The Volcker Myths
Eric Tymoigne
Associate Professor of Economics, Lewis & Clark College
“Aside from a few true believers, nobody at the FOMC took Monetarism seriously.”
Federal Reserve Chairman Paul Volcker is widely acclaimed as the person who vanquished and conquered inflation in the early 1980s. By implementing a monetary policy inspired from Monetarist prescriptions, he is thought as having restored the ability of the Fed to control the money supply and to bring down price instability. Yes, the economy suffered but the pain was worth it. Volcker received many accolades with Chairman Alan Greenspan considering him the “most effective chairman in the history of the Federal Reserve System”.
A careful reading of the Federal Open Market Committee (FOMC) transcripts and data available, however, provides quite a different narrative. Aside from a few true believers, nobody at the FOMC took Monetarism seriously. FOMC members understood that the Fed exists to provide an elastic currency; its purpose is to promote interest-rate stability not reserve-supply stability. As such, they understood that the Fed cannot control the quantity of reserves, even less so the money supply; indeed, the Fed never achieved the growth targets it set during the “Volcker experiment.” And while FOMC members believed that higher interest rates could help bring inflation down, they also understood that the interest-rate hikes they were planning would be unpopular, would be a major source of economic and financial instability, and could perversely contribute to inflation. This explains why FOMC members agreed to move to a Monetarist-light framework while at the same time being skeptical of it. The committee sought protection behind the money supply targets that seemed to suggest that the Fed was not responsible for the dynamics of interest rates. Finally, as FOMC members expected, the hikes did produce lots of pain, but inflation went down for reasons largely unrelated to the Fed’s policy; all the pain was for nothing.
Myth 1: A move to Monetarism
In October 1979, the Fed decided to change its operating procedures. It de-emphasized precise interest-rate target and focused on a reserve target (specifically non-borrowed reserve target). The expectation was that the control of the growth rate of reserves would allow the Fed to control the growth rate of the money supply, which, according to the quantity theory of money, would allow policymakers to control inflation. The change in operating procedures was not a complete shift to Monetarism but a “hybrid” that still involved managing the federal funds rate (FFR):
We are not — at least I am not — proposing that we go to a purely mechanical reserve targeting approach. […] There are all these elements of judgment that enter into the process. That, combined with the constraint on the federal funds rate, brings us to something of a hybrid. (Volcker, October 1979, FOMC transcript)
Practically, the change in procedure allowed for more fluctuations in the FFR. Instead of targeting a specific FFR or a narrow FFR range, the Fed targeted a wide FFR range. The widest target range was 13 to 20 percent in March 1980, and the highest range was 16 to 22 percent in May and June 1981 (Figure 1).
Lawrence K. Roos, President of the Federal Reserve Bank of St. Louis, was among the most impatient with the unwillingness of the Federal Reserve to move to a strict quantity target (FOMC meeting, September 1980):
MR. ROOS: Well, if the level of borrowing comes in higher than we would anticipate, [can’t] you reduce the level of the nonborrowed reserves path accordingly? Can’t you adjust your open market operations for the unexpected bulge in borrowing or the unexpectedly low borrowing if you ignore the effect on the fed funds market? Can’t you just supply or withdraw reserves to compensate for what has happened?
MR. STERNLIGHT: Yes we could. There’s always that question of how much we want to compensate for that high borrowing. We faces [sic] that kind of decision in [this statement] week.
CHAIRMAN VOLCKER: The Desk can’t [adjust] in the short run. It’s fixed. In a sense they could do it over time if people are borrowing more, as they may be now. They seem to be borrowing more than we would expect, given the differential from the discount rate. But in any particular week it is fixed.
MR. ROOS: Do we have to supply the reserves?
CHAIRMAN VOLCKER: We have to supply the reserves.
MR. ROOS: Why do we have to supply the reserves? If we did not supply those reserves, we’d force the commercial banks to borrow or to buy fed funds, which would move the fed funds rate up.
President Roos wanted to abandon any form of interest-rate target:
I think there’s a very basic contradiction in trying to control interest rates explicitly or implicitly and achieving our monetary target objectives. And I would express myself as favoring the total elimination of any specification regarding interest rates. (Roos, FOMC meeting, July 1981)
All the other Committee members strongly disagreed with his position even if some of them, like President Robert P. Black of Federal Reserve Bank of Richmond, shared some of President Roos’s views. The Fed was created to promote financial stability and that means maintaining stable interest rates. FOMC members recognized that, with the October move, the Fed was already deviating substantially from that purpose and further deviations was unwelcomed. They acknowledged that high interest-rate variability is harmful and that, ultimately, what people care about is the cost of money, not the growth of money supply (FOMC meeting, February 1982).
MR. WALLICH: The central banks that have the most credibility, such as the Swiss National Bank and the Bundesbank are pretty relaxed with respect to their targets. Sometimes one of them even abandons its targets. And yet they do not lose credibility because there is that basic belief that they will achieve better stability.
MS. TEETERS: More people perceive that we have 15–1/2 percent interest rates and 17 percent mortgage rates than whether we are [fostering growth of] the money supply at 1 percent or 2 percent or 3 percent.
VICE CHAIRMAN SOLOMON: The trouble is that everything we say here is true.
MS. TEETERS: Yes.
VICE CHAIRMAN SOLOMON: Even when we say different things.
Besides not abandoning interest-rate targeting, the Fed was never able to hit its money supply targets (Figure 2). If this did not push FOMC members to reconsider the new policy framework, their incapacity to target “money” did lead them to reconsider their view about money (FOMC meeting, December 1981):
MR. MORRIS: Well, Mr. Chairman, I think it is ironic that the Federal Reserve has switched to monetarism at the very time when our ability to measure the money supply has eroded dramatically and our ability to differentiate money from liquid assets is rapidly disappearing.
[…]
MR. BALLES: I share Frank’s frustration on knowing what money is these days.
Some argued that Goodhart’s law is what brought down the ability to target the money supply. Innovations in the financial system allowed banks and other financial institutions to bypass constraints on monetary growth. There is some validity to this but the problem is actually deeper. FOMC members relied on an incorrect understanding of the money creation process. The dynamics of the money supply accommodates the state of the economy and reserve supply accommodates (rather than lead) the growth of the money supply. The creation of bank money is driven by requests by households, businesses and governments to finance economic activities (“demand conditions”); it is not driven by the quantity of reserves. This is something post-Keynesians understand quite well: banks cannot create money if nobody asks for credit, they can’t force people and businesses to take on debts. Right before the shift to its new operating procedure, in March 1979, there is a discussion of this by the FOMC:
MR. EASTBURN: The other part of my question is: How much validity is there to the idea that what is happening to money is supply induced and not demand induced?
MR. AXILROD: Well, it’s very difficult to give an answer to that, President Eastburn, because we don’t control the supply of money and we make no effort to control it.
[…]
MR. AXILROD: President Eastburn, the only way I think I can answer is to say that, as you know, the System does no more than accommodate to whatever amount of money the public wants to hold at today’s interest rates. So in that sense we could always have more money [growth] if the System were to provide reserves more aggressively and let interest rates go down in the short run. That’s the way I would answer. [As for] whether it’s a demand or a supply phenomenon, it’s very difficult to disassociate the two.
The kind of questions these discussions raised were left aside when the new procedure was adopted in October 1979.
Myth 2: Volcker conquered price instability.
Even though the Fed was not able to meet its money supply growth target — standard monetary aggregates (M1, M2 and M3) usually grew faster than targeted — it is still argued that the Fed vanquished inflation. The argument can’t be based on the quantity theory of money given what happened to the money supply; instead, it has been argued that, by raising interest rates dramatically, the Fed crushed the economy and so inflation. There is reason to doubt this argument, as well.
The rate hikes did generate a recession and contributed to the S&L crisis, this channel helps inflation fall. At the same time, higher interest rates also contributed to higher inflation. Taken together, these two different channels of influence leave a mixed impact of monetary policy on inflation and favor other reasons for the fall of inflation. A strong candidate is energy given that inflation dynamics in the 1970s was largely influenced by energy; without the two oil shocks, the inflation spikes would not have occurred.
Rising interest rates can contribute to inflation through several channels. The one that keeps coming back in FOMC discussion in the cost channels. Higher interest rates mean higher business costs for indebted firms, and firms may pass the higher cost of their debts onto their customers:
Interest rates may be [low] after tax, or in real terms, but they are still contributing to cost and are creating, I think, some of the upward pressure on prices. (Teeters, FOMC meeting, May 1981)
This channel of influence comes back in the FOMC discussions over the following decades.
The previous section has shown that FOMC members were skeptical about the capacity of the Fed to control the money supply. However, some of them were also skeptical about the capacity of the Fed to control inflation and argued that the Fed has little to do with the fall in inflation:
May I remind you that we shouldn’t take too much credit for the price easing? I never thought we were totally at fault for the price increases that we suffered from OPEC and food; and I don’t think the fact that OPEC and food have calmed down has a great deal to do with monetary policy per se, except in the very long run. (Teeters, FOMC meeting, July 1981)
This comment is made before the large recession of 1982 that did contribute to lower inflation (although monetary aggregates continued to growth faster than targeted throughout 1982) and for which the Fed is responsible. However, this was merely a cyclical source of disinflation, the disinflation trend was due to “special factors,” as they are called by the FOMC members, such as oil price. Something similar occurred during WWII, during which the Fed left its precise interest rate targets unchanged throughout the war and inflation fell as war condition went away. Something similar is occurring today with inflation going down for reasons unrelated to monetary policy. In the end, one comes to conclude that the hybrid Monetarist experiment was misguided and unnecessary. A move to a full Monetarist experiment would have been a catastrophe.
Political and economic reasons behind the October 1979 shift
One may wonder why FOMC members persisted so long to apply a policy framework that most of them did not embrace. In fact, even though the Federal Reserve abandoned it in October 1982, the economic framework of FOMC deliberations was not really reconsidered until the end of 1990. Besides their (incorrect) belief that there was no viable theoretical framework at the time that could replace Monetarism, one has to look for political reasons to understand why FOMC members were so slow to change their way of thinking about monetary policy.
In terms of politics, the FOMC did not want to take the responsibility for the recession and financial instability that it knew would occur following its October 1979 decision. Monetary-aggregate targets provided a convenient shield:
I do think that the monetary aggregates provided a very good political shelter for us to do the things we probably couldn’t have done otherwise. (Teeters, FOMC meeting, February 1983)
I think the important argument, and really the reason why we went to this procedure, was basically a political one. We were afraid that we could not move the federal funds rate as much as we really felt we ought to, unless we obfuscated in some way: We’re not really moving the federal funds rate, we’re targeting reserves and the markets have driven the funds rate up. That may have had some validity at the time, and I had some sympathy for it. But as time goes on, I’ve become more and more concerned about a procedure that really involves trying to fool the public and the Congress and the markets, and at times fooling ourselves in the process. (Black, FOMC meeting, March 1988)
In December 1989, following a period of tightening and expected further tightening, President Gary H. Stern of the Federal Reserve Bank of Minneapolis suggested to go back to a monetary-aggregate target for precisely the same reason:
Well, I have only a little to add to all of this. I think Tom Melzer is probably right: We’re going to need to shift the focus to some measure or measures of the money supply as we proceed here if we can, both for substantive reasons and also because that has some political advantages as well, as we go forward. (Stern, FOMC meeting, December 1989)
In terms of economics, even though it was now effectively targeting the level of FFR, the FOMC was unwillingly to disclose this to the public because it still believed in the inflationary bias of precise interest-rates targets. As such, FOMC members were left with no core way to justify their decisions:
We’ve advanced from pragmatic monetarism to full-blown eclecticism. (Corrigan, FOMC meeting, October 1985)
Followed a period during which talking about the FFR became taboo and “the Committee [had] deliberately avoided explicit announced federal funds targets and explicit narrow ranges for movements in the funds rate” (Kohn, FOMC Transcripts, March 1991):
I must say I’m still quite reluctant to cave in, if you will, on this question that we can do nothing but target the federal funds rate. (Greenspan, FOMC transcripts, March 1991)
As a practical matter we are on a fed funds targeting regime now. We have chosen not to say that to the world. I think it’s bad public relations, basically, to say that that is what we are doing, and I think it’s right not to; but internally we all recognize that that’s what we are doing. (Melzer, FOMC transcripts, March 1991)
To admit to the public that the FOMC was targeting the level of the FFR would have suggested that the Fed had lost its (supposed) grasp on inflation; some smoke and mirrors were deemed necessary. Since at least the 1970s, with such work as Nicholas Kaldor’s The Scourge of Monetarism or Basil J. Moore’s work on endogenous money, some academics knew that interest-rate targeting is the only sensible monetary policy procedure and that it is not intrinsically inflationary. With the adoption of the Wicksellian/Fisherian framework in the late 1990s, FOMC members progressively became more comfortable with interest-rate targeting.
People named with their position at the time of the transcript:
Stephen H. Axilrod, Economist at the Board of Governors (1952–1986) and Staff Director for Monetary and Financial Policy.
John J. Balles, President of the Federal Reserve Bank of San Francisco (1972–1986)
Robert P. Black, President of the Federal Reserve Bank of Richmond (1973–1992)
E. Gerald Corrigan, President of the Federal Reserve Bank of New York (1985–1993)
David P. Eastburn, President of the Federal Reserve Bank of Philadelphia (1970–1981)
Alan Greenspan, Chair of the Federal Reserve System (1987–2006)
Donald L. Kohn, Economist, Director of the Division of Monetary Affairs from 1987 and Secretary of the Federal Open Market Committee (1987–2002)
Thomas C. Melzer, President of the Federal Reserve Bank of St. Louis (1985–1998)
Frank E. Morris, President of the Federal Reserve Bank of Boston (1968–1988)
Lawrence K. Roos, President of the Federal Reserve Bank of St. Louis (1976–1983)
Anthony M. Solomon, Vice Chair and President of the Federal Reserve Bank of New York (1980–1984)
Gary H. Stern, President of the Federal Reserve Bank of Minneapolis (1985–2009)
Peter D. Sternlight, Manager for Domestic Operations for the System Open Market Account (1979–1992)
Nancy H. Teeters, Governor (1978–1984)
Paul A. Volcker, Chair of the Federal Reserve System (1979–1987)
Henry C. Wallich, Governor (1974–1986)
