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Volcker Restored Fed’s Credibility on Inflation

Photograph by Diana Walker/Time & Life Pictures/Getty Images; Illustration by Jacqueline Di Milia Close

Photograph by Diana Walker/Time & Life Pictures/Getty Images; Illustration by Jacqueline Di Milia

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Photograph by Diana Walker/Time & Life Pictures/Getty Images; Illustration by Jacqueline Di Milia

Federal Reserve Chairman Paul Volcker sounded like James Bond during a telephone conference call with members of the FOMC on Friday, Oct. 5, 1979.

He stressed the confidential nature of the final memorandum they would be discussing at the emergency meeting the following day. The increased gyrations in interest rates under the new procedures could mean millions in profits or losses in markets throughout the world. Volcker also wanted to avoid leaks about the meeting itself and told his colleagues to arrive in Washington as inconspicuously as possible and to stay at different hotels.

At the beginning of the conference call, Peter Sternlight, who ran the New York Fed’s trading room, reported that a rumor of Volcker’s resignation was “having a downward effect on the securities market.”

Volcker knew that denials could be counterproductive, and he wanted to avoid fanning the speculative fever that had erupted during the week.

The events of the past seven days had erased any lingering doubts Volcker had about the need for drastic measures. The previous Friday, he had boarded an Air Force jet, along with Treasury Secretary William Miller and Charles Schultze, chairman of President Jimmy Carter’s Council of Economic Advisers, to attend a meeting of the International Monetary Fund in Belgrade, Yugoslavia. They had a stopover in Hamburg the next day to meet with Chancellor Helmut Schmidt. Volcker took the opportunity to brief the president’s two top economic aides about his plans. They were not pleased.

Unproven Links

Schultze, a traditional Keynesian, complained, “We’re not against raising interest rates, but the monetarist links are unproven and inflexible.”

Volcker said, “Rest assured that I will not put monetary policy on automatic pilot.”

Schultze worried about an exit strategy. “Once you go down this road, it will be difficult to go back.” Volcker emphasized, “Let’s take one step at a time. This is an opportunity we cannot pass up.”

Volcker had checked the foreign-exchange market before boarding the plane and reported that the dollar had fallen to 1.74 marks, capping a 4 percent decline since the Sept. 18 discount-rate debacle. Schultze considered the dollar a sideshow, but Volcker knew that the U.S. currency would take center stage in the meeting with Schmidt.

The West German chancellor did not disappoint. At a lunch for Volcker, Miller and Schultze, and the head of the German central bank, Otmar Emminger, Schmidt said, “The world needs stability much more than anything else.”

He was repeating a message Volcker had heard from him in February 1973, when the dollar was worth 3 marks. Now Schmidt had to be content with a more modest objective, one that reflected America’s diminished status: “I would like to get back into a world in which the dollar would be 2 marks and stable.”

Schmidt’s lecture cheered Volcker but irritated Schultze. A news conference scheduled at the end of the four-hour meeting was canceled. A joint press release stated that exchange-rate stability “and a strong dollar are in the interests of both countries.”

A very public lecture by former Fed Chairman Arthur Burns in Belgrade saddened Volcker as much as Schmidt’s private sermon had pleased him. On Sept. 30, as a prelude to the gathering of the world’s central bankers and finance ministers for the IMF meetings, Burns delivered the annual Per Jacobsson lecture, titled “The Anguish of Central Banking.”

Political Pressure

Burns said the Fed had been unable to control inflation because political pressures prevented the central bank from “frustrating the will of Congress to which it was responsible - - a Congress that was intent on providing additional services to the electorate.”

Volcker knew that government deficits made life difficult for the central bank, forcing the Fed chairman to tighten interest rates to painful levels to restrain private spending. But blaming the inflation of the 1970s on government deficits ignored the Fed’s timidity under Burns’s leadership.

The Wall Street Journal wrote that Burns had made clear “that given the political and economic forces feeding inflation in the industrial nations ‘it is illusory to expect central banks to put an end’ to the wage price spiral by themselves.”

The reaction in the markets suggested that Burns had irritated the speculators as well as the central bankers. The day after the speech, gold rose to $414.75 an ounce, a jump of 4 percent from the previous close. The speculative burst persuaded Volcker to cut short his stay in Belgrade and return to Washington to complete work on the Axilrod-Sternlight memorandum.

Volcker’s exit the following day from Belgrade created more confusion. In London, gold hit a record $442 an ounce, up more than 6 percent.

The Wall Street Journal reported that the gold spike was set off by Volcker’s early departure from the IMF meetings. The buying spree was fed by rumors that “South American central banks were dumping their dollar reserves” as were Arab oil- producing countries. Speculation that Volcker’s departure meant that “a new dollar-defense program would be initiated” triggered the subsequent sales of the precious metal.

The speculative gyrations persuaded Volcker to meet Oct. 4 with members of the Board of Governors. It was the day before the conference call inviting the entire membership of the FOMC to their clandestine gathering, and he wanted to build a consensus.

Commodities Run

The meeting identified “speculative activity in the gold market which appeared to be spilling over into other commodity markets.” Charles Partee, one of the dissenting board members in September, said he was alarmed because the gold-buying frenzy was spreading to copper, zinc and lead. “It leaves one with the thought that because of a run from currency -- a desire to get into goods and out of money -- we might have now a new development in our economic experience,” he said.

The touch of panic pleased Volcker. At the FOMC meeting the next day, he said the market “is ready to crack open, depending upon what decisions they see coming out of here.”

He presented two possibilities. The first involved traditional Fed actions such as a discount-rate move, an increase in the federal funds rate or a change in reserve requirements. The second was to adopt the transformation of Fed operations outlined in the memo, a focus on achieving a money- supply target “recognizing that would require a wider range for the federal funds rate.”

Volcker added that there were advantages and disadvantages to both approaches, but by “changing operating techniques” the Fed “might actually get more bang for the buck.” The chairman said he was ready to go “whichever way the consensus wants to go as long as the program is strong,” with the understanding that “we are not locked into it indefinitely.”

He knew he had disappointed the monetarists on the FOMC hoping for a permanent conversion to their doctrine, but they weren’t the ones who worried him. Lawrence Roos, president of the St. Louis Federal Reserve Bank, a monetarist stronghold, had been waiting so long for a trial run that he would vote in favor of anything with a monetarist fragrance.

The Keynesians were cause for greater concern. Volcker wanted to avoid dissents that would damage the credibility of the new procedures. He worried about Frank Morris, who had opposed his call to arms earlier in the year because of a weak economic outlook, and had accused the chairman of sacrificing the domestic economy to promote the dollar internationally.

Volcker was relieved when Morris spoke: “Despite my view that the recession is going to be sharp, I think we are in a situation where we have to be willing to do something dramatic today.”

Satanic Influence

Volcker thought that Henry Wallich, a former Yale economics professor, might buck the consensus. He had disparaged the monetarist links between money and economic activity and had warned Volcker away from its satanic influence. Wallich said:

“The main argument in favor of the reserve strategy is that it allows us to take stronger action than we probably could by the other technique.” He warned, however, that “there is that risk of interest rate uncertainty involved in the new strategy. We would have to guard against interest rates going in the wrong direction.”

Wallich had struck a nerve in Volcker that would remain exposed for years to come. The Fed chairman would be accused of pushing the new program as political cover for dramatically higher interest rates. He denied the premise during the FOMC meeting. “I’m not sure it’s self evident that in interest rate terms the new technique is stronger.”

Volcker prevailed. A press conference Saturday evening, Oct. 6, 1979, drew more than 50 reporters, many still wearing their weekend golf shirts. The unusual timing on a Columbus Day holiday weekend made the event feel like an emergency briefing by the chairman of the Joint Chiefs of Staff. But Volcker wanted to avoid a delay that would risk the leak of sensitive information to speculators.

The head of the CBS Washington bureau had asked the Fed’s public-relations chief whether to send his only TV crew, which was covering a papal visit to Washington. The spokesman answered that the newsman would “remember the press conference long after the Pope had left town.”

The news conference and press release highlighted the FOMC’s decision to concentrate on controlling the level of bank reserves and permitting greater variability in short-term interest rates. It also announced the decision to increase the discount rate by a full percentage point, from 11 percent to 12 percent, and the introduction of a special reserve requirement on bank borrowings that had eluded Fed control.

Volcker had managed to forge a monetary-policy sledgehammer without dissents. He hoped that the credibility conferred by the new monetary procedures would produce two different interest- rate effects. Federal Reserve operations dominate the overnight interest rate on loans of reserves between banks, but inflationary expectations dominate longer-term interest rates. The Fed chairman expected the new procedures to increase the volatility of the federal funds rate but reduce the interest rate on long-term bonds. He would be disappointed.

(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 last 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 2.)

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To contact the writer of this article: William L. Silber at wsilber@stern.nyu.edu

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net

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