“Economic policy,” he said, “has a kind of crisis of credibility.” As a result, “dramatic action” to combat inflation would not receive public support “without more of a crisis atmosphere.”
He did not have to wait long.
A public squabble erupted after a meeting at the Fed on Sept. 18, 1979. The morning began with Volcker’s second FOMC meeting as chairman and ended with the committee ratifying his recommendation “to make a little move” up in the federal funds rate. The vote was eight in favor and four against, with three of the four dissenters urging greater tightening. Volcker wanted tighter credit and higher interest rates to fight inflation but knew that some members of the FOMC were worried about a recession, so he emphasized caution.
No one but Wall Street professionals would have paid attention to the slight increase in the federal funds rate, the overnight interest rate on loans of reserves between banks, because the action occurs far from the public spotlight. The New York Fed’s trading desk sells government securities from its holdings to withdraw reserves from the banking system. These transactions push up the rate by forcing banks to borrow reserves.
However, a follow-up meeting of the seven-member Board of Governors that same afternoon was much more widely noticed. Volcker convened the board to discuss raising the discount rate charged on loans of reserves to commercial banks. Such decisions are announced immediately and are reported on the evening news with the gravity of a declaration of war.
Most financial-market professionals ignore the rhetoric. Banks borrow reserves at their regional Federal Reserve banks as a safety valve, after reserves have been drained from the market at the behest of the FOMC, and the discount-rate increase is a defensive parry to block the escape route. The Board of Governors controls the discount rate by legal statute, but it usually follows the lead of monetary policy established at the FOMC.
Sept. 18 was no exception. The board voted to approve an increase in the discount rate to a record high of 11 percent, a jump of half a percentage point, and explained in its press release that it acted “against the background of increases in other short term interest rates” and “to discourage excessive borrowing by member banks from the discount window.” The vote was four in favor and three against.
The half-point increase in the discount rate, the second since Volcker took office, pleased him. It confirmed the Fed’s commitment to tight money to control inflation.
The following morning, however, the front page of the New York Times described the split decision as though it were an armed insurrection among the rank and file. The 4-3 vote, the paper said, left uncertain whether the chairman “could continue to command a majority for his high rate policies. The split was seen as indicating a fundamental division within the Board over whether inflation remains a more pressing problem than recession.”
The divided board had not bothered Volcker until then. He felt confident he could marshal the same four votes to raise the discount rate again. But on Sept. 19, a second front-page article in the Times, with the headline “Gold Price Soars at Record Pace in Wild Trading,” delivered a knockout punch. The newspaper reported that transactions on the New York Commodity Exchange had become “chaotic,” and at times “there were temporarily no sellers, only would-be buyers.” Gold jumped more than $25 and hit a record price of $376.25 per ounce.
Public commentary confirmed the message. Wall Street economist Henry Kaufman, who had apprenticed with Volcker at the New York Fed in the 1950s and had been predicting higher interest rates since the beginning of 1979, sounded the alarm: “In effect, it is a vote against the established economic and financial system.” Undersecretary of the Treasury Anthony Solomon said the gold boom “cemented inflationary expectations,” and could be “very damaging.”
Volcker responded by asking an FOMC economist, Stephen Axilrod, and Peter Sternlight, manager of the system’s Open Market Account, to outline the plan that would revolutionize the Federal Reserve’s operating procedures. The two career employees drafted a confidential three-page memo. A single sentence captured the essence of the plan: The FOMC “would seek to hold increases in the monetary base and other reserve aggregates to amounts just sufficient to meet monetary targets and to help restrain growth in bank credit, recognizing that such a procedure could result in wider fluctuations in the shortest term money market rates.”
Volcker knew this would turn monetary policy on its head. The so-called aggregates referred to measures such as the money supply (checking accounts plus currency), or total bank reserves, or bank reserves plus currency (called the monetary base), that influenced total spending and inflation. The quantity theory of money, which Volcker had studied at Princeton University, taught that excessive increases in the money supply meant higher prices and inflation. Modern monetarists, led by Milton Friedman, resurrected the lessons of the quantity theory and urged the Fed to control money and the related monetary aggregates to keep inflation in check.
Volcker believed that controlling the aggregates could help restrain inflation in the long run, but would also produce wide fluctuations in interest rates in the short run, disturbing traditionalists on the FOMC. The new plan would be considered a monetarist takeover of the Federal Reserve System, and could create turmoil in credit markets by altering the Fed’s target of operations. Volcker thought it was worth the risk.
The Fed manipulates the supply of dollars available as currency and reserves by buying and selling securities in the government-bond market. These so-called open market operations occur quietly, by means of telephone contact between traders in the New York Fed’s trading room in lower Manhattan, managed by Sternlight, and Treasury securities dealers at commercial banks. But these obscure transactions had a profound impact on the federal funds rate. When the Fed sells securities and reduces reserves, for example, commercial banks are caught short of their legal requirement, so they borrow reserves in the federal funds market. This buying pressure drives up the overnight interest rate.
Sternlight aimed his traders’ transactions at the federal funds rate specified by the FOMC at the end of each meeting. If the FOMC wanted an increase in the rate, he ordered Fed traders to engineer a drop in reserves until they hit the target. Reserves would then be added if the rate went up too much and withdrawn if the rate went down.
Volcker recognized that this technical procedure, which had served since the Treasury-Federal Reserve Accord in 1951 to maintain orderly conditions in the money markets, now undermined the Fed’s credibility as guardian of the currency. Controlling the federal funds rate by adding or subtracting reserves meant that the Fed lost control over reserves made available to banks.
Volcker recognized that it had been a disaster for the Fed continuously to expand reserves and other monetary aggregates to keep the federal funds rate from rising too quickly. It had done precisely that during much of the 1970s, and the end result had been that banks made more loans and created more deposits than the Fed had promised. The excessive growth in the monetary aggregates had fueled inflation and inflationary expectations, destroying the central bank’s credibility.
Volcker and other members of the FOMC had rejected the monetarist approach of focusing on the monetary aggregates and permitting greater fluctuations in interest rates many times before. As recently as 1978, Volcker had dismissed the tight link between money and prices articulated by the quantity theory and put forth by monetarists to keep inflation under control.
Instead, Volcker based his support for targeting the monetary aggregates on the favorable impact on inflationary expectations and central-bank credibility, an approach closer to the then-emerging doctrine of rational expectations than to mainstream monetarism. He believed that the announcement of monetary growth ranges “sets a general framework for expectations about inflation” and added that “this role in stabilizing expectations was once the function of the gold standard, the doctrine of the annually balanced budget, and fixed exchange rates.” Volcker wanted to restore the gold standard without gold.
Volcker’s commitment to controlling the aggregates would require a drastic shift for the FOMC: abandoning the “prudent and cautious and gradual” approach to interest rates. He knew that anything less would fail to establish the Fed’s credibility. He thought the crisis of September 1979 justified the risk, and he would exploit that event to persuade the FOMC to implement an experiment it had thus far resisted.
But a visit with his Board of Governors colleague Henry Wallich to discuss the draft memo gave him pause. Wallich, who grew up in Weimar Germany, had a hatred of inflation that resembled a childhood phobia, but he worried more about losing control of interest rates. “The existing methods have the advantage that we know the interest rate and we don’t run the risk of the rate going in the wrong direction and creating dollar problems,” he told Volcker.
Volcker also was concerned about the dollar, but felt that the inflation-fighting credibility of the new operating procedures would win support abroad. He would learn the truth during a private lecture from an old friend, Helmut Schmidt, the chancellor of West Germany.
(William L. Silber is Marcus Nadler professor of finance and economics and director of the L. Glucksman Institute for Research in Securities Markets at New York University’s Stern School of Business. This is the second of three excerpts from his new book, “Volcker: The Triumph of Persistence,” which will be published Sept. 4 by Bloomsbury Press, and is on the long list for the 2012 Financial Times and Goldman Sachs Business Book of the Year Award. The opinions expressed are his own. Read Part 1 and Part 3.)
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