- 2. PaulA. Volcker Martin Feldstein asked me to comment on some of the significant events in monetary policy during my tenure as chairman of the Federal Reserve. I think that there are five periods that deserve particular comment: the Federal Reserve ’s adoptionof a more monetaristapproachto policy-making in 1979;the credit controlsand recessionof 1980;the relaxationof monetary policy beginning in late 1982;the Plaza Accord in September 1985; and the Louvre meeting in February 1987.
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- As early as the spring of 1982, I suggested a tripartite accord-White House, Congress,and Fed-to shiftthe policy mix to tighterbudget and easier money. It was a good idea then, and it has been a good idea ever since.
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- As for the decision to stop the decline of the dollar in 1987, Volcker said that the Treasurywas certainlyaware of his concernsabout inflation and more pointedly than about the implications of a continuing fall in the dollar. He thought that the Treasury had already become somewhat concerned about the implicationsof further dollar decline.Also, the Treasurywas concerned about internationalcooperationfrom Japan, which it wanted to undertake an expansionary fiscal policy.
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Barro, Robert, and Robert Gordon. 1983. Rules, discretion, and reputation in a model Barro, Robert, and Xavier Sala-i-Martin. 1990.Worldreal interest rates. NBERMacroeBlanchad, Olivier, and Lawrence Summers. 1984. Perpsectives on high world real inFeldstein, Martin. 1986. The budget deficit and the dollar. NBER MacroeconomicsAnGreider, William. 1987. Secrets ofthe temple. New York: Simon & Schuster. of monetary policy. Journal ofMonefaryEconomics 12, no. 1 (July): 101-21. conomics Annual, 15-6 1. terest rates. Brookings Papers on Economic Activity, no. 2:273-324. nual, 355-92.
- But the central question for today is, What were the implicationsof the accord for monetary policy? I read a lot of analysis that says that the Federal Reserve would have preferred to tighten policy for domesticpurposes but was forced into a looser policy in order to help bring down the dollar. That is not true. By 1985,I was quite concernedthat the U.S. economywas slowingdown, and the Japanese and European economies were very sluggish as well. There was no doubt in my mind that it was not the right time to tighten policy. In fact, it was the absence of any need or desire to tighten that provided a “green light†for the Plaza Agreement. Indeed, there was substantial argument with the Fed in favor of loosened monetary policy for domestic purposes, but one reason that I opposed that action was because I did not want the dollar to fall in value too suddenlyor confidencein our anti-inflationaryresolve to be undercut.
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- But, in the early 1980s, monetary policy, like fiscal policy, was completelyout of character. Krugman wondered why this was possible. One explanation might be the great intellectualconfusionthat was reigning in 1980. There was the monetaristlrationalexpectations belief, for example, that, if you strongly announced your willingness to sufferpain, you would not actuallyhave to suffer it. Monetarism also gave the Fed the ability to say that it was simply targeting monetary aggregatesand not actuallyplanning on a recession. Krugman also asked whether it was simply a “stealth tactic†for the Fed to use the trappings of monetarism to pursue an essentially orthodox disinflationary policy.
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- By 1980, economists inside and outside the Federal Reserve and the Treasury understoodthe qualitativerole of exchangerates, capitalmovements,and trade imbalancesin the transmission of monetary measures-and fiscal measures too-to the economy in a world of floating exchange rates and mobile financial funds. Qualitatively,things happened the way our theory said they would. But I guess that no one, even in the Fed’s international shop, foresaw how largethese effectscouldbe, how long they couldpersist, and how difficult they might be to reverse.
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- By the fall of 1982,the money supply began rising rapidly again. The money supply figures were clearlybeing distortedby the new money market accounts and other institutionalchanges,so this provided the occasionfor an announcement that we were not going to followM1 as religiously as we had been doing. In particular, we were not going to institute contractionarypolicy simply because the money supply figures were rising, and, in fact, we made another importanteasingmove in the fall. By the end of the year, a strongrecoverywas under way.
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- Charls Walkerasked the role of the presidentsof the Federal Reserve Banks in making policy. He wondered in particular whether they had supported or hindered Volcker’s efforts from 1980to 1982. Volcker saidthat there had been a very harmoniousboard duringthat period. People knew each other well and did not have very divergent views. Without question, however, the most monetarist people were some of the bank presidents. So Volcker said that he instinctivelyknew that many of the bank presidents would be enthusiastic over the new policy because they had at times in the past promoted somethinglike that themselves.
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- Demand management cannot take major credit for the improvement in the NAIRU, except that the previous deep recession may have helped discipline subsequent wage- and price-setting practices. Sharper foreign competition helped, a thin silverliningto the dark cloud of dollar appreciation.The decline in oil prices prior to August 1990 was a welcome contrast to the 1970s.whatever cleared the path for expansion, the Fed does get credit for following the path into new territory,cautiouslykeeping the recovery going as long as inflation remained well behaved.
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- Despite these handicaps, the Fed has been quite successful. Volcker and company, and then Greenspan and company, restored the reputation of finetuning and made it into a fine art.The proof is in the pudding. The economy grew steadily, if sometimes slowly, and eventually recovered the ground lost in the recessions. In 1988-89, unemployment was lowered well below what economistsconsideredthe lowest inflation-safe rates ten years earlier. Finally, aftermanaging a “softlandingâ€at this new and lowernonaccelerating-inflation rate of unemployment (NAIRU), for the last two years the Fed has managed to steer the economy between the Scylla of price acceleration and the Charybdis of recession. I don’t know how long that will be true, but it is true so far.
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- Feldstein agreed that there were many people within the administrationwho were takingevery opportunityto criticizethe Fed in 1983and 1984,especially as more and moreprivateforecasterswere predictinganotherrecession.Nevertheless, President Reagan often took the opportunity at news conferences to say that he was supportingthe Fed. Volcker added that, in his view, the most important single action of the administrationin helping the anti-inflation fight was defeatingthe air traffic controllers ’ strike. He thought that this action had had a rather profound, and, from his standpoint,constructive,effect on the climate of labor-management relations, even though it had not been a wage issue at the time.
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- Feldstein asked how effectivethe 1979“regime shiftâ€had been in convincing financial markets that the Federal Reserve was serious about reducing inflation. Volcker believed that the outcome of the regime shift was not as favorable as he had expected or hoped. The Fed wanted to show banks that they did not have an inexhaustiblesupply of money, so they ought to take more care about the credit they were extending. This is the reason that the Fed put a special reserve requirement on time deposit accounts in October. Yet the policy was not as effectiveas hoped becauseof deep skepticismin the market.One indication was that people interpretedthe fact that the Federal Reserve set monitoring ranges for the Federal funds rate as meaning that it was not really going to follow the new policy. Volcker added that this was why he was really not sure that there would have been a recession in March 1980without the credit controls.
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- Feldstein questioned whether it was a natural thing that the economy had turned around so quickly after the very sharp downturn in 1980. As Volcker had described it, the credit controls induced a drop in money demand so that interest rates fell automatically without any explicit action by the Fed. In response to lower interest rates, money demand increased, and the economy recovered, with the Fed just a passive player. Volcker clarified that the Federal Reserve had taken the discretionary step of increasing nonborrowed reserves on several occasions.
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- Feldstein then asked why the Treasurychanged its policy regarding the exchange rate between 1985 and 1987. In 1985, the Treasury seemed eager to push the value of the dollar down, whereas, in 1987, it wanted to keep the dollarfrom decliningany further. He wonderedhow much the decisionto stop the dollarfrom decliningwas due to Volcker’sconcernsabout an increasein inflation. Volckersaid that, under SecretaryDon Regan, the TreasuryDepartmenthad taken it as a badge of national honor that the valueof the dollar was high. They did not want to intervene,no matter how high the dollarclimbed.On the other hand, Treasury SecretaryJames Baker and Deputy SecretaryRichard Darman seemed to dislike the large trade deficit, and they were particularlyconcerned about the increasing protectionistpressuresin Congress. Volcker thought that this concern was really what had triggeredthe Plaza Agreement.
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- Geoffrey Carlinerasked how importantPresidentReagan’s supporthad been to the Fed in its efforts to fight inflation in 1981and early 1982.He also wondered whether the Fed would have received similar support from President Carter.
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- I am still saying these things, now to people who wony whether budget correction will cause recession. I hope I am right. The Fed might have to act faster,in larger steps,than they did in 1984-86. Twenty-fivebasis points every FOMC meeting would not be enough.
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- I mention this episode because it did unintended and unexpected longlasting damage. The return of double-digit short interest rates in mid-1984, raising long-term bond rates above 13 percent again, ratcheted the dollar up another big notch (20 percent nominal, 19 percent real, in the multilateral trade-weighted index). I realize that, as Paul Krugman convincingly argued, there must have been significant speculative content in the appreciationof the dollar. But U.S. interest rates had a lot to do with it. The merchandise trade deficit grew from $21.7 billion in 1983:4 to $29.3 four quarters later, the current account deficit from $18.3 to $30.0. Reversal of the deteriorationproved to be a slow and difficultprocess, even after the dollar’sexchangevalue fell.
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- I shall discuss only briefly the three years from October 1979, the period of seriousquantitativemedium-run targets for monetary aggregatesand of shortrun operating targets for quantitiesof reserves. History will confirm the praise that Paul Volckerearned from his contemporariesfor his resolute generalship of the war againstthe inflationof the late 1970s.Therecessionsdid not reduce inflationto zero, but they did lowerit to a comfortablerate, 4-5 percent, which proved to be stable during the subsequentcyclical expansion.
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- In 1979-80, many economistscontendedthat the way monetary policymakers could bring about a relatively rapid and painless disinflation would be to announce strict monetarist targets and operating procedures and to commit themselves to stickwith them regardless of what happenedto business activity and employment.Thus,businessmanagers and workerswould be put on notice that their livelihoodsandjobs dependon their own price and wage decisionsthey must disinflate.This popular academicview may have influenced the cliJames Tobin mate of opinion in the Federal Reserve System and the financial markets. I gather that it was not as important in Volcker’s own thinking as the need to obtain and display consensus in the system for a policy move appropriate to prevailing economicconditions.
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- Ironically,despitetheseinflationaryexpectations,there was also an expectation that a recession was starting. For several months before the summer of 1979, the Federal Reserve staff had been projecting that a recession would begin shortly.
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- James Tobin The new Fed monetary regime, beginning in the fall of 1982, changed both medium-run targets of policy and operating procedures. Although target ranges for intermediatemonetary aggregatesare still voted on and announced, as required by law, they have lost importance,as the markets know very well (see Mussa’sfigs. 2.8 and 2.9).
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- James Tobinstressed Krugman’squestionaboutthe extent to which the Federal Open MarketCommitteehad been influencedby the rationalexpectations/ monetarist doctrine in the late 1970s and afterward. The theory says that, by making a credible threat that there will be pain and suffering about which the Fed will do nothing, the Fed can acceleratedisinflation without as much pain and suffering.Had this theory been significantin the shift in policy during the period 1979-82? Summary of Discussion Volckerrespondedthat there had been a hope that the theory would work in a general way, but certainly no faith in the more extreme formulations.There was a view that, if the Fed was credible enough, then short-terminterestrates might go up, but long-term rates would remain stableor evengo downbecause everyonehad somuch faith in the new, powerfulanti-inflationprogram.In fact, however, long-term rates went up.
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Kydland, Finn, and Edward Prescott. 1977.Rules rather than discretion: The inconsistency of optimal plans.Journal of Political Economy 85, no. 3 (June):473-91.
- Let me begin in late 1979, when I went to Washington. Michael Mussa’s backgroundpaper accurately describesthe setting for monetary policy at that time. Inflationary expectations seemed to be rising, as there was little confidence in the financial markets that the Federal Reserve would effectively restrain an increase in inflation. One part of the problem, I believe, was that banks had lost any fear that they might ever be unable to raise funds for lending.
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- Martin Feldstein asked whether the Federal Reserve expecteda recessionto occur in 1980as a result of its change in monetary policy in late 1979. Summary of Discussion Volckerrespondedthat theFederalReservestaff (likemany others)had been projectinga recessionfor a long time but that it had not yet materialized.Thus, he thought that there was some risk of one occurringbut that he was not at all certain, as the economy seemed to be expanding despite the expectations and people seemed to be willing to borrow and lend. Volcker said that he knew that a recessionwould occur sooneror later,regardless of the short-term stance of monetary policy, and that even now he is not sure whether the economy would have had a recession in March and April if credit controlshad not been imposed. Volcker also noted that the White House had strongly urged (and authorized)the credit controls to make a politicalpoint as a supplementto the more traditionalmonetary restraint.
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McCallum, Bennett. 1988. Robustness properties of a rule for monetary policy. Camegie-RochesterConference Series on Public Policy 29 (Autumn): 179-203.
- Meltzer, Allan. 1987. Limits of short-run stabilizationpolicy. Economic Inquiry 25 . 1991.The Fed at seventy-five.In Monetary policy on the 75th anniversary of Tobin, James. 1980. Stabilizationpolicy: Ten years after. Brookings Papers on Eco(January): 1-14. the Federal Reserve System, ed. M. Belongia, 3-65. Boston:Kluwer. nomic Activity, no. 1: 19-7 1.
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- Monetary Policy For the management of aggregatedemand, monetary policy has been the only game in town since 1981.The Reagan administrationdisabled fiscal policy as a tool of macroeconomic stabilizationand dedicated it wholly to other goals, as discussed in other sessionsof this conference.Structuralbudget deficitsfar beyond previous peacetime experience clouded the environment to which the Fed had to adapt. No doubt the economic and political implications of the federalbudget complicatedthe Fed’s decisionproblems. There were othernew complexities and uncertainties: dramatically increasing international capital mobility; Latin American and other Third World debts; structuraland regulatory changes in American banking and finance; insolvencies,threatened and actual, amongAmerican financial institutions.
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- Monetary Policy Karamousis, Nicholas, and Ramond Lombra. 1989. Federal Reserve policy making: An overviewand analysisof the policy process. Camegie-RochesterConference Series on Public Policy 30 (Spring):7-62.
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- Not surprisingly,Federal funds rates, and other interest rates as well, have been less volatile since 1982 than in the preceding monetarist regime. Paul admits that he was astoundedby their volatility in 1980-82. Most of their recent volatility has been deliberatepolicy. When the Fed saw aggregatedemand growing too slowly,the FOMC lowered the fundsrate substantially(down564 basis points in six months fromJuly 1982).When demand was perceived to be growingtoo fast, the FOMC raised the rate (up 205 basis points in six months from February 1984). Likewise,the funds rate was lowered 163points in the seven months from February 1986 and raised 210 points in the eight months from July 1988.Other interestrates moved in the samedirections,longerrates of course by fewer points (see Mussa’s fig. 2.4).
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- Now let me turn to the Plaza Accord of 1985.This is an importantevent to discuss because the implications of the accord for monetary policy were the opposite of what is commonlythought to be the case.
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- Paul Krugmn noted that, in the discussionof budget policy,both Stockman and Schultzeconcluded that the standardbudget policy in the United States is essentiallyan equilibratingone but that there were unusual eventsat the beginning of the 1980s that changed matters. For monetary policy, most people would conclude that it normally has an inflationary bias, where the Federal Reserve fights recessions earnestly and responds to inflations somewhat late.
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- Short-run operating instruments are no longer reserve quantities but, as in pre-1979 days,Federalfunds rates. The differentialbetween the funds rate and the discount rate reflects the pressure on the banks’ reserve positions. Like most controllers, the Fed is a feedback mechanism, changing its instrument settings in response to discrepancies significant in size and duration between actual readings and projections of its target variables, on the one hand, and desired target paths, on the other.
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- The drag of the import surpluswas one reason that the recoveryof real GNP proceeded even more slowly in the two years after 1984,3.6 percent in 1985 and 1.9 in 1986, while unemployment hovered around 7.0 percent. Only in 1987-88, afterthe cautiouseasing of 1986finallytook effect, was the recovery completed,five and a half years after it had begun.
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- The interest rate limit for large certificates of deposit had been removed in June 1979,and the banksthoughtthat therewas no constrainton their ability to obtain credit. Although the cost of funds to banks was high, the inflationary environment meant that the banks did not let this high cost deter them from continuedlending.
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- The next interesting event was the easing of monetary policy in 1982.The recessionhad begun in mid-1981,but we did not adopt a stronglyexpansionary monetary policy until the summerof 1982.There were severalreasons for our cautious stance in the first half of that year. First, there was a big jump in the money supply around the beginning of 1982 that carried it above our targets.
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- Thus, concern about the value of the dollar caused monetary policy to be shaded more on the tighter side during late 1985 than on the easier side, although that shadingwas evident in a refusalto ease rather than an actual tightening. I emphasizethis point because it isjust the oppositeof what most commentatorswere saying at the time and have been sayingmore recently as well.
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- Under the new approach and operating techniques, that development was not conducive to any aggressivemoves to ease money. Second,althoughthe economy was in a recession, inflation had not fallen very much by early 1982.
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- Volcker also remarked that, although he received supportive comments on monetary policy from the administration,their statementsemphasizeda gradual approach. After 1979,Volcker realized that it was not realistic to decrease Monetary Policy the money supply graduallyand expect that the economy would suffer no adverse effects. The Fed could not control the money supply that closely. Thus, Volcker tried to remove the word gradual from all statementsafter 1979.
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- Volcker said that he thought that the Federal Reserve had received fairly good supportfrom Carter.Despitethe surgein interestrates, Cartermentioned monetarypolicy only onceduringthe 1980campaign.The Reagan administration was very monetarist and did not care about interest rates, and it encouraged the Fed to pursue tight money in early 1981.The economy continued to grow for a while despite the very high interest rates, but, when the recession finally occurred, the administration stopped encouraging the restraint on money,and a certainamountof snipingdeveloped.Volckersaid that he thought that there were probably many people in the White House and at the Treasury who tried to get PresidentReagan to criticizethe Federal Reserve at that point but that Reagan would not say anything bad about an anti-inflationary policy, which was important.
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- Was there any way to limit the cost? Some economists, myself included, had suggestedcombiningthe announcementof a firmdisinflationarymonetary policy with somevariant of incomespolicy,at leastguideposts.Therehad been a stab at incomespolicy in the Carter administrationin 1979,but it was abandonedjust at the crucial time. Rumor was that this decision was related to the contestfor the Democraticpresidentialnomination, specificallyto the position of organizedlabor.No incomespolicy was conceivablein the new administration, althoughPresidentReagan’s tough stand against the air traffic controllers in 1981 taught an exemplary lesson. One could say t ! ! a t the Fed itself was carryingout an incomes policy, albeit one that worked via actual pain and cost rather than by conjecturalfears.
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- William Poole said that one of the puzzles from the period 1979-82 is why both long- and short-term interest rates were so volatile. One answer could be that the markets did not gain confidence in the Federal Reserve’sconvictionto stickwith its policy until the economyhad suffereda considerableway through the recession.But Pooledid not believethat this explanationcompletelysolves the puzzle about why long rates were so volatile and followed short rates so closely.
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