A History of the Federal Reserve, Volume 2 (86 page)

The July meeting revised the projections for money growth in 1983 and gave preliminary indications for 1984.
⁶
Despite M
₁
growth far above the projected range for the year, no one considered reducing it. The FOMC discussed three options: raising the growth rate to incorporate the high first half, rebasing the growth rate, and keeping the same projection and ignoring M
₁
. Volcker spoke against rebasing, but most of the Committee favored that choice. Most of the discussion emphasized appearance, interpretation, and political issues. No one thought they would conduct policy to achieve the announced money growth rate, although some proposed doing so. Partee warned that the funds rate target was too slow to change in expansions (FOMC Minutes, July 12–13, 1983, 46).

The Committee split on the choice of M
₁
growth rates. A majority favored rebasing and setting the growth range at 5 to 9 percent for the rest of 1983 and for 1984. The central tendency forecast for nominal GNP growth, 9.75 percent, allowed monetary velocity to remain unchanged or rise about 4 percent.
⁷

The FOMC did not consider explicitly how their borrowing or free reserve target related to the monetary projection. Although they argued over the choice of borrowing target, the actual level of borrowing was generally above the target during this period. The difference was $400 million or more during July and August; extended credit borrowing was $578 and $491 in July and August. The federal funds rate was more nearly constant from month to month. Between July and December, the monthly average remained between 9.37 and 9.56. Monthly growth of the monetary base ranged from 3.5 to 13.9 percent.

The FOMC’s concern about inflation brought an early response. Real base growth reached a peak in July. It fell for the next two years. Real interest rates rose from 4 to 6.9 percent. Both measures show a more restrictive policy. CPI inflation rose above 6 percent in second quarter 1983. The funds rate rose modestly. By November, the twelve-month moving average of S&P 500 prices fell. Growth of industrial production began to slow in the spring of 1984. Chart 9.10 shows the real base growth and the
real interest rate. Both show a decisive move to tighten in 1983 and ease in 1985. By acting early, the FOMC showed the market the 1970s would not return.

6. Volcker began the meeting by warning about leaks. The policy discussion was held in executive session and most staff had to leave.

7. The members’ nominal GNP forecasts ranged from 7 to 11.25 percent. The staff forecast 8.3 percent.

In August, Volcker had the FOMC spend part of a day discussing forecasts and policy objectives. This was a rare event, and it showed again the different opinions held by the members. They used different frameworks and did not have the same objectives. Anthony Solomon pointed out that they did not have a common view of the effects of fiscal policy. In fact, they differed on basic points. Balles said the long-run effect of monetary policy is on the price level; fiscal policy affects real growth, productivity, and other real variables. Teeters disagreed. “She believed that the Federal Reserve affects real output in the long-run as well as the short-run” (FOMC Minutes, August 22, 1983, 14). Guffey thought the objectives in the Employment Act were “inconsistent” (ibid., 14). No one suggested making an effort to resolve differences.

Volcker took a vote on whether their long-run objective should be zero inflation. Most of the governors voted no; most of the presidents voted yes. President Boehne was an exception. He found the idea of the long run not useful, a theoretical concept without much relevance to the real world (ibid., 15). Ford and Roberts argued that the Federal Reserve should give more attention to the long-run consequences of its actions.

Board Vice Chairman Preston Martin opposed a zero-inflation goal. “If we were indeed to bend our efforts to achieve zero cpi inflation, how
ever measured, we would have a resultant unemployment level that would be destructive to the social fabric of their country” (ibid., 17). He wanted 2 percent inflation as a goal. Solomon said: “We’d be laughed at if we said our only legitimate objective is price stability” (ibid., 21).

John Balles persisted. To those who argued that there was a short-run tradeoff between inflation and growth, he replied that “the cost of trying to exploit that tradeoff may well be a procyclical monetary policy” (ibid., 22).

There was very little agreement and no convergence. Volcker cut off the discussion by asking what implications fiscal policy had for monetary policy. Specifically, if Congress raised tax rates, would the Federal Reserve commit to lower interest rates?

Wallich favored a one-year increase in money growth to offset some of the effects of a tax increase. He warned that the monetary increase must not be permanent, but he did not suggest how to prevent it. Partee reminded him that the Federal Reserve made that mistake in 1968. Gramley added, “We ended up with the worst of all possible worlds” (ibid., 34).

No one spoke in favor of coordination. That was an improvement. Volcker, mindful of his 1982 experience, reminded them that Congress would likely not agree to raise tax rates if they would not coordinate. Senator Byrd’s bill in 1982 had thirty-one cosponsors. It required the Federal Reserve to abandon money targets and adopt an interest rate target that kept real interest rates within their historic range. Congressman Jack Kemp proposed to introduce similar legislation in the House at the time. The majority leader, Senator Howard Baker, opposed the legislation but used the threat to urge Volcker to agree to lower interest rates if Congress reduced the budget deficit. Volcker did not make an explicit commitment, but he reduced the funds rate. Congress passed a bill raising revenues by about $100 billion. Volcker was less committed to policy coordination than William McChesney Martin had been in 1968, perhaps because he remembered that experience.

The discussion ended without reaching a conclusion. Most members who spoke opposed coordination in principle. Volcker did not think that was a politically acceptable answer. No issue of this kind was currently pending. He recognized limits to Federal Reserve independence.

At the October 1983 FOMC meeting, the staff reported that M
₁
, M
₂
, and M
₃
remained within their projected ranges for the first time since 1980. Volcker lowered the target for borrowed reserves on a conference call in early September. Total actual borrowing averaged $1 billion, confirming for President Guffey and others that their borrowing decisions had little or no importance; the desk and the chairman used an interest rate target. Average monthly borrowing from October through December ranged
from $774 to $906 million. By November, extended credit borrowing had become negligible. The federal funds rate remained in a narrow range— between 9.34 and 9.48 percent. Monetary base growth declined.

The October meeting had a lengthy discussion of monetary velocity. Axilrod opened the discussion by noting that the cyclical behavior of M
₁
velocity in 1982 and 1983 was not “unusual enough to have warranted downplaying the role of that aggregate in policy” (FOMC Minutes, October 4, 1983, 8). He remained cautious, however, citing the increased interest elasticity of M 1 .

Balles (San Francisco) pointed out that research at his bank showed no relation between M
₂
or M
₃
and nominal GNP. By this standard M
₁
“may be far from perfect but the alternatives are even worse” (ibid., 25). Wallich pointed out that the demand function for M
₁
may be stable even if the simple M
₁
-to-GNP relation is unstable.

The discussion ended there. The Committee did not reach a consensus and did not decide to maintain or disregard its M
₁
target. Volcker continued to make the operating decisions with support from Axilrod and Sternlight. The desk attempted to hit the borrowing target.

The November 14–15 meeting opened with a discussion of inflation. The staff first described three approaches—based on monetarism, the Phillips curve, and rational expectations. The staff dismissed rational expectations. The public is “not as sophisticated in forming their expectations as the rational expectations theory assumes” (FOMC Minutes, November 14–15, 1983, 5). This statement neglects the role of arbitrage in the markets on which the Federal Reserve relied for information. Open market rates can fully reflect information even if everyone does not know all the information.

The Board’s staff preferred the Phillips curve approach for analyzing inflation. It did not mention the errors made earlier. The staff recognized, however, that the natural rate of unemployment was not constant. Equilibrium unemployment at full use of resources had increased to between 6 and 7 percent, they estimated, because of reduced labor productivity growth and the relative growth in numbers of less experienced workers. Volcker did not share their view. “The Phillips curve that looked so persuasive when based on historical data without a long-term inflationary trend turned out to be less stable over time when policy was heavily influenced by the implied premise that we could ‘buy’ prosperity with a ‘little’ inflation” (Volcker, speech to American Economic Association, 1983, Board Records, December 28, 6).

The staff forecast called for “a small acceleration of prices in 1984.” It
gave four reasons including rapid real growth in 1983 and dollar depreciation. It did not include rapid money growth.

Volcker criticized the omission of the deficit as a factor affecting inflation. He did not appeal to economic theory. “A hundred and eighty million people out there . . . think there is some relationship” (ibid., 6). But he ended the discussion by challenging the members. “You have to come up with a better model or a different model if you don’t like these results” (ibid., 22). There was no response at the time. The staff continued to use the Phillips curve, but members did not commit to act on the staff forecast. Although the Federal Reserve was seventy years old, it did not have a common explanation of the causes of inflation or the role of money growth.
⁸

By November, most members expected growth to persist, so they favored a slightly tighter policy. Money growth had slowed from the early part of the year, but the staff predicted it would increase in 1984. The members proposed an increase in the funds rate from about 9 percent to 9.5 percent. One member asked for 10 percent. The more monetarist contingent—Balles, Black, and Horn—urged more attention to money growth and wanted to increase it. The majority favored no change.

The Committee voted to reduce the September-to-December target for M
₁
growth from 7 percent to 5 to 6 percent. The general view was that this was a message for the market, not a policy proposal on which they would act. Borrowing remained at $650 million.

The Federal Reserve then made the odd decision to implement the 1982 decision to return to contemporary reserve accounting effective February 4, 1984. They no longer tried to control money, so there was no reason for the change. They had resisted the change when it hindered their ability to control reserves or meet their reserve targets. In 1997 they reversed the decision and restored lagged reserve requirements.

Not all agreed that the change was constructive. Several expected increased volatility of the funds rate. President Black (Richmond) urged more “automaticity” in policy actions. “The Committee is really out of it once it chooses its initial borrowing target unless we have another meeting.” Roberts (St. Louis) agreed (FOMC Minutes, December 19–20, 1983, 6). When it was uncertain about how to implement policy, the FOMC agreed to have more “flexibility.” In practice, this gave discretion to Volcker. Several wanted reduced flexibility, but Volcker did not bring the issue to a vote.

8. Ted Truman briefed the FOMC on emerging market debt. Volcker told them that the creditor banks would soon be asked to increase reserves for losses by $300 million. He believed that many of the banks would write down loan values. He did not ask their opinion or consent to the increase in reserves (FOMC Minutes, November 14–15, 1983, 34–35).

Much of the discussion expressed concern about higher inflation in 1984. In his December 1983 speech to the American Economic Association, Volcker defined price stability as a situation in which decisions do not depend on expectations of inflation. Confidence had returned. In February, the Committee forecast real growth and inflation for 1983 at 3.5 and 3.9 percent respectively. The unemployment rate forecast for the fourth quarter was 10.6 percent. The actual values for growth and inflation were 6.5 and 3.6 with the fourth quarter unemployment rate at 8.5 percent. Reported inflation rose in the fourth quarter to 4.7 percent, but CPI inflation remained low, 1.6 percent in December. Those few who watched monetary base growth noted that it had started to decline, as shown in Chart 9.10 above. The SPF forecast for the next four quarters put inflation at 5 percent, 4.5 percentage points below the 1980 peak and the lowest value in a decade.
⁹

Axilrod recommended 4 to 8 percent as the range for M 1 growth. He forecast a 2 percent rise in velocity and 9 percent growth of nominal GNP. Morris and Solomon objected to the emphasis on M
₁
growth. They preferred credit or M
₃
. Horn and Black disagreed. Balles, Roberts, Keehn, and Partee joined them in seeking greater emphasis on M
₁
. Several members commented on the risks of inflation rising in 1985. Teeters reminded them that when they analyzed forecast accuracy, they found that they did well one or two quarters ahead. After that the errors were large. “By the time we get to a year-and-a half or two years out, the econometric models give us almost random numbers” (ibid., 41).

The FOMC did not vote on a growth rate for 1984 at this meeting. They turned instead to the near-term targets. Volcker began by proposing that the FOMC maintain existing restraint with an intention of tightening if the monetary aggregates and economy expanded rapidly. Most of the discussion proposed values for borrowing. Proposals ranged from $650 to $850 million. Volcker summarized the consensus as preferring to wait to tighten. He favored borrowing of $650 million in January. If the report on the December unemployment rate and M
₁
growth showed strength, he favored a slight move to restraint in early January.

The vote was six to four to keep the funds rate range at 6 to 10 percent. The four dissenters preferred 7 to 11 percent.

Looking back on the use of a borrowing target, senior staff wrote that “the relationship of borrowing objectives and the federal funds rate has not been very precise or stable. Moreover, for a variety of reasons, borrowing
objectives can not be achieved with great precision in a given two-week maintenance period. . . . [T]he federal funds rate can vary as much as a half percentage point for a given borrowing objective” (Kohn and Sternlight to FOMC, 1987. Board Records, December 11, 2).

9. Volcker said, “My ideal forecast always has a declining inflation rate” (FOMC Minutes, December 19–20, 1983, 32).