Volcker liked to doodle while listening to the discussion at the FOMC. Nothing fancy: a mindless row of triangles inside triangles that resembled a cubist’s rendition of the Grand Tetons. But on Friday morning, December 19, 1980, he stopped etching and took notes on what he was hearing.
Board member Lyle Gramley, who had spent most of his career as a Fed staffer, said, “We have adopted targets for growth of the monetary aggregates that … just don’t provide any room for real growth. And I don’t think we ought to back away from that. That’s what we’ve been trying to achieve … I’m prepared to accept a weak economy.”37
Charles Partee, who matched Gramley’s experience at the Fed, complained, “Traditionally … we wanted … to keep pressure off markets so as not to have excessive demand … It seems to me now we have gone far, far away from that. We now say … we are going to work to reduce inflation through monetary policy … In that context, I think we need to have a view of how weak an economy we are prepared [to accept].”38
Volcker saw an opportunity to turn Partee’s complaint into a new mantra for the Federal Reserve, but he waited until everyone had spoken before expressing his views.39 He then confessed his innermost thoughts in a soliloquy worthy of the lead character in a Shake-spearian drama, perhaps with the title To Be or Not to Be a Central Banker:
Partee’s point … deserves reiteration. We are in completely new territory for the Federal Reserve [and] economic policy. An implicit assumption that we are just avoiding excess demand is not the present policy. We have … taken the position … that we are going to do something about inflation maybe not regardless of the state of economic activity but certainly more than we did before … It is a very important distinction.
We obviously have a credibility problem—by “we” I mean the United States … The Federal Reserve is only part of that larger problem. But when we talk about credibility, I think far, far, too much emphasis is put on these monetary targets. When I listen to people talk about credibility and their discouragement about inflation—and they are plenty discouraged—what I hear [is] … “You brought us to the brink … and we got a little worried. [But] we have been through that kind of experience before and … it all evaporated and nothing happened” … and they said: “We shouldn’t have worried.”
Maybe I’m getting discouraged … but … when we take on this inflation fighting job—taken on by ourselves or taken on in a broader context—we should not look around for much of a constituency. If we … go to the brink or let some … things happen that we have not allowed happen during the entire postwar period, people … are not going to be very happy … And I’m not at all sure that we can change inflationary expectations without it happening. That, I think, is the nature of our problem.
I was out in Chicago yesterday and [asked a banker a question that illustrates the point.] “What do you fellows think you’re doing? You’re expanding your assets like crazy in the middle of interest rates rising; you’re eroding your capital positions; you’re getting more extended on liquidity; and you have every lending officer out there on the road.” His answer: “I sure do. If we get in trouble, the government will protect us.”
These are attitudes that go a little beyond whether we made or missed our monetary targets. In effect, one way of putting it is that they think if there’s a clash between the monetary target and a real problem in the economy, we are going to give way, whether we are inside the target or outside the target.40
Volcker ended his December rant from the heart with the usual FOMC practice of setting targets for various measures of the money supply, but that objective now took a backseat to the ultimate goal of reducing inflation. His belief that dousing inflationary expectations justified pushing the economy “to the brink” represented a break with the past. He accepted this painful objective to counteract the moral hazard problem he had described.41
Concern with moral hazard had started in the insurance business. Liberty Mutual Insurance Company, for example, worries that its automobile insurance policies make some drivers less vigilant about avoiding accidents. The company insists on a deductible in their policies so that drivers share in the damage and reduce their immoral behavior accordingly. Shakespeare’s rendition of moral hazard was more eloquent, of course. In his play Timon of Athens, he phrases a character’s support of capital punishment as a deterrent with “Nothing emboldens sin so much as mercy.”42 Shakespeare pinpoints why businessmen behave badly unless they worry about bankruptcy.
Before Volcker’s soliloquy on December 19, 1980, Lyle Gramley indicated he would tolerate “a weak economy” to bring inflation under control, but Volcker never specified how close to the edge he would go. He did not know but recognized that only a scary glimpse of the precipice would discourage inflationary behavior. He admitted to this unpopular perspective during the ABC network news program Issues and Answers.43 Interviewer Dan Cordtz said, “I don’t want to put any words in your mouth, but you seem to be saying that we really have to suffer a great deal … to get out of this.” Volcker responded, “People have to change their expectations and their behavior and that is always an uncomfortable process … we’ve got to affect people’s behavior … that we will all be better off to conduct ourselves in a non-inflationary way.”
Volcker defined the objective of price stability as “a situation in which expectations of generally rising (or falling) prices over a considerable period are not a pervasive influence on economic and financial behavior.”44 In December 1980, Americans found themselves far from that circumstance. Inflation stood at 12 percent per annum, and the economy had already recovered from the brief recession of 1980, setting the stage for another round of double-digit price increases.45 The best professional judgment among leading economists was that Americans should view the problem of inflation as being as intractable as urban graffiti.
Paul Samuelson, the MIT Nobel Prize winner, said, “In economies such as ours … the system is biased toward upward price creep.”46 Stanford University Nobel Laureate Kenneth Arrow saw “a self-perpetuating core of inflation” that would make it “very difficult to see any set of policies” to escape from it without forfeiting prosperity.47 And financial forecaster par excellence Henry Kaufman said that he had “considerable doubt” that the Fed could accomplish its ultimate objective, which is to tame inflation.48 He added for good measure that the Fed no longer had “credibility in the real world.”
But the marketplace supplied a glimmer of hope.
Volcker met Ronald Reagan on Friday, January 23, 1981, three days after the inauguration. Martin Anderson, the president’s assistant for policy development, had suggested to Volcker that the president visit him at Federal Reserve headquarters on Constitution Avenue.49 Volcker rejected that friendly gesture because it was too friendly. “I might have been overly sensitive about keeping the president out of the Federal Reserve building because of my earlier conversation with Arthur Burns, but it would have been unprecedented for a sitting president to visit the Fed chairman. The normal protocol was for me to pay a courtesy call at the Oval Office, but that was not what they wanted.”50 Instead, Anderson scheduled a lunch meeting for Volcker and the president on neutral ground, at the U.S. Treasury.
Volcker reviewed the disappointing record on inflation before he arrived at the meeting. Consumer prices had increased at an annual rate of over 12 percent during 1980, a decline from the more than 13 percent rate of 1979, but an embarrassing record for his first calendar year as chairman.51 However, two of Volcker’s favorite psychological indicators, gold and the dollar, offered some hope.
Gold had declined steadily after the discount rate move on September 25, 1980, dropping by 17 percent by the end of the year, to $589 an ounce, compared with $711 on the day before the rate increase. The dollar rose by 10 percent against the German mark over the same period, ending the year worth 1.97 marks per dollar, compared with 1.79 on September 24, 1980. Volcker had been especially pleased when the dollar hit 2.00 marks during mid-De
cember, recalling Chancellor Helmut Schmidt’s plea for stability at that level during his harangue against America’s weak currency before the Belgrade meetings. Volcker had checked earlier in the day on January 23, and the dollar was worth 2.02 marks.
The jump in the federal funds rate engineered by the FOMC during the last three months of 1980 had gained a measure of credibility for the central bank among international investors. In Volcker’s mind, these favorable votes in the marketplace counted far more than the negative newspaper quotes of economists. But the increase in the ten-year government bond rate to almost 12½ percent, a jump of three-quarters of a percentage point over the same period, tarnished the glow.52 Evidently America’s bond investors remained more skeptical of the Federal Reserve’s resolve than the international set—unless something else worried them more.
The president sat at the head of the table in the wood-paneled conference room pressed into service for the lunch. Volcker sat to Reagan’s left, and Donald Regan, the secretary of the treasury, on the right. Volcker had already met Regan, a former chairman of brokerage giant Merrill Lynch, and knew other members of the president’s economic entourage, including Murray Weidenbaum, chairman of the Council of Economic Advisers, who had worked for Volcker in the Nixon Treasury; David Stockman, a thirty-four-year-old former congressman who had been appointed budget director; and Martin Anderson, who had brokered the meeting. The president knew exactly where to begin.53
“You know,” said Reagan, “I was very pleased to read a prediction that the price of gold will nosedive below three hundred dollars an ounce. If that’s true, it would mean we’ve made great strides against inflation.”
“I could not agree with you more, Mr. President. In fact we’re well below the peak price of $850 an ounce of last January.”
“Well, I expect we’ll make even more progress going forward.”
The clutch of reporters and photographers was then ushered from the room, and the president continued: “But I do have a question that I’d like you to help me with.”
“If I can.”
“I’ve had several letters from people who raise the question of why we need the Federal Reserve. What do you suggest I say to them?”
Volcker suppressed a smile and would later thank Arthur Burns for the early warning. “Mr. President, there have been concerns along those lines, but I think you can make a strong case that we’ve operated quite well. Unfortunately, we are the only game in town right now fighting inflation … and I’m just quoting the treasury secretary. Once the budget gets under control we’ll have a better shot at taking the pressure off prices.”
Donald Regan nodded. He had gone on record saying, “When this administration takes over we’ll … deal with inflation in several ways at once rather than just one way.”54
They failed to deliver.
12. The Only Game in Town
Ronald Reagan, wearing a dark blue suit and blue-and-red tie, stood behind a lectern embossed with the presidential seal on Tuesday, January 19, 1982, the eve of his first anniversary in office.1 The news conference would highlight the performance of the U.S. economy during the past year, with Paul Volcker center stage. Reagan had complaints about both topics.
Congress had passed the president’s key legislative initiative during the summer of 1981, a tax-reduction bill sponsored by Representative Jack Kemp and Senator William Roth, which reduced the top personal income tax rate from 70 percent to 50 percent, among other changes.2 The rise in inflation during the 1970s had pushed up both wages and prices, leaving many middle-income Americans in higher tax brackets. The legislated decline in marginal rates, a centerpiece of Reaganomics designed to stimulate economic incentives, was long overdue. But a recession had begun about midyear that brought bad news. The unemployment rate had increased to 8.6 percent when the president addressed reporters in the White House Press Briefing Room, compared with a rate of 7.5 percent a year earlier, an increase of more than one million people without work.3
Progress on inflation, which had dropped substantially compared with a year earlier, was overshadowed in the president’s mind by the failure of interest rates to decline.4 High borrowing costs would impair the road to economic recovery. Reagan had written in his diary, “[I] dropped in on a meeting of [my] economic advisors— a roomful of our country’s greatest economists. None of them could explain why interest rates are so high.”5 President Reagan was not the only politician to complain. West German chancellor Helmut Schmidt said that real interest rates were at their highest levels “since the birth of Jesus Christ.”6
The ten-year government bond rate had increased to more than 14 percent when the president held his anniversary meeting with the press, an increase of more than two percentage points compared with when he took office.7 Two percentage points may not sound like much, but the jump in mortgage rates, which move in tandem with the Treasury bond rate, would raise the annual payments on a $100,000 twenty-year mortgage by more than $1,700.8 Volcker had promised that interest rates would drop after inflation declined. So far the reverse had occurred.
Helen Thomas, the dean of the White House Press Corps, began the questioning by lamenting the plight of the jobless, and other reporters followed with questions about sanctions against Russia and relations with the press. Reagan managed to avoid controversy, until a reporter asked, “Would you agree with those people on Capitol Hill who have called for Mr. Volcker’s resignation?” The president said, “Well, I can’t respond to that because the Federal Reserve System is autonomous … the members of that commission are term employees, they’re not serving at anyone’s pleasure … there’s no way that I can comment on that.”9
Reagan’s modesty, which he wore so well, belonged in the closet with his old cowboy hats. Volcker’s term as Federal Reserve chairman would expire in eighteen months, and Reagan would then have the pleasure of designating a new chairman. The president’s “no comment” response in January 1982 compared favorably with Congressman Henry Gonzalez’s earlier threat to impeach Volcker, but not by much. Gonzalez, a Democrat from Texas, had accused Volcker of “legalized usury beyond any kind of conscionable limit.”10 The congressman showed it was nothing personal by introducing two bills of impeachment, one for Volcker and the other for the rest of the Federal Open Market Committee.11
Soon after Gonzalez’s attack, Reagan had told a California audience, “The Fed is independent, and they are hurting us, and what we’re trying to do, as much as they’re hurting everyone else.”12 The White House rushed to explain that “they” referred to high interest rates and not the Fed itself, but that made Reagan sound like Jimmy Carter, who respected Paul Volcker but not his policy of high interest rates.
Reagan should have looked in the mirror for the scapegoat.
The mystery of high long-term interest rates in January 1982 begins with the remarkable drop in the rate of inflation during the immediately preceding three months compared with a year earlier. Inflation measured 4 percent per annum in the most recent quarter, versus 12 percent in the earlier period.13 And the Survey of Professional Forecasters reported a decline in expected inflation as well.14 The drop in inflationary expectations should have reduced long-term interest rates. Lenders prefer higher interest rates, of course, but competition whittles away the premium whether they like it or not. The ten-year bond rate should have mimicked the direction of the federal funds rate, which dropped from 20 percent to 12 percent during the year. Instead, the bond rate went its own way, rising from 12 to 14 percent.
The expected jump in the federal deficit following the 1981 tax cut could have caused the high long-term interest rates in January 1982. An increase in government borrowing to cover the revenue shortfall from the tax cut would drive up interest rates. And the structural budget deficit as a fraction of economic activity, in fact, almost doubled in the years after the tax legislation compared with earlier.15 But Treasury Secretary Donald Regan dismissed any connection between federal deficits and interest rates.
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p; In the beginning of 1982 Regan testified before the Senate Finance Committee, “There has been considerable concern that our projected deficits will put extreme pressure on credit markets and thus drive up interest rates. However … the historical record shows no such direct association of deficits and interest rates.”16 Instead, he shifted the blame for high interest rates to money creation by the Federal Reserve. “Interest rates are determined by the real rate of return on capital, the expected inflation rate and a premium for risk. Although deficits could conceivably influence expected inflation and risk, this would not happen … unless they were accompanied by excessive money creation.”
Allan Meltzer, the prominent monetarist from Carnegie Mellon University, confirmed Regan’s indictment of monetary policy. He had said during the summer of 1981 that bond rates would remain high as long as there was “skepticism about the rate of inflation and whether it is going to be reduced permanently.”17 In February 1982, Meltzer wore a bow tie and a friendly smile while testifying before the Senate Finance Committee, and gave Volcker a failing grade:
I enjoy hearing Mr. Volcker speak. I enjoy reading his statements. I agree with most of what he says but with little of what he does … While he has been making clear and definite statements about the need and the desirability of slow money growth … neither he nor previous Federal Reserve chairmen have remained within their target bands … And Mr. Volcker’s experience … in the last two years … [is] even worse. Not only is money growth highly uncertain, it is highly volatile … Is it any wonder that there is uncertainty in the financial markets? … The risk premium in the United States is extremely high … because one cannot be certain from the experience of any three-month period what the growth rate of the money stock will be in the next three-month period or for the year.18
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