Volcker (28 page)

Volcker 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. Volcker 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.

“Mr. Volcker is a gambler. He is betting high with a poor hand. The entire nation needs to hope that he beats the odds,” warned an editorial with the title “Mr. Volcker's Verdun,” published in response to the October 6, 1979, announcement.
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The editors at the
New York Times
likened Chairman Paul Volcker's attack on inflation to Marshal Philippe Pétain's battle near the city of Verdun, France, the longest and bloodiest encounter of the Great War. “By forcing interest rates to shoot up like a signal flare, Mr. Volcker, like France's Marshal Pétain at Verdun, seeks to assure his own forces that the enemy ‘shall not pass.' Marshal Pétain did hold the fort—at the cost of 350,000 casualties. No lives are directly at stake in slamming the gates on credit but the risks are nonetheless substantial.”

Economists on the left and right expressed their concern as well. John Kenneth Galbraith, a Harvard Keynesian and popular author with an acerbic wit, spoke at a dinner commemorating the fiftieth anniversary of the 1929 Crash, and recalled the escapades of some white-collar criminals. He warned the assembled that “trust in people who owe their intelligence to association with large sums of money … may be misplaced.”
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Noting that the Fed chairman had access to the vast financial resources of the central bank, he added, “The moral is that you hadn't better trust Paul Volcker either.”

Allan Meltzer, a monetarist from Carnegie Mellon University who would write a monumental three-volume history of the Federal Reserve, withheld approval of the October 6 initiative from a very different perspective: “I didn't send them a congratulatory telegram. I'm going to hold my breath and hope they don't mess it up.”
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Volcker never expected to win a popularity contest, but he resented being labeled a gambler. “The only time I ever rolled the dice was playing Monopoly with Janice and Jimmy—and I didn't like losing.”
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He was, of course, experimenting with an unproven strategy, but the old methods had failed, and doing more of the same would have gambled on the status quo. Risks prevailed either way.

The verdict in the marketplace on the Federal Reserve's announcement troubled Volcker more than newspaper editorials or professorial pronouncements. The government bond market in the United States was closed for the Columbus Day holiday on Monday, October 8, the first trading day following the Fed's announcement, but favorable responses in gold and foreign exchange, which trade worldwide, offered initial encouragement. The dollar rose to 1.794 marks, a significant jump of 2 percent from the previous Friday, and gold declined to $372 per ounce, a drop of 3.3 percent from its Friday close.
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Gold and the dollar confirmed the favorable European commentary on the American initiative. The manager of Zurich's Bank Rothschild said, “After all its past quarrels with the Fed, it now looks as if the White House may finally have bitten the anti-inflation bullet.”
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A foreign exchange dealer in Brussels added, “The United States has put its finger right on the spot this time.”
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And a report from a correspondent in Bonn summarized the sentiment: “The Fed actions bolster the reputation of Federal Reserve Chairman Paul Volcker as ‘a tough guy.' ”
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Meg Greenfield, a Pulitzer Prize–winning columnist at the
Washington Post
, made “tough” synonymous with leadership, “in the sense of being serious and consistent and aggressive,” and claimed that Americans also valued that trait.
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“A great deal of admiration has been expressed for Volcker's unambiguous and painful action to get hold of the runaway inflation—damn the side effects and cost, it had to be done. I happen to agree. But I also think there is something truly disturbing about the fact that … we are all sitting around hailing one among us who was obliged to take harsh measures to restrain our undisciplined
ways.” Leslie Pollack, chief investment officer of the brokerage firm Shearson Hayden Stone, concurred. “Volcker is the first Fed chairman in twenty-five years who's doing what he's paid to do.”
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The resumption of government bond trading on Tuesday, October 9, took the chairman down a notch. He had sanctioned the unprecedented two-percentage-point increase in the overnight federal funds rate, to 13.86 percent, but had not expected the ten-year bond rate to follow suit. Volcker thought the favorable effect of the new procedures in dampening inflationary expectations should have pushed down long-term interest rates, even if the actual rate of inflation remained high. Instead, the ten-year bond rate jumped from 9.6 to 9.93 percent, a huge one-day increase in that maturity range.
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And it was about to get worse.

Historical precedent had encouraged Volcker to believe he could raise the federal funds rate and simultaneously decrease the ten-year bond rate. He knew that the two rates usually move in the same direction because they both represent the price of lending dollars over different time horizons—one day for the federal funds rate and about 3,650 days for the ten-year bond. But the ten-year bond rate is more complicated than the overnight rate because bond buyers have to worry about inflation eroding the value of their investment over ten years. Lenders for one day do not worry about inflation because the price level does not change that much overnight, at least not in the northern half of the Western Hemisphere.

Volcker recalled observing a dramatic shift in long-term interest rates versus short-term interest rates during 1975, before he became president of the Federal Reserve Bank of New York. The federal funds rate declined to an average of 6 percent in July 1975, down from 13 percent a year earlier, while over that same period, the ten-year government bond rate rose from an average of 7.8 percent to over 8.0 percent.
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Short-term interest rates declined because the Fed tried to cushion the emerging recession, and long-term rates rose because investors worried about the inflationary consequences of the easier monetary policy.

Volcker thought the procedures announced on Saturday evening, October 6, could work in reverse. Higher short-term rates to fight inflation and lower long-term rates because investors believed the Fed's
new look would succeed. This twist in the yield curve would have confirmed the Fed's credibility. The market delivered a sobering message, and not just to Volcker.

The ten-year bond rate had spiked to over 10¾ percent when the FOMC gathered in the boardroom in the Fed's headquarters on Tuesday, November 20, 1979, the first meeting since the October 6 announcement.
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John Balles, president of the Federal Reserve Bank of San Francisco, sounded befuddled: “The only bad result I see from our October 6 actions is the very sharp rise in long-term interest rates. Maybe the school of rational expectations has an answer … because I can't get [one] from anybody else … To the extent that those rates are influenced by expectations of inflation I'm still wondering why … they went up instead of coming down.”
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During his confessional, John Balles had queried Mark Willes, seated at the long mahogany table in his capacity as president of the Federal Reserve Bank of Minneapolis, the hotbed of rational expectations thinking.
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Willes remained silent, but Balles solved the expectations puzzle himself. A decade of failed promises by the Fed to control accelerating inflation had promoted skepticism among rational bond investors. Balles urged his fellow members not “to rock the boat by any major change in the posture that we adopted … because I think we're right in the midst of a great credibility test … Our impact on long-term interest rates and inflationary expectations … will be messed up if we don't meet those goals that we've announced.”
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Volcker understood the power of credibility and had embraced monetarism to promote the cause. He had forsaken control over interest rates and adopted a “monetary targeting approach as a new … comprehensible symbol of responsible policy,” and told his colleagues on November 20, 1979, “When I appear in public or in private the first question I get is, ‘Are you going to stick with it?'”
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The question jogged Volcker's memory of Arthur Burns's mea culpa in Belgrade, when the former chairman lamented, “The Federal Reserve was willing to step hard on the monetary brakes at times—as in 1966, 1969, and 1974—but its restrictive stance was not maintained long enough to end inflation.”
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Volcker knew that failure to maintain
monetary restraint nurtured inflationary expectations, and he pledged to avoid making the same mistake he had observed in July 1975, when the economic downturn convinced the Fed to loosen credit and allow short-term rates to decline. The error may not have been obvious back then, before the Great Inflation had gathered force, but the accompanying rise in long-term interest rates was like a darkening sky before a storm.

The history of the past decade would haunt the Federal Reserve. In the meeting, Volcker warned the FOMC that their “sticking to it” under monetary aggregate targeting, which allowed interest rates to fluctuate with supply and demand for credit, might be misinterpreted.
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“I was at a lunch yesterday where there were some presumably sophisticated people … I went through my song and dance [about how] we are going to stick with it in terms of the money supply but that doesn't mean interest rates can't come down. I no sooner got finished with this ten to fifteen minute discussion when … a member of the Washington economic press … says, ‘Now, what I want to know is when are you going to change policy?' I said, ‘What do you mean by changing policy?' He says, ‘The first time interest rates go down.' ”

Volcker could have questioned the intelligence of all financial journalists, or just those gathered in the nation's capital, but instead he simply raised his palms in surrender. “There we are.”

Henry Wallich had told Volcker that he would regret the day he left interest rates to their own devices, and that he would have to pay for this Faustian bargain with the monetarists. Volcker had responded, “Sometimes you have to deal with the devil.”
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The bill from below would arrive shortly.

The price of gold hit an all-time high of $850 an ounce on Monday, January 21, 1980, a record that would last almost thirty years.
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International tensions in Iran and Afghanistan—it all started back then—combined with a worsening of inflation to an annual rate of 13½ percent during the last quarter of 1979, contributed to the speculative outburst.
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The more than doubling in gold prices between the November 20 FOMC meeting and the peak on January 21, 1980, created an uncommon interest in the precious metal.
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Harry Yaruss of the Rodman and
Yaruss Refining Company in New Jersey said that people want to “sell their gold before someone steals it,” and Jack Brod, owner of the Empire Diamond and Gold Buying Service in New York, hired an extra security guard to control the crowd outside his sixty-sixth-floor establishment in the Empire State Building.
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Inside Brod's office, a woman by the name of Anne Dawson exchanged several gold chains, a pin scarf, a gold locket, and a 1962 high school ring for $305. Another customer, Ernest Harvey, an employee of a textile company, offered four of his extracted teeth containing gold inlays, and walked away with $160. Jack Brod recalled, “We had a dentist come in with gold inlays and silver fillings … They were worth $3,000.”

J. Cantor Shoes in Yonkers, New York, had a small stamp and coin exchange in a corner of the shop. “Until four months ago you could sit and do nothing” in that end of the store, said the owner, Bob Cantor, “But now it's become positively wild.”
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A Yonkers widow handed Cantor several pieces of gold jewelry and said, with a touch of sadness, “Here are my husband's gold cuff links and tie clip. I know they are fourteen-karat gold.” A well-dressed woman in a fur hat and blue wool coat chimed in: “There's no sense keeping old jewelry lying around in drawers. And from everything I've heard lately, this is the right time to sell.”

The woman in the hat was right (making berets and derbies fashionable among Wall Street forecasters). The supply of antique jewelry and old dentures overwhelmed the speculative demand for gold and contributed to a collapse in price to $500 an ounce by April 1980.
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The decline would have buoyed Volcker's spirits, but a downward spiral in both the economy and the money supply tempered the celebration. A recession had taken hold that would test Volcker's commitment to the monetary aggregates, just as Henry Wallich had predicted.

Volcker had come under attack from enemies and friends, and sometimes it was hard to tell them apart. Donald Regan, the head of investment giant Merrill Lynch, explained that “we talk about B.V. and A.V., Before Volcker and After Volcker,” to measure the diminished profitability of the brokerage business.
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Regan would exact some revenge after becoming treasury secretary under President Ronald Reagan. Henry Kaufman, chief economist at Salomon Brothers, bypassed Volcker's
earlier invitation to “pick up the phone every now and again,” and turned to the press to describe members of the Federal Reserve Board as “reluctant gladiators,” fearful of fighting inflation by taking decisive action to retard the growth of credit.
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