A History of the Federal Reserve, Volume 2 (77 page)

The homebuilders were greatly affected by high interest rates and recession. Private housing starts had fallen from 1.8 million in September 1979 to 0.84 million in January 1982 when Volcker spoke to their convention. This was the lowest level since the summer of 1967 that had caused much discomfort and political reaction. It was rare for housing starts to fall below one million; this time it was below a one million rate for six months, and it remained below for several months to come.

Volcker recognized the problem. The year 1981 was “the most depressed in decades” (Volcker papers, Board Records, January 25, 1982, 1). He accepted, and claimed the public accepted, that the job of ending inflation fell to monetary policy. “But I think it is also fair to say that absence of consistent help from other policies can make the job more difficult” (ibid., 2).

Then came a cheerful note. “We can see multiplying and en
couraging signs that inflation has begun to subside—that we are turning the co
rner. . . . Any slackening of our commitment to see the effort through could only jeopardize prospects for full success” (ibid., 3). Changes in expectations and behavior had to occur. These “will work to unwind the inflationary process, perhaps faster than most economists have assumed” (ibid., 4). He was aware of the challenge to avoid a resurgence during the recovery. The key test will be sustaining the gains during a period of recovery and expansion” (ibid., 5).
¹¹²
Despite their heavy losses, the homebuilders gave him two standing ovations (Coyne, 2005, 315).

Reported growth of M
₁
from December 1980 to December 1981, at 2 percent, was far below the target of 3.5 to 6 percent, and M
₂
growth at 9.5 percent was only 0.5 percentage points above its band. For 1982, the FOMC tentatively agreed again to a target band of 2.5 to 5.5 percent for M 1 and 6 to 9 percent for M 2 .

The economy ended 1981 with the unemployment rate at 8.5 percent and rising. Hourly earnings had fallen from their peak but they rose 7.2 percent in the year to December. The twelve-month moving average of
consumer prices was down to 8.6 percent, three percentage points below the previous December. Double-digit inflation, it turned out, was over; the expected four-quarter inflation rate was 7.5 percent according to the Society of Professional Forecasters. More disinflation had to occur before the Federal Reserve could claim success.

112. Unlike Burns, Volcker did not blame labor unions for inflation. “Higher wage costs did not spearhead the inflation of the past decade. Labor and management were in large part reflecting inflationary forces originating elsewhere” (Volcker papers, Board Records, January 25, 1982, 5).

The year 1982 was a transition year. The FOMC ended targeting nonborrowed reserves. The Board lowered the discount rate from 12 to 8.5 percent. The federal funds rate declined from a 13.22 average in January to 8.95 percent in December. And the twelve-month average consumer price inflation fell from 8.1 in January to 3.8 percent in December. Consumer prices fell in December at a 4.9 percent annual rate.

Early in the year, the Board’s staff forecast called for recession to end and recovery to begin in 1982 with continued decline in inflation for the next three years. Unemployment fell slowly in their forecast but would remain above 8 percent with no inflationary money growth. Recovery was expected to start in the spring, but despite progress in reducing inflation, real interest rates remained historically high.

Annualized M
₁
growth was nearly 12 percent in January. President Balles (San Francisco) asked whether they were “intuitively trying to keep interest rates down” (FOMC Minutes, February 1, 1982, 23). Axilrod evaded the question by commenting on shifts in the demand for money. Gramley pointed out that the January bulge provided most of the M
₁
required to meet their annual target. He favored abandoning the M
₁
target. Others proposed to raise the base from which the money growth rate started or widen the band and aim for the top. Volcker reported that Congressman Henry Reuss proposed a 3.5 to 6 percent M
₁
band, as in 1981. Congressman George Hansen introduced regulation requiring the Federal Reserve to maintain zero inflation.

The policy consensus started to fracture. Balles wanted the HumphreyHawkins report to show what the FOMC expected. Roos joined him and added that the FOMC should improve its procedures to better achieve its targets. Teeters wanted to abandon the disinflation policy to increase real growth and reduce the unemployment rate. “If we stick to these targets, we end up with no growth for the fourth year in a row and unemployment of 9 percent or above. I think that’s politically very dangerous” (FOMC Minutes, February 1, 1982, 44). Frank Morris wanted to continue disinflation but abandon the M
₁
target. Members mostly supported either Morris’s or Balles’s positions.

Volcker recognized the control problem but made a sensible response. “Our credibility will be related more to making the right decision than to worrying too much about what the market says about it in the short-run”
(ibid., February 2, 1982, 48–49). He remained convinced that the Federal Reserve had to persist in its anti-inflation policy. He favored rebasing the monetary growth rates and opposed raising the announced growth rates to recognize the January bulge. His argument was that an increase in the growth rate would suggest an easier policy; a lower growth rate from the higher base would not. Much of the problem came from the NOW accounts. In his testimony to the House Banking Committee on February 10, he dismissed arguments based on a tradeoff between unemployment and inflation, insisting that lower inflation would bring lower unemployment rates. He dismissed the Phillips curve as a guide. “More inflation has been accompanied not by less, but by more unemployment and lower growth. We have not ‘traded off’ one for the other” (Volcker papers, Federal Reserve Bank of New York, Box 97657, February 10, 1982, 9). Then he added that “inflation itself is the greater threat to economic stability” (ibid., 10).

Volcker was not yet ready to abandon an M 1 target. He did not think they should put much weight on a month or two of disturbing data. He did not want to eliminate the January bulge immediately, but he wanted “to show some resistance” (ibid., 58). Since the FOMC had no way of knowing whether the January bulge was a permanent or transitory change, that seems the correct approach. But it did not satisfy everyone. Roos, with support from Black, wanted to eliminate the bulge, but Axilrod and Volcker argued that they did not know whether the demand or supply function had shifted and whether they would shift back.
¹¹³

When the Committee turned to short-term policy, they emphasized the uncertainty about short-term projections. The staff explained the high reported growth of M
₁
as a shift in demand. Under questioning by Roos (St. Louis), Axilrod agreed that it was difficult to forecast the demand for money, and he might have added that it was difficult also to explain what had happened ex post.

To strengthen credibility Volcker proposed letting the federal funds rate rise as high as 14 percent (from 13.2 percent average for January). But there were limits to his concern. After Volcker said “I would worry if the federal funds rate were 16 percent now,” Governor Partee, joined by Presidents Black, Ford, and Balles, suggested eliminating the band on the funds rate (ibid., 65–66). Morris, Boehne, and Volcker objected strongly.

The data hint that despite the discussion at the meetings, the System had an interest rate target. Monthly average federal funds rate remained
between 14.15 and 14.94 percent from February through June. This is the only period during alleged reserve targeting with so little variation in the interest rate. Monthly M 1 growth remained low in these months but varied between −3.5 and 6 percent. With consumer prices rising about 7 percent, the real federal funds rate was about 7 or 7.5 percent.

113. An extended discussion showed that the FOMC did not have a consistent interpretation of the short-term positive relation between higher money growth and a higher funds rate. Most members explained the positive relation as a positive shift in demand for reserves, not an expected reduction to reflect higher expected inflation.

The vote was unanimous for a near-term 12 to 16 percent federal funds rate, zero M
₁
growth, and 9 percent M
₂
growth.
¹¹⁴
The FOMC wanted zero M
₁
growth in the near term to offset excessive money growth in January.

Discussion of the annual money and credit ranges for the February Humphrey-Hawkins testimony brought out the problems in the economy and the conflicts in the Committee. Teeters urged lower interest rates to prevent failure of many savings and loans, but Volcker opposed because that would require too much ease, and Schultz pointed out that long-term rates were the key to the S&L problem. They depend on the deficit, he said. Voicing the main concern of those who wanted to continue the antiinflation policy, he said that “[i]f we give up, then the inflation problem is just going to explode again and the economy will be in terrible shape. We have to stay where we are and do our job” (ibid., 88).
¹¹⁵

Volcker responded by arguing that credibility is a stock that can be used when needed. “We do not build up credibility for the sake of building up more credibility. We build up credibility to get the flexibility to do what we think is necessary.
¹¹⁶
If I were concerned now . . . that this change [rebasing the target] is appropriate I would say the heck with that point. My trouble is that I am not convinced [the bulge] is going to stay” (ibid., 89).

Schultz rarely disagreed with Volcker, but he did now. Political pressure had increased. “The president will not do anything about the deficits. . . . [T]he central bank of the United States has far more responsibility than it ought to have. . . . We have not yet changed those inflationary expectations because everybody thinks that we are going to cave in to the political pressure that is going to be on us” (ibid., 90). The last remark recognized that congressional elections would come that year, and that tax reduction increased the deficit in the short-run. References to elections and political pressures are very rare in the minutes or transcripts, whatever influence these events may have had on discussions at lunch, during coffee breaks, or at other times.

114. Just before the vote, Balles made “a strong plea or caveat as the case may be . . . to avoid the big overshoots” in money growth. Volcker responded with a note of despair: “I wish I knew how to do that” (FOMC Minutes, February 1, 71).

115. Kane (1989) has an excellent study of the savings and loan problem.

116. This is the conclusion in Cukierman and Meltzer (1986) using a formal model.

Once Schultz opened the issue, others commented. The president’s counselor, Edwin Meese, had remarked publicly that the president would ask Volcker to discuss current policy. Gramley wanted to act ahead of any meeting with the president to avoid any suggestion that the System responded to political pressure. Nancy Teeters thought the System had to accept responsibility for 9 percent unemployment, but others blamed the administration’s fiscal policy for high interest rates and unemployment. Roos reported that he was asked that question frequently: “Are you fellows going to be able to stand the heat from the politicians during an election year?” (ibid., 95).

Volcker took a vote on raising the M
₂
growth rate but drew only five supporting votes. He chastised the Committee, calling its decision “silly” for putting so much emphasis on recent monthly or quarterly growth rates (ibid., 105). His testimony would stay with the unchanged M
₂
growth rate but suggest that they may exceed the range. In his February 10 testimony, Volcker said that the announced growth rates would change during the year if conditions changed.

Fearing the loss of political support, the FOMC had to choose between independence and ease. This time the System chose independence but was cautious about raising interest rates. The federal funds rate rose 1.5 percentage points in February to an average of 14.78 percent. By early February St. Louis and San Francisco proposed an increase in the discount rate from 12 to 13 percent. The Board deferred the decision. Other banks joined the request. The Board continued to defer action until March 1, when it disapproved the change.
¹¹⁷
The February meeting was Frederick Schultz’s last. He left the Board on February 11. His successor was Preston Martin, who became vice chairman of the Board on March 31. Although this was President Reagan’s first appointment, his votes were more like Teeters than Wallich’s or Volcker’s.
¹¹⁸
Martin’s background included long
association with the California housing industry, often a pressure group favoring lower interest rates.
¹¹⁹

117. Innovation in financial markets opened new issues about the scope of regulations and new ways of avoiding regulation. The latter included time deposits used to make third party payments avoiding regulation Q. The Board declared such accounts to be transaction accounts. In February, the Kansas City Board of Trade began to offer futures contracts based on the Value Line stock index. The Board discussed margin requirements because it deemed these contracts a substitute for options contracts. The Board of Trade raised its margin requirements, and the Board did not act.

118. Havrilesky and Gildea (1992, 402) classified thirty-two governors who served during 1951 to 1987 based on their “noncontractionary” votes. Preston Martin is fourth from the bottom, more expansionary than Teeters. Other Reagan appointees, such as Martha Seger and at times Wayne Angell, also favored lower interest rates to support supply-side actions. These were not helpful appointments.

Following tax reduction and a reduced rate of contraction of the real base, real GNP growth turned positive in the second quarter of 1982, but not in the third. In its economic report written at the beginning of 1982, the administration continued its support of Federal Reserve policy. The report expressed a preference for steadier decline in the M
₁
growth rate, but it did not criticize the Federal Reserve.

Volcker’s short-term gamble succeeded. M 1 growth turned negative in February. Quarterly growth was about 6.4 percent as originally reported. At the March 29–30 meeting, April’s money growth was a major concern. The staff forecast called for 8 to 10 percent followed by slower growth or decline in May and June. Typically, money growth rose in April because the public paid its income tax, and apparently the seasonal adjustment was inaccurate.

The FOMC divided. About half followed Governor Partee by choosing faster M
₁
growth. Volcker chose to give more weight to M
₂
and at one point chose a combination of M
₂
and M
₁
growth that were inconsistent based on the staff projections. His chief interest seemed to be avoiding a temporary decline in interest rates and increase in money growth that the FOMC would have to reverse.

The remarkable feature of the discussion was the commitment of many members to continue the disinflationary policy despite a 9 percent unemployment rate and a substantially slower inflation rate. After much discussion, the committee voted nine-to-two to keep the federal funds rate in the 12 to 16 percent range and to aim for a 9 percent annual rate of M
₂
growth and between 3 and 9 percent M 1 growth. The wide range on M 1 growth reflected the great uncertainty about both the monthly seasonal adjustment and the degree to which NOW accounts were used for transactions.

Balles asked why market interest rates remained historically high as the inflation rate fell. Axilrod gave three answers. First, “the world isn’t yet convinced that the rate of inflation isn’t going to get worse when we get out of this rather deep recession” (FOMC Minutes, March 29–30, 1982, 30). Second, variability in short-term rates resulted from efforts to control money. This put a premium in interest rates. Later, Axilrod added that the budget outlook “keeps the public convinced that inflation is not going to
get better. . . . [T]he odds are that when we get on the up side of the cycle inflation will get worse” (ibid., 31–32).

119. Contemporaneous reserve accounting again came up for discussion. Volcker gave a clearer statement of his position. “I do not think it is going to make a lot of difference in and of itself. . . . [T]here is a certain logic just in terms of being consistent with our present techniques. My concern is that people will read into it more than it is worth and we would get more flak rather than less” (FOMC Minutes, February 2, 19
82, 91).