A History of the Federal Reserve, Volume 2 (65 page)

Volcker was clear about the impending crisis. At the meetings on October 5 and 6, he referred repeatedly to the precipitate depreciation of the exchange rate and possible flight from the dollar and the rise in commodity prices. He didn’t claim there was a crisis; he expressed concern that one would come if inflation continued (FOMC Minutes, October 6, 1979, 12).

Those who dissented at the September 18 meeting agreed that the commodity markets and exchange rate reacted negatively to their dissent. They too believed a crisis might occur. They supported a policy change that they would have opposed strongly three weeks earlier. Some, including Volcker, recognized that the FOMC was unlikely to vote for interest rates high enough to reduce inflation. By choosing a reserve target, it could blame the market for the level interest rates reached.
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It was also an opportunity to make a major change. The president did not object openly. Key legislators favored monetary control (ibid., 8, 9). European policymakers expressed alarm at the fall in the dollar and urged decisive action (ibid., 17). Perhaps most important of all, the domestic public expressed concern about inflation. Data from Gallup polls starting in 1970, when annual inflation reached 6 percent, show only 14 percent named inflation or “the high cost of living” as one of the country’s most important problems. The percentage rose and fell with reported inflation. It did not remain persistently above 50 and as high as 70 percent until 1980–81.
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Volcker persuaded his colleagues to seize the moment.

The
Major
Change

The October 6 meeting did not dwell on the most important change. Perhaps without recognizing it, the System implicitly changed the weights on
unemployment and inflation. It now regarded control of inflation as its principal current responsibility. That had happened before. The FOMC recognized that its previous efforts failed because it did not persist when the unemployment rate rose. The change in operating procedures intended to signal the change in the System’s commitment to put greatest weight on inflation and expectations of inflation. Orphanides (2005, 1021) presents some evidence of this change. The change in objective was much more important and more durable than the change in procedures.

32. Charles Schultze described the procedural change as “a political cover. They’re not monetarists, but it allowed them to do what they could never have done. . . . They could never have done what had to be done if it looked as if they were the ones raising interest rates . . . But with fixed monetary targets they could just say, ‘Who us?’” Volcker disliked suggestions that it was a public relations move to avoid blame for the rise in interest rates. “I never thought it was that. . . . It was a very common thing to say that we just did it to obfuscate” (Mehrling, 2007, 178; Hargrove and Morley, 1984, 486). Schultze also described the administration’s guidepost policy. “We preached and promoted and jumped up and down, but with little effect” (ibid., 488).

33. I am indebted to Karlyn Bowman of the American Enterprise Institute for retrievi
ng the polling data.

The FOMC may not have recognized the change, but Volcker certainly did. In response to a question from the press, he rejected the Phillips curve tradeoff as a useful tool. Even more than in his colloquy on
Face
the
Nation,
cited earlier, he emphasized the centrality of ending inflation.

Question: How high an unemployment rate are you prepared to accept in order to break inflation?

Chairman [Volcker]: That kind of puts me in a position of I accept or unaccept or whatever. You know my basic philosophy is over time we have no choice but to deal with the inflationary situation because over time inflation and the unemployment go together. . . . Isn’t that the lesson of the 1970s? We sat around [for] years thinking we could play off a choice between one or the other . . . It had some reality when everybody thought prices were going to be stable . . . So in a very fundamental sense, I don’t think we have the choice. . . . The growth situation and the employment situation will be better in an atmosphere of monetary stability than they have been in recent years. (Volcker papers, Federal Reserve Bank of New York, speech at the National Press Club, Box 97657, January 2, 1980, 6)

The Federal Reserve now claimed that a policy of maintaining low inflation would increase employment in the long-run. Instead of trading off higher inflation to get lower unemployment, policy would lower both. Twelve years after Friedman’s (1968b) insistence on the effect of expectations, the Federal Reserve not only accepted that it could not permanently reduce unemployment by increasing inflation, but it now claimed that low inflation increased employment. Other leading central banks did the same. The way was open for inflation targets and other ways of recognizing that the principal, but not only, responsibility of a central bank was to maintain the value of money.

The changes in the Federal Reserve’s perception of its responsibility eventually produced good results. In the following twenty-five years, the United States experienced two very long expansions followed by two relatively mild recessions. The variability of output growth declined. The
United Kingdom also had a very positive response to persistent low inflation. The new anti-inflation policy remained in place until 2004.
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The policy change appreciated the dollar against the European currencies. “The increase of U.S. interest rates and the exchange rate, as well as their volatility, gave rise to vociferous complaints. . . . [T]he principal objection was to the level that interest rates reached in 1981” (Solomon, 1982, 356). The European countries were forced to choose between higher interest rates and currency depreciation. The latter raised energy costs because oil was priced in dollars. Important, also, was the swing in the current account deficit as United States imports fell. By the second half of 1980, the United States’ current account temporarily showed a surplus. Among the Europeans struggling with recessions, high nominal interest rates and declining imports were unpopular.

At the time and for many months, the market and the public remained skeptical about the response to the policy change. Short-term interest rates rose as expected, but the market expected higher short-term rates to persist, so long-term interest rates rose also. The three-month Treasury bill rate rose from 10.43 percent on October 5 to a local peak of 12.60 on October 26. It did not fall below 10.43 until May 1980. The ten-year constant-maturity Treasury bond, on the same October dates, rose from 9.53 percent to 10.89 percent. The long-term rate continued to rise, reaching 13.20 percent in February 1980, and did not temporarily fall below 9.53 until June 1980. Forecasts of expected inflation one quarter ahead reached a peak at 9.98 percent in second quarter 1980, but forecasts for four quarters ahead continued to increase until fourth quarter 1980. Using the inflation forecasts to compute real interest rates suggests that these rates remained modestly positive. But confidence in the Federal Reserve’s ability or willingness to keep its commitment remained low.
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FOMC members recognized the skepticism. This time they intended to continue the anti-inflation policy until inflation remained lower permanently. President Carter did not criticize the policy publicly during his campaign, President Reagan emphasized policies for growth and low inflation. Principal members of Congress, too, provided support.

34. Lindsey, Orphanides, and Rasche (2005, 207) quote Volcker’s comment on the
MacNeil/Lehrer
Newshour
on October 10, 1979. “I am not saying that unemployment will not rise. I am saying that the greater threat over a period of time would come from failing to deal with inflation rather than efforts to deal with it.”

35. Henry Wallich and Scott Pardee (manager of the international account) commented on European attitudes in November 1979. Wallich’s statement emphasized the importance of lower inflation. Commitments were not enough. “I think inflation coming down will be the most convincing single thing” (FOMC Minutes, November 20, 1979, 3). Domestic market participants made the same point. It proved to be correct.

The shift from interest rate to reserve targets, or the wider band on interest rate ranges, helped to implement and call attention to the change. Research suggests that the Federal Reserve’s commitment to reserve targeting was less than many of them said (Cook, 1984).
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A more transparent, coherent policy of controlling total reserves or the monetary base would have lowered the cost of reducing inflation. But persistence in a disinflation policy was the critical factor. As several members of the FOMC and the senior staff commented at the time, markets wanted to see what the FOMC would do when unemployment rose, when unemployment remained high, and when recovery came. Would inflation remain low in the next recovery? Would disinflation be permanent or, once again, a temporary break in a rising trend?

Policy actions and the anticipations they generated changed several times during the disinflation. Some of the public believed that Federal Reserve actions would lower inflation. Others had the opposite response;
expected inflation rose at least for a time. Goodfriend (1993) called these episodes “inflation scares” and used the spread between long- and shortterm interest rates to identify the scares. Chart 8.2 shows several periods when long-term rates increased relative to short. Periods such as spring of 1980, when the System abandoned its policy during the brief, sharp recession, or the fall of 1981 (with increased credibility in early 1982) or skepticism about the willingness to persist in disinflation during the summer of 1982 stand out in the chart.

36. Later, in an influential paper, Goodfriend (1991) analyzed interest smoothing in a model of Federal Reserve behavior. He showed that interest rate smoothing could generate an inflation process of the kind that occurred in the 1970s.

Chart 8.2 suggests that the public distinguished between the one-time increase in price level (or a temporary rise in inflation) and changes in persistent inflation. The oil price increase in 1978–79 raised short-term rates relative to long-term rates. The spread started near zero in 1979 and drifted lower as short-term rates rose and long-term rates remained in a narrow range until the October policy announcement. The announcement raised short-term rates relative to long, suggesting that the market’s initial response was perhaps uncertain as to its meaning and persistence.

The four-quarter anticipated inflation rate in the SPF survey rose slightly in fourth quarter 1979 to 8.2 percent, approximately equal to the increase in the deflator in fourth quarter 1979 but below the four-quarter average for 1980. Measured inflation rose after the announcement; the twelvemonth rate of consumer price increase reached a peak of 13.70 percent in March 1980, but the deflator did not reach a peak (12.1 percent) until fourth quarter 1980.

Policy
Actions,
the
First
Phase

Volcker spoke to the American Bankers Association convention on October 9, three days after the policy change. He outlined the changes, warned them to avoid loans that financed speculation in commodities, gold, or foreign exchange, and described the background to the new policy. He detected “a dramatic swelling of national concern about inflation,” and he called attention to congressional support for monetary targets (Board Minutes, October 6, 1979, 5–6). The speech carefully distinguished monetary and other factors affecting prices, including energy and slow productivity growth, but he did not absolve policy of responsibility. “We can no longer blithely assume we can ‘buy’ prosperity with a little more inflation because the inflation itself is the greater threat to economic stability” (ibid., 9–10).

The initial implementation of the policy change was discouraging. M
₁
growth for October reached a 14 percent annual rate, far above the 4.5 percent target for the fourth quarter. Axilrod estimated that bank borrowing
reached $3.1 billion, twice the FOMC’s estimate. He expected it to increase further. The federal funds rate rose to 17 to 18 percent, far above the FOMC’s range and the highest rates ever recorded to that time. Trading was light (FOMC Minutes, October 22, 1979, 1).

In the first of many partly reinforcing actions, the FOMC telephone conference chose to keep to the nonborrowed reserve path and allow the federal funds rate to stay at 15 percent or above. That meant that borrowing would remain high. Willis Winn (Cleveland) and several others proposed an increase in the discount rate. Larry Roos (St. Louis) and Mark Willes (Minneapolis) proposed announcing the targets for total reserves and the monetary base, but Volcker rejected both proposals. A higher discount rate would “push market rates up further.” He opposed giving the market more information. “We have more targets than we can meet already” (ibid., 9).

The result was a shift back to an interest rate target, keeping the ceiling at 15 percent and satisfying the demand for reserves by permitting banks to borrow from the discount window at less than the market rate. For the month of October, borrowing averaged $2 billion, twice the level of the previous January and $700 million more than in September.

Between October 26 and the next FOMC meeting on November 20, the Board rejected or deferred twenty requests for a 0.5 or 1 percentage point increase in the discount rate. The usual reasons were that the Board wanted to avoid higher interest rates and, in November, because money growth slowed from the torrid October pace. No one mentioned that persistent reductions in borrowing would assist in reaching the money growth targets. Instead, the Board backed away from its money targets. “Flexibility was necessary . . . rather than setting precise, fixed growth levels of the money supply by statute” (Board Minutes, November 9, 1979, 3).
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Volcker had difficulty getting people to understand the new procedure. The first question the public asked was “Are you going to stick with it?” He explained that interest rates could decline “when the economy declines particularly if the inflation rate is falling” (FOMC Minutes, November 20, 1979, 24). Years of experience had led the public to interpret any decline
in interest rates as easing and any increase as tightening. Communication that the policy had changed was difficult and made more so because the FOMC was itself less than certain about what it was willing to do and how long it would continue to subordinate control of interest rates to control of reserves and money growth.

37. Adding to the uncertainties, in November the Iranians occupied the U.S. embassy in Teheran and held the Americans captive. This also affected uncertainty about future oil prices. At the January FOMC meeting, Volcker explained to the presidents how he interpreted their requests for discount rate changes under the new operating procedures. “If you’re sending the Board a message about the discount rate, you’re sending us a message on where you think market rates should be . . . [t]his is why we didn’t act in October and November. . . . It was our judgment that at least in the short run, it wasn’t going to close the gap but was just going to put the market rates up further” (FOMC Minutes, January 8–9, 1980, 80). As Volcker noted, his argument depended on traditional Federal Reserve beliefs about banks’ reluctance to borrow as in Riefler (1930).