A History of the Federal Reserve, Volume 2 (95 page)

Eclecticism did not lead to any firm conclusion about what to do. Volcker summarized his judgment at the time as “no great desire to change things aggressively. . . . I don’t know where we are on the economy; it’s not looking very good. I do know the exchange rate is awfully high and I surely wouldn’t want to push it any higher. I would rather do the reverse. I don’t know what’s going on with M
₁
or M
₂
or M
₃
. I know they are giving out different signals, but I don’t feel very religious about M
₁
at this point” (FOMC Minutes, May 21, 1985, 34).
⁵⁶

For the year 1986, M
₁
far exceeded its pre-announced range, but M
₂
and M
₃
remained within their ranges, though near the top. Table 9.5 shows these ranges and the results recorded at the time.

In practice, no one paid attention to M
₃
. Members commented on M
₁
and M
₂
during the year, but those aggregates had minimal effect on policy actions. The models used by the staff to forecast the aggregates underestimated the size of changes. The velocities of each of the aggregates continued to decrease from 1981 to 1986 as expected inflation declined (memo, Donald Kohn to FOMC, December 10, 1986, chart 1).

The steady annual increase in velocity so apparent in data for the 1970s disappeared in the 1980s. The Board’s staff (and many others) tried to explain the change by considering the redefinition of the various aggregates following deregulation. M
₁
now included a large proportion of interestearning deposits, and these deposits grew most rapidly in the 1980s. Staff estimates suggested that the response to interest rates increased in the 1980s. The spread between the rates for deposits and open market rates rose markedly in the 1980s; in 1986 open market rates declined by 200
basis points while rates offered by banks on NOW accounts declined only 60 basis points (ibid., 3).

56. Volcker chose a borrowing target. Roger Guffey (Kansas City) asked what the federal funds rate would be. Volcker responded with irritation, “[Y]ou ask this question every time, Roger, and I’m not a prophet” (FOMC Minutes, May 21, 1985, 42). Lyle Gramley suggested a target for the federal funds rate. Preston Martin responded, “Shame on you, Governor Gra
mley!” (ibid., 43).

Surprisingly, the staff did not consider the effect of the change in inflation. Rising inflation in the 1970s reduced desired cash balances, increasing monetary velocity. Lower inflation in the 1980s did the opposite. The change was a one-time change spread over time as the public learned or believed that the decline in inflation was likely to persist. Over the fifteen years beginning in 1990, M
₁
velocity declined on average at a much lower rate than in the early 1980s, about 1.6 percent a year; M
₂
velocity was about unchanged.

Even the most persistent advocates of targets for monetary aggregates could not explain their behavior or forecast the size and growth of the new components. The FOMC lowered the federal funds rate when real growth was negative (−0.8). The funds rate declined from 8.14 percent in January to 6.56 percent in July. Growth turned positive in the third and fourth quarters but remained below 1.5 percent annual rate. The funds rate continued to decline, reaching 5.85 percent in October. Although Volcker claimed that his target was borrowed reserves, these do not show a comparable pattern. By early 1987, the growth slowdown ended, and the federal funds rate was back to about 6.5 percent. It remained between 6.5 and 7 percent until Volcker left in August 1987.

The Board reduced the discount rate four times in 1986, from 7.5 to 5.5 percent. The first reduction was the now famous decision in March to coordinate the reduction with Germany and Japan. The vote was four to three, with Volcker in the minority. Volcker wrote out his resignation, but Governors Angell and Martin agreed to delay the reduction as noted earlier (Coyne, 1998, 11–12).
⁵⁷
The second reduction, coordinated with the Bank of Japan, came on April 18, after deferring a reduction four days earlier. The remaining reductions on July 10 and August 20 were made without coordination. All four changes followed prior reductions in open market rates. Some reserve banks proposed an additional reduction to 5 percent after July 10, but the Board did not agree. Dallas, hurt by the oil price decline and agricultural distress, usually led these efforts, sometimes joined by other reserve banks. At 5.5 percent, discount rates reflected the decline in inflation and market interest rates.

The decline in interest rates came too late for troubled banks mainly
in agricultural and oil producing areas. In 1986, 189 banks ceased operations. Most of them were non-member banks. This compares to an average of 8 a year from 1980 through 1984 (Board of Governors, 1991, 527–28). Problems at the banks also affected thrift institutions. The problems continued for several years.

57. Coyne (1998, 14) thought that “[t]hings were never the same.” Volcker left eighteen months later. “The four votes came from President Reagan’s appointees and were prompted by White House staff” (ibid.).

Long-Term
Securities

At the end of the bills-only policy in 1960, the Federal Reserve portfolio held $24 billion of coupon securities, 89 percent of its portfolio. Over time, the amount held increased, but the proportion declined. At the end of 1985, system holdings reached $92 billion, 48.6 percent of the portfolio (memo, Normand Bernard to FOMC, Board Records, August 13, 1986, 9).

Paul Volcker asked why the System continued to purchase coupon securities. The account manager prepared a memo giving pros and cons. The principal advantages claimed were the information the desk received about the market and the enhanced market liquidity resulting from System purchases. (The latter is unlikely.) The main disadvantage arose because the System did not sell coupon issues. Their portfolio was, therefore, less liquid. Members’ opinions divided, but no one strongly supported either position. The account manager wanted to continue, and no one objected strenuously. Pressure from Congress was probably the most important reason for buying and not selling.

OTHER REGULATORY MATTERS

Financial fragility, legislative changes, and innovation continued to force regulatory change. The 1980s were very different from the 1930s. Deregulation became more attractive and tight regulation less attractive. Gradually the regulators recognized that every regulation offered an opportunity to profit from circumvention. Although regulators and Congress were not ready to repeal the Glass-Steagall Act, they began to move in that direction.

The Depository Institutions Deregulation Act mandated that ceiling rates for time deposits end on March 31, 1986. After that date, only the prohibition of interest payments on demand deposits and reserves remained of deposit interest rate regulation. The Board removed reserve requirements on some savings and money market deposit accounts at banks. It removed a $150,000 ceiling for business savings accounts, provided there were no more than three telephone transfers a month.

In June, the Board expanded the list of activities permitted to bank holding companies. The list now included consumer finance counseling, tax
preparation, commodity trading, credit bureau and collection services, and appraisal of personal property. The Board also granted a limited amount of insurance activity to the holding company. Later, this authority expanded.

The Board expanded the definition of primary bank capital to include perpetual debt. A bank could use preferred stock and perpetual debt as primary capital up to one-third of capital.

The Board recommended that Congress revise the Bank Holding Company Act to broaden holding company powers and reduce regulatory burden. It asked Congress to permit holding companies to underwrite municipal revenue bonds, mortgage-backed securities, commercial paper, and mutual funds. It suggested also that Congress consider insurance and real estate brokerage and insurance underwriting. These proposals were a first step toward ending the separation of investment and commercial banking required by the Glass-Steagall Act.

The Garn-St. Germain Act of 1982 permitted banks to make interstate mergers and acquisitions of financially troubled thrift institutions and failed commercial banks. The Board asked for amendments that reduced some restrictions and permitted acquisition of failing as well as failed banks. In a letter to Senator Riegle, chairman of Senate Banking, Volcker urged legislation to alter or remove Glass-Steagall restrictions.

Proceeding piecemeal within the context of a statute written in quite different circumstances can not assure results that are consistent with the public interest in promoting competition, serving consumer needs, and protecting the banking and financial systems.

Because of these concerns, all of the members of the Board join in expressing our strong recommendation that the Congress act on these and other banking issues as early as possible in the next Congress. (letter, Volcker to Riegle, Board Minutes, December 24, 1986)

CONCLUSION: WHY INFLATION DID NOT RETURN

A main, at times
the
main, objective in the years 1983–86 was to prevent the return of high inflation while maintaining expansion. There were two inflation “scares.” The System successfully reversed the first in 1983–84, thereby contributing to its credibility and the subsequent decline in long rates. The second in 1987 occurred in Germany and Japan as well. It appears related to the effort to coordinate expansion while maintaining a fixed exchange rate.

Two main changes occurred. First, the Volcker FOMC, Volcker himself, and his successor Alan Greenspan put greater weight on inflation control. Interest rates increased at times during recessions or periods of
rising unemployment if needed to control inflation. By 1994 the Federal Reserve finally accepted monetarist criticism and adopted counter-cyclical policies by reducing money growth during expansions and raising it during contractions. The Federal Reserve was less influenced by the idea that low interest rates always meant policy was expansive. No less important, FOMC members said repeatedly that low inflation encouraged and even facilitated high employment and economic growth. The facts supported them; the economy had three expansions of above average length in the twenty-five years after 1982. And the volatility of output and inflation declined, contributing to the belief that monetary policy had at last succeeded in restoring and maintaining economic stability.

Since the passage of the 1946 Employment Act, the Federal Reserve operated under some version of the “dual mandate” that after passage of the Humphrey-Hawkins Act became an explicit concern for both unemployment and inflation. Spokesmen for the Federal Reserve continued to accept the dual mandate, but the mandate was not precisely stated. In the early years, unemployment received most weight. Inflation became an objective when the inflation rate rose but only as long as the unemployment rate did not rise above 6 or 7 percent. After Humphrey-Hawkins and the disinflation, the Federal Reserve and other central banks recognized that the policy of abandoning inflation control to seek lower unemployment had brought more of both. The policy change sought to lower both by reducing inflation, keeping it low, and relying on clearer signals from relative prices and real returns to maintain growth and employment.

Second, market participants responded to excessive stimulus or perceived inflation by selling bonds, raising long-term interest rates, and bringing on an “inflation scare.” The Federal Reserve responded to the scares. In this way, market behavior reinforced Federal Reserve actions and conversely (Goodfriend, 1993). By 1994, the FOMC was confident enough about its operations and secure in its ability to resist pressure to lower interest rates to announce its interest rate decisions as they made them. This required agreement on process—that they targeted the federal funds rate. It showed also that there was much greater understanding that the FOMC’s success could continue if the market understood its actions, as rational expectations implied. With that recognition came heightened interest in communications, transparency, and rejection of the old idea that fooling the market was important or useful.

For an economist, it would be ideal to conclude that the Federal Reserve successfully applied modern economic theory to control inflation. Alas, it was not true. Members of FOMC did not have a systematic approach based on analysis and evidence. Much of the time, members did not know what
the operating target was. They voted for a target, but Volcker was eclectic. He did what seemed to him right at the time.

After Greenspan replaced Volcker, actions became more systematic at least as to choice of target. Greenspan’s FOMC used a federal funds rate target after late 1989, but the choice depended more heavily on Greenspan’s analysis of events than on any systematic economic model. The staff continued to use a Phillips curve to forecast inflation, but both chairmen did not.

The Federal Reserve in the 1980s and beyond accepted and relied on some monetarist propositions. It no longer denied that it was responsible for control of inflation; some accepted that money growth in excess of output growth caused inflation, and it asserted that low inflation was important for getting low and stable unemployment. Also it accepted that high interest rates reflected high expected inflation. It continued to insist that budget deficits caused inflation (memo, Volcker, Board Records, April 30, 1984, 2) and it did not develop successful procedures for controlling money growth.

Volcker expressed doubt about forecast accuracy. He relied on actual data, neglecting to say that revisions reduced data accuracy. At one point, November 1984, he recognized that imprecise forecasts made “fine tuning” impossible. But he did not take the next step—setting a medium-term target. Probably he did not accept that medium-term projections were reliable. The FOMC continued to respond to noisy current data.

The Federal Reserve staff continued to explain many of its forecast errors by claiming that the demand for money shifted. The staff, most members of the FOMC, and large parts of the academic and financial market community concluded that instability of the demand for money made control of money infeasible and undesirable. In 1988, the Federal Reserve staff reported on their research concerning monetary base control. The FOMC concluded that monetary base velocity fluctuated unpredictably in the short-run and required large changes in interest rates

At the time, Robert Rasche (1988) estimated the equations for velocity shown in the appendix to this chapter. His results, using monthly data for the St. Louis base (Appendix Table 1) and the Board’s version (Appendix Table 2) show that the response of base velocity growth to changes in personal income, prices, and interest rates changed very little in the 1980s from experience from the 1950s through the 1970s. The principal and only important change was a decline in trend growth from 2.5 percent a year to zero.

In 1986, the staff reported on its ability to forecast money growth. The results showed that average absolute quarterly errors were large, almost two percentage points at annual rates in 1985–86. Annual forecasts for
1974 to 1986 had an average absolute error of 0.8 percent. Years of policy change have large errors. Table 9.6 shows the forecasts and errors. The data suggest that control of inflation by controlling money growth is feasible if the Federal Reserve decided to pursue a medium-term strategy. And control of the monetary base requires the Federal Reserve to control only the size of its balance sheet. It can continue to set interest rate targets, but it must adjust the target at least quarterly to respond to the base.