Not much could be learned and, despite an intense effort, not much was. One general conclusion was that money had been more variable than in the past but “generally well within the range of foreign experience” (“Overview of Findings and Evaluation,” Study of New Monetary Control Procedure, microfilm, Federal Reserve Bank of New York, January 22, 1981, 5). Interest rates were more variable on all securities. The staff estimated that the variability in Treasury bill yields doubled, measured on weekly average (ibid., 8).
Increased variability of both money and interest rates suggests inefficiency. The report suggested some improvements in operating procedures, including use of contemporary instead of lagged reserve requirement ratios and changes in rules for discounting.87
Although the desk intervened in the foreign exchange market frequently, the staff study found no evidence that “changes in spot exchange rate variability were affected much by changes in intervention” (ibid., 11). The study also found that the new operating procedures did not pose “significant policy problems for other industrial countries, except perhaps for Canada and more recently Germany” (ibid., 12).88
87. A 1976 staff study recommended “moving to a contemporaneous reserve system” (Burns papers, Box B_B77, April 13, 2). The study recognized that bank objections were the main impediment. A 1977 study reached a similar conclusion but added that the change to contemporaneous reserve accounting would be mainly a short-term benefit (ibid., August 30, 1977). Both studies assumed reserve control in place of interest rate control.
The principal conclusion from the studies was that “a monetary targeting procedure is an effective means of communicating to the public the Federal Reserve’s objectives for monetary policy” (ibid., 16). However, the relation of monetary aggregates to economic activity is loose. “Unexpected shifts” lead to “undesirable interest rate movements” (ibid., 16). Furthermore, the report concluded that precise monthly control of money “does not seem possible” (ibid., 20).
Turning to operating procedures, the report recognized the difficulty of forecasting borrowing and the consequent slippage in monetary control. It considered, and rejected, several changes in regulation of the discount window. The report dismissed the frequent criticisms of failure to tie the discount rates to market rates. It said doing so would limit flexibility and “raises the danger of upward or downward ratcheting of market rates in the short-run that may be excessive for monetary control needs and unduly disturbing to the functioning of markets” (ibid., 26). This was a familiar System argument; it assumed a highly inelastic demand by banks for loans from reserve banks. Elsewhere, when useful, the System reverted to the argument that borrowing was restrictive because banks were reluctant to borrow. Discussion of borrowing is the weakest part of the report.
The staff report noted, again, that the System could “ strengthen the link between required reserves and deposits” by shifting to contemporary reserve accounting. “That advantage has to be weighed against the benefits . . . for reserve management by the banks” (ibid., 27). This very clearly compares the private cost to banks to the social cost to the economy.
One of the principal background studies by David Lindsey found that use of the monetary base net of borrowed reserves as the target in place of nonborrowed reserves would improve control. The FOMC ignored this finding and made no changes in reserve requirement or discount lending procedures to improve control. Chairman Volcker must have been relieved to learn that, under the new procedure, the money stock was not much more erratic, measured weekly or monthly, than before.
88. The reference to Germany differs from the recollection of Dr. Otmar Issing, then on the staff of the Bundesbank. Issing (2005) ignores the short-term fluctuations in the exchange rate that the report discusses and concentrates on the Bundesbank’s successful implementation of a medium-term strategy based on monetary targeting. Rich (2005) argues that, despite a floating exchange rate, the Swiss National Bank had difficulty controlling inflation until the Federal Reserve adopted monetary control to reduce inflation.
A review of the report concluded also that short-run control of monetary aggregates could not be tight, but “the results suggest that nonborrowed reserves and the nonborrowed monetary base are the preferred targets— distinctly superior to either total reserves or the total monetary base” (Goldfeld, 1982, 151).89
Issues about monetary control received attention in a debate between Federal Reserve’s senior staff and members of the Shadow Open Market Committee held at Ohio State University. Robert Rasche proposed a procedure for forecasting the money multiplier connecting the monetary base to the M1B money stock. Errors in his forecasts of the money multiplier one month ahead were uncorrelated, so he was able to conclude that the “multiplier can be forecast with sufficient accuracy so that the growth rate of M1B can be maintained within a range of plus or minus 1 percent on an annual average basis” (Rasche in Axilrod et al., 1982, 123). Spokesmen for the Federal Reserve agreed that control could be improved. They did not explain why the Federal Reserve avoided the necessary changes. They had the difficult problem of defending procedures that internal memos now show that they opposed.
Volcker summarized his conclusion. “We get just as good control, according to all these studies, by manipulating the federal funds rate. The operative question is whether we are willing to manipulate the federal funds rate in that way. I think that the main reason we went to another technique is that we probably are not” (FOMC Minutes, February 2, 1981, 31; emphasis added). This is, of course, correct up to a point. If the Federal Reserve moved the interest rate target “appropriately,” it could achieve control. It left open how it decided when and how much to move the rate. Tieing the discount rate to market rates “would have an explosive short-term situation either up or down that I find impossible to contemplate. The present situation is awkward and is imposed upon us partly, but not entirely, by lagged reserve accounting” (ibid., 38).
About the only decision reached was to adjust the nonborrowed reserve path more rapidly, but nothing more precise was said. As in other discussions, proponents of contemporary reserve accounting made their case but did not change Volcker’s views. Often he dismissed their proposals by saying “I wish I thought it worked that way” (ibid., 60).
Missing from the discussion was careful consideration of the horizon over which the FOMC’s decisions had their main effects. Both the staff report and the FOMC recognized that most of the data they watched were subject to relatively large random errors, but they did not ask: Why pay attention or respond to these noisy short-term data? Why not set a path and adhere to it until it was clearly wrong? Also, changes could be persistent or transitory. There was no way to distinguish promptly which type of change had occurred. Muth (1960) showed that gradual adjustment was the optimal response in the presence of a mix of persistent and transitory changes. The speed of response depended on the relative size of permanent and transitory variances. Further, some of the changes to which they responded were self-reversing. By responding promptly, their actions could increase variability.
89. Much later, a series of papers on targets and indicators of monetary policy concluded again that short-run control was subject to large errors, mostly random. It showed that all monetary aggregates experienced a large, sharp break in trend growth during the disinflation after 1979. Davis (1990, 75) attributed the break in base velocity growth to the decline in expected inflation.
A considerable part of the discussion concerned the perceived credibility of announcements. The best way to increase credibility was to announce what the System intended to do and then do it. Although Henry Wallich, especially, urged the FOMC to announce its decisions as the Bundesbank did, the chairman would not consider it. It took almost fifteen more years before the FOMC announced its planned action directly following its meeting.
A large literature considered the new procedures, particularly the positive response of interest rates at different maturities to growth of money above the tar
get or more than anticipated. One study that supported earlier findings found that: (1) unanticipated money growth raised interest rates, especially short-term rates, because markets expected the FOMC to remove some of the excess; and (2) for longer-term rates, the main explanation of the rise was an increase in expected inflation. The market anticipated that some of the unanticipated money growth would remain and that inflation would increase. If correct, this suggests the difficulty the FOMC faced trying to increase credibility and lower expected inflation if it continued its operating procedures.
POLICY ACTIONS IN 1981–82
Contrary to the original staff forecasts, the economy continued to expand in the new year, and inflation remained high. By late February, the staff forecast for nominal GNP growth rose to 15 percent growth at annual rates in the first quarter.90 Growth of the monetary aggregates gave different signals. M2 growth exceeded its target; M1 growth remained below. In late March, the FOMC adjusted the borrowing assumption to slow reserve growth, citing M 2 , and it permitted the federal funds rate to remain below the 15 percent lower band previously set. Monetary base growth remained variable but slowed on average. Between January and March, the federal funds rate fell from 19 to 14.7 percent.
90. The new administration’s forecast created an internal dispute. The supply-siders wanted to forecast a strong response of output to the proposed tax rate reduction. They proposed continued monetary growth to support their forecast. Monetarists wanted slower monetary growth to reduce inflation. The compromise was to let velocity growth increase at an improbable rate (Jordan, 2002, 8).
Most FOMC members did not want to repeat the sharp drop in interest rates in 1980, but some were more concerned by the slower growth of the narrow monetary aggregates. Volcker preferred to let the funds rate decline, and that is what they did. Roos (St. Louis) dissented. The decline proved temporary, and contrary to their tradition they soon reversed their action. By May, the FOMC had a prescribed range of 18 to 22 percent for the federal funds rate, and in June the monthly average rate was again above 19 percent, the highest recorded before or since.
The Board was reluctant to increase the discount rate during the winter of 1981. In January it rejected a request from St. Louis for a 14 percent rate when the federal funds rate averaged 19.1 percent. The Board cited the start of a decline in market rates. By April the funds rate had declined to a 15.7 percent average. The Board rejected requests for a reduction in the surcharge because it did not want the reduction to be misinterpreted as easing policy.
The monetarists in the administration watched the very large changes in money growth during the winter and early spring of 1981. They interpreted the changes as evidence that the Federal Reserve chose to undercut the president’s program. President Reagan met with Volcker to urge a more consistent policy. No explicit agreement resulted, but Volcker must have left the meeting assured that the president supported disinflation.91
Early in May, the Board approved an increase in the basic discount rate to 14 percent and an increase in the surcharge from 3 to 4 percent. By this time, the funds rate had increased to more than 18 percent. The Board declined subsequent requests for a 15 percent discount rate. Table 8.6 shows these data.
Judged by either the federal funds rate or growth of the real value of the monetary base (Chart 8.5 above), policy tightened sharply in the spring of 1981. By increasing interest rates in the middle of a recession, the FOMC increased its credibility. This was clearly a change in practice. Never before had the public seen an increase in interest rates with the unemployment rate at 7.5 percent. The first signs of possible success appeared. The twelvemonth average increase in consumer prices slowed to less than 10 percent for the first time in two years. Volatile monthly rates of increase declined as low as 7.7 percent in April. Second-quarter expected inflation for the next year fell to 8.7 percent.
91. Jerry Jordan, a member of the Council of Economic Advisers, recalls one discussion between Volcker and President Reagan. “The Treasury supply-siders were screaming in the press about the Federal Reserve undercutting the President. Volcker asked me whether the administration was ready to . . . formally ask him to ease up. I said no, keep at it. He was asked to a private meeting in the White House. President Reagan showed him a chart I had made of money growth and asked Volcker to explain it. Volcker was impressed that the president understood that inflation could not come down until money growth did, and he felt that the president had implied (or said) to stay with it” (Jordan, 2005).
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.92 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 severe 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 1
937–38 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.93
Growth of the monetary base and the federal funds rate moved over wide ranges in 1981, but both trended down. By December 1981, twelvemonth 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.
A History of the Federal Reserve, Volume 2 Page 57