A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  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, M1B 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” (Fogerty, 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.

  The legislation created a Deposit Institutions Deregulation Committee (DIDC) charged with elimination of regulation Q ceilings within six years. The members of DIDC included supervisors of the various institutions— the FDIC, the Federal Home Loan Bank Board, and the National Credit Union Administration—and the Secretary of the Treasury. Paul Volcker became chairman of DIDC. By June 1981, DIDC agreed to a gradual phaseout schedule. In July, a court invalidated the schedule. The DIDC adopted a new schedule in March 1982.75

  The Federal Reserve had wanted compulsory membership since its inception. Marriner Eccles tried frequently to convince President Roosevelt about its importance, but he did not succeed. Most subsequent chairmen tried. As interest rates rose with inflation, the cost of membership rose and the share of member banks to total banks declined. Between 1970 and 1979, member banks’ share of banking offices fell from 71 to 60 percent (Board of Governors, 1981, 470, 488). The number of insured nonmember banks rose rapidly. The Board claimed that the relative decline in member banks made monetary policy operations more difficult, although they never presented a cogent argument to support that position, and many of their staff did not believe it.76 The more plausible but unspoken reason was the desire for political support by bankers willing to accommodate their regulator in the expectation that their requests for mergers, branches, and powers would be treated favorably.

  74. The Board gave the banks that withdrew from membership prior to July 1979 eight years to restore required reserves. Many of these banks had invested their reserves in longterm securities that had fallen in value. Institutions with 85 percent of their loans in mortgages remained exempt from the requirements.

  75. The legislation authorized the Federal Reserve to price the services it performed for banks such as check clearing, float, provision of currency, etc. The legislation raised the ceiling for deposit insurance from $40,000 to $100,000 (a source of problems later in the decade), broadened the real estate holding powers of national banks, and broadened the range of collateral that the Federal Reserve could hold behind the note issue. DIDMCA passed the House on a vote of 380 to 13 and the Senate by voice vote. The vote suggests the change in sentiment about regulation. To try to hide the failure of savings and loans, the Federal Savings and Loan Insurance Corporation encouraged institutions to include a special certificate of indebtedness among its assets. Congress did not object.

  76. “The intellectual argument within the Fed . . . was that we really don’t need these reserves to conduct monetary policy anyway. So there was discussion amongst the staff that we were peddling legislation based on a premise that none of the economists believed in” (Guenther, 2001, 31). Guenther was the Board’s assistant for political work with the Congress at the time.

  DIDMCA did not require membership, but it required financial institutions to hold reserves set by the Board. Burns tried hard to get the legislation but did not succeed because of his poor relationship with Chairman Reuss of the House Banking Committee (Guenther, 2001, 29–30).

  After a false start, Miller began negotiations with Reuss.77 The legislation passed after he moved to the Treasury, but much of the agreement came during his term at the Board.

  Although the changes permitted by DIDMCA were long delayed, the timing was far from optimal. National NOW accounts caused shifts in asset portfolios and made the monetary aggregates more difficult to interpret at a time when the Federal Reserve gave more attention to them. Additional legislation, the Garn-St. Germain Bill in 1982, induced larger additional changes.78

  The difficulties faced by thrift institutions prompted reforms. In 1979, legislation permitted thrifts to make a limited number of variable rate loans, and in 1981 Congress extended that power. Also thrifts could begin to hedge interest rate risk in the futures market. DIDMCA extended their lending powers to commercial and personal loans.79 The Garn-St. Germain Depository Institutions Act permitted savings and loan associations to issue “net worth certificates” to the regulators in exchange for promissory notes. These gave the appearance of solvency to those who did not look carefully.

  Garn-St. Germain authorized banks, saving and loans, and mutual savings banks to issue money market deposit accounts (MMDAs) beginning December 14, 1982. And DIDC authorized a super-NOW account effective January 5, 1983. Banks and thrifts could pay market interest rates on these accounts provided the account balance exceeded $2,500. For the first time, the act permitted out-of-state banks to purchase failing banks and thrifts opening the way to interstate banks.

  The response to MMDAs again changed the composition of desired financial assets and obscured the meaning of monetary aggregates. The new instruments had different properties than the old M1. Time and savings deposits and money market funds declined in the first half of 1983, and some of these accounts continued to decline. By 1983, the Federal Reserve had given up control of M1 and M2. The new accounts and uncertainty about the data became the ostensible reason for ending the experiment.80 Failure to develop successful control of the monetary aggregates and a desire to reduce market rates were at least as important. Congressional pressure seems most important.

  77. The Board’s lawyers told Chairman Miller that the System could pay interest on bank reserves. This would have reduced the exodus of members. Miller floated the idea, but Reuss threatened to start impeachment proceedings if the System did that (Guenther, 2001, 30). And the Treasury did not want to reduce the revenue it received from the Federal Reserve.

  78. Timberlake (1993, 366–70) focused attention on a little-known provision of DIDMCA that permitted the Federal Reserve to use foreign assets as collateral for Federal Reserve notes. He noted that Volcker worked determinedly to get this power after it was removed from the House bill. The conference committee reinstated the provision.

  79. DIDMCA was not a completely coherent piece of legislation. The House and Senate produced separate bills that did not mesh. The bill that passed had elements from each.

  Authority to lend to non-bank financial institutions through the discount window promptly attracted attention, especially from mutual savings banks. Most of them suffered losses because their fixed-rate mortgages yielded less than the cost of their deposit liabilities. Failing to renew deposits would force liquidation of mortgages at a loss, impairing their capital. Renewing deposits meant higher interest payments and current losses. Either way, the System’s disinflation program threatened their survival. By September 1980, about 90 percent of the New York savings banks operated at a loss.

  The Board’s position was that it was the lender of last resort. Mutual savings banks and thrifts had to exhaust all other opportunities to borrow. Saving bank representatives disputed this interpretation. At a meeting with Paul Volcker, they “argued that their access to extended credit should be on the same terms governing commercial bank access to short-term adjustment credit” (memo, Chester Feldberg, Federal Reserve Bank of New York, Box 431.2, September 24, 1980; emphasis added). The Board did not regard the discount window as a source of extended credit. Volcker told them that the Federal Reserve would hold to its traditional position. “He did not believe it was appropriate to ap
ply the same rules to users of both adjustment and extended credit” (ibid.). The intended use of adjustment credit remained temporary shortfalls.

  The mutual savings banks and thrifts could not, at first, convince the Federal Reserve, so they appealed to Congress. The result: the Federal Reserve developed a program for long-term loans to “assist depository institutions with longer-term assets when they are confronted with serious prolonged strains on their liquidity arising from an inability to sustain deposit inflows. . . . [A]ssistance for thrift institutions in these circumstances should be available for rather extended periods” (letter, Paul Volcker to Congressman Fernand St. Germain, Board Records, December 22, 1980, 2). This letter at last recognized that the System was the lender of last resort to all solvent financial institutions.

  80. M1 rose $15 billion in first quarter 1983. Almost all of the increase was in “other checkable deposits” with little change in demand deposits. MMDAs increased by $280 million (Board of Governors, 1991, 64).

  Regulation Q

  Congress had at last approved the phase-out of regulation Q ceilings and its discrimination against small savers. The Board’s actions in 1980 worked in the opposite direction, limiting competition and imposing ceilings on the interest rates paid to consumers. Money market mutual funds restricted the extent of the harm; these funds bought unregulated large certificates of deposit and paid investors competitive interest rates.

  At the start of 1981, the Board authorized banks to issue 2.5-year nonnegotiable time deposits at a rate 75 basis points (0.75 percent) below the average yield on a 2.5-year Treasury security. Thrift associations could pay one quarter percent (0.25) more than banks.