Google books provides the extracts below from The Monetary Policy of the Federal Reserve.
(emphasis mine) [my comment]
... At the time, only a few academic economists like Irving Fisher and John Maynard Keynes possessed the modern conception of the central bank as a creator of money. The policymaking establishment considered such economists irresponsible (Roberts 2000. 91). Keynes abandoned monetary policy in favor of fiscal policy, perhaps, because of a belief that central banks lacked the conceptual framework and the will to pursue a policy of purposeful money creation (1.eijonhufvud 1968, 19).
It is hard to imagine the U.S. political system at the onset of the Depression abandoning the gold standard for a fiat money standard. A currency backed by gold was economic and political orthodoxy. The victory of William McKinley over William Jennings Bryan in the 1896 presidential election appeared to have forever tarred opponents of the gold standard as populist proponents of cheap money who would undermine the established social order. The Glass-Steagall Act of 1932 did give the Fed authority to back its note issues with government securities. However, the United States retained the gold cover requirements for currency issue.
Political attacks on the Fed as an institution also limited its ability to act radically. Senator Carter Glass, who had helped found the Fed, disliked the emergence of the New York Fed as the U.S. central bank. Real bills proponents like Glass blamed the stock market crash and subsequent economic malaise on the discount rate reductions that the Fed had made in 1924 and 1927 (Glass 1932). That criticism undoubtedly made the Fed conservative by requiring it to act with consensus, which limited the ability of the New York Fed to undertake unilaterally open market purchases.
In the real bills environment of the time, policymakers did not think of the Fed as a central bank capable of creating bank reserves. Instead, as E. A. Goldenweiser (1951, 161) explained, the Fed saw itself as a storehouse of the reserves of commercial banks. In the financial panics of the early thirties, its reaction was the defensive one of protecting those reserves:
That it a monetary easing could not have been put into effect is beyond dispute... That Federal Reserve banks could not fail the way commercial banks could as the result of deposit withdrawals, because the Reserve Banks could always issue notes to meet their deposit liabilities (member bank deposits), was not part of the System's thinking of the time.... Commercial bank concepts were simply being applied to a central bank to which they are not relevant.... A policy of large-scale open-market operations for the purpose of creating money directly and thus maintaining its volume... was not one that the System felt itself able to pursue.
Governor Harrison (U.S. Cong. 1932, 517) testified about Fed actions in fall 1931: "It would have been a very unwise and dangerous thing for the Federal reserve system to continue to dissipate its credit in the purchase of Government securities in such a time and yet in that situation last fall we would have had to do it had this bill been law for the price index was going down."
The gold standard also prevented the Fed from understanding its responsibility to manage its asset portfolio to maintain bank credit and the money stock. According to monetary orthodoxy, central banks should respond to gold outflows by raising interest rates. That meant reducing Federal Reserve credit by selling securities. Central banks competed for a given amount of world gold. They did not create their own reserves. In the early thirties, the Fed was trapped intellectually by monetary orthodoxy and real bills. As a radical central banker, it is unlikely that Governor Strong could have acted as Moses to lead the Fed into the land of modern central banking.
C. Transmitting U.S. Deflation through the Gold Standard
The United States had returned to the gold standard March 1919 upon ending its wartime gold embargo. Germany returned at the end of 1923; Britain, in early 1925; and France, in 1926. Allied war debts and the reparations payments required of Germany by the Versailles Treaty added to the fragility of the newly reconstructed gold standard. 'lb make the resource transfers ultimately required by the distribution of international debt, Germany would have had to run a balance of trade surplus with France and Britain. In turn, France and Britain would have had to run a trade surplus with the United States. In the protectionist world of the twenties, that was politically' unacceptable. The system stayed together only through capital outflows from the United States to Germany (Eichengreen 1995; Het/el 2002a; Yeager 1976, 333).
By the end of 1927, it appeared that Europe had successfully reconstituted the gold standard. However, in 1928, the Fed initiated a restrictive monetary policy. Governor Strong understood the problems that such a policy would pose for the Dawes Plan, which attempted to generate the capital flows necessary to make German reparations feasible. In July 1928, in a letter to the official overseeing reparations, Strong (cited in Chandler 1958,459) wrote: "The continued maintenance of very high rates in New York may ultimately present a real hazard to Europe and especially to the smooth operation of the Dawes plan. It may indeed provoke the very crisis which you seek to avoid."
By early 1929, higher interest rates in the United States forced foreign central banks to raise their discount rates. High U.S. rates disrupted capital outflows from the United States (Eichengreen 1995, 12). By the last half of 1929, foreign debt issued in New York was less than a third of its 1927 level (Chandler 1958, 456). Net capital outflows fell from $700 million in 1928 to $300 million in 1929 and 1930. Gold flows into the United States destabilized the newly reconstructed gold standards of Germany and Austria, which held minimal free gold reserves.
Prior to monetary restriction, the Fed's monetary gold stock had been falling. It went from $4.6 billion in 1927 to $4.1 billion in 1928 (for gold valued at $20.67 per fine ounce). Early in 1929, it began to rise and reached $5 billion in September 1931. France added to the strains placed on the international gold standard by returning to gold at a price that undervalued the franc and sterilizing the resulting gold inflows. Gold stocks of the Banque de France went from $1.1 billion in June 1928, the date of a franc revaluation in terms of gold. to $2.3 billion in September 1931. Inevitably, as the United States and France absorbed gold, banks would fail. In May 1931, the Kreditanstalt of Vienna failed.
In summer 1931, financial panic spread to Germany. The Reichsbank raised its discount rate from 5% in June to 15% on Ju ly 31. Believing that German banks were failing because of speculative credit extension, the New York Fed refused to lend to the Reichsbank to allow it to prevent the collapse of its banking system. At New York's urging, the Reichsbank closed its discount window to commercial banks, which had lent to German municipalities in violation of real bills principles. The gold reserves of the Reichsbank, which were $O.65 billion in January l929, fell to $O.23 billion in December 1931.
Financial panic then spread to Britain, whose banks had considerable exposure to German banks. In September 1931, Britain ceased redeeming sterling in gold. The shock to confidence that followed the end of the gold standard in Britain produced gold outflows from the United States, which lost more than $600 million in gold between August and November 1931. The New York Fed did not offset the gold outflows by purchasing securities. Instead, it raised its discount rate from 1.5 to 3.5% and reduced holdings of bankers acceptances. Market interest rates rose sharply.
D. The Roosevelt Monetary Standard
The United States did not extricate itself from deflation and depression through action of the Fed, which never purchased government securities purposefully to create money. Fed open market purchases (Federal Reserve credit) only accommodated the public's increased demand for currency manifested in bank runs (Figure 3.3). Just as the two recessions that made up the Great Depression involved an active attempt by the Fed to implement its real bill views, the two recoveries required sidelining the Fed as a central bank.
E. The Fed Attempt to Reassert Control
After the Fed froze its asset portfolio, the treasury controlled monetary policy. Through its control of gold purchases and sterilization, the treasury determined the growth of the monetary base. With the centralization of control in the new Federal Open Market Committee created by the Banking Act of 1935 and with a new, strong-willed board chairman. Marriner Eccles, the Fed attempted to reassert its prerogatives as a central bank. It did so through an attempt to reinstitute its borrowed-reserves operating procedures. As explained in the Appendix ("Borrowed— Reserve Operating Procedures"), they required the banking system to obtain the marginal reserves it needed through the discount window. As E. A. Goldenweiser (1951, 176) phrased it, to "bring the System in closer touch with the market... member banks should not be in a position to expand their operations substantially without being obliged to resort to the Federal Reserve Banks for accommodation."
To again force banks to the discount window, the Fed had to increase required reserves to eliminate the large amounts of excess reserves they had accumulated. Those excess reserves exceeded the Fed's holdings of government securities, which it needed to provide income. To avoid open market sales, the Fed turned to massive increases in reserve requirements. Under the influence of real bills, policymakers believed that the banking system's excess reserves could create inflation by allowing banks to extend credit for speculation, banks would do so to offset the negative effect on their earnings of the low level of interest rates. In his book Beckoning Frontiers, Eccles (1951, 288—9) wrote that high levels of excess reserves would allow banks to extend lending "beyond existing or prospective needs of business" and the result would be an inevitable "liquidation of holdings in a painful deflation."
On August 15, 1936, the Board of Governors raised reserve requirements by 50% to eliminate "what was superfluous to the needs of commerce, industry, and agriculture" (Ecdes 1951, 290). Also, the treasury began sterilizing gold inflows. The board later increased required reserve ratios to their statutory maximums by imposing an additional 33.3% increase to take effect in two steps on March 1 and May 1, 1937. From 1937Q1 through 1938Q2, M2 fell at an annuanzed rate of -1.9%. The economy reached a business cycle peak in May 1937. The trough occurred in June 1938 when money began a vigorous rebound.
After the Last increase in reserve requirements, banks again began to accumulate excess reserves. On December 31, 1940, the Fed petitioned Congress to raise the statutory maximums on allowable required reserve ratios. The report stated that "the Federal Reserve System finds itself in the position of being unable effectively to discharge all of its responsibilities." The report also expressed the concern that because of high levels of excess reserves some "interest rates have fallen ... well below the reasonable requirements of an easy money policy."
From World War II to the Accord
The juxtaposition of the Great Depression and World War II raised expectations dramatically of what government stabilization policies could achieve. In 1932, the unemployment rate rose to 23.6%. In 1939, it was still 17.2%. In 1945, the last year of the war, the unemployment rate was 1.9%.' The juxtaposition of massive unemployment in the Depression and full employment during World War II provided Apparently incontrovertible evidence that government spending could provide a countercyclical stimulus to the economy. The Employment Act of 1946 gave the government responsibility for full employment. However, there appeared to be no place for monetary policy in the arsenal of government policies.
I. A Changed Intellectual Environment
According to real bills, government could do nothing to arrest the painful economic adjustments that inevitably followed the collapse of a speculative mania. Depression had to run its course to eliminate excessive debt and to correct a maladjusted structure of wages and prices. The memoirs of Herbert Hoover (1952, 30) have forever associated this view with his Treasury Secretary Andrew Mellon, whom Hoover labeled a "leave it alone liquidationist":
Mr. Mellon had only one formula: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate." He insisted that, when the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. He held that even a panic was not altogether a bad thing. He said: "It will purge the rottenness out of the system. High cost of living and high living will come down. People will work harder, live a more moral life.
Spurred by the Great Depression, the economics profession began work on macroeconomic theories capable of refuting the pessimistic view that government was impotent to deal with recession once it had begun. The perceived cause of the Great Depression shaped the Keynesian response. Keynes's General Theory captured the prevailing sentiment that the Depression arose from a failure of the price system. The economy adjusted to shocks not through price changes but through quantity changes, that is, through changes in output and employment (Friedman 1974, Section 5). Furthermore, the concentration of economic power among large corporations and labor unions made changes in the price level an institutional datum rather than an equilibrating variable.
The view that pessimis m about the future could overwhelm the incentives of the price system received the name "elasticity pessimism." Because of the view that monetary policy operated through interest rates, this pessimism contributed to the belief in the impotence of central banks. Economists and policymakers viewed the low interest rates that prevailed during the Depression as confirmation that monetary policy was powerless to offset real disturbances.
In fact, as Table 3.1 shows, when real interest rates fell, the economy recovered. Table 4.1 shows the dramatic postwar reduction in both military expenditures and the government deficit. Despite the fall in fiscal stimulus, neither depression nor deflation reoccurred. Even with a massive military demobilization, the unemployment rate remained below 4% in the immediate postwar period. In time, the relative stability of the post—World War II economy made economists receptive to an explanation of the Depression other than the Keynesian one.
Friedman and Schwartz (1963a) offered the alternative, like the Keynesian response it also refuted the real bills counsel of despair. Their characterization of monetary policy by the behavior of the money stock rather than interest rates changed the perception of monetary policy in the Depression from easy to highly contractionary. However, the monetarist—Keynesian debate lay ahead (Hetzcl 2007a). After World War II, monetary policy was an orphan.
II. Postwar Inflation
Goodwin and Herren (1975, 9) summarize the environment that shaped stabilization policy in the post—World War II period: "America emerged from World War II with deep foreboding about post-war recession. An Elmo Roper poll for Fortune magazine in 1945 showed that only 41% percent of respondents believed that the United States would 'be able to avoid... a widespread depression.' In fact, inflation not recession turned out to be the primary postwar problem. Inflation soared with the end of wartime price controls. For the 12-month intervals ending June 1946 and June 1947, CPI inflation was 17.6 and 9.5%, respectively. Monetary policy, however, remained on hold.
After the entry of the United States into World War II, in April 1942, the treasury and the Fed agreed to freeze the prevailing term structure of interest rates. Rates went from 0.375% on 90-da treasury hills to 2.5% on long-term bonds. Given the problem with inflation after the war, why did the United States not free the Fed from its obligation to peg rates? The answer lies in the prevailing understanding of inflation, which reflected views formed during the experience with a commodity monetary standard.
That is, the behavior of prices arises from private behavior rather than central bank policy and "what goes up must come down." Figures 4.1 and 4.2 show indices of prices for the United States and England. For the United States, the price level rose and then fell with the War of 1812, the Civil War, and World War I. For England, this pattern appeared during the Napoleonic wars and World War I. Secularly prices exhibited no trend until World War Il.
This stationary behavior of the price level accorded with the real bills view that inflation arose from speculative activity by investors. In hearings on the 1945 Full Employment Act, Senator Robert A. Taft (R. OH) said, "My definition of inflation has always been an activity which is artificially built tip to an extent that we cannot permanently maintain" (Goodwin and Herren 1975, 1 7). Inevitably, deflation followed inflation as asset bubbles burst. In apparent confirmation of this view, people pointed to the recession that followed the post—World War I inflation and the stock market crash and deflation that followed the 1920s boom.
Goodwin and Herren (1975, 44) cite a 1947 report written by prominent economists including John Kenneth Galbraith and Seymour 1-i. Harris "... for a very dramatic expression that unrestrained inflation would lead to a very serious depression." In 1947, in an open letter recommending the veto of a bill reducing taxes, the Board of Governors (Board Miriues June 5, 1947,849) wrote: The longer inflationary pressures are sustained and readjustment deferred, the more serious the inevitable reaction will be ... the magnitude of which will depend largely upon how long inflationary forces are sustained."
was the incompatibility of the 0.375% peg on three-month treasury bills with the 0.875% peg on one-year certificates. Because banks sold short-term debt to the Fed and bought the longer term debt, which was just as liquid given the rate peg, the Fed ended up holding almost all outstanding short—term government securities. Although the short-term peg thus became irrelevant, no one questioned the 2.5% ceiling on bonds.
The Fed chafed at its inability to move short-term interest rates. However, the political environment precluded an open challenge to treasury dominance. Governor Eccles held the common belief that the postwar inflation arose from the government deficits incurred in World War II. To control inflation, he urged Congress to run large surpluses to extinguish government debt (U.S. Cong. November 25, 1947). He also wanted the power to prevent banks from making loans that would add to the stock of debt. He concentrated on a futile effort to persuade Congress to impose a supplementary reserve requirement on banks.
In an essay written before the Korean War, New York Fed President Sproul (1951, 315) expressed the common view that monetary policy could not affect inflation significantly without an unacceptable "contraction of employment and income." Sproul (1951, 298) wrote that the renewal of recession following the Fed's increase in reserve requirements in 1936 and 1937 made it "doubtful that credit policy would thereafter be used vigorously and drastically to restrain inflationary pressures." Sproul also expressed the accepted view that, because of the large amount of government debt outstanding, the Fed had to support the sale of government securities to avoid a "bottomless market" (U.S. l'rcasu 1951 Annual Report, 2b1).
The Fed could not have won a political contest with the treasury. By the end of the war, the military effort was consuming almost 40% of national output. The fear that reconversion to a peacetime economy would bring a return to depression shaped political views. The Board of Governors expressed its unwillingness to challenge the status quo in its letter to the directors of the Philadelphia Fed, who had urged actions to control the "spiral of expanding credit." Such a course, the Board of Governors (Board Minute's, May 28, 1947,811) argued,
would increase enormously the charge on the budget for servicing the debt. If the Secretary of the treasury were confronted with any such consequences... he would no doubt take the issue directly to the President who, in turn, would take it to the Congress... There can hardly be any doubt as to what the result would be. The "System's freedom of action" would in all probability be promptly terminated.
Ill. Explaining Recession with Gold Standard Expectations
The primary postwar m onetary puzzle is the decline in money growth and inflation given the Fed's interest rate peg (Friedman and Schwartz 1963a, 577). From I 942Q1 to 1945Q1, average annualized quarterly M1 growth was 23.7%; from 1945Q2 to 1945Q4. 10.3%; from 1946Q1 to 1947Q4, 4.7%; and from 1948Q1 to 1949Q4,
V. Creating a New Monetary Standard
In 1980, as a result of the interaction between the SCRP and the new operating procedures, the FOMC produced a small version of the stop-go cycle it was determined lint to repeat. That experience fortified its resolve not to initiate an expansionary policy in response to recession. The FOMC remained focused on establishment of credibility. Volcker told the FOMC (Board of Governors Transcripts February 2—3, 1981, 129): "Everybody likes to get rid of inflation but when one comes up to actions that might actually do something about inflation... one says: 'Well, inflation isn't that had compared to the alternatives.'... The history of these things in the past...is that when we come to the crunch, we back off"
Early 1982 tested FOMC resolve. Although the economy was contracting, the FOMC raised the funds rate. It focused on achievement of the M1 target as a litmus test of its commitment not to allow "go" periods of policy to follow "stop" periods. Governor Schultz (Board of Governors Transcripts February 2, 1982, 94, 108) commented: "To me...credibility... is really critical.... We have not yet changed ... inflation expectations because everybody thinks that we are going to cave in to the political pressure that is going to be on us."
For Volcker (1.S. Cong. February 25, 1980, 10, 22), money targets were a commitment device to constrain the FOMC to maintain a long-run focus on inflation rather than on economic stabilization: "There is little doubt that inflation cannot persist in the long-run unless it is accompanied by excessive expansion of money and credit." Money was an "automatic pilot" that would raise interest rates in response to inflation. In his statement, Volcker (U.S. Cong. February 25, 1980, 7— 17) emphasized how the commitment to monetary control would lower inflation by controlling expected inflation:
We have usually been more preoccupied with the possibility of near term weakness in economic activity... than with the implications of our actions for future inflation.... The result has been our now chronic inflationary problem with a growing conviction on the part of many that this process is likely to continue. Anticipations of higher prices themselves help speed the inflationary process.... Inflationary anticipations have tended to rise once again.... We cannot simply rail at "speculators" in foreign exchange or gold or commodity markets if our own policies seem to justify their pessimism about the future course of inflation.... Rising demands for wages and cost-of-living protection, anticipatory price increases, skyrocketing gold and commodity prices sharply deciding values in the bond markets — all of these are symptomatic of the inflationary process and undermine the economic outlook. But none of them are inevitable, provided we turn around the expectations of inflation.
In his first two years as chairman, Volcker experienced repeated instances in which the funds rate fell and then the bond rate rose (Figure l3.3). That sequence made clear that inflationary expectations could thwart the real effects of expansionary monetary policy. With the fall in bond rates in the last half of 1982, which accompanied the fall in the funds rate, the FOMC passed an important test. The next test would come in late spring 1983 when bond rates began to rise with an unchanged funds rate. Despite falling inflation, the FOMC increased the funds rate.
With that increase, Volcker started creation of a new nominal anchor. It was not the money target urged by monetarists, but rather the expectation of low, stable inflation. Later, Volcker (U.S. Cong. July 21, 1987,97) defined the Fed's objective in expectational terms. "Whatever the precise [inflation] statistics are, people should not be planning on inflation." Greenspan gave the same expectational definition (Chapter 15, n. 4). Inherent in these statements is the working assumption that monetary policy can shape the expectational environment in which price setters operate. Although neither Volcker nor Greenspan made the rational-expectations connection that associates the systematic part of monetary policy with the public's formation of inflationary expectations in practice it guided their conduct of
of three abstractions, each seemingly at odds with descriptive reality. First, the price level is a monetary phenomenon in that the central bank, which controls only a nominal variable (the monetary base), determines trend inflation. Second, the price system works in that moderate changes in the real interest rate keep output at potential (in the absence of monetary shocks that force unanticipated changes in the price level). Third, expectations are rational in that the public learns how to make its expectation of inflation conform to the consistent part of monetary policy. Together, these abstractions imply that a credible central bank can deliver price stability through conditioning the expectations of forward-looking price setters rather than through periodic recourse to the creation of excess unemployment.
The rational-expectations abstraction remains especially controversial. The emphasis here is on the evidence that despite the failure of the Fed to articulate the Consistent part of its behavior the public has adjusted its inflationary-expectations formation to that behavior. The monetary history of the twentieth century is that of the loss of the nominal anchor provided by a commodity standard and the fitful, often disastrous attempt to replace it with a paper standard. 'the initial failure of the Fed to accept responsibility for inflation and its continuing failure to explain the realized behavior of inflation in terms of monetary policy have made learning about monetary policy extremely difficult. Nevertheless, the public has adapted its expectations formation to monetary policy.
In 1983, inflationary expectations proxied for by bond rates replaced money as an intermediate target. Volcker never articulated the change in procedures. Greenspan, through his continued focus on shaping the expectational environment, turned Volcker's experiment into a new monetary standard. However, Volcker and Greenspan dealt with a succession of crises, and they interpreted monetary policy accordingly. The task of articulating the monetary standard they created must fall to their successors.
With lagged-reserves accounting, the reserves-demand schedule is vertical. Required reserves are predetermined because they depend upon deposits held two weeks in the past rather than upon deposits held in the current statement week. Also, desired excess reserves are interest insensitive. The intersection of the reserves supply and demand schedules determines the funds rate.
Consider the effect of a reduction in nonborrowed reserves. With the quantity of reserves demanded fixed in a given reserves-accounting period, borrowing from the discount window rises by an amount equal in magnitude to the reduction in nonborrowed reserv es. As a result, the marginal effective rate of interest on borrowed reserves rises. In Figure 13.6, R shifts leftward to R and intersects the unchanged R1 schedule at a higher funds rate. An increase in the discount rate produces the same increase in the height of the reserves supply schedule and, consequently, the same increase in the funds rate. ( R shifts upward to R'.) Figure 13.7 shows die relationship between the funds rate amid the discount rate for the period of nonborrowed reserves targeting.
Lagged reserves accounting renders infeasible a target for total reserves by making the reserves-demand schedule interest inelastic (verticaD. With a total-reserves operating target, the reserves-supply schedule is also interest inelastic. An attempt to target total reserves would produce a razor's edge situation. A reserves surplus would force the funds rate to zero and a reserves deficiency would force the funds own interest rates rather than through rate increases in the United States. Volcker (Board of Governors Transcripts May 19, 1987, 2) talked about "embarrassing" them.
During the inflation scare, President Reagan failed to reappoint Volcker [because he might have aggressively raised interest rates], whose departure came as a surprise to the markets. Although his replacement, Alan Greenspan, had been President Ford's CEA head and had headed a national commission on Social Security reform, he lacked Volcker's stature and credibility. Many in financial markets doubted whether Greenspan would be independent of the administration [he wasn't], and he lacked credentials as a central banker (Wall Street Journal June 3, 1987).
In August, the dollar began to depreciate again. Commentary attributed the associated rise in bond yields to fears of inflation and to foreigners' reluctance to hold bonds. In his last testimony, Volcker (U.S. Cong. July 21, 1987, 21, 23) summarized the challenge confronting Greenspan because of the inflation scare:
"We've had a burst of prices.., related to the oil and external situation.... Now do we relapse back to a lower rate of inflation ... or does that get built into... expectations?" Greenspan (U.S. Cong. March 5, 1985, 163) had already acknowledged the FOMC's focus on inflationary expectations: "The Fed is presumably keeping an eye on long-term interest rates as a gauge of inflation expectations. Should these show signs of beginning to rise steeply, the Fed could be expected to respond expeditiously with policies more heavily focused on lighting inflation."
As FOMC chairman, Greenspan (Wall Street Journal October 5, 1987) warned on This Week with David Brinkley of 'dangerously high interest rates" if financial markets' fears of accelerating inflation "start to mushroom." He continued: "There seems to be... a fear that.. the next step is to get it [inflation] out of control again.... lt's quite conceivable that if everybody gets it into his head that inflation is inevitable, they will start taking actions which will create" higher inflation.
Because a "sharp rise in long-term interest rates... had raised questions about the outlook for inflation, on September 4, the Hoard of Governors raised the discount rate and the FOMC increased the funds rate to 7% after its September 22 meeting (Hoard of Governors Record of Policy Actions Board, Annual Report 1987, 73). The 30-year bond rate, however, continued rising and peaked at 10.25% on October 19. That level of rates left the stock market overvalued, and it crashed that day. Figure 14.5 shows the 10-year bond yield and the ratio of forecasted earnings for the S&P; 500 companies to the S&P; 500 price index. The rise in bond rates preceded the market crash. Dollar politics determined the timing of the crash. In the week before, the dollar, stocks, and bond prices all fell on news of the August trade deficit. Although never publicly announced, the Louvre Accord had set "rather precise ranges" for the dollar exchange rate (Volcker and Gyohten 1992, 260). On October 15, as noted in an FOMC briefing by Sam Cross (Board of Governors Transcripts November 3, 1987, 2)) Secretary Baker "signaled displeasure with interest-rate trends in Germany, and there were press reports suggesting that the target range for the dollar would be lowered, or even that cooperation among the G -7 countries was breaking down. The dollar moved down abruptly against the mark... on the weekend of October 17." The New York Times (October 18, 1987) reported:
In an abrupt shift..., the United States is allowing the dollar to decline against the West German Mark, a senior Administration official said today. This means that the government is following through on Treasury Secretary James A. Baker 3d's comments Thursday implying that the United States would let the dollar fall in reaction to higher West German interest rates. Mr. Baker said today that West Germany "should not expect us to sit hack here and accept" rises in German interest rates.... Analysts and another senior Administration official ... said Mr. Baker's remarks... meant that the Administration and the Federal Reserve Board would not interfere if market pressures start pushing the dollar down somewhat against the German mark.
The New York Times (October 19, 1987) reported:
As Treasury bond yields rose above 10 percent last week and stock prices plummeted, the financial markets were focused on the dangers from abroad and unimpressed by assurances from senior government officials that interest rates were needlessly high and based on exaggerated fears of inflation... An adviser to the Deutsche Bank said, "The reason for the higher bond yields is the impaired inflow of foreign capital to the United States...." Foreign buying of Treasury bonds has already subsided this year, and there were periods such as in September, when Japanese institutions were actually net sellers of bonds.
On Monday, October 19, the Dow Jones industrials fell 22.6%.
Lack of credibility for government policies produced destabilizing shifts in investor sentiment in 1987. The promise of deficit reduction foundered with the failure of Gramm-Rudman. The breakdown of the Louvre Accord re-created the discrete changes in exchange rates that had characterized the fixed-rate Bretton Woods system. An inflation shock in the form of dollar depreciation set off an inflation scare.
Treasury Secretary Baker's public disputes with the Bundesbank and the Fed created doubts about the willingness and ability of the United States to maintain the valuc of the dollar. Baker expressed his unhappiness at the Board's September increase in the discount rate unmatched by reductions in interest rates in Germany and Japan. Governor Angell (Wall Street Journal May 2, 1994) later commented: "The precipitating factor in the 1987 stock market crash was the notion that the administration would accept a depreciating currency." Angell (New York Times August 24, 1997) also said, "I think there was a question about the Federal Reserve's credibility."
On Monday morning, October 19, when the market opened lower and continued to fall, the Desk engaged in nonstop telephone conversations involving the president of the New York Fed and several governors. In the afternoon, the Desk and the full FOMC held a telephone conference. The Desk concentrated on supplying the additional reserves that banks deman ded. Presidents of the Reserve Banks made clear that their discount windows were open. New York Fed president, Gerald Corrigan, made certain that brokers and dealers in the government securities market could continue to get credit to finance their operations regardless of market fears that the fall in stocks might have rendered some of them insolvent. The New York Fed notified government securities dealers that they could borrow government securities from the Desk's portfolio to collateralize repurchase agreements with banks.
Board Vice Chairman Manuel Johnson expressed concern that a rise in the funds rate above its previous level would indicate that the Desk was not fully meeting additional reserve demand. The Desk entered into a round of repurchase agreements Monday morning that supplied reserves in excess of what the prior week's projection indicated would be needed. Those repurchase agreements represented the Desk's only action before the afternoon telephone conference with the full FOMC. The issue never arose of reducing the borrowed reserves target to lower funds rate. The Fed concentrated on meeting unusual demands for liquidity. Only with the reduction in the funds rate on October 29 from 7.375% to 6.875% did the Fed associate its role in a crisis with an easing of policy rather than simply providing ample liquidity at an unchanged funds rate.
Central bank orthodoxy as distilled by Bagehot holds that in a financial crisis the central bank should provide liquidity at a high interest rate. There was no established precedent before Greenspan of lowering the funds rate in response to market volatility. For example, at its May 26, 1970, meeting, the FOMC had to deal with the crisis created by the Cambodian invasion. The DJIA had fallen 12% from beginning of year, its lowest level in six years. At the June 23 meeting, the Penn Central bankruptcy threatened the commercial paper market. Although the FOMC continued with the moderate decline in the funds rate begun in February, it reacted primarily by allowing banks to borrow freely at the discount window and by eliminating Reg Q ceilings on bank deposits of $100,000 or more (Maisel 1973, 38—45). Similarly, from October 26 through December 5, 1973, the DJIA fell 20% while the funds rate remained unchanged at 10%. Finally, during the collapse of Continental Illinois, which began in May 1984, the FOMC raised the funds rate from 10.25% in April to 11.625% in August.
Over 1988, core PCE inflation rose from 3.75% to 4.75% (Figure 14.1). In retrospect to avoid exacerbating inflation, the FOMC should have limited its response to the stock market crash to liquidity provision at an unchanged funds rate instead of creating stimulus through a funds rate reduction. The FOMC lowered the funds rate from 7.375% before the October 1987 stock market crash to 6.5% after its February 1988 meeting. Although growth had revived in early 1987, the funds rate did not rise significantly until late spring 1988 (Figure 14.6).29 Only after May 1988 did the real rate rise significantly (Figure 14.2). Although the Greenbook had predicted weakness, by spring 1988, it was clear that output was growing at an unsustainable rate (Figure 13.2).
Nevertheless, on February 24, 1986, in a split 4-to-3 vote, the board voted a decrease in the discount rate of half a percentage point. The vote was startling in that the chairman was in the minority. Later in the day, the board rescinded the action (Board of Governors, Record of Policy Actions Board Annual Report, 1986, 81). On March 6, it voted unanimously to reduce the discount rate. According to the Record of Policy Actions of the Board of Governors, the critical factor in making the vote unanimous was the willingness of key foreign central banks to lower their discount rates also. Volcker believed that a coordinated lowering of discount rates would avoid a further, sharp depreciation of the dollar.
As noted earlier, the decisions made at the February FOMC meeting indicated a majority sentiment in favor of no change in the funds rate. Although the contingent language of the Directive is vague, it indicated an emphasis on incoming data from the real sector. Both inside and outside the Fed, the most widely watched statistic on the real sector is the monthly nonfarm civilian payroll employment figure from the Labor Department. This statistic is the first available, comprehensive indicator of the behavior of real output. On February 7, the employment figure registered a gain of 56,000, the largest gain in the entire decade. This statistic is fairly volatile from month to month. Its average gain in the previous three months of 210,000, however, indicated steady growth in the economy (Figure 14.7).
On March 6, the hoard nevertheless approved a reduction in the discount rate by half a percentage points which carried through to a reduction in the funds rate. The board desired to move toward a more stimulative monetary policy. Reducing the funds rate via a discount rate decrease allowed it to do so without the dissents that could have arisen in forcing the issue at an FOMC meeting.
This situation recurred at the April 1, 1986, FOMC meeting. The Record of Policy Actions indicates that at the meeting FOMC members were divided on whether to emphasize the transitory disruption to energy-producing regions caused by the fall in the price of oil or the longer run positive effects for the overall economy of lower energy prices. The Record notes that "the staff projection presented at this meeting had suggested that the expansion in real GNP would strengthen by the second half of the year, after the relatively modest growth in the first half" (Board of Governors, Record of Policy Actions FOMC Annual Report 1986, 106). The directive asked the Desk to "maintain the existing degree of reserve pressure" and not to lean toward changing the funds rate in the intermeeting period either up or down. ("Somewhat lesser reserve restraint or somewhat greater reserve restraint might be acceptable.") The payroll employment figure available after the FOMC meeting indicated a continuation of moderate growth. The increase announced April 4 was 192,000, which followed a revised increase for the month earlier of 153,000. On April 18, the board nevertheless moved the discount rate down from 7% to 6.5% and reduced the funds rate to 6.875%.
At the May 1986 meeting, the FOMC again voted for an unchanged borrowed reserves target (and by implication an unchanged funds rate) and for a symmetric directive. At its July and August meetings, respectively, the FOMC voted to "decrease somewhat" and to "decrease slightly" the "existing degree of pressure on reserve positions." At both the July and August meetings, it adopted a symmetric directive. The use of the adverbs "somewhat" and "slightly'" suggested a reduction in the funds rate of 0.12 to 0.25 of a percentage point. In each case, however, after the FOMC meeting, the Board lowered the discount rate and the funds rate by half a percentage point. It also accompanied the discount rate reductions by language drawing attention to slow economic growth. In that way, it announced publicly an intention to stimulate growth [by sacrificing the dollar]. Between January and late August 1986, the funds rate fell from 8 to 5.875%. The hoard generated that fall entirely by a 2 percentage point reduction in the discount rate. Also, the reductions in the funds rate were large— half a percentage point rather than the usual 0.25 or 0.125 of a p ercentage poi fl t.
I. The Absence of an Articulated Greenspan Standard
The Greenspan FOMC never discussed strategy. The role of the FOMC was to accept or reject Greenspan's funds rate recommendations. Public characterization of monetary policy was also the chairman's prerogative — a characterization that reflected his nonmonetary view of inflation and inflationary expectations. Specifically, monetary policy is only one contributing factor to trend inflation and inflationary expectations. Greenspan testified (U.S. Cong. February 25, 2004, 28): "The low inflation rate... is the consequence of a number of things, largely globalization and the competition that has come from globalization and a whole series of structural changes, including... the bipartisan deregulation that has been going on for a quarter of a century." [bullshit]
restraint will involve containing pressures on our productive resources and, thus) some slowing in the underlying rate of growth of real GNP is likely in 1989. The central tendency o(GNP forecasts for this year of Board members and Reserve Bank presidents is 2—1/2 to 3 percent; abstracting from the expected rebound from last year's drought losses, real GNP is projected to grow closer to a 2 percent rate.
One can infer that FOMC members hoped to keep real growth enough below trend to raise unemployment but still high enough to prevent recession. However, the FOMC never implemented a strategy to effect such a soft landing. It never specified a NAIRU (nonaccelerating inflation rate of unemployment or full employment) value and a path for unemployment relative to NAIRU that would serve as an intermediate target path the way that money had served in the post-October 1979 period. Basically, the FOMC raised the funds rate steadily to a value that made monetary policy restrictive and then lowered it only cautiously when the economy went into recession. The disinflationary strategy was "opportunistic" in that it avoided any direct association between increases in the funds rate and in the unemployment rate.
IV. The 1994 Inflation Scare
In 1994, a resurgent economy tested the FOMC's resolve to attain price stability. By September 1993, the economy had begun to grow more strongly and bond rates rose (Figure 14.3). With an unchanged funds rate, the short-term real rate fell. From September 1993 through February 1994, it averaged 0.2% (Figure 8.3). By the February meeting, many FOMC members wanted to raise the funds rate by 1/2 percentage points. However, Greenspan was willing to move only cautiously. Early in 1994, Greenspan (Board of Governors Transcripts February 4, 1994, 55) opposed a significant funds rate increase:
It is very unlikely that the recent rate of economic growth will not simmer down largely because some developments involved in this particular period are clearly one-shot factors — namely the very dramatic increase in residential construction and the big increase in motor vehicle sales.... I've been in the economic forecasting business since 1948, and I've been on Wall Street since 1948, and I am telling you I have a pain in the pit of my stomach.... I am telling you — and I've seen these markets — this is not the time to do this [raise the funds rate 50 basis points]. (italics in original)
In the event, the economy did not 'simmer down" with a small funds rate increase. The UOMC moved the funds rate up by a quarter percentage point at each of the February and March meetings. Starting in late spring 1994, it began to raise the funds rate decisively. A series of increases left the funds rate at 6% in February 1995 — double its cyclical low of 3%.
In 1994, measures of resource stress flashed red. Capacity utilization rose from just over 80% in mid 1993 to 85% by yearend 1994. Vendor performance (the Institute of Supply Management or ISM measure of delivery times) moved from around 51 in 1993 to 65 by year-end. A consensus existed in the forecasting community that, if the unemployment rate fell to a value somewhat above 6% (the NAIRU), labor costs would begin to rise. The May 1994 Greenbook was unusual in that it gave an explicit number for the NAIRU — 6.5%. The economy passed that threshold when the unemployment rate fell from 6.6% in 1994Q1 to 5.6% in 1994Q3.
Financial markets continued to fear that the FOMC might let inflation revive. Citibank's Economic Week (June 13 1994) stated: "Capacity utilization...has been edging up toward 85%, the level at which inflation usually starts to heat up.... The remaining slack in the U.S. economy could be used up by year end.... Inflation ... will begin to heat up soon.
The 30—year bond rate, which reached a trough on October 15, 1993 of 5.8%, rose to 8.2% on November 4, 1994. The FOMC raised the funds rate at its February and March 1994 meetings in 0.25 percentage point increments from 3 to 3.5%. The dramatic rise in bond rates through most of 1994 conveyed the message from the markets that the FONIC was not moving aggressively enough to counter incipient inflationary pressures. Greenspan abandoned his hallmark quarter point funds rate changes and the FOMC raised the funds rate 0.75 percentage points after the May 1994 meeting; 0.5, after the August meeting; 0.75, after the September meeting; and 0.5 again after the February 1995 meeting. In 1994, the FOMC raised the funds rate without first seeing a rise in inflation. Between 1993 and 1994, CPI inflation (year-over-year) fell from 3.0 to 2.6%. That behavior earned the term "preemptive strike." (Greenspan (U.S. Cong. February 22, 1994, 12) likened raising the funds rate only after inflation had risen to "looking in a rearview in mirror.
For Greenspan (U.S. Cong. June 22, 1994, 23, 11—12), the association between above-trend growth and rising inflationary expectations implied a failure to restore credibility:
The rise in long-term rates has been partially an expectation of... increased inflation. After World War II ... tightened markets became increasingly associated with rising inflation expectations.... There remains a significant inflation premium embodied in long-term interest rates, reflecting a still skeptical ... view that American fiscal and monetary policies retain some inflation bias.... Having paid so large a price in reversing inflation processes to date, it is crucial that we do not allow them to reemerge.
The slowness with which the FOMC lowered the funds rate coming out of the 1990 recession kept the lid on nominal expenditure growth in the recovery. In 1994, when the economy began to grow strongly, the FOMC raised the funds rate sharply, restrained nominal expenditure growth, and offset a rise in inflationary expectations.
The combination of the 1990 recession, the restraint imposed on expenditure growth in the recovery, and the restrictive actions of 1994 created the conditions for a decline in inflation. From 1995 to 1996, inflation (year—over-year change in chain-weighted GPG deflator) fell from 2.3 to 1.9%. At the same time, real GDP growth rose from 2.3 to 3.4%. [the 1995-1996 is when gold manipulation truly begun]
Figure 15.1 exhibits the change from an unfavorable to favorabl e mix of real growth and inflation that began in 1996. That change occurred with stable nominal expenditure growth around 5.5%. The behavior of inflationary expectations is the key to understanding the change. As shown in Figure 15.1 in the first half of the decade, a modest decline in the bond rate required subpar real growth during economic recovery. In 1994, bond rates rose when real growth rose. In contrast, starting in 1996, the bond rate fell while real growth rose [Rubin became secretary of the treasury in 1995]. The 30-year bond rate, which averaged 7.4% in 1994, declined to 5.6% in 1998. The bottom solid line records one-year-ahead inflation forecasts from Global Insight. They fell from an average of 2.9% for the years 1991 through 1995 to 2.4, 2.2, and 1.9%, respectively, in 1996, 1997, and 1998. By the end of the decade, financial markets had stopped associating high real growth with a resurgence of inflation. The Fed had defeated the "bond market vigilantes." [by market manipulation]
International Bailouts and Moral Hazard
In 1995, the treasury led an IMF bailout of foreign investors in Mexico. The bailout set off a chain of destabilizing events. The amount of money potentially made available to prevent default by Mexico on dollar-denominated debt made banks willing to hold large amounts of short-term debt in U.S. allies. That debt made possible the Asia crisis. Banks made what looked like sure one-way bets in lending to Asian banks and then abandoned them en masse when currency devaluations caused insolvencies large enough to threaten the international safety net. The FOMC responded to the Asia crisis with expansionary monetary policy, which exacerbated an unsustainable rise in asset prices. The fall of lofty equity valuations created the 2000 recession.
I. The Mexico Bailout
By late 1994, the Mexican peso had become overvalued due to an unwillingness of the Mexican government to allow the exchange rate to depreciate sufficiently to compensate for domestic inflation. From 1990Q1 through 1994Q3, the Mexican CPI doubled. Over this same period, the U.S. price level rose by 18% and the peso price of the dollar rose by 30%. The combined rise of these last two variables, 48%, offset just less than half of the rise in the Mexican price level. By the end of 1994, U.S. goods looked 50% cheaper to Mexicans than they did at the beginning of the 1990s. Mexicans responded to the relative cheapening of U.S. goods by going on a shopping spree in the United States.
How did MEXICO maintain an overvalued exchange rate? Equivalently, how did it finance the associated trade deficit? In part, Mexico maintained the value of the peso by running down the reserves of its central bank. More important, over the years 1991 through 1993, Mexico benefited from heavy inflows of capital. The promise of a North American free trade zone plus low Mexican wages made Mexico an attractive place to invest. Troubles arose in January 1994 with the uprising in Chiapas and assassination in March of 1uis Donaldo Colosio, a presidential candidate and secretary-general of the Institutional Revolutionary Party (PRI). Thereafter, foreign investors became increasingly concerned about the stability of the peso.
economies in Asia collapsed with little obvious warning. Popular commentary attributed the crisis to the herd behavior of investors. But bankers are in the business of assessing risk. Why would they have lent in the first place on the basis of minimal information about the health of Asian banking s stems? And then why would they flee en masse? Moral hazard created by the IMF offers answers.
The IMF bailed out international investors in Mexico in early February 1995, the year that bank flows to Asia rose dramatically. Large money center banks believed that the United States and the other G-7 countries would use the IMF to prevent the financial collapse of strategically important countries. At a conference on Asia sponsored by the IMF and the Federal Reserve flank of Chicago in Chicago October 8—10, 1996, a director of the Deutsche Bundesbank, Helmut Schieber, said in comments that the Bundesbank had asked German banks why they had lent so heavily to Pacific Rim banks. According to him, they replied that they believed the IMF would bail them out in case of trouble (author's notes).
Led by the United States, the G-7 countries concluded from the Mexican experience that the IMF needed more resources. At the 1995 and 1996 G-7 summits, participants agreed on funding increases and an expedited decision-making process for emergency lending. They agreed upon a 45% increase in member quotas to raise IMF capital to $285 billion. They also agreed to create a new lending facility called the New Arrangements to Borrow with $21 billion in addition to the General Arrangements to Borrow. The U.S. share amounted respectively to $14.4 billion and $3.5 billion for each part. The amounts involved in subsequent IMF bailouts rose dramatically. During the Asia crisis, in billions, South Korea got a $58.2 package, Indonesia $47.7, Brazil $41, Russia $22.6, and Thailand $17.2.
From 1977 through 1989, capital flows to the emerging markets of Asia averaged about $16 billion per year. From 1990 to 1994, they rose to $40 billion. Then in 1995 and 1996, they surged to $103 billion annually, before falling to only $13.9 billion in 1997 (see IMF 1995, 33; 1998, 13). Large banks generated the sharp swings in capital flows. Over the period 1993 through 1997, portfolio investment by institutional investors and foreign direct investment remained steady at about $15 billion and $10 billion per year, respectively. Capital inflows from foreign banks to Indonesia, Korea, Malaysia, the Philippines, and Thailand averaged $16 billion per year from 1990 to 1994. Foreign bank lending then rose to $58 billion for most of 1995 and 1996. It fell to an annual rate of $22 billion in 1996Q4 and most of 1997. In 1997Q4 and 1998Q1, banks withdrew over $75 billion in funds. For example, in Thailand, short-term credit extended by foreign banks grew by 35% from December 1995 through June 1996. From June 1997 through December 1997, it fell almost 35% (World Bank 1998, 161).
The IMF characterized its assistance to Mexico as responding to a financial panic. In Mexico, as in Asia, its strategy was to put together an aid package with an enormous headline amount to convince investors that they could again invest safely in the country. To reassure investors, the IMF prevented foreign banks from losing money. The IMF pressures debtor countries not to default by never lending into arrears. (The IMF does not lend to a country if it is in default on its foreign debts.) As a result, banks had good reason to believe that they would be bailed out in the case of debt defaults. Krueger (1998, 2014) wrote: "It seems plausible that, especially after Mexico, bankers came to believe that the IMF would always bail them out and therefore they did not feel the need to concern themselves greatly with individual countries' economic policies." Greenspan (May 7, 1998, 4) said: "I pointed earlier to cross-border interbank funding as potentially the Achilles' heel of the international financial system. Creditor banks expect claims on banks, especially in emerging economics, to be protected by a safety net and, consequently, consider them essentially sovereign claims."
Furthermore, banks are in a strong position to ask their governments to pressure debtor countries to guarantee loans against default. The IMF must keep them in countries it is assisting; otherwise, newspapers will characterize IMF lending as a large bank bailout. In the case of Korea, government officials and regulators urged banks not to withdraw. The New York Times (January 2, 1998) reported: "Treasury Secretary Robert F. Rubin has also played a forceful role with the banks, personally calling chief executives at some of the largest banks to make them aware of America's interest in seeing South Korea through its economic crisis." Bank regulators in other countries followed suit (Wall Street Journal December 31, 1997).