A History of the Federal Reserve, Volume 2 (80 page)

The Committee was pleased by the decline in interest rates, concerned about the speed of decline, and uncertain about what to do next. Members agreed on two points. They wanted the decline in interest rates to continue, and they did not want a sharp decline followed by a rise. They found much less agreement on how to do that. As always, some insisted that the right policy was to keep to the money targets, but more members now wanted to control the funds rate directly. Governor Partee expressed what may have been in others’ minds. Weak money growth “would risk a second decline in the economy and [perhaps referring to proposed legislation] we
wouldn’t
survive
that
as
an
institution”
(ibid., 26; emphasis added).

Much of the discussion concerned whether M
₁
growth should be 5.5 or 6.5 percent in September. Actual M 1 growth in August and September was 16 and 19 percent. The federal funds rate remained about 10 percent, at the bottom of the range. Member bank borrowing rose to $933 million in September, far outside the range the FOMC set ($300 million).

On August 3, Senator Byrd introduced his bill to restrict Federal Reserve independence by requiring it to lower interest rates and abandon reserve targets. He had thirty-one cosponsors. Volcker continued to push for more spending reductions in his dialogue with members of Congress, and the congressional principals continued to urge lower interest rates.

In part, this was a replay of 1968. Congress and the administration bargained over the fiscal package. Volcker assured them that interest rates would come down if they reduced the deficit, but he did not say whether he would raise money growth. The pressure was considerable. He did not agree to a coordinated effort, but he now moved decisively to lower interest rates.

Volcker and the FOMC had given more attention to interest rates in recent months. Volcker now made the policy changes explicit, but only for internal discussion. “On these money growth targets, in substance, I don’t care. I think either of these two sets of numbers [5.5 and 6.5 percent] will make no difference, virtually, in what we actually do. . . . [W]e are within the limits of the growth targets anyway” (ibid., 28). He then proposed an interest rate policy that, as stated, depended on money growth.

131. Several weakened banks borrowed from their reserve banks. Governor Rice asked “whether we want to tell the market why there was a big bulge in such borrowings. . . . Chairman Volcker: This will have to be handled with a certain degree of flexibility” (FOMC Minutes, August 24, 1982, 15).

I would be totally unable to defend a policy on our part that brought the federal funds rate up to 11 or 12 percent in the coming period. I would be very hard pressed to justify in my mind a pronounced downward shift in the federal funds rate in the near term from where it is. . . .

If money growth comes in distinctly weak, we would ease up by some combination of measures, which would produce a little lower interest rates. If it came in as stronger or stronger than 5 percent, I would suggest that we probably would get some backing up of short-term rates.

I, frankly, cannot live in these circumstances, given what is going on in the money markets, with violent moves in short-term rates in either direction. It would just be so disturbing in terms of expectations, market psychology, and fragility that it’s just the wrong policy, period, during this particular period. (ibid., 29)

Prodded by Anthony Solomon, he specified a funds rate range of 7 to 10 percent.
¹³²

Robert Black (Richmond). What you’re really saying is that on the old procedures you would favor a money market directive. . . .

Chairman Volcker. That is correct. But how we lean would be guided by the money supply, assuming something drastic isn’t going on. (ibid., 30)

Governor Partee objected to Volcker’s proposal because it gave all the authority to the Chairman. Morris agreed. Both preferred a 7 to 10 percent band on the funds rate.

After a lengthy discussion of the wording in the directive expressing concern about how Volcker’s words “unusual volatility” would be interpreted, Volcker reluctantly gave up his wording and accepted a federal funds range of 7 to 11 percent. Money growth targets remained at 5 and 9 percent. The vote was ten-to-one, with Wallich dissenting and Gramley absent. Two days after the meeting, the Board voted to reduce the discount rate to 10 percent.

A month later, the FOMC held a telephone conference. There was no sign of economic expansion. Risks to financial markets seemed smaller, but not by much. Inflation continued to decline.

The purpose of the telephone meeting was to confirm and support Volcker’s decision to prevent an increase in the federal funds rate despite
the increase in borrowed reserves. “We should not follow—and I would not intend to—a mechanical application of those reserve positions but rather stabilize market conditions somewhere close to where they are presently or even slightly below where they have been in the last couple of weeks” (FOMC Minutes, September 24, 1982, 1).

132. It is hard to find support for his comment about violent moves in short-term rates. Weekly three-month Treasury bills in July and August declined every week from July 2 (12.81 percent) to August 27 (7.50 percent). Volcker later responded to a question by saying that he was unhappy with the speed with which rates declined.

President Ford (Atlanta) asked for a clarification of the policy change. “Do you want to cap interest rates at 10.25 percent?” (ibid., 2). Volcker denied there was a policy change. He would try to hold borrowings to around $500 to $600 million by moving up the nonborrowed reserve path. “It would be a misguided policy to follow a direction right now that is likely to create a pronounced increase in interest rates” (ibid., 3). In a response to President Roos (St. Louis), Volcker added that he wanted to prevent a rise in interest rates during the two weeks before the next FOMC meeting. He proposed to ignore reserve growth and stabilize money market rates.

Roger Guffey (Kansas City) wanted to vote on the proposal, so there would be a record of their decision. Volcker hesitated and decided not to vote and postponed any announcement.

By deciding to target borrowing, the System returned to the policy target used in the 1920s and the basis for the free reserve target in the 1950s and 1960s. As in the earlier periods, the intent was to have loose control of interest rates without explicitly choosing an interest rate target. At the time, some of the borrowing was for a longer term, made to sustain some of the troubled banks. This borrowing was unresponsive to interest rates and excluded from the definition of borrowed reserves. Other borrowing was sensitive to the interest rate relative to the discount rate, but the relation was not very tight. Inability to project borrowed reserves accurately was one of the main weaknesses in the System’s method of targeting money. Several FOMC members expressed these concerns emphasizing uncertainty about the amount of borrowing made by banks facing credit problems. Volcker’s concern was to avoid a rise in the funds rate from 10.25 percent at that time. Any concern about financial sector problems was more than matched by concerns about Congress.

The shift to easier money, judged by growth of M 1 in September without recourse to higher interest rates, induced a dramatic increase in stock prices. The S&P index rose 4 percent in the first week of September. The index had been rising slowly; prior to the September policy change, it had increased 25 percent in the year to August. Despite the gloomy forecasts and anecdotes at the FOMC, investors and speculators had become more optimistic. The decline in inflation and interest rates and the reluctance to slow money growth added to their optimism.

Weekly Treasury bill rates showed little response to the September
24 meeting, but ten-year Treasury rates continued to fall. By October 1 they were below 12 percent for the first time in two years. A year before these yields reached a peak of 15.68 percent, so the decline was more than 3.75 percentage points in a year.

The rise in stock prices, and the fall in long-term rates and in measures of expected inflation were inconsistent with the predictions of those who opposed policy ease. Volcker must have noticed these responses and was encouraged to continue.

With reserve targeting about to end permanently, the Board approved a return to contemporaneous reserve accounting beginning February 2, 1984. The change applied only to institutions holding $15 million or more in total deposits. Reports remained due on Wednesday with a two-day lag using deposits held during the two weeks ending the previous Monday. The change did not apply to time deposits.

Tentative agreement came on June 28 with Teeters and Gramley opposed. They claimed that eliminating lagged reserve accounting would increase interest rate volatility. One suggestion was to stagger settlement; half the banks would settle each week. After additional staff research, the Board rejected this proposal on the argument that monetary control would be weakened if the settling banks borrowed reserves from the other banks. A minority proposed to try the staggered system, but they did not prevail. On September 29, the proposal for contemporaneous accounting was adopted on a five-to-two vote with Gramley and Teeters still in dissent. Since reserve targeting soon ended, the decision had no effect on monetary control.

The staff forecast put off the recovery to 1983. Then Axilrod discussed the difficulties of forecasting or even interpreting M 1 . The All Savers Certificates, NOW accounts and other changes created the problem. As Chart 8.4 above shows, these problems did not affect the real monetary base. Growth of the real base turned positive in August. Real output rose slightly in fourth quarter 1982 and more strongly in the first half of 1983. Industrial production surged in January. The recession was over.

The October 5 FOMC meeting was a turning point; the FOMC ended monetary control. Volcker signaled his concern and his intention by speaking first. After noting disappointment at the slow pace of recovery despite lower inflation, he gave his interpretation of world economic problems. The world was in recession with unemployment at record (postwar) levels. “I don’t know of any country of any consequence in the world that has an expansion going on” (FOMC Minutes, October 5, 1982, 15). World trade was doing poorly. He then briefly summarized the problems of Mexico, Argentina, Ecuador, Chile, Bolivia, Costa Rica, Peru, Brazil, and Venezu
ela. “All of these countries are dependent upon sustained borrowing to maintain a semblance of equilibrium during this period” (ibid., 16). These countries depended heavily on loans from U.S. commercial banks, but the banks were “basically unable or unwilling to sell any substantial amount of domestic CDs and are having their lines from other banks cut back” (ibid., 17). Spreads in the euro-dollar market had increased. He suggested that the decline in Treasury yields was, in part, a flight to quality. Some banks tried to withdraw from international lending (ibid., 18). All of these problems increased uncertainty. Appreciation of the dollar added to the world’s problems.

Volcker then reviewed the problems of Latin American countries. He made two groupings. All the main countries, Mexico, Brazil, Argentina, and Chile, had problems with financing their debt. Several others— Ecuador, Peru, Costa Rica, Bolivia, even Venezuela—faced difficulties in financing, and some would likely default. Total external debt for these countries he placed at about $300 billion, much of it owed to banks in the United States.

Next, he reviewed problems at domestic banks. Many faced difficulties when borrowing in the market and had to pay a premium. Euro-dollar market rates had a risk premium over domestic rates “that is not explicable by normal arbitrage calculation” (ibid., 17). One result was that the decline in federal funds and Treasury bill rates had not extended to the rates faced by foreign banks, troubled domestic banks, and sovereign borrowers.

Volcker concluded his survey by emphasizing the uncertainty about domestic and international developments. If the members were not frightened by his summary, he ended by saying, “we haven’t had a parallel to this situation historically except to the extent 1929 was a parallel” (ibid., 19). Other members added to the gloom about problems in Argentina and Brazil. As these countries rolled over debts, they had to pay the real interest rates prevailing at the time. Soon many would default.

At the start of the Committee’s discussion, Volcker made clear that he regarded the situation as extraordinary. “This is not a time . . . for business as usual . . . extraordinary things may have to be done” (ibid., 19). He proposed setting the borrowing target at $200 or $300 million. “The implication is that we would keep the borrowing level more or less the same until something happened to throw us off—in economic activity, in financial markets, or in the actual growth of M
₂
and M
₃
” (ibid., 52). He made clear several times that he did not want interest rates to increase, and he did not want a target for M
₁
because the expiration of All Savers Certificates made the numbers meaningless.

Volcker left no doubt that he wanted discretion. In August, he had asked for a directive that permitted him to prevent any increase in interest rates.
He had not convinced the FOMC. Market rates had increased during the month. “I think it was a mistake to have that kind of directive last time. I think it would be more than a mistake this time, and it’s not going to be acceptable to me. Beyond that it is desirable to get some easing in this situation” (ibid., 31).

“The central point is that whatever the [monetary variable] is that we are operating on, it is a staff guess, which may or may not be right. I’m saying that I’m not willing to stake my life, so to speak, on that guess being right. The risks are too great. . . . [W]hat this is meant to convey is an operational approach that modestly moves the funds rate down” (ibid., 32).

One reason for resistance was concern about making a policy change to lower interest rates one month before the congressional election. Members rarely mentioned political events as reasons for favoring or opposing policy but Ford was unusually explicit.

I want to say, respectfully, that I’m flatly opposed to this. If we were to do this, especially now, I think it will consolidate any adverse opinions against us that are already out there about our motives for doing this at this particular time. . . . I have heard from more people than I care to describe to you comments questioning our integrity and our motives in the context of an election campaign. (ibid., 33)

Just three years earlier, Volcker told the members that the proposed change was a temporary move. Now he said they would restore the M 1 target once the All Savers Certificate and the new instruments allowed by the Garn-St. Germain legislation permitted transaction accounts to settle down. Later he said to Mehrling (2007, 183) that “we were getting boxed in by the money supply data . . . We came to the conclusion that it was not very reliable . . . so we backed off that approach.”

This time, he added a threat and responded to comments about the election.

It’s quite clear in my mind where the risks are. I think I made it quite clear where the risks are. I think I made it quite clear in terms of economic developments around the world. But if one wants to put it in terms of political risk to the institution: If we get this one wrong, we are going to have legislation next year without a doubt. We may get it anyway. . . . I’m not sure how it looks just in strict electoral terms, since that question has been raised, to sit here in some sense artificially doing nothing and then have to make a big move right after the election. I’m not sure that would wash very well in terms of anybody’s opinion of our professional competence as an institution. (FOMC Minutes, October 5, 1982, 50–51)