A History of the Federal Reserve, Volume 2 (62 page)

These monetarist criticisms of Federal Reserve actions emphasized the problem of using a short-term interest rate or money market conditions to describe monetary policy and to characterize the thrust of monetary policy as easier or tighter. A nominal interest rate must be judged against some benchmark such as sustained money growth relative to the growth of output or relative to the expected rate of inflation. Otherwise it contains little information about policy. Later, Taylor (1993) proposed an interest rate rule for judging the thrust of current policy actions that several central banks use. The Taylor rule advises the central bank to compare the nominal short-term rate to prevailing conditions, including current anticipations. Monetarists also insisted on the importance of policy persistence. The public had to be convinced that the Federal Reserve would persist in an anti-inflationary policy when unemployment rose, as they expected it would. If the public became convinced that low inflation would return, the social cost of reducing inflation would fall. Using this reasoning, Cagan (1978b) estimated a more rapid response to disinflationary policy than Tobin or Okun. The staff econometric model also predicted a more rapid response than Tobin.

Differences in the expected response of inflation to sustained disinflationary policy divided economists at the time. Nordhaus (1983, 254) described the Keynesian view of inflation. “Inflation is taken to be the sum of inertial, cyclical, and volatile or random forces. The inertial element is the inherited ‘underlying’ rate of inflation, particularly from wages, which changes slowly in response to experience and expectations.”
⁹
Inertial infla
tion was slow to adjust downward. Nordhaus described the principal cost of chronic inflation as the constraint imposed on economic activity. “The main reason policymakers have been unwilling to set higher targets for output and employment is simply their fear that higher targets would risk increasing inflation. . . . unemployment rates in the 2 to 3 percent range, and hence output 8 to 10 percent higher would surely have been much closer to the ideal output” (ibid., 265).
¹⁰

9. Academic literature at the time was dominated by models with rational expectations. The then current vintage had little or no effect of policy actions on real variables. President Mark Willes (Minneapolis) mentioned this work at times, but he did not get a response.

By adopting the new procedures and undertaking a sustained effort to reduce inflation, the Federal Reserve staff accepted several main criticisms of the monetarists.
¹¹
At Ohio State University on April 30, 1981, Stephen Axilrod and Peter Sternlight from the Federal Reserve debated Robert Rasche and Allan Meltzer from the Shadow Open Market Committee.
¹²
The topic was “Is the Federal Reserve’s Monetary Control Policy Misdirected?” (Axilrod et al., 1982, 119–47). The debate brought out agreement on objectives and the means to reach them. The Federal Reserve accepted that it had to control money growth to control inflation, a position it had denied in the past.

Important differences remained about how to improve monetary control, particularly how to forecast the money multiplier more accurately and control quarterly or semiannual money growth more effectively. Federal Reserve staff repeated their claim that tighter control of money growth required unacceptable fluctuations in market interest rates. Axilrod and Sternlight mostly refused to recognize publicly that part, probably a large part, of the interest rate volatility resulted from restrictions they imposed such as lagged reserve requirements.
¹³
Axilrod, however, accepted that variability would be reduced and control improved if the Federal Reserve made institutional changes. He did not suggest why they failed to do so. And he accepted the monetarist proposition that medium- and long-term control of money growth was most important for control of inflation. This was progress at least at the verbal level.

10. Fischer (1983, 275) commented, “The neo-Keynesian synthesis of the late 1960s was that inflation was not a serious problem. . . . [D]isagreements within the profession on the relative importance of inflation and unemployment is a source of differing views on desirable policy.”

11. Milton Friedman (1982) summarized the changing position of the Federal Reserve on the possibility of monetary control.

12. The Shadow Open Market Committee was a group of academic and business economists that met semiannually to critique monetary policy. Meltzer was co-chairman.

13. Although he did not say so in the debate, Axilrod made this argument each time the FOMC asked him to discuss lagged reserve requirements. The Board did not consider returning to contemporaneous reserve ratios until pressed to do so by members of Congress (Friedman, 1982, 111).

PERSONNEL CHANGES

Both Board members and reserve bank presidents changed during the disinflation. Table 8.1 shows the changes. Lyle Gramley was a career Federal Reserve staff member who returned as a governor after serving on the Council of Economic Advisers. Frederick Schultz was a Florida banker; he served as vice chairman. Anthony Solomon had worked with Volcker in the Nixon administration, and Gerald Corrigan was a Volcker protégé.

A NEW POLICY
¹⁴

Both the Board and the FOMC were divided in 1979, as they had been for some time. One group wanted more restrictive policy action to reduce inflation. The other expressed concern about a possible recession. By early August, when Paul A. Volcker became chairman, many forecasters thought a recession was coming. Others thought it had started. The preliminary report of second-quarter GNP showed a 3.3 percent decline at annual rates, in part as a result of the oil price rise and the wealth transfer to the oil exporters. “By not tightening, the Committee compounded its earlier errors, allowing inflation to accelerate further only to postpone and raise the cost of restoring stability” (Orphanides, 2004, 171).

Volcker thought that a recession was likely, but before becoming chairman he had repeatedly said that inflation was a bigger concern. He dissented from the directives during the spring because he wanted more
restraint. At his confirmation hearing, he repeated his concern about inflation, emphasized the central role of money growth for inflation, and expressed concern about the persistence of inflationary expectations.

14. An extended discussion of the policy change is Lindsey, Orphanides, and Rasche (2005).

Preparing for a Quadriad meeting in late September, Charles Schultze expressed concern about the increase in interest rates during Volcker’s chairmanship. He recognized “the dilemma facing economic policy generally and monetary policy in particular” (memo, Schultze to the president, September 25, 1979, 4–5). Growth of monetary aggregates had increased, but rising interest rates “have a delayed impact on the economy” (ibid., 5). Policy increased the risk of rising unemployment rates in 1980. Disinflation had not started but he urged the president to probe when Volcker could “begin easing a bit” (ibid.), although disinflation policy had not begun.

Volcker’s concern was inflation. The FOMC used a federal funds rate target but also announced objectives for growth of M
₁
and M
₂
. Its directives to the desk aimed to reduce money growth, and it had voted between meetings to raise the federal funds rate target to between 10.5 and 10.75 percent to keep M
₁
and M
₂
growth at annual rates between 2.5 and 6.5 and 6.5 and 10.5 percent respectively. At the August 14 FOMC meeting:

[t]here was little disagreement with the proposition that for the near term modest measures should be taken to direct policy toward slowing growth of the monetary aggregates. Control of monetary growth was regarded as essential to restore expectations of a decline in the rate of inflation over a period of time. (Annual Report, 1979, 183)

FOMC members were aware both that their statements lacked credibility and that market participants paid attention to reported growth of the monetary aggregates, but the statement showed the beginning of a change in members’ thinking.

In February 1979, the FOMC had agreed to hold growth of M
₁
, M
₂
, and M
₃
to ranges of 1.5 to 4.5, 5 to 8, and 6 to 9 percent for the four quarters of 1979. The proposed slow growth of M
₁
reflected an anticipated shift to NOW accounts.
¹⁵
At the August 14 meeting, the committee voted to raise the range for the federal funds rate by one-half point to 10.75 to 11.25 and to make the limits conditional on moderate growth of M
₁
and M
₂
. President Robert Black (Richmond) and Governor Emmett Rice dissented. Black wanted slower money growth; Rice expressed concern about recession. He wanted policy to remain unchanged. Volcker, aware of the
political problem, favored a less inflationary policy, but he wanted to “keep our ammunition reserved as much as possible for more of a crisis situation when we have a rather clear public backing for whatever drastic action we take” (FOMC Minutes, August 14, 1979, 22–23). On August 30, the FOMC voted to raise the upper end of the funds rate band to 11.5 percent, citing high money growth as the reason. Rice again dissented.

15. NOW accounts were negotiable orders of withdrawal, similar in many respects to demand deposits, but they paid interest. New England banks began issuing NOW accounts. Legislation, discussed below, extended their use to the rest of the country.

If Congress had doubts about Volcker’s intentions, they should have been dispelled by his testimony on September 5. He told the House Budget Committee about some of the costs of inflation. Unlike the Keynesians, he considered the costs higher than the costs of reducing inflation. One of the costs Volcker cited in his testimony was “the capricious effects on individuals” (Volcker, 1979, 738). A more specific cost cited was the reduction in after-tax returns to corporations. This return “averaged 3.8 percent during the 1970s . . . as compared to 6.6 percent in the 1960s. At the same time, the uncertainty about future prospects associated with high and varying levels of inflation tends to concentrate the new investment . . . in relatively short, quick payout projects” (ibid., 738–39). And he listed other costs including increased sensitivity, and more rapid response, of wages, exchange rates, prices, and interest rates.

He added that earlier in the postwar years, the response lag was longer, so real incomes increased more before inflation rose. Actions “all too likely to produce more inflation will in fact have only a small and short-lived expansionary effect. . . . [O]ur current economic difficulties are tightly interwoven. They will not be resolved
unless
we
deal
convincingly
with
inflation”
(ibid., 740; emphasis added). This reasoning dismissed the Phillips curve tradeoff as irrelevant to current outcomes.

On August 13, the Board rejected a request from San Francisco to raise its discount rate by 0.25 percentage points to 10.25 percent. After discussion at the FOMC meeting the following day, the Board on August 16 approved a 0.5 increase in the discount rate to 10.5 percent to support its open market policy. However, the Board did not approve any further requests for increases that month.
¹⁶

What proved to be a critical vote came on September 18. By a vote of four
to three, the Board approved an increase in the discount rate to 11 percent. Governors Partee, Teeters, and Rice dissented. They wanted to wait until they gained more information about the risk of recession. New York had asked for a 0.25 percentage point increase. Lindsey, Orphanides, and Rasche (2005, 196) show that the Federal Reserve made an announced tightening that morning. At the September 14 meeting, Cleveland, Richmond, Dallas, St. Louis, Minneapolis, and San Francisco asked for a 0.5 increase. The Board usually approved requests when made by so many banks, but it delayed its response on September 14 because only four members were at the meeting and they divided two to two. The opponents Rice and Teeters cited the “very high” interest rates at the time. They failed to distinguish between nominal and real rates.

16. The Shadow Open Market Committee (policy statement, September 17, 1979) remained skeptical. “The slow economic growth, high inflation, and high unemployment of the past decade cannot be blamed primarily on the oil cartel. Monetary policy caused consumer prices to rise at an average rate of 7 percent a year in the seventies. Mishandling of the 1974 oil price increase slowed the rate of investment and lowered the growth of productivity. Reliance on wage and price controls and on guidelines reduced the credibility of government without achieving any reduction in the average rate of inflation.” The statement clearly distinguished between a real shock to supply and excess aggregate demand induced by monetary expansion. It urged the government to separate inflation and the real and price
level
effects of the oil price
change. “The proper response to the oil price increase is a reduction in both government spending and taxes.”