOMC Minutes, March 26, 1985, 2). Later, as evidence increased that economic growth was slowing, and financial failures in Ohio and later Maryland became known, the dollar resumed its long depreciation.
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From a peak around 3.5 marks per dollar in early March the dollar reached 3.2 marks in mid-March. This was about the level in January, when the finance ministers agreed to intervene.

53. In the two months from mid-January to late March, central banks intervened with $10 billion. They considered this massive, but the exchange markets traded hundreds of billions a day at the time.

The most contentious issue about targets for monetary aggregates in 1985 was the extent to which the FOMC wanted to reduce inflation below 4 percent. Wallich and Gramley were in favor, but the proposal lacked general support. One problem was that the members had little confidence in the implicit forecast of monetary velocity. Frank Morris (Boston) said, “It seems to me that all we can do is assume that we’re going to get trend velocity, anything else is pure speculation.” Volcker responded, “The trouble is that we don’t know what the trend is” (FOMC Minutes, February 12–13, 1985, 48). Volcker remained humble about how much could be known about the future.

Financial
Fragility

Financial problems worsened during the winter. On March 1, 1985, the Board issued regulations to increase capital standards first proposed in July 1984. At the same time, it authorized the director of the Board’s Division of Banking Supervision and Regulation to issue preliminary notices if a state member bank or holding company had insufficient capital. The final notice required Board action (Board Minutes, March 1, 1985, 3–7).

In January, the Board became concerned about the solvency of deposit insurance agencies. The Federal Savings and Loan Insurance Corporation (FSLIC) eventually had to close as claims for payments rose. The Federal Deposit Insurance Corporation (FDIC) remained open, but insurance premiums increased. In January, the Board considered and approved increases in net worth for FSLIC-insured institutions proposed by the Federal Home Loan Bank Board (FHLBB). But both Boards were late in taking action. Part of the problem arose from the long-term portfolios of most savings and loans. Net worth would be slow to improve. In its letter to FHLBB, the Board commented that “we strongly support your efforts to tighten the capital requirements for FSLIC-insured depositories, and our questions concern whether the actions specifically proposed go far enough” (letter, Volcker to Edwin J. Gray, Board Minutes, January 2, 1985, 12).
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The FHLBB proposal revived interest in risk-related deposit insurance. Risk-taking institutions paid the same insurance charges as others. The incentive to take on risky investments increased as net worth declined. FHLBB proposed increased capital, improved and standardized accounting procedures, and better examination and supervision. Available resources limited examinations. The Board considered using private audits.
One member commented that the public now believed that the regulators accepted “too big to fail.” The main decision called for increased capital including use of subordinated debt, but the Board delayed implementation.

54. “Aggressive growth, even when capital is low is, of course, facilitated by the explicit and implicit protections afforded by FSLIC insurance and Home Loan Bank membership” (letter, Volcker to Edwin Gray, Board Minutes, January 2, 1985). Clear recognition did not lead to strong actions to protect taxpayers.

In February, the FDIC proposed to send a letter to directors of all member banks urging strong action and threatening loss of membership. The Board’s concern was that banks in agricultural areas would be subject to the threat because of their condition (Board Minutes, February 11, 1985, 6).

Failures and threats of failure increased beginning in March. A Florida securities dealer, ESM, suffered large withdrawals. The state of Florida could not quickly provide assistance. ESM applied to the Federal Reserve. Although some members expressed concern that ESM was certain to fail, and that loans would not save it, the Board approved the loans (Board Minutes, March 7, 1985, 2).

The next day the Board learned that the collapse of ESM hurt several Ohio savings banks. All had deposit insurance with the Ohio Deposit Guarantee Fund, a private insurance fund that insured 81 state chartered savings institutions. The report advised that the fund could not pay the losses and would fail. News of the problems at one of the banks, Home State, led to a run on others similarly insured. In the next two months, the problem spread to banks in Maryland, Massachusetts, and North Carolina that had private insurance.

The Board worked diligently to prevent failures. When the governor of Ohio closed the banks and allowed limited deposit withdrawals, the Federal Reserve agreed to lend enough to permit the withdrawals. Out-of-state banks acquired many of the failing institutions.

The Board did not follow the classical position set out by Bagehot more than a century earlier. He advised the central bank to lend freely to the market, against collateral at a penalty rate. The Board lent at standard rates to prevent banks from failing. Later many of the institutions were sold or merged. To its credit, the Board took an active role and did not repeat the errors made in the Great Depression.

The Board asked the Federal Advisory Council (FAC) to discuss regulation and supervision at its September meeting. FAC was critical of existing procedures. Regulators’ responsibilities overlapped. Their rules differed. Capital standards differed. No single rule applied to all institutions. The rule should be conditional on portfolio risk and problem assets. Off– balance sheet risks should be included. Also, regulators should concentrate on safety and soundness and reduce emphasis on social and political issues. FAC proposed improved quality of examiners (Board Minutes, September 6, 1985, Supplement 1–2).

The FAC proposed reform of deposit insurance that introduced more
market discipline. It favored risk adjusted premiums with rebates for conservative institutions. It criticized recent actions. “Greater market discipline can be accomplished by a very clear statement that absolutely no deposits above the statutory limit (currently $100,000) will be paid from the insurance funds in the event of failure” (ibid., 4). Then the FAC added, “Free market discipline will be effective only if a decision is made and explicitly communicated that depository institutions will be allowed to fail except where systemic risk prevails in the opinion of the regulators or other public interest factors are overriding” (ibid.).

Despite the proviso at the end, the FAC statement puts bankers in favor of failure and against bailouts. Within a few years, Congress adopted two significant changes in rules to reduce risk and give a larger role to market disciplines.

In 1989, Congress approved FIRREA, the Financial Institutions Reform, Recovery, and Enforcement Act. This act embodied congressional efforts to attribute problems in the thrift industry to malevolent owners and operators. There were such operators, but their contribution to the problem was much smaller than the press and members of Congress claimed. Regulation Q, inflation and disinflation, and the undiversified portfolios of most mortgage lenders played a much larger role. Like a depository institution, thrifts borrowed at short-term to lend at long-term, so periods of stress were inevitable. Reflecting congressional beliefs, FIRREA increased the number of individuals subject to enforcement actions. But it also lowered the “standard of harm” needed to support issuance of cease-and-desist orders. And it increased penalties for violations, thereby increasing incentives for responsible behavior (Brunmeier and Willardson, 2006, 24).

Two years later, Congress passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA). FDICIA represented a major change in regulatory policy toward market incentives and market discipline in place of prohibitions and requirements. The main new feature called for structured early intervention. Instead of waiting for failures to happen, regulators could require an end to dividend payments or closure of the institution before net worth disappeared. This provision watered down the proposal by George Benston and George Kaufman leaving many decisions to policymakers’ judgment instead of mandating a response. Congress talked about restricting “too big to fail,” but many observers believe it did not succeed (Broaddus, 2000; Stern and Feldman, 2004). Stern and Feldman conclude that FDICIA made only a small change in policymakers’ incentives (Stern and Feldman, 2004, 157). In the next banking crisis, 2007–9, the Federal Reserve and FDIC did not invoke FDICIA. Stern and Feldman’s prediction was correct.

Watching
and
Worrying

During most of 1985, the FOMC expressed concerns about uncertainty and did almost nothing. M
₁
grew rapidly during much of the year, a source of worry and reinforcement of concern about inflation. The FOMC kept the federal funds rate between 7.5 and 8.5 percent, allowing a modest decline as the economy slowed in the spring. As usual, nominal base growth declined with the funds rate. Judged by monetary base growth, policy remained slightly procyclical.

At the July meeting, President Edward Boehne (Philadelphia) addressed the uncertainty that concerned most of the members. “One prudent way to move forward, if we really don’t know quite what to do, is to go forward staying about where we are, keeping a very open mind about what we do three, four, five weeks from now, depending on how the economy comes in and the money numbers come in” (FOMC Minutes, July 9–10, 1985, 31).

Volcker replied, “That’s about the way I would read it, yes” (ibid.). Several others supported the proposal. No one suggested setting a mediumterm target. Almost everyone agreed to ignore rapid money growth. The main issue in contention was whether to rebase the annual target for M
₁
growth to accept earlier growth. By 1987, the annual increase in the CPI reached 4.25 percent.

Volcker frequently expressed concern about the effect of dollar depreciation on the price level and the measured rate of inflation, but he and others also noted rising protectionist pressures. Like Secretary Baker, they favored depreciation to improve the trade balance and reduce protectionist pressures. The dollar had fallen 17 percent in three months to July 1985, so the concern was immediate. If they recognized that depreciation would at most affect the price level not the maintained rate of inflation, they did not say so.
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Thus, they missed an opportunity to make clear their objective to themselves and others. Did they want to prevent the price level from rising? Or was their concern mainly with the sustained rate of inflation? Did they let the price effects of depreciation remain, or did they force other prices down to offset the price level effects of a rise in import prices?

Robert Black (Richmond) remarked that “the relationship between the level of borrowed reserves and the growth of M
₁
is very tenuous and we keep getting fooled by that. . . . I would like to see us insert in our operating
instructions to the Desk something more explicit” (ibid., August 20, 1985, 26). His proposal did not fit with Volcker’s eclecticism, and the Committee ignored it. Gerald Corrigan described their approach: “We’ve advanced from pragmatic monetarism to full-blown eclecticism” (FOMC Minutes, October 1, 1985, 33).

55. Volcker: “Well, if I could blink my eyes and wake up tomorrow with a lower dollar and no accompanying change in attitudes . . . I might argue that that is a good thing. But that is an impossible scenario. The question is: How do we get a lower dollar if that is what we inevitably have to get over time without throwing inflation off course, interest rates off course, and without overshooting on the down side” (FOMC Minutes
, August 20, 1985, 37).