A History of the Federal Reserve, Volume 2 (63 page)

When the Board reopened the issue on September 18, all members attended. Positions had not changed. Those favoring an increase cited strong money growth, high inflation and inflation expectations, and the spread between the discount rate and the market rate. Opponents emphasized the risk of recession and the high level of nominal rates.

Volcker was surprised and disappointed by the market’s reaction to the discount rate increase and the vote. He thought the reaction would be positive. This was the second increase in the discount rate during his short tenure as chairman. But the market interpreted the vote very adversely. Instead of taking this as a decisive sign of the new chairman coming in and taking more decisive action, they said: “See the Federal Reserve is at the end of its rope. . . . Instead of being a constructive impact on market psychology, as I interpreted it, it worked the other way” (Volcker, 2001, 2).

The surprising response was a sharp increase in commodity prices and market commentary suggesting that the Federal Reserve would have difficulty further increasing interest rates.
¹⁷
This was a critical factor for Volcker; he recognized that small increases in interest rates would be difficult to get and might not be adequate. Also, despite its acceptance by the staff and academics, he did not believe that forecasts based on the Phillips
curve were useful. What was plainly happening over a period of time, as the monetarists emphasized, was that both unemployment and inflation were rising, and further delay in dealing with inflation would ultimately make things worse, including the risk that any inflation would be large.

The Shadow Committee remained skeptical in February 1980, its first meeting after Volcker announced the new procedures. The committee urged the FOMC to control the monetary base. Research by Johannes and Rasche (1979) showed that the base multiplier could be predicted with greater accuracy than by Federal Reserve procedures. Rasche challenged Axilrod to explain why they did not adopt his procedure without getting a response (Axilrod et al., 1982, 122–23).

17. Between the second and third quarters, the Society of Professional Forecasters raised the predicted inflation rate by 0.6 percent to 9.67 percent.

In my own mind, I had about concluded that we could achieve several things by a change in our approach. Among the most important would be to discipline ourselves. . . . More focus on the money supply also would be a way of telling the public that we meant business. People don’t need an advanced course in economics to understand that inflation has something to do with too much money. (Volcker and Gyohten, 1992, 167)

Characteristically, Volcker offered a public statement about the problem and his proposed action in an appearance on a popular television Sunday talk show. As the show opened, the moderator, reflecting past experience, asked:

Moderator: At what point . . . do you expect your emphasis at the Federal Reserve will change from fighting inflation to fighting unemployment and recession?

Mr. Volcker: Well, Mr. Herman, I don’t think we can stop fighting inflation. That is the basic, continuing problem that we face in this economy, and I think that until we straighten out the inflation problem, we’re going to have problems of economic instability. So it’s not a choice either or, as I see it. I think we’ve got to keep our eye on that inflationary ball as we move along, particularly in the sense of keeping the money supply under control when moving to a reduced rate of growth in the money supply. (Volcker papers, Federal Reserve Bank of New York, transcript from
Face
the
Nation,
Box 97653, September 23, 1979, 1)

Later in the broadcast Volcker explained the difference between an oil price increase and maintained inflation. If the oil price stopped rising, “we can see the rate of inflation declining for that reason alone. What is important is that that explosion in oil prices doesn’t get translated into the wage and price structure generally” (ibid., 12–13). Throughout the interview he emphasized that progress against inflation would be slow. In the past the “main deficiency in policy . . . has been not having enough concern over the inflationary danger” (ibid., 31).

Volcker left Stephen Axilrod and Peter Sternlight (the account manager) to prepare new operating procedures intended to improve control of money. On a trip to the International Monetary Fund meeting in Belgrade,
Yugoslavia, he briefed Secretary Miller and Council Chairman Schultze. They were not enthusiastic.
¹⁸
In Hamburg, Germany, he discussed his plan with Helmut Schmidt, the West German chancellor and Otmar Emminger, president of the Bundesbank. Both were old acquaintances from Volcker’s days in the Treasury, and both urged him to go ahead. From their perspective, U.S. inflation and anticipations of continued and higher inflation weakened the dollar and appreciated the mark. This almost certainly brought pressure from German exporters, and they believed made it more difficult to prevent inflation in Germany.

Volcker left the Belgrade meeting early.
¹⁹
Gossip at the time said that he changed policy because he had been pressed hard to strengthen the dollar and slow inflation. In fact, he was well along toward that decision and had told the administration officials about his intention on their trip to Belgrade. “It was not true at all. I was just bored. I wanted to go home and get to work, so I went home and thought about it a little more” (Volcker, 2001, 3).

Charles Schultze believed that any restriction on monetary policy would increase unemployment, that the economy would be in recession in election year 1980, and that the policy would make it difficult for the president to win reelection. Doubtless he communicated these thoughts to President Carter and urged him to talk to Volcker. Soon afterward, Schultze changed his mind. On September 25, he sent a note to the president saying that “it is probably best that you don’t call [Volcker]. . . . [M]y advice is not to twist Volcker’s arm” (memo, Schultze to the president, Schultze papers, September 25, 1980). Reflecting his uncertainty about reserve targets, he urged the president to keep open the option of criticizing Federal Reserve actions later. “Even though I don’t believe such a public protest would be wise, there is no use narrowing your options now” (ibid.). A handwritten note on the memo added: “Paul called. I made the points. His decision is possibly best, but he understands my problem” (ibid.).
²⁰

18. Secretary Miller said he did not think the change was substantive. He thought (correctly) they would have to raise interest rates even to 20 percent (Miller, 2002, 26). Volcker did not share that view. He did not anticipate interest rates at 20 percent. Lindsey, Orphanides, and Rasche (2005) quote several Board members supporting Volcker.

19. By coincidence, the IMF invited Arthur Burns to present the distinguished lecture named for Per Jacobsen, a former managing director. In his lecture, Burns explained that control of money was necessary to control inflation, but that monetary control was not possible in a modern country. He blamed unions, the welfare state, etc. The difference between Burns and Volcker is that Volcker left the Belgrade meeting early to do what Burns said could not be done—control money growth. The different responses of the two men suggests a difference in their character that contributed to success in one case and failure in the other. Robert Black (Richmond) gives more weight to foreign reactions at Belgrade (Black, 2005).

20. Recall that Blumenthal and Schultze used leaks to urge the Federal Reserve to tighten monetary policy at the end of 1978 (Hargrove and Morley, 1984, 485). Schultze did not object
to Volcker’s program to reduce inflation by raising interest rates. “I didn’t want him to go to a monetarist set of targets. I wanted him to continue to target interest rates, in effect, just raise them a lot” (ibid., 486). Schultze later told Biven (2002, 242) that the genius of what Volcker did . . . was to adopt a system . . . in which he said we are not raising interest rates, we are just setting a non-inflationary path for the money supply, and the markets are raising the interest rates.”

President Carter did not act and did not threaten to oppose the policy if or when the Federal Reserve adopted it.
²¹
Volcker concluded: “My reading of the situation was that while the president would strongly prefer that we not move in the way we proposed, with all its uncertainties, he was not going to insist on that judgment in an unfamiliar field over the opinion of his newly appointed Federal Reserve chairman” (Volcker and Gyohten, 1992, 169). Public opinion polls contributed to the change. Concerns about inflation reached a peak in 1979. A growing number of people considered inflation at least as serious as unemployment (Fischer, 1984, 46). Politicians in Congress may have shared these concerns or reflected constituents’ concerns. They more willingly accepted a more decisive disinflation policy.

Volcker returned to Washington on October 2 and called a special FOMC meeting for Saturday, October 6. On the preceding Thursday, he met with the Board. The discussion emphasized speculation in commodities, gold, and the exchange rate. The London gold price started a sustained increase from about $300 an ounce on August 21. On October 2, it reached a local peak of $426, a 42 percent increase in less than six weeks. The trade-weighted dollar had fallen sharply also, as shown in Chart 8.1. Note the decline following the split vote on the discount rate in mid-September and the appreciation following the Federal Reserve’s policy change.

Volcker told the members that the staff had prepared some recommendations “designed to show
convincingly
the Federal Reserve’s resolve to contain monetary and credit expansion . . . to help curb emerging speculative excesses, and thereby to dampen inflationary forces and lend support to the dollar in the foreign exchange markets” (Board Minutes, October 4, 1979, 1; emphasis added). The proposed actions included three possible actions: increasing reserve requirement ratios, increasing the discount rate, and shifting to a reserve target.

The Board took no action in advance of the FOMC meeting. It agreed on “the seriousness of the present situation and on the need for action
along the lines outlined” (ibid., 3). It preferred the proposal for an increase in marginal reserve requirements on all increases in banks’ managed liabilities, the most restrictive
of the three proposals they were given. It was clear from the meeting that Volcker would not have opposition from Board members on Saturday.

21. Schultze urged Volcker to give up the reserve target and raise interest rates in the conventional way. “Once you tell the world this is the money target and we are going to follow it no matter what happens to interest rates, you have to stick with it and you have no flexibility” (Schultze, quoted in Grieder, 1987, 119). Schultze worried that the Federal Reserve would not retreat in a recession.

The following day, the FOMC held a conference call. Volcker made two points at the start. They would make no decisions that day, and any decisions made the next day about operating procedures would be “an approach for between now and the end of the year” (FOMC Minutes, October 5, 1979, 1). He acknowledged that adopting new procedures could make it difficult to abandon them, but he insisted that they would if desirable.

The staff reported that both real GNP and money had grown faster than the FOMC expected. Much of the higher GNP growth was in inventories; the staff expected a reversal in the fourth quarter. Rapid money growth in the second and third quarters put M
₁
growth above the annual target of 3 to 6 percent. M
₂
growth was no better, 12 percent against a target range of 5 to 8 percent. The System’s battered credibility had taken another hit. Volcker and others believed it would further damage their impaired credibility if they failed to slow money growth. Much of this discussion at the October 6 meeting was about how fast money should be permitted to grow
from September to December 1979. Each member had a copy of an Axilrod-Sternlight memo showing that if M
₁
grew at a 4.6 percent rate in the fourth quarter, growth for the year would be 5.3 percent.
²²

The memo indicated that the staff would estimate the monetary base and total reserves required to reach the FOMC’s proposed money growth. They would subtract currency and average member bank borrowing from the monetary base to get an estimate of nonborrowed reserves. Use of average borrowing reflected inability to develop a reliable model of bank borrowing. The desk was supposed to provide the desired growth in nonborrowed reserves. The memo recognized that changes in the demand for money and the multiplier relating reserves to money or failure to control reserve growth could create problems, so the staff would reassess target values for each meeting. The memo and Volcker emphasized that judgment would have to be used to decide both when and how much to adjust. Volcker retained that discretion between meetings.

Volcker recognized that to control money growth, the System had to control total reserve or monetary base growth. Nonborrowed reserves (seasonally adjusted) were the operating target because, Volcker said, they could not directly control borrowing or currency demand. However, if total reserves rose too much, the desk would have to lower the nonborrowed reserve path to offset borrowing. He added that increased borrowing would initially raise the market rate and encourage a move back toward the path for total reserves and the monetary base (Volcker papers, Board of Governors, February 1980).

Volcker pointed to two problems the Axilrod-Sternlight memo neglected: lagged reserve requirements and weak control of discounting.
²³
Banks had to hold required reserves against deposits held two weeks earlier. They could borrow to obtain additional reserves. Total reserves would increase, but not nonborrowed reserves. If the Federal Reserve increased the discount rate to reduce borrowing, the federal funds rate would rise.
The FOMC did not then discuss the alternatives—control total reserves or the monetary base and restore contemporary reserve accounting.
²⁴

22. The memo estimated that monetary base growth would average 8 percent in the fourth quarter. Actual growth was 8.6 percent.

23. “We are working with a two-week lagged reserve requirement. . . . [T]hat probably isn’t the most desirable [arrangement] in the world if we are operating on this kind of system. . . . But we have it, and that’s not something we can change overnight” (FOMC Minutes, October 6, 1979, 26). Banks, especially large banks with many branches, disliked contemporaneous reserve requirements because they were more costly to them. The Federal Reserve chose to support their preference, thereby placing their private benefit about the social benefit of improved reserve control. “With the volatility of the funds rate, more and more banks will be tempted to borrow. . . . How do we prevent that from happening?” (ibid., 32). In practice, the Federal Reserve subsidized borrowing in the next few years.