A History of the Federal Reserve, Volume 2 (88 page)

Board Vice Chairman Preston Martin cited political factors as a constraint on independent action especially in a quadrennial election year. “In order to add an element to the discussion that we have all been a little too polite to enunciate, I will say that we are in such an intense political environment at the moment, with so much scrutiny from the Hill and elsewhere about what we are alleged to be doing, that holding to the course . . . is called for both for economy and political considerations” (ibid., 34). The reference to politics made the comment unusual. FOMC members maintained the fiction that they ignored politics. The federal funds rate was above 10 percent with the unemployment rate at 7.4 percent. Also, the Continental Illinois failure and failure of other banks and savings and loans were major concerns at the time.

Henry Wallich disagreed with Martin. “One ought to hesitate a little before one takes for granted that financial fragility was necessarily a cause for relenting. The rule about a lender-of-last-resort operation is to lend freely but at a high rate” (ibid., 34). Volcker responded that his concern was not Continental Illinois; it was the effect of higher interest rates on the debtor countries and therefore on the lending banks. In practice this meant that the Federal Reserve supported the banks and did not make them show their losses on international loans. The market certainly recognized the losses at money center banks; the banks’ market values declined. Federal Reserve policy, however, provided a guarantee against failure but placed a restriction on its policy by making members more reluctant to raise interest rates if called for.

FOMC members had several concerns about financial fragility at this time. The savings and loan or thrift industry had many insolvent institutions kept from failure by public policy. Higher market interest rates would have widened the spread between the rates paid by the thrifts and market certificates that were now deregulated. A mark-to-market policy for emerging market debt would reveal insolvency at many banks, especially money market banks. Higher interest rates would worsen the position of the debtor countries and thus the creditor banks. The domestic agricultural sector was hurt by the appreciation of the dollar and by the interest payments required by farmers who had borrowed to buy farms during the period of high inflation and high nominal interest rates. Keehn (Chicago) reported that 15 percent of the farms were heavily indebted (FOMC Minutes, March 26–27, 1984, 36–37). And, as always, the members expressed concern repeatedly about the budget deficit. Raising interest rates increased cost to the Treasury.

The recurrent problem of “leaks” arose again. Volcker summarized a report by the General Accounting Office that suggested that the leaks came from Congress (ibid., January 30–31, 1984, 1). He appointed a committee to propose new procedures and later barred many bank staff from the part of the meeting that discussed current policy. Not until 1994 did the FOMC publish its decisions following the meetings. That ended the principal problem of policy leaks by reducing the amount of information that remained confidential.

Axilrod warned in January that money growth was too high in 1983 to reach price stability. He proposed a reduction in M 1 growth for the 1984 Humphrey-Hawkins hearing to a range of 4 to 7 percent from 4 to 8 percent. He proposed M
₂
growth at 6 to 9 percent in place of 7 to 10 percent. Balles, Wallich, Forrestal, Horn, Roberts, and Black urged more emphasis on M
₁
growth to control inflation. This led to a discussion of M
₁
. Wallich acknowledged that in practice the desk managed the federal funds rate. This led to the following exchange that shows that the members of FOMC lacked a clear idea about how Volcker implemented policy action and that Volcker acted on his own.

Vice Chairman Solomon. . . . “What you’re really saying is that we allow significant movements in M
₁
to influence our management of the funds rate gradually. . . .

Chairman Volcker. Manage our reserve position.

Vice Chairman Solomon. Well, in managing our reserve position w
e’re guided by the fed funds rate.

Chairman Volcker. Who is?

Vice Chairman Solomon. It shows the accuracy of our reserve calculations, right? Chairman Volcker. Seldom. (ibid., 26)
¹⁴

About a week after the March meeting, Henry Wallich spoke to an economic conference about operating procedures. He denied that the System had returned to pre-1979 interest rate control. The main evidence he cited was that the funds rate was more variable, especially at the end of each quarter. He then explained more fully:

If the interest rate established by this technique is not consistent with a stable rate of inflation, it will have an increasingly disequilibrating effect, causing inflation to accelerate or decelerate. . . . Thus, letting the market set
the interest rate for a given money-growth target is a safer way of achieving an equilibrium interest rate rather than trying to set it directly. (Wallich, speech to Midwest Finance Association, Board Records, April 5, 1984, 6)

14. That the New York Fed president was one of the ill-informed suggests the extent to which Volcker and the Board’s senior staff controlled decisions. It shows, also, the extent to which control had shifted away from New York.

Decisions at this time favored “flexibility.” This meant acting with discretion, in practice not achieving the growth rates or borrowing levels they announced if new information changed their minds or, more often, changed Volcker’s mind.
¹⁵
As in the 1970s, the emphasis given to interest rates or borrowing led to an unplanned decline in the growth rate of the monetary base from a twelve-month average of 10.7 to 5.8 percent between January 1984 and May 1985 followed by a sharp fall in real growth.
¹⁶

By late March, the funds rate reached 10.25 percent. Sternlight explained that the market anticipated an increase in the discount rate to 9 percent. On April 6, the Board approved the increase. The staff forecast that it expected inflation of 5.5 to 6 percent in 1985. SPF forecast put one-year expected inflation at 5.4 percent in third quarter 1984. This was a small rise from 5 percent in the second quarter, but it shows continued concern about the Federal Reserve’s actions.

The FOMC had a lengthy discussion about its proposed policy actions. Some wanted to slow money growth or raise interest rates. Morris (Boston) pointed to the two percentage point difference between the funds rate and the discount rate. Borrowing reached $1 billion. He proposed a one percentage point increase in the discount rate. Conscious of congressional reactions, Volcker replied that even half a point would see “an explosion” in Washington (ibid., 85). An “independent” Federal Reserve had to be aware of congressional attitudes.

Gramley reflected the unhappiness of many of the members who feared a return of inflation. “I think we’re pussy-footing. I think we’ve been sitting here for some months now looking at an economy that continues to exceed everybody’s expectations. This is going to come back to haunt us if we don’t decide to act” (ibid., 91–92). Wallich agreed. But Volcker expressed satisfaction with the modest changes he proposed and seemed more concerned by political response to a funds rate above 11 percent then to Gramley and Wallich’s concerns about inflation. Twelve-month average CPI inflation remained about 3.5 percent.

At the March meeting,
the vote was nine to three for a funds rate of 7.5
to 11.5 percent and M
₁
, M
₂
, and M
₃
growth of 6.5, 8, and 8.5 from March to June. Gramley and Wallich dissented because policy was not sufficiently restrictive and Martin because he wanted less restraint. In a speech at the end of April, Volcker recognized the progress against high inflation but added, “We haven’t passed the test of maintaining control over inflation during a period of prosperity” (speech to Wharton Entrepreneurial Center, Board Records, April 30, 1984, 2).

15. Earlier, Kydland and Prescott (1977) showed that this was a poor choice of tactics.

16. At the March meeting, the FOMC agreed to discontinue repurchase agreements in banker’s acceptances. Authority to do the transactions remained. A memo from Peter Sternlight discussed the pros and cons. The main argument against ending operations was that System operations allowed some smaller banks to participate (memo, Sternlight to Board, Board Records, March 12, 1984).

Between March and August the funds rate increased from an average 9.9 to an 11.6 percent rate. The operating target for adjustment plus seasonal borrowing remained at $1 billion during this period, but in order to avoid the appearance of internal problems, fewer banks were borrowing. Growth of the monetary base and money slowed. The unemployment rate remained above 7 percent; the market could see that policy had tightened. Although Volcker had expressed political concern about an 11 percent funds rate, and this was an election year, the average remained above 11 percent between June and September. This action was strikingly different from the actions in the 1970s, so it contributed to the credibility of the Federal Reserve’s commitment to low inflation.
¹⁷
Criticism of Federal Reserve policy declined after President Reagan defended the Federal Reserve at a news conference.

In May, borrowing from the Federal Reserve surged as Continental Illinois Bank (Chicago) tried to avoid failure. Gramley asked whether the desk offset some or all of the borrowing by removing reserves. The manager replied that interest rates were high at the time and the desk was reluctant to drain reserves but he was now beginning to drain excess reserves.
¹⁸
For the FOMC, Continental’s problems and the problems at other banks and thrifts added to concerns about international lending and to reluctance to raise interest rates. Volcker made this explicit by speaking before the policy discussion. He recognized that “it might take somewhat more aggressive action than we’ve taken before to bring the economy to a suitable path. . . . But, unfortunately, I don’t think that course of action is open to us. . . . My bottom line is that we’ve run out of room for the time being for any tightening” (FOMC Minutes, May 21–22, 27). Like previous chairmen, Volcker felt independence was constrained at the time.

Members of FOMC again as in the 1950s used different measures t
o express their policy preferences. Some used M
₁
; Wallich commented on the
return of free reserves; he preferred gross borrowing, the measure used by the manager. The FOMC could agree only on a directive that named different measures but they did not know whether they were consistent. The vote was ten to one. Boykin (Dallas) favored tighter policy. Nancy Teeters had left the Board, and her successor was not confirmed. Martha Seger joined the Board in July.

17. At about this time Congressman Jack Kemp organized some Republican members to propose legislation to limit Federal Reserve independence, including returning the Secretary of the Treasury as an ex officio member of the Board. The legislation did not advance, but the threat of congressional action always alarmed the Board.

18. Federal Reserve response to Continental Illinois’s problems is discussed below.

Despite the decision to make no change, the federal funds rate rose in June and July. The average July rate, 11.23 percent, was 0.91 percentage points above May. Actual and anticipated inflation continued to fall slowly. The ten-year Treasury rate at 13.4 percent had not begun to reflect lower inflation. The S&P 500 fell sharply in July and several subsequent months as the economy began to grow more slowly and investors worried about widespread financial fragility. The staff forecast anticipated modest interest rate increases, but predicted a 15 percent decline in the exchange rate.

The July 1984 meeting had to decide on the projections for growth and inflation announced to Congress and the public. This time Board members’ median expected growth for 1985 fell to 3.75 percent from 6.75 in 1984; median predicted inflation was 3.75 rising to 5 percent in 1985. The medians for the presidents were similar. The precise meaning was unclear because the members made different assumptions about dollar depreciation. Expected dollar depreciation added up to one percentage point to the 1985 median inflation forecast. The members agreed to keep projected M 1 and M
₂
growth for 1985 about unchanged at 4 to 7 and 6 to 8.5 percent. This represents a slight reduction for the upper end of the M
₁
and M
₂
growth rates.
¹⁹

Heightened uncertainty about growth and inflation, signs of slower growth, and increased banking problems made it difficult to reach agreement on proper action in August. Volcker took charge. After announcing ranges for the monetary aggregates, borrowing, and the funds rate, he told the Committee:

If we get a weaker employment number, weaker this number or that number—broadly lower than expectations, yes. If we have financial problems that are great enough, we would provide some liquidity. I don’t know how one judges that in advance. I think we have to play it by ear. (FOMC Minutes, August 21, 1984, 38)

19. Volcker’s testimony in the Senate blamed high interest rates on the budget deficit, not for the first time. He urged again that Congress reduce the budget deficit both as a way of achieving macroeconomic balance and to lower the size of the capital inflow. He warned about the inability to sustain the capital inflow and the risk of rising protection (statement, Paul Volcker to Senate Committee on Banking, Box 97645, Federal Reserve Bank of New York,
July 25, 1984, 4).

Two years had passed since the end of the explicit disinflation policy. Measures of actual and anticipated inflation remained about 3 to 4 percent. Unemployment rates had declined from more than 10 to about 7.5 percent. But nominal interest rates had not returned to the pre-1979 ranges. In September, the federal funds rate averaged 11.3 percent, and the ten-year Treasury note yielded 12.5 percent, only one percentage point below its local peak. The ten-year rate remained almost two percentage points above the level in October 1982. Apparently, the public regarded the risk of inflation as very high. The FOMC had no plan for lowering these rates. Several of its members shared the concern that inflation would return.

Volcker stated their puzzle. “It’s a very strange period. Every indicator normally would be associated with lower interest rates” (FOMC Minutes, October 2, 1984, 6). Chart 9.10 above shows that the real interest rate remained in the 6 to 7 percent range. The real value of monetary base growth fell persistently during this period. In October, the staff began to reduce its forecast.

Though unremarked at FOMC, nominal wage growth had declined steadily from its peak in the early 1980s. By 1984, the nominal rate of change was about 4 to 5 percent at annual rates. Chart 9.11 shows these data at quarterly rates. This proved to be a harbinger of lower real and nominal interest rates. It is difficult to reconcile the expectations reflected in interest rates and nominal wage growth.

During the summer and early fall, St. Louis voted regularly to raise its
discount rate to 9.5 percent. No other banks agreed with them. The Board recognized the large spread between the discount and the funds rate, but it rejected the requests because borrowing had declined and the economy showed evidence of slower growth. By mid-November evidence of slower growth prompted Chicago, St. Louis, Dallas, and San Francisco to ask for a reduction to 8.5 percent. New York, Philadelphia, and Kansas City joined them a bit later. The Board deferred the requests until November 21, when it approved 8.5 percent. The Board cited the slowing economy, the spread between the funds and discount rate, and slowing growth of M
₁
and M
₂
.