A History of the Federal Reserve, Volume 2 (61 page)

Skepticism about the persistence of low inflation remained in October 1982. The interest rate on a ten-year Treasury bond remained near 11 percent and the Society of Professional Forecasters predicted inflation near 6 percent. Inflation forecasts did not fall to 2 to 3 percent until 1985–86, when the ten-year interest rate reached 7 to 8 percent. Apparently the public had learned to distinguish between permanent and temporary changes (Friedman, 1957; Brunner, Cukierman, and Meltzer, 1980). It became convinced that the long period of high inflation was over only after experiencing a sustained recovery with low or declining inflation rates.
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Paul Volcker had the background and experience to be a successful chairman. Early in his career he worked at the New York bank, later as its president, and he served as undersecretary for monetary affairs during the collapse of the Bretton Woods system and its aftermath. Foreign central bankers and New York bankers knew him and had confidence in him. He was knowledgeable and strong-willed, and he recognized the importance of reducing inflation. He was also determined and committed to the task. “You needed someone like Paul, a total technical command, political savvy in the best sense within the System and able to go and explain this to the country. . . . I think he was unique, and it wouldn’t have been done this way without him. . . . Now in the end we might have done it one way or another, but they would never have had the nerve to raise interest rates so fast” (Axilrod, 1997, 9). “Paul was a very good chairman at the time . . . [H]e saw the time was right to kill inflation. . . . The President [Reagan] was willing to support him. The public was equally supportive and could get high interest rates from money market funds, so you weren’t going to get flack for driving interest rates up with people stuck with low interest rates on their savings accounts. I thought that was crucial in keeping Congress from the battle” (ibid., 8–9).

Axilrod (2005, 241), who worked closely with Volcker, described him as “an eminently practical person, who very well understood how important it was for the health of the economy and the country to bring inflation down and restore the Fed’s anti-inflation credibility. Moreover, he also had enough political astuteness to grasp that political and social conditions in the country at the time presented him with a window of opportunity for
implementing a paradigm shift in policy that might well make the process of controlling inflation more convincing and quicker. In his choice of policy instrument, he was a practical monetarist for a three-year period.”

4. This episode shows that the short-term interest rate does not express all the information in the term structure of interest rates or in asset prices and inflation anticipations. The Federal Reserve can manipulate the short-term rate. Changes in long-term rates, asset prices, and money growth suggest the degree to which market anticipations respond.

No less important, Volcker believed the task of lowering inflation was important for the country and the world. By moving from New York to Washington to become chairman, he gave up $60,000 a year in income, one measure of his commitment to the task.

Volcker’s method of operation was to work with a small staff. Joseph Coyne, in charge of the Office of Public Affairs at the time discussed Volcker’s management style.

Q. He has a reputation of being a man who kept his own counsel, who didn’t talk very much to the other Governors. Several complained that they really felt that they were out of the loop. . . . Is that fair?

A. Yes, that’s fair.

Q. He worked mostly with the staff?

A. He worked mostly with the senior staff. (Coyne, 1998, 9–10)
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Volcker did not come to the Board with a complete plan, and he had not decided to change the FOMC’s operating procedures. He had spoken about the role of money in inflation control on several previous occasions. The Board’s staff, however, had experience with reserve control from earlier efforts in the 1970s. Volcker assigned to Stephen Axilrod and Peter Sternlight the development of a technical control system.

At about the same time, Congress made a major change in regulations affecting interest rates and money by passing the Depository Institutions Deregulation and Monetary Control Act (DIDMCA). The act gradually eliminated interest rate ceilings for banks and financial institutions and empowered the Federal Reserve to require non-member banks to hold reserves. In exchange, non-member banks obtained the privilege of discounting at Federal Reserve Banks. The Federal Reserve had sought a legislated change of this kind at least since 1937 (Meltzer, 2003, 486–87). The change was overdue, but the timing was poor since permitting new types of accounts and removing interest rate ceilings changed the public’s preferred mix of monetary assets in a way that made forecasts of money growth difficult just at the time that the Federal Reserve chose to monitor money growth more closely.

5. From the Axilrod interview:

A. Many people on the staff thought they were excluded.

Q. Well, among the Governors also?

A. Yes, in a way they may have been excluded a bit from direct contact with him because he was more comfortable working with several people. (Axilrod, 1997, 10)

Appreciation of the dollar was a third major monetary event of the period. The Federal Reserve’s trade-weighted index appreciated from 85 to 135, after adjusting for price changes, between 1980 and 1985. Appreciation worked to reduce measured inflation, but it deepened the recession by raising prices foreigners paid for U.S. exports.

The Federal Reserve and political administrations from 1966 on had postponed or interrupted efforts to reduce inflation. Financial markets and the public had become convinced that commitments to end inflation would vanish once unemployment began to increase.
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Skepticism made the task more difficult; it was not enough to reduce the inflation rate temporarily. That had happened before, but it had not lasted. The public and financial markets wanted to see a permanent reduction in inflation, a reduction that persisted through the next expansion.

Past failures imposed two conditions: (1) anti-inflation policy had to continue after the unemployment rate increased; (2) inflation would not rise much during the expansion that followed the recession. Past experience made the task harder, but none of the principals anticipated how costly and painful disinflation would be. In practice, it was more costly than they anticipated but much less costly than predictions made by Keynesian economists at the time.

At his confirmation hearing, Volcker distinguished between real and nominal interest rates and explained that to reduce interest rates permanently, the Federal Reserve had to reduce inflation. He made the usual statements about the existence of non-member banks as a problem for monetary control and the changing nature of “money.” But in response to a direct question, he described control of money growth as “indispensable . . . if we’re going to have price stability. . . . If the growth of money is excessive over a period of time, we’re going to have inflation” (Senate Committee on Banking, Housing, and Urban Affairs, 1979, 12). Volcker added later that he saw no reason to use credit controls.

ANALYSIS AND BELIEFS

Several models or frameworks for analyzing the economy and monetary policy dominated systematic thinking at the time. The more popular Keynesian framework gave no special emphasis to money or money growth. Prices rose for many reasons, and inflation was the measured rate of price change. A leading Keynesian economist, James Tobin (1980a)
summarized Keynesian thinking about macroeconomics.
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The economy had an inflationary bias; any effort to stabilize the rate of inflation required a sacrifice of real output. To reduce the bias and the loss of output from disinflation, government had to use incomes policy (ibid., 69). As a member of the Council of Economic Advisors in 1961–62, Tobin proposed and introduced wage-price guidelines in the United States. Despite the many failed attempts to use incomes policies at home and abroad, he and many others held to this view in 1980.

6. Pressures to ease rose in 1982. Congressmen Jack Kemp and James Wright (the majority leader) called for Volcker’s resignation in 1982. Senator Edward Kennedy, Congressman Henry Reuss, Senator Robert Byrd, and thirty others introduced legislation requiring lower interest rates.

Tobin’s analytic framework had five main features: (1) Prices are marked up over costs, particularly labor costs. (2) Changes in aggregate demand change prices, wages, output, and employment by changing the tightness of product and labor markets as measured by unemployment and operating capacity. (3) According to Okun’s law, it takes a 3 percent change in GDP to change the unemployment rate by one percentage point. (4) At low unemployment rates, inflation increases and at high unemployment rates, inflation decreases, but the rate of decline is slower than the rate of increase. At the non-accelerating inflation rate of unemployment (NAIRU), inflation remains at the expected rate and the unemployment rate is constant. (5) Tobin saw little professional consensus on the relative effectiveness of fiscal and monetary policies and the proper indicator of monetary policy. He was pessimistic about the costs of the disinflation policy and highly critical of the Volcker policy (Tobin, 1987).

The Phillips curve was a core relation in this framework. It predicted that anti-inflation policy would increase the unemployment rate. Medium-term, this was not true; on average inflation and the unemployment rate rose in the 1970s and subsequently both declined in the 1980s. For medium- and longer-term policy, the positive relation was more important. Monetarists and rational expectationists explained the positive relation as a reflection of the dominating influence of expectations of inflation resulting from monetary expansion and policy errors. Volcker accepted this explanation. Subsequent studies showed that the forecasts had large errors principally because expected output or full employment output could not be measured accurately (Orphanides and van Orden, 2004; Stock and Watson, 1999).

Tobin (1983, 297) remained critical of the disinflation policies adopted in the United States and the United Kingdom at the end of the 1970s. “Like Okun, I would expect the process to be lengthy and costly, characterized by recession, stunted recoveries, and high and rising unemployment.” He speculated that it would take ten years. As late as 1981, he urged incomes
policies during a transition long enough to unwind the previous history of contracts, patterns, and expectations (ibid., 300).

7. Goodfriend (2005) has an excellent summary of Tobin’s framework.

A major difference between monetarists and Keynesians concerned the role of government. Keynesians saw the government’s role as one of managing the economy to minimize social cost of change. Government had a leadership role in adjusting aggregate demand up or down to achieve optimal results. Monetarists emphasized long-term institutional prerequisites for stability. If institutions gave proper incentives to the private sector, the economy would adjust. Although there were differences about the relative importance of fiscal and monetary actions and about the economy’s response to policy actions, the major difference was about the role of government. To monetarists, the economic system adjusted toward full use of resources if policies encouraged stability.

Monetarists agreed that reducing inflation would be socially costly. Failure of past attempts reinforced beliefs that disinflationary policies would stop once unemployment rose. Monetarists differed from Keynesians, however, by claiming that the Federal Reserve could reduce the social cost by increasing its credibility. Increased credibility affected price and wage adjustment by changing beliefs and anticipations of future inflation.

Monetarists accepted parts of the framework described by Tobin but emphasized the role of money growth for inflation and the long-run neutrality of money. Following Milton Friedman, they argued that inflation could not be reduced unless money growth declined relative to growth of real output, a proposition accepted by Volcker (Mehrling, 2007, 178). In the long run, the equilibrium levels of unemployment, output, and other non-monetary variables would be the same (after adjustment of tax rates) as before the disinflation. For the monetarists, price levels could change for many reasons, but sustained changes in the rate of price change resulted from excessive money growth—sustained growth of money in excess of output growth. They viewed the Federal Reserve’s job as preventing sustained price level changes. They restricted the term “inflation” to sustained changes in the rate of price change.
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Monetarists blamed Federal Reserve policy for procyclical monetary actions and for increasing the amplitude of both recessions and inflation. They offered evidence that—measured by money growth—policy was expansive during periods of increasing aggregate demand and inflation and contractive in recessions. They traced much of this problem to the
misinterpretation of member bank borrowing and interest rate changes. The Federal Reserve interpreted the rise in nominal interest rates during periods of economic expansion as evidence of restrictive monetary policy despite rising money growth; it took the decline of interest rates in recessions as evidence of easier policy despite a decline in money growth. Also, Federal Reserve spokesmen interpreted an increase in borrowed reserves as contractive. Monetarists wanted the Federal Reserve to avoid procyclical actions by controlling money growth, including the effect of borrowing. They recognized that if the Federal Reserve changed interest rates to control money growth, interest rate control would be effective and counter-cyclical. But they did not emphasize the last point and insisted on the importance of controlling money directly. However, they did not give sufficient attention to deregulation in the 1980s that made monetary aggregates less reliable indicators of the thrust of policy action.

8. Brunner, Cukierman, and Meltzer (1980) model permanent or persistent changes. Their model shows why unemployment and inflation can rise together, unlike the standard Phillips curve. And the model shows that a permanent disinflation can occur only if the public becomes convinced that policy will not bring back inflation.