A History of the Federal Reserve, Volume 2 (49 page)

After much discussion, the FOMC voted for an M
₁
growth range for 1979 of 1.5 to 4.5 percent, net of ATS deposits, and 3 to 6 percent for 1980. Wallich dissented on the 1979 vote, but the vote on 1980 was unanimous.

For the next two months, the FOMC voted unanimously for a funds rate kept at 10.25 percent, M
₁
growth of 2.5 to 6.5 percent, and M
₂
growth at 6.5 to 10.5 percent. The unanimous vote belied the different views. Referring to the funds rate, Morris said the manager should “move to 10 percent immediately . . . [T]he economy was clearly in a recession” (ibid., 43). Partee repeated the traditional argument that gave more weight to the prospect of recession than to actual inflation. He voted for 10.25 because of weakness in the dollar. He believed that West Germany, Britain, and others were deliberately appreciating their currency to reduce inflation. “I don’t think we ought to get dragged along with them into a worldwide depression” (ibid.,46).
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At the Bonn summit in July 1978, President Carter had agreed to decontrol domestic oil prices as part of a multilateral agreement to expand economic activity and reduce inflation. Decontrol meant higher prices for gasoline and heating oil. It was rational economic policy but certain to be unpopular politically. The president delayed carrying out his commitment, but as the 1979 summit of developed country governments approached, he felt obliged to honor his explicit agreement.

On April 5, 1979, in a television address to the nation, President Carter announced that oil prices would rise steadily beginning on June 1 and con
tinuing for twenty-eight months until domestic oil prices reached world levels. To pacify congressional critics, he asked Congress to pass a 50 percent windfall profits tax to subsidize payments by low-income consumers for fuel and public transportation. Congress passed the tax about a year later. The Reagan administration completed decontrol early in its term. The Iranian revolution overthrew the shah, held American officials hostage, and raised oil prices beginning in December 1978.

123. At the July meeting, Emmett Rice attended for the first time. He was sworn in on June 20, 1979, and resigned on December 31, 1986. He took the seat of Stephen Gardner, who died after less than three years on the Board. At this meeting, Chairman Miller complained about leaks to the press from FOMC meetings, an issue that arose many times in the past and would return.

President Carter returned from Camp David on July 15, 1979, and announced a new long-run energy program including subsidies for synthetic fuels production, mandatory conservation measures, and further decontrol of oil and natural gas prices but not gasoline (Solomon, 1982, 351). This speech is best remembered for his complaint that the public suffered from “malaise,” although he did not use that word. Economically, its largest impact was the firing of Treasury Secretary Michael Blumenthal and his replacement with G. William Miller.
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That left a vacancy at the Federal Reserve. Soon afterward, President Carter appointed Paul Volcker, a known anti-inflationist.
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The market’s reaction to the president’s speech started modestly but turned increasingly negative. At a telephone conference on July 17, Margaret Greene of the New York bank briefed the FOMC on the foreign exchange market. “The market responded to the Carter address with some disappointment—disappointment that some of the immediate questions about the economy have not been addressed and that the issues that were addressed were of a long-term nature” (FOMC Minutes, July 17, 1979, 1). The New York desk intervened to slow dollar depreciation. Since mid-June, the desk had sold $3.1 billion, mainly in marks. West Germany and Swit
zerland bought $3.7 billion of bonds denominated in marks and francs (ibid., 2).

124. Blumenthal’s relation with the White House staff, especially Eizenstat, and perhaps Carter had deteriorated. For Carter, inflation was a serious problem, and the advice he received seemed not to work.

125. Volcker made many speeches in the years before his appointment. In Senate testimony in 1976, he explained that inflation had many causes—oil price increases, devaluation—but included lax monetary policy. He did not accept the Phillips curve view that low inflation and low unemployment were alternatives. Sustained, disinflationary monetary and fiscal policies could achieve both. “We must choose a policy that in the somewhat longer run will be compatible with both” (statement, Federal Reserve Bank of New York, Box 35604, February 17, 1976, 9). Later that year, Volcker spoke to the American Economic and American Finance Associations. He recognized that all price increases (called inflation) were not monetary. Then he added, “Excessive monetary expansion is a sufficient condition for inflation, and in the longer run, it is equally clear that no important inflation can be sustained without money rising substantially faster than real income. . . . There is always some rate of monetary growth (perhaps zero) that will in principle achieve price stability” (Remarks, “The Contributions and Limitations of ‘Monetary’ Analyses,” Federal Reserve Bank of New York, Box 35605, September 16, 1976, 18). No one earlier came to the Federal Reserve chairmanship with these views.

Miller seemed concerned that a renewed run against the dollar had started. He asked the members to consider whether intervention was called for and what its consequences would be for the domestic economy. Volcker proposed an increase in the discount rate and the funds rate as an alternative to exchange market intervention. “I am extremely skeptical that intervention will be adequate to handle a situation of this sort” (ibid., 5).

Several members commented that the president failed to address inflation, a major concern of the markets. Sentiment favoring a discount rate increase dominated. The Board met following the meeting. On July 19, effective July 20, the Board voted unanimously to increase the discount rate by 0.5 to 10 percent, an unprecedented level.

Two days later, July 19, Miller held another telephone conference. Stephen Axilrod reported that M 1 had increased well above its target for three of the past four months. He proposed raising the funds rate to 10.5 percent.

Margaret Greene reported that the dollar had again come under pressure. Intervention by the Federal Reserve and the Bundesbank had slowed the decline, but sentiment remained bearish. The System had used swap drawings on the Bundesbank to finance $1.5 billion of intervention. The FOMC decided to let the funds rate rise to 10.5 percent, as they had agreed earlier if money growth exceeded its upper target. International concerns influenced many, a marked contrast with 1971. The FOMC did not vote because the July 11 directive provided for the increase. Based on their comments at the meeting, Teeters and Eastburn (Philadelphia) would probably have dissented. Morris (Boston) had urged easier policy. The rapid increase in money changed his outlook; he now favored 10.5 or even 10.625 percent.

INTERNATIONAL CRISES AND POLICIES

During the years from 1973 to 1979, the international system faced repeated problems and several crises. Many of the problems were new. Agreement by principal countries on how to respond came slowly. Principal countries floated their exchange rates but also intervened, heavily at times, to influence currency values. Individual currencies had floated before, notably the Canadian dollar in the 1950s, but the modern world had not experienced a time when there was no fixed anchor to currency values. To reduce risk in the past, asset owners could shift part of their wealth into a currency with a fixed exchange rate. No longer. Learning to function in a world of independent or interdependent individual countries policies took time.

The oil price increases in 1973 added another dimension. The effect of the oil price increase was similar to a tax on the use of oil paid to a foreign supplier or government. The tax reduced wealth and income in the importing countries and increased wealth and income of the oil-exporting countries. Several of the oil-importing countries, especially developing countries, ran large payments deficits.
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The OPEC countries did not choose to lend to the developing countries, so banking institutions in the developed countries borrowed surplus dollars from OPEC and re-lent to the developing countries. For a time this process, called recycling, seemed satisfactory. By the early 1980s, both bank lenders and country borrowers learned that lending and borrowing was temporary assistance that did not eliminate the need for the developing countries to adjust spending to reflect their permanently reduced wealth and income.

Failure to distinguish between permanent and transitory changes in measured inflation reflected two persistent problems. One was policymakers’ excessive concentration on near-term or current events and neglect of longer-term consequences of policy actions and other events. Second was the related but distinct problem of neglecting differences in persistent and temporary changes.
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Floating changed the role of gold in the international system. Historically, gold was used to settle international payments imbalances. With floating rates, exchange rate changes settled these differences. What role remained for gold? The United States and France had spent much time arguing about the role of gold during the 1970s. France wanted to return to a fixed exchange rate with settlements involving gold. The United States wanted to demonetize gold by floating and using SDRs when or if balances were settled by asset transfer.

Very often events settled the disputes and resolved differences. The oil price increases in 1973 put an effective end to discussions about fixed or floating rates (James, 1996, Chapter 9). Perhaps the main lesson from this experience was that, for fixed exchange rates to stabilize economies,
economic policies had to be compatible and external events relatively benign. This lesson was hard to learn; the Continental European countries tried several times to maintain a local fixed exchange rate system without enforcing common policies. Eventually, they adopted a common currency and a common monetary policy. And the market ended international policy discussions about recycling oil revenues by doing just that.

126. The effect of the oil price increase on the current account deficits of developing countries was a main concern at international meetings in the mid-1970s. In January 1975, the G-10 discussed a $25 billion fund to finance developing countries’ balance of payments deficits, as a “last resort.” The decline in spending and imports reduced these concerns following the oil shock but of course, raised new concerns about the depth and duration of the decline in spending and output (report of the meeting of G-10 ministers and central bank governors, January 16, 1975, Board Records). Throughout, the discussion did not distinguish between a recession and a permanent reduction in output. Recessions are temporary reductions in spending; the oil shock was a permanent wealth transfer to the oil-producing countries.

127. See Brunner, Cukierman, and Meltzer (1980) for a formal analysis.

Chart 7.15 shows trade weighted nominal and real exchange rates for the United States for 1973 through 1979.
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Slower inflation in the middle of the decade and higher inflation abroad slightly appreciated the nominal exchange rate in mid-decade. The real exchange rate depreciated steadily. By the end of 1979, the nominal trade weighted dollar was 14 percent below its early 1973 value; the real exchange rate depreciated more than 17 percent during the period.

Policy toward the dollar changed considerably. At times, policy called for “benign neglect.” At other times, policymakers intervened actively to influence the exchange rate or its rate of change. Some United States trading partners, particularly the Europeans, intervened from their side. When
the United States would not join them, they often claimed that the United States wanted to depreciate its currency to gain trade advantage.
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128. Real exchange rates use the Federal Reserve definition and weights and export and import prices.

Chart 7.15 suggests the source of many confl icts—real and nominal exchange rates move together (Mussa, 1986). Inflation rates adjust slowly, so expansive or contractive policies in a large country have persistent real effects that affect other countries and that floating does not eliminate instantaneously. Another side of this finding is that payments imbalances adjust with a lag.

Despite French resistance,
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IMF members adopted an amendment in 1976 that authorized countries to choose the exchange rate system they preferred. This included both fixed and floating rates, but it eliminated a rate fixed to gold (ibid., 272–73).

The United States Treasury, especially, wanted to reduce, then eliminate, the role of gold in the international monetary system. Arthur Burns was not convinced. But the Treasury persisted and reached agreement in July 1975.
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The agreement also instructed the IMF to sell one-sixth of its gold holdings to finance aid to developing countries and to return an additional one-sixth to member countries. The agreement effectively ended squabbles over the role of gold for the next two years. It was not renewed in 1978. By that time, the issue had become less important. During the next two decades, several developed countries sold part of their gold holdings. However, diminution of the role of gold did not shift the monetary system toward SDRs, as the United States intended. Countries held reserves principally
in dollars but also marks (later euros) and to a lesser extent yen and Swiss francs.

129. Intervention can be sterilized or unsterilized. Unsterilized intervention changes the monetary base, so it is an open market operation using currency purchases or sales in place of securities. Sterilized intervention does not change the monetary base. The central bank offsets the change in international reserves by moving domestic assets in the opposite direction. In a market as large as the market for dollar securities, unsterilized intervention cannot have much effect on the exchange rate. The main portfolio change arises from possible differences in the risk of holding Treasury bills or foreign securities. A substantial volume of research identified an “information effect” of sterilized intervention. The central bank (or banks) signal that they regard the nominal exchange rate as over- or undervalued. The market responds by adjusting the exchange rate unless new information shows that the central bank was mistaken (Dominguez and Frankel, 1993; Sarno and Taylor, 2001). This seems an inefficient way to announce policy or give the market information that the central bank or government thinks relevant. The magnitude and duration of the response seems small but remains a subject of research.

130. Finance Minister Jean-Pierre Fourcade gave the official French attitude toward floating in 1974. “Floating rates, though ‘an inevitable evil for the time being, will never constitute an acceptable response to the profound exigencies of a sound international payments system’” (quoted in Solomon, 1982, 268).

131. The breakdown of Bretton Woods with the closing of the gold window ended the twotier system for pricing gold that began in March 1968. The United States did not eliminate exchange cont
rols until 1974.