A History of the Federal Reserve, Volume 2 (70 page)

Despite the decline in interest rates, policy remained procyclical as in past recessions. Growth of money and credit declined; growth of the real monetary base remained negative throughout the recession and did not start a sustained rise until the trough in July. Expected real long-term interest rates are an exception; they declined from April to July. Chart 8.4 above shows some of these data.
⁶⁸

Beginning in July, the expected real interest rate began to rise. By yearend it had increased almost three percentage points. Judged by these rates, policy became severely restrictive and, as Chart 8.4 above shows, it became more restrictive in 1981, during the expansion early in the year and the recession that started in July.

Once again, growth of the real base tells a different story, more consistent with events in the economy. Although real base growth remained negative throughout 1981, it reached a trough in April 1980, then started to increase, with one brief setback, until May 1981. It then began a sharp decline foreshadowing the next recession.

The short 1980 recession had, at most, a modest effect on expected inflation. The measured rate of CPI increases reached a peak in March. The twelve-month moving average was 13.7 percent in that month. By August 1980, it was down to 12 percent. Much of the decline in the rate of increase represents the passing through of the one-time oil price increase. Average hourly earnings and the Society of Professional Forecasters’ inflation forecast show no evidence of a decline.
⁶⁹

Divisions became more pronounced within the FOMC. In the first eight
months, there had been five dissents, three of them by Henry Wallich who often favored a more restrictive policy, and two dissents favoring less restriction at the May meeting. After August, there were dissents at all six regular and telephone meetings. The vote in September and October was eight to four, with all the dissenters favoring tighter policy. The very rapid money growth during the third quarter made it difficult to hit the annual target of 4 to 6.5 percent for M
₁
B. Most of the dissenters wanted more effort to achieve the target; they feared higher inflation and reduced credibility and believed both made it more difficult to reduce inflation. Beginning in November, Nancy Teeters dissented at the next four regular and special meetings. She favored lower interest rates and expressed concern about the recovery.

68. Prodded by Governor Henry Wallich, the staff prepared a number of estimates of real interest rates and after-tax real interest rates. The latter assumed that the corporate tax rate was the relevant tax rate, a very doubtful procedure in view of the many tax-exempt institutions and the growing holdings of U.S. debt by foreign investors. The authors used four measures of expected inflation, including the average of the past three years, current inflation, and the Livingston survey. As in Chart 8.4, they found that real long-term rates were relatively high in 1980 compared to previous recessions (using three-year average inflation). As in the several charts used in the text here, the authors found “no easily discernible pattern in real rates during the initial quarters of an expansion” (“The Behavior of Real Interest Rates in the Postwar U.S. Economy,” Board Records, July 2, 1 980, 7). Short-term real interest rates were negative during the 1980 recession in most, but not all, the authors’ charts.

69. At the time, the Shadow Open Market Committee expressed considerable skepticism about the Federal Reserve’s commitment to its policy of controlling money growth in the first year (policy statement, Shadow Open Market Committee, September 22, 1980). The committee recommended elimination of lagged reserve accounting, prompt adjustment of the discount rates to market rates, and other changes in operating procedures. The House Banking Committee also called on the System to fix the discount rate to a market rate (FOMC Minutes, August 15, 1980, 12).

Volcker tried to find a compromise that would draw a majority. At one point, he expressed the difficulty as he saw it.

As one market caller put it to me the other day, if the money supply really goes up very sharply for a couple of weeks, we will have big increases in long-term interest rates. I think that is descriptive of the kind of dilemma we are in. I don’t know how we get out of that without going through a painful process of deflating the inflationary expectations, which are not deflated yet. And I don’t know how they get deflated without deflating the economy more than one would like to see it deflated. I don’t have a ready answer to that. (FOMC Minutes, January 8–9, 1980)
⁷⁰

In February, Volcker told Congress: “Dealing with inflation has properly been elevated to a position of high national priority. Success will require that policy be consistently and persistently oriented to that end. Vacillation and procrastination, out of fears of recession or otherwise, would run grave risks”
(Federal
Reserve
Bulletin,
1980, 214).

His problem was to convince the market and the public that he intended to carry the policy through. First, he had to convince some of his colleagues. Lawrence Roos pointed out that in the first three quarters of 1980, M
₁
B grew at rates of 6, −2.5, and 12.25 percent with a target of 4.5 to 6 percent. “ I don’t think these rates of growth in any way reflect any action that this group agreed upon or any policy or directive that we gave” (FOMC Minutes, September 16, 1980, 8). Volcker agreed. “The question
is whether we have control in the short-run, and I’m afraid this recent pattern that you point to shows that we don’t” (ibid., 8). But he made no suggestions for improving short-run control or giving more emphasis to the long-term.

70. Volcker did not take seriously the rational expectations claim that expectations would adjust quickly to his policy actions. The only proponent of rational expectations on the FOMC, Mark Willes (Minneapolis), had left to take a senior management position at General Mills. Both money growth and interest rates were highly variable, so it was difficult to hold firm expectations about future policy. Willes later claimed that a senior staff member warned him not to “shake things too badly or too loudly” (Foge
rty, 1992, 4).

To all the uncertainties about the economy, the System and the market had to factor in the uncertainties about the meaning of money growth rates at a time of institutional change and redefinition. Lyle Gramley added the usually unspoken concern about what Congress would do if there was another recession. “This country and the Congress may not have the tolerance to let us continue” (ibid., 37). The market’s conclusion was that inflation would rise. Between June and December 1980, the yield on ten-year Treasury notes rose 3.7 percentage points to 13.19. Goodfriend (1993, 12) describes this move as evidence of a new inflation scare.

Volcker did not mention Congress, but he was reluctant to “take all the risks on the side of interest rates and the economy. . . . I don’t think we can [say] . . . beginning tomorrow or whenever we will go out and in effect force interest rates up. And I would have great reservations about that kind of approach” (ibid., 41). He remained skeptical of forecasts and relied more on actual events. Roos (St. Louis) objected that this was fine-tuning of short-run targets, but he received no support. Much of the discussion was in vain. Money growth remained high in September, borrowing soared far above the staff estimate, and the federal funds rate rose to 12.8 percent for October, up almost four percentage points from July’s local low.

Inflationary expectations, reinforced by the policy reversal in the spring, forced more restriction than anyone on the FOMC had anticipated. In late September, the Board approved a 1 percentage point increase in the discount rate to 11 percent. Its announcement explained that it sought to reduce money growth. The Board followed with an increase to 12 percent on November 14, and it restored the 2 percentage point surcharge for large banks that borrowed frequently. St. Louis asked for a 2 percentage point increase, the largest ever, and three banks asked for 1.5 percentage points. Member bank borrowing began to fall. On December 4, the discount rate went to 13 percent, and the surcharge for heavy borrowers rose from 2 to 3 percentage points. Governor Teeters again dissented because she thought interest rates were too high. However, on December 22, the Board rejected requests for a 1 percentage point increase to 14 percent from Richmond and St. Louis and to 15 percent from Cleveland.

THE 1980 ELECTION

The minutes say very little about the election, and it does not appear to have affected Federal Reserve actions taken in September and October,
although it may have delayed one increase in the discount rate. Ronald Reagan, the Republican candidate, ran on a program to strengthen the military and reduce tax rates and inflation. Reagan’s election had little immediate effect on expected inflation. Markets remained skeptical—infl uenced by the effect on the budget deficit of the promised tax reduction and increased military spending.

The Carter administration increased spending but did not reduce tax rates. Table 8.3 shows Federal government outlays and the budget deficit for the years surrounding the 1980 election. The table shows that government outlays increased more in both real and nominal terms before the election than early in the administration of President Reagan. In a repeat of the shift from President Eisenhower to President Kennedy, President Reagan reduced tax rates after the election, a step that President Carter refused to take. During the campaign, with one exception, Carter did not openly criticize Volcker or Federal Reserve policy. Volcker responded, and the president did not repeat the criticism.
⁷¹

Ronald Reagan won the election. Several of the Board members favored tax reduction to stimulate business investment and increase productivity growth. But just as many expressed concern about higher budget deficits.

About a week after the election, the Board simplified reserve requirement ratios for all depository institutions. The new requirement dispensed with classification into
reserve city and country banks, an action the Board had considered since the 1930s. In its place, the Board divided institutions at $25 million in transaction accounts.
⁷²
Small banks and financial
institutions paid a three percentage point reserve requirement on transaction accounts; banks with more than $25 million in deposits paid twelve percentage points. For nonpersonal time deposits, the requirement depended on maturity. Under four years, the requirement was three percentage points; over four years, it was zero. The Board allowed eight years to phase in the new requirements. These requirement ratios remained unchanged throughout the 1980s and beyond. In the 1990s, the Board removed the three percentage point reserve requirement ratio for all time deposits.
⁷³
The Board’s announcement solicited opinions about a return to contemporary reserve accounting periods. It explained that the change would improve monetary control (Board Minutes, June 4, 1980).

71. In September and October 1980, President Carter complained about the very high interest rates resulting from what he called the Federal Reserve’s strict monetary approach. He emphasized Federal Reserve independence and disclaimed responsibility, but he urged the Federal Reserve to give more attention to interest rates. Volcker responded by saying that the Federal Reserve disliked volatile interest rates. He blamed the markets. “According to interviews with a number of key Federal Reserve officials, the Federal Open Market Committee still is paying close attention to interest rates” (Berry, 1980). Schultze (2005, 13) described President Carter in 1980 as “adamant on one thing, no tax cuts.” Schultze wanted to have an investment tax credit. “He wouldn’t do it. He was a fiscal conservative at heart.”

72. Beginning in 1982, the Board adjusted the base upward to reflect inflation. By 1989, the base was $29.8 million in transaction accounts. The base rose 20 percent, about half the rate of consumer price inflation.

FINANCIAL DEREGULATION

Remarkable and long-overdue decisions by Congress in the early 1980s repealed several rules adopted in the 1930s and deregulated many financial transactions. The spirit of the 1930s legislation was to limit competition between types of financial institutions with the stated intention of preventing destabilizing competition. Inflation and financial innovation had the opposite effect; as we have seen several times, regulation Q ceilings induced large flows of funds to and from the banking system whenever market rates rose above or fell below ceiling rates.

Of perhaps greater significance for Congress, thrift institutions could issue only fixed rate mortgages. During a time of rising interest rates, the thrifts were profitable. The short-term rates paid to their account holders remained below the long-term rates on their mortgage portfolios. When the Federal Reserve disinflated, short-term interest rates rose above long. To hold their accounts, the thrifts had to pay higher rates. They could only purchase mortgages that yielded lower rates than the rates they paid.

Regulation failed. On March 31, 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act (DIDMCA). As noted earlier, the act authorized nationwide NOW accounts. It required all depository institutions to hold required reserves either at the Federal Reserve directly or indirectly through other regulatory institutions or in vault cash, made all depository institutions eligible to borrow at the reserve
banks, and expanded the lending powers of thrift institutions to include business and consumer loans. The thrift institutions gradually lost the competitive benefit of a 0.5 percentage point higher rate that they could pay on liabilities.
⁷⁴

73. Earlier, the Board’s staff prepared a comprehensive report on reserve requirements including elimination of lagged reserve accounting, staggered settlement dates, and other proposals to simplify and smooth adjustment. The staff reported favorably on contemporaneous reserve accounting, but the Board did not adopt any changes. The comprehensive review was mainly the work of David Lindsey and Thomas Simpson. Separately, President William Ford (Atlanta) recommended contemporary reserve accounting in a September letter to the chairman.