A History of the Federal Reserve, Volume 2 (71 page)

The legislation created a Deposit Institutions Deregulation Committee (DIDC) charged with elimination of regulation Q ceilings within six years. The members of DIDC included supervisors of the various institutions— the FDIC, the Federal Home Loan Bank Board, and the National Credit Union Administration—and the Secretary of the Treasury. Paul Volcker became chairman of DIDC. By June 1981, DIDC agreed to a gradual phaseout schedule. In July, a court invalidated the schedule. The DIDC adopted a new schedule in March 1982.
⁷⁵

The Federal Reserve had wanted compulsory membership since its inception. Marriner Eccles tried frequently to convince President Roosevelt about its importance, but he did not succeed. Most subsequent chairmen tried. As interest rates rose with inflation, the cost of membership rose and the share of member banks to total banks declined. Between 1970 and 1979, member banks’ share of banking offices fell from 71 to 60 percent (Board of Governors, 1981, 470, 488). The number of insured nonmember banks rose rapidly. The Board claimed that the relative decline in member banks made monetary policy operations more difficult, although they never presented a cogent argument to support that position, and many of their staff did not believe it.
⁷⁶
The more plausible but unspoken reason was the desire for political support by bankers willing to accommodate their regulator in the expectation that their requests for mergers, branches, and powers would be treated favorably.

74. The Board gave the banks that withdrew from membership prior to July 1979 eight years to restore required reserves. Many of these banks had invested their reserves in longterm securities that had fallen in value. Institutions with 85 percent of their loans in mortgages remained exempt from the requirements.

75. The legislation authorized the Federal Reserve to price the services it performed for banks such as check clearing, float, provision of currency, etc. The legislation raised the ceiling for deposit insurance from $40,000 to $100,000 (a source of problems later in the decade), broadened the real estate holding powers of national banks, and broadened the range of collateral that the Federal Reserve could hold behind the note issue. DIDMCA passed the House on a vote of 380 to 13 and the Senate by voice vote. The vote suggests the change in sentiment about regulation. To try to hide the failure of savings and loans, the Federal Savings and Loan Insurance Corporation encouraged institutions to include a special certificate of indebtedness among its assets. Congress did not object.

76. “The intellectual argument within the Fed . . . was that we really don’t need these reserves to conduct monetary policy anyway. So there was discussion amongst the staff that we were peddling legislation based on a premise that none of the economists believed in” (Guenther, 2001, 31). Guenther was the Board’s assistant for political work with the Congress at the time.

DIDMCA did not require membership, but it required financial institutions to hold reserves set by the Board. Burns tried hard to get the legislation but did not succeed because of his poor relationship with Chairman Reuss of the House Banking Committee (Guenther, 2001, 29–30).

After a false start, Miller began negotiations with Reuss.
⁷⁷
The legislation passed after he moved to the Treasury, but much of the agreement came during his term at the Board.

Although the changes permitted by DIDMCA were long delayed, the timing was far from optimal. National NOW accounts caused shifts in asset portfolios and made the monetary aggregates more difficult to interpret at a time when the Federal Reserve gave more attention to them. Additional legislation, the Garn-St. Germain Bill in 1982, induced larger additional changes.
⁷⁸

The difficulties faced by thrift institutions prompted reforms. In 1979, legislation permitted thrifts to make a limited number of variable rate loans, and in 1981 Congress extended that power. Also thrifts could begin to hedge interest rate risk in the futures market. DIDMCA extended their lending powers to commercial and personal loans.
⁷⁹
The Garn-St. Germain Depository Institutions Act permitted savings and loan associations to issue “net worth certificates” to the regulators in exchange for promissory notes. These gave the appearance of solvency to those who did not look carefully.

Garn-St. Germain authorized banks, saving and loans, and mutual savings banks to issue money market deposit accounts (MMDAs) beginning December 14, 1982. And DIDC authorized a super-NOW account effective January 5, 1983. Banks and thrifts could pay market interest rates on these accounts provided the account balance exceeded $2,500. For the first time, the act permitted out-of-state banks to purchase failing banks and thrifts opening the way to interstate banks.

The response to MMDAs again changed the composition of desired financial assets and obscured the meaning of monetary aggregates. The new instruments had different properties than the old M
₁
. Time and savings deposits and money market funds declined in the first half of 1983, and
some of these accounts continued to decline. By 1983, the Federal Reserve had given up control of M
₁
and M
₂
. The new accounts and uncertainty about the data became the ostensible reason for ending the experiment.
⁸⁰
Failure to develop successful control of the monetary aggregates and a desire to reduce market rates were at least as important. Congressional pressure seems most important.

77. The Board’s lawyers told Chairman Miller that the System could pay interest on bank reserves. This would have reduced the exodus of members. Miller floated the idea, but Reuss threatened to start impeachment proceedings if the System did that (Guenther, 2001, 30). And the Treasury did not want to reduce the revenue it received from the Federal Reserve.

78. Timberlake (1993, 366–70) focused attention on a little-known provision of DIDMCA that permitted the Federal Reserve to use foreign assets as collateral for Federal Reserve notes. He noted that Volcker worked determinedly to get this power after it was removed from the House bill. The conference committee reinstated the provision.

79. DIDMCA was not a completely coherent piece of legislation. The House and Senate produced separate bills that did not mesh. The bill that passed
had elements from each.

Authority to lend to non-bank financial institutions through the discount window promptly attracted attention, especially from mutual savings banks. Most of them suffered losses because their fixed-rate mortgages yielded less than the cost of their deposit liabilities. Failing to renew deposits would force liquidation of mortgages at a loss, impairing their capital. Renewing deposits meant higher interest payments and current losses. Either way, the System’s disinflation program threatened their survival. By September 1980, about 90 percent of the New York savings banks operated at a loss.

The Board’s position was that it was the lender of last resort. Mutual savings banks and thrifts had to exhaust all other opportunities to borrow. Saving bank representatives disputed this interpretation. At a meeting with Paul Volcker, they “argued that their access to
extended
credit should be on the same terms governing commercial bank access to
short-term
adjustment credit” (memo, Chester Feldberg, Federal Reserve Bank of New York, Box 431.2, September 24, 1980; emphasis added). The Board did not regard the discount window as a source of extended credit. Volcker told them that the Federal Reserve would hold to its traditional position. “He did not believe it was appropriate to apply the same rules to users of both adjustment and extended credit” (ibid.). The intended use of adjustment credit remained temporary shortfalls.

The mutual savings banks and thrifts could not, at first, convince the Federal Reserve, so they appealed to Congress. The result: the Federal Reserve developed a program for long-term loans to “assist depository institutions with longer-term assets when they are confronted with serious prolonged strains on their liquidity arising from an inability to sustain deposit inflows. . . . [A]ssistance for thrift institutions in these circumstances should be available for rather extended periods” (letter, Paul Volcker to Congressman Fernand St. Germain, Board Records, December 22, 1980, 2). This letter at last recognized that the System was the lender of last resort to all solvent financial institutions.

80. M
₁
rose $15 billion in first quarter 1983. Almost all of the increase was in “other checkable deposits” with little change in demand deposits. MMDAs increased by $280 million (Board of Governors, 1991, 64).

Regulation
Q

Congress had at last approved the phase-out of regulation Q ceilings and its discrimination against small savers. The Board’s actions in 1980 worked in the opposite direction, limiting competition and imposing ceilings on the interest rates paid to consumers. Money market mutual funds restricted the extent of the harm; these funds bought unregulated large certificates of deposit and paid investors competitive interest rates.

At the start of 1981, the Board authorized banks to issue 2.5-year nonnegotiable time deposits at a rate 75 basis points (0.75 percent) below the average yield on a 2.5-year Treasury security. Thrift associations could pay one quarter percent (0.25) more than banks.

On February 27, the Board and regulators of thrift associations limited the return to 12 and 11.75 percent instead of 13.5 and 13.25 percent permitted under the formula. The Board’s announcement said that the Board voted unanimously to prevent disruption to financial institutions that held a high proportion of long-term mortgage loans (Board Minutes, February 27, 1980). Opportunities for interest rate regulation of this kind had vanished. The decision increased the outflow to money market accounts and was not renewed in April.
⁸¹

In these and similar decisions, the Board showed greater concern for the financial institutions than for the public. The proposed regulations held the nominal yield below the current rate of increase in consumer prices. Absent the competition from unregulated money market mutual funds, it seems likely that interest rate regulation would have increased. The existence of unregulated accounts, and the public’s heightened awareness of the opportunity they presented, had the opposite effect. Competition encouraged more rapid elimination of regulation Q than anticipated in the law.

A GROWTH INTERLUDE

The economy recovered in late 1980. Fourth-quarter growth at a 5.2 percent annual rate was followed by 8 percent growth in the first quarter. In the next two quarters, output declined modestly then rose modestly, so the level of real output was about the same in first and third quarters of 1981.
Industrial production began to rise in August 1980 and began to decline in August 1981.

81. On March 5, the Board considered a similar restriction on the yield paid on six-month floating-rate time deposits. The Board did not act because regulators of the thrifts would not agree “out of concern over the large deposit drain that could result if depository institutions were unable to offer certificates at rates comparable to those on other market instruments, particularly money market mutual fund shares” (Board Min
utes, March 5, 1980, 4).

Reported inflation rates declined. The GNP deflator reached a peak of 12.1 percent annual rate in fourth quarter 1980, then fell back temporarily to 6.7 percent in the second quarter of 1981. This was the lowest reported inflation rate since early 1978. Twelve-month average consumer price inflation declined steadily to 9.1 percent in June 1981. The four-quarter expected rate of inflation (SPF) declined slowly in 1981 from its all time peak at 9.4 percent at the end of 1980.

Most of the reductions in reported inflation resulted from the end of passing through of the oil price increase. It had less to do with the Federal Reserve’s disinflation, although it gave the appearance of progress. The market interpreted the fall as an end to the price increase, expected inflation unchanged. Ten-year bond rates remained between 13 and 14 percent in spring 1981. Monthly reported growth of M 1 and the monetary base continued to fluctuate over a wide range during this period with no discernible trend at the time. Looking back after the fact, both the nominal and real base declined in the first half of 1981 (Chart 8.5 above). The real base fell at a slower rate.

The trade-weighted dollar exchange rate rose slowly from July to November. The election appears to have strengthened the dollar; the System’s exchange rate index rose from 86.59 in October 1980 to 89.31 in November. And it continued to rise. By July 1981, it was 30 percent above its earlier trough. Against the mark, the dollar appreciated from 1.747 to 2.440, nearly 40 percent in the year to July 1981.

The Federal Reserve continued to intervene in 1980. One of the reasons for intervention was to buy marks when they declined in price to use to reduce the swap line and permit the Treasury to pay off the markdenominated Treasury debt issued by the Carter administration in 1978. By early December, the Carter bonds were fully covered.

The new administration opposed intervention. Treasury Secretary Donald Regan and Undersecretary Beryl Sprinkel announced that the United States would intervene only if markets became turbulent. At its March meeting, the FOMC agreed. Volcker said, “It is extremely difficult to identify any results from intervention per se economically” (FOMC Minutes, March 31, 1981, 15). He noted other reasons, such as acting cooperatively with other central banks.
⁸²
But, he added, “I’ve never felt eager about inter
vening anyway” (FOMC Minutes, December 18–19, 1980, 25). This must have come as an unwelcome shock to proponents of intervention at the New York bank.

82. The Federal Reserve intervened heavily in 1980. Volcker and several of the FOMC members did not understand exactly how the limits on intervention worked. The manager,
Scott Pardee, explained that the Federal Reserve had an overall limit and separate limits on the amount of marks and yen that it could hold. There was also a limit on the amount of warehousing (loan to the Treasury). The only limit on the Treasury’s Exchange Stabilization Fund was the amount of warehousing it did with the Federal Reserve plus its own limited resources. At the end of 1980, the warehousing limit was $5 billion. The Treasury had used $3 billion. The amount warehoused was a Federal Reserve asset, offset by an off-budget item for the forward contract with the Treasury (FOMC Minutes, December 18, 1980, 2–25).