THE FED CHAIR AS AN INSTITUTIONAL ACTOR

Created in 1913, the Federal Reserve System did not emerge in modern form until the Banking Acts of 1933 and 1935.Footnote ⁴ The first measure enhanced Fed control over the supply of money and credit, notably through establishment of the Federal Open Market Committee [FOMC] to coordinate buying and selling of government securities. The second authorized the president to appoint all seven members of the Fed’s Board of Governors, subject to Senate confirmation, and designate one to serve as chairman (a role hitherto performed ex-officio by the Secretary of the Treasury). The 1935 legislation also empowered the board to appoint the presidents of the twelve Federal Reserve Banks [FRB] located outside Washington, D.C., gave it effective control of the FOMC—whose membership henceforth consisted of the governors, the New York FRB president, and four other reserve bank presidents serving on a rotating basis (instead of just the twelve presidents as hitherto), and strengthened FOMC authority to set monetary policy.

Despite its authority being ill-defined in the New Deal bank reforms, successive chairmen built up their post to make its influence paramount in the monetary policy process. According to Berkeley economist Sherman Maisel, a Federal Reserve governor from 1965 to 1972, the chairman’s power derives from five elements of his role. As the Fed’s principal public spokesman, he is seen as its embodiment by the Washington community and the financial markets. As its primary representative, he is the official that the president, Congress, and foreign government officials consult about monetary policy. As manager of its large bureaucracy, his needs receive top priority from staff economists, thereby ensuring that he is the best-informed member of the Board of Governors and FOMC. The chairman is also the agenda-setter for Fed decision-making through his capacity to define the issues and options for discussion at meetings of these two bodies. Finally, his coalition-building ascendancy within them flows from his agenda-setting authority, access to staff expertise, and the prestige of his post.Footnote ⁵

In addition to building their internal power, successful chairmen have been adept at winning support from external constituencies. Although legally independent, the Fed is in reality interdependent with the financial markets, Congress, and—in particular—the president, whose support underwrites the credibility and legitimacy of its monetary actions.Footnote ⁶ According to Stephen Axilrod, a top staffer from the 1960s to the 1980s, “A great leader for monetary policy is differentiated not especially by economic sophistication, but by his or her ability to perceive when social and political limits can be pushed to make space for a significant, paradigmatic change in the approach to policy should it be required, as well as the courage and bureaucratic moxie to pull it off.” Based on this, he adjudged Paul Volcker “the essential man” in promoting the transformational monetary changes of the 1980s.Footnote ⁷

Volcker was highly respected within the Federal Reserve System for his integrity, ability, and public-service ethos. A Stevenson Democrat in the 1950s, he showed equal facility to work with administrations of both parties, thereby restoring the tradition of politically neutral chairmen following the overtly Republican Arthur Burns (1970–78) and the pro-Democratic William Miller (1978–79). Other than Burns, he was the first Fed chairman to have professional training as an economist, and he kept abreast of new thinking in monetary policy as his career developed.Footnote ⁸ More significantly, Volcker had greater financial experience than any chairman before or since. After joining the New York FRB as an economist in 1952, he spent most of the next thirty-five years in public finance—apart from spells with Chase Manhattan bank in 1957–62 and 1965–69, latterly as vice chair, and a Princeton senior fellowship in international finance in 1974–75. This career track included two tenures at the Treasury department in 1963–65 and 1969–74, latterly as undersecretary for International Monetary Affairs, a role in which he earned plaudits for managing the challenging process of removing fixed dollar-exchange rates in 1971–73.Footnote ⁹ Volcker returned to the top echelons of finance in 1975 as chair of the New York FRB, which is the Fed’s main link with international money markets.

Volcker’s reputation for competence in monetary operations instilled confidence within the Fed that his new strategy of money-supply control had a good chance of working, thereby helping to win FOMC support for it. In addition, his nuts-and-bolts skills meant that he could exercise day-to-day oversight to ensure that this policy innovation, with its complicated technical underpinnings, was implemented as he intended rather than as interpreted by Fed staff.Footnote ¹⁰ His long public career also equipped him with the skills to navigate Washington politics, an appreciation of the value of steadfast monetary strategy, and access to an unparalleled network of power brokers in government and finance at home and abroad. The benefits of a Fed chairman being so well connected in an age of increasing global interdependence were self-evident. William Miller, an Oklahoman with a corporate background and limited banking experience as Boston FRB director, lacked such clout. After Volcker, however, connectedness became an essential requirement for the post because of its significance for making monetary change happen.Footnote ¹¹

THE PRE-VOLCKER FED AND 1970S INFLATION

Volcker became Fed chair just as the high inflation of the mid-1970s threatened to become hyperinflation with the double-digit Consumer Price Index increases of 1979–80. Gallup survey respondents identified inflation as the most important problem facing the country each year from 1973 through 1980, with over three-quarters doing so in 1979.Footnote ¹² Unleashed by the Vietnam War’s overstimulation of the 1960s full-employment economy, inflation worsened exponentially in the subsequent decade as a result of oil-price shocks, global rises in commodity and food prices, the falling value of the dollar after termination of fixed exchange rates, and declining productivity. The Great Inflation bred an inflationary psychology whereby economic decisions were increasingly based on expectation of perpetually rising prices.Footnote ¹³ This made business planning and investment extremely difficult because of uncertainty about profits, dividends, and borrowing costs. It threw the bond market, the main source of long-term loan finance, into turmoil, eventually precipitating a mass sell-off of devalued assets by jittery investors at a total portfolio loss of $400 billion in late 1979 and early 1980. Meanwhile, consumers increasingly looked to beat inflation by buying on credit and paying later with devalued dollars.Footnote ¹⁴ Testifying to the panic in financial circles, Salomon Brothers managing director Henry Kaufman advocated a declaration of national emergency to tackle the inflation crisis in an address to the American Bankers Association in February 1980.Footnote ¹⁵

In the postwar quarter-century, presidents had successfully deployed fiscal policy, their chief instrument of economic management, in fulfillment of their obligations under the Employment Act of 1946 to promote “maximum employment, production and purchasing power.” They were less effective as inflation-fighters because fiscal policy had limited capacity to address the roots of the problem, was slow moving, and was increasingly inflexible as uncontrollable outlays on entitlements and interest repayment grew from 40 percent to 57 percent of total spending over the 1970s. Nonfiscal White House initiatives, such as Richard Nixon’s wage-price controls, Jimmy Carter’s wage-price guidelines, and his administration’s efforts to coordinate international responses to common economic problems, also failed to suppress inflation.Footnote ¹⁶

With presidents floundering as managers of prosperity, the Fed chairman seemed well placed to assume this role, but the central bank also lacked inflation-fighting credibility. As future Reagan Council of Economic Advisers [CEA] member William Poole commented, “It is hard to avoid the conclusion that monetary policy contributed to the many economic woes of the . . . period.” Like many analysts, he charged that the Fed had aggravated inflationary pressures owing to Arthur Burns’s failure to ensure observance of its own money targets.Footnote ¹⁷

The Federal Reserve had traditionally focused on controlling the price rather than the supply of money to ensure stable financial conditions. In the inflationary 1970s, however, it began manipulating the federal funds rate (the interest regular banks charge each other for overnight loans and the main guidepost for general rates) to exercise some control over money growth. Reinforced by several congressional mandates, it also published targets within which it looked to steer interest rates and money stock. While broadly holding to the former, the Burns Fed regularly allowed money quantity to exceed its own upper limits. Over his two terms as chair, the annual rate of increase in money was 5.9 percent for M1 and 9.0 percent for M2, compared with 4.6 percent and 7.2 percent, respectively, during the last two terms of his predecessor, William McChesney Martin. Despite applying the monetary brakes in response to the oil-price shock of 1974, the Burns Fed proved inconsistent in fighting inflation. It quickly reversed course to alleviate the sharp recession of 1974–75 that its restraint had precipitated and engaged in pro-cyclical ease when the economy was undergoing expansion in 1971–72 and 1977.Footnote ¹⁸

To some analysts, the Fed’s stand on money stemmed from its alignment with the Kennedy-Johnson new economics in the 1960s. In their view, it carried the idea that monetary policy could assist in maximizing economic performance into the 1970s. In line with much of the economics profession, however, the central bank overestimated targets for full employment (4.0–4.5 percent unemployment when the real measure was close to 6 percent) and potential output (2.5–3.0 percent for annual productivity growth compared to 1.5–1.0 percent in reality) in the era of stagflation.Footnote ¹⁹ Compounding this shortcoming, Burns himself was skeptical that monetary policy could have much impact in arresting an inflation that proved relatively insensitive to economic slack. In his view, business confidence was more significant than money as an independent influence on economic activity, which induced him to place more emphasis on the short–run velocity of money as a reflection of this confidence than its overall rate of growth.Footnote ²⁰

Other scholars offer a political explanation for the Fed’s failure to tackle inflation in the 1970s. In their view, this conformed to its habitual reluctance to antagonize the White House and Congress for fear of having its monetary powers reduced. As such, it would not pursue an independent course to stabilize prices if this contravened postwar political orthodoxy that jobs and prosperity were the foremost concerns of economic policy.Footnote ²¹ Speaking after he left office, Burns himself lent weight to this interpretation in declaring that the central bank alone had the capacity to stifle inflation but was unlikely to apply a “drastic therapy” owing to the constraints of “political forces.”Footnote ²²

FOMC meeting transcripts of the Burns era do not evidence any struggle between a desire to fight inflation vigorously and the needs of political reality, but testify more to his belief that monetary contraction had limited utility for attaining price stability. William Miller’s brief tenure as his successor offered further support for the significance of ideas in shaping policy. This Carter appointee initially evinced preference for nonmonetary measures to fight inflation, notably fiscal restraint and wage-price guidelines, and never abandoned his conviction that it was possible to “pursue a monetary policy that aims at a reduction of inflationary pressures while encouraging continued economic growth and high levels of employment.”Footnote ²³ International concern that he was soft on inflation sent the dollar plummeting on the money markets, prompting the Carter administration to institute a dollar rescue package in November 1978. Impatient with Miller’s continued reluctance to tighten, Treasury Secretary Michael Blumenthal and CEA chair Charles Schultze briefed against him to the media until the president ordered them to desist.Footnote ²⁴ Nevertheless, this represented an unheard-of instance of a Democratic administration trying to push the Fed toward greater monetary restraint.

VOLCKER AND THE CARTER ADMINISTRATION

Volcker’s stand on inflation suggested that the competing explanations of Fed policy on inflation were not mutually exclusive. He was convinced that price stability had to be the primary concern of monetary policy, even at the cost of a painful deflation. According to future Barack Obama administration CEA chair Christina Romer, “The Volcker revolution was the triumph of better ideas over worse ones.” Nevertheless, as one of Volcker’s successors recognized, he was also determined to ensure Fed independence lest political influences diluted its anti-inflation mission.Footnote ²⁵

As his FOMC votes of 1977–79 signaled, Volcker worried that the Fed had fallen behind the curve of inflation.Footnote ²⁶ His position evolved into what he termed “practical monetarism,” which recognized the fundamental importance of the money stock and its growth targets to the economy’s well-being, but also regarded nonmonetary factors—economic, political and social—as significant. Nevertheless, he eschewed what he considered the “extreme claims” of Milton Friedman and his monetarist followers that there should be a fixed annual rate of money growth, mandated if necessary through constitutional amendment. Top Fed officials generally agreed with Volcker that the periodic fluctuations in the real economy invalidated monetarist theory on this score. As Chicago FRB president Robert Mayo commented, “We have found no magic formula . . . [to make] monetary policy as simple as some of our academic friends believe it can be made.”Footnote ²⁷

In Volcker’s assessment, there could never be certainty about what level of federal funds rate would best regulate the money supply. Direct control of money quantity was therefore a more effective means of combating inflation. Observance of money growth targets would send the message to financial markets, business, and the public that the Fed was serious about enforcing price stability, thereby reducing inflationary expectations. As Volcker put it, “People don’t need an advanced course in economics to understand that inflation has something to do with too much money.” Nevertheless, he insisted on flexibility to amend targets as circumstances changed rather than adhere rigidly to those fixed amid economic uncertainty.Footnote ²⁸

This breech with full-bore monetarism was accompanied by the even more trenchant rejection of Keynesian belief that economic policymakers could manage a so-called Phillips curve trade-off to balance acceptable levels of inflation and unemployment. In his first congressional appearance as Fed chair, Volcker insisted that “we have to face squarely the adverse [inflationary] consequences of premature or unduly large moves to stimulate the economy. . . . That is the lesson of the 1970s, not just in the United States but elsewhere.”Footnote ²⁹

Arguably the most important appointment of his presidency, Carter’s selection of Volcker to lead the Fed was an act of desperation. Economic indicators had worsened since the CEA had informed him in March that “the anti-inflation program is likely to collapse if some price deceleration is not achieved soon.” By mid-year, all his advisers were warning of fast-approaching crisis.Footnote ³⁰ Carter’s hopes of finding new inspiration through a Cabinet reshuffle after the crisis-of-confidence address in July only roiled the financial markets about what direction he was taking. The Treasury vacancy resulting from Michael Blumenthal’s dismissal was eventually filled, after several potential candidates rejected the post, by moving Miller from the Fed. Approached by a White House search committee chaired by Richard Moe to take the latter’s place, three top bankers—David Rockefeller, A. W. Clausen, and Robert Roosa—turned the job down. Only then did Volcker’s name enter the frame on the recommendation of the administration’s Wall Street contacts, including Rockefeller himself.

The inflation-hawk reputation that made Volcker the financial community’s favored candidate conversely aroused concern among Keynesians consulted by the Moe Committee that his cure would be worse than the disease. Arthur Okun, formerly Lyndon B. Johnson’s CEA chair, warned that he would be “very right wing” and “dominated by international concerns” over the dollar. Carter CEA officials Charles Schultze and Lyle Gramley also worried that he would pursue greater restraint than needed. The president himself wanted a balanced monetary approach that reduced price instability without precipitating recession, but his anxiety to reassure Wall Street meant that he was in no position to require guarantees on this score from the only viable candidate to lead the Fed. Instead, it was Volcker who effectively laid down terms in establishing at what passed for his job interview with Carter that he would ensure central bank independence and tighten monetary policy.Footnote ³¹

Sworn in on August 6, 1979, Volcker immediately signaled a tough line on inflation by leading the FOMC into a 0.5 percent increase in the federal funds rate on August 14 and the Board of Governors into a 0.5 percent increase in the discount rate (the interest the Fed charges for loans to banks) two days later. These initiatives sent the prime rate climbing to a new peak of 13 percent within a month (the previous high was 12 percent in late 1974). Volcker attained another 0.5 percent increase in the discount rate on September 18, but the governors split four to three instead of being unanimous as before, with the dissenters worrying that this hike might cause recession without halting inflation. The division was interpreted in financial, media, and political circles as a sign that Volcker could not hold the Fed to further increases.Footnote ³²

To counter anticipation of interest rate-dissension, Volcker instructed Stephen Axilrod, staff director for monetary and financial policy, and Peter Sternlight, the FOMC account manager in New York, to develop plans for money-stock control, an approach considered but never implemented by the Burns Fed. Meanwhile, he built support for this strategy through discussions with individual FOMC members. Volcker also gained European backing, especially from West Germany, in discussions held en route to and during an International Monetary Fund meeting in Belgrade. He reported back to the FOMC that America’s partners would intervene in support of the dollar “to the degree they feel we have done something here.”Footnote ³³

Volcker’s maneuvers laid the groundwork for the FOMC’s unanimous approval of his key recommendations on October 6. It raised the discount rate a full point, instead of the usual fractions, to a record 12 percent, imposed new reserve requirements on member banks to reduce their lending capacity, and, most significantly, instituted new operating procedures to control money supply. Historically, once the FOMC had set the federal funds rate, its New York trading desk would buy or sell government securities to raise or lower money stock to the level required to reach this. The new arrangement reversed that process because the supply of money would henceforth determine the federal funds rate. The New York market manager was now charged to provide the banking system with the aggregate amount of reserves judged consistent with the money target set. Aware that this would likely produce considerable short-term variability in federal funds rates, the FOMC also established a broad tolerance range of 11.5 percent to 15 percent for movement between its scheduled meetings.Footnote ³⁴

Informed of the proposals beforehand, William Miller and Charles Schultze urged instead that the Fed raise the interest rates under its control by an unprecedented 2 percent as a show of anti-inflation commitment. Volcker, however, deemed it significant that Carter did not call him over to the White House to press this case. “My reading of the situation,” he later remarked, “was that while the president would strongly prefer that we not move in the way we proposed, with all its uncertainties, he was not going to insist on that judgment in an unfamiliar field over the opinion of his newly appointed Federal Reserve chairman.”Footnote ³⁵ While under no illusions about the risks of market panic and business decline, Volcker told the FOMC, “At this stage you’ve got to place your bets one way or the other and move.” In addition, he intimated that the new approach was a last roll of the anti-inflation dice: “There is no apparent encore for the Fed. We will have in effect shot our bolt.”Footnote ³⁶

The increasing difficulty of measuring the money supply made this the last opportunity for the implementation of the new policy. Owing to the Great Inflation’s transformation of middle-class Americans from savers into investors, “the theory and the law of money and credit,” one financial analyst observed, were “left far behind and gasping.”Footnote ³⁷ The rash of Depression-era bank failures, many attributable to excessive interest rates paid to attract depositors, had prompted enactment in 1933 of Regulation Q to cap interest on savings deposits. Charged with its implementation, the Fed had kept regular passbook account rates around 5 percent during the 1970s. Money held therein consequently lost value as inflation exceeded this level, thereby making investments more attractive. Seizing their opportunity, financial entrepreneurs devised ways of making money more liquid to circumvent Regulation Q, particularly through the creation of money-market mutual funds and cash-management accounts at brokerage houses. Recognizing that traditional regulatory structures no longer worked, Congress enacted the Depository Institutions Deregulation and Monetary Control Act of 1980 to phase out interest-rate ceilings, authorize variable-rate mortgages, and allow depository institutions to provide interest-bearing checking accounts.Footnote ³⁸

Scrambling to adjust, the Fed repeatedly tinkered with its money indices. At the outset of the 1970s, the only published measure was M1 (currency and demand deposits at commercial banks). By mid-decade, however, there were four more, the most important of which were M2 (M1 plus time deposits in commercial banks) and M3 (M2 plus deposits at savings banks, savings and loan associations, and credit unions). To better capture quantity, M1 was subdivided into two narrower transactions, M-1A and M-1B, M2 and M3 were refined somewhat, and a very broad L measure of liquid assets was established in February 1980, but these amended measures found little favor with FOMC members. Further adjustments followed in January 1982 (discontinuing M-1A and redesignating M-1B as M1) and February 1983.Footnote ³⁹

There were no grounds for expecting a new M1, the measure on which all others depended, to have the same characteristics relative to nominal GNP or average price level of an earlier one. Accordingly, Volcker faced expressions of doubt about the utility of aggregate indices as the basis for monetary policy, notably during FOMC discussions on December 19, 1980, over whether to continue money stock control at likely risk of recession. Even inflation hawk Governor Henry Wallich acknowledged that M-1A, M-1B, and M2 measures had “little reliability.” On this occasion, conviction that the public expected the Fed to take strong action against inflation ensured a large majority in support of Volcker’s preference to keep going. By late 1982, however, there was a new consensus that money-supply targeting was technically unsustainable. As Boston FRB president Frank Morris acknowledged, “We are approaching a critical watershed in the formulation of monetary policy. The policy structure of recent years . . . is being eroded by a wave of financial innovation which is making it more and more difficult to measure money stock.”Footnote ⁴⁰

The first iteration of the new policy had little effect in taming inflation because the Volcker Fed was inconsistent in its application. Despite unprecedented prime rates, prices continued to rise steeply in late 1979 and early 1980 on the strength of inflationary expectations, increasing energy costs (resulting from a new Organization of Petroleum Exporting Countries oil-price hike and Carter administration oil-price decontrol of 1979), and higher mortgage costs (due to rising interest rates).Footnote ⁴¹ In response, further monetary tightening, which raised the upper limit of federal funds rate tolerance from 15.5 percent to 20 percent, was accompanied at President Carter’s behest by Fed imposition of direct controls on consumer credit in March 1980. The combination of the federal funds rate rising to 19.4 percent and the startling effect of the credit controls on consumer behavior precipitated a sharp downturn in economic output equivalent to a 9 percent annualized decline in the second quarter. “We choked the horse,” Governor Nancy Teeters told colleagues on April 22. “Now do you want to completely strangle him or do you want to be able to ride him a little further down the line?” Although the FOMC preserved the monetary aggregate ranges set in October 1979, it moved decisively to revive the economy by reducing the lower limit of the federal fund tolerance range from 13 percent to 10.5 percent on May 6, following this with a further reduction to 8.5 percent on May 22.Footnote ⁴²

Under these directives, the federal funds rate fell to 9.4 percent by the end of June. It had undergone a remarkable decline of 10 percentage points over three months, thereby cancelling out all the tightening from November 1978 through March 1980 without any evidence that inflation was in decline. The Fed’s easing brought speedy economic recovery, but it remained wary of renewing full-throttle restraint. Beginning in August, the federal funds rate moved up by 4 points to reach 13 percent in late October, thereby reversing the normal pattern of pre-election ease, but this amounted to less than half its previous decline. Meanwhile, rapid money stock growth from May through September cancelled out the previous contraction. A new round of tightening in November–December brought M-1A down to its mid-range, where it had been in the first quarter, but still left M1-B and M-2 aggregates near their upper target limits. This did nothing to prevent consumer price inflation rising from its 11.3 percent level in 1979 to 13.5 percent in 1980.Footnote ⁴³ Testifying to the FOMC’s frustration, Minneapolis FRB President Gerald Corrigan remarked, “We’ve hit these [money] targets [for a year] . . . so where are the results?”Footnote ⁴⁴

Judged on its first fifteen months, the Volcker Fed appeared to signal that it would not inflict real pain to attain price stability. The unusual level of uncertainty associated with the unfamiliarity of new procedures, the sharp recession, and the presidential campaign offered some mitigation for its inconsistency in implementing monetary restraint. As Volcker acknowledged, however, “It was . . . a mostly wasted year restoring credibility in the attack on inflation.”Footnote ⁴⁵ This enhanced his determination to stay the course in the new tight-money cycle that began after the 1980 presidential election.

THE VOLCKER SHOCK, 1981–1982

The annualized growth rate of M-1B fell continuously from November 1980 to reach almost zero in October 1981, while M-1A registered negative growth for most of this period. Although less precipitous, the decline in M-2 was also substantial. Meanwhile, the federal funds rate stayed almost continuously above 15 percent (only previously reached in October 1979 and March–April 1980) and was often in the 18–20 percent range. Measured in real inflation-adjusted terms, it also remained exceptionally high within the 4–9 percent range. With unemployment starting from a higher point than for any previous business-cycle peak, the economy entered an increasingly deep recession in July 1981, but recognition of this did not produce monetary reversal as in 1980. M1 (formerly M-1B) grew very little in the first six months of 1982, M2 grew slowly to keep just under its 9 percent upper limit, and the real federal funds rate generally exceeded 8 percent. Meanwhile, the jobless rate climbed steadily to 9.6 percent in June 1982, a post-1945 high.Footnote ⁴⁶

At that juncture, the Federal Reserve changed course to avoid a prolonged slump. FOMC support for Volcker’s shock therapy had already started to waver. “I’ve had it with the monetary experiment,” Nancy Teeters told the meeting of May 18, 1982. “It’s time to put this economy back together again and to get some stability as to where we’re going and how our interest rates are going to operate.”Footnote ⁴⁷ The only consistent critic of money control since its inception in late 1979, she found increasing support for her view that rising unemployment was now a more significant problem than declining inflation. The CPI was currently in the process of increasing at an annualized rate of 6.2 percent, still high by 1950s and 1960s standards but less than half the 1980 level and the smallest rise since 1976. Accordingly, the central bank could move to monetary ease without damage to its anti-inflation credibility.

As official records indicate, the FOMC had hitherto underestimated the depth of the downturn. At the February 1–2, 1982, meeting, for example, some members suggested that it was no worse than the 1974–75 recession. Doubtless, too, continued support for restraint in the face of rising joblessness reflected psychological correction for overeasing in 1980.Footnote ⁴⁸ Moreover, the Reagan tax cuts and defense expansion were expected to generate strong recovery. Some FOMC members had long worried that the fiscal stimulus would aggravate inflationary pressures by setting off what one called “a great boom . . . in ’82.”Footnote ⁴⁹ Conversely, the Fed did not anticipate how the declining velocity of money would slow economic growth because consumers held it for longer as the spending incentive to beat inflation diminished.Footnote ⁵⁰

Monetary policy remained too tight too long in 1982, thereby inflicting unnecessary levels of business failure and unemployment. Implicitly acknowledging this, Volcker later declared: “It’s not that our policies were perfection but that the far greater error at that point would have been to fail to follow through long enough to . . . put inflationary expectations to rest.”Footnote ⁵¹ The shift to expansion began with FOMC agreement on July 19 for moderate increases of 2 percent and 1 percent, respectively, in the short-term growth targets for M1 and M2 and a half-point reduction in the discount rate to 11.5 percent. Further cuts in the discount rate put it at 8.5 percent by the end of 1982. Meanwhile, M1 and M2 money stock underwent rapid growth from August through December, with corollary decline in the federal funds rate from 15 percent in mid-July to 9 percent by year’s end. A stock market rally in August as realization sank in that the Fed had shifted course marked the start of the 1980s bull market. Nevertheless manufacturing remained in the doldrums because many companies had started up production to meet anticipated demand from the Reagan tax reductions, but cut back when this did not materialize. As a consequence, unemployment rose to 10.8 percent by the end of 1982; by then, the jobless numbered some twelve million.Footnote ⁵²

Anxious to strengthen recovery, the FOMC effectively ended money-stock targeting at its October 5 meeting, with only three dissenters (FRB presidents Robert Black, William Ford, and Karen Horn). Volcker told his colleagues, “It is desirable to get some easing in this situation.” To avoid communicating overconfidence that inflation was conquered, however, he insisted that the policy change should be presented as a temporary de-emphasis of the M1 measure for technical reasons. The justification for this was the imminent maturation of tax-free All-Star saver certificates, whose creation of new money would violate existing targets. In these circumstances, Volcker declared, the behavior of M1 in the short-term “is unknowable . . . to all the best brains in the world. It’s going to be an empirical question; we will discover what happens when it happens.” A dramatic press conference and a blitz of public statements had launched the money-control policy; a low-key, dryly worded press release announced its abandonment.Footnote ⁵³

Although its termination was never formally acknowledged, America’s monetarist experiment was over. For Volcker, it had been a means to shake up inflationary psychology, create “constructive uncertainty” in financial markets, and reestablish the Fed’s inflation-fighting credibility.Footnote ⁵⁴ For the remainder of Volcker’s chairmanship, the central bank adopted the conventional approach of controlling the price rather than the supply of money. It still set monetary targets but did not stick to them if other economic indicators like GNP growth, interest rates, and dollar fluctuations justified flexibility. Led by Milton Friedman, monetarists loudly condemned the Fed’s refusal to pursue stable money growth, warning that runaway inflation would soon follow an unnecessarily deep recession.Footnote ⁵⁵ The endurance of price stability undermined their critique, but their assumption of an effective money-stock measure was also a chimera. As Stephen Axilrod later observed, “We can no longer find it, if we ever could.”Footnote ⁵⁶

Volcker removed the word “gradual” from all central bank statements after he became chair to signal that the Fed “could not control the money supply that closely.” As well as offending Friedman, this conviction made for uneasy relations with the new Reagan administration, whose economic strategy assumed a stable and predictable reduction of money growth. Its Program for Economic Recovery projected a 50 percent diminution spread over six years to avoid substantial output loss and allow time for tax cuts to boost economic growth, but the Fed delivered 75 percent of this in 1981.Footnote ⁵⁷

Paradoxically, the administration’s initial concern was whether it could trust Volcker to sustain the battle against inflation in view of Fed inconsistency in 1980. Speaking for monetarists within its ranks, Treasury Undersecretary Beryl Sprinkel warned, “We have a large stake in the ability of the Federal Reserve to achieve a permanently slower and less variable rate of monetary expansion.”Footnote ⁵⁸ Once apparent that Volcker was turning the screws tight, however, supply-siders became his foremost administration critics. Wanting “slow, steady [money stock] growth over the long-term,” Treasury Secretary Donald Regan assumed that the Fed was simply engaged in another short bout of restraint before resuming the “tilt towards expansion” characteristic of the 1970s. More pessimistically, CEA chair Murray Weidenbaum and Assistant Treasury Secretary Paul Craig Roberts worried that a Fed-instigated recession would undermine the Reagan economic program.Footnote ⁵⁹

While publically supportive of Volcker, the president grew critical of tight money in private as the recession deepened.Footnote ⁶⁰ Donald Regan persistently urged easing in regular meetings with Volcker, going public with this message in early 1982.Footnote ⁶¹ Meanwhile, bipartisan opinion in Congress demanded a more orderly monetary policy, with some liberal Democrats and conservative Republicans finding common ground in demanding Volcker’s resignation. In June 1982, the Democratic-controlled House and the Republican-controlled Senate adopted a first budget resolution asserting that congressional reduction of the projected Fiscal 1983 deficit obliged the FOMC “to re-evaluate its monetary targets in order to ensure that they are fully complementary to a new and more restrained fiscal policy.” Even though its claims concerning deficit reduction were wholly unrealistic, this statement represented, in one scholar’s words, “an unprecedented congressional directive on monetary policy.”Footnote ⁶²

Volcker’s capacity to hold fast in these circumstances was remarkable. Social scientists have conceptualized the president–Fed chairman relationship as that of principal and agent, with the former capable of setting incentives (mainly through the power of appointment) and employing moral suasion (through the legitimacy of electoral mandate) to ensure that the latter broadly conformed to his preferences. According to economist James Galbraith, the Federal Reserve’s independence was politically fragile because “in any open battle before Congress with a president, [it] . . . would lose.”Footnote ⁶³ Nevertheless, Volcker’s hand included a number of trumps that outplayed Reagan’s strong suit.

First, Volcker was leading the battle against inflation, the primary concern of the American people; Reagan’s priority, by contrast, was tax reduction to achieve economic growth. Second, the public tended to blame inflation on escalating budget deficits rather than monetary policy, making overt criticism of Volcker politically risky. As one Office of Management and Budget official warned, “Scapegoating the Fed while we struggle with triple-digit deficits will do the administration a lot of harm.” Volcker’s public warnings about the inflationary consequences of the deficit in response to Donald Regan’s criticisms of monetary policy heightened such concern.Footnote ⁶⁴ Third, the money-control strategy meant that private banks effectively set the high interest rates of 1981–82. Accordingly, the Fed could disclaim responsibility for the economic pain, albeit disingenuously. This contrasted with the federal funds procedure, whereby, Governor Lyle Gramley remarked, “we explicitly take responsibility for what is happening to interest rates and then this becomes a very difficult world to live in.”Footnote ⁶⁵ Finally, the Fed chair never lost the support of the financial community. The White House could not ignore the danger that pressuring Volcker into changing course would fuel Wall Street’s worries about public debt monetization. As Alan Greenspan warned, “At root our problem is that the markets believe that the Federal deficit will continue to hemorrhage, inducing the Federal Reserve to create excessive money supply growth and hence inflation.”Footnote ⁶⁶

One sign of the unusual president–chairman balance-of-power was Reagan’s reappointment of Volcker in mid 1983. While Donald Regan was unenthusiastic, this had support elsewhere in the administration, particularly from White House Chief of Staff James Baker. A Treasury official later remarked, “We didn’t reappoint Volcker. The markets reappointed Volcker.” This was an exaggeration, but it still held considerable truth because the financial community regarded him as the essential guarantor of price stability. “Wall Street believes that anti-inflation policy is totally embodied in his person,” declared Goldman, Sachs’s Robert Giordano. Shortly before Volcker’s reappointment, a poll of 702 institutional investors and economists carried out by Wall Street investment firm A. G. Becker Paribas found that 77 percent of respondents considered him the best person to lead the Fed, with runner-up Alan Greenspan gaining only 6 percent support.Footnote ⁶⁷

Despite the disharmony, Volcker’s monetary strategy ultimately underwrote the political success of Reaganomics. The CPI rose on annual average by 3.5 percent in 1983–88 compared with 8.9 percent in 1973–80. Volcker had thereby acted as a credible agent for Reagan in providing a solution to inflation that in recent history was the single most significant factor (other than war) in the erosion of presidential approval.Footnote ⁶⁸ Election exit polls in 1980 showed that voters were more concerned about high prices than high taxes by a three-to-one margin.Footnote ⁶⁹ Amid the recession, polls showed similar majorities willing to sacrifice the outstanding installments of the Reagan personal tax cuts to curb the deficit, which was considered the principal cause of inflation. Later, in August 1983, White House pollster Richard Wirthlin’s surveys found that 47 percent of respondents thought large deficits affected the economy “a great deal” and 32 percent thought they did “somewhat.” Over three-quarters considered deficit control an important presidential responsibility and only one-third approved of Reagan’s performance on this score. With inflation at its lowest level since 1972, however, election-year polls consistently showed declining popular concern about deficits and correspondingly strong opposition, often by three-to-one margins or more, to sacrificing tax reduction to control them.Footnote ⁷⁰

ACCOMMODATING THE REAGAN DEFICITS

Volcker’s concern that huge budget imbalances fueled inflation underpinned his reluctance to ease as recession deepened. With recovery, he remained committed to keeping real interest rates relatively high to counter the inflationary effects of easy fiscal policy.Footnote ⁷¹ Administration officials in turn worried that massive federal borrowing would “crowd out” credit markets, forcing private borrowers to bid among themselves for what was left, which in turn would produce ever higher interest rates to kill the recovery.Footnote ⁷² Perhaps no one was more concerned about this than the president himself. Confronted with record out-year deficit projections in excess of $200 billion at the Budget Review Board on January 3, 1983, a distraught Reagan reportedly exclaimed, “How can we come out with that string of figures without driving interest rates right back up? How can we put this out without creating a public panic?”Footnote ⁷³ However, interest rates never rose as high as administration officials feared because Volcker’s monetary policy unexpectedly expanded the supply of credit by attracting huge capital inflows from abroad. In early 1984, when Arthur Burns, now ambassador to West Germany, communicated European complaints that U.S. fiscal imbalances distorted the international economy, Reagan bullishly responded, “I can’t accept their view that deficits are the cause of high interest rates.”Footnote ⁷⁴

Despite repeated public warnings that he would never accommodate huge deficits, Volcker inadvertently helped to fund them. In 1983, he dismissed as unrealistic a Fed staff estimate that capital inflows would exceed $75 billion annually, but they amounted to $85 billion that year, $103 billion in 1984, $129 billion in 1985, and $226 billion in 1986. This was a development Volcker initially tolerated because the strong dollar engendered by global demand for American assets drew in cheap imports, thereby acting as a restraint on inflation during the recovery.Footnote ⁷⁵

For the Reagan administration, the widening trade gap was an acceptable cost of the massive credit expansion that drove the economic recovery. Since markets determined exchange rates, CEA chair Martin Feldstein remarked, “It is as meaningless to say that the dollar is overvalued as it is to say that apples or typewriters are overvalued.” The strong dollar, he continued, “is a safety valve that reduces pressure on domestic interest rates” and the consequent trade deficit “allows the extra demand generated by the budget deficit to spill overseas instead of crowding out domestic investment.”Footnote ⁷⁶ Adapting to this logic, U.S. Treasury officials earned plaudits as “the greatest bond salesmen in history” through their efforts to boost America’s appeal to foreign creditors. In 1984, they promoted elimination of the 30 percent withholding tax imposed on interest earned by foreigners on their U.S. investments, organized a foreign-targeted program of security sales, and obtained congressional permission to issue so-called bearer bonds that could be held anonymously—as international investors generally preferred.Footnote ⁷⁷

There were limits to Fed and administration acceptance of international market forces, however. Volcker grew fearful that the dollar’s rapid appreciation “had gone from something constructive to a potential catastrophe” in creating an unsustainable consumer boom. Accordingly, the FOMC eased the federal funds rate in September 1984 to counter this danger. Further reductions lowered it from 11 percent in late 1984 to 6 percent in the second half of 1986 as the economy showed signs of slowing, inflation kept low, and world oil prices declined markedly. Recognizing that a strong dollar had, in Martin Feldstein’s words, “both pluses and minuses,” the Reagan administration worried that the slow postrecession recovery of manufacturing in the face of cheap imports could soon outweigh the benefits of credit growth. The rise of protectionist sentiment in Congress in 1985 strengthened this concern. Accordingly, new Treasury Secretary James Baker worked with Volcker to secure international agreement for an orderly dollar depreciation that would achieve a soft landing for both the American and world economies. Their main achievement was the Plaza Accord of September 1985, characterized by Volcker as “the most aggressive and persistent effort to guide exchange rates . . . since floating had begun more than a decade earlier.”Footnote ⁷⁸

Nevertheless, Volcker’s hawkishness against any sign of renewed inflation ensured a troubled relationship with the growth-oriented White House in Reagan’s second term. Unemployment did not drop beneath its 1980 level until 1986, but the Fed had no commitment to any quantitative target for its improvement. Instead, as joblessness continued falling and the dollar’s value declined by a third against other major currencies, Volcker’s fears about price instability resurfaced. The new round of interest-rate hikes that he instigated in 1987 aroused White House concern that the economy might slip into a new recession, thereby taking the gloss off Reagan’s record and harming GOP prospects in the 1988 elections.Footnote ⁷⁹

James Baker now opposed giving Volcker a third term, but uncertainty about Wall Street’s reaction inclined the White House to caution. The Fed chairman’s authority appeared invulnerable so long as this constituency supported him, even though Reagan appointees (four in number in 1986 and thereafter six) formed the majority on the Board of Governors. They had voted over his opposition to approve a Dallas FRB request to reduce its discount rate on February 24, 1986. Considering this tantamount to a coup, Volcker intimated his intention to resign, causing its proponents to annul the only vote he had ever lost for fear of the money-market response. No further votes went against him, but the episode left him feeling betrayed. “There was no way,” he reflected, “you could restore the sense of trust.” The president’s procrastination in offering a third term consequently made Volcker suspicious of not being reappointed on conditions that safeguarded his independence and reputation. The need for more lucrative employment to fund his ailing wife’s medical bills also weighed on his mind. Accordingly, Volcker decided to end the uncertainty by announcing on June 1, 1987, that he was stepping down from the Fed. Soon afterward, he accepted the chairmanship of Wall Street investment firm James D. Wolfensohn Inc.Footnote ⁸⁰

MONETARY METAMORPHOSIS

Upon learning that the troublesome priest had fallen on his own sword, James Baker delightedly commented, “We got the son of a bitch.”Footnote ⁸¹ However, Volcker’s departure left intact the monetary regime that he had established. In economic-policy terms, the 1980s were as much the Age of the Fed as the Age of Reagan, the more conventional historical label for the era. During these years, the Federal Reserve’s suppression of inflation was fundamental to the development of the credit-driven economy of late twentieth- and early twenty-first-century America, monetary policy became—in Keynesian luminary James Tobin’s words—“the dominant instrument of macroeconomic management,” and the Fed chair succeeded the president as the chief manager of prosperity.Footnote ⁸²

The credit expansion that began with the domestic financial changes of the 1970s and culminated in the foreign capital inflows of the 1980s underwrote the rise of finance. The Volcker Fed’s stabilization of money value was the essential catalyst for this development. The inflation shock therapy of 1981–82 was the first stage of this process, but the maintenance of relatively high interest rates thereafter was equally significant. With the removal of financial regulations, the only way to ensure the expansion of credit did not fuel inflation was by restraining demand through the interest rates that controlled its price. As historical sociologist Greta Krippner observed, “The result was to transfer inflation from the nonfinancial to the financial economy—where it was not visible (or conceptualized) as such.” Although not the outcome Volcker anticipated, the relatively high cost of capital promoted the so-called financialization of the economy, whereby the financial sector became the main source of profitability. Manufacturing had accounted for over 40 percent of corporate profits in 1968, well over double the 17 percent portion from finance, real estate, and insurance; by 2000, their respective shares were 10 percent and 45 percent.Footnote ⁸³

So long as those supplying capital were reassured that its value would not be eroded by inflation, credit remained available to those who could afford its high price. For this reason, Volcker and his successor, Alan Greenspan, could count on the financial community’s support whenever their anti-inflation priority conflicted with White House preference for growth of employment, wages, and family income as in 1981–82, 1991–92, and 1994–95. Explaining the Clinton administration’s reluctance to strong-arm Greenspan, National Economic Council chair Laura Tyson remarked, “We decided early on that the financial markets could misinterpret criticism of the Fed. And the Fed itself might react in unpredictable ways.”Footnote ⁸⁴

However, the Fed never fully regained the political cover of attributing interest-rate hikes to the market that money-stock targeting had furnished. From 1982 to 1987, it sought to use discount-window borrowing to let market forces exert some effect on monetary policy. The FOMC rule-of-thumb was that each additional $100 billion of borrowing at the discount window should represent approximately a quarter-point increase in the federal funds rate. In Volcker’s assessment, this operated as “a loose steering wheel” that allowed interest rates some latitude to fluctuate around an unstated target instead of aiming for a specific level. This process became less reliable after the failure in 1984 of Continental Illinois, the nation’s ninth largest bank, made other institutions wary that reserve-window borrowing might signal their own weakness. The Stock Market Crash of 1987 finally killed it off because the Fed wanted to make clear its support for the market by directly targeting interest rates.Footnote ⁸⁵

The Greenspan Fed worried, however, that direct targeting encouraged policy inertia because even small adjustments could produce huge market movements. To counter this, it adopted a disclosure policy in 1994 to explain and contextualize interest-rate adjustments. Conceived to reassure markets by establishing policy predictability, disclosure had the unexpected benefit that traders moved rates in anticipation of intended federal funds changes, thereby enabling the Fed to conduct fewer operations to obtain its goal.Footnote ⁸⁶ For some critics, the Greenspan Fed consequently grew more reliant on the market to exercise self-restraint than had its predecessor, but the speculative booms in dot.comshares in the late 1990s and real estate in the following decade proved it a lax disciplinarian with a tendency to loosen rather than restrict credit.Footnote ⁸⁷

It is beyond the scope of this article to assess whether the Volcker Fed inadvertently set in motion the developments that culminated in the financial crisis of 2007–8. Without doubt, however, its monetary policy changes were critical to the rise of finance in the late twentieth century. Whether the worst financial crisis since the early Depression years signals the end of the era of financialization is as yet unclear. Nevertheless, the Federal Reserve’s focus in the second decade of the twenty-first century on stimulating employment growth as the crux of recovery from the Great Recession suggests that the anti-inflation preoccupation of the monetary regime initiated by the Volcker Fed has run its course.