Volcker never expected to win a popularity contest, but he resented being labeled a gambler. “The only time I ever rolled the dice was playing Monopoly with Janice and Jimmy—and I didn’t like losing.”4 He was, of course, experimenting with an unproven strategy, but the old methods had failed, and doing more of the same would have gambled on the status quo. Risks prevailed either way.
The verdict in the marketplace on the Federal Reserve’s announcement troubled Volcker more than newspaper editorials or professorial pronouncements. The government bond market in the United States was closed for the Columbus Day holiday on Monday, October 8, the first trading day following the Fed’s announcement, but favorable responses in gold and foreign exchange, which trade worldwide, offered initial encouragement. The dollar rose to 1.794 marks, a significant jump of 2 percent from the previous Friday, and gold declined to $372 per ounce, a drop of 3.3 percent from its Friday close.5
Gold and the dollar confirmed the favorable European commentary on the American initiative. The manager of Zurich’s Bank Rothschild said, “After all its past quarrels with the Fed, it now looks as if the White House may finally have bitten the anti-inflation bullet.”6 A foreign exchange dealer in Brussels added, “The United States has put its finger right on the spot this time.”7 And a report from a correspondent in Bonn summarized the sentiment: “The Fed actions bolster the reputation of Federal Reserve Chairman Paul Volcker as ‘a tough guy.’ ”8
Meg Greenfield, a Pulitzer Prize–winning columnist at the Washington Post, made “tough” synonymous with leadership, “in the sense of being serious and consistent and aggressive,” and claimed that Americans also valued that trait.9 “A great deal of admiration has been expressed for Volcker’s unambiguous and painful action to get hold of the runaway inflation—damn the side effects and cost, it had to be done. I happen to agree. But I also think there is something truly disturbing about the fact that … we are all sitting around hailing one among us who was obliged to take harsh measures to restrain our undisciplined ways.” Leslie Pollack, chief investment officer of the brokerage firm Shearson Hayden Stone, concurred. “Volcker is the first Fed chairman in twenty-five years who’s doing what he’s paid to do.”10
The resumption of government bond trading on Tuesday, October 9, took the chairman down a notch. He had sanctioned the unprecedented two-percentage-point increase in the overnight federal funds rate, to 13.86 percent, but had not expected the ten-year bond rate to follow suit. Volcker thought the favorable effect of the new procedures in dampening inflationary expectations should have pushed down long-term interest rates, even if the actual rate of inflation remained high. Instead, the ten-year bond rate jumped from 9.6 to 9.93 percent, a huge one-day increase in that maturity range.11 And it was about to get worse.
Historical precedent had encouraged Volcker to believe he could raise the federal funds rate and simultaneously decrease the ten-year bond rate. He knew that the two rates usually move in the same direction because they both represent the price of lending dollars over different time horizons—one day for the federal funds rate and about 3,650 days for the ten-year bond. But the ten-year bond rate is more complicated than the overnight rate because bond buyers have to worry about inflation eroding the value of their investment over ten years. Lenders for one day do not worry about inflation because the price level does not change that much overnight, at least not in the northern half of the Western Hemisphere.
Volcker recalled observing a dramatic shift in long-term interest rates versus short-term interest rates during 1975, before he became president of the Federal Reserve Bank of New York. The federal funds rate declined to an average of 6 percent in July 1975, down from 13 percent a year earlier, while over that same period, the ten-year government bond rate rose from an average of 7.8 percent to over 8.0 percent.12 Short-term interest rates declined because the Fed tried to cushion the emerging recession, and long-term rates rose because investors worried about the inflationary consequences of the easier monetary policy.
Volcker thought the procedures announced on Saturday evening, October 6, could work in reverse. Higher short-term rates to fight inflation and lower long-term rates because investors believed the Fed’s new look would succeed. This twist in the yield curve would have confirmed the Fed’s credibility. The market delivered a sobering message, and not just to Volcker.
The ten-year bond rate had spiked to over 10¾ percent when the FOMC gathered in the boardroom in the Fed’s headquarters on Tuesday, November 20, 1979, the first meeting since the October 6 announcement.13 John Balles, president of the Federal Reserve Bank of San Francisco, sounded befuddled: “The only bad result I see from our October 6 actions is the very sharp rise in long-term interest rates. Maybe the school of rational expectations has an answer … because I can’t get [one] from anybody else … To the extent that those rates are influenced by expectations of inflation I’m still wondering why … they went up instead of coming down.”14
During his confessional, John Balles had queried Mark Willes, seated at the long mahogany table in his capacity as president of the Federal Reserve Bank of Minneapolis, the hotbed of rational expectations thinking.15 Willes remained silent, but Balles solved the expectations puzzle himself. A decade of failed promises by the Fed to control accelerating inflation had promoted skepticism among rational bond investors. Balles urged his fellow members not “to rock the boat by any major change in the posture that we adopted … because I think we’re right in the midst of a great credibility test … Our impact on long-term interest rates and inflationary expectations … will be messed up if we don’t meet those goals that we’ve announced.”16
Volcker understood the power of credibility and had embraced monetarism to promote the cause. He had forsaken control over interest rates and adopted a “monetary targeting approach as a new … comprehensible symbol of responsible policy,” and told his colleagues on November 20, 1979, “When I appear in public or in private the first question I get is, ‘Are you going to stick with it?’”17
The question jogged Volcker’s memory of Arthur Burns’s mea culpa in Belgrade, when the former chairman lamented, “The Federal Reserve was willing to step hard on the monetary brakes at times—as in 1966, 1969, and 1974—but its restrictive stance was not maintained long enough to end inflation.”18 Volcker knew that failure to maintain monetary restraint nurtured inflationary expectations, and he pledged to avoid making the same mistake he had observed in July 1975, when the economic downturn convinced the Fed to loosen credit and allow short-term rates to decline. The error may not have been obvious back then, before the Great Inflation had gathered force, but the accompanying rise in long-term interest rates was like a darkening sky before a storm.
The history of the past decade would haunt the Federal Reserve. In the meeting, Volcker warned the FOMC that their “sticking to it” under monetary aggregate targeting, which allowed interest rates to fluctuate with supply and demand for credit, might be misinterpreted.19 “I was at a lunch yesterday where there were some presumably sophisticated people … I went through my song and dance [about how] we are going to stick with it in terms of the money supply but that doesn’t mean interest rates can’t come down. I no sooner got finished with this ten to fifteen minute discussion when … a member of the Washington economic press … says, ‘Now, what I want to know is when are you going to change policy?’ I said, ‘What do you mean by changing policy?’ He says, ‘The first time interest rates go down.’ ”
Volcker could have questioned the intelligence of all financial journalists, or just those gathered in the nation’s capital, but instead he simply raised his palms in surrender. “There we are.”
Henry Wallich had told Volcker that he would regret the day he left interest rates to their own devices, and that he would have to pay for this Faustian bargain with the monetarists. Volcker had responded, “Sometimes you have to deal with the devil.”20
The bill from below would arrive shortly.
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p; The price of gold hit an all-time high of $850 an ounce on Monday, January 21, 1980, a record that would last almost thirty years.21 International tensions in Iran and Afghanistan—it all started back then—combined with a worsening of inflation to an annual rate of 13½ percent during the last quarter of 1979, contributed to the speculative outburst.22
The more than doubling in gold prices between the November 20 FOMC meeting and the peak on January 21, 1980, created an uncommon interest in the precious metal.23 Harry Yaruss of the Rodman and Yaruss Refining Company in New Jersey said that people want to “sell their gold before someone steals it,” and Jack Brod, owner of the Empire Diamond and Gold Buying Service in New York, hired an extra security guard to control the crowd outside his sixty-sixth-floor establishment in the Empire State Building.24 Inside Brod’s office, a woman by the name of Anne Dawson exchanged several gold chains, a pin scarf, a gold locket, and a 1962 high school ring for $305. Another customer, Ernest Harvey, an employee of a textile company, offered four of his extracted teeth containing gold inlays, and walked away with $160. Jack Brod recalled, “We had a dentist come in with gold inlays and silver fillings … They were worth $3,000.”
J. Cantor Shoes in Yonkers, New York, had a small stamp and coin exchange in a corner of the shop. “Until four months ago you could sit and do nothing” in that end of the store, said the owner, Bob Cantor, “But now it’s become positively wild.”25 A Yonkers widow handed Cantor several pieces of gold jewelry and said, with a touch of sadness, “Here are my husband’s gold cuff links and tie clip. I know they are fourteen-karat gold.” A well-dressed woman in a fur hat and blue wool coat chimed in: “There’s no sense keeping old jewelry lying around in drawers. And from everything I’ve heard lately, this is the right time to sell.”
The woman in the hat was right (making berets and derbies fashionable among Wall Street forecasters). The supply of antique jewelry and old dentures overwhelmed the speculative demand for gold and contributed to a collapse in price to $500 an ounce by April 1980.26 The decline would have buoyed Volcker’s spirits, but a downward spiral in both the economy and the money supply tempered the celebration. A recession had taken hold that would test Volcker’s commitment to the monetary aggregates, just as Henry Wallich had predicted.
Volcker had come under attack from enemies and friends, and sometimes it was hard to tell them apart. Donald Regan, the head of investment giant Merrill Lynch, explained that “we talk about B.V. and A.V., Before Volcker and After Volcker,” to measure the diminished profitability of the brokerage business.27 Regan would exact some revenge after becoming treasury secretary under President Ronald Reagan. Henry Kaufman, chief economist at Salomon Brothers, bypassed Volcker’s earlier invitation to “pick up the phone every now and again,” and turned to the press to describe members of the Federal Reserve Board as “reluctant gladiators,” fearful of fighting inflation by taking decisive action to retard the growth of credit.28
Kaufman’s complaint would have surprised most Americans. The prime rate charged by commercial banks to their most creditworthy borrowers hit a record 20 percent in April 1980, making the previous peak of 12 percent during July 1974 seem like a summer romance. Arthur Okun, the former chairman of the Council of Economic Advisers under President Johnson, said a month earlier, only weeks before his untimely death at age fifty-one, that he expected to see interest rates climb to peaks that “will never be surpassed in my lifetime or the lifetime of anyone now alive.”29 Okun died before the surge, but everyone else noticed, and anger spilled into the streets.30
In mid-April, Gale Cincotta, a consumer activist from Chicago and head of the National People’s Action coalition, led a five-hundred-person protest to the Federal Reserve’s doorstep in Washington.31 Volcker met with the leaders in his office and then confronted the crowd at the C Street entrance to the Fed’s white marble building. Mrs. Cincotta repeated the main message: “We are very upset about interest rates. They are killing us.”32 A man dressed in a shark outfit stood nearby wearing a sign indicating he was a loan shark, in case anyone missed the point.33 Volcker responded with “I’m with you, but we have to lick inflation first.”34
Inflation had increased to an annual rate of 15 percent when Volcker arranged an FOMC conference call on Tuesday, May 6, 1980.35 Six weeks earlier, President Jimmy Carter had enlisted Volcker’s help in administering a program of consumer credit controls designed to curtail spending while avoiding still-higher interest rates.36
Trouble followed.
Volcker had objected to controls because he believed that temporary measures to suppress spending would not reduce underlying inflationary expectations. The wage-price freeze in August 1971 had taught a painful lesson. Nevertheless, he went along with the White House request despite his reservations. “I found it impossible to resist … the President [who] had publicly supported … our risky and unprecedented monetary policy.”37 Volcker recalled Carter’s very public response to a question of whether he would support tight money policies even if it hurt him politically: “The number one threat to our economy is inflation.”38 William Miller, Carter’s treasury secretary, confirmed the message: “The President is very supportive of these actions because he’s determined to carry on the war against inflation.”39 And Charles Schultze, the chairman of the Council of Economic Advisers, added, “The basic thrust of what the Fed did was needed.”40
Volcker felt he owed the president, but he encountered resistance from a jealous Congress always guarding its monetary powers from encroachment by the executive branch. Republican senator Jake Garn questioned the precedent when Volcker testified on credit controls before the Senate Banking Committee. “As you may remember from your confirmation hearings, I have always been very concerned about the independence of the Fed.”41
Volcker justified his pragmatic compromise with the White House while puffing like a reluctant witness on a progression of cigars.42 “In no sense have we surrendered our independence. There are probably varying views within the Federal Reserve, but our actions were taken [because] … they would provide some supplementary usefulness in terms of what we’re trying to achieve.”
Garn respected Volcker, so he let it pass. “Well, my time is up.”
Volcker escaped further public recrimination, but the economy did not. Compliance with restrictions on consumer credit curtailed spending beyond what anyone had expected.43 Chase Manhattan and Citibank announced they would not issue new Visa or MasterCards, and Bank of America suspended applications for second mortgages.44 Janice Fried, a real estate agent in Brooklyn, had borrowed the $1,500 maximum on her Citibank Ready Credit checking account to help pay for a renovation on her home. Citibank had then increased her limit to $3,500, and she used the balance to help pay for a new Peugeot. After the controls were announced, Citibank sent her a letter reducing her credit line to $500. “That really got me,” said Mrs. Fried. “They trained us one way and now they are changing the rules.”45
The imposition of credit controls cut Mrs. Fried’s checking account and her spending, and similar effects throughout the country sent the money supply and the economy into a tailspin.46 The drop in money violated Volcker’s monetarist pledge to control the monetary aggregates. He had adopted the new procedures to prevent excessive money growth from feeding inflation, and that remained the Fed’s main priority, but he had to address the flip side of the monetarist coin: avoiding anemic money growth to prevent an economic collapse. Compounding the problem, the overnight interest rate had dropped to less than 12 percent from more than 19 percent a month earlier, signaling by conventional measures that the Fed had eased policy.47 Volcker organized the FOMC telephone conference call on Tuesday, May 6, 1980, to confront the bill of particulars that Henry Wallich had warned about.
“I think we’re in danger of making a great mistake,”48 Wallich began, after hearing the plan to jump-start the money supply by expanding bank reserves, a process that would force down the federal funds rate even further. “The real policy ac
tion is on interest rates, not on the money supply. Whatever happens to the money supply over a period of a month has next to no effect on the economy. But these [lower] interest rates—not only internationally but domestically—convey an impression of a drastic shift in policy and create expectations that we’re all for inflation as soon as we work out of this difficulty.”
Lawrence Roos took the other side, reminding everyone of the monetarist compact they had signed: “I think we recognize that the most important objective of the Federal Reserve today is to restore credibility … And I know of no way to destroy that credibility more quickly than to start dancing back toward the stabilization of interest rates after … all … of us have said that we’re no longer targeting on the fed funds rate.”49
Volcker saw merit in both points of view, having kept an eye on interest rates throughout the monetarist exercise.50 He tried to mediate: “Well, I think there is some question as to how credibility gets defined in these circumstances which I suppose is what the argument is about.”51 He meant that the credibility of the Fed’s commitment to controlling the money supply clashed with its commitment to maintaining high interest rates, and both served as ammunition in battling inflation.
Nancy Teeters had been a reluctant convert to monetarism on October 6, 1979, succumbing only because the new procedures promised a swift decline in interest rates if the economy faltered.52 She chided Volcker like a Sunday school teacher. “You know, Paul, I’m a little disturbed by the fact that when [the funds rate was] going up nobody was concerned about the speed at which it went up … If we are really going to follow this policy, then we’re going to have to let the market determine how rapidly it comes down. It seems to me we should give ourselves some leeway and if we’re wrong, the market will turn the rates around and they will go back up again.”53
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