A History of the Federal Reserve, Volume 2 (60 page)

Some members of FOMC recognized that judged by money growth, monetary actions were procyclical. The staff and the members interpreted falling or low short-term interest rates as evidence of more expansive policy.
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Often it reflected a decline in borrowing during the recession. Money growth declined, adding to the recessionary impulse. And the FOMC interpreted higher nominal interest rates as evidence of antiinflation action even if money growth increased. Almost always, the FOMC used nominal, not real, interest rates to gauge policy thrust.
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Although many members understood that reducing inflation required consistent long-term action, there is scant evidence of longer-term planning. Discussion at FOMC meetings was often between those who favored and opposed raising the federal funds rate an additional 0.12 or 0.25 percentage points. The staff did not consider expectations when making its forecast, as Lyle Gramley noted at one point; expectations entered the member’s discussion mainly as evidence of public attitudes and concerns.

Staff forecasts of inflation relied on a Phillips curve. As Orphanides (2001, 2003a, 2003b) documented, inflation forecasts typically underestimated inflation. Further, the record of the 1970s showed that inflation and unemployment rose together, on average, propelled by expectations of inflation. These errors did not shift concern from quarterly near-term changes to longer-term implications of the FOMC’s actions. Some recognized that FOMC actions had little effect on near-term changes and major effect on the maintained rate of inflation, but this occasional recognition did not lead to changes in procedures.

One important consequence was the failure to distinguish between permanent or persistent problems and transitory or short-term events. The oil price increases in 1973 and 1979 were the most notable examples. In part as a result of its short-term focus, the System did not distinguish the
one-time price level change induced by the oil price increases from the persistent inflation induced by its policy. The former was real, the latter monetary. If the Federal Reserve had a coherent view of its objective, it might have recognized that preventing a one-time p
rice level change by reducing aggregate spending worked to stabilize the price level. Controlling money growth worked to maintain inflation—the sustained rate of price change—and expectations of inflation.

195. The Board’s staff recognized many of the errors but could not or at least did not convince a majority of the FOMC. Also, the St. Louis staff argued vigorously for disinflation and pointed out errors and failures of the FOMC majority.

196. “I don’t think I ever used the words real funds rate in the blue book, but it was always in my head” (Axilrod, 1997, 21–22).

Rising unemployment and inflation did not protect the Federal Reserve from congressional legislation. Congress found its performance less than satisfactory. It legislated objectives and required more reporting and oversight. The 1970s, like the 1930s, suggest that poor performance is a greater threat to Federal Reserve independence than effective action to maintain stability.

Despite its problems in the 1970s, the members of FOMC never discussed how their actions affected inflation and output or whether they could agree upon a framework for improving performance. They argued many times that lower average money growth was necessary to control and lower the inflation rate; they were unwilling to let interest rate variability increase. No one suggested bold, decisive actions to end inflation.
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197. A former senior staff member suggested reforms after he left the Board. One of his proposals called for disclosure—announcement of policy actions when they were made. He quoted a former Governor, David Lilly, as supporting prompt disclosure. Pierce attributed unwillingness to announce decisions to its “penchant for secrecy” (Pierce, 1979a, 249). Unwillingness to accept responsibility is a reason for the “penchant.”

EIGHT

Disinflation

The policies of the past have failed.

—Ronald Reagan in Council of Economic Advisers, 1982, 10

With the best staff in the world and all the computing power we could give them, there could never be any certainty about just the right level of the federal funds rate to keep the money supply on the right path and to regulate economic activity.

—Volcker and Gyohten, 1992, 166

In July1979, President Carter spent two days at Camp David to reassess his presidency. Things had not gone well. Abroad a hostile government had replaced a friendly government in Iran. Militants soon thereafter seized the United States embassy in Teheran and held the staff hostage. Oil prices had increased, and some forecasters predicted that the price would rise to $100 a barrel, compared to $2 to $3 dollars in 1972. At home consumer prices rose 11 percent for the year and output had not increased for the first two quarters of the year. The unemployment rate was about 6 percent.

Forecasts brought little cheer. Predictions of recession were common; the Federal Reserve staff thought a recession was “imminent” (Volcker and Gyohten, 1992, 165). The Society of Professional Forecasters predicted that inflation would continue at the current 8 to 9 percent rate with nominal GNP rising about 8 percent. That implied zero real growth. The interest rate on ten-year government bonds at 9 percent suggested a real before-tax return near zero or negative. This was the highest reported nominal government bond yield in United States history to that time.

Some of the news conveyed by these data overstated the problem by failing to separate the one-time effect of a rise in oil prices from the per
sistent effect of excessive monetary growth. The GNP deflator, much less influenced by energy prices, rose 9 percent; hourly earnings increased 7.8 percent in the year ending in July, about the same as in the previous year. Even with these lower rates of inflation, the news was not good.

When President Nixon went to Camp David in 1971, he returned with announcements that the public thought would bring lower inflation and increased employment. President Carter’s return created less enthusiasm. He blamed the public for their “malaise,” although he did not use that word. Instead of announcing that problems required new policies, he asked his cabinet to resign. He soon announced changes. G. William Miller replaced Michael Blumenthal as Secretary of the Treasury. That left a vacancy at the Federal Reserve.

There were strong market pressures to fill the vacancy promptly. Disappointment and lack of confidence in U.S. policy started another run against the dollar. The gold price rose and the trade-weighted dollar fell to a new low. The president and his staff wanted to announce an appointment that would calm fears and reduce uncertainty about the administration’s program. The problem was that the president’s staff also wanted someone who would “cooperate” with them.
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Paul Volcker had strong views strongly held. When he met President Carter for an interview, he was “mainly concerned that the president not be under any misunderstanding about my own concern about the importance of an independent central bank and the need for the tighter money—tighter than Bill Miller had wanted” (Volcker and Gyohten, 1992, 164).

Stuart Eizenstat (1982, 70), the Domestic Policy Adviser, described the circumstances at the time. “With inflation raging and the president’s popularity plunging the president believed the economic situation was dire, and he wanted someone who would apply tough medicine.”

To President Carter’s credit, he appointed Volcker. Inflation was not just an economic problem. Polls showed that the public now listed inflation as a major problem, more serious than unemployment.
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Several authors
describe the president as uncertain about the consequences of his choice; Volcker had dissented against the FOMC consensus several times in the spring of that year, as Miller and Schultze knew. And his concerns about inflation were long-standing. Volcker had spoken about inflation and the need to reduce it many times. When he rejoined the Federal Reserve System as president of the New York bank, he told
Business
Week
magazine that “we’ve got to deal with both inflation and recession at the same time” (Volcker papers, Federal Reserve Bank of New York, Box 35581, August 4, 1995). He criticized a policy of shifting primary concern from inflation to unemployment. He claimed that he was not a monetarist, but he accepted that proper monetary policy had to pay more attention to the long-term effects of its actions, particularly growth of the monetary aggregates.

1. Grieder (1987, 45) lists four names of people under consideration: Tom Clausen of Bank of America; Paul Volcker, president of the New York Federal Reserve Bank; David Rockefeller, CEO of Chase Manhattan; and Bruce MacLaury, president of the Brookings Institution. Grieder claimed that the president spoke to Clausen, who declined (ibid., 46). Biven (2002, 239) quotes Lyle Gramley, a former Federal Reserve staff member and, at the time, a member of the Council of Economic Advisers, as saying that Charles Schultze, chairman of CEA, expressed “reservations” about Volcker. Schultze denied that story. He was hospitalized at the time and did not take a position on the appointment (Schultze, 2005).

2. Charles Schultze confirmed the importance of public opinion as a reason for President Carter’s concern (Schultze, 2005, 6). He blamed the oil price increase for the change. “It was the supply side shock inflation that turned the public mood very substantially” (ibid., 15). Robert Samuelson (2004, 21) quotes a survey taken in 1979. “For the public today inflation has
the kind of dominance that no other issue has had since World War II. The closest contenders are the Cold War fears of the early 1950s and perhaps the last years of the Vietnam War. But inflation exceeds those issues in the breadth of concerns it has aroused among Americans. . . . In a September 1979 survey, 67 percent of the public said that ‘holding down inflation’ was a bigger problem than ‘finding jobs’ (21 percent).”

Volcker discussed the role of money again after Congress passed Concurrent Resolution 133, stating that the Federal Reserve should maintain long-term growth of money commensurate with the economy’s long-run potential to increase production. Volcker accepted the importance of monetary control. “To my mind, monetary aggregate targets are a useful—even a necessary—gauge of appropriate monetary policy action in bringing inflation under control. But they do not in themselves alter the real problems and hard choices imposed by the economic structure” (“The Role of Monetary Targets . . . ,” galley pages, New York Federal Reserve Bank, Box 35606, December 30, 1977, 10).
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By January 1979, he compared the monetarist and cost-push positions and favored an eclectic approach that combined both. But he now described the monetary approach to inflation control as based on the proposition that “substantial and sustained changes in price performance are accompanied by or preceded by substantial and sustained changes in rates of money growth” (draft January 15, 1979, New York Federal Reserve Bank, Box 35581). He added that this relationship was “well established” for the long term but not generally in the short to medium run. No monetarist would have disagreed.

3. Volcker made clear that he did not favor targeting reserve or money growth without restricting the range within which the federal funds rate could move. But he joined the monetarists in his criticism of the Federal Reserve staff’s practice of explaining failure to meet reserve or money targets by claiming that demand for money shifted. “Portentously pointing to these ‘shifts,’ without further explanation seems to me something of a confession of ignorance” (Volcker papers, “The Role of Monetary Targets . . . ,” galley pages, Federal Reserve Bank of New York, Box 35606, December 30, 1977).

As his thinking and observations developed during the 1970s, he moved toward a more monetarist position that he later called practical monetarism (Mehrling, 2007, 177). He recognized that ending inflation required control of money, and he recognized that this could be achieved either by targeting reserve growth or an interest rate. What mattered was how much the interest rate changed to achieve desired control. Commitment also mattered. Volcker understood that ending inflation would not be painless or quick. “I had begun thinking about how one could practically adopt some of these monetarist ideas . . . to make policy more coherent and predictable” (ibid.).

President Carter’s summary of his first meeting expressed his own concern about inflation. “He [Volcker] made it plain, and it was mutual, that if he took the job he would want to do it in accordance with my previously expressed policy, that I wouldn’t try to put pressure on him or interfere in his best judgment” (Biven, 2002, 239, based on an interview with President Carter). To his credit, President Carter honored his pledge not to pressure Volcker except for the brief period when he insisted on credit controls.

Several in the Carter administration believed that price and wage controls, guidelines, or incomes policy were an important element of an antiinflation policy. These policies had been in place for several years, and in the summer of 1979, as inflation rose, the administration considered ways to strengthen them. Volcker believed that “if all the difficulties growing out of inflation were going to be dealt with at all, it would have to be through monetary policy. . . . [N]o other approach could be successful without a convincing demonstration that monetary restraint would be maintained” (Volcker and Gyohten, 1992, 164–65).

Volcker became chairman on August 6, 1979. Consumer prices rose at an 11 percent annual rate that month and average hourly earnings rose 7.8 percent. When he left the Board in August 1987, consumer prices had increased 4.2 percent in the most recent twelve months and average hourly earnings rose 2.2 percent. As far as most of the public was concerned, the inflation problem was over for the time.

President Carter gets credit for appointing him and President Reagan for supporting him through a deep recession. But Paul Volcker’s major contribution stands out. Unlike 1966, 1969, 1973, and other times, he persisted in an anti-inflation policy long enough to bring the inflation rate down permanently. Despite the added burden of an oil price increase that raised the reported rate of price change, reported consumer price inflation fell from a peak annualized monthly rate of 17 percent in January 1980 to about 5 percent in September and October 1982, when policy operations changed. Interest rates on ten-year Treasury bonds reached 15.68 percent (October 2, 1981) and remained above 10 percent from July 1980 to No
vember 1985. The unemployment rate remained at 7 percent or above for sixty-eight months from May 1980 to December 1985 and reached a postwar peak at 10.8 percent in November and December 1982.