A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  10. “Too big to fail” means that the consequence of failure by a “large” bank could not be accepted, so the Federal Reserve, the FDIC, or the government had to arrange financing to sustain the bank. Large was not defined. “Too big to fail” encouraged banks to expand their size. It violated Bagehot’s well-established principle that an insolvent bank should be allowed to fail and policy agencies should confine their efforts to preventing secondary consequences in markets. The problem was that regulators preferred to use public money rather than accept the risk of (usually unspecified) disastrous consequences, if failure occurred. Failure did not require that the bank disappear; bank equity had to pay for losses, and bank management had to be replaced. Later, Congress restricted lending to weak and failing institutions.

  On March 27, Paul Volcker testified on legislation under consideration in the Senate. He divided his testimony into five sections: (1) new definition of a bank, (2) definition of a qualified thrift, (3) procedures to streamline holding company applications, (4) powers of holding companies, and (5) statutory guidelines governing division of authority between state and federal government.

  Volcker expressed concern about growth in the size and number of “nonbank banks” that took deposits but did not offer loans.11 He had proposed earlier that a bank was an entity eligible for FDIC insurance that took deposits and made loans. He now excluded (1) industrial banks that were not federally insured and did not offer deposit accounts with checking privileges, (2) state-chartered thrift institutions, and (3) non–federally insured thrifts and industrial banks that would not be covered by the Bank Holding Company Act (Paul A. Volcker statement, Banking Legislation, Federal Reserve Bank of New York, Box 97645, March 27, 1984, 5–6). He proposed that consumer banks should be included with other banks and that securities companies and others be required to divest non-bank banks.

  The main concern about the regulation of thrifts was to regulate thrifts that engaged in banking activities as if they came under the Bank Holding Company Act. These were “qualified thrifts.” Thrifts that engaged entirely or mainly in mortgage lending would be exempt from banking rules. Volcker proposed 65 percent of the portfolio in mortgages as the cutoff.

  Volcker favored extension of holding company powers to permit holding companies to sponsor and distribute mutual funds, underwrite and distribute revenue bonds and mortgage backed securities, engage in real estate and insurance brokerage, own thrift institutions, and offer other financial services (ibid., 14). Congress considered these additional powers in the legislation before the Senate.

  Beginning in 1982 the Federal Reserve began to permit banks to invest across state lines. Congress was not willing to permit interstate banking or able to resolve conflicts between banks, investment banks, and insurance companies. Solvent existing banks were a principal source of capital, so the rules changed to permit acquisition of troubled banks by out-of-state banks. Resolving conflicts between banks and others and legislation to permit interstate banking came in 1994. The Depository Institutions Act of 1982 permitted adjustable rate mortgages and eliminated interest rate ceilings for savings and loans.

  11. Sears Roebuck and other retailers started to take deposits in the 1980s. The Federal Reserve disliked unregulated competition.

  Reform of regulation faced two major obstacles. Institutions and their trade associations supported regulations that favored them or put their competitors at a disadvantage. They fought to keep their advantages. Although the history of regulation showed that regulation often stimulated innovation to circumvent a regulation, regulators (usually lawyers) preferred prohibition to incentives as a regulatory procedure. Eventually, Congress adopted rules, such as structured early intervention, that increased incentives for prudent behavior.12

  POLICY ACTIONS IN 1984

  Inflation continued to slow in 1984 and the unemployment rate fell a bit. It remained below the expected value. Real growth slowed markedly. Table 9.2 shows the principal measures for 1984. The twelve-month average of monetary base growth ending in December slowed steadily from 10 to 6.8 percent. Ten-year Treasury yields ranged between 12 and 14 percent until the fourth quarter. By December the ten-year rate reached 11.4 percent. Using these data, the real yield remained at an extraordinary 7 percent or higher during the year.13

  The Federal Reserve raised the federal funds rate from 9.6 in January to a local peak of 11.6 percent in August. By December the funds rate was back to 8.4 percent, an unusual reversal in a short period. Member bank borrowing followed a similar path, rising until August, then falling. Borrowing reached more than $7 billion in August, much of it lent to Continental Illinois Bank as extended borrowing to prevent failure. The FOMC excluded extended borrowing from the measure it monitored.

  The Board approved an increase in the discount rate to 9 percent at seven banks on April 6 to more closely align discount and market rates and to reduce borrowing. This was the first change since 1982. It came after the Board dismissed two earlier requests in March and early April and two proposed reductions in January. Between April 6 and September 17, the Board dismissed or deferred fourteen requests for an increase in the discount rate to 9.5 percent. Beginning November 13, it received requests for reductions to 8.5 percent. It accepted a decrease on November 21. It approved a second decrease to 8.25 percent on December 21. The discount rate lagged behind market rates throughout the year. The Board changed the rate to align it more closely with market rates. This required a change in the level of the borrowing target; otherwise, borrowing was not expected to change.

  12. Benston (1997) is a thorough discussion of reasons for financial regulation and a proposal calling for increased use of incentives.

  13. The Bureau of Labor Statistics revised computation of the CPI by replacing measures of rental cost by measures of “rental equivalency.” This raised reported CPI growth.

  Much of the discussion in the first six months of 1984 repeated 1983. The members distinguished “flexibility” and “automaticity.” Flexibility meant discretion. The FOMC permitted Volcker to modify its instructions when he thought he should. Sometimes, but not always, the FOMC had a telephone conference. A minority opposed substantial discretion and urged automaticity—hitting the agreed target, especially the money growth target.

  Volcker and the staff included in the directive three money growth rates—M 1, M2, and M3—a borrowing objective, and a range for the federal funds rate. Modest efforts to relate borrowing and the federal funds rate target did not succeed very well. Volcker and the desk concentrated on different targets at different times. This also gave Volcker considerable discretion. The FOMC members did not agree on whether they faced higher inflation, recession, or both in the near-term. Also, bank failures and financial fragility made most members hesitant to propose major changes. Some expressed concern about the effects of higher interest rates on emerging market debtors and therefore on lending banks in the United States.

  Volcker expressed his uncertainty frequently. For example, at the May meeting, he said:

  My bottom line is that we’ve run out of room for the time being for any tightening. . . . I don’t know for how long. I don’t know what is going to happen in the weeks or months down the road, either to the economy or to the aggregates or these other things. I don’t have any sense here that we should be easing. But I do think we have to be concerned about a very potentially volatile and actually volatile set of attitudes here and elsewhere. (FOMC Minutes, May 21–22, 1984, 27–28)

  No one suggested that the lack of consistency in their actions added to uncertainty and volatility. There are, however, frequent statements about market anticipations of higher inflation. The lack of an accepted procedure increased attention to current data, often with large random elements and subject to subsequent revisions. This increased volatility also.

  Board Vice Chairman Preston Martin cited political factors as a constraint on independent action especially in a quadrennial election year. “In order to add an element to the discu
ssion that we have all been a little too polite to enunciate, I will say that we are in such an intense political environment at the moment, with so much scrutiny from the Hill and elsewhere about what we are alleged to be doing, that holding to the course . . . is called for both for economy and political considerations” (ibid., 34). The reference to politics made the comment unusual. FOMC members maintained the fiction that they ignored politics. The federal funds rate was above 10 percent with the unemployment rate at 7.4 percent. Also, the Continental Illinois failure and failure of other banks and savings and loans were major concerns at the time.

  Henry Wallich disagreed with Martin. “One ought to hesitate a little before one takes for granted that financial fragility was necessarily a cause for relenting. The rule about a lender-of-last-resort operation is to lend freely but at a high rate” (ibid., 34). Volcker responded that his concern was not Continental Illinois; it was the effect of higher interest rates on the debtor countries and therefore on the lending banks. In practice this meant that the Federal Reserve supported the banks and did not make them show their losses on international loans. The market certainly recognized the losses at money center banks; the banks’ market values declined. Federal Reserve policy, however, provided a guarantee against failure but placed a restriction on its policy by making members more reluctant to raise interest rates if called for.

  FOMC members had several concerns about financial fragility at this time. The savings and loan or thrift industry had many insolvent institutions kept from failure by public policy. Higher market interest rates would have widened the spread between the rates paid by the thrifts and market certificates that were now deregulated. A mark-to-market policy for emerging market debt would reveal insolvency at many banks, especially money market banks. Higher interest rates would worsen the position of the debtor countries and thus the creditor banks. The domestic agricultural sector was hurt by the appreciation of the dollar and by the interest payments required by farmers who had borrowed to buy farms during the period of high inflation and high nominal interest rates. Keehn (Chicago) reported that 15 percent of the farms were heavily indebted (FOMC Minutes, March 26–27, 1984, 36–37). And, as always, the members expressed concern repeatedly about the budget deficit. Raising interest rates increased cost to the Treasury.

  The recurrent problem of “leaks” arose again. Volcker summarized a report by the General Accounting Office that suggested that the leaks came from Congress (ibid., January 30–31, 1984, 1). He appointed a committee to propose new procedures and later barred many bank staff from the part of the meeting that discussed current policy. Not until 1994 did the FOMC publish its decisions following the meetings. That ended the principal problem of policy leaks by reducing the amount of information that remained confidential.

  Axilrod warned in January that money growth was too high in 1983 to reach price stability. He proposed a reduction in M 1 growth for the 1984 Humphrey-Hawkins hearing to a range of 4 to 7 percent from 4 to 8 percent. He proposed M2 growth at 6 to 9 percent in place of 7 to 10 percent. Balles, Wallich, Forrestal, Horn, Roberts, and Black urged more emphasis on M1 growth to control inflation. This led to a discussion of M1. Wallich acknowledged that in practice the desk managed the federal funds rate. This led to the following exchange that shows that the members of FOMC lacked a clear idea about how Volcker implemented policy action and that Volcker acted on his own.

  Vice Chairman Solomon. . . . “What you’re really saying is that we allow significant movements in M1 to influence our management of the funds rate gradually. . . .

  Chairman Volcker. Manage our reserve position.

  Vice Chairman Solomon. Well, in managing our reserve position we’re guided by the fed funds rate.

  Chairman Volcker. Who is?

  Vice Chairman Solomon. It shows the accuracy of our reserve calculations, right? Chairman Volcker. Seldom. (ibid., 26)14

  About a week after the March meeting, Henry Wallich spoke to an economic conference about operating procedures. He denied that the System had returned to pre-1979 interest rate control. The main evidence he cited was that the funds rate was more variable, especially at the end of each quarter. He then explained more fully:

  If the interest rate established by this technique is not consistent with a stable rate of inflation, it will have an increasingly disequilibrating effect, causing inflation to accelerate or decelerate. . . . Thus, letting the market set the interest rate for a given money-growth target is a safer way of achieving an equilibrium interest rate rather than trying to set it directly. (Wallich, speech to Midwest Finance Association, Board Records, April 5, 1984, 6)

  14. That the New York Fed president was one of the ill-informed suggests the extent to which Volcker and the Board’s senior staff controlled decisions. It shows, also, the extent to which control had shifted away from New York.

  Decisions at this time favored “flexibility.” This meant acting with discretion, in practice not achieving the growth rates or borrowing levels they announced if new information changed their minds or, more often, changed Volcker’s mind.15 As in the 1970s, the emphasis given to interest rates or borrowing led to an unplanned decline in the growth rate of the monetary base from a twelve-month average of 10.7 to 5.8 percent between January 1984 and May 1985 followed by a sharp fall in real growth.16

  By late March, the funds rate reached 10.25 percent. Sternlight explained that the market anticipated an increase in the discount rate to 9 percent. On April 6, the Board approved the increase. The staff forecast that it expected inflation of 5.5 to 6 percent in 1985. SPF forecast put one-year expected inflation at 5.4 percent in third quarter 1984. This was a small rise from 5 percent in the second quarter, but it shows continued concern about the Federal Reserve’s actions.

  The FOMC had a lengthy discussion about its proposed policy actions. Some wanted to slow money growth or raise interest rates. Morris (Boston) pointed to the two percentage point difference between the funds rate and the discount rate. Borrowing reached $1 billion. He proposed a one percentage point increase in the discount rate. Conscious of congressional reactions, Volcker replied that even half a point would see “an explosion” in Washington (ibid., 85). An “independent” Federal Reserve had to be aware of congressional attitudes.

  Gramley reflected the unhappiness of many of the members who feared a return of inflation. “I think we’re pussy-footing. I think we’ve been sitting here for some months now looking at an economy that continues to exceed everybody’s expectations. This is going to come back to haunt us if we don’t decide to act” (ibid., 91–92). Wallich agreed. But Volcker expressed satisfaction with the modest changes he proposed and seemed more concerned by political response to a funds rate above 11 percent then to Gramley and Wallich’s concerns about inflation. Twelve-month average CPI inflation remained about 3.5 percent.

  At the March meeting, the vote was nine to three for a funds rate of 7.5 to 11.5 percent and M1, M2, and M3 growth of 6.5, 8, and 8.5 from March to June. Gramley and Wallich dissented because policy was not sufficiently restrictive and Martin because he wanted less restraint. In a speech at the end of April, Volcker recognized the progress against high inflation but added, “We haven’t passed the test of maintaining control over inflation during a period of prosperity” (speech to Wharton Entrepreneurial Center, Board Records, April 30, 1984, 2).

  15. Earlier, Kydland and Prescott (1977) showed that this was a poor choice of tactics.

  16. At the March meeting, the FOMC agreed to discontinue repurchase agreements in banker’s acceptances. Authority to do the transactions remained. A memo from Peter Sternlight discussed the pros and cons. The main argument against ending operations was that System operations allowed some smaller banks to participate (memo, Sternlight to Board, Board Records, March 12, 1984).

  Between March and August the funds rate increased from an average 9.9 to an 11.6 percent rate. The operating target for adjustment plus seasonal borrowing remained at $1 billion during this peri
od, but in order to avoid the appearance of internal problems, fewer banks were borrowing. Growth of the monetary base and money slowed. The unemployment rate remained above 7 percent; the market could see that policy had tightened. Although Volcker had expressed political concern about an 11 percent funds rate, and this was an election year, the average remained above 11 percent between June and September. This action was strikingly different from the actions in the 1970s, so it contributed to the credibility of the Federal Reserve’s commitment to low inflation.17 Criticism of Federal Reserve policy declined after President Reagan defended the Federal Reserve at a news conference.

  In May, borrowing from the Federal Reserve surged as Continental Illinois Bank (Chicago) tried to avoid failure. Gramley asked whether the desk offset some or all of the borrowing by removing reserves. The manager replied that interest rates were high at the time and the desk was reluctant to drain reserves but he was now beginning to drain excess reserves.18 For the FOMC, Continental’s problems and the problems at other banks and thrifts added to concerns about international lending and to reluctance to raise interest rates. Volcker made this explicit by speaking before the policy discussion. He recognized that “it might take somewhat more aggressive action than we’ve taken before to bring the economy to a suitable path. . . . But, unfortunately, I don’t think that course of action is open to us. . . . My bottom line is that we’ve run out of room for the time being for any tightening” (FOMC Minutes, May 21–22, 27). Like previous chairmen, Volcker felt independence was constrained at the time.