Photograph © Bettmann/CORBIS; Illustration by Jacqueline Di Milia
How Volcker Launched His Attack on Inflation
When Paul Volcker took over as president of the Federal Reserve Bank of New York on Aug. 1, 1975, he became a permanent member of the Federal Open Market Committee, the panel within the Federal Reserve System responsible for managing credit conditions and interest rates.
The New York Times labeled him a “monetary pragmatist,” adding that he was “philosophically sympathetic” with Fed Chairman Arthur Burns, meaning “that he leans toward tight money policies and high interest rates to retard inflation.”
Burns still had a reputation as an inflation hawk. He had testified that the Fed was “determined to follow a course of monetary policy that will permit only moderate growth in money and credit,” making it “possible for the fires of inflation to burn themselves out.” Yet during his eight-year tenure as chairman, Burns failed to control prices, which increased at a rate of 6.5 percent a year, an unprecedented pace for peacetime.
Volcker wasted little time asserting his independence. In November 1975, after just three months on the job, he dissented from Burns’s position at the FOMC, saying that he felt the right approach was “to hold interest rates fairly steady.” He dissented again eight months later, in July 1976.
There was, in fact, little to dissent about at the time. High interest rates and tight credit in 1974, before Volcker arrived at the Fed, had triggered a sharp recession. Inflation declined to 5 percent in 1976 from 12 percent in 1974. Investors celebrated by pushing down the price of gold almost 50 percent between Dec. 30, 1974, and Aug. 31, 1976. The drop in demand for gold reflected more than just the measured progress on inflation; it meant that inflationary expectations had stabilized, as well. It did not last.
Jimmy Carter beat the incumbent Gerald Ford in the presidential election of November 1976, an election dominated by concerns about high unemployment and high inflation. The country had gone through a sharp recession the previous year and the unemployment rate still averaged almost 8 percent. Although inflation had declined to 5 percent in 1976, less than half its 1974 level, it was almost the same as was considered embarrassing in 1969.
Stagflation -- the lethal combination of high unemployment and high inflation -- reflected a change in consumers’ behavior. The “buy now, pay later” philosophy adopted by those with jobs overwhelmed the spending restraint of the unemployed, resulting in higher prices. Economists had to rework their thinking to take account of Milton Friedman’s warning that gains in employment would disappear once inflationary expectations caught up with reality.
Volcker understood the power of expectations. At his very first FOMC meeting on Aug. 19, 1975, he had warned the optimists on the committee not to be encouraged by the projections “for reduced inflation emanating from some econometric models,” which he said “did not take adequate account of the important factor of expectations.”
The need to consider the inflationary consequences of monetary policy even with unemployed resources wasn’t yet the conventional economic wisdom. Keynesian economic models ignored inflationary expectations, but the market for gold bullion did not. By 1978, gold signaled renewed concerns with inflation and on July 28 the price passed its previous peak of $197.50, and would trade as high as $243.65 later in the year.
For Volcker, those concerns were compounded by another event.
In March 1978, G. William Miller had replaced Burns as Fed chairman. As the former president of Textron Inc. (TXT), an aerospace conglomerate, Miller had limited experience in banking and economics: he was a director of the Federal Reserve Bank of Boston, a largely ceremonial position. Fed chairmen don’t need a doctorate in economics -- Burns was the first to have one -- but Miller’s lack of experience in finance would hurt his credibility among international bankers and on Wall Street.
During the first half of August 1978, the dollar sank to new lows against the German mark, a fresh vote of no confidence in America. On Aug. 15, 1978, Volcker told the FOMC, “I think it’s important particularly in view of the international situation that we correct the misapprehensions about our lack of concern over inflation.”
Volcker thought “domestic and international price stability went hand in hand,” and he wanted this reflected in the FOMC Directive, the instructions for monetary policy voted on at the end of each FOMC meeting. Volcker believed that the dollar’s role in world trade depended on price stability. Americans could no longer consume more cars and televisions than they produced if foreigners were unwilling to hold dollars.
But Volcker had to shoulder some of the blame for the dollar’s weakness. He had voted with the majority of the FOMC to slowly push up the federal funds rate, the overnight rate on loans of reserves between banks, as a way to discourage excessive spending and inflation.
The FOMC operated with a delicate touch, like a team of brain surgeons, raising interest rates in quarter-percent increments at each meeting. Mark Willes, a member of the committee, had urged Volcker privately to “push up rates more aggressively to convince people that we are serious about controlling inflation.” Volcker answered, “The FOMC doesn’t operate that way.”
He would change his mind before long.
The FOMC increased the federal funds rate to 9 percent in October 1978, a jump of more than 2 percentage points over a six-month period. But Willes wasn’t impressed. The “buy now, pay later” philosophy followed by many Americans confirms that an interest rate of 9 percent isn’t high if wages and prices are increasing at about the same rate. It pays to borrow and buy something tangible, such as a big house, a small diamond, or a compact bar of gold, to reap the capital gain and repay the loan in cheaper dollars.
The rate of inflation averaged more than 9 percent during the three months before the FOMC meeting of Oct. 17, 1978, and Volcker began to think that Willes had been right. He told his colleagues that “we’ve been a little too easy,” while “inflation has gotten worse.”
The foreign-exchange market noticed. On Oct. 30, 1978, one dollar purchased 1.72 German marks, an all-time low, representing a decline of more than 20 percent in a year. On Nov. 1, 1978, the U.S. undertook a massive dollar-rescue operation. Treasury Secretary Michael Blumenthal convinced President Carter of the need for drastic measures, and elicited his support for a significant increase in interest rates by the Fed.
The rate increase restored a shine to the tarnished dollar, but Volcker expected the gains to fade without follow-through, especially if inflation accelerated. He had good reason for concern. Corporate borrowing showed no signs of tapering off with the increased cost of funds.
By the March 20, 1979, meeting of the FOMC, almost five months after Treasury’s rescue of the dollar, the annual rate of inflation had moved into double digits. Volcker sounded the alarm. “I think we’re in retreat on the inflation side; if there’s not a complete rout, it’s close to it.” But Volcker faced a battle within the FOMC over whether to raise interest rates. Frank Morris, the president of the Boston Fed, recommended easing policy to avoid a recession.
Morris knew that FOMC members responded more to the domestic economy than to international finance, in keeping with the Fed’s congressional mandate to promote full employment and price stability, with no mention of foreign exchange. Morris said Volcker’s recommendation to tighten credit was inconsistent with those priorities and he carried the day. The FOMC refused to tighten, and Volcker, with three others, voted against the decision. The press labeled the FOMC dissenters “the Volcker minority.”
In the three months ending June 1979, prices increased at an annual rate of almost 13 percent. The president’s approval ratings, meanwhile, declined to 30 percent in June 1979. On July 15, Carter made a televised speech from the Oval Office. He addressed the details of the country’s dependence on foreign oil and described America as suffering a “crisis of confidence.” He said that “the phrase ‘sound as a dollar’ was an expression of absolute dependability until 10 years of inflation began to shrink our dollar and our savings.”
Two days later, Carter requested the resignation of his senior staff. The house cleaning was intended to signify a fresh start. Instead, it created confusion. The president removed five members of his Cabinet, including Treasury Secretary Blumenthal who had called for an increase in interest rates after the “Volcker minority” had urged a tightening.
Carter’s Cabinet shakeup triggered an overnight jump in gold to more than $300 an ounce, a record price at the time. The president replaced Blumenthal with Miller, the Fed chairman.
Volcker met with the president in the Oval Office on July 24, 1979, to talk about the vacancy at the Fed. The discussion lasted less than an hour, and Volcker thought it had not gone well. Returning to New York that night, he met his two best friends, Larry Ritter and Bob Kavesh, both professors at NYU’s Graduate School of Business, for dinner.
“Well, I blew it,” Volcker told them. “I said that I attached great importance to the independence of the Federal Reserve and that I also favored a more restrictive monetary policy.”
Volcker was disappointed about not getting the job he had trained for his entire professional life, the job that provided the opportunity to rescue his country from crisis.
At 7:30 the next morning, he was awakened by a call from the White House.
(William L. Silber is Marcus Nadler professor of finance and economics and director of the L. Glucksman Institute for Research in Securities Markets at New York University’s Stern School of Business. This is the first of three excerpts from his new book, “Volcker: The Triumph of Persistence,” which will be published Sept. 4 by Bloomsbury Press, and is on the long list for the 2012 Financial Times and Goldman Sachs Business Book of the Year Award. The opinions expressed are his own. Read Part 2 and Part 3.)
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