A History of the Federal Reserve, Volume 2
Page 58
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.).94
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 Reserve 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).95
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.96 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 statements 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.
The press and many commentators dismissed the administration forecasts as a rosy scenario. They failed to notice, or comment, that it did not differ greatly from the FOMC consensus. Looking back, it was not wildly inaccurate; it overestimated both inflation and growth. Inflation fell more than projected, and the average unemployment rate in fourth quarter 1981 reached 8.2 percent, 0.5 above the administration’s projection.
At the Humphrey-Hawkins hearings and on many other occasions, Volcker supported the administration’s tax cuts, but he always warned that their proper size depended on willingness to reduce non-defense spending. Growth of non-defense spending slowed, but defense spending and total outlays increased more. The budget deficit rose above $200 billion in fiscal year 1983. The many who argued that a large deficit would prevent a reduction in inflation or raise interest rates were proved wrong. Foreigners financed a large part of the increased budget deficit. And they continued to do so driven in part by an unwillingness to reduce exports to the United States by permitting their currencies to appreciate against the dollar and in part by the expected return on dollar assets.
Volcker also used the hearing to tell Congress about the staff study of the new control procedures. He blamed the imposition and removal of credit controls for the increased variability of both money and interest rates in 1980. “There was little evidence that alternative operating techniques would improve short-run monetary control” (ibid., 14).
A later study, Gilbert (1994), concluded that the Federal Reserve did not follow its announced procedures consistently. At times, it moved aggressively to adjust its path to achieve its monetary targets, but it did not always do so. Cook and Hahn (1987) reached a similar conclusion. They found that the Federal Reserve frequently returned to interest rate control.
The Federal Reserve found policy discussions with the new administration difficult. “The supply-siders were fighting with the monetarists, and the monetarists were fighting with the Federal Reserve. President Reagan did not understand this area. Once in a while, I was asked to go see him. He would drift off into some Irish jokes” (Volcker, 2001). A more charitable interpretation was that the president accepted the general thrust of Federal Reserve policy and paid little attention to squabbles about policy.
At regular meetings of the Council of Economic Advisers and the Board of Governors, “there was very little discussion of anything of substance” (Jordan, 2002, 3). “It was a tense atmosphere not especially friendly. . . . Occasionally we met jointly with them and with the Treasury staff and Undersecretary Sprinkel and Assistant Secretary [Craig] Roberts which made it a lot more strained” (ibid., 1).97 President Reagan creat
ed a Presidential Economic Policy Advisory Board (PEPAB) of outsiders to counsel on policy. PEPAB, headed by George Shultz before he became secretary of state and later by Walter Wriston, met about four times a year with the president.98 In 1981, probably in the fall, several members of PEPAB urged the president to persuade Volcker to ease monetary policy and reduce the risk of recession during the 1982 election year. President Reagan rejected that advice. Uncharacteristically, he criticized specific individuals, Arthur Burns, Paul McCracken, and Herbert Stein, for easy money during the 1972 election year under cover of price and wage controls. This made a post-election recession unavoidable. “He said he would not do something to help the chances of Republicans in Congress in 1982 only to have to see the need for restrictive policies afterwards” (Jordan, 2005). At a cabinet meeting about the same time, some cabinet members urged more expansive policies, but the president opposed.99
From its low point in July 1980, the index of weighted average exchange value for the dollar rose to a peak in February 1985. The increase on the July 1980 base was 87 percent. Despite the recession in 1981, the index advanced 17 percent. Table 8.9 shows the index value in January and July for 1980 to 1985.100 The real exchange rate rose also but much less. The evidence (Meltzer, 1993) suggests that disinflation and rearmament adequately account for the very strong appreciation of the real trade-weighted dollar from 1980 to 1985 and its subsequent depreciation from 1986 to 1988.
97. I asked Jordan explicitly whether the conflicts between the anti-inflationists and the tax cutters affected President Reagan. “I’m sure it had no effect on him whatsoever. The key elements of what he wanted to do, eliminate inflation and cut tax rates, were in stone as far as he was concerned” (Jordan, 2002, 5). Donald Kohn recalled relationships during the period. Volcker and Treasury Secretary Don Regan did not get along. At meetings, Volcker and Undersecretary Sprinkel discussed fishing, then ignored each other.
98. Most of the members had served in an economic post in a previous Republican administration, but Milton Friedman and Walter Wriston were exceptions. Later, I became a member, but I was not present at the meeting discussed in the text.
99. As part of the budget process, the administration had to produce a forecast of inflation. To make the deficit smaller, James Baker and David Stockman “raised the inflation numbers so they could show more revenue and smaller deficits. Sprinkel, [Lawrence] Kudlow, and I were told by Baker to stay silent” (Jordan, 2005). The supply-siders’ concern was that an admission of the true deficit would prevent Congress from approving the tax cut. In fact, Congress increased the size of the tax cut substantially and indexed personal income tax rates to inflation. The tax bill passed the House by 238 to 195, a comfortable margin, and received only 11 negative votes in the Senate.
100. Meltzer (1993) estimated equations for the level and changes in the trade-weighted real exchange rate based on Friedman (1953) using annual data for 1962–91 and 1972–91. The estimates suggest that the principal determinants of both levels and changes were the lagged value of the real exchange rate, real money balances, and real government debt (or changes in these variables in the equation for changes).
Despite the appreciation of the dollar and the rise in oil prices, the United States’ current account moved from deficit to surplus. Foreign governments, especially in Europe, complained about the level of U.S. interest rates and dollar appreciation. Since the market quoted oil in dollars, appreciation of the dollar raised the cost to non-dollar countries (Solomon, 1982,357).
The European response was to establish the European Monetary System (EMS) in 1979. The Bundesbank accepted the new obligations for currency market intervention without abandoning its system of monetary targets. It became the dominant European central bank, and the mark became the anchor currency in the European Monetary System (Baltensperger, 1999, 440).
Faced with a choice between stability of the external and internal value of money, the Bundesbank chose to limit domestic inflation. Between 1978 and 1982, consumer prices in Germany rose by 23 percent; this was half the rate in the United States. Despite Germany’s superior control of inflation, however, the dollar appreciated. The Bundesbank did not attempt to prevent currency depreciation although its restrictive monetary policy worked to strengthen the mark against the principal European currencies. Between 1979 and 1981, the Bundesbank raised Germany’s money market interest rate from 3 to 12 percent and reduced its monetary target. Its control of money was superior to Federal Reserve control but not so restrictive as to prevent all inflation.
In July, Volcker testified to the Joint Economic Committee on the international effects of disinflation in the United States. As always, he emphasized the importance of ending inflation and reminded the committee that market interest rates would not decline until inflation and expected inflation declined permanently. Again, he insisted that the market, not the Federal Reserve, set the interest rate and that slower money growth was necessary to ensure lower inflation and interest rates.
Foreign central bankers, he said, did not question the necessity of reducing U.S. inflation. He insisted that the Federal Reserve did not have an exchange rate policy. The market set the exchange rate, not the Federal Reserve (Volcker papers, Board of Governors, July 15, 1981).
Volcker did not express concern about dollar appreciation, but he also did not go as far as the administration, which cited appreciation as evidence of success. The demand for dollars rose, they said, because markets expected its policies to work. Instead of complaining about job losses, they boasted about the capital inflow and foreign investment in the United States.
At the July meeting, President Anthony Solomon (New York) seemed to urge the Federal Reserve to intervene jointly with the Bundesbank to weaken the dollar. This set off a general discussion of the exchange rate and the response to intervention. Governor Wallich asked whether intervention would affect the exchange rate. Solomon gave a hedged response: “If we had consistent and cooperative intervention both by the Bundesbank and ourselves, yes, they [exchange rates] would be significantly lower because the foreign exchange market would be influenced by that to some degree. And so maybe would corporations. . . . If the psychology is not handled in such a way that the psychology of the traders is influenced by our cooperative intervention, then it’s self-defeating” (FOMC Minutes, July 6, 1981, 8). But Solomon never mentioned whether intervention was sterilized or unsterilized. He emphasized cooperative action with the Bundesbank.101
Lyle Gramley and Gerald Corrigan supported Solomon, but Volcker again was skeptical about prospects for joint intervention. Solomon replied that the German government favored joint intervention, but the Bundesbank opposed. Reflecting the Treasury’s opposition, Gramley asked, “Does it make any difference what we think?” (ibid., 12). Volcker replied, “Of course, we have independent powers. We endeavor to cooperate internally as well as externally” (ibid., 12). Apparently, he believed that the Federal Reserve could pursue its own exchange rate policy, but he was not prepared to do so without strong support from the FOMC. As Wallich put it, the case for intervention depended on shifting the exchange market demand or supply curves by changing psychology, and he did not expect that to happen (ibid., 13).102 The Board expressed its concern about the effect of United States’ interest rates on foreign countries (Board Minutes, July 14, 1981, 2). Usually the Treasury initiated intervention, and the Federal Reserve sterilized the monetary effect. At the time the Treasury opposed intervention.103
101. Sterilized intervention does not change the monetary base. It substitutes domestic assets for foreign exchange or conversely. The only economic effect is a change in the risk position of the market and the central bank reflecting any differences in risk of domestic and foreign assets. This effect would be very small for countries with large stocks of debt and money outstanding. Unsterilized intervention would change the exchange rate if, and only if, it was perceived as a policy change. If it provided or withdrew reserves as expected, it could change the compos
ition of the monetary base without changing its expected value. See Broaddus and Goodfriend (1996) for a review of the literature and implications for monetary policy. Hutchinson (2003) claims evidence that sterilized intervention has a small, most likely temporary effect on the exchange rate.
The FOMC remained divided in 1981. Members expressed more concern about reliance on the monetary aggregates, especially M1, because of institutional changes. Volcker expressed doubts about data accuracy, but he would not change procedures or give up the anti-inflation policy. As the economy returned to recession, Governors Teeters and Partee favored less restraint, but the FOMC continued to vote for monetary restraint and lower inflation. This was a turning point. With the unemployment rate approaching 8 percent in the fall of 1981, the Federal Reserve did not ease. Nothing like that had happened in the postwar years. Market participants and the public recognized the change. Expected inflation rates began to decline slowly. The peak in expected four-quarter inflation shown by the SPF index, 9.4 percent in fourth quarter 1980, fell to 7.5 percent in fourth quarter 1981. A year later, it was 5.6 percent.
At the nine meetings, including inter-meeting telephone conferences in 1981, the minutes record ten dissents, five in favor of less restriction (mainly Teeters and Partee) and four in favor of more (mainly Wallich).104 The directives continued to specify targets for money growth usually with a six percentage point band on the federal funds rate.