A History of the Federal Reserve, Volume 2 (66 page)

Even a relatively hawkish member like Governor Coldwell showed ambivalence very early in the program by using interest rates to evaluate policy thrust. “I’d like to keep the Committee’s focus on the inflation side for the moment. I do think the chances of [recession] are high next year; and we will have to face the problem of to what extent we allow the rates to go down next year” (FOMC Minutes, November 20, 1979, 19).

After listening to the November discussion and the large amount of time spent debating small differences, President Roos (St. Louis) said: “I think we have to set longer term targets and be prepared to do what is necessary to achieve those longer-term targets. One thing that I think would be devastating . . . [would be to] worry about whether we ought to reduce the upper limit of the fed funds rate from 15.5 to 14.5 percent” (ibid., 27).

M
₁
growth ran ahead of the target range in October but slowed in November. By November, year-to-year growth of industrial production had fallen to zero. Money growth ran below target; borrowing declined, so the manager added to the path for nonborrowed reserves. When the FOMC met in early January 1980, many expressed satisfaction with the outcome.

What should they do next? Some wanted to announce money targets for the next three years. Willes (Minneapolis) and Roos (St. Louis) made the case for credible announcements to give the market as much information as possible and reduce expectations of inflation. The majority, led by Nancy Teeters, argued that the System had too little information and would have to change its path. They wanted no announcement beyond the one-year growth rates required by Humphrey-Hawkins.

Monetary innovation added to the difficulty of choosing a path and announcing it to the public. The staff prepared new definitions of money to take account of NOW accounts, automatic tellers, money market funds, and other new instruments. M
₁
A and M
₁
B replaced M 1 ; they differed mainly by the amount of NOW accounts. These were expected to increase, if Congress voted to permit the change. That made it difficult to specify growth rates. Following new legislation, the staff expected a large one-time change. The composition of other monetary aggregates also changed.
³⁸
However, only M
₁
A and M
₁
B were available weekly, so they received most attention from the Board’s staff, the manager, and the marketplace.

38. M
₁
A and M
₁
B differed by adding into M
₁
B NOW accounts, automated teller balances, credit union share balances, and demand deposits at mutual savings banks. M
₂
added savings and small time deposits, overnight repurchase agreements, euro-dollars, and money market mutual fund shares.

A December memo from Charles Schultze expressed surprise that the economy avoided a recession. He noted that slow productivity growth had raised costs and prices but kept unemployment low. He expected recession in 1980 with mild recovery late in the year. Oil prices received most attention; he forecast an increase to $29 a barrel, but interest rate increases would cause a decline in housing starts and automobile sales. The forecast decline in GNP was 1.3 percent for the year followed by a small, 1 percent, increase in 1981. His forecast of the GNP deflator was 9 percent in 1980 and 9.3 percent in 1981; the forecast unemployment rate rose in both years to 7.8 and 8.7 percent respectively (memo, Schultze to the Economic Policy Group, Schultze Papers, December 13, 1979).

The Board’s staff also forecast a recession in 1980, but it predicted a larger decline of 2.25 percent, followed by slow growth of 1.25 percent in 1981. The projected increase in oil prices was 60 percent in 1980. The inflation forecast called for 8 percent inflation in 1980 and slow decline thereafter. The actual inflation rate (deflator) was 9.9 percent, and real growth was near zero. Data for 1980, however, reflected President Carter’s use of credit controls and the public’s reaction.

Chairman Volcker expressed concern about inflationary expectations at the January meeting. “All the financial data are within our immediate objectives [but] I don’t think we’ve made as much expectational progress . . . as conceivably might have been hoped” (FOMC Minutes, January 8–9, 1980, 32). The ten-year constant maturity bond yield continued to increase slowly. Between October 5 and January 4, it had increased one percentage point to 10.5 percent. Quarterly data on expected inflation from the Society of Professional Forecasters had increased also. In first quarter 1980, the expected increase in the deflator was almost 10 percent.
³⁹

Chart 8.3 compares actual and expected inflation from the Livingston survey. Forecasts show no evidence of heightened credibility. Forecasts for 1981 made in 1980 eventually exceeded actual inflation. Forecasters remained skeptical that the new program would succeed. Interest rate reduction in the spring of 1980 probably reduced credibility. Many observers saw it as a repeat of the response to a rising unemployment rate that ended previous attempts to reduce inflation.

What should the FOMC do? The more hawkish members, Coldwell
and Wallich, wanted to reduce the M
₁
growth rate to 4 percent. Partee and Teeters opposed any additional increase in interest rates as the economy headed into recession. The compromise called for 4.5 percent money growth with the federal funds rate range unchanged at 11.5 to 15.5 percent. Although the Committee was divided, the vote was unanimous.

39. Volcker anticipated increases in the CPI for the next three months including some large increases (FOMC Minutes, January 8–9, 1980, 32). Monthly CPI inflation rates rose from 12.6 percent in December 1979 to 17.1 percent in January and March 1980. March 1980 was the peak monthly and twelve-month rate of reported CPI inflation.

The new procedure and the high variability of money growth forced some desirable changes in operations. The staff set monetary targets for a quarter ahead that, it believed, were consistent with its annual target. The FOMC gave attention to the credibility of its announcements of annual targets. Several expressed concern that “few people in the financial markets . . . believe that we’re going to stick with the policy we announced October 6th” (ibid., 66).
⁴⁰

The FOMC could not decide on the relative weight to place on interest rates and money growth. Lawrence Roos (St. Louis) wanted to ignore rate fluctuations to concentrate exclusively on money growth. Most others dis
agreed. The staff argued that interest rates and availability of credit affected decisions, so they could not be ignored. Henry Wallich wanted to avoid negative real rates in recession, and Robert Black (Richmond) expressed concern about effects on the exchange rate and foreigners’ interpretations of policy.

40. President Morris (Boston) accepted part of the monetarist claim that traditional policy was procyclical. “Traditionally, following our earlier policies, we have supplied very little monetary growth in the early part of a recession. We have encouraged a sharper decline in the economy thereby. We lagged in reducing interest rates and then when the unemployment rate got really high, we turned around and produced very rapid rates of growth in the money supply. That led to very big swings in the economy, which I think are counterproductive in the long run to controlling inflation” (FOMC Minutes, January 8–
9, 1980, 72).

The FOMC did not reconcile the different positions. Although it did not discuss how much fluctuation in interest rates it would tolerate, it made public the inter-meeting interest rate band in the delayed publication of the directive. This neglect, or deliberate omission, made the policy less transparent than it could have been. Although FOMC members worried about credibility, they would not agree with Mark Willes’s frequent statements that, in effect, warned that to be more effective the System had to decide upon and announce a coherent strategy.

Goals
and
Control
Procedures

The Federal Reserve did not announce or choose a long-term goal for inflation. Nor did it specify whether its goal was to end the sustained rate of inflation resulting from excessive aggregate demand or, in addition, to prevent the price level increase resulting from the oil shock. In fact, they did not distinguish the two in their discussions.
⁴¹

Monetarists argued that the proper goal was to end excessive aggregate demand by immediately slowing the rate of increase in the monetary base to a steady 6 percent rate (Shadow Open Market Committee, 1979 and 1980). The oil supply shock would pass through the economy; the price level would remain higher but the result would be a one-time increase spread over time. By trying to prevent the one-time price level increase, the Federal Reserve would use monetary policy to offset a real shock. This would require additional loss of output.
⁴²

The FOMC discussed lagged reserve accounting at its February 1980
meeting. No one disputed that lagged accounting made control of money under nonborrowed reserves target more difficult. The Board’s staff report repeated and strengthened its earlier conclusions: it favored contemporary reserve accounting. However, most of the presidents believed that member banks generally favored lagged reserve accounting. The account manager, however, “came out feeling that there is not all that much advantage to it” (FOMC Minutes, February 4–5, 1980, 4).

41. To respond to frequent complaints about the opacity of their control procedures, the Board’s staff prepared a memo describing procedures more fully. The memo emphasized the judgments that the staff had to make when deciding on the reserve path. Their procedure involved estimating the currency drain, the spillover into non-member bank deposits and into CDs that were not part of M
₁
or M
₂
. One of the weakest links was the estimate of borrowed reserves. The staff assumed that borrowed reserves would remain “close to the level prevailing around the time of the FOMC meeting, though varying a little above and below that level” (memo, “The New Federal Reserve Technical Procedures for Controlling Money,” Federal Reserve Bank of New York, Box 97657, January 30, 1980).

42. Economic theory does not conclude that price level stability—rolling prices up or back following one-time shocks—is preferred to constant expected inflation. The latter leaves the price level to vary as a random walk but maintains zero expected inflation for long-term planning.

The members divided on the issue. Those who spoke in favor usually added that they would not act immediately. Congress had under consideration legislation that would increase System membership. They did not want a ruling that agitated the banks. The FOMC took no vote and made no change.

In February 1980, Volcker testified again at Joint Economic Committee hearings. He reinforced and reiterated his main themes—infl ation control had to have priority. This time he emphasized that forecasts were not very reliable. A major failing in the past came from “relying too heavily on uncertain economic and financial forecasts” (Volcker papers, Board of Governors, February 1, 1980, 2). He attributed many of the failures to “transitory and misleading movements in the latest statistics” (ibid.).
⁴³
But neither he nor his successors followed a strategy that minimized short-run influences on their actions.

The
1980
Recession

The National Bureau of Economic Research set January 1980 as the start of a mild six-month recession. Real GNP declined 2.5 percent, and the unemployment rate rose to a peak rate of 7.8 percent. Using a common unofficial measure of recession, two consecutive quarters of negative growth, the 1980 experience does not qualify as a recession.

Both the administration and the Board staff expected a recession at the February meeting. The staff was pessimistic about the depth of the recession, but they expected a larger decline in reported inflation, from 11.4 percent in 1980 to 8.6 percent in 1981.

The changed attitude on the FOMC became apparent. Despite the prospect of recession, the FOMC majority favored slower money growth. Governors Teeters and Partee favored an easier policy, but went along with the consensus. Many spoke about the uncertainty caused by redefinition of
the aggregates, the oil shock, hostages in Iran, an election year tax cut, and differing outlooks for economic activity and inflation. But their own credibility and public commitment to slow money growth and inflation was a strong force favoring slower money growth.
⁴⁴

43. Later, he described forecasts as equally likely to be right or wrong. He emphasized control of monetary aggregates, lags in response, and determination to continue anti-inflation policy (Volcker papers, Board of Governors, Summer 1980).

Several favored a wider band on growth of the aggregates to recognize their uncertainty and increase the prospect of meeting their targets. Mark Willes (Minneapolis) made the opposite case. “If the time pattern of the economy is very unpredictable, then there’s no way we can respond to change it in a predictable way and, therefore, we ought not to be responding. We ought to respond less rather than more, the greater the uncertainty about the outlook” (ibid., 51). He favored picking a long-run non-inflationary path for money and keeping to it. His comment drew no response. Most of the others argued as usual over small differences in the annual growth rates for the various aggregates. The Committee, with two dissents, voted for a quarterly target of 5 percent for M
₁
B and 6 percent for M
₂
. Governors Wallich and Coldwell dissented because they wanted a more restrictive policy for the next quarter. They agreed with the annual targets of 4 to 6.5 and 6 to 9 percent for M
₁
B and M
₂
growth.

The Board’s Humphrey-Hawkins procedures required the System to announce its macroeconomic projections for the current and following year. The projections gave a range for inflation and real growth. The unusual feature was a relatively deep projected recession in 1980, as much as −5 percent for the year with a slow recovery in 1981. The FOMC expected the unemployment rate to rise to 8.5 percent by year-end 1980 with little change in 1981. The actual rate was 7.2 percent in December. Projections of inflation proved more accurate and no less pessimistic. For 1980 and 1981, the projected ranges reached 9 to 10 and 7.75 to 9.5 percent. Actual changes in the deflator were 9.5 and 8.6, in the middle of the projections.

Money grew more rapidly than anticipated in February. On February 22, the FOMC held a telephone conference to authorize an increase in the upper limit of the federal funds rate to 16.5 percent. A group that only narrowly approved an 11 percent discount rate in September for fear of recession voted unanimously for an upper limit of 16.5 percent for the federal funds rate after the recession started.

44. The February meeting came before President Carter asked for credit controls. Governor Frederick Schultz commented: “In the area of consumer credit, more and more banks are cutting back on the availability of consumer credit and are increasing the price and other factors. . . . Sears and Penneys and others have recently made those kinds of announcements” (FOMC Minutes, February 4–5, 1980, 43).