Volcker (27 page)

As I look at these two approaches there are advantages and disadvantages … to both of them … My feeling was that by … changing operating techniques … and thereby changing psychology a bit, we might actually get more bang for the buck … [But] we run a risk almost whatever we do … If we are lucky, this change [in technique] will improve our chances of reaching our money supply targets … [but] it has some built-in pressure to move interest rates downward … if money supply begins running low … [and] that would be unsettling internationally.
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Volcker then related the reservations of CEA chairman Charles Schultze and Treasury Secretary William Miller. “I discussed the whole problem … with the Administration … They are ready for a strong program [but] … they shy away very strongly … [from] a shift in technique at this point because … that is the more risky course for a variety
of reasons … [especially] concern about locking ourselves into a technique … that might not be suitable in light of all the circumstances.”
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Volcker concluded his overview with a qualification that made him sound like a reluctant bride planning a divorce: “I am prepared … to go with whichever way the consensus wants to go as long as the program is strong, [but] if we adopt a new approach [it should be understood that] we are not locked into it indefinitely … And … early next year … we would have a thoroughgoing ground up decision as to whether we wanted to maintain … it … [or] return to our more traditional practices.”
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Volcker knew he had disappointed the confirmed monetarists on the FOMC hoping for a permanent conversion to their doctrine, but they were not the ones who worried him. Lawrence Roos, president of the St. Louis Federal Reserve Bank, had been waiting so long for a trial run that he would vote in favor of anything with a monetarist fragrance. “I assume that my credibility with you and my colleagues would be severely jeopardized if I came out in opposition to this proposal. I also was told by my father to keep my mouth shut when things are going well.”
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He followed the old man's advice.

The Keynesians were cause for greater concern. Volcker wanted to avoid dissents that would damage the credibility of the new procedures. Charles Partee provided a glimmer of hope, repeating his earlier alarm over the speculative excesses in the base metals. But Volcker worried about Frank Morris, who had opposed his call to arms earlier in the year because of a weak economic outlook. Morris had accused Volcker of sacrificing the domestic economy to promote the dollar internationally.

Morris spoke up right after Partee. “I agree with Chuck … 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 … And I think our credibility will really suffer if we announce a change in procedure and then fail to have the guts to go through with it.”
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Volcker never felt comfortable showing affection, but he thought (for a nanosecond) about kissing Frank Morris, even though Morris was halfway down the twenty-seven-foot-long table. Instead, he praised his old friend by repeating (twice) the most important word Morris had said, just in case anyone had missed it. “If I may just interject, Frank, I
agree with what you are saying … But presumably the guts will have to have a number on it—the degree of our guts on the upside [for interest rates].”
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Morris jumped back in. “Well, that's right. But it's got to be a pretty big number.”
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“I understand.”
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Volcker nodded in agreement, just like the elder Roos would have advised.

Volcker thought that Henry Wallich's academic pedigree gave him license to buck the consensus. The former Yale economics professor had disparaged the monetarist links between money and economic activity and had warned Volcker away from its satanic influence. Volcker listened carefully when Wallich spoke. “I think the main argument in favor of the [new] reserve strategy is that it allows us to take stronger action than we probably could by the other technique. We are much more constrained in the [traditional approach] by the appearance of very high interest rates. In the new strategy interest rates become almost a by-product of a more forceful pursuit of the aggregates … [In fact] 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.”
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Partee interjected: “Which is what direction—up or down?”
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“It is quite clearly down … It involves a signal that we've switched policy and the markets are going to respond accordingly … But we need to watch this [new] strategy … for interest rates and for the exchange market so that we don't get surprised by interest rate movements when they could be harmful.”
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Volcker should have let them fight it out, but he could not permit the discussion to pass unchallenged. Wallich had irritated a nerve that would remain exposed for years to come. Volcker would be accused of pushing the new program as political cover for dramatically higher interest rates. He denied the premise. “I'm not sure it's self evident that in interest rate terms the new technique is stronger. It may or may not be, depending on what happens to the money supply. I think that is inherent in the new technique … I don't think at this stage … we know the answer … We'll never know the answer no matter how long we talk.”
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The press conference at six o'clock on Saturday evening, October 6, 1979, in the Federal Reserve's boardroom drew an unhappy crowd of more than fifty reporters, many still wearing their weekend golf shirts. The informality of the assembled journalists contrasted with the majesty of the great seal of the United States embossed on the front wall of the cavernous boardroom, with the eagle's ten-foot wings spanning the crowd below. America's coat of arms framed Volcker preparing to announce the central bank's most important decision in its history.

The unusual timing, Saturday evening on a Columbus Day holiday weekend, made the press conference feel like an emergency military briefing by the chairman of the Joint Chiefs of Staff. Volcker had asked his special assistant, Joseph Coyne, to call the media immediately after the FOMC had adjourned at four o'clock, to offer full disclosure to all. A delay would risk the leak of sensitive information into speculators' hands, lining their pocketbooks when markets opened Sunday night in Asia. The head of the CBS Washington bureau asked Coyne whether to send his only TV crew, which was covering the pope.
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The Fed's public relations chief answered that he would “remember the press conference long after the Pope had left town.”

Volcker began with a disclaimer: “I will tell you that the major purpose of this press conference is to show that I have not resigned—the way the early rumor had it yesterday—and I'm still alive—contrary to the latest rumor. We have been busy during the day … developing a series of actions that is reflected in the release in front of you … I think in general you know the background … the inflation rate has been moving at an excessive rate … and the anticipations of inflation have been unsettling to markets both at home and abroad.”
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The 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 Federal Reserve's 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.
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Volcker had managed to forge a monetary policy sledgehammer without dissents and was pleased to entertain questions from reporters.

The decision to increase the discount rate by a full percentage point provoked a question related to the September 18 dissents. “The Board
split four to three in raising the discount rate by just a fraction. What has happened since then to change the Board's mind?”
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Volcker replied, “What has changed since then is quite clear … business data [have] been good and better than expected, the inflationary data [have] been bad and perhaps worse than expected, and we have had developments in markets [suggesting] … the dangers of instability and inflationary expectations.” He paused, and then allied himself with the earlier minority. “I was not voting for more than a half percent discount rate increase two weeks ago. In that sense I changed my mind too.”

The consequences of the new operating procedures garnered the most attention, with some questions triggering friendly banter.

“Are you saying hands off altogether on the federal funds rate?”

“Cautious central bankers never talk in extremes but I think the banks will have to learn … how to make reserve adjustments.”

“But [the rate] still won't be completely free to go as high as it might?”

“I don't know what you think is ‘as high as it might.' There will be substantial freedom in the market.”

Other questions created more controversy, both contemporaneously and going forward.

“Mr. Volcker, what domestic economic effects would you anticipate from this series of actions? Would you expect it to further slow the economy or deepen the recession?”

“I would hope … and expect that these actions would ultimately have a settling effect on financial markets. I think it is basically good for longer term interest rates … because they are sensitive to inflationary expectations.”

The reporter followed up: “But in immediate terms does it have an effect that will tend to slow down economic growth … in this country?”

“Well, you get varying opinions about that. I don't think it will have important effects in that connection. I would be optimistic about the results of these actions. But we're in an area dealing with economic events that are not fully predictable.”

William Greider, a columnist for
Rolling Stone
and formerly with the
Washington Post
, disparaged Volcker's response to the reporter's question in a retrospective on the October 6, 1979, news conference:
“Volcker evaded the point and concealed his real expectations.”
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Greider should have checked the record.

Volcker had been grilled about the same issue at his public confirmation hearings more than two months earlier, by Wisconsin senator William Proxmire, chairman of the Senate Banking Committee. Proxmire understood money and finance better than most members of Congress, having received an MBA from Harvard Business School, and he was not shy about displaying his expertise. “Dr. Arthur Okun … a former CEA [Council of Economic Advisers] Chairman and a highly respected economist … found that when the Fed had tightened the money supply … [it caused] a terrific price in the loss of jobs and loss of production … [And] this may not be the way to cope with inflation. What is your response to that?”
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Volcker respected Proxmire's intellect as well as his reputation as a maverick. The Wisconsin senator irritated the Washington bureaucracy with his monthly Golden Fleece Award for “frivolous government spending.”
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Proxmire had conferred the honor on the Federal Aviation Administration for spending $57,800 on a study of the physical measurements of 432 airline stewardesses, paying special attention to the “length of the buttocks” and how their knees were arranged when they were seated. A $27,000 study by the Justice Department on why prisoners wanted to get out of jail received the Golden Fleece Award as well.

Volcker expected the independent-minded senator to understand an unconventional perspective on monetary policy. “I think we have to be very careful about the implications of studies [like Okun's] … Part of the difficulty … [is] that the prolonged nature of the [current] inflation has changed expectations, it's changed the way people look at their personal lives … I think it's fair to say the economy probably doesn't react the same way you, and certainly I, were brought up to think … It's perhaps symptomatic of some of the new problems … that we find some evidence recently that actions [such as tight monetary policy] that are interpreted as dampening the inflation rate have a favorable impact … the long term interest rate will decline instead of going up—whereas … easier money … [has] a rather perverse effect … that is counterproductive.”

Volcker's observation that tight money would lower long-term interest rates found little support in the reigning econometric models;
those models' flawed view of expectations made them useless props in the discussion. But he had made this same point, reflecting a rational expectations approach to monetary policy, at his first FOMC meeting as chairman: “I think we are in something of a box—a box that says that the ordinary response one expects to [monetary] easing actions may not work … They won't work if they're interpreted as inflationary … On the other hand, a tightening action obviously has risks too … But to some degree the perversity of reactions can help us there. I think there is some evidence, for instance—if a tightening action is interpreted as a responsible action … that long-term rates tend to move favorably.”
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Volcker never identified himself with the extreme rational expectations theorists, and would privately refer to “those crazy economists up in Minnesota” (including future Nobel Prize winner Thomas Sargent), who warned everyone about the impotence of a fully anticipated monetary policy.
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But Volcker had accepted an even more controversial tenet of their doctrine when it was still a newborn, “that concern about the inflationary consequences of policy cannot be postponed until the economy approaches … full employment.”
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Belief in the favorable response in long-term interest rates to tight money required even less of a religious commitment to rational expectations than worrying about inflation with unemployed resources.