A History of the Federal Reserve, Volume 2 (74 page)

After the strong rise in first quarter 1981, output declined in the second, rose modestly in the third, then declined sharply for the next two quarters. Table 8.5 above shows the variable growth of real GNP during this period.

Volcker’s testimony to the Joint Economic Committee in February 1981 repeated themes from earlier statements. He stressed the importance of reestablishing credibility, the need for consistency and persistence, and the importance of spending reductions and deregulation. He described the economic situation as unsatisfactory, citing high inflation and “dismal” productivity growth. He emphasized the importance of evidence showing slower inflation and claimed to see changes in public attitudes “which would make things possible now that have not been possible in the past” (Volcker papers, Board of Governors, February 5, 1981, 8).

In a television appearance, Volcker repeated these monetarist themes. Short-run changes were not predictable; reducing inflation and restoring growth required patience and persistence. The right trend would show slower money growth, but there would be more bad news before good results became clear. He suggested progress would be seen by late 1981 or early 1982 (Volcker papers, Board of Governors,
Face
the
Nation,
March 22, 1981).

By June 1981, the conflict between monetarists and supply-siders broke open within the administration. The chief economist at the Office of Management and Budget, Lawrence Kudlow, and Jerry Jordan at the Council of Economic Advisers foresaw that with the economy slowing, continued monetary tightening and the proposed tax cut would greatly increase the
budget deficit. They proposed to revise the winter’s “rosy scenario” forecast in the midsummer report.
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The supply-siders objected strenuously, claiming that Congress would not vote for the tax cuts if faced with the projected deficits (Grieder, 1987, 396–98). The supply-siders won that argument. Tax reduction passed the House by 238 to 195 and 89 to 11 in the Senate.

The reduction in marginal tax rates was an attempt to sustain or increase growth during the disinflation. Table 8.7 shows estimates of the marginal tax rates in 1980 and after the reduction. The table shows a marginal tax rate reduction of 13 to 14 percent using either estimate. For comparison, the 1964 tax cuts reduced marginal rates by 14 percent (Barro and Sahasakul, 1986) or 20 percent (Hakkio et al. 1996) for high-income taxpayers. At the same time, Congress indexed individual tax rates for inflation in 1981, and it reduced corporate tax rates. In 1982, the administration agreed to increase corporate tax payments to respond to criticism of the excessive corporate reduction and the large budget deficit. Chart 8.7 shows marginal tax rates for individual taxpayers. The last two columns include additional tax reduction in 1986.

Once the tax bill passed, Budget Director David Stockman proposed budget reduction to the president. Defense Secretary Caspar Weinberger wanted increased spending on the military. President Reagan chose increased military spending. For the rest of Reagan’s presidency, budget deficits fluctuated around $200 billion a year, from 4 to 6 percent of GNP.

The National Bureau includes the 1981–82 recession on its list of se
vere recessions since 1920, a class that includes the recession of 1923–24, 1948–49, 1953–54, 1957–58, and 1973–75 but excludes depressions. At the time, some commentators and journalists compared 1981–82 to the Great Depression or the 1937–38 depression. This was a typical overstatement by journalists and politicians usually for political effect. The critics did not distinguish between a 3 percent and an 18 percent decline in real GDP. Table 8.8 compares the 1981–82 recession to the 1937–38 depression and to two severe recessions that the National Bureau ranked
as more severe than 1981–82. The worst part of the 1981–82 recession came in two quarters, 1981:4 and 1982:1. By the fall of 1982, the S&P index of stock prices began a sustained rise, forecasting the recovery that soon came.

92. “Rosy scenario” was the name given to the administration’s forecasts when they presented their first budget. The forecasts showed strong growth to satisfy supply-side economists who claimed a strong response of output to the tax cuts. The rosy scenario called for 3 percent growth in 1982 and 5.2 percent in 1983. Actual growth was −1.5 and 7.8 percent in the two years. The
1982 error especially discredited the administration’s forecast. Critics ignored the 1983 result. The forecast overestimated inflation in 1982 and 1983 by about two percentage points in each year.

Highly variable output growth added to the uncertainty created by the monetary aggregates. The surge in NOW accounts at the start of the year made it difficult to separate portfolio shifts from policy induced changes in the money growth rate using System procedures.
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Growth of the monetary base and the federal funds rate moved over wide ranges in 1981, but both trended down. By December 1981, twelve
month moving average base growth was down to 5.26 percent, 2.5 percentage points below the growth rate when reserve control started. The federal funds rate in December 1981 averaged 12.4 percent, 6.5 percentage points below December 1980 and 1.3 percentage points below October 1979. Measures of annual inflation had begun a sustained decline. But ten-year constant-maturity Treasury yields remained at 14 percent. Real interest rates remained high; the public was not convinced that the Great Inflation was about to end permanently.

93. The Federal Reserve used the seasonally adjusted money stock in its calculations. There was no reliable basis for seasonally adjusting NOW accounts. The staff considered several alternatives and elected to seasonally adjust M 1 B (including NOW accounts) because the seasonal was similar to the former demand deposit seasonal (FOMC Minutes, April 28, 1981, 1). Who could know if that was right given the short history of NOW accounts?

The System’s anti-inflation policy had considerable support in the country. At the Federal Advisory Council’s April 30 meeting, the Board heard that the FAC members regarded inflation as the “nation’s most serious economic problem” (Board Minutes, supplement, April 30, 1981, 1). Further, the council commended monetary policy actions, specifically citing the “sharp rises in interest rates during the fall . . . to control growth of the monetary aggregates” (ibid., 7). It urged the Board to “stay the anti-inflation course” (ibid.).
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Third, the new administration seemed determined to reduce tax rates and increase defense spending. The FOMC members viewed these changes as inflationary. As usual, they thought that they were the only group acting to reduce inflation. The difference—and it was an important change from the past—was that many no longer believed that monetary policy alone would not be effective. They were not helpless; they were responsible for inflation and for ending it.

Relations with the administration had two very different aspects. President Reagan spoke strongly about the importance of ending inflation. In February 1981, the administration issued a statement of its program. The section on monetary policy recognized the central role of the Federal Re
serve and its independence of the administration. It supported the general thrust of System policy, but it called for “stable monetary policy, gradually slowing growth rates of money and credit along a preannounced and predictable path” (Reagan Administration, 1981, 24).
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94. Anecdotal references at the FOMC meeting reinforced the FAC’s view. For example, President Balles (San Francisco) commented on discussions with heads of two lumber companies. Both urged the System to complete the disinflation program despite the decline in housing starts and the demand for lumber (FOMC Minutes, May 18, 1981, 11). Other FOMC members told similar stories.

President Reagan’
s first budget projections called for three years of budget deficits followed by budget surpluses in 1984–86 (ibid., 12). Almost all the spending reductions were listed in “all other” and were not explicitly named. That category fell by $50 billion by 1984, a reduction of more than 25 percent. Of course, Congress approved the spending increases but rejected most of the reductions. Instead of the projected $30 billion surplus in 1986, the federal government ran a budget deficit of $230 billion, 5.7 percent of GNP.
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Like central banks everywhere, the Federal Reserve considered the deficits inflationary or requiring higher interest rates to avoid financing them.

By early 1981, the twelve-month moving average of consumer prices fell below 10 percent, more than seven percentage points below the peak. In a survey of forecasts based mainly on Keynesian models, Okun (1978) found that the models predicted a 10 percent decline in output for one year for each permanent percentage point reduction of inflation. The early results showed this forecast to be highly inaccurate. As the rational expectationists emphasized, the cost of reducing inflation would fall as the public became convinced that the reductions were permanent. Their predictions did not allow, however, for skepticism about the persistence of policy after years of failed efforts.

The prevailing Keynesian orthodoxy claimed that the tradeoff between inflation and unemployment was socially unsatisfactory unless guidelines or controls held inflation down. Volcker dismissed this claim and substituted another. In late February 1981, he testified as required by Humphrey-Hawkins legislation. Much of his testimony repeated state
ments he had made to private groups and to Congress. Notable was the shift away from the tradeoff between inflation and real growth. Instead, low inflation was a principal means of ultimately reaching high employment and stable growth. “The rapid rise of prices clearly is the single greatest barrier to the achievement of balanced economic growth, high employment, domestic and international financial stability, and sustained prosperity” (Volcker, 1981, 3). He also stressed the importance of anticipations.

95. The proposal for monetary policy followed the repeated recommendations of the Shadow Open Market Committee. I wrote the first draft for the administration; Beryl Sprinkel served as undersecretary of the Treasury for monetary affairs, and Jerry L. Jordan soon thereafter became a member of the president’s Council of Economic Advisers. Both had been members of the Shadow Committee. Both criticized lagged reserve requirements, discount policy, and seasonal adjustment. The draft called for steady reductions in base growth of one percentage point a year until 1986, when base growth would reach 3 percent. Volcker did not like the commitment to a one percentage point reduction in money growth for several years. “I knew that such precision would be impossible to achieve in the real world and, achievable or not, it would look like the administration was trying to order the Fed. I somehow succeeded in talking them out of that kind of language” (Volcker and Gyohten, 1992, 175).

96. Weidenbaum (2005, 9–10) describes the conflict over economic assumptions in the Reagan budget. To reconcile differences, the forecast had a large improbable rise in monetary velocity.