A History of the Federal Reserve, Volume 2 (85 page)

The consensus was not complete, and agreement was surrounded by ambiguity, reflecting the uncertainty the members felt. Recovery had started but many doubted its strength and duration. Inflation had fallen, but it might return. Those who did not want to announce a target for M
₁
offered as alternatives M
₂
and broader aggregates including M
₃
and debt (Morris). Corrigan (Minneapolis) favored a GNP target, a position he shared with the Council of Economic Advisers. He did not mention either how that would be done or whether the Federal Reserve could offset all non-monetary influences on GNP, since they could not reliably forecast quarterly velocity.

William Ford (Atlanta) strongly criticized the consensus. “We’re generally in favor of leaving M
₁
in, although with much less emphasis. . . . I don’t think it’s too much of a stretch of the words to say we want to [fine] tune the economy. . . . We think we can do it. We’ve all used the word flexibility. . . . and everyone is advocating the wider bands” (ibid, 31). Ford then argued against fine-tuning and urged more consistent adherence to a target “over a long period of time and just let it go in a steady way and the market will know what we’re going to do next” (ibid.). Ford concluded that in fact the System had returned to an interest rate target but didn’t want to say so. He did not favor that procedure, but he preferred that they state clearly and unambiguously what they were doing.

Volcker agreed that targeting and flexibility were opposites. “The Committee is on two horses. . . . One is targeting and one is flexibility” (ibid., 32). He did not accept that they were targeting interest rates. “We can look at a lot of things in addition to interest rates, which I think is probably what we’re doing” (ibid., 32). He did not acknowledge that the manager had to have a target. He continued to use borrowed reserves defined as adjustment plus seasonal borrowing but excluding long-term borrowing used to assist failing banks.
³

The members agreed on a range of 8 to 9 percent for central tendency
growth of nominal GNP in 1983 with the deflator rising 4 to 5 percent and real GNP 3.5 to 4.5 percent. Actual values were very different, 10.4 and 6.1 percent. The M 1 growth projection was 4 to 8 percent. At the midpoints, these projections assumed 2.5 percent velocity growth. There was general agreement on a cyclical rise in velocity at the start of the recovery.

3. Looking back in 1987, staff members David Lindsey and James Glassman concluded that the borrowing target gave “considerable influence over conditions in the federal funds market . . . while still enabling the funds rate to fluctuate” (Board Records, 1987, July 1, 2). They showed that short-term fluctuations in the funds rate often differed considerably from expected values but the differences did not persist. Their econometric estimates showed a standard error for 1982–87 of $230 million (ibid., table 1). This seems large relative to average borrowing.

When choosing the projected ranges, most members forgot their concerns about uncertainty and argued about differences of one-half percent. Volcker did not seem to take the projected ranges very seriously. He cut off discussion of small differences and later told the FOMC: “I don’t know how soon I would have . . . any conviction on what the velocity is of M 1 ” (ibid., 72).

The Committee divided eight-to-four on the choice of long-term targets for the aggregates. Governor Wallich and Presidents Black, Ford, and Horn dissented. They wanted a less expansive policy than 4 to 8 for M
₁
and 7 to 10 for M 2 .

Choosing a short-term target brought out a wide range of opinions about what was likely to happen.
⁴
The Committee voted eleven-to-one to “maintain the existing degree of restraint.” Although large one-time adjustments occurred, money growth for fourth quarter 1982 reached 13 percent, so restraint on reserves did not correctly describe recent monetary actions. The Committee agreed that “lesser restraint would be acceptable in the context of appreciable slowing of growth in the aggregates” (ibid., 97). The range for the funds rate was put at 6 to 10 percent. President Ford dissented because the Committee made no mention of tightening to slow money growth.

Roger Guffey (Kansas City) took issue with the draft statement. He wanted lower interest rates and proposed a lower discount rate. Ed Boehne (Philadelphia) joined him. Henry Wallich argued that they could not reduce interest rates until money growth slowed. A majority agreed to foreclose any move to tighten policy, without agreeing on what that meant. It seems likely that most wanted an agreement not to increase interest rates. Presidents Ford and Roberts (St. Louis) opposed the decision. Ford reminded the Committee that in the past, they delayed too long before tightening because they based policy on current conditions instead of looking ahead six months or more to the conditions likely to be in place when the policy would impact. This is one of the few clear statements urging less attention to recent events. The Committee ignored it.

The Committee could not agree on whether to include language saying
that it would ease if money, credit, or economic conditions justified the change. The vote was five to five, with Volcker and Ford abstaining. The final decision made additional ease depend on money growth falling below the long-run path, a decline from 13 to less than 8 percent. The borrowing target was $200 million. Actual borrowing in February was $582 million. The federal funds rate averaged 8.5 percent, well within the band.

4. Volcker said, “I think the probabilities are that we are beginning a recovery. But I would not discount at all the [other] possibility” (FOMC Minutes, February 8–9, 1983, 83).

The policy decision was no easier when the FOMC met in March. The staff and several members recognized that real interest rates and money growth had very different implications. Monthly money growth was well above the 4 to 8 percent annual target. Twelve-month average monetary base growth rose to 9.3 percent. But the real interest rate on a ten-year Treasury note remained about 5.5 percent. The FOMC ignored the aggregates. “In that context, the present monetary situation looks relatively restrictive” (FOMC Minutes, March 28–29, 1983, 4).

Sternlight explained that borrowing had greatly exceeded the $200 million target. No one objected. The reserve banks wanted lower interest rates, so several requested a reduction of the discount rate to 8 percent. The Board deferred action on the requests from at least six banks on eight different dates in January and February, citing growth of the aggregates. On March 7, the Board disapproved the reduction. The following week, Richmond proposed an increase to 9 percent. The Board at first deferred action, then rejected the request on March 21. Banks reduced the prime rate by 0.5 percentage points to 10.5 percent.

The staff described the recovery as “well underway” and raised its growth forecast for the first quarter to 4.1 percent (from 3.5). The earlier forecast proved correct. Inflation remained low. Several members remained skeptical about the duration of the recovery. Despite high real rates, the strongest sector was the housing sector with 1.6 million starts. Guffey (Kansas City) expressed concern that higher interest rates would terminate the recovery in housing. Gramley said that recoveries tend to cumulate initially. Greater strength seemed likely. Volcker again expressed concern about more defaults on international debt, and Partee added concern that export growth would remain low.

Robert Black reminded the members that “most of the time the majority has been wrong. . . . I have less and less sympathy for discretionary monetary policy” (ibid., 32–33). No one commented. Preston Martin expressed concern that banks and thrifts continued to buy fixed rate mortgages.

The FOMC had to combine these diverse views into a short-term policy statement. The members did not agree on whether to adopt a money market or aggregate objective. Volcker favored the aggregates. “If we stop targeting them, we’ve got to tell the Congress we are going to stop targeting
them” (ibid., 45). But he again expressed concern about velocity, so he did not want strict monetary targeting. Banks and markets watched M
₁
growth. This was a main factor driving members back to monetary targets.

Volcker urged a cautious approach, and the FOMC concurred. They set M
₁
growth at 6 to 7 percent, a borrowing target of $250 million believed consistent with an 8.5 percent funds rate. The FOMC agreed to maintain about the existing restraint. Volcker continued to act as he wished. Actual borrowing in April was $1 billion, and the average funds rate was 8.8 percent. The monetary base increased at almost a 12 percent annual rate. M 1 growth declined slightly in April, but the staff projected 24 percent annual growth in May (FOMC Minutes, April 29, 1983, 1).

Nevertheless, at a telephone conference on April 29, Solomon (New York) and Guffey (Kansas City) urged lower interest rates. Others objected, and Volcker agreed that it was not appropriate to act on data for one month. Discount rate decisions at the banks show difference of opinions and confusion. In a rare, open display of differences in outlook, Richmond, later joined by Atlanta, Dallas, and Cleveland, proposed to increase the discount rate by 0.5 to 9 percent; Boston, Chicago, Kansas City, San Francisco, and Minneapolis voted for reductions of 0.25 or 0.5 percentage points Later Philadelphia and New York joined them. At one time or another during the spring and early summer seven banks requested a reduction. The Board deferred or disapproved all the requests. By late June it too divided. Some governors wanted to approve an increase but others feared that the economy would slow. Governor Teeters dissented from the decision to defer action because she wanted to reject any increase.

Division of opinion declined in July. Five banks requested an increase. The others voted to keep the discount rate unchanged. Despite the strong recovery and the large (nearly one percentage point) spread between the federal funds rate and the discount rate, the Board kept discount rates unchanged.

The Board began to repeat the mistakes of the 1970s. The unemployment rate in May and June was 10.1 percent, and the twelve-month rate of CPI inflation fell to 2.5 percent. They disregarded growth of the aggregates and delayed responding to the increase in nominal and real longterm interest rates. By the new year, twelve-month CPI inflation was above 4 percent, nominal ten-year Treasury bonds yielded 11.8 percent, and SPF inflation expectations had increased. The staff based its inflation forecasts on the short-run Phillips curve; with a 10 percent unemployment rate, they did not anticipate the increase.

At the May meeting, Governor Wallich asked the account manager for his impression of what the market thought the Federal Reserve used as a
target. Sternlight replied it was free or borrowed reserves. This surprised President Black, who asked why market participants did not believe they used a funds rate target. Sternlight replied:

I think they would feel, with some reason, that if we were aiming at free reserves or borrowing we are aiming at something that has a likely range of variation in the federal funds rate but not a federal funds rate target in the very narrow sense where the Desk pinpointed within 0.12 points or so a particular funds level and intervened every time there was ever so little a variation from that. (FOMC Minutes, May 24, 1983, 2–3)

Later Volcker added that “M
₁
is getting relatively less emphasis; that does not mean no emphasis. I suppose we remain someplace in the vague area” (ibid., 18). He did not mention how the free reserve or borrowing level reflected that emphasis. It seems clear that he did not fully trust any single measure and made discretionary judgments based on his interpretation of accruing data. The members could discuss and vote, but he decided between meetings and influenced decisions at meetings.

Despite historically high real interest rates, most of the members thought the economy would be stronger than the staff forecast of 5 percent annual growth. Those who disagreed cited the negative effect of high real interest rates on recovery abroad (Solomon), the budget deficit (Corrigan), and inflation (Balles and Ford). Ford also mentioned possible banking failures in Tennessee following the failure of banks controlled by the Butcher family.
⁵

The Committee could not agree on a policy. The FOMC in 1983 had little common sense of direction or agreement on action. In May, some wanted to increase the borrowing target from $250 to $350 million. They described that as more restrictive, a sign that the free reserve interpretation remained strong. Guffey thought that was dishonest because actual borrowing was above $350 million. No one agreed. Gramley wanted $400. The vote was six to six, with Solomon, Guffey, Morris, Rice, Roberts, and Teeters voting no. Some wanted higher borrowing, some lower. Some non-voting members accused Roberts (St. Louis) of fine-tuning. He “reluctantly” voted for $350, although he wanted $400, a level he considered more restrictive. After a seven-to-five vote, the FOMC adjourned.

The final directive called for a slight increase in restraint. It mentioned that “lesser restraint would be appropriate in the context of more pro
nounced slowing of growth of the broader monetary aggregates relative to the paths implied by the long-term ranges and deceleration or M
₁
” (ibid., 57). Earlier, Morris and Solomon had objected to mentioning M 1 .

5. Beginning in April, the Board began to remove regulation Q ceilings on interest rates by reducing the maximum maturity subject to ceilings. At the same time, it reduced the maximum maturity of time deposits subject to reserve requirements. By October 1, 1983, the Board had eliminated all ceiling rates.

Vice Chairman Solomon. What you’re saying is that even though we have deemphasized M
₁
, when it’s large we have to take it into consideration.

Chairman Volcker. I think that’s precisely what we’re saying.

Vice Chairman Solomon. I don’t agree with that. (ibid., 51)

Once again the staff underestimated the strength of the expansion. The FOMC held a conference call on June 23 at which the staff reported that the Commerce Department expected real growth of 6.6 percent annual rate in the second quarter. Expected M
₁
growth was 11.5 percent in June. From March to June, M
₁
rose at a 12 percent annual rate, twice the rate forecast at the March meeting. Twelve-month growth of the monetary base rose to 10.4 percent. Long-term interest rates rose by ten to twenty basis points to 10.9 percent at the meeting date. Borrowing reached $600 to $700 million, twice the target level. The federal funds rate rose to 9 percent. Sternlight said the market was uncertain whether the Federal Reserve wanted more restraint.

Volcker started the discussion at the June meeting by saying that borrowing was between $400 and $500 million. This excluded almost $1 billion of extended borrowing. He wanted to keep it there. He proposed raising the funds rate to 9 percent. No one objected, and all interpreted the higher borrowing level as a modest move toward restraint.

July brought the last reduction in tax rates voted in 1981. The economy continued to expand, and the staff again raised its forecast. The Board’s inflation forecast for 1984 was 4 percent. Most private forecasters predicted 5 to 6 percent inflation. Based on its inflation forecast, the staff predicted a decline in long-term interest rates by late 1984. That proved to be early.

At the July 12–13 meeting, discussion began about why the interest rate remained at 11 percent when inflation had fallen to about 4 percent or less. Axilrod blamed fear of additional policy tightening. The market expected short rates to rise, as they later did. The Treasury had prepared a paper claiming that there was no necessary association between budget deficits and interest rates. This was received with considerable skepticism. Gramley quoted a survey of bond buyers showing expected inflation for five to ten years had increased and was now 6.5 to 7 percent. The one-year SPF forecast called for 4.95 percent.

Axilrod reported that staff research showed that M 1 growth was not distorted by deregulation and new types of accounts. Deregulation produced
both inflows and outflows, but on balance the two were about the same. M
₁
now had a larger saving component and was more interest sensitive, but it was not distorted. He proposed that they raise the annual target from 4 to 8 percent to 7 to 11 percent. And he remarked that high money growth was one main factor leading to the strong recovery.