A History of the Federal Reserve, Volume 2 (68 page)

Neither the Federal Reserve nor the president’s advisers expected the strong public reaction. Although credit card use remained unrestricted, people cut up their credit cards and mailed them to the government or the Federal Reserve. “It wasn’t just consumers who were sending the credit cards. I’m told business firms were going around canceling loans. They had been borrowing too much” (Schultze, 2005, 12). Between February or March and July 1980, the unemployment rate rose from 6.3 to 7.5 percent. Real GNP growth fell from 4.1 percent in the first quarter to −9.1 percent in the second. Industrial production declined at 25 to 30 percent annual rates in the spring. This was the sharpest decline in any postwar quarter.
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The effort to reduce spending without raising interest rates had a much stronger response than traditional monetary actions.

No sooner had credit controls come into effect than the Federal Reserve agreed to a $1.1 billion loan to the Hunt brothers, who lost heavily speculating in the silver market. On March 26, a large brokerage, Bache Halsey, told Volcker that it had lent $200 million to the Hunts to buy silver. It was close to bankruptcy. The reason was that the silver market had collapsed. The price reached $52 an ounce in January; by late March it was down to $10. Twelve domestic banks, four branches of foreign banks, and five brokerages had lent more than $800 million. The Hunts had large losses and could not repay the loans all at once.

Subsequently, market participants learned that the Hunts had purchased futures to bet on a higher price. The contracts came due on March 31; settlement required an additional $665 million. If the Hunts defaulted as expected, the silver market and probably others would decline. Volcker and the Board wanted to avoid that outcome, but they were reluctant to open
the discount window to banks with good collateral. Thirteen banks, mainly those that had lent to the Hunts, agreed to extend long-term loans totaling $1.1 billion to avoid a panic.

52. He referred to experience earlier. Banks circumvented or avoided credit limits by shifting their loans to overseas branches not subject to controls. In April, the Board adopted a temporary seasonal program to assist member and non-member banks making loans to small businesses and farmers. Small housing contractors were an example of an affected group.

53. Frederick Schultz, vice-chairman of the Board of Governors, administered credit controls. Controls worked poorly. “Every time we put out a regulation to try to take care of one problem, we would find that we had created two or three others in the process” (Schultz, 2005, 346). “It shouldn’t have done anything, logically. We didn’t want it to be very much. . . . I never saw anything like it in my life! . . . [T]o the very day, to the very week, there was a sharp reaction”
(Mehrling, 2007, 181).

The problem of controlling excessive money growth reversed soon after credit controls began; growth fell below the target. In place of conflict over how high to place the upper band on the federal funds rate, the FOMC argued over how low to place the lower band. Following the March meeting, the federal funds rate reached a weekly average of 19.38 percent. By the April meeting it was at 17 percent. A week later, the rate was 13.5 percent.

The staff report for the April 22 meeting lowered the forecast for output and reported on the very rapid decline then underway. Auto sales and housing starts had been weak in the winter. Housing starts plunged from an annual rate of 1.5 million in December to 900 thousand in April. Inflation remained high. Consumer and producer prices rose at 18 or 19 percent annual rate in the first quarter. Nothing like this had happened in the peacetime United States and rarely even in wartime. The staff forecast CPI inflation at 17 percent for the year. The actual rate was 11.7 percent. Volcker typically praised the forecasters but expressed deep skepticism about their accuracy. He did not add that his unwillingness to change procedures added to the difficulty of forecasting money growth, reserves, and other variables.

In the midst of the uncertainty created by monetary targeting and credit controls, on March 31, 1980, Congress passed the Monetary Control Act, giving the Federal Reserve additional powers that it had long sought but also deregulating financial institutions to promote competition (Timberlake, 1993, chapter 24). Effective September 1, 1980, all depository institutions maintaining transaction balances or nonpersonal time deposits became subject to reserve requirements. The law specifically included non-member banks, thrift institutions, credit unions, and money market funds. Non-member banks and thrift institutions could hold their reserves at Federal Home Loan Banks, the Central Liquidity Facility of the National Credit Union Administration, or with banks or other institutions that held reserves at Federal Reserve Banks (Annual Report, 1980, 66–67). In exchange, the Federal Reserve permitted these institutions to borrow at the discount window and Congress broadened their lending powers to permit them to compete with banks.
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Congress also passed legislation gradu
ally phasing out regulation Q interest rate ceilings and permitting interest payments on consumer transaction accounts. And it raised the maximum deposit insurance coverage to $100,000.

54. Kenneth Guenther served from 1975 to 1979 on the Federal Reserve staff. His duties included liaison with members of Congress, and he was active in the negotiations leading to the Monetary Control Act. Although the act passed while Volcker was chairman, much of the work was done by Chairman Miller, working with Congressman Henry Reuss. The act also required the Federal Reserve to price its services, such as check clearing, at market prices.
This addition was very attractive to the large banks (Guenther, 2001, 30–31). To support its position, the Federal Reserve used the bogus argument claiming that non-member deposit institutions hindered its ability to control the monetary aggregates. According to Guenther, the Board’s staff believed that they were peddling legislation based on a premise that none of the economists believed in (ibid., 31). Goodfriend and Hargraves (1983) show that the Treasury preferred uniform requirements to provide revenue.

Historically high interest rates in the United States relative to foreign rates strengthened the dollar. As interest rates declined after March the dollar depreciated. The Federal Reserve, the Treasury, and foreign central banks intervened using outright purchases and borrowing on swap lines or repaying.

Member bank borrowing declined also in April. The staff anticipated $2.75 billion in early April, but the weakening economy and the surcharge on borrowing by large banks reduced the total. By the end of April, the staff expected borrowing of $1.25 billion including $600 million to a distressed bank.
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Staff forecasts of short-term changes were often wrong, and this was particularly true of borrowing. Under the method used to set growth of nonborrowed reserves, forecast errors for borrowing often resulted in large errors in total reserve growth.

At the April 22 meeting, several members recognized that the recession was a test of reserve control. These members wanted to maintain a firm policy. Others wanted to lower interest rates and increase money growth in response to recession. Frank Morris (Boston) stated the case for maintaining a restrictive policy.

If we abandon, for all practical purposes, our money growth targets at the first occasion we find interest rates that are uncomfortable, then how is the market going to have any confidence that when we require uncomfortable interest rates on the up side we will not then also abandon our money growth targets? We would be right back where we have been. . . . We’ve simply got to ride it through. (FOMC Minutes, April 22, 1980, 13)

Governor Charles Part
ee warned of the risk.

55. The Federal Reserve loaned $600 million to First Pennsylvania Bank & Trust early in April to prevent the bank’s failure. This was again a misapplication of Bagehot’s principles—protecting the bank not the system. This seems part of the “too big to fail policy” that encouraged risk-taking, mergers and giant size. The Federal Reserve has persisted in avoiding announcement of its policy action in a banking panic. This encourages bailouts because there are always concerns that failure will cause a panic. Bagehot’s rule warned them to pre-announce that the Federal Reserve would protect the market, not the distressed bank.

When we get into a decline, it has always seemed to me extremely difficult to forecast how far it might go because there are dynamics involved. There have been shocks: Chrysler, a major bank that has been referred to, silver, and the possible failure of a brokerage firm. (ibid., 15)

The FOMC voted ten to one to maintain its money growth objective about unchanged at 5 percent annual rate “or somewhat less” for M
₁
B in the first half of 1980 and a federal funds rate of 13 to 19 percent. Henry Wallich dissented; he wanted slower money growth and a higher federal funds rate. Part of the problem at this meeting and throughout the period was that market participants continued to watch the federal funds rate and other short-term rates. They interpreted a decline in these rates as an easier policy, even if the System insisted that it controlled money growth, not interest rates. The very strong response to credit controls made interpretations more difficult.
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For those who watched M
₁
growth, policy in this period seemed to repeat previous experience. M
₁
B growth declined sharply in the winter of 1980, then reversed. By summer, this closely watched policy indicator was above the growth rate when the new policy started. Chart 8.6 shows these data. Control problems in spring 1981 are large. During the entire 1979–82 period, money growth varied over a wide range. Control was far from perfect or even adequate.

Many market participants believed that the Federal Reserve had abandoned its anti-inflation program once the unemployment rate reached 7 percent or higher. This had happened before and made observers skeptical. The surge in money growth during and following the recession effectively ended the first phase of the program. Volcker and the FOMC had to start again in the fall.
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On April 16, the Board opened the discount window for seasonal borrowing to small non-member banks. Non-members with less than $100 million in deposits could borrow to “meet the credit needs of farmers, small businesses, and other priority users” (Annual Report, 1980, 77).
Under the Monetary Control Act, these banks would have to hold reserves at Federal Reserve Banks beginning September 1, 1980. This action suggested that the Federal Reserve thought it could influence the allocation of credit, an error it should have learned from Benjamin Strong’s writings in the 1920s.

56. FOMC members disliked the credit control program, made many negative comments, and expressed an interest in repeal beginning in May.

57. Otmar Issing (2005) compared West German and United States experience. Inflation in Germany rose to 6.3 percent in 1981, but this was mainly the one-time effect of oil price increases. The Bundesbank targeted central bank money (the monetary base). It reduced monetary growth targets beginning in 1981, achieved its targets, and promptly reduced inflation. Issing gives credit to Bundesbank policy and its experience with monetary targets. He showed that Germany’s long-term interest rates remained far below rates in the United States. The plausible reason was lower expected (and actual) inflation.

The sharp decline in output was a test of anti-inflation policy. Would the Federal Reserve retreat as it had in the past? Or would it ignore the recession? The market reduced interest rates. The federal funds rate fell below the FOMC’s 13 percent lower limit. With the discount rate at 13 percent, and a three percentage point surcharge for large banks, any further decline in demand for reserves would reduce discounts. Excluding the longer-term loan to First Pennsylvania, discounts were $500 million. The staff projected further declines in discounts with downward pressure on the funds rate. Monetary base and money stock growth were negative in April. By a vote of seven to three, the FOMC lowered the lower bound on the funds rate to 10.5 percent. Guffey (Kansas City) and Solomon (New York) voted no because they wanted a smaller reduction in the funds rate. Wallich wanted to maintain the 13 percent rate. In the afternoon, the Board approved removal of the three percentage point surcharge for large bor
rowers. Wallich voted against because he believed the market would interpret the move as evidence of easier policy that would reduce credibility of the anti-inflation program.

The rapid decline in growth and spending continued. Real GNP fell at a 9 percent annual rate in the second quarter, the most rapid rate of decline in the postwar years before or after. Inflation (deflator) remained high, 9 percent annual rate in the second quarter. The unemployment rate in April rose to 7.0 percent from 6.2 percent in March. By July, it reached a local peak at 7.8 percent, an increase of 2.1 percentage points in a year. It then declined.

The Board’s staff had considerable difficulty both in setting and achieving targets for reserve and money growth. With borrowing reduced to low levels, nonborrowed and total reserves moved closely together. Reluctance of the FOMC to allow the funds rate to decline reduced reserve growth. The staff reported that M
₁
B fell at a 14.5 percent annual rate in April, remained unchanged in May, and rose at a 16.75 percent annual rate in June. For the first six months of 1980, M
₁
B rose at a 1.75 percent annual rate, far below the FOMC’s target.
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Money growth was again procyclical.

On May 22, the Board moderated credit controls by reducing marginal reserve requirements on managed liabilities of large banks and the special deposit requirement on increases in consumer credit. The new ratios were half the old. But credit controls remained. Chairman Volcker sent a letter to the banks explaining that “bank loans appear to be running comfortably within the 6 to 9 percent guideline” (Board Minutes, May 22, 1980).

A month later, the Board agreed unanimously that the time had come to remove credit controls. Some members wanted to keep controls on growth of money market mutual funds, but the majority rejected this proposal. On July 2, the Board voted to eliminate credit controls effective the next day. The administration agreed.
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By year-end Congress repealed credit control legislation effective June 30, 1982.

The longer-term effect of credit controls was counterproductive. Despite warnings from several FOMC members, the Federal Reserve responded to high interest rates and rising unemployment by giving up its antiinflation policy. Monetary base growth rose modestly. By July 1980 the federal funds rate had fallen to 9 percent, almost half its April level, and the SPF expected rate of inflation rose, so real interest rates fell. Whatever
its intentions, the FOMC had again appeared to abandon its anti-inflation policy under administration pressure and to show itself unwilling to pay the cost of disinflation. The episode increased skepticism and further weakened the Federal Reserve’s credibility.

58. The Board’s staff, as usual, explained the decline in money growth as a result of shifts in the demand for money. They made no mention of the bound on the federal funds rate as a source of the problem.

59. During July the Board removed special deposits and other parts of the credit control program.